Special report: How Washington took the U.S. to the brink

(Reuters) - The world's largest economy was headed toward an unprecedented default, and all Washington wanted to talk about was the manner in which the president had left a room.

A White House meeting in mid-July between President Barack Obama and congressional leaders had ended with sharp words as Obama clashed with the brash Republican House majority leader, Eric Cantor.

Now Cantor was back on Capitol Hill, dishing details to a scrum of reporters -- a shift from the terse, vague statements that usually followed such meetings.

"He said to me, 'Eric, don't call my bluff. I'm going to the American people with this,'" Cantor said in his Southern drawl. "I was somewhat taken aback."

Republican aides filled in the gaps. Obama had "stormed out of the room," one said. At the White House, aides pushed back. One official demonstrated to reporters exactly how Obama had ended the meeting -- lightly pushing his chair back from the table, standing up deliberately, walking away calmly. "He didn't storm out. He just got up and walked into his office," one said.

That evening -- July 13, 2011 -- was one of the lowest points in the struggle to avert fiscal disaster and put the nation's budget on a sustainable path.

Congress needed to extend the country's $14.3 trillion debt ceiling before Tuesday, August 2, the date the Treasury Department would begin running out of cash to cover the country's bills. But Republicans and Democrats were deadlocked.

INSIDERS UNITE

As the deadline drew closer, the two sides abandoned a series of efforts to reach agreement, searching for the right combination of policies and personalities to get a deal done. In the end, it fell to two consummate Washington insiders to prevent the talks from collapsing.

A Reuters examination of the months-long showdown over the debt ceiling found that:

* Vice President Joe Biden and Senate Republican Leader Mitch McConnell emerged as critical players in the final stretch of the talks, as theirs was the only cross-party relationship built on decades of trust.

* Despite a belief among many rank-and-file Republicans that the government could muddle through a default, party leaders never doubted the Treasury Department's warnings that economic catastrophe was a real possibility if they didn't reach a deal by August 2.

* Although House of Representatives Speaker John Boehner, the top U.S. Republican, was eager to strike a bold deal with Obama, it was ultimately necessary for Boehner to distance himself from the White House to convince his House Republicans to back the final deal.

* The business community played an important behind-the-scenes role, with two White House foes -- Wall Street and the Chamber of Commerce -- rallying support for a compromise backed by Obama.

This account of America's journey to the brink of default is based on interviews conducted over the past six weeks with dozens of elected officials, business lobbyists and aides in the House, the Senate and the White House.

A ZEAL FOR CUTS

The U.S. congressional elections in November 2010 set the stage for confrontation over the congressionally mandated cap on the outstanding total of federal government borrowings. Republicans had harnessed voters' anxiety over the economy and soaring deficits to capture the House of Representatives.

Accusing Obama of overreaching with his stimulus package in 2009 and his drive for healthcare reform, Republicans vowed to slash spending and rein in the federal government's size.

A campaign document -- the "Pledge to America" -- promised to cut spending by $100 billion in the first year alone, back to the levels in place in Republican President George W. Bush's last year in office.

The newly elected Republicans, 87 in all, were not interested in compromise. Many felt a greater obligation to the grassroots Tea Party activists who had sent them to Washington than to the party elders who ran the place.

In a budget fight with the Democratic-controlled Senate that took the government to the brink of a shutdown in April, Republicans managed to cut spending by $38 billion, the largest domestic cut in U.S. history.

Still, 59 House Republicans voted against the bill because it did not go far enough.

BOEHNER'S BATTLELINES

That was a mere skirmish. The big battle lay ahead as the government was fast running up against its $14.3 trillion credit limit and would need Congress to raise it further. In early May, Boehner laid out his conditions for a debt-ceiling increase: spending cuts would need to exceed the amount of new borrowing authority.

Instead of billions of dollars, the debate would be measured in the trillions.

It would be a chance for Boehner to show his new troops that he could use the levers of Washington to get results.

An avid golfer and a chain-smoker, the 61-year-old Boehner is from an older generation than many of the Tea Party conservatives whose election to Congress made it possible for him to become House Speaker.

The seasoned legislator and former businessman grew up in Ohio from a family of modest means and worked as a janitor to help put himself through college.

Obama, 49, had a comfort level with fellow Midwesterner Boehner despite their philosophical differences. The speaker reminded the president, a former state senator from Illinois, of Republican legislators he used to play poker with in Illinois and with whom he forged bipartisan deals.

Both men are even-tempered and view themselves as Washington outsiders. Each has ambitions of transforming Washington and making a big mark on policy.

