Standard & Poor’s (S&P) has downgraded their U.S. Government long-term AAA debt rating to AA+ for the first time since granting it in 1917. While forewarned, it still seems to have taken investors by surprise. Fitch and Moody’s recently re-affirmed their top-tier rankings of U.S. long-term debt, however. We do not expect S&P’s downgrade will have much impact on interest rates or the sale of Treasuries to finance U.S. borrowing, particularly if both Moody’s and Fitch continue to maintain their current top-tier ratings. The consequences of S&P's U.S. Government downgrade will likely have a greater emotional impact on investor sentiment, exacerbated by the European chaos, than any longer term impact on the economy or fixed income liquidity. Learn more from NIFCU$ at http://www.nafcu.org/nifcus

1. INVESTMENT INSIGHTS AUGUST 8, 2011
Standard & Poor's Downgrades U.S. Government: increasing downgrade and/or default risk, driving yields
So What Now? lower. The cut in credit rating by one notch to AA+ was
forewarned by S&P as far back as April. The three main
One of the three primary U.S. credit rating agencies, credit agencies, including Moody's Investor Service and
Standard & Poor’s (S&P), has downgraded their U.S. Fitch, had warned during the budget debate that if
Government long-term AAA debt rating to AA+ for the Congress did not cut spending by as much as $4 trillion
first time since granting it in 1917. There was no change over 10 years, the country faced a risk of downgrade.
to the short-term debt rating of A-1+. While forewarned, Fitch and Moody's have recently reaffirmed the long-
it still seems to have taken investors by surprise. The term AAA/Aaa credit rating of the U.S. government long-
consequences of S&P's U.S. Government downgrade term debt, even if qualified with a negative outlook. We
will likely have a greater emotional impact on investor do not anticipate further ratings action until at least
sentiment, exacerbated by the European chaos, than October 1st, when the FY2012 budget is due, although
any impact on the economy or fixed income liquidity. most are focused on the plan deadline for Deficit
Historically, sovereign downgrades were rooted primarily Reduction Commission.
in economic issues, without the political factors and
increasing legislative dysfunction currently cited by S&P. Capital Market Reaction
Historical Context of S&P’s Decision Intuitively, investor reaction should negatively impact
Treasuries prices more than equities, but equity
Credit downgrades are part of managing fixed income investors have suffered more than bond investors since
strategies. When a debt rating is lowered from AAA by June, from the heightened risk of U.S. Government
one notch, the resulting price adjustment is usually downgrade and/or default. If Treasury yields do not rise
modest, but issuers can expect to pay a slightly higher materially, in excess of 0.5-1.0%, it makes little sense for
yield, reflecting a higher risk premium. Thus, a one notch equities to be adversely impacted---10-year Treasury
sovereign downgrade from AAA generally has had yields have actually fallen 0.65% since June 30th. There
limited adverse effect on either fixed income or equity is indeed heightened investor nervousness and
markets beyond a day or two. S&P calculates the 1945- increasing risk aversion, given recent Eurozone policy
2010 average yield differential of 5-30 year maturities uncertainty that has tended to accentuate any global
between one notch corporate credit rating differences to equity volatility. While S&P’s downgrade may exacerbate
be less than 0.25%, ranging from 10-40 basis points, investor risk aversion, we don’t expect the fallout to
depending on prevailing credit spreads at the time. linger very long, as the actual economic implications
become well understood. We do not expect reduced
Even if the U.S. Government is eventually downgraded liquidity for any fixed income securities, including
by two or more credit rating agencies, we would expect Treasuries, debt of related government agencies, and
the rise in the annualized cost of capital to be less than municipalities that receive federal funds.
