Hubris Meets Nemesis

“…….a central bank should always be able to generate inflation, even when the short-term nominal interest rate is zero …[this] more direct method, which I personally prefer, would be for the Fed to announce ceilings for yields on all longer-maturity Treasury Debt.   Ben Bernanke 2002

Last week Moody’s Investors Service said that the top Aaa ratings of key Western nations face new challenges that increase the possibility of a downgrade. Not one of the big countries was spared – the USA, the UK, France and Germany all came under the microscope for evaluation as to possible future downgrades. Specifically, the  ”distance to downgrade” for these four sovereigns has been reduced, the credit rating agency said in a statement, meaning their credit quality within that top category is declining. In addition a contrast was drawn between the key European states, who are pursuing deficit reduction strategies and the USA which for the time being is not.

By now the events in the US have revealed glimmers of the true picture previously hidden behind the avalanche of economic disinformation that has enveloped the country since the onset of the GFC. The average American is now very aware of the hardships of living in a nation being driven by policies that do not substantively address the very real weaknesses in the economy, and which have been obscured or soft-pedaled by the Government as well as the apologist economists associated with it. The population is also becoming increasingly aware of the dangers of not facing up to the issues that need to be addressed urgently in order to avoid  a slide into an even worse predicament.

However, the Obama Administration, for its part seems to disregard the fact that the economy continues to bleed cash and jobs. It professes to have saved the country by adding Trillions to the National Debt, by allowing many US banks to pretend that they are solvent, and that by following the “diktat” of its ultra-Keynesian advisors that taking on even more debt is the road to salvation. Ordinary Americans are being forced to pick up the tab for the bank failures, pick up the tab for the policy failures, fund insolvent institutions through the payment of net interest margins associated with “carry” trades and are being forced pick up the tab for ill-advised borrowing policies.

Whilst we agree with pretty much all of what the Moody’s reports have to say about the general picture regarding Sovereign default in the countries mentioned as well as elsewhere; we completely disagree with the focus of these reports as being on the “distance to downgrade”. As students of Sovereign Debt we observe that default is not a gradual process, much less one that can be accurately measured using “black box” algorithms or the like. The default process is one that moves akin to a step function: when one or more factors exert too much strain on the underlying structure of debt finance, the whole edifice comes tumbling down very quickly.

 It takes knowledge, experience and judgement to identify the unique factors in each situation that are material to avoidance of the disaster scenario.  In the present case we can identify numerous risk factors that if they continue to be left un-managed or mis-managed could see the United States enter a default scenario or if not outright default, then a situation where a further, and more substantial, loss of geo-political and economic clout  becomes a reality. What follows is a partial list of these myriad danger signals:

Policy Misalignment

Judging by the comments of Bernanke, Paulson and others in the lead-up to the crisis, it is clear that the US authorities completely underestimated the extent of the economic crisis, failed to identify its causes and failed to devise and put forward appropriate solutions. Apart from not allowing the stimulus alternatives and other pieces of economic legislation to be debated by Congress, the Obama Administration has compounded the mis-diagnosis by clinging to the notion that the GFC triggered a cyclical /liquidity problem (which it is not) rather than a structural/ solvency problem (which is what it is).

 As another example of the implications of this error, according to a recent Flow of Funds Report, Washington has been piling on debt at an 18.5% annual rate since the beginning of the year while households have been reducing debt by around 2.5%. Since every dollar of government debt is a promise to tax the private sector in the future with interest, this orgy of public spending has swamped the rational and strenuous efforts of the private sector to return to a sustainable expenditure track and income/savings balance.

Tax Receipts Crashing

Government Tax revenues are slowing. According the Heritage Foundation the problem has some scale: US federal tax receipts are tracking at around 14.8% of GDP, compared to 20.6% in 2000 and a 30 year average of slightly over 18% of GDP.  The US Government is being squeezed between too slow a rebound in tax revenues and the limitations on how quickly it can realistically take its funding requirements to the US Treasury auctions. This cash management information is signalling trouble ahead simply because the economy is recovering much more slowly that what was assumed in Administration fiscal forecasts.

How can we credibly expect a rebound in tax receipts when employment patterns are so weak? The U-3 numbers are tracking just shy of 10% and the U-6 series is at 16.6%. No jobs means that taxes aren’t getting paid.

State and Local Governments are Bankrupt or Going Bankrupt

Slowing revenues at the Federal level are also reflected at lower levels of government. Moreover, Investment in State and Local issuance has completely dried up. As a consequence States and cities across America are amassing scary, yet non-market fundable, budget shortfalls in record time. California as a whole is best known for being on the verge of debt default, but California is not the only State with a Government and its cities on the brink. Moreover, according to the Economic Policy Journal, 32 states are now technically bankrupt, and are borrowing money from the Federal Treasury (read “printed money”) just to keep up with unemployment benefits. The National League of Cities has reported that U.S. municipalities will come up short on debts to the tune of up to $80 billion this year.

