Comment du jour, on the Fed-overdraft solution: “It’s a pragmatic solution to a dogmatic problem” — Reuters
Someone is wrong on the internet — FT
The WSJ identifies Kai-Lai Grace Ho as “salad platform head at Fresh Express” — WSJ
How disastrous is the increasingly-inevitable downgrade of US sovereign debt going to be? I talked to David Gaffen about this yesterday, and he reckons it’s probably not going to be such a big deal. And he’s backed up today with a report from Fitch Ratings, behind a registration wall here.
The fact is that Treasury bonds are going to remain the global fixed-income benchmark, simply because there’s no alternative. There are $9.3 trillion in marketable Treasury securities outstanding — that’s five times the debt stock of triple-A countries like France, Germany, or the UK. And when it comes to liquidity, the gap is even bigger: daily Treasury volume of $580 billion is 17 times higher than the next most liquid triple-A security, UK gilts. And UK gilts are denominated in pounds, which is hardly a global reserve currency; they’re certainly not much use for, say, financial institutions needing collateral for their dollar-based triparty repo transactions.
Oh, and one other thing: it turns out that beyond mystique-and-aura, there’s really no substantive difference between triple-A and double-A anyway: “the long-term credit performance of ‘AAA’ rated versus ‘AA’ rated issuers,” says Fitch, “is statistically negligible”.
So I’m willing to go out on a limb here, and declare that even if the US gets downgraded, Treasuries will still remain the lowest-yielding securities in the world. Triple-A issuers like the World Bank or Johnson & Johnson might have a better credit rating, but they’ll still have higher borrowing costs and higher yields than the US government. At these rarefied levels the liquidity of Treasuries is vastly more important than whatever negligible difference in credit risk there might be between the US and someone marginally safer.
That said, even Fitch concedes there will be “near-term volatility” in the immediate aftermath of a downgrade. On top of that, the repercussions for things like muni bonds, which will get downgraded at the same time, are much less predictable. And over the long term, people are going to think for a little bit before rushing to Treasuries as the ultimate safe haven. And investors hate being asked to think. Have no doubt: this entirely avoidable downgrade will increase US borrowing costs. A downgrade won’t end the primacy of the Treasury market. But it will still cause real harm.
I’m not sure where this meme originated, but people are saying with great confidence these days that Treasury has to borrow money just to pay the interest on the national debt. It simply isn’t true.
Here’s Michael Kinsley, last week:
Nobody knows for sure what will happen if Aug. 2 arrives with no deal made. But there’s good reason to expect the worst. The U.S. has fallen into the classic debtor’s trap of borrowing to pay the interest on previous borrowing. This means that even if we shut the government down completely, bills would still be coming in and interest payments would still be coming due, and we’d be unable to pay them.
And here’s Chris Wilson, today:
Here’s one way to express how catastrophically screwed the U.S. government’s finances are: If the entire U.S budget were cut to zero, effective immediately—the military, all entitlements, the electricity bill for the Capitol—there still wouldn’t be enough money to cover the payments on old debt that come due every day.
The fact is that Treasury can easily cover interest payments from tax revenues alone. We raise about $180 billion a month in taxes; interest payments come to about $30 billion a month. If the government shut down completely and did nothing but collect taxes and pay off the national debt, it would be running a profit of a good $150 billion a month.
Which is why I’m pretty confident that we’re not going to suffer a payment default on Treasury bonds. They’re called Treasury bonds for a reason: they’re issued by Treasury, which ultimately is going to make the determination about what payments to prioritize if the debt ceiling isn’t raised and we run out of money. Given the catastrophic consequences of a payment default on Treasury securities, those bonds will always have first priority — even if that opens up the White House to accusations of treating Chinese bondholders better than our uniformed military.
One confusion here might surround the difference between principal and interest payments coming due. When a principal payment comes due, that can be a huge amount of money — but when a bond is paid off, the national debt goes down by that amount. As a result, you can roll over the debt by issuing new securities, and not breach the debt ceiling. It’s only the interest payments which matter, unless the markets start refusing to roll over US national debt. And there’s no chance of that happening.
