Debt ceiling: Understanding what's at stake

CBS News:
By 

ALAIN SHERTER / 

MONEYWATCH/ October 7, 2013, 7:40 AM

(MoneyWatch) It is the economic calamity that no one expects and everyone fears.

Experts agree that failing to raise the nation's debt ceiling by Oct. 17, when U.S. officials say the government will run out of money to pay its bills, would gravely wound the economy, and perhaps even throw it back into recession. Because Treasury bonds and the dollar are cornerstones of the global financial system, meanwhile, the shock wave would be felt around the world.

Play VIDEO

Bank CEOs: Don't play games with debt ceiling

"The potential is disastrous," said Gus Faucher, senior economist with PNC Financial Services Group. "We would see interest rates spike across the board. We'd see a huge crash in the dollar. People count on lending their money to the federal government and getting it back, and if that trust is taken away -- it's never happened that we haven't met our obligations as a nation -- then that has very, very negative consequences for the U.S. economy."

The consequences are so severe that, even as the government shutdown enters its second week, most seasoned political observers still expect Congress to ultimately reach an eleventh-hour deal to lift the government's borrowing limit.

But what exactly is the debt ceiling, and exactly how worried should Americans be that it could come crashing down?

What is the debt ceiling?

English: Chart of the United States' debt ceiling from 1981 to 2010 in $ trillion. This chart tracks the debt ceiling at the end of each calendar year. Years are color coded by congressional control and presidential terms highlighted. Data source: http://www.treasurydirect.gov/NP/BPDLogin?application=np Modified chart by http://commons.wikimedia.org/w/index.php?title=User:LibertyUSArocks&action=edit&redlink=1 to remove New York Times logo and make more NPOV. (Photo credit: Wikipedia)

The debt ceiling is the total amount of money the U.S. government can borrow (by selling Treasury bonds) to pay its obligations, including interest on the national debt, Social Security and Medicare benefits, and many other payments. That limit is currently $16.7 trillion, although technically the government already exceeded it in May. The Treasury Department has since used various measures to continue borrowing. 

During World War I, amid uncertainty regarding the total costs of funding U.S. involvement in the conflict, Congress created the cap in 1917 to put an upper limit on federal borrowing. Since 1960, Congress has raised the debt ceiling 78 times.

How is the debt ceiling changed?

Lawmakers can adjust it by passing a standalone bill or by including it in another piece of legislation as an amendment.

U.S. debt from 1940 to 2010. Red lines indicate the Debt Held by the Public (net public debt) and black lines indicate the Total Public Debt Outstanding (gross public debt), the difference being that the gross debt includes that held by the federal government itself. The second panel shows the two debt figures as a percentage of U.S. GDP (dollar value of U.S. economic production for that year). The top panel is deflated so every year is in 2010 dollars. (Photo credit: Wikipedia)

Does raising the debt ceiling increase the federal debt?

No. Lifting the borrowing limit simply allows the government to pay its existing bills. That debt exists whether or not Congress authorizes additional borrowing, and to avoid default it must be paid.

Why can't Congress and the White House avoid lifting the cap by cutting federal spending?

Because preventing the government from borrowing to meet its obligations would require all discretionary spending, such as for defense, education, housing and other annual appropriations, to stop, according to the Congressional Research Service. Most of the outlays for mandatory programs, such as Social Security, also would have to be halted, while taxes would need to rise to ensure the government had money to spend. Deep spending cuts and tax hikes would throw the economy into recession.

Why is Oct. 17 a critical date?

Play VIDEO

Lew: Raise debt ceiling to avoid default "abyss"

Treasury Secretary Jacob Lew recently forecastthat on Oct. 17 the government would have about $30 billion on hand. That isn't enough because the government spends as much as $60 billion per day. "If we have insufficient cash on hand, it would be impossible for the United States of America to meet all of its obligations for the first time in our history," he said last week in a letter to congressional leaders.

What happens if Congress doesn't raise the debt ceiling?

If the government runs low on cash, it will have to withhold a range of payments. Retirees might not get their Social Security checks, especially worrisome for the millions of Americans who depend almost entirely on the social insurance program for income. The same goes for Medicare and Medicaid recipients. Holders of Treasury notes, from Wall Street and other global banks to foreign governments, also could get stiffed, jeopardizing the solvency of many financial institutions and choking off global credit flows.

