In Bonds We Trust

There has been more than a  lot of talk on the seemingly perpetual interest in bonds, the reasons why they may or may not be over priced, and whether or not we are in or are creating a new credit bubble.  So it only seems fair to ask how much debt are we really talking about?

As aggregated by The Securities Industry and Financial Markets Association, and sorted by category of the type of debt, below is an estimate of total US Debt outstanding as of March 31, 2010.  Total debt in the United States at the end of the first quarter 2010 was over $35 Trillion Dollars.   By clicking here you can be taken directly to the excel data source from SIFMA.

Outstanding U.S. Bond Market Debt in Billions $ (Source: SIFMA)

Outstanding U.S. Bond Market Debt in Billions $ (Source: SIFMA)

The elephant in the room is that total debt outstanding has tripled from about $12 Trillion in 1996 to nearly $36 Trillion in 2010. A quick check for inflation using the BLS Inflation Calculator and the $12.265 Trillion that was outstanding in 2006 is equal to about $17.065 Trillion in 2010.  Thus in real terms the amount of debt outstanding has still effectively doubled.  There is certainly a deeper question as to why, but the easy answer certainly is why not?  So long as folks have been making their interest payments, and can be perceived to keep doing so, it shouldn’t really matter.  One may argue that we were terribly under levered in 1996, not sure if that person would be me, though.  Nonetheless, the chickens came home to roost back in 2008 when it was more than apparent that vast amounts of this debt would never be repaid in full.

The “good” news I suppose is that since 2007 (arguably the last full year before the US went into crisis mode), is that total debt levels have “only” risen an additional 9% over three years from $32.3T to $35.2T.  I say “only” because in fact that is really much slower than debt levels were growing between 1996 and 2005.  Take a look at the chart below which illustrates the year-over-year growth rates in each column.

Outstanding U.S. Bond Market Debt YoY Growth in % (Source: SIFMA)

Outstanding U.S. Bond Market Debt YoY Growth in % (Source: SIFMA)

The rate of growth in total debt outstanding actually started coming to a screeching halt in 2007 and 2008.  It was clear even before the bubble burst that we could not securitize endless amounts of debt and that there might in fact be a limit to the supply of Asset Backed and Mortgage Backed securities folks might want to buy.  Of course Wall Street used alchemy (think synthetic CDOs) to try to propel the debt bubble a little further, but when the house of cards began to unravel, there was neither an abundance of credit worthy borrowers, or enough unsuspecting investor appetite to continue the growth trajectory of the prior decade.

In fact, and almost suspiciously, total debt levels stopped growing as quickly back in 2006.  Anyone who has read “The Big Short”, “Too Big to Fail” or any of the other post crisis tell-all books knows that the “smart money” was well aware of the impending doom.

Comparing pre-crisis debt levels to the most recent data, it is no surprise that Treasury Obligations have ballooned from 2007 levels by nearly 60%.  More surprisingly is that Money Market Obligations have contracted dramatically from 2007 to 2010 declining by about 29%.  Less surprising considering how much cash has been yielding.

Other interesting observations:

-The largest gain in total debt outstanding was in the Asset Backed Security Marketplace which grew 500% between 1996 and 2009, thanks if full part to the securitization marketplace (Wall Street’s Alchemy).

-The next largest gain from 1996 to 2009 was of course in Mortgage Backed Securities which nearly quadrupled growing by 270%.  Again thanks to Wall Street’s Alchemy.

-The gains in Treasury Obligations outstanding ironically have increased the least, in percentage terms, but the most in dollar terms with Treasuries more than doubling, growing by 108%.

-If Money Market flows are in fact cyclical (not enough data here to prove anything), it might reason that we could actually be closer to a recovery than the bears believe.  The reason being that Money Market balances actually decreased over the three years during the recession in 2001-2003, and then precipitously rebounded when the economy gained steam.  We are now at another three-year period where Money Market balances have dropped dramatically.  While it is this might be indicating that the low yield on cash has in fact been helping prod investment, it’s probably better to reason that a large part has gone into US Treasuries instead.

-Mortgage related debt levels seem to have hit a ceiling.  This is likely bad news for the housing market, as mortgage debt is essential for pervasive home ownership.  What is not told here is the size of bad debt outstanding (rough estimates are about 10%).  This bad debt ultimately is likely to end up written down at some point in the future.  The faster this happens the better it is for the housing market, but ironically the worse it will be for the economy.  Nonetheless, we likely have seen the highest levels of home ownership in the years past than we will ever see in our lifetimes in the years ahead.  The good news, is that holders of quality mortgage-backed securities will likely benefit from a fairly permanent reduction in supply (or at least ceiling on growth).

-With all the rhetoric on Municipal Issuer defaults, and concerns for mounting state and city debt levels, it looks as if Municipal Debt levels have slowed dramatically, at least a positive sign of prudence.

-The biggest beneficiaries of historically low interest rates, as measured by the two sets of issuers with the largest increases in debt outstanding since 2007 have been the US Treasury and US Corporations.  In fact, the outstanding issuance of Mortgage Related, Federal Agency, Money Markets, and Asset-Backed Debt have all been in decline.  One interpretation is that the average Joe has not been able to access the current low rate environment, but that those rates have been reserved for the largest and most “credit worthy” borrowers.

