The pros on Wall Street are betting Washington will strike an 11th-hour deal to avoid a U.S. debt default and downgrade, but if they're wrong, small investors and ordinary savers could be in for a real shock.
The bond market took it in stride this week when Moody's and Standard & Poor's said they could cut the top U.S. credit rating if failure to raise the country's legal borrowing limit forces Treasury to default on some of its obligations.
If the Aug. 2 deadline comes and goes without a deal, though, a downgrade could drive up borrowing costs and pummel stock markets. Advisers worry that average savers who invest in retirement and college savings accounts could be hit hardest.
"If the U.S. defaults, every investor with a 401(k) or individual retirement account or a college savings fund would see account values plunge," said Greg McBride, senior financial analyst at Bankrate.com in North Palm Beach, Florida.
The worst case scenario would look a lot like 2008, analysts said, when the collapse of Lehman Brothers froze world credit markets and sparked frenzied asset selling.
"A lot of people lost 50 percent of their money and had to spend two or three years getting back to even," said Lance Roberts, chief executive of Houston-based Streettalk Advisers, which manages $400 million for mostly oil and gas industry retirees.
A default could knock up to 50 percent off the benchmark S&P 500 index, he said, which would set savers back again and hurt those with little time left to plan for retirement.
Total U.S. retirement assets were $18.1 trillion as of March 31, up 3 percent from the end of 2010 and just below an all-time high reached in the third quarter of 2007, according to the
Investment Company Institute, an association of U.S. investment firms based in Washington. Retirement savings accounted for 37 percent of all household assets through March, ICI reported.
Insurers and pension funds, typically large holders of Treasury debt, could run into trouble, too,McBride said.
"If pension funds have to sell at 97 cents on the dollar," he said, "they may have difficulty meeting their obligations."
As the world's safest asset, U.S. Treasuries are a mainstay of mutual and pension fund portfolios and are universally accepted as collateral because of their top credit rating.
A downgrade would make investors think twice about just how safe they are, and margin calls could unleash a wave of selling in stocks, hitting retirement savings hard.
"Investors would rapidly re-price assets to reflect the fact that Treasury debt is no longer risk-free. This is a connection that I don't think the average consumer makes," said McBride.
If investors start demanding higher returns for holding riskier U.S. debt, the rise in bond yields would crank up borrowing costs for consumers and businesses, which could tip a still fragile economy back into recession.
"If you're a borrower looking for a car loan, it's not going to be a good time to apply for one," said Kathy Jones, fixed income strategist at Charles Schwab in New York. "This is not an economy that needs the added stress this would bring."
U.S. growth slowed sharply in the first quarter of this year, and the pace of hiring ground to a halt last month, while the jobless rate rose to 9.2 percent.
Treasury says it will default if the $14.3 trillion debt ceiling is not raised by Aug. 2. Congress has balked, though, and wants the White House to commit to spending cuts first to rein in a budget gap that's running above $1 trillion a year.
Talks have not been going well.
Yet the bond market is still calm. Yields are hovering near historic lows, and even after Moody's warned that it would cut the U.S. rating if it defaults, the government's cost to borrow for 10 years stood at a paltry 2.91 percent.
Speaking before a Senate committee Thursday, Federal Reserve Chairman Ben Bernanke said a default would be a "calamitous outcome" and said higher interest rates would slow growth and raise the large U.S. budget deficit even further.
"So it is really going in the wrong direction in terms of fiscal stability," he said.
(Editing by Leslie Adler)