Play VIDEO

Financial markets wary of looming debt ceiling deadline

The U.S. also would struggle to pay the interest on its debt, including a $6 billion payout due at the end of the month. At that point, the U.S. would be in default of its obligations. The value of Treasury bonds and the dollar would nosedive. The nation's borrowing costs would soar as anxious investors demanded a higher return to buy suddenly shaky U.S. debt. And because the interest rate on Treasuries provides a benchmark for rates on other loans, from mortgages and credit cards to car and student loans, borrowing would become far more costly for consumers and businesses. Stock markets in the U.S. and elsewhere around the world would almost certainly plunge.

"When stock prices fall, investment or other spending to expand a business is more costly," the Treasury Department said in a report last week outlining the potential impact of the debt-ceiling fight. "The effects on households and businesses, moreover, are reinforcing. Less capacity and willingness of households to spend, when businesses have less incentive to invest, hire and expand production, all lead to weaker economic activity."

In short, the already fragile economic recovery could stall.

Haven't we been here before?

Play VIDEO

Not raising debt limit would make Congress "a deadbeat," Obama says

There is recent precedent for such turmoil. Consumer confidence plummeted after lawmakers squared off over the debt ceiling in the summer of 2011, while the Standard & Poor's 500 stock index dropped nearly 20 percent. Hiring among small businesses slowed. Ever after a deal was struck to raise the cap in August of that year, credit rating agency Standard & Poor's downgraded U.S. debt for the first time ever.

Beyond the immediate economic fallout of defaulting on its debt, for the U.S. the symbolic blow might be even greater. In the post-World War II era, Treasuries and the greenback have -- for better and for worse -- served as the foundation of the global financial system. A default would shatter the faith on which that system relies.

How much danger are we in?

Although financial markets are not yet in panic mode, the standoff in Washington has them worried. Unlike during the 2011 dispute, when Republicans and most Democrats favored cutting federal spending, the stark division over Obamacare suggests there may be less room for compromise this time around. One clear sign of distress: Interest rates on short-term Treasury bonds rose last week, as investors seek greater yields to offset what they perceive as the greater risk of holding the debt.

Still, most economists, stock analysts and, for all the pointed rhetoric on Capitol Hill, even congressional leaders themselves downplay the chances of a default. The belief is that common sense, or at least a sense of political self-preservation, will prevail.

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Are Earnings Credits a Good Deal?

Keeping cash in bank deposits can offset service fees, but the savings may not be as large as the treasury department thinks.

CFO.com:
Bruce C. Lynn

Most creditworthy companies are holding more cash and cash equivalents (i.e. short-term investments) than at any time in the last decade.

What is not so clear is what companies plan to do with all of this liquidity. Some investors have decided that it belongs to them and have sued companies (see Apple) to force them to return some of it. Other companies are content to just invest their “excess” cash in financial assets until that time when investing it in current or future businesses makes economic sense.

But there are fewer safe choices for short-term cash investing, and even the perceived safest choice — depositing the money in a commercial bank — comes with risks and, perhaps more important, costs.

Companies investing excess cash in financial assets, according to the latest Association for Financial Professionals’ liquidity survey, are investing in fewer asset classes. In 2012, most companies used less than three “investment vehicles” (Treasuries, bank accounts, money market funds, for example), the survey found. In 2009 the number of permitted investment vehicles was closer to eight. ...

Evidence of this search for safety over yield is the increase in the use of bank certificates of deposit (CDs) as an “investment” vehicle. According to the AFP survey, 50 percent of companies have cash in bank CDs, ...

Besides, companies still need bank services, and using balances to pay for them has proven effective for companies and banks. ...

As a result of federal monetary policy and the market volatility for short-term loans from the Federal Reserve Banks, financial institutions have taken to using their earnings credit rate (ECR) as a “chip” to get companies to keep deposits in banks. (Earnings credits are applied to a company's average daily balance and are used to pay for banking fees.) Example: I have a client with about $400 million in a top-tier bank. The bank is offering this client an ECR of 50 basis points. This same client is using another well-known bank, but that bank is offering an ECR about a third of that rate for a smaller deposit balance.

English: Category:JPMorgan Chase (Photo credit: Wikipedia)

... In the old days an ECR was actually market-based. Banks used the T-bill as an index. Today ECRs are “administratively” (i.e., relationship) based. Several years ago JP Morgan actually admitted to this approach.

Even at 50 basis points a bank can still make a decent spread by lending the deposits to others, but be careful what you wish for. Some banks will give a large ECR to corporate customers but charge them above-market prices for cash management services, effectively neutralizing some of the largesse. This sleight of hand is relatively easy to do. Example: everyone “knows” what LIBOR is, but who knows the market price for an ECR or a lockbox? Maintaining a bank account? A funds transfer? The large banks offer more 1,500 different cash-management services, so for the customer bidding out cash-management services is a cumbersome method of price discovery.

