US Debt Downgrade – Let’s Get Real!

The topic de jour on the cable ‘news’ outlets is a possible downgrade of United State Treasury debt. Granted the antics in congress are sophomoric at best and certainly cause for concern, but to worry much about a possible downgrade of US debt is even more absurd.

First, the ratings agencies have a woeful track record of actually making any calls with respect to bond ratings of publicly traded companies. Where was S&P and Moody’s when Ernon collapsed? Why did so much toxic mortgage debt that led to the credit crisis in 2007 and 2008 receive a AAA stamp of approval from these same agencies that now threaten to downgrade US Treasuries? Why were the ratings agencies asleep at the wheel when AIG went so deep in the red that the US Government had to step in and bail them out? It is hard to see how these agencies have any credibility left. Perhaps this is just their way of inserting themselves into what is basically a political discussion, or maybe they have been wrong so often they feel a need to generate publicity for themselves.

Secondly, the US debt problem is not one of the ability to pay, but rather a political posturing for an upcoming election. Take a look at the following chart of countries that currently have AAA ratings for their sovereign debt.

Countries with AAA rating

	GDP (Billions)	Public Debt	Public Debt as % of GDP
United States	$ 14,720.00	$ 8,670.00	58.9%
Australia	$ 889.60	$ 199.27	22.4%
Austria	$ 332.90	$ 234.36	70.4%
Canada	$ 1,335.00	$ 453.90	34.0%
Denmark	$ 204.10	$ 88.99	43.6%
Finland	$ 185.40	$ 89.73	48.4%
France	$ 2,160.00	$ 1,814.40	84.0%
Germany	$ 2,951.00	$ 2,213.25	75.0%
The Netherlands	$ 680.40	$ 439.54	64.6%
Norway	$ 276.40	$ 131.84	47.7%
Singapore	$ 292.20	$ 299.21	102.4%
Sweden	$ 354.00	$ 144.43	40.8%
Switzerland	$ 326.90	$ 130.76	40.0%
United Kingdom	$ 2,189.00	$ 1,674.59	76.5%
Total Ex US	$ 12,176.90	$ 7,914.27	65.0%

You should note that the United States GDP is greater than the GDP of all other AAA rated countries combined. The US debt as a percentage of GDP is less than the weighted average of all the other countries and is about the midpoint of this group.

Now ask yourself which of these counties you would trust more than the US to lend your money to. Some on this list are just too small. Those in the European Union have their own debt woes via the weaker partners in the EU (Portugal, Ireland, Greece, and Spain) and there is some concern about the stability and permanence of the Euro itself. Some say China is the next world economic power. But even after a decade of break neck growth, the GDP of China is yet only a third that of the US. Besides who would trust their money to a state controlled economic system where wealth can be wiped out by fiat and true economic growth is questionable.

Finally, consider what alternatives a global investor has. There is not enough liquidity for the global economy to function without the US. Regardless of what the rating agencies threaten the US dollar and by extension US Treasuries, have always been and will likely continue to be for the foreseeable future, the de facto safe haven of the world. There is no country with the economic or military might to unseat the United States at the present time. When the going gets tough, everyone still turns to the United States as a refuge and looks to the United States for leadership. If US debt were downgrade to AA it would make no difference whatsoever. In the long run, all other debt is valued in relation to US debt. Sure maybe there would be a week or two of confusion, but in the end, regardless of the ranting of debt ratings agencies investors have voted with their pocketbooks that the United States is the premier credit on the face of the planet, and that should be enough.

Understanding Money Supply and the Federal Reserve

I have to disagree with the talking heads I've seen on television recently, warning investors of hyper inflation. According to these 'experts' a serious bout of inflation is imminent due to the tremendous injections of liquidity by the Federal Reserve. I believe these pundits are overlooking one of the most basic factors in economics and I fear some of the talk is more politically motivated than financially motivated. While it is true that the Federal Reserve has been pumping money into our economy, the important thing these pundits miss is the 'why'.

There are two components to the effective money supply in the US economy. One is the amount of cash flowing through the economy, and the second is the velocity of the cash flowing through the economy. Of the two, the velocity of money is the more important.

