ASSET CONSULTING GROUP

U.S. Debt Crisis

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July 18, 2011

Executive Summary
Extremely high federal debt levels have historically been associated with major wars, but the current situation is a result of both a decade-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 federal government 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, Moodys and Fitch) have placed U.S. debt under review and have threatened a downgrade 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 another significant 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 active duty military, however, those programs that may see delays in payment might include food stamps and welfare, unemployment benefits, 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

2011 Asset Consulting Group. All Rights Reserved.

U.S. Debt History

Since the inception of the U.S. Treasury in 1792 the level of U.S. debt as a percentage of GDP has risen significantly, and has spiked during periods of war Government expenses have generally exceeded revenues during the last 40 years (except for a brief period in the late 1990s), and the resulting deficit has been financed by borrowing The cost of the rising debt has to some extent been offset by a secular decline in interest rates over the last 30 years The U.S. federal debt ceiling was $49 Billion in 1940 and was subsequently raised to $300 Billion in 1945, to pay for WWII During the 2001-2011 period (war in the Middle East), the debt ceiling has been raised from $6 trillion to over $14 trillion

WW II

Iraq War

WW I Civil War

U.S. Interest Rates (1980 2010)

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U.S. Debt History

Composition Of U.S. Government Spending Actual Projected

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 debt has been rising Defense spending (as a percentage of total spending) has also been falling, aside from an uptick in the mid 80s and again during the war in the Middle East Social security and welfare programs have ballooned from around 16% of total spending in the early 1960s to nearly 50% of total spending, currently

Although the debt ceiling is currently raising much debate, it has been raised 15 times in the last 20 years and 79 times since the inception 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 interest payments 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 around 0.60%
Source: Thompson Reuters Datastream, Standish

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U.S. Debt Current Dilemma

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

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, IRS refunds, defense vendors, food stamps and others could suffer
2011 Asset Consulting Group. All Rights Reserved. 4

U.S. Debt Future Implications

Summary The bond market is currently pricing in a high likelihood that that Congress will raise the debt ceiling before August 2 However, should a debt downgrade occur , there could be several negative repercussions in the short-term Short-Term Yields on U.S. treasuries could rise as the U.S. loses its safe haven 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 central banks further diversify their reserves into the Euro, Yen, other faster 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 investors seek to reposition their portfolios to avoid significant loss of capital
US Treasury Yield Curve 5.00% 4.50% 4.00% 3.50% 3.00% 2.50% 2.00% 1.50% 1.00% 0.50% 0.00% 0 5

Yield-to-Maturity

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 since May 16. 14-Jul-11 10 15 20 16-May-11 25 30
5

Years-to-Maturity

Long-Term Assuming the current debt ceiling deadline is met, over the longterm 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.

2011 Asset Consulting Group. All Rights Reserved.

Appendix A

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Appendix B

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Appendix C

2011 Asset Consulting Group. All Rights Reserved.

 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 managers composite data and actual returns of specific investors may vary.