Debt talk damage has already been done

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

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.

"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.

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.

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."

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.
  • As the value of the holdings erode, other governments holding U.S. debt, from China to the U.K., would have to reconsider buying new U.S. debt. If demand weakens, the Treasury would be forced to pay even higher interest rates to complete new auctions of fresh debt.
  • Weakening demand for U.S. Treasuries would further lower the value of the dollar.

"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."