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July 21, 2008

How the War, Tax Cuts, and the Swaps Market Debased the U.S. Financial System

John P. Hussman, Ph.D.
All rights reserved and actively enforced.

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Just a note: The Strategic Growth Fund approached its 8-year anniversary by closing Friday at a fresh all-time high, including reinvested distributions. Meanwhile, the S&P 500 has achieved a negative total return since the inception of the Fund on July 24, 2000 (the latest performance chart shows the record through 6/30/08).

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To understand the origins of the current U.S. financial crisis and soaring credit defaults (which will ultimately be borne in large part by U.S. taxpayers), we have to go back not just to the housing bubble, but to two destabilizing decisions made even earlier: the Iraq war, and the 2001-2003 tax cuts. We'll then examine the way that fiscal policy interacted with the swaps market to put a mountain of bad credit on the balance sheets of financial institutions that are partially backed by the U.S. government.

I've previously written about the imprudence of the Iraq war from the standpoint of national security (the end of the May 19 comment includes those pre-war sentiments), but what is relevant here is the effect that the fiscal policy of the past 8 years has exerted.

In 2001, the U.S. initiated a series of major tax cuts amounting to about $500 billion, benefiting primarily individuals with a high marginal propensity to save, despite an already large fiscal deficit. (As an investor, my only defense to the inherent hypocrisy of criticizing this is that all of my own benefit has gone to charity). In addition, the Iraq war heaped on further direct costs of $500 billion. Nobel economist Joseph Stiglitz recently estimated the long-term total of direct and indirect costs of the war to the U.S. economy at $3 trillion.

It is widely believed that the enormous fiscal deficit created by these policies has been “stimulative.” The key question is, “stimulative to what?” Surely, not much of the answer can be found in stock valuations. Stock prices reflect the discounted present value of future cash flows. Even if the entire $500 billion was the present value of long-term cuts in dividend taxation, the “fair” present value of the U.S. stock market would increase by exactly the amount of the reduced tax burden. On a total stock market capitalization of about $15 trillion, $500 billion in tax cuts work out to a gain in value of about 3.3%. Clearly, the Bush tax cuts provided little impetus for anything but a short-term bounce in stock prices.

Combined with the costs of the Iraq war, however, they did produce a chain of transactions that weakened the U.S. economy and debased the U.S. financial system.

One of the first effects of the U.S. fiscal deficit was a deterioration of the U.S. trade position. By definition, if the U.S. imports $100 worth of “stuff” from other countries, it must export $100 worth of “stuff” in return. Suppose that we import $100 of foreign goods and services, but we are also running a federal deficit, so we pay for part of that by exporting $30 of Treasury securities to foreigners. By necessity, our total exports of goods and services will only be $70. This is not a theory, but an accounting identity (the surplus on capital account – in this case $30 of securities exported to foreigners – is always the reverse of the deficit on current account, in this case a -$30 trade deficit on goods and services).

Put simply, the massive fiscal deficit of recent years has required the U.S. to run a deep current account deficit. Moreover, our need to foist government liabilities into foreign hands has resulted in a large depreciation in the value of the U.S. dollar (if foreigners were eagerly snapping up our “stuff,” the U.S. dollar would be appreciating instead). When the domestic savings of the nation as a whole are insufficient to finance government deficits and private investment, foreign savings must be imported through the sale of securities. Our insufficient national saving has had the effect of strengthening the hand of foreign competitors, and continues to require us to sell U.S. assets into foreign hands to finance the shortfall (last week's agreed takeover of Budweiser – the Great American Beer – to a foreign company is particularly emblematic).

Origins of the housing bubble

During 2002 and 2003, short-term U.S. interest rates hovered at very depressed levels, partly because of Fed policy, but primarily because credit risks were of great concern, so investors were willing to accept very low yields on Treasuries owing to their lack of default risk. At the same time, the depressed rate of interest triggered a refinancing boom in the mortgage market and easy credit for home buyers, particularly if they financed at floating interest rates. On the spending side of the economy, low short-term interest rates contributed to a consumption binge, a housing boom, and a deterioration of the U.S. trade position.

On the investment side of the economy, the growing trade surpluses of foreign countries, coupled with a tendency of high income individuals to save their tax cuts, created a source of demand for newly issued securities. Foreign countries, particularly China, began to defend their growing competitiveness by trying to hold down the value of their currencies. To that effect, these countries accumulated large volumes of U.S. Treasury securities. This helped to finance the deficit, though at the expense of our own trade position and manufacturing workforce, and prevented the dollar from depreciating at an even faster rate. Meanwhile, U.S. investors stretched for yield by seeking securities with slightly more risk, but still with the implicit backing of the U.S. government. They found those securities in the mortgage market.

Why didn't we see a boom in corporate investment and capital spending instead? Well, generally speaking, tax cuts have the potential to stimulate corporate investment in plant, equipment and other productive assets, but that requires companies to issue new stock with the intent of making additional capital investments. If new stock is not issued, any funds going “into” the stock market in the hands of a buyer are immediately taken “out” of the stock market in the hands of a seller, leaving the next holder of the funds to find a newly issued security somewhere else in the economy.