Those aspirations drove their on-again, off-again talks aimed at a far-reaching, bipartisan "grand bargain" that would put the United States on sounder fiscal footing for years to come.

On a golf outing in mid-June, the two agreed to work together on a broad deficit-reduction deal. "Let's give it a try," Obama told the speaker.

The following week, at a secret White House meeting, they agreed to have their staff draw up options. The aim was to craft a plan that would cut deficits by roughly $4 trillion over 10 years.

A 'GRAND BARGAIN?'

The challenges were steep. Democrats would have to agree to rein in cherished social programs like the Medicare health plan for retirees and the disabled. Republicans would have to accept a tax-code overhaul that would increase revenues through the elimination of tax breaks and deductions.

Boehner's enthusiasm for the "grand bargain" was not shared by his colleague, Senate Republican leader Mitch McConnell.

McConnell had confided to Vice President Joe Biden that he thought it was unrealistic to try to accomplish such a sweeping deal in the weeks before August 2 deadline.

The Senate Republican leader worried it would lead to a dead end when pressure was building to resolve the debt-limit standoff. Rating agencies were warning they might downgrade the country's top-notch credit score and, while there was no sign of panic yet in financial markets, investors were growing nervous.

McConnell, 69, had served in the Senate since 1985 and witnessed firsthand the divided-government battles of the 1990s, when Republican House Speaker Newt Gingrich and an earlier generation of firebrand conservatives went toe-to-toe with Democratic President Bill Clinton.

MEMORIES OF 1996

That confrontation led to a shutdown of the federal government and provoked a public backlash against Gingrich and his party. With the Republican brand tarnished, Clinton sailed to re-election in 1996.

McConnell, whose party is a minority in the closely divided Senate, viewed the 2012 elections as a chance to gain dominance in the chamber.

He feared the debt-limit fight would put that in jeopardy while also bolstering Obama's re-election prospects.

If Treasury Secretary Timothy Geithner's warnings were right -- and both McConnell and Boehner believed they were despite skepticism among their rank-and-file -- the fallout from a debt default would be calamitous, causing stocks and the dollar to sink and interest rates to surge.

Mortgage rates and business borrowing costs would spike, potentially sending the economy into another recession. That would mean Republicans -- whom Democrats had accused of intransigence over the debt limit -- would share in the blame for the economy's woes and suffer voter wrath as a result.

Many in the White House viewed McConnell as more of a tactician than a visionary and someone more focused on party politics than on setting policy. In the quest for a grand bargain, Boehner would make a better partner, they thought.

But in the end, after Boehner twice broke off talks with the White House, administration officials relied heavily on McConnell as an emissary to the speaker, and came to view him as a crucial player.

A BOND BETWEEN RIVALS

The administration's chief link to McConnell was Biden, 68, a 36-year veteran of the Senate with rock-solid Democratic credentials who nonetheless had a strong rapport with the Republican leader.

The two seemed to speak the same language from their years in the Senate together. Their bond grew closer when they worked together on a tax-cutting deal just before Christmas late last year, according to people who know both men.

"C'mon Mitch, you know what I'm dealing with here," Biden would sometimes tell McConnell -- Senate-speak to describe the pushback he would face from Democratic Party activists if he gave too much ground.

According to a former Biden aide, McConnell seemed to appreciate that Biden understood the GOP leader faced similar constraints within the Republican Party.

In April, Obama tapped Biden to lead a panel of lawmakers that would lay the groundwork for a deal. In an ornate corner room just off the Senate floor, the group pored through stacks of government and private-sector reports to identify more than $1 trillion in mutually acceptable spending cuts.

As the talks stretched into June, Biden gradually built up a rapport with Cantor, the House majority leader, who was leading the Republican side.

REPUBLICAN RIFT

In less than 10 years in Washington, Cantor had quickly climbed to the top rungs of Republican leadership. But his sharp elbows had earned him enemies -- some from within his own party.

He and Boehner had a cool relationship, say people who know both lawmakers. The rift extended into the lobbying community, where Republicans identified themselves as "Boehner people" or "Cantor people."

At the end of June, Cantor abruptly walked out of the Biden talks, saying the two sides could not agree on taxes. The "principals" -- Obama and Boehner -- would have to take it from there.

Even before the Biden talks began, members of Boehner's office dismissed them as political theater.

"This thing will ultimately get decided by Boehner and Obama," a Boehner aide said.

After weeks of back-channel negotiations with Obama, Boehner decided on July 22 that he could not work with the White House and would have to forge a deal with Democrats on Capitol Hill.

