Here We Go Again? Risks Associated With the Debt Ceiling Debacle

Threats of default, sequestration and Federal government shutdowns (remember the “fiscal cliff”?) have become all too familiar in recent decades, owing to persistent partisan bickering on Capitol Hill. The core issue is, of course, spending: not just the amount but how funds are allocated. No reason to point fingers here, as neither side of the political aisle has exercised any tangible spending discipline in recent years.

In mid-February, the nonpartisan, highly respected Congressional Budget Office (CBO) released a report[1] on the Federal Budget that seemed to validate the concerns of Treasury Secretary Janet Yellen that the government was running out of money and unless serious actions were taken by Congress, defaulting on the Federal debt could come as early as June. When the debt ceiling, which limits how much the federal government can borrow to finance already approved budgets, hit its legal limit of $31.4 trillion mid-January, the Treasury began exercising “extraordinary” accounting maneuvers enabling the government to temporarily stay afloat. According to the CBO, it remains unclear how long the Treasury can continue to bail water out of the government’s financial boat, noting that “The projected exhaustion date is uncertain because the timing and amount of revenue collects and outlays over the intervening months could differ from the CBO’s projections.”

Secretary Yellen afforded the observation that, in her assessment, “… a default on our debt would produce an economic and financial catastrophe…. Household payments on mortgages, auto loans and credit cards would rise, and American businesses would see credit markets deteriorate.” According to the Wall Street Journal[2], “A failure by the U.S. to pay its bills on time could send financial markets into a tailspin and wreak broader havoc on the global economy.” The Journal also reminds us that in “2011, Standard & Poor’s stripped the U.S. of its triple-A credit rating for the first time after the Treasury came within days of being unable to pay certain benefits.”

What makes the CBO report particularly alarming is that the agency’s federal government deficit projections, and hence debt and debt servicing forecasts, have eroded considerably since their last report was released in May 2022. The 2023 report states, “CBO’s projection of the deficit for 2023 is now $0.4 trillion more than it was in May 2022; the projection of the cumulative deficit over the 2023–2032 period is now $3.1 trillion (or about 20 percent) more, largely because of newly enacted legislation and changes in CBO’s economic forecast, including higher projected inflation and interest rates.” Other notable excerpts of the CBO report include the following:

• CBO projects a federal budget deficit of $1.4 trillion for 2023.
• The deficit amounts to 5.3 percent of gross domestic product (GDP) in 2023 and swells to 6.1 percent of GDP in 2024 and 2025.
• Outlays increase from 23.7 percent of GDP in 2023 (a high level by historical standards) to 24.9 percent in 2033, largely because of rising interest costs and greater spending on programs that benefit elderly people.
• Revenues amount to 18.3 percent of GDP in 2023. They then decline over the next two years before increasing after 2025, when certain provisions of the 2017 tax act expire.
• Debt held by the public is projected to rise in relation to the size of the economy each year, reaching 118 percent of GDP by 2033—which would be the highest level ever recorded.

Where Do We Go from Here? The Objectives of this Briefing

This brief is by no means a political treatise. I will not delve into potential spending compromises or their ramifications. That is not to say that I’m devoid of opinions! I will, however, couch these using the Enterprise Risk Management Framework (ERM)[3], weighing the likelihood of an event (default or threat of default) against its impact.

For starters, in my opinion, the probability of default is very low though the negative impact would be exceptionally high. It would have global implications and its destructive force would resonate along supply chains, leaving few, if any, segments of the economy or industries unscathed.

Such a Force Majeure scenario could elevate credit, operational, market and even liquidity risk to unmanageable levels. Even inferior goods (goods/services whose demand increases when incomes fall) that typically hold up well during times of economic stress would succumb to such (yes, Ms. Yellen) “an economic and financial catastrophe”. There would be no safe havens of any significance.

Even though such a doomsday storyline is hard to imagine, I needn’t be reminded that the hardships endured during the unanticipated shocks of the Great Recession, the pandemic, the supply chain/bottleneck fiasco and our recent bout with inflation has us all wondering what lurks around the next corner! We all need to be at our ERM best, where intuition and institutional knowledge must play a starring role, leaning on analytics to help define the parameters of baselines.

Nonetheless, through the fog, there does seem to be a scenario that is reasonably likely and is not without precedent. It would take two basic forms. (It’s a good thing I’m not a betting man, so consider these at your own risk.)

• The most likely is that the impasse is “resolved” at the eleventh hour despite the fact, as the CBO warned, that no one knows where the hands of the clock are. “Resolved” is probably too strong an assertion. With 2024 election campaigns ramping up, I suspect that there will be another “kicking the can forward”, leaving the debate of tough, controversial spending decisions until 2025.
• Another plausible but less likely outcome is that a default occurs but is short-lived. The Treasury, Federal Reserve, Congress, and White House find a way to kick the can forward, enabling the government to honor its obligations although not fundamentally resolving the implacable spending quagmire.