Ultimately, savings are always intermediated to a “real” borrower who actually spends the money. Wherever you observe a boom in one type of spending, you'll observe a boom in the new issuance of the related security. A boom in government spending is accompanied by new issuance of government securities. A boom in bank lending is accompanied by new issuance of bank liabilities, and so forth.

With China and other foreign countries absorbing Treasury securities directly, and U.S. corporations still coming off of their late-90's investment binge, the beneficiaries of the tax cuts absorbed newly issued securities primarily in the form of mortgage obligations and the bulk of the real investment was spent to build residential homes to excess. We are now seeing the results of that overinvestment.

So the policies of recent years have indeed been stimulative. But stimulative to what? Primarily to unproductive investment and poor credit. There is nothing wrong with debt that is incurred to obtain productive assets, legitimate national security, or the relief of suffering. In this instance, there is little to show but liabilities. The U.S. is now saddled with a burdensome federal debt, a deep current account deficit, reduced competitiveness, a weakened financial system, a tragic and needless loss of life on both sides of the war, and a growing indebtedness that allows major U.S. companies to be picked away by foreign hands like apples from a tree.

Transforming risky debt into government backed paper

To complete the story, we have to ask how such a destabilizing amount of high-risk lending was able to take place just because government interest rates were low. Didn't the markets make risky credit expensive enough to limit the exposure of the U.S. economy to financial strains and default? In light of the massive loan losses in the U.S. banking system and the recent problems with Fannie Mae and Freddie Mac, I thought it would be useful to recap the origin of this, which I warned about in a 2003 piece called Freight Trains and Steep Curves:

“So the real question is this: why is anybody willing to hold this low interest rate paper if the borrowers issuing it are so vulnerable to default risk? That's the secret. The borrowers don't actually issue it directly. 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 . These are held by investors precisely because they piggyback on the good faith and credit of Uncle Sam.

“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 borrowers at a fixed 6%. Now GM issues bonds yielding 7%, and enters a swap with Citibank, in which Citibank pays GM 5% fixed in return for floating. (Specifically, both parties agree on some notional principal, say $100 million, and each makes payments to the other, determined by multiplying a fixed or floating interest rate by that principal amount. The market for this sort of transaction is huge).

“Well, now GM is paying an actual interest rate of floating + 2% (pay 7% to bondholders, get 5% from Citibank, pay Citibank floating). Meanwhile, as compensation for the credit risk it has accepted all around, Citibank earns a fixed 1% margin regardless of interest rate movements (pay depositors floating, get 6% from mortgages, pay 5% to GM, get floating from GM). Neat. And since Citibank is federally insured at the depositor level, and “too big to fail” at the institutional level, Uncle Sam is now a counterparty that effectively shares the risk in the case that GM or homeowners default. Similar transactions serve to swap risky corporate and mortgage borrowing into safe government agency paper issued by Fannie Mae and Freddie Mac.

“In short, the U.S. financial system is in a delicate balance. On the issuer side, a great many borrowers have linked their debt obligations to short-term interest rates. This is tolerated by the financial system because the debt has been swapped out through financial intermediaries, so investors get to hold relatively safe instruments like bank deposits and Fannie Mae securities. This 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.”

What now?

As with the stock market bubble of the late 1990's, it is generally true that bad investments tend to go bad. There is little to prevent that from occurring. The only question is who bears the cost. Essentially, the Federal government issued hundreds of billions in debt, much of the proceeds which tax cut beneficiaries invested in mortgage bonds, without concern about loan quality because the debt had been tied to the good faith and credit of Uncle Sam, and now we've got to issue more government debt to bail out the losses from the bad investments.

One of the reasons that the recent credit crisis has been so wrenching is that the losses are being borne by institutions that have the explicit or implicit backing of the U.S. government, so it feels like the things that ought to be safe really aren't safe. But that is no accident – bad credit sought out those institutions and their government backing, as the inevitable result of the swap markets (as described above). In the end, the implicit and explicit backing of the U.S. government – which allowed all of this to occur – is also what will be called upon to clean up the mess.

So far as policy is concerned, the way toward renewed peace and prosperity is to move in the direction of fiscal discipline, increased risk-based regulation of entities that draw directly or indirectly on government assurances, credible and even-handed diplomacy, and a reaffirmation of our commitment to human rights (as Jefferson saw them, not as a grant of the State, but as an inalienable aspect of humanity itself).

On the question of taxes, it is always wise to seek a flatter tax and a broader base, but flattening the income tax is not appropriate unless we also flatten the Social Security tax so that it applies to all forms of income, without a cap, but at a lower rate. While high income earners do pay the majority of income taxes, their share of total taxes is much more balanced because of the Social Security cap and the exclusion of non-wage income from that tax. As economist Alvin Rabushka notes, the cap exists primarily "to maintain the fiction that Social Security is a retirement insurance program in which contributions are linked to benefits, rather than what it is—a transfer of income from workers and the self-employed to retired people." As it happens, over 70% of U.S. households pay more directly and indirectly in payroll taxes than they do in income taxes. In my view, the most efficient tax structure would be a set of flat, broad-based income and Social Security taxes, with a large initial exclusion.

