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The debt ceiling and what it might mean for your clients' portfolios

The most common debt ceiling questions, answered

The U.S. government reached its $31.4 trillion debt limit—known as the “debt ceiling”—on January 19. It’s not the first time, and it likely won’t be the last. How should you prepare your clients for a possible U.S. default, and what does this mean for their portfolios now and in the future.

What is the debt ceiling?

Most simply, the debt ceiling is how much money the U.S. government has to fund its spending – that is, the maximum amount that the government can borrow using bonds – for existing legal obligations like Social Security, Medicare, military salaries, interest on national debt, tax refunds and other payments. It’s currently set at $31.4 trillion.

The most important thing to remember is that this number is tied to previous spending – not current or future spending. Basically, it’s paying back the legal obligations the government has already made.

Why do we even have a debt ceiling? Enacted as part of legislation allowing the government to issue war bonds for World War I, the ceiling was put in place in 1917 to placate legislators who were opposed to runaway debt. It’s been lifted 78 times since 1960, under both Republican and Democratic administrations.

It’s past January 19, has the government defaulted?

No. The Treasury Department can employ what are known as "extraordinary-measures" -  basically, fiscal accounting maneuvers, like scaling back investments in retirement plans for federal employees - to avoid default until what is called the “X date”, which is at least June. Despite the name, these measures are not that “extraordinary” and have been used by Treasury secretaries from both sides of the aisle to allow the government to continue to function.

Once these measures have been exhausted, the only option is to raise or suspend the ceiling. After negotiations between Congress and the White House started earlier this year, talks have stalled, in part due to the lack of response to the White House’s annual budget proposal on March 9.

What happens if the debt ceiling is not raised or suspended?

At the most basic level, the government will run out of cash and be unable to issue new debt or pay its bills, and could default on its debt if it can’t make payments to bondholders.

The ripple effects of a default would be serious.

“If that happened, our borrowing costs would increase and every American would see that their borrowing costs would increase as well,” Treasury Secretary Janet Yellen said on January 20, the day after the debt ceiling was reached. “On top of that, a failure to make payments that are due, whether it’s the bondholders or to Social Security recipients or to our military, would undoubtedly cause a recession in the U.S. economy and could cause a global financial crisis.”

The repercussions of default are still in play months later. A breach of the debt ceiling would spark a “prolonged downturn and global financial crises,” Secretary Yellen said on March 30. “It could upend the lives of millions of Americans and those around the world."

Last fall, the chief economist at Moody’s Analytics anticipated that failure to raise the debt ceiling could result in a loss of up to 6 million jobs, wipe out $15 trillion in household wealth and increase unemployment to near 9%.

How should we prepare for the worst-case scenario? What about the market volatility?

It’s important to note that there has never been a U.S. government default. This is one of the reasons why the dollar is one of the world’s strongest currencies and why the world’s credit markets depend on it. But just having this uncertainty over the next several months will likely contribute to “flare-ups” in financial market volatility that will impact savers, investors and everyone.

This is not the first time in recent history that this same scenario has unfolded. In fact, looking at the 2011 debt ceiling crisis – which avoided a default - is instructive as a roadmap to what might happen today: stocks plunged (particularly those in industries which are closely connected to government, like defense and health care), mortgage rates soared and the U.S. credit rating was downgraded for the first time ever.

Knowing that some market turmoil is likely, investors might want to take a broad look at their portfolios, and assess their appetite for risk. Money market funds may see a mass selling or freeze if there’s a market panic, extending to other asset classes, particularly the stock market. Companies with the highest exposure to the U.S. government will likely take the biggest hit. Building up a cash safety net would be beneficial during times of volatility, and looking at real assets and high-quality stocks and bonds in foreign currencies.

How could investors' wallets be impacted by a default?

401(k) and financial markets at risk – A default would threaten the value of bonds, equities and the dollar, which would wreak havoc on the already financially precarious domestic and international markets.

Social Security and Medicare at risk – Almost one-third of the federal budget goes to Social Security and Medicare. A default could cause delays in payments, and risks to other government obligations like military and contractor salaries, and payments to agencies and state and local governments.

Consumer interest rates may rise – A downgrade by the credit agencies of U.S. Treasury bonds would raise borrowing costs for consumers, since mortgages, auto loans, credit cards and other types of consumer debt are linked to the Treasury market.

Stock market volatility – If 2011 is anything to go on, stocks went down - even more so for companies connected to government spending – and the volatility spiked.1

Is there anything that can be done to avert a default?

Two “extraordinary measures” are already working to help keep the money flowing - selling and suspending investments for federal employees’ retirement funds – to be made whole again after the debt ceiling is rectified.

There are other options – although these are more theoretical than anything else. The Treasury department can try to avert disaster by prioritizing payments, such as paying bondholders first. Some other unprecedented options have come up like selling the nation’s gold reservesminting a trillion dollar coin or invoking the 14th amendment to override the debt limit.

Is there a way to keep this from happening again?

While the debt limit could be eliminated by statute – which Treasury Secretary Yellen has called for – doing so would be deeply unpopular, resulting in these perennial crises. If the ceiling is here to stay, the best way to neutralize the controversy is in the budgeting and appropriation process at the outset, so the limit would not need to be raised later when bills became due.

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