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  • U.S. Government Debt - The Ultimate Subprime Loan (Part 3)

    U.S. Government Debt – The Ultimate Subprime Loan (Part 3)



    Nathan Kawaguchi


    In Part 1 of this series, we covered why we believe U.S. Government debt closely resembles the subprime loans that sparked the financial crisis of 2008-09.  In Part 2, we addressed the question of, “Who will finance this massive debt?”  Now in this third and final part of the series, we will look at what investors can do to protect themselves against the potential consequences of this problem.


    Before we discuss what we can do to protect ourselves, we must first understand the range of possible outcomes.  In all of our research, we always begin with the idea that there is a range of possible outcomes and each of those outcomes has a probability of actually materializing.  As an extreme example, there is a possibility that a giant meteor crashes into Earth tomorrow and causes worldwide destruction.  However, we would assign a very low probability to that event.  There is also a possibility that the sun will rise in the east and set in the west.  We would assign a 99.9% probability to that event.  We do not assign a 100% probability because there is a remote possibility that the magnetic polarity of Earth suddenly reverses.


    The potential problems we see related to U.S. Government debt may never materialize.  Maybe the United States will enter an age of unprecedented prosperity and we will easily manage all of our debts.  While that is possible, we simply don’t assign a very high probability to that scenario.  And perhaps foreign countries will allow us to devalue our currency and continue to finance our deficits with no problems.  This also has a very low probability.  We also see a low, but slightly higher probability for historically low interest rates over an extended period.


    We believe there are three main consequences to the U.S. Government debt problem, all of which are interrelated.  These are a lower (devalued) U.S. dollar, higher inflation and higher interest rates.  In our view, higher interest rates will be the most likely outcome for which we will have to prepare ourselves.  However, let’s go over some possible solutions to each of these problems.  Remember that the consequences are interrelated, so these solutions could apply to multiple outcomes.


    To protect ourselves from inflation, investors could buy hard assets such as gold, oil, other raw commodities and real estate.  Investors could also purchase securities of companies that own these hard assets.  However, there are a couple problems with buying hard assets.  The first is that most hard assets don’t produce any recurring cash flows (an exception being real estate), so how does an investor figure out what hard assets are worth (and subsequently, how does a value investor buy something at a discount which cannot be valued)?  Secondly, if we experience high rates of inflation, how will we know which specific assets will be impacted, and by what degree?  People usually think of inflation in a very broad sense, but inflation certainly impacts different assets at different rates over different periods of time.  Just look at the market cycles of gold, oil, sugar, real estate and others.


    Investors could also buy Treasury Inflation-Protected Securities (OTC:TIPS).  There are a couple problems with TIPS, but the main issue we have is that TIPS are adjusted according to official CPI numbers, just as cost-of-living-adjustments on retirement benefits.  We are highly skeptical of the inflation numbers reported by the government.  And we are not alone on this issue (see


    To protect against a weak U.S. dollar, investors could buy foreign currencies, assets denominated in foreign currencies, securities of companies that own assets denominated in foreign currencies and securities of companies that earn profits in foreign currencies.  However, we run into the same valuation problems with currencies that we do with hard assets.  What is a currency worth?  We could examine purchasing power parity data, but that tells us nothing about the future of a currency.  What if other countries have similar problems to those here in the U.S. (which many older, developed Western nations do, by the way)?


    To protect against higher interest rates, investors could buy adjustable rate or floating rate debt, and short-term debt that can be reinvested at higher rates later.  Adjustable rate or floating rate debt would be good choices as long as the issuer can support the higher interest payments.  And holding short-term debt and cash is substantially similar to holding adjustable or floating rate debt as it is later reinvested.


    We must admit that for the first time ever, we are seriously considering the possibility of owning hard assets for which we have no way of valuing.  In doing so, we realize that we are, in part, speculating.  Therefore, if we choose to go down that path, it would only be with a small portion of our capital, perhaps 10-20% at most.  We have already, and will continue to look for opportunities to diversify our securities into companies that earn profits denominated in foreign currencies.  But for the substantial majority of our investments, we will continue to do what we have always done.  We will hold cash while we search for undervalued opportunities.  We know of no better way to protect purchasing power than to buy significantly undervalued securities in companies that are able to pass higher input costs along to their customers.  Finding such opportunities requires hard work and patience, both of which we have ample supply.

