I begin to re-think the “US as Giant Hedge Fund.” Hedge funds are in the business of making money, whereas the Treasury, despite its protestations, surely knows it is going to lose money. So thus far the hedge fund analogy fails.
Here’s a better one: Paulson and Bernanke are just like a freshly married couple about to buy a home in California in 2005. Sure, it costs $650K, and they only make $75K between them, but the initial payments are modest and the house will surely appreciate. Here's the deal: they pay only 1.6% on their "2-28 mortgage," meaning that the mortgage will reset in two years at a rate just above LIBOR.
This transaction, which the California couple is now greatly regretting, is the perfect picture of what the US government now proposes to do. With short term rates near zero, it has a cheap source of financing for its debt; the flight to safety has given it the opportunity to take out an adjustable rate mortgage with a super-low teaser rate. As of September 30, 2008, the rate on its short-term bills was only 1.6%, well below levels (4.7%) of a year before.
The problem is this: if average interest rates on government debt go up, as I think it very likely they will, the government’s debt will “reset” to a higher level—just like that now underwater couple that is faced in 2008 with much higher reset mortgage costs to pay down the debt on a depreciating asset. Notes Mr. Mortgage: "The same household that earns $75k per year that two years ago could buy a $650k home with no money down can now buy a $275k home with 10% down. It now takes at least $150k a year and a large down payment to buy a $650k home."
The following chart of mortgage resets, on the happy analogy of our California couple, suggests something of what is in store for the US government's debt over the next several years. (There is more on the government's debt structure here.)
"Hair of the dog that bit you" is indeed, as Jim Grant says, "the unifying theme" of the government’s response to the insolvency of our financial institutions. It's Alt-A all the way.
Q&A with David Einhorn
6 hours ago