Did we really need any further proof that our lawmakers are short-sighted and irresponsible? Not really, particularly if it comes with a $100 billion tab. Yet that is the estimated cost of one possible consequence of partisan squabbling and politicians' inability to look further ahead than their next election.
A short-term and a long-term problem
By delaying an agreement to extend the federal debt ceiling and refusing to tackle long-term budget reform, Congress puts the U.S. at risk of rating agencies downgrading its credit rating. Moody's (NYSE: MCO) has said explicitly that a technical default -- which will occur unless the debt ceiling is raised before Aug. 2 -- would force it to place the U.S. on review for downgrade.
The debt ceiling is in some sense a sideshow with regard to the elephant in the room: the need for structural budget reform to address unfunded liabilities (Medicare, Medicaid, and Social Security). A research group at McGraw-Hill (NYSE: MHP), S&P Valuation & Risk Strategies, now estimates that a downgrade might mean a $100 billion drop in value across outstanding Treasury debt, and that analysis assumes that the debt ceiling is raised.
That number sounds realistic; there is a precedent for this, after all. In 1979, the U.S. Treasury failed to repay a measly $122 million in Treasury bills on schedule. An academic study later found that this technical default cost the Treasury an extra 60 basis points (one basis point equals one hundredth of a percentage point) on some federal debt. The Economist estimates that would equate to $86 billion a year today, or 0.6% of GDP.
Companies would share taxpayers' misery
But the $100 billion is by no means the extent of the total cost of a downgrade. First, the Treasury's annual interest cost would increase by between $2.3 billion and $3.8 billion. In addition, bond investors price corporate bonds at a spread to the risk-free rate -- the yield on same maturity Treasury bonds. A rise in Treasury yields would almost certainly result in an increase in companies' financing cost, as the risk-free rate and the spread would increase.
Companies have had it good in this low-yield environment. Whirlpool (NYSE: WHR) issued a $300 million bond at a yield of just 4.85% at the beginning of the month, less than 2 percentage points above the same maturity Treasuries. Blue chips Philip Morris (NYSE: PM) and AT&T (NYSE: T) also issued debt in the second quarter, the former to fund share repurchases and the latter to finance the acquisition of T-Mobile. These companies can afford the hike, but that's beside the point.
Playing chicken in taxpayers' cars
Do I expect that Congress will eventually reach an agreement in order to avoid a technical default? Yes, but I can't dismiss the risk that it won't. Lawmakers are playing a dangerous game of chicken, and if they crash, it will be up to U.S. taxpayers to foot the repair bill.
With Congress courting a default, no wonder gold prices are near historic highs. One little-known gold miner is making a fortune; find out which tiny gold stock is digging up massive profits.
