It’s often hard to identify a bubble before it bursts. But the herd mentality of buying bonds, the certainty among so many investors that they were safe (remember “home prices have never fallen” or “the Internet will change everything”?), and the sheer volume of the money make me think it was indeed a bubble, albeit one of the quieter ones we’ve seen. Here’s an astonishing statistic for you: According to growth-fund manager Jim Oberweis, “the roughly $650 billion total [in bond inflows in 2009 and 2010] matched the equity fund net inflow during the Internet bubble period of 1998 through 2000.” So, one buying spree was a mirror image of the other, only a decade later. I’m certainly not expecting anywhere near the selloff we’ve seen in stocks or housing, but I also wouldn’t be surprised to see losses beyond the 9% decline bonds experienced in their worst 12 months. Now, I don’t think investors should panic and dump their bond funds with the same alacrity they bought them. But I do think people should gradually shift bond holdings to shorter maturities, which are less vulnerable to sudden price corrections. And here’s the good news: Kinniry said 95% of the cash flows into Vanguard bond funds went into short- and intermediate-term funds with maturities of five to seven years and less. “We don’t see very much at all in the long-term space,” he added. That, of course, is where the biggest losses can occur. - Howard Gold, What to do before the bond bubble bursts, MarketWatch, January 28, 2011
July 26, 2011
As America debates its debt, its debt ceiling, and the indebtedness of future generations, let’s make sure we all understand what we are talking about. Also, let’s look at an example of how the debt permeates through our society.
Why does the US have debt?
Because the stewards of the country’s Treasury, Congress, spends more than it takes in in tax receipts.
What is the debt?
The US issues bonds, notes, and bills that promise to pay principal and interest at maturity of the issue. The principal is meaningless. A printing machine produces principal to infinity. The interest, on the other hand, is a problem. Almost all of the current debt will have to be rolled over (re-financed) before 2020 at interest rates that prevail at the time of re-issue.
How much is the debt?
Let’s refer to the following website: www.treasurydirect.gov/govt/reports/pd/mspd/2011/opds062011.pdf. As of June, 2011, the official amount of Treasury debt issued is $14,343,088,000,000. In case we have trouble with all those commas, that figure represents ‘trillions’ of dollars in debt.
How much interest expense does the country pay each year on the debt?
In 2011, the US will pay $385.8 billion in interest coupons. That’s down from $413.9 billion paid in 2010 because interest rates have been falling while debt has been rising. In the end, it is not the debt that crushes a nation but rather the interest coupon required to facilitate a growing debt.
We now live in a completely artificial environment whereby the Federal Reserve works to orchestrate a contracting interest coupon so the debt can be perpetuated. Banks make money by lending. The Fed made $90 billion in 2010. That’s more than Exxon and Walmart combined! We can all see who really benefits from massive debt. One can read my article ‘Why US Treasuries Will Eventually Yield Nothing’ to learn more as to why interest coupons will continue to fall.
Who owns the debt?
Here’s where it gets interesting. From the same website as previously referenced, the public owns $9,742,223,000,000 and roughly two-thirds of that is in the form of notes or intermediate term maturities. Another $4,600,864,000,000 in Treasury debt is listed as ‘Intragovernmental Holdings’. Nearly all of that $4.6 trillion is Treasury debt known as ‘Government Account Series’ (GAS) issue.
What’ the difference?
$4,580,584,000,000 of the $4,600,864,000,000 GAS debt is non-marketable. That means there is no market in which to sell this debt. In other words, if Treasuries should begin a bearish trend and sell off, investors that hold marketable Treasuries could sell their holdings to limit their losses. Holders of non-marketable Treasuries cannot.
Who holds non-marketable Treasury debt?
Interestingly enough, US citizens do. The Social Security Trust Fund holds 57% of the non-marketable Treasuries. Federal government employees are tied to the non-marketable debt through their retirement plan with a 17% ownership. Take a look at the following chart.
Explain how federal employees are affected?
