Thursday, October 03, 2013

Treasury Default = Depression

Financially Challenged Legislators Do Not Understand

Richard X. Bove
Vice President Equity Research Financial Sector bover@raffcap.com 813.388.2900

Some Unbelievable Polls

A number of polls are now underway asking the American people whether they believe a default on U.S. Treasury debt would be a positive or negative development. A shockingly high number of Americans 50% among some groups - think that it would be good. Therefore, this comment is being written from a point of disbelief that there would actually be a reason to write it. Treasury Numbers Pensioners In the broadest terms the Treasury debt of the United States is owned as follows:
Breakdown Total Treasury Debt Holders Owned by Agencies of U.S. e.g., FICA Leaves Publicly Held Debt Owned by the FRB Leaves Treasuries Owned by the Private Sector Americans Foreigners Unaccounted for Treasury Breakdown % Billions $16,738.3 100.0% $4,831.7 $11,906.6 $1,936.6 $9,970.0 $4,364.3 $5,600.6 $5.1 28.9% 71.1% 11.6% 59.6% 26.1% 33.5% 0.0%

Looking at the debt in its broadest terms, it is immediately apparent that the largest holders of this debt are the Social Security fund and other government agencies and pension funds. Stopping interest payments on the debt and preventing the refunding of this obligation would ultimately harm everyone on Social Security plus those who are on government backed pensions. Federal Reserve According to Treasury figures the Federal Reserve owned $1.9 trillion of the debt at the end of the second quarter. The Federal Reserve releases at the end of June 2013 are in agreement with this number. Treasury Securities, therefore, back 54.5% of the Fed balance sheet. A default in the Treasury debt would cause the value of these securities to plunge. This would raise the question of what is behind the value of the dollar. Depending on the size of the decline it could wipe out the equity at the Fed. At the end of June the Feds equity was $63 billion or 3.3% of the size of the Treasury holdings. These numbers ignore the Feds ownership of Agency and mortgage backed securities which are guaranteed by the Treasury. They equaled $1.3 trillion. They would drop in value in line with the Treasury Securities. Together all of the securities noted equaled 91.1% of Fed assets at the end of June. They also equaled 51 times the Feds equity. Federal Reserve Flow of Funds Statistics While the Treasury numbers are the most authoritative concerning the size of the debt, the Federal Reserve publishes its own set of statistics to represent what the United States owes (see Table on following page). The FRB numbers do not include Agency holdings of Treasuries so this amount was estimated. The FRB, however, provides a better breakdown of American ownership of Treasury debt. Households The first data point that catches the eye is the amount of Treasury debt owned by American households. It equals $1.2 trillion. Defaulting on the debt would immediately impact the interest payments on these funds.

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Thursday, October 03, 2013

Treasury Default = Depression

A broader analysis shows the following:
Breakdown Es timated Total Treas ury Debt Holders Es t. Owned by Agencies of U.S. e.g., FICA Leaves Publicly Held Debt Owned by the Federal Res erve Leaves Treas uries Owned by the Private Sector Americans Households Businesses State & Local Governments Depository Institutions Insurance Companies Pension Funds Money Mark et Mutual Funds Investment Funds GSEs ABS Issuers Brok ers & Dealers HoldingCompanies Total Americans Foreigners Unaccounted for FRB Breakdown Billions % $16,744.6 100.0% $4,831.7 $11,912.9 $1,936.6 $9,976.3 $1,192.8 $97.8 $526.6 $194.0 $261.0 $720.0 $449.0 $539.6 $75.5 $21.2 $165.6 $20.9 $4,264.0 $5,600.6 $111.7 28.9% 71.1% 11.6% 59.6% 7.1% 0.6% 3.1% 1.2% 1.6% 4.3% 2.7% 3.2% 0.5% 0.1% 1.0% 0.1% 25.5% 33.4% 0.7%

Funds It is not my intention to comment on every sector shown in the above table. However, a few require special mention. Money Market Mutual Funds Should the United States government default virtually every money market mutual fund (MMMF) in the country would break-the- buck i.e., be unable to pay investors 100 cents on every dollar invested. At present, MMMFs that do not actually earn enough money to pay back 100 cents on the dollar are subsidized by the fund management company. A Treasury default would make this virtually impossible and millions of Americans would lose billions of dollars. Mutual Funds The indentures of most bond and balanced mutual funds require that they immediately divest their holdings of defaulted securities. This could cause hundreds of billions in Treasuries to be sold immediately when the default was announced. Depository Institutions Lets shift to another government document. This would be the FDICs aggregate balance sheet of the American banking industry. Here are some data points: x x FDIC-Insured American banks own $166 billion in Treasury securities (the FRB claims $194 billion). They own an estimated $1.68 trillion in agency guaranteed debt (the FRB claims they own a bit more than that $1.73 trillion).

A reasonable estimate would be that the U.S. banking industry owns $1.85 trillion in government backed securities. It has $1.63 trillion in equity. If the Treasury and related securities were in default, one does not know what they would be worth. Assume a Latin American valuation of 10 to 20 cents on the dollar and an estimated $1.28 trillion in U.S. banking equity would be wiped out. If you think this is an extreme assumption, consider the following: x x In addition to the U.S. backed securities the banks own, they own an additional $1.27 trillion in other securities that would plunge in value. They have $7.73 trillion in loans which would also fall in value. Moreover, some unknown number of the loans are also guaranteed by the U.S. government e.g., FHA and VA mortgages.

P L E A S E S E E I M P O R T A N T D I S C L O S U R E A N D A N A L Y S T C E R T I F I C A T I O N L O C A T E D I N T H E A P P E N D I X O F T H I S R E P O R T .

