CROSS-SECTOR RESEARCH

The Next Round Of Congressional Budget Talks Looms Large For U.S. Rated Credits
Primary Credit Analysts: John J Bilardello, Senior Managing Director, New York (1) 212-438-7664; john.bilardello@standardandpoors.com Devi Aurora, Senior Director, New York (1) 212-438-3055; devi.aurora@standardandpoors.com Erkan Erturk, PhD, Senior Director, New York (1) 212-438-2450; erkan.erturk@standardandpoors.com Farooq Omer, CFA, Senior Director, Hightstown (1) 212-438-1129; farooq.omer@standardandpoors.com Gabriel J Petek, CFA, Senior Director, San Francisco (1) 415-371-5042; gabriel.petek@standardandpoors.com David C Tesher, Managing Director, New York (1) 212-438-2618; david.tesher@standardandpoors.com Joel C Friedman, Senior Director, New York (1) 212-438-5043; joel.friedman@standardandpoors.com Secondary Contacts: Beth Ann Bovino, Senior Director, New York (1) 212-438-1652; bethann.bovino@standardandpoors.com Marie Cavanaugh, Managing Director, New York (1) 212-438-7343; marie.cavanaugh@standardandpoors.com

Table Of Contents
Financial Institutions Funds Insurance Structured Finance Corporates U.S. Public Finance Related Criteria And Research
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While political brinkmanship over funding the federal government and raising the debt ceiling will likely resurface as the next set of deadlines approaches, Standard & Poor's Ratings Services expects it to be milder than it was in October. That said, the recent agreement in Washington does little to address the longer-term uncertainty about fiscal issues, and without further measures we expect imbalances will begin to grow again in several years. Whether the credit quality of the borrowers we rate is hurt by another round of political gridlock--as well as continuing sequestration-related federal spending cuts--depends, to a large extent, on the severity of the effects on the financial markets and the real economy. Our economists estimate that the October shutdown shaved 0.6 percentage points from annualized fourth-quarter GDP--or, in other words, the economy will expand $24 billion less than we previously expected. In this light, we've reduced our 2013 real GDP growth forecast to 1.6% from 1.7%. OVERVIEW A renewed fiscal impasse may hurt volumes, revenues, and asset quality but would likely have only a moderate effect on financial institutions' ratings, given our already modest expectations of the economic environment. Renewed uncertainty about fiscal negotiations is unlikely to affect money market funds, unless acute market volatility destabilizes their net asset values. Our outlook for North American insurance sectors remains largely stable, and we expect the effects of further sequestration and additional cuts in government spending to be minimal. The next round of sequestration cuts and potential political uncertainty will have a limited effect on structured finance collateral and credits, in our view. Corporate credit conditions remain encouraging, but sectors most exposed to sequestration, such as defense, will face some headwinds. U.S. public finance sectors with direct exposure to the federal government--such as health care--could see a weakening in credit quality under certain stress scenarios.

On Jan. 15, 2014, new sequestration cuts are scheduled to begin. They total about one-third of the 2013 cuts, which remain in effect, and are geared more toward defense spending, which was less affected by the 2013 cuts. Many in Congress would like to revamp the sequester, although with different offsetting measures: some favor higher revenues, others more targeted spending cuts, and others various combinations thereof. The budget conference, established by the October deal and led by Rep. Paul Ryan (R.-Wis.) and Sen. Patty Murray (D.-Wash.), is tasked with reconciling the House and Senate budget resolutions in recommendations due on Dec. 13, 2013. We think it will be difficult to make progress on a plan that addresses the fundamental imbalances that would cause the debt burden to start to edge upward in a few years, but there is strong incentive to rationalize the sequester, which is very unpopular. Greater certainty on fiscal issues would likely support GDP growth, so the budget conference's success in addressing the sequester and other issues will be crucial in preventing yet more drag on an economy that is still struggling to recover from the Great Recession. Currently, we expect that the economy will grow by 2.5% in 2014, down from our previous projection of 2.8%.