Civilian federal employees hired before 1984 were covered by the Civil Service Retirement System (CSRS) and those hired after 1984 were covered by the Federal Employees Retirement System (FERS). Both plans had investible assets directed to the Civil Service Retirement and Disability Fund (CSRDF). This is a defined benefits retirement fund for retired Federal employees. This retirement benefit extended by the taxpayer is structured as an annuity. Like everything for our government employees, a defined benefit plan is the ‘Cadillac’ of retirement plans. According to the Office of Personnel Management (OPM), they estimate the cost of the FERS annuity to be 12.5% of employee pay. The federal employee pays .8% and you and I pay the other 11.7% of that contribution. The federal government makes supplemental payments into the CSRDF on behalf of employees covered by the CSRS because employee and agency contributions and interest earnings do not meet the full cost of the benefits earned by employees covered by that system. But, it is an annuity and it is totally controlled by the government. The government controls the payout. The government controls the allocation of the invested funds. And, the government controls the ownership of the funds. That means the employees have no rights to the money listed in the plan under their name.
This retirement benefit extended by the taxpayer is structured as an annuity. Like everything for our government employees, a defined benefit plan is the ‘Cadillac’ of retirement plans. According to the Office of Personnel Management (OPM), they estimate the cost of the FERS annuity to be 12.5% of employee pay. The federal employee pays .8% and you and I pay the other 11.7% of that contribution.
The federal government makes supplemental payments into the CSRDF on behalf of employees covered by the CSRS because employee and agency contributions and interest earnings do not meet the full cost of the benefits earned by employees covered by that system. But, it is an annuity and it is totally controlled by the government. The government controls the payout. The government controls the allocation of the invested funds. And, the government controls the ownership of the funds. That means the employees have no rights to the money listed in the plan under their name.
What is in the CSRDF?
As the retirement fund of civilian Federal employees, the funds are 100% invested in special-issue Treasury securities that count against the national debt. Contributions to the fund can be, and are suspended when a debt ceiling prohibits further expansion of the national debt. Current investments in the fund are redeemed by the Treasury while contributions are suspended. If and when further governmental borrowing is allowed, by law, the fund is then made whole again.
How much money is in the CSRDF?
According to an article authored by Katelin Isaacs at www2.pennyhill.com/?p=14318, the CSRDF reported a balance of $734 billion at the beginning of 2009. Here’a the part that I like. As with everything in our world today, the CSRDF is unfunded to the tune of $674 billion. It turns out that the CSRS was never funded while the newer and less generous FERS was and is funded. What we have is a dollar figure based on ‘imaginary value’ derived from Treasury note par value.
How is the CSRDF funded?
According to the OMB, the fund will have an income of $98 billion (estimate) in 2010. A full $3 billion will come from employee contributions. The other $95 billion will come from interest ($40 billion) and well, essentially tax payers. Expenses, or payouts, are expected to be around $70 billion for the same year. Again, all investments are required to be in US Treasuries. Still, the fund has a lot of ground to make up.
What if the US Treasury debt is capped or sells off?
We can see that civilian Federal employees and retirees could be hurt severely. If the debt can’t be expanded. the CSRDF will not get funding and retirement obligations will not be met. Should the Treasury notes and bills experience a loss in value due to selling pressure, the CSRDF will likely lose value and find itself more unfunded than originally thought. Even at best, the current Treasury Secretary has borrowed from the existing holdings of the fund to apply to the national debt to make it seem less threatening. Outright default on held Treasuries would surely diminish the value of the fund.
How does the US government get away with this type of accounting?
I really like this part. What you are about to read explains our world and our fiscal predicament perfectly. Please read this next sentence very carefully. Quoting from the source listed below, ‘According to the U.S. Office of Management and Budget (OMB), balances in the trust fund are... available for future benefit payments and other trust fund expenditures, but only in a bookkeeping sense.’ That statement ought to engender confidence in the government.
But what about the part that is unfunded?
From the same source listed above, the fund is in no danger of insolvency because the unfunded gap will eventually close. Want to know how? This article that I am quoting from is from the Congressional Research Service written by Patrick Purcell in June of 2009. It says,
‘The decline in the ratio of CSRDF outlays to salary expense after 2020 will occur mainly because future retirees will receive smaller pension benefits under FERS than they would have received under CSRS.’ Does that sound like austerity? I suppose too, that actuaries could estimate rising taxes, rising interest rates, rising numbers of contributors (more government hires), and declining benefit recipients due to death. Or maybe, they are just dreaming!
