Answers to the 7 big “what-ifs” of debt default

July 29, 2011

The debt negotiations are getting down to the wire. Republican and Democratic lawmakers are scrambling to broker a deal to raise the country’s $14.3 trillion debt ceiling before Tuesday, when the Treasury will no longer be able to borrow funds to meet all of its obligations. That’s why major credit rating agencies are considering a downgrade of U.S. debt.

What does that mean for consumers? Here are some answers we compiled from Reuters Money experts:

Should I be worried that I won’t receive my Social Security benefit in August?

Not immediately. Social Security’s coffers are full enough to make the August payments. And cash flow is positive – the system generates more from current revenue than it spends on benefits and its own administrative costs. The main source of revenue is the payroll tax paid by employers and employees (the Federal Insurance Contributions Act, or FICA); other income sources include interest payments on bonds in the Social Security Trust Fund (SSTF) and taxes paid by higher-income beneficiaries.

Last year, revenue totaled $781 billion, while outgo was $713 billion. And even if funds aren’t on hand in a given week to pay benefits for timing reasons, the SSTF can redeem bonds to make up the shortfall.

But here’s the rub: the bonds are obligations of the U.S. Treasury back to the SSTF. A government debt default would put us in uncharted waters, and it’s entirely possible that the Administration could refuse to redeem bonds or divert payroll tax receipts to meet other pressing obligations.

Social Security advocates don’t agree on what might happen.

“[Obama’s statement] was a foolish bluff,” says Eric Kingson, co-director of the Strengthen Social Security coalition. “There’s no excuse for checks not being issued, and the White House’s willingness to use the threat is symptomatic of their lack of regard for the institution. Their willingness to use it as a negotiating chip is unfortunate.”

But Max Richtman, acting CEO of the National Committee to Preserve Social Security and Medicare, worries that the government might decide not to fund the interest on Social Security’s bonds, which would leave the program short of funds.

“We really don’t know — it’s completely uncharted territory. Social Security is cash flow positive if you count interest on the bonds. But which obligations will the government put at top of list of priorities, and who decides that? Is it paying the interest on those bonds? Will it be paying the military? There’s so much uncertainty as to who gets paid, how much and when.”

What if I just filed for benefits, or plan to file next month? Could I lose my benefits in the event of a government default?

No, but processing of your application could be delayed if the Social Security Administration is forced to lay off employees or shut down in the event of a government funding crisis.

Will interest rates on mortgages, car loans, student loans and credit cards rise?

Yes. Like any average Joe or Jane who misses a credit card payment, the U.S. will be socked with higher borrowing costs if it defaults on its debt. If the U.S. loses its coveted triple-A rating, which is expected, the cost to service its debt will rise. And that will have a significant ripple effect.

Greg McBride, senior financial analyst at Bankrate.com, says either a ratings downgrade or debt default would result in higher borrowing rates for consumers and businesses alike. “More of a concern is that a prolonged default could cause credit markets to freeze altogether, and we will have real problems,” he says.

It’s impossible to speculate how much rates will go up, he says. “There are a lot of variables at play. The downgrade will lead to a more modest increase in rates. However, that increase would be permanent.” Folks who have variable debt such as a credit card balance or adjustable-rate mortgage can take a little comfort in this: “You are going to see higher interest rates eventually, anyway, because rates are so low,” McBride says.

Alas, consumers won’t see higher rates on saving products, such as certificates of deposit or money market accounts. “Those products won’t improve until loan demand picks up, any downgrade or default will only hold back loan demand,” McBride says.

What’s the outlook for the U.S. dollar?

Fear that the United States will lose its AAA credit rating or even default on its debt is driving foreigners away from U.S. assets, and the dollar is taking the biggest hit.

Recent trading in currency markets indicates overseas investors have been voting with their feet. They have also been giving short shrift to recent Treasury auctions.

Traders say Asian central banks, among the world’s biggest dollar holders, have been steady buyers of alternatives to the dollar such as the Singapore dollar and other Asian currencies as well as the Canadian, Australian and New Zealand dollars. “Foreigners are at the vanguard of the drop in the dollar,” says Dan Dorrow, head of research at Faros Trading, a currency broker/dealer in Stamford, Connecticut. “I don’t think anyone expects a catastrophic U.S. default. But a downgrade will make them more aggressive in moving away from the dollar.”

