The Debt Ceiling and You: Is It Time to Panic?

Until this point it would have been natural to assume that Congress would put aside partisan concerns and increase our borrowing capacity, as it has done 74 times since 1962. However, with the Aug. 2 deadline nearing and both parties continuing to bicker, investors need to consider how the looming debt-ceiling debacle could play out in our portfolios.

What's at stake if the United States fails to pay its bills? No one knows for sure, but things could get ugly.

• Last month, the International Monetary Fund warned that a debt default could spur "a severe shock to the economy and world financial markets."

• Yesterday, Credit Suisse cautioned that the stock market could fall 30% if the United States defaults.

• Skipping a payment to Treasury bond holders would almost certainly lower America's AAA credit rating, which would increase borrowing costs for the government, companies, and homeowners - and thus slow economic growth.

Thanks to Congress' last-minute gamesmanship, merely increasing our borrowing capacity may no longer be sufficient to stave off a credit-rating downgrade. When Standard & Poor's put the government's credit rating on negative watch last week, the rating agency warned that Congress and the administration must also provide a credible plan to address our nation's growing ratio of debt to GDP. With the two parties still far away from such a solution, the stock market is beginning to show signs of stress.

How Concerned Should Investors Be?

Should investors be concerned that the United States will lose its AAA credit rating? And if so, how should they prepare? To find the answers, I turned to two Motley Fool economic experts: Morgan Housel and Matt Koppenheffer. Although the current climate is scary, our experts agree: Selling into panic is rarely a successful strategy.

Rich Greifner: Guys, where would you place the odds that the United States will lose its AAA credit rating?

Matt Koppenheffer: To this point, I've remained optimistic and assumed that the likelihood of that outcome remained pretty low. With Aug. 2 right around the corner, though, it's hard to maintain that optimism. It's also important to remember that there isn't some clear calculation done to determine the credit rating, nor is it bond investors "voting with their dollars." It's a bunch of eggheads at Standard & Poor's and Moody's that wield this very significant power like Smeagol with his ring. As you pointed out, these folks may decide to knock the U.S. down a rung even if the debt ceiling gets raised in time.
Right now, I'm down to a coin flip - a 50% chance that the United States' credit rating falls at least one notch.

Morgan Housel: History backs up that 50% figure. We're on "negative" credit watch right now - basically, on the rating agencies' "naughty" list. And 56% of the time countries have found themselves on that list in the past, they've been downgraded.

The rating agencies have explicitly said that any plan forged by Congress and the president will need to cut the deficit by around $4 trillion over the next decade to avoid a downgrade. None of the proposals currently put forth by either political party come close to that. It's been frustrating to watch them submit plans that they have to know still risk a downgrade. I think it shows how seriously they're taking this matter.

Rich: Stock market experts are divided on the potential impact of a credit-rating downgrade. Some advocate moving to cash, while others believe a downgrade is already incorporated into current prices. Where do you stand?

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Morgan: I'm sure there'd be a short panic in the stock market, but long-term, I don't think it will be horrific. Where a downgrade could get us into trouble is in the federal budget.

If interest rates rise just 0.7% - which is the difference between an average AAA-rated country and an average AA-rated one - it adds $100 billion a year to the cost of servicing the national debt. It would also slow GDP growth on the order of 1% a year, which could ding employment growth by nearly 1 million jobs. I think this is where those who think a downgrade would be a flesh wound lose credibility - the economy is so large and we're in so much debt that even small changes in interest rates make huge differences.

Matt: With the standoff in full effect, there are really two downgrades that we need to think about. First is the "we raised the ceiling but the cuts weren't enough" downgrade. On that one I'm on the same page as Morgan - it would be bad, but it wouldn't turn the United States into a financial sinkhole.

The other scenario is if we don't get an agreement by Aug. 2 and there is a default of any sort, there could be much more severe consequences. I could float some thoughts on what could unfold in that scenario, but to be honest I'd rather not think about it. But if you're curious how the bond market feels about countries that scare them as credit risks, check out the current yields on Greek bonds.

Rich: Yikes! Final question: What advice would you give to investors as the debt-ceiling deadline approaches?

Morgan: Don't panic. Don't sell everything because you think the floor will drop out next week. That's the worst thing you could do. If things get hairy, be thankful for the opportunity to pick up your favorite companies on the cheap.

Remember one thing: The three best times in U.S. history to invest in the stock market were 1933 (during the Great Depression), 1982 (inflation scare), and 2009 (financial crisis). Market panics are detrimental only to the extent you allow them to be.

Matt: Panicking rarely does anybody any good. Particularly in the stock market. Or with bears, fires, or a potential NFL lockout, for that matter.

As I've watched this lunacy unfold, I've been looking over my own portfolio, and I'm pretty satisfied that I own high-quality companies at good prices. I also have a decent chunk of cash. If the market does sell off, I may see some near-term losses, but I'm confident that the returns over the longer term will still be attractive. Meanwhile, I could get the chance to pick up some more of what I own - and maybe some of what I don't - at better prices. For me, the magic of doing good work up front and buying right is that I don't end up feeling like the rug is about to be pulled out from under me at times like this.

See their profiles for more stock market analysis from Motley Fool analysts Rich Griefner, Matt Koppenheffer and Morgan Housel.