The Debt Ceiling Debate

Earlier in the month, when I was looking at which stories I would include, I did not think that the Feature story would have to be one about the US potentially defaulting on its obligations and losing its AAA credit rating. Unfortunately, due to the inaction by our politicians, it's become the biggest story
 

The Issue

If lawmakers fail to raise the debt ceiling by next Tuesday, the Treasury Department has said it will no longer be able to guarantee that it can pay all of the country's bills in full and on time. That's because the Treasury will not be taking in enough revenue to cover all of the bills coming due in August. Estimates have the government being about $134 billion short for the month of August. And without a debt ceiling increase, it will be prohibited from borrowing new money in the bond market to make up the difference.
 

How will it impact you?

No one really knows what the full impact is going to be. Will the US be able to pay our military? Or will the 28 million people taking Social Security receive their check every month? The consensus: the Treasury will prioritize who to pay first and who to put off. At the top of the list of who gets paid would be investors; those owed interest on the US debt. The Treasury department has said they will communicate the prioritized list as August 2^nd approaches. I don't think that this plan will give anyone comfort, if and when the list is published.

How will it impact your investments?

The fevered media attention has a lot of people wondering whether they should move their money around to protect their situation. My recommendation: if you have a long term plan for your financial investments, then you should stick to it. There are a lot of ways that this can play out. The politicians could surprise (maybe shock) us and actually come up with an agreement in time to defuse the default threat. Depending on the agreement, the market could still drop if investors perceive it as a lousy deal, or it could rally if the deal is to their liking.

You may find moving your investments into cash, for the short-term, is a risk-free way to protect your savings from potential Armageddon. But if the setback that people seem certain is coming doesn't actually occur, or is much more mild than anticipated, you have moved your money unnecessarily and you could miss out on any gains if and when the market rebounds while you are still in cash. The most recent example of this is people who put their investments into Cash AFTER the market crashed in 2008 and still have it there now after the market has gained over 50% since 2008.

If your goal is simply to avoid short-term losses altogether, the answer could be to keep all of your money in FDIC-insured savings accounts, but most people need some growth in their investments to account for things like inflation.

Credit Default Swaps

With all of the focus on the US Debt Ceiling issue it is easy to forget about the problems that a select group of countries in Europe are having right now. If you thought that you heard the last of Credit Default Swaps with the credit crisis of 2008, they make a return appearance with the credit problems that a select group of European countries are going through.

Credit default swaps are insurance that pays off when a borrower defaults

1. You make a purchase of $100 million in Italian Government Bonds
2. You are nervous that the Italian government may not be able to pay the interest on those bonds so you enter in an agreement with a third party (usually a large bank or hedge fund) to buy what amounts to insurance on the $100 million in bonds
3. If Italy defaults in the next five years the third party who you bought the insurance from must make you whole and pay the interest that you were to receive.

The beauty of these financial products is that risk can be transferred from people who do not want to assume the risk to those that are happy to bear it. The ugly is that credit default swaps, like any insurance, is only as reliable as the company promising to pay. If the banks that sell protection to each other all started suffering loan, losses it could blow up the financial system. This is what happened a couple of years ago when a $182 billion bailout was given to AIG who sold loads of underpriced protection on overrated US mortgage backed securities.