What about Social Security?
Yep, the Social Security Trust Fund is required to own US Treasuries and as previously pointed out, the fund owns 57% of the non-marketable Treasury inventory. As with the CSRDF, if US Treasuries fail (default), so too will the Social Security Trust Fund. Also, as with civilian Federal employees and their retirement funds held by the CSRDF, a 1960 Supreme Court ruling established that contributors to Social Security do not have a right or an entitlement to receive benefits from the Social Security Trust Fund. The government can cut either off whenever it wants. The debt debate should be bringing the phony pension accounting to light in both Social Security and the CSRDF. Sadly, both now depend on ever expanding debt.
Hopefully this little article will help with the understanding of the US debt and some of the ramifications of current, and probably ongoing debt debate.
As we can see, our modern world is tentacled with pervasive debt. Putting a limit on that debt is not as easy as it might sound. Letting the debt continuously expand is clearly an exercise of surrender at the vault of the elite banks.
Yes, Treasuries held in trust funds and pensions are valued at par. But if the Treasury is not allowed to borrow more money to pay the interest on currently issued Treasuries, default will occur rendering the paper worthless. On the other hand, if the Treasury is allowed to expand the debt unimpeded, the increased supply will erode the value of currently issued debt either through inflation or supply/demand dynamics.
The government is now exposed as an irresponsible fiduciary as it requires certain retirement programs to hold only one security - the one that it issues. The US Treasury note might turn out to be one of the most risky securities on the market. To make matters even worse, the reported balances in some retirement programs like the CSRDF are only balances in a ‘bookkeeping sense’.
Maybe we are playing musical chairs only all the chairs are make believe. Maybe what we should really take from the debt debate is the illusion of fiscal soundness. In other words, we are in an ocean of debt that threatens to drown us but fortunately we have a boat. However, the boat only exists in our minds through the power of imagination. The boat is not real. We just can’t afford to open our eyes and see that the boat is not real because the ocean will consume us.
Barry M. Ferguson, RFC is President and founder of BMF Investments, Inc. - a fee-based Investment Advisor in Charlotte, NC. He manages several different portfolios that are designed to be market driven and actively managed. Barry shares his unique perspective through his irreverent and very popular newsletter, Barry’s Bulls, authored the book, Navigating the Mind Fields of Investing Money, lectures on investing, and contributes investment articles to various professional publications. He is a member of the International Association of Registered Financial Consultants, the International Speakers Network, and was presented with the prestigious Cato Award for Distinguished Journalism in the Field of Financial Services in 2009.
© 2011 Copyright BMF Investments, Inc. - All Rights Reserved
Disclaimer: The views discussed in this article are solely the opinion of the writer and have been presented for educational purposes. They are not meant to serve as individual investment advice and should not be taken as such. This is not a solicitation to buy or sell anything. Readers should consult their registered financial representative to determine the suitability of any investment strategies undertaken or implemented.
Originally Published on October 18, 2010
After reading Michael Lewis' wonderful book The Big Short: Inside the Doomsday Machine, I recommended it to a friend. As my friend is a financial professional, I knew he would enjoy a book about how a few obscure hedge fund managers, and their clients, handsomely profited from the collapse of America's subprime-mortgage market. This friend knew that, starting in June of 2005, I had written extensively about the United States' housing bubble (see articles, here, here, here, here, here, here, and here).
So the meltdown in the subprime-mortgage market came as no surprise to either of us; but it definitely caught Wall Street by surprise. Upon finishing the aforementioned book, my friend called me and asked a thought-provoking, two-part question: "What is the next big short and how do we profit from it?"
Sovereign debt certainly has been in the financial headlines in 2010; with Greece getting the lion's share of attention. In the midst of Greece's debt crisis, Standard & Poor's downgraded Greece's credit rating to "junk" status. S&P's rationale for this rating reduction was straight forward:
"The downgrade results from our updated assessment of the political, economic and budgetary conditions that the Greek government faces in its efforts to put the public debt burden onto a sustained downward trajectory." What is not stated by S&P is that by joining the European Union, Greece no longer has its own central bank so it can't paper over its debt crisis by printing more money.
