10 October 2008

We interrupt this program...

by Satyajit Das October 06, 2008

"We interrupt regular programming to announce that the United States of America has defaulted …"

On 30 October 1938, the American Radio Drama series Mercury Theatre aired "The War of the Worlds", directed by Orson Welles. Adapted from H.G. Welles’ novel, the first half of the broadcast was scripted as a series of dramatic news bulletins of a Martian invasion. Listeners who had missed or ignored the opening credits assumed that the invasion was real. People fled their homes. Police were swamped by panicked phone calls. Today the financial equivalent of this broadcast would be the announcement: "we interrupt regular programming to announce that the United States of America has defaulted on its debt!"

Pay back in devalued dollars…

Default is the failure to honour contractual obligations; in the case of debt, non-payment of interest or principal payments due to the lender. The financial impact of default is the loss suffered by the lender.

Lenders to the United States ("US") government have already suffered significant losses. The losses have not been from non-payment but because repayments have been in a constantly debased currency – the dollar.

Assume a Japanese investor bought 30 year US Treasury bond in 1985 when the US$/ yen exchange rate was US$1 = Yen 250. Based on an exchange rate of US$1 = Yen 105, the investor has lost 58% of the investment. The investor can take comfort that at the low of US$1=Yen 84, the investor would have lost 66%. European investors who bought US government bonds in recent years would have also suffered significant losses. Based on the highest US$/ Euro exchange rate (Euro1 = US$ 0.85) and recent trading levels (Euro1 = US$ 1.56), the investor would have lost (up to) 46%.

Given that in a typical sovereign default the investor loses 50% to 80% of the value of the investment, the losses suffered are not far short of default. Despite "strong dollar" official policies, a case can be made that the US is in the process of defaulting on its obligations via a systematic devaluation of its currency.

Debt for all ….

US problems are evident from other indicators. The US national debt as of March 2008 stands at US$9.4 trillion. This equates to over US$30,000 per person in the U.S. population or a little over US$60,000 per head of the U.S. working population. The US national debt has grown by US$3 trillion (50%) since 2000, when it was US$6 trillion. In 2007 alone, it grew by US$500 billion, from US$8.7 to US$9.2 trillion. In 2005, it was 67% of US GDP, up from 51% in 1988. Prior to the current crisis, the Office of Management and Budget projects that total debt will rise to US$12.3 trillion in 2013.

Of the US$4.7 trillion in private hands, US$2.4 trillion (51%) is held by foreign investors. Japan holds around US$600 billion (24%) and China holds US$500 billion (around 20%). U.K., Brazil and the oil exporting countries own about 6%. Middle East and Russian holdings may be higher as Belgium, Caribbean Banking Centers and Luxembourg (8%) may be vehicles for investments by oil-exporting countries wishing to avoid disclosure. As James Fallow writing in The Atlantic noted: "every person in the (rich) United States has over the past 10 years or so borrowed about $4,000 from someone in the (poor) People’s Republic of China."

The debt figures do not include significant private sector debt (both corporate and consumer). It does not include "hidden" liabilities - unfunded public (Social Security) and private pension arrangements or unfunded medical and health obligations (Medicare and Medicaid).

In June 2008, Peter Orszag, Congressional Budget Office Director, did not mince words when testifying before the Senate Finance Committee: "…the U.S. economy faces the long-term threat of ‘collapse’ unless major reforms on health care spending are instituted in the coming years." The federal budget, according to Orszag, is on an "unsustainable path" with health care costs growing much faster than the overall economy. Unless health care spending is brought under control, Orszag noted that the American economy faces crippling problems that "would make our current economic difficulties look tiny". In July 2008, Richard Fisher, head of the Dallas Federal Reserve Bank, speaking in a private rather than official capacity noted that "the unfunded liabilities from Medicare and Social Security...comes to US$99.2 trillion over the infinite horizon". This equates to US$1.3 million per family of four - over 25 times the average household's income.

The debt figures also do not include "off-balance sheet" liabilities - the US$5 trillion plus in debt and guarantees of the government sponsored enterprises ("GSE") - Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation)- that is supported by modest levels of capital (about US$81 billion). In mid 2008 these obligations became de facto part of US national debt with astonishing speed.

US national debt is also shortening in maturity. In December 2000, the average length of US public debt held by private investors was 70 months. As at March 2008, the average length had shortened to 53 months (a decline of 24%). 71% of this debt is due in less than 5 years; 39% is due in less than 1 year. In the Clinton/ Rubin years, the Treasury stopped issuing 30 year bonds (the decision was reversed by the Bush administration). The ostensible rationale was that projected US budget surpluses would allow the government debt to be retired. In reality, shorter dated bonds took advantage of lower shorter interest rates to reduce interest cost and boost surpluses (this was the US government’s version of the carry trade). The US must now "roll over" significant amounts of debt in the coming years.

