Know Before You Owe: The Student Loan Crisis

By Lori Eason, CFP(R)

Last week, President Obama announced some changes to the government's plan to help ease the burden of student loan debt. This comes after the student debt level has reached $1 trillion, surpassing the amount of credit card debt in the United States. Student loan debt has also been a recurring theme brought up by many Occupy Wall Street protestors. Unfortunately college tuition and fees are rising at an alarming rate making it difficult for many parents and/or students to afford a college education, but is this proposal the relief students are looking for? While I could write a whole article on increasing college costs or my thoughts on this whole Occupy Wall Street movement, I'd like to focus on what changes the government is proposing and how they will help or hurt students.

To give a little background, I am very familiar with the burden of student loans. I fortunately only have a small amount of student loans because I received the Hope Scholarship which covered my entire tuition, my parents helped with my other expenses and I worked during the summers to save up for the school year. My husband, on the other hand, accumulated a large amount of student debt by going to pharmacy school. By marrying him, I get to join in on the fun of making payments on a student loan that feels like a second mortgage. Thankfully, he chose a field in which he knew he'd be able to pay back his debt. We are hoping to have it all paid off in 3 years.

So now on to the relief proposed. Last year President Obama presented and Congress approved the "Pay As You Earn" proposal which will allow students to cap their student loan payments at 10% of their discretionary income and this debt will be forgiven after 20 years of payments. This was actually a revision to the Income-Based Repayment IBR) plan signed in September 2007 by President George W. Bush. The previous version allowed students to cap their federal student loan payments at 15% of their discretionary income and forgave the debt after 25 years. The new, more lenient requirements were originally set to go into effect in 2014. Obama announced last week that they will go into effect in 2012 instead.

While this new proposal has certainly gained a lot of hype, the truth is it will only financially benefit a small handful of students and it will actually cause the majority of students who take advantage of it to pay more interest when all is said and done. Here's the scoop. To be eligible for the Income Based Repayment (IBR) plan, a former student's monthly payment based on a 10 year payment plan must be higher than 10% of his or her adjusted gross income. Because the IBR payment is a percentage of income, as the debtor's income increases, so will the payments required. If the debtor marries, the spouse's income will also be included in determining whether or not eligibility requirements are met. If the income reaches a level at which 10% is higher than the 10 year payment plan amount, a partial financial hardship no longer exists. At this point, any unpaid interest that has accumulated would be capitalized (added to principal) and the debtor will now be capped at the 10 year payment plan's monthly amount. In addition, if there was any additional capitalized interest owed, that would be paid after the original amount was paid off in 10 years. In many cases, if a student has a hard time finding a job, the amount of interest paid if any might not cover the interest outstanding which results in negative amortization and the loan balance growing.

So who stands to benefit from this proposal? The only group I can see financially benefiting would be those students who have an extremely high debt to income ratio over a long period of time. If the debtor's income remained fairly low for 20 years and he or she had a high loan balance, it is plausible that there would be a substantial amount of principal and accrued interest that would be forgiven. I think it's safe to say that college was clearly not the right path for an individual who can't find a decent paying job in 10 or 20 years.

I would certainly expect that the majority of college graduates, though they may have a hard time finding a well-paying job immediately, would eventually get to a level of income that would force them into the 10 year payment plan. This would most likely mean that they would pay off their student loans well before the 20 year point at which loan forgiveness occurs. That being said, in this job environment, I do believe there are students who would benefit in the short term from a cash flow standpoint. For those graduates who can't find a job or who are underemployed and unable to pay the standard payment, this could give them a break and allow them to get their feet on the ground. But keep in mind, if they don't meet the minimum interest payment, their outstanding loan balance will grow from the accumulation of unpaid interest during this time and when they do find an appropriate job, they will owe more.

I'd now like to switch gears to another fairly recent proposal that I am a fan of. Last year the Consumer Financial Protection Bureau was created and they have since introduced a "Know Before You Owe" campaign for student loans to help students make educated decisions when it comes to paying for college. I can honestly say that as a 17 year old kid, I had no idea what I was signing when I filled out my FASFA application so I am in favor of new steps to help students understand what they are getting into. Currently, schools send students a letter before each school year that details the financial aid they can use. The "Know Before You Owe" initiative proposes a "thought starter" form that colleges can use to present financial aid information to prospective students and their families. This new "thought starter" would not only show the total cost of attendance and the financial aid available to you, but it would also show how much the student would owe in student loans upon graduation and his or her estimated monthly payment. This would help give students a perspective on the impact of taking out student loans. It would also show the student's college cost compared to the national average of other categories of schools and the US student loan default, graduation, and retention rates.