Conversely, the United States' central bank loves to use its printing press and is actively purchasing U.S. Treasury bonds with the objectives of keeping interest rates low and spurring economic growth in the U.S.; which will not work. As of October 15, 2010, a 30-year Treasury bond was yielding 3.98%. In addition to the Federal Reserve's monetizing of Uncle Sam's debt, such a low yield has also come about as individuals and large institutions, including banks, perceive U.S. Treasuries to be a safe haven; hence they are lending to this "AAA" rated borrower in droves. As George Goncalves stated:
"Treasury bonds are gaining ‘rock star' status…" Considering the heady levels the bond market has attained, is it possible that a bond bubble has emerged in the United States?
Egon von Greyerz, of Matterhorn Asset Management, certainly thinks so. He believes, indeed, there is a bond bubble of global proportions. Here is what he stated in a recent article:
The bond market is the biggest bubble in financial markets worldwide, in our opinion. Investors around the world are worried about the state of financial markets and therefore believe that government bonds represent a safe haven. These investors will receive the most enormous shock on two accounts. Firstly, no government will be able to repay the debts outstanding. So there will either be government defaults, moratoria, or money printing that totally destroys the value of the bonds. Secondly, interest rates are likely to go up significantly to at least 10—15%, totally destroying the value of the bonds.
Financial-market luminaries, such as Marc Faber, Jim Rogers, and Peter Schiff do believe U.S. Treasury bonds are in a bubble. In fact, in this interview, Jim Rogers states he is considering shorting U.S. Treasury bonds. If Rogers is thinking about shorting bonds, you should too.
The investment seeks total return, before expenses and costs, that inversely correlates to the price movements of Long Treasury bonds. The fund employs, as its investment strategy, a program of engaging in short sales and investing to a significant extent in derivative instruments, which primarily consist of futures contracts, interest rate swaps, and options on securities and futures contracts. It invests at least 80% of net assets in financial instruments with economic characteristics that should perform opposite to fixed-income securities issued by the U.S. government.
I did not take this short position without undertaking appropriate research. In January of 2005, LRC published my essay titled Should the US Government's Sovereign Credit Rating be Downgraded to Junk? Here we are, over five years later, and Uncle Sam's financial condition is much "junkier."
When I wrote the above-mentioned essay, the U.S. Government's balance sheet revealed a deficit net worth of over $7.7 trillion. As of fiscal year-end September 30, 2009, the U.S. Treasury is reporting that Uncle Sam's net worth is a mind-numbing deficit $11.5 trillion — I have included the 2009 balance sheet, below, for your viewing displeasure.
|(In billions of dollars) 2009|
|Cash and other monetary assets (Note 2)|| |
|Accounts and taxes receivable, net (Note 3)|| |
|Loans receivable and mortgage backed securities, net (Note 4)|| |
|TARP direct loans and equity investments, net (Note 5)|| |
|Beneficial interest in trust (Note 6)|| |
|Inventories and related property, net (Note 7)|| |
|Property, plant, and equipment, net (Note 8)|| |
|Securities and investments (Note 9)|| |
|Investments in Government sponsored enterprises (Note 11)|| |
|Other assets (Note 12)|| |
|Total assets|| |
|Stewardship land and heritage assets (Note 27)|| |
|Accounts payable (Note 13)|| |
Federal debt securities held by the public and accrued interest (Note 14)
|Federal employee and veteran benefits payable (Note 15)|| |
|Environmental and disposal liabilities (Note 16)|| |
|Benefits due and payable (Note 17)|| |
|Insurance and guarantee program liabilities (Note 18)|| |
|Loan guarantee liabilities (Note 4)|| |
|Liquidity guarantee (Note 11)|| |
|Other liabilities (Note 19)|| |
|Total liabilities|| |
|Contingencies (Note 22) and Commitments (Note 23)|| |
|Net position:|| |
|Earmarked funds (Note 24)|| |
|Non-earmarked funds|| |
|Total net position|| |
|Total liabilities and net position|| |
But the news gets much worse. It is important to understand Uncle Sam does not have "his" financial statement prepared according to generally accepted accounting principles (GAAP). Most notably, if you go to page 158 of the U.S. Government's 2009 audited financial statement (Table 6), you will see that the net present value of future Social Security and Medicare costs is $107 trillion. Under GAAP accounting, it could be argued that such liabilities would be included in the U.S. Government's balance sheet as accrued liabilities. One could confidently assert, therefore, that Uncle Sam's liabilities exceed assets by over $118 trillion. How the rating agencies continue to rate the United States as a AAA risk completely escapes me. Uncle Sam's financial condition is a train wreck. Without the Federal Reserve's printing press, this confidence game couldn't keep moving forward.For up-to-date information, with respect to the debt and liabilities the U.S. is racking up at warp speed, I suggest visiting U.S. Debt Clock.org. As of October 15, 2010, the national debt was approaching $13.6 trillion and unfunded liabilities were approaching $111 trillion. One would suppose even Alexander Hamilton would be alarmed at such surreal figures. Ah, but the bond market is forecasting tranquility and absolute safety for the next 30 years.
