Loans to Congress: The Untold Debt Story

Includes: TBT, TLT
by: Zachary Scheidt

What if I walked up to you this afternoon and asked you personally for a loan? I know, we probably haven’t met and already you are uncomfortable with my overt start to our conversation. But let’s run with this for a few minutes… Assuming you had the money to lend, and I appeared to be a legitimate borrower with every intention to repay the loan, you might actually consider the transaction. After all, loaning someone money can be a benefit to both the borrower and the lender – I would have the capital needed for whatever project I was undertaking, and you would negotiate a reasonable return for the capital you trust me with.

Treasury securities are not all that different. In fact, a good friend and colleague of mine likens treasury liabilities to Loans to Congress. Essentially, buyers of these securities are allowing the US government to borrow capital, and Congress is the body primarily responsible for spending that money. So let me pose my original question to you from a different standpoint. If your congressman walked up to you this afternoon and asked you personally for a loan – would you consider lending him money? Would your answer change if he offered the full faith and credit of the United States as a guarantee on your principal? Well, many investors today are saying “yes” to this request – possibly without fully understanding the risks involved.

Three Considerations for Lending Money

When loaning money to an individual – or for that matter when loaning capital to a corporation – there are three primary categories that must be analyzed in order to make a rational decision. Banks perform this type of analysis all the time as part of their underwriting process. In order to distribute capital, lenders should look at the borrower’s position on these three factors.

  1. Revenue or Income – What type of cash inflow is expected to be used in order to repay the loan?
  2. Fiscal Strength – What shape is the borrower in financially – what assets and liabilities should be considered?
  3. Ongoing Expenses – What level of operating expenses or household spending is in place and how will that affect repayment?

As far as revenue or income is concerned, I would likely be a decent credit risk. I receive a monthly check from a publishing company which has employed my services to write a series of financial newsletters. I own an investment advisory which yields and increasing amount of revenue, while also performing some consulting work on the side. It makes for a busy life, but a lender would see a diverse and stable source of revenue which would certainly be attractive.

Looking at Uncle Sam, the revenue base is more complicated. Currently, the Internal Revenue Service (IRS) is dealing with low receipts as the economic recession has caused both businesses and individuals to earn less and therefore pay lower taxes. Now Congress can easily pass laws requiring higher tax rates (and I believe we will see this as a trend over the next several years), but that strategy can be self-defeating. Not only could citizens and businesses move offshore to countries with better tax rates, but heavy taxation can also lead to frustration where employees and employers alike simply do less business because there is less incentive to succeed.

The Issue With Printing

Now when we talk about our Loans to Congress (Treasury Securities) most people feel relatively safe because the notes are backed by the full faith and credit of the United States of America. Even if the economy tumbled to the point where revenues were cut in half – or by 80%, the US could still print the money necessary to pay for the treasury liabilities. So we are secure knowing that even with a worst-case scenario, the income stream can come from the printing press.

OK, let’s assume I made the same argument to a banker when I was applying for a loan. ”Sir, I have an off-set printer in my basement that can turn out genuine $100 bills and while I don’t intend to make use of this, you should know that if my revenue decreases I will resort to printing these bills and you will still get paid.” Of course this is highly illegal (and for those spoofs out there reading, I actually do not have an off-set printer in my basement. But even stepping away from the legality of the situation, why would that be such a bad idea? Why is printing money illegal in the first place?

The act of illegally printing money can have a devastating effect on the local or even national economy. As cash floods the system, the laws of supply and demand come into play. More cash chasing fewer goods leads directly to inflation. It’s not a theory, it’s a fact! As this money circulates, the value of each dollar will decline. The US government places a high priority on guarding against counterfeit money as a means of protecting the integrity of our currency.

But in our Loans to Congress example, the government is essentially making the other side of the counterfeit argument. ”If we get into trouble, you can rest assured that we will simply print more cash in order to make sure that you get paid.” Why is that not comforting?

Fiscal Strength

Moving on to our second metric worth considering before making a Loan to Congress, we want to look at the fiscal strength or balance sheet for anyone we lend money to… If you were looking at my personal finances, you may have been comfortable with the income side of my equation, but the balance sheet may paint a different story. As a dad with six kids and some medical issues in the family, we have accumulated a bit of debt from hospital admissions, surgical procedures, and medical specialist consultations. On top of that, we have the mortgage on the house, and a mortgage on a rental property.

While the family is making progress working down these balances, the numbers would be enough to cause a banker to raise his eyebrows and consider charging a higher interest rate. After all, the more debt that is on our balance sheet, the more risk the bank is taking. The only saving grace for our family would be the progress we have made over the past few years in decreasing those liabilities.