Now take a look at the same date, in “Common Size” form, where each amount is represented as a percent of total debt outstanding in the year reported.

Outstanding U.S. Bond Market Debt in % of Total Debt by Year (Source: SIFMA)

Outstanding U.S. Bond Market Debt in % of Total Debt by Year (Source: SIFMA)

Other than the changes in Mortgage Related, Treasury and Asset Backed debt outstanding, the other columns have experienced modest changes from 1996 to 2010.  Note that what looks like a dramatic decline in Treasury Debt relative to total debt outstanding is deeply obfuscated by the fact that the US Government is effectively guaranteeing the two largest mortgage companies in Freddie Mac and Fannie Mae, not to mention the large amounts of Asset Backed securities that still reside on the federal balance sheet.  In fact if you add those three columns (Treasury, Mortgage Backed & Asset Backed) and compare the totals between 1996 and 2010 you get 53.5% and 55.4% respectively.

Thus over the 14 years of data here, all that really happened was that we moved (in relative terms) about 10% of national debt off the balance sheet of the Treasury Department into the Private Sector, while simultaneously doubling the total debt outstanding.  In other words you might say we doubled the kids allowances without any proof that they knew how to manage their own money.

Thus the gaffe (and/or Con depending on your appetite for conspiracies) is that the US Government was able to improve its own credit ratings, enhance the global standing of the USD, and sell our debt by off-balance-sheeting new debt to its off-balance sheet entities, Freddie Mac and Fannie Mae.  Like most SPE’s (Special Purpose Entities) Freddie and Fannie were (intentionally or not) able to obscure risks in the mortgage market from to US Goverment’s balance sheet.  As publicly traded private companies, they were of course subject to some forms of regulation, but as separate entities, their risks and liabilities were never directly reported on the balance sheet of the US Government, until of course they were bailed out in 2008.

The irony of this arrangement is that it is effectively no different from what Lehman Brothers and a host of other investment banks did (and still do) to tidy up their finances.  This allows them to issue more debt at lower rates, which of course helps them make more money (until it backfires).

We as a country are certainly at a tipping point.  We have borrowed seemingly beyond our means, and we did so knowingly by hiding our own risks from the world and from one another.  This is not much from the homeowner who goosed his mortgage application, or the mortgage broker who did it for him.  The world of finance, and more importantly the world of credit is based on trust, transparency and the promise of repayment.  When trust is broken, transparency is obfuscated, and loans (bonds) go unpaid, the system as we now know can come to a crashing halt.  Lenders stop lending and even begin to call in loans.  Borrowers go bust.  Trust is difficult and expensive to rebuild.  Imagine if no one trusted the US Government would be solvent enough to guarantee the financial system like they were able to in 2008.

The best thing that came out of the credit crisis is that underwriting standards were set a new highs at least for a while.  This created a drag on the economy, and still does.  However, do we really want to force credit to unworthy borrowers, or find new ways to hide the risks of repayment?

In general, we need to borrow less, earn more, and save more.  As a country, we have been educated on the benefits of borrowing by lenders more than by parents or teachers.  Most lenders are not advertising the pitfalls of being a borrower.  Student loans are sold on the myth of income differentials for those with a higher education.  Campus promotions during freshman year in college lure us in: a chance to have more money than we earn at our disposal.  All we are really shown is a minimum monthly payment, and we think if we avoid late charges, we are doing well.  For many people carrying a credit card balance is a necessity, but for most it begins as an option.  How well do most 18 year understand money and credit, or investing? Those who are not as fortunate to go to college are usually and sadly starting from an even less knowledgeable place as it pertains to building and managing personal debt and finances.

For some of us who are more “privileged”, our parents create a bad habit by giving us their card in our name “for necessities or emergencies”.  All this teaches us is to figure out which merchants won’t raise a flag on our parent’s bill. I distinctly recall friends buying CD’s (before iTunes) at the campus book store specifically because the charge showed up as “books”.

People need to set limits and boundaries for what can and should be financed where interest is being charged.  Moreover, corporations need to be careful offering teaser rates, or even zero interest rates to entice consumers.  Credit issuers need to focus more on margins and less on volume.  Anyone who cannot afford to finance your product is probably not someone you want to lend money to.  Consider the financing wars that helped, at least in part, to bankrupt GM, and nearly bankrupt Ford.  I remember for the years leading up to 2008 being totally floored that you could buy a car with little to no money down, a small monthly payment and no interest.  Of course the car companies did this to goose declining sales, but the net effect was to give cars to people who simply could not afford them, and that was before gas at the pump touched $4 a gallon.

In my opinion, one of the most egregious uses of credit/debt is to pay for food.  I have never understood people who put groceries or dinner on a revolving line of credit so that they can buy more clothing or gadgets.  American’s have been weened, in many cases not at their own fault, on the idea of paying Tuesday for a hamburger today.  This is a dangerous proposition.  Of course it is not a problem if we are able to pay for that hamburger, with interest on time.  Sadly, many forget that we consume a lot more hamburgers than iPods or sneakers and that those little charges add up.  Of course I cannot just blame younger generations, it seems that as far back as the 1950’s our parents may have been covertly corrupted as kids:

Or maybe we’ve just always been a country of moochers!


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