Debt Ceiling

I’m still willing to bet that there is no way that the US will default, maybe I am tempting black swans here… What are the chances that we’ll still be in deadlock one week from now? Anybody into game theory? bchadwick?

@Palantir, put your money where you mouth is. Naked Short Sell a *hit load (like $10,000 worth) of Aug 20, SPY Put Options! If you did that I would truly believe that you were definitely 100% sure there would be no default. Until then you’re just talking and talk is cheap. FYI…I want to see trade confirms if you do it!

I wouldn’t do it because I’ve held the view for the past 6 months that markets are way overvalued. Now if this week markets start tanking starting tomorrow. I would definitely buy.

Well it’s going to tank tomorrow; China, HK, and India indexes are all down right now! With China down 2%! Somehow I’m doubtful you’re buying tomorrow.

It’s more likely than not that the US won’t default, but it’s still way more likely than it ever was in the past, and the consequences are so God-awful that it is really irresponsible not to consider that investment scenario and how you would act if that happened. This is a situation that is tailor made for options, but of course, then you have a counterparty that may go bust too. I’d think it could be difficult to dynamically hedge instruments that are supposed to be risk-free. I wish I’d had the courage of my convictions to buy GLD call options 10 days ago when I was about to pull the trigger on it. However, given that my ability to take risk is constrained right now, so it was the correct decision not to do it.

bchadwick Wrote: ------------------------------------------------------- > It’s more likely than not that the US won’t > default, but it’s still way more likely than it > ever was in the past, and the consequences are so > God-awful that it is really irresponsible not to > consider that investment scenario and how you > would act if that happened. > > This is a situation that is tailor made for > options, but of course, then you have a > counterparty that may go bust too. I’d think it > could be difficult to dynamically hedge > instruments that are supposed to be risk-free. > > I wish I’d had the courage of my convictions to > buy GLD call options 10 days ago when I was about > to pull the trigger on it. However, given that my > ability to take risk is constrained right now, so > it was the correct decision not to do it. Since my book is leaning long, I actually just purchased SPY OTM puts and hedged it with the underlying.

Obama announced not long ago that the debt deal has to be done by July 22 so the legislation for it could get written within time. I suppose its still possible, but it would need to be done within a few days and the legislation would have to be crammed.

I think it’s freaking ridiculous that they waited this long to get a deal (assuming there is an 11th hour deal)! Obama should have, early on, just taken the GOP deal regarding dollar for dollar cut per increase in the debt ceiling (about $2.4 Trillion over 10 years). That way it would have been a conversation about negotiating what to cut. Now, it seems like they wasted 3-4 months negotiating with the GOP; when all along any rational person knew that the GOP was not going to agree to an increase in taxes. After the debt ceiling vote then you can have a showdown over taxes and shutdown the government for 6 months (who cares) but now is not the appropriate time to try to bargain over taxes. At the end of the day, Obama loses if there is 10 - 20% market drop due to a default. If there is a default, there will be a Republican President and a Democratic Congress.

I had a feeling to buy SPY Puts a couple of weeks ago, but at the end of the day, I think that they will put something together and pass it. I really do not think that Congress and the Senate would be so stupid as to NOT pass something. Obama says that he will veto a short term solution, but I think he would sign a short term solution if presented this week. Kicks the debt problem out a bit further and it would give him a perfect opportunity to say that the damn Republicans held the American people hostage while trying to prolong tax cuts for the rich and that he did what he had to do to keep the American economy recovering. (BTW I am definitely not an Obama fan…I just have a funny feeling what he would say)

There are three big things here: 1. Avoiding the Default 2. Raising the Debt Ceiling 3. Keeping the AAA Rating It’s widely expected that 1 will be achieved. Most likely by achieving 2. The big question is on 3. Even if US has the financial capability to maintain its AAA rating, the rating agencies will view the whole political dog fight very negatively. As many have said over the weekend, there could still be a downgrade. If that happens, how do we trade on it?

I’m trying to get a piece out on this today… but having writers block because there are so many darned feedback loops.

AlphaSeeker Wrote: ------------------------------------------------------- > The big question is on 3. > > Even if US has the financial capability to > maintain its AAA rating, the rating agencies will > view the whole political dog fight very > negatively. As many have said over the weekend, > there could still be a downgrade. > > If that happens, how do we trade on it? Who cares if there is a downgrade? The rating agencies have zero credibility in this regard. What happened to the Treasury markets when the agencies put the US on watch for a downgrade last week? Answer: nothing. What has happened to Japan’s interest rates since they have been downgraded by the rating agencies? Answer: rates have fallen. Ratings agencies have no justification for rating sovereign credits where a fiat currency issuer has allowed foreign countries or the private sector to accumulate its bonds as reserves through running trade imbalances. There is zero risk of default by the US gov’t on $US dollar denominated obligations, therefore the only determinant of interest rates is Fed policy, which is a function of expectations about future growth and inflation. The rating agencies get paid to rate things, whether they add any value or not. Therefore it is no surprise that they continue doing so even though it is clearly a colossal waste of time.

^ I largely agree with you on rating agencies’ credibility… But not on the market perceptions. On Japan though, people recently cite Japan’s falling rates after downgrade. The reality is that Japan has been in a dire defationary enviornment, which really keep a lid on how high the rate can go. Also Japanese bonds are largely held by domestic investors, which makes them less sensitive to many macro market factors.

