14 RISKS WITH SUPPOSEDLY " SAFEST" SECURITIES / MONEY AND MARKETS ( VERY HIGHLY RECOMMENDED READING - A MUST READ )

14 Risks with Supposedly "Safest" Securities

by Martin D. Weiss, Ph.D.

Dear Gonzalo,

When AT&T, California, New York City or virtually any other borrower wants your money and offers its bonds for sale, it's required to give you a prospectus that properly discloses all the relevant risks.

It has a legal obligation to tell you about any material weakness, hidden liabilities or contingencies that could diminish your chances of getting paid in full.

Every major borrower in America's must submit to this discipline ... except, unfortunately, Uncle Sam.

Uncle Sam publishes no prospectus ... provides no risk disclosure ... issues no warnings ... and is virtually immune to related lawsuits by regulators or investors.

If you want to buy long-term U.S. Treasury bonds, you must do so almost exclusively based on pure faith.

But what if the U.S. government did have to publish a prospectus for its bond offerings?

What risks would it have to disclose? What skeletons would it reveal?

Jim Grant, editor of Grant's Interest Rate Observer, provides the answers by publishing what a 30-year Treasury-bond prospectus might look like.

Here's the litany of risks that Grant documents (in quotes), plus my interpretation of his points — along with my comments — below each ...

Risk #1. "Improper payments by the federal government continue to increase despite the Improper Payments Information Act of 2002."

The government pays hard dollars to recipients who are not eligible for payment. It pays for services that were never received. It pays full price for services normally sold at a discount. And it pays twice or more for the same services rendered only once.

Trivial errors? Not quite.

In fiscal 2009 alone, the government estimates that it made improper payments of $98.7 billion or about 5 percent of the total $1.9 trillion in related expenses.

That was nearly DOUBLE the improper outlays of just two years earlier ($49 billion) despite legislation aimed at reducing this problem.

If a business corporation was consistently making these egregious blunders, most lenders wouldn't touch it with a ten-foot pole. But Uncle Sam continues to do it with impunity.

Risk #2. "Material weakness from ineffective internal controls over financial reporting that resulted in a disclaimer of opinion by the Government Accountability Office."

If you're running a public corporation and your auditor refuses to certify your financial statements, you've got big trouble.

Unless you can promptly correct the problem, you won't be able to raise money. And it may soon be next to impossible to stay in business.

Yet, shockingly, the U.S. government has failed its audit 13 years in a row. And as Grant points out, in 2009 alone, independent auditors found 38 material weaknesses in 24 agencies they audited.

Risk #3. "The dollar may not continue to enjoy reserve currency status and may decline in the future."

Ironically, this risk is both the most obvious and the most widely ignored.

Treasury bonds are denominated in dollars. But no one — certainly not the U.S. government — can guarantee that the dollar will continue to hold its value or even that it will retain its status as a world currency.

If the U.S. dollar falls, so does the underlying value of U.S. Treasury bonds.

Risk #4. "The Federal Reserve, as part of its response to the financial crisis, may be exposed to significant credit risk."

The Federal Reserve System has taken on large credit risks with its extension of credit to American International Group (AIG), its massive purchases of mortgage-backed securities and other expensive efforts.

In this respect, the Fed, is not very different from large commercial banks that got into trouble in the financial crisis: It is severely undercapitalized — with just 2.3 cents in capital for every dollar of debt on its books.

Worse, the Federal Reserve Bank of New York, the branch actually holding the high-risk assets, has only 1.4 cents in capital per dollar of debt. And that assumes the securities that it inherited from AIG are worth what the Fed's models say they're worth. In reality, especially given the poor liquidity of those toxic assets, they would probably fetch a lot less if sold on the market.

Any significant losses in their portfolio holdings, argues Grant, could leave the New York Reserve Bank with its capital impaired.

Risk #5. "Foreign official institutions hold a significant amount of U.S. government debt."

Foreigners hold about half of all marketable U.S. Treasury securities. At the same time, the U.S. dollar accounts for 62% of all foreign exchange reserve holdings, according to the IMF.

But if the dollar falls in value, the worldwide demand for U.S. dollars and dollar-denominated bonds — U.S. Treasuries — could fall precipitously.

My take: That, in turn, could force the government to pay exorbitant interest rates or even impair the government's ability to roll over its maturing debts.

Risk #6. "The United States is the dominant geopolitical power and has significant overseas commitments."

The U.S. military is engaged in large-scale overseas conflicts; operates 716 sites in 36 foreign countries; and guarantees the security of many sovereign nations.

This implies major drains and stresses — present and future — on the nation's finances.

Risk #7. "The government is exposed to large contingent liabilities from its intervention on behalf of various financial institutions during the 2008-2009 crisis."

