"We interrupt regular programming to announce that the United States of America has defaulted …" Part 1

By: Satyajit Das

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 in panic. Phone calls swamped police. 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!"

Default entails 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 government have 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 a current 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 the current 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. The problems of the US are evident in a number of other indicators.

The US national debt as of March 2008 stands at US$9.4 trillion (that’s 12 zeros to the right of the decimal). 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 $6 trillion. In 2007 alone, it grew by $500 billion, from $8.7 to $9.2 trillion. In 2005, it was 67% of U.S. GDP, up from 51% in 1988. The Office of Management and Budget projects that total debt will rise to $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 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 July 2008 these obligations became de facto part of US national debt with astonishing speed. Any problem with the solvency of either institution may have implications of the AAA credit rating of the US.

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. Shorter dated bonds took advantage of lower shorter interest rates to reduce the interest cost and boost surpluses. The Treasury Secretary would have been aware of this variation of the "carry" trade from his investment banking days. The US must now "roll over" significant amounts of debt in the coming years.

High levels of debt are compounded by the "twin deficits" – the 2008 budget deficit forecast is US$380 billion (2.4% of GDP) and the current account deficit is expected to exceed US$ 700 billion (4.6% 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 losses on sub-prime mortgages and the current credit crisis. Losses incurred are in excess of US$ 250 billion. There is every likelihood that the losses will increase. The banking system needs additional capital despite having raised over US$200 billion to date. The Federal Reserve has bailed out Bear Stearns and further bailouts are possible. The Fed has provided over US$400 billion in funding support to the financial system. The US national debt statistics set out above do not take into account borrowings required to support the financial system.

Confidence in US financial markets has suffered. The unregulated growth of the network of securitisation and off-balance sheet vehicles – the "shadow banking" system – to the point where it now threatens the financial system has perplexed foreign observers. Byzantine US GAAP 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.

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

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".

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? Fact it seems don’t matter, at least until they do.

 

 

© 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).

At the time of publication the author or his firm did not own any direct investments in securities mentioned in this article although he may be an owner indirectly as an investor in a fund.

 

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