US Debt musings from an int’l economics kid, turned scrappy tech entrepreneur

A good friend Thomas just posted his analysis of the financial situation, here, on his “View From The Bottom”.  One of his gifts is explaining complicated stuff in plain english, so I took notice.  I had some followup questions that turned into much more than a comment on his post.  But Thomas (and David, and, and), I want to know what you think of this….

As a non-financial guy & someone not well-informed by US perspectives on this stuff…but as someone who spent so much of my university schooling in foreign unis looking at international economics…I am longterm extremely bearish on the US economy.  In all my studies, seemingly every possible longterm economic health indicator made things look really bad for my country (balance of trade, rate of education, sustainable national competitive advantage, and most importantly, debt).  Sure, we have greatest universities, plentiful natural resources, many of the world’s most sophisticated institutions, and are still the world’s largest economy…but everyone already knows this stuff…The stuff that we don’t think about as often…the comparative trends…don’t look good.

US Trade, as % of DGP
US Trade Deficit, as % of DGP

(source for trade deficit chart: NYTimes & Bureau of Economic Analysis).

Take for example, our (Im)Balance of trade, which has been going south for many decades.  It is now massive (we are at -$500 Billion on a ‘good’ year).   The way I understand this is…if this were a company, it would mean “Amount of $ Sales to other Companies” minus “Amount of $ Purchases from Other Companies”, divided by “How Big Domestic Economy Is”.  So with a deficit around 5% of GDP, that’s like a company earning $95 but spending $100 to do it, while all the employees do a lot of trading goods and services among themselves.  But overall, the company is losing $ every year, for many decades.

So…our country chronically buys more than it sells…we buy lots of goods (think oil and plastic toys) and we sell lots of services (think consulting firms), but we buy a lot more oil and hondas than we sell services and fords.

US Annual Balance Of Trade
US Annual Balance Of Trade

(Source for Balance of Trade Chart:  US Census Bureau Dept of Trade Stats)

In a way, this extraordinary “imbalance of trade” since the 60s/70s has no choice but to directly result in mounting debt.  Because our imports so vastly exceed our exports – where does that money come from?   Well, the way I simplify things is that this is where debt comes from.  If we receive WAY more stuff from other countries than we send to them, then someone is lending us that $ (think China & Saudi Arabia), and that means over time, our ability to repay them becomes riskier and riskier, and so our currency becomes less valuable.  Thus, we have to spend more of our currency to buy more of the foreign goods we need, and the cycle reinforces itself.

The crazy thing is that this is commonly available knowledge.  We all know we buy tons of oil and stuff from China.  We all know we have a big national debt.  But somehow, professors in our finest institutions still think that our government is absolutely “good for it”.  Despite us losing $ every single year, our governments bonds are still called the “risk free rate.”  How insane is that?

As an entrepreneur, I’m hard-coded to manically focus on increasing the # of things I can sell and limiting what I have to buy…but our country’s overall position is exactly the opposite.

Plus, maybe I’m old-school, but I’ve always been the type of person that was severely bothered by owing anything to anyone ($4 latte to mortgages)…and I generally consider debt to be a dangerous thing to play with, etc.  So coming from that perspective the US debt situation seems all the more egregious (#s so big that when I look at them, they make me freak out and I don’t want to think about it anymore).

A couple of times in Finance class, I would ask the professor something like “why do we call this the risk-free rate – does that mean there is 0 chance that our country defaults on its debt?”.  Everyone would look at me like I’m from Mars…but if my company had the debt, income, and competitive profile of the US economy, I would be absolutely mortified (like, in the full etymological meaning of the word).  And if our country’s balance sheet was anonymized and we all analyzed it in, we would all say “yeah, this company is totally SOL”.

Seriously, what would an honest rating agency rate our bonds at (if you took away a bunch of zeros and measured it against what we consider to be healthy financial organizations…)?  Would our country receive the same type of ratings that Apple would get right now on its debt?  Hah, no way!  So I sort-of expect a long term, protracted, and painful downward trajectory for our economy.  I don’t like to think like this, but I would have to deceive myself to look at these types of numbers and believe otherwise.

I’m jaded enough about the longterm outlook, that when stuff like the housing crisis and this pop up, I’m not like “OMG the sky is falling”, I’m more like “well yeah, okay so THIS is how this prolonged downward cycle is playing out right now…that all of these elephant hiccups are just a sign of an inevitable obvious X0 year decline.”

But then again, I’m not a finance expert, I don’t watch the news, and I’m not well-informed about what’s going on this week, or even this month.  What I’m wondering is about the big picture, the three-decade picture, and it is twofold:

(1) when (ya know, I assume this is not an IF) the moment of reckoning comes, how bad of a situation are we in?  Like Argentina 2001 where banks close, lower third falls into seriously awful shape, avg person’s savings catastrophically melted away…?  I guess that maybe splits into two different answers?  The upper quartile of the society will probably have their $ squirreled away in asian banks or whatever and be able to eat, enjoy, and have a safe life…?  Meanwhile, the lower quartile will grow into the lower 3 quartiles and life will be miserable?