Thursday, October 03, 2013

Treasury Default = Depression

It is my strong belief that a true default by the United States Treasury would wipe out bank equity. All bank lending to the private sector in the United States would stop, immediately. Existing loans would not be rolled over. Immediate repayment would be demanded. Foreign Debt Both the Treasury and the Federal Reserve agree that foreign entities own $5.6 trillion of Treasury debt. Lets take a closer look here.
Countries China Japan OPEC Caribbean Banking Brazil United Kingdom Russia Luxembourg Taiwan Hong Kong Switzerland All Other Totals

Treasury Breakdown Billions % $1,275.8 22.8% $1,083.4 19.3% $256.8 4.6% $290.8 5.2% $253.7 4.5% $162.6 2.9% $138.0 2.5% $150.6 2.7% $186.2 3.3% $124.2 2.2% $180.4 3.2% $1,498.1 26.7% $5,600.6 100.0%

A default by the Treasury would create real problems for these countries problems that go well beyond losing money on the Treasuries that they hold. Lets use China as an example. With Hong Kong, it owns $1.4 trillion in U.S. debt or 25.0% of all foreign ownership and 11.6% of all U.S. public debt. The International Monetary Fund counts all $1.4 trillion as reserves at Chinas central bank. By my estimate this means that approximately 41% of Chinas $3.4 trillion in reserves are backed by U.S. Treasuries. A decline in the value of Treasuries due to a U.S. default would have a similar impact on the value of Chinas currency as it would in theory have on the U.S. dollar. Reserve Currency To this point this whole discussion is theoretical. What is not theoretical is that the discussion of the possibility that the U.S. would actually default has a real impact on every country in the world that holds Treasuries. It tells them as clear as can be that they are at risk. The reserves in their central banks are not based on a nation with a stable and secure economy. The value of their reserves is be based on an erratic and politically charged government that may destabilize their central banks and they cannot stop it. The message is clear. Do not put yourself at risk to this government. Get rid of Treasuries and substitute them for other currencies or securities. This would end the U.S. dollars reign as the worlds only reserve currency and it would force the U.S to actually repay its debt. Conclusion It is actually shocking that I would write a comment of this nature. The devastation to the United States would be so severe that it would take decades to recover from the Depression caused by a default and the attendant dumping of trillions of dollars of U.S. Treasury securities on the global financial markets. One would think that the impact would be so devastating that it would be unthinkable. Yet, this comment is being written because polls are suggesting that a large number of Americans and many in Congress actually believe that a Treasury default could be positive. Moreover, the media is still trying to grasp how to deal with this story. It has entered the national debate.
Note: Please be aware that the numbers in this comment grossly understate the actual obligations of the United States government. For example, the GSE debt and guarantees is believed to equal $7.6 trillion on top of the $16.7 trillion the U.S. owes. Moreover, there is no number provided for all of the debt guaranteed by the U.S. outside the mortgage sector. It is also in the trillions. God spare us from the fools who lead us.

P L E A S E S E E I M P O R T A N T D I S C L O S U R E A N D A N A L Y S T C E R T I F I C A T I O N L O C A T E D I N T H E A P P E N D I X O F T H I S R E P O R T .

Thursday, October 03, 2013

Treasury Default = Depression

Financial Analyst Institutional Sales Richard X. Bove Joseph Bove Vice President Equity Research Vice President Institutional bover@raffcap.com Sales 813.388.2900 bovej@raffcap.com 646.572.3378 Appendix: Analyst Certification and Other Important Disclosures

Ed Bugniazet Managing Director bugniazete@raffcap.com 646.572.3389

Ed Perley Perleye@raffcap.com 646.572.3386

Analyst Certification I, Richard X. Bove, certify that with respect to each security or issuer that I covered in this report; (1) all of the views expressed accurately reflect my personal views about those securities or issuers; and (2) no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by me in this research report. Regulatory Disclosures Analyst Stock Ratings Definitions Rafferty Capital Markets (RCM) ratings, effective January 2, 2013, are defined as follows: Buy A stock that at initiation displays projected Price-to-Book ratio less than 100% and projected Earnings Direction greater than zero. The rating may be maintained following initiation as long as it is deemed appropriate, notwithstanding price fluctuations that would cause the rating to fall outside of the above parameters. Hold A stock that at initiation displays projected Price-to-Book ratio less than 100% and projected Earnings Direction less than zero; projected Price-to-Book ratio between 100% and 200% and projected Earnings direction less than 10%; or projected Price-to-Book ratio greater than 200% and projected Earnings Direction greater than 10%. Sell A stock that at initiation displays Projected Price-to-Book ratio greater than 100% and projected Earnings Direction less than zero. The rating may be maintained following initiation as long as it is deemed appropriate, notwithstanding price fluctuations that would cause the rating to fall outside of the above parameters. Distribution of Ratings RCM must disclose in each research report the percentage of all securities rated by the member to which the member would assign a "buy", "neutral" or "sell" rating. The said ratings are updated on a quarterly basis. Below is the distribution of RCMs research recommendations: Buy: 64.5% Hold: 32.3% Sell: 3.2% There are 31 stocks under coverage Market Ratings Negative A 10% expected decline in S & P 500. Neutral The S & P is expected to trade within 10% bounds up or down. Positive A 10% expected rise in the S & P 500. Valuation and Risks The primary risks to achieving our target price include general market fluctuations, unexpected shifts in economic activities, and/or unexpected reversals in company fortunes. Additional Information is Available upon Request to Barbara Martens at Rafferty Capital Markets, LLC, 1010 Franklin Avenue, Garden City, NY 11530 or 516.535.3800
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Thursday, October 03, 2013

Treasury Default = Depression

Other Disclosures
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