America’s Strategic Default

July 18, 2011

There are two kinds of debt defaults – the kind you make when you can’t afford the payments, and the kind you make when you can, but choose not to. 

The latter now represents an increasing percentage of mortgage defaults – the kind you get when homeowners realize making payments on a $400,000 mortgage for a Vegas condo bought for $425,000 in 2005 doesn’t make a whole lot of financial sense, especially when their neighbor’s condo just sold for $125,000.

There is a lot of fear in the financial press (but not the financial markets) that the U.S. government might default on its debt if the debt ceiling isn’t raised for the umpteenth time in the last near-century . One thing our debt ceiling doesn’t do is actually create a ceiling on our debt; it seems the only purpose of the ceiling is to create a political football every so often.

There is no risk of a debt default currently priced into the market. Ten-year government bonds yield just under 3% today. No one wants to lend their money at 3% to a questionable borrower. That doesn’t mean a panic can’t start, perhaps from a debt downgrade or a run away from government debt, baseless or not. What people would do with the trillions of dollars they have in government debt is anybody’s guess. It can’t all go into the thin gold market. CDs are backed by the government.

Playing the “what would happen?” game here is tough. Just a few short years ago, the U.S. government halted the last major financial panic by stepping in and backing debt. But what if the government is at the center of the crisis? Who can back the U.S. government? Certainly not the European governments. They’re already in crisis mode. Many European countries already have debt issues and downgrades. Maybe China will step in. If we go down in flames, China’s Factory of the World model is certainly going to have some problems.

The next least-risky debt area in the world is probably municipal bonds, as strange as that sounds. Just a few months ago, the muni bond market was in a panic about possible mass defaults. We wrote about how this was not going to happen. Since then, muni bonds have done well, and halfway into the year, muni bond defaults are running about 1/3 of last year’s low rate. However, states financial future is related to federal government support, so this is by no means a can’t lose area.

The big areas of concern rarely turn out to be trouble for investors. Inflation comes to mind. It’s the trouble you don’t see coming that you have to worry about, if you even have to worry at all. Apparently, financial journalists need to remind us how dangerous government finances have become, although they didn’t spend much time in the mid-2000s talking about how bad real estate-related financing had become. We need to know what to do if inflation goes into double-digits, but we apparently didn’t need to be concerned about triple-digit P/E ratios in growth stocks back in the late 1990s.

Investors are also scared of stocks. They’re still pulling money out of U.S. stock funds even though markets have rebounded somewhat since the drop a few months ago. Some new money is going into foreign stock funds, although U.S. markets have largely fared better, and many big foreign markets have more troubling economic problems than our self-inflicted debt showdown.

Greece, Italy and the like wish they had problems as simple as choosing to continue to make debt payments that are a mere 15% or so of government revenues, revenues that are low by historic standards relative to GDP, given multiple tax cuts.

Most new money is going into taxable bond funds, although yields are barely higher than what safer, large U.S. stocks pay today. Will corporate debt do well if government debt gets into trouble? Probably to a point, but debt problems tend to spread out and hurt all debt. Holding domestic stock in low leverage companies is probably safer than debt in this nearly impossible government default situation, although in all likelihood, any investments with any degree of risk, including real estate, will slide. 

The real takeaway from this debt problem is that there’s really no truly safe way to earn money anymore. Safe money yields are averaging less than 2%, and may continue to do so for years to come. There’s too much money in the world looking for a safe place, and this excess demand is lowering the returns on safe money.

The most likely outcome from the debt showdown is a slowing economy resulting from consumer anxiety over possible cuts in the future on top of actual cuts, and actual tax increases at the federal level to match the ones many states have already made. There are two possible problems for our economy related to our growing gap between revenues and spending: not doing anything, and trying to fix it too quickly.