So when people talk about a US default, the reality is that the US is not going to make a payment default on its bonded debt. Instead, there will be other, weaker forms of default. The US sends out 200 million checks a month, and all of those are government obligations of one form or another. They’re not debt, in the way that Treasury bonds are debt. But they’re obligations all the same, and market confidence would indeed be rattled if the government found itself unable to make good on them. But that kind of confidence-rattling is nothing compared to what would happen if Treasury bonds started going into default.
John Carney has an intriguing post today: what if, in the short to medium term, the debt ceiling really doesn’t matter at all?
This is nothing to do with the 14th Amendment or with coin seignorage — this is just the simple mechanics of bank accounts. Treasury has an account at the Fed; at last count it was in credit to the tune of roughly $77 billion. Money’s coming in; money’s going out. Come August 2, it’ll be down to zero. But hey, zero’s just a number. We’ve all gone overdrawn at our bank at some time or another: why should Treasury be any exception?
The idea here is that after August 2, Treasury can simply carry on with business as usual. Money will come in to its bank account; money will go out. And the balance will dip below zero: Treasury will have an overdraft at the Fed. You think the Fed’s going to bounce Treasury’s checks?
The question is whether the overdraft counts as national debt for the purposes of calculating the debt ceiling. And Carney thinks there’s a good case to be made that it doesn’t:
The debt ceiling applies to the face amount of obligations issued under Chapter 31 of Title 31 of the U.S. Code—basically, Treasury notes and bills and the other standard kinds of government debt—and the “face amount of obligations whose principal and interest are guaranteed by the United States Government.” But overdrafts on the Federal Reserve wouldn’t be Treasurys and they aren’t explicitly guaranteed by the U.S. government.
There’s no reason why this state of affairs couldn’t continue for months. Treasury would continue to spend money, as instructed by Congress in the budget, and Treasury’s overdraft at the Fed would continue to rise. The Fed, for its part, would have two choices when it came to cashing Treasury’s checks: it could either simply print the money, or else it could sell some of its assets — it owns $1.6 trillion in Treasury bonds — and use those proceeds instead. Either way, any bank presenting a check from Treasury could cash it, no problem.
This seems to me by far the most elegant solution to the debt-ceiling problem, should Congress not get its act together by August 2. Treasury just keeps on spending, and the Fed would of course continue to honor the checks: failure to do so would trigger a massive recession and directly violate its full-employment mandate, for starters. There would be people saying that the Fed overdraft should by rights be included in the total national debt, but they would have no particular standing to try to get that point of view enforced by a court of law.
And of course if Treasury has a back-up overdraft facility at the Fed, that would only serve to shore up — rather than endanger — its precious triple-A credit rating.
So, have at it, people. Why isn’t this the first best solution to the debt-ceiling problem, should we find ourselves in that dreadful situation?
Muhammad Yunus is in town, plugging the new movie about Grameen America, the US version of his hugely successful Bangladeshi microfinance institution. It’s three years old at this point, and growing fast: it already has four branches, in Queens, Brooklyn, Omaha, and Manhattan, and plans to open another two by year-end. At the moment it has about 6,500 members, growing at a rate of about 5,000 a year.
I had a fascinating conversation with Yunus yesterday; he really is a very impressive individual. He’s not letting his setbacks at Grameen slow him down: he’s busy building lots of social businesses like Grameen Danone, where the startup capital is provided in a form where the original investor can never take out more than they initially put in. In short, he’s still working hard at what he’s done for most of his life, and what got him the Nobel Prize: using the power of capitalism to power improvements in developing-country living standards, rather than predatory behavior.
I asked him, then, what he was doing in the US, with a relatively small organization working in the world’s richest country. And he pointed to his left, where Gayle Ferraro, the director of the documentary, was sitting. “We have been doing this for 35 years in Bangladesh, we never got into a movie” he responded. “You do it in the richest country in the world, just a tiny little bit, it becomes a movie.”
