Sovereign subprime

In my opinion, the next default wave (other than commercial real estate, Alt-A residential, and option adjustable rate mortgage residential) will be public instead of private debt.

Greece is working hard to illustrate why I’m worried about this, as is Argentina, the Baltic states, Spain, Italy, Portugal…you get the picture.

But, it’s not just smaller countries that are getting into the subprime spirit, it also includes (currently) prime credits like Japan, the United Kingdom, and (shock, horror!) the United States.

And, it’s not just countries, it includes other public debtors like California, New York, Dubai World, Fannie Mae, etc.

How did this mess get so bad? The same way subprime borrowers and lenders got into trouble. Namely, public bodies are spending more than they are taking in, and lenders are doing a lousy job making sure borrowers can repay. This is not rocket science.

Whether it’s California, the U.K., or Greece, the problem is incurring too many obligations while not taking in enough revenue to pay.

Japan is unique in that it’s as much of a demographic time bomb as anything else. Their real estate, stock market and banks collapsed 20 years ago, but they decided not to face the music. Added to this, their population isn’t having enough kids to replace the elderly, and they won’t allow enough immigration to make up for that deficit. Finally, a big dash of inflexible labor markets and decreasing savings rates and you get a country most likely unable to pay its debts.

How do countries go into default? If they are small, they tend to get bailed out by bigger countries or the International Monetary Fund. Big countries, on the other hand, tend to inflate their way out of debt. The trouble there is that when lenders (bond buyers) realize inflation is the solution, interest rates take off. Not a pretty picture.

The financial crisis of the last two years has made this problem dramatically worse. Instead of letting bad borrowers and lenders face the music, governments of the world have bailed out uneconomic borrowers and uncritical lenders. We haven’t eliminated the debt problem, we simply shifted it from private to public. But, the scale is so large, as are the promises governments have made to pay future benefits, that the end-game is much sooner than anyone thought.

When will these defaults come about? Probably not for several years in the case of prime credits, but much sooner for smaller sovereigns. This is likely to stir credit markets and cause a lot of volatility in commodities and stocks.

It used to be you could count on countries, or at least the right countries, to pay their debts. But now, it costs less money to insure against the default of IBM than it does the U.K. May you live in interesting times, indeed.

This is a good time to be very selective of investments (especially debt), to be prepared for very volatile markets, and to expect higher interest rates and inflation. It may take some time to arrive, but when it does, you won’t want to own low interest debt or highly indebted companies.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

Do the markets care about the $2.4 trillion deficit?

I read a depressing and thought-provoking article last weekend in the Financial Analysts Journal by Jagadeesh Gokhale and Kent Smetters called, “Do the Markets Care about the $2.4 Trillion U.S. Deficit?”

It was depressing in that it spells out quite clearly why the national debt is more like $63.7 trillion and the national deficit is more like $2.4 trillion instead of the reported numbers which are an order of magnitude smaller.

The big difference results because the U.S. government does not include its obligations to Social Security and Medicare in its debt and budget calculations. Hypocritically, such accounting by any private sector company would be illegal. (By the way, the government doesn’t argue with these numbers. In fact, the U.S. Treasury, the Council of Economic Advisers, the Office of Management and Budget, and the Offices of the Actuary at the Social Security Administration and the Centers for Medicare and Medicaid Services agree that such numbers are valid, and tend to provide even more pessimistic projections.)

The thought-provoking question raised in the article is: why haven’t financial markets reacted to these clearly negative numbers? If such numbers were taken seriously by financial markets, U.S. interest rates would almost certainly be significantly higher.

The authors hazard a few hypotheses on why rates haven’t jumped.

First, explicit government debt is real, whereas unfunded liabilities are not. Or, “paper debt must be paid off, but unfunded liabilities are subject to future changes in laws and could be altered.”

Second, Stein’s Law: “That which cannot go on forever won’t.” Or, “don’t worry, they’ll figure out some way to fix this.”

Third, the future is too uncertain to be predictable. Or, “there’s no need to worry because we aren’t smart enough to figure out what the future may hold, anyway.”

Fourth, foreigners will bail us out. Or, “the Chinese, Japanese and other foreigners will just keep buying our debt no matter how financially irresponsible we show ourselves to be.”

Not surprisingly, the authors don’t find any of those hypotheses satisfactory. Neither do I.

In my opinion, the market is just too short term oriented to care. Or, “this problem will not become a crisis for another 10 or 20 years, and I don’t take anything into account beyond the next 6 months to a year.” Judging by the way the market reacts to short term news, this sounds most plausible to me.

Our problem is that this long term issue will become short term at some point. And if those pesky foreigners decide to stop playing the game early, then rates may move up sooner than many are guessing. I’m not going to predict when this will come to a head, but I’m certainly not expecting low interest rates forever.

Disturbingly, higher interest rates will probably be accompanied by a lower dollar and higher inflation. And, this will probably be followed by slower economic growth and higher unemployment. We just better hope that rates don’t move up until the housing market rebounds, or we could really be in for a real headache.

It’s okay, though, because if you look out far enough and expect these things to happen, it’s relatively easy to plan and prepare for them.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.