To understand the implications of Standard & Poor’s lowering the credit rating of U.S. government debt by one notch to AA+, we first have to understand why U.S. debt was downgraded, and maybe more importantly what was not part of the reason for the downgrade. Let’s start with the latter.
The title of the statement on the downgrade is very revealing, especially the word order, “United States of America Long-Term Rating Lowered To ‘AA+’ On Political Risks And Rising Debt Burden.” In reading the S&P statement on the downgrade, the U.S. debt wasn’t downgraded because it didn’t have the ability to pay its debt obligations today; the U.S. does.
U.S. debt was downgraded because it nearly didn’t have the go-ahead from U.S. leaders to agree to pay the debt obligations today. That is why S&P’s primary focus was on the process used to increase the debt ceiling. There is the ability to pay one’s debt, and then there is the choice to pay one’s debt.
While I am not addressing whether the downgrade was warranted, I will say that S&P got it right when it focused on the political process. Think of the Republicans and Democrats as two partners in a real estate partnership or two members in an L.L.C. They had the means to borrow the money necessary to continue operations including servicing their debt; however, they very nearly weren’t able to agree to do what was necessary to pay the debt, i.e. raise the debt ceiling – that was the reason for the downgrade.
A borrower’s ability to service its debt and their ability to agree to service their debt are two different things. In the five C’s of lending this falls under the “C” that stands for character – will you do whatever it takes to meet your financial obligations. The U.S. character has been impaired. As a result, continued rhetoric and indications that either party might be willing to default on its debt will have the same effects as a real estate partnership that does the same: They will pay a higher interest rate and at some point if it continues long enough will have increasing difficulty borrowing money.
The difficulty that Democrats and Republican had in agreeing to do what was necessary to service their debt obligations was painfully obvious. This is what led to the downgrade, not whether the U.S. had the ability to service its debt today. Is there a possibility that at some point, again like in a real estate partnership, the U.S. debt will rise to such a level that you start having to pay a higher rate of interest? Yes. Given what was going on in the European Union and the rate on 10- year Treasury notes, it doesn’t seem we were there, yet.
With this heightened concern, why haven’t rates on U.S. Treasuries skyrocketed? While there are a number of reasons, including favorable expectations regarding inflation, in the near term the U.S. can thank the EU to a large degree. The rate on U.S. Treasuries is a function, among other things, of inflation, creditworthiness of the U.S. and alternative sovereign debt investment opportunities.
The recurring fears of sovereign debt default by various EU member countries is making the U.S., even with all its political dysfunctionality, look better than it otherwise would. We may have difficulties in taking the steps to agree to pay our debt, but we have the capacity to pay our debt. Conversely, there are very real concerns regarding the ability of various EU member countries’ ability to pay their debt.
The larger impact for commercial real estate could be on the demand side, at least in the near term. Companies and consumers are already hesitant to spend. Downgraded U.S. debt will likely only increase that hesitancy given the increased uncertainty it creates. There could be a negative impact on consumer and business confidence and thus spending, which could translate into reduced economic activity and as a result reduced commercial real estate demand, at least in the interim.
At this point there seems to be minimal negative impact on the cost of capital for the U.S., which is the starting point from which the real estate industry’s cost of capital is figured. This could change in the future. Whether it does depends on many factors, including, as S&P correctly pointed out, the functionality of the partnership between Republicans and Democrats. That is why they call it the study of politcal economy.