It is appalling that a small minority of extremists in Congress can hold the nation hostage by threatening to drive the economy over a cliff if the administration does not agree to the repeal of laws that they dislike.
There is a way to stop them. Treasury Secretary Jack Lew should declare it to be administration policy that the U.S. government will not default on its debt. To that end, he should prepare to issue consols, should Congress refuse to enact timely increases in the debt ceiling.
It's appalling that political hacks like James Leitner and Ian Shapiro aren't immediately strung up by their toenails, after an indictment and trial of course, for proposing something that is blatantly unconstitutional.
The Congress shall have Power To lay and collect Taxes, Duties, Imposts and Excises, to pay the Debts and provide for the common Defence and general Welfare of the United States; but all Duties, Imposts and Excises shall be uniform throughout the United States;
To borrow Money on the credit of the United States;
Only Congress has the power to give Treasury the right to issue "consols."
Absent that explicit authorization Treasury has no such right.
As such anyone buying such "consols" is in fact buying nothing, as without authorization to issue they are null and void and create no obligation upon the United States.
Indeed, were Treasury Secretary Lew to issue such a thing he would be guilty of black-letter fraud and since his act would be undertaken without legal authorization in law or fact he would be personally exposed to being held accountable for that fraud.
My recommendation, should such a thing occur, is that we should send his ass out to whoever buys such worthless trash and let them deal with him as they see fit.
While we're at it let's send Leitner and Shapiro -- and anyone else who advocates this sort of garbage -- with him.
There are a lot of hard-headed people out in the investment and banking world.
Most of them are hard-headed because they have never known anything else. A few are a bit smarter -- they know that their business model is cooked if the underlying assumptions change and they're being intentionally dishonest in trying to grab the last few nickels in front of the steamroller, and to hell with you (their customer.)
Then there are those who have it figured out and are attempting to find a way to adapt to what is going to happen.
More than 30 years ago I fell into the trap of believing the press on alleged "100mpg carburetors" that were supposedly "suppressed" by oil companies. This was in the time of the Arab Oil shocks and it was all the rage to blame evil oil companies for the fact that American cars typically got 15 mpg. There were several who claimed that such 100mph carbs existed but had been bought out and suppressed or that their inventors had been murdered.
I fell for it.
The reason that these claims were a scam became clear to me later on -- I hadn't had a physics class yet and thus didn't understand thermodynamics. Specifically, I did not understand that the best efficiency a heat engine can obtain is the difference between the combustion and exhaust temperature in Kelvin, and that this was a theoretical maximum that is never achieved (since some of the energy goes out the exhaust pipe as heat, some more is blown into the air through the radiator, and still more is lost directly to the air via the engine block and other components, never mind losses in the gearbox, differential and similar.)
If I had understood this I would have also understood that 100mpg for a typical car when one accounts for rolling and aerodynamic resistance was impossible. There simply weren't enough BTUs of energy in the gasoline when one accounted for the maximum theoretical efficiency, to get there.
The arithmetic said this couldn't happen, in short.
Now I want you to pay particular attention to this chart for a few minutes.
Note the long-term trendline -- downward. But also note the pink boxes. The first was 1987, and we all know what happened in October. The second was the dislocation that led me to be able to pick up Class "A" office space in Chicago for 1/5th the going rate, along with taking advantage of a number of other opportunities -- in short, being able to take advantage of it was what made MCSNet, my former Internet company, so successful. The third was the causative feature that led to both LTCM and the Tech Implosion. And the last was what set off AIG and Lehman, along with the rest of the crisis, as banksters and their minions, along with Americans, refused to deal with the short-term counter-trend move higher in rates.
But make no mistake, all four of those were counter-trend moves in a secular bull market for bond prices -- and a bear market for rates that stretched over 30 years.
What you need to understand about this dynamic is that in a secular bull market for bond prices the value of the "asset" in those instruments goes up over time as the coupon goes down. Bonds are typically highly leveraged both in terms of trading activity and the underlying things they fund. The truth of this is self-evident to anyone who bothers to look -- when was the last time you saw a municipality, state or national government actually pay one off, and how often do corporations pay them off instead of simply rolling them over?
What led to the blow-up in home ownership was a shift in trend of average Americans from taking out a mortgage and paying it off to mimicking the behavior of governments and corporations, rolling and refinancing the debt into ever-lower rates. When there was a short-term cyclical change in this trend those people got murdered.
