Debt Ceiling Extortion

September 24, 2013Danny Vinik 7 Comments

I have no doubt that Congress will raise the debt ceiling. Republicans simply have no choice, but to accept defeat and move on. The United States government pays its bills. Period.

Beyond that though, it’s remarkable how idiotic this argument has become.

Republicans cannot hold the debt ceiling hostage.

In 2011, the last time debt ceiling brinksmanship almost caused an international financial crisis, Republicans were screaming that any debt ceiling increase must be offset by equal spending cuts. The entire goal was to reduce the deficit. While playing chicken with the debt ceiling was irresponsible then, there was at least a bit of logic in terms what Republicans were holding hostage and their ransom demands.

This time though, Republicans are holding the debt ceiling hostage while demanding a one-year delay in Obamacare. There is no connection between the two. Republicans are using the debt ceiling to extort the President. Worse, some Republicans seem ready to breach the debt ceiling if Obama does not back down and agrees to delay his signature legislative achievement. This is where things get absurd.

If we do breach the debt ceiling, it will likely have a significant, long-term negative impact on our debt. Rates on U.S. Treasury notes are lower than any other bond because investors are 100% confident that the U.S. will repay its creditors. The chance that a debtor doesn’t pay its creditor is called credit risk. Companies and countries close to bankruptcy have high credit risks. But the United States is never close to bankruptcy because the dollar is the world’s reserve currency and the U.S. can print its own money. It can always pay back its creditors. That’s why interest rates on Treasury bills are so low. But, if we breach the debt ceiling, that non-zero credit risk rises substantially. Suddenly, it becomes a very real possibility that the U.S. could not pay its creditors. Even if Treasury prioritizes bond payments so it does not technically default on its debts, the act of breaching the debt ceiling will likely shock investors and force them to increase the risk assessment of Treasury notes. That means considerably higher-interest rates for the U.S. in the long-term and thus higher interest payments.

In 2011, J.P. Morgan estimated that rates on Treasury Bills would rise 50 basis points if we breached the debt ceiling. They predicted that it in the long-term, that would add $75 billion per year to the deficit. Compare that to the sequester, which was the result of the 2011 debt ceiling deal. It cut spending by $1.1 trillion over 10 years. Breaching the debt ceiling would effectively undo nearly three-quarters of those cuts in the form of increased interest payments.

So, in 2011, Republicans were so concerned about the deficit that they took the debt ceiling hostage to extract $1.1 trillion in spending cuts.
Now, Republicans are so concerned about Obamacare that they’ve taken the debt ceiling hostage and risked adding $750 billion to our long-term debt.

If Republicans were so worried our long-term debt two years ago, why are they willing to undo most of those spending cuts this time? Does that seem like Republicans actually care about our debt and are using the debt ceiling as a principle to get our fiscal house under control? Or does it seem more like an irresponsible, reckless party risking a global financial collapse in order to extort the President?

That’s why President Obama and Senate Democrats cannot and will not negotiate on the debt ceiling. There is nothing principled about Republican arguments here. The debt ceiling is simply a mechanism to hold the President hostage and force his hand. That’s unacceptable. Enough with debt-ceiling histrionics. Our democracy does not work that way.

Richmond Residents Are The Ones Harmed By Eminent Domain

September 24, 2013Danny Vinik Leave a comment

Richmond, California’s use of eminent domain continues to move forward. As regular readers know, the entire plan is a fraud intended to rip off investors so that Mortgage Resolution Partner (MRP), the firm supplying the capital to Richmond, can profit. Why Richmond agreed to take MRP up on it’s ridiculous plan has been unknown for a while now. Maybe they really don’t understand it. Maybe there is corruption involved. It’s unclear.

What is clear though is that the ultimate losers from this play will be Richmond residents. Investors are (rightfully) infuriated by Richmond’s decision to move forward with eminent domain and have filed a lawsuit attempting to block the plan. A judge threw out that suit, saying it was “premature,” but the legal battles are just beginning. Once the city does seize the mortgages, investors will file suit again. Hopefully a judge immediately sees through this highway robbery and isn’t fooled as well. This entire thing is an unnecessary and costly waste of time.

