Hussman on debt bubble:
A final concern involves debt and interest rates. The major force shaping economic dynamics over the coming decade is likely to be an unwinding of the extreme leverage that individuals, businesses and the U.S. itself (via its record current account deficit) have accumulated. I've written at length about the impact that the current account deficit is likely to have in dampening sustained growth in domestic investment. Individual and corporate balance sheets are no healthier, of course, and this will make the U.S. economy vulnerable to future debt crises and shifts in the profile of interest rates.
As I've noted several times in recent years, the U.S. financial system has made a very large bet on the continuation of a steep yield curve (very low short-term interest rates and higher long-term rates). Many U.S. corporations have swapped their long-term (fixed interest rate) debt into short-term (floating interest rate), to the extent that an increase in short-term rates could substantially raise default risks. Similarly, a growing proportion of homeowners have refinanced their mortgages into adjustable rate structures that are also sensitive to higher short-term yields. Finally, profitability in the U.S. banking system is unusually dependent on a steep yield curve, with a widening net interest margin (the difference long-term rates they charge borrowers and the lower short-term rates they pay depositors) accounting for all of the strength in bank earnings in recent years.
Of course, if somebody owes short-term interest, somebody else must be earning it. Who owns all of this low interest rate paper if the companies issuing it are so vulnerable to default risk? That's the secret. The companies don't actually issue it. Instead, much of the worst credit risk in the U.S. financial system is actually swapped into instruments that end up being partially backed by the U.S. government.
See, a risk-averse investor might be somewhat reluctant to lend short-term money directly to, say, General Motors. To see how the U.S. government becomes a counterparty to this debt, grab a pen.
First, suppose that Citibank gets money from its depositors at a floating rate, and lends to mortgage holders at a fixed 6%. Now GM issues bonds yielding 7%, and enters a swap with Citibank, in which Citibank pays GM 6% fixed in return for floating + 1% (the U.S. swaps market for this kind of transaction is huge). Well, now GM is paying an actual interest rate of floating + 2% (pay 7% to bondholders, get 6% from Citibank, pay Citibank floating + 1%). Meanwhile, Citibank is earning a fixed 1% margin regardless of interest rate movements (pay depositors floating, get 6% from mortgages, pay 6% to GM, get floating + 1% from GM). Neat. And since Citibank is federally insured, Uncle Sam is now a counterparty that effectively shares the risk in the case that GM defaults. Similar transactions serve to swap risky corporate and mortgage borrowing into safe government agency paper issued by Fannie Mae and Freddie Mac.
Now make no mistake, I do strongly believe that bank deposits and government and agency debt are safely backed by the U.S. government and that this is a good commitment. The holders of stock in banks or mortgage companies like Fannie Mae and Freddie Mac may not be so secure. For several years now, our stock selection approach has led us to avoid large commitments to financial company stocks.
The key point is that a lot of debtors have linked their borrowing to short-term interest rates. This is tolerated by the financial system because the debt has been swapped out through financial intermediaries like banks, so investors get to hold relatively safe instruments like bank deposits and Fannie Mae securities. Still, the mountain of debt in the U.S. financial system - tied to short-term interest rates - is ultimately and perhaps somewhat inadvertently backed by the U.S. government. This is likely to result in future money creation. Meanwhile, we aren't very willing to own much in the way of financial or mortgage company stocks, because these institutions may be vulnerable to credit problems even if their depositors and bondholders are not.
As with the other factors I've noted in this update, the debt situation does not necessarily resolve into short-term implications. Still, the situation is important enough to warrant constant monitoring. We're certainly willing to accept market risk when trend uniformity is favorable, but this is no seal of approval regarding the state of the financial markets, economy or geopolitical situation. The next decade will be very challenging, and there's no sense in being glib about it just because investors appear willing to accept greater risk over the near term.
On the basis of some of the minor divergences that have developed in recent sessions, we've taken a tiny position (less than 1% of total assets) in put options. But even that tiny position is sufficient to hedge nearly half of our exposure in the event of a deep decline. Assuming that market action remains clean, I expect that we'll sell these back out within a few weeks. "Clean" in this respect means market action that either clears or fails to extend the divergences we've seen lately. That's the most probable outcome, but we'll watch closely.
In the bond market, investors are not only allowing for the possibility of deflation, but have priced the expectation of falling inflation into the market. This leaves bond investors vulnerable. There's no question that the Fed will cut rates by at least 25 basis points. 50 is a possibility, but given the bit of strength in recent economic reports, it's an outside possibility. However, market determined interest rates are unlikely to follow, and I wouldn't be at all surprised if market interest rates were to move substantially higher, particularly on the short-term end (where the real risk seems to be).
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