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I read a good article today in the NY Times.  Here’s the opening paragraph:

If the United States were any other country, these would surely be days of panic and austerity in Washington. With debts spiraling higher, a trade deficit exceeding $700 billion a year, and its currency plunging for years, the government would be forced to cut spending and jack up interest rates in a frantic bid to attract investment.

Very true, unfortunately the day when we’ll be forced to do just that is coming.  It might be later this year, or it may be 10 or more years away, but no one that I’m aware of has repealed the law of supply and demand.

The article mentions this, saying on page 2: Yes, foreigners have been lending alarming amounts of money to Americans, who have spent extravagantly in excess of their means, economists say. One day, balance will be restored in line with the basic laws of economics — perhaps chaotically, and probably via a substantial fall in the dollar’s value.  (emphasis mine)

If you want to know why the dollar is eventually doomed, read this:  When Americans head to the mall, backed by foreign largesse, they drive there burning gasoline made from oil pumped abroad, notably the Middle East. They drive home carrying electronics and clothing churned out in Chinese and Japanese factories. Making these goods absorbs commodities — energy from Australia and Africa; cotton from Texas and California; iron ore from Brazil and India.

That explains a lot to those unfamiliar with international finance - it even touches (in part) on why commodity prices have risen so drastically in the past few years.

Regardless of when it happens, we will eventually be forced to raise interest rates and borrow less from overseas.  Even if we eventually do that, inflation will still be rampant - it’s the only way the government can pay its’ debts. 

Inflation makes old debt cheaper to pay off, because you’re paying it off with inflated dollars.  Neat scheme (everyone from the Pharaoh’s to the Romans, to us has tried it) but it always fails.  No nation has ever inflated it’s way to prosperity.  And all paper money eventually returns to its’ intrinsic value - zero.

gk

This is something I’ve said would happen eventually.  Well, I haven’t said it here, but I’ve said it on a family email list where we discuss lots of weird subjects.  :-)  From todays’ Daily Reckoning Australia newsletter: “Treasuries tumbled after the government’s $9 billion auction of 30-year bonds at the lowest yields ever chased away investors,” reports Sandra Hernandez at Bloomberg. You reap what you sow, Chairman Bernanke. Prepare to reap the whirlwind.

It looks like we’ve reached the point where the Fed is stuck between a rock and a hard place.  They are being forced to lower rates to fight off a recession (which is probably already here) but no one wants our money at these ridiculously low rates.  The dollar isn’t worth much these days, but (although some are calling for the dollar to rebound) I don’t think we’ll see a meaningful correction in exchange rates as long as the fundamental factors which drove it down don’t change.

By fundamental factors, I mean stuff like Americans spending more than they make - personally, in business, and in government - which forces us (collectively) to borrow money from foreigners to keep things running.  What happens when foreigners no longer want to invest in the dollar (via US Treasuries)?  Rates have to rise to entice them to invest.  Although this is the first evidence I’ve seen of it, I think this will become more widespread.  Rates will rise while we go through a recession - or worse.

Play it through to see the end game….  The cost of borrowing goes up so businesses and individuals have to pay more to borrow the same amount.  Mortages cost more, auto loans cost more, credit card rates cost more - and perhaps most importantly - the government has to pay more to pay interest on our huge (thank you Mr Bush!) national debt.   All while the economy is slowing down.  That drives up unemployment, the dollar keeps falling (because we’re still spending more than we earn) and inflation starts to skyrocket. 

Does anyone remember 1979 and 1980?  I think we’re in for a repeat of that at the minimum - and we could potentially be looking at the 1930’s again.  I recommend paying off your debts, piling up cash, and keeping your powder dry.  Picking up some gold or silver on price dips like we’ve seen the past few days wouldn’t hurt either.  That’s good advice at anytime, but especially now with Bernanke dropping cash from helicopters….

That’s right, Bernanke has said he’d do anything to prevent deflation.  Here’s his speech from November 21st, 2002.

In the same speech he said “If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets.”

