U.S. Credit Rating Drop ‘Inevitable’ Even With Deal to Stave Off Default

Only seven days stand between the U.S. and the effects of a credit default. But a downgrade of the nation’s stellar AAA credit rating seems a lot more likely, and a lot sooner.

The White House had been alerted repeatedly over the past month by rating agencies that without a strong, long-term plan to restructure the country’s debt, they would lower America’s credit rating as soon as this Friday, according to two officials familiar with the process. The White House was warned that the deal would have to be significant—and not a short-term fix over the next few days to avoid a credit drop.

Analysts with Moody’s and Standard & Poor’s, the nation’s top two rating agencies, declined to be quoted on the record, indicating that even benign statements about timing and ratings decisions can rattle markets and startle investors. But earlier this month, both agencies placed the U.S. government on notice of a downgrade of at least one notch, if not more, to a AA rating. In a written statement, S&P analysts said they believed "there is an increasing risk of a substantial policy stalemate enduring beyond any near-term agreement to raise the debt ceiling."

On that point, both agencies have been right. Having gotten back on track last week, negotiations broke down again on Friday after Speaker John Boehner announced that he was backing out of White House talks because of a lack of trust. A frustrated President Obama held a brief news conference Friday afternoon calling the move "hard to understand."

Efforts to raise the debt ceiling are back on track this week, but with decreasing good will between the parties. Senate Majority Leader Harry Reid had prepared a package carved almost exclusively around Republican demands, including major budget cuts and no tax revenues. Speaker John Boehner also crafted a package over the weekend that he could sell to Democrats, and perhaps more important, to his own caucus. But the parallel efforts indicate a widening divide between the parties and chambers, and a near-impossibility of bringing everyone together legislatively on one plan by week's end.

Taking his message to the country Monday night, Obama stressed how unprecedented it would be to see a credit downgrade. If the debate heads much further, he said, "For the first time in history, our country's AAA credit rating would be downgraded, leaving investors around the world to wonder whether the United States is still a good bet." Just minutes later, Boehner responded to Obama. He didn't mention the country's credit, but accused Obama of repeatedly wanting "a blank check."

Some analysts have given up hope for the U.S. maintaining its rating. “We’re at a point that the odds of having a downgrade make it pretty much inevitable,” says Peter Cohan, a financial analyst and head of venture capital firm Peter S. Cohan and Associates. "I see a downgrade as being inevitable. The question is whether markets see that as being significant."

With so many moving parts in the global economy, it’s difficult to measure the precise impact of a U.S. credit downgrade on the global economy. One specific effect would be a mass sell-back of U.S. bonds. Billions of dollars in outstanding bonds are held by people, countries, and agencies that only hold bonds guaranteed by AAA sellers. All of those would likely move immediately to sell in the wake of a credit downgrade, or change internal policies to retain the bonds. The ratings of all viable U.S. institutions, including Fannie Mae and Freddie Mac, would fall as well, potentially increasing mortgage-interest rates and borrowing costs on other loans.

More difficult to measure would be the loss of American financial prestige. Reduced confidence in the dollar, say some analysts, could result in reduced borrowing for U.S. economic growth. Difficulty getting credit could retard the economic recovery and send long-term waves through the financial system. Some parts of Wall Street have already begun to hunker down.

One of the best examples may be Japan, which had its credit downgraded in January from AA to AA-minus. The impact sent ripples through its financial system, causing the yen to fall compared with other major currencies, and steepened the cost of insuring debt it held from several other countries including Spain, Italy, and Ireland. But the U.S. impact could also be overstated. "I think it’s very open to question how much a ratings downgrade would make," says former IMF chief economist Michael Mussa, now with the Peterson Institute for International Economics. "But we can be sure it wouldn’t be a positive development."

Still on the table is the 14th Amendment option, a route where Obama would essentially raise the debt ceiling by executive order, thus bypassing Congress entirely, and at whatever limit he desired to get beyond the next election. The amendment, which states "The validity of the public debt of the United States…shall not be questioned," hasn’t been tested. Earlier this month, President Bill Clinton urged Obama to go that route and let Republicans take up issues of legality with the courts. Obama, however, has batted down the prospect several times, noting on Monday "that's not how our democracy functions."