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How a debt ceiling crisis and U.S. default would annihilate your 401(k)

Posted By Claes Bell On 10/08/2013 @ 2:30 pm In Investing | 10 Comments

If you’ve been tuning out the dire warnings coming from economists and politicians about a possible debt ceiling crisis, I can’t really blame you. Politicians in particular spend a lot of time stirring up public fear about supposedly imminent but ultimately nonexistent crises in order to push their policy agenda (“the domino theory,” “death panels,” etc.).

But I believe a failure to raise the debt ceiling, and the default of Treasury debt it would trigger, would have real and seriously crappy consequences, particularly for all the people invested in the stock market through their retirement plans.

Here’s why: Most asset-pricing models, the mathematical tools used by big investors to price stocks, incorporate what’s called the risk-free rate. The risk-free rate is the return you can expect to earn on an asset that carries no risk at all, and most investors worldwide use U.S. Treasuries as the basis for that rate.

“How could anyone with a brain in their head and access to CSPAN consider anything related to the U.S. government risk-free?” you might be asking right now. That’s a valid point, but what’s the alternative? Government debt from countries in the eurozone, where a destabilizing breakup always seems right around the corner? Debt from Japan, where the government owes twice its annual gross domestic product to investors?

Anyhow, if Congress refuses to raise the debt ceiling, it’s likely that the U.S. government would eventually default, failing to make interest payments to some of the many investors who hold trillions of dollars’ worth of Treasuries. Suddenly facing the risk they wouldn’t get paid what they were promised, global markets would demand a higher rate of return for taking on that risk, and Treasury rates would go up. In effect, the global standard for the “risk-free rate” would be blown up.

So how would that punch a giant smoking crater in the middle of your 401(k)? Well, besides the wave of fear a U.S. default would probably touch off worldwide, most mathematical models price stocks based on how much they pay investors relative to their “required rate of return,” which is usually calculated as the risk-free rate plus some sort of risk premium — an extra cushion to compensate investors for the chance they’re taking that an investment won’t pan out.

Models differ on exactly how they come up with a target for a stock’s price, but basically, if a company earns a lot of money or consistently pays a lot of dividends compared to their required rate of return, like Apple or Exxon Mobil, its stock price is high; if they don’t, it’s low.

In the event of a default and a massive increase in the risk-free rate, that hurdle suddenly becomes a lot higher. Stocks that used to look great will look a lot less great, and stocks that looked so-so will look downright horrible. Overnight, the price investors would be willing to pay for the stocks in your 401(k) would probably fall a lot and stay there for a good long while. After all, it seems doubtful that the mistrust created by even a temporary default by the U.S. government would subside anytime soon, if ever.

And before you get all excited that you put your money in real estate and think you can just sit back and watch the stock market burn in your big fancy house, the risk free rate also affects real estate values. After all, a higher risk-free rate means higher mortgage rates, and higher mortgage rates mean potential buyers of real estate will have to pay more for financing, meaning they won’t be able to borrow enough to pay you as much for that house you’re selling.

Basically, the vast majority of assets owned by American households would take a big hit, and we’d all have to listen to gloating from the people who’ve been stashing all their money away in gold [3] and bitcoins for the next few years or decades.

Does this mean I think you should liquidate your 401(k) and put all your money into gold bullion? No. I have no plans to get out of stocks, and I still expect Congress to avoid committing what amounts to economic suicide, even with the levels of dysfunction on display today. One thing worries me though: I’ve seen some politicians in the media say that hitting the debt ceiling wouldn’t trigger a default, or that a default wouldn’t be a big deal. I guess it’s possible they’re right — but I wouldn’t bet my retirement on it.

What do you think? Are you worried about the debt ceiling?

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