Comments on the US Debt Crisis

In the wake of the Congress failing to vote last night on a measure to raise the debt ceiling, I would like to leave you with another perspective on the pending American debt issues.  This article is from Norman Raschkowan, Chief North American Strategist, Mackenzie (note the image below is from the same source).

The issue: the U.S Congress establishes a limit of total Federal Government debt that the Treasury may borrow at any time – the debt ceiling. It is expected that this “debt ceiling” will be hit by August 2^nd. Unless Congress authorizes a new, higher debt ceiling, the Treasury will then no longer be able to borrow the money necessary to fund the government’s operating expenses or interest costs.

The Republicans now control the House and are thus in a position to prevent passage of the legislation to increase the ceiling. They are using this power to try and force future deficit reduction through spending cuts, while the Democrats want tax increases as part of the plan. In truth, the politicians have a number of options open to them that would not undermine the economic recovery.

For example: entitlement programs (Medicare, Medicaid, Social Security) need to be addressed or no long term progress can be achieved in reducing the U.S deficit. They could introduce clawbacks of Social Security, as we have done in Canada, or they could postpone entitlements from age 62 to age 65 for future beneficiaries (ie. those 45 or under today).

Taxes: they could increase taxes on certain items (gasoline, alcohol, tobacco) to both promote social welfare and stronger finances. They could also introduce a national VAT – the U.S is one of the few developed countries without a Federal sales tax.

This is really political “theatre” that will have important consequences. I am hopeful that they will reach a deal before August 2^nd, because no one wants to experiment with what happens if the government hits the limit. It did happen once before, and the government “closed down” for 6 days (of note: in this scenario, the politicians continue to get paid, just the workers don’t) - this could happen again. And, even if they go past August 2^nd, the U.S will not technically be in default until they miss an interest payment – I believe the next one is due August 15^th. As highlighted in the chart below, the U.S will continue to have revenues in August (income taxes withheld, excise taxes, duties, royalties, etc.), they will just not be sufficient to cover expenses. So, the government will have to choose who they pay, and who they don’t. So long as they choose to pay their interest, and they continue to roll-over maturing notes and bonds (which does not increase the total amount borrowed) they will not be in default – it’s just that their FICO score will drop. And, per the chart below, if they choose to delay payments to defense contractors they will have the $ to pay the military, Veterans Affairs, Welfare, and Federal salaries. They can probably go forward on that basis for 2-3 months if they need to.

Even without a default, I think this will still have a negative economic impact because of the damage to business and consumer confidence. If the U.S does eventually default, the primary issue is not its impact on government finances, it is that people who purchased default insurance will expect to be paid and Treasury bonds will no longer be useful as collateral behind derivatives trades. This could create a lot of turbulence in capital markets because of its impacts on liquidity. Given the 9.2% unemployment level in the U.S, I don’t think any politician wants to be associated with this as we go into the 2012 election year.

Here’s hoping sanity prevails.

Norman

Have a great weekend!  I will be updating the blog with news on the issue as we receive it next week.

Tracey

Bedtime Stories and Market Wisdom

I came across this article written by Don Reed, President and CEO of Franklin Templeton Investments Corp. it appeared on  Advisor.ca earlier this week, I hope you enjoy it. 

Is the sky falling? Or is it just an acorn hitting investors on the head?  I have been revisiting children’s fairy tales in recent months – I am blessed with four grandchildren and they are avid listeners at bedtime. Chicken Little is a favorite.

You may remember the story. A young chick believes that the sky is falling when an acorn falls on its head. The chick decides to tell the King. On its journey, the chick meets other animals, shares the disastrous news and soon many are on the quest to see the King. Unfortunately, it all ends badly for the irrational fowl and his new friends. A fox invites the group to its lair and eats them all.  Chicken Little would be at home on Bay Street in the summer of 2011.  But instead of an acorn, it’s a billion dollar IOU hitting our feathered friend on the noggin.  Debt is the story of the day. It’s dominating the business pages and many investors are convinced that the sky is falling.  First, there is Greece. At the time of this writing, many Athenians are enraged by the government’s austerity plan to tackle the country’s economic woes. The plan is critical if Greece is to receive the next installment of a €110-billion ($155-billion U.S.) bailout loan from the European Union and the International Monetary Fund.  Without it, Greece faces the prospect of becoming the first euro zone country to default on its debts — a potentially disastrous event that could drag down European banks and affect other financially troubled European countries. There’s some speculation Italy, the euro zone’s third largest economy, may soon face its own credit crunch.

Then, there is the United States.  President Barack Obama and his allies are pushing the Republican-dominated Congress to extend the government’s ability to borrow money. The U.S. government is rapidly approaching its current borrowing limit of $14.3-trillion. The Obama administration is warning that if the debt ceiling is not raised by August 2, the country would face its first default, potentially throwing world financial markets into turmoil.  Many Republicans are not convinced disaster would ensue if the debt ceiling isn’t raised, and some administration officials worry that the markets could take a financial plunge before Congress acts.  The U.S. crisis may sound hauntingly familiar. In a case of debt deja vu, it was the Bush administration almost three years ago that struggled to persuade Congress to intervene at the height of the financial crisis. The $700-billion plan to rescue banks was defeated initially in the House, freezing credit markets and sending stock markets into a nose dive. The measure finally passed in September 2008.  Unfortunately, debt worries have fuelled a stomach-churning ride for investors with the Toronto Stock Exchange roiling up and down hundreds of points for much of 2011.  Emotion is the crux of the problem. I believe many investors are reacting to short-term noise – er … news – and letting fear and greed get the better of them. Volatility in the marketplace breeds uncertainty. Investors, large and small, are in a panic and rethinking their investment strategies. Looking back at past markets, some of the best returns have been realized by objective, disciplined investors, buying when most other market participants have been in full retreat.  Canadian investors are uniquely positioned to take advantage of the global equity market. The Toronto Stock Exchange recovered smartly in 2009 and 2010. Today, despite short-term volatility, Canada’s leading exchange is not far from its 2007 record trading high.  Global stocks have recovered too, but nowhere near the trajectory of our resource-rich Canadian market. Many international blue chip equities remain well below previous highs. When our fully-valued Canadian dollar is factored into the mix, it means some of the world’s best global opportunities are for sale at bargain prices.