I have no doubt that the U.S. financial system will come out of this, albeit with higher capital requirements and lower profitability, as a result of more stringent constraints on leverage. Interest rate swaps and credit default swaps should also be subject to far higher risk-based capital requirements than they are now (presently, those requirements translate into only one or two basis points of cost annually).

On the subject of personal finance, if your bank account is FDIC insured in excess of your account balance, your money is safe. If you own a money market fund or other mutual fund, then even if your fund is held at or managed by a bank or broker that fails, the securities held within the fund are the property of the fund's shareholders, not of the bank or broker, and can't be used to settle the bank's or broker's obligations (peek at the prospectus anyway so you know what you own, since the value of the securities can certainly fluctuate). Ditto for stocks and bonds that you own in an account at an investment bank. Even the week Bear Stearns went bust, SEC chairman Christopher Cox was correct in saying that “At no time during the week of March 10th through the 17th were any of the customers of the Bear Stearns' broker-dealers at risk of losing their cash or their securities.”

The main thing to worry about is counterparty risk in over-the-counter agreements – that is, deals that are made directly with the financial institution itself (the Hussman Funds have no such positions). Most individual investors don't have exposure to such risk outside of perhaps hedge funds. You might take some extra precautions with bank deposit balances that exceed the FDIC limit, though the FDIC has generally taken on a significant portion of those as well. As for some of the hyperactive doomsday pieces being emailed around that reference numbers like $8.2 quadrillion of default risk and so forth, those figures are based on the notional value of all traded derivatives, without netting them or considering the amount by which they are “in-the-money.” Those emails can safely be ignored.

There are almost certainly more financial losses to come, but we are presently in the heavy season of mortgage resets, so the worst will likely be behind us before year-end. The stock market has discounted a good portion of the losses, but I strongly doubt the process is complete. Unfortunately, we'll probably have additional “phases” of this downturn, as earnings disappointments, recession recognition, and cuts in forward estimates have only started.

Despite the powerful rally last week, financial companies face further, significant dilution. When you are at 25 times leverage against book value, it only takes a loss of 4% of your loan portfolio to wipe out your shareholder equity, so it is unwise to imagine that you can tell what is a “low” price for a financial company by comparing it to the prior earnings before the losses started emerging, or even to book value when book value itself is in question. My impression is that FDIC insured banks are less vulnerable than investment banks, and that Fannie Mae and Freddie Mac will survive in their present form, though much of their equity value will be diluted away.

Market Climate

As of last week, the Market Climate for stocks remained characterized by unfavorable valuations and unfavorable market action. We certainly saw the “clearing rally” that I discussed last week, which may persist for somewhat longer. My concern, however, is that interest rates began acting badly last week, which has historically been a risk factor that tends to cut “bear market rallies” short. The Strategic Growth Fund remains fully hedged, but with about 2% of assets in index calls which provide a positive “local” exposure to market fluctuations without exposing the Fund to unchecked losses if the market enters a fresh plunge. Rather than allowing our gains to run in that index call position, I clipped our holdings back to about 2% on Friday, largely because of that tenuous interest rate behavior. In the event that the market's recent strength is cut short prematurely, that 2% of call option value is the only thing that stands between our current investment position and a full hedge.

In bonds, the Market Climate last week was characterized by relatively neutral yield levels and tenuous yield trends. The two countervailing forces in the bond market here are credit risks, which tend to increase the demand for default-free assets like Treasuries, and the risk of significant new supply of Treasury securities to absorb losses at Fannie Mae, Freddie Mac, and other financials with some form of government backing. Normally, widening credit spreads significantly improve the likelihood of falling inflation and interest rates. Presently, the bond market appears concerned with an unusual potential financing burden, so we haven't observed the decline in yields that would normally be associated with widening credit spreads.

That said, broadening economic weakness is likely to send commodity prices lower as the year continues, which should combine with credit concerns to ease the rate of inflation substantially by year-end. In that environment, some of the fresh Treasury supply is likely to be absorbed by investors seeking safety from default risk. The remainder will likely be financed at the cost of a lower U.S. dollar.

Though there is some tendency for commodity prices (in U.S. dollars) to move inversely to the value of the dollar, most of that is due to pass-through. That is, if you hold the price of a commodity constant in terms of some foreign currency, and the dollar depreciates against that foreign currency (i.e. the foreign currency becomes more expensive), then the commodity price in terms of U.S. dollars also becomes more expensive as well.

Presently, I expect that we'll observe both deterioration in the U.S. dollar and deterioration in commodity prices over the coming quarters (which is another way of saying that commodity prices are likely to fall more sharply in terms of foreign currencies than they are likely to fall in terms of dollars).

For now, the Strategic Total Return Fund continues to carry a duration of about 2.5 years, primarily in U.S. Treasury securities, with just over 15% of assets in foreign currency positions.

NEW FROM BILL HESTER: Experimenting with the Market's Median Valuation

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