Thursday, July 28, 2011

Debt Ceiling: Potential Implications

By Larry Swedroe

To date, we have had lots of rhetoric but no real progress on meaningful deficit reduction. Yet, the August 2 deadline looms. If you’re like most investors, you’re concerned about the potential implications of reaching that deadline without a resolution. Let’s look at some of the potential fallout if such a situation were to occur. (Of course, keep in mind that my crystal ball remains cloudy as always. And thanks to my friends at Appleton Partners for sharing their thoughts with me on this subject.)

The government has two big payments due in the first part of August:

  • It owes about $32 billion in Social Security and other payments on August 3.
  • It owes about $31.5 billion in debt service and redemption on August 15.

I doubt that the Treasury would suspend any debt payments, because the long-term cost of a default would be too high. But it’s seems certain the government would need to defer payment on other debts and subsidies.

One of the most important implications of a failure to reach agreement on extending the debt ceiling and/or failing to put in place credible deficit reduction programs is that the ratings agencies would likely downgrade Treasury debt. They’ve already warned about this prospect. If that happened, Treasury bills would no longer be the benchmark “riskless” asset. In addition, there are several other bonds that would likely suffer reviews and downgrades:

  • Government-sponsored entity or such related debt
  • Prerefunded bonds backed by Treasuries
  • Bonds relying heavily on capital market access, such as variable-rate demand notes and commercial paper

However, there doesn’t seem to be any reason to believe this would harm the credit ratings of AAA-rated corporate bond issuers, nor the AAA ratings of any state issuers in the municipal market. Each situation would be evaluated on its own unique characteristics and exposure to the Federal government (direct or indirect). Those not as reliant on the Federal government will likely keep their rating.

There are some other implications to consider. The most important one is that there would likely be a disruption in the liquidity of the markets (both stock and bond). While it would likely be brief, it would also likely create great volatility, and markets could easily “seize up,” with liquidity disappearing. As I stated in my post on July 18, forewarned is forearmed.

While we’ve always preached the merits of maintaining very strict credit standards, maintaining those standards (and not stretching for yield, which can be tempting in a low-rate environment) is more important than ever. In addition, it’s also more important than ever to be sure to have sufficient liquidity in highly liquid assets (such as bank accounts).

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