Now That We've Got a Debt Deal, What Should the Rating Agencies Do?

They may declare the threat of downgrade over, but should they quell their criticism?

600 capitol peek REUTERS Jonathan Ernst.jpg

Congress has passed a deal to raise the debt ceiling and cut some spending, so the market can exhale: the U.S. will not default. But the almighty arbiters of risk have yet to rule -- what will the rating agencies say? The three big ones all expressed serious concern over the debt ceiling negotiations, threatening to downgrade the U.S.'s pristine AAA rating should politics force the nation to miss an interest payment. But now that this possibility appears dead, what should the rating agencies say?

Remember, the agencies wanted to see three things come out of a debt deal. Most importantly, they wanted to see the debt ceiling rise. The amount by which it would rise also needed to be sufficient to ensure that no further political risk would plague U.S. debt before the 2012 election. Finally, they wanted a credible, long-term deficit reduction plan in place to put U.S. borrowing on a more sustainable path. Based on these demands, the raters ought to, and probably will, make a few points.

Point 1: We Affirm the U.S.'s AAA-Credit Rating

First, the U.S.'s AAA-rating should be ruled as safe, for now. With the debt ceiling raised through the 2012 elections, the threat of default is clearly behind the nation until at least 2013. The deficit reduction plan that the deal includes should also help the U.S. to avoid additional debt ceiling risk in the foreseeable future.

Point 2: We Will Maintain Our Negative View (Maybe)

But although the U.S. rating should be affirmed in the short-term, at least one agency might not be entirely content with the deal. It calls for a minimum of $2.2 trillion in deficit reduction. That's not bad, but it falls short of the $4 trillion target that Standard and Poor's said would be a good start, but possibly the minimum needed to keep the U.S.'s rating intact.

Ultimately, the agencies need to sit down and reassess the U.S. debt picture with the new deal in place. Is the minimum spending cuts it would require enough to put the U.S. on a better trajectory so that its debt outlook is stable? If not, then the U.S. should remain on negative watch until additional, more aggressive deficit reduction deals are put in place.

And indeed, there's little doubt that the agencies are still concerned about U.S. political risk. If anything the debt ceiling debacle confirmed their fears. Lawmakers have developed a bad habit of waiting until the last possible moment to act. This can have disastrous consequences if anything goes wrong, as we saw in 2008 when the first bailout vote failed and the market plummeted. Until the partisan climate changes in Washington to better embrace real compromise, the agencies should have a hard time feeling comfortable with U.S. political risk.

Upon Reflection: Were the Agencies Right to Be So Vocal?

When reassessing the U.S. situation, the agencies may also want to pause and reflect on their own actions during the debt ceiling fight. In particular, were they right to make so much noise about the possibility of default? After all, many pundits have criticized the agencies for acting like something new and unusual was afoot in Washington, since it has made a habit of coming to the brink of disaster before acting.

Although it's easy to criticize the agencies for their loud complaining, we have the benefit of living in a world where the U.S. government finally did get its act together and pass a bill to raise the debt ceiling and reduce some debt. For all we know, the agencies' stern warnings were exactly what Congress needed to push through a compromise. Without hearing that the agencies were willing and ready to downgrade U.S. debt, some lawmakers might not have believed that a temporary default would have been that big of a deal.

But more importantly, the agencies have a duty to notify the market when default is imminent. And the reality is that, had the U.S. failed to raise the debt ceiling, default might have occurred. While the agencies expected Congress to eventually come to an agreement -- an expectation they made abundantly clear -- they also needed to alert the market about what would happen if the negotiations had failed to provide a deal. If the agencies had remained silent on U.S. debt throughout the process, they wouldn't have been doing their job.

So good for the agencies for not being intimidated by Washington and pushing the politicians to come to an agreement. But now it's their job to calm the markets with an "all clear" signal. Although that might not mean all is well with the fiscal health of the U.S., it should be enough to prevent any further concerns about U.S. debt over the short- to medium-term.

Image Credit: REUTERS/Jonathan Ernst