Thursday, July 28, 2011

U.S. Debt Default?

In my most recent quarterly letter I touched on the topic of “what if the U.S. Government defaults?” I had hoped that a brief reference would suffice, but as the debt ceiling negotiations have morphed into a combination of an Alfred Hitchcock movie and Saturday Night Live, it is clear that further coverage is necessary. There is beginning to be a high degree of nervousness exhibited by individuals as evidenced by a couple of queries I have received, very slow or no response times on a financial web site I needed to access and reports I am getting from a major discount brokerage firm. When nervous, the markets can get volatile and more irrational, is that possible?

As previously noted, because the U.S. Treasury can produce more dollars at any time, paying off debts and meeting financial obligations need not be challenging. The only limitation on this ability is an overall cap on the amount of debt the Government can issue. The Treasury has stated that the debt ceiling needs to be increased in order for the Government to continue to operate on all Federal levels without interruption. This increase requires the passage of legislation, and therein lays the problem.

Our legislators and administration have decided to use this process to create a theater to highlight their prospective political positions. Call it “The Battle of the Headlines”, or more age appropriate, “The Battle of the Sound Bites”. Keep in mind that this vote is not about current spending, but about making payment for amounts already spent. Said another way, the vote is about whether to honor debts and promises made by current and previous elected officials.

Normally, these debt limit increases are accomplished with little or no fanfare. The limit was increased seven times during the George W. Bush presidency, and 74 times since 1962. If the country continues to grow, the debt ceiling will need to be raised again in the future. However, there have been a couple of times over the last 50 years when the process devolved into the vaudevillian nightmare we now find ourselves in.

The most recent such event was in November 1995, when a Newt Gingrich led house challenged President Clinton. The government reduced non-essential services to preserve funds to honor commitments for four days in November, and then again from December 16th through January 6th of 1996. The stock market actually increased during the period, with the largest decline being about 4% and lasting a couple of days. No debt payments were missed. There were apparently a couple of missed Treasury bill payments during a skirmish in 1979 with little long-term effect. And of course, the 1971 repudiation of the gold standard by Richard M. Nixon might be viewed today as a technical default, so we’ve been there before, and the world didn’t come to an end.

However, the current situation differs in many ways from these previous events. The economy is very weak with a sustained, high level of unemployment. And it seems the rhetoric this time has been much more threatening, with the suggestion of debt rating downgrades from the rating agencies and mention by the administration of the likely default on debt expenditures and missed social security payments. It also needs to be recognized that the Government plays a much larger role in the economy now as compared to recent periods and investors have not yet recovered from the post traumatic stress syndrome induced by the market crash of late 2008 and early 2009.

As for the actions I have taken to protect portfolio values, I somewhat reduced exposure to stocks during the second quarter because of a number of factors, including the Euro problem and our debt limit issues. I also moved client cash assets into money market funds that are 100% U.S. Government and into U.S. T-bills to avoid exposure to European banks. Many of the companies we hold are more solid than the U.S. Government and banks, and hold much of their large amounts of cash overseas in other currency, which is a much better hedge against U.S. problems than selling out, paying some taxes, and watching the market rebound when elected officials agree to extent the debt ceiling. As I see nowhere to hide from this situation after numerous thought exercises, other than what I have already done, I stand ready to try and take advantage for my clients of any disruptions that occur.

Clearly what is happening in Washington is political brinksmanship and drama. I have yet to hear anyone say that they don’t want to increase the debt limit. So I expect that a rabbit gets pulled out of the hat either at the last minute, or after, to avoid or quickly cure a Government default. The unknown element this time (there is always one) is the Tea Party. Are they or their base so extreme that they cannot find middle ground? I think their constituents will be more in favor of raising the debt limit when the Social Security checks fail to show up.

Regarding the long-term unsustainable imbalances that result from government spending in excess of revenue collection, adjustments will have to be made, and the sooner the better. The problems are fixable and the citizens of the U.S. appear to be waking up to the idea that action is required. Remember, it was only a decade ago that the United States Government was running a surplus.

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