(Refiles to clarify U.S. triple-A credit rating in 11th paragraph)
By Tim Reid
WASHINGTON, June 28 (Reuters) - Budget talks to win an urgently needed increase in U.S. government borrowing authority have entered a critical stage, with President Barack Obama now leading negotiations with Republican lawmakers.
Here are some possible scenarios for how a debt limit deal might or might not be passed by Congress before Aug. 2, when the Treasury Department says it will run out of ways to service government debt without an increase in the borrowing cap.
The focus of the Obama-led talks is to get a package to slash the long-term deficit. If substantial savings can be identified — up to $2.5 trillion over 10 years — then enough Republicans will probably agree to a corresponding raise in the $14.3 trillion borrowing cap. A roughly $2.4 trillion boost in the debt limit will allow the United States to meet its obligations beyond the November 2012 presidential election.
Any deal needs to allow enough time for Democrats and Republicans to sell it to rank-and-file members and then get a vote through both the Republican-controlled House of Representatives and the Senate, where Democrats have a majority, before Aug. 2.
The best outcome, in terms of keeping markets calm and reassuring investors, would be for Obama and House Speaker John Boehner to reach a deal early in July. Yet this seems increasingly unlikely, for both sides appear to be digging their heels in. The White House says any deal must include additional revenues but Mitch McConnell, the Republican leader in the Senate, has flatly rejected the idea.
In deficit-reduction talks led by Vice President Joe Biden, the two Republicans in the negotiations — Representative Eric Cantor and Senator John Kyl — rejected the idea of closing tax loopholes as a way to raise revenue, including tax breaks to big oil companies and the owners of corporate jets. The talks collapsed last week after they walked out over the tax issue.
Given the current stalemate, there is a strong likelihood that talks will drag on through July. A last-minute vote in Congress to avert a U.S. default — similar to the late-night compromise that avoided a government shutdown in April — now appears to be the likeliest option.
What a final deal would look like is unclear. At the very least, the White House and Democrats may have to give substantial ground on Medicare, agreeing to significant cuts in the government-run program for the elderly, a key Republican demand.
In return, Republicans could agree to revenue-increasing steps such as limits on mortgage reduction relief for the wealthy and the repealing of an ethanol blenders credit. That could help get the Democratic votes needed to pass the debt ceiling increase. Some Republican lawmakers also appear open to bigger cuts in defense spending, especially as a way to avoid tax hikes.
But a last-minute deal carries substantial dangers.
Three credit-rating agencies — Standard & Poor’s, Moody’s Investors Service and Fitch — have warned that they could strip the United States of its coveted triple-A credit rating if Congress fails to raise the borrowing cap by Aug. 2.
Moody’s warned that if substantial progress on a debt deal is not made by mid-July, it expected to place the U.S. government’s rating under review for a possible downgrade.
Although markets continue to remain calm, with yields on U.S. Treasury bonds very low, the credit-default swap market is already reflecting the growing uncertainty. CDS contracts on U.S. debt — insurance policies on the risk of default — have risen substantially in recent weeks.
“After July 4, if there is no progress, investors will start growing increasingly anxious,” Mark Zandi, chief economist at Moody’s Analytics, told Reuters.
SHORT-TERM DEBT LIMIT RISE
With the White House and Republicans far apart on the issue of taxes, and with just over a month until the Aug. 2 deadline, some lawmakers believe a short-term deal to raise the borrowing cap by just a few months is becoming a serious option.
Such a deal would probably include spending cuts identified in the Biden talks with a commensurate debt ceiling rise until, perhaps, the beginning of 2012. The U.S. Treasury burns through $125 billion in credit each month.
Dick Durbin, a leading Senate Democrat, and McConnell have both raised the possibility of a short-term boost.
But they have received swift rebukes from their own parties. Conservative Republicans, especially in the House, are loathe to cast multiple votes on increasing the U.S. debt ceiling.
Both parties recognize that revisiting the controversial issue in the midst of next year’s election campaign could play badly with voters already deeply worried about the sputtering economy and high unemployment rate.
Markets will likely react badly to a short-term increase.
“The muddle-through notion ... requires another decision later to kick the can down the road, and then you don’t know how it’ll get kicked the next time,” said Adnan Akant, head of foreign exchange at Fischer Francis Trees & Watts in New York.
“So it brings fear that the next time it’ll get kicked worse.”
There is the possibility that the debt limit will be raised several days after the Aug. 2 deadline.
This could happen if talks drag on past July or an eleventh-hour debt ceiling vote initially fails. Lawmakers will be mindful of what happened when the House initially failed to pass the Bush administration’s bailout of the financial sector in September 2008 — stocks plunged nearly 800 points in response and a chastened House approved the bailout a few days later.
Moody’s has said that a ratings downgrade would likely occur “shortly after” a debt ceiling default, indicating that if a deal looks to be within reach when the Aug. 2 deadline is passed, then Congress has a few days’ grace to boost the borrowing cap before a downgrade.
But it is unlikely that the markets will remain calm in the event that the deadline is missed, even for a few days.
Having had months to reach a deal — U.S. Treasury Secretary Timothy Geithner began issuing warnings to Congress about the debt limit in January — a missed deadline will signal that the White House and Congress are not capable of solving the country’s long-term deficit problems, rattling investors and major creditors, such as China.
Geithner and Ben Bernanke, the Federal Reserve chairman, have repeatedly warned that failure to raise the debt limit will have “catastrophic” repercussions for the U.S. and global economy.
A default will likely lead to market panic, a devastating spike in interest rates, lack of credit, a plunging U.S. dollar and another, potentially more severe, recession, with repercussions for the global economy.
Geithner insists there is no “Plan B” if the U.S. begins to default and that he cannot prioritize payments with funds available.
Analysts say that in the event of a default, the U.S. Treasury will have no option but to pay interest on the debt first, so that no payments to creditors are missed.
Treasury will then have to decide who to pay next, and how much. About $23 billion in Social Security checks are due to be paid on Aug. 3. Geithner will also have to decide in what order he services Medicare and Medicaid obligations, and paychecks for U.S. troops.
John Koskinen, the White House budget official who had to formulate a payment plan during two government shutdowns in 1995 — but never had to deal with a default — said there is no option but to prioritize.
If the federal government defaults, Koskinen said, you have to pay “the debt, Social Security, Medicare, Medicaid and defense. You need to pay as many people as possible who are expecting payment — and they are the key programs.”
“But once you have made those, you are already in the hole. You have to start looking at beginning to shut everything else down. Whatever you do, it would probably be the biggest financial challenge the government has had in its history.”
Editing by Ross Colvin and Philip Barbara