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“Unmitigated disaster” in chart form

This entry was posted by Sam Jones on Wednesday, July 16th, 2008 at 11:09 and is filed under Capital markets, People. Tagged with Fannie Mae, freddie mac. You can follow any responses to this entry through the RSS 2.0 feed. Responses are currently closed, but you can trackback from your own site.

1. Jul 17   18:04 Posted by The Liberty Papers »Blog Archive » Worth 1000 Words — Or 381 Words After Inflation [report]

   […] So what does it mean when the chart of CDS contracts on US Treasury bonds, the worlds main “risk-free” debt, looks like this? […]

2. Jul 17   1:40 Posted by dhome [report]

   Perhaps some research into Milton Freidman’s concept of “Irredeemable Debt” might useful to understand how the US has and will continue to avoid paying its debts. That and this fact: “The United States’ external liabilities are denominated in its own currency”.
   The key to the problem is, as has been pointed out by others, that the US Treasury has, since July 1944, had a custodian role for the world’s reserve currency. The US has, since the late 1960s, persistently abused that role to its benefit by allowing a progressive and unremitting devaluation of the USD which helped a) in reducing its debts to importers and b) improving its export competitiveness (sound familiar today?). Both largely paid for the American Miracle – not the financial “expertise” of its business leaders as even using the above methods, the US still has/has always had a ballooning trade deficit! As former Treasury Secretary Lawrence Summers said: “There is something odd about the world’s greatest power being the world’s greatest debtor.”
   In 2004, total net US foreign liabilities were approaching a quarter of its GDP. In 2008, half way through “sub-prime”, it is getting closer to one third. Add Standard and Poors estimate of 10% for bailing out Fannie and Freddie and its easy to see why more and more “people” have become concerned with US Treasury’s now total lack of financial probity and manifest conflict of interest in their role of custodian of the world’s reserve currency. The gathering move to switch to a different global currency system or systems will continue and accelerate ensuring global financial instability.
   The US and its allies, namely those creditors that stand to lose the most from a totally un-supported USD – China, Japan and the UK as the top three holders of US debt, will try and stop any such switch from happening,. The standard US defense used to go like this: “The U.S. dollar will remain dominant in global trade, payments, and capital flows, based as it is in a country with safe, well-regulated financial markets.” “Safe” and “well-regulated” are maybe not totally convincing adjectives to describe what has happened since 2004 but they have been using them since the first USD crisis 40 years ago!
   So rather than a frontal attack on the US Treasury, a progressive switch will be/is being made using the tools made available by financial globalisation – funds and commodities without borders. This is already occurring as some sovereign wealth funds (a growing alternative to US Treasuries) and a few oil producers are shifting out of the USD. They will use/are using commodities as their currency of choice. They will, naturally, be the “bad guys” (Congress will call them speculators and deem that they are not acting in “the national interest”), however, as recent events have clearly demonstrated; the world can not afford to have partisan dollar printers in control of the world’s reserve currency any longer.

3. Jul 16   19:36 Posted by Kamekon [report]

   @taxloss - excellent question under any nuclear scenario. But if it’s only a matter of a technical default on Treasury debt (see comments below), then creditworthiness of CDS counterparties shouldn’t be a major concern.

   (See http://tinyurl.com/6zfek9 for an example of political risk: “Gingrich Threatens U.S. Default If Clinton Won’t Bend on Budget “.)

4. Jul 16   19:24 Posted by Stacy-Marie Ishmael [report]

   @TaxLoss, @The Word, this just out from UBS on spread between Treasurys/Bund:

   “We acknowledge that there are no safe bets in today’s investment environment and decisions are being made on a ‘least bad’ outcome rather than in expectation of the highest return. Even so, what keeps the Bund/Treasury spread close to the widest levels (in favour of Treasuries) since the millennium?”

   ‘The problems in U.S. agencies show the difficulties engulfing the U.S. financial sector are likely to remain intractable for months, if not years, to come. It would take a miraculous turnaround in capitalisation for the threat of government support to retreat completely. Even if the worst is over in the short-term, the delinquency and foreclosure rate driving concerns still has some way to go. At some point, investors in Treasuries could be faced with an explicit (rather than implicit) contingent claim on the U.S. government balance sheet”

5. Jul 16   14:34 Posted by TheWord [report]

   @taxloss, that is so much the right question to ask…and so much the last question any sane person wants answered. It’s one of these times when I hope the markets are being irrational, because the other outcome is not worth contemplating.

