Copyright 2012 by John T. Reed
I have watched governments around the world, especially in the developed world, behave in fiscally irresponsible ways. They have also misbehaved jerking bond buyers around and trying to intimidate people and institutions into buying bonds and holding bonds they do not really want. I wondered if corporate bonds might end up actually being considered less risky than government bonds.
Well, guess what!
That day has arrived.
On the last page of the 2/23/12 Wall Street Journal is a graph and story that say that government bonds of the U.S. and top European countries now cost more to insure against default that the bonds of blue chip private corporations in those same countries. For example, the insurance premium to insure 10 million euros of U.S. government bonds for five years is $36,000; for a five-year IBM bond, $32,000.
That spread is even greater for the European countries and their top corporations.
Government never posts collateral. That has not changed. But corporations do have collateral and that was mentioned in the Journal article.
What has changed are the character and capacity of the government.
Governments, or at least ours, used to be considered utterly beyond reproach. They would never even think of default or even making the slightest change in the terms of the bonds.
Lately, however, governments, including the U.S. government, have been treating bond buyers like crap.
In the U.S., look at the way Chrysler secured bond holders were treated in the Chrysler bankruptcy. The president of the United States essentially rearranged the well-established bankruptcy law to say that, in effect, the UAW union workers who owned no Chrysler debt or stock, took precedence over the bond holders of the secured bonds. Secured bonds take precedence over unsecured bond holders the way your mortgage lender takes precedence over your credit card lender in the event you go bankrupt. Secured creditors take the security that was pledged for their loan first, then all unsecured creditors fight for shares of the remaining equity in the bankrupt estate, if any. Obama, behaving as if he were king not president, simply ignored that and denounced the secured bond holders publicly for even suggesting they should have priority. I am not sure how he got away with it. I guess by simply intimidating the secured bond holders into agreeing to a change in the terms, it was like an out-of-court settlement in which the bond holders “voluntarily” abandoned their legal rights and promised not to sue.
Similar things happened with home mortgages, throughout his administration, Obama has been browbeating and suing and otherwise pressuring mortgage bond owners to agree to take less than the borrowers agreed to pay in terms of principal amount, timing, and interest rate.
In Europe, Greek bondholders have been jerked around again and again. Private bondholders have been made subordinate to government bondholders even though the bond terms promised that would not happen. They have been pressured, denounced, threatened, and so on.
Bondholders in other European countries have also been mistreated and pressured to buy or hold government bonds they really do not want. Banks especially have had menacing calls from their federal government regulators.
Are these various governments going to get away with this?
Apparently, with regard to existing bonds, yes.
But what about future sales of bonds to private citizens or companies.
Good luck with that, jerks.
You are already getting the message on your future bond auctions in the form of ratings downgrades and increasing sovereign default insurance premiums.
A great many organizations, like banks and pension funds, are either required to buy sovereign bonds or encouraged to do so by laws, regulations, and internal policies. Ostensibly, the purpose of these laws, etc. is to protect the safety of the deposits. But increasingly, the real purpose is to force entities to buy the bonds the government cannot sell to private bond buyers.
But ultimately, private citizens will see bank depositors and pension savers losing their savings because of the irresponsibilty and bad character of the federal governments.
While there IS a regulatory relationship between banks and pension funds and insurance companies and so on, there is NOT a regulatory relationship between the depositors, savers, and customers of the various financial institutions with eiter those institutions or the govenment. The depositors, pension savers, insureds, and so on do not have to give their money to banks, pension funds, and insurance companies, and they will not as they increasingly perceive that the money is either earning a substandard return or is at too much risk.
Government overplays its hand. I saw a microcosm of this at West Point. We cadets had to take all the same courses except for one elective per semester junior and senior year. Our professors were almost all officers who outranked us. I was in a group of guys who chose Russian for our elective. We intended to take four semesters of advanced and military Russian. All went well into November of our senior year. Our instructor, who was also going to be the instructor for the only spring semester advanced Russian class, informed us there would be a 2,000-word paper required in that class.
