Rope Limit

I remember the debates from the late 70s or early 80s about government borrowing out private borrowing.  At that time, I thought it was likely, but it was seemingly proven false.  If nothing else, the long time of survival after that is proof enough.

Now with the US government borrowing more and more, and guaranteeing more and more debts of Fannie and Freddie, it really looks like the US Government is running up against its rope limit, i.e., that amount that it can borrow without raising its interest rate significantly.

Think of all that they are implicitly guaranteeing, and $500B+ deficits going out as far as the eye can see.  All of the programs the US government proposes relies on the idea that larger deficits will be readily absorbed by the rest of the world, as well as some US investors.

Think of the Fed buying $1 trillion of MBS, and the US Treasury buying $220 billion of MBS.  Why should our government borrow to own mortgage loans?  (For these purposes, I count the Fed as a part of the government.)

The government is trying to support residential real estate prices, rather than letting the system clear by letting prices fall further, and letting the financial system absorb large losses.  Many financial firms would fail, and have to go through bankruptcy, but after the crisis was past, the US economy would grow rapidly, unencumbered by bad debts, as it grew rapidly after 1941.

Government actions tend to prolong large crises rather than resolve them.  Small crises are another thing — the government seem to help, but merely builds up the problem of bad debt for a larger crisis.

As the US government has stretched to bail out the residential mortgage market over the last three months, is has faced a situation where additional support for the residential mortgage market did not matter.  Additional borrowing by the US government did not matter, because the US Government is increasingly a bank or a hedge fund, borrowing to buy residential mortgages.  The borrowing is becoming so great that government debt investors are looking at the residential mortgages to understand what value truly lies behind the promises of a US Treasury security.

This is just my gut felling but as the US government has acted over the last month, borrowing and offering guarantees with abandon, amid economic weakness and a wide yield curve, I have been surprised by the continued widening of the yield curve.

It is as if the US Government has finally reached its “rope limit,” the line in the grass where the dog can go no further.  If true, we are near an inflection point in the markets, though with little idea of where we go, because central banks could act in favor of inflation or deflation.

I wish I could say more here, but a barbell of long Treasuries and money markets could offer some protection of purchasing power.  The inflation argument is the easy one, but I can’t say that will happen with certainty.


  • Saloner says:

    Thank you for the sobering note that rounds an eventful year off.

    More generally, I thank you for the excellent education you provide through the blog too, and, if I may, wish you and your family a wonderful 2010, and beyond.

  • Greg says:

    David — In Brazil, where (until Lula) successive governments spent with wild abandon and deliberately destroyed the local currency again and again, select companies regularly enjoyed lower borrowing costs than the government.

    The obvious example is Companhia Vale Rio Doce (ADR ticker in the US is “VALE”). Vale has for decades been considered a lower credit risk than the Brazil government, and had lower borrowing costs to prove it.

    Some will argue that Vale’s USD revenue stream (as opposed to a BRL revenue stream) was preferred, but that is just a long winded way of saying Vale had true revenue, and the Brazil government had printed monopoly money.

    As the US government becomes little more than a mortgage hedge fund with a money losing entitlement/welfare arm attached — why couldn’t the same happen here?

    Why couldn’t “true” AAA rated firms like Exxon, Pfizer, IBM, Google, etc end up with lower borrowing costs than the spendthrift government?

    Already, those companies borrow at better rates than the spendthrift California state government — and as California goes, so goes the nation

  • But What do I Know? says:


    It’s not only companies that appear to be better credit risks–I can borrow at 5% for a 30-year mortgage, while the Treasury borrows at 4.75%, and I have a prepayment option that has to be worth more than 25 bps.

    Maybe it has something to do with the declining collateral I’m sitting in :>)

  • chris g says:

    Greg, VALE had lower borrowing costs in foreign currencies than the Brazilian treasury because it had a stream of revenue from foreign sources. Brazil had no such stream (directly). Brazilian government ALWAYS has a lower borrowing cost in their own currency. ALWAYS. Each company has a blended “cost of capital” which includes borrowings from all countries/currencies.

    Walmart just borrowed $1 billion in Euros to fund further buybacks of Walmart shares. It has a nice revenue stream in Euros. Stuff like this happens all the time. It’s beautiful. That’s why warren buffett just doubled his position in Walmart. It doesn’t make owning Walmart bonds denominated in USD any safer! If dollar craps, and you hold dollar denominated walmart bonds, I promise you walmart will pay you back with crap dollars. They’re not going to pay you more!?!

    From Walmart’s point of view, their borrowing costs are lower if they borrow in currencies with lower interest rates. They are allowed to borrow at favorable rates in those foreign countries cuz they have revenues in that currency. Same thing happened with VALE.

  • David says:


    Your recent posts about the limits of sovereign borrowing, the nationalization of private debts at the expense of taxpayers and the attendant refusal to let bad businesses die, the ultimate inability of the US to service its liabilities, the imbalances brought on by the US-China relationship, and your reference to identifying important turning points suggest to me that you are analyzing (and questioning) the sustainability of the current macroeconomic framework. I have been spending a lot of time considering this as well. The two most elucidating pieces I have read are the following:


    Together these texts delineate convincingly that the Chinese currency peg is the central distortion behind the massive (and growing) structural imbalances; these analyses have helped lead me to the conclusion that either there will be a sizable revaluation of the Yuan in the next several years or else we are headed for an acute financial crisis in the US and/or a serious trade war. (I am not trying to pin the blame on China–only suggesting that this is the inflexibility that is preventing the system from self-correcting).