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As part of the budgetary discussions, legislators may address the debt ceiling, which Congress must raise by Feb. 7, 2014--or whenever after that the Treasury exhausts its use of extraordinary measures. All told, this is a fairly aggressive time frame for politicians to negotiate some sort of lasting deal. And lingering uncertainty will likely weigh on consumers, whose spending accounts for nearly 70% of GDP. If Americans are afraid that Congressional leaders are bracing for another standoff, increasing the risk of another shutdown or worse, they may be reluctant to open their wallets, which will likely make for a lackluster holiday shopping season. In any event, the many issues that various industries and sectors face may remain until legislators strike a long-term deal. We detail below the potential effects of certain conditions on financial institutions, structured finance, corporate entities, and public finance borrowers.

Financial Institutions
Legislators' failure to pass an appropriations bill or renew a continuing resolution could precipitate another shutdown in Washington, but would likely have only a moderate effect on financial institutions' (FI) ratings, in our view. While such a scenario may hurt volumes, revenues, and asset quality, most FI ratings already factor in our expectations for modest economic growth, and a measured dip in GDP because of extensive cuts in government spending likely wouldn't influence ratings or outlooks en masse. We recently revised our view of the trend for economic risk in the U.S. banking sector to stable from positive (see "Economic Risk For The U.S. Banking Sector Will Likely Take Time To Improve Substantially," published Oct. 25, 2013). We based this on our expectations that operating conditions for U.S. banks will likely be softer for a longer period than we had anticipated, and that an improvement in economic risk (which we associate with lower credit losses or higher bank loan growth, for example) will be slower than we previously thought, given the gradual pace of the economic recovery. We also expect it will be more challenging for banks to generate future profits because they will need to depend more on revenue growth and operational cost control (positive "operating leverage") and less on credit leverage--the key contributor to bank profitability since 2010. Near-term growth prospects have ebbed. Given our expectations for a second round of sequestration cuts, renewed gridlock could further dampen growth prospects through lowered consumer and business confidence--factors that contribute significantly to banks' sustainable earnings growth. Although we believe uncertainty around fiscal policy could flare up again early next year, we expect the Federal Reserve to maintain its accommodative monetary policy and continue its asset purchases at close to its current pace. In the absence of a more convincing economic recovery, we believe that legacy credit losses related to real estate, which remain well above the historical mean, may take longer to subside than we initially expected. This means the "correction phase" for the U.S. banking sector (as defined in our criteria), indicating high or increasing credit losses, could linger well into next year and 2015. We expect credit losses of about $58 billion-$60 billion this year and $55 billion-$58 billion next year. We may raise these estimates depending on how GDP growth forecasts evolve. Generally speaking, we consider that financial institutions are better-positioned to face unexpected stresses than they were a few years ago, in terms of capital and liquidity. During the recent confrontation in Congress, we received many

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inquiries from market participants interested in our views on the potential impact on FI ratings. Then, as now, we didn't anticipate that the political impasse would lead to a change in the sovereign rating. Contrary to our expectations, if Congress does not raise the debt ceiling again and the U.S. misses a debt payment or participates in a debt exchange we view as distressed, we would continue to be guided by the severity of the economic scenario that we think may accompany such a situation and the financial sector's ability to withstand certain pressures, such as liquidity temporarily drying up, banks' willingness to extend liquidity to clients to avert a worse situation, and the likely path of the sovereign rating. Although we expect most FIs should be able to cope with a temporary market disruption given that they have built up their liquidity buffers, the magnitude of the ratings impact would largely depend on the Fed's and other market constituents' ability to prevent a crisis of confidence in the financial system.

