Iceberg! Right Ahead!!!! The Growing Moral Hazard in Bond Markets

11/30/2010 Portland, Oregon – Pop in your mints…

What in the world will become of the Bond Markets?  The question troubles us.  Equity and Commodity Markets are free to be basket cases.  It is their very nature, it comes with the territory.  One day you are up, one day you are down.  You would be a fool to take them too seriously.  But Bond Markets are another story.  People expect more out of Bonds.  Like an older child, they are expected to act "responsibly."  While a reasonable person may store his vacation funds in equities, he puts his retirement in Bonds.  Bonds are supposed to be reliable and only issued by parties who over time have made good on their word to return money to the lenders as agreed.

But what happens to this dynamic when the money itself becomes suspect?  As we have investigated in prior Mints, what passes today as money is in large part an impostor.  Like all impostors, it looks great from a distance but up close it is easy to see something is amiss.  Once the impostor is discovered, at a minimum the impostor is asked to leave the party.  If the impostor happens to be the host, the party ends altogether.  The current impostor money is hosting the party in the Bond Markets.  How much longer can it last?

How long until Bond Markets run aground?

Our guess is longer than you or I can imagine, fellow taxpayer.   Delusions die hard.  The attendees have been there a while and are a bit tipsy.  Besides, it's a great party.  Can't meet your capital requirements?  Take some cheap money.  Can make your upcoming redemptions?  Put some treasuries on your balance sheet and anyone will lend you what you need.  No, the attendees have no interest in spotting the impostor.

Take our most recent example, Irish Bonds.  One day they are becoming worthless, the next day, good as gold.  What to make of it?  What happened overnight to mend them?  We are told that they have been "bailed out" by the EU and IMF.  But where do they get the money?  Enter the Impostor.  Does that mean Portugal and Spain will be bailed out as well?  Who knows, but if recent history is a guide, signs point to yes.

Are US Bond Investors riding without a Safety Belt?

And while across the pond Bond investors are safely strapped in on the roller coaster ride, here in the US the investors are wondering if that "click" they just heard was their safety strap being undone.  They face the contradiction that, while the government has pumped some $350 Billion into Fannie Mae and Freddie Mac so that their Bonds would not go bad, one of its bankruptcy trustees is busy damaging any real collateral that may have backed those bonds.  How much is a mortgage backed security worth when you can't prove that you own it?  We don't know but our guess is less than previously thought.

Of course, this quandary too will be solved by the modern miracle of impostor money.  And since bailouts are now commonplace, we are now observing a market phenomenon popularly called the "Moral Hazard."  While this hazard takes many forms, it basically means that dishonesty replaces honesty as the basis for commercial transactions.  In the Bond Market, it means that borrowers are issuing bonds with no real intention of paying them.  Rather, they rely on the impostor money to come to the rescue.  Under normal circumstances, investors would demand higher yields in exchange for this risk.  But since the impostor money enters the system via the Bond Market, this protective mechanism (higher yields) is not properly functioning at this time.

But morning must come.  The ball cannot go on forever.  Once the delusion dies off Bond Investors will realize that fundamentals in the Bond Markets are being readjusted.  No longer does it matter if the borrower can repay, rather, due diligence must discover whether or not the borrower has enough clout with a big brother that will step in and pay if the borrower cannot.  This is the new normal.  But now that the impostor money the bonds are likely to be paid back in is under the microscope, It is easy to see how the Bond Market is aboard the Titanic as the faint cry sounds above the music and merry-making, "Iceberg!  Right Ahead!!!!"

Stay Fresh!

David Mint

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Key Indicators for Tuesday, November 30, 2010

Copper Price per Lb: $3.72
Oil Price per Barrel:  $85.15
10 Yr US Treasury Bond:  2.82%
FED Target Rate:  0.20%

Gold Price Per Ounce:  $1,367

MINT Perceived Target Rate*:  5.25%
Unemployment Rate:  9.6%
Inflation Rate (CPI):  0.1%
Dow Jones Industrial Average:  11,052
M1 Monetary Base:  $1,763,900,000,000
M2 Monetary Base:  $8,707,500,000,000

*See FED Perceived Economic Effect Rate Chart at bottom of blog.  This rate is the FED Target rate with a 39 month lag, representing the time it takes for the FED Target rate changes to affect the real economy.  This is a 39 months head start that the FED member banks have on the rest of us on using the new money that is created.