Frankly, I’m not a huge fan of Grameen America, which is being parachuted into the media capital of the USA with no real understanding of what has come before it: it looks like a media stunt as much as a real attempt to help the poor. Case in point: if you’re online, it’s much easier to find celebrity endorsements from the likes of Matt Damon and Hugh Jackman than it is to find the addresses of Grameen America’s branches. When I asked about this, Vidar Jorgensen, one of Grameen America’s lead board members, told me blithely that their borrowers weren’t online.
Jorgenson also told me that, essentially, Grameen America had nothing to learn from the credit union movement. He told me that Grameen America was already the second-biggest microfinance institution not only in New York but in the country; that kind of thing only makes sense if you consider member-owned community development credit unions not to be microfinance institutions. He told me that almost no credit unions are profitable. And he was adamant that none of Grameen America’s borrowers could ever get a loan anywhere else. “Credit unions won’t touch these,” he said. “Every time they make a loan, they have to reserve against it 100%. These are people at or below the poverty level. Anybody with enough assets to get a loan would actually be above our standards. We actually go to people’s houses to make sure they’re not too affluent. They have to be down to our standards in terms of income and assets.”
That kind of talk contrasted quite starkly with what I was hearing from Yunus. When the conversation came around to Kiva, for instance, Yunus told me that he found the emphasis on very poor borrowers to be “undignified”.
If you go to the Kiva website, said Yunus, you see an individual whose poverty is being used to gin up donations. Which doesn’t dignify her. “After all, she’s paying interest. Why should you advertise her as someone who’s deserving of donations? It’s an undignified way of doing it. She’s running a business. Respect her as a client. As somebody who’s paying full cost.” Meanwhile, Grameen America, a registered charity, is asking for donations, saying that “your contribution is a tax- deductible way to help families in need”.
As someone who sits on the board of a profitable community development credit union which is significantly larger than Grameen America, I’m aware that Grameen America has spent a good amount of time talking to New York credit unions, and even toyed at one point with the idea of becoming a credit union itself. But it decided to go its own way, and has partnered with banks, not credit unions — Citibank and Capital One are the main ones — to get its members fee-free microsavings accounts.
And here’s the biggest shortcoming of Grameen America, for me. It’s not a depository institution, so it can’t offer savings accounts of its own. And it’s not even much of a lender: for all that its officers love to talk about dreadful payday lenders with their predatory loans, Grameen America only really has one product: the micro-business loan for people to start up small home-based businesses. Making sandwiches for local construction workers, helping people out with hair braiding, baking delicious Dominican pastries — that kind of thing. They take a relatively small initial investment, and yield a relatively small income.
But demand for loans is so much greater than that. Most people, especially if they’re poor, need consumption-smoothing loans. Many just need cash until payday. Others want to be able to buy a television, or a car, or just pay overdue bills. Perhaps they’re in hock to a loan shark, and desperately need money to get out of that particular vicious spiral. For all those people, and many more, Grameen America offers no help at all. (And, of course, men need loans too; so far, all Grameen America’s borrowers have been women.) I specifically asked about people who were looking to get a job, rather than to become self-employed; I was told that Grameen wasn’t for them, either, and that such ambition is probably silly right now, given the unemployment rate.
Grameen America is even limited on its own terms: while it will help women get from zero to a slow walk, in terms of building a business, it won’t help them much after that. At Lower East Side People’s, we lent one woman money to expand her baking-at-home business, and then, when that was successful, graduated her to a much larger small-business loan so that she could rent her own storefront in the East Village. That kind of thing wouldn’t be possible at Grameen America — they stay small.
Grameen America, then, is quite good at reaching the goals that it sets for itself, not least because its board includes some fabulously wealthy people who are more than capable of throwing millions of dollars at the organization until it does what it’s designed to do. At the end of 2010, Grameen America had $3 million of cash in the bank, another $2 million pledged and on its way, and just $3.3 million in total loans outstanding; it actually had fewer loans than it had equity. (The financial statement is hard to find on the web, so I’ve put it here.)
