CNNMoney: Should USA Still be AAA?

Submitted By Trader Mark
I will keep posting on this topic until the farce that is AAA rating is removed from the good ole US of A by the major agencies. Just keep in mind there were only 7 "AAA" rated companies in America about 18 months ago - two were General Electric (GE) and AIG (AIG). You know how that turned out. The denial on our sovereign rating by the "credit agencies that matter to the press" will take much longer. This will be the third such piece on the blog... [Apr 15, 2008: Could the US Lost its AAA Rating?] [Nov 12, 2008: CNBC Europe - USA May Lose its AAA Rating]

There is simply no way we could pay our OLD obligations [Jul 28, 2008: US Budget Deficit to Half a Trillion] [Mar 26, 2008: Annual Spring Entitlement Warning Falls on Deaf Ears] on the path we were heading; and now we've made those obligations look like child's play. [Mar 25, 2009: Taxpayer Welfare to the System $3 Trillion Down, $9 Trillion to Go] So either tax rates double (at least) across the board, growth rates of our economy move from the normal 2-3.5% of a mature 1st world developed country to 8-12% per annum, or we simply print money to either inflate our way or Banana Republic style simply monetize the debt (sold from US Treasury to Federal Reserve). We have seen in the past two weeks when push comes to shove, and desperation sets in - what the path is. We said that Uncle Ben was setting the path for this in December [Dec 1, 2008: Uncle Ben Signals the End Game]

And lo an behold, the great helicopter drop of all time is being hinted at - the actual buying of US Treasuries by the Federal Reserve (since at some point no one will have the capital to do so)... as hinted today by Uncle Ben himself. The end game is fast coming upon us....

As we did in November....

Minerd doubts that private savings in the U.S. and foreign purchases of Treasury debt will be sufficient to meet those government cash requirements. That leaves the Fed to take up the slack; that is, monetization of the debt. (in English this means when there is no buyer for US Treasuries we will create the buyer in house: the Federal Reserve. So the left hand will be buying from the right hand i.e. desperation... banana republic style)

Clearly these moves of monetization - generally done by 3rd world countries that most people could not place on a map - are the actions of a "AAA" rated country... (p.s. the UK is going all banana as well) In simplistic terms, we simply borrowed from one credit card to pay off another. We can now borrow at pathetically low rates because all the world is in fear, and ALL THINGS BEING EQUAL the U.S. is still seen as safe haven. What happens if the bulls get their faith based call that we'll be "all good" in 12-18 months? Money will flow out into riskier assets and the cost to government for debt will jump... and jump... and jump. And costs to service said debt load will jump... and jump... and jump. And more and more of our yearly national GDP will be used to pay for nothing more than debt. You all have budgets at home - you know how it works when you need to pay 14% rather than 3% on a credit card.

Currency is all about faith... the faith that the IOU of that fiat piece of paper means something other than a nice picture on a green shaded parchment. Over time, these sort of actions and the growing realization there is no way to offset future liabilities with any rationale asset growth will cause loss of faith in the currency. But that's the bet the powers that be are willing to take in our national ethos of kick the can down the road. Fix the fire in your living room and worry about the one on the roof later.

If you believe this thesis, "eventually" shorting iShares Barclays 20+ Year Treasury Bond (TLT) or going long Ultrashort Lehman 20% Year Treasury (TBT) will be the play.... since I think this crisis takes much longer to play out than the consensus, I'm using the more conservative play of the former rather than the latter. In a few years - or when the globe returns to the "new normal" I do believe this will be one of the biggest home runs in investing history. But not until things begin to return to a state of normalcy.

