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By Alex Dumortier, CFA | More Articles June 28, 2011 | Comments (9)
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Did we really need any further proof that our lawmakers are short-sighted and irresponsible? Not really, particularly if it comes with a $100 billion tab. Yet that is the estimated cost of one possible consequence of partisan squabbling and politicians' inability to look further ahead than their next election.
A short-term and a long-term problemBy delaying an agreement to extend the federal debt ceiling and refusing to tackle long-term budget reform, Congress puts the U.S. at risk of rating agencies downgrading its credit rating. Moody's (NYSE: MCO ) has said explicitly that a technical default -- which will occur unless the debt ceiling is raised before Aug. 2 -- would force it to place the U.S. on review for downgrade.
The debt ceiling is in some sense a sideshow with regard to the elephant in the room: the need for structural budget reform to address unfunded liabilities (Medicare, Medicaid, and Social Security). A research group at McGraw-Hill (NYSE: MHP ) , S&P Valuation & Risk Strategies, now estimates that a downgrade might mean a $100 billion drop in value across outstanding Treasury debt, and that analysis assumes that the debt ceiling is raised.
That number sounds realistic; there is a precedent for this, after all. In 1979, the U.S. Treasury failed to repay a measly $122 million in Treasury bills on schedule. An academic study later found that this technical default cost the Treasury an extra 60 basis points (one basis point equals one hundredth of a percentage point) on some federal debt. The Economist estimates that would equate to $86 billion a year today, or 0.6% of GDP.
Companies would share taxpayers' miseryBut the $100 billion is by no means the extent of the total cost of a downgrade. First, the Treasury's annual interest cost would increase by between $2.3 billion and $3.8 billion. In addition, bond investors price corporate bonds at a spread to the risk-free rate -- the yield on same maturity Treasury bonds. A rise in Treasury yields would almost certainly result in an increase in companies' financing cost, as the risk-free rate and the spread would increase.
Companies have had it good in this low-yield environment. Whirlpool (NYSE: WHR ) issued a $300 million bond at a yield of just 4.85% at the beginning of the month, less than 2 percentage points above the same maturity Treasuries. Blue chips Philip Morris (NYSE: PM ) and AT&T (NYSE: T ) also issued debt in the second quarter, the former to fund share repurchases and the latter to finance the acquisition of T-Mobile. These companies can afford the hike, but that's beside the point.
Playing chicken in taxpayers' carsDo I expect that Congress will eventually reach an agreement in order to avoid a technical default? Yes, but I can't dismiss the risk that it won't. Lawmakers are playing a dangerous game of chicken, and if they crash, it will be up to U.S. taxpayers to foot the repair bill.
With Congress courting a default, no wonder gold prices are near historic highs. One little-known gold miner is making a fortune; find out which tiny gold stock is digging up massive profits.
Fool contributor Alex Dumortier holds no position in any company mentioned. Click here to see his holdings and a short bio. You can follow him on Twitter. The Motley Fool owns shares of Philip Morris International. Motley Fool newsletter services have recommended buying shares of AT&T, Moody's, and Philip Morris International. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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A technical default will only occur if Obama chooses not to pay the debt.
If congress does nothing, Obama has the authority to decide what is paid, and what is not paid.
Legally Obama could choose to be very partisan and cancel all payments to red states.
Obama could choose to gain favor with his anti war base by cutting defense spending.
Obama could choose to delay federal employee checks for a few days to buy an extra week or so of negotiations.
Obama could choose to default on the debt, potentially making future debt carry a higher interest rate. This possible choice is the one that is creating all the fear in the media, even though it is not a likely outcome.
Alex,
Your headline....Will Congress Flush $100 Billion Away?.......is a few years too late and several hundred billion dollars too low.
Obama called it the "stimulus" and promised it would rev up the economy and keep unemployment below 8%.
I suppose, to him and like-minded Congressmen, $100 billion is the federal equivalent of pocket change.
c5700
You have Philip Morris tagged as MO, did you mean PM USA or PMI?
Are you referring to Philip Morris the international company (ticker PM), or Philip Morris USA, the subsidiary of the Altria Group (MO)? Usually, "Philip Morris" refers to the former, but you seem to have the ticker of the latter.
Yes they will. I'll be very surprised if they don't. Relieved, but still surprised.
Don't the taxpayers always foot the bill for Republican stupidity?
Wait, wait!
Why cut badly needed social services when we could eliminate subsidies for coal, oil and corn derived alcohol?
Plus, we could briskly withdraw our troops from Bush's 2 inane and unjustified wars and trim the military budget way back.
Last, we should reinstate all the "Temporary"tax cuts for the wealthy.
We were much more prosperous when the wealthy paid their fair share.
That'[s how we balanced the budget last time,mostly.
Instead of pointing fingers at this party or that, or this policy or that, I think all Americans should think about OUR debt and our lenders. Let's put it like this, would you buy a bond from a country that is openly talking about defaulting? We are already in hot water, and those that can do the buying may want some promises short of that they will want some points. We will begin to see this debate being carried out in the bond markets through July. Either way the markets will soon decide, or QE 3,4,5....
Tygered:
The taxpayer foot the bill for ALL government stupidity. Democrats are just as stupid as repubicans. I am neither one.
As far as what ever the government ends up doing, (I am fairly certain they will increase the debt ceiling just like they always do) the US will eventually have to default because there is no way they can ever pay. This could come very soon depending on whether there are any buyers for the debt. If not, then the Fed will end up createing more money out of thin air to buy it (QE3).
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