In my last post I discussed the nation’s financial condition, and contrasted national bankruptcy with personal bankruptcy.  In this post I will contrast the nation’s credit rating with personal credit rating.

I.          The Nation’s Credit Rating

Some time ago I wrote “Bankruptcy And Your Retirement Accounts”, in which I talked about the growing problems with retirement funds that had invested in various types of government debt.  I observed that since many states and municipalities had large unfunded obligations on such things as employee pension and medical plans, the quality of some state and municipal bonds as investment vehicles could be headed toward junk bond status.  In passing I referred to the recent downgrading of federal debt.

Well, it looks like a further downgrading of federal debt is in the offing – perhaps even before Christmas. In the November 22, 2011 edition of the Wall Street Journal’s Market Watch, Sue Chang reported:

The failure of the supercommittee to reach a compromise on a debt-reduction plan exposes the U.S. sovereign rating to more downgrades, with ratings agencies expected to fire their first salvo by the year’s end.  “It is just a matter of time before the government’s rating is cut,” Steve Ricchiuto, Mizuho Securities’ chief economist, said in a report.  “I would not be surprised if S&P puts the Treasury on watch for another downgrade in the weeks ahead and that Moody’s or Fitch move before the Dec. 23 date when the legislation implementing the Super Deficit Committee’s recommendations were scheduled to be enacted,” he added.

So what if federal debt is downgraded.  Why should you care?  To appreciate the importance of the downgrade, it helps to understand how, and why governments incur debt.

The why is pretty easy:  a government incurs debt to pay for projects that it doesn’t currently have the resources to fund.

What about the how?

Sometimes a government with the authority to print money (in this country only the federal government has that authority – and no, casinos don’t have licenses to print money, it just seems that way) just rolls off large quantities of currency.  The newly printed currency initially has the same value as the currency already in circulation.  However, once the surge in currency is realized by the market, the value of the currency drops because currency obeys the law of supply and demand.  And as I pointed out  in my post on personal bankruptcy and national bankruptcy, the U.S. National Debt Clock shows that our currency supply is growing at an alarming rate.  Thus, as the federal government blasts out massive quantities of new currency, the buying power of that currency drops.  This is called inflation because the money supply has been inflated.

Unfortunately, my waist has been experiencing a bit of inflation as well.  But like the rest of the 99%, I’ll be starting a diet and exercise program on Monday.  I’ll let you know which Monday, as soon as I find out myself.

Another way in which a government can incur debt – the more commonly used way – is to borrow the money through the selling of securities such as bonds.  Investors buy the bonds because the issuer promises to eventually repay the face value plus interest.  Among the entities who purchase U.S. debt is China.  In fact, the Chinese hold about eight percent of our national debt .

How is the interest rate on bonds determined?  Just like any other kind of interest bearing investment, the riskier the investment, the higher the interest rate has to be to lure investors from safer investments.  The level of risk is reflected in the credit rating of the government issuer.  Therefore, if the U.S. debt is downgraded, the U.S. will have to pay a higher interest rate to attract investors.

If the U.S. has to pay a higher interest rate, then a larger amount of the federal budget will have to be devoted to the interest payments, and that portion of the budget is then unavailable to fund public projects.

Right now the fifth largest budget item is the net interest on the debt, which, as of 6:57 p.m. on November 22, 2011 is about $0.218 trillion. Since the 2011 budget is about $3.6 trillion, this means that 6.1% of the entire federal budget is currently devoted to interest payments.  With another downgrade, the interest rate will have to increase, which will ultimately increase the percentage of the budget devoted to interest payments to the country’s creditors.  This will undoubtedly lead to louder calls for tax increases (a.k.a. legalized theft), so we really should care.

How can this be fixed?  The federal government must live within its means, and cut its spending to the level of its income.  After all, the rest of us have to do this.  Will it happen?  Of course:  as soon as we see pigs flying like birds.  I suspect that the current collection of cretins running the show has a Louis XV (1710-1774) mindset: “Après moi, le déluge.” (“After me, the deluge.”)  In the French case, the deluge was the French Revolution, which began in 1789, just fifteen years after Louis XV died, and ended the Bourbon monarchy along with the life of the next king, Louis XVI.

Sobering questions:  What will be the American deluge?  And when will it happen?

II.        Your Personal Credit Rating

Just as the nation’s credit rating affects its ability to borrow and the interest rate it must pay when it does so, so your personal credit rating affects your ability to borrow and the interest rate you must pay when you do.

If Bill Gates ever needs to borrow money – admittedly, somewhat unlikely at this point – he would obviously be eligible for the lowest rate available.

If you’re underemployed, or unemployed, and need to borrow, you might have difficulty finding a willing lender, and those who are willing will charge you a very high interest rate.  (You know the type:  Question:  “What’s in your wallet?”  Answer:  “Ahhh!  It’s a loan shark; quick, get it off of me!”)

And when I say a very high rate, I do mean a very high rate.  I have had clients who have loan shark loans with triple digit interest rates.  The worst I have seen was an annual rate of 481% on an unsecured loan – i.e., one where no collateral was involved.  The worst rate I’ve seen on a secured loan was an annual rate of 150%, where the collateral was a previously paid-off car.  If you’re on one of those treadmills you’ll never pay the debt off.  At that point bankruptcy makes a lot of sense.

What will happen to your credit rating as a result of bankruptcy?  Amazingly, it will improve.  For more details on this somewhat counter-intuitive fact, read my post “Rebuilding Credit After Bankruptcy”.  That post also gives a roadmap for rebuilding credit after bankruptcy.

If you’ve used Uncle Sam as a role model and have gotten deeply into debt, contact a good bankruptcy attorney and rid yourself of that ball and chain.