Summarizing The Various Debt Plans And What Happens After The Now Assured US Downgrade

Tyler Durden's picture

For those confused by the cornucopia of assorted debt ceiling "plans" out in circulation, Citi's Amitabh Arora has released the definitive guide for what plan does what in terms of proposed deficit reduction, probability of passage of the Congress, Senate and the President, and likely outcome to the US rating. As table 1 below shows, UBS' prescient call from last Thursday that a US downgrade is inevitable, was spot on. It also explains why the entire sellside industry, and media, have been in damage control over what now appears to be an inevitable AA rating of the world's reserve currency. Alas, just like with Lehman, nobody really has any idea what will happen to capital markets once the Poor Standards or Moody's headline of a AA cut hits the tape: one thing is certain - there are trillions in US invested money market funds, structured finance debt and munis that have rating mandates and demand a super secure (AAA) threshold, and especially an A-1+ short-term rating. Should there be a massive flow out of these securities and into other asset classes, the outcome is absolutely unpredictable. More importantly, Citi touches on a topic that has not seen prominent mention anywhere else: namely the acceleration of the GSEs status from conservatorship to receivership should there be no prompt resolution on the debt ceiling. For agency paper holders this may be a topic that merits much more diligence.

So without further ado, here is Arora's summary of how he sees the world:

  • We expect little chance of a large debt reduction package being passed by August 2nd. A package with the least controversial cuts (~$1.5 trillion) is the most likely outcome of the debt ceiling negotiations
  • We see a 50% chance of a rating downgrade to AA.
  • We see little forced selling from the main holders – central banks, commercial banks and money managers - of Treasury, agency MBS and agency debt. Accordingly, we see little market impact.
  • A ratings downgrade could significantly widen spreads in the government guaranteed student loan market (FFELP program) since investors in this sector require a AAA rating. The other securitized product markets should be relatively unaffected with exception of a few fully defeased deals (CMBS, CLO equity repacks and CLNs), which are invested in Treasuries.
  • Long-term municipal debt should be affected more by the spending cuts built in the package than by the ratings downgrade. Some short-term municipal instruments could be affected if the banks providing liquidity backstops are downgraded as well.

Here is the tearsheet table everyone has been waiting for:

Summarizing these various plans:

  • Extend (and Re-Visit) — Given the late date and lack of clear consensus, there is an increased probability that a temporary fix will take place. This could take the form of a very small increase ($100-250 billion) which would merely serve as a stop-gap to allow current negotiations to continue. This is a likely scenario only if it appears that a meaningfully break-through is at hand, but the time to get it through the political process would not meet the default deadline. This could also take the form of a larger increase ($1 trillion) that would allow negotiations to continue into 2012. This seems like a less likely outcome. The short-term version would likely avert a sovereign downgrade (assuming a large deal followed) while the longer-term version would likely result in a downgrade to double-A.
  • McConnell Plan — This is the plan that no one really likes, but is politically expedient. It solves the issue of raising the debt ceiling, gives politicians cover to not raise the debt ceiling and accomplishes very little on the long-term fiscal issue. The plan would raise the debt ceiling by a total of $2.5 trillion over two years unless a two-thirds majority revoked the increase. This is $300 billion cut relative to baseline forecasts that would need to be resolved by the President through spending cuts and with tax increases. It seems very likely this would result in a downgrade of the US sovereign to double-A.
  • ‘Gang of Six’ Plan — This is the most plausible grand plan available. It would reduce the deficit by just under $4 trillion over 10 years — likely enough to delay a downgrade of the US sovereign. Specific details of the plan are thin, but the plan appears to relay on about 75% on spending cuts and 25% on increased revenues. The trick it has is that it fixes the AMT, which allows it to increase taxes relative to the plausible baseline scenario while cutting taxes relative to the CBO baseline scenario. This trick gives it some hope to get through the Republican House that has pledged no new taxes. However, the tax increases will include reductions in mortgage interest and charitable contribution deductions that make that hope very low.
  • Cut, Cap and Balance — This plan requires that the deficit be cut in half next year, federal spending to be limited to 18% of GDP and for Congress to pass a Balance Budget amendment to the Constitution. Given the drastic cuts involved in the plan it would certainly allow the United States’ triple-A sovereign rating to be maintained. This plan passed the House of Representatives on Wednesday, but is very unlikely to pass the Senate and the President has stated that he will veto this bill if it is able to pass the Senate.
  • Default — Perhaps even more unlikely than the Cut, Cap and Balance is that no plan at all is reached prior to either a default on US Treasuries or a default on other US spending obligations. Obviously this event would lead to a downgrade of the US sovereign risk below triple-A. The rating agencies have differed on their guidance with Moody’s suggesting ‘Aa’ based on expectation of it being a shortlived event, S&P suggesting ‘SD’ or selective default and Fitch suggesting ‘B+’.

