Free Markets, Free People

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Closer to the edge

The grand compromise over the budget and debt ceiling was scuttled by the House. So, the expected Republican surrender didn’t emerge yesterday or today. And everyone was so hopeful, too. Anyway, we now move closer to at least a technical default on US Securities, and, as a result, Fitch announced today that the US rating was being put on watch for a possible downgrade.

Chicago-based Fitch, the third-largest of the major debt-rating companies behind Standard & Poor’s and Moody’s Investors Service, put U.S. Treasury bonds on Rating Watch Negative, which is sometimes but not always a first step before a downgrade. Fitch said in a statement that it still thinks the debt ceiling will be raised in time to prevent a default.

Fitch said the government would have only limited capacity to make payments on the $16.7 trillion national debt after Treasury Department’s emergency measures run out Thursday.

Speaker Boehner did come up with a plan for some sort of House bill, but he abandoned it at the end of today, apparently not having the votes to pass it.

Last-minute protests from conservatives in the House created a day of delay and confusion in Congress’s efforts to avoid a U.S. debt default, as Republican leaders failed to craft a GOP budget proposal that could muster enough votes to pass.

In an embarrassing retreat for House Speaker John Boehner (R., Ohio), House leaders had to cancel plans to bring a GOP bill to the floor for a vote Tuesday night.

At this point, under Congressional rules, I don’t see how a debt deal can be struck that can pass Congress and be signed by the president before the Treasuries emergency actions on the debt run out on the 17th.

The markets are starting to get cautious about all this. There were 3- and 6-month T-Bill auctions today. They didn’t go especially well. The rate for the 3 month jumped 10 basis points, while the 6-month yield rose 9 basis points from last week. Last month’s 4-week auction was weak, as well.

Doom approaches! Or not.

Meanwhile, the Chinese government is calling for a de-Americanized world.

“The world is still crawling its way out of an economic disaster thanks to the voracious Wall Street elites,” the commentary said. “Such alarming days when the destinies of others are in the hands of a hypocritical nation have to be terminated.”

“The congressmen are behaving irresponsibly not only for other countries but also for” the United States’ “own creditors,” said Mei Xinyu at the Chinese Academy of International Trade and Economic Cooperation, which has ties to the Commerce Ministry. “They are gambling the U.S. future on their political-struggle interests.”

I don’t know what they’re complaining about. After all, we’re funding a great portion of their defense budget with the interest payments on the US bonds they own, so I don’t see why….oh. Wait. If we default, those interest payments stop. OK. I think I’m beginning to see what they’re so upset about. I imagine our messy democratic maneuverings are also a bit foreign and frustrating to a one-party dictatorship, too.

If only we had a dictatorial, one-party, state here, we could do these things so much more efficiently. Just like Tom Friedman always says.

I like the phrase, “political-struggle interests.” You gotta hand it to those Commies, boy. You just can’t beat ‘em for catchy political sloganeering. “The running dogs of the capitalist-imperialist forces” has always been a favorite of mine.


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Observations: The QandO Podcast for 13 Oct 13

This week, Michael and Dale discuss the government shutdown.

The direct link to the podcast can be found here.

Observations

As a reminder, if you are an iTunes user, don’t forget to subscribe to the QandO podcast, Observations, through iTunes. For those of you who don’t have iTunes, you can subscribe at Podcast Alley. And, of course, for you newsreader subscriber types, our podcast RSS Feed is here.


The most important issue in the country today (Updated)

Monty Pelerin, writing in The American Thinker, is thinking about the unthinkable. What would happen if the US held a bond auction..and no one bought any bonds? Even worse, what would happen if we were to default on the $16 trillion in bonds already outstanding?

What occasions this thinking is something he read in Bob Woodward’s new book on the Obama administration, a portion of which is excerpted in the Washington Post. This excerpt discusses last year’s debt ceiling crisis. In it Treasury Secretary Timothy Geithner tries to explain how bad it would be if credit markets stopped buying Treasuries.

But, here’s the thing:

Credit markets have (or nearly have) stopped US government debt financing. That’s why we have the Federal Reserve, the counterfeiter of last resort. If government can raise the debt limit, then it would be legal for the Treasury to issue new debt. The Treasury’s sibling, the Fed, would buy it by printing new money. That would allow the government to pay its bills for a while longer…

No one will buy US Treasuries other than the Federal Reserve. Raising the debt limit only puts the government more hopelessly in debt, ensuring that Treasuries will be even more difficult to sell. Without intending it, Geithner admits that Bernanke will be printing money until the electricity is shut off or until hyperinflation shuts everything economic down. In either case, we reach his "indelible, incurable" situation which will "last for generations."

