Top 6 Ways a U.S. Credit Rating Downgrade Could Cost Americans

Last Updated Jul 27, 2011 1:39 PM EDT


One day after President Obama used a televised national address to make a case for compromise, the White House literally started to think about a Plan B, recognizing that Congress still hadn't moved any closer to seeking a compromise deal.

The President can keep talking a big ticket, grand bargain-type deal, but the odds now seem infinitely long that Congress will agree to any large package. At this point, the scramble is to get any deal done to increase the debt ceiling before August 2nd. Neither the Boehner nor Reid debt ceiling plans that were proposed on Monday -- and that have no chance of passing both houses without serious compromises -- seek more than $3 trillion in deficit reduction over a 10-year period.

And that's $1 trillion less than the $4 trillion in deficit cuts Standard & Poor's says is needed to give the U.S. a solid chance of avoiding losing its AAA-rating. Both S&P and Moody's have issued warnings that the United States could face an unprecedented downgrade in its pristine credit rating if substantive progress isn't made on deficit reduction.
While it's still far more likely than not that Washington will indeed get the debt ceiling raised in time, there could nonetheless be collateral damage from Washington's lack of spine to get a bigger deal passed. We're now facing a best-case scenario where a last-minute debt deal is done under the wire, but in the ensuing months, one or more debt rating agencies may nonetheless decide to knock our stellar credit rating down because of the lack of substantive deficit reduction. In fact, some market watchers say a downgrade is inevitable. What's unknowable -- because it has never happened in the U.S. -- is what impact a credit downgrade would have on our financial lives.

Some possibilities:

1. U.S. borrowing costs rise $100 billion. With a lower credit rating, the theory is that investors will insist on being paid a higher yield to buy our Treasury debt. (Though Nobel Laureate Paul Krugman offers Japan's experience after it was downgraded as a counter-argument to the conventional wisdom.) A new report from JP Morgan Chase says a 60 to 70 basis point rise in lending rates could end up costing the U.S. an extra $100 billion in interest payments on Treasury debt. Standard & Poor's came to the same $100 billion conclusion nearly a month ago. For all the rhetoric about no new taxes, a downgrade that causes our borrowing costs to rise is effectively a tax hike. Same goes for states and municipalities; if there is a general rise in interest rates triggered by a downgrade, that impacts the borrowing costs for cities and states. Depending on the health of municipal coffers where you live, that could end up meaning higher taxes, or reduced services.

2. Variable rates tied to government benchmarks will rise. Any variable rate borrowing you do -- from an unpaid credit card balance, to private college loans -- would likely rise along with any move that pushes the prime rate higher.

3. Mortgage rates could rise as well. Same theory applies here. As rates rise, so, too, do mortgage rates. Just what the housing market doesn't need right about now.

4. Mortgage-backed bonds would likely face a downgrade. If the mother ship takes a downgrade hit, so will its close relatives, bonds issued by Fannie Mae and Freddie Mac. That could lead to price declines for mutual funds that own these issues.

5. Money market mutual funds could come under pressure. A few weeks ago, we were stuck on the potential consequences for U.S. funds with exposure to European bank debt, given the fiscal problems raging from Greece to Ireland, Italy, and Spain. Well, now we have to worry about the impact any hiccup in payment of U.S. Treasury payments could have on funds that hold lots of government paper. To be clear, this is an alarmist position. All the major bickering players in Washington have been unified in the need to raise the debt ceiling, and as long as that happens, Treasury will have no problem making its payments in a timely manner. In addition, even if the debt ceiling isn't raised by August 2nd, Treasury Secretary Timothy Geithner is hard at work on a contingency plan that would make hard calls on what bills to keep paying. You better believe Treasury debt is at the very top of the list. Not merely because of U.S. money market funds, but more importantly, we can't afford to skip payments to China, Japan, and other major consumers of U.S. debt. And the new word in D.C. is that Treasury may in fact be able to handle all bills for a week past the August 2nd deadline, before having to make any of those hard choices.

6. Foreign imports and vacations could cost more. A hit to U.S. credit quality would likely cause the U.S. dollar to weaken. That's good for U.S. exporters, but for U.S. consumers looking to buy foreign goods and travel abroad, a weaker dollar means paying more.

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    • Carla Fried

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