The downgrade is coming:

Given the likelihoods of each of these plans (or ones that resemble them) we think that the odds of a US sovereign rating downgrade are relatively high. Once again we want to emphasize that the likely outcome is based on long-term fiscal issues, not a debt ceiling breach. While we see very little chance of a default and massive US sovereign downgrade - we see a better then 50% chance that thedeal to increase the debt ceiling is not strong enough to prevent a downgrade to double-A in 2011.

Next, Amitabh looks at what the various UST holders will do in an event of a downgrade. Naturally, this is a very biased perspective:

We will split the above categories into five groups to discuss likelihood of reaction to a downgrade to double-A.


Household, Corporate & Government — Domestic households, corporations and government entities (including the Fed) are unlikely to sell a meaningful amount of Treasuries on a downgrade to double-A Most of these entities will have very US-centric portfolios and the lack of alternative US triple-A securities will likely result in investors maintaining Treasury holdings.


Financial Institutions — US Banking and insurance institutions are also unlikely to want to sell due to a downgrade to double-A. There is also no risk weighting impact of this type of a downgrade under any of the Basel frameworks. A downgrade into the single-A category could potential motivate sales from these institutions based on Base II/III. However, this is extremely unlikely in the nearterm absent a technical default.


Money Managers — The majority of money managers will not sell due to a downgrade to double-A Keep in mind that most are index benchmarked and the change in their benchmark would mostly mirror the change in their assets, absent an overweight to the assets that are downgraded.


Money Markets — Under a downgrade scenario to double-A it is expected that the US would continue to hold a short-term ‘A-1+’ rating which would mean that US Treasuries remain first tier securities. Therefore, we would expect that there would be limited selling of short-term Treasuries by money market funds. [ZH: we disagree completely with this superficial analysis]


Foreign Official — Central Bank and Sovereign Wealth Funds are likely to modestly sell and modestly reduce future purchases of Treasuries. We think that very few would be forced sellers at the double-A level — although some potentially could be. However, we think that this would forever change the view of US Treasuries as a riskless asset. In practice, this type of an action would likely slightly accelerate the diversification out of US Treasuries into other assets that have been under way for decades.


Other Foreign — We expect that there would be few forced sellers, but more sellers by choice in this category. It is more likely that these investors are in out of benchmark investments and these investors are certainly non US centric. While foreign financial institutions may have many of these securities matched versus US dollar liabilities, many investors are likely to look at other triple-A assets worldwide as a substitute.

And while all of the above is largely part of conventional wisdom, what isn't is the concern what a "no deal" outcome would have for the GSEs. In short: ugly.

Failure to reach a debt-ceiling agreement by August 2nd is a more threatening scenario for Agency MBS than a downgrade. The possible ‘no-agreement’ outcome introduces a few low-probability yet significant tail risks to the Agency MBS market:

  • Triggering of Receivership — If the Treasury is not able to transfer payments to the GSEs under the Treasury Preferred Stock Agreement, receivership of Fannie Mae and Freddie Mac will likely be triggered. However, a debt-ceiling impasse would need to last until at least September 30th for this outcome to become a real possibility.
  • Potential for Large-Scale Selling — If no debt ceiling agreement is reached, the US Treasury may accelerate sales of MBS in order to create room underneath the debt ceiling. If receivership is triggered, the GSEs will likely shed assets more quickly than the currently mandated 10% per year.

