S&P Move Isn't a Shock but Adds to Gloom

http://online.wsj.com/article/SB10001424053111903366504576492320060981338.html

• MARKETS
• AUGUST 6, 2011, 10:39 P.M. ET

S&P Move Isn't a Shock but Adds to Gloom

For Markets, 'Lehman Effect' Isn't Likely

By E.S. BROWNING, MARY PILON and SERENA NG

Standard & Poor's first-ever downgrade of U.S. Treasury debt could lead to some market tumult next week, investors and analysts said Saturday. Over time, though, the downgrade might do little more than mark a moment in the decline of U.S. economic strength, they said.

There may be an "adverse market reaction," said Paul Dales, senior U.S. economist at research firm Capital Economics. But it "won't be long before the markets focus once again on the economic fundamentals," which he described as "not great."

S&P downgraded the U.S. government's AAA sovereign credit rating, an unprecedented action that could send shock waves through the global financial system. WSJ's Money & Investing Editor, Francesco Guerrera, reports. (Photo: Getty Images)

Mr. Dales said "the loss of America's AAA rating is the clearest sign yet that the fallout from the global financial crisis will be felt for many years to come."

While the timing of Friday evening's downgrade surprised some market participants and followed a tumultuous week for global markets, others noted that the possibility of S&P's move had been well telegraphed for weeks while Congress wrangled over raising the debt ceiling.

Keith Springer, president of Springer Financial Advisors, said Friday night's downgrade by S&P "isn't exactly news to the markets, which have already been pricing in the threat of a downgrade—hence, last week's selloff."

Janet Tavakoli, an independent credit analyst and longtime critic of S&P and rivals Moody's Investors Service and Fitch Ratings, said the U.S. downgrade was long overdue and the one-notch move to AA+ didn't reflect the true state of the country's woes. "People are now acknowledging that we haven't fixed anything. That we're not growing," Ms. Tavakoli said.

A downgrade of U.S. debt is looking more inevitable every day. What would be the immediate effects? Many believe nothing much happens. Others say America's financial backbone would be crippled. WSJ's Jason Bellini explores the likely scenarios.

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As for market action, Mr. Dales predicted that the Standard & Poor's 500-stock index will stay close to its current level of 1,200, while Treasury yields will remain around 2.5%, given overall fundamentals.

Few bond investors are constrained to holding triple-A-rated debt, he said. For those that are, Moody's and Fitch haven't changed their triple-A rating on long-term U.S. government debt.

In addition, banking regulators said Friday night the move wouldn't affect the risk-based capital requirements for U.S. banks, Mr. Dales noted. That is likely to limit the potential fallout for thousands of commercial banks and savings institutions.

Michael Yoshikami, chief executive and chief investment strategist at Ycmnet Advisors in San Francisco, said he doesn't "expect much impact," at least in the short run.

LIVE BLOG: Reactions to S&P Downgrade

Follow live coverage, as the world reacts to the U.S.'s downgraded credit rating.

"When people around the world panic, what do they run to?" he said. "It's still Treasurys, and you could see that this past week."

Even without a AAA label from S&P, Treasurys are expected to remain a haven for investors, banks and financial institutions all over the world that need a place to park their U.S. dollars. While some risk-averse investors have sought to buy gold and bonds issued by companies and countries whose AAA ratings aren't under threat, markets for these assets aren't nearly as large and deep as the market for Treasurys and bonds guaranteed by U.S. federal agencies like Fannie Mae and Freddie Mac, analysts note.

Others said any downgrade-fueled selloff in Treasurys would create a buying opportunity for bargain-hunting investors.

"I would be a buyer because I just don't see the U.S. defaulting on dollar-denominated debt despite the downgrade," said Michael Cheah, a senior bond fund manager at SunAmerica Asset Management.

Vidak Radonjic, who advises family offices on hedge-fund investing, said he doesn't expect a "Lehman effect" on Monday, referring to the panic that cascaded through financial markets in September 2008 when securities firm Lehman Brothers Holdings Inc. collapsed into bankruptcy over a weekend.

