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The New CDO

Summary

Global debt is rising faster than GDP.

The dollar is the reserve currency of emerging markets.

Haven't we seen this before?

“…the unreality of reality” The Great Gatsby

The concept of the Collateralized Debt Obligation (CDO) and CDO2 came to the forefront of investor’s attention in 2008 when enough attention was paid to then to understand the risk instead of assuming the reward. The media, legislators and general public were incredulous when they learned that BBB tranches from one security were consolidated with others to concoct a AAA tranche in a new security. In simple terms, the underpinnings of a newly minted AAA security consisted of BBB securities. The ultimate in the expression someone’s trash is another’s treasure.

This historical aberration is not an aberration, in fact it isn’t even historical. The underpinnings of the emerging market central banks’ financial strength rest with the dollar. A diminution in the dollar’s purchasing power in other currencies and gold could create devaluation in multiple developing markets simultaneously. The International Marketing Fund is exercising the same prudence that the investment banks did while creating a CDO2.

“It is invariably saddening to look through new eyes at things upon which you have expended your own powers of adjustment.” ― F. Scott Fitzgerald, The Great Gatsby

The International Monetary Fund collects data on the financial matters of the world’s sovereign countries. Recent numbers place global debt at $184 trillion or 225% of global GDP. On a per capita basis, it is 2 ½ average household income. Despite a ten year grind out of the Great Recession; 225% of debt to GDP exceeds the peak of 2009 by 11 points.

The dollar acts as a reserve currency (think of it as a substitute for gold) and is held by the central banks of emerging economies. The IMF protects country specific data bit does aggregate the results for 91 countries. This group of 91 countries has approximately $11.5 trillion of reserves in their central bank with about $6.5 trillion in dollars and $2.2 trillion in euros. Thus, the dollar is being looked upon as the stalwart of economic stability for the developing world. Charles Ponzi would be proud.

“All the bright precious things fade so fast, and they don't come back.” ― F. Scott Fitzgerald, The Great Gatsby

Nixon’s abandonment of the gold standard resulted in the dollar being a fiat currency, one that is effectively backed by nothing. The Bretton Woods agreement that set forth that the dollar would be a reserve currency allowed the United States to exploit is economic dominance as much of the developed world rebuilt. The dollar was backed by half of the known reserves of gold therefor it made economic sense to have the dollar the reserve currency. This strong dollar was beneficial when the world was buying from US multinationals but became problematic when the rest of the world entered the global marketplace after rebuilding. The overvaluation of the dollar led to the rational outcome of other central banks selling the dollar by redeeming gold, this resulted in Nixon leaving the gold standard as sovereign financial strength would be the result of economic factors rather than vaults of gold.

You can't repeat the past.”F. Scott Fitzgerald, The Great Gatsby

The Congressional Budget Office predicts that by 2049, the government deficit will be 8.7% of GDP. These numbers are by economists desperately trying not to be alarmist. If we were at that point today the annual deficit would be about $2.0 trillion. Here is a summation of just one of the risks suggested by the forecast:

The projected increase in federal borrowing would lead to significantly higher interest costs. In CBO’s extended baseline projections, net outlays for interest more than triple in relation to the size of the economy over the next three decades, exceeding all discretionary spending by 2046.

The baseline predictions have interest costs greater than any other discretionary spending category. These assumptions do not utilize feedback mechanisms relevant in a complex adaptive system such as the bond market. The dollar will not be able to repeat the past, that would be the best-case scenario.

“…they were a satisfactory hint of the unreality of reality, a promise that the rock of the world was founded securely on a fairy's wing.”F. Scott Fitzgerald, The Great Gatsby

The dollar has been put into the position of being the bedrock of central bank solvency globally. The Japanese Yen and the Euro currently have negative interest rates while the dollar remains the currency of choice over the other two. Al three are participating in a game that will end badly. As the central banks of the developed countries pump liquidity into their economies in order to obtain muted growth yet inflated asset prices, there will come a day when more liquidity is no longer the answer. These countries are now addicted to low rates because of ever increasing government spending and the collection of tax receipts eventually correlated to increased asset prices. Higher interest rates will raise interest expense while decreasing asset prices. The traditional cycle that led to a tightening of monetary supply to cool off a heated economy has been replaced with cutting rates at stock market highs to grow at 2-3%.

The United States has a $20 trillion economy therefor 3% growth is $600 billion. The government is going to run a larger deficit than the growth of GDP. The argument can be made that there is no growth absent government spending. The CBO must believe this as their numbers raise the deficit in parity with the dollar growth of GDP. Are we really a no growth economy masquerading as a low growth economy?

“Reserving judgements is a matter of infinite hope” F. Scott Fitzgerald, The Great Gatsby

As the reserve currency of the emerging markets, the dollar is supposed to maintain purchase power parity with other developed countries. If that is not the case, the holders of the dollars as a reserve currency are becoming poorer. The assumption that the dollar will always be the world’s reserve currency is common wisdom. We have led ourselves to believe that other countries will not judge the efficacy of maintaining dollars in the central bank and have borrowed from the constituents that our currency is supposed to backstop in a world economic crisis. The new CDO2 is emerging market currency backed by the United States dollar.