If you studied economics is college you will recall that the velocity of money is normally a function of bank reserve requirements, which are set by the Fed. Simply put, if the reserve requirements are set at 20% then each dollar does the work of five dollars (100/20). If the reserve requirements are set at 10% then each dollar does the work of $10 (100/10).

I say under normal conditions because what we have seen during this credit crunch is anything but normal. Usually banks lend as much as they are allowed to lend based on the reserve requirements. That is how they make profits. However, because of loose lending standards in the past and questionable reserves, lending in our economy has slowed to a virtual crawl. Couple this decreased lending with increased reserve requirements for non bank financial entities such as Merrill Lynch, Morgan Stanley, and Goldman Sacks and you have created a serious speed bump for the velocity of money in our economy.

As lending contracts, the velocity of money in our system contracts. Because velocity is usually a multiplier of the physical currency in circulation any contraction in velocity reduces the effective liquidity in our economy many times.

The Federal Reserve's policy of providing liquidity to our ailing economy is not currently inflationary, it is simply an attempt to offset the slowing velocity of money. Without this infusion of liquidity there is a real danger of deflation, which is much harder for the Fed to fight than inflation. It is easier to slow the economy down than it is to speed the economy up.

The Federal Reserve will need to be vigilant as the economy eventually improves. The liquidity injected into the system could become inflationary as the velocity of money through our economy accelerates. But that won't occur until the credit crunch abates, which is a problem we would all like to see come sooner rather than later. Until then investors should not be overly concerned with inflation. Coming to the party too soon is nearly as bad as staying too late.

Understanding The Credit Crunch - Part 2

An earlier post Understanding The Credit Crunch remains one of the most widely read entries on this blog. The fact that many are still grappling with how we got into this predicament, explains how exasperating the problem is. The Federal Reserve has been aggressively lowing interest rates, opening the loan window to more firms, and accepting more collateral in an effort to stem the damage. The problem has spread well beyond the sub prime sector with the auction rate preferred market freezing up and municipal securities falling in value being examples of just how far the credit crunch has spread.

To briefly elaborate on my previous post, the problem stems as much from leverage as it does from credit quality. Margin requirements, which are determined by the Federal Reserve, allowed hedge funds and other institutional investors to borrow against their bond holdings and leverage their investment to many times their invested capital. Just like in the 20's, as long as prices rose the leverage allowed for much more profit. However, when prices began to fall it was like someone shouting 'fire!' in a crowded theater, everyone rushed for the exits at the same time and many were trampled in the stampede.

You probably can understand leverage best by thinking of your own home. Most people have seen the price of their home go up substantially over the last decade. Yet the long term compound increase in the median home price has averaged a little over 6% a year. How can so many people make so much money in real estate if prices only rise about 6% annually? The answer is leverage. If you had bought a home 10 years ago for $100,000 and it appreciated at 6% then today it would be worth about $179,000, a profit of $79,000. But you were unlikely to pay cash for your home. Instead you put down 10% or $10,000 and borrowed the rest. So that means your cash investment grow from $10,000 to $79,000 for an annual return on invested capital of about 23% a year! Nice work if you can get it.

As long as prices rise your leverage works hard for you. But woe to those who buy at market peaks. If your home falls by 10% you have lost all of your equity. Any further decrease leaves you underwater on your 'safe' investment. This is what has happened to many homeowners, and it is the same problem in the credit markets. The leverage has wiped out the equity of many aggressive investors, forcing liquidations which suppresses the prices of those securities and causes the liquidation of even more types of investments, in a vicious circle that has threatened to cause a collapse of the banking system.

That is why the Federal Reserve stepped in to work out a deal for Bear Stearns, if BS had gone into bankruptcy is could have caused a collapse of confidence in an already shaky system and led to a total collapse of our banking system. That the Fed has taken such extraordinary steps is a testament to just how serious this problem has become.

Fortunately, at least some in our government and in governments around the world understand how dire our circumstances are and have begun to take the concerted steps necessary to bring balance back to the global banking system.