On the U.S. downgrade by S&P, "most astute market participants saw this coming for some time," Mr. Radonjic said. As a result, the aftermath "should be less significant."

S&P's downgrade doesn't directly impact short-term obligations, which are the focus of money funds' mandates. Unless ratings firms decide to downgrade short-term debt, "money-market funds would not be affected by any change in the AAA/Aaa rating," according to mutual-fund trade group the Investment Company Institute.

There is less chance of a repeat of a big money-market fund seeing its net asset value fall below $1 a share--or breaking the buck. In 2008, the Reserve Primary Fund, a money-market mutual fund ostensibly as safe as cash, said it owned Lehman Brothers debt with a face value of $785 million and that its net asset value was below $1 a share. But the fund's exposure was to one borrower. That's a different scenario than the funds today that are exposed to Treasuries.

There also is less likelihood big investment banks will face questions about liquidity. In September 2008, the Federal Reserve approved the conversion of Goldman Sachs and Morgan Stanley to bank holding companies in a move that increased oversight but gave the firms access to savings deposits and the greater stability and continued access to Federal Reserve lending.

Still, the reaction to Friday night's move by S&P wasn't entirely calm. The downgrade, even if anticipated in recent market woes, comes at a delicate time. The Dow Jones Industrial Average finished last week down nearly 700 points, its largest point decline since the heart of the financial crisis in October 2008,

"The cop-out is to say this is all priced in, but I think the market will react," said Brian Gendreau, investment strategist at Cetera Financial Group. "In fact, I'm more worried by the stock market than by the bond market."

S&P Downgrade

• S&P Press Release
• S&P Official: U.S. Downgrade Was Due in Part to Debt-Ceiling Brawl
• S&P Downgrades the U.S.: Five Things
•  Video: What Happens Next?

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The reason: Any rise in the cost of borrowing for the U.S. government that could follow from downgrade could have ripple effects on many sovereign, corporate and consumer borrowing costs. That could send stocks lower.

"If we did see a rise in the global cost of capital," said Mr. Gendreau, "you could see the cost of capital around the world rise, and that means lower investment" and possibly less borrowing by consumers. "Whether we see that or not, frankly we don't know."

An important question mark is Asia. If Japanese owners of Treasuries, for example, exit the government debt, that could set the tone for Monday. Another question mark is whether investors with triple-A mandates—such as owners of debt sold under the Temporary Liquidity Guarantee Program—might have to exit, though the fact there that there now is a split-rating could negate that.

Some saw higher borrowing costs as inevitable. Barry Ridings, the vice chairman of U.S. investment banking at Lazard Freres & Co. who advises companies on restructuring debts, said that while the immediate impact of the downgrade on Corporate America remains hazy, interest rates are likely to rise at some point, making it harder for challenged companies to get needed financing.

"The worst case, rates spike immediately. The best case is they go up gradually over the next year. Either way, the cost of borrowing is going to be higher, which will likely mean more distress for some companies," he said.

Marc Lasry, a prominent Democratic fund raiser and hedge-fund manager who saw the news on his BlackBerry last night while dining with friends, said if economic woe persists, the Federal Reserve could once again start buying bonds, which he said would be "a positive." Either way, he said, there will be anxiety for some time to come.

The economy is "going to take longer to turn around," he said. "It's going to take a year or two longer and that's why people are nervous."

Meanwhile, John Kanas, a longtime New York banker who is chief executive of BankUnited Inc. in Miami Lakes, Fla., was hosting a dinner party for about a dozen friends at his home Friday night when he received an email about the downgrade from one of his employees. He read the email to his dinner guests.

"There was a moment of extreme quiet and then people turned to me and said 'what does it mean?' I told them none of us really knows. It was a sobering moment," he said Saturday.

Mr. Kanas said that his bank began holding more cash during the debt-ceiling talks, but "we have no plans to do anything that would be considered reactionary until we see where the market settles out."