Meanwhile, Muhammad Yunus is, still, spot-on in his diganosis of the microfinance industry globally. He’s trying to get it more regulated, he’s pushing for national ID numbers so that lenders will know when someone already has too many loans; he thinks there are too many players right now; he wants microfinance institutions to be funded domestically and sustainably, rather than from for-profit or even not-for-profit foreigners bearing cheap dollars. The only thing I worry about with regard to Yunus is that since he got his Nobel Prize, he’s being co-opted as a kind of mascot by do-gooders in the US at places like Grameen America and Whole Foods. The publicity is welcome, I’m sure. But it does have a tendency to perpetuate the idea that the microfinance involves rich people making charitable donations to improve the lives of poor people. Which is not really the story of Grameen at all, even if, for the time being, it is a large part of the story of Grameen America.
Ezra Klein reckons I’m wrong about the tactical failures among Democrats which led to the current debt-ceiling fiasco and the probable loss of America’s long-prized triple-A credit rating. The big failure, he says, wasn’t at Treasury, and wasn’t at the White House: it was in the Senate. Specifically, this is all the fault of Harry Reid.
The reason we’re hitting the debt ceiling, remember, is that the budget passed by both Republicans and Democrats forces us to do so. As a result, the obvious time and place to raise the debt ceiling is when you pass the budget. This isn’t just obvious now, it was obvious then. And the person who thought it was a bad idea? Harry Reid. Here’s Reid on December 8, 2010:
Reid also said that he would like to push off raising the debt ceiling until next year — when Republicans control the House, but that he has not discussed the matter yet with his caucus.
“Let the Republicans have some buy-in on the debt. They’re going to have a majority in the House,” said Reid. “I don’t think it should be when we have a heavily Democratic Senate, heavily Democratic House and a Democratic president.”
This has to rank very highly in the annals of tactical own-goals. As Ezra explains:
The election was over. Nancy Pelosi was still speaker of the House. Harry Reid still had 59 Democrats in the Senate. The Bush tax cuts were expiring. And Democrats had a perfectly popular and intuitive position: Extend the cuts for the middle class but, in a time of deficits and sacrifice, sunset the cuts for the rich.
Republicans, of course, didn’t want to allow the Bush tax cuts for the rich to expire. They were, in fact, desperate to preserve them. Which meant Democrats had the leverage.
What was Reid thinking? Basically, he didn’t want to give the Republicans a stick with which to beat the Democrats at the next election. Voting for debt-ceiling raises is never particularly popular, and it’s an easy and obvious electoral strategy for any Republican running against an incumbent Democrat to wheel out her vote on the debt ceiling.
But as any bond-market borrower knows, the most expensive money in the world is the money you haven’t raised yet. In the case of the debt ceiling, it had to get passed; there was no point in getting greedy. And I’m sure that Reid is rueing his decision right now. Forcing a majority-Republican House to vote to raise the debt ceiling might have seemed like a good idea at the time. But it’s not exactly the epitome of leadership. Indeed, it seems to have led the country straight into something which risks being downright catastrophic.
Many thanks to Van Tsui and Scott Barber for putting this chart together for me. We’re all used to seeing yield curves — charts which show the yield, for any given credit, at various points along the maturity spectrum. This chart is different: it’s a price curve. It just shows the price at which Greek bonds are trading, plotted according to their maturity.
And it’s really odd.
To understand just how odd this chart is, it’s important to realize that in the Greek bond exchange, there’s only one menu of options for anybody holding a Greek bond. It doesn’t matter if your bond is maturing in six months or if it’s maturing in 26 years, the instruments you’re given the choice of swapping into are all exactly the same.
The way that the bond exchange has been structured, the new Greek bonds are all going to trade at roughly the same price, at least in the first instance. If they didn’t, then everybody would simply pile into the most valuable instrument. We won’t know exactly what price they’ll be trading at until they start changing hands, of course, but I’ve marked a range between 62 and 75 cents on the dollar in the chart. At 62 cents on the dollar the bonds would be trading at an exit yield of 13%; at 75 cents on the dollar they would be trading at an exit yield of 9%. Chances are, when the bonds start trading, they’ll be somewhere in that range.
