The Daily Dose: Debt Ceiling's Ugly Backstory

 | Oct 16, 2013 | 11:00 AM EDT  | Comments
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Stock quotes in this article:

hd

,

low

Debt ceiling! Those are two words that on paper are easily understood and happen to appear once a year, similar to a holiday.

Depending on your dictionary of choice, the debt ceiling is a mechanism to limit the amount of debt that can be issued by the Treasury. When the debt ceiling is raised, everything is fine and well, right? Wrong.

First, the debt ceiling being such a newfound element to the national stage (who heard of it before 2009?) post the Great Recession has meant that it's a sitting duck to be politicized. With that politicization come debates inside and outside the government that impact how global business is conducted today and how executives plan to do business in the future. This is an issue that is not going away in our lifetimes.

Second, as a result of the debt ceiling not fully being understood by those in D.C., the real life impacts of a wind down clock go under-appreciated. That leads to negative surprises in the economy and within various asset classes.

The debt ceiling is more than a date! It's the secret glue that holds the U.S. financial system together. Tinker with that blend, and one broken link triggers other links to be snapped.

 Here is how to think about the far-reaching effects of failing to raise the debt ceiling (save for future use of course).

Credit Cards

Have a variable rate APR on your card plan, and then expect higher rates, instantly. Ditto for those with fixed rates, though you will have to be notified 45 days in advance.

Why this Occurs

Holders of U.S. debt, whether it's leading financial institutions or a country like China, may sell our debt on fear of us not being able to make good on our obligations. The problem, however, is that these sellers of our debt will have trouble finding buyers. So prices will be sent lower, which leads to higher rates. If the U.S.'s credit rating is downgraded again, as it was initially by firm S&P on Aug. 5, 2011, it may send yields even higher as more sellers of our debt rush for the exits.

Web of Destruction

Financial institutions, reeling with losses on their Treasury debt, may opt to sell stock to raise cash so that their business partners stay confident in their operations. They may also jack up rates on loans to compensate for increased risks of doing/conducting business from a small business that now has no clue on global demand for its goods and services.

Housing

Mortgage payments spike for those that reached earlier in 2013 to buy a home using an adjustable rate mortgage. At the time, they thought rates would remain low forever. These folks now have to deal with monthly payments that their jobs can't support, defaults increase, shares of banks get walloped. Everyone loses.

  • Those wanting to own a home are shut out of the market, and are now forced to rent. They likely will have to deal with landlords increasing rents to take advantage of sticky economic situation.                                                                                                                                                                     
  • As the housing market recovery gets uprooted, fewer sales at Home Depot (HD) and Lowe's (LOW) will occur, and naturally at the companies that sell items inside these stores (example: Whirlpool appliances). The aftershock? Lower stock prices for all of these companies. Note these stocks are widely held in 401ks and individual investor accounts due to their steady and rising dividend payments. Households essentially get hammered by higher mortgage payments, higher rents and then lower stock prices on investments they were told were safe!

401k

•   Investors could receive confusing advice from their confused financial advisors, and decide to incur a tax penalty to exit the stock market entirely. This would be them giving up on the future to survive today. Result: households take a tax hit and an impact from stocks they cashed in at lower values (millennial mention here possibly, their accounts could be entirely wiped out, which has a psychological impact).

•   Investors are told to ride out the storm, being forced to watch as their retirement savings evaporate north of 20% by some projections. What does that do? It causes people to adjust their spending plans today for a lower future standard of living. Stock prices head even lower.

In Closing

Everyone out there has to understand that their finances are exposed to a dizzying array of elements, all of which are held in critical balance in this digitally connected world. In the case of the debt ceiling, what worries me is the complacency on the part of financial professionals regarding this issue, suggesting that their clients (aka households) remain ill-prepared for worst-case scenarios or at the very least, to profit from the risks.

Stats to Use

  • There is currently $3.04 trillion outstanding in consumer borrowing (mostly in new auto and school loans). Default risk example.
  • MasterCard, Visa, and American Express all pay their shareholders dividends. Do these go away in the event of a default?

Debt Ceiling 2011 (summer) Rundown:

  • July 21, 2011: Dow hit its high of 12,274
  • August 2, 2011: Dow was at 11,866
  • October 3, 2011: Dow bottomed at 10,655 as the economy felt the lagging impact of the debt ceiling mess, including the S&P rating downgrade.
  • January 12, 2012: all losses related to the debt ceiling were recouped on the Dow.
  • Black Monday
  • August 8, 2011 -- Monday after the Friday night S&P rating down downgrade
  • Dow: 5.55%, 6th lowest in history
  • Nasdaq: 6.90%
  • S&P 500: 6.66% (creepy)

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