6. Jul 16   14:21 Posted by pegnu [report]

   @wdm, ny: yes, you can’t have one country consuming more than it produces forever.
   This crisis has been a real eye opener for me. I never realised before how utterly insane the world’s financial system was.

7. Jul 16   13:44 Posted by Anonymous [report]

   I would argue that the US Govt is already deafulting, and has signalled it’s sintent to continue doing so, by allowing inflation to carry above 4% with no indication of when or whether it will bring that rate back down.

   If you were a buyer of US-debt when inflation was at 2%, and (with hindsight naively) expected it to continue at that level, then a 2% additional devaluation over 10yrs is a lot of value destruction, techinical default or not.

8. Jul 16   13:38 Posted by wdm, ny [report]

   The U.S. will, no doubt, default at some point on account of its unique position as issuing the reserve currency. The only question is timing.
   It can, for example, decide that a large class of foreign holders are “bad guys” and punish them..Something like this or the debt-equity swap I mooted last week will certainly happen. U.S. taxpayers would prefer to renege than suffer in the short run.

9. Jul 16   13:34 Posted by taxloss [report]

   I suppose you’ve also got to ask how the counterparty to the CDS could possibly be more creditworthy than Uncle Sam.

10. Jul 16   13:25 Posted by Anonymous [report]

    @kamekon. OK, so the question becomes, why would the senate allow the default to occur, given the expected huge loss of confidence in fin markets, and the resulting long-term economic damage.

11. Jul 16   13:05 Posted by Carlomagno [report]

    How much debt does the Treasury have to roll-over on a weekly or monthly basis?

12. Jul 16   13:03 Posted by Kamekon [report]

    @ Anon: some googling yielded this: “Treasury bonds are exposed to political risk. These bonds don’t have traditional credit risk because the federal government can print as much money as is necessary in order to avoid defaulting on its debts. However, the government must constantly issue new debt in order to pay off its maturing debt and the U.S. Senate must authorize the issuing of any new debt. In the event of a political dispute, it’s possible that the Senate could refuse such authorization, thereby causing a technical default.” (http://www.finweb.com/investing/us-treasury-securities.html).

13. Jul 16   13:00 Posted by Anonymous [report]

    I must be missing somthing here. The US government defaulting on USD denominated debt. Given the Fed has given the two-fingered salute to inflation fears, why wouldn’t it print as much money as neccesary. The alternative would surely be worse.

14. Jul 16   12:51 Posted by Kamekon [report]

    @ G Cox: these CDSs also provide protection against mere technical (”non-nuclear”) defaults.

15. Jul 16   12:50 Posted by Sam Jones [report]

    The CDS spread shown above is not necessarily tracking armageddon or default of the US treasury. For starters, the CDS would deliver under a technical default - i.e. late payment after two days.

16. Jul 16   12:27 Posted by G Cox [report]

    Carlomagno. The circumstances necessary to create a US Treasury default would be total economic and financial meltdown as one would get just before nuclear holocaust… ‘game over’.

17. Jul 16   12:21 Posted by pegnu [report]

    I have the same question as G Cox. If the US Gov defaults it’s game over.

18. Jul 16   12:13 Posted by Carlomagno [report]

    G. Cox: could you elaborate. Quick googling shows that there’s $9.5 trillion of US public debt outstanding. Compare to the notional outstanding amount of CDS, which was over $65 trillion in 2nd half of 2007 according to ISDA.

19. Jul 16   12:04 Posted by Carlomagno [report]

    or even nigh…

20. Jul 16   12:03 Posted by Carlomagno [report]

    The end is night!

    http://www.nakedcapitalism.com/2008/07/merrill-us-may-face-financing-crisis.html

21. Jul 16   11:58 Posted by G Cox [report]

    What is the point of this.If the Treasury defaulted, no counterparty would be around to pay up.