By Cyrus Sanati
FORTUNE -- The U.S. should expect further hits to its credit rating if Congress continues to carelessly dance on the edge of insolvency. The view that the U.S. might somehow escape this latest government meltdown without some sort of response from the credit rating agencies proved false last night after Fitch, one of the "big three" credit rating agencies, broke ranks and placed the country on what it calls, "ratings watch negative."
While technically not a downgrade, the move by Fitch is significant as it signals that the ratings agencies might not sit back and let the U.S. blow itself up financially as many had expected. If Congress gets the hint and comes to a workable agreement before Thursday's default deadline it might save itself and the country further humiliation. But if the wrangling continues past Thursday and into next week, then Congress should expect further "negative" press releases from the credit rating agencies.
It was almost as if Harry Reid, the Democratic leader of the Senate, had some sort of foreknowledge of things to come. Tuesday morning Reid took to the Senate floor to express his frustration over a Republican "compromise" measure to end the budget battle, which he felt was a nonstarter.
"The deadline is looming," Reid said on the Senate floor Tuesday. "Ratings agencies are talking about downgrading us as early as tonight."
It is unclear how Reid came to that conclusion. His aides told Time later that day that the senator "had not been briefed" by the ratings agencies. Political pundits and market watchers later dismissed Reid's comments as political puffery. But after the markets closed for the day, Fitch came out with a press release announcing that it was placing the U.S. on what it calls "ratings watch negative." While it wasn't a downgrade, it was enough to spook the markets, provoking a massive sell-off in after-hours trading. That quickly reversed after markets opened, and the Dow Jones Industrial Average (INDU) surged 150 points Wednesday morning.
Fitch already ascribed a negative "outlook" to U.S. sovereign debt, but this new negative "watch" label is a bit more severe, as it is seen as the final step before an official downgrade. Fitch warned in its release that such a downgrade could come at any time and that it would be based on what happens in the coming days. Even if the government manages to resolve the situation before the October 17th debt ceiling deadline, Fitch said it could still issue a downgrade if it felt that the risk of a similar "episode" could occur in the near future. Unfortunately, that seems all but certain at this point.
The latest proposals in the House and Senate would fund the government through either December 15th or January 15th and would raise the debt ceiling through February 17th. It is unclear why either side would want to repeat this hellish and ridiculous budget battle in a couple of months. Doing so would not only make the U.S. public uneasy, it would also probably force Fitch to officially downgrade the U.S., thus stripping the nation, probably forever, of its perfect triple-A credit rating.
Fitch's move surprised the more cynical of Wall Street observers yesterday. The common view on the Street was that Fitch and the rest of the "big three" credit rating agencies, which include Moody's (MCO) and Standard & Poor's, wouldn't dare downgrade the U.S. amid fear, among other things, of political retribution from Washington.
If Fitch did downgrade the U.S., that would leave only Moody's as the last of the "big three" credit rating agencies ascribing a perfect triple-A rating to U.S. sovereign debt. The company has said repeatedly that it believes that this budget battle is just political theater and that in the end Congress will hash things out and pay its debts. But it would be naive to think that it will just sit by and allow the U.S. to continue banging its head against the wall without some sort of response.
Tuesday, the firm released a report to its subscribers outlining its views in detail. It says it would maintain a triple-A rating even if the U.S. breaches the debt ceiling and fails to meet non-debt obligations such as government employees' salaries or Social Security and Medicare payments. But that doesn't mean the U.S. can keep playing with fire indefinitely. Moody's noted that even though it would expect any default to be short-lived and cured with 100% recovery, it would still downgrade all Treasury bonds one notch into the Aa rating category and would hold it there on review for yet another possible downgrade until the default is cleaned up.
Standard & Poor's stands as the only member of the big three that doesn't already ascribe a perfect triple-A credit rating to U.S. sovereign debt. Given the hell it went through with the government after it downgraded the U.S. sovereign in 2011, the company has been screaming at the top of its lungs that the debt ceiling debate is "unlikely" to change its U.S. sovereign rating. It would be maintaining its AA+ rating on U.S. debt for the foreseeable future and would only consider changing it if there was a major change in the economic climate. Nevertheless, the firm, which took major heat after downgrading the U.S. in 2011, has said that it would place the U.S. in SD (selective default) and put the overall sovereign rating under review if it misses a debt payment.
None of the big three believe the U.S. will end up being a deadbeat for very long, but they are all cautious about the nation's future and how it will be perceived in the international markets if it does default. Nevertheless, further moves to delay paying its debt obligations would put the U.S. one step closer to a downgrade for all three. While some might not believe that is such a big deal, it does irrevocably change the way U.S. debt will be categorized for some time to come. The sad part is that this could have all been avoided had Congress just done what it was supposed to do and pass a budget on time.
Ratings agencies might have warned of a downgrade when Washington struggled to raise the debt limit in 2011, but they've been pretty quiet this time around.
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