We were active-duty U.S. Army soldiers with the grade of cadet, four ranks below his major rank. We were also extremely disciplined to call superiors sir, salute them, obey them, and so on. So we very respectfully said to him, “Sir, electives generally do not require papers because they are hard and time-consuming and cadets avoid them when they can, which is the case, by definition, with an elective.”
That major was one of the relatively rare non-West Point graduates in the faculty. He flipped out and chewed us out along the lines of he was a major and we were cadets and the inmates were not going to run the asylum yadda yadda. We met privately among ourselves afterward and all but one of us said, “Screw him. I’ll pick another elective for last semester.” The one cadet who went ahead and took the class was not some great lover of the major or the subject. He was just congenitally horrified at hurting the major’s feelings. He was also congenitally timid as we saw in a prior incident where he was also the odd man out.
So I switched to Seminar on Public Policy which resulted in my being one of two cadets chosen to represent West Point at an annual college conference at Principia College in IL. Such trips were considered fabulous deals by cadets who were normally treated like medium security prison inmates. All my classmates but the one also switched other electives. Major 2,000-Word Paper and the wimp did a one-student seminar.
Did the major outrank us the way the federal government outranks banks, pension funds and insurance companies? Yep,
IF we signed up for his course. Once we heard about the 2,000-word paper, we did not.
I wrote an article about throwing your weight around too much in such If-law situations. If you open a bank, you must put X% of your capital in our federal government bonds. Government thinks that means all banks will put X% of their capital in federal government bonds. No, it means that citizens who want to comply with that new law will continue to own banks or start new ones, but that citizens who do not care for the new law will close their bank or not start the one they were going to start.
Like the major, the federal government mistakenly interprets its powers over broadly and fails to take into account that we may focus on the IF rather than comply with the new rule. IF you take fourth-semester advanced Russian… IF you operate a bank…
Another issue is the difference between a transaction and a relationship. If you are married, you know what a relationship is. Boy, do you! In a relationship, you have to take the long view. You cannot go to war with your spouse over every single bit of misbehavior by him or her. You have to look at the big picture. You have to say, “Is this one incident worth losing the whole relationship over?”
Sometimes it is. And sometimes you have to hold your ground in ways that end the behavior in question but not the relationship.
In a transaction, like stopping for a burger on a road you are never likely to travel again, you can complain and demand correction if you burger has ketchup when you said you wanted no ketchup. There is no bigger picture or longer view.
Yesterday, I got a book delivery from R+L Carriers, A.K.A. R&L Transfer, Gator Freightways, Inc.; Greenwood Motor Lines, Inc.; Paramount Transportation Systems, Inc. I have gotten about 100 book deliveries from many companies over 29 years. We ask them to put the pallet(s) in our home garage. We quickly remove the book cartons from the pallet(s) and hand the pallet(s) back to the driver because pallets are impossible to get rid of.
When R+L called to schedule the delivery, I told them about how we handled them. The woman on the phone, powerful bureaucrat she, informed me they would leave the pallet on the driveway and not put it into the garage which is about 15 feet away. She further informed me they would not take the pallet back. I protested and explained we had had a hundred other deliveries and this is the way we always did it.
She showed me who the boss was.
For that transaction.
But I do not do transactions with shipping companies or book manufacturers. I have relationships with them. At times, I need a favor like expediting. At times, they need a favor like my overlooking a few damaged books or letting them take extra long because someone else needs expediting. You keep the big picture and long view in mind. I pay thousands of dollars per year to some trucking companies and tens of thousands of dollars per year to some book manufacturers (what laymen would call a printer). Generally, I let the book manufacturer select the shipping company because they, too, have relationships and their trucking company relationships are more important to them than mine are to me.
However, henceforth, my requests for bids to the manufacturers will contain the words “R+L Carriers A.K.A. R&L Transfer, Gator Freightways, Inc.; Greenwood Motor Lines, Inc.; Paramount Transportation Systems, Inc. may not be used to ship these books to me.” The fact that I say that will usually not alone be enough to cause a book manufacturer to stop using R+L. But if others make similar complaints, it might result in R+L losing an account.