Well, remember that sovereign risk is about: 1) the ability to pay the debt (currently not in doubt in the short term) 2) the willingness to pay the debt (currently doubts in the short term) Technically, issue 1 is not an issue, because the US can theoretically print up whatever is needed to make payments. The concern would be that doing this will increase the yield demanded by investors who fear being paid in inflated dollars. This could then turn into a feedback loop of runaway inflation, which would not necessarily mean that the US couldn’t pay, but it would have all sorts of other nasty effects. It’s important to realize that printing money does not automatically lead to runaway inflation, but that it increases the chance of it… much like taking Vicodin for chronic pain doesn’t automatically mean that you get addicted to it, but it does become a significant risk. Issue 2 is the one that we’re really worried about. Normally, Issue 2 comes up when you have a government that is indebted to foreigners and must pay in a foreign currency. Therefore they cannot run the printing presses and are forced into choosing between satisfying domestic supporters vs foreign creditors. If they choose the domestic supporters over the foreign creditors, then it’s a default. The US may be in a situation very similar to Issue 2 here. The Tea Party Republicans won’t agree to anything that isn’t 99% what they demand, and don’t really care if a voluntary default happens, because the economic collapse it will provoke can be used in the next election to strengthen their hand. The horrific thing is that it will probably work. So basically, the Tea Party wing’s best strategy is to force the economy into collapse and blame Obama for it. This is why they can hold out for 99% or 100% of what they want. The irony is that there’s no inability to pay here, it’s just a voluntary default. And the fact that it’s voluntary is what will make investors think twice when it comes to buying US Debt, and that will push up yields. And Treasury Yields are the base of the required return equation for stocks. Stocks are high duration instruments. So it may be time to freaque out after all.

Right, but the same thing that holds for Japan holds for the US as well: there is no default risk since both issue their own currency and owe debts in that same currency. Therefore there will be no default risk premium built in, even if the ratings agencies downgrade the US. That is the difference between a country like Greece which “borrows and then spends” to a country like the US, which “spends and then issues bonds to soak up excess liquidity”. The difference is fundamentally operational in nature. If the US government decides to default there could theoretically be a risk premium built in from the fear. At which point I would think the only “safe” and liquid investmet alternative would be cash, which is effectively short term US debt yielding 0%. So investors would trade one type of US debt (treasuries) for another (dollar bills), and drive up the theoretical interest rates. However at whatever point the government decided to begin paying its bills again, the risk premium would immediately go away as the tradeoff is between a risk free asset earning 0% and one earning 3%. Agree with bchadwick that the feedback loops quickly become quite difficult to follow.

@Dwight, the statement “there is zero risk of a default” is blantantly inaccurate/false and is not something I would expect from a AF poster (maybe something from an uninformed politician). The fact is that I can be a billionaire and still default (i.e. strategic default on your house that is under-water). Default is an issue of non-payment NOT an issue of available assets or one’s ability to pay. And to that point, the legal definition of default is; “To default on a debt is to fail to pay it upon its due date. Default in contract law implies failure to perform a contractual obligation.”

Yo! Extremely valuable insight folks. Keep it going.

Dwight Wrote: ------------------------------------------------------- > Therefore there will > be no default risk premium built in, even if the > ratings agencies downgrade the US. That is the > difference between a country like Greece which > “borrows and then spends” to a country like the > US, which “spends and then issues bonds to soak up > excess liquidity”. The difference is > fundamentally operational in nature. US and Americans borrow and spend too. Our situation is just not as dire as Greece yet. It takes a long while for a giant to fall… A death by a thousand cuts. Also, US is definitely not issuing bonds to mop up liquidity now (call sterilizing). Only China and a few other countries, where FDI is strong and growth is rapid, have that “luxury” now. We, the US, borrow to pay our bills. In you think about it, it’s like we are stealing from our kids piggy bank and cookie jars. Because, what we borrow now will be paid back by them.

@Dwight, again you make more incorrect statements; what you have to understand is that finance is not a matter of plugging equations into excel and getting an output. I always wonder why so many financial professional neglect the psychological/emotional aspects of finance. You said, “at whatever point the government decided to begin paying its bills again, the risk premium would immediately go away”. That’s a statement not grounded in any type of research. Are you aware that many decades after the great depression there were people still putting money “under their mattresses”. That is so say, you have no idea to what extent such an event may alter the trading/investing behavior of market participants. Without modeling the behavioral aspects, you have your head stuck in a textbook that has little to do with the real world.

The key inflection point will be the moment that foreign creditors demand the US pay debt in another currency and the US agrees to do so. I don’t think that day is near, yet, but it will be a critical change-point in the economic order if it ever happens. Dwight, I’m not sure I understand what you mean about “the US … issues bonds to soak up excess liquidity,” could you elaborate on that? If investors decide that cash in mattresses is safer than 90d T-bills, that’s an interesting dynamic. I’ve been 65% “in cash” for about two and a half months now, and now I’m wondering if that cash is in 90d T-bill money markets and what happens if a default actually does happen. Which maturities of Treasury securities are the ones that won’t be paid? Will I lose principal, or only interest? The debt ceiling says that no new debt can be taken on, but presumably old debt can be rolled over. Anyone have any perspective on this stuff?