Client Login
Global Liquidity Management - United States ▼
Products
Insights
Education
About Us
 
 

GOLDMAN SACHS GLOBAL INVESTMENT RESEARCH - US Daily: Q&A on the Debt Limit (Phillips)

Published 11:19 PM Mon Jan 7 2013

  • The debt limit was formally reached last week, and we expect the Treasury's ability to borrow to be exhausted by around March 1. Like the previous debt limit debate in the summer of 2011, the debate seems likely to be messy, with resolution right around the deadline. That said, like the last debate we would expect the Treasury to prioritize payments if necessary, and we do not believe holders of Treasury securities are at risk of missing interest or principal payments.
  • The debt limit is only one of three upcoming fiscal issues, albeit the most important one. Congress also must address the spending cuts under sequestration, scheduled to take place March 1, and the expiration of temporary spending authority on March 27. While these are technically separate issues, it seems likely that they will be combined, perhaps into one package.

Q: What is the debt limit?

A: It is a legal limit on Treasury's borrowing imposed by Congress. Under the constitution, Congress, not the Treasury, has authority to borrow. Congress delegates this authority to the Treasury. Instead of approving each single debt issuance (as was done many years ago) it imposes an overall limit on debt that may be issued, leaving the Treasury to work out the details. The limit is currently $16.394 trillion.


Q: What is covered under the debt limit?

A: Marketable and nonmarketable debt held by the public, the Fed, and in government accounts. Debt held by the public ($11.6 trillion) consists of marketable securities held by domestic and foreign investors ($9.9 trillion) and marketable securities held by the Federal Reserve ($1.7 trillion). Intragovernmental debt ($4.9 trillion) consists almost entirely of nonmarketable debt held by government trust funds. Most of these trust funds finance specific programs, like Social Security.


Q: When will it be reached?

A: The formal limit has already been reached but the Treasury probably has enough headroom to last until March 1. The Treasury reached the statutory limit on debt on December 31. Since then, public debt outstanding has been held at $25mn under the limit. Even though the Treasury has reached the limit, it can continue to borrow through use of "extraordinary measures."

The Treasury has instructed Congress that it expects to have about $200 billion in "extraordinary measures" at its disposal, which will allow it to continue to borrow under the debt limit. January tends to be a low-deficit month and will probably produce a monthly deficit of $20bn to $30bn. February is a heavy deficit month, and in the last three years has produced a deficit of $220bn to $230bn. This year's February deficit is likely to be smaller than those years, as is the fiscal year deficit as a whole, but it still looks likely to be at least $200bn.

On December 28, the last business day before the debt limit was reached, the Treasury's cash balance stood at $59bn. Along with the "extraordinary measures," this should allow the Treasury to continue to pay its obligations without an increase in the debt limit until at least sometime in the second half of February, even if the budget deficit is at the high end of the range of the last few years. If the deficit over the next two months is slightly lower than the last few years, as we expect, the Treasury seems likely to get to March 1 before it exhausts its funds. Likewise, if the Treasury is able to increase the amount of headroom created by its "extraordinary measures" beyond the $200bn it has estimated, it might also extend the date it would exhaust its borrowing capacity.


Q: What are the "extraordinary measures" the Treasury can use to extend the deadline for raising the debt limit?

A: The primary strategies involve disinvesting government trust funds of Treasury securities. These have been ahead of several previous debt limit increases and have come to be known as "extraordinary measures." There are three primary strategies the Treasury can use to create additional headroom to borrow under the limit:

