barcap - policy outlook - us debt vf

GOVERNMENT POLICY AND FINANCE GROUP

July 27, 2011

WASHINGTON POLICY OUTLOOK: US GOVERNMENT DEBT CEILING & BUDGET DEBATEBARCLAYS DOES NOT PROVIDE LEGAL ADVICE. ACCORDINGLY NOTHING IN THIS DOCUMENT IS OR IS INTENDED TO CONSTITUTE LEGAL ADVICE. YOU SHOULD CONSULT YOUR OWN LEGAL AND COMPLIANCE DEPARTMENTS.

Overview Democrats and Republicans in Washington, DC continue to negotiate a compromise as the nation nears the Treasury-imposed August 2 deadline to increase the debt ceiling. As the House and Senate work through the current plans, this situation presents two key issues: (1) Should Congress pass legislation to allow the federal government to raise the $14.3 trillion debt ceiling, and if so, by how much and under what constraints; and (2) How should the US federal government address the longterm fiscal imbalance. From Europes austerity measures to the debt ceiling in the US, this debate is part of the larger discussion on determining the proper role of government in todays society. In the US, this debate is further complicated by the upcoming 2012 Presidential election. We expect to see lots of political posturing at over the next few days, as Washington works towards a compromise to raise the debt ceiling and put forward a credible deficit reduction package. Executive Summary 1. Debt Ceiling & Budget Update A. Understanding the Facts B. Current Deficit Reduction Plans C. Understanding the Credit Perspective D. Key Areas of Negotiation in Revenues and Spending


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US GOVERNMENT DEBT CEILING & DEFICIT DEBATE

Debt Ceiling & Budget Update A. Understanding the Facts Given the number of issues at play, below are several of the key facts in this debate. As detailed below, the US federal governments total public debt outstanding has increased substantially in the wake of the recent economic crisis, hitting the current statutory debt ceiling of $14.3 trillion (see chart below) Date: While the US Treasury can use certain cash management options, the US would otherwise default on its obligations after August 2, 2011 assuming the debt limit is not raised (US Department of Treasury, Debt Limit: Myth v. Fact) Definition: US Treasury defines the debt limit as the total amount of money that the United States government is authorized to borrow to meet its existing legal obligations, including Social Security and Medicare benefits, military salaries, interest on the national debt, tax refunds, and other payments. The debt limit does not authorize new spending commitments. It simply allows the government to finance existing legal obligations that Congresses and presidents of both parties have made in the past (Ibid, as above) Historical Precedence: Since 1960, Congress has acted 78 separate times to permanently raise, temporarily extend, or revise the definition of the debt limit. This happened 49 times under Republican Presidents and 29 times under Democratic Presidents o Constitutional Authority: Does the President need Congressional approval to increase the debt limit?o

Treasury Secretary Geithner mentioned that the nations debts are addressed in the Constitutions 14th Amendment (the validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned) and that the President may not need Congressional approval (http://www.archives.gov/exhibits/charters/constitution.html)

Legal scholars argue that defaulting on public debt might violate the 14th Amendment (US must fulfill its promise to repay its creditors) In an interview in July 2011, former President Bill Clinton noted if he were President and Congress failed to raise the debt ceiling by August 2, he would raise the debt ceiling, invoking his constitutional authority without hesitation, and force the courts to stop him (Los Angeles Times, July 19, 2011)

o

I think the Constitution is clear and I think this idea that the Congress gets to vote twice on whether to pay for [expenditures] it has appropriated is crazyit looks to me like theyre going to make an agreement, and thats smart Former President Bill Clinton, The Los Angeles Times, July 19, 2011

US Total Public Debt Outstanding ($ trillion) and as a Percentage of GDP$ trillions 16 Debt Held by the Public 14 Intragovernmental Holdings 12 Total Public Debt / GDP 10 8 6 4 2 0 1981 1983 1985 1987

Debt as a % of GDP 120% From 1991-2007, US Debt-to-GDP was at approximately 60%, a market acceptable level100% 80% 60% 40% 20% 0% 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011

______________________________________________________ Sources: TreasuryDirect.gov (US Department of the Treasury), the Congressional Budget Office (CBO), and the Bureau of Economic Analysis (BEA) Note: Debt held by the public for 1981-1996 is from the CBO; GDP figures from the BEA; and 2011 estimate of GDP is the BEAs quarterly figure that is a seasonally adjusted annual rate


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A.