In other countries where the bottom falls out, the middle class disappears, things get less safe, people’s savings implode, and things get really really ugly (crime, shortages, etc).  What if this happens to the biggest economy on the planet?  I keep asking myself, are we caught up, freaking out about this particular short-term problem, when the bigger issue is the longterm situation which is much worse than we are all anticipating it will be?  The US has been so wealthy (relatively) for so long that most Americans (including myself), can’t imagine what a really bad outcome looks like.

So does that play out where our insurance programs explode?  A run on the banks?  Or seniors have all of their pensions go poof?  And then discretionary expenditures drop further, and then corps shrink, and investment dries up, and social services shrink, and on and on?   Please tell me I’m not glass-half-emptying this to death?  Is there a bright spot?  Something I don’t understand that makes this all okay?

But really, if this wasn’t the largest economy of all time, the global icon of freedom and national wellbeing, and on and on, wouldn’t we just all say “yeah they’re on the brink of bankruptcy”?  And if so, when a country does go completely bankrupt – this might not even be close to being the kind of relatively lovely place to live that it has been for a century, will it?

And (2) how soon is this happening?  I have been looking at these events…the housing thing, this debt thing, other “woah, what happened??” moments…as “well, yeah, this is one of the kerfuffles that will eventually fit together with all the others over the next 10 years?  30 years? 50 years? that is one of those “well we should have known this would eventually happen”.   One of the handfuls of steps in this inevitable march towards serious catastrophe (ie not a two-year blip, but a way-of-life altering mess).

So I’m curious if you, someone who is actually well informed about what’s going on, agrees with this overall picture?

And really, what I am curious to know more of what you think – how big of a mess do you think the US debt situation is, mid & longterm…Should I trade my $s for yen and move to Canada?

Finally, as all of this is obviously depressing – what would we have to accomplish to change our path?  Do we have what it takes, as a society to course-correct?  We gotta try…

Why’d The Economy Crash, Our Savings Plunge, and the Huge Investment Banks Disappear? put together a tremendous insider story about the underpinnings of the economic mess we’re in:  excessive leverage on securities made of rolled up subprime mortgages, by speculators who bought despite home price-to-income ratios skyrocketing, and investors that saw this coming and made a killing shorting bonds made of this junk.

Who saw this coming?  Certain brilliant skeptics that had been a part of the inner workings of this complex web of financial engineering.

I’m only beginning to learn how this complex and disconcerting web became a monster.  This Conde Naste article does an excellent job of painting the horrifying picture.  Excellent work by Michael Lewis in producing this piece.  I’ve copied excerpts of this article below:

“In retrospect, pretty much all of the riskiest subprime-backed bonds were worth betting against; they would all one day be worth zero. But at the time Eisman began to do it, in the fall of 2006, that wasn’t clear. He and his team set out to find the smelliest pile of loans they could so that they could make side bets against them with Goldman Sachs or Deutsche Bank. What they were doing, oddly enough, was the analysis of subprime lending that should have been done before the loans were made: Which poor Americans were likely to jump which way with their finances? How much did home prices need to fall for these loans to blow up?”

“The smart trade, Lippman argued, was to sell short not New Century’s stock but its bonds that were backed by the subprime loans it had made. Eisman hadn’t known this was even possible—because until recently, it hadn’t been. But Lippman, along with traders at other Wall Street investment banks, had created a way to short the subprime bond market with precision.”

“Here’s where financial technology became suddenly, urgently relevant. The typical mortgage bond was still structured in much the same way it had been when I worked at Salomon Brothers. The loans went into a trust that was designed to pay off its investors not all at once but according to their rankings. The investors in the top tranche, rated AAA, received the first payment from the trust and, because their investment was the least risky, received the lowest interest rate on their money. The investors who held the trusts’ BBB tranche got the last payments—and bore the brunt of the first defaults. Because they were taking the most risk, they received the highest return. Eisman wanted to bet that some subprime borrowers would default, causing the trust to suffer losses. The way to express this view was to short the BBB tranche. The trouble was that the BBB tranche was only a tiny slice of the deal.”

“But the scarcity of truly crappy subprime-mortgage bonds no longer mattered. The big Wall Street firms had just made it possible to short even the tiniest and most obscure subprime-mortgage-backed bond by creating, in effect, a market of side bets. Instead of shorting the actual BBB bond, you could now enter into an agreement for a credit-default swap with Deutsche Bank or Goldman Sachs. It cost money to make this side bet, but nothing like what it cost to short the stocks, and the upside was far greater.”