In the same way that I believe owning a home is not a birth given right, neither is a college education. Students need to have access to affordable student loans, but they also need to learn responsibility and understand that this money must be paid back with interest. There are apparently people out there that think a college education should be free. When professors start lining up to work for free, maybe that will be an option. Many people who did not graduate from college have gone on to become very successful in their careers (Steve Jobs, Bill Gates, Henry Ford, etc.). I don't think that college is for everyone and a lot of thought needs to be put into what career to choose and how much is a reasonable amount to spend on a particular degree. This would mean researching job prospects and salaries of the field a student is interested in pursuing before deciding to take on student debt.

To conclude, I do believe there is room for improvement when it comes to educating students on loans and the student loan industry itself. How ironic is it that at 18 years old with no credit history you can't get a credit card, but yet you can borrow as much as your parents paid for their house? With this new "Pay as You Earn Proposal," the devil is in the details and these details are not easy to find or understand. I fear that some students might incorrectly assume that college loans just go away in 20 years and that they may be motivated to borrow more than what is necessary. This can be a very costly mistake even though students think it is an easy decision since after all, they are investing in their future. Keep in mind that student loans are not even dischargeable in normal bankruptcy proceedings, so students need to be very cautious when deciding how much is too much.

The 411 on 401k Fees

With traditional pensions practically a thing of the past in the private industry, 401k plans have become the most common tax-deferred way to save and I would guess that many of you currently have a 401k. I'd also be willing to bet that some of you have 401ks at old employers. Because people are often unsure of what to do with these savings, we are frequently asked if it is a good idea to leave a 401k account with a previous employer. Our answer is always the same; No.

A 401k is a great savings vehicle while you are employed, especially if your employer matches even some of your contributions. Even without a match, saving into a 401k has substantial tax benefits since you are allowed to contribute up to $16,500 pre-tax ($22,000 if you are over 50). But 401ks are not perfect. They have several disadvantages, two of which are fairly significant: higher fees and limited investment choices. When you change jobs, an IRA becomes a much better alternative.

401k fees have received a lot of scrutiny over the years due to lack of transparency. Since 2007, the U.S. Department of Labor has been putting together a set of regulations that require 401k plan sponsors to better disclose information regarding the plan. A big part of this disclosure involves the plan fees and expenses. Up until now, it has been almost impossible for participants to understand how much they have been paying to participate in their 401k plans. These new rules are meant to improve the quality of 401k plans and make them more consistent from one employer to another. Unfortunately, they don't apply to 403b and 457 plans even though they suffer from the same shortcomings. These regulations were supposed to take effect this July, but have been pushed back to April 1st, 2012, mostly due to service providers arguing that it is too much work to make the changes. This is all but certain the final deadline.

Interestingly, this lack of transparency has meant that not only have many 401k participants not been aware of all the fees associated with their plan, but in some cases, the employer has not been aware either. This makes it difficult for the employer to select the best plan for its employees. Once the new regulations are in place, there will be a lot more disclosure from the plan sponsor to the employer and from the employer to the participant. Those employers who have been lax on choosing the best plan for their participants will now be forced to be more prudent in their selection since employees will be able to see every fee they are charged. Plan providers who have been overcharging for their services will be exposed and either pushed out by competition or forced to clean up their act. We view these new regulations as a much needed change in the 401k industry.

401k service providers have long gotten away with bundling fees which makes it difficult to identify how expensive a 401k plan is and what exactly the fees are paying for. The two most common categories of 401k plan fees are plan administration fees and investment fees. Administrative fees include fees associated with recordkeeping, accounting and legal fees involved with the day to day operations of the plan. In some plans, the administrative expenses are covered by investment fees and deducted from investment returns. Otherwise these expenses are either paid by the employer or charged directly against plan assets. Large employers often pick up the tab on expenses, but many smaller employers can't afford to do that. Another type of fee that participants may encounter is individual service fees, but these are pretty uncommon and are associated with optional features such as plan loans.

By far the largest component of 401k fees is investment fees. Investment management fees are generally stated as a percentage of the amount invested in each particular fund. There may also be sales charges associated with the buying and selling of shares. Some mutual funds have sales charges known as front-end or back-end load charges which are assessed either up front when you invest in a fund or when you sell the shares. One type of mutual fund fee expected to receive serious scrutiny is 12b-1 fees. These are ongoing fees paid out of fund assets to cover commissions to brokers.

