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Posts Tagged ‘budget cuts’

Effects of the Credit Downgrade

Late Friday afternoon, Standard & Poor’s (S&P) announced it was downgrading the credit rating of U.S. Treasury securities from AAA to AA+ and retained its negative outlook.  Although S&P previously announced it was considering a downgrade, the announcement was a bombshell dropped at the end of a tumultuous week of economic and political news.

  • After weeks of political posturing and rancorous debate, Congress passed the Budget Control Act of 2011, increasing the debt ceilingPresident Obama signed the legislation on August 2, thereby avoiding a potential default by the U.S. government.
  • After the debt deal was done, Moody’s and Fitch Ratings announced they would retain their AAA rating of U.S. Treasuries but continue to monitor U.S. fiscal health.
  • The Dow Jones Industrial Average ended a 9-day losing streak with a blistering 334 point decline; wiping out all of the gains for 2011.
  • S&P capped the week by announcing their downgrade.

Since Friday afternoon, politicians, economists, and pundits have been discussing the impact of the downgrade.  There has also been a lot of pointing fingers of who is to blame for  tarnishing the image of the U.S.  It has also left a lot of people wondering about the real implications of a downgrade in the credit rating of the U.S. Government.

Here are a couple of things I think you can expect from the downgrade.

  • There is a bruising to the American pride and psyche.  Nothing has changed since Friday, but most Americans want to believe we are the best of the best.  The downgrade is likely to increase the uncertainty and pessimism of the American consumer.
  • Interest rates won’t change immediately.  Interest rates are effectively determined by the free markets, not by S&P.  A credit ratings agency simply tries to assess the risk of a particular security, but it’s up to the market to decide the interest rate.  Don’t expect interest rates to change in the near future, but there could be some upward pressure on rates if investors become more leery about the fiscal stability of the U.S. government.
  • The stock markets aren’t going to crash.  As anticipated, the markets were battered yesterday and lost about 5% of their value, but it’s not a direct correlation to the S&P ratings change.  Remember the Dow took a 334 point hit last week before S&P made its announcement.   Furthermore, the 10-year Treasury yield fell from Friday’s rate of 3.558%. This means investors bought more Treasuries; the very securities that are supposedly more risky.  The selloff is more attributable to the poor outlook of the global economy and European sovereign debt worries.  Investors are seeking stability, so they’re buying up Treasuries and gold.

There is one potential redeeming element which may come from the downgrade, but it’s far from certain.  This might serve as a wake-up call for our political leaders to get serious about the fiscal future of our country.  As I wrote last week, the debt deal was long on promises and short on spending cuts.  In my opinion, a 0.6% cut in spending for 2012 is a pittance in light of overall spending.  The rating downgrade could prompt our leaders to get serious about tackling the debt and deficit.

No longer is it just extreme fiscal conservatives who think it unrealistic for the U.S. government to overspend by $1 trillion each year without consequence.  Standard & Poor’s is a significant player in the global economy.  You may question the timing and motivation of their downgrade, but it should serve as a clarion call of the long-term risks and ramifications of our debt and deficit spending.  I can only hope our politicians are listening and have the courage to do something about it.

Details of the Debt Deal

After weeks of political wrangling, Congress and President Obama enacted the Budget Control Act of 2011.  The legislation provides for an immediate increase the debt ceiling of $400 billion, averting a potential default by the U.S. government.  Avoiding default is probably the one thing most Americans are pleased with in this bill.

The debt deal is long on political rhetoric and short on details.  While many of our political leaders are touting the success of this legislation as a significant step towards dealing with the fiscal challenges of our country, there is little discussion of what is actually going to happen.  Beyond deferring the most significant spending cuts to a Joint Select Committee (JSC) composed of 12 Congressional leaders, evenly divided by house and party, there are few details of how the actual spending cuts are going to be achieved.

The Congressional Budget Office scored the spending cuts to be $2.1 trillion between 2012 through 2021. Of this amount $917 billion is supposed to be guaranteed in exchange for allowing the Treasury to sell another $900 billion in bonds.  The remaining $1.2 trillion is supposed to be determined by the JSC.  At this point, no one knows what is going to be cut to achieve any savings.