Huh?  Basically Bernanke said that if the government (via the Treasury Dept) printed more money, then the same government (via the Federal Reserve) bought the same amount of treasury bonds, it’s the same thing as the private sector producing something.  To translate this into your personal life, Bernanke is saying that you’re better off if you take out a second mortgage, then use that money to pay yourself to cut the grass.  What the hell is he smoking?

Sorry for the side track rant, the main point of this post is to let people know that today the US Government tried to get anyone to loan them money at 4.41% but no one would give them money at that rate.  The rate on those bonds at the end of the day was 4.51%.  There’s a good story with all the details at Bloomberg.com.  Here’s part of it:

The auction yield on the new long bond was the lowest since regular sales of the security began in 1977, according to Steve Meyerhardt, an official in the Bureau of the Public Debt in Washington.

In today’s auction, indirect bidders, the class of investors that includes foreign central banks, bought 10.7 percent, the lowest on a new 30-year bond since the Treasury resumed sales of the maturity in February 2006 after an almost five-year hiatus. The 20 primary dealers bought 89 percent of the sale, the most since sales resumed.

“Most of it was a dealer auction which meant that customers themselves didn’t put their money where there mouths were,” said James Collins, an interest-rate strategist in Chicago at Citigroup Global Markets Inc., a primary dealer. “The market knows dealers are going to have to sell the issue at a steep discount.”

Regardless of what the Fed does with short term rates, real rates are going up as we become less credit worthy as a nation.  Who will we borrow from in order to keep spending more than we earn tomorrow?

gk

I have a “My Yahoo!” page setup with a couple of portfolio’s, one to view the funds I have available in my 401k.  The other has a few stocks that I own in various accounts, such as the kids college funds, a Roth IRA, and a small “play” account.  The second portfolio also has a few stocks that I’m interested in, plus the major indexes so I can tell at a glance what the market is doing whenever I’m interested.  So with one click on a favorites button, I can see what’s happening during the day.

With the Fed due to announce on Thursday, I was was curious to see how the markets would react, so I checked my custom Yahoo! page several times during the day.  It never fails, when the Fed does ANYTHING, the markets react big time - the only question is will they go up or down? 

All morning the market was down slightly, 30 to 40 points most of the day.  When the Fed announced at 2:15pm, there was an instant surge up, with the Dow up as much as 200 points very briefly.  Then the news hit about Financial Guaranty Insurance being downgraded from AAA to AA.  Stocks immediately took a nosedive, and ended the day right about where they’d been until the Fed announcement - down about 40 points.

In case anyone is wondering why a downgrade of a fairly insignificant bond insurer caused such a downturn, I’ll try to explain it as I understand it. 

Bond insurers do just what their name suggests - they insure corporate and municipal bonds.  It’s an important function which allows corporations and municipalities to sell their bonds at a lower rate than they might get based on their own rating.  For example, lets say that Memphis needs a new sewage treatment plant at a cost of $100 million.  They don’t have $100 million laying around, so they need to borrow it - but (lets assume) they already owe $200 million for other projects, and there is some doubt that they will have the money to repay the sewage bonds on time.

The city of Memphis might be able to sell their bonds at a 10% interest rate (all these numbers are 100% made up - they’re for example use only!) on their own, but if the bonds are insured by a AAA rated insurance agency, they may be able to sell them at a 6% rate - which saves the city a LOT of money on a 20 or 30 year bond.   Let’s assume that the insurer also insured other debt instruments, such as mortgages, derivatives, and CDO’s (Collateralized Debt Obligations), as most of them do in order to have a broader customer base. 

Now what happens when the bond insurer doesn’t have enough money to pay off the claims they’ve insured?  Those city of Memphis bonds were that were yielding 6% because they were insured by a AAA rated (investment grade) insurer, are suddenly being guaranteed to be repaid by a AA (”less than” investment grade) insurer.  The bond ratings are only as good as the insurer, so guess what happens?  Yup, the rate goes up to match the increased risk.

Note that this doesn’t affect bonds that have already been sold.  The people who have bought them will be repaid on time, and at the going rate when they were purchased.  The problem is that very few people actually hold onto bonds for the whole term - they sell them on the secondary market in order to free up their money for something else; buying a home, car, sending little Sally to college, or to move the money to something that they think will give a better return.