If global investors lose faith in the dollar, that could weaken its dominant position in global trade and its role as the world’s reserve currency. Over time, diminished demand for dollars would make it harder for the United States to finance itself at low interest rates.

The bottom line? It will be more expensive to travel overseas, drink French wine or buy Japanese cars.

What’s the outlook for U.S. Treasuries?

The Treasury market has held up better than the dollar, but bonds haven’t been let off the hook entirely. Foreigners, who hold nearly half of outstanding Treasury debt, have been less active buyers at auctions this month. Still, the 10-year yield has held below three percent for most of July, less than a percentage point from its multi-decade low.

That’s partly because domestic investors have picked up the slack in recent debt sales, suggesting they see no alternative to U.S. government bonds even in the face of a default or possible downgrade.

Indeed, analysts say even with a downgrade, Treasuries would remain the benchmark for world fixed income markets, as Fitch Ratings noted this week.

Terry Belton, global head of fixed income strategy at JPMorgan Chase, said a downgrade would probably add just five to 10 basis points to yields in the short run. But it could cost the U.S. government up to 70 basis points, or about $100 billion, in added borrowing costs over time as foreigners look to invest their money elsewhere.

Will we still pay our soldiers?

While a group of Congressmen pushed forward a bill this week to ensure that the active military servicemen still get paid in the case of default, there’s no firm plan yet. The White House hasn’t made any assurances and either has the Treasury Department. Some financial organizations that service military clients, like USAA and the Andrews Federal Credit Union, have stepped up to say that they will advance pay if there is a default. “Rest assured, USAA has continued to manage its financial resources to meet our commitments to members in their moments of need,” says CEO Joe Robles in a statement.

What will a default actually mean for military members and their families? “The bigger concern has got to be interest rates,” says Sarah Gilbert, the wife of an army reservist and a personal finance writer who was formerly an investment banker. She says military families have been through pay stoppages before – during the last government shut-down, they actually halted all military pay a week early – but what will really hurt is if interest rates go up even a little bit. “There’s no wiggle room,” she says. “Military families are so dependent on debt because they have to move so much, they are living on small budgets and they are mostly young families that don’t have a lot of established savings. If interest rates go up, you’re looking at foreclosures, collections and not being able to pay bills.”

Is there an upside to higher interest rates?

Barry Glassman, president and certified financial planner at Glassman Wealth Services in McLean, Virginia, says higher interest rates are good for retirees and folks who have fixed mortgages. “I don’t know anyone with a five-year Treasury bond who doesn’t believe they won’t get their interest and principal back. If yields do jump, my clients would love 10-year Treasuries with a five percent coupon,” Glassman says.

But McBride of Bankrate.com says it’s going to be a bumpy ride for most folks. “There are no winners here. You’re best bet is to sit tight and pull the seat belt a little tighter,” he says.

With reporting from Mark Miller, Steven Johnson, Beth Pinsker and Linda Stern.

3 comments

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Posted by Dollar Index- issue of raising debt ceiling « Stockresearch52′s Blog | Report as abusive

it is really intersting not to see any american posting their thoughts and opinions on the issue that corcern future of their country. I think that they need to read this article with attention and they find out that losing the AAA credit rating note of the USA will trigger loss of the prosperity and wealth in the country. I think that this challange will concern the democracy of the usa in the following years. striping of the AAA credit note will cause the transition of the society from the status of middle class to the working class and poverty status. The corporate power will take the lead of the counrty following this transition.

Posted by Mahmut | Report as abusive

This is a oportunity for make the rich more rich, and the poor more poor… Why the middle and the low class of US will suffer more than the high class, that non mencion to the rest of the world that put the confidence in buying the bons of the US goverment, so my pension in the future will suffer for this… Even if I live and work in Chile! That is simply not fair…

Posted by Gaston_E | Report as abusive

The first people who should not get paid are members of congress. They’ve been spending like idiots for 30+ year, and the result is the current mess. A downgrade is needed in order to bring these nutsballs to their senses. They’ve been doing D work and now want an A grade. Ridiculous.

Posted by SteveBush | Report as abusive