From what has been released, the bill calls for $21 billion of spending cuts in Fiscal 2012 and $42 in 2013.  Not surprisingly, the substantial cuts happen far in the future, which means there is always the chance the cuts won’t happen.  For those of us who believe government spending is on an unsustainable path, this is not very encouraging.  Here are a couple of things to consider.

President Obama’s 2012 Budget  proposal calls for $2.6 trillion in revenue and $3.7 trillion of spending; resulting in a $1.1 trillion deficit.  The House passed a budget with $2.5 trillion in revenue and $3.5 trillion of spending; racking up a $1 trillion deficit.  According to the debt deal, spending will be trimmed by a measly $22 billion.  This is about 0.6% of all federal  spending for the coming year.

Talking in trillions and billions can seem rather esoteric, so think in these terms.  Assume you make $50,000 this year.  If you managed your finances like the federal government, you would spend over $70,000, borrowing the difference.  If you cut your spending like Congress and the President have proposed, you would only trim your spending by $420 for the next year.  That’s right… just a mere $8 per week, even though you’re overspending by $20,000.  Given those parameters, would you say you were serious about changing your spending habits by cutting $8 per week?

Many politicians and commentators are calling this a historic piece of legislation.  They refer to it as a down payment on our debt and an important first step.  This may be true, but it’s an indication of how difficult it is for Congress to cut federal spending.   If they can barely manage to trim $22 billion, how are they going to come anywhere near close to $1 trillion?  It would take over $1 trillion of additional cuts and/or revenues to balance the budget, before we can even begin to pay down the debt.

The debt deal further illustrates the Congressional propensity to defer hard decisions.  Effectively, it will be a future Congress and potentially a different President, who will have to make the hard decisions to cut spending and balance the budget.  Given the history and culture of Congress, it’s no wonder the debt deal is long on politics and promises and short on specifics and spending cuts.

Decoding the Debt Debate

If you’re following the current debate on raising the debt ceiling, you’re probably frustrated.  Your angst may be triggered by, the partisan bickering, the lack of great leadership or the uncertainty of what may happen and what it all means.

Politicians from all political persuasions and affiliations have become very adept at obfuscation.  Knowing whatever they say or do can and will be used against them in a future election, politicians have become very proficient in deflecting and dodging direct answers.  They speak in vague terms and try to boil everything down to a 30 second sound bite.

Politicians and political commentators often use terminology that is confusing and often misleading.  You almost need a secret decoder to decipher what they are saying.  I don’t all of the secret codes, but I have a few.

As you listen to the debate, the following are a few terms to keep in mind.

  • The National Debt – The cumulative amount of money owed by the U.S. government. These are actual bonds held by various investors (including the Chinese government and your friendly bank).  The total outstanding debt is approximately $14.5 trillion.
  • The Debt Ceiling – The total amount of bonds the U.S. Treasury is authorized to issue.  The debt ceiling is currently equal to the National Debt.  A law must be passed to increase the debt limit.
  • Deficit – This is the amount of money the government is spending in excess of revenues it collects in one fiscal year (October 1 – September 30).  The deficit for fiscal 2011 is projected to be $1.4 trillion.
  • Credit Rating – Every bond traded on a public market is rated by an independent credit rating agency, which assesses the financial strength of the issuer and the likelihood of default.  The lower the rating, the higher the interest rate required.  For bonds already issued, a change in credit rating will often influence the price at which the bond is traded on the market.

Aside from these terms bantered about, I believe there are a few important factors you need to pay close attention to in any deal that is reached.  These will be the types of issues our  political leaders will attempt to obfuscate.

