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Henes: The US Will Choose Not to Default on Its Bonds

Imagine that you took out a mortgage to buy a house and now you need to borrow more to make your mortgage payments. Would the bank make that loan?

To meet its current obligations, the United States needs to issue treasury bonds. Unless the debt ceiling is raised, the United States will not be able to issue bonds and, therefore, will not be able to meet all of its obligations. The mainstream discussions about the debt ceiling focus on the potentiality of a bond default by the United States.

But the talk about a default — technical or otherwise — misses the point.

The debt ceiling may or may not be raised. In today’s political climate, with the political make up of Congress and the important fiscal issues being debated, anything could happen. But, even if the debt ceiling is not raised, the United States will not default on its debt. The talk about a United States default is political and a red herring. The United States will only default on its debt if it chooses to do so.

While the United States will not default on its debt, the current debate surrounding the debt ceiling and how the United States will position itself to live within its means is critically important. For the foreseeable future, the United States will need to continue to add debt to its already bloated balance sheet if it wants to meet all of its obligations in the ordinary course. To fix this unsustainable addiction and need for debt, leaders with tremendous political will need to step up and make prudent economic decisions.

So, why won’t the United States default on its public debt if the debt ceiling is not raised (again)?

The United States has many monetary obligations. One of those obligations is to make interest payments on its outstanding public debt. Other obligations relate to defense spending, social security, education and public employees. The United States does not have the funds to pay all of its obligations, but it has more than enough money to make its current interest payments on its public debt.

The total receipts of the federal government for the fiscal year are approximately $1.5 trillion. The total amount of interest owed for the first 8 months of fiscal year 2011 was approximately $275 billion. Consequently, the federal government’s receipts are sufficient to make the interest payments on the public debt. However, the budget deficit for the first 8 months of fiscal year 2011 was approximately $929 billion. So, if the debt ceiling is not raised, thereby precluding the United States from incurring more debt, it will not have the receipts to cover all of its obligations and need to decide which obligations to extend (i.e., “stretch” or leave unpaid for a time) and which to pay.

While the United States may need to struggle with determining which obligations to meet until the debt ceiling is raised and this dilemma sounds alarm bells, we’ve seen it before in smaller settings. For instance, in 2009, California gave tax payers IOUs rather than tax refunds. In the corporate setting, when a company runs into a financial problem, it will sometimes “stretch” its payables to preserve its liquidity. If the company has a pure liquidity problem — and not a debt problem — simply buying time may allow the company to work its way through its financial problems without the need for any restructuring of its balance sheet. However, if the company also has a debt problem, the time it has bought will not allow it to slip through unscathed, but rather the company will need to restructure its balance sheet.

The United States has a debt problem which was caused by the debilitating combination of excessive public debt and staggering unfunded liabilities, both of which continue to grow. The amounts are astounding and attempting to come up with a plan for fixing this problem is daunting.

The outstanding public debt of the United States is more than $14.3 trillion. In addition, the United States has more than $61 trillion of unfunded obligations, which is made up mostly of medicare and social security. To put this in context, to cover those unfunded obligations, each household in the United States would need to pony up $534,000. The balance sheet (and off balance sheet, as unfunded obligations are not on it) of the United States is bloated with an unsustainable and unsupportable amount of debt. It must be restructured for the economy to truly grow and remain strong in the long term.

The words used in the debate about the debt ceiling should be chosen carefully. Whether it gets raised on or before August 3rd is not the critical concern. The critical concern is that the United States has too much debt and cannot meet its obligations without adding more debt to its balance sheet. Everyday obligations should not be paid with debt proceeds. And a debt problem cannot be fixed by adding more debt. (In other words, you can’t stop a flood by adding water.)

This all needs to be resolved in a restructuring of the federal government’s balance sheet, which will be accomplished — eventually — through the federal budget. Making the right decisions is difficult and debatable, but for a politician worried about being re-elected it is even more difficult.

It’s time for our leaders to stop the default rhetoric and find a way to cross party lines and start the long, complex process of fixing the debt problem facing the Unites States.

Jon Henes is a partner in the Restructuring Group of the law firm of Kirkland & Ellis. Jon's practice involves representing debtors (including portfolio, privately-held and public companies), creditors' committees and distressed investors (including hedge funds, private equity funds and companies) in acquisitions, restructurings and bankruptcy cases.