In other words, bonds are traded almost like stocks, and almost as often.  When you have a bond fund in your 401k and you move money in or out of it, someone is buying and selling those bonds, be they government bonds as in the example above, or corporate bonds, or maybe even someones mortgage.  So, if I owned a $1000 city of Memphis sewer bond yielding 6% and I wanted to sell it to get my money out, no one in their right mind would settle for a 6% return because it’s no longer investment grade (AAA) rated.  They will demand a higher interest rate to compensate for the increased risk.

You need to realize that the interest rate doesn’t actually change, the price of the bond changes instead, which is effectively the same thing.  If the price I sell the $1000 bond at is $900 instead of $1000, the effective yield to the new owner (assuming it’s a 10 year bond) is 6.667% instead of 6%.  And it yields 7.454% if they hold it for the full 10 years to maturity.  At least that’s what the calculator at http://www.moneychimp.com/articles/finworks/fmbondytm.htm says.  Your mileage may vary. 

The thing to keep in mind is that as the bond is worth less on the secondary (reseller) market, the effective interest rate goes up.  The opposite is also true - if the price of the bond is worth more, the interest rate (yield) goes down.  That’s why Treasury bonds (which are backed by the US Government and your tax dollars) are considered a “safe haven” in times of turmoil.  More people want them because they are the safest investment you can make, so the price goes up.  Simple supply and demand.

Now back to the Memphis sewer bond.  If the insurance company is now rated lower, those sewer bonds are now riskier, so they drop in price.  No one wants to buy or trade them anymore.  The secondary market has dried up, and (since I can’t sell them and do something else with my money) we have a credit crunch.  I can’t invest that money in a new business, I can’t invest that money in the stock market, and the asset I paid $1000 for is only worth $900, so I can’t borrow as much using that bond as collateral.  My net worth has also decreased by the amount that the bond has dropped in value.

Extrapolate this out.  Instead of an individual owning  one or two bonds, imagine that I’m an institutional bank or investment company, such as Bear Stearns.  I have billions of dollars in bonds - both government and corporate - that I own as assets.  In order to get a better return for my shareholders, I’ve borrowed against those assets (just like you or I might take out a second mortgage using our home as an asset) and invested the borrowed money in the stock market, or other places where I think I can get a better return on my investment.  

Overnight my assets  have dropped in value by a good percentage just because the insurer of my AAA rated bonds was rated one notch lower.  What happens?  Since I’ve borrowed against the assets which have dropped in value, I suddenly owe more than what the assets are worth - just like if I’m “upside down” on my car loan or mortgage.  I can’t sell it for what I owe on it, so I’m stuck with something that’s worth a lot less than I owe. 

This is happening at most of the major banks and investment companies all at the same time - the credit crunch “crunches” even tighter.  No one will buy my assets for anything near what I owe on them, so I owe a lot more overall than what what I’m worth.   What can I do?  There are three ways to approach it:

1)  I can ‘fess up and admit that I owe a lot more than my assets are worth.  I produce a quarterly earnings report that shows how much my assets have fallen in price.  That’s what the major investment banks have been doing.  That’s essentially what happened when Merrill Lynch “wrote down” $7.9 billion in the 3rd quarter.  The same for when CitiGroup reported $18.1 billion in write offs.  And when UBS writes down $14 billion, and when (pick your bank writes down billions more).

2)  I can pretend everything is fine and do nothing.  I can say that everything is coming up roses in my report, and everyone believes me.  After all, there really isn’t a loss until you sell the asset for less than you paid for it.  But that’s a house of cards, just like if you or I were upside down on our car loan.  You have to keep making the payments long after you’ve paid what it’s actually worth.   But you can’t sell it and you can’t borrow against it.  Your money is locked up and unavailable to loan to anyone else.

3)  I do what most banks and investment company are doing - at least in my opinion.  I combine the previous two methods.  I write down some assets, but I don’t dare write down all of them that are affected - because that would make it clear that my prestigious company is nothing but a house of cards.  But eventually I will have to come clean and fess up, because the stuff I’ve invested the borrowed money in (mainly other peoples debt obligations) isn’t going to pay enough for me to keep making my payments on the original loan (bond) that I bought.