Every 401k plan is different and so are the types and amounts of fees. While as an employee you don't have direct control over which plan your employer chooses, come April you will at least have a much clearer picture of what expenses you are paying. Armed with knowledge, employees who think they are paying an unreasonable amount in fees will be able to approach their employers and ask for some lower cost alternatives. Hopefully employers will use this as an opportunity to make sure that the plan they have in place is in the best interest of the employees. I don't think they want to get caught fielding complaints from unsatisfied employees.

While these new regulations are sure to improve 401k plans, an IRA held at a brokerage firm is still a superior long term alternative. Once you have left an employer, you are eligible to roll over your 401k into an IRA without incurring any taxes. If you have changed jobs over your career multiple times, you can roll all of these 401ks into a single IRA consolidating your assets and making them easier to keep up with. But perhaps most importantly, your investment choices are infinitely greater with an IRA than the handful you have to choose from in a 401k plan.

In conclusion, I want to reiterate the point that 401k plans are a great savings vehicle for employees. But there is definitely room for improvement and I am glad the Department of Labor's regulations are finally being put into place. Transparency is extremely important when it comes to the cost of services, especially with one's retirement on the line.

More Triple Digit Days

By: Charles Webb

We've been busy in the Alder Financial pressroom this summer. Again, we're seeing more extreme volatility in the markets and once again, it's all about Europe. We've written over the past couple of months that we felt the stock market was going to be largely driven by news coming out of the Euro Zone. That's exactly what we're seeing today.

Today's selloff came after U.S. federal bank regulators expressed concerns that Europe's debt crisis could spill over to the U.S. banking system. Some of Europe's biggest banks have major operations in the U.S. and rely heavily on borrowed funds to finance those operations. The worry is that the Euro Zone debt crisis could eventually hinder the ability of European banks to fund loans and meet other financial obligations here in the U.S.

U.S. regulators are seeking to avoid a repeat of the 2008 financial crisis, when the global financial system began to seize up, and are turning up the pressure on these banks to transform their U.S. operations into self-financed businesses. This would better insulate them from liquidity events in their home countries. The most immediate concern is how these banks are going to refinance their maturing debt in the coming years. While these banks are adequately funded now, one lesson from our own banking crisis a few years ago is how quickly those resources can disappear.

In addition to the banking news, the market is reacting to more weak economic data released this morning. This data shows a continuing deterioration in manufacturing and home sales as well as higher inflation. The uptick in inflation was largely driven by higher gas and food prices.

The worry is that we're headed into another recession next quarter. GDP has recently slowed considerably and is barely in positive territory. This is where the events in Europe become so important. Most of the economic recovery so far has come from rising exports, thanks largely to the weak dollar. Much of those exports have gone to Europe. Should Europe suffer a major setback, the chances are pretty good that we'll see what little growth we have here disappear.

The decline in stock prices are now reflecting another recession. If we're able to avert this, the recent selloff represents a buying opportunity. Otherwise the summer's selloff is justified. Our opinion is that another recession is technically likely but would be short and far less severe than the last one. We've positioned our client portfolios as defensively as we can without making a huge bet in one direction or another.

With cash yielding nothing and the Fed announcing it will remain that way for the next year and a half, we believe bonds are the only place to hide. This is why we continue to be overweighed in that asset class and focused on current income. We're still positioned to wait this out.

Our forecast for this year has been subdued by recent events but remains positive. Our belief is that the headline risk coming out of Europe will begin to subside by the end of September. We're hopeful that stocks will get a bounce off these levels and finish the year modestly in the black. Add this to the cash income, and we'd wrap up the year with a respectable total return.

Another Week, Another Crisis

By Charles Webb

Standard & Poor's was kind enough to send us home over the weekend with a credit downgrade of U.S. long-term debt. This would have been unimaginable only a couple of years ago, but here we are. Now we're faced with the first day of trading in what many think of as a new financial world, a world in which U.S. debt backed by the U.S. dollar is no longer the unquestioned safe haven in troubled times.

So what does all of this actually mean? Well, we've written fairly extensively over the past few months on the subject of sovereign debt and the dollar and have touched on the subject of a possible downgrade. Now that it's here, it's a good time to put all of the pieces together.

The first thing that is important to acknowledge is that a downgrade on sovereign debt is very different than a downgrade on corporate debt. A downgrade in the corporate world is serious stuff. It directly affects the rate a company will pay when it borrows money, either from a bank lender or from the bond market when it issues debt. Nations, on the other hand, issue their debt via an auction process and the interest rate paid on those bonds is strictly based on the bids received. Thus, their cost of borrowing is a function of the demand for their bonds. That demand is only marginally (at best) influenced by a credit rating agency. For a major economic power like the U.S., the rating is meaningless. What we have there is a moral defeat and not a financial one.