Funds
Standard & Poor's rates 346 U.S. dollar-denominated 'AAAm' rated money market funds with more than $2.2 trillion in assets. Renewed uncertainty about fiscal negotiations would likely have a negligible impact on our ratings on these funds, unless accompanied by acute market volatility. Leading up to the debt-ceiling deadline in October, as well as in 2011, we observed relatively modest fluctuations in net asset values (NAVs). We observed that funds limited to investments in U.S. Treasury and agency securities were positioning themselves to deal with any uncertainty by trying to avoid securities that matured in the few weeks following the debt-ceiling deadline. They also generally maintained above-average amounts of overnight liquidity and an overall shorter weighted-average maturity to minimize the effects that widening spreads and redemptions would have on their NAVs. In the unexpected event that Congress does not raise the debt ceiling in 2014 and those money market funds holding Treasuries incur a delay in interest payments, this wouldn't lead to automatic rating actions. As part of our criteria, a fund's rating is ultimately related to the short-term ratings on the underlying bonds. However, if the marked-to-market NAVs destabilize due to depleted available liquidity in the fund, widening credit spreads, and large redemption requests, among other factors, we could take negative rating actions on affected U.S. dollar-denominated principal stability fund ratings (PSFRs). Before we place any PSFR on CreditWatch negative, we would endeavor to obtain the fund's daily marked-to-market NAV per share and asset balances to determine whether deterioration in its NAV warrants a rating action.

Insurance
Despite the disruption caused by the recent government shutdown, our outlook for North American insurance sectors remains largely stable, and we expect the effects of further sequestration and additional cuts in government spending on ratings to be minimal. As a mature industry, we generally expect life insurance sales to grow proportionally with GDP. However, a slight reduction in our GDP forecast likely wouldn't hurt life insurers' solid capital adequacy and liquidity, which we view as key underpinnings for our stable ratings outlook. As a result of slow GDP growth, interest rates could stay low, making products such as fixed-deferred annuities and universal life insurance less attractive for consumers and insurers.

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We see the property/casualty sector as having low to medium sensitivity to changes in GDP; therefore, the modest growth we anticipate shouldn't be a major ratings factor. In particular, demand for personal-lines insurance, such as automobile and homeowners, is fairly steady because many policyholders consider these products nondiscretionary items. Nevertheless, slow economic expansion may limit the growth of insurance needs. For health insurers, a sustained trend of employment growth, along with the migration of government-sponsored business toward managed care, has been a key positive. Because employment has a direct impact on the availability of insurance--and consequently affects the mix of business in the marketplace--any decline in workplace-based coverage or funding for government-supported products could slow revenue growth. With the housing market's gradual improvement, business writings in the mortgage insurance sector have been growing, and we expect overall profitability in 2014. However, unfavorable economic conditions resulting from budget cuts could delay this. Insurers typically hold a portion of their investments in U.S. Treasuries, despite their generally lower yields, because these securities have traditionally been considered risk-free and a dependable source of liquidity under almost any foreseeable circumstance. However, the prospect of a selective default on Treasuries arising from Congress' recent threat to not raise the debt limit and the recent temporary increase has brought this longstanding assumption into question. Insurers' holdings of Treasuries relative to capital vary greatly but are often significant and, in some cases, are greater than an insurer's total available capital. This direct exposure is one reason we typically limit ratings on insurers to that of the sovereign. In the unexpected event of a selective default, we would closely monitor U.S. Treasuries' market value and the potential effects on insurers' capital adequacy. Our analysis of insurers' liquid assets and their ability to cover stressed levels of insurance liability outflows indicates that temporary illiquidity in U.S. Treasuries would have a minimal impact on our assessment of most insurers' liquidity positions. This is because of the typical payout pattern and restrictions on surrenders that exist in many insurance liabilities. Although unexpected, anything other than a temporary impairment of Treasuries would likely result in negative rating actions for some insurers, with a higher proportion of their capital exposed to these securities.

Structured Finance
Standard & Poor's expects the potential adverse effects of the now-ended 16-day partial government shutdown on structured finance collateral and credits to be minimal in the short term, given current strong consumer and commercial fundamentals. Now that the impasse in Washington is over, the main focus has shifted to economic data, lower economic growth forecasts, and the Fed's potential tapering of delays to early next year. Given the expected second round of sequestration cuts due in January, a revival of political uncertainty could lower growth prospects in an already-slow economic recovery, potentially weakening consumer confidence and hurting the jobs market. If Congress fails to pass an appropriations bill or renew a continuing resolution when the current extension expires in January 2014, we would be concerned with the potential near-term increase in consumer defaults affecting auto loans, credit card payments, student loans, and mortgage payments. New sequester cuts go into effect in January and the debt ceiling must be raised by early February.

