Debt Tsunami Not a Serious Threat

It looks like in the next few years newly issued Treasury and agency guaranteed residential mortgage debt may create a debt tsunami that will swamp the economy. Fortunately, looks can be deceiving.

While interest rates are likely to rise for both long maturity Treasury notes and bonds and agency guaranteed residential mortgage debt, rising rates are not because of a lack of investment demand or failing confidence in the U.S. Government. Instead, as I have written for months, the all-in cost of capital for most domestic institutional investors is higher than the net yield on Treasury and agency guaranteed mortgage debt. The inability of domestic institutions to earn a profit at current interest rates isn’t the same thing as a lack of desire, capacity or confidence.

But of course yields are too low for private market investors to make money. After all, since December the Federal Reserve has been executing a program of open market purchases of Treasury and agency guaranteed mortgage debt designed to drive interest rates below market clearing yields. So, it shouldn’t be a surprise that among private investors there is an upward interest rate drift that can only be offset with more aggressive Federal Reserve intervention.

Private institutions can’t make money buying Treasury and agency guaranteed mortgage debt because the operating expenses of most institutions are very close to the investment yield on the Treasury and agency guaranteed mortgage debt. Unless the Federal Reserve is somehow able to magically force operating expenses of domestic institutions downward, market clearing yields are going to rise. At higher interest rates the private market won’t have any trouble absorbing the forward calendar of debt issuance.

To understand whether or not the volume of newly issued debt will swamp investor demand each type of debt needs to be broken down and analyzed individually and compared to sources of investment liquidity.

Residential Mortgage Debt
The amount of new mortgage debt isn’t a problem because basically there is no net new mortgage debt being created.

There are two ways to create new mortgage debt; (i) refinance existing mortgage debt and (ii) finance home sales.

Refinancings, by definition, result in a repayment of old mortgage debt held by investors. For every dollar of refinanced mortgage debt that is issued there is a dollar of old mortgage debt that is retired. As a result, old mortgage debt investors receive cash that they recycle into newly created mortgage debt (or other investments like Treasury securities).

Mortgage debt created by home sales falls into two categories: new home sales and sales of existing homes.

The proceeds from purchase money mortgage debt created from sales of existing homes generally are used to pay off mortgage debt of the selling home owners. So, mortgage debt created through existing home sales is like refinancing debt, generally it doesn’t create net new mortgage debt.

If for some reason the debt tsunami worriers are agonizing about increased mortgage debt created from new home sales that should be the least of their concerns. If new home sales weren’t stuck in the mud there wouldn’t be a credit crisis or a deep recession which are the underlying causes of the debt tsunami. The United States should only have the problem that new home sales are so high it isn’t clear how they are going to be financed.

Treasury Debt
There is plenty of demand for long term Treasury notes and bonds, just not at current interest rates. The natural buyers for Treasury debt are domestic banks, thrifts and insurance companies. These institutions have more than $1 trillion of excess liquidity which continues to grow every day. The pool of domestic cash sitting on the side lines gets bigger every day because of a combination of increased U.S. savings and accommodative Federal Reserve policy.

However, domestic financial institutions are sitting on the sidelines and not buying. The problem is that domestic financial institutions know that they can’t make money buying Treasury securities at current interest rates and no matter how much they would like to own long term Treasury notes and bonds they can’t invest.

When interest rates on long term Treasury debt rises above 5% domestic institutions will start to be large scale buyers. These institutions will start to make a reasonable profit without taking on unreasonable risk or leverage from purchasing long term Treasury notes and bonds.

Debt tsunami worriers need to pick something else to anguish about, at least for a while. Obviously, the current deficits can’t last forever but they aren’t in danger of swamping the economy for a long time. And, interest rates are inevitably going to rise but then again long term interest rates aren’t being set by the marketplace. Rising interest rates aren’t a source of worry but rather the beginning of the end of the great recession.

Comments

[User 143167:]

It is not a serious threat to the debt repayment as long as the government explicitly back it, but it IS a serious threat to your currency instead.