Triggering of Receivership


In the event there is no agreement reached on the debt-ceiling, the US Treasury will need to begin prioritizing its obligations. Such obligations include interest on the national debt, tax refunds, military salaries, Social Security and Medicare benefits, along with their obligation to Fannie Mae and Freddie Mac under the Treasury Preferred stock agreement. If the Treasury fails to provide funds to Fannie Mae and Freddie Mac through the stock purchase agreement, the organizations will likely be placed into receivership. In their 10Q, Fannie Mae notes receivership as a possibility if the government exceeds its authorized debt ceiling:


"Because of the credit-related expenses we expect to incur on our legacy book of business and our dividend obligation to Treasury, we will continue to need funding from Treasury to avoid triggering FHFA's obligation [to initiate receivership].

Although Treasury committed to providing us funds in accordance with the terms of the senior preferred stock purchase agreement, Treasury may not be able to make funds available to us within the required 60 days if providing the funds would cause the government to exceed its authorized debt ceiling.”

Fannie Mae would need to receive a payment from the US Treasury by around September 30th, 2011 in order to not be placed into receivership; the Treasury will very likely be able to fulfill this obligation. Even if an agreement is not reached by August 2nd, the US Treasury would still have two months to send payment to Fannie Mae without triggering receivership. In our view, the Treasury would choose to sell MBS and send the proceeds to Fannie Mae and Freddie Mac over missing the capital injection. Over the last year, payments to Fannie Mae and Freddie Mac have not exceeded $10billion per quarter (Figure 8).


Potential for Large-Scale Sales


If no agreement is reached regarding the debt ceiling, the potential for large-scale selling of Agency MBS arises from two sources:

  • US Treasury — In order to create room under the debt ceiling, the US Treasury may decide to accelerate sales of Agency MBS. At the end of June, Treasury holdings of Agency MBS totaled roughly $95 billion.
  • Fannie Mae/Freddie Mac — If the Treasury fails to fulfill its obligation under the Treasury Preferred stock purchase program, the GSEs will be placed into receivership and assets will be liquidated. At the end of May, Fannie Mae and Freddie Mac owned roughly $550 billion of Agency MBS combined.

Another question is what happens to trillions in structured credit which has a AAA floor:

Moody’s states that its A2 rating is a likely sovereign debt floor in order for a structured rating to qualify for triple-A. Below this rating, the probability of extreme loss scenarios would become more significant and inconsistent with triple-A structured ratings.

We hope to have much more data on the key structured finance variable shortly.

Next up, parsing the downgrade impact on munis, which is especially relevant to portfolios with rating mandates:

As rating agencies move closer to downgrading US debt, there is increasing (and justifiable) concern among municipal market participants regarding the potential impact on their market. In our view, we still believe that the possibility for a technical default due to a failure to increase the debt ceiling is remote. But then, a few months ago, we didn’t expect the political wrangling on the debt ceiling to come to such an impasse. Will we witness an instance of cutting off one’s own nose to spite one’s face? It remains to be seen.


There is a difference in the language by S&P and Moody’s regarding the conditions leading to a downgrade of US debt but in our view, a downgrade by both rating agencies is likely in the absence of a major deal on deficit reduction.


The possibility of a US debt downgrade will affect some municipal sectors more than others. Moody’s is reviewing the ratings of all directly linked munis (7,000 ratings/$130 billion) while indirectly linked munis may also be placed on review for possible downgrade. They have outlined the sectors that will be more affected, versus those that will be less affected, and we largely agree with their analysis


Directly Affected Sectors


Healthcare bonds, housing revenue bonds, pre-refunded bonds, federal highway grant anticipation bonds and GOs of states that are more closely linked to the federal government, among others.


Indirectly Affected Sectors


Higher education and other non-profit sector bonds, GOs of states that are less closely linked to the federal government and local GOs that are vulnerable to economic weakness but less reliant on Federal transfers, among others.


Less-Affected Sectors


Revenue bonds that have standalone ratings and are not reliant on the US for support, highly rated taxable university bonds, VRDNs with unconditional support backed by bank LOCs and tobacco MSA bonds, among others.


