The delay over raising the U.S. statutory debt limit could cause the country's 'Aaa' bond rating to be downgraded, which would lead to a default on U.S. Treasury debt obligations, said Moody's Investors Service.

The rating agency yesterday placed the country's investment grade bond rating on review for a possible downgrade if the situation is not resolved on a timely basis.

On June 2, the rating agency announced that a rating review would be likely in mid-July unless there was meaningful progress in negotiations to raise the debt limit.

Moody's believes that there remains a real possibility that the debt limit will not be raised in time to prevent a missed payment of interest or principal on outstanding bonds and notes.

As such, there is a small but rising risk of a short-lived default that would fundamentally alter Moody's assessment of the timeliness of future payments, and a 'Aaa' rating would likely no longer be appropriate.

"However, because this type of default is expected to be short-lived, and the expected loss to holders of Treasury bonds would be minimal or non-existent, the rating would most likely be downgraded to somewhere in the 'Aa' range," Moody's said.

A downgrade would cause widespread damage and would immediately affect the 'Aaa' ratings of financial institutions directly linked to the U.S. government: Fannie Mae, Freddie Mac, the Federal Home Loan Banks, and the Federal Farm Credit Banks.  

It would also mean that any securities either guaranteed by, backed by collateral securities issued by, or otherwise directly linked to the U.S. government or the affected financial institutions would also be on the line for a downgrade, Moody's said.

In other words, any ratings of structured finance deals that are directly linked to the U.S. government would move with any future rating action that Moody's takes on the U.S. government.

These credits include RMBS with significant exposures to the guaranty provided by the GSEs, the U.S. Department of Housing and Urban Development,the U.S. Department of Veterans Affairs, structured notes fully backed by the U.S. Treasurys or agencies, ABS backed by FFELP student loans and CMBS with defeased loans fully secured by U.S. Treasury obligations.

"Transactions with concentrated eligible investment exposures to U.S. government credit risk are subject to potential event of default risk if an interest payment is missed," Moody's analysts said. "We do not expect placing the U.S. government under review for downgrade to affect the large majority of structured ratings because of their high credit enhancement levels, strong liquidity positions, and/or minimal reliance on the U.S. government credit."

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