Pay Whatever You Want

The US government announced a rather interesting policy change about how mortgage lenders are to treat unemployed homeowners. Essentially, they have been told to write down the loans to what a government formula says the borrower can afford instead of what the property is actually worth. As outlined in the attached article, lenders are supposed to write down the loans so that payments do not exceed 31 percent of the borrowers can afford. What is even more interesting is that in some cases there can be no payments made, period.

This is definitely the most aggressive move that the federal government has made to keep people in their homes. They have, effectively, made it so that many unemployed individuals do not need to worry about making mortgage payments which they can not afford. The government will subsidize the lenders so some of the pain in writing down these loans is blunted. Obviously lenders have previously been reluctant to foreclose on homes and write down the value of their loans, until absolutely necessary, as doing so would force them to admit losses. Neither of those actions were desirable for the holders of mortgage debt.

Such a move by the government was likely made in response to a very high recidivism rate amongst borrowers who have previously had their loans modified along with the abnormally high unemployment rates. This move was made not only to keep people in their homes, but also to prop up home prices and prevent additional mortgages from going under water. The government has long been hesitant to make such policy changes in the past because they realized the numerous moral hazards which would arise from this type of program.

This program is one that will make life easier for a large number of people who have fallen on tough times. Yet it does so with incredible costs, both immediate and potential. The government has essentially taken the losses of the lenders onto its own books with little potential upside. Additionally, they have added a huge incentive for all borrowers to abuse the system. Individuals who purchased homes they could never afford using exotic mortgages now have the potential of their debt being (practically) forgiven. To say this practice would be unfair is a huge understatement and as such there will be a great deal of resentment.

It is impossible for a system to work where a person purchases something based on its market value and then has the value changed, after the fact, not to what the market dictates but to what they can afford. This violates the concept of a contract. Yes, people who are unemployed should have certain safety nets below them. However, they should not be rewarded for failed gambles they have taken.

Consequences of Debt

With the exception of a handful of years during the last half century the United States has funded its government expenditures through debt in addition to taxation. As the government (both at the state and federal levels) discovered that it was more popular politically to issue bonds instead of tax its citizens this practice expanded exponentially. Traditionally, government debt was seen as safer than its corporate or private counterparts. Since it was seen by markets as safer, it has also been cheaper. People would accept less interest payments because they knew they would have a better chance of getting their money back.

However, this era might be in its final stages. I'm not talking about the practice of the government's use of debt to increase spending, but its being able to pay less to do so. There has been much speculation (on this blog and major news outlets) that the US government was in danger of losing its ultra-safe AAA bond rating. If the rating were to go away, the markets would likely demand more interest to make up for the perceived increased risk.

But the market might not be waiting. Bloomberg recently reported that the United States government is now paying a higher interest rate than AAA rated Berkshire Hathaway - a private company. This essentially means that there are people who will loan money to a company than the United States government. The company can only fund its repayment of this debt by earning revenue while the government can back its repayment by taxation and by printing money.

Such a move is very odd. How can the bonds of a private company be cheaper than debt backed by the federal government? Honestly, I don't know - this makes little sense. As I have previously said, the government can just print new money while Berkshire Hathaway can not. It would have to earn money or issue new debt while there always exists a chance it can't repay and goes bankrupt. Is this implying that the United States could go bankrupt? I think not.

Instead, I believe that the US paying more in interest than a private corporation is a sign that those who loan the government money are trying to force it to issue less debt. Foreign countries are scared that the money they are paid back will be worthless. Only the government can devalue the dollar, a private company can not. This message is one that the US government should be very concerned with. If new public debt can not be issued, than the currency must be devalued. Such an action would likely only spiral out of control and lead to hyper-inflation as foreign countries and private citizens become less inclined to purchase treasury debt.

The Piggy Bank Is Empty... And It Has To Be Paid Back

Almost since the inception of the Social Security system, the program has collected more in taxes than it paid out in benefits. Rather than segregating this excess so that it could be used to pay future obligations, the Federal government diverted this money to its general accounts to be spent on all forms of spending. In return the government gave the Social Security Administration (SSA) special Treasury bonds. This has been a very useful way for the government to spend without needing to raise taxes. It was, essentially, a slight of the hand using brilliant accounting.

Unfortunately it looks like this practice is coming to an end. This year, the government will pay out more benefits than it collects, so the bonds will need to be redeemed. While the SSA has the money to pay out its immediate obligations using their bonds, the Federal government may have a difficult time figuring out how to repay without issuing more debt (or printing money) in its place. This is going to become a huge problem for the Federal government as a major source of funds is drying up and they have debt they have never had to pay before coming due.

