U.S. debt downgrade trigger a financial crisis?

As we approach Treasury’s debt-ceiling deadline, attention has shifted from the risks of a default on Treasury debt to the risk of a downgrade of U.S. credit. Many are asking whether a downgrade could itself lead to a financial crisis. With the example of 2008 still fresh in many minds, the question has become: Would it be as bad as the Lehman Bros. bankruptcy?

Some market observers speculate that a downgrade would be a non-event: Japan, for example, went from a rating of AAA to AA without much drama. Others suggest that a downgrade would increase Treasury’s borrowing costs by $100 billion a year or more, making our already unsustainable deficit trajectory even worse.

There are no rules to define what is systemic and what isn’t — or to accurately predict the consequences of an economic shock. Each crisis is unique. How exactly it will affect financial markets, companies and our economy is impossible to know. Nonetheless, recent examples offer guidance.

In 2008, a number of once-cherished beliefs were turned upside down: (1) that home prices in America would never fall; (2) that AAA-rated subprime securities are sound; (3) that a major investment bank would never fail. Consumers, investors and companies allocated capital according to these truths. When the beliefs were revealed to be false, massive shocks were inflicted on the economy as financial markets rapidly adjusted to account for these new risks.

Banks had to reduce their leverage and rein in lending. Companies froze investment. Consumers cut spending and started saving. As a result, the economy plunged into recession, and millions of jobs were lost. Unemployment shot to 10 percent.

The question now is whether U.S. Treasury bonds, which anchor the global economy, really are the gold standard, the risk-free financial instruments they have been trusted to be. What will happen if that truth is revealed to be false?

Four factors in particular can help assess the magnitude of the financial impact from an undermined truth:

(1) How strongly is the belief held?

In 2008, investors around the world generally believed that major U.S. investment banks were so large they would never be allowed to fail. In the six months leading up to Lehman’s bankruptcy, however, it came under increased funding pressure and its stock price slowly collapsed. Markets were not completely convinced that the government would have the will or the ability to save Lehman; otherwise investors would have continued lending to it, as they did to Fannie Mae and Freddie Mac, which had no trouble borrowing money before they were rescued only days ahead of the Lehman bankruptcy.

By comparison, U.S. Treasurys have been defined for decades as the risk-free financial instrument throughout global financial markets. Faith in Treasurys is far stronger than it ever was in Lehman Bros. This suggests a far bigger shock than Lehman if this truth is proven false.

(2) How big an asset class does the belief support?

U.S. Treasurys are a $14 trillion market — the single biggest security market in the global economy. In comparison, Lehman had approximately $600 billion of liabilities before it failed, less than 5 percent of the size of the Treasury market. Treasurys are held by virtually all 8,000 banks in America and nearly all insurance companies, corporations, pension plans and millions of individuals’ 401(k)s. This scale suggests a far larger shock than Lehman.

(3) How wrong was the belief?

Here, Treasurys are not as bad as Lehman. Even if the U.S. credit rating is downgraded, almost no one believes we will actually default on our debt. The United States is not entering bankruptcy, and its debt is not junk. Lehman debt ultimately proved to be worth a fraction of its face value. To some, this suggests a U.S. downgrade would produce a more modest shock than Lehman. But a small deviation from a cherished belief can be as shocking as a large deviation from a weaker belief.

(4) What is the economic context in which the shock is taking place?

Although the United States is technically no longer in recession, the U.S. economy is growing slowly. Unemployment remains at 9.2 percent. Europe is awash in its own fiscal crisis, and much of the developed world is struggling. When Lehman collapsed, U.S. unemployment was at 6 percent, but the economy was contracting and housing markets were plummeting. The global economic context in September 2008 was probably worse than today, but our economy remains vulnerable.

These factors suggest that a U.S. downgrade has the potential to be as bad or perhaps worse than the Lehman shock. The more strongly held a belief, and the larger the asset class it supports, the greater the potential damage to the economy when the belief is turned upside down. We may not be certain what will happen if U.S. credit is downgraded, but there is no upside to finding out.

The writer, a managing director of the investment management firm Pimco, served as an assistant Treasury secretary during the George W. Bush administration. He established and led the Office of Financial Stability and the Troubled Assets Relief Program until May 2009.