Partial disinvestment of the federal employee defined benefit pension fund (creating $33bn to $93bn in headroom). The Civil Service Retirement and Disability Fund (CSRDF) receives contributions for current employees of $2bn per month and pays out $6bn per month to former employees. Once the debt limit has been reached, the Treasury may redeem securities equal to expected payments and may suspend new investments. The amount of the redemptions depends on the Treasury's declaration of a "debt issuance suspension period" (DISP). For each month it is expected to last, the Treasury can redeem one month's expected payments. In prior debt limit impasses, DISPs have been declared to last as short as two months to as long as 12 months, creating headroom of between $12bn and $72bn, along with a few billion more from non-investment of new inflows. A similar provision related to postal retirement creates $17bn more in flexibility. The upshot is a minimum of about $33bn in headroom and an upper bound of $93bn (in the case of a 12-month DISP), though the law is vague so it is at least possible that an even longer DISP could be declared if necessary.
Disinvesting the "G Fund" ($156bn in headroom). The "Thrift Savings Plan" is a defined contribution system for federal employees, which provides several investment options including the G Fund that invests only in government securities. Federal employees and retirees currently have $156bn invested in the G Fund, and the Treasury can temporarily replace some or all of those Treasuries that count toward the debt limit with an IOU that does not.
Disinvesting the Treasury's Exchange Stabilization Fund ($23bn in headroom). This fund can be used by the Treasury in a number of ways, with little oversight by Congress. The $23bn portion of the fund invested in dollars is in non-marketable Treasuries, which could be disinvested immediately if necessary.

Q: What happens if Congress does not raise the limit by the deadline?

A: The Treasury would need to immediately reduce outlays to equal income. Without an increase in the limit, the Treasury would not have cash on hand to pay obligations as they come due. Over the next three months, the Treasury is likely to spend roughly 40% more than it takes in, and without a debt limit hike it would need to immediately eliminate this deficit. While the Treasury would probably be able to prioritize spending, it isn't clear what the priorities are, and regardless of which priorities were chosen, the overall reduction in federal spending could result in a sharp downturn in near-term economic activity if it persisted for more than a very short period.

Ahead of the 1985 debt limit increase, the General Accounting Office (GAO, now known as the Government Accountability Office) advised the Senate Finance Committee that the Treasury had the authority to choose the order in which to pay obligations. Whether this opinion still holds today in light of legislation enacted since then is unclear. Prioritization did occur previously, following expiration of a temporary increase in the debt limit on July 1, 1957. As the federal government began to run a budget deficit, the Treasury was forced to delay payments to federal contractors in order to avoid breaching the limit (see for example Treasury Sec. Douglas Dillon's account of the events in "Key Areas in Current Economic Policy", Federal Reserve Bank of New York Monthly Review, June 1963). More recently, as the debt limit approached in early 1996, the Treasury indicated that failure to raise the debt limit would result in failure to make Social Security payments, though Congress provided relief before any delay occurred (see "Debt Ceiling: Analysis of Actions Taken During the 1995-1996 Crisis," GAO, 1996.)


Q: What about Treasury-related payments?

A: A failure to pay interest or principal is unlikely, as it was in the last debt limit debate. The Treasury has around $35bn in semi-annual coupon interest to pay on February 15. There is a good chance that the Treasury's "extraordinary measures" will last longer than this. However, smaller payments of around $6bn and $1bn are scheduled on February 28 and March 15, around the time the Treasury will exhaust its borrowing ability. If Congress has not increased the debt limit by that point, the Treasury seems likely to prioritize spending to make sure these payments are made or to extend its "extraordinary measures" so that it can borrow the amounts to make the payments. The Treasury's ability to roll over existing debt is even less likely to be affected, since replacing maturing debt with new issues should not add to stock of Treasury securities outstanding. Nevertheless, significant volatility could occur around Treasury auctions should Congress fail to raise the debt limit in a timely manner.


Q: If other non-interest payments are missed, would that constitute a default?

A: Not from the rating agency perspective. While some of the public commentary has referred to a failure to make scheduled payments on other obligations as a "technical default," the rating agencies are not required to respond in any particular way to a failure to make other payments. Ratings assigned by the three major rating agencies relate to the government as an issuer of securities and the payment of interest and principal on those securities. That said, a failure to make a scheduled payment could still be seen as a sign of increased risk, so it could still have ratings implications. For example, Fitch Ratings has said it might downgrade the US rating by one notch if the debt limit is not raised in a timely manner; it seems likely that an inability to make scheduled payments would trigger the type of downgrade Fitch has described.


Q: How long might the debt limit increase last?