    For more insight and other investment research, visit us at

    Disclosure: No positions
    Mar 03 4:18 PM | Link | Comment!
  • U.S. Government Debt - The Ultimate Subprime Loan (Part 2)

    U.S. Government Debt – The Ultimate Subprime Loan (Part 2)



    Nathan Kawaguchi



    In Part 1 of “U.S. Government Debt – The Ultimate Subprime Loan,” we covered the various factors that lead us to believe why the government debt of the United States could potentially be much worse than the subprime loan problem.  In this article, we will address the question of, “Who will finance this massive debt?”


    As estimated in Part 1, we believe that we will have to finance approximately $4.4 trillion in 2010, $2.034 trillion in 2011, $939 billion in 2012, and well over $1 trillion per year thereafter, in a combination of refinancing upcoming U.S. Treasury security maturities and new financing of estimated budget deficits.  That is a lot of debt to finance at a time when the strength of the dollar and American economic dominance are being questioned.


    If we are to finance this debt rather than raise taxes and/or devalue (inflate) the dollar, then we can either finance our debt internally or we can look to foreign investment.  We will first look to our foreign neighbors who have financed a large part of our debt thus far.


    According to the U.S. Treasury, foreign investments in U.S. Treasury securities increased from $3.0 trillion to $3.6 trillion between November 2008 and November 2009.  That is an increase of roughly $600 billion.  The largest holders of our government debt are China and Japan.  During that time period, China’s holdings increased $77 billion (from $713 billion to $790 billion).  Japan’s holdings increased $132 billion (from $625 billion to $757 billion).  Other top holders including U.K., Oil Exporters, Caribbean Banking Centers, Brazil, Hong Kong, and Russia collectively increased holdings by $237 billion (from $839 billion to $1.076 trillion).


    According to the U.S. Census Bureau, we have been running an average savings rate of 2-3% here in the U.S. over the past decade.  This rate increased in the past six months to 4-5% in response to the economic crisis.  These savings rates were on disposable incomes that have averaged around $10 trillion over the past few years.  These savings can find their way into U.S. Treasury securities through various conduits such as mutual funds, insurance companies and other financial institutions.


    Now we will make some generous assumptions for those who have doubts about our perspective.  If we assume that foreigners continue to be willing and able to finance our debt at current levels, then they should be able to absorb approximately $600 billion per year.  And assuming that U.S. citizens continue to keep savings rates elevated at 5% on roughly $10 trillion of disposable income, we should be able to absorb an additional $500 billion.  We consider these assumptions to be generous because other countries are facing similar challenges to ours and there is no guarantee that disposable incomes and savings rates can remain elevated here in our difficult domestic economy.


    This leaves us approximately $2.9 trillion short in 2010 and $900 billion short in 2011.  This means that the Federal Reserve (the lender of last resort) will likely need to step in and purchase almost $4 trillion of U.S. Treasury securities over the next two years and monetize the debt.  Those who understand the fractional reserve banking process will quickly recognize the inherent danger of such actions.  The Federal Reserve has already doubled the size of its balance sheet over the past year to over $2 trillion.  Our current problem could easily more than double it again from current levels.


    Of course, these are generalizations and the mechanics could certainly work out differently.  For example, the Federal Reserve has been buying more mortgage securities lately, which provides foreign holders and financial institutions liquidity to soak up the new U.S. Treasury securities (this is effectively swapping mortgage debt for government debt).  The velocity of money could remain low for an extended period, which could reduce the threat of inflation.  However, a further decline in global economics could lead to another wave of risk reduction, which could widen interest rate spreads again and move money from corporate and other debt into government debt.  With all of the “what-ifs,” we believe our overall point is made clearly.


    Another potential problem could come from an increase in interest rates.  Increased rates could come simply as a function of supply and demand forces.  They could also come in the form of a risk premium required by investors who may question dollar-denominated assets.  A rise in interest rates would place additional pressure on our budget deficit and could require further debt issuance.


    No matter what happens, we always come back to the most fundamental economic principle: supply and demand.  And we believe there is simply too much coming supply of U.S. Government debt for the amount of demand.  In our next article, we will discuss what we can do to protect ourselves from the potential fallout from this problem.

