A Termite-Riddled House: Treasury Bonds

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When termites eat your house, you don’t notice a thing. You
don’t hear a thing, you don’t see a thing – you’re
house stands there, silent and staid, while you and your family
happily go about your days, without a care in the world –

– until your house crashes on top of your head.

Right now, we are at a stage where Treasury bonds are as weakened
as a termite-riddled house. They look fine: Nice glossy coat of
paint, pretty shingles, bright clear windows, sturdy-looking plankings
on the open-aired porch.

But Treasuries are well on their way to a complete collapse. Why?
Because of the way they have been mishandled and mistreated by the
Federal Reserve Board, and the U.S. Treasury. Whether by incompetence
or by design, U.S. Treasury bonds have become the New & Improved
Toxic Asset. The question is no longer if they will collapse –
it’s when.

Let me explain why.

First of all, what exactly were Toxic Assets – does
anybody remember? I do: They were bonds made out of bundles of dodgy
real estate deals. They didn’t seem dodgy at the time. What’s
that old expression, “safe as houses”? At the time they
were made, those bonds seemed safe as houses. Now we call
them “Toxic Assets” – because now, we know better.
But back then – before they collapsed – they were
called “Mortgage Backed Securites”, or “Commercial
Mortgage Backed Securites”, or else “Collateralized Debt

Essentially, all these sophisticated-sounding terms were to emphasize
that the bonds were secured loans – the houses and commercial
real estate were supposed to back up these debts. If the payments
failed, the properties could be confiscated and auctioned off. So
the bonds would be repaid. So the bonds were safe – safe as
houses. Or so it was thought.

Of course, we saw how that show ended.

For those who missed those exciting episodes, a recap: Sub-prime
mortgages began to default first, as the economy slowed down. This
in theory should not have affected Mortgage Backed Securities based
on those sub-prime loans. But the real estate which had been purchased
with sub-primes weren’t worth what they had been purchased
for – they were worth much less. So the bonds backed by the
sub-prime loans began to explode.

Soon after the sub-primes, alt-A loans and prime loans, and finally
commercial real estate – their prices all began to collapse,
and so the bonds manufactured out of these loans also began to explode.

All those banks holding all those “safe as houses” MBS’s
and CMBS’s and assorted CDO’s all of a sudden found that
those bits of paper were not safe as houses. They were so un-safe
in fact, that the banks damned near went broke – they would
have, too, if it hadn’t been for the Fed and the Treasury,
who bailed them out: The Treasury with TARP (cash), the Fed with
“liquidity windows” (more cash).

But even that didn’t work – so we got “extend
& pretend”, whereby the accounting rules were suspended
in order to create the illusion of solvency among the TBTF (Too
Big To Fail) banks. (My discussion of that
is here
.) That’s how bad the Toxic Assets were.

The reason these debts became “toxic” was that it became
obvious in 2007–’08 that those bonds would never be repaid.
They couldn’t be repaid: The properties which backstopped
the value of the bonds had fallen irretrievably in price –
or more properly, the real estate bubble which had goosed the valuation
of those properties to absurd, Tulipmania levels had finally burst.

So even if the real estate was foreclosed and sold at auction,
the holders of these now-Toxic Assets would only receive a fraction
of the nominal price of the bonds. What had once been worth 100
was now worth 80, 60, 40, and in some cases, Cop Snacks.

I’ve never liked the term “asset”, when discussing
bonds. They’re not “assets” – they’re debt.
They’re a loan. And a loan only has value so long as it’s
being repaid. If the debtor defaults – or tries to pay back
the loan with something of less valuable than what was originally
lent out – then this “asset” becomes a loss.

So to prevent these catastrophic losses, Backstop Benny –
Ben Bernanke, Chairman of the Federal Reserve – essentially
did the ol’ switcheroo on the Toxic Assets: In order to save
the banks whose balance sheets depended so heavily on these now-dead
turds, the Fed purchased the Toxic Assets at their nominal price.
Then the banks – the so-called Too Big To Fail banks –
took that cash and purchased U.S. Treasury bonds.

I have yet to find a better chart than this
one here
, that describes so succinctly how the Fed expanded
its balance sheet to bail out the banks. (Hat tip Ashley Huston
at WSJ.com: Alex Lowe designed the chart, based on reporting by
Phil Izzo – extra-special kudos to them both.)

Meanwhile, the U.S. Treasury, in its attempts to finance bailouts,
stimulus, health care, Social Security, and endless pointless wars,
went into further debt – to the tune of $1.4 trillion dollars,
roughly 10% of U.S. gross domestic product, for both 2009 and 2010.

Or to put it another way – a very scary way – in both
2009 and what’s projected for 2010, the Federal government
has issued $1 of Treasury debt for every $1 of tax receipts. Between
the actual budget deficit, plus Social Security liabilities, the
U.S. Federal government is in the hole for about $13.5 trillion
– or roughly 100% of GDP: That is what the Federal government
owes. And if 2011 continues to be the same (as is almost certainly
to be the case), then another $1.5 trillion or so (give or take
a couple of hundred billion dollars) will be added to that tab.

All told, the United States will have a fiscal-debt-to-GDP ratio
of 100% this year, and 110% next year – if not higher, depending
on the tax receipts in 2011. A lot of wishful thinking is going
on for 2012, but the way the numbers are playing out, another trillion
dollars’ worth of debt is very likely in the offing –
which would put the total fiscal-debt-to-GDP ration to 120%.

(Funny: That number – 120% – reminds me of something
. . . what was it? Oh! Right! Greece! This past spring, Europe
had a medium-sized meltdown when Greece – roughly 2% of the
EU as measured by GDP – revealed it was running a 120% fiscal-debt-to-GDP
ratio. The Europeans and the IMF finally caved and bailed out Greece.
Ah, the Greeks! But I digress, sorry – after all, the United
States is not Greece. The United States has absolutely
nothing in common with Greece – not at all! First of all,
buddy, and for your freakin’ information, the United States
is roughly 45 times the size of Greece, and . . . oh . . . wait
a sec . . . )

Let 2012 take care of 2012 – right now, September 2010, we
have 100% fiscal-debt-to-GDP, in an environment of falling tax receipts
and more strains on the various social safety nets. Right now, we
have debt matching tax receipts dollar-for dollar. Right now, the
interest on the outstanding debt, for 2010 according to government
, is $375 billion – in other words, 25¢
of every dollar of tax receipts goes to pay interest. Right now,
with recent economic numbers, the likelihood of a turn-around are
unlikely – so because of the inevitable political pressure
come the winter, more “stimulus” is likely in the offing.

Meaning more Treasury bonds, floating out into the market.

But who is buying all this new Federal government debt? Why, that’s
very simple: The Federal Reserve.

the rest of the article

3, 2010

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