This is exactly why I like the idea of being short U.S. Treasury bonds. Wall Street analysts, for the most part, will not sound the alarm indicating a bond bubble has emerged. After witnessing the subprime-mortgage collapse and then the ensuing bailout of Wall Street, I have concluded Wall Street is a criminal enterprise designed to separate you from your money. So don't expect any help from these crooks.
As for the rating agencies, such as Fitch, Moody's, and Standard & Poor's, they won't sound the alarm simply due to the fact that they are incompetent. After Enron, MBIA, and the entire subprime mortgage-backed securities disaster, who takes the rating agencies seriously anymore? So while institutions and individuals flee to the alleged safety of long-term U.S. Treasuries, AAA rating and all, the "shorts" properly view Uncle Sam as a subprime borrower; and have detected an opportunity to profit when the Treasury-bond bubble bursts.
As a quick tangent, I highly recommend Christine Richard's book covering the downfall of MBIA. It is titled Confidence Game: How a Hedge Fund Manager Called Wall Street's Bluff. This book masterfully details how a hedge fund manager skillfully dissected MBIA's business model and financial condition; and then openly questioned its AAA rating via a critical research report. The backlash, against this hedge fund manager, was vicious. In the end, he was vindicated when MBIA was stripped of its AAA rating and imploded. The reward for his lonely battle, against Wall Street and the rating agencies, was over a billion dollars in profits for his investors via astutely purchasing credit-default swaps and shorting MBIA's common stock.
Aside from the above-mentioned inverse bond fund, there are other vehicles available to short U.S. Treasury bonds. There are exchange-traded funds (ETFs) that appreciate as bond prices fall (examples linked here and here). There is also a mutual fund "that corresponds to one and one-quarter times (125%) the inverse (opposite) of the daily price movement of the most recently issued 30-year U.S. Treasury bond." To be sure, there are other vehicles for shorting Treasury bonds; but the purpose of this essay is to provide an idea allowing one to profit when the Treasury-bond bubble bursts — further research and risk assessment are up to you.
Without a doubt, I do see U.S. Treasury bonds as the next big short. Uncle Sam, after all, has a subprime financial condition yet is rated AAA. Keep in mind the hedge fund managers, who profited from the subprime-mortgage meltdown (as chronicled in The Big Short), waited several years for their positions to pay off; thus patience is a virtue when holding a short position in U.S. Treasury bonds. Even if interest rates rise and bond prices drop like a stone, the U.S. could ban the short-selling of Treasury bonds. Political risk, therefore, must be considered when taking a short position in T-bonds. Consequently, shorting T-bonds is not a risk-free proposition. This aside, I savor the idea of making money by shorting the long-term debt of the retarded, clumsy "debtaholic" known as Uncle Sam.
Eric Englund [send him mail], who has an MBA from Boise State University, lives in the state of Oregon. He is the publisher of The Hyperinflation Survival Guide by Dr. Gerald Swanson. He is also a member of The National Society, Sons of the American Revolution. You are invited to visit his website.