“The arrangement bore the same relation to actual finance as fantasy football bears to the N.F.L. Eisman was perplexed in particular about why Wall Street firms would be coming to him and asking him to sell short. “What Lippman did, to his credit, was he came around several times to me and said, ‘Short this market,’ ” Eisman says. “In my entire life, I never saw a sell-side guy come in and say, ‘Short my market.’””

“And short Eisman did—then he tried to get his mind around what he’d just done so he could do it better. He’d call over to a big firm and ask for a list of mortgage bonds from all over the country. The juiciest shorts—the bonds ultimately backed by the mortgages most likely to default—had several characteristics. They’d be in what Wall Street people were now calling the sand states: Arizona, California, Florida, Nevada. The loans would have been made by one of the more dubious mortgage lenders; Long Beach Financial, wholly owned by Washington Mutual, was a great example. Long Beach Financial was moving money out the door as fast as it could, few questions asked, in loans built to self-destruct. It specialized in asking home­owners with bad credit and no proof of income to put no money down and defer interest payments for as long as possible. In Bakersfield, California, a Mexican strawberry picker with an income of $14,000 and no English was lent every penny he needed to buy a house for $720,000.”

“More generally, the subprime market tapped a tranche of the American public that did not typically have anything to do with Wall Street. Lenders were making loans to people who, based on their credit ratings, were less creditworthy than 71 percent of the population.”

“All that was required for the BBB bonds to go to zero was for the default rate on the underlying loans to reach 14 percent. Eisman thought that, in certain sections of the country, it would go far, far higher.”

“A full nine months earlier, Daniel and ­Moses had flown to Orlando for an industry conference. It had a grand title—the American Securitization Forum—but it was essentially a trade show for the ­subprime-mortgage business: the people who originated subprime mortgages, the Wall Street firms that packaged and sold subprime mortgages, the fund managers who invested in nothing but subprime-mortgage-backed bonds, the agencies that rated subprime-­mortgage bonds, the lawyers who did whatever the lawyers did. Daniel and Moses thought they were paying a courtesy call on a cottage industry, but the cottage had become a castle. “There were like 6,000 people there,” Daniel says. “There were so many people being fed by this industry. The entire fixed-income department of each brokerage firm is built on this. Everyone there was the long side of the trade. The wrong side of the trade. And then there was us.”

“You have to understand this,” he says. “This was the engine of doom.” Then he draws a picture of several towers of debt. The first tower is made of the original subprime loans that had been piled together. At the top of this tower is the AAA tranche, just below it the AA tranche, and so on down to the riskiest, the BBB tranche—the bonds Eisman had shorted. But Wall Street had used these BBB tranches—the worst of the worst—to build yet another tower of bonds: a “particularly egregious” C.D.O. The reason they did this was that the rating agencies, presented with the pile of bonds backed by dubious loans, would pronounce most of them AAA. These bonds could then be sold to investors—pension funds, insurance companies—who were allowed to invest only in highly rated securities. “I cannot fucking believe this is allowed—I must have said that a thousand times in the past two years,” Eisman says.”

“On July 19, 2007, the same day that Federal Reserve Chairman Ben Bernanke told the U.S. Senate that he anticipated as much as $100 billion in losses in the subprime-mortgage market…Steve Eisman had become a poorly kept secret. Five hundred people called in to hear what he had to say, and another 500 logged on afterward to listen to a recording of it. He explained the strange alchemy of the C.D.O. and said that he expected losses of up to $300 billion from this sliver of the market alone. To evaluate the situation, he urged his audience to “just throw your model in the garbage can. The models are all backward-looking.  The models don’t have any idea of what this world has become…. For the first time in their lives, people in the asset-backed-securitization world are actually having to think.” He explained that the rating agencies were morally bankrupt and living in fear of becoming actually bankrupt.”

“Not so for hedge fund managers who had seen it coming. “As we sat there, we were weirdly calm,” Moses says. “We felt insulated from the whole market reality. It was an out-of-body experience. We just sat and watched the people pass and talked about what might happen next. How many of these people were going to lose their jobs. Who was going to rent these buildings after all the Wall Street firms collapsed.” Eisman was appalled. “Look,” he said. “I’m short. I don’t want the country to go into a depression. I just want it to fucking deleverage.” He had tried a thousand times in a thousand ways to explain how screwed up the business was, and no one wanted to hear it. “That Wall Street has gone down because of this is justice,” he says. “They fucked people. They built a castle to rip people off. Not once in all these years have I come across a person inside a big Wall Street firm who was having a crisis of conscience.””

I, personally, don’t know nearly enough yet to know exactly what I think about all of this.  I believe that the majority of the junior analysts at these firms knew little of what they were doing.  I also know that a lot of the leaders of these organizations made an absolute killing off of the crisis that they helped create.  I am interested in seeing how this plays out.