    For additional insight, visit us at

    Disclosure: No positions
    Mar 02 9:24 AM | Link | Comment!
  • U.S. Government Debt - The Ultimate Subprime Loan (Part 1)

    U.S. Government Debt – The Ultimate Subprime Loan



    Nathan Kawaguchi


    The recent financial crisis is said to have originated with the subprime loan collapse, which later spread throughout the entire global financial system.  The size and characteristics of subprime loans that contributed to the collapse can be found in another widely held investment: U.S. Government Debt.


    Before we get into the specifics of what concerns us, we should let readers know that we are value investors.  We agree with James Grant of Grant’s Interest Rate Observer, who said, “There are no bad investments, only bad prices.”  This is another way of saying that with any investment, we look for a margin of safety to protect us against loss of purchasing power.  We do not believe that U.S. Government securities offer such safety at current levels.  Should inflation and interest rates increase significantly, owners of “risk-free” government debt will find that their investments, in fact, carry much risk.


    Let’s first look at the characteristics of loans that make them subprime.  Many of the troubled subprime mortgage loans underwritten in 2005-2007 were made to borrowers with poor credit history.  This results from either an inability or an unwillingness to make timely payments.  One could certainly argue that the U.S. has a poor credit history.  The difference is that the U.S. has benefited from the kindness of foreigners to refinance its debt and have, at times, opted to “print money” rather than default.  Surely, troubled subprime borrowers would have seriously considered the options to continuously refinance or print money, if given the opportunity.


    Many subprime loans also typically carried variable interest rates or rates that were fixed for a few years before becoming adjustable.  According to the December 2009 Monthly Statement of the Public Debt of The United States, upcoming debt maturities are $2.92 trillion in 2010, $861 billion in 2011 and $708 billion in 2012, excluding non-marketable Government Account Series (NYSE:GAS) debt.  And GAS debt is substantial, as it includes over $4.5 trillion held by Social Security and other government trusts.  All of this will need to be refinanced at whatever the market rate is at the time—just like an adjustable rate loan.


    Some subprime loans were also considered risky because they were not fully-amortized, but instead were made with interest-only payments.  Most bonds make interest-only payments with a balloon principal payment due at maturity.  Government notes and bonds are no different.  Is all of this starting to sound familiar?


    Yet another problem with subprime loans was that many of them had little or no down payment.  And because the housing market was grossly overpriced in many parts of the country, the collateral was of low quality.  Government debt has no collateral—only a promise to pay from the U.S. taxpayers—similar to a promise to pay from subprime borrowers.  This leads us to our next point.  Many subprime borrowers had very high debt-to-income ratios.  Viewed from this perspective, the U.S. has an outrageous debt-to-income ratio that is currently around 100%, and it is expected to run large budget deficits far into the future.


    According to the recent Office of Management and Budget’s estimated Budget of The U.S. Government, deficits are projected to be $1.449 trillion in 2010, $1.173 trillion in 2011, $939 billion in 2012 and around $1 trillion per year into the foreseeable future.  And these figures continue to be revised upward.  Adding these figures to the upcoming debt maturities, the U.S. will have to refinance approximately $4.369 trillion in 2010, $2.034 trillion in 2011, $1.647 trillion in 2012 and well over $1 trillion per year thereafter.  We will save the “Who will finance this massive debt?” question for a later article (along with “What Can Investors Do About It?”).  The point is this is a potentially serious problem waiting to explode.


    Possible outcomes include default, restructuring, devaluation (inflation), higher tax rates, or some combination of these.  Economic prosperity, higher savings rates and increasing foreign investment could also solve this problem, but we shouldn’t rely on these, particularly in a questionable global economic environment where foreign investors are becoming increasingly worried about the U.S. dollar.  If that wasn’t enough, a change in the world reserve currency status of the U.S. dollar during this troublesome period could potentially cause a worldwide depression.


    Readers must be thinking at this point that we are pessimists.  We consider ourselves realists.  As value investors, we are always concerned more with downside risk than upside potential, and we see no larger risk than the U.S. Government subprime loan over the next 5-10 years.

    For additional insight, visit us at

    Disclosure: No positions
    Feb 26 3:50 PM | Link | Comment!
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