Prepare for U.S. Downgrade: Wall Street

By Shanthi Bharatwaj 07/25/11 -

Analysts from the largest Wall Street banks warned Monday that the U.S. could face a downgrade even if an agreement to raise the debt ceiling is reached, unless the plan makes ambitious and credible cuts to the deficit.

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Citigroup Inc| C DOWNBank of America Corporation| BAC DOWNMarkets have for months believed that policymakers will reach an agreement over deficit reduction and avoid default. But with policymakers still at an impasse over the debt debate a week away from the deadline, investors are weary of rosy headlines.

That means policymakers will no longer have the luxury of debating without pressure from the markets according to Citigroup(C_) economist Steven Weiting. "A confidence building agreement might be reached at any time. Perhaps continued very late bickering should have been expected," he wrote in a note." But markets should be focused on a likely sovereign ratings downgrade on all but the most ambitious of fiscal consolidation agreements. Policymakers' press comments increasingly suggest this is out of reach in the near term."

He expects a ratings downgrade to come as soon as an agreement is reached- "unless the most ambitious of bi-partisan plans is revived."

Weiting also expects the budget acrimony to continue for some time to come. "With demographic and entitlement cost realities ignored by the extremes on both sides of the political spectrum, like the red ink, agonizing budget debates will still loom as far as the eye can see once the 2011 debt ceiling debate is resolved."

Martin Mauro, fixed income strategist at Bank of America Merrill Lynch (BAC_) expects Congress to raise the debt ceiling by August 2 but will arrive at the debt reduction package in two stages, which could lead to downgrades in the municipal market and maybe an S&P downgrade to U.S. Treasury debt by the end of the year.

He also expects a ratings downgrade for Treasury debt would translate to a similar downgrade for municipal pre-refunded debt and the debt of Fannie Mae(FNMA.OB)and Freddie Mac(FMCC.OB).

"We recommend that investors position for a short-term agreement that will likely avoid default, yet not resolve the long-term debt challenges. This outcome would likely lead to a downgrade of Treasury debt by S&P and perhaps other rating agencies," the analyst wrote in a note. However the analyst does not view more extreme scenarios-Treasury default or prolonged period of debt prioritization as very likely.

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