Standard & Poor’s Additional Downgrades Effects on Lending

On Friday August 8th, Standard & Poor’s followed up their Friday August 5th downgrade of U.S. Debt from AAA to AA+ with the downgrade of the debt associated with a number of other agencies including Fannie Mae, Freddie Mac, and the 12 Federal Home Loan Banks to AA+. Although we believe the impact of the downgrade is minor at this point, certainly downgrading these important institutions that support lending could negatively impact the banking industry and interest rates.

Fannie Mae & Freddie Mac combined provide a majority of the credit for the housing market within the United States. All of the loans originated through these agencies are sold into the capital markets. Part of the attraction for investors in buying Fannie Mae & Freddie Mac loans are the fact they pay a fixed interest rate return and are guaranteed by the U.S. Government. Because Standard & Poor’s downgraded U.S. Government Debt, they were forced to downgrade the rating on the Fannie Mae & Freddie Mac securities the government backs. Likely this downgrade could mean increased borrowing costs to consumer customers as Fannie Mae & Freddie Mac are forced to charge higher interest rates to attract the investment capital to back these mortgage loans.

However, since the announcement by Standard & Poor’s, mortgage rates have actually fallen further, driven more by a combination of the government’s desire to keep interest rates in check and the weakening of the economy, which has seen a flood of capital leave the stock market for the bond and fixed income markets. Investors don’t seem to be too concerned with the downgrade, and remain confident that the U.S. Government will continue to stand behind the Fannie Mae & Freddie Mac loans sold.

The 12 Federal Home Loan Banks supply capital to the Banking industry though lines of credit to many banks. Banks rely on this capital to maintain liquidity. Since Bank’s tend to lend out a large portion of their deposits, they need access to immediate capital should deposit balances fall and the Bank cannot bring back in loan dollars quickly enough to meet depositor needs. In addition, Bank’s must maintain certain minimum liquidity ratios to meet government standards, and often times use loans from the 12 Federal Home Loan Banks to do so. Because the 12 Federal Home Loan Banks are backed by the U.S. Government, Standard & Poor’s was forced to downgrade their credit rating as well.

In theory this downgrade should lead to increased borrowing costs for Bank’s as the money supplied by the 12 Federal Home Loan Banks becomes more expensive, as a result of the money coming from the U.S. Government being more expensive. Any increase in borrowing costs to the Bank’s would typically get passed through to the Bank’s customers in the form of increased borrowing costs for consumer and commercial loan customers. However, to date the Bank’s have not seen a material increase in borrowing costs related to this move by Standard & Poor’s, and it appears Bank’s are not likely to do so on this move alone.

Overall interest rates have stayed steady or even in many cases fallen since the announcement by Standard & Poor’s. Most of the change has been driven by a combination of bad economic data and an overall weakening of the economy. Although investors did not like the downgrade by Standard & Poor’s, they also don’t believe it is that bad, and so long as the other rating agencies keep their AAA status on U.S. debt, the effects on borrowing costs of the Standard & Poor’s downgrade are going to be nominal. To date the effects have been relatively minimal if not non-existent on consumer and commercial loan pricing. However, should additional downgrades occur, it is clearly likely borrowing costs could be negatively impacted and interest rates climb substantially to all loan customers. Future downgrades are likely going to be the result of economic performance and how the U.S. Government manages it’s debt, and is unlikely to occur immediately, but is a risk to occur at anytime.