Today as we see Treasuries and dollar sell-off due to speculation of Saudi Arabia ending the Dollar peg and the ongoing rally in Gold that have accompanied the Fed's 50bp rate cut, it would be interesting to explore the sub-prime crisis and how it applies to Sovereign Debt. I believe that US Government Debt may be the ultimate subprime loan.
The best way to illustrate my point is to explicitly show some main points, assumptions, and hypotheses.
- Treasury bonds are the global financial system equivalent of subprime loans. They both are loans made to an entity who at the time is not likely to be able to repay the loan unless more loans are taken out to do so. When we slash interest rates to enable refinancing of mortgages we also slash
- The dollar on a global financial scale is analagous to collaterized debt obligation on a domestic financial scale. Just as banks have benn in the business of selling these, we have been in the business of selling dollars.
- The strength of the dollar against our major trading partners is essentially the credit quality of our Treasury Bonds. If the dollar is weakening, our credit quality is deteriorating and foreign investors should demand a higher interest rate. This credit deterioration is offset by the fact that the excess of dollars are transferred to the foreign holders through consumption. This enables us to maintain a stable and low interest rate of a much more credit worthy entity as long as the dollars that eventually flow abroad offset the loss due to currency devaluation.
These may seem like bold statements to some, so let me explain.
The subprime crisis is defined by lax lending standards to people who have a credit rating far inferior than a prime borrower. It has been both caused an exacerbated by the lender's ability to securitize risk, and keep lending and lending (and lending), which has effects of diluting the credit quality of the borrowing base in aggregate and inflating asset prices to a level where they can only be kept up with more credit. Loans are accounted for as assets on balance sheets because a portfolio of loans have a positive expected value. A subprime loan in essence has a risk factor that outweighs its return. After subtracting opportunity costs, a sub-prime loan has a negative expected value. Securitization enabled banks to make loans that would intuitively seem like a dumb move, but because they simply earn the the interest rate minus the overnight rate - without having to factor in the default rate. Since purchasers of these products usually are not banks (and don't have to borrow money at the overnight rate - although many of them are highly leveraged) they essentially earn the interest rate minus the default rate. Although in reality the situation is a bit more complex than this, this is bascially the nuts and bolts of the situation. This is a very complicated as well as delicate situation. If a market dislocation occurs and the overnight rate shoots up the trade unravels. If the default rate increases (or creditworthiness of the borrower), the trade unravels. And, most importantly if the price of the underlying collateral (in most cases a house) decreases, the trade unwravels. If all three things happen (although we have seen that they are very correlated), then the proverbial shit hits the fan.
Much like a bank, the US government basically is in the business of selling dollars. Banks buy dollars at a the overnight rate and sell them at the prime rate. They capture the spread between the two. From a balance sheet point of view we also make a profit by buying dollars less than we sell them for. We borrow dollars through taxes and the issuance of debt in order to pay for our expenses (governement programs) and create national wealth. This is done through various fiscal, monetary, and economic endeavors. We must both maintain order and stability and stimulate our economy so that we collect tax revenues. Essentially, we want to ensure that the tax revenue we recieve is equal to or greater than what we spent plus interest cost. When we run a fiscal deficit, we are not at an operating profit, and must issue more debt to repay the interest. Doing this essentially floods the market with more US debt and should not last forever - unless of course we have a market that has to buy our debt. By expanding the money supply, we create more dollars which buy up foreign goods and enable us to issue more debt to keep the enterprise alive. We are flooding the market with dollars, but do not realize the implications, because interest rates remain stable and dollar weakness isn't felt as much at home. Essentially the dollar is an asset backed security, securitized by a pool of government loans which on a global scale essence subprime loans. This structured product does well as long as consumers are spending (which depends on asset price inflation among other things).
When running a fiscal deficit in this global economy where foreigners own most of our debt and are our major market for it, if our consumers slow down, our collateral deteriorates and so does the value of our debt. The dollar - which is backed by this should also decrease. If we increase the supply of dollars - which have more value domestically than abroad, the holders of dollars abroad experience a decrease in the value of their investment. If our dollars fuel enormous growth abroad, they are willing to take that hit because it pays off. If our dollars do not fuel that growth abroad - if they are not used for consumption of foreign goods, and are used as a means to rescue banks - essentially domestic means, foreign holders may no longer realize the positive externality the devaluation of their current holdings and strike against the paper currency. This creates a dollar liquidity process in which the government must step in and buy the dollars - causing asset deflation.
In the domestic market the tipping point for subprime mortgages was when the housing market starting to decline. This created a liquidity crisis in corporate credit markets as market participants boycotted risky debt which thereby has caused consumer credit to dry up. Could this decrease in consumer credit coupled with a dollar devaluation due to the rate cut be the tipping point in the market for dollars? Could the flight to gold be a flight to quality in the currency markets?
If you refuse to pay your mortgage, the bank steps in and takes your house. Since we refuse to pay our taxes will our creditors step in and take ours?
Have we begun to foreclose on our country?
Technorati : dollar, inflation, mortgages, subprime, treasuries
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