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Life after a debt downgrade: Clawing back to AAA

July 18, 2011: 10:30 AM ET

We know how the U.S. can lose its top-notch credit rating. The question is how do we restore it? The answer isn't so simple.

By Tory Newmyer, writer

FORTUNE -- It would be relatively easy for the U.S. to lose its prized AAA credit rating. All our policymakers need to do between now and Aug. 2 -- when the federal government reaches the end of its borrowing authority -- is nothing. At that point, the Treasury would default on some of its debt obligations, leading the credit ratings agencies to downgrade.

Clawing our way back to AAA, however, would be another matter.

Even a short-lived default would likely spell an extended hangover for our credit rating, meaning, at a minimum, higher interest rates and more downward pressure on our shaky recovery for months, if not years. To regain our gold-plated borrowing status, both Moody's (MCO) and Standard and Poor's -- which braced the debt ceiling negotiations last week by warning they are reviewing U.S. debt for a possible downgrade -- said they would need to see the Feds adopt a sizable, credible deficit reduction package.

But sovereign debt ratings, unlike their metric-based corporate cousins, involve a mix of quantitative and qualitative judgments. And both ratings firms are warily eyeing the dysfunction in our political system as they make their evaluations about the nation's creditworthiness.

Moody's, for one, is explicit: a default would set the precedent that partisan deadlock could pitch us off the cliff, and to restore a AAA rating, the firm would want to see fundamental process reform. "We don't presume to tell the government what to do," says Steven Hess, Moody's lead analyst of U.S. debt in the firm's sovereign risk group. "But in order to be rated AAA, we want to be assured the government continues to pay its obligations on time. What we mean is fixing it somehow so that we could be assured this wouldn't happen again for that reason."

What would that involve? "Abolishing the debt limit would be one way to go," Hess says. "I'm not saying we recommend that. There are various ways they could do it," pointing to Senate Minority Leader Mitch McConnell's proposal to essentially hand the authority to President Obama as another possibility.

Ratings agencies in charge?

Hess' assessment should present a quandary to ultra-conservative Republicans in Congress who remain skeptical about the consequences of a debt-ceiling blow-up. If they overplay their leverage in these negotiations, the ratings agencies could force them to forfeit that power down the line in order to undo the damage a default inflicted on our credit status.

But, then, it would be difficult to imagine the same lawmakers who are ignoring warnings from those firms (and the President, the Treasury Secretary, and the Federal Reserve Chairman, among others) suddenly surrendering their prerogative -- a fact Hess acknowledges. "We wouldn't expect that this would happen instantaneously," he says. "The political differences between the parties wouldn't have disappeared, so actually having such a reform would be difficult… And without it, it'd be hard to imagine the government going back to AAA anytime in the near future after a default."

Conservatives bristle at the notion the ratings firms could wield so much influence over our policymaking process at all. Steve Hanke, professor of applied economics at Johns Hopkins University, points out the firms hardly have a sterling reputation themselves, after enabling the risky bets on Wall Street that precipitated the financial crisis. And now, "they're swinging a tremendously big club around."

Hanke says if the U.S. loses its AAA rating because we default, but Congress then hikes the debt ceiling in short order, the ratings firms should move quickly to restore our top-tier status. "Why would you throw something in there that might be getting near to some kind of Constitutional change in the way things are done, when the proximate cause of the downgrade was addressed?" he says.

The reason, according to Doug Elliott, a fellow at the Brookings Institute, is that the firms take a long view of risk to distinguish between the AAA rating and its nearest alternatives. "AAA is supposed to be something that would take a long time between having that rating and some default many years hence," he says. "If there's just been a default, even for a short period, you're going to have to show them something to convince them that won't happen again in a year or two years… So they may simply take the opportunity, having already cut the rating, to say, 'We'll leave it at this to reflect the longer-term risk, unless you do something significantly more convincing in terms of cutting the deficit itself,'" along with an overhaul of how the borrowing authority is managed.

Though the record is relatively thin, the experience of other borrowing nations knocked from the top-tier suggests it's a long slog back to AAA. It took Canada nine years of committed debt and deficit reduction to reclaim their status after a 1993 downgrade. Japan, downgraded in 1999, is two notches below AAA and nowhere near regaining its old status.

Hess, of Moody's, says the peculiarity of the U.S. system -- that Congress authorizes expenditures it can later refuse to finance -- adds to the complication. "It doesn't really exist elsewhere in the world," he says.

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