I think it's best to frame this discussion more as a political failure than a financial one. No one, including S&P, thinks that the U.S. will default on its debt. The only risk that holders of U.S. treasuries face is what I earlier described as a soft default. That is to say that higher interest rates and a weaker dollar will hurt current bond holders by devaluing the purchasing power of their future interest income. This is no small thing to foreign investors that hold trillions of dollars in treasuries. There has been a real concern in recent years about holding U.S. dollar denominated assets when the Fed has been pursuing a weak dollar monetary policy while also running massive fiscal deficits. The irony surrounding S&P's downgrade is that there is absolutely nothing in their announcement that hasn't been widely understood for at least two years. That's why I call this a moral defeat or simply the cherry on top of a pile of bad news.

The Financial Fallout

Wall Street often thinks of macro trading strategies as risk-on or risk-off. Risk-on usually means buying stocks- i.e. going long risky assets. Risk-off is the opposite and usually leads to a flight to the safest asset - i.e. U.S. treasuries. What does a risk-off trade look like now? Well, it turns out that it looks like it always has. Treasuries are rallying driving rates down. Not exactly what the textbooks teach. This is why we don't think this downgrade will actually lead to higher consumer rates or hurt the economy long-term. The economic damage will result for the same reason as the downgrade and not from the downgrade. Obviously, this is too much debt and the prospect is for even higher debt levels in the future.

Once again, we are benefiting from the focus on Europe. Due to their own debt chaos, the U.S. treasury market remains the only game in town. There certainly are other nations in better fiscal shape, but those markets simply aren't deep enough to accommodate the required liquidity. Quite simply the world doesn't have anywhere else to park $10 trillion.

Short-term we expect to see a lot of volatility. That is to be expected as market participants digest this news. We still view this as headline risk and are far more concerned with the fundamental underpinning of the economy. The only way this downgrade could affect things long-term is if it leads to higher rates. We just don't see that happening.

Make no mistake, stock prices over the last few weeks, today and in the coming weeks have and will be driven by fears of slowing GDP that could lead to another recession. Market sentiment is pretty low right now. This downgrade is only exacerbating that feeling. As we've seen in the past, attitudes can turn quickly.

Don't be surprised to hear of other downgrades over the week. Because the federal government backstops a lot of other debt issuers, this downgrade is going to trickle through. We're already seeing rating changes on Fannie Mae and Freddy Mac, as well as several other agency debt issues. Once again, I don't expect this to have much of an impact. In fact, spreads on many of these bonds, including treasuries, have widened over the past couple of months. This implies that the market has been pricing in this rating change for weeks.

The Political Fallout - warning: if you're politically sensitive stop reading here. This is about to get very opinionated.

As I stated earlier, this event is primarily a political failure. Standard & Poor's really didn't downgrade our debt as much as they downgraded our fiscal policies. This is the result of an abject failure of leadership in this country. The federal government has run deficits for decades. Not surprising as that's what governments do left unchecked. Only from time to time has Congress been serious about addressing our country's debt and spending level. Even then, they usually just gave it lip service. The last time any real effort was made was during the Clinton presidency when the Republicans took control of the House and Senate.

Over the ensuing years of Republican control, the party in charge became drunk with power (because this is what politicians do) and went on a spending binge. Government spending exploded with all of the fresh tech-bubble tax revenue in the late 90's. We then had to suffer through the Bush presidency that never saw a spending bill worth vetoing. Add a couple of wars and we were off to the races. From there we then went to a Democratically controlled Congress and Senate led by a very activist arm of the party. Two years later president Obama was elected.

Federal spending has expanded exponentially to the point that we now borrow 40 cents of every dollar. This trend has been particularly egregious over the last three years - all in the name of stimulus. So let's take a moment to talk about stimulus spending and how it's supposed to work. I'll try to do this without getting lost in the weeds of economic theory.

By nature, government fancies itself as the solver of problems (real or imaginary). As such, Keynesian economic theory has always been very popular in governments around the world. Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes. Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the public sector, including monetary policy actions by the central bank and fiscal policy actions by the government to stabilize the business cycle. One might call a recession an inefficiency. Keynesian economic theories were first presented in The General Theory of Employment, Interest and Money, published in 1936.

Part of this theory incorporates the concept of the multiplier effect. This theory believes that, for a number of reasons, for every dollar of government spending you will get a larger number back in GDP. The president's first set of economic advisors seemed to think that we would see a 1.5 multiplier. This means that for every dollar they spent, the economy would see a $1.50 increase in GDP (I'm not sure where this brain trust came up with that figure but it seems to be the same place they got unemployment not exceeding 8%). From here the Stimulus Bill was born and all other policy responses were based. In all fairness, stimulus spending was Bush's first response too, although nowhere near in size.

