The U.S. government is making the same borrowing mistakes that led to the housing crash
During the housing frenzy that took off around 2004, Americans gorged on adjustable-rate mortgages, featuring super-low “teaser” payments that enticed folks to buy more house than they could afford. By 2004, half of all home buyers were using ARMS, triple the share three years before. But the teasers lasted just a couple of years, then loans “reset” at much higher rates–––two million families saw their payments climb by as much as 35% in the last four months of 2007. That rippling shock hastened the storied flood of foreclosures that wrecked the housing market.
Today, folks are taking a much more prudent approach to financing their homes. They overwhelmingly going with 30-year loans at fixed rates. Since the family can make the monthly nut from day one, and their paychecks grow over the years, the ever-flat payment takes less and less of mom and dad’s incomes. That helps them build a nice nest egg, so they can keep paying, and keep the ranch or colonial, if one or even both of them are out of work for a few months. Nothing does more to keep homeowners sleeping soundly than borrowing safe and long.
Indeed, America’s homeowners took the ARM disaster to heart. But it appears that the new Biden Administration, just as the Trump team before it, is making the same mistake as the crowd that fell for teaser rates in 2007. Biden asserts that America can afford to spend the $1.9 billion on his American Rescue Plan, followed by a phase two that would raise more trillions for rebuilding infrastructure and other initiatives, because interest rates have sunk to historic lows, and are destined to stay there. At her Senate confirmation hearing, Janet Yellen, Biden nominee for Treasury Secretary, declared that “Right now, with interest rates so low, the smartest thing we can do is act big.” She added, “The world has changed. I believe the future is likely to bring low interest rates for a long time.”
Yellen did provide notes of caution. “It is a risk that interest rates will rise,” she warned. She also endorsed the “the 30-year fixed choice is safer” approach. “There is an advantage to funding the debt…when interest rates are very low by issuing long-term debt.”
But in the past year, the U.S. has mostly financed the explosion in federal borrowings by selling Treasuries that come due in less than a year, more often in under six months. It’s unclear from Yellen’s statements whether she’ll attempt to float new debt at longer, safer maturities. One of two scenarios are mostly likely. In the first, the Biden Administration holds to primarily borrowing extremely short. That’s tempting, because it’s the course that would keep interest expense lowest, and help curb deficits, in the immediate future. But the risks are towering, because a jump in the likes of 6-month Treasuries, which were at double today’s levels 15 months ago, would swamp the budget.
Second, Yellen could shift a higher proportion of the new borrowings to longer-term bonds. One problem is that the recent spike in yields on 7 and 10-year Treasuries could mark the start of a trend. Inflation is heading upwards faster than projected a few months ago, so the confluence of rising prices and a rebounding economy could push yields on the benchmark 10-year, and all other Treasuries long and short, well beyond today’s levels.
The most fundamental problem is sheer size of a debt load that was already huge and growing with no end in sight before the pandemic struck. The gigantic, ongoing spending gauged to recharge the economy will swell the debt mountain to as much as $26 trillion by the close of this year, a jump of over 50% from 2019. Put simply, that burden is now so big that we’re suddenly much more vulnerable to any rise in rates. A jump of .5 points overall means America’s tab for interest will be half-again higher than if the same increase happened in 2019.
So far, the U.S. has minimized the potential damage by financing most of the blowout at the shortest maturities, where rates plunged all during last year. Amazing, that’s kept our interest burden shrinking at the same time debt exploded, and given the Biden team confidence that it’s safe to keep the splurge going. Even if the Biden-Yellen team pursues a more traditional strategy by shifting the mix more towards longer-term securities, it will still be selling trillions in bonds with maturities of less than a year. We could easily have $9 trillion in that “ARM category,” equivalent to half of all debt last year, by the end of 2019.
The Biden team appears to be way underestimating the danger ahead. Rates are highly volatile, and a shift back to even the levels of early last year will drive interest expense from the declining trajectory now projected by the CBO, to a rapidly-rising curve that will greatly deepen future budget deficits already on a dangerous course.
Of course, the riskiest scenario is the one followed in the past year, and the one that most resembles the misadventure in ARMs.
The latest data on debt and deficits from the U.S. Treasury provide an update through December 31, 2000. Hence, it’s more current than the numbers for the fiscal year ended in September. In that calendar year, the U.S. experienced a borrowing rampage that’s been big news. What’s mostly overlooked is the change in when that new debt comes due. At the close of 2019, U.S. debt held by the public stood at $16.66 trillion. (That’s the amount financed by marketable securities.) Of that number, $2.34 trillion or 14.5% was in 30-year Treasury Bonds, and $9.9 trillion or 60% in Treasury notes with maturities of over one to ten years––as we’ll seen, most are on the short tranche of that scale. Just 26% sat in either Treasury bills or T-Bills at less than one year, or such securities at floating and inflation-protected bonds (TIPS) whose rates aren’t fixed, but move with the market, meaning they can jump at short notice.