Via CNNMoney

When the Federal Reserve announced last week it was buying $300 billion in long-term Treasury notes, the move was viewed as one of the safer bets the central bank has made recently. After all, the Fed has either bought or announced plans to spend trillions of dollars on troubled mortgages and other types of questionable consumer debt in the past year. At the same time, the Fed has been loaning money to banks and companies that couldn't get funding elsewhere.
So the purchase of AAA-rated Treasurys, the highest credit rating that a bond can have, is probably the least risky thing the Fed can do these days. Investors agreed: The prices of long-term Treasuries rose after the Fed's announcement, pushing their yields lower. (Bond prices and yields move in opposite directions.)
But is the purchase of Treasurys really as safe an investment as it seems? Some think the U.S. may not be able to hold on to its perfect credit rating indefinitely considering how much money the Fed, Congress and the Treasury Department have thrown at the economy in their attempt to lift it from this recession.
"The only reason someone who bought a Treasury can get their money is that the government is able to borrow more money to pay them off," said Peter Schiff, president of brokerage firm Euro Pacific Capital. "It's impossible for us to just keep going deeper and deeper into debt."
Still, that seems to be exactly what the government will be doing. According to credit rating agency Moody's, the amount of U.S. Treasurys held by the public, including foreign governments, is expected to rise to $7.8 trillion by the end of the government's fiscal year in September, up from $5.8 trillion a year earlier. (that's simply staggering growth in 1 year - 34%! And you ain't seen nothin' yet kiddo) What's more, Moody's predicts that this figure could increase to $9 trillion by September 2010, since the government is likely to take advantage of the current low rates to finance its various bailout efforts. (this would be growth of 55% over 2 fiscal years)
But strong demand for Treasurys does little to assure those who think there will be big problems ahead. Critics of federal spending worry that once concerns about the value of the dollar or the government's debt load start to turn, it will turn quickly, sending Treasury prices plunging and longer-term interest rates soaring.
"Anyone who buys a lot of [long-term Treasurys] now might be crazy," said Brian Wesbury, chief economist at First Trust Portfolios. "It's the biggest the bubble in the world." (Wesbury has been quite possibly the most wrong chief economist over the past 18 months of any I see on financial entertainment TV - but for once I agree with him)
Higher bond rates can have significant costs for the nation since it would drive up the price that the government has to pay to borrow money. And any increase in how much the government has to spend on interest payments could lead to a reduction in the amount of money available for other government spending.
Even President Obama acknowedged that risk... "The limit is our ability to finance these expenditures through borrowing," he said. "People are still buying Treasury bills. They still think that's the safest investment out there. If we don't get a handle on this and also start looking at our long-term deficit projections, at a certain point people will stop buying those Treasury bills."
With the U.S. dependent on foreign investors to buy much of its debt, maintaining overseas confidence in U.S. Treasurys is particularly crucial. That's why when Chinese Premier Wen Jiabao said earlier this month that he had "some worries" about the safety of the more than $700 billion in U.S. Treasury debt his country holds, it got the attention of bond traders and government officials. Some experts think the Fed's move to start buying Treasurys was at least partly a response to Wen's remarks. (remember when the Chinese say jump, we jump. The Chinese "hinted" they really wanted us to guarantee Fannie and Freddie debt explicitly rather than implicitly - within days Uncle Hank Paulson jumped and did it.... luckily for us, this is a co-dependent situation - China can't do much about it because if we don't overlever our homes and credit cards to buy all their stuff their economy implodes. We're in this together friends from the East!) "Is that a coincidence? Hmm. I think not," said Kevin Giddis, managing director of fixed income at Morgan Keegan. "I think it certainly helped the Fed make its decision."
So far, major credit rating firms such as Moody's and Standard & Poor's have yet to take any steps to lower the U.S. credit rating -- despite the increased spending and concerns about rising budget deficits. (I won't even begin making mocking remarks about listening to the major ratings agencies after the disaster they have wrought the past decade)
Nonetheless, officials with Moody's and S&P defend their current AAA ratings for U.S. debt. They say that the U.S.' debt level as a percentage of gross domestic product and interest payments as a percentage of tax revenue are well within the range found in the other 17 nations that still have AAA ratings. "To some extent you have to grade on the curve here."
Still, some smaller rating agencies have already lowered their U.S. rating. Egan-Jones Group actually removed the AAA rating from U.S. debt four years ago, well before the current crisis in financial markets prompted trillions in government bailouts. (now Egan-Jones on the other hand is considered a realistic agency who actually warned of much of the carnage that was to come. Funny how the one who warned of the hell that was to break out in our financial situation is also agreeing with the very obvious conclusion... while the major credit agencies do their usual. And this was 4 YEARS ago before all the new obligations) "There is little doubt that the obligations of the U.S. government have risen faster than their means to absorb those obligation," said Sean Egan, the firm's managing director.
Egan doesn't think there is much threat of the government defaulting on its debt. But he said that government policies will lead to a severe devaluation of the dollar, which could leave investors almost as bad off as a default. (and this is exactly the point I made above... kids, get your US pesos converted into Australian dollars, or Norweigen Krones or something that will actually have "faith" behind it over the next 5 years. We're going out banana style!)
Egan argues that S&P and Moody's would be extremely reluctant to cut their ratings on U.S. debt. So if anyone is going to downgrade their opinion of the government's creditworthiness, it will be the marketplace that reacts first, not the agencies. "People aren't stupid. They figure this out over time," said Egan. (agree)

[Sep 29, 2008: Barron's - The Pain of Delevering]

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