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In the long run, another shutdown in Washington, combined with a shrinking economy, could weaken consumer/commercial fundamentals because key economic factors, including the labor markets, consumer confidence, retail sales, home prices, and the stock market, would deteriorate. This, in turn, would especially hurt the credit quality of speculative-grade credits across structured finance sectors. Under an extended shutdown and default scenario, we would focus on the following direct or indirect factors to evaluate any potential adverse effects on structured finance credits: Any indirect effect from the deterioration in economic and sector credit fundamentals; Our views on the U.S. sovereign rating, with a downgrade below certain rating thresholds potentially triggering increases in required collateral postings for some credits, based on the requirements in their transaction documents; Counterparty dependencies and reactions of bank ratings, since banks are sponsors or counterparties to some structured transactions; and The schedule of specific Treasury bond maturities/coupon payments for transactions with defeased collateral. We do not anticipate the political impasse will lead to a change in the U.S. sovereign rating, but if Congress does not raise the debt ceiling again and the U.S. misses a debt payment or engages in a debt exchange we view as distressed, we would continue to be guided by the severity of the economic scenario that we think may accompany such a situation and the financial sector's ability to withstand certain pressures, such as liquidity temporarily drying up, banks' willingness to extend liquidity to clients to avert a worse situation, and the likely path of the sovereign rating. In a hypothetical situation where the sovereign rating does change, the potential adverse impact could generally be felt across structured finance sectors, but the following structured finance asset types would be directly affected: Asset-backed securities: Federal Family Education Loan Program student loan transactions could be adversely affected because these loans benefit from the Education Department's guarantees of at least 97% of defaulted principal and accrued interest; Asset-backed commercial paper (ABCP) and letters of credit: Ratings would generally track the bank and U.S. sovereign ratings because banks provide liquidity and credit support to ABCP programs; Structured credit: Defeased tobacco bond transactions, principal-protected notes, and National Credit Union Administration-guaranteed trust transactions could be adversely affected; Commercial mortgage-backed securities (CMBS): Large loan/single borrower or other CMBS transactions with largely defeased collateral could be immediately affected; and Residential mortgage-backed securities: Many transactions don't include government guarantees and wouldn't be affected, but transactions with Federal Housing Administration or other federally insured loans could be directly affected.

Corporates
As we assess the ramifications that the budget uncertainty poses for U.S. corporate borrowers, we will factor in the economic scenario that we believe will accompany prevailing circumstances. The U.S. economic outlook remains uncertain given the lack of a longstanding budget and debt-ceiling agreement, among other reasons. In turn, outside of a debt-ceiling resolution, the 2014 sequester is the prevalent budget-related risk now looming over the U.S. corporate landscape. Against this macroeconomic backdrop, we expect sectors most exposed to sequestration, such as defense, will face some headwinds, with consumer discretionary sectors suffering potential softness amid fragile consumer

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sentiment. If an impasse continues early next year, with further cuts in expenditures necessitated as a result of either budget cuts or prioritization of payments, but the government still manages to service its debt obligations through alternative means, we would expect the impact on the corporate sector to be moderate. The exception would be corporate sectors that rely on either government purchases (such as aerospace and defense, and technology companies), or subsidies and funding (health care companies). Despite the recent government shutdown and debt-ceiling standoff, corporate credit conditions remain encouraging. Borrowing costs continue to be extremely favorable and consumer confidence continues to recover. However, those sectors most affected by a material curtailment of government spending would be as follows.