In 2020, total debt grew by a staggering $4.3 trillion to almost $21 trillion. The volume of T-Bills, TIPs and floating debt jumped by 105%, from $2.4 to $4.96 trillion. By contrast, the safer Notes and Bonds rose by less than two-thirds that amount. Of the total increase, 62% came from Bills or floating rate bonds. By the end of last year, 33% of all borrowings were in that category, a jump from 7 points since 2019, on total debt that than expanded by over a quarter.
Those year-over-year comparisons still don’t give the full picture of how much our debt timetable tightened in the past year. Let’s start with T-Bills. Even for those one-year-or-less securities, the U.S. leaned short. A report in January from the Office of Debt Management reveals that 90% of Treasury bills, net of those that matured, were issued at terms of 22 weeks or less. As for longer-dated Notes (one to ten year instruments), half of were issued at three years or less. The U.S. raised only $832 billion, less than one-fifth of the new debt sold, in highly-safe maturities of five to thirty years.
The swing to T-Bills has in the past year lowered the average maturity on all U.S. marketable debt from 70 to 63 months. It’s obvious why the Trump Treasury banked so heavily in T-Bills. Their rates staged one of the most stunning drops in the history of U.S. capital markets. The yield on 3-month T-Bills cratered from 1.54% at the start of 2020 to .09% by year end, a fall of 94%. Long rates fell sharply as well. But that trend didn’t do nearly as much to hold down overall interest costs.
Why? Two-thirds of all borrowing are still in securities with maturities of five years or more. Since those 5, 7, 10 and 30-years roll off slowly, the average rates on that long-dated debt are multiples of what the U.S. is paying on T-bills. As of December 31, the Treasury was paying 1.7% on Notes and 3.4% on Bonds, down from 2.1% and 3.9% respectively a year earlier. That slight decrease in average rates on longer-dated debt provided little help, since an increase in newly-issued 10 and 30 years blunted the drop in rates. The big lever was the astounding drop in rates on the T-bills that mainly paid for the blowout in expenditures.
A reckless bet?
But is it reckless to bet that T-bill rates will remain at current levels? One-third of the entire debt load is either due in less than a year (T-Bills) or in floating-rate instruments where rates can spike quickly, interest on the remaining two-thirds is locked in for much longer periods. As late as September of 2019, yields on both 8 and 26 week bills stood at 2%. Moody’s Investor Services predicts that inflation will reach 2% this year, and J.P. Morgan Chase CEO Jame Dimon on his Q4 earnings call said that prices could rise 3% or even 4%. The CBO expects growth to exceed 5% for the year as the economy rebounds from the COVID crisis. The yield on the 10-year has already jumped from under .7% in September to 1.1%.
What happens if all the forecasts of “low-rates to the horizon” are wrong? The Committee for a Responsible Federal Budget was forecasting a $2.3 trillion deficit for this year before Biden unveiled his $1.9 trillion plan. That extra spending alone would put the shortfall at a minimum of $4 trillion. Let’s assume half that amount is borrowed in T-bills, though we don’t know that for sure. But if that’s the case, total marketable debt would go from $21 to $25 trillion by the end of 2021, and T-Bills and other floating bond holdings would rise from $7 trillion to $9 trillion.
Then, let’s imagine that in the second half of 2021, the average rate on T-bills goes back to 2%. Maturities are so short we’d have to refinance most of them by early 2022. In 2022, the cost of that T-bill and floating debt alone would be rising to something like $180 billion from just under $5 billion. Interest payments would explode to around $580 billion. That’s more than $200 billion higher than in 2019, and it would kill the rosy view that spending can jump while interest payments fall. At $580 billion, interest would be absorbing over 2.5% of GDP, well above the 2% the former Treasury officials Larry Summers and Jason Furman deemed dangerous in a recent article. Summers and Furman believe a spending splurge is the way to go, and predict getting to 2% of GDP won’t happen.
But it might. And if it does, interest will keeping a bigger and bigger share of national income. Even if rates are below the pace of growth in national income, interest will take increasing bites because our deficits, driven by the surging cost of entitlements, will grow so rapidly. The ARM mishap showed us that you shouldn’t risk borrowing $1 million to buy a house when the payment could double two years from now, on a salary that’s inching up and can no longer stretch to make those big payments. Trump took that risk, but departed before it could backfire. Now, the new administration’s doubling down on the belief that the “world has changed.” But if the world goes back to anything like normal, betting the house will prove to be a loser.