The Trigger In The Next Meltdown

By TAN Kee Wee

(MediaCorp 938LIVE’s Money Talks, Thursday, 11 September 2008, 7.50 am and 7.20 pm)

For many months, the big question was whether US interest rates would go up or down. US policy makers have indicated that since inflation was manageable, US rates are not likely to go up till later next year.

But the weekend takeover of US mortgage giants Freddie Mac and Fannie Mae suggests that US interest rates could go up much earlier.

Let’s do a recap. A few months ago, investors sold off shares of Freddie and Fannie on fears that they would collapse. But disaster was averted in July after the US Treasury Dept stepped in with pledges of liquidity. It also guaranteed all the US$5 trillion bonds issued by the two mortgage giants.

Apparently, those show of words did not work. Hence the latest takeover. Right now, markets are cheering. But looking ahead, the picture doesn’t look good. Here’s why.

Normally, when you want to save someone from bankruptcy, you must have lots of money to back you. For the US Treasury Dept, its backing is mainly its Treasuries. These are short and long term bonds sold by the US Treasury Dept to investors worldwide. The money is used to run the US government.

The value of outstanding US Treasuries is about US$5 trillion, that’s twelve zeros, with half of that held by non-US investors. This US$5 trillion war-chest is more than adequate to save a firm like Bear Stearns.

But it is debatable whether that is enough to back both Freddie and Fannie, and their equally large US$5 trillion worth of mortgage-backed bonds, half of which are held by non-US investors.

Certainly, after Freddie and Fannie, there isn’t enough in the war-chest to help other troubled firms. The biggest danger now is that confidence would soon evaporate among investors of US Treasuries.

Investors buy US Treasuries for the dividends, and because they have confidence in how their money will be used. If the US Treasury Dept starts using the money to help save other bankrupt firms, that can’t do much for confidence.

Once confidence is lost, we will be staring at a meltdown in the market for long term Treasuries. Investors need not sell all their Treasuries, just a 10% fraction would do. Or they could buy less. This is equally disastrous because Treasuries must be issued continuously to replace maturing ones.

This would be a one-in-a-hundred years financial meltdown. But it has happened before. In 1980 investors stopped buying long term US Treasuries after they felt that nothing was being done to control US inflation.

As a result, prices fell. So swiftly was the fall that the market for long term US Treasuries came to a standstill. If nothing was done then to revive the market, the pay cheques of the US President and American soldiers worldwide would have bounced.

The solution in 1980 was to kill inflation at all costs. That was when US interest rates were hiked to 20%, which was way above the 15% inflation rate. Higher interest rates made US Treasuries attractive again. But in the process, credit was cut and the US economy plunged into a recession.

This meltdown in the market for long term Treasuries could appear in the next few months. But first, there must be a trigger. This trigger is very likely to be a weakening US dollar.

In the past few weeks, while the books of Freddie and Fannie were being examined, the US dollar has, miraculously, strengthened against most currencies. This is good news for non-US investors of Treasuries should they convert their investments back to their local currencies.

But if the US dollar were to weaken again, or if the market expects it to weaken, non-US investors would start to buy less US Treasuries. Or they could start selling. This sell-off would trigger the sell-off in the US dollar, forcing the US Fed to raise interest rates.

The world will probably be dragged through another roller-coaster ride. How bad can this next financial meltdown be? To paraphrase former Iraqi leader Saddam Hussein, it could be the “mother of all meltdowns”.