In today’s Markets and Money, your editor cops a hiding from friends and foes alike for his callous, insensitive, and sub-human views on taxation. Plus, Merrill’s David Rosenberg warns that chances of a re-test of the March lows are “non-trivial.” And Russia warns of energy wars to come.
First though, if you think Australia’s entry into-deficit land doesn’t eventually threaten its credit rating, let us take you back to the quiet London conference room of a hedge fund, circa 2003. Your editor was in the small crowd, along his friend and author Addison Wiggin, listening to an informative speech by a U.S.-based analyst on the “duration gap” between Fannie Mae’s short-term liabilities and its long-term assets.
It may not sound that exciting, but what transpired over the next thirty minutes was a real eye opener. The analyst pointed out that if you borrow short-term and lend long-term, you expose yourself to changes in interest rates. You may have to refinance your debt at much higher interest rates, while the value of your long-term assets falls.
This was a problem, for the GSEs, the analyst insisted, because their assets-residential U.S. mortgages or mortgage backed securities-paid off over their long-term while their liabilities-the bonds they issued to finance their purchases of mortgages in the secondary market-were short term.
Even though the GSEs enjoyed lower borrowing costs than other corporate borrowers because of their implied U.S. government guarantee, he said, they would face higher borrowing costs if interest rates spiked. If that were to happen, the GSEs would likely be unable to grow their balance sheets or earnings. When your business is essentially borrowing money to buy mortgages, higher interest rates not only make borrowing more expensive, they also (as we’ve seen lately) affect the value of your assets. Higher interest rates meant death for the GSE growth model, he predicted.
For the GSEs, the rest has been history. While the financial media were busy glorifying the results of the bogus stress tests last week, Fannie Mae quietly reported a $23.2 billion first quarter loss (this followed a $25 billion fourth quarter loss). It also asked the government for another $19 billion in ‘capital’. The company said, “persistent deterioration in housing, mortgage, financial and credit markets continued to adversely affect our financial results.”
To his credit, the analyst in our London conference room saw all of this coming. After his presentation we stuffed a few canapés in mouth and asked him this question, “If what you said about the GSEs is correct, and the U.S. government is forced to make its implied guarantee of GSE debt explicit, wouldn’t the increase in Federal liabilities threaten the U.S. credit rating? After all, you’re talking several trillion dollars [at the time] in GSE debt. That would be a big increase in government liabilities.”
“Oh. Well. Gee. I don’t know about that. I mean, if that happened it would mean….well…it would mean…”
“The end of the dollar standard and the end of the dollar as the world’s reserve currency?” we helpfully suggested.
“Well, yes,” he chuckled. He seemed to regain his composure. “That’s highly unlikely. I mean, that’s a major development. It would be a big deal. That probably wouldn’t happen. It can’t, really.”
“But isn’t what you’ve just described exactly the sort of thing that could damage a country’s credit rating?”
“Yes. But like I said, it’s unlikely. I have to go.”
Remember, that was before GSE liabilities exploded and the U.S. government-through the Fed and the Treasury-piled on trillions in new liabilities to deal with the global financial crisis. Fast forward to IOUSA star David Walker’s article in Tuesday’s Financial Times.
“Long before the current financial crisis,” Walter writes, “a little-noticed cloud darkened the horizon for the US government. It was ignored. But now that shadow, in the form of a warning from a top credit rating agency that the nation risked losing its triple A rating if it did not start putting its finances in order, is coming back to haunt us.”
Moody’s rating service warned last January that if the U.S. government made no policy changes with regard to Social Security and Medicare, “we would have to look very seriously at whether the US is still a triple-A credit.” At the time, Moody’s said that “look” would come in ten years time. But we reckon with the huge explosion in U.S. liabilities via the TARP and the budget deficit, that look may come sooner rather than later. And when it does, all bets about the value of U.S. liabilities (bonds) are off.
Here in Australia, the three credit ratings agencies (Moody’s, Fitch, and S&P) say the prospect of a $58 billion Federal budget deficit doesn’t threaten Australia’s credit rating. Not yet it doesn’t. But don’t be surprised if the question comes up later this year.
We suspect that government tax takings will be smaller than the budget forecasts. And the budget assumes the economy will have “above trend” growth of 4.5% next year. And of course, no one is planning for a government-bailout of commercial property, residential mortgages, or the corporate bond market.
Maybe all that seems a little far-fetched right now, especially when Aussie companies have been successful at raising new capital through the equity markets and the private bond market. But in 2003, a roomful of investment professionals and money managers found it hard to believe the credit quality of the U.S. government was at risk from growing deficits. They were wrong, and those deficits are much worse now. That’s the fate Australia wants to avoid.
With debtor governments tapping the global savings pool to rebuild public and private balance sheets (or just hand out money) it reminds us of another idea we discussed in London in 2004: that energy is becoming a kind of capital. Russia’s new National Security Strategy reaches the same conclusion.
The Kremlin’s policy paper says, “The international policy in the long run will be focused on getting hold of energy resources including in the Middle East, the Barents Sea shelf and other Arctic regions, the Caspian and Central Asia.” It then added, rather ominously, “Amid competitive struggle for resources, attempts to use military force to solve emerging problems can’t be excluded.”
Energy wars can’t be excluded. But for equity investors-and just for the people of the planet-it would be better if oil stocks rose because the market was bidding up the oil price as opposed to, say, a border war in one of the “stans” over oil and energy.
And as we’ve written in our “Long Aftershock” report, there are plenty of structural reasons in the oil market (collapsing capital spending in 2008) to believe an oil supply crunch is around the corner. Either way-macro-economically or geopolitically-the stars are aligned for higher oil prices. Naturally, NYMEX crude oil prices fell to just under $58 in New York trading on Wednesday.
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