Readers, please note that the recent $26 Billion “State Aid Plan” passed by Congress a couple of weeks ago does not actually give the States the money. It merely mandates that they have to match-fund any federal transfers in order to receive them in the first place. In other words the “rescue package” adds to the States’ fiscal burden, it does not reduce it (See “Policy Misalignment”)

 Insolvent Banking System

Readers of this blog know that we have estimated the number of insolvent and/or severely impaired banks in the US to be well over 2000 institutions, far higher than the 800 or so that were supposedly on the FDIC watchlist earlier this year. April 2^nd, 2010 marked the first anniversary of the date when FASB 157 was suspended and with it came the abolition of “mark-to market” accounting. The Administration left FASB no choice but to change their guidelines using the notion that this move was a temporary deferral of the rules, instituted in order to allow time for the banks to adjust to the toxic assets on their books. What progress have banks made in moving assets off of their books in the “Extend and Pretend” environment?  How much closer are these banks to regaining financial health? The answer is: “No one knows for sure”, because the problems have been swept out of view as a consequence of the removal of the `mark-to-market` rules.

The bottom line here is not only that the entire response to the banking debacle in the US wrongheaded, it is also a violation of the Prompt Corrective Action Law which mandates that the regulatory response to financial institution failure must be decisive, transparent, economically rational and that it be implemented in the early stages of a problem situation.

Housing Market  Near Death

The US housing market, a key driver of domestic consumption and wealth accumulation in the Post WWII period is all but dead and is not showing any signs of imminent re-animation. The full force of the plunge in US housing activity after the expiry of the homebuyer tax credit was revealed today in the form of a massive 27.2% decline in existing home sales in July. Sales are now 34% below April’s tax credit-induced peak, well below the previous cycle low back in November 2008 and at a level not seen since June 1993. At the current pace of sales it would now take 12.5 months to erase the inventory overhang, well above the 7 months that has historically been consistent with stable prices. Mortgage applications for home purchase remain close to their recent 14-year low. All of this is happening despite record low mortgage rates. Most observers now concede that weak housing activity is constraining the already fragile and tenuous growth prospects for the general economy.

Debt Issuance  Patterns

 Usually, a Sovereign debt management strategy features limits on issuance of short term debt in order that the debt portfolio not become too sensitive to rate resets and liquidity conditions in the funding markets. Thus, a typical issuance strategy for Sovereigns would be to seek 80% fixed rate term debt, perhaps 20% in floating maturities and perhaps a small portion in inflation indexed stock. In addition, debt managers try to aim for an average maturity of the overall portfolio that will shield it from interest rate volatility usually by aiming for a duration range of 4-6 years. Stable borrowing strategies also feature a diversification of funding sources.

The current situation in the US reflects anything but this. The Chinese and Japanese who together own about 40% of the Treasury stock held offshore are limiting their purchases of Treasuries. China has in fact sold down some of its holdings recently. Britain another large holder is in no position to support the Treasury’s borrowing program. It is not probable that this behavior will change in the future.

The upshot of this is that in the recent US Government fiscal year over 70% of issuance has been in the one year and under (i.e. short dated and floating) portion of the maturity spectrum. Issuance in the 10 year and over maturities has so far constituted less than 7% of the funding requirements. As the deficits projected for the next few years are very large, this disproportionate short-dated issuance will vastly increase the vulnerability of the US Government Budget to rising rates and market funding conditions, placing pressure on the Fed to maintain low rates and possibly imperiling the Dollar as reserve currency should it come under speculative attack. The focus on short-dated issuance in a situation where gargantuan deficits are in store is a very significant risk factor. Ironically, a key risk factor affecting the US dollar is precisely the debt managment connundrum described above.

Off Balance Sheet Federal Government Liabilities

At last count these amounted to around USD 52 Trillion or around 4 times larger than annual GDP. There is no further comment needed here.

Hanging by a Thread

The situation in the United States is reaching a critical point. Key economic indicators are signalling a weak activity profile, Fed and Treasury  policies have not worked and more of the same tonic might in fact prove very dangerous, and offshore investors and trading partners are growing increasingly nervous and unsure of the economic stewardship of the World’s still-largest economy and that whose currency is the principal reserve asset for the Global Financial System.

Given the foregoing it is not be surprising that there are reports of significant stress between members of the FOMC coming out of the Beltway and the growing difficulties that Bernanke is having riding herd on this increasingly restive group of Senior US Central Bankers. However much stress and nervousness there might be at present, to us it seems that, given the results so far, the real difficulties, dangers, and hard choices unfortunately still lie ahead.

Posted in Banks, Bond Market, Canada, Crisis, Economy, Fed Policy, Restructuring | No Comments »