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Will there be a bank run on Treasury debt?



July 31, 2008 – Comments (5)

First, a disclaimer. Getting rid of bad loans to the US government is not a must. It is not inconceivable that foreign governments, central banks and sovereign wealth funds, and even foreign companies and individuals will be just happy to lose most of their dollar hoard provided that they lose it gradually, 3-4% a year, year after year after year. The assumption that people are stupid works too often, in fact, it works most of the time, and governments, if anything, are even more stupid than the people. In addition, taking this position is a natural choice for you if you're an official in a banana republic and want to win friends in Washington, DC. There is no sure way to gauge the degree of stupidity and corruption in third-world countries holding US debt, so it is uncertain when the bank run on the US bond system will take place and whether it will take place at all.

If we assume some healthy instincts on the part of these foreign entities, the only question is the timing of their exit from US bonds. There are many excellent reasons for them to dump worthless US debt, but the basic reason is that they have now reached the point where any further accumulation of debt becomes self-defeating because the debt loses its value at a faster rate. To take a simple example: if you save $1000 a month and your bank pays you interest that is 3% below the official inflation, then during the first year this rip-off is not a major concern. You're losing 0.25% a month in terms of purchasing power, but after the first 10 months of saving, your savings still grow 10% a month. Suppose now that you've accumulated $400,000 in that bank. Well, now your saving activity is equivalent to pouring water into a leaking pot because you're losing purchasing power at exactly the same rate as you add new liquidity.

For sovereign wealth funds, who own some 3 trillion dollars, this moment is dangerously close. They should be making 10% a year to maintain their purchasing power, but Uncle Sam is reluctant to pay more than 4%. This means SWFs are losing some $180 billion a year in real terms. But SWF are only the tip of the iceberg, which also includes fixed-income dollar assets of central banks, government reserve funds, state-run companies, private companies and individuals. It is time to consider a change of strategy.

The need is not equally strong for all countries. Oil exporters will have a chance, indeed, will be forced, to consume all their savings when oil drops. As far as they are concerned, even a leaky pot can perform its stabilizing function. Holding bonds is still a terrible idea for these countries, and they should be diversifying into stocks instead, if only because S&P and oil are countercyclical. But at least they have a shorter time horizon, so if they're going to use the money in 5-7 years, the US Treasury will not steal all their savings though inflation. It will steal only 25-30% of the total. For China and Japan, however, there is no chance to use their cash hoard efficiently at the trough of the economic cycle. Being immune to extreme cycles that reduce OPEC economies to feast-to-famine stories, these countries will not experience such deep troughs down the road. To these countries, an SWF is a future generations fund as opposed to a cash hoard for a rainy day. If their economies grow sick, it will be a chronic malaise rather than an acute crisis. Moreover, if there is one thing that threatens their economies, it is the practice of paying an annual tribute (crossed out), subsidy (crossed out), stupidity tax (Finally! That sounds right!) to uncle Sammie. For these two countries that intend to hold on to their savings for 20 years or longer, it will be a terrific idea to get rid of treasury slime almost at any cost.

The basic strategy for sovereign wealth funds is clear: sell bonds, buy real assets, and try to time your selling and buying to get the highest price for your bonds and pay the lowest price for the the real assets. If you're a small SWF, all you can do is try to time the market by watching the big guys. If you're a big SWF, you may have a more tempting opportunity: dump enough paper to provoke a financial crisis that would make American assets really cheap. In either case, you have to ask yourself the question what happens if the US government refuses to let you buy real assets or lets you buy real assets and then either confiscates them or changes the regulatory environment in a way that is likely to make these assets nearly worthless. The first answer to this question is that we are talking about a basic risk, which cannot be removed no matter what. If you believe the US government can confiscate the stocks, buildings, or private businesses that you buy, you should assume that it may just as easily confiscate your bonds as well. In other words, you should still do the right thing and stop worrying about things you cannot change. The second answer is that you can protect yourself from confiscations to a certain degree by taking a short position in the US dollar. If you encourage your companies to borrow as many dollars as the amounts owned by your SWFs plus the net reserves of your central bank, then the chance of confiscations, defaults on promises and arbitrary changes of regulatory environment will be much smaller because you can always respond in kind. It also helps if US investors already own a substantial chunk of property on your territory. This instantly removes all incentives to play the confiscation card. Unfortunately, both China and Japan look very vulnerable in that regard. On the other hand, the European Union, Korea, OPEC countries and especially Russia are much better protected. By the way, kudos to Russian financial authorities: they accumulated a huge reserve fund without exposing themselves to the danger of government default on obligations (perhaps because they know a thing or two about defaults from the first-hand experience). The Central bank and Ministry of Finance are the only parts of the Russian government that seem to have brains. As a result of their policies, Russia has nothing to lose from the collapse of the US bond market, but it's a real pity that we can't say the same thing about China and Japan. These countries should really take some dollar loans before the dumping starts.

