Super Committee - on the Brink of Failure, Will it Matter?

FBR Capital Markets said that with a midnight deadline and both sides deadlocked, it appeared that a deal for the U.S. Congress joint select committee on deficit reduction - colloquially referred to as the Super Committee - was untenable at this point.

Unfortunately, it appears that the only catalyst to force a deal at this point would be a negative market reaction. Both sides have made the political calculation that they have the upper hand resulting from failure and will pivot towards messaging blame towards the other party, said Edward Mills, an analyst at FBR Capital Markets.

If failure does occur, it is because the delay in automatic budget cuts was not immediate enough to create a true crisis for members of Congress and press attention on the super committee was less than anticipated, said Mills.

Mills said that according to conversations with Washington contacts, committee members have been discussing the possibility of a backup plan that would pass about $600 billion to $800 billion of cuts and interest rate savings.

The committee would then send instructions to the House Ways and Means and Senate Finance Committee to develop remaining savings. These committees are responsible for the tax code and entitlements, Mills explains.

This would allow the Super Committee to avoid total failure but punt the most controversial provisions to a later date. Republicans have been more favorable towards this idea than Democrats, with the Democrats viewing this as a way for Republicans to lessen defense cuts.

Mills said that with cuts not starting until January 2013, there will be numerous occasions for Congress to alter the automatic budget cuts and there will be significant speculation that the cuts will not occur, especially for the defense budget.

In recent days, former Senator Phil Gramm (author of the legislation that this budget process is modeled after) has argued that Congress and the President have a specific process to alter the automatic cuts prior to January 2013.

Mills said that under this scenario a privileged resolution, which can be amended but not filibustered, could be passed to alter the automatic cuts. This bill would likely occur just prior to the January 2013 deadline, allowing the 2012 elections to determine which cuts will actually occur.

Mills said additional debt downgrades of U.S. debt will be the most immediate fallout of the Super Committee's failure. S&P, which based its original downgrade on political dysfunction, gains significant political cover by Super Committee failure and could use it as a catalyst for an additional downgrade.

The continued inability of policymakers to find common ground even when traditional barriers have been removed will place even greater pressure for Moody's and Fitch to join S&P and at the very least weigh on investor sentiment, said Mills.

We believe this will place considerable scrutiny on the outcome of the 2012 election and if the winners will be able to adopt the necessary fiscal reforms. The sector most impacted is clearly defense as the recipient of $600 billion in cuts between 2013 and 2021, Mills added.

With numerous opportunities for Congress to rework and program the actual cuts, it is too soon to assess the direct impact but Mills does anticipate that this will weigh on investor sentiment in the defense space until he receives more clarity.

The Super Committee is a joint select committee of the United States Congress, created by the Budget Control Act of 2011 on Aug. 2. The committee comprises twelve members of Congress - six from the House of Representatives and six from the Senate, with each delegation evenly divided between Democrats and Republicans.