BASE_Max_630_378Take a look at the monetary base of the United States, which I would describe simply as all the money of all types floating around in the economy. You know why that number has jumped massively since 2009? Because the Fed has been the major buyer of US treasuries, and it buys them by simply printing new money.

Now, the US Dollar is the world’s reserve currency. What that means is that it is expected to be strong, stable, and plentiful enough—though not too plentiful—to be used as the primary backup currency for the entire world’s global trade.

But, since 2009, we have essentially financed our massive debt, which is now at 104% of GDP by having the Fed print the money to buy the Treasury’s bonds. The chart you see here is the result of two separate rounds of Quantitative Easing of that sort, and the Fed is now considering QEIII.

Now, Greece, the sick man of Europe’s financial system, has a debt to GDP ratio of 128%. At the current rate of spending, we could reach that within a decade. But we won’t, of course, because at some point between 104% and 128% of GDP, we will have so much debt that the US will be the world’s financial sick man. At some point credit markets will simply not bid on US Treasuries, because the specter of inflation or default will loom so large that only the Fed would be stupid enough to show up at a bond auction.

When that happens, current foreign holder of US treasuries will face intense pressure to divest themselves of them.  Prices will collapse, and interest rates will skyrocket.  If the Fed steps in to buy those treasuries to support the price—which they almost certainly will, because politicians will demand it—we will then be clearly seen as fully monetizing the debt.

At that point, foreign holders of US dollars will demand that some other currency or asset be used as a reserve, at which point foreign holders of dollars will scramble to repatriate those dollars as quickly as they can.

The dollar will then become worthless in foreign trade, and we will face massive hyperinflation in the US.

On our current spending path, with our current level of debt, this is inevitable, and we have no idea when it will happen. We are literally a single bond auction away from a complete and utter collapse of the US financial and monetary system. We just don’t know when, exactly, that bond auction will be. It might be this week. It might be five years from now.

But, I repeat, at this point, barring a massive change to our fiscal and monetary policy, it is inevitable. There is no way credit markets will continue to buy US Bonds as our debt to GDP ratio climbs towards that of Greece. When that happens, we will either monetize that debt or default on it. Either way, the result will be years, if not decades, of American poverty.

And once that process starts, there will be no way to stop it.  We can’t come back a week later and say, "hey, we fixed it!" Once it starts…we’re done.

After WWII, the US debt to GDP ratio was 124%. At the end of WWII, we slashed government spending by 50%, and eliminated the most onerous and confiscatory wartime taxes, and, though marginal rates were still high, offered a myriad of exemptions that essentially ensured that no one paid the marginal rates. We also scrapped the entire wartime system of industrial production regulation and eliminated rationing. And, of course, we had the only fully industrialized economy left in the world, as everyone else’s had been bombed, if not back into the Stone Age, at least into the Age of Reason, and we became the world’s chief industrial power, exporter, and global business leader.

To do something similar today, we’d have to completely eliminate the entirety of the Federal government, with the exception of the Departments of State, Defense, Justice, Interior, and Treasury, and cut Social Security, Medicaid and Medicare spending by at least 50%.

That’s not going to happen. I believe the current Republican plan to attack the debt and balance the budget won’t even eliminate the budget deficit until sometime around 2040.

Ha ha ha ha ha ha ha ha ha ha ha ha ha ha ha ha ha ha ha!b That’s rich. Like we have 30 years available to fix this. It is to laugh.

Update: And, this morning, right on time, I see that House Speaker John Boehner says he’s "not confident" that Congress and the administration can reach a debt deal. In which case, Moody’s has already warned that they will downgrade the US credit rating by another step. Meanwhile, the rumor is that the Fed is now preparing for another $840 billion in quantitative easing.

That bond auction just keeps getting closer.


Dale Franks
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Oh. This can’t be good…

Via Zero Hedge, I’ve acquired this very interesting little chart, that shows the number of margin calls on its credit-extensions to counterparties. Huh. Now, see, I just wrote that, and I have no idea what it means. It’s just lots of economic gobbledy-gook when you write it out in a single sentence like that.  But, here, let’s take a gander at the chart, then I’ll explain, in human terms, what it tells us.

20120306_ECB

So, the European Central Bank (ECB) had this great idea, which was to implement a European version of Quantitative Easing. They called it the Long-Term Refinancing Operation, or LTRO.

