I have managed to go since August 20th without mentioning Brett Arends of the Wall Street Journal. It hasn’t been easy, but for 59 posts I have stayed on the wagon. Until now. Arends’ Wednesday column was just too strong a temptation. It had the siren-call title of "Are Your U.S. Treasury Bonds Safe?" How am I supposed to ignore that? I am only human.
Needless to say, the column lacked a yes/no answer to its headline. Sure, "Standard financial theory defines "the risk-free rate of return" on money as the rate of return you can earn on Treasurys" but this time is different: the government is now in the control of politicians who like to spend money and don’t like to raise taxes.
But as the U.S. government piles borrowing atop more borrowing, it begs a financial question that is not utterly ridiculous: Are your U.S. Treasury bonds safe?
Okay, I have two objections to this. First, when I misuse "begs the question" somebody from the Begs The Question Police points out my error in the comments within hours. Why the walk for Arends?
Second, there is a big difference between a question that is "not utterly ridiculous" and one that doesn’t have an iron-clad obvious answer. "What time is it?" comes to mind.
Treasuries are risk-free because it is essentially inconceivable that the government will not pay them off as promised. In fact, it is simply impossible for the government not to be able to do so. It has the power to invent dollars out of thin air, so if it came to it the government could make good by just printing money. (Those dollars may not be worth anything, but that’s a different problem.)
Any scenario in which the government defaults is really a repudiation scenario, in which it can pay what it owes but chooses not to. Sort of a strategic default writ large, except that the Feds won’t be handing over any keys to the creditors.
I will admit that such a scenario is conceivable, in the sense that we can invent an imaginable narrative that ends up with a US debt repudiation. The same is true for scenarios of Earth being invaded by robotic aliens. The government stiffing its creditors would take a Dr. Strangelove-like series of well placed madmen in Washington, and possibly the help of a few villains from early James Bond movies. (The old good ones starring Sean Connery, not the new bad ones starring Vladimir Putin.)
Alas, as I have pointed out in my discussions of lotteries and the like, we all have difficulty dismissing the possibility of anything that we can imagine. Arends based his piece on recent prices for credit default swaps (CDSs) on Treasuries.
(In case you have already forgotten, a CDS is an insurance policy on a bond, basically a third party guarantee that the debtor will pay. Think of it as hiring somebody to cosign a loan you are making to a shaky borrower.)
I am going to admit that I was surprised that CDSs on Treasuries existed at all. So you can imagine my shock at finding out that the going rate is, according to Arends, 0.34%, meaning that to insure $1M in treasures against default in 2010, it will cost you $3,400. That may not sound like a lot, but consider that the bonds may be yielding only 2% to begin with.
And it gets worse. Again according to figures Arends cites, it would cost 3% of principal to insure Treasuries for five years. This is nothing more than price gouging and I am not going to sit idly by while it happens.
So I am here announcing that I, Frank Curmudgeon, will guarantee up to $1 Billion in US Treasury Bonds against default for five years, for the low low price of only 1%. That’s right, the first investor to wire me $10M gets the peace of mind that only a guarantee against default can bring.
Cynics amongst you might object that I don’t have $1B to make good if need be. That’s a valid point. But the same problem exists for anybody writing CDSs on Treasuries.
A US Government default would be a financial Armageddon on the scale of, well, the Earth being invaded by robotic aliens. I should have a good analogy here involving Lehman Brothers but I am having trouble coming up with one that really captures the sense of scale. US default is to Lehman bankruptcy as the Hindenburg is to a twenty minute air traffic delay?
US debt, from the reserves held by the Chinese government to the little pieces of paper with pictures of US presidents used as money, is a big part of the foundation of the global economy. Take that away and the whole thing comes tumbling down. When Lehman went under panicked investors bought Treasuries. If the Treasuries ever become worthless, buy automatic weapons and ammunition.
Not to dissuade any of my potential customers, but you would have to have a hole in your head to think that a CDS on US Treasury debt would ever be paid off. (I am dying to find out that AIG is one of the outfits selling CDSs on Treasuries. If you don’t think that would be funny, consider who is currently backing them up.)
Yes, your US Treasury Bonds are safe. Inflation may mean that the dollars you eventually get paid are not worth as much as you hoped, but you will get paid. That’s as certain as anything can ever be.