What You Need to Know About the Debt-Ceiling Crisis

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Here's the headline of the year: Apple (NAS: AAPL) now has more cash than the U.S. Treasury. As of Wednesday, the U.S. government had an operating balance of $73.7 billion. Apple has $76 billion in the bank.

Laugh at that, feel free to shed a tear, and now here's the latest on the debt-ceiling debacle.

The House of Representatives has passed a bill to cut the deficit by just under $915 billion, raise the debt ceiling, and move toward a balanced-budget amendment in the Constitution. Both the Senate and President Obama have already indicated that the bill is dead on arrival. It's now up to each chamber of Congress to settle their grievances and craft a bill that can pass by Tuesday, when the Treasury says it will run out of cash if the debt ceiling is not raised.  

What is the debt ceiling? It's a self-imposed limit on the Treasury's ability to borrow. Reaching the debt ceiling does not mean the U.S. is bankrupt. Investors around the world are breaking down the doors at the Treasury to lend us money. This is a purely self-inflicted crisis.  

Importantly, raising the debt ceiling is not merely about making room for future spending. It's about Congress deciding whether it wants to pay for the laws Congress has already passed and is committed to. The ceiling has been raised 87 times since 1945, almost always without fanfare.

What happens to the government if the ceiling isn't raised? The Treasury says it will run out of cash on Tuesday. Others think higher-than-expected tax receipts could extend that by a few days. President Obama has indicated he's open to extending the debt ceiling for a few days if more time is needed to hammer out a last-minute deal.

If the Treasury does indeed run out of cash, someone won't get paid. Whether that ends up being bondholders who are owed interest -- meaning defaulting on our debt -- is unknown. The government will take in $2.1 trillion in tax revenue this year and owe around $200 billion in interest payments to bondholders. Yes, there's plenty of revenue over the course of the year to cover interest payments, but this isn't a fail-proof backstop. Money flows into the Treasury in lumpy amounts that can fluctuate wildly from month to month. It isn't a lack of annual revenue, but a cash-flow problem, that could cause the Treasury to default.

Furthermore, some legal scholars have indicated that the Treasury cannot prioritize payments to bondholders, but this is still a gray area. Others say the Treasury can't prioritize based on ethical arguments, such as paying Social Security checks in favor of defense contractors. In that case, payments might be made first-come, first-served.

Bottom line: No one really knows what will happen. We've never before faced this problem.   

What happens to markets if the ceiling isn't raised? That's the trillion-dollar question. In an actual default, there would undoubtedly be some degree of panic, particularly in the banking sector (think September 2008). Banks and money-market funds that rely on Treasury bonds as bedrock assets would be thrown into disarray. The financial system is held together by confidence. Losing it is not something you want to play with.

But the odds of default are low. More likely is a credit downgrade from one of the major rating agencies if a deal to raise the debt ceiling doesn't also significantly cut future deficits. This would probably push the nation's credit score from AAA (perfect) to AA (still good). All major rating agencies have the U.S. on "negative" credit watch, meaning a downgrade could happen in the near future. Historically, countries are downgraded 56% of the time they find themselves on negative watch.

A downgrade wouldn't be catastrophic, but it shouldn't be taken lightly. In general, an AA-rated nation pays more to borrow money than an AAA-rated nation -- interest rates are higher by 0.7%, on average. A rise of that magnitude could hammer the stock market and increase the cost of mortgages, credit cards, and other forms of borrowing.  

As I wrote this morning, a 0.7% rise in interest rates would add $100 billion a year to federal borrowing costs and could slow economic growth by around 1% a year. As a rule of thumb, that could cost roughly 1 million jobs.

What should I do with my money? Probably nothing. There's never a good time to panic, and decisions made during emotional upheavals are usually regrettable. If you were happy with your portfolio last week, you should be happy with it next week. This, too, will pass.

We've known this day was coming for almost nine months. Why are we just starting to vote days before default? Feel free to direct your frustration to your local Congressperson.

At the time this article was published The Motley Fool owns shares of Apple. Motley Fool newsletter services have recommended buying shares of and creating a bull call spread position in Apple. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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