Following the historic U.S. credit downgrade, Standard & Poor's president Deven Sharma talks about the market sell off, the president's response and why the Treasury might be taking this all so hard.
FORTUNE — For those who doubt that credit ratings still wield power, look no further than Monday’s market rout.
The selloff followed a controversial decision by Standard & Poor’s to downgrade the United States from AAA, the gold standard in credit ratings, to AA+. Even though S&P’s head of sovereign ratings John Chambers has downplayed the move (“It’s like going from indigo to navy blue”), already fragile stock markets plummeted, and the world’s finance ministers were forced to discuss the situation.
With stocks still shaky, gold prices soaring and talking heads debating whether this is market panic or 2008 redux, FORTUNE spoke with Deven Sharma, the president of S&P, the company that at the eye of this particular storm. Sharma, who became head of the McGraw-Hill (NYSE: MHP) division in September 2007, talked about the stock market slide, his company’s reputation, the controversial $2 trillion revision and why he liked Obama’s public response to the downgrade.
Given that the U.S. downgrade was widely anticipated, what do you make of the sharp stock market selloff?
First, markets act on information when they want to, and they always over- and under-shoot. Greece is the classic example. We talked about the problems there for years, and nothing happened. We lowered the rating on Greek sovereign debt to BBB, and spreads stayed just below levels for AA rated bonds. But when we lowered the rating to BB, we saw spreads hit CCC bond levels.
There are many factors that could be influencing the markets: the debt situation in Europe, the economic slowdown in the US, a slowdown in high-growth markets that could impact U.S. companies with a mix of global revenues and uncertainty around how U.S. government will achieve the $1.5 trillion in cuts. I’ve heard many people say, and I agree, that we are in uncharted territory.
What did you think of the speech President Obama gave in response to the downgrade?
People say that we’ve heard what he had to say before, but he is the president and he was calling for a sense of urgency about [America’s indebtedness]. I was encouraged that he began by saying that we have two challenges, the rising debt level and the economic process by which we create an action plan to address the debt. Those were the two reasons [why we downgraded the U.S.]. Obama recognizes this is a serious problem, and as a citizen I personally thought, hey, maybe there is hope that things will get sorted out.
Will the U.S. credit downgrade make Obama a one-term president?
Listen, I’m not going to weigh in on the election. Our role is to speak to credit risk. If politicians can come up with a game plan to address debt levels, figure out a way to drive growth, and lower unemployment, it will be good for everyone and for the country broadly.
What hope do you have that our politicians can deliver? Given that we have the reserve currency, the argument has been made that people will buy our debt and interest rates will stay low, and politicians won’t feel compelled to act. It’s akin to Japan, which also had a structural mechanism that kept rates low even after the country lost its AAA rating. Japan has done nothing to ease political gridlock and fix its debt problem.
That’s an interesting comparison. Japan did not regain its AAA rating in the nine to 15 year period typical of other countries that lost AAA ratings. They are funded by domestic savings, so the government has not been pressured [to make hard decisions] by higher interest payments. But the Japanese population is aging and, at some point, they will have to stop buying Japanese bonds and spend their savings in retirement. Then Japan will have to borrow from outside the country. Then what happens?
As for the U.S., the dollar is the reserve currency and we have the benefit of printing money. The question then is, at what point do people look for alternative currencies. Then what happens? There are limits to these mechanisms.
S&P’s competence has been called into question by the Treasury because of a $2 trillion error that your analysts made when they looked at the U.S. debt situation.
Let me clarify. This was not an error. It was a change in assumptions based on conversations we had with the issuer. That is part of the ratings process for any credit [including corporate, sovereign, and structured credit]. We talk to the issuer. If they have feedback, we listen. If we agree, we have no qualms about saying that we will adjust our analysis.
In this case, the Congressional Budget Office had different scenarios for discretionary spending growth, and we picked the scenario by which discretionary spending grew at the same rate as GDP. Then the Treasury pointed out that the budget act caps discretionary spending growth at the rate of inflation. After further conversation with the Treasury and CBO, we agreed with them and adjusted the analysis.
But that adjustment wasn’t enough to change our minds. Today, America’s debt level is 74% of GDP, or $11.4 trillion. Our initial assumption was that it would grow to $14.7 trillion in 2015. After we adjusted our analysis, we still see debt hitting 14.5 trillion in 2015. The debt is still rising, and moving to an unsustainable level, which the president acknowledged.
Was Treasury trying to spin this conversation?
I would only say that the downgrade was a momentous event for the Treasury and not an easy one. We have to make calls that create difficult situations for people globally. When we downgrade other countries, the reaction is equally strong.
Have you invested in bodyguards for your sovereign debt rating team yet?
You can imagine some of the email traffic has been interesting. But, hey, people have all kind of reactions. We have to focus on our organization purpose and role.
For better or worse, will downgrading the U.S. impact S&P’s reputation?
I hope over time that people recognize that we are objective and independent. We call risks as we see them with a forward-looking view.
It’s hard to say how our decision Friday will be taken. You have to look at it in the context of history, five, ten, or 10 years from now. If [U.S. political dysfunction] doesn’t change, history will say that we made the right risk call. When we downgraded Japan it was the second largest economy and it was coming off so much economic strength. People wondered, what the hell we were talking about. But now Japan has more than 200% debt to GDP and the problem there is big.