Washington has made so many promises and granted so many open-ended guarantees to so many institutions, its true contingent liabilities are virtually incalculable. But here are the main ones Grant covers:

• The FDIC's deposit insurance fund (DIF) has a deficit of $20.9 billion, with a credit line on the Treasury which can further drain government finances. But that merely reflects losses in the banks that the FDIC has bailed out so far.

• The far bigger threat comes from banks that may fail in the future, such as the 702 institutions on the FDIC's list of problem banks, with total assets of $402.8 billion at year-end 2009.

• Worse, some of the nation's biggest — and potentially most vulnerable — banks aren't even on the FDIC's official list, although the U.S. Treasury is fully committed to picking the tab in case of a failure.

• Fannie Mae and Freddie Mac are another financial black hole for U.S. government finances. The Treasury has already sunk $97.6 billion into the mortgage companies and, as a Christmas "gift" to America last December, it removed all limits on future capital infusions for three years.

• FHA also relies on the Treasury for financing. By law, its reserve ratio is supposed to be at least 2 percent. But in reality, it's only about a half of a percent. Small problem? Not exactly. FHA mortgages are now dominating the entire industry.

• But all of the above are potentially dwarfed by the government's financial market interventions since the debt crisis began, according to Grant's estimates. Those interventions alone have totaled $8 trillion, or 55 percent of GDP.

Risk #8. "Mandatory outlays for retirement insurance and health care are expected to increase substantially in future years."

The Treasury itself estimates that the present value of future social insurance expenditures — such as Social Security and Medicare — is $46 TRILLION! And that's AFTER subtracting future revenues the government will collect on those programs.

Risk #9. "Ratings agencies may withdraw or downgrade the U.S. government's current AAA/Aaa rating without notice."

Moody's has already warned that, unless major debt reduction measure are put into place, or unless the economy is a lot stronger than expected, the U.S. government's triple-A rating may be in jeopardy.
My view: If the rating agencies fail to downgrade the U.S. Treasury department, global investors will take the initiative and effectively put into place their own downgrade — by demanding yields that correspond to lower rated bonds.

Risk #10. "The U.S. economy is heavily indebted at all levels, despite recent de-leveraging."

Total credit market debt in the U.S. was $52.6 trillion at the close of last year's third quarter — 369 percent of GDP, the highest ever.

Risk #11. "The increase in government debt as a result of the financial crisis in advanced countries may lead to greater concern over sovereign debt."

Due to the Greek crisis, global investors are seriously questioning the security of other sovereign debts, especially in nations with shaky budgets and huge deficits.

Even if no major country defaults, these fears could drive up borrowing costs for any government associated with poor fiscal controls and other risks — like those we're talking about right here.

Risk #12. "U.S. states and municipalities are experiencing severe economic distress and may require intervention from the federal government."

Forty-one states are facing budget shortfalls in 2010, according to the Center on Budget and Policy Priorities. This poses a threat to federal finances whether Washington decides to bail out certain states or not.

If Washington bails out the states, it will be on the hook for even more money. If it fails to bail out the states, the state cutbacks could threaten the economic recovery, delivering more fiscal troubles to Washington anyhow.

Risk #13. "Elected officials may not take the necessary steps to ensure long-term debt sustainability and may take actions counter to the interests of bondholders."

There's no political will to fix the problem. If anything, politicians have proven that they are more than willing to take steps that make it worse.

Risk #14. "A rise in interest rates could adversely affect government finances."

Right now, Uncle Sam is getting a bargain with low interest costs. But the combination of chronically massive deficits and these 14 risks make continued low interest rates an almost unimaginable scenario.

At 6 percent, the government's interest expense would surge from $187 billion to $528 billion; at 8 percent, it would be $704 billion. Just for interest! Strictly in one year!

Why These 14 Risks Can Impact You NOW

When you buy a Treasury bond that doesn't mature in 20 or 30 years, and when serious questions like these are raised about the long-term future, you can't just say "I'll cross that bridge when I get to it."

Quite to the contrary, dangers that normally might not appear until decades from now could strike just as soon as investors perceive them to be a problem. They could slam the value of your bonds starting today.

Right now, for example, the yield on 10-year Treasury notes is within a hair of surging through a critical 4 percent barrier. When it does, don't be surprised if bond prices go into a nosedive and long-term interest rates spike upward.

Follow-Up Steps

First, sell all long-term Treasury bonds, but do not abandon Treasury bills. They are short term. They are not vulnerable to price declines. And as a practical matter, there are no safer alternatives.

Second, hedge against potential dollar weakness with a modest allocation to gold-related investments.

Good luck and God bless!

Martin