What we have seen in the past two and a half years has been a giant experiment in Keynesian economics and the results are not looking promising at all. This experiment has come at a great cost to our public debt and, in my opinion, not shown much in the way of working. Not only have we had trillions of dollars thrown at the economy, but we've also vastly increased baseline expenses in perpetuity. This is at the heart of the S&P downgrade and the pushback from the public at large.

One thing that I find very disheartening is the response from the White House. Instead of honestly critiquing their results, the reaction is to blame others and want to double-down on this experiment. To be sure, all the president's men came out in full attack mode this past weekend blaming all of this on S&P's analysis. Absurd. Is there anything that S&P said on Friday that everyone else doesn't already know? S&P essentially declared that on present trend the U.S. debt burden is unsustainable, and that the American political system seems unable to reverse that trend. This is not news.

So after trillions spent on "investments" like cash for clunkers, cash for caulkers, cash for first time home buyers, making work pay, cash for green energy, cash for high speed rail, etc., we now have the latest grand idea - an infrastructure bank. This is simply code speak for more stimulus spending. It's a "bank" funded with - can you guess? More debt to invest in our infrastructure. Sounds very shovel ready in my opinion.

To me it sounds like these people are so very in over their heads and out of ideas. I've never been a big believer in the multiplier effect. I think instead all it does is postpone the inevitable. All of these programs have done nothing but drag out this recession/recovery. A great example was the housing price bust. Untold amounts of money were paid to folks to buy homes sitting on the market and thus create demand. It worked. That is until the program ended and then prices fell yet again. Interestingly, they fell by about what the credit was. So instead, the housing price decline lasted a couple more years with prices ending up at basically the same place. In the meantime, our kids have just paid the down payment on a stranger's home.

The bottom line is that the spending must stop and their other favorite solution, raising taxes, would be counterproductive. It's unclear to me how you fix a spending problem by throwing more money at. That's a bit like solving alcoholism with another drink.

This leads me to another complaint. The blame game isn't going to help matters. I'm perplexed to see time and time again the president go on national TV demagoging entire industries and large segments of our population. One of the other themes seen this weekend was that the downgrade was the fault of the Tea Party movement. I fail to see how a movement that arose out of the desire to curtail spending is in anyway responsible for the situation we find ourselves in today. Of course, what the administration is really saying is that those members of Congress aligned with the Tea Party objected to a balanced approach - i.e. raising taxes. Once again, this problem didn't spring up because of any tax shortfall thus the solution won't be found there. At best, higher taxes would only slow (and not by much) the decline in our fiscal situation. There just aren't enough corporate jets in this world or hedge fund managers to make a difference.

S&P did mention in their report that one problem they saw was an unwillingness to raise taxes. One important thing to note here is that they are not in the job of writing economic policy. They would rather see the deficit gap close as quick as possible regardless of the long-term consequences - give the man another drink and he'll be quiet for a while.

In Summary

This too will pass. If the politicians won't adequately address the problem, the market will force the issue. This is a wakeup call to Washington. The president used to say that elections have consequences. This downgrade will have consequences too and it won't be financial but instead will be felt at the polls. We should all be furious with everyone in Washington who contributed to this mess. Good credit is nothing to play around with and is very hard to get back once you've lost it.

There Will Be Days Like This

By Charles Webb

It's never easy to sit back and watch the Dow drop five hundred points. But it happens. From a technical standpoint, the last two weeks have put the U.S. and most foreign stock indices in "market correction" territory (down 10%).

Yesterday's action was the culmination of a steady deterioration in the fundamental data over the last two months in the U.S. and continued liquidity uncertainty coming out of Europe. The primary emphasis here has been poor Jobs data and revised lowering of GDP for 2011. In Europe, it's just been more of the same - declining quality of sovereign debt.

From a technical trading standpoint, a number of key thresholds have been crossed on the downside leading to more momentum lower. All of this adds up to a glut of bad news and very little to look forward to.

After today's rout, most stock indices have erased their year-to-date gains and are now negative for the year. The Dow Industrials are down 1.67% and the S&P lower by 4.58%. Higher quality corporate bonds have been the place to be in the past four weeks with those indices up 4-5%.

There really isn't anything unusual about what is going on right now and we've seen plenty of days like this over the years. Admittedly, it's hard to remain optimistic after a big selloff, but our outlook for the year is still positive on stocks, although slightly less than we had at the beginning of the year. The problem now is that we don't see a catalyst for a change in sentiment in the near future. Until then, stocks are likely to drift lower.