Jun 05 11:07 AM

[rogersails:]

"As a result, old mortgage debt investors receive cash that they recycle into newly created mortgage debt" . Really ? This is a big assumption.

Jun 05 11:25 AM

[Moon Kil Woong:]

It is not just the Federal government blowing up the inflationary cycle. It's the Fed financing Fannie Mae and Freddie Mac and $8 trillion in debt instruments, dropping Fed Fuinds rates to zirp forever, and expanding thei balance sheet to $2.2 Trillion and counting. All in all they have spent the entire Federal budget for 2009 and then sum in inflationary pressure.

So you are right, it's not long term Federal debt we should be concerned about as much as a mad Fed with no government oversight. Ben Bernake is following in the Footseps of Greenspan in making a mockery ourt of the thing we call US currency and the US monetary system.

Jun 05 01:20 PM

[whidbey:]

That is certainly a rosy scenario Mark, however it does not hang together, your glowing generalities notwithstanding. High interest rates hold down growth and equities, and there is no sign that we can pay for our social programs in the out years without a trillion dollars a year more revenue from taxpayers. Long term interest rates are set by the marketplace - if the Treasury wants to sell them. Do they have access to your insights at Treasury?

Does your logic always resemble chopped liver?

" Obviously, the current deficits can’t last forever but they aren’t in danger of swamping the economy for a long time. And, interest rates are inevitably going to rise but then again long term interest rates aren’t being set by the marketplace."

Jun 05 02:55 PM

[Jasper M:]

And in related news, bullets aren't dangerous. Xeno's paradox tells us that they can never really reach you, thus, we are all immune. Yay!

Jun 05 05:38 PM

[PainfullyAware:]

I thought Russia had some issues with Not being able to service their debt in the late 1980's. Isn't this a similar concern with the US since our "Representatives" decided to disregard the Math of Economics.

I do not see Debt as a bad thing UNTIL the self reinforcing cycle of Default And Loss Dominoes get enough momentum.

The "Producers" are under assault because Nefarious Shenanigans required Tax Payer Money to keep them hidden from view. If we were operating in an "Honorable" System where you reap the benefits or detriments of your decisions I might agree with you. However we have crossed over to something more sinister and the "Rot From The Inside" will eventually erode the structure to the point of "Reorganization".

There is more than just "Debt" helping our demise; it is only one factor.

Jun 05 05:44 PM

[Between The...:]

Interesting theory. Geithner's prescription for countries in fiscal distress when he was at the IMF was to raise interest rates to encourage investors to hold debt in the local currency. Yet the Fed feebly tries to hold interest rates down while promising not to monetize the debt. Is this contradictory behavior?

Jun 06 12:34 AM

[American in...:]

Japan did all things you mentionned for an entire decade without creating a surge in inflation. In fact, the Lost Decade was deflationary.

As John Maynard Keynes would have said, "You are the slave of defunct monetarist philosophers."

Monetarism is a rule of thumb that holds only when the velocity of money is stable. However, the velocity of money has been skyrocketing and hence the rule of thumb is invalidated.


On Jun 05 01:20 PM Moon Kil Woong wrote:

> It is not just the Federal government blowing up the inflationary
> cycle. It's the Fed financing Fannie Mae and Freddie Mac and $8 trillion
> in debt instruments, dropping Fed Fuinds rates to zirp forever, and
> expanding thei balance sheet to $2.2 Trillion and counting. All in
> all they have spent the entire Federal budget for 2009 and then sum
> in inflationary pressure.
>
> So you are right, it's not long term Federal debt we should be concerned
> about as much as a mad Fed with no government oversight. Ben Bernake
> is following in the Footseps of Greenspan in making a mockery ourt
> of the thing we call US currency and the US monetary system.

Jun 06 08:58 AM

[Fred Voetsch:]

"It looks like in the next few years newly issued Treasury and agency guaranteed residential mortgage debt may create a debt tsunami that will swamp the economy. Fortunately, looks can be deceiving."


I remember hearing this exact same type of comment back in 2007 about subprime. I still recall hearing everyone on Fast Money talking about how it had only taken a few weeks and the problem was over.

