S&P: Why we downgraded our U.S. outlook

April 25, 2011: 11:07 AM ET

How does the rating agency decide when to downgrade its outlook for sovereign debt? It turns out that politics does influence the decision.

Nikola Swann knew that he would be thrust into the firestorm raging in Washington D.C. over America's growing debt burden.

Swann is the analyst at Standard & Poor's who monitors the United States for events that could threaten the country's status as a top-tier borrower. From his perch in Toronto, Swann has watched the US inject billions of dollars into AIG (AIG), the nation's largest banks, and the mortgage companies Fannie Mae (FNMA) and Freddie Mac (FMCC). He has studied the effect that zero percent interest rates and quantitative easing have had on the country.

But it wasn't until this spring's political gridlock destroyed any hope for productive conversations about the economy that Swann felt that US might someday struggle to pay its debts. The government had come close to shutting down over the budget. It was unclear whether Congress would raise the debt ceiling to accurately reflect what the country will spend this year. And Republicans and Democrats were unwilling to reconcile their vastly different plans to tackle the deficit.

As we all know, Swann issued a report last Monday saying that S&P now has a negative outlook for the US, and could downgrade the country's top triple-A credit rating if politicians can't find a way to work together. The report sparked debate over whether America would be able to service its growing debt load.

The White House and Treasury attempted to dismiss the outlook as too focused on politics, and therefore too subjective to have any meaning.

But with good reason, politics is among the most important factors in sovereign ratings. Countries, unlike companies, can set the very laws that affect their ability to pay creditors. For example, GM's (GM) debts and pension obligations grew so large that the company simply could not sell enough cars to pay the tab. The company had to file for bankruptcy. The United States, on the other hand, can raise taxes, print money, and reform welfare programs and entitlements, all in the name of servicing debt.

"S&P does not try to influence policy for any sovereign credit, but politics does influence creditworthiness," says Marie Cavanaugh, an S&P sovereign credit analyst and member of the company's criteria committee.

How S&P makes sovereign ratings

Analysts like Swann study five broad areas, including political institutions and trends; the economy and its growth prospects; the revenue picture (including how a country can raise money, what it spends on, and how much debt it has); monetary flexibility; and how liquid the market is for that country's debt.

Like many sovereign analysts, Swann is an economist by training. He has also worked at the Bank of Canada and the Canadian Federal Government Department of Finance, and he is the primary analyst for several government entities Bermuda and Canada.

Analysts not only read all they can, they meet with government officials and central bankers at least once a year, says Cavanaugh. These so-called management meetings might also include heads of companies if the country is economically dependent on a single industry, like mining or tourism, as well as important economists.

Swann spent much of this month talking to Treasury and members of the White House economics team to explain why he was so worried about DC's political gridlock. The only credible plan to deal with the deficit will be one that Democrats and Republicans can agree on, Swann believed, and he was worried that politicians right now aren't inclined to work together.

Based on conversations and studies, Swann wrote a report recommending that S&P put the US on negative outlook, meaning that it could be downgraded in the next two years if politicians can't agree on a way to deal with the deficit. It wasn't the most severe downgrade warning (that would be negative watch, which means a downgrade within 60 to 90 days), but it was a big move for country that has been rated triple-A since 1941, when Standard Statistics merged with Poor's Publishing.

In the week leading up to the downgrade, Swann's report was distributed to a team of about half a dozen other credit analysts, and then debated for hours. "Rating decisions are made by a committee that consists of sovereign analysts from different continents," says Cavanaugh. "After the primary analyst gives a short oral report, we go through the five categories." Former analysts at S&P and Moody's (MCO), which has a similar process, liken the procedure to a cross between and academic debate and a cross examination.

The committee voted on Swann's report, and ultimately agreed to downgrade S&P's US outlook. Depending on country-specific rules, S&P generally announces credit committee results within days of the vote. The White House reportedly tried to get S&P to change its mind about downgrading the outlook for the US before it announced the downgrade, but it was just too late.

Hopefully our politicians will use the S&P's report as cover to put aside bi-partisan fighting and come up with a deficit reduction plan they can agree on. Swann at least gave the government fair warning. Markets tend not to be so generous.

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Katie Benner
Katie Benner
Writer, Fortune

Katie Benner joined Fortune in October 2006. As a writer for the magazine and the website, she focuses on Wall Street and the economy. Prior to joining Fortune, Benner worked at TheStreet.com, CNNMoney, and as a freelancer in Beijing for China International Business, the South China Morning Post, and as a columnist for Beijing Review. She has a B.A. in English from Bowdoin College.

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