In the end though, investors will be okay here. MRP’s plan will fail. The losers will be Richmond residents, which Moody’s made clear last Friday. The credit rating agency named the plan “credit negative.” From the report:

The eminent domain program is credit negative for the city because it will likely lead banks to raise mortgage interest rates and reduce mortgage availability, which will in turn limit the growth of property values and related taxes

…

Lenders will factor in the additional risk by raising mortgage interest rates or decreasing their availability

None of this is surprising, but it’s still sad to hear.

If this plan was done properly, Richmond would offer up a fair value to investors. Some of those investors may disagree with Richmond’s valuation. There would be quibbling and the two sides could look to work out a fair deal. Some banks may be wary of the additional risk and factor it into higher rates, but the rise would be small. If investors are properly compensated, they won’t be too upset to offload defaulted, underwater mortgages. They may not even put up much of a fight. In the end, mortgage rates wouldn’t rise much, if at all. But MRP’s plan is such a ripoff that if it were to go through, banks would jack up rates. Luckily that won’t happen, but it shows what a mess this entire situation is. MRP’s plan is a fraud, Richmond fell for it and its residents pay the price.

The Unemployment Rate is Just One Indicator

September 23, 2013Danny Vinik 1 Comment

One criticism of the Fed’s recent communication strategy has been that it relied too heavily on the unemployment rate as an indicator of the health of the labor market and communicated that reliance to the market. As I wrote earlier, the unemployment rate is falling, but the economy is barely improving. In his June prepared statement, Fed Chairman Ben Bernanke said:

And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around midyear. In this scenario, when asset purchases ultimately come to an end, the unemployment rate would likely be in the vicinity of 7 percent, with solid economic growth supporting further job gains

The Fed projections at the time expected the unemployment rate to be at 7.2-7.3% in the fourth quarter of this year. In August, the unemployment rate fell to 7.3%, well ahead of the Fed’s projections. Except this was not the result of above-average economic growth. On the contrary, financial markets tightened and the August jobs report was disappointing. The drop in the unemployment rate was not representative of the overall economy.

Bernanke had hinted that the unemployment rate would be around 7% when asset purchases fully ended, but it had not even begun tapering yet. That was one major reason that so many journalists and investors expected the taper last week. Yet, this is once again not the Fed’s fault. The central bank could have done better in a number of areas. The long silence from the Fed governors provided little guidance for investors and Bernanke should have emphasized more that the Fed uses many different pieces of economic data to judge the labor market, not just the unemployment rate. But fundamentally, this was the market misreading the Fed.

Investors took one economic indicator and assumed the Fed would base its monetary policy on it. Worse, they knew that the drop in the unemployment rate was not the result of improving economic growth. It should have been common sense that the Fed would not that into account. But it wasn’t. There’s no doubt the Fed and Bernanke could have been more clear, like NY Fed president BIll Dudley was today and Bernanke was in his press conference last week. There, the chairman emphasized that the Fed looks at other economic indicators as well:

Last time, I gave a 7 percent as an indicative number to give you some sense of, you know, where that might be. But as my first answer suggested, the unemployment rate is not necessarily a great measure in all circumstances of the–of the state of the labor market overall. For example, just last month, the decline in unemployment rate came about more than entirely because declining participation, not because of increased jobs. So, what we will be looking at is the overall labor market situation, including the unemployment rate, but including other factors as well. But in particular, there is not any magic number that we are shooting for. We’re looking for overall improvement in the labor market

Too many commentators overreacted to what Bernanke said in June. The 7% unemployment rate number was treated as a trigger, not a threshold, even as Bernanke emphasized that it was the opposite. The unemployment rate was treated as the pivotal economic indicator influencing Fed decision-making. If you take a step back and look at the economic growth the past three months, there were few reasons the Fed would taper and many it wouldn’t. The most important thing is that the economy underperformed Fed expectations. Yet, it was conventional wisdom that the taper was coming. That doesn’t mean Bernanke couldn’t have been clearer in June, but it means it was a fundamental misreading by journalists and investors. The Fed’s over-reliance on one economic indicator doesn’t change that.