For the bonds which are trading at or near that range, the exchange makes sense. You swap one bond for another bond worth pretty much the same amount, and Greece gets a bailout at the same time. Net-net, you’re better off.
But for bonds trading significantly above 75 cents on the dollar, there’s a lot of reason to stay out of the exchange. We’re talking the bonds maturing in the next year or two here — for them, you’d be much better off holding them to maturity, or even just selling them on the secondary market.
Odder still are the bonds trading at very low prices, below 40 cents on the dollar, or, in some cases, below even 10 cents on the dollar. What on earth are they doing down there?
All of those bonds can be tendered into the exchange for new bonds which are likely to be worth at least 60 cents on the dollar: it’s free money. Just buy a long-dated low-coupon Greek bond, tender it into the exchange, sell your new bond, and double your money. Why hasn’t that price difference been arbitraged away? And, more generally, why aren’t the blue dots all arrayed in a nice straight line at roughly the level the market expects the new bonds to trade at?
I suspect that what’s going on here is that we’re seeing artifacts of an extremely illiquid market. Over the past year or so, as the Greek fiscal crisis got steadily worse, mark-to-market bond investors sold their bonds to banks, who were willing to pay a premium for them, partly because they were eligible to be used as collateral at the ECB. And the banks are holding on to their Greek bonds now, promising to tender them into the exchange. As a result, there’s no real liquid market in Greek bonds any more, and the prices seen in this chart aren’t available to any old bond investor looking for a quick flip.
Embedded in that mechanism is an implied quid pro quo. The banks will make a lot of money, at least on a mark-to-market basis, by tendering their long-dated Greek debt. In return for that profit, they will tender their short-dated Greek debt as well, even though doing so doesn’t make a lot of rational sense.
This helps explain why the official description of the bond exchange splits the par bond into two seemingly identical parts: a “Par Bond Exchange” where bondholders get a new 30-year bond with a step-up coupon rising from 4% to 5%; and a “Par Bond offered at par value as a Committed Financing Facility,” where bondholders roll maturing bonds into exactly the same thing.
Why make a distinction between the Par Bond Exchange and the Par Bond offered at par value, when both involve swapping your old bonds for the same new 30-year bond? Because the second one, the Committed Financing Facility, can be spun by the banks as them putting new money into the deal. And in a certain sense they are: they’re voluntarily giving up the extra money they could get by holding or selling their short-dated Greek debt.
All of this is in one sense much more complicated than it needs to be. Why construct a hidden and implicit quid pro quo, when you could do a normal bond exchange instead, and swap existing debt into new debt of similar or slightly higher value? Greek bonds, as the chart clearly shows, are worth anywhere from 10 cents on the dollar to 110 cents on the dollar: why should they all be swapped into the same thing?
On the other hand, this is at heart an old-fashioned London Club debt restructuring, as opposed to an Argentina- or Ecuador-style bond exchange. Bondholders look at their holdings on an instrument-by-instrument basis, while bankers are more prone to thinking about their exposure to any given credit as one big risk to be restructured.
So this exchange might well work, insofar as Greece’s debt is overwhelmingly held by banks. But don’t think of it as a template for future restructurings.
What does it mean, when a bank takes a 21% haircut on its Greek debt? With the release of Deutsche Bank’s results yesterday we have an interesting case in point: the bank took an impairment charge of €155 million on its Greek government bonds. That’s just under 10% of Deutsche Bank’s stated €1.6 billion in Greek sovereign exposure.
Deutsche Bank is well aware of the size of the haircut, of course — but not all of its Greek exposure comes in the form of securities classified as “financial assets available for sale.” Still, it would have been nice to have been told the size of the writedown in percentage terms, rather than just in cash terms.
