Washington Update – Debt Ceiling: Deja Vu All Over Again?

As expected, on Friday, Feb. 7, 2014, U.S. Treasury Secretary Jack Lew notified Speaker of the House Boehner that Congress must raise the debt ceiling by Feb. 27, or the Treasury would be left “with only cash on hand and any incoming revenue to meet our country’s commitments.” In other words, the country risks default. It is estimated that the United States would have just $50 billion cash on hand, but also noted that could be higher or lower depending upon the pace of tax refund filings. February is traditionally the highest deficit spending month of the year because the Internal Revenue Service sends out many tax refunds.

The debt limit is the total amount of money that the U.S. 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. When the debt limit or “ceiling” is reached and Treasury exhausts its financing alternatives, aside from ongoing cash flow, a federal agency may continue to obligate funds, but Treasury cannot borrow to meet federal outlays due to a shortage of cash. Under normal circumstances, the Treasury has sufficient financial resources to pay all obligations arising from discretionary and mandatory spending, including interest payments on the debt.

Beginning in 1789 and for approximately 130 years thereafter, Congress generally had to act each and every time Treasury needed to borrow money. Since World War I, however, Congress has provided Treasury with increasing flexibility to manage the federal debt. In more recent times, Congress has set a limit on the amount that Treasury can borrow without congressional action. That is the debt ceiling. Treasury cannot borrow more unless Congress votes to raise the ceiling. The debt limit was previously suspended until Feb. 7, and Treasury has been using “extraordinary measures” to manage.

In the past, the Treasury, when faced with a nearly binding debt ceiling has used special strategies to handle cash and debt management responsibilities. Since 1985 these measures have included:

• Suspending sales of nonmarketable debt (savings bonds, state and local series and other nonmarketable debt);
• Trimming or delaying auctions of marketable securities;
• Underinvesting or disinvesting certain government funds (Social Security, Government Securities Investment Fund of the Federal Thrift Savings Plan, the Civil Service Retirement and Disability Trust Fund, Postal Service Retiree Health Benefits Fund and Exchange Stabilization Fund); and
• Exchange Treasury securities for non-Treasury securities held by the Federal Financing Bank (FFB).

Medicare, Social Security and Debt Ceiling

If Treasury delays investing a federal trust fund’s revenues in government securities, or redeems prematurely a federal trust fund’s holdings of government securities, the result would be a loss of interest to the specific trust fund. This could worsen the financial situation of the affected trust fund(s) and accelerate insolvency dates. Public Law 104-121 was enacted to prevent federal officials from using the Social Security and Medicare trust funds for debt management purposes except when necessary to provide the payment of benefits and administrative expenses of the program.

The Social Security and Medicare trust funds were created to account for monies that are dedicated to those programs. The fund accounts maintained by the Department of the Treasury provide a mechanism for keeping track of all program income and disbursements. Accumulated assets of the funds represent automatic authority to pay program benefits (that is, no annual legislation is needed to spend a portion of trust fund assets on these costs). If the trust funds were exhausted, congressional action would be needed to pay benefits not covered by current program revenues.

While the trust funds are treated separately under budget rules, it is important to understand the flow of funds between general revenue and the trust funds. The Medicare program has two trust funds: the Hospital Insurance (HI) and the Supplemental Medical Insurance (SMI) trust funds. The HI trust fund is financed primarily by payroll contributions. Other income includes a small amount of premium revenue from voluntary enrollees, a portion of the federal income taxes beneficiaries pay on Social Security benefits and interest credited on the U.S. treasury securities held in the HI trust fund. The SMI trust fund is financed largely by transfers from the general fund of the Treasury, with beneficiary premiums making up the rest of the necessary funds. Beneficiaries pay 25 percent of Part B costs in the form of monthly premiums.

When a trust fund invests in U.S. Treasury securities, it has loaned money to the rest of the government. The value of the securities held is recorded in the budget as “debt held by government accounts” and represents debt owed by one part of the government to another. These securities constitute a liability for the Treasury, as the loan that must be repaid when the trust funds need to redeem securities in order to make benefit payments. As with marketable bonds, these special Treasury securities are backed by the full faith and credit of the U.S. government.

A rough analogy would be that the United States general fund would be like a checking account from which purchases of all sorts can be made, while the trust funds are like a retirement savings account, which has specific rules for withdrawals. For example, the SMI trust fund receives large transfers of varying size from the general fund, depending upon on how much the program spends, not on how much revenue comes into the Treasury. If non-dedicated revenues become insufficient to cover both the mandated transfer to the trust funds and expenditures on general government programs, Treasury borrows to make up the difference.

Could the Treasury Prioritize the Bills They Pay?

Some have argued that prioritization of payments can be used by Treasury to avoid a default on federal obligations by paying interest on outstanding debt before other obligations. Treasury officials, however, have maintained that there is no formal legal authority to establish priorities to pay obligations. In other words Treasury would have to make payments on obligations as they come due. The Congressional Research Service, however, has pointed to two different interpretations: In August 2012, the Treasury Inspector General stated that “Treasury officials determined that there is no fair or sensible way to pick and choose among the many bills that come due every day.” In 1985, however, the Government Accountability Office wrote to then Chairman of the Senate Finance Committee, that it was aware of no requirement that Treasury must pay outstanding obligation in the order in which they are received. Regardless, the federal government’s inability to borrow or use other means of financing implies that payment of some or all bills or obligations would be delayed.

Timing, Congressional Activity and Politics

Congress is set to leave town this week for the President’s Day State and District Work Period. Last week, House leadership announced their intention to hold a vote Wednesday on a debt ceiling bill that would lift the ceiling until February or March 2015. However, they also are proposing reversing changes to cost of living benefits for the military that had been included in the budget deal passed just a few months ago and attaching this to the debt ceiling legislation. The restoration of those cuts costs $6 billion. The legislation would pay for the restoration of that funding by extending the Medicare sequesters cuts for providers. At one time, there was discussion of including a nine-month patch to avoid a reduction in Medicare physician fees, but that will not be included.

It is unclear that such a bill would pass the House and it is not likely that the House leadership would bring a bill to the floor that would fail. House and Senate Democrats, as well as the White House, have said they want a “clean” debt ceiling bill — a bill that addresses only the debt ceiling and has no other items attached to it.

Passing a bill on Wednesday in the House gives the Senate virtually no time to deal with it before they leave for recess.

Conclusion: If Congress cannot act this week, when it returns from its recess it will have no choice but to focus on passage of a debt ceiling bill. It will have little time to debate without the threat of default.

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If you have any questions, please contact Stephanie Kennan, Senior Vice President, or Brian Looser, Assistant Vice President, at McGuireWoods Consulting.

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