The two sides had come tantalizingly close to a deal, but stumbled again over the tax question.

Boehner felt the White House had shifted the goalposts at the last minute.

White House officials believed Boehner's departure stemmed from an unwillingness -- or an inability -- to take on the conservative rebels in his party. If Boehner had been willing to shake hands publicly with Obama on a "grand bargain," they said, there would have been a way to woo enough mainstream Republicans and Democrats to pass the bill.

They also disagreed with any suggestions that they had shifted the goalposts.

'A BOWL OF JELL-O'

"Dealing with the White House is like dealing with a bowl of Jell-O," Boehner said angrily at a press conference that night.

Obama called him back to the White House the following day and told him he should not be left out of the process.

"Mr. President, as I read the Constitution, the Congress writes the laws. You get to decide if you want to sign them," Boehner responded, according to his aides.

The action moved back to Congress. Like the deal that Boehner and the White House had abandoned, the latest plan would separate the relatively easy decisions -- curbs on annual discretionary spending -- from the difficult reforms to benefits and the tax code.

It wasn't the "grand bargain" Obama and Boehner had sought, but it would deliver trillions in savings and cover the nation's borrowing needs past the November 2012 elections.

There was one catch. The plan would require another debt-ceiling vote in a few months to ensure Congress would sign off on the second set of savings, and Obama had already ruled that out.

Around 10 p.m., on Saturday, July 23, Obama called Boehner to tell him he would veto the bill if it reached his desk. But he suggested that they could find another way to ensure Congress would actually follow through with the tax and benefit changes envisioned by the plan.

GOING SEPARATE WAYS

Congressional staff continued work on the plan the next day. Boehner told Fox News he would press ahead with his own legislation if the two sides could not agree. With no progress made on the enforcement mechanism, known as a "trigger" in Washington-speak, that appeared to be the case.

Boehner told Republicans he would unveil his version of the plan on Monday, July 25, while the Democratic leader of the Senate, Harry Reid, decided to advance a rival plan. Another effort had failed.

The final week would put Boehner's leadership to the test.

Boehner unveiled his plan to Republicans that Monday in a meeting room in the bowels of the Capitol. It wouldn't tie a debt-limit increase to the balanced-budget constitutional amendment, as many of them wanted, but it would deliver more than $2 trillion in savings. A vote was set for Wednesday, July 27.

Boehner launched a two-front lobbying blitz, alternating between in-person meetings with wavering lawmakers and phone calls to conservative media figures like talk radio host Rush Limbaugh and columnist Charles Krauthammer.

On Monday night, he touted the plan directly to a national audience, as television networks granted him air time to respond to a prime-time speech by Obama.

'READY TO DRIVE THE CAR'

Boehner's rally continued on Tuesday morning at the Capitol Hill Club, a social club for Republicans. Boehner's lieutenants took the lead. Cantor bluntly acknowledged that "the debt limit sucks." Kevin McCarthy, the House Republican whip, or lead vote counter, showed a clip from "The Town," a 2010 movie about bank robbers.

"I need your help," said a character played by Ben Affleck. "You can never ask me about it later and we're gonna hurt some people."

"Whose car are we going to take?" asks another character.

The message: it was time to get the job done, no matter how messy. The film clip appeared to win over at least one convert.

Representative Allen West, an outspoken Tea Party-aligned freshman, stood up and shouted: "I'm ready to drive the car!"

OBAMA'S UNLIKELY ALLIES

But momentum shifted as the day wore on. Outside conservative groups like the Club for Growth and the Heritage Foundation urged a vote against the bill.

At the White House, aides were batting away suggestions that Obama had been sidelined.

"He's working tirelessly, meeting with his economic team, doing a lot of outreach, exploring all opportunities for compromise," said senior White House adviser Valerie Jarrett.

Obama worked the phones, talking strategy with Democratic leaders and developing options for the final endgame.

Jarrett, one of the administration's envoys to the business community, said her phone was ringing off the hook with calls from retailers and other business owners worried about the prospect of another debt-limit fight in December if Obama was forced to accept Boehner's two-step plan.

The White House was also actively reaching out to the business community to spell out the dire consequences of a default.

The administration found an ally in the Chamber of Commerce, a group traditionally aligned with Republicans, who now urged the party to back the bill.

The financial services industry was also on the same page as the administration on this issue, despite its many skirmishes with the White House during the debate over Wall Street reform in 2010.

JAMMED CIRCUITS

In his public address on Monday night, Obama had implored Americans to intervene directly by calling, emailing or posting messages on Twitter to their lawmakers.

