Picture Yourself as a Loan Officer, and Uncle Sam Wants a Loan

Interest-Rates / US Debt
Apr 02, 2011 - 09:55 AM
By: Richard_Shaw

Picture yourself as a loan officer for a moment.

Then imagine a very nice and sincere, but obviously clueless, person comes to you and says, my husband and I earn $100,000 per year, and we have found the home of our dreams with everything we have always wanted. It's price is $3.5 million, and I am here to request a mortgage in that amount from you.

What would you do? Would you laugh? Would you fall off of your chair? Maybe - but you would probably say:

"Do you realize that you are proposing to have a debt that is 35 times your family income? Do you have any idea what the debt services on that would be? Sorry - No, I cannot help you with that dream."

You know that is perfectly crazy. It would be impossible for that nice couple to ever service the debt.

Well guess what, if you buy treasuries you are a loan officer for yourself, and the U.S. government is that clueless person looking for a loan from you.

When you ask them for the financials, they look at you with sincere and clueless eyes and say, well we want to buy the society of our dreams and it only costs $75 trillion and we have an income of about $2 trillion.

What would you do? Would you laugh? Would you fall off of your chair? Maybe - but you should probably say: "No Way!"

Let's see why.

In today's Bloomberg, Bill Gross (who runs the world's largest bond fund) said that Treasuries "have little value" because of the U.S. debt burden, which he cites as being $75 trillion when the present value of Social Security, Medicare and Medicaid commitments are added to outstanding U.S. Treasuries.

Warren Buffet recommends avoiding all long-term fixed income bets because the purchasing power of the US dollar will fall. He said, "We are out-Greeking the Greeks" (referencing the sovereign debt crisis there).

Gross said $75 trillion is about 5 times our GDP - a frightening number. But, let's make it a bit more frightening by comparing it to the money the Federal government actually has available to service that debt.

According to the Tax Policy Institute and the White House websites, the 2011 Federal tax receipts from personal and corporate income taxes, and from Social Security and Medicare taxes, is projected to be $2.174 trillion.

That means the $75 trillion debt burden is 34.5 times the total Federal tax receipts. That's an eye popper.

To make it even worse, the composition of the Federal expense budget is currently 10.9% higher than receipts, meaning we are adding at least $1.645 trillion in additional debt this year (not counting increases in present value of social entitlements).

Over the five years that follow (2012-2016) the additional deficit projected to be added to Treasury issuance is $3.769 trillion.

So for the six years including 2011 - 2016, the NEW Treasury debt (not including additions to social entitlement present value obligations) is $5.414 trillion, or 2.5 times the entire Federal tax receipt projected for 2011.

The current Federal budget, according to the White House website, is composed of approximately 66% "Human Services" (Social Security, Medicare, etc); 20% Defense, and 5% interest payments; which together totals 91%. The remaining 9% is spent twice over, due to the deficit spending.

* Current Treasury debt is $14.2 trillion
* Current interest payments are $207 billion

Therefore the average interest rate on outstanding debt is 1.46%. - not a high number, but likely to rise.

As the interest rates rises, the cost of issuance for new debt and for rolling over old debt will rise, taking the interest payments to even higher levels, and absorbing more of the Federal budget.

Nobody can payoff 35+ times their gross income in debt without default.

The politicians are in a box.

They are first and foremost concerned about re-election. They know they can't get re-elected if they tax enough to solve the problem, and such taxes would probably kill the golden goose anyway.

They know they can't cut current social entitlements enough to solve the problem without the Wisconsin union protests looking like a minor league warm-up for what would happen in Washington, D.C., followed by their defeat at the polls.

Therefore, once kicking the can down the road doesn't work any more, and cutting future social entitlements doesn't solve current needs to pay debts and balance budgets, what do they do? Simple - debase the currency and create inflation to pay fixed dollar obligations with ever more worthless currency.

If you combine the probability of the U.S. solving its debt problem by debasing the currency (inflation) as a better choice than outright default, with the negative real after-tax rates for most taxable investors on all maturities of Treasury debt, there just aren't any good reasons (other than very short-term parking during a panic) to own Treasuries.

And this is NOT an April Fools joke!

By Richard Shaw