Aerospace and defense

Although hard to quantify, the effects of another protracted government shutdown on individual aerospace and defense companies would again be directly correlated to the time period of the curtailed expenditures. The longer cuts are in place, the more significant the damage. Assuming the Department of Defense (DoD) has the flexibility to prioritize payments, we believe war-related spending and pay for uniformed personnel would continue undiminished. So the impact would be greater on procurement, research and development, and operations and maintenance--where most contractors generate their revenues. Routine operations, such as training and maintenance (some of which is provided or supported by contactors), would likely be curtailed significantly in an attempt to continue production on higher-priority military programs. A protracted budget impasse could again hurt issuer cash flows, with even large contractors eventually being forced to take extreme measures (e.g., layoffs or stopping payments to suppliers) to preserve cash. We now assume the 2014 sequestration cuts will total $109 billion, including the approximate $85 billion incurred in 2013, with the bulk of the increase being targeted to all components of the defense sector. In 2013, sequestration cuts for defense were ultimately expanded to include security spending (State and Homeland Security, etc.). However, as currently stipulated, the 2014 sequestration cuts will be more narrowly targeted to DoD contracts. The fiscal 2013 sequestration cuts, which totaled about $37 billion for the military, have so far had only a modest effect on U.S. defense contractors, with most seeing revenue declines in the low- to mid-single digits. However, orders from the DoD have decreased further, which indicates additional revenue declines in the next few years. The DoD limited the impact of the cuts on defense contractors in 2013 by furloughing civilian employees, reducing operations and training, and utilizing unobligated funds from prior years (funds that were appropriated in prior defense budgets but were never spent) to make up some of the shortfall. In addition, some defense companies' 2013 revenues benefited from an increase in sales to foreign customers. To preserve profit margins, defense companies proactively reduced overhead costs to coincide with lower demand and, in some cases, preemptively divested businesses anticipated to be targets of future cuts. We believe the additional $20 billion of defense-related 2014 sequestration cuts won't materially hurt large defense contractors' credit quality because their programs are diverse and their liquidity is solid. They are also likely to continue generating substantial free cash flow even as revenues and earnings modestly decline. However, credit quality could deteriorate if these firms choose to offset lower earnings by increasing shareholder rewards or pursuing

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large debt-financed acquisitions. The impact on smaller defense contractors is harder to determine without knowing exactly which programs will be cut, but it could be more substantial because these companies generally have less-diverse programs and fewer financial resources. We believe the cuts will likely fall most heavily on Army programs, service contracts (such as for training or maintenance), and short-cycle products (those ordered, produced, and delivered in less than a year). Cuts to large procurement programs are also possible, but the effects on companies' revenues and earnings likely won't materialize until after 2014. In a scenario where Congress doesn't raise the debt ceiling in time and prioritization of interest payments necessitates additional severe spending cuts, we could place the ratings on some defense contractors on CreditWatch negative. In turn, we may also lower the ratings on many smaller pure defense contractors to the 'CCC' category or lower due to their limited financial resources. We could also take selected rating actions on other aerospace suppliers that have material defense sales.

Technology
At this time, we can't determine the full extent of how sequestration will affect DoD agencies and their respective government contracts and, as a result, its impact on rated government IT contractors also remains somewhat uncertain. Nevertheless, almost all rated government contractors in the technology sector are already feeling the impact of sequestration. A smaller governmental IT budget has created funding uncertainty, task order and project delays, and increased competition and pricing pressure. Because rated government contractors in the technology sector are primarily service providers, another government shutdown would mean the permanent loss of revenue for maintenance and support programs, and the deferral of research and development or acquisition programs. Government contractors typically carry cash balances that allow for working capital fluctuations, but not significantly more. Because the government shutdown in October only lasted two weeks, a liquidity crunch was a concern but not one that had a lasting impact on government contractors' business operations. If a protracted government shutdown or a wider range of maintenance and support programs are cut or deferred, we would expect government contractors rated in the 'B' category or lower to be most affected due to their more limited scope of operations and limited financial flexibility.

