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A Credit Downgrade For U.S. May Be Unavoidable

With all the talk of the pending "fiscal cliff" and how to deal with it, little mention is being made of the fact that we are rapidly approaching the current debt ceiling of $16.390 trillion. Our current debt subject to debt ceiling limitations is $16.040 trillion leaving us with a debt ceiling surplus of just $350 billion.

Our budget deficit for 2012 will exceed $1.2 trillion - approximately $100 billion a month. Without Congressional action on the debt ceiling we should run out of money by the end of January, 2013. The confluence of the "fiscal cliff" issues and the debt ceiling dilemma present a particularly troubling matter for Congress in the next few months.

For those who have forgotten, Standard and Poor's issued a credit downgrade for the U.S. in 2011. The debt ceiling battle of 2011 was a precursor to the much more onerous problems facing Congress today. The following excerpt from an article I wrote for the December, 2012 issue of Futures Magazine - Dealing With The Fiscal Cliff Is A "Catch-22" Dilemma - gives an overview of the events leading up to the 2011 credit downgrade by Standard and Poor's:

In 2011 U.S. debt had climbed to the point where it was close to equal total GDP. Deficit spending was out of control and the cost of fiscal stimulus was rapidly becoming a serious problem. The debt ceiling increase was the focal point of a Congressional battle that was bringing the country close to default on scheduled payments for the first time in the country's history. Finally, a compromise was reached and President Obama signed the Budget Control Act of 2011 into law on August 2, 2011 allowing an increase in the federal debt ceiling subject to provisions that would address the debt and deficit in 2013.

Even though the Budget Control Act of 2011 was enacted in time to avoid default, on August 5, 2011 - just a few days later - Standard & Poor s downgraded the United States credit rating for the first time in the country's history. The market's response to the Congressional battle over the debt ceiling and the subsequent credit downgrade resulted in a sharp sell-off in stocks. On August 1, 2011 the S&P 500 closed at 1286. On August 9, 2011 the S&P put in a low of 1101 - a drop of almost 15% in 6 trading days. The following excerpt explains Standard & Poor's reason for the credit downgrade:

"The downgrade reflects our opinion that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics.

More broadly, the downgrade reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011.

Since then, we have changed our view of the difficulties in bridging the gulf between the political parties over fiscal policy, which makes us pessimistic about the capacity of Congress and the Administration to be able to leverage their agreement this week into a broader fiscal consolidation plan that stabilizes the government's debt dynamics any time soon.

The outlook on the long-term rating is negative. We could lower the long-term rating to 'AA' within the next two years if we see that less reduction in spending than agreed to, higher interest rates, or new fiscal pressures during the period result in a higher general government debt trajectory than we currently assume in our base case."

Standards & Poor's assessment proved particularly prophetic as Congress did indeed struggle to reach a broader accord. After several attempts to reach agreement the final version of the Budget Control Act specified an initial debt limit increase in two phases totaling $900 billion. In exchange for the concession on the debt ceiling the bill specified a total of $917 billion in spending cuts over 10 years.

An additional provision of the Budget Control Act allowed the President to request another increase in the debt ceiling of $1.2 to $1.5 trillion subject to a congressional motion of disapproval. In exchange for the additional increase provision the Budget Control Act called for spending cuts equal to $1.2 trillion, again spread out over 10 years.

The Joint Select Committee on Deficit Reduction, more commonly referred to as the "Super Committee" was formed to identify specific spending cuts equal to the $1.2 trillion debt ceiling increase provision. The "Super Committee" was a bi-partisan committee and after months of work trying to agree on specific spending cuts the committee concluded their work without arriving at an agreement.

The impact of the "Super Committee's" failure to arrive at specific cuts was anticipated. If the "Super Committee" failed to achieve their mandate then Congress could grant the additional $1.2 trillion debt ceiling increase by simply not acting to disapprove the request but in so doing, across the board spending cuts referred to as "sequestration" cuts would be implemented."

