Standard & Poor's has threatened to downgrade the U.S. sovereign rating, which is currently 'AAA', to 'D', meaning a default in the country's credit worthiness, if the government fails to honor U.S. Treasury debt payments. On this predicament, the IMF said: "At the opposite extreme, an excessively front-loaded adjustment could hurt the recovery. And a worsening of financial turmoil in European sovereign and bank debt markets could hurt U.S. growth through financial sector linkages.

Moody's Investors Service said early this month it expected to place the U.S. government's 'Aaa' rating on review for possible downgrade, if there were no progress on increasing the statutory debt limit by mid-July. If a debt-ceiling related default were to occur, Moody's would likely downgrade the U.S. sovereign rating. A rating in the 'Aa' range would be the most likely outcome.

John Chambers, chairman of the sovereign rating committee of Standard & Poor's, told Reuters on Tuesday that U.S. Treasury bills maturing on Aug. 4 would be rated 'D' if the government fails to honor them. Unaffected Treasuries would be downgraded as well, but not as sharply, he said.

"If the U.S. government misses a payment, it goes to D," Chambers told Reuters. "That would happen right after Aug. 4, when the bills mature, because they don't have a grace period."

Moody's warned on June 2 that it would put the U.S. rating under review for a downgrade unless there's progress on increasing the debt limit by mid-July.

Debt limit exhausted

Budget negotiations between U.S. President Barack Obama's Democrats and Republicans fell apart in Washington earlier this week.
The amount the U.S. government can borrow to help finance its operations is limited to $14.29 trillion and the government reached that borrowing limit in May. Treasury Secretary Timothy Geithner said that the U.S. needs to raise that limit as the U.S. Treasury Department is due to pay off $30 billion in maturing short-term debt on Aug. 4.

Geithner has pushed back against calls from a group of Republican lawmakers to prioritize paying interest on debt and cut spending instead of raising the debt ceiling.

Republican lawmakers have suggested that the debt limit should not be raised, and instead the federal debt be "capped" at the current $14.3 trillion federal debt limit. The Republicans have proposed that instead of raising the cap, the government pay interest on its debt, while stopping other government payments.

"The United States in now required to borrow approximately 40 cents for every dollar of expenditures. Your proposal would require cutting roughly 40 percent of all government payments. These deep cuts would be felt by all Americans, and they would risk throwing the economy back into recession," Geithner said in a letter to Republicans.

Increasing the debt limit is necessary to allow the United States to honor obligations previously authorized and appropriated by Congress, Geithner said.

"In August of this year, for example, more than $500 billion in U.S. Treasury debt will mature. Under normal circumstances, investors who hold Treasuries purchase new Treasury securities when the debt matures, permitting the United States to pay the principal on this maturing debt. Yet in the scenario you advocate, in which the United State would be defaulting on a broad range of its other obligations, there is no guarantee that investors would continue to re-invest in new Treasury securities. In fact, some market participants have already indicated that they would be disinclined to do so. As one of the major ratings agencies concluded in a recent report, failure to pay non-debt obligations "would signal sever financial distress and potentially imminent debt default," prompting the U.S. sovereign rating to be place on "Rating Watch Negative.""

Senator Jim DeMint and 16 other Republican Senators said in a letter to Geithner last month that capping the federal debt at $14.29 trillion would not, in and of itself, lead to default. "The Treasury takes in more than enough money from taxpayers to cover interest payments on the national debt. According to the Congressional Budget Office, tax revenue is estimated to be $2.23 trillion in Fiscal Year 2011 while net interest payments will only amount to $213 billion. Even if the debt ceiling remains where it is, there will be more than enough money in the Treasury to make the government's debt payments, thereby avoiding default," the Republicans wrote to Geithner.

Geithner in his letter yesterday, cited a 2010 comment in which DeMint was quoted as comparing the debt limit to a credit-card charge: "You don't have much choice if you charge something on your credit card. You have to pay it, and that's effectively what this debt limit is ... we've already spent the money. The question is now, do we shut down the government, or do we fund what we've already done."

IMF: shock to global economy

The U.S. economy continues to recover at a modest pace, but has hit a soft patch. Concerns about risks, including the lack of a credible deficit reduction plan, persist, the International Monetary Fund (IMF) said after wrapping up its annual review of the world's largest economy.

An IMF team, led by IMF Acting Managing Director John Lipsky, met with Treasury Secretary Timothy Geithner, Federal Reserve Chairman Ben Bernanke, senior government officials, and representatives from the private sector during May 27-June 27.

"The U.S. economic expansion remains only moderate. At the same time, there are significant challenges ahead that will need to be dealt with decisively if the expansion is to strengthen," said Lipsky at a press conference on June 29.

"The expansion could outpace our forecast if consumer confidence improves faster than we expect, but, on the downside, still-weak fundamentals pose risks to the housing markets. Moreover, a loss of fiscal credibility could cause an increase in interest rates or a sovereign downgrade, with significant global repercussions," he added.

"At the opposite extreme, an excessively front-loaded adjustment could hurt the recovery. And a worsening of financial turmoil in European sovereign and bank debt markets could hurt U.S. growth through financial sector linkages," Lipsky noted.
The debate over the debt ceiling has not yet been resolved. A failure to raise the debt ceiling would lead to a severe shock to the global economy, the IMF statement said.

The IMF has 187 member nations and lends money to countries with troubled finances.

Lock-step for related entities

Moody's said that ratings directly linked to the U.S. government would move in lock-step with the any sovereign rating action. These ratings include those on 'Aaa'-rated bonds issued by banks and others guaranteed by the U.S. government. It also includes Fannie Mae, Freddie Mac, the Federal Home Loan Banks and Federal Farm Credit Banks whose own 'Aaa' ratings are based on support from the U.S. government. The ratings on municipal supported transactions, pre-refunded municipal bonds, and structured securities that hold government linked debt as their primary collateral would also move in lock-step with the sovereign rating.

According to Moody's, the 'Aaa' ratings on U.S. companies, financial institutions, and the 'Aaa (sf)' ratings on structured finance transactions not directly linked to the U.S. sovereign rating would generally be resilient to a one- or a two-notch sovereign downgrade because the credit linkages to the U.S. government are sufficiently weak. Some 'Aaa'-rated states and local governments, however, may be more vulnerable to credit pressure under the circumstances that would lead to a sovereign downgrade and in turn more vulnerable to rating actions, says Moody's.