Health care
Given the nature of the services that health care providers offer, the sector is more sensitive to a reduction in government spending than it is to variations in economic growth. While GDP doesn't have much of an effect on health care spending, the prospects for Medicare and Medicaid reimbursement clearly do. Medicare and Medicaid represent about half of total health care spending in the U.S., and any curtailment of payments would hurt, with providers who cater to the elderly, the disabled who are covered under Medicare, and the indigent most exposed. Furthermore, if Medicare and Medicaid payments to the insurers who participate in these lines of business were reduced, they could then curtail claim payments, increasing revenue pressure. As a result, most insurers aren't in a position to meaningfully decrease expenses, which severely reduces profitability. Even in a scenario where government spending reductions last for only a short time--say, around a month--10% of the portfolio could be affected.

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Borrowers most at risk are those at the low end of the 'B' category (or lower), those with less-than-adequate liquidity, and those that depend significantly on Medicare or Medicaid for reimbursement. These issuers have little cushion to absorb reduced revenue and cash flow.

Consumer-driven sectors
With consumer confidence on the mend, we expect that another temporary government shutdown wouldn't immediately affect ratings on retailers and restaurant companies, but would contribute to already-soft demand for some subsectors. In any scenario, the knock-on effects on the consumer and on liquidity in the capital markets would be the main catalysts for any diminished credit quality. The same holds true for borrowers in the entertainment, leisure, and lodging sectors. For consumer goods makers, if economic conditions worsen sharply and consumer sentiment erodes because of fiscal and political gridlock, Americans could shift their purchasing preferences to lower-priced products, including private-label for the more nondiscretionary products within consumer nondurables. Given a more cost-conscious consumer, we would anticipate margin pressure in the food, beverage, and personal care sectors. Within consumer durables, we would expect to see some deferrals of purchases for larger appliances, furniture, and bedding, which, in turn, would affect volume and cash flow. Meanwhile, a reduction in demand from an economic slump would hurt many U.S. homebuilders, and we could see a stall or outright reversal of the recovery that has been underway in many markets. If consumer sentiment sours, home sales could again slow and cancellation rates could rise, decreasing the pricing power that recent home price increases provided builders. In addition, robust debt issuance over the past two years could weigh on homebuilders' debt-protection measures if the growth we expect in 2014 fails to materialize. If, contrary to our expectations, the U.S. were to miss a debt payment, the effect on corporate ratings would, in all likelihood, be more severe but hard to quantify in advance. We would need to reassess major shifts in the real economy, consumer sentiment, and the financial system's stability. On top of the hit to the economy, which would affect companies directly by reducing aggregate demand, the potential for a crisis of confidence could disrupt the financial markets by cutting off existing and new sources of funding for both corporate borrowers and consumers. While the vast majority of the companies we rate have manageable near-term debt maturities--in part because of the abundant refinancing activity we've seen the last few years--those that rely on short-term debt (such as commercial paper [CP]) may have to draw on their backup bank facilities if they find it difficult to access the confidence-sensitive CP markets. Also, as was the case during the financial crisis of 2008-2009, industries that require large amounts of consumer credit (such as housing and auto manufacturing) may see demand for their products fall even more dramatically if the capital markets and financial institutions were to tighten credit while grappling with their own unprecedented uncertainties.

U.S. Public Finance

State and local governments
Recent federal spending reductions, such as those under sequestration, have had a relatively muted effect on states' credit quality. This is because most federal aid to states (roughly 80%) is nondiscretionary spending, which is exempt

