A Termite-Riddled House: Treasury Bonds

by Gonzalo Lira

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 Obligations”.

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 projections, 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.

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September 3, 2010

Copyright © 2010 Gonzalo Lira