published Wednesday, July 20th, 2011

Personal Finance: Earlier defaults made U.S. borrowing costlier

By Travis Flenniken

There has been much speculation as to the events that will unfold if the United States actually defaults on its debt in early August as a result of failing to raise the debt ceiling.

Most economists and market analysts agree that a default will likely cause interest rates to spike and asset values to fall. The degree of which these changes occur is, of course, unknown because default on U.S. debt has never occurred in the history of our nation, right?

Well, actually it has.

In the spring of 1979, our country was in technical default after missing an interest payment of $120 million on its Treasury bills.

Professors Terry Zivney and Richard Marcus co-authored a report called "The Day the United States Defaulted on Treasury Bills" in which they recall the effect on interest rates after a disruption in U.S. debt payments. The authors report that in the late 1970s, the government missed interest payments due to "an unprecedented high interest from small

investors, a delay in raising the debt ceiling, and a word-processing equipment failure."

Investors owning T-bills maturing on April 26, 1979, were informed by the U.S. Treasury that it could not make its payments on time. The Treasury was also late at redeeming T-bills which became due on May 3 and May 10, 1979.

The Treasury characterized the missed payments as a delay and not a default. However, technically, by missing an interest payment, the U.S. was in default.

The missed payments were eventually made. After initially refusing to pay additional interest to cover the time for the delay, the Treasury eventually settled up. However, the real added cost to the Treasury was from the change in its borrowing costs as a result of the disruption.

Zivney and co-author Richard Marcus concluded that while the incident affected only a fraction of 1 percent of the U.S. debt, short-term interest rates- about 9 percent -- increased 60 basis points.

The higher rates remained even after the default was remedied and late-payment penalties had been paid. The researchers concluded that the default led to a persistent increase in all Treasury rates, which meant higher total borrowing costs for the government.

The study concluded that failure to make timely interest payments during a two-week period cost the government about $6 billion a year in additional borrowing costs.

In 1979 total U.S. debt was approximately $800 billion. The current federal debt amount is $14.5 trillion, roughly 18 times more than in 1979. While interest rates are much lower than in 1979, the costs of a payment disruption would likely be exponentially larger today because of the country's debt-level relative to 1979. This increase in our nation's borrowing costs will have a direct adverse effect on the federal deficit, digging the hole even deeper.

When it comes to credit standards, risk factors are the same for nations as they are for individuals. If an individual is late on a mortgage payment, their credit is adversely affected, regardless of the reason.

As a result, their borrowing costs will increase. If our nation's legislators fail to negotiate a way to pay the country's obligations on time, even temporarily, it can have a lasting effect on future borrowing costs; not just for the government, but for everyone.

Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Travis Flenniken, CFA, is vice president of investments with DeMoss Capital -- demosscapital.com. Submit questions to his attention by writing to Business Editor Dave Flessner, Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by emailing him at dflessner@timesfreepress.com.

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