I urge investors to be wary of the short-term headlines and remain focused on their long-term financial goals and aspirations. It’s tougher than you think – that’s why relying on the experts for fund management is crucial.  First, active fund managers are very nimble and best positioned to take advantage of market opportunities. In many ways, 2011’s choppy markets are exactly the type of environment where tactical asset managers excel and add significant value. Experienced, engaged investment professionals are best positioned to take advantage of market trends and position the portfolio more advantageously. They have the investing acumen to identify undervalued companies with strong long-term prospects. A skilled equity fund manager will remain focused on long-term goals and keep the short term noise at bay.  Don’t get me wrong. The U.S. and Greece, along with its European partners, have some critical days ahead. Governments will be forced to make some tough decisions. Taxpayers will pay the price. We are in for some unsettling times ahead.  I can guarantee the market will react to news with a mix of shock and awe. Volatility will continue with investors spooked one day and then ready to pop champagne corks the next.  But the sky is not falling. Unlike our friend Chicken Little, patient investors will keep their emotions in check and avoid a nasty final encounter with a hungry fox.

Don Reed is President and CEO of Franklin Templeton Investments Corp.

Filed by Don Reed, editor@Advisor.ca

As the week comes to a close it looks like both the US and Greece will come to an agreement, which will probably set off a few champagne corks. 

Have a great weekend, and enjoy the heat!

Tracey

CPP Debate

A July 5th study from the Institute for Research on Public Policy (IRPP) has renewed the debate on the future of retirement plans in this country.  Many pieces have been published arguing both sides of the studies’ findings; so this week I’d like to summarize the issue and outline both sides of the debate.

The study’s findings state that  “25 to 30 percent of today’s modest-and middle-income workers are not saving enough to avoid a significant drop in their living standards at retirement” Furthermore, people are living longer, and decreasing savings will only make the problem worse.  The plan suggests three options for resolving the issue; a mandatory defined benefit program, or one of two defined contribution plans.  He suggests a national defined benefit program would be the most beneficial and would entail an expansion to the existing Canada Pension Plan.

Detractors to the plan include Neil Mohindra, Director of the Centre for Financial Policy Studies at the Fraser Institute.  He argues that Canada has one of the lowest senior citizen poverty rates in the world and an increase to the pension amounts would not prevent poverty but would increase lifestyle income.  Mohindra bluntly explains that the IRPP solutions will “save a minority of retirees from having to downgrade to basic cable by forcing all working Canadians to contribute more of their earnings to a government-sponsored defined-benefit plan, such as an enrichment of the existing CPP”.  He argues that optional programs such as RRSPs allow individuals to choose their own level of retirement savings and allows them to balance the choice of saving against other investments such as paying down debt or investing in a small business or education.

Proponents of expanding the CPP suggest that a defined benefit plan provide somewhat higher benefits per dollar invested than individual savings plans.  They suggest that by pooling many beneficiaries with many different ages into one overall plan; they are able to increase the potential benefit because a higher risk can be tolerated with investment choices. 

The debate will continue as Federal and Provincial governments will meet later this year to discuss any potential changes.   If you have any thoughts or comments on this subject or would like more information I’d love to hear from you.

Mortgage Rate Changes

On Monday of this week, Royal Bank, TD Canada Trust and Laurentian Bank all raised fixed rates on closed mortgages.  On Tuesday, The Bank of Montreal and CIBC followed suit and raised their rates as well.  Across the board the posted rates increased by .10 to .15% on popular 5 year mortgages.

Although changes in mortgage rates have a large impact on Canadian families’ cash flow it is confusing as to how the interest rates are derived and what factors influence changes in the rates.  I’ll try and outline some of those factors in the post today.

Mortgages rates in this country come in two main flavours, fixed and variable.  The variable rates (or adjustable rates) can and often will change over the term of the mortgage.  They are tied to the prime rate plus or minus a modifier.  For example, a borrower with strong credit and a strong application may get a mortgage with a rate of prime minus .80%, at today’s prime rate of 3.00% their current rate would be 2.20%.  The prime rate itself is derived by the banks taking the key overnight rate offered by the Bank of Canada and adding a margin.  Thus your variable interest rate is linked to the key rate set by the bank of Canada, (see here as to how the bank sets the key rate).

Fixed interest rates are established in a slightly different way.  They are derived from the yield on Canadian Government Bonds of similar term.  For example, for a 5 year fixed mortgage, the lender will look to risk free 5 year government bonds as a baseline rate.  They will then add a rate premium for expenses, profit and additional risk of lending that money in the form of mortgages.  For more information on projections on fixed rates please check out the Bank of Canada website.

Mortgage borrowing choices can be confusing.  I am always available to offer some 3^rd party advice on these tough issues.

Have a nice weekend!