Understanding the Facts (continued) Prioritizing Payments: Given Treasury daily inflows and outflows as well as the threat of rating downgrades, the US Treasury claims that prioritizing payments is both operationally impossible and politically impractical. According to the US Treasury, if the government were to prioritize payments to investors, this would bring about the same catastrophic economic consequences as a debt default by raising doubt of the full faith and credit of the US for all investors. The looming threat of rating downgrades adds credence to the Treasurys statement, Legislation to prioritize payments would simply represent default by another name August 2 & Upcoming Obligations: The US Treasury has publically stated that August 2 is the deadline for Congress to increase the debt ceiling. Providing support for that deadline, according to the Bipartisan Policy Center, if the cash shortage begins on August 3, as projected by Treasury, the government could find itself unable to make a $23 billion Social Security payment that has to go out that day. This analysis used data dated from June 2011 o Recent analysis from Barclays Capitals Interest Rates Research Analysts indicates there may be some additional flexibility on this date. Analyzing recent cash flow statements, they advocate that the deadline for the government is actually August 10, not August 2It now appears that tax receipt inflows from July 14 to date have been considerably stronger than we were expecting. This suggests that the date on which the Treasury will run out of cash to pay its obligations might not be August 2; it might be around August 10 insteadIt is always possible, however, that just as inflows have surprised to the upside in the past five days, they will surprise to the downside over the next fewBut most importantly, the sooner policymakers come to a deal, the sooner this source of uncertainty will disappear. Ajay Rajadhyaksha & Interest Rates Research, Barclays Capital, Is August 2 really August 2?, July 22, 2011

B. Current Deficit Reduction Plans Recent Developments Senate Plan Put forward by Majority Leader Harry Reid on July 25 and endorsed by the White House, the latest plan claims to cut $2.7 trillion in spending over 10 years and raises the debt ceiling by $2.4 trillion Cuts include: $1.2 trillion in discretionary spending over 10 years; $1 trillion in savings from the military draw downs in Iraq and Afghanistan; $100 billion in mandatory savings (eg, Fannie Mae/Freddie Mac reforms, agricultural reforms, etc.); and $400 billion in interest savings No changes to entitlements (Medicare, Medicaid, and Social Security) Establishes a joint Congressional committee of 12 members tasked to present options for future deficit reduction where the recommendations will be guaranteed an up-or-down vote on the Senate floor, a provision not afforded to previous commissions Similar to the Democratically-offered Senate plan, earlier this week the Republican House plan proposed an immediate $1 trillion raise in the debt ceiling tied to legislation that includes discretionary spending cuts aimed at reducing spending over a 10-year period. The $1 trillion increase would only provide room under the debt ceiling until early 2012, a timeline not supported by the President o On July 26, the Congressional Budget Office released its formal estimate of the current House plan, stating that it would only reduce budget deficits by about $850 billion over the next 10 years, not the $1 trillion previously stated by House Speaker, John Boehner o On July 27, House Republican Leadership responded, announcing plans to modify their proposal to deepen spending cuts further than originally proposed o Bill would create a bipartisan, bicameral joint committee composed of up to 12 lawmakers, responsible for achieving the $1.6-$1.8 trillion in savings by November 23. Assuming a majority of the committee approves the reduction proposal, it would be fast tracked through both chambers with no amendments permitted, protected by an up-anddown majority vote on December 23

House Plan


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B. Current Deficit Reduction Plans (continued) House Plan (continued) o House plan requires both the House and Senate to vote on a Balanced Budget Amendment by the measure after October 11, but before the end of the year. Notably, it does not require passage by a 2/3 majority for a constitutional amendment House Republicans will have to produce all (or almost all) of the necessary 217 votes to pass this plan. Why 217? Due to two vacancies, there are currently only 433 voting Members of the House, 240 of whom are Republicans, 193 of whom are Democrats o o We anticipate during the day on Friday, the House plan will be brought to the floor for a vote. Assuming the House plan passes, the bill will be sent to the Senate for consideration as a privileged vehicle (Senate Majority Leader can immediately start debate on final passage) Currently, the Senate is awaiting the House vote before moving forward with their plan.