It was actually pretty simple. The banks would go to the ECB and get an LTRO loan by providing collateral of some sort—generally A-rated securities. By which, I mean a security that at least one rating agency has rated as "A". Like, you know, Italian bonds. They don’t actually have to give the collateral to the ECB or anything, just let them know that, "Hey, we’ll just keep it safe, and can hand it over if we really have to." On the strength of those assurances, and the sterling quality of the collateral in question, like Spanish bonds, the ECB then gives the banks a huge hunk of cash. The banks then get to keep the money for up to three years, but are only charged the average overnight rate of interest.

Now, as long as the securities you put up for collateral are good, like Irish bonds, it’s a pretty sweet deal. Alas, if the securities turn out not to be so reliable, the ECB will make a "margin call", that is to say, they will demand the banks come up with additional cash or other assets to cover the collateral.

As you can see from the charts, that is exactly what the ECB is is starting to do. That’s troublesome.  You see, the ECB has a €3 trillion balance sheet. But it only has a bit under €11 billion in actual assets. So the ECB has a leverage ratio of a little under 300:1. So, it really does have to go after better assets from the banks if the initial collateral turns, you know, sucky.

The problem then is, as Tyler at Zero Hedge puts it:

The rapid deterioration in collateral asset quality is extremely worrisome(GGBs? European financial sub debt? Papandreou’s Kebab Shop unsecured 2nd lien notes?) as it forces the banks who took the collateralized loans to come up with more ‘precious’ cash or assets (unwind existing profitable trades such as sovereign carry, delever further by selling assets, or subordinate more of the capital structure via pledging more assets – to cover these collateral shortfalls) or pay-down the loan in part. This could very quickly become a self-fulfilling vicious circle – especially given the leverage in both the ECB and the already-insolvent banks that took LTRO loans that now back the main Italian, Spanish, and Portuguese sovereign bond markets.

Essentially, the LTRO program is beginning to suck higher quality assets out of the banks to meet the margin calls that are issued when the initial collateral’s value starts to go belly up. Sucking those higher-quality assets into the ECB’s LTRO collateral program, mean that they can no longer be used to finance business and consumer credit, and, thus, spending. The banks essentially become bond storage warehouses, that don’t actually do any business.

That slows the economy, of course. Which means that those original A-Rated securities stand e much better chance of defaulting, in which case, they’re worth nothing. As Seeking Alpha explains:

The real menace comes in the event of a further weakening of the Eurozone economy. If the economy were to contract, the collateral that the banks have pledged to the ECB may cease to be "performing" (seemingly the only hard criterion for collateral for the second round of LTRO). The ECB would be at risk–and ultimately so would the banks that pledged the defaulting securities.

Any defaults, be they of collateral or the banks themselves, would be a serious issue for the ECB. The ECB is supporting its EUR 3 trillion balance sheet with EUR 10.76 billion in capital–leverage of nearly 300 to one. With the fiscal situation of European sovereigns already strained to the breaking point, it’s hard to see where the money to cover the defaults could come from. This issue of a ballooning balance sheet, coupled with shaky collateral and the 3-year tenor of the ECB loans, is precisely why Trichet and Weber would not go the Draghi route. They bristled at the risk.

The odds of a calamity of the sort that would endanger the ECB are not great, but nor are they impossibly long.

Well, that huge jump in margin calls may be an indicator that those not "impossibly long" odds are getting shorter and shorter. And I wonder how much exposure US banks have to an LTRO default through credit/FX swaps. Probably…really a lot.

So, we got that goin’ for us.

~
Dale Franks
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Observations: The QandO Podcast for 20 Nov 11

This week, Bruce Michael, and Dale record the most pessimistic podcast ever.

The direct link to the podcast can be found here.

Observations

As a reminder, if you are an iTunes user, don’t forget to subscribe to the QandO podcast, Observations, through iTunes. For those of you who don’t have iTunes, you can subscribe at Podcast Alley. And, of course, for you newsreader subscriber types, our podcast RSS Feed is here. For podcasts from 2005 to 2010, they can be accessed through the RSS Archive Feed.


Observations: The QandO Podcast for 13 Oct 11

In this podcast, Bruce Michael, and Dale discuss Obama’s “Americans are lazy” comment, the failing EU. and the presidential race.

The direct link to the podcast can be found here.

Observations

As a reminder, if you are an iTunes user, don’t forget to subscribe to the QandO podcast, Observations, through iTunes. For those of you who don’t have iTunes, you can subscribe at Podcast Alley. And, of course, for you newsreader subscriber types, our podcast RSS Feed is here. For podcasts from 2005 to 2010, they can be accessed through the RSS Archive Feed.


