Political Risk

Mt St Helens crater and Toutle River, Cascade Range, Washington, 2011 (image on Photoshelter)

Discussions between Congress and the White House regarding raising the National Debt Limit are an example of the considerable political risks in our current system. My concern is that failure to agree on a solution to raise the debt limit may cascade into financial disaster. It is a balance-of-risks issue that our leaders will ultimately be judged on.

Political risk issues include:

• The polarization of political parties such that the more extreme elements dominate each party, and become nominated for office, crowding out the moderates.

• The emergence of non-elected individuals ‘asking’ that candidates sign ‘pledges’ which politically tie candidates to certain positions, limiting their flexibility to act.

• The inability of politicians to act in the interest of the nation.

Politicians need to be able to consider the best interest of the nation as a whole. Their inability to do so jeopardizes our nation. The clear and present danger is that the United States will default on its debt on August 3, 2011 if the national debt limit is not raised by that time.

Should the United States default on its debt, there would be serious ramifications. Ratings agencies have already given warnings regarding our debt rating. In this July 14, 2011 Bloomberg story, Moody’s placed the United States’s Credit rating under review for a downgrade. In this July 16, 2011 LA Times article, Standard and Poor’s has also warned that they may cut the United States’s top AAA debt rating as a result of the lack of an agreement to raise the debt limit.

In an article in Reuters 7/18/2011, Moody’s stated that the United States should “eliminate its statutory limit on government debt to reduce uncertainty among bond holders”.

A decrease in the United States’s ratings by rating agencies would likely result in an increase in the interest rate that our country pays on our debt. This would increase the cost of financing the United States debt and also have reverberations throughout the marketplace, driving up interest rates generally. Failure to raise the debt limit could conceivably cascade into a financial catastrophe.

The seriousness of what could be a cascading financial disaster is brought home by an article in the Insurance Journal: S&P Threatens Downgrade of Insurers, Financial Firms Over Debt Ceiling” indicating that S&P could downgrade a number of financial institutions should the government fail to act to raise the debt limit.

Currently, Treasuries are regarded as “risk-free” currencies. Should our Government’s rating be downgraded they and other government securities may well be assessed higher capital charges in regulatory and rating agency models. The securities would included various securities including Fannie Mae and Freddie Mac, the latter two key to the mortgage market. Increased capital charges may potentially result in financial institutions being downgraded by rating agencies. If a financial institution is so downgraded as a result of the government failing to act on the national debt, it could trigger other events. “Ratings triggers” in the financial institution’s policies could be triggered, allowing a large withdrawal of policyholder funds from large investors, perhaps at book value,

An increase in the interest rate would have impact in the marketplace, in valuation of assets, in home and auto loans and refinancings. It would alter institutional and personal behavior. Depending on the size of the interest rate increase, an increase in rate could impact stable value funds that promise payout at book value. Importantly, it would cost more to finance the United States debt with a higher interest rate.

Treasuries have been long regarded as ‘safe’ and it is be “interesting” to speculate how changes in their quality rating would reverberate throughout the financial marketplace in the event the U.S. government fails to raise the debt limit by August 3, 2011.

President Obama does not want to “kick the can down the road” instead preferring a longer term solution to the problem that includes spending cuts and revenue increases. The Republicans do not want to consider revenue increases. Some have signed a pledge not to increase taxes and are constrained by that.

The danger is that the United States will default on its debt on August 3, 2011 if it does not raise the debt limit.

We have an examples in history where one small thing cascaded into a major calamity. One event that comes to mind is the Great Seattle Fire of 1889 where glue boiling over into a gasoline fire ignited wood chips and eventually burned down 32 blocks of Seattle, including business district, wharves and railroad terminals.

Do we want our government leaders shackled by the bounds of rigid ideology, watching the debt limit “glue pot” boil over into the “incendiary” market of interest and credit risk, cascading into a market conflagration that “burns” many in our economy?

I would hope our leaders get wise and come to an agreement that will avert disaster in our financial markets. Maybe I am wrong. Maybe these risks won’t materialize or will do so to a minor extent. However it is uncharted waters and do you want to bet the farm that the serious risk will not materialize? President Obama needs to consider a short term deal that gets us over this deadline. The Republicans need to consider raising taxes, even if it means violating a pledge not to raise taxes.

In 2012 the voters will hold our leaders accountable if they watched the pot boil over into the flames and cascade into disaster when they could have come to agreement.

It is an issue of balance-of-risks. The risks of watching the debt pot boil over and cascade into a financial conflagration over over some ideological shackles are just not worth it.