During this highly complex and volatile environment a few potential outcomes still remain: (1) If the House passes their plan on Friday, the Senate could then vote on the House plan later over the weekend. The Senate requires 60 votes to limit debate (cloture) on the House plan, thereafter moving to a fall vote. After both chambers pass a plan, the President may sign or veto the plan. It is highly unlikely the Senate will approve the Boehner House plan (2) Assuming Boehners House bill dies in the Senate, House Leaders and Senate Majority Leader Reid will enter new rounds of negotiations that blends

Estimated Timeline: The following is what we estimate as a possible timeline for activity over the coming days based on the rules of the Senate and House of Representatives The House will vote later this week, likely on Friday, on their respective bills. President Obama has already endorsed the Reid Plan, and released a separate statement that his senior staff recommends he veto the House plan

Key US Policymakers in Debt Debate

Barack Obama President

Joe Biden Vice President

Tim Geithner US Secretary of The Treasury

Ben Bernanke Chairman of the Federal Reserve

Key DemocratsSenator Harry Reid Senate Majority Leader (Nevada)

Key RepublicansRep John Boehner Speaker of the House (Ohio) Rep Eric Cantor House Majority ) Leader (Virginia)

Rep Nancy Pelosi House Democratic Leader (California)

53 Democrats + 47 Republicans = 100 Total

Senate

Rep Steny Hoyer House Democratic Whip (Maryland)

240 Republicans + 193 Democrats + 2 Vacant = 435 Total

House of Representatives

Mitch McConnell Senate Minority Leader ( Kentucky)


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B. Current Deficit Reduction Plans (continued) their approaches. The House passes the blended approach, sends a privileged message to the Senate. Senate Majority Leader Reid would then file cloture to limit debate on the bill over the weekend with a final vote on Monday. If it passes, it is presented to the President for signature The Grand Compromise: Championed by President Obama, which stems from the Simpson-Bowles Commission and, more recently, from the bi-partisan group of Senators known as the Gang of 6. This plan is largely seen as what a bi-partisan compromise would look like, but will not before August 2. This plan includes cuts to discretionary and defense spending, slight changes to Medicare and Social Security, as well as revenue raisers. They intend to lower marginal tax rates, broaden the tax base, limit deductions, and raise taxes on capital investments. House Republicans, namely the Tea Party, have been against this grand compromise and the Speaker of the House, John Boehner, has refused to move forward on this package without the support of his party members Plan B Option from Senators Mitch McConnell (RKY) and Harry Reid (D-NV): This plan is gaining more traction amongst moderate Republicans and Democrats. In this plan, Obama may raise the debt ceiling three times over the next year for a total increase of $2.5 trillion, there would be $1.5 trillion in spending cuts, and the plan would convene a bipartisan committee of 12 lawmakers to report to Congress on how best to lower the deficit, reform entitlements, and reform taxes o Unlike the last Congresss Debt Commission, this committees plan would be ensured an up-or-down vote on the floor. Credit rating agencies may look at this option as a plausible political framework at addressing the $14 trillion debt load to help address the US long-term fiscal imbalance Cut, Cap, and Balance plan: Cuts spending in the current fiscal year, caps the total amount of federal government spending to about 20% of GDP, and has a Constitutional amendment requiring the federal government to balance its budget every year. Largely on party lines, this passed the House of Representatives by a vote of 234-190. Of note, 9 Republicans voted against this package, including Michele Bachman and Ron Paul, both of whom hope to win the Republican nomination for the 2012 Presidential election. This is a helpful reminder that we are approaching an important election. Lastly, while the House passed this package, the Senate will not support itYes, many want government to start living within its means, and many are fed up with a system in which the deck seems stacked against middle-class Americans in favor of the wealthiest few. But do you know what people are fed up with most of all? Theyre fed up with a town where compromise has become a dirty word. They work all day long, many of them scraping by, just to put food on the table. And when these Americans come home at night, bone-tired, and turn on the news, all they see is the same partisan three-ring circus here in Washington. They see leaders who cant seem to come together and do what it takes to make life just a little bit better for ordinary Americans. Theyre offended by that. And they should be. The American people may have voted for divided government, but they didnt vote for a dysfunctional government. So Im asking you all to make your voice heard. If you want a balanced approach to reducing the deficit, let your member of Congress know. If you believe we can solve this problem through compromise, send that message. President Barack Obama, Address by the President to the Nation, July 25, 2011

The sad truth is that the President wanted a blank check six months ago, and he wants a blank check today. That is just not going to happen. Because there is no stalemate in Congress. The House has passed a bill to raise the debt limit with bipartisan support. And this week, while the Senate is struggling to pass a bill filled with phony accounting and Washington gimmicks, we will pass another bill one that was developed with the support of the bipartisan leadership of the U.S. Senate. I expect that bill can and will pass the Senate, and be sent to the President for his signature. If the President signs it, the crisis atmosphere he has created will simply disappear. The debt limit will be raised. Spending will be cut by more than one trillion dollars, and a serious, bipartisan committee of the Congress will begin the hard but necessary work of dealing with the tough challenges our nation faces. House Speaker John Boehner (R-OH), Address to the Nation on GOP Plan to Address Americas Debt Crisis, July 25, 2011


