Standard & Poor's stated that the U.S. Treasury's support of the two GSEs impacted its choice to revise the outlook on the U.S. long-term sovereign credit rating to negative from stable.

A report from Barclays Capital said that the announcement seemed like a surprise to the bond market as 30-year yields reversed their early morning rally while the yield curve steepened right after the announcement.

Analysts have in the past emphasized the U.S. deficit's "unsustainable nature" and have outlined the probable factors that would drive a lowering of the U.S. 'AAA' rating. However, they had thought that the rating agencies would wait until after the 2012 elections before taking any action. 

The fact that there is no agreement on fiscal issues in Washington, D.C. creates risks for the U.S.'s credit profile, analysts said. Rating agencies seem, Barclays said, to be emphasizing the same point.

Meanwhile, according to a report from Royal Bank of Scotland (RBS) analysts, this change should also impact longer-term GSE debt.

In its report released today, S&P estimated that it can potentially cost the U.S. government as much as 3.5% of GDP to appropriately capitalize and relaunch Fannie Mae and Freddie Mac, which is added to the 1% of GDP already invested.

Aside from these two agencies, S&P also cited another ABS asset class — student loans. "The potential for losses on federal direct and guaranteed loans (such as student loans) is another material fiscal risk, in our view," S&P stated, noting that the risks from the U.S. financial sector are higher versus what it was before 2008.

The GSEs' finances will affect the soveriegn rating. "We estimate that the government might have to inject up to $280 billion to cover losses at Fannie Mae and Freddie Mac; this includes $148 billion already spent," S&P stated. By the rating firm's estimates, that $280 billion could increase to $685 billion "if the government capitalizes Fannie and Freddie on a commercial basis."

RBS analysts said that although S&P does not assign issuer credit ratings to either agencies because of the conservatorship, the firm's stable outlook for Fannie and Freddie debt is driven by its outlook for the U.S. sovereign rating.

The researchers gave the example of S&P saying that the stable outlook for Fannie Mae's debt is a reflaction of the stable outlook S&P's sovereign group assigned to the U.S. sovereign rating.

This is why the outlook revision on the U.S. long-term sovereign credit rating to negative from stable should also affect longer-term Fannie Mae and Freddie Mac debt. RBS analysts added that the agencies five-year and longer are underperforming swaps currently by 1.5 to 2.5 basis points led by the old 10-year and 30-year sectors. But, there had been some better selling in intermediate agencies before the announcement that having an impact on the sector as well.

According to RBS, the Federal Home Loan Banks (FHLB) are capitalized by member financial institutions, even though they are a GSE. The rating firm's 'AAA'-rating rationale includes the FHLBs' GSE status. Thus longer-term FHLB debt should not be immune to the outlook revision for the U.S.'s long-term credit rating

The rating agency's $280 billion projections for Treasury GSE support is mostly based on losses from the guarantee business. The $685 billion is a result of the government replacing both GSEs as well as proving the capital for the successor entities.

"We think that this outcome is highly unlikely as it implies a government-owned entity with the taxpayers bearing the cost of capitalization," RBS analysts said, adding that most the housing finance proposals are to limit government support and the cost to the taxpayers, RBS said.

Debt Ceiling

Barclays analysts said that S&P's announcement was not really about the debt ceiling. which is not even mentioned in the the rating agency's release. By contrast, the reason why U.S. government ratings came under pressure in 1995 to 1996 where Moody's Investors Service placed portions of the U.S. government's debt on negative watch was what was then the debt ceiling impasse. This means that even if the debt ceiling debate were to be resolved in the near term, it would not be enough to restore the outlook to stable.

On the other hand, the longer that debt ceiling negotiations drag on, the bigger the apparent distance between the two political parties and the greater the likelihood of a downgrade down the road. In turn, this would mean a steeper Treasury yield curve, higher yields on the long bond, narrower longer-term swap spreads, and a flatter swap spread curve.

The key to a stable outlook is that there be a concrete plan for deficit reduction that need not only to be agreed upon, but also put in place by 2013, according to Barclays analysts. This will be very challenging, they added.

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