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BubbleOmics: U.S. Treasuries are Not a Bubble, Federal Debt Target 150% GDP

Interest-Rates / US Bonds Mar 22, 2010 - 03:34 AM GMT

By: Andrew_Butter


Best Financial Markets Analysis ArticleLast September I started jumping up and down crying “US Treasuries are a Bubble – TAKE COVER”.

I was wrong, now I’m biting my tongue…What Was I THINKING???  I’ve been slowly going through a 180 Degree change of mind over the past six months which cumulated in about February (just as the whole world started to say that US Treasuries were a bubble).

Here’s is where my thinking is now:

We have all seen the underlying chart – but what’s interesting to me is the ratio of Private to Federal debt in USA.

When Private Sector debt takes off, the “Value Added” generates lots of tax, so the Federal government can coast along building nice things like underpasses for turtles and financing covert operations to “Keep Americans Safe”.
Look at the ratio in 1933 or so, back then Private Sector debt was 7.4 times Federal Debt (plus or minus).  And look at that, in 2008, BINGO the magic 7.6 or thereabouts was hit and then…. BOOM!!

So if history repeats (it doesn’t always, but it’s always good to bear that possibility in mind), then expect Federal Debt to go up by the same amount to its peak as it did before, that’s as the mal-investments in the private sector from the crazy (private-sector) lending get washed out of the system.

And Oh MY!!!

Oh My, Oh My!!…like you are sitting on the top of a roller-coaster….is THAT the amount of de-leveraging that’s going to occur?

Let’s hope history does not repeat!

Of course then (1) the Central Bank stood back an “watched” as the de-leveraging started to happen and made things worse (some people say), by starting a trade war, this time it’s different (perhaps).

In which case perhaps what will happen is that around the time private sector debt gets down to 200% of GDP (i.e. it drops by about $20 trillion), the system will “re-boot”.

I suppose we are half-way there in the sense that line for private sector debt presumably assumes “face” value (like if someone’s going to pay it back), the good news is that out of the $20 trillion of private label bonds issued over the past ten years or so, it looks like easily half of them are not going to get paid back (that’s the beauty of non-recourse lending), so once those losses are acknowledged (the extend and pretend can’t go on forever), well, we will be almost half-way there.

The bankers etc might argue a bit about that logic, but the reality is that if you hold a note on a loan that is not going to be paid back, that’s not an “asset”, that’s toilet-paper.

In which case, perhaps “history will repeat” at Point [A].

Or there could be a war – some historians say that the reason the Japanese attacked Pearl Harbour was the result of a trade war between USA and Japan, well there is one of those on the horizon, certainly if the Nobel Laureate who was advocating a housing bubble as the cure for all America’s ills in 2000, has say in the matter.

The of course there is Iran and the possibility of a $300 oil price (and a chance to find out in both cases just how effective Russian-made 3M-82 Moskit anti-ship cruise missiles (NATO designation: SS-N-22 Sunburn), really are).

In that case well it could be Plan B.

There again now USA is at war, albeit this time against a broadly “unseen” threat, although the $3 trillion that some people say will have been spent by the time that’s over is not an insubstantial amount of money to borrow, and the way things work, well that could easily be $5 trillion by the end of hostilities (40% of GDP right there).

That’s of course if America wins the war!

My opinions by-the way on the cost/benefit analysis of that enterprise, in which my own country (Once-Great Britain); was convinced by the self-serving lies of Tony Blair to join in-on, are summarized here:

On that note, I’d just like to remark the old days you used to go to war for plunder (slaves, dancing girls, and gold), these days, well, I’m not quite sure…but what I really want to know is “where are the slaves and the dancing girls my taxes paid for?”

Anyway – back to the real world, what happened in USA was the following:

Once Upon A Time:

In the “olden” days people buying bonds were the most boring people in the world, I know that because my brother was (still is) one of them, and talking to him about his job is about as thrilling as counting sheep, or it used to be.

In those days the people buying bonds were basically pension funds and insurance companies, that had predictable liabilities in the future (everyone dies eventually), which they covered by buying bonds; so they didn’t really care that the yield was not that sexy, and in any case, the government required that they hold a certain proportion of their assets in bonds.

Then what happened was in about 1987 they changed the rules so that you could hold a AAA rated “private label” bond instead of a US Treasury and get more or less the same risk weighting (A US Treasury has a 0% risk weighting, a “private label” gets 20%, which is one reason the yield is more than the equivalent Treasury).

Then the Fun REALLY Started

Some “clever” bankers worked out that you could borrow short-term and buy that Private Label stuff, and make a margin on the difference in the yield. Clever Eh!!

And thanks to the 20% you could theoretically gear that 49 times, so even if you were talking about really small spreads, multiply that by 30 or 40 which is what Lehman etc did, and you are making money for nothing (and dancing-girls for free).

So instead of boring old farts from Pension Funds and Insurance companies being the market for bonds, where they would basically buy them and hold onto them for thirty years, the market filled up with “thrusting” young-blood, clamouring for more and more bonds so they could do their little magic trick turning water into gold.

Another word for that is that the market-place filled up with speculators.

That’s what causes bubbles…that’s called BubbleOmics 101.

Of course they had all sorts of “hedging” and “risk management” strategies to prove that they were in fact adding some economic value, and that what they were doing was “safe”, but in reality they were just gaming a hole in the system, for their own gain, and destroying economic value (and a good part of what once made America great), in the process.

And to keep playing the “game” they needed more and more AAA cannon-fodder, and so there was this huge push to manufacture, more and more. And guess what?

Predictably, quality standards slipped, and there came a time when you could slip a “friendly” rating agency half a million dollars and they would stamp their AAA “opinion” on just about anything, even a bottle of melamine tainted milk.

So that’s pretty standard BubbleOmics, people were paying too much for stuff, much too much.

Now everyone realises that stuff is not worth what they paid for it, nothing new about that, the “malinvestments” from the past are getting slowly…ever so slowly separated out of the system.

According to “The General Theory of BubbleOmics”, since it took about ten years for all of those malinvestments to be made, it’s going to take 10 years for them to clear, like up to about 2020.

On the other hand the really bad bubble was from 2005 to 2008, so perhaps by 2012 everything might get back to “normal”, depending on how long everyone goes on extending and pretending.

In the mean-time the boring old pension funds, insurance companies and SWF (they are basically pension schemes), are still going to want to buy (real) AAA debt, and they don’t want  any of that toxic rubbish with an opinion from a firm that is proves to be a bunch of whores, they want the REAL stuff.

And that’s all they are going to be buying until at least one of the morons on the sell-side of the securitization business realises that “you can fool some of the people some of the time but not all of the people all of the time”, and starts to release the information to the buyers so they can do their own due diligence.

Until then, don’t expect US long-term treasury yields to go up much.

Unless of course nominal GDP ticks up, but there’s not much chance of that with all the de-leveraging going on, so don’t hold your breath…more like “Hang On” while the roller coaster goes where roller coasters go next.

By Andrew Butter

Twenty years doing market analysis and valuations for investors in the Middle East, USA, and Europe; currently writing a book about BubbleOmics. Andrew Butter is managing partner of ABMC, an investment advisory firm, based in Dubai ( ), that he setup in 1999, and is has been involved advising on large scale real estate investments, mainly in Dubai.

© 2010 Copyright Andrew Butter- All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

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