Multiple troubles…

High levels of debt are compounded by the "twin deficits" – the 2008 budget deficit forecast is US$400 billion (3% of GDP) and the current account deficit is expected to exceed US$ 800 billion (over 4% of GDP). The US savings rate is extremely low. US consumers have relied on asset appreciation (primarily housing and also stocks) as saving. In recent years, borrowing against asset values to fund consumption has reduced even this.

One mainstay of the US economy has been its financial system – "financial" engineering has long overtaken "real" engineering. Lawrence Summers, a former Deputy Secretary of the US Treasury, proudly extolled the merits of the US financial system in a 2001 speech at the London Stock Exchange in the following terms: "… the United States is the only country in which you can raise your first US$100 million before you buy your first suit." He gave short shrift to critics who felt that US financial sophistication was synonymous with financial instability: "[That belief] is observed in inverse proportion to knowledge of these matters."

The US financial system has been badly affected by the current credit crisis. Financial institutions have incurred losses in excess of US$500 billion. There is a strong likelihood that the losses will increase.

By September 2008, the US banking system was experiencing significant liquidity and solvency issues. A number of major commercial banks (Washington Mutual; Wachovia) and broker dealers (Bear Stearns; Lehman Brothers; Merrill Lynch) have been forced to merge or have filed for bankruptcy. More banks are expected to fail in the near future.

The Federal Reserve and US Treasury has been forced to undertake aggressive actions to support the financial system. The Fed has provided almost US$500 billion in funding support to the financial system. The US government has also committed to financing (up to) US$ 1.4 trillion of mortgage backed securities currently held by Fannie Mae and Freddie Mac.

The Federal Reserve and US Treasury have already entered into arrangements to finance JP Morgan’s acquisition of Bear Stearns. They have also directly supported AIG, the insurance giant.

In September US Treasury Secretary Henry Paulson introduced a plan that would commit the government to providing (up to) US$700 billion to purchase mortgage-related assets from financial institutions. Faced with a run on money market funds, the government also agreed to provided US$400 billion to guarantee money-market mutual funds. Government support for financial institutions in this financial crisis is already approaching 6% of GDP (compared to less than 4% for the 1980s Savings and Loans crisis).

The claims on the government are by no means over. The Federal Deposit Insurance Corporation ("FDIC") has around US$ 45 billion in funds available to meet its obligations. Given the expected increase in bank defaults, it is possible that the FDIC may need added capital and funding from the government. Other GSEs, including the Federal Home Loan Banks, have aggressively increased mortgage lending and may also require re-capitalisation. Non-financial industries, such as the troubled automobile and airline sectors, may also need government support. Congress has already approved a US$25 billion low cost loan to the automobile sector.

Additional government borrowings (perhaps up to an additional US$2-3 trillion) may be necessary to support to the financial system. This would mean that US government debt would reach a level of around 70% of GDP, a level not seen since 1954, when the US was repaying the costs of World War II. The additional debt may ultimately lead to a review of the USA’s AAA rated sovereign debt rating.

While the rescue boosted financial markets, the long-term impact on the US budget and current-account deficit and ultimately the US dollar is unlikely to be positive.

Financial engineering….

Confidence in US financial markets has suffered. The growth of the network of securitisation and off-balance sheet vehicles – the "shadow banking" system – without regulatory oversight to the point where it now threatens the financial system has perplexed foreign observers. Byzantine US accounting practices (especially off-balance sheet debt, mark-to-market and derivative accounting) and the failures of rating agencies (a substantially US phenomenon) have also affected confidence.

The veracity of economic information has been questioned. Bill Gross of Pimco and other commentators argue that the official measure of "inflation" significantly understates actual levels because of statistical adjustments made over the past 25 years. In a 1998 speech during the Asian financial crisis, Lawrence Summers preached the merits of American-style "transparency and disclosure". It is the US that now needs "transparency and disclosure".

Mohamed El-Erian, Pimco Co-Chief Executive of PIMCO summed it up on 25 June 2008: "What has suffered most is the credibility of the most sophisticated financial systems in the world."

There are other dimensions to the malaise. John Gapper, a columnist for the Financial Times observed on 8 May 2008: "If anyone doubts the problems of US infrastructure, I suggest he or she take a flight to John F. Kennedy airport (braving the landing delay), ride a taxi on the pot-holed and congested Brooklyn-Queens Expressway and try to make a mobile phone call en route. That should settle it, particularly for those who have experienced smooth flights, train rides and road travel, and speedy communications networks in, say, Beijing, Paris or Abu Dhabi recently. The gulf in public and private infrastructure is, to put it mildly, alarming for US competitiveness."

