Wall Street bracing for possible downgrade of U.S. credit

Wall Street’s top concern is no longer that the United States will fail to increase the federal limit on borrowing by Aug. 2 but that political leaders will fall short in their negotiations over an ambitious plan for taming the nation’s debt, according to financial analysts.

If President Obama and Congress are unable to reach such an agreement for reducing the debt, credit-rating firms — in particular, Standard & Poor’s — could cut the top-notch U.S. debt rating, sending a shock across U.S. financial markets.

S&P has said that raising the $14.3 trillion debt ceiling by the deadline, and thus avoiding a potential default, is not enough to avoid a downgrade. In any case, analysts say, many on Wall Street remain confident that Washington will cut a last-minute deal to raise the debt limit before the government runs short of money to pay all government bills and interest on existing debt.

But there’s not as much confidence about efforts to reach an agreement on debt reduction.

So Wall Street bankers have begun discussing plans for responding to a downgrade of U.S. credit, according to people familiar with the talks. Specifically, banks want to find ways to prevent a repeat of the 2008 financial crisis, when investors acting as a herd started demanding tens of billions of dollars in collateral from banks because of fears about their health.

Meanwhile, some financial firms have begun taking steps because of their own mounting concerns about what could happen in the bond market in the coming months. J.P. Morgan Chase has reported that some financial companies have started shifting from longer-term investments to bonds that will be paid back in the next seven days.

“The possibility that the United States could be downgraded for the first time is seeping into investor consciousness,” said Ajay Rajadhyaksha, the senior U.S. debt strategist at Barclays Capital.

Still, while concern on Wall Street is intensifying, it remains mild. Interest rates paid by Treasury bonds have stayed very low over the past few months — both at moments when political leaders appeared close to a deal and when they were far apart. Low yields suggest investors think there is little risk in holding them.

Even if the government fails to raise the debt ceiling, some analysts say, the expectation among investors is that the Treasury would use daily tax receipts to stay current on outstanding debt.

Political leaders, however, are increasingly worried that markets could turn against them at any time — and might be more likely to do so after the dramatic collapse Friday of negotiations between President Obama and House Speaker John A. Boehner (R-Ohio).

The speaker told GOP colleagues Saturday that he wants to announce a plan before Sunday night, when the the first signs of a market backlash could come, as exchanges open for weekday trading in Tokyo, Hong Kong and Shanghai.

Government officials are already planning for a potential failure to raise the debt ceiling. Tax revenue will allow Treasury to afford only about 60 percent of bills in August.

One key issue is whether the Federal Reserve, which handles payments on behalf of the Treasury Department, will be able to stop millions of electronic wire transfers from occurring if Treasury runs out of funds. Officials say they can stop all payments but that it could be difficult to change the systems so they can pay some bills and not others.

Another issue is whether investors will show up to buy Treasury bonds Aug. 4, when a large auction is scheduled. Treasury officials have been in talks with top domestic banks as well as foreign investors.

According to people on Wall Street, foreign central banks, one of the biggest investors in Treasurys, have signaled that they would continue to to buy the bonds. Other investors would also likely show up, officials have been told, but could demand higher premiums.

One of the major concerns turns on a short-term market where banks borrow cash from money market funds. Banks usually put up Treasury bonds as collateral.

Banks are worried that these funds, which are basically glorified savings accounts, will begin to demand more collateral if a downgrade occurs, which is what has happened in other countries that have faced downgrades.

If money market funds ask for more collateral, banks could suddenly face tens of billions of dollars in demand for new money, which could lead to a credit crunch.

Zachary A. Goldfarb is a staff writer covering the White House, focusing on President Obama’s economic, financial and fiscal policy.
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