If default won't result in missing Social Security checks or unpaid bond interest, what's the big deal? by Bill Gee
(centrist)
Thursday, July 28, 2011
As the August 2nd deadline approaches, both Democrats and Republicans are full of dire warnings or they are caustically cavalier about the danger we face should the debt ceiling and/or the nation’s fiscal restructuring fail to materialize. They talk about missing Social Security checks, late or defaulted interest payments, government shutdowns, or they’re saying that nothing at all is going to happen. I even heard someone compare this crisis to the Y2K crisis!
They’re all wrong, and I think they know it because for all their faults, I don’t think Obama, Boehner, Reed, Cantor, and everyone else in Washington are particularly stupid. The real danger lies in the bond market itself, but since the average American doesn’t really understand how the bond market works, they’re restricting their talking points to things that we all can understand.
Let’s fix that so that we can actually have a constructive conversation on the real dangers here.
How Bonds Work 101
A US Treasury bond is an investment vehicle where the investor agrees to purchase a portion of the US Budget deficit in exchange for an annual or semi-annual interest payment over a specified period of time. Currently, you can purchase bonds for as little as six months or as long as 30 years.
This is how it works. Let’s say that you want to purchase a $10 million US Treasury bond that pays interest semi-annually for ten years on August 1, 2011. We’ll go with the July 27 10-year bond rate of 3.01%. This means that every six months for the next ten years you will receive a check or a wire from the US Government for $150,050, and on August 1, 2021, you will receive a check from the government for $10 million at maturity.
Now it gets a little more complicated.
As the investor, you are agreeing to pull your $10 million out of circulation for ten years. That’s a long time. You could be investing your money in lots of other places and get a much better return on your investment. Also, when we consider that over that ten-year period your money could be losing value due to inflation, you might even see a net loss in its overall value! Therefore, to sweeten the deal, the US Treasury agrees to sell the bond to you at a discount, which will amortize every six months. For simplicity, let’s say that the Treasury gives you a $1.5 million discount. Therefore, you will be paying the Government $8.5 million for a $10 million bond. The Book or Carry Value of the bond will represent what you paid for it, and every six months that you own the bond, it will increase in value by $75,000 until at the end of ten years its Carry Value will match its Par Value of $10 million.
Your return on your investment is calculated as follows:
Original Investment: $8.5 million
20 Interest Payments of $150,500 each: $3,010,000
Total Accrued Discount: $1.5 million
Your Total Return on Investment = $4,510,000
(By the way, all that interest income is only taxed at 15% rather than the 35% that people who actually work for a living have to pay!)
Simple, right? If you decide to buy and hold your bond until it matures in ten years, then you have no problem. But what happens if you want to sell your bond to another investor before it matures?
The Bond Market
The Market Value of a bond is a reflection of Supply and Demand, and has very little to do with the Par or Carry Value of the bond itself although how close a bond is to its maturity date will factor significantly into the current price.
For example, let’s say that you have held your bond for six months, and now you are looking to sell it. How much is it really worth, and will you realize a greater return on your investment?
Each day, Standard & Poors and dozens of other pricing agents provide estimated Market Prices for every security in existence. Pricing is calculated based on Demand, Supply, and the overall rating of that security. Bond traders use these prices when they offer bonds for sale in the market. If you can sell your bond for a price above the amortized book value, you made a profit, if you sell your bond below the amortized book value, you suffered a loss.
Currently, the only way you will realize a loss on the sale of a Treasury bond is if there are too many bonds in the market, which are driving down the market price. That’s not happening…yet.
The Importance of the Rating
Here is where we run into the real problem with the debt crisis. Currently, US Treasuries (and all other securities that are backed up by the Full-Faith-And-Credit of the United States) are rated AAA by the three major rating agencies. What this says is that you (the investor) can be absolutely 100% confident that on August 1, 2021, that $10 million bond you purchased will pay you the full amount of the Book Value, plus all interest including the amortized discount. In other words, you can “take it to the bank”.
Therefore, you are free to sell that security on the open market, you can use that security as collateral for a loan, and you are free to use either the book value or the market value on your balance sheet as an asset in your financial statements.
So what happens if S&P and the other rating agencies downgrade our securities?
First of all, what they are saying is that you (the investor) can be reasonably confident that on August 1, 2021, that $10 million bond you purchased will pay you in full, but you cannot be 100% confident that it will do so. (More like 95% to 98% confident. Still excellent, but not perfect.)
So what does that mean?
What that means is that it is more risky to use your Treasury bond as collateral for a loan. You will now need to report the bond at Market Value on your balance sheet, which is much more unpredictable. It means that with less-than-perfect confidence in the value of that bond, other investors in the market may be less willing to buy it from you, which will further degrade its Market Value.
In other words, a ratings downgrade will significantly slow down or reverse the economic recovery as credit will freeze (again!).
Other Effects
As I have stated in other postings, many institutional investors such as insurance companies, pension funds, 401K’s and trust funds require that a certain percentage of the securities they carry have to be AAA rated in order ensure their long-term value to their investors.
During the financial crisis, AAA-rated Mortgage-Backed Securities were suddenly downgraded to BBB or worse. Therefore, insurance companies and other statutory investors had to sell them in order to be in compliance with the law. This flooded the market with “toxic” bonds, many of which were purchased for pennies on the dollar as their market values sank to almost nothing. As a result, many of these institutions saw their asset values go down significantly as they were forced to realize billions of dollars in investment losses.
Now imagine the same thing happening with US Treasury bonds, Fannie/Freddie MBS’s, FDIC Insured Asset-Backed Securities, and every other bond out there that is backed by the US Government’s credit rating… The snowball effect is almost too scary to contemplate.
So Now You Know
Now you know that the threat to America’s financial security has less to do with its ability to pay its bills on time and more to do with the fact that the financial world has grown so dependent on our outstanding credit (deserved or not), that even the most slight downgrade is likely to throw the bond market on its head. The flood of bonds into the market will result in billions if not trillions of dollars in realized losses, which will undoubtedly cause many firms to fail and will cause real investment to stop dead in its tracks. Unemployment will likely go up significantly.
Ron Paul understands all this and believes that a credit downgrade might be a good thing. His logic is that the longer we delay a credit downgrade, the worse it will be when it eventually happens, and perhaps he is correct.
We are entering uncharted territory that is likely to change everything we believed to be true up to this point in our lives.
Did you like this article? If you did, Thumb It! 8
thumbs so far
The views expressed
in this article are those of Bill Gee only and
do not represent the views of Nolan Chart, LLC or its affiliates.
Bill Gee is solely responsible for the contents
of this article and is not an employee or otherwise affiliated
with Nolan Chart, LLC in his/her role as a columnist.
