The eyes of the world are fixed on Congress as the debt ceiling deadline approaches.  Will they or won’t they reach agreement?  What will happen if the squabbling continues past the deadline?

Since the 1917 passing of the Second Liberty Bond Act establishing a debt ceiling, the debt ceiling has been raised 77 times.  In fact, it has been raised 3 times already during the Obama administration and was raised 7 times during the George W. Bush presidency.  The process is usually automatic.  We need to borrow money for various projects and programs and everyone is on board. 

This year the politicians are playing by different rules.   Many of them have said enough is enough.  Let’s balance the budget and make meaningful progress towards paying down our national debt.  Republicans and Democrats have squared off and are offering competing solutions to the national debt problem.   

It seems unlikely that Congress will fail to raise the debt ceiling by August 2^nd.   There is simply too much at stake and they are, after all, politicians.  They don’t want to be anywhere near the train wreck that will occur if they fail to reach a compromise.   Many are up for re-election next year and none want to face angry constituents still smarting from the recent financial crisis and the bad economy that followed. 

The collective capital markets appear to be betting heavily that Congress will reach a compromise and thus avoid a possible default on US debt.   If default was seen as likely, the yield on the 10-Year Treasury note would not be a historically low 3%.  It would be more like Greece’s 16%. 

The rating agencies also appear to believe that the government will find a way to make good on its obligations.  Although they have put US debt on downgrade watch, Standard and Poor’s and Moody’s continue to give US Government bonds an AAA rating, the highest rating for safety. 

However, there is still a realistic chance the members of Congress will let the deadline pass without resolving their differences.  If that happens, the government will not have authority to borrow money until a compromise is reached.  Does that mean that the government will default on its debt obligations? 

Not necessarily.  The government currently borrows approximately 40% of its budget.  Without the ability to borrow, the Treasury could choose to pay the interest on its debt from other sources.  Deep cuts in other areas would be necessary, but default is not inevitable.  This is not unprecedented.  We only have to look back to the Clinton era, 1995 and 1996, to find two government shutdowns. 

Even if default is not inevitable, Congress clearly believes that the time is ripe to address the problem of the mounting national debt.  Does this mean we are on the brink of disaster?  How bad is this problem, really?   To answer this, let’s explore the following debt facts: 

1. Current public debt (bills, notes and bonds issued by the Treasury) is currently $9 trillion.  This sounds like a stunning amount and, indeed, it is, but it is only about 60% of 2010 GDP. 

2. Intergovernmental debt (obligations to government programs such as Social Security) is $5.2 trillion.  With a growing population of retirees and ever-increasing life spans, Social Security and Medicare are the major source of debt tension.  These expenses are expected to explode over the next decade.  However, they are expenses that can be adjusted and the levels of these obligations are subject to accounting manipulation.

3. The obligations of the government sponsored enterprises, Fannie Mae and Freddie Mac, are not included in these debt numbers.  Fannie Mae and Freddie Mac hold mortgages and guarantees totaling about $5 trillion.  The amount of this debt that is repaid by mortgagors depends on market conditions.  Default rates on mortgages prior to 2007 ran below 2%.  After 2008, the ability and willingness of the public to pay their mortgages has become more cyclical. 

 

Historic Perspective of Debt to GDP

The red line indicates the Debt Held by the Public (net public debt) and the black line indicates the Total Public Debt Outstanding (gross public debt).  The difference is that the gross public debt includes funds held by the government (e.g. the Social Security Trust Fund).  http://fms.treas.gov/bulletin/index.html

4. We all know as borrowers that we must one day pay back or roll over our debt, but in the meantime we must pay the interest.  The government, too, must pay the interest on its debt (bills, notes and bonds outstanding), or else be in default.  Interestingly, while debt levels have risen, interest rates have fallen.   This, of course, makes interest payments lower and easier for the government to pay.  More than 60% of the current public debt is in the form of notes and bills with maturities of less than 10 years and interest rates of less than 3%.

Estimated Government Interest Paid on Debt ($billions)

Source - GAO audit of public debt, FY 2009

 

5. Of course, we do not live in isolation.  We operate within the greater global economy where goods, services and capital are free to move.  If we are to understand our creditworthiness, a major factor is our debt and GDP relative to our trading partners.  Below are the 2010 estimates of Debt/GDP ratios for selected countries:

 

Country	2010 Estimated Public Debt/GDP ratio
Japan	225%
Greece	144%
Italy	118%
Singapore	102%
Belgium	99%
Ireland	94%
France	84%
Portugal	83%
Germany	79%
United Kingdom	77%
Austria	70%
Netherlands	65%
Spain	63%
United States	59%

Source: Wikipedia, Eurostat and CIA World Factbook 2010.

 

 

 

6. Lastly, consider the media sound bite that China will sell its holdings of our government bonds, causing a panic rise in interest rates.  The graphic below shows the holders of our public debt.  Approximately 28% of our public debt is owned by international holders.  China represents 26% of this 28%, or about 7%—a relatively small percentage of the total.

Estimated Ownership of US Debt Securities

Source: Wikipedia, http://fms.treas.gov/bulletin/index.html

No one knows for certain what Congress will decide to do.  Its actions could shock capital markets.  However, the general theme of what Congress is trying to accomplish is fiscal responsibility.  Long-term, this will be good for the financial markets and the creditworthiness of our government.  The process of getting there, however, may cause short-term disruptions throughout the global financial markets. 

As portfolio managers, our concern is how developments in the capital markets affect our clients’ portfolios.   We have significant experience navigating uncertain and difficult times.  Our investment process has been refined over more than 20 years—a period that includes crises, bubbles and disasters of all varieties.  We are confident in that process and believe it will continue to serve our clients well.   

But we are not alone.  Our portfolios are highly diversified and include many of the world’s best investment managers.  In the fixed income area we rely primarily on two outstanding managers: Bill Gross of PIMCO and Jeffery Gundlach of Doubleline.  Together with these and other “genius” managers, we are keeping a close eye on the debt ceiling issue and will position our portfolios accordingly.   

Please contact Geremy van Arkel at 404‐604‐2299 (office) or 404‐406‐4281 (cell) if you have any questions.

Much of the data used in this article was obtained through: http://fms.treas.gov/bulletin/index.html, http://en.wikipedia.org/wiki/Debt_ceiling#Debt_ceiling and, http://en.wikipedia.org/wiki/List_of_sovereign_states_by_public_debt .  While we believe these sources to be accurate, there is no guarantee that every statistic quoted in this article is precise, and all are subject to change.

 

 

 

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www.frontierasset.com