Portfolios that invest only in triple-A rated securities may seem limited, as the mandate is not directly visible, but rating restrictions can adversely affect muni holdings. Figure 14 shows the municipal holdings as of Q1 2011, and, below, we discuss the impact of a possible downgrade on the some of the larger institutional portfolios.

Mutual Funds: Most funds limit concentration risk along the rating scale of investment-grade securities. For instance, a high-grade tax-exempt portfolio might hold 20% of its assets in triple-A securities, 40% in double-A-plus securities and 40% in double-A securities. We note, however, that portfolio mandates can change. Still, Treasuries would be the benchmark, and deployment out of taxexempts due to the correlated downgrade should be muted.


Commercial Banks/Insurance Companies: Holdings are affected by risk weight-based capital requirements in Basel II and III. If risk weights go up, CAR goes down (CAR6 = Equity Capital/Risk-Weighted Assets). Commercial banks typically hold high-quality municipals, and, thus, the impact on risk weights should be low but not insignificant.


Tax-Exempt Money Market Funds: SEC Rule 2a-7 requires money market funds to invest 97% of their portfolio in Tier 1 securities. Typically, these are securities with a short-term rating of VMIG1/SP1/F1 or better but other clarifications may apply.

Depending on the size and extent of the downgraded, there could be some spillover affect of rendering a sizeable amount of TOBs ineligible on the long-end of the market.


Closed End Funds: Leveraged tax-exempt closed end funds, like other closed end funds, typically face risk from an inverted yield curve and asset coverage requirements. Currently the leverage ratios aren’t comparable to the levels seen in 2008 and we aren’t predicting an inversion of the yield curve. Thus, we expect the impact on closed end funds, which have duration of 10YRS and under, to be somewhat muted.

Lastly, a quick look at funding markets:

The standardized supervisory haircuts according to Basel III are show in Figure 17. But, in financing transactions, municipals require a higher haircut versus comparable corporate securities (Figure 18) because corporates are more widely accepted as collateral in the funding markets and are perceived to be a lot more liquid.

While the haircuts are unlikely to increase across the credit spectrum, muni financing transactions could be affected with regard to downgrade triggers, margin maintenance and substitution clauses. Lenders are typically required to substitute loaned securities with UST or cash in case the security is downgraded below BBB- /Baa3. In the event of a disruptive downgrade, we expect regulators to come out with guidance fairly quickly, much like the ECB did at the start of the Euro peripheral crisis.

Bottom line: the with the above just a sampling of the broad across the spectrum impacts, to say that anyone has any idea what will happen should the US go from AAA to AA is pure lunacy. And for anyone who plans on buying any rate exposed instruments (or, of course, stocks) on that "catalyst" we have two words: good luck.

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Archimedes's picture

But, but, but.....Timmy said "The US will NEVER lose it's AAA rating!".

Spirit Of Truth's picture

Ben promised him to print any money necessary to buy U.S. debt, so payment is guaranteed!

Investors: The $1 Billion Armageddon Trade Placed Against The United States

Ghordius's picture

I still don't believe the US will lose it's AAA rating this year.

Even in a glaring technical default the rating agencies are still paid by the TBTF banks and they would have to take up capital because of the Basle rules.

It's a great cover-your-ass-posturing-political-exercise. With a whoopee, we've found the way out parade at the end.

ibjamming's picture

It won't...Obama will declare that money will be created as needed...the Constitution says that the credit of the US will not be questioned.  The peole will agree because nobody who would riot, wants to be left without a check.

Transitory Disinflation's picture

Somewhere there is a room full of men all mass debating over the ills of the world.

mophead's picture

What will happen after a downgrade? Bonds will rally, watch and see.

SheepDog-One's picture

Tell it to mom and pops and the kids when theyre all moving back in. Enjoy.

SheepDog-One's picture

Effects of US going from AAA to AA? Surely better than expected, highly bullish. Besides, we've got a cool new 'Uber Congress'.

Id fight Gandhi's picture

You joke but you're probably right. Greece for all accounts has defaulted and the world now doesn't care, it did a few weeks ago, but who can remember back that far?

How much will rates go up as US bonds become more risky. Will the entities that hold aaa grade only jettison them as they no longer fit the risk model portfolio, or is this the new normal and keep on trucking?

