The U.S. Debt Default Chaos Makes Banks Look Vulnerable

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Just when the sluggish economy had started to show some encouraging signs, the news of the U.S. hitting the debt ceiling of $14.29 trillion reared its head. There have been several debates on whether to raise the ceiling. But now the only way out seems to be a hike in the debt limit, or else what would follow would be "catastrophic economic consequences," as Treasury Secretary Timothy Geithner has warned.

The debt crisis has almost gobbled up economies such as Greece, Ireland, and Portugal. At the moment, it's staring us right in the face. And in case you think this debt demon would shy away from pouncing on the world's biggest economy -- you are being a bit too complacent. The U.S. budget deficit last year stood at 8.9% of gross domestic product. Standard & Poor's has already lowered its outlook for the U.S.' long-term credit rating to negative from stable, and the looming debt default poses a serious threat to its coveted AAA credit rating. While this is a huge concern, there are other problems gnawing at the edges.

The colossal debt burden is already projecting a negative image for the U.S., and this is prompting major foreign securities holders to trim their treasury holdings. China, the biggest foreign owner of U.S. debt, reduced its holdings by $9 billion in March, as compared to the previous month. This was a fifth consecutive monthly reduction.

Banks on the brink
Needless to say, almost all the industries would take a hit. One wrong move, and it could spell disaster. But at this point in time, the banking industry looks more vulnerable than others. The beleaguered American banks had somehow managed to keep themselves from collapsing during the ugly financial crisis. And now, when they are rebounding from the crisis, the possibility of the country defaulting on its debt raises an unavoidable question -- would the magnitude of the effects be a repeat of Lehman Brothers? Or something even worse?

U.S banks have been coming back strong after going through one of the worst phases in history. They are now focusing on declining provisions for loan losses. In fact, this has been a wide-ranging trend across the industry and has enabled both big banks such as Bank of America (NYSE: BAC  ) and Citigroup (NYSE: C  ) and regional banks such as BankAtlantic Bancorp (NYSE: BBX  ) and Hudson City Bancorp (Nasdaq: HCBK  ) to witness a significant improvement in their credit quality. Interest rates are at an all-time low at the moment and banks are reluctant to lend now.

If the U.S. defaults on its debts, interest rates will soar drastically and will hamper all commercial activities. Costs of credit ranging from business and consumer loans to home mortgages, auto financing, and credit cards would go through the roof. More importantly, a default would inevitably call for measures like cutting down on federal spending. Banks that buy bonds directly from the Federal Reserve, either to hold or resell to consumers, would take a severe hit, and this will subsequently cripple the whole economy.

The Foolish bottom line
But even if the U.S. manages to escape a default, which is more than likely to happen, the key question remains unanswered. How many times is the U.S. going to raise its ceiling? The massive public debt going out of control definitely remains a huge concern. In fact, as pointed out by JPMorgan, any delay in hiking the debt ceiling may have an adverse effect on the markets. Watch out, Fools.

Fool contributor Zeeshan Siddique does not own any of the stocks mentioned in the article.The Fool owns shares of Bank of America and also holds a short position in the stock in a different portfolio. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (5) | Recommend This Article (31)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 21, 2011, at 12:50 PM, jimmy4040 wrote:

    The European Debt Crisis is likely to be worse for the big banks listed than our own. They own an increasing percentage of debt from Greece, Ireland, Portugal and Spain, as you go up the scale. Restructuring is almost inevitable and they will probably take a haircut.

  • Report this Comment On May 22, 2011, at 6:29 PM, neamakri wrote:

    I am confused. Congress spends and spends on credit (Treasury notes) then raises the debt ceiling. Too much meaningless B.S. I say just get rid of the fictitious debt ceiling ...voila more headache.

    People in congress have plenty to argue about without the meaningless, fictitious debt ceiling. Stop wasting time and get to other business.

    Mark Twain: "First God made idiots. That was practice. Then He made school boards."

  • Report this Comment On May 24, 2011, at 1:24 PM, techy46 wrote:

    Nobody's going to keep buying the US debt unless they cut the annual deficts by both cutting spending and increasing taxes. Like it or not, this time Obama's right and the Repubs are greedy aholes.

  • Report this Comment On May 31, 2011, at 2:42 AM, dlewenz wrote:

    The ability for the United States Treasury to pay back the 14.3 trillion in T-bills is just not possible based on the current economic conditions the country is in. Nor is it possible any time soon based on a government that is out of control in size, scope, and entitlements. No one in Washington wants to take the Castrol medication. Balance the budget in 5 years, and start to pay down the debt via elimination of all entitlements. This country was not built on entitlements and will be the death of this nation unless we regain fiscal responsibility in Washington.

  • Report this Comment On June 24, 2011, at 4:37 PM, constructive wrote:

    "This country was not built on entitlements"

    Right, it was built on slavery.

    The founding fathers and the generations that followed helped expand public services like public schools, fire fighting, and postal delivery. They were nation-builders who sought to improve the lives of citizens, not small government anarcho-capitalists.

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