The factors identified are well known. Lawrence Summers once observed: "In this age of electronic money investors are no longer seduced by a financial dance of a thousand veils. Only hard accurate information on reserves, current account and fiscal and monetary conditions will keep capital from fleeing precipitously at the first sign of trouble." Why haven’t the "electronic herd" abandoned the US? Facts it seems don’t matter, at least until they do.

Reserve the currency….

High levels of debt are sustainable provided the borrower can continue to service and finance it. The US has had no trouble attracting investors to date. In recent years, the United States has absorbed around 85% of total global capital flows (about US$500 billion each year) from Asia, Europe, Russia and the Middle East. Risk adverse foreign investors preferred high quality debt – US Treasury and AAA rated bonds (including asset-backed securities ("ABS"), including mortgage-backed securities ("MBS")).

Warren Buffett in his 2006 annual letter to shareholders noted that the US can fund its budget and trade deficits as it is still a wealthy country with lots of stock, bonds, real estate and companies to sell. In reality, a significant portion of the money flowing into the US was not used to finance productive investments but funded government spending and (sometimes speculative) property.

The real reason that the US actually has not experienced a sovereign debt crisis is that it finances itself in it own currency. This means that the US can literally print dollars to service and repay it obligations.

In February 1988, Thomas Moore, a member of the Presidents’ Council of Economic Advisors recognised this: "We can pay anybody off by running a printing press, frankly… so it is not clear to be how bad [the transition to net debtor status] is." In other words, the dollar printing presses could be run to service debt. In fairness, Mr. Moore was not advocating this as "sound policy".

The special status of the US derives, in part, from the fact that the dollar is the world’s major reserve and trade currency. The dollar’s status derives, in part, from the gold standard that once pegged the dollar to the value of gold. The peg and full exchangeability is long gone. The aura of stability and a safe store of value based on the perceived strength of US economy and American military power has continued to support the dollar. In 2003, Saddam Hussein, when captured, had US$750,000 with him – all in US$100 bills.

The dollar's favoured position in trade and as a reserve currency is based on complex network effects. Many global currencies are pegged to the dollar. The link, sometimes at an artificially low rate, like the Chinese Renminbi, is used to maintain export competitiveness.

This creates an outflow of dollars (via the trade deficit that is driven by excess US demand for imports based on an overvalued dollar). Foreign central bankers are forced to purchase US debt with dollars to mitigate upward pressure on their domestic currency. The recycled dollars flow back to the US to finance the spending. This merry-go-round is the single most significant source of liquidity creation in financial markets. Large, liquid markets in dollars and dollar investments are both a result and facilitator of the process and assist in maintaining the dollar’s status as the world’s primary reserve currency.

The dollar’s dominance may be coming to an end. There is increasing discussion of re-denominating trade flows in currencies other than US$. Exporters are beginning to invoice in Euro or Yen.

In the early 1970s Japanese exports were invoiced almost exclusively in dollars. Today only 50% of Japanese exports are invoiced in dollars. Around 40% of Japanese exports are invoiced in yen, an increase from 34% in 2001. The decline in dollars held outside the US from 1.83% of world trade in 2002 to 1.22% in 2006 may reflect changes in its role in global trade.

The Taj Mahal now does not accept payment of its entrance fee in dollars preferring the "strong" Rupee. Apparently super models and even drug dealers now prefer Euros to dollars.

There are proposals to price commodities, such as oil and agricultural goods, in currencies other than dollars. Some countries have abandoned or loosened the linkage of their domestic currency to the dollar. Others are considering such a move.

Foreign investors, including central banks, have reduced investment allocations to the dollar. The dollar’s share of reserves has fallen from a high of 72% to around 60%.

Foreign investor demand for US Treasury bonds has weakened in recent times. Low nominal (negative real) rates on interest and dollar weakness are key factors. Foreign investors are also beginning to question the credibility of the Federal Reserve and US Treasury.

For example, the debt of Fannie Mae and Freddie Mac had long been regarded as "implicitly" backed by the US government despite the absence of any explicit guarantee. Foreign investors, including more than 60 global central banks, hold over $1,400 billion in securities of US agencies including Fannie Mae and Freddie Mac.
On 23 July 2008, the Financial Times, reported that the US embassy called the Kuwait Investment Authority ("KIA"), the world’s sixth-biggest sovereign wealth fund, to reassure them about the "soundness" of bonds issued by Fannie Mae and Freddie Mac after Kuwait’s minister of finance announced that the KIA was not planning to invest in their debt in future. Yu Yongding, a Chinese economist and former advisor to China’s central bank, recently warned that: "If the US government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic. If it’s not the end of the world, it is the end of the current international financial system."

