Don’t Worry About The Debt Tsunami
Posted on: June 24, 2009 - Email Article - Printable Version
It looks like in the next few years newly issued Treasury and agency guaranteed residential mortgage debt may create a debt tsunami that will swamp the economy. Fortunately, looks can be deceiving.
While interest rates are likely to rise for both long maturity Treasury notes and bonds and agency guaranteed residential mortgage debt, rising rates are not because of a lack of investment demand or failing confidence in the U.S. Government. Instead, as I have written for months, the all-in cost of capital for most domestic institutional investors is higher than the net yield on Treasury and agency guaranteed mortgage debt. The inability of domestic institutions to earn a profit at current interest rates isn’t the same thing as a lack of desire, capacity or confidence.
But of course yields are too low for private market investors to make money. After all, since December the Federal Reserve has been executing a program of open market purchases of Treasury and agency guaranteed mortgage debt designed to drive interest rates below market clearing yields. So, it shouldn’t be a surprise that among private investors there is an upward interest rate drift that can only be offset with more aggressive Federal Reserve intervention.
Private institutions can’t make money buying Treasury and agency guaranteed mortgage debt because the operating expenses of most institutions are very close to the investment yield on the Treasury and agency guaranteed mortgage debt. Unless the Federal Reserve is somehow able to magically force operating expenses of domestic institutions downward, market clearing yields are going to rise. At higher interest rates the private market won’t have any trouble absorbing the forward calendar of debt issuance.
To understand whether or not the volume of newly issued debt will swamp investor demand each type of debt needs to be broken down and analyzed individually and compared to sources of investment liquidity.
Residential Mortgage Debt
The amount of new mortgage debt isn’t a problem because basically there is no net new mortgage debt being created. There are two ways to create new mortgage debt; (i) refinance existing mortgage debt and (ii) finance home sales.
Refinancings, by definition, result in a repayment of old mortgage debt held by investors. For every dollar of refinanced mortgage debt that is issued there is a dollar of old mortgage debt that is retired. As a result, old mortgage debt investors receive cash that they recycle into newly created mortgage debt (or other investments like Treasury securities).
Mortgage debt created by home sales falls into two categories: new home sales and sales of existing homes.
The proceeds from purchase money mortgage debt created from sales of existing homes generally are used to pay off mortgage debt of the selling home owners. So, mortgage debt created through existing home sales is like refinancing debt, generally it doesn’t create net new mortgage debt.
If for some reason the debt tsunami worriers are agonizing about increased mortgage debt created from new home sales that should be the least of their concerns. If new home sales weren’t stuck in the mud there wouldn’t be a credit crisis or a deep recession which are the underlying causes of the debt tsunami. The United States should only have the problem that new home sales are so high it isn’t clear how they are going to be financed.
Treasury Debt
There is plenty of demand for long term Treasury notes and bonds, just not at current interest rates. The natural buyers for Treasury debt are domestic banks, thrifts and insurance companies. These institutions have more than $1 trillion of excess liquidity which continues to grow every day. The pool of domestic cash sitting on the side lines gets bigger every day because of a combination of increased U.S. savings and accommodative Federal Reserve policy.
However, domestic financial institutions are sitting on the sidelines and not buying. The problem is that domestic financial institutions know that they can’t make money buying Treasury securities at current interest rates and no matter how much they would like to own long term Treasury notes and bonds they can’t invest.
When interest rates on long term Treasury debt rises above 5% domestic institutions will start to be large scale buyers. These institutions will start to make a reasonable profit without taking on unreasonable risk or leverage from purchasing long term Treasury notes and bonds.
Debt tsunami worriers need to pick something else to anguish about, at least for a while. Obviously, the current deficits can’t last forever but they aren’t in danger of swamping the economy for a long time. And, interest rates are inevitably going to rise but then again long term interest rates aren’t being set by the marketplace. Rising interest rates aren’t a source of worry but rather the beginning of the end of the great recession.
Please stay tuned for Part II of Don’t Worry About the Debt Tsunami coming shortly.
-Mark Sunshine
Disclosure: This article is taken from the website Sunshine Notes with the permission of the original author. All questions regarding disclosure should be referred to the original author.
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