S&P's Take on the Default Debate

Photograph by Scott Eells/Bloomberg

When Standard & Poor’s talks about the outlook for the creditworthiness of the federal government, people listen, even if they don’t always agree. It was S&P that downgraded the U.S. from AAA to AA+ after the 2011 debt-ceiling crisis.

I just got off the phone with Marie Cavanaugh, a managing director in the sovereign ratings group. Here are some of the main points she makes:

Grace period. There’s been talk in Washington and New York that the government could briefly miss interest payments without triggering a default because rating agencies would grant the U.S. a grace period. Cavanaugh splashes a bit of cold water on that notion. True, she says, S&P honors grace periods that are written into bond covenants. She says S&P will observe a grace period equal to the length of the one in the covenant or five days, whichever is less. But she notes that short-term debt generally does not feature grace periods, so “we normally assume payment on the day it’s due.” An exception would be some kind of natural disaster—and a stormy stalemate in Washington does not rate as one.

Zero deficit. One extreme way for the U.S. to avert a default after hitting the debt ceiling would be to cut the deficit to zero overnight. That way the Treasury Department would have enough money coming in from taxes to cover all expenses, including interest payments, as they came due. But such a dramatic spending cut—far steeper than the one in sequestration—would have a “fairly negative” impact on the economy’s growth rate, Cavanaugh says, and therefore on its long-term ability to generate tax revenue. So not a great option.

Selective default. If the U.S. does miss interest payments, it will be categorized as SD, for selective default. Typically when nations come out of default and catch up on back payments, they’re given a credit rating in the range of CCC+ to B. But that’s because “the default is a product of increasing political and economic stress, deteriorating economic conditions, difficulty in accessing financing domestically and abroad,” Cavanaugh says, adding, “None of those things apply here.” (Well, you could argue with her about political stress.)

“Stable.” When S&P downgraded the U.S. credit rating in August 2011, it kept its outlook “negative.” But earlier this year it raised the outlook to “stable” in light of a faster-than-expected reduction in the federal budget deficit. “Stable” means that S&P foresees a less than one-in-three chance that it will revise the rating up or down in the next two years. Brinkmanship has worsened since then, but the economy is still on an upward path, Cavanaugh says. Bottom line: Nothing that has happened lately has caused S&P to change its rating or outlook on the U.S. as a creditor.

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