Will Congress Let US Default, Stocks Crash to Get a Deal?

Investors and analysts say there is a possibility that some members of Congress would knowingly let the US default on its debt, causing a market collapse that would provide political cover for them to compromise on the deficit without upsetting their constituents.

“Without a clear pathway to agreement on raising the debt ceiling, we note the increasing likelihood that Congress may need a catalyst, such as a negative market reaction to the debt ceiling debate, to force it to cut a deal,” said FBR Capital’s Ed Mills, who puts a 25 percent chance at a deal not being reached by the Aug. 2 deadline.

“Each party’s base appears unwilling to accept capitulation, raising the incentives for brinkmanship," he said. "It appears increasingly likely that neither side will be willing to concede ground until it is unavoidably clear that a crisis is imminent.”

Congress and the White House have set a target date for July 22 to reach an agreement, and Treasury Secretary Tim Geithner said Aug. 2 would be the final due date to avoid a default.

If Congress were to miss that August deadline, it could cause a dramatic decline in stocks because it would signal to international investors that Washington is too divided to get its finances together and therefore the cost for the U.S. to borrow should be much higher, investors said.

“There is a definite argument to be made that under duress the Congress would miraculously come to an agreement on the debt ceiling,” said Alec Levine, associate director of listed derivative sales and strategy at Newedge Group. “If you recall, TARP—first vote failed, market tanked; 2nd vote successful, so there is precedent.”

The Troubled Asset Relief Program, a $700 billion program to firm up financial institutions, was unexpectedly voted down initially by the House of Representatives during the height of the credit crisis in 2008, causing a 700-point drop in the Dow Jones Industrial Average.

Certainly a similar reaction would give House members another “we had no choice” excuse. However, what lawmakers may not realize is that they may not have the luxury this time of playing with the markets to make a point.

“Passing TARP a day or two later made no difference because ultimately, its passage was all that mattered,” said Dan Greenhaus, chief global strategist for BTIG. “With the debt ceiling, there is no going back. You cannot re-convince markets of your seriousness, of your desire to not default. The market may recover shortly after if the default is short enough, but the U.S. will forever pay a price for its inability to increase the ceiling.”

Federal Reserve Chairman Ben Bernanke said this much in his testimony to Congress on Wednesday, saying that a failure to raise the debt ceiling would cause a “huge financial calamity.” Still, the Fed Chief’s warning may too fall on deaf ears.

“A vote to increase the debt ceiling is a vote in support of the entire national debt,” said FBR’s Mills. “Of great concern to many Members is that polling data show overwhelming opposition to raising the debt limit, even after voters are informed of the negative consequences of not raising the limit and a default.”

Between a bipartisan agreement and an outright default, there is a third option. The FBR analyst believes that if an agreement can’t be reached by August 2nd, Congress could pass a short-term increase and the Treasury could order a prioritization of payments such as paying interest on Treasuries over Social Security payouts.