0.25%. Instead, the downgrade is likely to have greater
impact on political and legislative policy decisions, such The reasons cited by S&P for the downgrade hinged on
as imposing stricter fiscal discipline, beyond the deficit several factors that the credit rating agency was unable
reduction goal of $2.1 trillion recently agreed upon, or to overcome. John Chambers, Chair of S&P’s Rating
even enacting a constitutional balanced budget Committee, criticized the large and increasing debt
amendment. At a time when we observe the thought- burden from unsustainable spending, now in excess of
provoking and wrenching social unrest across Europe 25% of GDP, as well as a lack of "effectiveness, stability,
due to difficult government austerity decisions necessary and predictability" of U.S. [political] policy-making at a
to restore fiscal stability in Europe, moving toward critical time when fiscal challenges are increasing. In
balancing the U.S. Government’s budget has never been other words, S&P believes that the political environment
so likely to become politically correct. has increased the difficulty of addressing our high debt
level and expected fiscal deficits. Controversy over
The S&P downgrade came less than a week after raising the debt ceiling, distinct and independent of the
Congress agreed to spending cuts that would reduce budgeting process, has increased policy uncertainty and
debt versus the projected baseline by more than $2 the likelihood of default. Fundamentally, there is no
trillion—equities have been particularly volatile in recent option for a democracy but to expose the angst of
weeks, while Treasuries have rallied in spite of legislative policy decisions. Greater predictability of a
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2. European Parliamentary government may seem
preferable, according to S&P’s logic, but countries such The U.S. Government has the flexibility to improve the
as Greece, Ireland, Spain, Italy, France, and the U.K. current fiscal situation, but the risk of default increases, if
are generally in worse condition and have been left with future debt ceiling increases continue to be politicized.
few and unpalatable options to reduce fiscal deficits,
including sale of national assets, privatization of What Can We Do to Reduce the Fiscal Deficit?
services, and deep across-the-board entitlement cuts.
1. Link Future Debt Ceiling Increases To Fiscal
There is also debate about whether S&P’s analysis may Budget Authorization---A key issue cited by S&P is
have exaggerated the expected U.S. fiscal deficit over the increased political uncertainty of tying previously
the next 10 years. Mr. Chambers cites a need to turn routine debt ceiling increases to agreement on
back entitlement growth, while providing sustainable fiscally responsible spending cuts. Most other
growth in economic activity. In observing struggling countries do not have a separate legislated debt
Eurozone countries attempting to turn around their fiscal ceiling. Never before has our fiscal deficit spiraled
deficits, our expectation is that this downgrade can out of control so quickly as to require multiple
provide further political impetus to meaningfully reverse significant increases in the debt ceiling over such a
the course of our own increasing fiscal deficit. short period. Procedurally linking budget legislation
to customary debt ceiling increases would likely
Comparison of U.S. Fiscal Budget Projections reduce the implicit risk of a U.S Government default,
which so concerned S&P.
S&P has taken this action despite their current fiscal
budget projection that the U.S. will remain within the 2. Receive an Demonstrably Effective Plan from the
range of Debt/GDP ratios of AAA rated countries. Congressional Commission on Deficit Reduction
Increasing U.K. Debt/GDP is expected to exceed 80%,
which is greater than the 74% U.S. Debt/GDP level 3. Balanced Budget Amendment---A constitutional
expected in 2011, and up from less than 60% recently. balanced budget amendment would preclude the
By 2015, S&P forecasts U.S. Debt/GDP to rise to 79%, need to increase the debt ceiling, except under
which would still be less than France’s expected extreme circumstances of war or unexpected crisis.
increase to 83%. If S&P believes that the United States
should be downgraded, the United Kingdom and France 4. Reduce Treasury Debt---The Federal Reserve
must also be at risk, but there is no indication of similar holds assets totaling more than $3 trillion, including
concern. Nor does it seem appropriate that U.S. $1.6 trillion in Treasuries. More than half of bonds
Government debt should be rated on par with other AA held are a liability the U.S. government owes to
rated countries like Belgium, Japan, Italy, Spain, Qatar, itself. Thus, the balance sheet can be reduced by
and Slovenia. Thus, political predictability was materially refunding Treasuries and selling previously-
significant in S&P’s decision. distressed securities. An easily achieved 50%
reduction in the balance sheet would increase debt
Investors restricted to investing in only AAA securities capacity by $1.5 trillion. Increasing headroom on the
should still be able to continue owning Treasury bonds, debt ceiling is desirable right now, and would nearly
as Fitch and Moody’s recently re-affirmed their top-tier eliminate default risk until 2014, at least.
