Debt ceilingUntil this point it would have been natural to assume that Congress would put aside partisan concerns and increase our borrowing capacity, as it has done 74 times since 1962. However, with the Aug. 2 deadline nearing and both parties continuing to bicker, investors need to consider how the looming debt-ceiling debacle could play out in our portfolios.

What's at stake if the United States fails to pay its bills? No one knows for sure, but things could get ugly.

  • Last month, the International Monetary Fund warned that a debt default could spur "a severe shock to the economy and world financial markets."
  • Yesterday, Credit Suisse cautioned that the stock market could fall 30% if the United States defaults.
  • Skipping a payment to Treasury bond holders would almost certainly lower America's AAA credit rating, which would increase borrowing costs for the government, companies, and homeowners - and thus slow economic growth.

Thanks to Congress' last-minute gamesmanship, merely increasing our borrowing capacity may no longer be sufficient to stave off a credit-rating downgrade. When Standard & Poor's put the government's credit rating on negative watch last week, the rating agency warned that Congress and the administration must also provide a credible plan to address our nation's growing ratio of debt to GDP. With the two parties still far away from such a solution, the stock market is beginning to show signs of stress.

How Concerned Should Investors Be?

Should investors be concerned that the United States will lose its AAA credit rating? And if so, how should they prepare? To find the answers, I turned to two Motley Fool economic experts: Morgan Housel and Matt Koppenheffer. Although the current climate is scary, our experts agree: Selling into panic is rarely a successful strategy.

Rich Greifner: Guys, where would you place the odds that the United States will lose its AAA credit rating?

Matt Koppenheffer: To this point, I've remained optimistic and assumed that the likelihood of that outcome remained pretty low. With Aug. 2 right around the corner, though, it's hard to maintain that optimism. It's also important to remember that there isn't some clear calculation done to determine the credit rating, nor is it bond investors "voting with their dollars." It's a bunch of eggheads at Standard & Poor's and Moody's that wield this very significant power like Smeagol with his ring. As you pointed out, these folks may decide to knock the U.S. down a rung even if the debt ceiling gets raised in time.
Right now, I'm down to a coin flip - a 50% chance that the United States' credit rating falls at least one notch.

Morgan Housel: History backs up that 50% figure. We're on "negative" credit watch right now - basically, on the rating agencies' "naughty" list. And 56% of the time countries have found themselves on that list in the past, they've been downgraded.

The rating agencies have explicitly said that any plan forged by Congress and the president will need to cut the deficit by around $4 trillion over the next decade to avoid a downgrade. None of the proposals currently put forth by either political party come close to that. It's been frustrating to watch them submit plans that they have to know still risk a downgrade. I think it shows how seriously they're taking this matter.

Rich: Stock market experts are divided on the potential impact of a credit-rating downgrade. Some advocate moving to cash, while others believe a downgrade is already incorporated into current prices. Where do you stand?

Morgan: I'm sure there'd be a short panic in the stock market, but long-term, I don't think it will be horrific. Where a downgrade could get us into trouble is in the federal budget.

If interest rates rise just 0.7% - which is the difference between an average AAA-rated country and an average AA-rated one - it adds $100 billion a year to the cost of servicing the national debt. It would also slow GDP growth on the order of 1% a year, which could ding employment growth by nearly 1 million jobs. I think this is where those who think a downgrade would be a flesh wound lose credibility - the economy is so large and we're in so much debt that even small changes in interest rates make huge differences.

Matt: With the standoff in full effect, there are really two downgrades that we need to think about. First is the "we raised the ceiling but the cuts weren't enough" downgrade. On that one I'm on the same page as Morgan - it would be bad, but it wouldn't turn the United States into a financial sinkhole.

The other scenario is if we don't get an agreement by Aug. 2 and there is a default of any sort, there could be much more severe consequences. I could float some thoughts on what could unfold in that scenario, but to be honest I'd rather not think about it. But if you're curious how the bond market feels about countries that scare them as credit risks, check out the current yields on Greek bonds.

Rich: Yikes! Final question: What advice would you give to investors as the debt-ceiling deadline approaches?

Morgan: Don't panic. Don't sell everything because you think the floor will drop out next week. That's the worst thing you could do. If things get hairy, be thankful for the opportunity to pick up your favorite companies on the cheap.

Remember one thing: The three best times in U.S. history to invest in the stock market were 1933 (during the Great Depression), 1982 (inflation scare), and 2009 (financial crisis). Market panics are detrimental only to the extent you allow them to be.

Matt: Panicking rarely does anybody any good. Particularly in the stock market. Or with bears, fires, or a potential NFL lockout, for that matter.

