Moody’s reiterates credit-rating threat

Moody’s Investors Service on Wednesday moved toward downgrading the Treasury’s AAA credit rating, considered the gold standard in world markets for most of the last century, warning that signs of a breakdown in the increasingly acrimonious budget negotiations have raised the likelihood of default.

The Wall Street agency said the U.S. rating will be cut to AA within weeks unless Congress raises the $14.3 trillion debt ceiling in time to prevent a delay in payment of principal and interest on Treasury bonds after Aug. 2.

The agency said it also will lower in tandem the triple-A ratings of major financial institutions linked to the federal government, including Fannie Mae, Freddie Mac and the Federal Home Loan Banks, setting off a tumultuous cascade in the nation’s most critical and sensitive financial markets.

Moody’s action, which was announced after the afternoon close of most Wall Street markets, could set off a sharp reaction in global markets when they reopen Thursday. The dollar immediately plummeted after the announcement in overseas trading, while the beleaguered euro - which has also been pummeled recently by growing debt woes within the Eurozone - rose at the dollar’s expense.

Prior to Moody’s action, Federal Reserve Chairman Ben S. Bernanke warned once again about the grave consequences of not raising the debt ceiling in time and said the U.S. is prepared to continue making principal and interest payments on Treasury obligations for as long as it can if the government runs out of borrowing authority - even if that means not making Social Security payments on time next month.

“Clearly, if we went so far as to default on the debt, it would be a major crisis,” he told the House Financial Services Committee, and that would “throw shock waves through the entire global financial system.”

Alluding to the impact on Fannie Mae and other institutions that are propping up the weak housing market by funding most mortgages made in the U.S. today, Mr. Bernanke said even a temporary delay in Treasury bond payments could “throw the financial system into enormous disarray and have major impacts on the global economy.”

To continue meeting its debt obligations, the government would immediately have to cut spending everywhere else by about 40 percent, he said, making “fairly significant cuts” to such cherished programs as Medicare, Social Security and military pay.

“It’s possible that simply defaulting on our obligations to our citizens might be enough to create a downgrade in credit ratings and higher interest rates,” not only on the Treasury’s debt, but also on loans taken out by U.S. residents and debt securities of U.S. corporations across the board, he said.

While Mr. Bernanke sounded a harsh warning to Washington, his remarks overall were soothing to markets as he raised publicly for the first time the possibility that the Fed would revive a controversial easing program it ended last month if the economy continues to falter and unemployment rises.

From Moody’s perspective, the financial crunch brought on by months of politicking and posturing over the government’s $1 trillion-plus budget deficits is getting perilously close.

“There is a small but rising risk of a short-lived default,” which - however brief and inconsequential for investors - would “fundamentally alter” Moody’s view of U.S. creditworthiness, the ratings agency said, because it would show a Congress willing to toy with the nation’s rating for political purposes.

Once downgraded, the U.S. could only reattain its previous top rating if Congress adopted a process that ensures that the debt ceiling will be raised in a timely way in the future, the agency said.

“A return to a Aaa rating would be unlikely in the near term,” Moody’s said.

Standard & Poor’s Corp., Wall Street’s other top credit-rating agency, has sounded similar warnings of possibly downgrading the U.S. rating.

Paul Coughlin, S&P executive managing director, said he expects the Treasury to give priority to debt payments over other government obligations, but he said such a monumental juggling act could only go on for a short time before the system breaks down. He noted that the Treasury may have difficulty finding investors willing to roll over the government’s existing debt at a scheduled auction Aug. 4.

Meanwhile, the damage to the U.S. economy would be enormous as the Treasury is forced to cut or delay nearly half the government’s spending obligations, he said.

“Moving to a balanced budget overnight” next month, as some in Congress have been advocating, “would constitute a profound shock to U.S. economy,” he said. “It would be as much of a shock as Lehman Brothers’ [bankruptcy in September 2008], maybe even more. It would be pulling out an enormous amount of demand overnight.”

A prolonged debt impasse, he added, “would imply a very profound debt shock and probably another recession in the U.S.,” not unlike what the economy just weathered in 2008 and 2009.