So what can we do in the meantime? Since the economy crashed in 2007, our investment strategy has been to focus on increasing the cash flow in our client portfolios and adding predictability to the returns with bonds. Those efforts are still paying dividends today (literally). While many of our highest yielding securities have paid down over the last couple of years, our overall portfolio income remains strong and valuations less volatile. In most cases, our clients' portfolios are cash flowing around 4% and the values are back to the pre-crash levels. That's no small feat considering the Dow Industrials are still down 18% from the highs in 2007.

Going forward, we want to stay out of cash. You'll probably be hearing a lot in the financial press about cash being a safe haven. In real terms though, (taking inflation into account), cash balances only guarantee losses. The Federal Reserve has been pushing investors out of cash for several years in order to get that capital working in the economy. They've done this by keeping short-term rates near zero. We don't see that attitude changing anytime soon.

Instead, we'd like to keep everyone fully invested and slightly over-weighted in bonds. Our expectation is that stocks will struggle for the next month or two and then come back in the fourth quarter. We think the market needs to see two months of a positive trend in employment and GDP to really turn around. Growth is now just about flat and there are real fears of slipping back into a recession. We don't think that will happen but even if it did, it would likely be very short and shallow.

The best real-time gauge of market sentiment will be the news coming out of Europe. The Euro Zone economy is larger than the U.S. and thus is a significant global trading partner. The fear is that a significant slowdown in their economy would have a ripple effect around the world. This is especially a threat here in the U.S. and could be the difference between slow growth and no growth in our economy.

We of course will keep our clients informed as things change. For now we feel that everyone is situated about as best as can be hoped for. Once again, we think cash flow is the key to avoiding the need to sell into this market. Remember that the only two days you care about what something is worth is the day you bought it and the day you sell it. You don't want to be in a position to have to sell into this market. That's when investing becomes gambling.

Perspectives On The Debt Ceiling Debate

By Charles Webb

"For those who say further responsible spending reductions are not possible, they are wrong. . . For those who say more taxes will solve our deficit problem, they are wrong. Every time Congress increases taxes, the deficit does not decrease, spending increases." – Ronald Regan

The debate over the U.S. statutory debt limit has come down to the wire. The U.S. Treasury has stated that if an increase in the debt ceiling is not in place by August 2nd, they will run out of funds to pay all of their bills. Yet with just days left before the deadline, political brinkmanship in Washington shows no sign of letting up.

There are so many ways in which this political crisis can play out. Each one is further complicated by the fact that there is no way of knowing precisely how financial markets will react if this deadline is breached. For decades, U.S. Treasuries have served the global financial markets as an unquestioned source of liquidity. When this conventional wisdom is thrown out the window, the world looks like an unpredictable place and financial markets hate unpredictability.

As we see it, there are four possible outcomes. The first and most desirable outcome is that a consensus is formed around a spending plan that puts this country on a sustainable fiscal path. By contrast, the current path is quickly running out. The can has been kicked down the road so many times that the road has simply run out. Even the Congressional Budget Office acknowledges that our current situation is unsustainable.

Scenario 1

This best case scenario would immediately raise the debt ceiling, putting any short-term uncertainty to rest, and institute a fiscal austerity plan in place that would bring the country’s outstanding debt to within a reasonable percent of GDP. In the short-term, stocks would rally, Treasury spreads would narrow and the dollar would strengthen. Medium-term, this would put downward pressure on economic growth and slow the recovery. Four trillion dollars in cuts over ten years, it is estimated, would reduce GDP by about 0.5% per year for the next five years. This deleveraging cycle would be very similar to what we’ve seen in the private sector over the last three years; a sharp impact short-term but lasting benefits long-term. It would be the take your medicine now approach.

Scenario 2

Similar to the first, scenario two would have a last minute deal struck by Congress and government operations would not be interrupted. However, this deal involves only an incremental increase in the debt ceiling in exchange for ongoing discussions on a larger fiscal agreement. Standard & Poor’s has repeatedly stated that they would still consider downgrading the status of U.S. debt if they believe a credible long-term solution to the rising debt burden has not been found. However, even if this were to occur, it would likely have a relatively minor impact on the U.S. economy as other ratings agencies do not appear inclined to follow.

With the risk of a shut down in government operations and a debt default having been averted, we suspect markets would take a downgrade by a single agency in stride. Nonetheless, worries about the long-term prospects to deal with the fiscal imbalances would persist. This scenario would bode for continued weakness in the U.S. dollar, but not a sharp decline from current levels. Bond yields would be largely unaffected, as markets would go back to fretting about the sub-par pace of economic growth.

