Video Update: Why Does the Debt Ceiling Exist?

Last week, we talked about the next phase of the banking crisis that’s likely on its way after the failure of First Republic Bank (FRC).

This week, we’re talking about the debt ceiling crisis and why it exists in the first place.

Chief Analyst Adam Galas discusses the events that led up to the current debt ceiling crisis, what the present predictions dates are for default, and shares how an upcoming Fortress Portfolio play will more than recoup all losses from VF Corporation (VFC), Kilroy Realty (KRC), and Highwoods Properties (HIW).

Your Fortress Portfolio is built to withstand market volatility, recessions, record-high inflation, interest rate hikes, and any other economic or personal setback.

As Adam shows, with the power of this portfolio, you can make money while you sleep, reset your financial situation, and protect your savings from even the most severe banking crisis.

Click below to watch the video or read the transcript.

Happy SWAN (sleep well at night) investing,

Brad Thomas Editor, Fortress Portfolio

Welcome Fortress Portfolio members to another weekly video update.

Today is part two of our series on the debt ceiling, and we will be talking about why it exists.

Now, I am making a multipart series because the debt ceiling is one of the most complex but important concepts in economics or the world today.

How important?

Well, according to a study by the U.S. Joint Economic Committee, a three-month default would plunge our economy into a recession 50% worse than the Great Financial Crisis.

We’re talking about a 6.1% decline in GDP (compared to 4% for the Great Recession), 8 million job losses, and a 45% stock market crash from today’s levels.

That means a 53% peak decline from record highs. That would mean $19 trillion in market wealth would potentially be gone in a matter of months… And an extra 850 billion to $1.7 trillion in higher borrowing costs for the government, driving deficits even higher over the next ten years.

The average 401K would lose $20,000, and the average 30-year mortgage over 30 years would cost an extra $130,000.

Now, the good news is that we still have some time.

Treasury Secretary Yellen just affirmed her June 1 estimate. Goldman Sachs (GS) thinks we have till June 7, Moody’s: June 8, and JPMorgan (JPM): June 9.

Oxford Economics thinks that if we get to July 15 when $111 billion in corporate taxes are expected, we might get to July 18.

Most optimistic of all is the Congressional Budget Office, which says that if we can make it to June 15, we can probably make it to July 31.

But either way, the point is we’re just weeks from potential economic catastrophe, possibly much worse than the Great Recession.

In fact, six months of defaults is estimated to result in a 12% contraction in the U.S. economy, basically a depression the likes not seen since 1930.

So why does the debt ceiling exist?

Why does the Sword of Damocles hang over our heads representing an economic nuclear bomb threatening us with doom and destruction?

Well, the debt ceiling was created in 1917 by the Liberty Bond Act, and most people would be surprised to find out that it has nothing to do with preventing deficit spending.

Now, before this act, when Congress wanted to authorize any kind of spending, say, a tank, army uniforms or even desks for the White House, they had to specifically state:

Well, in WWI, this was insane. Untenable. We were going to lose the war.

So U.S. Department of the Treasury came to the conclusion that it would be better to pass a law and let the Treasurer deal with the details.

In 1939, Congress extended this to cover every kind of debt so that the Department of the Treasury could basically have one giant pot of money that they could spend. And they would determine whether they would sell one-month Treasury bills, 30-year bonds, and/or anything in between.

But, in 1974, the Congressional Budget and Impoundment Control Act gave Congress the power of the budget.

Up until this point, the White House and the President would set the budget and Congress could vote yay or nay, but they couldn’t say what was in it.

Now things flipped.

Today, the White House can propose a budget, but it’s really just a wish list.

At present, Congress determines how much we spend and tax.

Now, how do we know that the debt ceiling has nothing to do with deficits?

Because it wasn’t designed to handle that.

Congress has raised the debt ceiling over 90 times in the 20th century at an average of once or twice every year or two.

And since 1962 alone, we’ve raised it 78 times, including 18 times under Reagan, eight times under Clinton, seven times under George W. Bush, six times under Obama, three times under Trump, and once so far under Biden.

And this year, would be the second time under Biden.

Now, the reason the numbers keep going up is very simple. We raise it by larger amounts or simply suspend it entirely.

Now, in these 78 raises, it’s been 49 raises under Republicans and 29 under Democratic presidents. In other words, this is not a partisan issue.

That’s because the debt ceiling has nothing to do with future spending.

It’s about spending on what Congress has already authorized. So let me give you an example of how this actually works.

Congress recently authorized a $1 trillion defense spending bill.

Once the president signs it, we are constitutionally obligated to spend that as laid out in the budget.

Now, right now the government is borrowing about 20% of what it is spending, meaning that we’ll need to borrow $200 billion for that trillion in defense spending.

When the president signs the bill, Treasury doesn’t go out and just sell $200 billion in bonds and stick it in a vault labeled defense spending.

In fact, that trillion dollars isn’t sitting in any one place. The government spends it as it goes.

Every day, millions of people basically send money into the government and the government sends money to millions of people.

So in order to pay defense contractors and military pensions, as well as paychecks, the debt has to be issued as needed.

Essentially under the current debt ceiling, Congress is telling the president we voted to buy $1 trillion in defense and we’ll vote to pay for it later.

Well, remember, the debt ceiling was created in 1917 to help us win WWI.

It was created for convenience.

And in 1974, it became obsolete when Congress regained control of the budget.

So if that’s the case, then why is it that we haven’t had more crises every year or two for the last 90 years?

That’s because of something called the Gephardt rule, which is a parliamentary rule that says when Congress authorizes to spend more than it takes in and thus raises the debt, it will automatically raise the debt ceiling.

