What Happens if the U.S. Debt Ceiling Is Hit?

The national U.S debt is made out of bonds. Well, technically, they could also be a bill or a note, but for our purposes, we're going to call them all bonds. They're not just how the federal government takes out debt. Bonds can be given out by cities, banks, and corporations. Because a bond is basically an IOU, an investor buys a say, a thousand-dollar bond. The government or business pays them interest on it in installments, and at the end of the term, their thousand dollars back.

That amount of interest is based on how risky that bond seems to investors. Companies that have a long history of paying their debts, say Microsoft, pay a lower interest to bondholders. The bank Credit Suisse paid nearly 10 percent on some riskier bonds before those were wiped out when the collapsing bank was taken over. The higher the risk, the higher the reward.

Investors are always calculating what's the extra return they want for the extra risk they're taking. A lot of investors will ask, what is the return they would get if there was no risk at all? And their answer to that question has always been to look at the U.S treasury bond.

The U.S treasury is seen as the safest and soundest borrower on planet Earth, which is why it's considered a benchmark for all investments. A benchmark is really the base off of which a lot of other borrowing is done. A lender will want to have something larger than that benchmark that's considered to be the lowest possible rate. If the U.S treasury is issuing at four percent, then corporate bonds or mortgage bonds or other governments might issue it five percent or six percent. 

Cosider the 30-year mortgage rate and Triple A rated investments, considered the safest corporate bonds. They go up and down in relation to the U.S debt, which is always the lowest benchmark. It's kind of like the sun; everything revolves around that benchmark, that U.S treasury rate. It's more than just the rate of the bond; it's the bonds themselves that are so central to Wall Street firms, banks, companies. A lot of financial institutions keep money in U.S treasury bonds. It's just always expected that the U.S treasury is going to make good on its debt.

Bonds could be affected two ways by this debt ceiling debate. A contentious fight could make investors worry they may not get their money back on time, and as a result, they would most likely demand a higher interest rate for their risk. The same could happen if the big three credit rating firms have the same fear and downgrade the U.S AAA credit rating.

The worst-case scenario is if Congress doesn't raise the debt ceiling, and the U.S is unable to pay investors on time and actually defaults. Then U.S bonds, the benchmark, would be proven unsafe investments. If the value of the bonds goes down, financial portfolios would too. Investors would demand higher interest rates for their higher risk, and that would raise interest rates for everyone. It's kind of like being hit by a meteor when you don't have confidence that the benchmark itself is going to be paid off. It creates uncertainty in financial markets, and when there's financial chaos, very often, companies lay people off. So, everybody has a stake in this.

An analysis by Moody's looked at the different scenarios. If the default is brief and the treasury prioritizes paying investors but not, say, senior social security, the already fragile economy would have a mild recession with close to a million jobs lost. If the default goes on for weeks and investors aren't paid, the economic downturn would be comparable to 2008, costing more than seven million jobs and wiping out 10 trillion dollars in household wealth.

To avoid both scenarios, the House, Senate, and White House must agree to raise the debt ceiling before the June 1st deadline. Many experts call it a game of chicken, but a game where we all lose if they don't raise it before the clock runs out. Foreign party leaders were still debating raising the debt ceiling as the deadline to default got closer. But they do agree on one thing; defaulting on our debt is not an option. It will have catastrophic consequences as the U.S treasury uses tax revenue and debt to pay the country's bills, like funding government programs, Social Security, and paying interest on existing debt.

If it runs out of money and isn't able to pay these investors back, that's default, and that's what would happen if Congress doesn't raise the debt ceiling to allow the treasury to take on more debt. This would cause massive upheaval in financial markets, stock price is falling, interest rates rising, probably the dollar falling too, and that could affect a wide range of your own financial life. In a worst-case scenario, it could cause a whole new recession because U.S debt has become the core of the economy, from Wall Street to banks to interest rates.