The practice of the Federal government repaying SSA bonds is one that will only increase in the coming years. With each year that passes, more individuals will collect Social Security benefits and the system will be strained as this is not offset by additional payroll tax revenue. The SSA will redeem more and more of these bonds thus pulling more and more money away from the general accounts of the Federal government. This debt will almost certainly have to be monetized or refinanced. Any attempts to refinance the SSA debt may be made difficult by (potentially) rising interest rates which will make this a very expensive government endeavor.

The SSA is able to pay its obligations, for now. An additional long term problem that the Federal government may face from the Social Security program is what happens when it becomes insolvent. The SSA can use its bonds to make up its deficits for many years, but not indefinitely. At that point, they will either have to refuse to cover the payments that were promised to workers or to find new money to pay them. The Federal government would become a likely candidate to cover this shortfall (in addition to new taxes).

The headaches that Social Security will cause for the Federal government are about to begin. The government has gotten used to a source of funds that really were not theirs. Now this money needs to be paid back. Not only is the source gone, but the double whammy of having to pay new debts is about to hit as well.

The States Are Broke

I heard rumors that it might happen months ago, but I finally read today that several states would actually do it. Due to budget problems, a number of states, New York in particular, have plans to delay paying tax refunds to their citizens. Obviously there will be severe repercussions for making people wait to be repaid their over-payments. The problems that will likely arise range from voter anger at the polls to retarding the local economy.

Almost all of the states are currently running budget deficits. They generally pay for these deficits by taking out debt against future revenues. However, this practice does not always prevent liquidity problems for individual states. As a states debt increases, they might have the money to cover what they owe but do not always have the cash on hand to physically pay it. Famously, this happened last year in California when the state was forced to make some payments through I.O.U.s. This year, some states have found a new pile of cash to raid in order to remain liquid - unpaid income tax refunds. These states are hoping to use this money to cover their spending while making their citizens wait to be paid. Such a move might be advantageous as it uses cash on hand and, in most cases, is interest free. Hopefully, the refunds will be paid later in the year.

One of the largest problems that delaying refunds will cause is voter anger. Many people are eagerly waiting for their tax refunds to supplement their normal income, or lack-there-of. These citizens will not be quick to remember who caused them to be late on their rent check or car payment. Incumbent politicians in these states will likely be punished come their next election.

Another problem that will likely be caused by delayed payments is the slowing of local economies in these states. By not putting this money into the hands of people, who will likely spend it quickly, local businesses may experience slower sales than otherwise expected. Upon receiving my refund each year, I generally go out and spend a large part of it as do many other people. This spending can provide added revenue for businesses, potentially spurring additional investment and added hiring. Thus, but delaying these refunds local economic activity may be stagnated.

As several states consider delaying paying their citizens tax refunds this year, their governments must consider many potential consequences. They can grant themselves a delay in feeling some fiscal pain and gain an interest free loan. Yet, by following this policy they risk angering their constituents and hurting their economies. Such a decision must be carefully thought over before being implemented.

Breaking the Peg

For the past several decades, the Chinese government has attempted to boost its exports through a policy of undervaluing its currency. They used an artificial currency peg in order to stabilize the value of their currency, the renminbi (also known as the yuan), in comparison to the US dollar. They pegged the renminbi below its market value in order to make their goods cheaper on foreign markets and thus to increase demand for their production.

The Chinese have pursued their peg through a fairly complex policy of buying dollars from their citizens after they sell goods to the United States, then issuing yuan denominated debt and purchasing dollar denominated debt. In essence, they are taking dollars from their people, giving them back renminbi and buying debt from the American government. The net effect of this is to flood their domestic markets with yuan while pulling dollars out of their economy. This makes the dollar relatively expensive in relation to the yuan. The artificially cheap renminbi allows their goods to be relatively inexpensive on foreign markets, and this results in greater demand for Chinese goods. They constantly have a new supply of dollars as their factories sell goods to US companies and then sell the dollars back to the government.

However, this policy may soon be changing. A Chinese central bank governor recently signaled that they may un-peg their currency. He said that they would not be maintaining their current monetary policy 'indefinitely' and that they may allow their currency to float in order to speed up economic growth. The bank has gone so far as to study the potential effects of ending the peg.

Any move to end the peg would have huge effects on the world's economy. First, by increasing the value of their own currency the Chinese would make their goods more expensive in foreign markets. Likely, this would tamp down some of the huge demand for their production. However, the Chinese would likely replace the demand by selling more of their goods domestically. For foreigners, like Americans, this would probably cause the prices of many imported goods to rise. Gone would be the days where imported goods could be sold for a fraction of domestic ones. This might be inflationary for the US, but could likely give some support to the domestic manufacturing industries.

Other major affects would likely take place in the world's financial markets. The huge surplus of dollars the Chinese currently enjoy would likely dry up. This may cause them to purchase less foreign debt. This could force interest rates in the United States to rise as the government finds fewer major borrowers for Treasuries. Additionally, the Chinese would have less currency to invest in foreign companies. This might cause stagnation in the price of financial assets.

