July 28th, 2011

Oscar from Olympia, WA:


What are the implications of the debt ceiling crisis?


Friedenthal Financial:


There are two main issues surrounding the debt ceiling crisis. First is the issue of potential default (or delayed payment) by the US government on its obligations. Obviously if the government doesn’t have the funds to make payments, it needs to borrow funds. If the debt ceiling is not increased, it has no ability to do so. The second issue is the possibility that S&P and/or Moody’s would downgrade US debt, which could have a ripple effect in our financial system.


At the root of the debt ceiling debate is the massive budget deficit (currently about $4T/yr). The pace at which we reduce the budget deficit will directly impact the pace of future debt ceiling increases. The rising Debt to GDP ratio is one of the primary causes of potential ratings downgrade.


Clearly the best case scenario is for Congress to quit this political game of chicken and come up with a plan to reduce budget deficit and increase the debt ceiling. If they do NOT do so by the August 2nd deadline, does that mean there will be a default? Technically, the government could hold back (delay) payment of operating expenses, such as Social Security, Medicare, or government contracts. While this might not technically be considered a default, it is most certainly a very dire circumstance that could be met with a downgrade of debt ratings. There is significant speculation that even if a moderate budget deficit reduction is achieved, with a debt ceiling increase, there may still be a ratings downgrade, simply because any budget deficit still increases government debt and our total debt is high relative to the size of our economy (GDP).


If Congress doesn’t raise the debt ceiling in time, is there anything the President can do? Some experts say that Obama can unilaterally raise the debt ceiling under the 14th Amendment of the Constitution, citing the validity of the nation’s public debt “shall not be questioned.” Even if this is possible, it would clearly only be a short term fix and doesn’t address the underlying issue.


Could the US just print more money to pay its bills? They could….but it would just further devalue the currency and cause more domestic inflation. As such, this is not a long term solution, and doesn’t mitigate the risks of a ratings downgrade.

A true default seems very unlikely. A prolonged delay in payment of services also seems unlikely. However, the combination of events that could lead to a downgrade in US debt ratings, may not be so far-fetched. The consequences of a downgrade are not completely clear. If the US is perceived to still be the safe haven in a riskier world, the demand for US debt (treasuries) will still remain. If the spectacle caused by the political circus dealing with our debt ceiling leads investors to require higher yields for US debt, we could see more substantial market turmoil. Some institutional investors, domestic and foreign, may be forced to liquidate some or all of their US Treasury holdings to comply with internal policies regarding AAA bond ratings. Even if policies don’t dictate such, bank capital requirements may increase for lower rated bonds, causing a similar liquidation.


There are two commonly referenced Debt metrics.


Net Debt – This is the sum of all government obligations held by entities (Public and Private) outside the Government of issue.


Gross Debt – This is the total of Net Debt as well as debt and other obligations that the government owns itself.  Examples include US government bonds held by the US Treasury as well as the Social Security Fund.  The Debt Ceiling is based on Gross Debt.


The graph below illustrates the change in US Gross Debt as a percentage of GDP.


Source: Bloomberg


Most foreign countries report Net Debt as a percentage of GDP.  So, for purposes of comparison, the table below illustrates Net GDP as a percentage of GDP by country.


Source: Bloomberg


Note that the graph above is as of 12/31/2010. 2Q GDP figures will be released tomorrow (7/29/2011). Given the increase in debt, our ratios are expected to increase.


We hope that helps and provides fodder for discussion.  Please let us know if we can be of further service!


The Friedenthal Financial Team

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