As I've watched this lunacy unfold, I've been looking over my own portfolio, and I'm pretty satisfied that I own high-quality companies at good prices. I also have a decent chunk of cash. If the market does sell off, I may see some near-term losses, but I'm confident that the returns over the longer term will still be attractive. Meanwhile, I could get the chance to pick up some more of what I own - and maybe some of what I don't - at better prices. For me, the magic of doing good work up front and buying right is that I don't end up feeling like the rug is about to be pulled out from under me at times like this.

See their profiles for more stock market analysis from Motley Fool analysts Rich Griefner, Matt Koppenheffer and Morgan Housel.


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169 Comments

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Canis Lupis

First of all, the very concept of a "debt celling" makes no f*cking sense

August 02 2011 at 1:01 PM Report abuse rate up rate down Reply
Jennie

Well what happen to our money we put in their hands all our lives??? An the oil has been going down an guess what GAS has not moved down in over a week or so but it has been going UP. They don't have bills to pay out an I bet U they got their ck for the last year or should I say for years .

August 01 2011 at 12:19 PM Report abuse rate up rate down Reply
frank1946

There a no Savings in this Bill, loss of AAA Rating will cost $ 1 Trillion, net savings from reduction of Military
Activity $ 1 Trillion, CBO Basline over ten years is $ 1 Trilloin............................so Zero Spending Reductions !

Only in Washington, DC............................GOP/DEMS are only Gypsies ! Gyping Taxpayers one more time !

No wonder S & P is telling us it must be a net $ 4 Trillion cut ! Fiscal Year is Oct. 1 so all of this starts all
over again !

August 01 2011 at 1:09 AM Report abuse +2 rate up rate down Reply
goldaxe

They are all worried about being tossed out or worse.So they will toss us under the bus.

July 31 2011 at 11:26 PM Report abuse rate up rate down Reply
savemycountry911

It looks like the Republicans gave in to the takers of America.

July 31 2011 at 9:56 PM Report abuse +2 rate up rate down Reply
1 reply to savemycountry911's comment
bushsnitemare2

TISSUE?

August 01 2011 at 12:31 PM Report abuse +1 rate up rate down Reply
Iselin007

Somebody's paying for those outsourced jobs but don't look at us were the ones who have been ripped off.

July 31 2011 at 8:48 PM Report abuse -1 rate up rate down Reply
1 reply to Iselin007's comment
raspberriesoh

Won't matter anymore about the outsourced jobs. If manufacturing returns, it will be automated due to technological advances. This has been coming since Henry Ford's assembly line.

July 31 2011 at 8:50 PM Report abuse -2 rate up rate down Reply
Iselin007

Why panic now they let the jobs leave the country an tried to pump the economy with housing/loan frauds to cover it up. Raise the debt ceiling our pockets have all ready been picked!

July 31 2011 at 8:31 PM Report abuse +2 rate up rate down Reply
thagrus

BOHICA.......................Bend over here it comes again!

July 31 2011 at 8:23 PM Report abuse rate up rate down Reply
thagrus

A super congress ...............................what a way to pass the buck and kick the can down the road . What is wrong with our present congress are they not adept enough to do their job?

July 31 2011 at 8:13 PM Report abuse +4 rate up rate down Reply
1 reply to thagrus's comment
raspberriesoh

They are disgusting. Nuke the darn lobbyists and set term limits so we don't have to worry about our elected officials being accountable to anyone but those who elected them.

July 31 2011 at 8:46 PM Report abuse +1 rate up rate down Reply
hman570

yes the Congress is close to a deal that will leave the American with less then they had yesterday, while big oil, special interest, and the rich still don't have to pay any taxes? If this is not getting the shaft I don't know what is? It seem that Oboma is not a leader at all, for those of you that voted for him I hope the Change was worth it? Nothing but lip service, and he gave into the Republicians like a chicken looking at a fox! what do you think is going to happen with this Super Congress they are shoving down our troats, and we have no say in the matter, because the politicians think we are to dumb to make such decissions?? Well I hope that everyone remembers these days when they get to the voteing boths next election!!!! God help up all as the cuts are coming and coming big time, while the rich get richer and big oil makes billions off the people!!

July 31 2011 at 7:24 PM Report abuse +1 rate up rate down Reply
1 reply to hman570's comment
raspberriesoh

Hey -- wake up! Time to pay the piper. Did you think this unbridled gravy train was going to last forever? If we don't rein it in now, there will be NOTHING left for future generations. Quit being so selfish.

I'm disgusted because this was a real opportunity to make some significant changes to our tax code and meaningful debt reduction. It ended up being a dog and pony show. Our kids will pay the price.

July 31 2011 at 8:43 PM Report abuse +4 rate up rate down Reply