Debt Deal Doesn't Lift Threat of Credit Downgrade

An eleventh-hour deal to raise the U.S. debt ceiling may have postponed an embarrassing default by the U.S. government, but it does little to remove the threat of an imminent credit downgrade.

I think the threat of a downgrade is still very much alive, said Peter Cardillo, chief market economist at Avalon Partners, a New York-based financial services firm.

Indeed, Cardillo believes theres a 70% likelihood the U.S. will lose its coveted 'AAA' rating.

Unfortunately, the bottom line is that (the agreement announced Sunday to raise the U.S. debt limit) is not a one-shot deal to lower the deficit. It basically comes in increments. I suspect that may not satisfy what the credit agencies are looking for, Cardillo explained.

For months, the three credit rating firms -- Standard & Poors, Moodys Investor Services and Fitch -- have warned that they will downgrade U.S. credit if political leaders in Washington dont address the nations long-term debt problems.

The firms have strongly emphasized the long-term aspect.

Last month, both S&P and Moodys announced plans to review nearly all U.S. government issued debt as a result of Washingtons failure at that point to reach a deficit agreement.

To stress its point on the need for a long-term solution, Moodys said at the time that once their review was completed, any new potential rating would depend on whether a substantial and credible agreement is achieved on a budget that includes long-term deficit reduction.

The firms said Monday they still need to see the details of the deficit reduction deal before any decision is made on whether to remove or go forward with their threat of a downgrade. More cuts are needed to stabilize the U.S.s annual budget deficit-to GDP ratio, S&P told FOX Business.

On Sunday night, President Obama announced the broad outline of deal that would raise the U.S. debt ceiling while shaving $2.4 trillion in spending. The House and the Senate are expected to vote on the plan Monday or perhaps Tuesday.

The outline of the pact came just two days before an Aug. 2 deadline set months ago by the Treasury Department, which claimed the U.S. would run out of cash to pay its bills if no debt agreement was reached by then.

Broadly, the agreement raises the debt ceiling by $2.4 trillion in two phases and cuts $917 billion in spending over the next decade. The rest of the cuts -- $1.5 trillion worth -- will be determined later by a group of congressional leaders. Presumably, those cuts will come through a mix of tax reforms and savings squeezed from entitlement programs such as Medicaid and Medicare.

Meanwhile, on Monday afternoon the Congressional Budget Office issued a report saying the deal would save $2.1 trillion over the next 10 years. Either way, the figures fall far short of the $4 trillion in savings the credit ratings firms have demanded in exchange for allowing the U.S. to retain its 'AAA' rating.

To Cardillos point, while the deal staves off a default by the U.S. on its debt obligations by providing for funding past the Aug. 2 deadline, it may not go far enough to please the credit rating firms.

S&P has been especially pointed in outlining its deficit reduction goals. John Chambers, S&Ps head of sovereign ratings, said on a client conference call late last week that $4 trillion in cuts is merely a good start.

Critics are saying the debt proposal is too vague and merely postpones the hard decisions that need to be made regarding the spiraling costs of so-called entitlement programs approved over the years by politicians and now wildly popular with their constituents. Namely the health-care entitlement programs Medicare, Medicaid and the retirement benefits program Social Security, all of which threaten to bankrupt the country as millions of baby boomers approach retirement age.

For instance, the deal claims to cut trillions in spending, but the details of which government programs will affected must be decided at some future point by Congressional committees, enhancing the likelihood of more partisan bickering.

At a time when unemployment remains stubbornly high, deficit reduction has emerged as a key issue in next year's presidential election The numbers speak for themselves: the U.S. national debt stands at a record $14.5 trillion; the debt limit is $14.3 trillion, which needs to be raised to avoid a default; the U.S. is projected to run a record $1.4 trillion federal deficit in 2011.

Mohamed El-Erian, chief executive of bond fund giant PIMCO, said in an interview Monday with ABC News that the debt limit agreement would provide some temporary benefits by removing the threat of default. But this relief will be short, he said.

We have one rating agency out there that said it would downgrade unless certain things happen, and these things are not happening fast enough. If the U.S. loses that 'AAA' status, it will be much more difficult for the U.S. to restore growth, so its unambiguously bad, El-Erian continued.

Analysts have said a credit downgrade would likely have swift and severe repercussions across the global financial landscape.

For decades, U.S. Treasury bonds have been viewed as the safest of all investments. A downgrade would change that perception. If U.S. debt is viewed as riskier than it once was, the interest rate paid to purchasers of that debt will increase, making it more expensive for the U.S. to issue debt.

And since the interest rates of many types of debt issues are tied to U.S. Treasuries, interest rates across the board will rise, making it more expensive for state and local governments, as well as many corporations, to issue debt as well.

At the same time, Cardillo believes the initial reaction to a downgrade will be dramatic, but that the markets will adapt and recover. U.S. debt is still safer than most other debt being issued around the globe, he noted.

Does a downgrade mean people wont buy U.S. Treasuries? Probably not, he said.