Monday, May 16, 2011

The debt ceiling debate

Here's a little bit of information that you might find interesting in the midst of all of the breathless debate about raising the US debt ceiling -

The US raised its debt ceiling in 2002, 2003, 2004, 2006, 2007, TWICE in 2008, TWICE in 2009 and 2010.

Wait, what? We do this every year - sometimes twice a year - and it's suddenly a great debate?

Well, let's think this through. What's changed since the last increase in the debt ceiling in Jan 2010? Hmmm, something that happened in November 2010, maybe? Yes, for the first time in President Obama's term he's facing a split Congress and that's the cause of the great uproar.

There should be very little debate over actually raising the debt limit. I don't like it anymore than the next guy, but US Treasury Bills and Bonds play a critical role in the global financial system. If you alter their role in the market by spooking investors with talk of default it could lead to higher interest rates on our $14.3 trillion of debt which would lead to ....... you guessed it - more debt.

Also, consider that all of those pensions that we love so much in the US are heavily invested in treasury debt. Spook the market, rates will rise, the value of those bonds will fall and your pension will become more underfunded. To make up that gap your school districts and local governments will have to divert more of their operating budget to the pension plan resulting in positions being eliminated.

This is a little overly dramatic, but hopefully you see my point that there are many interlocking pieces to this puzzle and taking a stand like "don't spend what you don't have" is a simple minded approach to a very complex debt issue.

Consider the following analogy:
Let's assume a famous basketball player moves to Miami and takes out a $20 million loan for a new place on Palm Island. Player ABC easily earns in excess of $20 mil but he still decides to take out a mortgage on the property. Instead of taking out a traditional mortgage he takes out a 5 year loan for $15 mil and a 90 day loan for $5 million. Every 90 days he just rolls the smaller loan over into a new loan and his total interest payments are lower than they might be with a traditional loan.

After an unfortunate twitter incident player ABC is suspended for 6 months without pay.

No problem - he signed a $140 million contract, right?

Well, after 90 days he goes to roll over the $5 mil loan and the bank says “Not so fast - you’re over your debt ceiling given your lower earning potential.”

Okay, so player ABC is still a AAA rated NBA superstar, but now he has a serious cash flow issue.

This is one of the many serious implications of not raising our debt ceiling - our cash flows won’t match our payment requirements and that could in theory trigger a default which is an unacceptable scenario.

At the end of the day this is posturing among the various political parties (note that President Obama voted against raising the debt limit in 2008 as a Senator) and any member of Congress with more than a few votes under his or her belt will have flipped and flopped on this issue more than Joe Girardi trying to set his line-up card.

Cheers!

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