The inability of Congress to arrive at a decision in 2011 was part partisan politics and part lack of a viable solution. The assumption that an answer exists for the extraordinary and unprecedented debt crisis we find ourselves in today presumes a solution exists that will work to avoid recession in 2013. Virtually everyone is suggesting that a solution can be forthcoming if only Congress will get to work. What, I ask, is the solution?

This inclination to embrace optimism and ignore the facts in the face of an irresolvable fiscal dilemma is particularly disconcerting to those who see the matter with an objective clarity. A few weeks back I received an e-mail from Stan Crouch that provides a lucid and concise perspective on the mindset that permeates the industry and drives the debt and deficit discussion.

Stanley J G Crouch October 8 at 7:37am

J S,

There is a natural long bias in the markets and in the people who populate the industry. This is a very powerful force which rules all and informs everyone's opinion, including the political class and the Fed.

Trust me...It is pointless to argue with a generation and Industry-types steeped in the notion of bullishness borne of their training and conditioning.

You obviously understand where we are in the long-cycle Credit Bubble's aftermath and what must mathematically occur.


Stan's observations are grounded in reality and present the need for a counterview to the discussion of the "fiscal cliff" and more importantly to the overall debt crisis that is about to overtake us as Congress again grapples with the debt ceiling issue in coming months. The "fiscal cliff" is the focal point for the moment but it is a mere microcosm of the real problem. The real problem is the rapidly accelerating trajectory of the national debt as our government does all it can to avoid recession.

It is an inconvenient truth that the nature of markets include both periods of expansion followed by periods of contraction. Our fiscal and monetary leaders; our financial media sources; and our industry analysts insistence on denying the fact that the contraction phase is just as important to a long term vibrant economy as the expansion phase only serves to magnify the impact of the contraction phase when natural market forces finally overwhelm all other forces and the contraction phase becomes economic reality.

Understanding the nature of the "credit bubble"

The inclination to look at specific market metrics as signs of a recovering economy while ignoring the macro picture is akin to "failing to see the forest for the trees". In recent weeks we have found renewed enthusiasm from improving home sales, increased building permits, upward shifts in retail spending and very modest improvement in unemployment. We are pleased with the fact that a good number of companies are meeting or beating profit estimates. All these positives - however modest - fuel the recovery rhetoric.

However, these arguments ignore a number of major macro dynamics. For instance, there remains a serious problem with "underwater" mortgages despite recent improvement in this area. There are still approximately 10.8 million mortgages that exceed property value. That number represents 22% of the total mortgage market. The total value of negative equity in the mortgage market remains at approximately $689 billion and presents a continuing risk problem to those holding the mortgages. Although at the present time approximately 85% of these mortgage are being serviced in a timely manner a recession would likely result in an appreciable increase in defaults.

To understand the significance of this one must first understand that it was the "housing bubble" that precipitated the "banking crisis" in the first place. The "housing bubble" was nothing more than an easy credit policy that existed in the U.S. for decades. It allowed almost everyone to participate in the "American Dream" by buying a home - with little or no money down in most cases.

When one uses leverage relatively small shifts in asset value can put the owner of that asset in jeopardy. If you buy an asset - a house in this case - for $200,000 and put 5% down on that house and borrow the rest you are using leverage. You control the asset for a mere $10,000.

If inflation drives the value of the house up by 2% in a year to $204,000 you end up with a $4,000 gain on the asset or 2%. However, as it relates to your actual cash investment you made a 40% return since you control the asset for a mere $10,000 of your own money.

That's the good side scenario. What happens if the rush to build new houses to meet increased demand accelerates to the point where the industry overbuilds? At that point an unsold inventory of new houses ends up putting a lid on the appreciation of housing values. Builders begin to lower the value of these new houses to get them sold. Suddenly older houses that people are trying to sell are being listed for less than appraised value as well as they are a part of the housing inventory and must be valued in relation to the newer houses.

The impact to the individual homeowner is that the asset - in this case his house - is now worth less. Assuming a 5% drop in the value of the house, the significance of this downward shift in house value to the leveraged buyer who put up a mere 5% is that the buyer has effectively lost 100% of his investment.