  • Time Horizon – The time horizon for the spending cuts and additional revenues will be calculated over the next 10 years.   If Congress and the President agree to cut $1 trillion in spending, it won’t all come in fiscal 2012.  They may sound like everything is happening this year, but any plan will be adopted over the next decade.  Raising the debt ceiling is the only thing to take effect immediately.
  •  Timing – Look at the timing for when additional revenue is received and spending cuts are enacted.  If history repeats itself, the revenues will start to be received soon, and the  bulk of the spending cuts will happen in the latter years.  In the world of pork barrel politics, elected officials use government spending to buy votes, and the termination of programs will frequently cost votes.  Thus, politicians have a real incentive to defer spending cuts to another day.
  • Details –It won’t be easy, but do your best to understand the details of the plan.  Congress is trying to make major changes to the tax code, Social Security, Medicare and  Medicaid, and they’re rushing to get it done in the next few days.  I don’t think you want a repeat of Nancy Pelosi’s famous quote, “We have to pass the bill so you can find out what is in it.”

I believe this is a serious issue, and how it is resolved could have far-reaching implications for the future.  No one knows what will happen if the government defaults on its debt, since it has never happened.  As I previously wrote, I think Congress will and should raise the debt ceiling, but it also needs to curtail government spending.  Racking up over $1 trillion of debt each year is just as perilous as defaulting on the current obligations by not raising the debt ceiling.

I also have serious reservations about our leaders’ability and willingness to cut spending.  The 2011 budget compromise is a good illustration of this.  Although they supposedly agreed to $38 billion in spending cuts, most of it was accounting gimmicks and money that wasn’t going to be spent anyway.  One analyst calculated the reduction in spending on specific programs to be less than $1 billion in comparison to fiscal 2010.

As the debate continues forward, follow closely.  Here’s why.  Last week, President Obama was pushing a plan to cut spending by $3.7 trillion and add $1 trillion of new revenue, for a net decrease of $2.7 trillion over the next decade.  Sound like a reasonable compromise?  Before deciding, you may want to consider this.  When the Administration presented their 2012 budget to Congress, they also provided a 10-year budget estimate.  The Administration projected total deficits over the next 10 years to be in excess of $9 trillion.  If the current deal cuts it by $2.7 trillion, that still means we’ll add over $6 trillion to the national debt, pushing out total debt close to $21 trillion by the end of the decade.  Still think it’s a good deal?

To me this is a good example of why we must watch this closely.  Despite the political rancor, everyone in Washington is looking for a deal which will make them look good.  Let’s just make sure the American people get as good of a deal as our politicians.

U.S. Credit Rating Outlook – Is the Third Time a Charm?

You may have heard the cliché, “The third time is a charm.” When it comes to the future credit rating of the U.S. government, the cliché, “Three strikes and you’re out,” might be more applicable.

Presently, there is a lot of discussion concerning the U.S. debt limit.  After borrowing $14.3 trillion, the U.S. government has reached its limit on how much money it can borrow.  Accounting gimmicks and creative cash flow techniques are allowing the government to continue spending approximately $3 billion each day more than it receives in revenues.  However, the U.S. Treasury is expected to exhaust these measures by early August.  Unless Congress acts before then, the U.S. government will default on some of its obligations.   You can read this article for a discussion on why I doubt this will happen.

A few weeks ago, two major credit ratings agencies, Moody’s Investors Services and Standard & Poor’s provided a negative outlook on U.S. debt.   This doesn’t  mean that they have downgraded the credit rating, but it’s an indication to investors that this is a realistic possibility in the near future.

On Wednesday, Fitch Ratings said it was putting U.S. debt on watch for a credit downgrade later this summer.  This will be the third major credit ratings agency to state their concerns regarding the current debt and deficit situation of the U.S. government.

All three of the agencies have expressed doubt that the U.S. government will default on its debt. The negative outlooks reflect a general lack of confidence in the ability of Congress and the President to reach a meaningful agreement to significantly alter the current trajectory of the debt and deficit spending.

If you follow politics, you probably are not surprised by the current lack of progress and substantial political posturing.  Washington frequently reaches agreement right before a deadline expires, and often enacts a temporary postponement to give itself more time.  Consequently, I don’t think the ratings agencies are really surprised by the current delays.  Instead, I think the negative outlook is driven by their pessimism of our political leaders to make significant changes in fiscal policy.

They realize that raising the debt ceiling is easy.  It’s a simple vote Congress passed many times in recent years.  The real obstacle is reaching an agreement to dramatically reduce the annual deficit, which could come via spending cuts or increasing revenue.

