Tuesday, December 1, 2009

Adjustable Rate Time Bomb

You may have heard in the news recently that the United States has funded its debt through "short term" bonds, and that this may become a "problem" as we move forward.

So what does that mean? Lets discuss and put some numbers together.

The term "short term" debt became popular as the year 2000 hit when many people in the country began financing their homes with adjustable rate subprime mortgage. When you get a $500,000 loan for a home with a 2 year "ARM", that means your interest rate will adjust after the second year and begin to float up or down with the current market rates. This option allowed homeowners to lock in at below market rates for two years because lenders knew they would be protected in the future.

When discussing government debt, the situation is different for the borrower. Imagine that instead of a homeowner borrowing $500,000 you are Obama borrowing from the Chinese. You decide you want to borrow the money for a two year term because the interest payments are lower and it will save the country some money.

Here is the big difference: When the government bonds/debt come due after the two year period, Obama then has to pay out the full $500,000, its not just an interest rate that starts to float. It is the equivalent of the homeowner having to pay the lender the full $500,000 at the end of the two year term. (In real estate they call this a "balloon" mortgage and it is popular in commercial real estate. More to come on that another day.)

Why does this matter? Because the vast majority of our debt over the past few years has been financed with short term debt that will be coming due.

Within the next 12 months the treasury will have to re-finance $2 trillion in short term debt.

Over the past few years our foreign lenders have decided to "roll" the debt. This means that when the bonds come due for payment they just put the money right back into treasury bonds.

Everyone assumes this will continue to be the case moving forward. But what if its not? What if some investors asked for their money back?

The government has no money to pay for these obligations. Remember, on top of this $2 trillion coming due, Obama plans to run a $1.5 trillion deficit this year.

This means he has to sell $3.5 trillion in debt in the open market this year.

If the entire savings of Americans during good economic times were used to help cover the difference it would total around $600 billion. This leaves him $2.9 trillion short that he must convince the rest of the world to buy.

I've discussed briefly in the past what options this leaves the country......

1. Declare Bankruptcy
2. The Federal Reserve purchases the debt

.........but I want to discuss option 2 just a bit further.

The following graph shows the contents of the Federal Reserve's balance sheet over the past two years:



As you can see they took unprecedented and unimaginable steps during the fall of 2008 to "save the financial system." We are now feeling the consequences of their decisions as we have seen a huge stock market rally, the dollar get hammered, and precious metals setting new records every day.

The question on every one's mind is, where do we go from here?

Bernanke has stated that he has an exit strategy in mind to remove the excess money he has printed over the past year. However, as you can see by the chart above, the Fed's balance sheet is now composed in large part of mortgages and treasury debt.

In order for him to shrink the size of the balance sheet he would have to sell hundreds of billions in mortgage debt into a market that does not exist right now. He would have to sell hundreds of billions in government debt into a market where we need $3.5 trillion purchased next year.

He has boxed himself into a corner.

The truth is that he will not shrink the size of his balance sheet, but it will explode in size as we move forward. If he does not continue to buy mortgages the market will collapse. If he does not continue to buy government debt then we will have to declare bankruptcy as a nation.

If only the city of Dubai had the printing press that we have here. Our default has been hidden by an ocean of liquidity.

All paths lead to a coming currency crisis. Most people within the financial world feel that as long as the dollar falls slowly and gold continues to rise slowly, then it will be a healthy rebalancing of the global economy.

I believe that the decline will not be orderly and there will be a rush to the exits. I expect this to take place sometime over the next 18 months.

While gold is long overdue for a large pull back, and the dollar is long overdue for a short term rally, the long term direction of these two markets is in the early stages.

During the gold and silver bull market back in the 1970's, over 70% of the move in the markets occured during a three month period in November, December, and January of 1979-1980.

I expect the same thing to happen this time only on a much larger scale. During this period the only thing that will matter is the number of ounces of gold and silver you own. Do not pay attention to the short term price movements or the dollar price which will soon mean nothing.