In a declining interest rate environment turning the crank of leverage higher both makes you money (because every refinance lowers your debt service on a given amount of debt) and the additional credit issued into the economy makes everyone else's assets go up in price as well. But even if you don't personally turn the crank you still win due to everyone else's actions.
In a rising rate environment turning the crank of leverage higher loses money instead because now the interest payments go up for each refinance instead of down!
But if you take down leverage not only do you crystallize your own loss you also contract total systemic credit and thus cause other people to lose value too.
The winning position for an individual or corporation in a rising rate environment is to have no leverage. Those firms are the ones that have the opportunity to pick up assets or needed business resources at pennies on the dollar from others who are forced to sell.
This will be the winning strategy for the next couple of decades.
This is not to say that there won't be cyclical decreasing rates in a generally-bearish market for bond prices. There will be. But it is to say that the trend is shifting and that in fact it must shift, simply on the math -- there is nowhere else to go.
The Japanese were able to prevent this and instead flatten their bond market for two decades but they did it by consuming essentially the entirety of their population's saved capital! We have virtually no saved capital to consume and as such that option is not available to us.
Municipalities, state and national governments would be well-advised to do the same thing but they can't because they're too far into the hole. They also can't raise taxes in sufficient amount to get out of the hole because the earnings power of their citizens is insufficient to allow them to do so. As Detroit discovered any attempt to continue to feed the pigs at the trough via ever-high taxation drives out the people who produce and instead of raising more revenue it collapses the funding base instead. The same applies to nations; witness Greece.
The problem with the game-playing that has been put into the market since 2008 to "buy time" (to quote the BIS) is not that it delays recognition and adjustment. It is that every shift of this sort is exponentially worse in terms of the impact on the economy when it reverses, and arithmetically it must eventually reverse.
This is not a cyclical, short-term change folks. It's a secular shift and right now absolutely nobody is talking about what it means.
Realize this -- we are now back to where we were in the depths of the collapse in 2008 and 2009 in terms of rates, but asset prices are much higher. They're too high by half or more on that basis and what was predicated on a short-term cyclical move.
This does not mean that we will instantly see rates shoot higher and the entire economy collapse. But there is extremely strong support for any instrument at zero, and we're very close to there right here and now. At best The Fed and Government games can buy themselves a short amount of additional time -- but not much more.
The secular shift is upon us and you either recognize this and adjust your personal and corporate world to comport with what is certain from an arithmetic perspective or you will suffer the consequences for not doing so.
There's a little problem poking its head up out of the ground here in the form of the 10 year Treasury (TNX.)
You can see the technical gap that turned back the rally in yields (upward) earlier this spring. This time it looks like we're going go through and head higher.
Around the top of that gap, which is near 2.2% or a bit higher, is a potential landmine in the form of a hedging problem.
See, the MBS market (mortgages) is more-or-less correlated with the 10 year Treasury. As Treasury yields rise the duration of existing mortgages tend to extend, because you have a rate you cannot beat and in addition if you buy a different house you have to get a new mortgage at a higher rate. The direct impact on affordability is a problem for the housing industry but for the holders of MBS the nightmare scenario is to hold very low interest-paying debt into a rising rate environment where the duration of what you hold is extending!
Remember that the change in current value of a bond is more-or-less the change in interest times the remaining duration. Debt that the debtor can choose to prepay at any time without penalty (e.g. mortgages) have a variable duration that is under control of the debtor rather than the creditor, as a fixed-term, fixed-interest mortgage can be prepaid by the homeowner but the creditor cannot force the homeowner to either refinance or prepay out.
This means that losses in a rising rate environment in these instruments tend to feed on themselves, as the higher rates go the more duration on existing debt extends.
In turn the usual means of addressing this risk is to hedge it off by using the instrument most-closely linked to that market, which is the 10 year Treasury.
The problem is that The Fed has basically become the market for that issue.
This could get a bit interesting in that the market has this concept that "The Fed is in control."
There may well be a lesson to be taught here as to exactly how "in charge" The Fed really is if this trend in the bond market continues.