So in our example, when they voted to borrow $200 billion to fund defense spending, they would automatically raise the debt ceiling by $200 billion.

This is like saying if you agree to buy a car, you line up the financing ahead of time. It’s just common sense.

But in 1995, we got rid of the Gephardt rule.

Why? For one simple reason.

So that politicians could weaponize the debt ceiling. This started in 1995 when Newt Gingrich was Speaker of the House.

The Republicans used the debt ceiling to force a government spending shutdown so that they could have a showdown on government spending.

And in 2003, 2004 and 2006, Joe Biden cast protest votes against the Iraq War, thus voting not to raise the debt ceiling.

Now, it’s important to point out the votes were already available and there was no chance it wouldn’t be raised.

In 2011, the Tea Party forced Speaker John Boehner into a showdown with the Obama administration. They brought us within two days of default.

And that’s why S&P downgraded us from a triple-A. And to this day, we’ve never regained that rating.

In 2013, there was another showdown.

And most recently in 2021, all the Republicans in Congress cast protest votes like Biden did 20 years before.

But again, all the votes were available to pass the debt ceiling.

So what were all the Republicans in Congress protesting in 2021?

Well, deficit spending itself. By refusing to vote for it, they forced Democrats to raise it.

They could potentially use it in 2022 as a campaign issue.

Now, once more, we stand at the brink of disaster and both sides are saying that default is unthinkable.

With the one exception being Donald Trump, who reversed himself in 2019 after saying that the debt ceiling was sacred and we could never even consider defaulting.

Now both sides appear unwilling to budge.

Now, in part three of this series, we’ll go through the various options on both the congressional and White House sides.

We’ll also explore why the deficit is so hard to get under control and most importantly, how we can prevent the debt fueled doomsday that so many people are worried about.

But today, I want to close this week’s update with a subscriber question from Gene M.

Well, the reason for not using a trailing stop is that long term buy-and-hold investing is the most powerful and proven way for regular people like you and me to grow our wealth and income over time.

And even with perfect market timing, the economy won’t beat, buy-and-hold investing.

The one exception being the Great Depression… And even then, it only beat it by 2%.

But the reason for introducing stops is because of the shocking truth that 44% of all stock investments turn into disasters.

And this applies to all stocks since 1980, varying slightly by sector.

For example, 59% of technology stocks fall 70+% and never recover. For energy stocks, it’s 65%.

Now, remember, Fortress Portfolio is heavily invested in energy stocks, though we focus on midstream, which is the utility part of the sector and thus the safest and most stable cash flows.

But the reason for the stop is to ensure that if the wheels fall off the bus, you minimize your losses to levels that can be easily recouped by dividends.

So let me give you an example. When VF Corporation (VFC) cut its dividend three months after raising it for the 52nd consecutive year, we recommended selling it.

We took a 0.3% loss at that time. And since then it’s fallen another 20%.

Likewise, when the banking crisis caused office rates to fall 30% as a sector, we were naturally stopped out of both Kilroy Realty (KRC) and Highwoods Properties (HIW). We took 1.2% losses on both picks.

So in total our 30% hard stop loss triggered a 2.7% cumulative loss for those three picks.

But the hard stop loss policy mitigated an even bigger loss in the case of VF Corporation (VFC). And because of the way the Fortress Portfolio picks are allocated, without lifting a finger or making any changes, our dividends could recoup that amount within five months.

But we’ll be selling Magellan Midstream (MMP) soon for a profit in order to buy ONEOK, Inc. (OKE).

And in next month’s issue, I’ll explain in even more detail why ONEOK, Inc will be the newest Fortress Portfolio stock.

For now, you should know that ONEOK Inc. announced on Sunday that it would be acquiring MMP for $18.8 billion.

So we will be cashing out of MMP with a 25% gain, almost ten times those cumulative losses we experienced.

But even without this profit gain, our dividends alone could have wiped out any kind of losses that we incurred.

So finally getting to the next part of the question, why is the stop loss 30% and not 20% or 40% or 10% or 50%?

Well, 20% is simply too conservative. Every company will suffer a 20% bear market at some point.

Even Johnson & Johnson (JNJ), the lowest volatility stock in the S&P, experienced several 20+% bear markets over the last several decades.

30% is much more reasonable and 40% is too risky.

Last up, why use hard stops and not trailing stops?

Well, remember the goal of the stops is to prevent you from owning the next General Electric (GE). It is not to lock in short term gains or minimize volatility.

Let’s consider the example of U.S. Bancorp (USB), one of our recent recommendations.

Now, this has about a 150% upside to fair value by 2025. So, if the price does return to fair value by 2025, well, the thesis has obviously worked. It didn’t blow up just as we said it wouldn’t.

But, if you use a trailing stop, then whenever a U.S. bank falls 30% from record highs, you will be stopped out.

And you might think, well, what’s the problem with that?

But remember, you can’t forget about taxes. Taxes will eat into your gains.

And what we’re looking for are not just 30% gains, 50% gains, or even 100% gains.

We’re looking for thousands of percentage gains over time fueled by an ocean of dividends.

Now, risk management is vitally important. And when we hit 100% gains, our risk management requires us to sell half our position in order to recoup our original investment and start playing with house money.

But beyond that, we let our world beta winners run because stops are aimed to minimize fundamental risk, not stock price risk.

As Warren Buffett explains, fundamental risk means the risk of permanently losing your initial investment. It’s not about volatility or short-term gains.

So thank you for joining us this week, and I hope you join us next week for part three of this series on the debt ceiling.

I want to remind everyone to please send in your questions and feedback so I can respond to them in these videos and our monthly issues.

Just remember, I can’t legally provide personalized investment advice.

Until then, this is Adam Galas wishing you and your family safe investing and a healthy and joyous week.