The Rising Sea of Debt, Part One of Two
Although we are somewhat agnostic with respect to the theory of global warming, we nevertheless find it a useful metaphor for understanding what is happening at present in financial markets. Imagine an apparently safe, productive city with many factories belching “debt” from their smokestacks. This debt subsequently “rains” down into the seas, which represent the credit risk of that debt. But some of the debt remains unseen, high up in the atmosphere, where it holds in the heat, contributing to a dangerously rising sea of debt, which one day, suddenly swamps the city. What appeared to be safe, productive and sustainable is shown to have been a mirage.
Now of course astute observers might have noticed years in advance that the sea was rising. Some of them might have tried to warn the owners of the factories that they were creating too much debt. Yet the owners were earning attractive profits and the management big bonuses. If any one of them were to have scaled back operations, then the others would have taken up the slack, pocketing those same profits and bonuses for themselves. No, these short-sighted owners and managers, blinded by greed, kept producing more and more of that debt until, one day, when the levees broke, they discovered the folly of their ways.
For many, “Market Failure” is blamed, in whole or in part, for the great financial crisis of 2008, which stubbornly refuses to go away. Yet we completely disagree with this line of thinking. Indeed, the truth is the exact opposite. We call it “Regulatory Failure”. Now what do we mean by that? Well consider our global warming metaphor above: What if the factories in question were being subsidized with artificially low interest rates? How about also direct government subsidies of various kinds, such a housing benefit for employees? Finally, what if a major factory, following years of poor risk management, had been bailed out some years before, rather than been allowed to fail? Naturally, given the above subsidies and also the implied bail-out in the event of calamity, factory owners would be less than concerned about the rising sea of debt. As for investors, no doubt they might have wanted a higher yield on the factories’ debt, but as long as they were confident that, as in the past, a factory in danger of default would be bailed out, they accepted lower yields. In our metaphor, the unseen debt that remains in the atmosphere represents the excess debt issued as a result of these various subsidies and moral hazards, which are the ultimate cause of the dangerously rising sea of debt, rather than the “forces of nature”, that is, the free and unregulated market.
Once the debt levees break, investors are forced to react. In a panic, they seek to reduce credit risk. The most obvious way investors go about reducing credit risk is to sell assets. Obviously, if everyone tries to sell at once, this forces prices sharply lower and, if such securities are used as collateral in the interbank lending market, this can wipe out a substantial amount of bank capital and, in an extreme case such as fall 2008, threaten to bring down the entire system.
If regulators get in the way of panic selling, however, say by limiting price movements or removing price discovery from the market, then investors will naturally begin to seek ways to hedge their exposure by selling other assets that are correlated in some way to the distressed assets. This can quickly result in these other assets also becoming subject to panic selling, causing the same problem elsewhere. Yes, the government and central bank may try to build new levees or otherwise divert the flow of risk for a time, but as King Canute demonstrated, you can decree all you like but you can’t force the sea to recede. As financial contagion spreads unpredictably like a flood around hastily improvised defenses, regulators get increasingly desperate. Once things get to the point that the entire financial system is in danger, the urge becomes overwhelming to just step up and outright guarantee whatever credit risk is causing the problem. In 2008, for example, the Federal Reserve guaranteed a pool of highly illiquid, toxic mortgage debt that had contributed to the demise of Bear Stearns. Following the Lehman Brothers bankruptcy later that year, the Troubled Asset Relief Program, or TARP, was created to allow essentially any bank holding a dangerous amount of toxic or illiquid debt to receive guaranteed funding from the US Treasury. Eventually, the liabilities of Fannie Mae and Freddie Mac were eventually assumed by the Treasury in a conservatorship.
Other countries also took aggressive measures. In the UK, for example, nearly all major commercial banks were at risk of failure as a result of a general contagion effect and so the government injected a huge amount of equity, which it mostly retains to this day. Notable here is that the UK in fact followed the lead taken by Ireland some weeks earlier, when it provided a blanket government guarantee for all bank liabilities.
Now, such action can slow contagion, to be sure, but can it stop it? As the sovereign steps in to provide ever more explicit guarantees for the financial system, this places the sovereign in the front line, facing investors who may still desire to reduce credit risk. Just because credit risk has been assumed by the sovereign does not in any way imply that the risk has disappeared; rather, it has merely changed form, from private to public. Debt which investors previously thought would be serviced via private sector economic activity, such as the generation of corporate cash flows to service corporate debt, or the generation of household incomes to service household debt, now must be serviced by the government, which implies that it must be paid for out of future tax revenue. Now think about this for a minute.