The million-dollar question is: will the dumping of bonds, when/if it starts, knock down the US banking system? I would like to be able to give an affirmative answer to that question. The shock therapy treatment for the US economy would be good for the whole world, but ultimately, nobody would benefit from it more than Americans themselves. The collapse of speculative bubbles should flush excesses out of the system and give the real economy a breath of oxygen, and the short-term dislocations would offer a convenient entry point for investors, both American and foreign. But real life is always more complicated than theoretical models. The popping of the debt bubble will not happen in an instant, besides it will be extremely hard for the several key players to come to  an understanding and dump their bonds at once. So, much as one would like to see a sudden crisis that bankrupts every bank in the US,  there is a greater chance that the crisis will run its course in slow motion.

If you're an SWF, the main issue you have to face is the relative advantages of gradualist vs. radical approach. The gradualist strategy is attractive in many ways. First, it's your best chance to get rid of a large part of your portfolio before people realize what's going on. Second, you also get plenty of time to reinvest the proceeds into RE and equities without causing a major market pop (remember, we are talking about trillions of dollars, so it's hard to invest them in one day). Your long time frame drives the market into a state of exasperation. Everybody gets so tired of the secular bear that as soon as the market rallies a little bit, people are happy to hand their real assets to you for 50 cents on the dollar. That was the case in the 70s. After ten years of abortive bear market rallies, American investors became trained to sell into a rally like a Pavlov's dog, which is why Buffett feels so nostalgic about these stock valuations. For a huge behemoth like the Chinese SWF, a decade-long war of attrition holds a definite attraction.

Of course, there is a price to pay. First, you give the Fed enough time to cheat you out of your hard-earned T-bonds through inflation. Second, you give the US economy plenty of time to adjust to the new reality: boost the export sector, prop up the housing market, move the money of US investors into foreign securities. As a result, you may never get a deep discount you were hoping for.  

The other, more radical approach, involves higher risk and higher reward. You dump the bonds rapidly and them rapidly reinvest the proceeds at your chosen price point. This strategy is basically a gambit because it implies huge nominal losses when you pull the funds out of a collapsing bond market. The justification of that strategy is that it's all right to inflict some pain upon yourself as long as you inflict greater pain on everyone else, and a rapid dumping of trillions dollars' worth of bonds can achieve just that. As a minimum, you can help the US banking system over the Styx river by making the bonds they own worth 25-30% less than today. Then, ideally, you reenter the market and buy a 49% stake in any other bank you choose for just $0.99. As a more ambitious goal, you can hope that the disappearance of credit would send the US housing market into a knock-down. The incredible bargains that follow will more than compensate you for your nominal losses. Ideally, you will want the Dow to plunge 80% from its peak, and real estate to drop 50%, repeating the experience of the Great Depression, and you will want to achieve this goal by knocking out the bond market, which will knock out the financial system, which will knock out the mortgage market, and then after real estate tumbles, the stock market won't hold either. The systemic crisis will give you a convenient entry point that you need. The problem is that this appealing scenario is not guaranteed. It will be real pity if you undersell your bonds only to have some other SWF pick these bonds at a discount price while the Great Depression you're hoping for never arrives. For this reason I think most SWFs will choose a gradualist Fabian strategy over a rapid cavalry charge. You won't hear any cries of "Fire". People will be elbowing their way to the exit door in complete silence.

In either case, it is important to understand that there is no way for bondholders to get out of the debt trap unscathed. The Treasuries market is a place where you pay $1 to enter the game and $2 to quit. Once the selling starts, you will have to book losses on your bond investment. But it is also important to realize what got you into this situation in the first place. The money was lost the moment you lent it to people who never intended to pay it back to you. Postponing the moment of truth in an effort to avoid the pain would be equivalent to doubling down on the bankrupt Enron so that you don't have to show your losses on the Capital Gains form and your wife doesn't suspect that you're stupid. If you avoid the decision for now, you will have to make it next year when it will be even harder, and if you postpone it indefinitely, Bernanke's Fed will make the decision for you.