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C. Understanding the Credit Perspective In terms of the credit ratings, all three major credit agencies have stated that if the government fails to raise the debt ceiling by August 2, the US government risks losing its coveted AAA rating, which obviously brings into question the notion of a risk-free asset Most aggressively, S&P has said there is a 50% chance it would downgrade its rating of long-term US debt within three months due to the policy stalemate and the lack of a credible solution to the rising debt. S&P wants to see an agreement of $4 trillion, which will be very difficult in the current political climate

Credit Outlook of the US [T]here is at least a one-in-two likelihood that we could lower the long-term rating on the U.S. within the next 90 days If Congress and the Administration reach an agreement of about $4 trillion, and if we to conclude that such an agreement would be enacted and maintained throughout the decade, we could, other things unchanged, affirm the 'AAA long-term rating and A-1+ short-term ratings on the US

View of the Related CreditsS&P may downgrade other entities that are implicitly and explicitly tied to the US government, including thousands of municipal issuers

Sources: Standard & Poors, Research Update, July 14, 2011, and US Negative Creditwatch, July 18, 2011

Aaa bond rating of the government of the United States on review for possible downgrade The specific rating that would be assigned at the conclusion of the review once such a default is cured would depend on (1) the speed with which the default is cured; (2) an assessment of the likely effect on future borrowing costs; and (3) whether there is a change in process for raising the debt limit that would preclude another default. A return to a Aaa rating would be unlikely in the near term, particularly if there were no progress on the third consideration

Moodys may downgrade financial institutions directly linked to the US government: Fannie Mae, Freddie Mac, the Federal Home Loan Banksthe Federal Farm Credit Bankspre-refunded municipal bondscertain housing bondsand other municipal ratings Bonds issued by the governments of Israel and Egypt that are guaranteed by the US government were also placed on review for possible downgrade

Source: Moodys Investors Services, Credit Analysis, Aaa bond rating of the government of the United States on review for possible downgrade, July 13, 2011

In the extremely unlikely event that a coupon or principal payment on a rated US Treasury security is missed, the default event will be recognised with downgrades of the affected securities from AAA to B+ If the default event persists or renders a significant portion of Treasuries nonperforming, the US sovereign rating would be downgraded from AAA to Restricted Default (RD)

If the US sovereign rating were downgraded to RD, there may be negative rating consequences for the entities whose issuer and issue ratings are underpinned by US sovereign support The ratings of US states and municipalities would not be directly and immediately affected

Source: FitchRatings, Thinking the Unthinkable What if the Debt Ceiling Was Not Increased and the US Defaulted?, June 8, 2011


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D. Key Areas of Negotiation in Revenues and Spending Individual Tax Reform: Democrats have discussed raising top marginal tax rates and removing select deductions while Republicans have repeated that they will not accept tax increases (eliminating tax deductions may be possible) Corporate Tax Reform: Both parties may consider lowering the corporate tax rate from 35% to 25-28% and removing many of the deductions which are considered spending items through the tax code Repatriation of Foreign Earnings: Both parties have discussed this with conditions such as the capital must be invested to create jobs or used to fund an infrastructure bank (Senators Schumer (D-NY) and Kerry (D-MA) are strong supporters). The Freedom to Invest Act of 2011 (HR 1834) would provide a reduced dividends deduction rate of 85%, yielding a maximum tax rate to 5.25% for one of two years (Sponsors: Representatives Kevin Brady (R-TX), Jim Matheson (DUT), Jim Cooper (D-TN), Devin Nunes (R-CA), Jared Polis (D-CO), and Bob Dold (R-IL)) Social Security Taxes: Final plan may increase the amount collected either by increasing the cap on the amount taxed or the tax rate applied Discretionary Spending: Under all the plans, there is consensus to limit growth of discretionary spending, while some also advocate freezing spending at historical levels or eliminate certain programs Defense Spending: Traditionally not feasible, defense spending cuts are on the table as the military looks to evolve to new threats Social Security and Other Mandatory Spending: Future fiscal sustainability of US government requires changes in mandatory programs. AARP, a lobbying group for retirees, is open to discuss benefit cuts and other reform plans to strengthen the system Healthcare Spending: Democrats are offering to cut billions of dollars from Medicare and Medicaid if Republicans will accept tax revenue increases. Hospital lobbyists have vowed to fight any spending cuts in efforts to reform the underlying drivers of costs related to Medicare and Medicaid benefits

