It is widely assumed that Washington will raise the U.S. debt ceiling in a last minute deal prior to August 2.  But what would happen if Democrats and Republicans fail to come to a timely agreement?  Many difficult legal issues would be raised.  Washington could find itself in uncharted legal territory.

The U.S. debt ceiling has been raised more than 70 times.  Most of the time, this process has not been controversial.  However, this time the debt ceiling debate has polarized Washington.  Republicans are demanding massive spending cuts, without tax increases, in exchange for their support for raising the debt ceiling.  Democrats are countering with a mixture of spending cuts and tax increases.

The debt ceiling is currently set at $14.3 trillion.  Until the debt ceiling is raised, the federal government can spend only from current revenues.  Treasury Secretary Tim Geithner has informed Congress that without being able to issue new debt the government would reach the point where it can spend only from current revenues on or around August 2.  Currently, Treasury needs approximately $125 billion in credit each month.  If the debt ceiling is not raised, the government would be forced to radically reduce spending.  Approximately 40% of current federal spending is borrowed.

While the prospect is still considered remote, a failure to raise the debt ceiling in a timely manner could raise a number of difficult legal issues.  Among these issues are the following:

First, fundamental legal questions would be raised about which creditors of the United States would be paid in the days following August 2.  The U.S. Treasury would continue to receive revenues after August 2 (although not enough to pay all of its bills on a current basis).  Who would be paid on time and in full?  Treasury bond investors?  Social security recipients?  Soldiers fighting overseas?  There is little legal precedent for these questions.

Second, credit rating agencies could downgrade the credit rating of U.S. debt, which would have complex legal, economic and market psychology knock-on effects.  Credit rating agencies have stated recently that they would probably downgrade the U.S. credit rating if the government fails to increase the debt ceiling.  Such a downgrade could have a variety of significant implications.  The cost of servicing future U.S. debt could go up.  Foreign investors might diversify away from investing in U.S. debt.  From a legal perspective, a downgrade of U.S. debt would be highly significant because the terms of numerous financial contracts and investment mandates require AAA ratings for certain types of investments.

Third, given that trillions of dollars of Treasury debt are used as collateral across the financial system, a delay in raising the debt ceiling could upset the infrastructure that facilitates daily trading.  The contractual arrangements underlying collateral arrangements are complex.  In most collateral arrangements, contracts are quite specific about the type of collateral that must be provided.  If the terms of these contracts cannot be fulfilled, trading can be affected very quickly.  As witnessed during the recent financial crisis, stress in one market can quickly affect others given the high degree of interconnectedness of markets and certain asset classes.

The investment community appears to be sanguine about the risk that the United States could lose its AAA rating.  This is reflected in the fact that Treasury bond yields are currently at very low levels.  But nonetheless, the issues raised by the possibility of U.S. debt being downgraded are real and are worth close attention.

Certainly, the White House and Congress need to seriously discuss federal deficits, the debt ceiling and spending priorities, especially as the economic recovery remains soft.  But four weeks is a very short time to be acting on proposed spending cuts of as much as $2 trillion over ten years.  Fundamental, large-scale fiscal reform should be worked out in an open, transparent and thoughtful manner.  Hopefully, the potential risks associated with a downgrading of U.S. debt will focus minds in Washington as they debate federal deficits and raising the debt ceiling over the next few weeks.