In a world of indecision and timidity Moody Investor Services has taken a bold and decisive stance (please note the sarcasm)…after years of recession, fiscal irresponsibility, political corruption, and cronyism they have decided to place the credit rating of US Government debt on review. The timing just happens to be right before the government has to make a big decision on the debt ceiling. Moody’s has taken the bold stance that if the US defaults they may downgrade our debt…way to go out on a limb guys. Normally I’d just ignore stories like the one that hit the screen today, but in the digital age information can spread rapidly and I thought I’d provide some clarification before this story got out of hand. Moody’s said that the US has been placed on review for possible downgrade because there is a possibility that the debt ceiling won’t be raised in time and the Treasury will default.
There are a few funny things going on here. First is the timing…which is obviously aimed at prodding politicians into getting something done. The second is the logic being used…” we are going to downgrade the U.S. if they don’t raise their debt ceiling”. In other words…if you don’t borrow more money we are going to downgrade you. I understand what Moody’s is saying, but on a fundamental level how much sense does this make? Moody’s thinks we are in terrible financial shape and the only way they see to keep our high quality credit rating is to borrow more. This is like the cops at a DUI check point telling you “unless you drink a few more beers we’re gonna give you a ticket.”
I’m not at all concerned about the US Treasury missing a payment on an obligation…in my opinion that is a zero probability scenario. However, I understand that everyone on this distribution list is sure to get some questions on this topic over the next few weeks and I thought I’d provide some ammunition to help you answer these.
A CFO’s survival guide
Over the last few years we’ve fielded the following question in one form or another “is FNMA/FHLMC/US Treasury going to default?” Today’s article from Moody’s will only serve to increase the number of phone calls you get from directors and shareholders on this topic. These inquiries will likely be of two types…the first will be concerned and very interested in hearing your answer, the second will be in a near-panic and frantically seeking your answer. Given the probability of you having to field such phone calls I wanted to provide a primer/refresher on the topic of “Why the GSE’s/Treasury won’t default”. I’ve answered the question so many times that it prompted a Market Update piece in March of 2010 which I’ve attached for reference.
Much of the attached write-up centers on the GSE’s…but the U.S. Treasury is even higher on the totem pole so anything you read about the importance of the GSE’s will count doubly so for the U.S. Treasury. Without much further intro…here is the write up from back in March of 2010 that discusses the likelihood of a default by the GSE’s…if you have any questions just let me know.
Steve Scaramastro, SVP
800-311-0707
March 2010 write up
Why Barney Frank is wrong…and I am right
Barney, Barney, Barney…today Mr. Frank is in “fear monger” mode. I don’t know if he is trying to flex a little muscle to get some attention or if he is trying to prove that ignorance truly knows no bounds inside the halls of Congress. This morning he made a statement to effect that the future of Fannie and Freddie debt holders might involve haircuts or bonds not being paid back at all.
Mr. Frank either doesn’t understand the nature of the global financial system, or he’s willing to look like a complete buffoon to get some attention.
Before anyone gets too worked up about Barney’s statements let me point out a few facts, and then we’ll look at why we will never see anything like what he just mentioned.
In the beginning
Fannie and Freddie were created by the by the government, they were allowed to trade in the market with lower risk premiums due to their quasi-government nature (the implied full faith and credit), and they were mismanaged by the government (think “congress appointing their cronies to positions within the GSE’s and forcing them to lower their lending standards and help create this mess in the process”). They have become so large that their debt is distributed throughout the global financial system, and I don’t know of a single bank in this country that doesn’t own their paper. If you buy bonds and you don’t own GSE paper then you are in an exceptionally small minority of institutions. Another material point is that they currently have “unlimited” lines of capital from the US Government. The government owns responsibility of the GSE’s…Barney Frank can’t come out and say he’s bailing anyone out by allowing the GSE’s to meet their commitments. The politicians created the mess at the GSE’s and they are responsible for cleaning it up.
If Mr. Frank thinks that he has the ability to force a “haircut” on the holders of this paper then he needs to be tested for drug use right now. This is a move that would destroy much of the US banking system virtually overnight…it would also extend to foreign countries…some of whom own a tremendous amount of our debt and who would quite willingly punish us by dumping it on the market and causing interest rates to skyrocket.
Secondary effect
Any failure to pay 100% principal WILL result in a downgrade. There is no way around it. Fannie and Freddie would be immediately downgraded to “D” by the ratings agencies. Now a “D” in high school was a passing grade for me…but for the GSE’s it stands for “Default” and it occupies the absolute lowest rung on the credit ratings scale. This downgrade would cause a massive secondary effect.
To help you visualize the impact of a downgrade I’d like you to think back to all of the Gulf War footage we got to see on TV. Footage where an F15 Strike Eagle drops a laser guided 500 lb. bomb right on top of a tank…you get the initial explosion which is pretty impressive, but then you get what is called a “secondary”. The “secondary” is where the fun really starts…it’s where all of the fuel and ammo that was onboard that tank blows up as a result of the first explosion. The secondary is what spreads the damage far beyond what would have been done by the initial impact.