Telephone circuits on Capitol Hill seized up, email messages bounced back and Web sites crashed under the load.

The anxiety at the White House was building.

"It's fair to say that nobody here had any doubt that this was going to go right up to the line, even as we urged Congress not to take it right up to the line," one administration official said. "That's just the way Congress works."

Still, the path toward a deal was far from clear.

Over at Treasury, Geithner was trying to figure out what to do if Congress failed to reach a deal in time.

Should the government make debt service a top priority to prevent a meltdown on Wall Street? That could delay paychecks to soldiers, benefit checks to retirees, and payments to government contracts, sending ripples through the economy.

Back at the Capitol, Boehner's troubles mounted.

Representative Jim Jordan, a leader of the Republican Party's right wing, predicted Boehner wouldn't get the votes he needed from his own party. Democrats united against his bill.

The Congressional Budget Office, the official scorekeeper, said it would only deliver $850 billion in savings, rather than the $1.2 trillion it claimed. Late that evening, Boehner decided to rewrite the bill to make sure it complied with the party's vow to extract spending cuts greater than the size of the debt limit increase. That put off a vote until at least Thursday.

'FIRE HIM!'

The acrimony spilled into the open Wednesday morning, July 27, in the party's basement meeting room.

Representative Greg Walden, a Boehner ally, read aloud an email from a Jordan staffer that urged outside conservative groups to convince undecided members to vote against the bill. Many lawmakers in the room viewed the message as a betrayal of the Speaker. As the Jordan staffer stood uncomfortably against a wall, lawmakers chanted, "Fire him! Fire him!"

The usually jovial Boehner turned the screws. "Get your ass in line," he said. There was laughter, but the message was unmistakable.

As the meeting adjourned, lawmakers predicted the bill would pass. But a large number remained on the fence. Boehner spent the day listening to their concerns -- the cuts weren't big enough, the special committee might raise taxes, the balanced-budget amendment has been watered down.

Thursday morning, July 28: another meeting, another chance to rally the troops over fruit and doughnuts and signs that read "Play like a champion." Representative Mike Kelly, an alumnus of Notre Dame University, drew upon his school's storied legacy as he urged members to "put on your helmet, buckle your chin straps, run out onto the field and beat the shit out of your opponent!"

Doubters like Jordan stayed silent. As the meeting adjourned, they told reporters that their opposition had not changed.

With the rewritten bill ready to go, Republican leaders scheduled a vote for late Thursday afternoon. As debate started on the House floor, Boehner, Majority Leader Cantor and Whip McCarthy continued to meet with doubters, making the case that the party needed to stick together if it wanted an acceptable final product.

At 5:25 p.m., the Republican troika abruptly yanked the bill from the House floor with only one minute left of debate. They didn't have the votes.

'BLOODY AND BEATEN'

As floor action turned to naming post offices, Boehner summoned the holdouts to his office just off the Capitol rotunda. Whatever he was doing wasn't changing any minds.

"I'm a bloodied and beaten 'no,'" said Representative Louie Gohmert of Texas, one of several conservatives who had downplayed the consequences of a technical default, as he left the office.

At the beginning of the year, Republicans had enacted a ban on earmarks, the pet spending projects that had come to symbolize waste and corruption in the public imagination. That meant that Boehner had fewer carrots to offer reluctant members -- no highway overpasses.

"It is the most refreshing thing in the world to see what is going on here. These kinds of negotiations a couple of years ago would have cost $20 billion," said Representative Jeff Flake of Arizona, whose anti-spending stance had made him an outcast in the party in the past decade.

The five Republicans who represent South Carolina headed from Boehner's opulent suite to the Capitol's small, private chapel to pray.

As they knelt beneath a stained glass window depicting George Washington, they weren't praying for guidance, just strength to maintain their stand.

"I think divine inspiration has already happened. I was a 'lean-no,' now I'm a 'no,'" said Representative Tim Scott.

19 BOXES OF PIZZA

The action moved downstairs to McCarthy's office. The jovial 46-year-old Republican whip, from California's dusty interior, was a novice vote counter. He had presided over a few embarrassing setbacks earlier in the year. Now he was facing a true disaster.

As the night wore on, 19 boxes of pizza from Al's Pizzeria disappeared into McCarthy's office.

The holdouts weren't looking for pork-barrel spending or other favors -- though they didn't refuse the pizza. Instead, they wanted to strengthen the balanced-budget clause. That would certainly doom the bill in the Senate, but at that point Boehner just wanted to get it out of the House.