Following the announcement of the US government’s US$700 billion plan to restore confidence to the financial system, Kwag Dae Hwan, head of global investment… with South Korea’s $220 billion National Pension Fund noted: "The image of U.S. Treasuries as a safe haven has been tainted by the ongoing financial debacle … A big question mark hangs over whether the U.S. can deal with an unprecedented amount of debt. That is unnerving all the investors, including me."

A mere United States security …

Investors around the world are now faced with a deterioration in the creditworthiness of the world’s largest borrower. Scrooge’s nightmare, described by Charles Dickens, in which "solid" British assets are changed into "a mere United States security" may become a reality.

Foreign investors may not continue to finance the US. At a minimum, the US will at some stage have to pay higher rates to finance its borrowing requirements. Ultimately, the US may be forced to finance itself in foreign currency. This would expose the US to currency risk but most importantly it would not be able to service its debt by printing money. The US, like all borrowers, would become subject to the discipline of creditors.

For the moment, the dollar is hanging on – just. This reflects structural weakness in the Euro and Yen based on deep-seated problems in the respective economies. The artificial nature of the Euro is also problematic.

The dollar is also a beneficiary of the "too big to fail" syndrome. Foreign investors, especially central banks and sovereign investors in East and South Asia, Russia and the Gulf, have substantial dollar investments that would show catastrophic losses if the US were to default or its currency devalue. The International Monetary Fund ("IMF") estimated that Gulf Cooperation Council (Saudi Arabia, the United Arab Emirates, Qatar and other Gulf States) may lose US$400 billion if they decide to stop pegging their currencies to the dollar.

Every lender knows Keynes’ famous observation: "If I owe you a pound, I have a problem; but if I owe you a million, the problem is yours." In history’s largest Ponzi scheme, foreign creditors must keep supporting the US. As the old observation goes: "The only man who sticks closer to you in adversity than a friend is a creditor."

Traders have a saying: "Don’t panic but if you are going to panic, panic first." The present MAD (mutually assured destruction) pact that binds the US and its creditors is fragile. Dollar holders are acting like a cartel. A break in the cartel - a major investor deciding to exit in the belief that it can get out – could be extremely disruptive.

Does any of this matter? Walter Wriston, then chairman of Citigroup, opined that: "Countries don't go broke". In 1982, shortly after this statement, Mexico, Brazil and Argentina defaulted inflicting near mortal losses on Citibank.

Sovereign debt crisis, especially in emerging markets, are characterised by high levels of debt, especially foreign borrowings, poor fiscal policies, persistent trade deficits, a fragile financial system, over-investment in unproductive assets and a sclerotic political system. Arturo Porzecanski (in Sovereign Debt at the Crossroads (2006)) noted that: "Governments tend to default specifically when they must increase spending quickly (for instance, to prosecute a war), experience a sudden shortfall in revenues (because of a severe economic contraction), or face an abrupt curtailment of access to bond and loan financing (e.g. because of political instability). He further observed that: "governments with large exposures to currency mismatches and interest rate or maturity risks are, of course, particularly vulnerable."

Can the status quo continue? The US must ultimately pay the piper. Max Winkler, who had warned against the excesses of the boom that culminated in the Great Depression, in his book Foreign Bonds: An Autopsy (1933) noted: "The history of government borrowing is really the history of government defaults."

Taking the cure …

So what must the US do to remedy the problem? In 1989, John Williamson described certain economic prescriptions - the Washington Consensus – that became a "standard" reform package promoted for crisis-wracked countries by the IMF. The controversial, much criticised package includes: fiscal policy discipline; redirection of public spending from subsidies; tax reform; market determined and positive real interest rates; competitive exchange rates; trade liberalization; liberalization of inward foreign direct investment; privatization of state enterprises; and deregulation. Resolution of the problems facing the US requires adopting many elements of the standard IMF economic reform package for emerging markets.

Some elements, such as fiscal and monetary discipline, are politically difficult if inevitable. Reform of farm subsidies must overcome deep-seated resistance.

Markets are restless for action and do not wait. The US dollar has weakened and is likely to fall further. This helps exporters, tourism and will ultimately attract inwards foreign investment.