Part of the problem here is that the exchange offer is rather opaque; Joseph Cotterill says that the structure of one of the discount bonds, in particular, is “still stumping analysts.” Here’s how the IIF describes it:
A Discount Bond Exchange offered at 80% of par value for a 15 year instrument. The principal is partially collateralized with 80% of losses being covered up to a maximum of 40% of the notional value of the new instrument. The collateral is provided by funds held in escrow. These funds are borrowed by Greece from the EFSF. The EFSF funding costs are covered by the interest earned on the funds in the escrow account so there is no funding cost to Greece of this collateral. The funds in escrow are returned to the EFSF on maturity, if not used, and the principal on the bond is repaid by Greece.
Let’s say you swap €1,000 face value of Greek debt into this new instrument. The first thing that happens is that you take a haircut: the new bond, which carries a coupon of 5.9%, will have a face value of only €800.
The second thing that happens is that Greece will borrow 40% of that sum — €320 — from the EFSF, the European bailout fund. It will put that money into an interest-bearing escrow account; the interest on the money will be enough to repay the interest that the EFSF is charging Greece.
And this is where things become unclear. In the event that there are “losses,” then 80% of your losses will be repaid out of that escrow account.
But what does that mean?
My first thought was that it was something to do with a possible second haircut. Say bondholders were asked to take another 10% haircut on the new bond. That would be €80, and of that €80 the escrow account will repay you €64, which means your actual haircut would only be €16, or 2%. This continues up until the losses reach 50% of the value of the new bond, and the escrow account pays out in full. After that, there’s no money left and all further losses you suffer entirely. That would be quite elegant, since it’s unlikely Greece would impose a second haircut of much more than 50%. But then I realized that coupon payments are just as important as the face value of any principal. If you reduce the principal by 10% and the coupon remains the same 5.9%, then you lose 10% of all your coupon payments, too. Let’s say there are 12 years left on the bond when the second restructuring happens — then a 10% haircut wouldn’t just knock €80 off your principal repayments, it would also knock €57 off your total coupon payments. Presumably 80% of that, or another €45, would also have to come out of the escrow account. So now the escrow account is looking rather thin. Let’s say there’s another restructuring after 3 years with a more realistic 30% haircut, and the coupon staying at 5.9%. Then the escrow account loses €192 in principal and another €135 in interest, for a total of €327. We’ve already exceeded the amount of money in the account — it’s wiped out.
And the other question, of course, is when the money would be paid out of the escrow account. Would it pay out at the time of restructuring, even for payments which aren’t due for another decade or more? Or would it just sit there in escrow, paying out little €5.66 partial-replacement coupons every six months until it ran out of money? It’s a big difference, since €5.66 today is worth a hell of a lot more than €5.66 in ten years’ time.
I’m sure answers to these questions will slowly emerge — but for the time being, if you’re a bank tendering into the exchange, I think you can more or less write down your bonds by any vaguely plausible amount you like, and probably get away with it. If you’re marking to market, of course, it’s easy. But if you’re holding old Greek debt on your books at par, then — especially if you swap into another par bond — you probably have very wide latitude in where you mark the new debt. And if you swap into a discount bond, for the time being almost no one understands exactly what that’s reasonably going to be worth.
Update: Thanks to my commenters, especially Greycap, for pointing out that it’s just the principal, not the coupon payments, which are partially collateralized. But in a way this only makes things much worse. If Greece wants to restructure the bond, it will now have every incentive to push back maturities and reduce coupons to zero, rather than other options — because that wouldn’t trigger a payout of collateral. It seems very easy to game to me.
My favorite bit of the NYT’s latest Murdoch story: the byline saying “Tim Arango contributed reporting from Baghdad” — NYT
Judith Klausner is my new favorite artist — JG Klausner
R.I.P Steve Lacey — Geekwire
“For the first time ever, developing countries as a group have been growing faster than industrial countries” — Rodrik
Apple’s paying less than $35/sqft for its space in Grand Central Terminal — NYP
Susan Sontag: the kind of person who puts on a bear suit and looks utterly miserable — Tumblr
Would you live in the Nineties for a million dollars? — National Review