Scenario 3

The third scenario arises if the political impasse takes us past the August 2nd deadline. In all probability, this would eventually be followed by a ratings downgrade by Standard & Poor’s, and there would certainly be heightened risk of action by other rating agencies.

In this scenario, we end up with a double hit on the economy. The first hit comes from the direct impact of withdrawing government funds from the economy equal to their financing shortfall - estimated to be $135 billion for the month of August. The second hit comes from the indirect impact of a potential rise in Treasury yields and flight out of equities due to deteriorating market sentiment.

There is no way in knowing how long the political impasse would last if it were to occur. If we assume a political resolution is not found for the entire month of August, a reduction of $135 billion from the economy would equate to an annualized 1.5 to 2 percentage point drag on GDP growth in the third quarter. The market reaction would be serious. At the very least you would see a flight out of risky assets, like equities. Similarly when Congress initially failed to pass the TARP legislation in late 2008, the S&P 500 suffered one of its largest single day drops on record (-9%).

The likely public reaction would certainly lead to a quick compromise in Washington and much of the market reaction would reverse itself. However, the lost GDP would leave the economy in much worse shape than it is today. Overall, the impact would be directly related to the length of time past the August 2nd deadline it took to reach an agreement.

Scenario 4

In this scenario the U.S. government actually defaults by not making or is late in making its interest payments. This would be totally unimaginable and we don’t think there is a remote chance of this happening. This event would take us into uncharted waters in modern finance.

Financial markets would simply freeze. Every asset class would drop in value. Stocks, bonds and even money markets would take severe hits. It’s even uncertain what commodities like gold would do. An economic recession/depression would surely follow from the total freeze in U.S. credit markets.

A Little of Our Opinion

Depending on how long it takes Congress and the President to reach an agreement, the impact could range from a short-term negative to disastrous. The financial market’s impact will depend on how long this impasse takes to get resolved.

It must be recognized that federal spending must be sharply reduced to stabilize the debt to GDP ratio. As we’ve stated before, this is a spending problem and not a revenue problem. As such, this situation must be confronted from that perspective and there will be some negative economic effect from this deleveraging.

To try and address this issue by raising taxes is counterproductive in our opinion. It’s important to understand that there are three basic inputs to production (GDP): materials, labor and capital. These are not substitutes for one another but instead must be used together. When the government collects taxes or runs up debt, it is consuming capital that would otherwise be available to the private sector and thus retards economic growth.

In the current debate we’ve heard a lot about taking a balanced approach to fixing this crisis. This of course means raising taxes as well as cutting spending. Our objection to this is that taxes are already going up almost a trillion dollars beginning in 2013 due to the healthcare legislation passed last year. We don’t think that adding more taxes in this economic environment is a good idea nor do we think it would help long-term. Clearly government is necessary and must be funded, but to what extent? I’m reminded of the saying that traffic will always fill the roads, meaning that no matter how many times you expand the freeways, traffic will always increase to the road’s capacity. Government spending is much the same way. No matter how much is collected in taxes, politicians will always find a way to spend it – and then some. This is how votes are bought and constituents pleased.

The Bottom Line

We think that scenario 2 is the most likely outcome. We also think that the debt ceiling increase will get finalized at the last minute and maybe even a day or two after August 2nd. Expect the markets to be volatile over that time and the news to be disheartening. We strongly believe it would be a mistake to change or make any investment decisions based on this news. Whatever hedges that could be put in place would be destroyed once a compromise was reached.

You’ll hear a lot of news about our AAA credit rating. While this shouldn’t be taken for granted, the reality is that there is enough demand in the treasury market that it will look through what is clearly a political event and not a true default.

In the end, the markets will trade on the fundamentals of the economy and not the headlines. That’s what we’re focused on when it comes to our clients’ portfolios. We still feel pretty good about the fundamentals.

The Almighty Dollar

By Charles Webb

A weak currency is the sign of a weak economy, and a weak economy leads to a weak nation - Ross Perot

In April, we wrote an article about this county’s exploding Federal debt problem. This month we’d like to expand on that topic by looking at a closely related subject -the dollar’s steep decline and its implications.

The quality of a country’s debt is directly linked to the value of its currency. The reason for this has to do with a specific type of risk associated with sovereign debt.

There are basically two types of risk when investing in foreign sovereign debt. The first and most obvious risk is credit risk, or the risk of outright default. That is to say that the country simply can’t make the interest payments and can’t repay the debt at maturity. Since most countries can print their own currency, the risk of outright default is very unlikely. The exception to this is if the country is part of an economic union such as the Euro and thus can’t print money at will – i.e. Greece, Spain, Ireland, etc.