A: It could last as long as two years or as short as a few months. President Obama has made clear he does not want to return to periodic debates on the debt limit and he is likely to push for at least a two-year extension, which would probably require an increase of around $2 trillion. House Speaker Boehner insists that any debt limit increase should be matched with spending cuts of an equal amount (when measured over ten years). If lawmakers were able to agree on a "grand bargain" involving significant entitlement cuts as well as new revenues, this could allow for enough budgetary savings (if not spending cuts) to allow a debt limit increase lasting two years or so.

However, another increase in tax revenue beyond the one enacted last week seems off the table for now, and there is little left to cut from the "discretionary" segment of the budget that was already cut significantly in 2011. The only major area of the budget left to cut is "mandatory" spending--mainly entitlement programs--but neither party has proposed more than several hundred billion dollars in specific, politically achievable cuts in this area.

If Congress can't agree on cuts to match a substantial increase in the debt limit, lawmakers have a few other options. Congressional Republicans could shift their goal to enacting a few key changes to entitlement programs, rather than hitting a particular dollar target. To make a smaller budget deal look larger, lawmakers might also consider a cap on overseas war spending, which could produce several hundred billion dollars in savings compared with official projections, even though most realistic budget projections (including our own) already assume this spending will decline. Either strategy could allow the debt limit to be increased by at least $1 trillion, good for about a year.

If neither of those strategies work out, the fallback plan would simply be a smaller increase in the debt limit. While larger increases in the debt limit that last 1-2 years have become the norm over the last decade, this was not always the case. In prior periods it was not uncommon to see increases that lasted only a few months, or in some cases just a few days. So while we assume that Congress will enact a longer-lasting increase in the debt limit this year, it would not be unheard of for one or more short-term extensions to come before the longer-lasting increase.


Q: How does the debt limit relate to other upcoming fiscal debates?

A: The debt limit is the most important of three separate fiscal issues Congress must address in Q1. Beyond the debt limit, congressional leaders and the President must work out two other issues: further delay in spending cuts under "sequestration" and an extension of government spending authority. While these are separate issues, it is clearly possible that all three could be wrapped up into one agreement.

Spending cuts under sequestration are scheduled to take effect from March 1, 2013. Those cuts had been scheduled to take effect January 1, but were delayed two months as part of the fiscal compromise reached last week. In the upcoming debate lawmakers will aim to delay those cuts once again, offsetting the increased spending that would result with savings (spread over ten years) from other areas of the budget.

A month later, on March 27, the temporary extension of spending authority (known as a "continuing resolution") that Congress enacted last year expires. Congress is likely to extend spending authority to September 30, the end of the current fiscal year, but lawmakers must first agree on a spending level. If no agreement is reached by March 27, all non-essential government operations funded by congressional appropriations would cease. However, while this sounds severe, it is far less of a risk to the economy or the market than a failure to raise the debt limit, since the lapse would be temporary and the payments that would cease are clearly categorized, would have no effect on Treasury financing nor on most payments to individuals, and are of a smaller overall size.


Alec Phillips


Jan Hatzius - Goldman, Sachs & Co.
(212) 902-0394 jan.hatzius@gs.com

Alec Phillips - Goldman, Sachs & Co.
(202) 637-3746 alec.phillips@gs.com

Jari Stehn - Goldman, Sachs & Co.
(212) 357-6224 jari.stehn@gs.com

Kris Dawsey - Goldman, Sachs & Co.
(212) 902-3393 kris.dawsey@gs.com

David Mericle - Goldman, Sachs & Co.
(212) 357-2619 david.mericle@gs.com

Shuyan Wu - Goldman, Sachs & Co.
(212) 902-3053 shuyan.wu@gs.com

Michael Cahill - Goldman, Sachs & Co.
(801) 884-4621 michael.e.cahill@gs.com

 

Legal and Certification Disclosures
We, Jan Hatzius, Alec Phillips, Jari Stehn, Kris Dawsey, David Mericle, Shuyan Wu and Michael Cahill, hereby certify that all of the views expressed in this report accurately reflect our personal views, which have not been influenced by considerations of the firm's business or client relationships.

For Reg AC certification, see above. For other important disclosures, go to www.gs.com/research/hedge.html