Debt Crisis Update - 7-19-11

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ASSET CONSULTING GROUP

U.S. Debt Crisis

July 18, 2011



1© 2011 Asset Consulting Group. All Rights Reserved.

Extremely high federal debt levels have historically been associated with major wars, but the current situation is a result of both adecade-long war in the Middle-East, escalating costs associated with government entitlement programs, and government stimulus

programs

The current level of U.S. debt as a percentage of GDP (80%) has only been exceeded once before, during the post WWII era

The U.S. Treasury has already reached the self imposed $14.29 Trillion debt ceiling and if it is not raised by August 2nd the federalgovernment will be forced to delay or default on payment of debts (although this is a very low probability event)

As a result the three major Rating Agencies (S&P, Moody’s and Fitch) have placed U.S. debt under review and have threatened adowngrade

Democrats and Republicans are unlikely to agree on significant policy changes prior to the 2012 elections

In the unlikely event that Congress does not raise the debt ceiling by August 2nd, the short-term effect could be anothersignificant market correction which in turn could dampen consumer spending and lead to another recession

It is likely that the Treasury could still make interest payments on U.S. debt, pay Social Security, Medicare, Medicaid and activeduty military, however, those programs that may see delays in payment might include food stamps and welfare, unemploymentbenefits, IRS refunds, Departments of Education, Labor, Justice, EPA etc.

Over the long-term a loss in confidence in the U.S. government and a higher perceived credit risk could raise the cost of borrowing for the U.S. and further hinder economic growth

Executive Summary





3 © 2011 Asset Consulting Group. All Rights Reserved.

As a result of declining interest rates, interest payments as a

percentage of total federal spending have generally been

declining for the last 20 years, even though the level of debthas been rising

Defense spending (as a percentage of total spending) has

also been falling, aside from an uptick in the mid 80’s andagain during the war in the Middle East

Social security and welfare programs have ballooned fromaround 16% of total spending in the early 1960’s to nearly 50%of total spending, currently

U.S. Debt History

Although the debt ceiling is currently raising much debate, it has

been raised 15 times in the last 20 years and 79 times since theinception of the U.S. Treasury

The U.S. government has never officially defaulted on its’ debt,however a technical default did occur in the Spring of 1979 due to a

mechanical/operational issue that caused a delay in interestpayments on $120 Million of Treasuries

Although the 1979 incident was a technical default, the cost of borrowing for the U.S. government initially increased by around0.60%

Actual

Composition Of U.S. Government Spending

Source: Thompson Reuters Datastream, Standish

Projected




The Treasury currently spends around $300 billion a month while

government revenues are approximately $180 billion per month (the$120 billion difference is financed with debt)

Monthly interest payments on U.S. debt are approximately $18 billion,so monthly interest payments are technically covered by revenue by

around 10 times

Although interest payments are likely to met, eventually other

government obligations would be delayed, but likely for some

relatively short period until the debt ceiling is raised

U.S. Debt – Current Dilemma

If the Treasury were forced to prioritize spending to

not exceed $180 billion per month, they could technically cover interest on debt, Social Security, Medicare and

Medicaid and active duty troops

Other obligations like unemployment insurance, IRSrefunds, defense vendors, food stamps and others couldsuffer




U.S. Debt – Future Implications

Summary

The bond market is currently pricing in ahigh likelihood that

that Congress will raise the debt ceiling before August 2

However, should a debt downgrade occur , there could beseveral negative repercussions in the short-term

Short-Term

Yields on U.S. treasuries could rise as the U.S. loses its’ safehaven status, but a weaker growth environment would likely induce an extended period of Fed easing, so this may cap the

upper limits of interest rates in the near-term

The U.S. dollar could continue to weaken as foreign centralbanks further diversify their reserves into the Euro, Yen, otherfaster growing emerging market currencies and even potentially into gold

Investment Grade and High Yield Credit would likely

experience a widening in spreads, as investors anticipate

another economic downturn and spike in default rates

Volatility may increase across financial markets as investorsseek to reposition their portfolios to avoid significant loss of

capital

US Treasury Yield Curve

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

3.50%

4.00%

4.50%

5.00%

0 5 1 0

1 5

2 0

2 5

3 0

Years-to-Maturity

Y i e l d

- t o - M

a t u r i t y

14-Jul-11 16-May-11

Bond markets have anticipated that Congress

will reach an agreement to raise the debt ceiling

prior to August 2. Long-term government

bond yields have actually declined s ince May 16.

Long-Term

Assuming the current debt ceiling deadline is met, over the long-term some combination of reduced government spending

and tax reform will still be required to reduce the debt level

Fiscal reform in the U.S. could have an initial dampening

effect on the economy , but lower wage growth, a weaker

dollar (higher exports) and more private sector spending

could make the U.S. more competitive over the long-term

China and Japan hold 46% of total U.S. debt , and should they start selling U.S. treasuries, this could add upward pressure on

interest rates and raise the cost of borrowing for the U.S.




Appendix – A




Appendix – B




Appendix – C



© 2011 Asset Consulting Group. All Rights Reserved. Asset Consulting Group is the sole owner of all rights, title, and interest to the materials, methodologies, techniques, and processes set

forth herein, including any and all intellectual property rights. No part of this document may be reproduced, stored, or transmitted by any means without the express written consent of Asset

Consulting Group.

The information contained in this report is based on information obtained by ACG from sources that are believed to be reliable including: subscription services and information provided

directly from the managers themselves. ACG has not attempted to verify the accuracy of the information provided, but believes it to be reliable and representative of the portfolios being managed by the manager. However, investor specific investment policies may cause dispersion in returns from the manager’s composite data and actual returns of specific investors may vary.

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Debt Crisis Update - 7-19-11

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