2010 US Government Collections($ in billions)Customs Duties $25.3 1% Estate and Gift Taxes $18.9 1% Misc $95.9 4% Individual Income Taxes $898.6 42% Corporate Income Taxes $191.4 9% Social Insurance Taxes $864.8 40%

US Government Spending and Revenue($ in billions)$4,000 $3,000 $2,000 $1,000 $0 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010

Excise Taxes $66.9 3%

Healthcare Defense Interest

SS & Other Mandatory Discretionary Revenue

_________________________ Source: Congressional Budget Office (CBO)

_________________________ Source: Congressional Budget Office (CBO)


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CONTACT INFORMATION Patrick Durkin [email protected] (212) 526-9772DisclaimerThis document is not intended as, and shall not constitute, legal, investment, tax, financial, accounting, or other advice. You must independently determine, with your own advisors, whether you require legal advice and, if so, from whom you should obtain such advice. Barclays accepts no liability whatsoever for any losses, consequential or otherwise, arising from the use of this document or reliance on the information contained herein. Barclays does not guarantee the accuracy or completeness of information which is contained in this document and which is stated to have been obtained from or is based upon trade and statistical services or other third party sources. No representation is made as to the accuracy or completeness of any information contained herein. All opinions and estimates are given as of the date hereof and are subject to change and Barclays assumes no obligation to update this document to reflect any such changes. IRS Circular 230 Disclosure: Barclays Capital and its affiliates do not provide tax advice. Please note that (i) any discussion of U.S. tax matters contained in this communication (including any attachments) cannot be used by you for the purpose of avoiding tax penalties; (ii) this communication was written to support the promotion or marketing of the matters addressed herein; and (iii) you should seek advice based on your particular circumstances from an independent tax advisor. Notwithstanding anything herein to the contrary, each recipient hereof (and their employees, representatives, and other agents) may disclose to any and all persons, without limitation of any kind from the commencement of discussions, the U.S. federal and state income tax treatment and tax structure of the proposed transaction described herein and all materials of any kind (including opinions or other tax analyses) that are provided relating to such tax treatment and tax structure. For this purpose, tax structure is limited to facts relevant to the U.S. federal and state income tax treatment of the proposed transaction described herein and does not include information relating to the identity of the parties, their affiliates, agents or advisors. BARCLAYS CAPITAL INC ., THE UNITED STATES AFFILIATE OF BARCLAYS CAPITAL , THE INVESTMENT BANKING DIVISION OF BARCLAYS BANK PLC, ACCEPTS RESPONSIBILITY FOR THE DISTRIBUTION OF THIS DOCUMENT IN THE UNITED STATES. ANY TRANSACTIONS BY U.S. PERSONS IN ANY SECURITY DISCUSED HEREIN MUST ONLY BE CARIED OUT THROUGH BARCLAYS CAPITAL INC., 745 SEVENTH AVENUE, NEW YORK, NY 10019. NO ACTION HAS BEEN MADE OR WILL BE TAKEN THAT WOULD PERMIT A PUBLIC OFERING OF THE SECURITIES DESCRIBED HEREIN IN ANY JURISDICTION IN WHICH ACTION FOR THAT PURPOSE IS REQUIRED. NO OFFERS, SALES, RESALES OR DELIVERY OF THE SECURITIES DESCRIBED HEREIN OR DISTRIBUTION OF ANY OFERING MATERIAL RELATING TO SUCH SECURITIES MAY BE MADE IN OR FROM ANY JURISDICTION EXCEPT IN CIRCUMSTANCES WHICH WILL RESULT IN COMPLIANCE WITH ANY APPLICABLE LAWS AND REGULATIONS AND WHICH WILL NOT IMPOSE ANY OBLIGATION ON BARCLAYS OR ANY OF ITS AFILIATES. THIS DOCUMENT DOES NOT DISCLOSE ALL THE RISKS AND OTHER SIGNIFICANT ISSUES RELATED TO AN INVESTMENT IN THE SECURITIES/TRANSACTION. PRIOR TO TRANSACTING, POTENTIAL INVESTORS SHOULD ENSURE THAT THEY FULLY UNDERSTAND THE TERMS OF THE SECURITIES/TRANSACTION AND ANY APPLICABLE RISKS. Barclays Bank PLC is registered in England No. 1026167. Registered Office: 1 Churchill Place, London E14 5HP. Copyright Barclays Bank PLC, 2011 (all rights reserved). This document is confidential, and no part of it may be reproduced, distributed or transmitted without the prior written permission of Barclays.

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barcap - policy outlook - us debt vf

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