It’s not a charm that a third credit rating agency has a negative outlook on U.S. debt.  It could be viewed positively if it motivates our political leaders to reach an agreement, but based on recent statements and reactions… don’t count on it.  Instead of being a charm, I suspect the recent ratings outlook is more like another strike.

Raising the National Debt Ceiling

Within a matter of days, the U.S. Treasury is expected to hit the ceiling on its authority to borrow money on behalf of the U.S. Government.  Treasury Secretary Geithner has already made plans to extend this timeframe by a couple of months.  Most of it involves deferring payments and accounting gimmicks to buy the President and Congress more time.

I have no doubt that the debt ceiling will be raised.  With a projected budget deficit of nearly $1.5 trillion this year, there is no way our politicians will balance the budget any time soon.  Thus, the Treasury will need to continue to borrow more money to fund the government.  The real issue is how much more borrowing will be allowed and what spending cuts and fiscal reforms will be enacted.

For the most part, the debate over raising the debt ceiling is political theater and brinkmanship.  Sadly, it’s another example of the dysfunction in Washington.  If it wasn’t so serious, it would be funny.  A couple of years ago when George W. Bush was President, the Democrats resisted raising the debt ceiling and the Republicans argued that it was necessary.  Now that President Obama occupies the Oval Office, it’s exactly the opposite.  The Republicans are balking and the Democrats are calling them irresponsible.

Most of the Members in Congress would like to raise the debt limit by $2 trillion, which would fund the government until after the 2012 election.   At the current rate of overspending, the limit would be reached shortly after the 113th Congress is seated and the President is inaugurated in 2013.

Earlier this week, Speaker Boehner said that the Republicans want to cut spending by the same amount that the debt ceiling is raised.  Given the recent agreement on the 2011 budget, it’s doubtful the Republicans will come anywhere near this goal.  While campaigning in 2010, the Republicans promised to cut $100 billion from the 2011 budget.  The final  agreement was $38 billion. Of that amount, a substantial portion included accounting gimmicks and money that wasn’t going to be spent anyway. If they couldn’t agree to cut spending by $100 million, how in the world will they ever come close to eliminating a $1.5 trillion annual budget deficit?

If you believe the U.S. Government needs some significant changes in its fiscal policy, then you must pay very close attention to what happens, and you’ll need to do some digging to get to the truth.  It’s unfortunate, but you can’t take statements by our elected officials at face value.  Most of what they say is political posturing and spin.  Rarely do they tell the whole truth.  There is often more to the story.  The real truth of the $38 million of spending cuts in the latest budget deal is a prime example.

As much as I am troubled by the growing national debt, I think raising the debt ceiling is necessary.  To immediately cut $1.5 trillion of spending from a $3.5 trillion budget is too much too quickly. However, it doesn’t mean that significant changes can’t be made.  The President and Congress need to stop patting themselves on the back for cutting less than 1.5% of total spending.  It’s a pittance in relationship to the magnitude of the problem.

Raising the debt ceiling is necessary to avoid a current crisis, and making significant cuts to the current spending and fiscal policies is needed to evade a long-term catastrophe.

Spending Cuts and Accounting Gimmicks

Three weeks ago, President Obama and Congress reached an agreement on the 2011 Federal budget.  Keep in mind that the government’s fiscal year started on October 1, 2010.  Thus, we were already more than six months into the year before they could reach an agreement of how to spend money for the current year.  How they are able to do that is a different discussion.

After they reached an agreement on the 2011 budget, members of both sides of the aisle trumpeted their success in reducing Federal spending and moving towards more fiscal restraint.  Even for those who wanted greater cuts, they conceded that it was a good start.  According to the budget agreement, federal spending is will be reduced by $38 billion.  This may seem like a lot of money, but keep it in perspective.  This amount is approximately 1% of the total $3.5 trillion of federal spending for 2011 and less than 3% of the projected $1.4 trillion budget deficit.  It’s a good start, but certainly not what you might consider draconian cuts.