This simplistic analysis of what precipitated the "housing bubble" and subsequent crash in housing prices is only part of the story. It is the "securitization" of mortgages that led to the "bank crisis" and more specifically, the concerted effort on the part of government to include the lower income group in the "American dream" of home ownership.

The legislative actions that led to the "housing bubble" and subsequent "bank crisis" are complex and have evolved over time. It is a subject that requires a thorough presentation to be fully understood but for purposes of this discussion we will focus on just two elements of the "securitization" of mortgages. The first point of focus is the legislation that recognized Mortgage Backed Securities (MBS) as legal investments for banks and equivalent to U.S. Treasury securities:

"In 1984 the government passed the Secondary Mortgage Market Enhancement Act (SMMEA) to improve the marketability of private label passthroughs, which declared nationally recognized statistical rating organization (NRSRO) AA-rated mortgage-backed securities to be legal investments equivalent to Treasury securities and other federal government bonds for federally-charted banks."

Politicians tend to focus blame for the "banking crisis" on the banks themselves and certainly the banks do share a very small portion of the blame. The majority of the blame though must be assumed by politicians. It is hard to argue that the banks encouraged politicians to allow them to make irresponsible, high risk mortgages.

The truth is the politicians encouraged the banks to make these mortgages and in fact they made that a mandate which brings us to the second focal point of this discussion - the move to include all Americans in the "American dream" of home ownership including those in the "low income" category. The Housing and Community Development Act of 1992 set the wheels in motion and directed Government Supported Enterprises (GSE) to expand their mandate to include this "low income" sector:

In 1992, President George H.W. Bush signed the Housing and Community Development Act of 1992. The Act amended the charter of Fannie Mae and Freddie Mac to reflect Congress' view that the GSEs ... have an affirmative obligation to facilitate the financing of affordable housing for low- and moderate-income families in a manner consistent with their overall public purposes, while maintaining a strong financial condition and a reasonable economic return; For the first time, the GSEs were required to meet "affordable housing goals" set annually by the Department of Housing and Urban Development (NYSE:HUD) and approved by Congress. The initial annual goal for low-income and moderate-income mortgage purchases for each GSE was 30% of the total number of dwelling units financed by mortgage purchases and increased to 55% by 2007.

Today we know the outcome of the liberalization of these credit standards but without a crystal ball who could have predicted that these legislative moves would result in a financial crisis of such systemic proportions back in 1992? The answer is that many did in fact see the handwriting on the wall. Consider the following commentary on the subject - all in advance of the eventual collapse:

In 1999, The New York Times reported that with the corporation's move towards the subprime market Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government-subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980s.

Alex Berenson of The New York Times reported in 2003 that Fannie Mae's risk is much larger than is commonly held.

Nassim Taleb wrote in The Black Swan: "The government-sponsored institution Fannie Mae, when I look at its risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup. But not to worry: their large staff of scientists deem these events 'unlikely'.

In his 2006 book, America's Financial Apocalypse, Mike Stathis also warned about the risk of Fannie Mae helping to trigger the financial crisis: With close to $2 trillion in debt between Freddie Mac and Fannie Mae alone, as well as several trillion held by commercial banks, failure of just one GSE or related entity could create a huge disaster that would easily eclipse the Savings & Loan Crisis of the late 1980s. This would certainly devastate the stock, bond and real estate markets. Most likely, there would also be an even bigger mess in the derivatives market, leading to a global sell-off in the capital markets. Not only would investors get crushed, but taxpayers would have to bail them out since the GSEs are backed by the government. Everyone would feel the effects. At its bottom, I would estimate a 30 to 35 percent correction for the average home. And in 'hot spots' such as Las Vegas, selected areas of Northern and Southern California and Florida, home prices could plummet by 55 to 60 percent from peak values.

As it turns out a crystal ball wasn't necessary to see into the future in this case. In fact, well in advance of the collapse in housing that led to the "banking crisis" there were credible warnings of the coming fiasco but as Stan Crouch points out ". . It is pointless to argue with a generation and Industry-types steeped in the notion of bullishness borne of their training and conditioning." The truth is no one wanted to hear these "doomsday" warnings. America was in a bull market - a veritable economic "race horse" - and reining that "race horse" in wasn't about to be considered.