Observations: The QandO Podcast for 25 Sep 11

In this podcast, Bruce Michael, and Dale discuss the Republican presidential field, and the apparently inevitable Greek default,

The direct link to the podcast can be found here.

Observations

As a reminder, if you are an iTunes user, don’t forget to subscribe to the QandO podcast, Observations, through iTunes. For those of you who don’t have iTunes, you can subscribe at Podcast Alley. And, of course, for you newsreader subscriber types, our podcast RSS Feed is here. For podcasts from 2005 to 2010, they can be accessed through the RSS Archive Feed.


House debt plan rejected by Senate

That’s twice now that the Democratically controlled Senate has rejected the GOP House’s plan on the debt ceiling and debt.

The onus, now, is on the Senate to do something.  That means Democrats and Harry Reid.

Feeling all warm and fuzzy about that right now?   After all, it’s been about 900 days since Senatorial Democrats have offered up a budget – one of the primary duties of Congress.  In fact they’ve instead spent all their time rejecting Republican proposals and then tried to blame Republicans for inaction and intransigence.  The irony, of course, apparently escapes them.

The 59-41 vote, on a motion to table the resolution passed by the House less than two hours before, ran mostly along party lines, easily reaching the simple majority required to sink legislation in the upper chamber.

Six Republicans joined Democrats to table the Boehner resolution: Sens. Jim DeMint (S.C.), Lindsey Graham (S.C.), Orrin Hatch (Utah), Mike Lee (Utah), Rand Paul (Ky.), and David Vitter (La.).

Boehner’s office said the Senate’s refusal to take up the House plan puts the blame on Democrats if the U.S. defaults.

“For the second time, the House has passed a reasonable, common-sense plan to raise the debt limit and cut spending and, for the second time, Sen. [Harry] Reid [D-Nev.] has tabled it," spokesman Michael Steel said in a statement. "The responsibility to end this crisis is now entirely in the hands of Sen. Reid and President Obama.”

Hard to argue otherwise, wouldn’t you say?

Of course this isn’t the end game, but Senate Democrats have to pull a few Republicans into the game before they can execute it and escape blame:

Senate Democrats’ strategy is to send such a compromise vehicle back to the House on Tuesday, which would put intense pressure on House GOP leaders to accept it or risk a national default after Aug. 2.

If Reid can persuade at least seven Republicans to join the Democratic caucus in passing debt-limit legislation, it would give him the upper hand in the standoff with Boehner.

Chicken Politics … all bloody chicken politics.  If 7 Republicans join Reid, they’ll have sold Boehner and the rest of the GOP down the river.  If they don’t, Reid and Obama are going to try to blame Senatorial Republicans for any default.

~McQ

Twitter: @McQandO


Observations: The QandO Podcast for 17 Jul 11

In this podcast, Bruce, Michael, and Dale discuss the fight over the debt limit.

The direct link to the podcast can be found here.

Observations

As a reminder, if you are an iTunes user, don’t forget to subscribe to the QandO podcast, Observations, through iTunes. For those of you who don’t have iTunes, you can subscribe at Podcast Alley. And, of course, for you newsreader subscriber types, our podcast RSS Feed is here. For podcasts from 2005 to 2010, they can be accessed through the RSS Archive Feed.


How screwed are we?

I have to admit, I sometimes get tired of being the voice of doom. Sadly, our political class–Republicans and Democrats alike–seems determined to follow the worst policy options available. So, doom slouches closer. The proximate doom they’re fiddling with this time is the approaching debt limit. Now, I yield to no man in my hatred for ever-increasing government spending, but this debt-limit battle is pointless.  We will increase the debt limit. We have no choice.

Here’s the current situation:

OMB estimates federal revenues for 2011 will hit $2.17 trillion. Granny, our servicemen, and other such untouchables — by which I take him to mean Social Security, Medicare, national defense, and debt-service payments — will add up to $2.21 trillion, meaning that even if we cut the rest of the federal budget to $0.00 — no Medicaid, no food stamps, no Air Force One — revenues still would not cover these untouchables, according to OMB estimates…

Our deficit is about 40 percent of spending this year; continued recovery, if the estimates hold, will do some of the work for the 2013 regime, but even under current forecasts that are arguably too rosy, we’ll still be running a 26 percent deficit in 2013.

Even if we eliminate every penny of spending this year except for Social Security, Medicare, and Defense, we still can’t cover this year’s spending.  And next year’s spending projects an economic recovery will save us, and reduce the deficit to 26% of spending. Absent such a recovery, next year we’ll be back to another 40% deficit.

