Saturday, July 30, 2011

What Happens If USA Debt Is Downgraded? (Video) *Disagreements on the effects*

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The Debt Ceiling Day of Reckoning is Tuesday, August 2, 2011
Ultimately the issue is confidence in the full faith and credit of the United States of America


AAA Credit Rating Even if the Congress reaches a debt ceiling agreement, unless it is a credible, medium-term fiscal plan the United States of America credit rating could still be downgraded. A short-term fix by Congress may not be enough. Moody's stated July 29 the USA should keep AAA credit rating, with negative outlook, if bondholders continue to be paid. Moody's had already placed the USA on review for a possible downgrade and previously said it would downgrade the United States to the "Aa" range, still considered investment grade, if the debt ceiling and budget is not resolve satisfactorily. Moody's has warned the USA to resolve the debt ceiling political deadlock or a short-term negative outlook rating is imminent. Fitch has stated they will cut the U.S. ratings to "restricted default" after a few missed debt payments. Previously, Fitch has stated that the USA would be placed on "watch negative" if Congress did not raise the debt ceiling by August 2. In addition, if the USA misses the August 15 coupon payment, then Fitch would place the USA rating on "restricted default". S&P in April had previously placed the U.S. rating on negative outlook, which means a downgrade is likely in 12-18 months. At that time, S&P cut the USA to a long-term negative outlook for sovereign credit. Now S&P has placed the USA on CreditWatch Negative with a 50% chance of a credit rating downgrade in the next 90 days. In addition, if spending is actually cut by any material amount, this will negatively impact the weak USA economy (and already has), rightly or wrongly, regardless of political beliefs. August 2, 2011 is the Day of Reckoning and a bi-partisan resolution of this problem does not appear probable, in our opinion.

USA Total Debt The USA has about $17+ trillion of funded debt that is currently rated AAA. This is compromised of $9.7 trillion is Treasury bonds, $7 trillion in FNMA (Fannie Mae) and FHLMC (Freddie Mac), FDIC-insured bonds, and other debt. There is also AAA state and municipal debt, but this is not guaranteed by the federal government.

What Would Happen? Since a USA credit rating downgrade from AAA to AA has never happened before, this is uncharted territory. One scenario is that nothing much happens, because U.S. Treasury bonds will continue as a safe haven plus the U.S. Dollar is the reserve currency of the world.  An extreme scenario is that Treasury bonds sell off, stocks will drop, and the cost of borrowing will rise throughout the USA financial system. Banks, insurance companies, money market funds ($2.7 trillion), pension funds, and retirement plans (401Ks) have huge holdings of AAA U.S. Treasury bills, notes, and bonds. Most likely, the holdings would continue as AA holdings if related regulations were changed. The $4 trillion repurchase agreement (repo) market could be affected by additional collateral requirements (providing more U.S. Treasury obligations as collateral), which could in some cases decrease liquidity.

Consumer Costs If U.S. Treasuries were downgraded to AA and interest rates rose on U.S. Treasury obligations, then consumer interest rates, borrowing costs, would rise. Mortgage rates are pegged to U.S. Treasury rates. FNMA and FHLMC (Fannie Mae and Freddie Mac) would also lose their AAA credit rating, being guaranteed by the U.S. Treasury, and their interest rates would rise. Mortgage rates would rise in an already depressed USA housing market. Potentially, other consumer interest rates such as for autos, credit cards, and student loans could also rise.

State and Local Governments There could be an indirect impact on USA state and local government borrowing, who already have their own potential credit problems. This would increase their borrowing costs via higher a interest rate environment. Moody's is reviewing 15 states and about 440 local governments for possible downgrades. Such downgrades would raise their borrowing costs even more.

What Happens if U.S. Debt Gets Downgraded? A downgrade of U.S. debt is looking more inevitable every day. What would be the immediate effects? Many believe nothing much happens. Others say America's financial backbone would be crippled. WSJ's Jason Bellini explores the likely scenarios.



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