Gang Of SIX Plan Offers Hope

With just two weeks left until the federal government runs out of money to pay all of its bills, President Barack Obama seized on the "Gang of Six" plan as a "very significant step" and urged congressional leaders to start discussing it.

"My hope ... is that they tomorrow are prepared to start talking turkey and actually getting down to the hard business of crafting a plan that can move this forward in time for the August 2nd deadline," Obama said.

The U.S. government will default on its obligations by that date if Congress does not allow the Treasury to sell more debt. That could force the U.S. economy back into recession and wreak havoc on global financial markets.

White House talks on a comprehensive deficit reduction deal have stalled over tax increases, which Republicans oppose. Obama, a Democrat, said he hoped the "Gang of Six" proposal -- which would require each party to ease back from entrenched positions -- could help form the basis of an agreement.

A broad deficit reduction package would clear the way for Congress to approve an increase in the $14.3 trillion federal debt ceiling. A backup plan by Senate Republican leader Mitch McConnell has gained momentum as a way to raise the ceiling and may end up incorporating parts of the "Gang of Six" proposal.

Senate Budget Committee Chairman Kent Conrad, one of the six Democratic and Republican senators who have been working since December on a deficit reduction plan, said the proposed $3.75 trillion in savings over 10 years contains $1.2 trillion in new revenues.

'11TH HOUR'

Obama's decision to speak to reporters about the "Gang of Six" plan even before he had fully read it showed the sense of crisis that is enveloping Washington as the clock ticks toward the August deadline.

"The problem we have now is we're in the 11th hour and we don't have a lot more time left," the president said.

The stalemate on debt talks has shaken global markets and credit rating agencies have warned they might downgrade the U.S. top-notch AAA rating if lawmakers do not agree on a broad-based deficit reduction plan.

A $3.75 trillion budget cut plan would exceed market expectations, said RBS Securities Treasury strategist John Briggs in Stamford, Connecticut.

News of the "Gang of Six" plan sent prices of 30-year U.S. bonds sharply higher and helped push U.S. stocks to their best day since March.

The plan quickly won support from many senators, including some conservative Republicans, and was rapidly gaining traction despite the fact it includes tax increases. Republican Senator Roger Wicker said it could pass the 100-seat Senate with a healthy majority of 60 or 70 votes.

But some aides urged caution, saying even if the plan proves popular in the Senate, there may not be time to craft it into detailed legislative language and then have it assessed by the Congressional Budget Office -- a necessary step -- before August 2.

Speaker of the House of Representatives John Boehner, the top Republican in Congress, has some concerns with the "Gang of Six" proposal, his spokesman Michael Steel said, adding the plan falls short in "some important areas."

BACKUP PLAN STILL BEING CONSIDERED

The "Gang of Six" plan came as White House and congressional negotiators worked on the premise that the only viable political solution to avoid default might be the backup plan proposed by McConnell.

His plan would hand Obama the authority -- and the blame -- for raising the $14.3 trillion debt ceiling. Democratic Senate Leader Harry Reid has proposed changes to make it attractive to Democrats, including up to $1.5 trillion in spending cuts.

"If there ... we can improve upon the legislation that we are doing, I am happy to take elements of the Gang of Six and work with them to get that done," Reid said.

Reid said he would like to begin consideration of the backup plan as soon as possible. Aides said that likely would not be until Saturday due to procedural hurdles.

The No. 2 Republican in the Senate, Jon Kyl, said he expects the McConnell plan to be approved in the Senate.

Obama said the backup plan was an important fallback in case lawmakers cannot agree on a broad deficit reduction plan.

Moody's Investors Service analyst Steven Hess said the McConnell/Reid plan would avoid any immediate downgrade of the coveted AAA rating.

But he said the plan did not offer a big enough deficit reduction and could result in a negative outlook on the rating, a sign of a possible downgrade in 12 to 18 months.

In the Republican-controlled House, a vote was expected on Tuesday on a deficit-reduction plan that would drastically cut and cap spending and require an amendment to the Constitution requiring a balanced budget. Obama said he would veto it.

The vote is largely symbolic as the measure is unlikely to pass the Democratic-controlled Senate. But it gives Republicans a chance to argue the need for deep spending cuts.

That could give Boehner, loathe to see Republicans blamed for a debt default, political cover to pursue a deal including less dramatic spending cuts than his party has so far sought.

Who would follow Geithner?

