This Ticking Time Bomb Will Cost Trillions

Earlier this decade, homeowners learned the hard way what happens when cheap and easy credit dries up. Unfortunately, the lessons of Main Street haven't filtered through to Washington -- and both taxpayers and investors will be left holding the bag.

Waiting for the inevitable
For more than a year now, short-term rates have stayed at rock-bottom levels. The Federal Reserve cut the fed funds rate in December 2008 to its current target between 0% and 0.25%, and it hasn't budged since. Despite concerns that leaving the rate so low would lead to a falling dollar and leave open the possibility of inflation, the Fed still shows no signs of raising it in the near future.

Based on past history, it's fair to assume that the Fed merely wants to ensure that the economy is truly on the path to a sustained, strong recovery before tightening monetary policy. Yet there's another big reason why keeping rates low has become extremely important. Unfortunately, it's a problem that could cost trillions of dollars to get resolved.

How to run the Treasury
With a multitrillion-dollar debt to finance, the Treasury has a tough job. It not only has to raise money, but also needs to figure out how exactly to position its debt portfolio to minimize the government's borrowing costs.

The problem, though, is that with borrowing, short-term needs are sometimes in conflict with what's best for the long term. Just as homeowners got trapped by attractive adjustable-rate mortgages whose payments skyrocketed after those teaser rates expired, so, too, has the government become increasingly addicted to cheap interest-rates on short-term paper. Here are the ugly facts:

  • As of the end of March, the Treasury had $1.84 trillion in short-term Treasury bills that will come due within the next year. The yields on those borrowings range from 0.055% to 0.545%.
  • A bit less than $700 billion in Treasury notes will also come due by March 31, 2011.
  • Add that together, and you get over $2.5 trillion due within the next year -- out of a total of around $7.75 trillion that the Treasury has issued in marketable securities.

Keeping a third of your borrowings in short-term paper is a huge bet on rates staying low. As long as the Treasury can roll over that $2.5 trillion at current rates -- right now, three-month bills yield just 0.16% -- then things will remain relatively fine.

But at some point, rates will rise. Just three years ago, the government had to pay more than 5% on three-month Treasuries. If a five-percentage-point hike happened now, then the Treasury's borrowing costs on that $2.5 trillion would rise by $125 billion a year -- each and every year that rates were high.

One reasonable suggestion would be to lock in long-term rates now, especially if you think rates are due to rise across the board. But if you do that, then you'll have to pay between 3.7% and 4.6% on debt maturing between 2030 and 2040. That would basically lock in an assured $1 trillion rise in interest payments over the next 10 years.

Hurting corporate America
The problem isn't limited to the government, either. Many companies have borrowed huge amounts via short-term commercial paper at low rates. Here's what the same five-percentage-point rate hike could do to the interest expenses of some of the biggest borrowers in the S&P 500:

Company

Commerical Paper Outstanding

5-Percentage-Point Rate Hike Increases Annual Financing Costs by:

Net Income, Trailing 12 Months

General Electric (NYSE: GE  )

$49.7 billion

$2.5 billion

$10.4 billion

JPMorgan Chase (NYSE: JPM  )

$46.6 billion

$2.3 billion

$10.2 billion

US Bancorp (NYSE: USB  )

$14.6 billion

$730 million

$2.0 billion

Ford Motor (NYSE: F  )

$6.4 billion

$320 million

$2.7 billion

Coca-Cola (NYSE: KO  )

$6.3 billion

$315 million

$7.1 billion

Caterpillar (NYSE: CAT  )

$2.4 billion

$120 million

$895 million

Source: Yahoo! Finance; Capital IQ, a division of Standard and Poor's.

Those higher costs will take a considerable bite out of these companies' earnings. And that's only looking at the shortest end of their debt structures. Most of these companies, along with hundreds if not thousands of others, will also have longer-term debt coming due in the near future that will have to be refinanced.

Adding to the pile
Furthermore, none of this analysis considers the huge budget deficits we're running right now. Those deficits will need financing as well -- and the huge supply of future Treasuries could push interest rates higher still.

In that light, Fed Chairman Ben Bernanke's calls for meaningful budget deficit reduction make sense. Until the government gets its finances under control, Bernanke's job -- along with Treasury Secretary Tim Geithner's -- will just keep getting harder. And from an investor's perspective, you'll want to make sure the companies you invest in can handle their debt no matter what happens to rates in the future.

What's your solution to the Treasury's addiction to low rates? Sound off in the comments below.

