Surprise! Your "rich" uncle smokes. Now what?

Today I called to wish a client Happy Birthday when he surprised me with an unusual question. "Why do bonds go down when interest rates rise?" he asked.

A good question, but not the kind of question I usually hear when I'm doing financial planning for young doctors. After I had answered it to his satisfaction, we started talking about today's news, and the US credit downgrade.

Putting the U.S. Credit Downgrade in Perspective: An Analogy

As we spoke, I started to ask myself, "How on earth can I even begin to explain what this downgrade means, in a way that a doctor will understand?" After all, creditworthiness is an imprecise science. In fact, it's fairly nuanced. So I gave him this analogy to try to put things into perspective:

  • Imagine that you have a rich uncle.
  • Despite the fact that he's rich, he still asks you to loan him money.
  • You've been loaning him money for years.
  • Your rich uncle has always paid back every penny you've loaned, with interest.
  • Your rich uncle has an odd smell about him, literally.
  • The aroma is vaguely familiar yet unwelcome.

Does your uncle smoke? Maybe he does, but he's never mentioned it to you.

Then one day, you're visiting him at his house, chatting in his office, and there in the middle of his desk lies a pack of cigarettes.

You ask, "Uncle, are those your smokes?"

"Yes," he says with a shameful grin. "They're mine. I've been smoking for years and I was just too embarrassed to tell you about it. I'm trying to quit."

As a physician, you know that he's more likely to die than if he never smoked at all. He will probably live a long life, albeit a miserable one.

You wonder if there is going to be a time when he becomes sick and unable to repay your loan. And you think to yourself, "My uncle might die some day and fail to repay the loans I've made." But today, he seems fit as a fiddle.

So what do you do? You make a note of it, you keep a more watchful eye on him, and you review the situation from time to time.

And voila! Just like that, you have just downgraded your uncle's credit rating.

Are you going to stop lending to your rich uncle? Of course not. The chances are still excellent that your uncle will continue to repay what he borrows, with interest, just as he always has in the past.

Smoking, and Abusing Credit, are Bad Habits

By now you've figured out that your "rich" uncle is Uncle Sam, the loans are US sovereign debt or "treasuries", and you are US, the citizens of the United States (and the Chinese too, of course).

Hopefully some day, our nation will kick this nasty habit and become a healthier, more fiscally fit nation. In the mean time, don't worry too much about the downgrade. Like smoking, the damage is not irreversible, it's not life ending, and there's still time for us to change our ways.

Oh, and there's one more thing. We're still an AA+ credit risk, which is very, very good.

If you have questions about the downgrade, or the stock market hysteria du jour, feel free to contact me.