Get Ready for a U.S. Debt Downgrade?

Interesting days, these. Over the next week, either the Republican and Democratic parties will come together and raise the debt ceiling -- as they have 87 times since 1945 -- or neither party will blink from its current footing. In the latter case, the U.S. risks defaulting on its debt (or, at minimum, payments like Social Security) by next Tuesday.

Most still think the ceiling will be raised. That includes the market, which has shrugged off this whole charade as a non-event. Stocks remain near multiyear highs, interest rates near historic lows. No panic yet.

But even if the debt ceiling is raised, this story isn't over. The odds remain uncomfortably high that the U.S. will lose its AAA credit rating over the coming weeks if an agreement to raise the ceiling doesn't pass the rating agencies' sniff test.

When Standard & Poor's put the government's credit rating on negative watch last week, it made one thing clear: Raising the debt ceiling alone isn't enough to avoid a downgrade. Any credible plan has to slash future deficits and raise the ceiling by more than a token amount:

Congress and the Administration might ... settle for a smaller increase in the debt ceiling, or they might agree on a plan that, while avoiding a near-term default, might not, in our view, materially improve our base case expectation for the future path of the net general government debt-to-GDP ratio ... Based on this, we believe that an inability to reach an agreement now could indicate that an agreement will not be reached for several more years. We view an inability to timely agree and credibly implement medium-term fiscal consolidation policy as inconsistent with a 'AAA' sovereign rating.

It elaborated: "If Congress and the Administration reach an agreement of about $4 trillion [in deficit reduction over a decade], and if we to conclude that such an agreement would be enacted and maintained throughout the decade, we could, other things unchanged, affirm the 'AAA' long-term rating."

And what if the plan doesn't cut $4 trillion?

That's the problem. There currently aren't any plans to cut $4 trillion from the deficit over a decade. A few of that size emerged in recent weeks, but they were instantly shot down as politically unpalatable. The current proposal put forth by the Republican House aims for $3 trillion in cuts. The plan drafted by the Senate Democrats calls for $2.7 trillion.

Another problem is the duration of a debt ceiling increase. Even if the ceiling is raised and it meets deficit-reducing standards, a downgrade could still occur if the ceiling is only raised for a short amount of time, causing us to relive this mess a few months down the road. 

That's effectively how the Republican House's proposal, led by Speaker John Boehner, would work: The ceiling would be raised by $1 trillion today, and would need another raise sometime next year. The Senate Democrats' plan, pushed by Majority Leader Harry Reid, would raise the ceiling by a larger amount, providing enough borrowing authority to make it through 2012. The difference between the two could in itself spark a downgrade. Erin Burnett -- formerly of CNBC and now at CNN -- noted yesterday:

Really interesting this afternoon, when I was talking to an investor who had met with the ratings agencies at Standard & Poor's, talking about the potential of a downgrade ... and they said the Boehner plan probably wouldn't hit the hurdle to prevent a downgrade. Even if that deal was reached, you could still get a downgrade ... Whereas the Reid plan, even though a lot of the parts of that are seen by many as gimmicks, probably would pass that hurdle and you wouldn't get that immediate downgrade. That's an interesting distinction.

Interesting, indeed.

What could happen after a downgrade? Nothing good. Since these problems are entirely self-inflicted and avoidable, we'd become the laughing stock of the world. JPMorgan Chase (NYSE: JPM  ) CEO Jamie Dimon brought up another issue: Many financial transactions require AAA-rated collateral. Almost invariably, that's Treasuries. A downgrade could send these transactions into disarray.

More importantly, interest rates would rise, and the value of debt would fall. That could spark a special kind of hell for big banks, which have broken down the doors at the Treasury in recent years to load up on as much public debt as they can: 

Bank U.S. Government Debt Held
Bank of America (NYSE: BAC  ) $332 billion
JPMorgan Chase $194 billion
Citigroup (NYSE: C  ) $191 billion
Goldman Sachs (NYSE: GS  ) $112 billion
Wells Fargo (NYSE: WFC  ) $84 billion

Source: The Wall Street Journal.

The best solution to this mess is what Moody's (NYSE: MCO  ) recommended last week: Get rid of the debt ceiling altogether. It serves no purpose other than political flamethrowing and fostering market uncertainty. Alas, there's exactly zero chance of that happening anytime soon.

Fool contributor Morgan Housel owns B of A preferred. Follow him on Twitter @TMFHousel. he Fool owns shares of and has created a ratio put spread position on Wells Fargo. The Fool owns shares of and has opened a short position on Bank of America. Motley Fool newsletter services have recommended buying shares of Moody's. 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 (15) | Recommend This Article (13)

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 July 26, 2011, at 3:40 PM, DukeTG wrote:

    This is a pretty pessimistic view. As Churchill said, you can always count on Americans to do the right thing...after they've tried everything else.

    Seriously though, we're all doomed.

  • Report this Comment On July 26, 2011, at 5:19 PM, Borbality wrote:

    extremely frustrating when the amount that our debt payments will increase if we're downgraded will probably dwarf any of the spending cuts or tax increases they're squabbling about on the news.

  • Report this Comment On July 26, 2011, at 5:37 PM, sheldonross wrote:

    "Get rid of the debt ceiling altogether."

    Or we could get rid of the debt... that also solves the problem. But yeah , let's just take away the credit limit and see what happens.

