published Wednesday, July 6th, 2011

Personal Finance: Risk-free treasuries face default turbulence

By Travis Flenniken

The United States has maxed out its credit. As early as Aug. 2, our nation will have essentially exhausted its capacity to borrow as determined by law.

It’s not the first time. In fact, the U.S. has bumped up against the debt ceiling, raising the limit on 10 occasions since 2001. There have been five debt limit increases since 2008. Each time the federal government has reached its maximum borrowing capacity, Congress has voted to approve more borrowing with relatively little resistance or attention from anyone.

This time it’s different.

Never before in our nation’s history have we amassed this level of debt at such a brisk pace. Our nation is currently projected to spend about $1.5 trillion more each year than it makes in tax revenue (i.e. a budget deficit). It has to borrow funds to bridge the difference. Each year that the government has a budget deficit, it increases the federal debt. If a new debt ceiling of $16.7 trillion is approved by Congress (the amount which was voted down by Congress this spring), it will be about twice as high as it was in 2006.

Our elected officials appear to be at a stalemate; Republicans are vowing to vote down an attempt to raise the ceiling without serious cuts to spending, and want no increase in taxes. Democrats seem to agree that spending should be cut, but not without an increase in taxes. All the while, the deadline looms.

The debt ceiling may be arbitrary, but the deadline is real. On Aug. 3, experts have projected that the government will have about $12 billion in receipts and $32 billion in committed payments, including a $23 billion Social Security payment. Just for August, there will be a shortfall of $134 billion.

If treasuries are riskier

What would a default of U.S. debt look like?

No one really knows. Never before in modern history has a leading industrialized nation defaulted on its debt. Perhaps the closest was Argentina, which defaulted on its debt in 2002 when it missed a $132 billion interest payment.

However, the comparison isn’t very helpful when you consider that at the time Argentina’s economy represented about 0.376 percent of total world output, while the U.S. economy represents about 26 percent.

U.S. government debt is considered to be without risk. The risk and return considerations of all investments in the world are measured against the risk-free rate of return, or the yield on U.S. Treasury notes. If risk-free notes are no longer without risk, it will likely reverberate throughout all investments everywhere, creating an increase in relative risk levels, and an immediate adjustment to investment values.

Interest rates would spike on fixed income securities and, in all likelihood, liquidity would dry up.

Think this is overblown? Jamie Dimon, CEO of JP Morgan recently told PBS said every company and insurance fund with treasuries would be hurt and the problem could snowball.

“Automatic, you don’t pay your debt, there will be default by ratings agencies,” Dimon said. “All short-term financing will disappear. I would have hundreds of work streams working around the world protecting our company for that kind of event.”

Prioritized payments

The Treasury Department could choose to avoid default by prioritizing payments, which would require it to choose from roughly 80 million monthly payments. According to a study by Politico’s Jerome Powell, if the Treasury prioritized payments it would require that it slash 44 percent of monthly payments, which could include funding for the Departments of Labor, Justice, Commerce, military active duty pay and veteran’s benefits, Pell grants, food stamps and many others.

There is also a high probability that U.S. debt would be downgraded and borrowing costs would go up, further increasing the budget deficit.

China is no. 2

Contrary to popular belief, China is not the largest holder of U.S. debt. The largest lender to the United States is the U.S. As of the end of 2010, about 53 percent of U.S. debt is held domestically by individuals, institutions and the Federal Reserve. The next largest holder is China, holding about 9.8 percent of the total. A close third is Japan, which held about 9.6 percent at the end of 2010. The United Kingdom owns 5.1 percent and a basket of oil producing nations holds 2.6 percent of U.S. debt.

There have been recent rumblings as to the constitutionality of Congress allowing the U.S. to default on its debt. Treasury Secretary Tim Geithner, at a breakfast meeting in June, read aloud the 14th Amendment from a pocket-sized version of the U.S. Constitution. The Amendment states “The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.” While President Obama has been silent on the issue, legal scholars are debating if the 14th Amendment allows the president the power to circumvent congressional approval for a debt ceiling increase.

Most investors believe that the likelihood of a debt default is very low, as indicated by the 600 point gain in the Dow Jones industrial average last week.

However, the longer Congress debates, the closer the August deadline approaches. If political theater continues with no real progress toward an agreement, the market may begin to get jittery. If nothing is resolved in the next two weeks, real thoughts of the worse-case scenario will likely work into investor psyche. However, if an agreement is made and real improvements to the budget are implemented, it could be a very positive signal for investors.

Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Travis Flenniken, CFA, is vice president of investments with DeMoss Capital — demosscapital.com. Submit questions to his attention by writing to Business Editor Dave Flessner, Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by e-mailing him at dflessner@timesfreepress.com.

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