rankings of U.S. long-term debt. We do not expect S&P’s
downgrade will have much impact on interest rates or 5. Federal Reserve Stops Paying/Lowers Interest of
the sale of Treasuries to finance US borrowing, 0.25% on Bank Reserves---Deposits would seek
particularly if both Moody’s and Fitch continue to out higher rates of return, likely increasing bank
maintain their current top-tier ratings. We also don’t lending. Calls for additional quantitative easing are
believe that S&P’s decision alone will have any impact misguided, in our opinion, and would be ineffective
on the haircut or concession associated with government with 10-year Treasury yields approaching 2.5%.
securities posted as collateral. A joint statement issued
last Friday evening (8/5) from the Federal Reserve, 6. Seek Areas of Agreement to Bolster Growth and
Federal Deposit Insurance Corporation (FDIC), National Investment---We believe U.S. economic growth
Credit Union Administration and Office of the would benefit from approving pending trade
Comptroller of the Currency noted that: agreements and permanently reducing the 35% tax
on repatriated earnings, which has historically
“For risk-based capital purposes, the risk weights for increased inflow of foreign earnings, now estimated
Treasury securities and other securities issued or to exceed $1 trillion offshore. While many countries
guaranteed by the U.S. government, government agencies, in recent years cut corporate tax rates, the U.S.
and government-sponsored entities will not change. The continues to have the second highest combined1
treatment of Treasury securities and other securities issued
or guaranteed by the U.S. government, government
corporate tax rate in the OECD of 38.2%, surpassed
agencies, and government-sponsored entities under other only by Japan at 39.5%, offering no incentive to
federal banking agency regulations, including, for example, bring profits home and re-invest. Lowering the
the Federal Reserve Board’s Regulation W, will also be
unaffected.” 1
Varies by location, but includes federal, state and local taxes
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3. repatriation tax rate from 35% to 15% would be tax rates have never been successful in reducing
more comparable to other countries, while likely fiscal deficits.
encouraging greater U.S. investment. Likelihood of
passing these ideas into law is increasing, with 9. Exploit Our Flexibility--- Unless we get our fiscal
expanding bipartisan support. Senator Schumer and deficit under control, the U.S. Government risks
other Democrats now believe a lower repatriation tax further downgrade and investors could demand a
rate would increase government revenues, bolster higher risk premium in the form of higher interest
investment spending, and thereby increase jobs. rates. The U.S. fiscal budget includes many policy
choices that still provide significant opportunity to cut
7. Address Regulatory Uncertainty--- Health Care our fiscal deficit, unlike many countries in the
and Financial Reform rulemaking is lagging behind Eurozone, but it will require finding agreement on
schedule. Extended uncertainty has made it difficult tough political decisions by Congress and the
for corporate officers to make long-term strategic Administration.
decisions about hiring and investment. Efficiencies
can also be gained by looking at ways to improve Conclusion
many costly provisions in both laws. With the 2012
election approaching, meaningful legislation We have outlined just a few options that could reduce
becomes increasingly difficult, so the risk of a policy our fiscal deficit and put America on a more sustainable
mistake declines with increasing gridlock. path to fiscal balance. Any meaningful progress will
impact someone adversely, so the political will must be
8. Tax Reform---High tax rates with complexity motivated by some greater cost---S&P’s downgrade and
incentivize efforts to exploit loopholes and other tax the specter of European-like austerity decisions that
avoidance strategies. Thus, the cost of collecting ignite worrisome social unrest have changed the
taxes and complying with our complex tax code is calculus of government deficit spending. Someone has
estimated to have risen to over 30% of total taxes to pay. Future generations have no vote, but the
collected, according to several studies. A flatter and consequences to them are now visible. We must cut
simpler tax code could increase revenue and reduce U.S. government spending from 25% to below 20% of
the overhead cost of tax compliance, even if overall GDP, the well-defined limit of tax revenues able to be
tax rates fell for most taxpayers. As spending now collected, irrespective of tax rates. Our debt limit is no
exceeds 25% of GDP, while revenues have never longer theoretical.
exceeded 20% of GDP, the fiscal deficit will require
significant changes to our national priorities, plus David Goerz, SVP - Chief Investment Officer
cost efficiency gains, to close the gap. Increases in http://commentary.highmarkfunds.com
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