Finally, you should try to achieve at least some understanding with your most significant partners. The last thing you need is a white knight who volunteers to rescue the bond market at precisely the wrong moment. The huge bubble of Treasury debt deserves nothing but vultures picking up bonds when their yield reaches 10%, and knowing the propensity of the Fed to create money out of thin air, even that will be too generous. While you cannot be sure how other countries will respond, you can at least control your own bankers, achieving some level of coordination. And, last but not least, you shouldn't forget the key element of the puzzle - oil. It will be unfortunate if the right hand of your government - the SWF - buys S&P indexes while the left hand promotes cheap oil policy that tends to give S&P a boost. If you're an oil exporter and are planning to boost production, you are well advised to put your plans on a shelf while your SWF is going on a buying spree. If you're an importer, it's also the right moment to replenish your strategic oil reserves.

As always, the strategy may be sound, but the execution will be critical. As any attempt to dump treasury paper in mass leads to a collapse of the dollar, making all dollar-denominated assets much cheaper, a responsible management of a SWF must carefully time their exit and entry points. It would be a tragic mistake to take a 25% hit on your bond portfolio only to invest the proceeds into dollar assets just as the dollar plunges against all other currencies. In the long run, you will still come out ahead even if you do your job semi-intelligently. But the conversion of bad loans on your books into tangible profits will not necessarily be a quick and easy process. After all, if the debt bubble persists, and your dumping of bonds fails to initiate a global run on the bond system, you may well find yourself buying American stocks at prices not that much different from today's.

5 Comments – Post Your Own

#1) On July 31, 2008 at 6:21 PM, LordZ wrote:

Holy moley, I tried to read what you wrote, but I could not, you lost me dog....

I am not a SWF

single white female

let alone a sukin wealth fund

so wtf ???

screw SWF

frack them

let them keep their assets in their mattresses and see how much more their assets will deflate...

or get stolen...

maybe I'll try to read when I calm down a few more of your paragraghs, but dog the first 3 lost my attention...


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#2) On August 01, 2008 at 9:37 AM, FoolishChemist (93.18) wrote:

I just glanced at it and when I saw SWF I was thinking of single white females.  I guess you can tell where my mind is.

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#3) On August 01, 2008 at 3:37 PM, Nainara (< 20) wrote:

Zloj, your commentary is an interesting read, as SWFs are potentially the biggest players in the future world of capitalism, but are yet much ignored by we, the armchair macro-economists. How these central banks and SWFs play their hands in the next decade may very well determine geopolitics for the next hundred years or more. In some ways, they're the standing armies of the 21st century.

However, also consider that SWFs do not exist in a void as do investors. They are political entities and there are many more political factors involved in their decisionmaking than pure profit.

Also consider that the biggest reserves of dollars and treasuries are as-of-yet still held by the central banks around the world, which are relatively inert and slow to react. The CIC, for example, only holds a paltry 200 billion of China's total foreign reserves which are approaching the 2 trillion mark. A significant migration of funds into the CIC or Japan's proposed SWF will have major implications and set off a lot of alarms. (Almost like a new-age declaration of war)

Because of this, I suspect that any moves toward the exit will be slow, stealthy, and unpublished. As the dollar is essentially a zero-sum game, I don't expect to see much cooperation or coordination between the players. It's also in nobody's interests to elicit a protectionist reaction from the American public and congress. In spite of that, Henry Paulson's successor had better be prepared to make a lot of trips and do much heiny kissing.

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#4) On August 01, 2008 at 5:31 PM, agchris02 (< 20) wrote:

The greatest threat facing the United States is the devaluation of the dollar (I believe in another blog I said the greatest threat is our fiscal irresponsibility).  There are steps that can be done to combat this, much like any other company struggling with debt:

1) Slash the budget

2) Turn your company (e.g US govt) into a profit making entity (this is easy as you get to tell the consumers how much to spend --- e.g. taxes). 

3) Enter into an aggressive buy back period, buying back the debt.

Now then, the ramnifications of such actions are staggering, as are the potential domestic reprecussions.  To significantly slash the US budget thousands upon thousands of jobs would have to be slashed, government projects pared down, future SS benefits written off, and medicare reworked.  The ripples this would put through the system would make the current stage of slow groth seem like  Nirvana.  However, as Zloj noted, the problem can only get worse.  Do we amputate the toe now, or the leg later?

I have not worked out yet the total consequences of taking such action, maybe I'll blog on that sometime next week, but I do NOT think sitting and waiting for the world to realize our debt is much, much, riskier than they think.   

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#5) On August 01, 2008 at 5:56 PM, Nainara (< 20) wrote:

As I tell my coworkers frequently, the question of what ought to happen is purely academic. The question that really needs to be addressed is what's most likely to happen, followed by, how can I benefit from it?

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