Not If, But When
Research for Online Investors

by John Dalt

9/21/10

Any business that operates vehicles driving on the highways, or planes flying in the air must embrace a central premise; “It is not IF an accident will happen, it is WHEN.”  The risk may be miniscule, but the odds eventually catch up with you.  How many trips to the grocery store can you take before the car gets “tagged” in the parking lot?

Arnaud Mares with Morgan Stanley’s London Office wrote a research report with a similar resignation to the certainty of sovereign default.  Titled “Ask Not Whether Governments Will Default, but How” the paper supposes that governments must impose a loss on someone, because they cannot support current debt and future demands for services.

Mr. Mares looks at current debt to GDP ratios, but observes the important distinction between GDP and the taxing ability of the state to service the debt.  In other words; What is the tax raising ability of the state?  France taxed at a rate of 48% of GDP, whereas the U.S. taxed at the rate of 14.8% of GDP in 2009.  France’s Debt/GDP ratio is 77.6% compared to the U.S.’s 53%.  When looked at as a ratio to taxing ability; France has debt at 161.7%, but the U.S. sits at 358.1%.  Of course the U.S. can raise taxes.  France is already taking almost half of GDP in taxes and would have difficulty increasing the percentage.

Does this mean the U.S. needs to DOUBLE tax rates?  The political difficulty of this action is obvious.  Look at the actions in Greece.  Loopholes have been closed and collection enforcement has increased.  In the U.S., Oh! Bama wants to extend the Bush tax cuts for married filers making less than $250,000.  The administration wants to increase the percentage of tax receipts paid by high income earners.  Who else is available to “take one for the team?”

Bondholders.   Look at the stakeholders (interest groups) in the government; we can see that pensioners may have to take a haircut with reduced social security under some modification plan.  Taxpayers may have to pay more, and perhaps not just the “wealthy.”  Broad based tax increases, even small ones, will raise more revenue than punishing high income earners.  Do we think that bondholders will be protected?

A look at the government’s treatment of bondholders in the GM bankruptcy is instructive.  They were sacrificed for the “greater good.”  Will this happen in the future on sovereign debt?  Mares believes it will.

Mares observes that sovereign bondholders have been sheltered from losses in the recession of the last two years.  Homeowners have lost value in property, government employees expect a reduction in government expenditure, and taxpayers expect an increase in tax rates.

Mares believes this cannot continue.  Bondholders are a minority and will be politically vulnerable.  While bondholders are primarily retired pensioners, their interests are not aligned with the interest groups for retirement benefits.

Mares coins the term “financial oppression” to describe the alternative to outright default.  There are two ways bondholders can be damaged according to Mares.  We have chronicled the dangers of inflation and how it damages bondholders by reducing the purchasing power of the money that is returned at bond maturity.

The second form of financial oppression is to maintain effective negative rates of return on bonds by distorting the interest rates offered.  Does this sound familiar?  It is exactly what the Fed it doing through Quantitative Easing.  Bloomberg covers the report.

This economic argument is presented to help us understand the macro trends affecting the market and our businesses.  Today’s article gives us a view into Mr. Mare’s observations on the problem facing governments around the world.  These problems are not restricted to the U.S., France and Greece.  Great Britain, Germany and other industrialized economies all face the same problems.

The universality of the challenge makes the problem even more insurmountable, as the cures will not be isolated to one or two countries but have to be applied on a widespread basis.  You may want to re-read the quotes from Annaly’s Salvo at the end of our article NLY; Great Company, Bad Timing.  The games played with interest rates over the next few years (decades) can exert great harm on many investors and retirees.

Harry Reid (D-Nev) is pushing for passage of a Defense Authorization bill in the Senate today.  He has attached language that ends “Don’t Ask, Don’t Tell.” The Defense bill also contains an immigration amnesty proposal called the Dream Act, this program allows aliens to be granted citizenship if they attend college.  Calling this the Dream Act is poetic, as in if you can dream it the liberals will come up with a way circumvent it.

His re-election may need divine intervention!

The Dream Act sounds like a reasonable way to reward citizenship on those that excel and work hard to better themselves.  A few problems have come to the surface; the age limit on participants is 35 years old, they can be in the country illegally, there are minimal academic requirements, and Dream Act beneficiaries would be eligible for federal scholarships, grants and work-study programs.

The Dream Act has been defeated before, but attaching it to the Defense Authorization bill is intended to run it through, or beat opponents over the head with an accusation they opposed funding our troops.  The cloture vote failed earlier today 56-43, to which Harry Reid said, “We’re going to vote on the Dream Act.  It’s only a question of when.”

Quote:
Concentrated power has always been the enemy of liberty -- Ronald Reagan

The information presented in this newsletter is based on generally available news releases, corporate filings, current events, interviews and the editor’s opinions.  It may contain errors and you should not make investment decisions based solely on what you believe you have read here.  Do your own research, it is your money.  If you lose it, it is your responsibility, not ours or your grandmothers!  The editor may or may not have a position in any securities discussed.  The editor may have held a position in a security earlier, or in the future.

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