The second type of risk associated with foreign debt is currency risk. This is the risk of a decline in the value of the currency of which the debt and payments are being made. It is possible for an investor to lose money on a foreign bond if its currency declines at a rate higher than the bond’s coupon. For example, if a bond pays 4% per year but the underlying currency depreciates at 5%, an investor would cumulatively lose around 11% over ten years. That’s not exactly a risk-free investment and is one of the reasons the international community is so concerned about the persistent decline in the value of the U.S. dollar.

So what causes the value of a currency to decline? There are many factors that lead to changes in the value of one currency relative to another. The biggest one, though, is greatly expanding the supply of that currency.

As we mentioned in the last article, in this electronic age, the money supply isn’t grown by the printing press but done so via the central bank’s open market operations. The current phrase for this is “quantitative easing”. The Fed does this by purchasing bonds (usually their own – i.e. treasuries) in the open market and paying for them by crediting the seller’s bank account.

Since the housing bust and the ensuing banking crisis, the Federal Reserve has attempted to support the economy by pumping billions of dollars into the banking system. These activities are in addition to the government’s fiscal activities or stimulus spending and have greatly expanded the money supply.

The flood of new dollars has created a kind of soft default on our debt that is calling into question the soundness of our Treasury bonds and their AAA rating. Foreign investors have become very concerned about what they perceive as an unstated weak currency policy which is leading to real losses on the trillions of dollars of treasury debt held by foreigners.

So why does this matter to us? After all we’re not taking the losses, it’s the other guy. Quite simply those are our creditors and we depend on their appetite for our bonds to fund our government’s spending binge. At some point, our creditors will lose faith in the soundness of the dollar and demand higher rates on our bonds to compensate for the currency losses. Those higher rates will affect everything from mortgage rates to business loans, not to mention how it will exacerbate the deficit.

A Breif History of the Dollar

Since 1945, most of the world has been on a dollar standard. Today, for emerging markets outside of Europe, the dollar is used for invoicing both exports and imports, it is the intermediary currency used by banks for clearing international payments, and the intervention currency used by governments. To avoid conflict in targeting exchange rates, the rule of the game is that the U.S. remains passive without an exchange-rate objective of its own.

After World War II, the Bretton Woods agreement put the dollar at the center of foreign trade by requiring the U.S. to exchange gold for dollars at the request of trading partner governments. Other countries would hold dollars in reserve to underpin their own currencies. The gold standard imposed discipline on the U.S. and gave everyone else a stable and liquid reserve currency.

The plan worked well until the 1960’s, when U.S. deficits led to a meaningful increase in the money supply. Wary trading partners then began to exchange dollars for gold until 1971 when the U.S. closed the gold window, refusing to trade gold for dollars.

Instead of switching to another reserve currency, the global economy kept on buying dollars. At that point, it was as if the U.S. was given a virtually unlimited line of credit from the rest of the world.

Americans proceeded to borrow more and more in the ensuing years. This addiction to debt crept into every level of society - from federal and state governments, to consumers and businesses. From 1970 to 2009, total debt in this country rose from 170 percent to 350 percent of GDP.

The Dollar Today

So why are foreigners still willing to loan us money? Quite simply, we’re the only game in town. Countries that run large trade surpluses with the U.S. find themselves with ever-growing balances of dollars on their hands. They have to do something with this cash and they find themselves with little alternative but buy U.S. treasuries with those dollars.

The lack of alternatives is the key. If there was an alternative, you would see an immediate drop in the number of investors lining up at the treasury auctions. With fewer interested buyers, rates would be bid up, leading to higher interest rates throughout the economy.

These higher rates would devastate consumer spending, the real estate market and business growth. In addition, the percent of tax receipts required to service $8 trillion of debt rolling over at these higher rates could easily double. This would create a death spiral of higher deficits leading to higher borrowings and yet higher rates and so on.

This is why it’s so important for the federal government to get its fiscal house in order. The United States has benefited greatly in many ways due to its standing in the financial community. The threat posed by our massive deficits that seem to have no end could permanently reduce our standard of living.

The key to maintaining our global prominence rests on the dollar’s reserve status. Because of the uncertainty of our monetary policy, long-term, the rest of the world is actively looking for an alternative. Fortunately for us there isn’t one. At one time it was hoped that the Euro would be become an alternative. Europe’s own debt crisis has dashed any hopes of that and has bought us more time to fix things here. Let’s hope Washington can get their act together in the meantime.