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Economists Warn Of 'Turmoil' Amid Threat Of U.S. Credit Downgrade

Moodys Downgrade

First Posted: 07/14/11 06:53 PM ET Updated: 09/13/11 06:12 AM ET

Major credit rating agencies have called the reliability of American government debt into question, warning that they could issue a punishing series of downgrades if Congress does not increase borrowing authority by early August.

A downgrade of U.S. credit, unthinkable not long ago, is now a real possibility. Even a brief debt default would prompt Moody's Investors Service to dock the government's sterling rating, the agency said Wednesday in a release. Another warning, issued privately to lawmakers by Standard & Poor's and reported widely, was perhaps even more chilling: Even if the government stays current on its debt payments but halts spending on other items due to the lack of a timely debt deal, the agency might issue a downgrade.

It's a prospect that has left economists and financial executives wringing their hands, sketching out scenarios that involve widespread panic, a freeze in markets and even a return to a 2008-style recession. The pronouncements of credit rating agencies, despite their battered reputations in the wake of the housing boom and bust, influence global markets on a daily basis. If the United States government, whose creditworthiness has long been the lynchpin of the global financial system, gets its rating downgraded, the consequences could be disastrous, experts said.

"Forget a recovery in housing," said Nariman Behravesh, chief economist of the economic research firm IHS Global Insight. "You'd get a sell-off probably in U.S. bonds. It's not a trivial matter. That would then influence corporate borrowing costs, it would influence consumer borrowing costs, it would influence mortgage rates."

Washington lawmakers remain locked in a debate over the terms of a debt ceiling increase, with Republicans insisting they will not vote to give the government more borrowing authority unless their demands for deficit-reduction are satisfied. Democrats and top economic officials, including Federal Reserve Chairman Ben Bernanke, have criticized that approach, arguing that it is irresponsible to threaten the full faith and credit of the U.S. as a means to trim the nation's budget.

If Congress does not raise the limit by Aug. 2, the nation will be forced to abruptly freeze spending, which could prompt a default, the Treasury has said. "We have no way to give Congress more time to solve this problem," Treasury Secretary Tim Geithner said in remarks Thursday.

Following through on a pledge it made in early June, Moody's placed the triple-A bond rating of the U.S. government "on review for possible downgrade" Wednesday, saying the probability of a default is no longer "de minimis." With negotiations seeming to grow only more contentious, the nation might not be able to do something as simple as pay its bills, thereby tarnishing its top rating.

A downgrade, which would imply that U.S. debt is no longer "risk-free," would likely send interest rates soaring as yields on Treasury securities would rise, economists said. That could freeze the flow of cash through the economy, as borrowing would likely be constrained.

Worse, it's not just the U.S. government's rating that would be downgraded. The ratings of thousands of borrowers are tied to the federal government's rating. Bonds issued by U.S. municipalities, the mortgage giants Fannie Mae and Freddie Mac and even by the governments of Israel and Egypt could have their ratings threatened, Moody's said.

Moody's would dock the ratings of at least 7,000 municipal credits if it slashes the U.S. government's grade, Bloomberg News reported.

"There is madness in Washington," David Kotok, chairman and chief investment officer of Cumberland Advisors, said in a recent note. "These fools and idiots we elect to represent us passed the programs and budgets that spent the money. The controversy over future spending has nothing to do with the existing debt ceiling."

Economists expressed exasperation at what some have called an "artificial" or "self-created" crisis. Although Moody's noted in its report that it was concerned about the absence of a long-term plan to reduce the federal deficit, the more pressing need -- the one that could prompt a downgrade if not done on time -- is raising the debt ceiling, the agency said.

"At this point, what we're waiting to see is an actual raising of the debt limit, regardless of how they get there," Steven Hess, lead U.S. analyst at Moody's, told the Wall Street Journal.

Despite the ongoing drama, Treasury securities seem to be hardly affected. Yields on 10-year U.S. debt are around 2.9 percent, roughly equal to the lowest value this year, which was reached in late June, according to Bloomberg data. An array of worrisome macroeconomic risks, including the sovereign debt crisis in Europe, has investors taking refuge in U.S. government debt, pushing down yields and increasing the value of their investments.

"Despite everything that's happened in Washington in the last day or two, most investors still think a settlement is coming and default will be avoided," said John Richards, head of strategy at Royal Bank of Scotland in the Americas.

But some investors are betting on default. The price of insurance contracts on U.S. debt rose nearly 8 percent on Thursday, reflecting an increased demand for those derivatives, the Wall Street Journal reported.

Some economists said a U.S. sovereign downgrade ultimately would not cripple the economy, as markets would adjust. There's no equivalent to Treasury securities, which serve a central role in the world's economy, said Kevin Logan, chief U.S. economist at HSBC. For that reason, investors would eventually learn to live with a lower rating, Logan said.

But in the short term at least, a downgrade could still cause disruptions, he said. Some entities are required to hold highly-rated securities, often to comply with regulations.

"If the triple-A government debt is suddenly double-A one day to the next, what does the entity do?" he asked. "Sell all it has? And if it does, what does that do to interest rates on all that debt?"

"It could create turmoil," he said, "as everyone tries to figure out what's the correct pricing for all this stuff."

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