Washington – The political stalemate in the nation's capital over the federal debt and budget deficits is increasing the chances of what seemed highly unlikely until very recently: that ratings agencies could downgrade the creditworthiness of the U.S. government.

If this happens, it'll send shock waves across the U.S. economy that will hit consumers and businesses, both struggling through a weak economic recovery.

The debt-ceiling debacle already is weighing on the economy. Here's a closer look at what a ratings downgrade would mean:

Q: What is a downgrade exactly?

A: When the United States issues government bonds, they're assigned a credit rating that reflects the risk of default on that debt instrument. Many pension funds and average investors are required to buy AAA-rated Treasury bonds because they're considered the safest.

Ratings agencies have warned that if they determine that whatever Congress does fails to improve the national debt outlook sufficiently, they may change the U.S. debt rating to AA or lower. That would mean the United States no longer is viewed as the safest of bets; investors instead would look to Germany, France, Great Britain and Canada as safer.

Q: Why could there be a ratings downgrade even if the debt ceiling is raised?

A: Moody's Investors Service and Standard & Poor's, when putting U.S. bonds on a credit watch in mid-July for a possible downgrade within 90 days, said they feared that the political stalemate could lead to a solution that didn't significantly alter the course of the mounting U.S. debt. Right now, those fears seem warranted.

Only an agreement that cuts at least $4 trillion over 10 years from the projected rate of debt growth would be seen as “significant.”

Q: If we're seen as a weaker bet than France, why does that matter?

A: For starters, the U.S. government would have to pay a higher interest rate to investors in its bonds, which would be viewed as a riskier asset. Since the United States already borrows to pay the bills it owes, that's the equivalent of having your personal credit rating fall and the interest rate on your credit card go up. Even if you borrow less, the rising cost will make reducing your debt harder. You enter a debt trap.

Q: OK, but that's the government. How would the private sector get hurt?

A: When Standard & Poor's put the U.S. government's credit rating on a negative watch list on July 14, it also put several insurers, financial clearinghouses, hedge funds and securities depositories on the list. That shows damage already has been done. Also on the list are AAA-rated securities issued by Fannie Mae and Freddie Mac, since these housing-finance giants are now in government hands after being taken over by the Bush administration.

Q: That's mostly Wall Street. How about Main Street?

A: Among those on the S&P watch list are insurance groups Knights of Columbus, New York Life Insurance Co., Northwestern Mutual Life Insurance Co., Teachers Insurance & Annuity Association of America, United Services Automobile Association and others. All have big holdings in U.S. Treasury securities.

S&P did stress that AAA-rated U.S.-based firms such as Microsoft, Exxon Mobil, Johnson & Johnson and Automatic Data Processing Inc. won't necessarily lose their top ratings. Corporate borrowers, many flush with cash, probably wouldn't see a downgrade.

Q: Are there local effects?

A: Numerous municipal housing bonds backed by the U.S. government are on the watch list, too, threatening local finances. If U.S. government debt gets a downgrade, the S&P and its main competitors Fitch Ratings and Moody's Investors Service will review state, county and municipal bond issues with an eye toward possible downgrades.

Moody's signaled July 13 that at least 7,000 AAA municipal credits and $130 billion in municipal debt linked to the U.S. government also could be downgraded. This would raise future borrowing costs for them. Moody's even added bonds issued by the governments of Israel and Egypt that are guaranteed by the U.S. government as up for a downgrade.

Q: How does this affect me directly?

A: Lots of U.S. lending rates are based at least in part on the interest rates on U.S. government bonds. These include mortgages, car loans and student loans. If there's a ratings downgrade and U.S. bond yields rise, that will spill over eventually into lending rates across the economy. This will add another head wind to the weak recovery.

Q: Just how weak is this recovery?

A: The Federal Reserve released its Beige Book of latest data Wednesday, showing the economy decelerating from May through July. Second-quarter growth numbers will come out Friday; they're expected to show very slow growth for the first half of the year.

“The U.S. economic picture for the first half of 2011 will not be a pretty one. One will remember the slowdown in the manufacturing sector, a bounce-back in the unemployment rate, weak housing, poor confidence and the debt-ceiling debacle,” Gregory Daco, U.S. economist for forecaster IHS Global Insight, wrote in a note to investors.

On The Web

S&P action on July 14

Pew report on states

Moody's action on July 13

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