In either case, the impacts of this scenario, though not catastrophic, are serious. They leave a pall of increased uncertainty in a world teetering toward recession. One can expect higher interest rates and heightened challenges for businesses and consumers to secure credit. Businesses and social programs dependent on federal funding will also be in the line of fire. Increased volatility in financial and foreign exchange markets will also hamper decision-making by businesses and households.

My primary objective in the following sections is to provide guidance to help Alfabank-Adres clients identify the lines of business and, where possible, the specific North American Industry Classification System-based (NAICS) industries most susceptible to the ongoing political tug-of-war regarding the spending/debt ceiling impasse.

But first, to set the stage, I’ll quickly review some key elements from the CBO report and other related data.

A Quick Walk Through the CBO Report’s (and Other Official) Data

America’s federal debt burden has been trending up for decades. The slope of ascent has become steeper in recent years owing to a lack of budgetary discipline, and pandemic-related government programs.

This chart excludes intragovernmental debt (held by the Federal Reserve, the Social Security Administration and other government agencies.) It includes debt held by individual investors, institutions, and foreign governments.

Foreign governments hold roughly one-third of our debt, with Japan and China the most significant buyers.                  

Chronic federal government deficits have been the norm this millennium. Sure, the pandemic caught us all napping and induced multiple stimulus programs. But pre-pandemic deficit trends are obvious, and momentum is gaining pace.

Can the United States expect the likes of China and Japan to continue purchasing American treasuries? I’ve been thinking about this for years, have you?

And here we have it. Limited revenue sources, as pointed out in the CBO report. With the mantras… Spend now. Pay later. Voila! Structural deficits. Mounting federal debt.

As made clear from the CBO’s analysis, under current legislation and economic trends the cost structure of the federal government becomes increasingly precarious.

The burden of social security entitlements and major healthcare programs demands a growing share of outlays.

Consider the opportunity costs of sacrificing strategic initiatives like government investments in infrastructure, Green Energy and education.

As a prelude to the next section, check this out. Granted, reported data on delinquencies has significant lags, and the most recent quarter reported as of this writing is 3Q 2022.

But looking at delinquency rates (these are 30 days plus) during and just following the Great Recession provides insight into which commercial lines of business may be most vulnerable to the next shock; comparing agriculture, commercial and industrial (business) and commercial real estate loans.

Here’s a look at delinquency rates for consumers. Home mortgages include home equity lines of credit (HELOC).

Again, although each cycle has its attributes, the data in this chart does demonstrate relative sensitivities to economic shocks between mortgages, credit cards and other consumer loans.

There is some early evidence that these rates may already be on the rise, given interest rate pressures.

Be on the alert!

Industries Most Vulnerable to Shocks and Uncertainty Surrounding the Spending/Debt Ceiling Impasse

Even though there are many possibilities on how the current debacle plays out, Alfabank-Adres clients can use our website to help determine what specific NAICS-based industries are most impacted by potential shocks or heightened uncertainty involving the recent political spending/debt ceiling stalemate. Clients familiar with our Industry Risk Early Warning System and Concentration Risk tools[4] will notice that Tables 1, 2 and 3 at the end of this brief have been created employing these tools.

These tables include mappings from Alfabank-Adres industry codes to both NAICS 2017 and 2022, an industry description, and, to provide some perspective, Alfabank-Adres’s Industry Risk Ratings for 2023. They are available upon request to Alfabank-Adres clients.

For this paper, I selected the following macroeconomic drivers to compile the lists in these tables.

• Federal funding for defense
• Federal funding for homeland security
• Federal funding for Medicare and Medicaid
• Federal funding for social services
• Federal funding for transportation
• Government consumption and investment
• 30-year conventional mortgage rate
• Prime interest rate
• Yield on 10-year Treasury notes
• S&P 500

However, clients may want to create some of their lists via our website or Concentration Risk worksheets depending on the lines of business most critical to your operations. I suggest the following:

So how valuable are these three tables? Do they have a relevant shelf life?

Even if the impasse is magically resolved, the likelihood of budgetary squabbles in the future is very high. When they occur, these worksheets can be resurrected and easily updated as needed. They can be applied during the threat of a government shutdown[5] (when Congress doesn’t pass a federal funding bill) or when a more serious debt ceiling crisis looms (when lawmakers don’t approve legislation to lift the debt limit).