My business alone is not big to R+L, but I have a little clout with the book manufactures because the dollar volume is orders of magnitude bigger. So I doubt any book manufacturer, even one who always uses R+L, will refuse to bid on one of my books. I mentioned the problem with R+L to the book manufacturer in question—McNaughton and Gunn. They told me they once got a lot of complaints about one trucking company in the LA area and stopped using that company at all.
So yesterday, R+L’s wicked witch of the west showed me who was boss in that transaction. Henceforth, I will show R+L who’s boss in the relationship.
Might I forget? Banta, a book manufacturer did one of my books, probably around 1985. They charged a 10% surcharge on the shipping—probably about $40. I complained that I had never seen that before (or since I now would add). They said I agreed to it. Sure enough, it was in the gray print on the back of the bid I had signed. “Okay,” I said, “you got me. Now waive it because it’s not normal custom in the business or you will never get another request for bid from me.” They refused. I paid it as agreed without another word.
on that transaction.
Years later, maybe 1998, their sales reps accosted me at a book publishers convention in the exhibit area.
Got any books coming up?
Can we bid?
I used you once. You added a 10% surcharge for shipping. No one else ever did that to me.
[Laughing] When does your statute of limitations run out?
I 2010, I read the fine print on the U.S. government TIPs bonds I had bought a quarter of a million dollars worth of. After uttering a stream of profanity, I sold them all at the next Treasury auction date. That money is now in Canadian dollars and short term money-market stuff.
So Banta, R+L Carriers, and the U.S. government have shown me they were the boss at various times. But ultimately, I am the boss with regard deciding WHETHER to deal with them. And so are you.
Federal governments in the U.S. and Europe have treated bond buyers like crap. Now they will reap the whirlwind. They have mistaken their chauffeured limousines and fancy offices for signifying monarch-like powers. But when it comes to bonds, they are just another peddler and we are the prospective customers and treating your customers like crap is not a way to keep them coming back.
The other of the Three C’s of Credit is capacity.
When FDR was inaugurated president in 1933, the U.S. debt-to-GDP ratio was 17%. Accordingly, the U.S. government could and did borrow a huge amount of money for the New Deal and World War II. Our debt-to-GDP ratio peaked at 122% after World War II. Everyone knew the war was going to end and that we were going to cut federal spending by 60%, which we did.
Now, we have no world war and no New Deal or Great Depression, and we are NOT going to cut federal spending 60%, but we still have an end-of-World-War-II-size debt-to-GDP ratio of 102% and climbing so it will be 122% around April of 2013.
A debt-to-GDP ratio of 60% is considered the max for entry to the euro zone. 90% is reportedly the tipping point of federal financial difficulty. We are on the wrong side of both guidelines. That is why we have been downgraded from AAA to AA+ by S&P and had our outlook downgraded to negative. That is why it costs more to insure a U.S. government bond against default than an IBM bond. And that is why the private bond buyers including institutions are going to stop buying U.S. government bonds.
The U.S. government and the governments of Europe have overplayed their hands. But I see no indication they recognize that. The Greek government and people think they can continue to spit in the face of the bond market ad infinitum. They are about to find out otherwise. Hopefully, the rest of the world will be so horrified by what happens in Greece that they will wise up and pull back from the cliff. But I really do not expect that. I think Greece and the rest of the euro zone are going over the cliff, which will drive some money to the U.S. bonds. But eventually, we, too are going over the cliff if we do not make that debt-to-GDP ratio start falling instead of rising. As of now, the U.S. debt-to-GDP ratio should match the current Greek debt-to-GDP ratio around August 2014.
Unlike Greece, we have no big brothers who can bail us out. So logically, the bond market should not let the U.S. debt-to-GDP ratio go as high as Greece’s. But logic often does not always guide the markets.
John T. Reed