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from reduction under sequestration, and is often held as restricted funds separate from general operations and debt service. (See "U.S.-Style Fiscal Federalism Buffers State And Local Governments From Another Federal Shutdown -Somewhat," published Oct. 30, 2013.) But when the federal appropriations authority disappears altogether--as in the recent 16-day federal shutdown--states could ultimately be forced to choose between funding important federal social service programs from their own sources or abruptly shutting them down. While the effects of such a shutdown on states' credit quality wouldn't be immediate, we believe that they could become more acute over time. Following a future shutdown, it's far from certain that states would be made whole for federal programs funded out of their own budgets. On the other hand, states that opt to shutter their social-service programs as soon as federal funds dry up, which could occur within weeks of a shutdown, risk economic contraction that outstrips near-term cash savings. In either case, a state's revenue and credit profile could encounter stress within a relatively short time. Medicaid, for example, could become a liability for states in a more severe shutdown due to its sheer size; the program represents the single largest expenditure in many state budgets. To the extent any state opted to support Medicaid (or other federally funded programs) in the absence of federal aid, we would examine its budget and cash flow capacity for signs of operating stress. For both state and local governments, heightened cash pressures from operations during an extended shutdown could be exacerbated by a loss of market liquidity of Treasury bills, which typically make up a large portion of their portfolios. Meanwhile, tax revenue collections could be dampened by volatility in the equity markets and a loss of consumer confidence, further weakening credit quality. Most local governments, however, are less directly exposed to federal revenue pressures. Because of their generally high credit quality and revenue independence, combined with their revenue-raising flexibility over the medium term, we expect their ratings will hold up reasonably well in a shorter shutdown. A much longer period could strain local governments' near-term resources and perhaps create liquidity crises for certain weaker obligors. School districts, which rely heavily on state funding, could be among the first to feel the downstream fiscal effects of a prolonged federal shutdown if states are squeezed on the revenue side.

U.S. public finance housing

In the event of another federal government shutdown, we would consider the potential effects on unenhanced and subsidized multifamily projects because of their reliance on government subsidy and insurance guarantee payments for mortgage and/or bond payments and defaulted single-family or rental property mortgages. We believe the risk stemming from a shutdown will likely relate most to whether the federal bureaucracy that processes insurance claims or subsidy payments continues to operate. We verified that in the recent shutdown these functions were still taking place, but if this were to change in any future shutdown, these types of issues could be affected. In a more severe scenario involving federal payment prioritization, some of these payments could be jeopardized, which could lead to negative rating actions. That said, many of these issuers have an average six months of reserves to cover bond payments if the federal government doesn't meet the contracted subsidy or guarantee payments. Ratings based on Fannie Mae and Freddie Mac ratings, as well as those based on the sovereign rating (e.g., Ginnie Mae guarantees or mortgages insured by the Federal Housing Administration and Veterans Administration [VA]) could

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suffer if the sovereign rating changes unexpectedly. Some ratings in the U.S. public finance housing sector have direct links to the federal government and, as such, might change with any adjustment to the sovereign rating. We would also examine single-family indentures with significant VA and Department of Agriculture loan insurance to assess the effects.

U.S. public finance infrastructure

Standard & Poor's U.S. Public Finance Infrastructure group covers public power entities, rural electric cooperatives, water and sewer utilities, and transportation facility operators, among other revenue-generating enterprises. For these borrowers, demand and consumer preference are critical to cash flows and credit quality. Even in the event that a debt ceiling-limit impasse resurfaces, and the issue remains unresolved for longer than we anticipate, we believe most of these borrowers would generally be able to maintain balanced operations because many of their services (water, sewer, electricity) are essential and customer receipts that support operations and debt service would flow in a timely manner to avoid service interruptions. By comparison, transportation credits could be hurt by a drop in consumer confidence or workplace layoffs. Entities that depend on market access for liquidity to meet maturing financial obligations, nondiscretionary capital spending, or operations could see ratings impairments, depending on how a debt-ceiling crisis affects the financial markets. Weaker economic conditions caused by such an event could further stress credits. Ratings on borrowers that we find show an unwillingness or inability to adjust rates to sustain financial margins and liquidity levels commensurate with their ratings might be more vulnerable. Within our power portfolio are credits that we treat as government-related entities whose ratings reflect the interplay among their stand-alone credit profiles, an assessment of their link to and role vis--vis the federal government, and the sovereign's rating. Utilities that constitute a government-sponsored enterprise and a federal power marketing administration do not receive Congressional appropriations and were able to use operating revenues to meet financial obligations and provide service without compromise throughout the sequestration. Nevertheless, we believe the federal power marketing administration is uniquely exposed to an interruption in federal funding and Treasury operations. Of concern is the mandate that federal agencies, including power marketing administrations, must exclusively use the U.S. Treasury for their banking and borrowing relationships. A potential loss of access to this liquidity, which is critical to operations and to meeting financial obligations to lenders, could have negative implications for stand-alone credit profiles. Additionally, we anticipate that any delays or potential reductions in federal transportation funding could hurt the credit quality of bonds backed by federal grant anticipation revenue vehicles (GARVEEs). More specifically, if, counter to our expectation, Congress does not raise the debt ceiling and a shutdown lingers, highway GARVEE ratings that have no added state support and are sensitive to a sovereign downgrade, as well as transit GARVEE ratings, would likely be affected. We would also evaluate other infrastructure finance credits that rely on federal grants for funding capital projects to see if liquidity and debt levels would change to levels not already incorporated in current ratings, although we don't expect this to drive many rating changes.