The problem now is that we know the big banks can't fail because the debt has been transferred to the taxpayer. THAT is now the problem and the average tapayer already had too much debt.

This suggests a zombie economy for years and years to come and given that the stock market is still above historic fair value and overpriced based on any historically relevant valuation, I expect to see bear market rallies that sucker in investors for years to come. I will finally go long for good once the majority of people won't go near the stock market.

Jun 06 03:24 PM

[Gregman2:]

Thanks for this--your basic premise is enlightening, however, the debt tsunami may be less about mortgage debt than other forms. Unfunded liabilities and various long-term obligations indicate that systemically we're under water. But, a little sunshine here and there is good.;-)

Jun 06 05:42 PM

[Living4Divi...:]

Japan and US are not comparable.
Japan was a net creditor. US is a net debtor.
Japan is an net exporter. US is a net importer.
Japan had extremely huge asset inflation (TSE up to PE of 60, One block of Tokyo worth one US City) - US had merely huge asset inflation
Japan handled their problem differently then we are.

Japan and US are not comparable, our fates will not be the same.

On Jun 06 08:58 AM American in Paris wrote:

> Japan did all things you mentionned for an entire decade without
> creating a surge in inflation. In fact, the Lost Decade was deflationary.
>
>
> As John Maynard Keynes would have said, "You are the slave of defunct
> monetarist philosophers."
>
> Monetarism is a rule of thumb that holds only when the velocity of
> money is stable. However, the velocity of money has been skyrocketing
> and hence the rule of thumb is invalidated.

Jun 09 06:15 PM

[austrian63:]

Agreed. The same "experts" who are now telling us "green shoots' are everywhere and we can truly vastly inflate the monetary base when booms created by vastly increasing the monetary base become busts and therefore we can prevent recessions forever, never saw the economic slowdown that started in 2007 coming.

The fact they are now telling us to (1) not worry about currency devaluation and (2) the U.S. national debt is not close to being a burden on the domestic and world economy, confirms my very cautious outlook of slow to no growth for the next decade. A reduction in the rate of economic contraction is not growth but the "market" has been treating as such.

Strap on your selt belts for the next wave of insolvencies.


On Jun 06 03:24 PM Fred Voetsch wrote:

> "It looks like in the next few years newly issued Treasury and agency
> guaranteed residential mortgage debt may create a debt tsunami that
> will swamp the economy. Fortunately, looks can be deceiving."
>
>
> I remember hearing this exact same type of comment back in 2007 about
> subprime. I still recall hearing everyone on Fast Money talking about
> how it had only taken a few weeks and the problem was over.
>
> The problem now is that we know the big banks can't fail because
> the debt has been transferred to the taxpayer. THAT is now the problem
> and the average tapayer already had too much debt.
>
> This suggests a zombie economy for years and years to come and given
> that the stock market is still above historic fair value and overpriced
> based on any historically relevant valuation, I expect to see bear
> market rallies that sucker in investors for years to come. I will
> finally go long for good once the majority of people won't go near
> the stock market.

Jun 17 01:04 PM

[GFive:]

Umm, is this a joke?

Your whole argument about Treasuries is that there is $1 trillion in domestic reserves sitting on the sidelines.

In case you hadn't noticed, our wise & benevolent government is burning through a $2 trillion dollar deficit. Per year.

Even with the demand from foreign state banks trying to keep their currency pegs, it's a stretch to say there is enough appetite for Treasuries at the current rate they are getting printed.

Higher rates will allow them to tap into a larger share of the pool of money that is still out there. However, once the pool is exhausted if the government is still spending far beyond it's means then rates go up exponentially. There simply won't be anyone with money left to buy our debt no matter what rate is printed on the certificate.

The fact that even cheerleader Bernanke has publically expressed concern should be a clue that it is probably already too late.

Rates will start to go exponetial soon & foreign currency pegs are going to get blown away. Bernanke might monetize some more debt to slow it down, but it's not a pretty picture. At what price will treasuries be selling for before a Democratic congress with a Democratic president signing every spending bill into law realizes they need to REALLY cut spending?

Jun 18 01:42 PM