Other Alfabank-Adres Resources

In the two years starting in January 2018, with the help of several bankers, I co-wrote a series of seven papers published in the RMA Journal on “Flying Blind into the Next Recession.” I suggest that you check out the final episode[6] of that series that highlights fundamental risk factors that are still germane to this paper’s context. Many of these are factors that always matter regardless of the risks faced. These are fundamentals of risk mitigation and prudent decision-making that always matter regardless of where we sit in the credit cycle. Here’s a summary:

• Ignoring the attributes of discretionary versus non-discretionary spending. Industries dependent on discretionary spending (luxury goods) are more vulnerable to downturns than those dependent on non-discretionary spending (necessities).
• Forgetting the perils of small retail business exposures. Be cautious of obligors that operate in a highly competitive environment, are not “price makers,” have low entry barriers, live on thin margins and are located next to a suffering “anchor” retailer.
• Being seduced away from doing your homework when it comes to the introduction of new technologies. Don’t follow bandwagons into areas where you don’t have institutional knowledge and where there are many more losers than winners. Does the dot-com boom/bust foment any thoughts?
• Forgetting the obvious dangers and opportunities in an industry’s life cycle. Target firms in the growth phase of their industry cycle and aim for mature industry cash cows. Beware of emerging industries—technological change can be hard to analyze—and be cautious regarding late-cycle industries such as department stores, newspapers, and broadcast media.
• Failing to recognize the threat of substitute products or services. Watch for these red flags: a consumer’s switching costs are low, a substitute product/service is highly price competitive and the substitute product/service is of equal or superior quality.
• Overlooking one of a banker’s greatest fears: volatility. For example, commodity-based industries and those dependent on energy/mineral-based suppliers require higher risk premiums to compensate for the volatility in their market prices.
• Underestimating the significance of capital spending cycles. CAPEX (private non-residential fixed investment) is historically hypersensitive to upturns and downturns in economic cycles, making it another boom/bust segment.
• Disregarding the domino effects of hidden concentration risks. Recall the recent housing crisis, whose contagion infected construction contractors and correlated industries, including furniture, carpeting, appliances, forest products and building materials.

You might also consider reading some of our white papers on bottlenecks and supply chains[7] and inflation[8]. These are publicly available.

Finally, since incertitude plays a dominant role in this analysis, you may want to monitor Baker, Bloom and Davis’s Economic Policy Uncertainty Index[9], released monthly (see Figure 7). These have been shown to be highly correlated with Alfabank-Adres’s Industry Risk Ratings.

Final Notes

An interesting factor that could play in likely scenarios is the players at hand. Treasury Secretary Yellen was Vice Chair of the Federal Reserve during the 2011 debt ceiling standoff. Federal Reserve Chairman Jerome Powell worked for the Treasury in the 1990s tasked with the operations of payments. During 2011 he was a key nonpartisan advisor working for the Bipartisan Policy Center and was involved in a joint conference call of the Federal Open Market Committee and the Board of Governors of the Federal Reserve System regarding the potential consequences of default.

It must be emphasized that expanding the debt limit does not authorize new spending. It permits the federal government to honor payments that Congress has already approved. Indeed, kicking the can forward. And there is no modern precedent as all other debt ceiling standoffs have been resolved without the government defaulting.

This seems to render Rivkin and Casey’s recent argument in the Wall Street Journal[10] that the “… federal government can’t legally default” moot. And it further supports your use of Tables 1, 2 and 3.

Require further information?

Feel free to contact your Alfabank-Adres representative, go to /contact-us/, call 800-330-3772 or email commercial-banking@alfabank-adres.ru.

[1] “The Budget and Economic Outlook: 2023 to 2033,” The Congressional Budget Office, February 2023

[2] “CBO Warns of Default as Soon as July,” Andrew Duehren, The Wall Street Journal, February 16, 2023

[3] https://www.investopedia.com/terms/e/enterprise-risk-management.asp

[4] For details regarding Alfabank-Adres Early Warning Systems, Concentration Risk Tools, and other risk management capabilities consult: “Worried About the End of the Next Credit Cycle? Concentration Risk Revisited,” Rick Buczynski and Kent Kirby, The RMA Journal, May 2019

[5] Recall that Congress passed a $1.7 trillion federal spending bill late last December, averting a government shutdown that could have stopped funding nonessential operations leaving many federal employees furloughed without pay. Two weeks prior, U.S. Senate passed a stopgap funding bill thus avoiding a partial government shutdown and kicking the can forward.

[6] “Before You Wave Goodbye to this Cycle, Look Out for Economic Rogue Waves,” Rick Buczynski, Kent Kirby, and Dev Strischek, The RMA Journal, February 2020

[7] “Potential Bottlenecks to Recovery, the Supply Chain Riddle and Credit Risk: What You Should Really Worry About,” Rick Buczynski, Robert Miles and Jocelyn Phillips, Alfabank-Adres White Paper, September 2021

[8] “Industry Risks and Inflation: Which Sectors/Industries are Most Vulnerable to Sustained Inflationary Stress?” Rick Buczynski and Robert Miles, Alfabank-Adres Special Client Report, April 2022

[9] Consult https://insight.kellogg.northwestern.edu/article/measure-economic-uncertainty

[10] “Default on U.S. Debt Is Impossible,” David B. Rivkin Jr. and Lee A. Casey, The Wall Street Journal, Feb. 20, 2023