  • Report this Comment On July 26, 2011, at 8:51 PM, vrpirata wrote:

    This article is misleading. The Federal Reserve is a private company whom shareholders are private domestic and foreign banks. The Fed creates currency out of thin air and exchanges it for real assets. The Fed gets a lot for nothing. Every dollar the Fed prints steals away our country wealth.

    Why would our Government keep borrowing Dollars from the privately-owned-Fed when our government can actually coin our money free of interest (U.S. Constitution Article 1 Section 8)? Oh wait, I know, Plutocracy.

  • Report this Comment On July 27, 2011, at 3:40 AM, PostScience wrote:

    @vrpirata

    You are correct that every dollar printed reduces the value of the other money in circulation.

    But as this acts as a de-facto tax on accumulated cash, it hurts the rich more than the poor. Rich people have cash. Poor people have debts. Inflation reduces the value of both.

    In my opinion, a higher inflation target (say 4-5%) is just what the country needs. This would not only make it easier to pay off government debt, but would allow the consumer to escape from his debt burden as well.

    It would also have the advantage of forcing the wealthy to "use it or lose it", either putting their cash back into the economy, or seeing it devalued over time.

    Personally, I have about 25% of my portfolio in cash, and I imagine that most other well-off individuals do as well.

    Time to fire up the printing presses, for the good of America!!

  • Report this Comment On July 27, 2011, at 12:34 PM, lefkowitz wrote:

    this article did not address what effect on stock market will be, if credit rating of US debt is lowered.

  • Report this Comment On July 27, 2011, at 12:53 PM, dbtheonly wrote:

    Lefkowitz,

    Do you remember what happened to the Titanic? The stock market will make it look tame. That's why I have stops on everything.

    But for the record:

    Financials, with Treasuries downgraded & thus worth less, book values drop.

    Interest rates rise so home buying stalls worse than ever. Construction suffers.

    Things will be much worse if ther is an actual default.

  • Report this Comment On July 27, 2011, at 2:16 PM, vrpirata wrote:

    @PostScience

    I’m not against printing money and having inflation as a way to reduce our country debt.

    What I’m against is for the privately-own-Fed to do the printing and then to charge us interest on the money they create out of nothing. It should be our Government the one that does the printing and as a result the money printed by our Government is interest free.

    The Fed buys real assets (US Treasury Bonds), taking ownership of our countries wealth with money created out of nothing. We are giving away our country to the Fed with every dollar we allow them to use to buy our debt. We (our government) should do the printing, not the Fed.

  • Report this Comment On July 27, 2011, at 2:32 PM, vrpirata wrote:

    If our Government did the money printing instead of the privately-owned-Fed, we will not only not pay interest on the money printed, we would also be debt free. Freeing billions of dollars needed to cover the Interest on our debt to the Fed.

    Because the Fed is the only entity that can print dollars, and every dollar is created in exchange of debt (US Treasuries). How can we pay our debt to the Fed when the dollars needed to cover the interest doesn’t exist? And therefore we are forced to be issue more debt to create the Fed-dollars to pay the Fed-interest?

    The only way out is to get rid of the Fed and for our Government to take back its constitutional right of printing our money debt and interest free.

  • Report this Comment On July 27, 2011, at 3:25 PM, Rubiksman wrote:

    This whole thing makes me soooo angry. It seems as though the people representing us aren't listening. Have you heard one "normal" person say, "I'm against raising the debt ceiling"? I haven't.

    Also, I don't understand why politicians are so firmly against cuts (Dems) or taxes (GOP). Don't they realize that a healthy medium is the way to go? And if there is a so called "Balanced Budget Bill" doesn't that imply raising taxes to meet expenses? Come on Washington!

  • Report this Comment On July 27, 2011, at 3:27 PM, TMFHousel wrote:

    <<Have you heard one "normal" person say, "I'm against raising the debt ceiling"? I haven't.>>

    Unfortunately, yes. Polls show a frighteningly high number of average Americans don't want the ceiling raised at all.

  • Report this Comment On July 27, 2011, at 3:35 PM, Rubiksman wrote:

    Ok, so I should have phrased that differently. Have you heard any intelligent Americans say that?

    I would consider my mom an average American, and you're right, she doesn't want it raised, and unfortunately trying to explain to her why it's bad is like talking to a brick wall.

  • Report this Comment On July 27, 2011, at 3:37 PM, DukeTG wrote:

    Can we change "normal" to "normal and well informed"?

    I have to believe that most of the "normal" people who say don't raise the debt ceiling are ignorant of what the debt ceiling really is, and of its history (has no connection to what Congress decides to spend, raised 80-ish times over the years, under both parties, always voted against by the minority, etc, etc).

    If a person understands all this and still says don't raise it, then as far as I'm concerned they are abnormal (and living in a cuckoo clock).

  • Report this Comment On July 27, 2011, at 3:40 PM, TMFHousel wrote:

    ^ Agree 100%.

  • Report this Comment On July 27, 2011, at 4:59 PM, stan8331 wrote:

    The debt ceiling is an abstract concept a lot of folks don't understand. If you ask the question "Are you in favor of the United States refusing to pay the bills it already owes when they are due?" I'm guessing well over 70% of the public would answer "of course not".

    Unfortunately, the small percentage of zealots who would answer yes seem to be running things in Washington these days.

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