The 2012 "lame duck" session

America has not been this perfectly divided along party lines since the Civil War and that translates to more of the same regarding the debt and deficit - no action. The election is over and it's time to get to work. The question before Congress - what should be done to avoid the "fiscal cliff" and recession?

The answer is that no palatable solution exists. We are going into recession in 2013 regardless of what we do. If we postpone tax hikes and spending cuts we are probably going to get a second credit downgrade. Standard and Poor's has certainly suggested as much:

We could lower the long-term rating to 'AA' within the next two years if we see that less reduction in spending than agreed to, higher interest rates, or new fiscal pressures during the period result in a higher general government debt trajectory than we currently assume in our base case.

At the end of August, 2011 our debt was $14.684 trillion. Today our debt is $16.235 trillion - a 10.5% increase. GDP, on the other hand increased from $15.163 trillion in the 3rd quarter of 2011 to $15.775 trillion in the 3rd quarter of 2012 - a 4% increase.

The facts are simple - our debt trajectory is simply unsustainable. We either go over the "cliff" and into recession by doing nothing or we don't go over the "cliff" and go into recession as our debt soars every higher and our credit rating suffers a further downgrade.

There is even a very legitimate argument for suggesting that the scheduled tax hikes and spending cuts are not enough. Assuming we reduce the deficit - currently running in excess of $1 trillion a year - by the scheduled $600 billion we are still running a deficit of over $400 billion a year and that assumes tax revenues don't fall as we slip into recession.

The "Catch-22" Congress finds itself in combined with the sharply partisan divide in Congress suggests that no action will be taken during the "lame duck" session. The general consensus of opinion is that Congress will take some sort of patchwork "kick the can" approach to the problem but such an approach will do nothing to remedy the problem.

Washington's impotence as markets finally force a resolution

As a nation - and for that matter on a global scale - we have wrestled to avoid the consequence of excess for years. It can be argued that government policy initiatives have been marginally effective but only to the extent that government policy has delayed - not avoided - the ultimate impact of these excesses.

The truth is government created a credit "bubble". The easy money policy put into place by Congressional mandate and built on the back of excess leverage with the Secondary Mortgage Market Enhancement Act and the Housing and Community Development Act of 1992 was a huge mistake. The idea that we could fuel economic growth through use of excess leverage and inflation was a horribly flawed idea.

Politicians on both sides of the aisle spanning a period of at least 20 years bear the responsibility. Attempts to shift the blame to the banks as many in Washington do wreaks of hypocrisy and a blatant refusal to accept blame for the fix we are in today. The truth is our government leaders have failed us and the sooner recognition and acceptance of that fact occurs the sooner we can get on with the process of paying the price for these political blunders.

Rather than act to protect the public against the excess of the private sector - motivated by profit - our government actually promoted and literally mandated that the private sector banking system participate in these excesses. Our political leaders simply ignored warnings from credible sources making no attempt to rein in the excess until it was too late.

Washington's refusal to recognize that we can't build sustainable growth and prosperity solely through a policy of "borrow and spend" has continued since the recession. The inconvenient truth is that there simply isn't a palatable solution.

Today we are at a point where we are damned if we do and damned if we don't as it relates to the fiscal cliff. The preposterous idea that Congress - at this late date - needs to finally get to work and solve the problem presumes a solution that avoids recession.

For decades we have worked to build a "house of cards" with excess leverage. When the "housing bubble" burst we started the natural process of ridding the economy of that excess leverage as we moved into recession. Monetary and fiscal policy initiatives interrupted the contraction phase of the cycle but the fact remains we still have a huge inventory of "underwater" mortgages that continue to weigh on the economy.

We still have work to do to accomplish the completion of the contraction phase of the business cycle. An industry that continues to cling to the idea that a solution exists that will prevent the natural cyclical contraction and deleveraging that must occur is an industry in denial. The markets have been pricing in the inevitable result of a sustained recession since Ben Bernanke announced QE3 on September 13. The recent 300 point sell-off is the worst one day sell-off in a year but it is just a precursor of things to come.