    Interestingly, it seems as though Europe is in many ways a microcosm of the US-China relationship with Germany being the surplus country lending to the periphery. Because developing Europe is inherently less stable than the US, and due to the inflexible currency mechanism within Europe, I suspect that this flashpoint will ignite prior to any further crisis led by the US. However, given that Europe is in many ways bearing the worst of the undervalued Yuan, crisis in Latvia, Greece, Hungary, Spain, and/or Austria would only serve to further the pressure toward China to revalue meaningfully. If I have enticed you to read those aforementioned studies, then I would love to hear your response when you are done as I find your analysis to be among the very best. Regards.

  • Greg says:

    @chris g — your argument makes no sense at all.

    If you think the dollar is going to be “crap” (in your words), then you want to be out of all USD denominated assets period. Treasury bonds are denominated in USD. That wasn’t my argument at all.

    If you think the dollar is on a long term decline (which it has been for decades and shows no sign of turning) — then “true” IG corporates are clearly a better bet. Corporates pay cash — the Treasury is paying PIK, even if they bamboozal you with fancy accounting gimmicks.

    Many quasi-government bonds (FNM, FRE, TVA, all munis, etc) should yield higher than IG corporates, since they will not be paid — any “repayment” you get is at the whim of political forces. Congress has to balance making FNMA bond holders secure with paying Social Security payments. When (not if) they are forced to reneg on one or the other … see GM and Chrysler for the answer

    Mortgage bonds, backed by the full faith of Tim Geithner (there is no legal basis for his actions), are not the same thing as bonds backed by the full faith of the US government.

    I agree the full faith of the US government isn’t what it used to be. They clearly intend to “pay back” their debt with depreciated dollars, and I would not put it past the crooks in Washington to somehow pay even less to non-US holders (some sort of “terrorism tax” on OPEC countries?).

    But all this quasi government crap is being honored at the whim of Tim Geithner, who has all the popular support of Goldman Sachs. Bailing out Wall Street fat cats is not something Obama can afford (politically speaking) to do long term.

    Either Goldman bonuses get canceled, and the rest of Wall Street with it — or else there will be huge political pressure, in a Congressional year, “to make banks pay for what they have done”. We are already seeing early signs of this.

    The US government isn’t supposed to be in the mortgage hedge fund business. There is no reason to believe that if the going gets tough, that these Treasury policies won’t be unwound in favor of direct aid to home owners (government aid that voters can “see”, and doesn’t involve paying Wall Street en route).

    Geithner sees this problem coming, which IMHO is why he is trying to comingle the FNMA mortgage problem with “normal” US debt. But unless the companies are formally nationalized (meaning US debt levels more than double, and entitlement programs get canceled) — the Treasury backing is nothing more than the current policy of the current Treasury Secretary … both of which can change faster than you can say “Read my lips, I did not have sex with my intern”

    Someone will have to take a loss. Will it be politicians? Nope, they don’t have any money. The elderly (via entitlement programs)? Try getting elected on that platform.

    Or will it be the fat cats on Wall Street who just took $20 billion in bonuses after being bailed out by taxpayers?

    Oh I know, everyone on Wall Street is going to move to Geneva, next door to the London bankers who made the same absurd threat

    VALE pays lower interest rates because its payments are not subject to the vagaries and uncertainty of politics — government bonds are.

    Same will be true in the USA

  • Thanks to all for the comments.


    I’ll read those pieces. They look very interesting.

    I recently put out to a Linkedin group that I am a part of a piece from the FT on the China peg, which is the biggest distortionary force in the world today.

    I’m kind of an odd duck because I have both quant and economic historian skills to varying degrees. On the bright side, when mercantilism ended, it was the mercantilists that lost. So, China and OPEC take whacks and might lose more than the US, but the ending will definitely be messy.

    If US Treasury bonds lose a lot of value, there are going to be a lot of impaired banks globally. The benefits of having the deepest debt markets will become the worst of all worlds for the foreigners relying on it as a store of value.

    Of course, we will have our own large troubles as well, but what form they takes relies on monetary policy at the time.

  • Ryan says:


    I incorrectly entered your name as my own in my last post. With respect to the ft article about Wen linked above. In terms of the imbalances between the US and China, the US has clearly chosen higher indebtedness over higher unemployment/slower GDP growth and this has only served to perpetuate the macroeconomic distortions in the world; there has been little political appetite in this country for even minor recessions over the past 15-20 years and the consequence is that we are now facing a severe one.

    On the other hand, as the Great Depression elucidated, it is the creditor nations with the most to lose from major trade disputes. China’s massive industrial capacity, margin structure, and export dependency make them particularly vulnerable to protectionism. While China is following the same export-led industrialization path as Germany and Japan, those nations let their currencies rise by 50-60% during the first twenty years of their transition. If China remains inflexible about the Yuan, I think that either: (1) extreme, disruptive protectionism is likely to emanate from the US, Europe, and/or Japan which will leave China the biggest short-term loser; or (2)the imbalances brought on by the consequent US fiscal and monetary policy will reach such extremes that the world will be forced to confront rolling sovereign debt/currency crises across the globe in the next 3-5 years. Both of these alternatives would likely leave China much worse off than a revaluation. It is always possible that we continue to muddle along with the status quo without crisis, but I suspect that the problems brewing in Europe will serve as a catalyst toward forcing conflict regarding the current currency system.