The dirty little Washington secret is that a substantial portion of the $38 billion won’t actually reduce federal spending for programs or personnel. Check out this Washington Post article which reveals some of the maneuvers and gimmicks utilized to account for the cuts.   Granted, there will be real cuts and reductions, “But some of the worst-sounding trims are not quite what they seem, and officials said they would not necessarily result in lost jobs or service cutbacks.”  One example cited is the $4.9 billion for the Justice Department’s Crime Victims Fund.  The money was allocated to a reserve fund that wasn’t going to be spent anyway, yet Congress counted it as part of their “spending cuts.”

Although it may seem like a rather trivial matter, it’s a good indication of how Washington works and the way our political leaders think and act.  In  Washington World, money you wanted to spend, could have spent, or even thought of spending all count as “spending cuts.”

If this were true, then I have cut millions of dollars from my spending… but it’s not real.  It makes no difference to my bank account how much money I thought of spending or wanted to spend, but didn’t.  It only counts if I don’t spend it, and it stays in my account.  This is common sense to the rest of the world, but it seems elusive to Washington politicians.

Understanding Washington World and the political spin of politicians will be very important as Congress and the President wade into the battle over the 2012 budget, raising the debt ceiling and tackling the annual deficits and national debt.  It’s in vogue to talk about spending cuts and deficit reduction, but there is often more to the story than what is being said.

This is an issue you should care about whether you support the current spending by the U.S. government or believe it needs to be dramatically reduced.  To me, it’s an issue of honesty and integrity. Hopefully, this matters to you irrespective of your political affiliation or philosophy.

Bill Gates Rips Government Accounting Practices

I would encourage you to read this short article published by the Wall Street Journal.  Last week, Bill Gates, co-founder of Microsoft and one of the richest men in the world, called out state and local government on their dubious accounting practices.   

Mr. Gates claimed that states use “tricks” to balance their budgets and the reporting is “riddled with gimmicks.”  He also said that some of the governmental accounting practices are “so blatant and extreme,” that “Enron would blush.”  Several former Enron executives are serving prison sentences for their role in the collapse of the company.  Do you think any government leaders will be facing charges for accounting improprieties any time soon?

Having practiced public accounting for the past twenty years, I agree with Mr. Gates’ general premise.  Governmental entities have some of the most bizarre accounting practices and principles.  Of course, it helps when you get to write your own rules.  Like Enron, the government may be following the technical provisions, but they may be obscuring the real financial picture.  Private enterprise would not be able to get away with the same shenanigans that our state, local and federal government perpetrates on a continual basis.

The article mentions Mr. Gates’ concern about the way states are accounting for their pension liabilities.  If you’re watching the news, you know that public workers’ pensions are a hot political issue nationwide.  Although I don’t know specifically what Mr. Gates was referring to, I do have at least one idea of what it might be – the rate of return used to calculate the future pension obligations.

A friend and former colleague of mine recently asked a state treasurer in a public forum what rate of return they were using to calculate the state’s future pension obligations.  The treasurer nonchalantly replied that it was 8%.  Without being too antagonistic, my friend queried if this was a little aggressive given the current market conditions.  The state treasurer replied that is was a rate allowed by the Governmental Accounting Standards Board.  He further explained that the rate was acceptable for governmental accounting purposes since no state had ever gone bankrupt, unlike private companies.  He also made mention that every 0.25% decline in the assumed rate of return increased the state’s current pension contribution by $___ million.

Given the current market conditions, you must invest fairly aggressively to receive an 8% rate of return.  Being aggressive is not the investment strategy most government pension plans use, nor should they.  The bottom line… a lower rate of return could exponentially increase the future obligation, making a current budget crisis worse.  Although a lower rate might be more reflective of the current market conditions, states continue to use the same rate to minimize to help balance their budgets.

Keep in mind these accusations are not coming from some uneducated, right-wing radical with a political axe to grind.  This is coming from one of the richest men in the world, who knows a little about money and financial principles.

Although it’s wonderful that Mr. Gates is raising this issue, I doubt much will change.  Accounting theory and principles can be esoteric and hard for people to understand en masse.  However, common sense is fairly simple, and the more these issues are raised, the more people will realize that this is another examples of politicians who live by a different set of rules than the rest of the world. 

We can only hope things change before it’s too late.