The effects of ending the yuan-dollar peg would be many. The Chinese government would cause their exports to decrease by making them more expensive. Such a move might help workers in the US as domestic production would be able to better compete with cheaper imports. However, this would come at a price. The price of goods would likely rise causing inflation. Additionally, such a move would force interest rates to increase making it more difficult to borrow money and issue debt.

To (Re)Pay or Not to (Re)Pay

A rather interesting article appeared a few days ago on the Bloomberg news wire. I for one did not realize that Iceland was having a referendum on whether or not they should repay the debt to the British and Dutch governments they incurred when their banking system had to be bailed out recently. The Icelandic citizens will be able to vote to either repay the debts of about $16,000 per citizen or to refuse to pay back their creditors. The issue here is two fold. First, what happens if the money is not paid back; and, secondly, should the money be paid back.

Obviously, there will be serious ramifications should the repayment measure be defeated. As the author pointed out, Iceland has an application to join the European Union. This would need to be approved by both of their main creditors, the UK and the Netherlands. It is fairly simple to assume that both of these nations would reject expanding the EU if their money is not repaid. Being unable to join the EU would be a blow to Iceland's attempts to expand its' economy and further integrate itself with the rest of Europe. Likely, this would result in slower growth or even economic stagnation. Additionally, Iceland will have an incredibly difficult time issuing new debt. Their credit ratings would crash and they would be forced to pay usurious interest rates on any debt they issued. Of course, this is assuming anyone would loan them money again. If unable to issue new debt, they might be forced to devalue their currency and open their people up to the threat of inflation.

The crucial part of this vote is should the money be paid back to creditors - is it in the interest of Icelandic citizens to allow their government to pay its debts? The article's author makes a three-fold case that the proper vote should be 'no'. His justification is that the debts were not the Icelandic peoples' fault. Instead, the blame lies with the bankers, the foreign governments and the depositors whose accounts needed to be repaid. The bankers took excess risk, the foreign governments wanted to bail out their own citizens (most of the failed deposits were held by UK and Dutch citizens) and the depositors also took risks by putting their money in non-guaranteed, high yield accounts. The problem with this justification is that it was still the Icelandic government who took out a loan to cover their banks' debts. The government did not have to do this, and when it did, it agreed to pay back the money.

Unfortunately for the Icelandic people, though it may be very expensive, the costs of not paying back their debt might be prohibitive. By voting 'no' they would, essentially, push their country away from European integration and borrowing money in the near future. Iceland would be forced to maintain a self sufficient and independent economy. Yet, by voting 'yes' the Icelandic people would force huge sums of their wealth abroad to creditors. This move would weaken the government and force it to take out additional debt as much of their revenue would be pushed to its creditors. However, a 'yes' vote would likely make joining the EU infinitely easier as they would have the support of the UK and the Netherlands.

I, for one, am grateful that I do not need to vote in such an election. The choices for Iceland and essentially lose-lose. There is no way for them to 'win' in this election. They are either forced to separate themselves from the EU and international credit markets or to impoverish themselves by paying huge sums to settle what is a questionable debt. If I was forced to vote, I would probably choose the 'yes' option. The debt was taken out by the Icelandic government, so it should be paid back by the government.

An Opening at the Fed

With the announcement today by Donald Kohn that he will leave the Federal Reserve board at the end of his term has given President Barack Obama an opportunity to shape the future monetary policy of the United States. Kohn, who was initially appointed as Vice Chairman by President Bush has been hailed as an incredibly influential member of the group which effectively determines the country's monetary policy. With this, and any other vacancies, Obama has the opportunity to nominate candidates who are sympathetic to his policy views.

This aspect is incredibly important with the Federal government following an expansionary fiscal policy driven largely by debt. The Fed has become a major purchaser of government obligations as traditional buyers lack the capacity to absorb larger quantities of Treasury Bonds. Additionally, the Federal Reserve's board is tasked with determining several very influential interest rates and dictating how much capital firms are required to hold on deposit.

Obama can, by appointing those who agree with him, shape the board to be sympathetic to the policy he and his allies in Congress carry out. He will likely look for someone who will be relatively dovish on inflation and who might hope to continue the policies of 'quantitative easing' through purchases of government debt.

Some have seen the Federal Reserve as a defacto fourth branch of the Federal government. Much like the Supreme Court, the Executive and Legislative branches have abilities to oversee the bank and nominate some of its members. Some people might even go so far as to say that the Fed is more important than some of the formal branches of government. With this retirement, President Obama has been given an additional opportunity to further influence the bank. Likely, Obama will find a nominee who will fervently support his policies through dovish monetary policy and continued support for purchasing Treasury debt.