THE BASIS POINT

Stats On Government Shutdowns & Market Reaction

I was “spanked down” by a few folks about my analogy yesterday about the US deficit being like someone who runs up their credit card. Here are a couple of responses:

“The debate about the debt ceiling isn’t analogous to asking for an increase in one’s credit card limit; it’s analogous to a strategic default on one’s mortgage. The real question is this: If I earn $3,000 a month and the limit on my credit card is $5,000, and I spend $6,000 every month, is it better for me to decrease my spending and/or increase my income, or after debating with the missus for several weeks, just stop paying the bills? I mean, after all, she’s the one who made all those purchases (why do women need all those shoes, anyway?), and she bought most of the stuff before I married her…and besides, I thought we’d be earning more by now, and the interest on all this debt is just killing me, and the house isn’t worth what I paid for it…”

“Let’s face it. A responsible family would decrease their spending in the immediate term, look for ways to increase their income in the longer term, cut up the credit cards, and figure out a way to pay the bills. And if they didn’t pay the bills, they would face the consequences … an embarrassing credit score, no more easy credit, and any credit they could get would come at a very high price.”

Government Shutdown?
One should remember that since 1976 there have been 17 shutdowns, with the 1995/96 shutdown of 21 days the longest in modern history.

If on August 2nd there is no budget deal, then we should see number 18. Oddly enough, the last shutdown occurred precisely when Italy and peripheral Europe were going through their last major crisis of confidence. If there is no deal in the early part of this week, the Treasury will issue a statement to the market and outline it’s directive to the Fed as to the priority of payments and it will outline an alternative auction structure for Treasury notes and bonds . Most other governments never shut down as parties bicker over spending – in fact Belgium hasn’t even had a government since 2010 and there has been no shutdown. The world will not end and the US government will eventually keep on spending, with the financial markets hoping for growth to cure the US debt problems combined with some spending cuts.

But markets (stocks, bonds, whatever) don’t like uncertainty, and certainly would not like a downgrade of the United States. One can expect this uncertainty to continue to weigh on risky assets in the short-term – like the stock market. There is the potential that banks could see higher capital requirements for mortgage securities. (Currently, Ginnies are a zero risk weighting, while conventionals are 20%.) Banks may not rush to sell MBS’s, but their appetite for the product could drop. Central banks could sell, or reduce their future purchases of, mortgages in a downgrade scenario. But from a cash flow perspective, few experts expect Ginnie, Fannie, or Freddie cash flows to be affected. But they could be downgraded if US government debt is downgraded, and this would lead to higher mortgage rates.

Fannie Downgrades Housing Predictions
Under the “what else can happen” category, Fannie downgraded its housing predictions for this year. Fannie’s economists believe that mortgage interest rates will move up just slightly over the year to finish at 4.7% and rise again in 2012 to an average of 5%. Total mortgage originations in 2011 will decline to $1.07 trillion from $1.51 trillion in 2010 (about 30%) and decline further still next year to $999 billion. Single family mortgage debt will fall an additional 2.6 percent from $10.54 trillion to $10.26 trillion. Home prices are expected to decline further this year and next. The median price in 2010 for a new home was $221,800. This year it is expected to be $216,900 and in 2012 $214,100. Existing homes are expected to sell for a median price of $165,600 this year and $163,700 next, compared to $173,000 in 2010.

Kroll on Bond Ratings
Many in the industry wonder why the rating agencies seem to have escaped a good portion of the blame for mis-rating countless securities and helping to cause the credit crisis. It is a complex question, but some rating agencies are working to solve it.

Kroll Bond Ratings, for example, recently published an Investor Bill of Rights for bond investors:

“Article l: Kroll Bond Ratings will make its research reports, including criteria and analysis, supporting its published, non-subscriber ratings available to every fixed income investor without charge.

Article II: Kroll Bond Ratings will make its transaction analyses available on its website in a timely manner and will provide a forum to respond to investor questions.

Article III: All ratings and analyses will be clear, transparent and usable for investors, thereby avoiding rating conclusions derived from a ‘black box.’

Article IV: Kroll Bond Ratings will confirm that its analysis includes appropriate and professional due diligence as part of the rating process.

Article V: All ratings will be subject to ongoing review throughout the life of the security or entity to ensure that the rating is accurate.”