Debt ceiling: What happens if Congress doesn't raise it?

NEW YORK (CNNMoney) -- Prospects for a debt-ceiling deal dimmed late Friday afternoon when talks broke down between President Obama and House speaker John Boehner.

Lawmakers will continue negotiating, and a deal is still ultimately possible, but what happens if lawmakers fail to act by the Aug. 2 deadline?

Well, it's hard to say, because lawmakers have never before put the United States in a position where it can't pay all its bills.

But it wouldn't be pretty. A failure to raise the debt ceiling would likely send shockwaves through the underpinnings of the financial system -- and possibly ripple out to individual investors and consumers.

The federal government would be forced to prioritize its payments. It would risk defaulting on its financial obligations. And if that happens, credit rating agencies would downgrade U.S. debt.

"Even if Washington did raise the debt ceiling after just a few harrowing days following a default ... we envisage that the economy could fall quickly back into recession," rating agency Standard & Poor's said in a report Thursday.

Federal Reserve Chairman Ben Bernanke said the fallout could be "catastrophic" and "self defeating."

Markets and Money: Investors continue to assume that Congress will do the right thing and raise the ceiling by Aug. 2. If Congress dashes those expectations, no one can know exactly how the markets will react.

But most think they will react, and not well. And the longer the crisis drags on, the worse conditions will get.

Some bond experts expect that contrary to popular belief, Treasury rates won't rise but stocks may tank. In other words, there will be a move out of risk-based assets and a flight to safety in bonds.

So interest rates may stay low, but Americans' investments may get whacked. Or, Treasury yields could become volatile and start to climb as investors lose faith that lawmakers have the political will to be fiscally responsible.

That would push the cost of U.S. debt higher. And it could cause rates on consumer loans -- like mortgages and car loans -- to climb higher as well.

Federal Fallout: If the debt ceiling isn't raised, the federal governmentwon't be able to pay 44% of its bills worth an estimated $134 billion, according to a Bipartisan Policy Center analysis.

Bernanke: Debt ceiling breach 'calamitous'

On an annualized basis, it's the rough equivalent of cutting spending by $1.6 trillion -- which is nearly all of so-called discretionary spending, including defense.

Why? It's basic math: The United States doesn't bring in enough revenue to pay all its bills -- with monthly deficits averaging $125 billion.

And Treasury won't be allowed to borrow new money to make up for the gap between revenue and spending.

Technically, it wouldn't be a "cut" in spending so much as a postponement. That's because the bills the Treasury Department puts off will have to be paid once the debt ceiling is raised.

If government spending were to suddenly dry up, it would send a ripple effect through the economy and slow growth.

U.S. Credit Rating: All three major credit rating agencies have warned in recent days that they are considering a downgrade of the nation's debt.

To date, the United States has enjoyed its AAA rating in part for having always stood behind its debt and paid its bills on time. As a result, U.S. Treasury bonds are considered the world's safe-haven investment.

Hold up! Still no deal to raise the debt ceiling

If the U.S. were to lose its AAA credit rating, foreign investors, who hold about half of all U.S. Treasuries, might demand higher interest rates in exchange for holding the debt.

And other major holders of U.S. debt, like pension funds, states and insurance companies, would be put in the awkward position of having to decide whether to take their money to other safe-haven investments.

For at least two of the rating agencies -- Moody's and S&P -- raising the debt ceiling is not enough. They also want to see lawmakers agree to substantial debt reduction.

Standard & Poor's has already said there is a a one-in-two chance it would downgrade the United States within 90 days.