Logo of the United States Federal Deposit Insurance Corporation, which incorporates the seal. (Photo credit: Wikipedia)

Finally, both of the banks my client uses continue to charge it 13 basis points for FDIC deposit insurance, insurance they can no longer use with the re-instatement of the 250,000 coverage limit. This cost lowers the “net” ECR. Actually identifying this rate is not easy, given the opaque nature of the cost analyses sent to the customer.

Confusion over total or net costs may lead a company to hold cash or buy bank CDs, thinking the approach will bring both safety and return; however, there is a flaw in this choice.

• Whether a company needs to keep funds in a bank for operating reasons or whether it buys a CD, it is taking on the credit risk of the financial institution.

• Deposits at a bank generate an FDIC charge for insurance that cannot be fully used, inflating total service costs and reducing the net ECR to the company.

• Buying a CD will eliminate the FDIC expense which, in the case of my client, is a large monthly number. But it will not eliminate the credit risk.

• Buying Treasury bills directly or investing in government money market funds will eliminate credit risk and could yield a larger, safer return.

No good deed goes unpunished. Companies that buy CDs with fixed maturities will have to spend more time on their cash forecasts, so that the cost of being short (overdraft charges, early termination fees) does not become significant. Even money-market funds may not give companies the freedom to redeem at any time, given some of the latest regulations which will soon be imposed on the investment community by the Securities and Exchange Commission.

Speaking of regulations, the death of Regulation Q has allowed banks to pay interest on checking accounts; yet, few banks have really trumpeted this new ability. There may be many reasons for this omission but one that suggests itself is that it is not in a bank’s best interest to get into a highly visible “interest rate arms race” with the competition when its ECR “stealth campaign” is working just fine.

Bruce C. Lynn, CTP, is a managing partner at Financial Executives Consulting Group. He has more than 20 years of 20 years of corporate and banking experience in all aspects of treasury and financial management, including treasury operations, cash management, strategic planning, credit, and treasury systems. He is a Certified Treasury Professional and has an MBA from New York University’s Stern School of Business.

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The Deflation Scenario

You probably worry about inflation-but deflation, too, is a threat you need to understand.

Financial Planning
By David E. Adler
November 1, 2010

Image via WikipediaMost planners keep their eyes on inflation. But the Fed has worries in the opposite direction: Once unthinkable, deflation is now a threat. In September, the Fed's Open Market Committee Meeting found "measures of underlying inflation are currently at levels somewhat below those the Committee judges [optimal]."

…Extremely low inflation can easily tip into deflation, and several economic indicators are flashing red. Most critically, the CPI is dangerously low, at less than 1%. Investor and consumer confidence and demand are at similarly depressing levels. And the overall economy is still deleveraging.
That's why some economists can't rule out the possibility of deflation. "I would say there is a fifty-fifty chance of deflation occurring within the next 12 months," says Ibbotson Associates' economist Francisco Torralba.

Image via WikipediaThinking through deflation and its effect on … portfolios-and lives-requires new and possibly unfamiliar approaches, since deflation has been rare since the end of World War II. … The bigger challenge facing advisors is that much of their job is helping people to achieve their dreams. What will happen to these dreams if deflation becomes a reality?

MORE DEBT, FEWER ASSETS

Deflation is devastating because people's debts increase in real terms, while the value of their assets, including business inventories, decline. If it tips into a severe spiral, borrowers default, credit becomes impossible to obtain and the wheels of commerce stop spinning. "If the Fed can't stop deflation, we are looking at the possibility of government default," says Jon Ruff, director of research for real assets and strategies at Alliance Bernstein.

Ruff puts very low odds on severe deflation happening-less than 6%-and adds that it's highly dependent on whether we see a double-dip recession. But other analysts, citing new academic research, are less optimistic.

