By John W. Schoen Senior producer
updated 7/26/2011 3:40:54 PM ET 2011-07-26T19:40:54

As Washington dithers over raising the nation's debt ceiling, investor confidence is flowing away.

Major Market Indices

There's a week left before the Aug. 2 deadline to raise the federal government's borrowing authority so it can pay its bills on time to avoid a default. Bond rating agencies and the investors who rely on them are rapidly losing conviction that debt issued by a dysfunctional government is a risk-free bet that deserves a top-notch credit rating.

"The issue is not just whether Moody's or Standard and Poor's were to downgrade (U.S. Treasury debt), it's whether the market decides to downgrade," said Rochdale Securities bank analyst Richard Bove.

"If they lose faith in the Congress and the government to, in essence, create a solid security for the buyers of that security, then you get the downgrade," he said.

A downgrade could raise borrowing costs for consumers, businesses and government agencies.

Republicans and Democrats remained deadlocked Tuesday over competing plans to raise the debt ceiling. In a televised address Monday, President Barack Obama warned that failure to increase the borrowing limit could bring a devastating downgrade of U.S. debt.

Story: Obama, Boehner clash on TV on debt endgame

"For the first time in history, our country's triple-A credit rating would be downgraded, leaving investors around the world to wonder whether the United States is still a good bet," he said in remarks televised from the East Room of the White House.

The sentiment was echoed overseas, where many investors hold U.S. Treasury securities as an investment. "An adverse shock in the United States could have serious spillovers on the rest of the world," warned Christine Lagarde, managing director of the International Monetary Fund.

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Despite weeks of intense talks, the two sides appear far apart on a deal to reduce the long-term budget deficit, which would clear the way for Congress to lift the $14.3 trillion borrowing limit. The longer Congress and the White House dicker over details of conflicting budget plans, the less those details matter. Attention has now shifted to the more fundamental issue of whether the government has lost control of the budget process.

"We live in a highly interconnected international financial world that is really based upon confidence," said financial services industry lobbyist Paul Equale. "And without confidence, both domestically and internationally — that the United States is mature enough and has a system that can handle making the big decisions — without that confidence we're going to see things like the dollar becoming less important as the world's reserve currency."

The likelihood of an outright U.S. default Aug. 2 remains fairly remote. The cost of paying interest on the national debt consumes roughly 10 cents out of every dollar the Treasury collects. So the government will almost certainly have enough cash to make those payments a week from now. But other payments, from Social Security and Medicare checks to the payroll for active-duty military personnel, are at greater risk.

First Thoughts: The search for a compromise

The threat of a cash squeeze after the deadline has also softened a bit amid reports that the Treasury is taking in slightly more revenue than it projected back in May when the debt ceiling was reached. That could give negotiators on both sides another week or so to come to an agreement before payments are missed.

There is also speculation that if both sides remain dug in, a short-term increase in borrowing authority could extend the deadline another month or so to keep working on a variation of the proposed $4 trillion package of spending cuts and revenue increases that has proven elusive.

But heading off an outright default may not be enough to avoid a downgrade of the top AAA rating assigned to U.S. Treasury debt. A missed interest payment would almost certainly bring a downgrade. But failure to reach a deal by Aug. 2, or a smaller deal that lacks teeth, also could cost the government its AAA rating.

On July 14, when it gave notice that a downgrade was possible, rating agency Standard and Poor's said it might act even if an agreement is reached that doesn't "stabilize the U.S.' debt dynamics."

Executives from major rating agencies are scheduled to testify before a congressional panel Wednesday on their role in the debt ceiling talks.

No matter what the credit raters decide, investors holding U.S. debt may not wait for the official word of a downgrade.

"At some point, if we keep dithering with the issue, the market will become concerned about our willingness to pay — not necessarily our ability to pay off, but our willingness," said Erik Ristuben, chief investment officer at Russell Investments. "The worst-case scenario is our cost of capital as a nation goes up significantly as our creditors hold that attitude against us."

Story: Deficit reductions — it’s all in how you measure

A credit rating downgrade could over time add up to 0.7 percentage point to bond yields, members of a U.S. securities industry group said on Tuesday.