Timothy Geithner said Thursday that he plans to stay on as Treasury Secretary for the foreseeable future. But that hasn't stopped speculation about who might take his place later this year.

Sources told CNN and other news outlets Thursday that Geithner is considering leaving the Obama administration later this year, once negotiations on raising the government's debt ceiling and cutting the budget deficit are complete.

Geithner's family is moving back to the New York suburbs where they lived before he took office so his son can finish high school there. And as the head of Treasury through the worst financial crisis in a generation, and the last key member of President Obama's original economic team still on the job, a desire to leave wouldn't be a shock.

Geithner tried to tamp down the reports of his imminent departure when speaking in Chicago Thursday by saying he wasn't planning on leaving anytime soon.

Still, economists and Washington experts were already talking about who might take over the high-profile job.

Near the top of the list is current White House Chief of Staff Bill Daley, a close Obama confidant and someone who was brought in at least partly because of his good relationship with the business community.

Before taking the job in the administration earlier this year, Daley had been an executive at JPMorgan Chase (JPM, Fortune 500). He also served as Secretary of Commerce in the second term of the Clinton Administration.

Also at the top of many lists is Erskine Bowles, the Democratic co-chairman of the president's bipartisan commission on cutting the budget deficit. Bowles, who had served as White House Chief of Staff in the Clinton administration, would be an relatively easy pick to get confirmed given the budget cutting emphasis in Congress today, according some experts.

But when contacted Friday, Bowles, 65, appeared to take himself out of running for the job, saying that he is not interested in any full-time job at this point in his career.

"I am looking forward to being useful in part-time endeavors," he said.

Investment banker Roger Altman is another name that has been mentioned, but his name has surfaced for previous openings on the Obama economic team without ever getting tapped for a position.

And White House Budget Director Jacob Lew, who has been central to negotiations on the debt ceiling and deficit reduction, is another name suggested by experts.

Jamie Dimon, chairman and CEO of JPMorgan Chase, who is often described as "Obama's favorite banker" is another prominent name mentioned. A spokesman for the nation's second largest bank holding company had no comment on whether his boss would be interested in the job.

Greg Valliere, chief political strategist, Potomac Research Group, said he doesn't think it'll be a good idea for Obama to pick someone from Wall Street, given the government help banking giants like JPMorgan -- along with rivals likeCitigroup (C, Fortune 500) and Bank of America (BAC, Fortune 500) -- received during the crisis three years ago.

"I just think that Wall Street is not the way they would go. It could be an albatross for this administration," said Valliere. "And having him berating [Federal Reserve Chairman Ben] Bernanke in public three weeks ago certainly didn't help his case."

Valliere said that he thinks Obama should try to go with a high-profile Treasury Secretary outside of banking and Washington -- someone like Berkshire Hathaway (BRKA, Fortune 500) Chairman Warren Buffett, an earlier supporter of Obama four years ago, or New York Mayor Michael Bloomberg.

"I think he should do something bold and swing for the fences. I think Mike Bloomberg would be an electrifying pick," he said. "The only problem is that he could stray from the reservation on the message. But he's an entrepreneur who knows about creating jobs."

Bloomberg has denied interest in an administration post in the past, and has said he intends to complete his term as mayor which runs through 2013. A spokesman in the mayor's press office declined to comment Friday.

But the political reality is that it might be impossible to get any replacement for Geithner confirmed by the Senate in the year before a presidential election, said Jaret Seiberg, a research analyst at MF Global Inc.'s Washington Research Group.

Seiberg pointed out that 44 Republican senators have vowed not to confirm any nominee to head the new Consumer Financial Protection Bureau because they want the new agency's powers substantially trimmed. The same political battle could lead that group to block a Treasury nominee as well, he said. Even Alexander Hamilton would have trouble getting confirmed today, he said.

"The problem is there is no ideal candidate out there," said Seiberg. "I think it's a Herculean task to get anyone through the Senate right now. That's why at the end of the day, we're likely to have Geithner stay in place."

Valliere said if confirmation becomes the major hurdle to a new Treasury chief, he could see Secretary of State Hillary Clinton moving over to Treasury, with Sen. John Kerry taking her spot at State. Past and current senators have an easier time winning confirmation than do outsiders, he said. And he said that the Treasury job has become a diplomatic job as much as a finance job in the current interconnected global economy