"When the core CPI inflation rate falls below 1.5%, the risk of deflation increases," Torralba says, in part because the Fed can only lower interest rates so far before hitting zero. …
The United States faced similar risks of deflation in 2002, Torralba says. After the dot-com crash and the terrorist attacks of 2001, inflation in the first few months of 2002 barely nudged above 1%. But the economy escaped the threat; economic conditions that year were a far cry from the high unemployment and brutal deleveraging of today.
Consumer expectations about deflation, which can become a self-fulfilling prophecy, are alarming. The 10-year expected inflation rate by consumers, as measured by the Federal Reserve Bank of Cleveland, was only 1.54% as of mid September, and that expectation has been declining since 2008.
Finally, there are signs the economy is undergoing a regime shift, where deflation has replaced inflation as the primary threat. The main reason is that the rise in global labor productivity and supply drive down prices on manufactured goods, particularly without a rise in global demand. However, globalization trends also increase price pressures on commodities and other industrial inputs. The picture is far from simple.
Robert Tipp, chief investment strategist for fixed income at Prudential, believes this is the case. The re-emergence of deflationary pressures in the 21st century goes beyond the high unemployment and debt levels of U.S. consumers to encompass other macro factors, principally globalization, according to Tipp. "Deflation is not a likely scenario, but it will crop up on the risk spectrum for years," he says.
DEFLATION PORTFOLIOS
Financial planners searching for insight into how different investments respond to deflation can look to history for guidance. … [The] United States itself offers deflationary parallels, most recently in the 1930s.
Brian Gendreau, market strategist for Financial Network Investment Corp., an RIA based in El Segundo, Calif., says, "I go back to the very slow economy from October 1937 to August 1939. Banks and companies were flush with cash, and deflation was 5%." Gendreau, who is also a finance professor at the University of Florida, notes that during this period equity valuations fell by 36%.
But there were a few bright spots: Stocks that paid high and stable dividends, such as public utilities, did well as investors piled in. During these two years, prices for high-grade corporate bonds and municipals also appreciated. In general, investors sought yield and safety, and they were rewarded for it.
Parallels with the past are not exact, of course. The price of gold, for instance, declined by 1.2% from 1937 through 1939. Although Gendreau does not think deflation is a definite, he does believe that it remains a risk. …
So is it too late to make the bond play Gendreau suggests? If you look at history, he argues, it isn't. Bond yields were already low at the beginning of 1937, but yields continued to decrease (and prices continued to rise) well until 1941, two years after the deflation ended.
A MULTI-FLATION STRATEGY
Planners may be familiar with the idea of deflation and may even be taking steps to hedge against it via large fixed-income or Treasury allocations. … More critically, Ruff argues, the traditional deflation protection offered by Treasuries could be overwhelmed by the possibility of government default that would accompany severe deflation. Even without a true default, the risk alone could depress prices.
… Many analysts believe that despite the immediate concerns about deflation, the greatest long-term threat is still inflation. So in addition to the deflation protection offered by high-quality bonds, portfolios also need hedges against inflation….
"We are in a multi-flationary world; you can't say deflationary or inflationary," says Ben Marks, president and CEO of Marks Group Wealth Management in Minnetonka, Minn. "Instead, you have different headwinds affecting different asset classes." As Marks points out, there is excess supply in housing, commercial real estate and the labor market. As a result, the United States is experiencing deflationary pressures in all three sectors. At the same time, new demand for commodities from emerging economies is creating inflationary pressures. Finally, he doesn't rule out the possibility of stagflation, last seen in the 1970s….
From an investment perspective, Marks is cautious about fixed income. Even though bonds are the natural hedge for deflation, he believes that the market has already priced this in. Instead, he makes carefully selected equity investments in sectors and companies that can survive deflationary pressures.
His focus is on best-of-breed companies that will win market share as rivals go under. Or he looks at firms with unique products and pricing power.
Marks also invests in growth trends, targeting industries that he believes will flourish regardless of deflation or inflation, such as wireless technology. He focuses on companies that have built up an extensive infrastructure, creating high barriers to entry for competitors….
The Depression-era-type portfolios embraced by many planners are one approach to a dark period. But there are dangers in being overly defensive. The economy could revive sooner than advisors and economic forecasters have planned for. "Investors need some selling discipline. The economy will not be weak forever," Gendreau says.
David E. Adler contributes regularly to Financial Planning. His most recent book is Snap Judgment.

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Vanguard - Cash balance plans can hold hidden risks for plan sponsors

Vanguard

Vanguard | 08/31/2010

Legislative and accounting changes that require faster funding and balance-sheet pension cost disclosure—not to mention a 2008 market that devastated funding ratios—have given rise to a new respect for risk and volatility on the part of defined-benefit (DB) plan sponsors.

Plan sponsors who move to a cash balance plan from a traditional defined benefit (DB) plan may not always realize they are trading interest rate risk for investment risk, Vanguard’s chief actuary maintains.

