Saturday, July 16, 2011

The Coming Unnecessary Disaster

. Saturday, July 16, 2011

I've recently had a few people ask me what the big deal is about the debt ceiling. A little default couldn't be that big of deal, right? And who cares what the ratings agencies think? I've found it distressingly difficult to get across just how serious this is. So let's start with this excellent primer from Ezra Klein:

It all comes back to U.S. Treasury bonds, which are the foundation of almost all other financial products — the base of the global financial pyramid.

If the federal government’s borrowing costs rise, so will everyone else’s. Mortgages rates will jump, car loans will be harder to come by, universities won’t be able to float bonds, cities won’t be able to fund themselves.

Treasuries are supposed to set the rate of “riskless return” — the price of loaning someone money and knowing, with perfect certainty, that they’ll pay you back, with interest. So when lenders decide how much to charge, they start with the riskless rate and then add to it to cover the risk that you won’t pay them back, and the inconvenience of having to wait for you to pay them back.

It’s a practice called benchmarking, and it’s everywhere: in your mortgage, your credit card, your car payments, the loan you took out to hire three new employees at your business. It’s even common internationally. The fact that Brazilian loans tie themselves to the American government’s debt just shows the high esteem in which the world holds us.

The most basic financial pricing formulas, the ones you learn about in Finance 101 like CAPM and Black-Scholes, depend in large part on a riskless, liquid baseline financial asset, which has long been understood to be US Treasuries. In other words, if T-bills are no longer "riskless", then the value of basically every financial instrument in the world comes into question. As I've mentioned previously, a Treasury default will make current financial regulations, which rely on risk-weighting to determine capital requirements where Treasury debt has a 0% risk weight, more or less meaningless. And because all of this is networked together, it can lead to big problems.

“There’s a whole credit structure,” says Pete Davis, president of Davis Capital Investment Ideas. “Think of it as roads and bridges, but it’s finance, it’s all connected, and it’s all on top of Treasuries. . . . So when you shake the basis of it, everything on top of it shakes, too.”

Or let's put this another way. If you thought things were bad when investors became convinced that Lehman Brothers and AIG were not as safe as they'd thought, what do you think will happen when people think the same about the US government? This has the potential to be very devastating. Klein puts it well:

Running in the background of every day’s trading is the accumulated wisdom of an almost endless number of calculations: How much money does J.P. Morgan Chase have? How likely is Des Moines, Iowa, to pay its bills? What will interest rates be next year? How many people will buy homes in 2013?

These calculations undergo incremental updates almost constantly. That’s fine. Occasionally, they need to be dramatically updated. That’s manageable. But if they all need to be updated at once, and if no one really has the information to update them because Treasuries are suddenly unreliable? That’s catastrophe.

And it's a catastrophe that doesn't need to happen. The ratings agencies appear to be more spooked about the US political process than real pressures on sovereign debt. And for good reason. The US government can borrow for the next five years at negative real interest rates. Literally. Other people will pay us to take their money:

Moreover, unlike other countries the US can borrow -- again, at negative real interest rates -- in its own currency. We don't have to worry about exchange rates or some technocrats in Frankfurt. This could be due to the dynamics I discussed earlier, in which there appears to be a shortage in high-quality investment assets. Regardless of the cause, we are flirting with a disaster the severity of which very few people seem to understand for no good reason at all.

The Bond Vigilantes are no longer invisible... they're just in the form of ratings agencies rather than bond markets. And we need to take them seriously. There's a reason why other countries are trying everything, including dispatching riot police to combat thousands of protesters, in order to avoid default. It's a very bad thing. It's a big mistake to treat it so flippantly.


The Coming Unnecessary Disaster
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