And the politicians of both parties are nowhere near to making the appropriate cuts in the budget in years farther out than that.  The biggest deficit reduction package currently on the table is for $4 trillion over the next 10 years. Which sounds impressive, until you remember that the actual projected budget deficit over the next 10 years is $13 trillion. So, we’re still $9 trillion short of closing the budget deficit for the next 10 years.

But, wait! It gets better!  This $13 trillion figure assumes that interest rates will remain stable where the currently are. If interest rates for treasuries go up by 1%, that wil add 1.3 trillion to the deficit over the same period.  As the moment, the Office of Management and the Budget (OMB) projections are for a stable average interest rate of 2.5%. Of course, the current 20-year average is closer to 5.5%, so a return even to normal interest rates will add up to $3.9 trillion to the deficit.

But the magic doesn’t stop yet! OMB forecasts growth rates of between 4%-4.5% from 2014 to 2014. The average trend rate of growth is between 2.5%-3% however. So, if we don’t get the strong growth the OMB is predicting over the next three years, and the following years, we’ll need to add another $3 trillion or so to the deficit over the next decade.  And, frankly, if you believe Goldman Sachs today, a return to trend rates of growth seems..unlikely, as they’ve lowered 2Q GDP growth to 1.5% from 2.5% and 3Q to 2.5% from 3.25%.  They also forecast unemployment at end of 2012 to be 8.75%.

So, the best case scenario is that we’ll add $9 trillion to the deficit over the next decade. A return to historical growth and interest rates–even if we assume the $4 trillion of budget cuts will actually happen–means a 10-year deficit of $16 trillion. Essentially, we will more than double the National Debt, pushing the debt to GDP ratio to about 160% by 2021.

And that’s the good news.

The bad news is that, in the current debate over the debt ceiling, everyone involved seems determined to play chicken with a default–even if only a selective default–of US treasury obligations.

Tim Pawlenty even suggested that a technical default might be exactly what Washington needs to send a wake-up call to the politicians about how serious the situation is. Others, like Michelle Bachmann, and a not inconsequential number of Tea Party caucus members are steadfastly against raising the debt ceiling for any reason at all.

This is insanity.

Any sort of default, even a selective default that would suspend interest payments only to securities held by the government, while paying all private bondholders in full, will have completely unpredictable results. The least predictable result, however, would be business as usual. A technical default–i.e., delaying interest payments for a few days–or selective default, or any other kind of default is…well…a default. It is a failure to make interest payments.

The most obvious possible result of any sort of default will be to eliminate the US Treasury’s AAA rating, and push interest rates up sharply. If we’re lucky, we’d be talking about a yield of 9%-10%…and an additional $5 trillion added to the deficit (running total in 2021: $21 trillion added to the national debt).

And, again, that’s a best case scenario. Because it assumes that everyone will be willing to hold their T-Notes through all of this.  If any major overseas institution or government–say, China–decides to unload their holdings, it could be the start of a flight from treasuries that will destroy the US Dollar in the FOREX, vastly increase the price of imported goods, like, say, oil, and spark uncontrollable hyperinflation in the US. The life savings of every person and institution would be wiped out.

Naturally, yields on interest-bearing instruments would then pull back on the stick and climb for the skies. Not that it’d matter much at that point, since the currency would merely be ornately engraved pieces of durable paper.  Suitable for burning in the Franklin Stoves with which we will be heating our homes, in the absence of oil.

Flirting with default is extraordinarily reckless. I don’t even have the words to begin to describe how badly any sort of default might go.

The thing is, we don’t know–we can’t know–what the results of a technical or selective default might be.  It might be the judgement of worldwide investors that there are no better alternatives to US-denominated securities, so they’ll just have to ride out a technical default, and accept their interest payments coming a few days late. It might be their judgement that unloading their US-denominated securities and losing a little money is better than the risk of losing everything through a currency collapse. It might be a lot of things, and we have no way of knowing which of those things might come to pass.

As Tim Pawlenty says, a default might be a wake up call.  From an exploding phone filled with napalm and plutonium.

Whatever political points might be at stake, is it worth this level of risk?

The safe path here is a simple $500 billion debt limit increase. That’ll give us 6 months to figure things out, and try to discover some way to get our fiscal picture under control, and avoid a default. Government spending is out of control, but a default is really not the best way to impose fiscal discipline.

~

Dale Franks
Twitter: @DaleFranks