Debt Ceiling: the Story that Won't Go Away

New York Times: The Centrist Cop-Out, Paul Krugman
Wall Street Journal: House Postpones Vote on Boehner Debt Plan, Naftali Bendavid and Carol E. Lee
Wall Street Journal: Lending Markets Feeling the Strain, Liz Rappaport and Matt Phillips

The ongoing "crisis" over increasing --or not-- the Federal debt ceiling has become unavoidable.  It is all over the news; one plan after another has crashed and burned as unable to pass the Congress (House Postpones Vote on Boehner Debt Plan); the stock market is down for its 5th consecutive day; Wall Street's industry association, SIFMA, has been holding conference calls to hammer out the operational nitty-gritty of how to handle a debt default that really should not be happening (Lending Markets Feeling the Strain).

This morning I watched CNBC as Becky Quick hammered Maryland Democratic Representative Steny Hoyer for blaming the other side, and not doing enough to avert the crisis.  But in his op-ed today, Nobel laureate Paul Krugman argued that the news media, in its attempt to be even-handed, has neglected to squarely place the blame for the deadlock where it belongs: on the "extremism" of Congressional Republicans.  I agree with him.  Though all agree that long term deficits and debt--caused largely by health-care and retirement costs and wars-- are out of hand and must be addressed, there is absolutely no reason to link action on this to the short-term operational decision to lift the debt ceiling.  Other developed countries do not even have a debt ceiling.  It was the decision of Congressional Republicans to use the debt ceiling as a weapon to dismantle social programs which the majority of Americans want and expect.   The absolute refusal to allow the expiration of the "temporary" Bush tax breaks on the wealthiest Americans is deeply irresponsible.  America already has the greatest gap between rich and poor of any developed country on earth and it has been steadily widening--is this good for our nation?   All compromises, including the latest one worked out by Republican House Speaker Boehner, have foundered on the insistence by some to maintain the tax burden on the wealthiest at its lowest level since the 1920's.

I hope this will be resolved.  I hope the debt ceiling will be lifted.  I hope that both sides will be steadfast in building consensus for an aggressive plan to put the fiscal house in order, with a sensible mix of spending cuts and fair revenue enhancements, which economists agree is the proper course of action.  But if the Republican intransigence continues, I have a guess about what will happen.  There will be a temporary government shutdown which will be resolved in a matter of days or weeks; we will not default on our debt, but there will be a delay in cutting checks and providing services.  Lots of money will be wasted digging out from the mess that the temporary shut-down will cause.  And in 2012, tea-party affiliated Congressmen who came in in 2010 with a "mandate" will be swept out just as quickly.  Remember Newt Gingrich in the 1990s?  It could happen again.

US Default: Neon Swans

Last year, as a hedge against inflation I bought a moderate position of 10-year US Treasury Inflation Protected Securities (TIPS). I have watched the value of these securities go up by more than 10% -- not because of 10% inflation, but because of falling interest rates. I feel tempted to sell them to cash in on the unrealized gain. Perhaps gold would be better as an inflation hedge anyway (though I have read there is no clear correlation), and I can be fairly certain that at some point in the next ten years interest rates will creep up again from their absurdly low present levels, and I will lose my 10% gain if I hold the TIPS to maturity as I originally intended.

Now, with the various branches of the government flailing about in so-far fruitless attempts to raise the debt ceiling and avoid default by August 2, I wonder if it might be a good time to sell. On the other hand, no one else seems to be selling -- yields on US Treasuries do not seem to be rising and falling based on political news about the debt ceiling--the market is sanguine, and it almost seems unpatriotic to sell at this point

Jason Zweig's column in today's Wall Street Journal refers to the possibility of a default or downgrade of US Treasury debt as a neon swan: "an event that is unthinkably rare, immensely important and blindingly obvious", riffing on Nassim Taleb's "Black Swan". He remarks that "many investors seem to be coping with what seems like an obvious risk by simply closing their eyes."

This puts me in mind of the temporary Newt Gingrich-led government shut-down of 1995. I was working in the client administration area of a large international financial institution, which was custodian for a good chunk of US Government Debt held by Japanese institutional investors--billions of dollars worth of T/Notes and T/Bonds. At that time, we used to receive a pile of faxes every day from our customers in Tokyo: inquiries on everything from fee bills to 1 penny rounding differences on multi-million dollar settlements. There was virtually nothing on the looming government shut down which was all over the press, and how it would effect them.

I wish I had kept a journal back then.  As I recall, a day finally did come that we did not get paid interest on some Treasury issues (the operations staff had to manually reverse automatic postings that the system had made) I approached the head Japanese relationship manager, and asked him how we would explain this to the customers. He asked me to draft something. I made a brief write-up, explaining that processing of the payments had been delayed because of the government shut-down, which they had probably read about in the newspaper. The fax went out, the payments were made a couple of days late, and we never heard anything more about it.

There are about $14 trillion of US Treasuries outstanding, and foreign countries hold over $4 trillion, of which China and Japan each hold about $1 trillion (see http://www.treasury.gov/resource-center/data-chart-center/tic/Documents/mfh.txt) . Maybe the market is sanguine because there is so much money involved --the vested interests are so powerful-- that no amount of political in-fighting can change the basic facts. I also suspect that any S&P, Moody's or Fitch downgrade will also be a non-event. Those who hold debt balances in the hundreds of billions will do their own analysis, and make their own decisions, regardless of what a few analysts in an office in Manhattan decide.

Let's hope I'm right.

$157 Billion Greek Bailout

This morning's Wall Street Journal speaks of a new $157 Billion Greek bailout: Greece Gets New Bailout as U.S. Nears Brink

An admission of defeat by all involved: ECB President Trichet was unable to avoid a "technical default"; German Chancellor Merkel was unable to avoid spending more of her frugal citizens' money.

The Dow went up over 1% yesterday, partly on this news, which at least showed some leadership by Europe, and brought some certainty.

On the other hand, there are a lot of questions:

What about Greece's primary deficit? The country is spending more than it takes in, even before it services its debt. On this basis, they will run through any and all bailout money that they receive (around 100 billion in 2010, over 150 billion in 2011 --quite a bit for a country with a GDP of around $310 billion). I wonder if major political reforms/purges will be needed in order to accomplish the necessary economic restructuring.

Suggestion number 1: stop worrying about Turkey. I understand that a part of the problem has been huge unnecessary military expenditures over the years, which I can only assume have been accepted by the population because of anti-Turkish paranoia. Maybe leadership in some sort of Eastern Mediterranean free trade zone would help Greece's economy.

Suggestion number 2: Sweep out the Greek political class, and put people who are not implicated in the current mess in charge. Dominique Strauss-Kahn should be available soon :)

Will the technical default cause CDS contracts to pay out? WSJ's Steven Fidler says "probably not", because the deal for private sector contributions is voluntary, then follows up by asking "What use is default insurance if there's a default and no payouts?" (see A Guide to the New Deal in Athens: How a 'Selective Default' Works)

If you ask me, Credit Default Swaps (CDS) should not be allowed. I cannot buy insurance against your house burning down, because I have no "insurable interest", and doing so would give me an incentive to set your house ablaze. The word "swap" in the CDS acronym is a fig leaf, just put there to allow lawmakers to pretend that they are not insurance, and can be used by financial institutions in an unregulated fashion. New regs are trying to change this, but the CDS market is still murky and opaque -- its been 8 years since Warren Buffet called these and other derivatives "financial weapons of mass destruction". A large part of what makes a Greek default so scary is that it is impossible to tell what exposures are out there, and what dominos will fall if Greece stops paying off.