Is the US Bankrupt?

* Is the US Bankrupt? – Yesterday an article appeared on Bloomberg entitled: “The US is bankrupt and we do not even know it” by Laurence Kotlikoff, a Boston University professor. The author cites an IMF report which says that the US government would need to cut its deficits by 14% of GDP in order to put the US on a sustainable path to fiscal health. That is almost $2 trillion of budget cuts. I do not see that happening. I will assume you are familiar with the plethora of fiscal issues, but most of them center on the future projections of transfer payments, including social security and health care subsidies. The numbers bantered about add up to tens of trillions of dollars over the course of decades. The author’s thoughts about the consequences of the US’s fiscal dilemma is:


“And (the government’s fiscal irresponsible behavior) will stop in a very nasty manner. The first possibility is massive benefit cuts visited on the baby boomers in retirement. The second is astronomical tax increases that leave the young with little incentive to work and save. And the third is the government simply printing vast quantities of money to cover its bills.”


While I agree with the author’s assessment about the current state of affairs, to me the challenge is to figure out how the US government will navigate the stormy seas it has created. The bulk of our fiscal problems are the result of Bush and Obama policies. For the record, I am tired of listening to Obama blame Bush for the deficit legacy he left him with, since Obama’s legacy will be worse than Bush’s deficit legacy. Nonetheless, push will come to shove and these problems will be solved. The question to figure out is if a crisis will solve our problems, or whether we can navigate our way to a viable path without a crisis.


For one, let me say that the government has already embarked on an inflationary agenda, by virtue of the QE (money printing) strategy the Fed has embraced. The precedent for these actions is what the Fed has done in the 1940′s. This concept is one which no one has managed to understand or consider. Nor is anyone in the popular media talking about this. To repeat what I have said before: the Fed managed to impose an interest rate cap during WW2, with long bonds capped at 2.5%, and the Fed successfully managed to hold the line on this level of interest rates in the late 1940s, and after the war, when we had 25 consecutive CPI readings above 8%, a high monthly reading above 19%, and a 2 year average of 12.5%. How was that possible? The Fed basically bullied market participants to accept the price floor or yield cap on government debt. If you are a bond trader, this is a great situation, since you can go out there and buy bonds anytime it gets near the price floor, knowing that you have the “Fed Put” to bail you out. In fact, knowing that the Fed is there for the markets will encourage investors to buy bonds at yields just below the Fed’s cap.


So my question or comment is: how many trillions of dollars of bonds will the Fed need to buy to maintain a rate cap at, say 4% on the long bond, and 3% on the 10 year? With the size of the US publicly held debt at $8 to $9 trillion, and expected to grow by $1.3 to $1.5 trillion a year, it would probably take a few trillion dollars of Fed purchases, or at least the threat of purchases to successfully implement a rate cap. Furthermore, there is about $5 trillion of agency backed MBS and another $1+ trillion of agency debt which might need to be back-stopped as well. So long as there is no inflation, then it is likely that the Fed will print trillions of dollars, first in the name of preventing deflation. If the Fed ever starts targeting interest rates, it is game over for shorting bonds, because they can just print as much currency as possible to soak up the supply of bonds. This would eventually result in inflation, despite the horrific state of the US housing market, and its 40% contribution to CPI. And as our experience in the 1940s showed, it is possible to have double digit inflation with very low interest rates.


As for the authors other two dire predictions, I think it is almost a certainty that the level of benefits promised to the baby boomers will be drastically cut back, eliminating a good portion of the unfunded liabilities. The astronomical level of taxes which the author promises to follow are unlikely in my opinion. While it is probable that taxes will rise, there is a limit on the level of taxes which any government can expect to impose and enforce with successful collection. In other words, as tax rates go up, more and more participants in the economy will revert to conducting commerce off the books, actually resulting in a drop in government revenues over the long term. I will also add that with the level of interest rates getting closer to zero, and with the Fed’s aggressive money printing operations, that you will see the level of currency in circulation going up dramatically to support the burgeoning “cash” economy.


To summarize, I am moving towards an opinion that the Fed will enable there to be low interest rates despite tremendous deficits, and ultimately, this has the potential to avert a debt crisis. I also expect the expected level of social security and health care benefits to drop as we move forward in time. I do not think the US is bankrupt. How can anyone with a printing press be bankrupt?


* Agency MBS refinancing discussions – over the past month, there have been considerable discussions and comments about how the government should lower the interest rate charged to homeowners who are underwater on their GSE backed loan. The thinking is that this would lower their monthly payments and give them a better incentive to make good on their mortgage payments. With the average rate on many mortgages above 5.5%, there is a modest amount of savings which could be used to reduce the homeowner’s payment burden, or conversely, the savings could be automatically funneled into paying down the loan balance. In fact, there is supposed to be a housing summit next week at the Treasury Department, where such topics will come to the fore. In anticipation of such an outcome, the prices of premium agency MBS has dropped over 1% during the last  2 weeks. While this sounds fine and good, I see numerous problems with implementing such a strategy:


1>  There is somewhere between 15 and 20% of agency MBS securitizations which are delinquent. If the government were to refinance these loans at lower rates, then this would represent a size-able amount of the overall supply which will have to be sold into the market place. In turn, this would put some pressure on mortgage rates to rise. 


2>  If the government establishes this precedent, then holder of MBS securities will demand a higher rate of return since their investments in agency MBS will be subject to arbitrary prepayments due to delinquent borrowers, should rates drop further in the future. A rise in mortgage rates could undermine the ability to offer lower rates to these borrowers.


3>  Is this fair for existing mortgage holders who are making good on their mortgage payments? You know the answer and how I feel on this topic.


Aside from the structural problems of what will happen to mortgage rates if this sort of plan gets implemented, I think it should be addressed that banks are already making outsized profits from their issuance of agency MBS. For example, thecurrent mortgage rate is 4.30, and FNMA 3.5s are priced at 100. A bank making a new loan will keep 55 bps for making the loan, after 25 bps is paid for the FNMA guarantee fees. In the securities market, there is a 2.5 point difference between FNMA 3.5s and FNMA 4s, which serves as a guide as to the value of what 50 bps of servicing is worth. Should the banks be allowed to make 2.5 points for making these loans. That seems excessive to me. Something should be done to manage what the banks can make, or the government should fund smaller mortgage origination operations to provide competition to the big banks, which now dominate the mortgage origination business.


* The Ghost of the Bull Market – James Paulsen was on CNBC again this morning,  with his stupid smile and unshaven scribble of facial hair. According to James, the markets fell yesterday because they were left to the worst their collective imagination could conjure up. In other words, he gives no credit to the idea that there are reasons why the stock market should fall. He went on to suggest that future economic data will support a rising stock market. Good luck James!


* Trading Points – Stocks – Stocks broke through their recent support of 1105, and has taken out, but not yet closed below the secondary support level of 1085. This is a good sign that the resumption of the bear market has begun. A core short was recommended yesterday to the ‘real time distribution, via in the money put options, when the S&P was at 1095.


* The Euro – after trading up to 133, from its recent low of 118, the Euro turned tail, and dropped to 1.28. In a similar vein, this suggests to me that the Euro has begun a resumption of its sell-off. Better levels to sell the Euro exist above 1.30, which we could see on a corrective bounce.


* Gold – has also shaken off its recent correction to 1160, and is now back to $1213 an ounce. While I have fundamental and technical reasons to like gold, I am less certain as to how it will do if the stock market is dropping like a rock, which I expect. I do not see any reason to sell gold, and would recommend a core position in gold if you do not own any.