“Generally, cash balance plan sponsors have the same goals and desires as any other plan,” said R. Evan Inglis, a principal in Vanguard Strategic Retirement Consulting and the chief actuary supporting Vanguard’s clients. “They are looking into ways that they can reduce risk. But reducing investment risk is actually easier with a traditional plan.”

That’s because while cash balance plans are technically DB plans since they provide a guaranteed level of benefit payable to a participant, the benefit is expressed as a lump-sum amount.  However, a traditional pension plan expresses its benefit as an annuity, payable over the participant’s lifetime.

As a result, it is more difficult to invest in assets that match the liability of the cash balance plan than it is to invest in assets that match the liability of a traditional pension plan, Mr. Inglis said. A traditional plan’s liability acts as a long-term bond, which means long bonds can be used to hedge the risk inherent in pension funding levels, he said. This can be a powerful risk-management tool because pension liabilities and bonds both change in value the same way when interest rates change. Investing in long-term bonds minimizes risk, but also allows for potentially a relatively high return.

On the other hand, the liability for a typical cash balance plan is not very sensitive to interest rates, Mr. Inglis said. The liability itself is more stable and predictable, especially because final average pay and early retirement provisions add volatility to a traditional plan. However, because there are no specific assets that will match the liability, the funded status of a cash balance plan is difficult to control, he said.

The original concept for cash balance plans was to credit a relatively low rate of interest to participant accounts and invest in a balanced portfolio that would generate investment earnings higher than the interest crediting rate, he said. That is likely (but not certain) to work fine over a very long time frame, but doesn’t allow for substantially eliminating uncertainty and volatility, Mr. Inglis said.  The reason is that most cash balance plans invest in a traditional balanced portfolio and cannot take advantage of liability-driven strategies that effectively reduce risk, he said.

Cash balance plan features
There are different ways, however, that cash balance plans can be structured, affecting the level of risk and ability to minimize risk.
Most cash balance plans credit a market rate of interest, which changes each year. The most common interest crediting rate is the 30-year Treasury rate. … For a cash balance plan that credits the 30-year Treasury rate to participant accounts, however, investing in 30-year Treasuries doesn’t match the liability, Mr. Inglis said. Each year when the interest crediting rate changes, there would be a gain or loss on the 30-year Treasury assets that’s not matched to the accounts, he said.
Other common interest crediting rates are the 10-year or 1-year Treasury rates. Plans that use the 1-year Treasury rate to credit interest on participant accounts can match the liability pretty well by investing in 1-year Treasuries, Mr. Inglis said. Doing so, however, sacrifices quite a bit of return relative to a traditional portfolio made up of 60% stocks and 40% bonds, he said.
Cash balance plans that use a fixed rate of interest for participant accounts are interest rate sensitive and allow for somewhat easier risk mitigation at higher rates of return, he said. Other plans have interest rate floors. “For example they may credit the 10-year Treasury rate with a minimum of 5%,” Mr. Inglis said. “When you do that you’ve introduced some interest rate sensitivity.” It’s hard, however, to actually invest in anything that matches the liability, he said. There may be some complex derivative strategies that match such a structure, Mr. Inglis said.  But it’s unlikely that most sponsors of cash balance plans are interested in such complicated approaches….
Accepting the efficient frontier

Image via Wikipedia

Beyond such strategies, however, there is little cash balance plan sponsors can do but accept that managing a cash balance plan means taking on investment risk they wouldn’t have to face managing a traditional DB plan.

“There’s just really no reasonable strategy you could adopt to minimize that risk other than to invest in cash or short bonds,” Mr. Inglis said. “That’s kind of the traditional efficient frontier approach.”
It’s a distinction that often goes unnoticed by many plan sponsors, he said.
“Plan sponsors with a traditional pension plan think: ‘Well, there’s a lot of volatility in this plan. We want to get rid of that and replace it with this cash balance plan because it is less risky, less volatile,’” he said. That’s true, however, only if both a cash balance and traditional DB plan invest in the same mix of stocks and bonds, Mr. Inglis said. Sponsors of traditional DB plans are more and more moving to a strategy when it can match its liability with long bonds.
It’s understandable that some employers have moved to cash balance plans. Many employees seem to understand the account balance concept offered in cash balance plans and appreciate the value of an account balance more than the value of a promised annuity. Also, younger participants may appreciate that the value of their benefit increases faster than in a traditional pension plan where much of the value accrues after age 45.
However, the potential to reduce risk and make costs predictable has to be considered alongside potential advantages.