A Toothless Debt Deal Won’t Stop a U.S. Credit-Rating Downgrade – Or the Aftermath that Follows

It's often said that the sign of a good compromise is that both parties walk away dissatisfied – but that's not necessarily true of the debt deal Congress is close to passing.

To be sure, both parties are dissatisfied with the outcome of this contentious battle. Progressive Democrats are disappointed that planned cuts to government spending won't be augmented with tax increases, while fiscally conservative Republicans are angry that the cuts to spending haven't gone far enough.

But the truth is, regardless of their party allegiances, all Americans should be disappointed in their policymakers for the same exact reason: After months of political kabuki theater, the debt deal that's working its way through Congress is toothless, ineffectual and will do little or nothing to prevent a crushing blow to the markets and the dollar.

The facts of the debt deal are as follows:

  • The deal raises the debt ceiling by $900 billion to $17.7 trillion.
  • It cuts spending by $917 billion over the next decade and a special congressional committee will be assigned to find another $1.5 trillion in deficit savings by late November.
  • If Congress comes up with the savings, or passes a balanced-budget amendment to the constitution, the government will accrue another $1.5 trillion boost the debt ceiling – sufficient to pay the country's bills through 2013.
  • If Congress fails, the president will be granted a $1.2 trillion debt-ceiling extension – but automatic, government-wide spending cuts (half of which will come from the defense budget) will take effect in 2013. There will be no automatic tax increases.

The United States at least may have will have avoided default, but the country is still enrapt in debt and likely to incur a credit-rating downgrade.

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The Secret Way to Profit from the U.S. Debt to China

Perhaps the biggest reason our country is facing a contentious debt-ceiling debate is because of the massive U.S. debt to China.

It's easy to forget that China is the world's largest buyer of U.S. Treasuries and it has as much to lose in this high-stakes game of chicken as does the United States.

Indeed, China's rapid growth over the past decade has resulted in a new paradigm.

Go back 10 years, and nobody worried about the U.S. debt to China. No one ever talked about the Chinese yuan replacing the dollar as the world's reserve currency. Or wondered whether the U.S. would ever owe China more than it could possibly pay.

And why would we ever worry about China?

At the time, the U.S. was the biggest economy in the world, with the most powerful markets and currency. When we walked into a G-7 meeting, we were used to getting exactly what we wanted. We said "jump" and the rest of the world said "how high?"

Back then, China wasn't even invited to those meetings.

But as you know, things have changed – even if the average American politician and citizen doesn't want to admit it.

We can no longer burst into a G-20 meeting and simply demand what we want. We must contend with the demands of China – the freshly minted economic superpower that happens to be our largest creditor.

Who's the Boss?

China has grown to be the second largest economy in the world now. And how did they grow rich?

Simple: They've saved while we spent. They invested while we went into debt. They went without while we lived beyond our means. We expanded and issued bonds to pay for our debt. China bought up those bonds and earned huge sums of interest off of us.

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How the Debt-Ceiling Debacle Will Spark a Short-Term Drop in Gold Prices

I'm an avowed gold bull, and I truly believe that gold investors will end up benefiting from the biggest bull market of our time.

But we have to be honest: Investor psychology plays a crucial role in shorter-term investment results. And recent trading patterns clearly demonstrate that most of the recent increase in the price of gold is due to the debt-ceiling debate in Washington, as well as the European sovereign-debt crisis that continues to lurk in the background.

The bottom line: The debt-ceiling debacle could cause a short-term drop in gold prices.

Congressional leaders as of early Sunday afternoon had yet to reach a debt-ceiling deal, but said they were close to an agreement that they hoped would prevent default.

As of late Thursday, gold was trading within 1% of the all-time high of $1,628.05 reached on Wednesday, and was poised to record its first monthly increase in three – all because of the debt-ceiling deadlock and the fear that a U.S. government default would level the global financial markets. Spot gold has surged 7.6% in July.

If you think about it, a number of things just don't add up. For instance:

  • The 30-year U.S. Treasury bond is yielding just 4.31% – meaning the rate is virtually unchanged since the start of the year. But with Standard & Poor's saying there's a 50% chance it will downgrade the United States' top-tier AAA credit rating – something once considered bulletproof – you'd expect that yield to be surging as "rational" investors dump U.S. debt. Right?
  • In fact, a quick glance at yields on the one-month, one-year, two-year, five-year, 10-year, 20-year – and every maturity in between – shows that yields are down from the start of the year, meaning investors are still buying U.S. Treasuries, despite record deficits and the fast-approaching debt-ceiling deadline. If there's a risk of a downgrade and a default, shouldn't those same "rational" investors be avoiding all new purchases, even as they dump current holdings?

