Wednesday, October 15, 2008

Uncle Sam's A.R.M.

As many home-owners have or are in the process of discovering, adjustable rate mortgage (A.R.M.s) payments can quickly become unmanageable when rates reset. As interest charges double or triple the wisdom of a long term fixed rate mortgage becomes clear.

Fortunately the wise men at the Treasury Department are well versed in such matters and didn't succumb to the temptation of "teaser" rates.



According to the US Treasury, as of June 2008 (thus not inclusive of the recent bail-outs and mortgage market nationalization), of the $2.72T in government debt owned by foreigners, $1.2T has a duration of under 2 years. In other words, interest rates on that $1.2T ($1.4T including interest payments) will be reset in the next 24 months.

Expanding the scope to include all US external debt, as of June 2008, of the $11.7T of debt owned by foreigners, $6.3T has a duration of under 2 years.

One of Hyman Minsky's claims to fame is his research on the transition from financial stability to fragility in a capitalist economy experiencing a bubble- the Financial Instability Hypothesis.

The Levy Institute, continuing Minsky's research, argues: The aim of these hypotheses is to show that the normal functioning of “a capitalist economy endogenously generates a financial structure which is susceptible to financial crises”because of the higher sensitivity of the economy to changes in income, cash commitments and asset prices. Thus, it is important to explain how the financial structure of the economy (or a sector) changes. This implies studying how it is affected by the prevailing convention regarding the appropriate balance-sheet and cash-flow structures, and by thedevelopments in the productive economy: both the expectation and actual sides of the economyaffect the financial structure of the economy.

The logic of this financial instability hypothesis is that during a prosperous economicperiod, there are forces that progressively lead the economy from conservative financialpositions (hedge positions) to positions for which the articulation of cash flows is high andbalance sheets are illiquid and highly leveraged (Minsky 1986a, 210-211):

The logic of this theorem is twofold. First, within a financial structure that is dominated by hedgefinance, there will be a plentiful supply of short-term funds, so that short-term financing is“cheaper” than long-term financing. Accordingly, firms will be tempted to engage in speculativefinance. Second, over a period of good times, the financial markets will become less averse torisk. This leads to the proliferation of financing forms that involve closer coordination of cashflows out with cash flows in—that is, narrower safety margins and greater use of speculative andPonzi financing. (Minsky 1986b, 5)

In other words, Minsky, a proponent of financial regulation, argued that unregulated finance was prone to succumb to the temptation of lower short term rates. Debt duration would decrease and financial stability would be lost.

And so it has.

With the fiscal deficit expected to rise dramatically over the next 2 years, the US Treasury will not only need to finance that expansion, it will also need to roll-over the maturing short term debt.

Good luck.

In the event foreigners are reluctant to buy all this new paper, some horse trading might ensure. For instance, our creditors might be willing to extend additional finance if we agreed to changes in the international financial architecture, such as are being proposed now.