The recent financial crisis is said to have originated with the subprime loan collapse, which later spread throughout the entire global financial system. The size and characteristics of subprime loans that contributed to the collapse can be found in another widely held investment: U.S. Government debt.
Before we get into the specifics of what concerns us, we should let readers know that we are value investors. We agree with James Grant of Grant's Interest Rate Observer, who said, "There are no bad investments, only bad prices." This is another way of saying that with any investment, we look for a margin of safety to protect us against loss of purchasing power. We do not believe that U.S. Government securities offer such safety at current levels. Should inflation and interest rates increase significantly, owners of "risk-free" government debt will find that their investments, in fact, carry much risk.
Let's first look at the characteristics of loans that make them subprime. Many of the troubled subprime mortgage loans underwritten in 2005-2007 were made to borrowers with poor credit history. This results from either an inability or an unwillingness to make timely payments. One could certainly argue that the U.S. has a poor credit history. The difference is that the U.S. has benefited from the kindness of foreigners to refinance its debt and have, at times, opted to "print money" rather than default. Surely, troubled subprime borrowers would have seriously considered the options to continuously refinance or print money, if given the opportunity.
Many subprime loans also typically carried variable interest rates or rates that were fixed for a few years before becoming adjustable. According to the December 2009 Monthly Statement of the Public Debt of the United States, upcoming debt maturities are $2.92 trillion in 2010, $861 billion in 2011 and $708 billion in 2012, excluding non-marketable Government Account Series (GAS) debt. And GAS debt is substantial, as it includes over $4.5 trillion held by Social Security and other government trusts. All of this will need to be refinanced at whatever the market rate is at the time--just like an adjustable rate loan.
Some subprime loans were also considered risky because they were not fully-amortized, but instead were made with interest-only payments. Most bonds make interest-only payments with a balloon principal payment due at maturity. Government notes and bonds are no different. Is all of this starting to sound familiar?
Yet another problem with subprime loans was that many of them had little or no down payment. And because the housing market was grossly overpriced in many parts of the country, the collateral was of low quality. Government debt has no collateral--only a promise to pay from the U.S. taxpayers--similar to a promise to pay from subprime borrowers. This leads us to our next point. Many subprime borrowers had very high debt-to-income ratios. Viewed from this perspective, the U.S. has an outrageous debt-to-income ratio that is currently around 100%, and it is expected to run large budget deficits far into the future.
According to the recent Office of Management and Budget's estimated Budget of The U.S. Government, deficits are projected to be $1.449 trillion in 2010, $1.173 trillion in 2011, $939 billion in 2012 and around $1 trillion per year into the foreseeable future. And these figures continue to be revised upward. Adding these figures to the upcoming debt maturities, the U.S. will have to refinance approximately $4.369 trillion in 2010, $2.034 trillion in 2011, $1.647 trillion in 2012 and well over $1 trillion per year thereafter. We will save the "Who will finance this massive debt?" question for a later discussion. The point is this is a potentially serious problem waiting to explode.
Possible outcomes include default, restructuring, devaluation (inflation), higher tax rates, or some combination of these. Economic prosperity, higher savings rates and increasing foreign investment could also solve this problem, but we shouldn't rely on these, particularly in a questionable global economic environment where foreign investors are becoming increasingly worried about the U.S. dollar. If that wasn't enough, a change in the world reserve currency status of the U.S. dollar during this troublesome period could potentially cause a worldwide depression.
Readers must be thinking at this point that we are pessimists. We consider ourselves realists. As value investors, we are always concerned more with downside risk than upside potential, and we see no larger risk than the U.S. Government subprime loan over the next 5-10 years.
Before we get into the specifics of what concerns us, we should let readers know that we are value investors. We agree with James Grant of Grant's Interest Rate Observer, who said, "There are no bad investments, only bad prices." This is another way of saying that with any investment, we look for a margin of safety to protect us against loss of purchasing power. We do not believe that U.S. Government securities offer such safety at current levels. Should inflation and interest rates increase significantly, owners of "risk-free" government debt will find that their investments, in fact, carry much risk.
Let's first look at the characteristics of loans that make them subprime. Many of the troubled subprime mortgage loans underwritten in 2005-2007 were made to borrowers with poor credit history. This results from either an inability or an unwillingness to make timely payments. One could certainly argue that the U.S. has a poor credit history. The difference is that the U.S. has benefited from the kindness of foreigners to refinance its debt and have, at times, opted to "print money" rather than default. Surely, troubled subprime borrowers would have seriously considered the options to continuously refinance or print money, if given the opportunity.
Many subprime loans also typically carried variable interest rates or rates that were fixed for a few years before becoming adjustable. According to the December 2009 Monthly Statement of the Public Debt of the United States, upcoming debt maturities are $2.92 trillion in 2010, $861 billion in 2011 and $708 billion in 2012, excluding non-marketable Government Account Series (GAS) debt. And GAS debt is substantial, as it includes over $4.5 trillion held by Social Security and other government trusts. All of this will need to be refinanced at whatever the market rate is at the time--just like an adjustable rate loan.
Some subprime loans were also considered risky because they were not fully-amortized, but instead were made with interest-only payments. Most bonds make interest-only payments with a balloon principal payment due at maturity. Government notes and bonds are no different. Is all of this starting to sound familiar?
Yet another problem with subprime loans was that many of them had little or no down payment. And because the housing market was grossly overpriced in many parts of the country, the collateral was of low quality. Government debt has no collateral--only a promise to pay from the U.S. taxpayers--similar to a promise to pay from subprime borrowers. This leads us to our next point. Many subprime borrowers had very high debt-to-income ratios. Viewed from this perspective, the U.S. has an outrageous debt-to-income ratio that is currently around 100%, and it is expected to run large budget deficits far into the future.
According to the recent Office of Management and Budget's estimated Budget of The U.S. Government, deficits are projected to be $1.449 trillion in 2010, $1.173 trillion in 2011, $939 billion in 2012 and around $1 trillion per year into the foreseeable future. And these figures continue to be revised upward. Adding these figures to the upcoming debt maturities, the U.S. will have to refinance approximately $4.369 trillion in 2010, $2.034 trillion in 2011, $1.647 trillion in 2012 and well over $1 trillion per year thereafter. We will save the "Who will finance this massive debt?" question for a later discussion. The point is this is a potentially serious problem waiting to explode.
Possible outcomes include default, restructuring, devaluation (inflation), higher tax rates, or some combination of these. Economic prosperity, higher savings rates and increasing foreign investment could also solve this problem, but we shouldn't rely on these, particularly in a questionable global economic environment where foreign investors are becoming increasingly worried about the U.S. dollar. If that wasn't enough, a change in the world reserve currency status of the U.S. dollar during this troublesome period could potentially cause a worldwide depression.
Readers must be thinking at this point that we are pessimists. We consider ourselves realists. As value investors, we are always concerned more with downside risk than upside potential, and we see no larger risk than the U.S. Government subprime loan over the next 5-10 years.