"That's on the order of $100 billion over time that we will add to our funding costs," said Terry Belton, global head of fixed income strategy at JPMorgan Chase. He was speaking on a conference call organized by the Securities Industry and Financial Markets Association, also known as SIFMA.

Over time, he said Treasury yields could rise 60 to 70 basis points on a credit downgrade -- "a huge number because we're talking a permanent increase in borrowing costs."

Because U.S. Treasuries are the benchmark for safe investments, even a small rise in interest rates would have widespread impact:

  • Higher rates on Treasuries would raise the cost of new government borrowing, increasing the budget deficit.
  • Rates on U.S. Treasuries are also the benchmark for rates on bonds issued by Fannie Mae and Freddie Mac to provide capital for mortgages. Raising the cost of mortgages would put more downward pressure on home prices and further destabilize the housing industry.
  • State and local governments, already reeling from painful budget cuts, would see their borrowing costs rise. That could force them to make further spending cuts, raise taxes or both.
  • Higher rates would lower the value of debt already held by investors. U.S. banks, which directly or indirectly hold roughly $1.7 trillion in Treasuries, would see their capital base shrink, forcing them to cut back on lending, according to Bove.

"If the dollar goes down, as it already has, what happens to inflation?" said Bove. "And if inflation goes up, can the Federal Reserve in fact control interest rates? It's a rolling disaster."

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Video: Obama, Boehner go head-to-head on debt

  1. Closed captioning of: Obama, Boehner go head-to-head on debt

    >>> we begin this morning with the debt showdown in washington . nbc's kristen welker is at the white house with more.

    >> reporter: good morning to you. with that deadline looming there's a heightened sense of urgency to get something done here at the white house and on capitol hill . this after a night of political theater in which both sides still seem as far apart as ever.

    >> tonight i want to talk about the debate we've been having in washington --

    >> reporter: for only the seventh time in his presidency mr. obama delivered a prime time speech painting a dire picture of what will happen if congress doesn't raise the debt ceiling by next week.

    >> interest rates would skyrocket on credit cards , on mortgages and car loans, which amounts to a huge tax hike on the american people .

    >> reporter: despite weeks of partisan wrangling the president still pushed for a balanced approach, cut spending and raise tax revenue .

    >> the only reason this balanced approach isn't on its way to becoming law right now is because a significant number of republicans in congress are insisting on a different approach, a cuts only approach, an approach that doesn't ask the wealthiest americans or biggest corporations to contribute anything at all.

    >> reporter: with time running out the president called for compromise.

    >> i'm john boehner .

    >> reporter: but just two minutes after the president spoke, house speaker john boehner gave his side.

    >> the sad truth is that the president wanted a blank check six months ago and he wants a blank check today. this is just not going to happen.

    >> reporter: boehner seemed to reject all talk of compromise, backing a house gop plan that the two-step approach. first, slash spending by 1$1.2 trillion and raise the debt limit, then revisit the issue next year before the 201 election.

    >> obviously i expect that bill can and will pass the senate and be sent to the president for a signature. if the president signs it, the crisis atmosphere that he has created will disappear.

    >> reporter: earlier the president did put a plan aford with harry reid which would raise the debt limit to 2013 , after the election. it calls for $2.7 trillion in spending cuts. but boehner said that's not the answer.

    >> the solution to this crisis is not complicated. if you're spending more money than you're taking in, you need to spend less of it.

    >> reporter: monday night the president urged viewers to call congress to push for his approach before it's too late.

    >> if you want a balanced approach to reducing the deficit, let your member of congress know.

    >> this debate is not about president obama and house republicans, it isn't about congress and the white house . it's about what is standing between the american people and the future we seek for ourselves and our families.

    >> it's a dangerous game that we've never played before, and we can't afford to play it now.

    >> in washington more spending and more debt is business as usual . i've got news for washington , those days are over.

    >> reporter: now, looks like speaker boehner 's plan will be voted as early as tomorrow. one more interesting note, despite the fact that the president had been calling for this balanced approach with spending cuts and new tax revenues , noeither the house nor senate plan includes new revenue.

    >> thank you. jim cramer is the host of " mad money " on cnbc and chuck todd is political director. good morning.


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