That’s basically what’s happening in the markets right now - but it’s actually 10 or 100 times worse than this.  That’s because banks and investment companies don’t do what I described above - they do it times 10 or 100.  No one really knows the real numbers, but it goes something like this:

I get a sub-prime home loan from a local bank at a ridiculously low teaser rate that resets in 2 or 3 years.  My local bank doesn’t want to wait that long to get their money back, so they sell my loan to someone else.  The company who purchases my loan (at a discount) also wants to use their money for other things, so they bundle my sub-prime loan with other (mostly prime, but a mixed bag) loans and bonds and sell it to someone else.  My sub-prime loan is a very small part of the overall loan, so you’ll probably get most of your money - if not all of it - back at this point.  Besides, this company paid an insurance premium on the whole thing (it’s actually broken up into “traunches” at this point, but that’s another subject) to be insured by an AAA rated bond insurer.

But the company who now “owns” your AAA rated sub-prime mortgage also wants to get higher returns than the discounted teaser rate (here’s where your super low ARM for the first 3 years hits everyone else) they are getting on paper, so they again bundle it with other loans and bonds, and sell it to someone else.  After all, it’s investment grade AAA rated (and because of the discounts in price every time it’s sold) lot’s of pension funds and other conservative investors will buy it for the nice interest rate they’ll receive.

And the returns will only get better as the teaser rates adjust!  That’s assuming that I can pay my mortgage after my rate resets anyway.  If I can’t, the whole house of cards falls down.  My loan is bundled with hundreds or thousands of others at this point, so if I default on the loan (that I can no longer pay because I was stupid and bought more house than I could afford) it affects the whole bundle.  The owner of that bundle has to take a write off for the amount of my loan - so that AAA rated insurer has to pay up for my non-payment.

But guess what?  How was that AAA rated insurer making money?  By investing their capital into AAA rated debt instruments - thats’ right, the insurers assets are in the same (or a derivative) of the same AAA rated securities that they’re insuring.  So they can’t pay up, because the sub-prime mortgages that they own as assets aren’t making their payments either.

The same debt has been resold over and over.  The same debt has been counted as an asset by 3 or 4 or 10 different companies - because it’s been leveraged multiple times.  An example of leverage is when I buy a stock or bond “on margin” from my broker.  In effect, I’m borrowing money from my broker based on nothing but my guarantee to repay them when the asset goes up in value.   But because my neighbors’ house has also gone down in value (because of the foreclosure on my sub prime loan) none of these leveraged assets are worth what they were. 

The biggest problem is that NO ONE KNOWS where these sub prime mortgages are today.  They’ve been bundled with other prime loans, sold as CDO’s, used as assets against leveraged loans, etc.  No one wants to purchase them so the price keeps falling.  And as the price of a bond (or any other debt instrument) falls, the interest rate goes up.

So regardless of what the Fed does with interest rates, real rates are going up right now.  And the value of all those “assets” held by banks and investment companies is going down.  I think it’ll take years for all of this bad debt (and the subsequent write downs) to work their way through the system.  I don’t know who, when, or where, but I think more than one major bank will fail.  Its’ assets will be bought by another bank and/or the government, but the end result will be the same.  We’re borrowing money to pay back borrowed money.  At some point this always fails.

Personally, I think we’re in for a repeat of the late 1970’s, with high interest rates, little to no growth, and higher inflation.  Because of all the leveraged debt, I think the true picture will only be clear years from now.  Some are saying that we’re entering a deflationary period.  It could be, but my money is betting that “you ain’t seen nothing yet” regarding write downs and losses.  When this house of cards comes down, no one will want the dollar, so it’ll inflate dramatically - especially if the Fed keeps lowering rates and effectively printing more money.  It’s simple supply and demand, and we’ve got way to much supply right now.

This post ended up being a stream of consciousness type of post.  I had one point in mind (the importance of bond insurers) when I started, but it morphed into the other types of debt that make up this house of cards.  It’s way longer, and much more rambling than I originally intended, but hopefully it will provide some insight.  As always, if you spot a factual error, please let me know so I can correct it.  My intent is to enlighten, not to obscure.

gk