Even with that change, Boehner still appeared to be short of the 217 votes he needed. At 10:30 on Thursday night, the House adjourned without a vote.

House Republicans met in their basement clubhouse again on Friday morning, July 29. The holdouts came under more pressure -- this time from other rank-and-file members who said they were undermining the party's negotiating position. But a final count showed that the votes appeared to be there.

"I love you guys," Boehner said in a moment of levity.

The bill passed Friday evening on a vote of 218 to 210 -- just one vote more than needed. The Senate defeated it two hours later, and the House retaliated on Saturday by defeating a proposal put forth by Harry Reid, leader of the Democratic majority in the Senate.

Another week had elapsed, and Congress was no closer to consensus.

While the legislative chess game played out, Biden called McConnell on Wednesday and Friday.

MCCONNELL'S BOTTOM LINE

Out of loyalty to Boehner, the Senate Republican leader had refrained from talks with the White House for most of the week.

On Friday morning, McConnell told Biden there was "no daylight" between the two Republicans, but told the vice president to try later in the day.

"Call me back after these votes and I will tell you what it will take to get my support," McConnell said, according to a Republican aide.

Biden and McConnell spoke again Friday evening and in the early afternoon on Saturday. Negotiations began in earnest around 3 p.m., after the House defeated Reid's bill.

Tuesday, August 2, was three days away.

White House chief of staff Bill Daley's office became Grand Central Station for a rolling series of meetings among White House staff. The meetings moved on Sunday to the vice president's office and later to the Oval Office.

On Saturday, Obama asked Biden's chief of staff, Bruce Reed, whether his wife was angry that he was spending his wedding anniversary at the office.

"Previously, I was on negative watch but I've now been officially downgraded," Reed deadpanned.

CLIMACTIC PHONE CALLS

After months of high-profile meetings, nearly all of the negotiations on the final weekend took place by phone.

In the big gatherings, participants tended to emphasize "talking points" because of the expectation that the conversations would spill out into the public. Smaller meetings allowed participants to cut to the chase, according to an administration official, and details could remain private.

On Saturday night, a media report surfaced that there was a tentative framework for a deal.

White House reporters seeking an update chased a top communications aide toward the Oval Office, only to be told later that the two sides had not arrived at a deal yet.

Indeed, the negotiations ended up going down to the wire.

At 5 p.m. on Sunday night, White House officials discussed whether Treasury Secretary Geithner should make a statement to the financial markets that evening or perhaps the following morning.

GEITHNER'S GAME

Geithner, in his former role as head of the Federal Reserve Bank of New York, was one of the chief financial firefighters during the global markets meltdown triggered by the collapse of Lehman Brothers in September 2008.

Asian markets were about to open. The crisis had already roiled U.S. debt markets and taken a toll on the dollar and Wall Street stocks.

Administration officials feared worse bloodletting if investors returned to their desks at the start of the week without clarity on whether there would be a deal.

Geithner and a small team of aides had been quietly working on contingency plans in case Congress missed the August 2 deadline to raise the debt ceiling. Treasury had planned to brief markets on those plans no later than Monday.

Private-sector analysts believed that in a worst-case scenario, Geithner would be prepared to tell markets he would put a priority on paying the government's debt in order to avoid default -- even if that meant taking the politically explosive step of delaying payments to Social Security recipients and others.

PULLING THE TRIGGER

But the Treasury secretary never had to show his hand.

The final sticking point in the talks centered on the terms of the deficit-cutting "trigger." Democrats wanted automatic cuts in military spending if Congress balked at the second round of deficit reduction.

Biden and McConnell spoke four times on Saturday, five times on Sunday, circling around the two stumbling blocks that remained -- the nature of the "trigger" and the size of the defense cuts that Democrats wanted. McConnell kept in contact with Boehner.

On Sunday, July 31, there were less than two full days before Default Day. As Obama's budget director, Jack Lew, crunched numbers on the Republican defense cut proposals, the White House feared it might not get a deal. Biden spoke with Boehner around 4 p.m. and said, "We just can't get there."

McConnell floated a compromise to widen the trigger to all security-related programs -- the State Department, veterans' care, nuclear security -- and not just the Pentagon.

At 8:15 p.m. Sunday, Obama made a final call to Boehner as White House aides listened nearby.

"Do we have a deal?" Obama asked.

There was a moment of suspense, then: "Congratulations to you, too, John."

(Additional reporting by Richard Cowan, Rachelle Younglai, Laura MacInnis, Dave Clarke, Alister Bull and Jeff Mason; Editing by Jackie Frank)

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