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: 

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.