Not-for-profit health care

Aggregate ratings in the not-for-profit health care sector are generally weaker than in other parts of public finance, with only 17% rated in the 'AA' category--a distribution that has always reflected our view of government reimbursement

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risk. Although the federal government shutdown does little to reverse our view of this potential risk, the specific funding sources for this sector are relatively protected. Similar to states' Medicaid linkages, the not-for-profit health care sector's provider payments depend on federal disbursements for Medicare and Medicaid. Therefore, the sector should be somewhat inoculated from a federal shutdown, as long as it does not disrupt these permanently appropriated payments. On the other hand, credit quality could weaken if, for whatever reason, the federal government initiates payment prioritization. Any cutbacks to funding for Medicare and Medicaid would strain liquidity levels across the sector. The potential for state funding disruptions in Medicaid would also be a risk, which could further weaken liquidity. Investment-grade not-for-profit health care providers (more than 90% of rated providers) generally have relatively strong liquidity, which has improved over the past several years and provides flexibility from a credit standpoint. If the federal government again approaches its statutory debt ceiling, it could unnerve investors and possibly disrupt the financial markets. We would expect this to have consequences for investments, an important component of not-for-profit health care providers' cash flow and margins, and for issuers that depend on market access. The credit quality of those providers with weak liquidity profiles or the lack of flexibility to make adjustments, and providers that rely significantly on Medicare and Medicaid are most at risk from a credit standpoint.

Higher education/independent schools/not-for-profits

As with not-for-profit health care, ratings in this sector are generally lower than the broader public finance distribution. If the federal government were to prioritize its payments, the funding of grants and research would be the primary risk for the sector. However, because federal research grants tend to be multiyear awards with annual appropriations, a short-term federal government shutdown would not immediately affect these institutions' long-term funding. Additionally, universities would have adequate time during a shutdown to adjust the budgets of their projects, which tend to be self-funded. We would expect any cut in revenue to be matched with a corresponding cut to expenses. Higher-education institutions with a significant health care component would face the added risks relating to Medicare and Medicaid funding, although this would affect a small portion of overall revenues. Public higher-education institutions could be at risk to lose state funding if federal funds are reduced to states. Higher-rated institutions generally have more diverse revenues and better liquidity, allowing them to manage short-term disruptions. Any recurrence of the threat of a federal breach of the statutory debt ceiling could rile the financial markets and erode endowments and overall liquidity. In the longer term, a weaker economy could hurt demand, fundraising, and investment performance. The credit quality of those with weak liquidity profiles, a lack of flexibility to make adjustments, and that rely significantly on government funding sources are most at risk. Writer: Joe Maguire

Related Criteria And Research

Request For Comment: Methodology And Assumptions For Ratings Above The Sovereign--Single Jurisdiction Structured Finance, Oct. 14, 2013 Methodology And Assumptions: Request For Comment: Ratings Above The Sovereign--Corporate And Government Ratings, April 12, 2013

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The Next Round Of Congressional Budget Talks Looms Large For U.S. Rated Credits Credit FAQ: Understanding Ratings Above The Sovereign, Aug. 8, 2011

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