Foreign investment has been slow. Weak economic growth and concerns about the US financial system have offset the effects of a lower dollar. The "closing down sale" of US assets - real estate, companies and infrastructure assets - has begun. InBev, a Belgian based brewer has launched an unsolicited bid of US$46 billion for Anheuser-Busch, the brewer of Budweiser, the quintessential American beer. Abertis Infraestructuras, a Spanish infrastructure company teamed with Citigroup, submitted US$12.8 billion, the largest bid, for the right to lease the Pennsylvania Turnpike for the next 75 years. Foreign investors have provided a substantial amount of the capital needed to re-capitalise the US financial system.

Increasing foreign investment is politically sensitive in America. Surveys show that most American would prefer key businesses to remain in American hands. Public concern about investment by Sovereign Wealth Funds ("SWF") reflects this financial xenophobia.

In 2008, the Government Accounting Office’s ("GAO") overturned the US$35 billion contract awarded to a combination of an American corporation Northrop Grumman and European EADS for US military mid-air refuelling aircraft after a challenge by Boeing. Foreign investors view the decision as a sign of implicit resistance to foreign investment in sensitive and strategic areas of the economy.

Business leaders have spoken out in favour of foreign investment. In his 2007 letter to shareholders Warren Buffett noted that foreign investment was a function of misguided US policies and not "some nefarious plot by foreign governments". Stephen Schwarzman (the head of private equity firm Blackstone) struck a shriller note in an opinion piece in the Financial Times in June 2008: "… hostility is dangerous … The US is the world’s largest debtor nation and we are now in an uneasy relationship with our creditors. … If we were forced to rely mostly on domestic borrowing, we would have to pay very high interest rates. The consequences would be increased inflation, a dollar falling even faster and very slow (or negative) economic growth. If the investment climate for SWFs is poor in the US, the countries with large dollar reserves (which are the owners of most of the SWFs) could … look for alternatives."

The "adjustment" may be under way. The dry measured economic prose of the Washington Consensus does not capture its human elements. It will require reductions in US real wages and living standards on a scale that those who have not experienced it first hand cannot understand. Just ask the average citizen of many Asian countries (post the 1997/ 1998 monetary crisis), Argentina and any other country that has taken the IMF’s "cure".

A character in Siri Hustvedt’s novel The Sorrows of an American (2008) records the following diary entry at the time of the Great Depression: "A depression entails more than economic hardship, more than making do with less. That may be the least of it. People with pride find themselves beset by misfortunes they did not create; yet because of this pride, they still feel a pervasive sense of failure… People become powerless."

In the twentieth century, the US and the dollar overtook Great Britain and the Pound Sterling as the pre-eminent global economic power and currency. A similar epochal tectonic shift in the global economic order may be commencing.

The shift is not inevitable. There is much to admire about the US. It remains wealthier than other nations including the new titans - China and India. America remains a science and technology powerhouse. It accounts for 40% of total world spending on research and development, and outperforms Europe and Japan. For example, between 1993-2003 America’s growth rate in patents averaged 6.6% a year compared with 5.1% for the European Union and 4.1% for Japan. America’s economy with its growing population, secure legal and property rights and well-developed financial markets has been attractive to investors.

However as Warren Buffett in his 2006 annual letter to shareholders observed: "Foreigners now earn more on their U.S. investments than we do on our investments abroad … In effect, we’ve used up our bank account and turned to our credit card. And, like everyone who gets in hock, the U.S. will now experience ‘reverse compounding’ as we pay ever-increasing amounts of interest on interest. …. no matter how rich you are, borrowing on top of borrowing is not a great long-term financial plan. I believe that at some point in the future, U.S. workers and voters will find this annual 'tribute' (of interest payment on the debt) so onerous that there will be a severe political backlash … How that will play out in markets is impossible to predict – but to expect a 'soft landing' seems like wishful thinking."

The Economist magazine wrote that: "…public credit depends on public confidence…The financial crisis in America is really a moral crisis, caused by the series of proofs …that the leading financiers who control banks, trust companies and industrial corporations are often imprudent, and not seldom dishonest. They have mismanaged…funds and used them freely for speculative purposes. Hence the alarm of depositors and a general collapse of credit…" The words appeared over 100 years ago on 2 November 1907 during the 1907 crash.

The US faces a challenge to re-establish its economic credentials. Without drastic and radical action, America’s ability to continue to borrow from foreign investors to meet its financing requirement is likely to become increasingly difficult.

The mass hysteria and panic that followed the broadcast of Orson Welles The War of the World played on fears about an attack by Germans. It is interesting to speculate whether a broadcast on a default by the US on its sovereign debt would play on the secret fears of global markets triggering a similar panic.

"We interrupt regular programming to announce that the United States of America has defaulted on its debt!"

© 2008 Satyajit Das All Rights reserved.

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

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