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Investors Lose Confidence in the US Government

Interest-Rates / US Debt Oct 15, 2011 - 10:47 AM GMT

By: Dr_Jeff_Lewis


The equity markets staged a rally on Monday, with a buying spree that was largely seen as a response to European fears. Quietly, the same investors who purchased corporate stock on the open markets moved out of other investments, primarily Fannie Mae and Freddie Mac securities.

The move was noteworthy because Fannie and Freddie paper has long been seen as nothing more than another US Treasury obligation. After the fall of Lehman Brothers, the United States announced that it would guarantee the debts of the two largest government sponsored entities. Thus, “too big to fail” was born, and government sponsored entities now had a pad of blank checks from the US Treasury which could be drawn at any time against the taxpayer.

In 2009, the decision by the federal government was enough to encourage plenty of confidence. Investors reasoned that a guarantee to pay the surplus of the losses from Fannie Mae and Freddie Mac was, as any rational person could conclude, the same as owning a similarly structured debt from the US Treasury. Besides the fact the debt is one-step removed from the Treasury—the US government would have to balance Freddie and Fannie’s books and then the payment would be made from Fannie or Freddie to investors—government sponsored entities were as good as US Treasury securities.

No Longer

Now that there are renewed fears about a global recession, investors seem unlikely to accept the government’s word at face value. While the government did agree to absorb the losses from Fannie and Freddie regardless of their size, that didn’t mean the government couldn’t back off from the terms.

Investors now fear just that. In the event of a worst case scenario, will the US government stand behind auxiliary debts, or will it allow some debt obligations to be left behind while others are paid in full?

News reports of the dividing line between Fannie and Freddie debt obligations attempt to downplay the disparity. According to mainstream publications, the spread is the result of Federal Reserve bond buying, which tends to pick one debt or the other. The media contends that since the Fed’s efforts are concentrated, the spread is an obvious natural result of major market participation.

Hypothesis Fails to Scrutiny

The suggestion is an interesting hypothesis for the disparity in debt pricing, but it doesn’t make for good science. It especially does not hold to the modern practices of financial modeling, which would never allow an investor to pay more for one future dollar than it would for the same future dollar. A dollar from the US Treasury in the future is a single dollar, it shouldn’t matter how the funds flow.

Besides, given the complexity of the market, and the sheer number of algorithmic traders in the markets, any spread that is unwarranted is annihilated immediately by rapid trading algorithms. If there is a spread big enough to be arbitraged and yet not small enough to ignore, then it comes as a result of risk pricing. Otherwise, the spread would be eliminated, instantaneous profits earned, and the news would go unpublished.

As subtle shifts in confidence trend in a system over-burden with dollar-denominated obligations, we could be witnessing the beginning of a stampede toward the new real ‘modern’ assets: gold and silver.

By Dr. Jeff Lewis

    Dr. Jeffrey Lewis, in addition to running a busy medical practice, is the editor of and

    Copyright © 2011 Dr. Jeff Lewis- 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.

© 2005-2019 - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.

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