Post S&P: Here's What's Next

WASHINGTON, DC-Standard & Poor’s has gone on a downgrading spree following its move Friday to lower the US credit rating to AA+. On Monday it downgraded the credit ratings on senior debt issued by most of the Federal Home Loan Banks, as well as that issued by the Federal Farm Credit Banks and on 126 Federal Deposit Insurance Corp.-backed issues.

Worst of all, from the commercial real estate perspective, it downgraded the debt of Fannie Mae and Freddie Mac Monday morning to AA+, following its downgrade of US debt on Friday. Why? "The downgrades of Fannie Mae and Freddie Mac reflect their direct reliance on the US government," S&P says in a statement.

Meanwhile states--Virginia and Maryland chief among them--are waiting anxiously to see where the ax might fall as S&P continues to calculate the impact of last week’s debt ceiling agreement in Washington.

None of this was unexpected, nor was it, strictly speaking, necessary as the entire investment and business community world was aware of the precarious nature of US fiscal finances and the overwhelming assumption that it would continue to pay its debts. "The downgrade contains no new information about the quality of US debt or the likelihood of default," Sam Chandan, principal of Chandan Economics, tells GlobeSt.com. "The textbook analysis suggests a limited market response."

That said the practical ramifications are already becoming clear. The Dow Jones has plunged some 3% by noon on Monday. Treasury yields--in large part because of the widely-held assumption that the US is good for the money--fell slightly on Monday.

Still there will be an impact and in some cases, such as with multifamily borrowers, it will not be pleasant. Here is what to expect from the events of the past forty-eight hours and beyond:

Fannie and Freddie tighten up. The GSEs will have no choice but to tighten requirements now that their credit is downgraded, says Jeffrey Rogers, president and COO of Integra Realty Resources. "They may require higher equity in deals. This could slow the market down and may even draw prices down a bit." By how much remains an open question, Rogers says, but all in all, "this is not good for the multifamily industry at all."

Mortgage REITs will feel the impact too. Again, however, to what extent remains to be seen. Given that they purchase agency paper as their business model, this is not surprising. One remediating influence will be interest rates, which the Federal Reserve is very likely to keep low.

Confidence, never strong to begin with, will erode. Perhaps the downgrade was expected, Chandan says--although Treasury officials say they were shocked--but investors and consumers will add this to a growing stockpile of evidence that the recovery is faltering. "Those are real issues that will negatively impact the stock market and shake confidence in the near-term."

Treasury yields will, ironically, stay put in the near term. In fact, by stoking fears about the outlook, the downgrade may actually push yields lower, Chandan says. "Investors are nervous, and that will result in a flight to quality. That means capital flowing into Treasuries, in spite of the ratings adjustment, which may push yields even lower than we observed during the recession."

But not in the medium and long run. Eventually Treasury rates will rise as sovereign investors seek to diversify into the debt of other highly-rated countries like Australia, Canada and Germany "even if the adjustment away from Treasuries is only on the margin," Chandan adds.