There was much gnashing of teeth in the mortgage-backed securities industry last April, when U.S. District Judge William Pauley of Manhattan ruled that mortgage-backed certificates are debt, not equity. That finding, in turn, led Pauley to conclude that MBS trustees are subject to the federal Trust Indenture Act of 1939, which imposes duties on bond trustees. Under the TIA, Pauley said, MBS trustees can be liable if they fail to notify investors of deficiencies in the trust's underlying mortgage loans and fail to act on those deficiencies. Beth Kaswan ofScott + Scott, who represents the Chicago pension fund that brought the suit before Pauley (which named Bank of New York Mellon as Countrywide's MBS trustee), told me at the time that the "watershed" decision was a way for investors to get around MBS pooling and servicing agreements, which typically require 25 percent of a trust's investors to band together before they can bring any action against an issuer.
There's been relatively little notice of this, but it has potentially-enormous consequences. If this ruling -- that MBS certificcates are in fact debt, then liability could be extended under the TIA which would upend the attempt to play the game that a trustee has only a "ministerial" duty.
At issue is the fact that MBS trustees are typically paid a relatively-nominal fee and do basically nothing, other than have their name on the deal. If they suddenly are responsible for monitoring and reporting breaches of reps and warranties on the underlying loans, then suddenly they have a duty to surveil those notes and actually be a gatekeeper on the integrity of the deal itself.
This, of course, would include whether the physical notes bearing endorsements were ever delivered to the trustee in the first place!
It would be a grand day indeed were we to finally get a ruling that when you claim to be something (e.g. "Trustee") that you really have to act like one!
This fight isn't over, needless to say, and probably won't be in the immediate future -- but it does bear watching.
Private-equity firms are adding debt to the companies they own in order to fund payouts to themselves, a controversial practice now reaching a record pace.
Leonard Green & Partners LP, Bain Capital LLC and Carlyle Group LP are among the firms using the tactic, which rose in popularity before the financial crisis.
In these deals, known as "dividend recapitalizations," private-equity-owned companies raise cash by issuing debt. The proceeds are distributed in the form of dividends to buyout groups.
Let's just call this what it is -- a screwing.
It's nothing other than a cynical version of arbitrage for the simple reason that it attempts to goad the market into providing a forward arbitraged level of cash "now" against prospective future operating earnings which the private equity shop takes today, leaving the execution risk with the debtholders.
It's clever and legal, but only works when you can find a bunch of rubes that will take on the risk at an undersized rate of return. That, in turn, is stoked by interest-rate "policies" that are suppressive of risk-adjusted rates (ZIRP and QE anyone?) which Bernanke and others assert are all "positive" in their impact on the economy.
That latter assertion is a knowing lie; there is no such thing as a free lunch but there are plenty of people who hope that when you see a pretty face poking out from the under the sheets you'll immediately strip and jump in bed without pulling back the covers to ascertain whether what's there is actually a pretty girl!
These bets always eventually end in disaster for someone, and the PE firms that pull this crap are simply insuring that the disaster isn't theirs, it's yours.
That's real special, isn't it?
But is this something that should be prohibited? I don't know. There's a fairness issue here that rears its head, but then again, it's damn hard to swindle an honest man, isn't it?
Where We Are, Where We're Heading (2013) - The annual 2013 Ticker
The content on this site is provided without any warranty, express or implied. All opinions expressed on this site are those of the author and may contain errors or omissions.
NO MATERIAL HERE CONSTITUTES "INVESTMENT ADVICE" NOR IS IT A RECOMMENDATION TO BUY OR SELL ANY FINANCIAL INSTRUMENT, INCLUDING BUT NOT LIMITED TO STOCKS, OPTIONS, BONDS OR FUTURES.
The author may have a position in any company or security mentioned herein. Actions you undertake as a consequence of any analysis, opinion or advertisement on this site are your sole responsibility.
Looking for "The Best of Market Ticker"? Check out Ticker Classics.
Market charts, when present, used with permission of TD Ameritrade/ThinkOrSwim Inc. Neither TD Ameritrade or ThinkOrSwim have reviewed, approved or disapproved any content herein.
The Market Ticker content may be reproduced or excerpted online for non-commercial purposes provided full attribution is given and the original article source is linked to. Please contact Karl Denninger for reprint permission in other media or for commercial use.
Submissions or tips on matters of economic or political interest may be sent "over the transom" to The Editor at any time. To be considered for publication your submission must include full and correct contact information and be related to an economic or political matter of the day. All submissions become the property of The Market Ticker.