So what will we see if tomorrow's (Tuesday's) deadline comes and goes, and no deal is reached down on Capitol Hill?

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How Investors Should Prepare as the Debt-Ceiling Deadline Approaches

U.S. President Barack Obama earlier today (Friday) addressed the nation about the debt-ceiling deadline, urging Congress to find a way "out of this mess" – something investors have made repeated pleas for. The lack of progress on the debt-ceiling debate has angered many investors who find themselves in a frighteningly uncertain position. "What's happening in […]

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U.S. Debt Ceiling: How To Protect Your Wealth From The Debt Ceiling Increase

U.S. Debt Ceiling: How To Protect Your Wealth From The Debt Ceiling Increase If Congress and President Obama can't agree on a U.S. debt ceiling increase, it could cause an unmitigated economic disaster – one so unprecedented that government and private analysts can't even accurately figure out all the potential consequences. To avert this crisis, […]

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The Debt-Ceiling-Debacle: The Surprising Way a Default or Downgrade Could Crush the Global Economy

If there's a "worst-case scenario" for this whole debt-ceiling debacle, this is it.

After studying everything that could happen due to a downgrade of the United States' top-tier AAA credit rating, and the potential default on its debt, we found a scenario that would result in forced asset sales that are so widespread that global stock-and-bond markets would plunge – and economies around the world would crash.

Tangible evidence that this frightening scenario could really play out surfaced on Monday, when the Chicago Mercantile Exchange (CME) announced it was increasing the "haircut" that it applies to U.S. government debt posted as collateral by traders transacting on the exchange.

The retail investors who didn't just ignore this announcement altogether probably dismissed it as a boring bit of administrative housekeeping by the CME. In truth, however, this kind of re-evaluation of U.S. Treasury securities, widely used as loan collateral, could trigger global margin calls and widespread asset sales. If that occurs, it's only a matter of time before the ripple effects of escalating margin calls could weigh down asset prices around the world.

Let's take a look at how and why this could happen.

The "Haircut" Nobody Wants

Because U.S. Treasury bills, notes, and bonds are considered "risk-free" they are every lender's preferred collateral class.

All of America's too-big-to-fail banks, major securities broker-dealers and giant hedge funds – and most of the world's biggest financial institutions – hold hundreds of billions of dollars of U.S. Treasuries that they use as collateral to borrow in the overnight and term "repo" market.

Traders use their U.S. Treasury securities to borrow more money to buy still more Treasuries, as well as other more-speculative securities. The intention is to leverage the capital they have by borrowing against balance-sheet assets to take on bigger positions.

But what happens if there's no debt-ceiling deal by Tuesday – the theoretical day after which the country won't be able to pay its bills?

The actual answer to that question may not matter as much as the uncertainty that's been created. In fact, even with a deal – meaning there's no default – it's likely the United States is facing a reduction in its top-tier AAA credit rating.

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The Debt-Ceiling Debacle: Another Way Politicians Could Ruin America

John Powell is worried – perhaps even scared.

Powell has watched the whole debt-ceiling debacle unfold down in Washington. He knows that our elected officials literally hold this country's future in their hands. He also knows that our leaders love nothing more than to squander opportunities and currently are poised to foul up our economy even more than it already is.

"Darn right I'm worried," Powell, a Money Morning reader, told us in an e-mail. "It's unbelievable. In 64 years I have never seen Washington so dysfunctional."

In response to some bleak USA Today/Gallup Poll results last week, we asked you, our loyal readers, to tell us how you think Washington has done with the debt-ceiling debacle. Most of you came to the same frightening conclusion: Our politicians' selfish antics have jeopardized our future.

Take Powell, who told us that he feels Washington's political posturing and brinksmanship has been a hindrance to the U.S. economy. But here's what really troubles him: He believes that with the way the system and our leaders currently function, none of this is fixable.

"Politicians are decimating the middle class and creating a new class of poor, banks and corporations are sucking the life out of the economy, and there's 9.2% unemployment – plus those whose benefits have run out – and Washington isn't doing anything to change this," wrote Powell.

Powell isn't alone.

The USA Today/Gallup poll showed that four in 10 of those surveyed thought Washington's job on the debt-ceiling debacle was the worst they've ever seen in their lifetimes.

Two-thirds of respondents said elected leaders in Congress were putting their own political interests ahead of the country's interests – leaving U.S. taxpayers to suffer.

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The Debt-Ceiling Debate: The Death of the "Risk-Free" Investment

There's an old investing axiom that says "there's no such thing as a free lunch" – which basically tells us we can't earn a profit without taking some risk.

And whether or not the United States defaults on its debt when the federal government hits its debt ceiling on Tuesday, the threat by Standard & Poor's to downgrade the United States' top-tier AAA credit rating means there will also be no such thing as a "risk-free" investment.