As we look at the balance sheet for Uncle Sam, the picture is much different. Not only do we see an eye-popping number eclipsing $10 trillion dollars, the level of indebtedness continues to rise at an alarming rate! This week the Treasury Department is scheduled to sell more than $80 billion in notes and bonds to the general public as part of its ongoing funding process.

In addition to the explicit debt in the form of outstanding treasury securities, the US government has made enormous agreements to backstop financial and industrial institutions which still have a very real risk of failing. The FDIC has a $500 billion dollar credit line which it can borrow from the Treasury should it need additional capital and many of the stimulus and rescue programs of the past year have included Treasury guarantees on loans and asset values.

The fiscal strength of the US government is not in a state that should make lenders feel comfortable. Ironically, we are currently operating in an environment where yields on treasuries are some of the lowest in history. Investors are flocking to the “relative safety” of treasuries because the risk in other asset classes is high. Unfortunately, the risks in Treasuries are masked, but still significant.

Ongoing Expenses

The final issue that a lender should consider before making a Loan to Congress, or a loan to any other applicant, is the level of ongoing expenses which must be paid. After all, as your borrower is paying his expenses, there needs to be enough cash left over to eventually pay off the loan.

On a personal level, my household would likely have a difficult time meeting standards in this regard. With my oldest turning 10 last month, there is less than a decade until the college expenses start to hit. And with my youngest two just turning a year old (twins), it is likely that quite a few dollars will go to the hallowed halls of many of this nation’s higher education institutions. Top it off with five weddings to pay for (yes, David has five little sisters), I am basically out of luck when it comes to long-term expenses.

Turning to Congress, the picture doesn’t get much brighter. We are in the middle of a raging debate over health care and how much responsibility should be taken on by the government. Health care costs have been rising sharply over the last several years (rightfully so considering the advances in medicine and what we receive for these costs). At the same time, the current population is entering a demographic phase where there will be significantly higher need for long-term medical care.

At a time when we can ill afford to debate this issue, it appears that the US government will begin spending billions (if not trillions) to ensure health care is provided to every citizen. Now don’t get me wrong, I’m a compassionate guy and want the best for each of our countrymen… But from a financial perspective, we are running into some pretty serious challenges.

Add to that, the cost of social security which is the biggest (legal) Ponzi scheme in history, and you have a recipe for disaster. The young and emerging workforce paying into the system will not be able to keep up with the withdrawals from retirees and within the next few years, this source of government funding will quickly become a net exporter of money. So the long-term prospects for government expenses makes for a dismal picture and it is difficult to rationalize lending money to this type of institution.

Alternative Capital Allocation

So what is the solution? What should investors who need stability and income do? Well, unfortunately, there are precious few “good” solutions right now when you consider the risk and potential return for investment capital. But I do think that long-term treasury securities are some of the most dangerous vehicles to own for the reasons mentioned above. Eventually when rates are ratcheted higher and lenders require a higher return for the risk of 30 year treasuries, the face value on these Loans to Congress will drop significantly and cause huge losses for many who believed they were in “safe investments”

Instead, I would consider very short-term treasury securities and bank deposit products (FDIC insured of course) for capital that you simply must have protected. Over time, it makes sense to diversify into resource rich investments including precious metals, commodities, and foreign currencies with higher yields. While these asset classes may sound more risky, the benefit of diversification, coupled with a conservative approach can actually add stabilization to your true purchasing power or real net worth.

Gold and silver have had a sharp run in recent weeks and while I like them as investments for a long-term approach, there may be some weakness in the coming few weeks as investors take profits. Using pullbacks to slowly add exposure can be a conservative way to approach these trending markets.

Similarly, commodities have volatility, but can offer stability. Aside from hiring a commodities broker, you can also look at individual equities which have exposure to the agriculture, energy, or metal prices. Many of these investments can be in blue chip names that actually pay healthy dividends and yield capital appreciation. This can be significantly better than the tiny yields currently paid on treasury securities.

Finally, foreign currencies can offer diversification and better returns. Consider the Australian dollar. The country recently increased its equivalent of the Fed Funds rate, and Australia is rich in natural resources. This bodes well for its currency which is holding up strongly against other currencies despite our turbulent markets.

The bottom line is that when you make an investment (whether in treasuries, metals, commodities, equities – or loaning capital to an individual or business) you need to understand the risks and potential rewards. Loans to Congress have underlying risk that may not currently be priced by the market. Having a defensive approach to your investments may include a more diversified approach – after all, you are the one who has to live with the risk and return for your own investments.

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