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Fool contributor Dan Caplinger is no sapper -- he'd prefer never to build the time bomb in the first place. He owns shares of General Electric. Ford Motor is a Motley Fool Stock Advisor selection. Coca-Cola is a Motley Fool Income Investor pick and a Motley Fool Inside Value choice. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy recommends cutting the blue wire -- no, wait, the red one. Yeah, that's it.


Read/Post Comments (7) | Recommend This Article (33)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 03, 2010, at 12:58 PM, stan8331 wrote:

    We know short-term rates can't stay at or near zero forever. Any projection showing how low our interest payments would be if short-term rates stayed at their current levels for 10 years is a dangerous fantasy. If Treasury doesn't start locking in long-term rates soon, we'll just find ourselves in another bursting bubble.

    Deficits must come down as well, but with such a large percentage of the budget being non-discretionary, any meaningful cuts are going to be painful. Tax increases are the other option, but there is a limit to how much more can be gained from soaking the rich.

  • Report this Comment On May 03, 2010, at 8:14 PM, ChrisBern wrote:

    Stan, good point--it seems like the gov't really needs to lock in at least a good portion of that $2.5T into long-term rates. Maybe locking in 1/2-2/3 of that now would be smart, although as the article suggests, this will start costing us billions more in interest immediately and so it may be politically difficult to approve.

    As far as budget trends, first, the current administration wasted a tremendous opportunity with national healthcare to address rising medical costs. The plan which passed will break even on costs, at best, and at worst, will cost us more. If you look at projected national budgets, the #1 concern BY FAR is the rising cost of Medicare. This needs to be addressed ASAP.

    I don't believe most politicians in office these days have the political backbone to do what will be necessary to stem the deficit spending tide. As you said it will require large tax increases (which nobody wants) and/or large spending cuts (which likely won't happen because there are too many sacred cow programs and lobbying forces alive in Washington). I believe politicians will try to keep passing the buck to the next round of congressmen and presidents, until eventually things will get so bad (Greek-like?) that someone will win a campaign on the premise of "real change", meaning lowering spending and reducing the size of government once and for all.

    Also I believe the Treasury/Fed printing press will be in full gear to deflate the dollar, which is the secret way to cut into the deficit without affecting people's pocketbooks or pork directly.

  • Report this Comment On May 03, 2010, at 10:18 PM, zed260 wrote:

    well technicly the funding costs for 3 months or less is even lower almost all short term tresury debt is held by the federeal reserve most intrest gained from it goes back to tresuery(around 95 percent to be exact)

    http://money.cnn.com/2010/01/12/news/economy/fed_profits.for...

    2009 $383,071,060,815.42 was intrest expese paid on debt subtruct the profit from fed that was givin back to tresury

    or around 331 biillion in net intrest on the natinal debt

    of course since your not counting the debt the Treasury holds itself in trust fund and itnrest on it the annual instreast expense on all public debt was 150 billion in 2009

  • Report this Comment On May 07, 2010, at 5:01 PM, AQ1USN wrote:

    I expect that these interest rates will hold until after the election. Then the politicians will be able to deal with it, if they have the fortitude even then.

    My thinking is the rates will rise after December. Then Congress can rush something through in January.

  • Report this Comment On May 07, 2010, at 11:29 PM, SwingCorey wrote:

    My thinking is that, before the U.S. Fed does something like "monetize the debt", China and Japan will step up and demand their money. This will hold us in check (and in debt) for a LONG time.

    We got ourselves into a huge whole, and there's no Chapter 11 Bankruptcy for nations.

  • Report this Comment On May 08, 2010, at 11:52 PM, Zeppelin6880 wrote:

    stan8331

    "We know short-term rates can't stay at or near zero forever."

    Have you seen what's happened in Japan the last 5 or 10 years? Their 10 year bond has been under 2% for the last 10 years, currently stands at ~1.3%, and has even gone as low as 0.5% (~2004). Their short-term notes are even lower (virtually zero). Never say never about US rates being kept this low for so long. If domestic buyers of treasury debt step up and start buying in large quantities (as has been the case in Japan for the last 15-20 years, allowing their government to run massive deficits without rates going up), you never know how long rates can stay this low. Do I think this a likely scenario? No, of course not. I foresee the CPI doubling over the next 10 years, mostly coming the latter half of that time frame. Only time will tell...

  • Report this Comment On May 14, 2010, at 2:28 AM, SPARTANBURG wrote:

    Well there's always the option of the International Monetary Fund that was created for short term lending. It may be far fetched but when you're between a rock and a hard place you might as well turn to a friend (IMF) rather than a foe(China).

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