This new financial reality will alter the global-investing landscape forever.

And though it will put a hurting on hedge funds, investment banks and the rest of Wall Street, the death of the risk-free investment may prove beneficial to those of us who are America's ordinary retail investors.

Let me explain …

Modern Portfolio Tomfoolery

A central assumption of modern financial theory (also known as "modern portfolio theory," or MPT) is about to collapse: From Aug. 2 forward, there will no longer be such a thing as a "risk-free" investment. Banks and hedge funds will be turned upside down, but even those of us who regard modern portfolio theory as mostly rubbish will discover that the financial markets have started to function in very different ways.

Modern financial theory was originally developed at Carnegie-Mellon and the University of Chicago in the 1950s, and since then has become a dominant element of every Wall Street operation (helping Wall Streeters make boatloads of money, as a result).

One of the core precepts is that there are such things as "risk-free" investments, in which an investor's principal is 100% safe – not 99.5% safe, but 100%.

For example the Capital Asset Pricing Mode (CAPM), a central theorem of modern financial theory, says there is a "frontier" of optimal investments, and that investors can achieve any mix of risk and return on that frontier by combining risky and risk-free investments (or, to increase risk, leveraging themselves).

Similarly, the Sharpe Ratio, used by professional investors in hedge funds and pension funds, evaluates securities and portfolios by the "excess return" generated over a risk-free investment. That helps money managers determine whether they are paid sufficiently for their risk. In options theory, the Black-Scholes model assumes the ability to "delta hedge" an option by buying or selling the underlying security, and borrowing or investing the proceeds at the same risk-free rate.

Finally, risk-management theory assumes the possibility of eliminating risk from portions of the portfolio, so that the Basel bank regulatory systems, for example, weight Treasury securities of Organisation for Economic Co-operation and Development (OECD) governments at zero. That allows banks to hold unlimited quantities of Treasuries, without having to allocate capital to those holdings.

The Death of the "Risk-Free" Investment

If U.S. Treasuries are not AAA-rated, then they are not risk-free – pure and simple.

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'Washington Math' Adds Up to the Debt-Ceiling Deadlock

If you've been wondering why your elected officials in Washington can't reach a basic compromise to break the debt-ceiling deadlock, consider this: They can't even get their numbers straight.

Not only do the competing Democratic and Republican plans differ on what counts as a spending cut, the Congressional Budget Office (CBO) has disputed numbers in both plans.

Perhaps most galling – fiery rhetoric to the contrary – is that the plans actually differ very little.

With "Washington Math," there's no such thing as a definitive answer.

Congress has until Aug. 2 to raise the federal debt ceiling beyond the $14.3 trillion limit; after that the government won't have enough money to pay 40% of its bills. But the fuzzy numbers, questionable arithmetic and political posturing have created an impasse that threatens to push the United States over a financial cliff.

What do we mean by fuzzy numbers? Read on.

Senate Majority Leader Harry Reid, D-NV, has proposed a plan that would save $2.7 trillion over 10 years, raising the debt ceiling by the same amount. That would allow the United States to borrow until 2013.

But Speaker of the House John Boehner, R-OH, has dismissed half of Reid's package – the $1.1 trillion in savings from winding down the wars in Afghanistan and Iraq – as imaginary.

"The Senate is struggling to pass a bill filled with phony accountingand Washington gimmicks," Boehner said Monday night in his response to the primetime speech made by U.S. President Barack Obama.

Boehner's own plan was supposed to save $1.2 trillion over 10 years and raise the debt ceiling far enough to allow about six months of borrowing.

The Democrats took no issue with any of Boehner's proposed savings, but on Tuesday the CBO did. The nonpartisan agency determined that Boehner's plan would in fact save only $850 billion.

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U.S. Debt Default Would Be Worse Than Lehman Brothers Collapse

Each day that passes without a deal to prevent a U.S. debt default brings the United States closer to a financial calamity that would be more severe than the failure of Lehman Brothers in 2008.

Dueling speeches from U.S. President Barack Obama and Speaker of the House John Boehner, R-OH, Monday night did nothing to resolve the impasse between Republicans and Democrats over how to reduce budget deficits and raise the debt ceiling past the $14.3 trillion limit by Aug. 2.

The contentious rhetoric of recent days has raised concerns that lawmakers will fail to reach a compromise by the deadline – with disastrous consequences.

"I've never, never seen a breakdown like this," Paul Light, a U.S. government scholar, told Reuters. "This is a defining moment in America's inability to act."

Should the deadlock over avoiding a U.S. debt default endure past Tuesday's deadline, it will trigger a financial crisis of vast proportions:

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