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U.S. Defaults On Debt! - Part 1

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Not quite - but transparency and disclosure urgently needed.

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On October 30, 1938, the American Radio Drama series Mercury Theatre aired Orson Welles's "The War of the Worlds". Adapted from the novel by H.G. Wells, 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. Police were deluged with panicked phone calls.

The financial equivalent of this broadcast today? "We interrupt regular programming to announce that the United States of America has defaulted on its debt!"

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

Those who have made loans to the U.S. government have suffered significant losses - not because of non-payment, but because repayments have been made in a badly debased dollar.

Assume a Japanese investor bought 30-year US Treasury bonds in 1985, when the exchange rate was US $1 = Yen 250. Based on a current exchange rate of US $1 = Yen 105, the investor loses 58% of his investment. But the investor can take comfort: At the previous low of US$1=Yen 84, he would've lost 66%.

European investors who bought US government bonds would also suffer significant losses: Based on the highest US$/ Euro exchange rate (1 Euro = US $0.85) and the current trading levels (1 Euro = US $1.56), the investor would have lost as much as 46%.

These losses are comparable to those incurred in a sovereign default, in which the investor typically loses 50% to 80%. Despite official "strong dollar" 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 US national debt stands at $9.4 trillion as of March 2008 (that's 12 zeros to the right of the decimal). That's the equivalent of $30,000 per person, or a little more than $60,000 per member of the U.S. working population. The national debt has grown by $3 trillion (50%) since 2000. 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 $4.7 trillion in private hands, $2.4 trillion (51%) is held by foreign investors. Japan holds around $600 billion (24%), China holds $500 billion (around 20%) and the U.K., Brazil and oil-exporting countries own about 6%.

Middle Eastern and Russian holdings may be higher, since oil-exporting countries wishing to avoid disclosure may be using Belgium, Caribbean Banking Centers and Luxembourg (8%) as vehicles for investment.

As James Fallow noted in the Atlantic: "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 omit "off-balance sheet" liabilities: The $5 trillion-plus in debt and guarantees carried by the government-sponsored enterprises (GSEs), Fannie Mae (FNM) and Freddie Mac (FRE), which are supported by modest levels of capital (about $81 billion).

In July 2008, these obligations became a de facto part of the US national debt with astonishing speed. Any problem with the solvency of either institution may have implications for the AAA credit rating of the US.

The national debt's maturity is also shrinking. In December 2000, the average length of US public debt held by private investors was 70 months. As of March 2008, this had declined by 24%, to 53 months. 71% of this debt is due in less than 5 years; 39% is due in less than a year.

In the Clinton/Rubin era, the Treasury stopped issuing 30-year bonds (a decision reversed by the Bush administration). The ostensible rationale: Projected 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've been aware of this variation on 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 $380 billion (2.4% of GDP) and the current account deficit is expected to exceed $700 billion (4.6% of GDP).

The US savings rate is also extremely low. US consumers have relied on asset appreciation (primarily housing and also stocks) instead of saving. In recent years, borrowing against asset values to fund consumption has reduced even this meager form of "saving."

One mainstay of the US economy has been its financial system: "Financial" engineering has long outstripped "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: "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 subprime mortgages and by the current credit crisis. Losses are in excess of $250 billion, and in all likelihood losses will increase.

The banking system needs additional capital, despite having raised over $200 billion to date. The Federal Reserve already bailed out Bear Stearns, and further bailouts are possible.

The Fed has provided over $400 billion in funding support to the financial system - and the US national debt statistics set out above don't take borrowings required to support the financial system into account.

Confidence in US financial markets has suffered. The unregulated growth of the securitization network and off-balance-sheet vehicles (the "shadow banking" system) now threatens the financial system - a fact that perplexes foreign observers.

Byzantine GAAP accounting practices (especially off-balance-sheet debt, mark-to-market and derivative accounting) and the failures of rating agencies (a distinctly American phenomenon) have also affected confidence.

The veracity of economic information has also been questioned. Bill Gross of PIMCO, among others, argue that the official measure of "inflation" significantly understates actual levels because of statistical adjustments made over the past 25 years.

Mohamed El-Erian, Co-CEO 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" - something of which the U.S. is now sorely in need. And John Gapper, a columnist for the Financial Times, observed:

"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? It seems facts don't matter - until they do.

See Professor Das' U.S. Defaults On Debt! - Part 2 here.
No positions in stocks mentioned.

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