UPDATE 1-Downgrade seen adding $100 bln to US funding costs

Tue Jul 26, 2011 2:01pm EDT

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By Steven C. Johnson

NEW YORK, July 26 (Reuters) - A downgrade of the United States' AAA credit rating is a bigger risk than a default and could over time add up to 0.7 percentage point to bond yields, members of a U.S. securities industry group said on Tuesday.

"That's on the order of $100 billion over time that we will add to our funding costs," said Terry Belton, global head of fixed income strategy at JPMorgan Chase. He was speaking on a conference call organized by the Securities Industry and Financial Markets Association, also known as SIFMA.

Over time, he said Treasury yields could rise 60 to 70 basis points on a credit downgrade -- "a huge number because we're talking a permanent increase in borrowing costs."

That would make it more costly for consumers and business to borrow money and could land the economy back in recession.

A default on the country's obligations would be even more disruptive, call participants said, and could ripple across financial markets, but was less likely.

The U.S. government hit its $14.3 trillion borrowing limit in May and the Treasury said it will run out of money to pay its obligations if the limit is not raised by Aug. 2.

An increase has been held hostage to political squabbling. Republicans in Congress have refused to lift the debt ceiling without a long-term deficit reduction plan but remain at odds with the White House over the proper mix of spending cuts and tax increases needed to do it.

Belton said the odds of a default were "virtually zero," noting that there were enough tax revenues to tide the government over in case a deal is not struck by Aug. 2.

Missing an interest payment "would be a far worse scenario and one I definitely think all members of the House and Senate would want to avoid," said Mike Hanson, senior U.S. economist at BofA-Merrill Lynch. He said it was "a low risk but, unfortunately, it is not zero."

FOREIGN DEMAND

Even if the debt ceiling is lifted and default averted, Standard & Poor's has said there's a one-in-two chance it could still cut the U.S. credit rating without a credible deficit reduction plan.

Investors think that means savings of $3 trillion to $4 trillion over 10 years. Republicans and Democrats are pushing competing plans, both of which fall short of that target.

In the short term, a downgrade would have a more subdued impact on markets, Belton said, with bond yields likely to rise five or 10 basis points.

Markets had feared a move to AA would spark forced selling, but Belton said "most investors have indicated they would be able to continue to hold them."

The "wild card" remains foreign demand over the longer run, sine the U.S. depends heavily on overseas investors -- mostly central banks -- to finance its deficit.

Belton said he expected demand for the $99 billion worth of fresh two-, five- and seven-year Treasury debt this week to be "on the weak side" and warned of even more concern if a debt ceiling impasse forces Treasury to postpone future auctions.

He said an eight-day auction delay surrounding a debt ceiling debate in 1995 cost the government 25 extra basis points in financing costs. (Additional reporting by Emily Flitter; Editing by James Dalgleish)

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