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American debt mistakes continue

By Daily Bruin Staff

May 13, 2010 9:00 p.m.

SUBMITTED BY: Myer Rickless

The U.S. Department of the Treasury has made the same mistake that millions of American home buyers did during the housing bubble of 2002 to 2006: It has taken out an adjustable-rate mortgage on the national debt.

The federal funds rate, which sets the baseline for short-term interest rates in the U.S., was lowered to 1 percent in 2003 and only raised incrementally by a meager 4 percent by 2006. This made abandoning the traditional 30-year fixed-rate mortgage for an adjustable-rate mortgage much more enticing, with the borrower taking advantage of the artificially low short-term interest rates usually for the first five years.

The interest rate would then be reset to the long-term market rate. Since the monthly payment for the first five years would be substantially less than with a traditional mortgage, home buyers were lured into buying houses that were far more expensive than what they could have afforded. Borrowers were only required to show the bank that they could afford to make the initial payments, with some buyers actually earning less annually than a year’s worth of reset payments.

So why would someone buy a house knowing going into it that they couldn’t afford the payments after the reset? Possibly more confusing: why would a bank loan money to people to buy houses, knowing full well that they couldn’t afford the payments after the initial period and were essentially guaranteed to default?

The answer is that the U.S. was in a housing bubble, and no one thought it would ever end.

Therefore, the thinking went like this: Before the interest rate reset, the borrowers would just refinance and either short-term interest rates would still be low or their home would have appreciated so much that they could just sell it and cash out the appreciation. For the bank, if the borrowers defaulted, it would just foreclose and sell it in a hot real estate market.

Everyone’s a winner, and everyone looks like a genius, right?

Wrong.

As short-term interest rates rose from the years 2004 to 2007, and home prices began to correct, many who had been lured into adjustable-rate mortgages found their homes significantly under water, with no bank willing to refinance them. As the first wave of adjustable-rate mortgages taken out in 2002 to 2003 came due in 2007 to 2008, many homeowners were in big trouble and had no way to meet their new mortgage payments. Inevitably, those borrowers defaulted and their homes were foreclosed on, and so triggered the economic collapse of fall 2008.

Fast forward to today and the U.S. Department of Treasury has made the same mistake. With the federal funds rate at the zero-to-0.25 percent range and the yield on Treasury notes at 50-year lows, the Department of Treasury has taken the same bait that adjustable-rate mortgage borrowers did.

The average maturity of the federal government’s $12.9 trillion debt has fallen from 72 months in 2000 to 57 months most recently. More troubling is that more than 25 percent, or more than $4 trillion of our debt, will be due in the next 12 months, and almost 55 percent, or more than $7 trillion, will be due in the next three years.

The problem is that we don’t have the money to pay off this year’s mature notes. We are hoping, as Bernie Madoff was hoping toward the end of his Ponzi scheme, that investors, mainly the Chinese, Japanese, Saudis and Europeans, roll over their Treasury notes into new, preferably long-term bonds.

When our foreign creditors lose confidence in our ability to pay our “worse than Greece-like” debt levels, they will begin to stop rolling over their treasuries and instead ask for their money back. After all, Greece went bankrupt because its 2010 budget deficit is projected to be 12.2 percent of its gross domestic product, and its estimated government debt was 110 percent of GDP. In fact, the U.S. 2009 budget deficit was just less than 10 percent of GDP, with the 2010 deficit projected to reach 10.6 percent. Also, if you include the $400 billion contingent liability of Fannie Mae and Freddy Mac, total U.S. debt will surpass 100 percent of GDP by the end of the year. Furthermore, if you include the unfunded liabilities of Medicare and Social Security, total U.S. debt is more than 800 percent of GDP.

Moody’s Investors Service recognizes the dire situation our nation finds itself in and stated in March that the U.S. could lose its AAA rating on treasury debt. Not surprisingly, the free-market has already beat the ratings agencies to it by offering lower yields on some U.S. corporate bonds than in equal length treasuries.

When our creditors lose confidence in our ability to repay them, they won’t sell their U.S. treasuries on the open market, which would incur huge losses. They could just let them mature and ask for their money back.

China has already begun allowing its nearly $1 trillion in U.S. debt to mature rather than rolling it over. The Associated Press reported on April 15 that China has reduced its holdings of U.S. Treasury debt by an annualized rate of 15.6 percent in February, following a trend that began in November 2009.

As foreigners begin to refuse to roll over their debt, interest rates will spike. Co-founder of Pacific Investment Management Company and manager of the world’s largest bond fund Bill Gross said on March 24 that “bonds have seen their best days. … Real interest rates are moving higher.”

As interest rates increase, the true cost of financing the national debt will begin to manifest itself. Debt not rolled over by foreigners will probably be bought by the Federal Reserve. If that were to happen, we would begin to experience runaway inflation.

Predicting inflation in the future, Gross went on to say, “Excess borrowing in nations including the U.S., U.K. and Japan will eventually lead to inflation as governments sell record amounts of debt to finance surging deficits.” If prices begin to rise, the Federal Reserve will likely be forced to raise the federal funds rate to defend the dollar (as Paul Volcker was forced to do in the late ’70s and early ’80s by raising the federal funds rate to 20 percent). If the federal funds rate was raised to only half of its height under Volcker, the interest on the national debt could reach $1.2 trillion a year and could consume as much as 50 percent of federal tax revenue.

Furthermore, the White House projects additional budget deficits totaling $8.53 trillion over the next 10 years.

When our national adjusted-rate mortgage resets, all bets are off.

Rickless is a third-year history student.

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