Downgrading America

If you had been living on another planet the last three years, you would be
shocked to learn that the credit-rating agency, Standard and Poor’s (S&P), has
placed the current AAA credit rating for the debt issued by the U.S. Treasury
on a "negative watch" status. Most of us who live on planet earth had already
concluded that the credit worthiness of our sovereign debt would be
downgraded—unless Congress and the president were to fix the nation’s debt
problem. Although the financial markets reacted to this "negative watch" news
as if it wasn’t really news, S&P did get the nation’s attention. After all, it
was the first time since the attack on Pearl Harbor (70 years ago) that a
downgrade on the outlook for U.S. Treasury securities had been issued. Like
Pearl Harbor, Americans don’t have a minute to waste in responding to the

What prompted this change in the credit outlook by S&P? To answer that
question, consider the following:

Suppose you were to buy a home using a 30-year, fixed-rate, $200,000 mortgage
that cost you 5 percent. Your monthly payment would be $1,070 for 30 years.
Your debt level is initially fixed and declines going forward. Other than the
assumption that you have the income security to maintain the monthly payments,
the risks associated with the debt and its cost are defined and fixed.

Now consider the case of our national debt. The level of debt is not fixed.
It’s set to grow almost exponentially going forward. The cost of funding the
debt is not fixed either. Current Treasury debt yields are at a historic low
and set to rise going forward. The assumption that we have the ability as a
nation of taxpayers to service our debt via tax revenue is dependent on the
variability of the growth rate of the U.S. economy going forward. Clearly, the
risk connected to our ability to service our nation’s debt is not defined and
fixed; yet, it’s set to rise dramatically.

Specifically, the total federal debt level will exceed $14.3 trillion in the
very near future. The portion of that debt held in the form of marketable
securities is over $9 trillion. The current interest expense on the marketable
portion of the debt is $200 billion (2.2 percent). Over 20 percent of this debt
will mature in under one year and just under 50 percent of the debt will mature
in less than three years. Moreover, the annual deficit (new debt) is projected
to be over $1.5 trillion and will remain as an additional ongoing annual
borrowing requirement for as far as the eye can see.

America’s current borrowing cost is at a historic low of about 1 percent
compared to a historical average cost of funding slightly over 5.5 percent. As
noted above, the current annual budget interest expense is projected to be $200
billion per year. What happens if the cost of financing returns to anywhere
near the historic average of over 5.5 percent?

A [2]recent analysis published by Lawrence B. Lindsey projects that marketable
debt held by the public could rise to $13.1 trillion by 2015 and $16.7 trillion
by 2019. The interest expense is projected to rise to $847 billion by 2015 and
$1.15 trillion by 2019. As a percent of the tax revenue flowing into the
federal treasury, interest expense could easily exceed 30 percent and approach
as much as 50 percent. All other forms of budget expenditure would be
threatened by this major claim on the nation’s tax base. This is the future
financial trap being laid out by the policies of the current government and
finally being acknowledged by S&P.

Oh, and here’s the rest of the news flash S&P forgot to mention for our
professional political class in Washington:

The day of reckoning for this national financial train wreck is approaching
much faster than you think. The federal government’s current policies of extend
and pretend will no longer appease the financial markets. If our politicians
don’t fix the nation’s debt problem on their own terms now, with substantive
and credible policy changes, then the financial markets will fix the problem
for them later. Specifically, later is sometime between now and the November
2012 elections. The clock is ticking.

— Fred A. Kingery is a self-employed, private-equity investor in domestic and
international financial markets from New Wilmington, Pa., and a guest
commentator for [3]The Center for Vision & Values at Grove City College.