Conrad Murray's picture

Exactly. The US can default and nothing will come of it. All the circle jerkers at the top will just change the rules if they fail to scare the money from their victims. No way they will take losses. There will be no implosion, there will be no loss of reserve status. At best there will be a dip to buy before all the sheep realize they've been had again.

downrodeo's picture

No one needs anyone we don't even just pretend...



GoinFawr's picture

David Bowie would like a word with you.

Id fight Gandhi's picture

Is anyone else like wtf? Why the stock market keeps holding up and the bond rates are so low?

GIANTKILR's picture

It's called: M-A-N-I-P-U-L-A-T-I-O-N!

Transitory Disinflation's picture

Treasury To Stop Funding Its Market Manipulation Fund To Delay US Bankruptcy

After pillaging the G Fund and Civil Service Retirement and Disability Fund (CSRDF), aka the Government retirement funds, Tim Geithner was just forced to resort to the final debt ceiling extension measure: suspending reinvestment in the Exchange Stabilization Fund, better known as the mechanism by which the Treasury manipulates the stock, bond and FX markets, often times indirectly (thank you Brian Sack and Citadel fat pipe) and on occasion with CIA assistance.

Tramp Stamper's picture

They can get more money from the cia slush funds that is holding all that money made from gun running and drug trafficking

Going Loco's picture

Anyone who is confused by the behaviour of the stock market in current circumstances needs to read this:

The author, Nadeem Walayat has been 100% right about 100% of the things he has written about since 2007 - in this article he explains why stock markets continue to rise and why 90% of people who read ZH and other similar blogs are doomed never to make money - our minds become numbed by fear.

ZH is a wonderful resource; I an amazed it is free and I will still use it to keep informed. But it is very important not to let fear grab you by the bollocks because if you do this you will never make any money.

mess nonster's picture

We are all pilgrims aboard the Patna, asleep on our way to the Holy City. The doomed ship drives on into the stillness, the rusted bulkhead slowly buckles under the immense pressure of the incoming sea...When did the crew let down the dory and escape? We will never know.

Troy Ounce's picture

The big problem is that governments are more scared of rating agencies than their voters.

This has to change.

Cash_is_Trash's picture

This has to change.

Nah, this fear is good.

; -)

Global Hunter's picture

and the ratings agencies are scared of the government

Id fight Gandhi's picture

Now that you mention GSEs how can we separate them from the national debt? All goes down together.

Sudden Debt's picture

Tyler, what do you think a downgrade would do to the stockmarket?

Greece it's stockmarket for example is at par with gold since the downgrades. Could the DOW do the same?

Id fight Gandhi's picture

Do you mean a purely numeric par? Gold,index?

I'm stunned that greece has defaulted and the euro barely budged.

lolmao500's picture

The AA rating is a joke. America should be downgraded way below that. It's gonna be interesting to see what China does/says when they see their holdings of $ lose hundreds of billions of value in a very short time.

SheepDog-One's picture

'AA' lolmao based on nothing but a printing press. People who think this is the 'new normal' are about to be rudely awakened....just think 'SS icewater bath plunge at 3 AM', and youre close.

SheepDog-One's picture

Once the endgame is complete, seizing everyones pensions and 401K's for 'Treasury annuitization', then they dont really care that everyone is 3rd worlded and starving.

$5 trillion sitting in ETF 401K's and pensions, and people think thats not the target? Please. 

They know the days of fleecing the public are over, bottom line you cant squeeze more golden eggs from the dead goose. 

wombats's picture

Why only downgrade to AA?  Isn't that just a slap on the wrist?  Wouldn't a downgrade to near Greece levels be far more realistic and honest?  Just asking...

Hansel's picture

The rating agencies have a policy of not downgrading anything until after they default.  Enron, Bear Stearns, AIG, GM, Greece, etc.

TomGa's picture



So much for bipartisan two-part plans... (from the Washington Post) 25 JULY 11  “The Speaker, Sen. Reid and Sen. McConnell all agreed on the general framework of a two-part plan. A short-term increase (with cuts greater than the increase), combined with a committee to find long-term savings before the rest of the increase would be considered. Sen. Reid took the bipartisan plan to the White House and the President said no.”