Previously debt was originated, priced and traded in the marketplace based on estimations of how much risk was involved in a given private enterprise’s or household’s ability to service that debt. Following the implementation of a sovereign guarantee for the banks, the assumed debt is now going to be priced and traded based on estimates of the future tax revenue that can be devoted to debt service. This is where it gets interesting: What if a country already has a large debt burden to service? What if that country is also growing weakly or perhaps falling into a nasty recession? What if that country is increasingly politically unstable, with a coalition government that has just been brought down by a minority party withdrawing its support? How comfortable will investors be with this? Will they believe that their credit risks have declined materially? Or will they choose to keep on selling?
Well, we have just described Ireland and why investors are continuing to reduce their exposure to Irish credit risk. Recall that, in 2008, the government assumed the debts of the financial system in an attempt to stop an incipient bank run and restore confidence. This worked for a time, but with the country growing weakly, the sovereign debt burden has been growing exponentially to the point where it looks highly unlikely that that debt can ever be paid back at face value. Therefore, investors are understandably still trying to reduce their Irish credit risk by dumping the debt. However, this debt is held as capital by European banks, which will realize huge losses unless the value of the debt recovers. So, European policymakers have got into action to “offer” Ireland a huge loan–which they call a “bailout”–which will probably take decades to pay back, consigning the Irish economy to a generation of high interest payments, higher taxes, a reduced potential growth rate and, quite probably, a lower standard of living.
But wait a minute! Recent polls show that the Irish don’t WANT this “bailout.” They would PREFER TO DEFAULT. Just as a homeowner can make a perfectly rational economic decision to walk away from a mortgage which exceeds the value of their home, so the Irish can make a perfectly rational decision that, rather than spending the rest of their and their children’s lives servicing a colossal debt, they can JUST SAY “NO!” by defaulting, walking away and starting over. The doomsayers respond to this by pointing out that the Irish government will find it difficult to access the debt markets again following a default and would do so only at far higher borrowing costs. Yes, that’s right, but ISN’T THAT THE POINT!? Just as the Irish may not want to eternally service a debt that was foolishly run up by well-compensated bank executives, they don’t want their government to ever have the option of assuming such a grotesque amount of debt ever again. “What’s that you say Mr. Politician? Can’t access the capital markets to save a failing bank? OK, let ‘em fail. Can’t raise debt to pay for bloated, unsustainable welfare programs? OK, end the programs. Can’t finance some pet project in a representative’s district to help him get reelected?
Cancel it. Now let’s move on and get back to the business of working for a living, providing for our families and paying a reasonable, modest amount in taxes for essential services as we go along, rather than piss our hard-earned incomes away on debt that we can’t realistically service; on mismanaged private enterprises that have gone bankrupt; on welfare programs that we can’t afford; and on political pork that serves no purpose other than to keep incompetent, corrupt politicians in power. Oh and by the way, we Irish fully understand that what we owe in debt, we owe largely to the English, who occupied our country for centuries, occasionally with brute military force. Well take this John Bull: WE DEFAULT!”
Of course, although Ireland, Greece, Portugal and some other countries in comparable circumstances might choose to default on their debts, in other countries, default is relatively less likely. This is especially true of those countries that can print the money required to service their sovereign debts. Sure, it might result in a devalued currency and inflation, but then doesn’t that in fact achieve what investors set out to do in the first place, when they decided they wanted to reduce their credit risk? The more a debt is devalued in real terms, that is, through devaluation and inflation, the more the credit risk declines, as it becomes easier to service that debt.
In this regard, isn’t it convenient that the Fed’s recently adopted QE2 program requires the Fed to purchase almost exactly the amount of planned US Treasury issuance during the coming six months? As markets anticipated the policy, the dollar declined sharply in value. Now with the euro-area in crisis and a potential war brewing in the Koreas, the dollar is suddenly much stronger. Well, guess what: This makes US Treasury debt more difficult to service. The Fed is not going to welcome this one bit. But if at first you don’t succeed in devaluing your currency, print, print again! Surely it is only a matter of time before the QE3 leaves the dock to follow her sister ship out into uncharted waters.
[Editor’s Note: The above essay is excerpted from The Amphora Report, which is dedicated to providing the defensive investor with practical ideas for protecting wealth and maintaining liquidity in a world in which currencies are no longer reliable stores of value.]