The secondary effect from any failure to pay on the part of the GSE’s will come right after the downgrade. Every bank in the country that owns this paper will have an immediate and ginormous loss that runs straight through to capital. If you have 30% of your assets in the portfolio and 80% of that goes into default you’ve got a real problem. Imagine the impact to capital if you have to mark all of your Agency debt from 100 down to say…20.
Your losses will be compounded because you’re not allowed to own “D” rated paper which means you will be forced to realize the loss by selling it. When you go to sell your junk bonds you’ll quickly realize that a crowd has formed because everyone is selling their bonds. More and more people sell which pushes prices lower and lower in what is commonly referred to as a fire-sale. The GSE market will spiral into the deck where it will leave a giant smoking crater similar in size and historical significance to the meteor impact that killed the dinosaurs (I’m watching a lot of Discovery Channel lately so please forgive the analogy). And this is just the impact on the domestic banking system.
Now look at the situation faced by foreign central banks. Some of these folks are ALREADY talking about selling US Securities…this type of action will solidify and accelerate those plans. This will add even more selling. “Panic selling” doesn’t really begin to describe that activity that will be taking place at this point. I wouldn’t expect US Treasuries to be the safe haven after this. I don’t think investors will continue to view debt from the same folks that just blew up the financial system with the GSE default as “safe”.
If you’d like to take it further you could even move on to how many American citizens would have their retirement savings wiped out by this move. It will be tough to get reelected after you torpedo the entire country’s banks, jobs, and retirement dreams. Feel free to come up with some more and shoot them back to me…the possibilities are almost endless.
And do you think anyone would be willing to buy a US “Housing Finance” bond EVER in the future after this fiasco?
Prove it
Lest you think I am merely being an alarmist look at the “secondary effect” we got from the failure of Lehman Brothers. Lehman is a much smaller institution than the GSE’s yet their demise pushed the US financial system to the verge of collapse. When the powers-that-be decided that Lehman was where the bailouts stopped it set in motion a very unintended set of consequences.
Lehman’s default shook the foundation of our economy because their debt was widely held by money market funds. Money markets are tremendously important pools of capital that provide the liquidity for our economy. These funds are the oil in our economic engine. When Lehman defaulted it caused losses in money market funds. Money market funds aren’t supposed to “do” losses. You put a dollar in and you get a dollar out. If you get less than a dollar than the fund “broke the buck” as we say. Breaking the buck is the death knell for a money market fund. So Lehman caused a lot of losses for money market funds. Losses were so widespread that concern that began as a ripple from a corporate bond default, then formed waves, which in turn became a tsunami.
Half of the liquidity in money market funds in the country was poised to leave OVERNIGHT. The sell orders were on the books and ready to be executed when the firms that run the order books raised the alarm. Treasury got a phone call describing the carnage that was about to unfold and they immediately put a Full Faith and Credit Guaranty on all money market funds to avoid the panic. Think about that for a moment…they let Lehman fail and in turn were forced to insure all money market funds in the country against loss. This huge impact was just from the default of a single corporate issuer…Lehman Brothers. This example should provide some very recent insight into what type of events can be triggered by a default of a big institution. If Lehman can do that much damage just think of what the GSE’s hold in store.
In summary
SO…the GSE’s fail to pay or force a haircut, they kill most of the banks in the country in the process (through OTTI capital write-downs on their GSE debt), they anger foreign central banks to the point that they sell their holdings partly out of self-defense and partly as a punitive measure, the secondary effect that we love so much roils through to the rest of the investing world in the form massive liquidations in response to the downgrade to “D” and giant swathes of the American public see their retirement portfolios wiped out.
In my opinion there is nobody in politics that is going to light the fuse on that scenario. If your goal were to destroy the US economy and set us on an equal economic footing with say…Kurdistan…then I’d say it’s a good plan. Short of that…ain’t gonna happen.
I believe that my view on the GSE’s is far closer to reality than Mr. Franks’. It seems to me that the most likely scenario is that existing debt of the GSE’s gets “grandfathered” into a Full Faith and Credit status, then they can re-invent the GSE’s and release them into the wild as healthy institutions whose debt going forward will have a much clearer status.
This allows you to avoid nuking the financial system, and at the same time privatize a function that should have been private this entire time anyway. It moves a few trillion worth of obligations onto the Federal balance sheet but hey…that doesn’t seem to bother anyone nowadays.
Wrap it up already
In summary the GSE’s do not have the ability to miss a payment or force a haircut on bondholders. The markets seem to agree with this assertion as well…they are unmoved by Barney’s blabbering today. Don’t lose any sleep over the misguided ramblings of one Congressman.
I’m sorry if I’ve gone on longer than you or I wanted…but I can get passionate about these topics. Halfway through this piece it began looking more like a manifesto of some sort rather than a market update but some things just need to be said. In my view it is pure ignorance for someone of Frank’s stature to be spouting off in such an irresponsible manner on a topic like this. I can only imagine the phone calls his secretary is fielding this morning…most of them from people far more important than me. “Congressman Frank you’ve got Bernanke on line 1, Geithner line 2, Obama line 3, and some fixed income guy from Memphis on 4…”
I hope everyone has a great weekend. If you have any questions or if there is anything I can be doing for you just let me know.
Steve Scaramastro, SVP
800-311-0707
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