SheepDog-One's picture

Oh well so much for that...time for 'Uber CONgress'.

unununium's picture

This story might merit the introduction of a new background color for the pin.  Not the <blink> tag though.  Let's save that for CPL inbound missiles airborne.

oogs66's picture

Euphoria in Europe already seems to be done.

Franken_Stein's picture


Put the criminals in the clink !


the not so mighty maximiza's picture

The privately owned Federal Reserve will continue printing no matter what the congress does.

caerus's picture

There's also this...

Amendment XIV

Section 4. The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned. But neither the United States nor any State shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States, or any claim for the loss or emancipation of any slave; but all such debts, obligations and claims shall be held illegal and void.

RobotTrader's picture

Bears are not getting much traction on this news.

Bonds and stocks are not really off that much from their highs.

Version 7's picture

Folks are in extasy with the new layout.

andybev01's picture

The only bears that your typical Jane & Joe are interested in are in Yellowstone and messed up a couple of kids last week.

That's the only carnage that they understand.

Commander Cody's picture

Default means we wouldn't pay on our debt obligations.  We could meet debt obligations with the current revenue stream.  Only thing, there would be other things that might not get paid, like subsidies to corporations, salaries to the bloated government structure, bennies for thieves, etc.  Tough choice, eh?

AustrianEconomist's picture

A downgrade is a must if the rating system is not a complete fraud already. The US should be a CCC rating just above junk because that is reality. There is no way for the US to make any significant budget cuts, the US is bankrupt, end of story.

Check out the latest from the Capital Research Institute (CRI):

The Financial System - A House of Cards

Contra_Man's picture

Tonight on TMZ: "The NYSE's TMV"

Yardfarmer's picture

glass ceilings, debt ceilings and ceiling wax. the current media circus over the so-called "debt ceiling" is more smoke and mirrors over layering the 800 pound behemoth that has financial markets and the world economy in a death grip strangle hold-OTC derivatives. for that you might more appropriately require a debt galaxy with several black holes to absorb the insane and exponentially quadrillions of "debt" inextricably bound up with convoluted counter party madness. the architects of this universal economic iron maiden foresaw its consequences and they and their minions will mercilessly extract every penny in gold from the inviolable contractual obligations that encumber and are presently suffocating the institutional and sovereign entities upon which these vampires are battened 

hedgeless_horseman's picture

For what it is worth (very little) I believe it is sealing wax.

highwaytoserfdom's picture

Gang of six brekdown from 

To talk even remotly about liquidating the the five banks with derivative exposure which Paulson moved GSE's with these clowns called the "gang of six" only Corburm had a real job. Like Stephen Moore but his " Club for Growth" is a sham for stalling real growth..  Moore wors for WSJ owned by Newscorp.  You have  bankers and  FED cronies stopping job growth and iniovation...  Video rental? Is that the best we can do?   Here is tha "Gang profiles"  


remind you of the guy who figured this thing out  141 years ago.  

"The Rothschilds, and that class of money-lenders of whom they are the representatives and agents -- men who never think of lending a shilling to their next-door neighbors, for purposes of honest industry, unless upon the most ample security, and at the highest rate of interest -- stand ready, at all times, to lend money in unlimited amounts to those robbers and murderers, who call themselves governments, to be expended in shooting down those who do not submit quietly to being robbed and enslaved." Quote by: Lysander Spooner
(1808-1887) Political theorist, activist, abolitionist
Source: "No Treason #6" (1870)




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oldmanagain's picture

CNBC seems to believe that providence will provide a good outcome.  

Bush tax cuts are the real monster in the room.  Blaming SS is pure baloney. Medical expenses are going thru the roof but could be socialized and be much cheaper, and better.  Same with education.

The current debate favors the 2%.  They could win as they control the game. However, this outcome is not viable.  Many that now support the 2% are very rapidly going to see how bad they have been duped.

At some point, the globalists will be cut off, this is not good but probably necessary to start over on a more constructive path.  AS I write, I listen to a plea to help the our global banks with relaxed rules and rates.