Batten Down the Hatches for the Dog Days

This could be a stormy summer. Like the mortgage debt crisis three years ago that blew up and froze the financial markets, there's a nontrivial chance the government debt crisis could do the same this summer. Government debt, normally the investment of last resort, is starting to look hinky. With respect to the federal debt ceiling, some Republicans in Congress seem intent on provoking a default in August. Biting the hands that feed us--i.e., stiffing investors in U.S. Treasury securities--hardly seems like a good idea for a debtor nation. But "smart politician" is virtually an oxymoron these days.

More than America, the Euro bloc lurches inexorably toward default. For the moment, Greece is the only nation that is likely to formally default. However, all Euro bloc members have pretty much assumed de facto responsibility for all the sovereign debt and bank debt of all member nations. So a default by Greece is, in effect, a default by the entire Euro bloc. Such a development would not be well-received in the financial markets. But Euro bloc leaders are divided about what to do, and progress toward true resolution is seen about as often as the ivory-billed woodpecker.

Although another financial crisis is a low probability event, the simultaneous dysfunction in Washington and Europe could make things go haywire in the dog days of this summer. After all, nothing has been done since the last credit crunch that would preclude another one this year. What to do?

Love cash. Have a cash lovefest. Build up your emergency fund and put it in a bank (making sure it's 100% covered by FDIC insurance). Avoid non-essential big purchases for the next few months to increase cash on hand.

Be cautious with money market funds. If U.S. Treasury securities actually default, money market funds might have to break the buck. A sudden spike in interest rates could reduce the value of their T-bills and impose losses on the funds. Although the extent of such losses is likely to be comparatively small, given the very short maturities that money market funds are supposed to hold, it's not impossible that a freeze-up in the Treasury securities market could result in money market losses and perhaps momentarily limit access to your account. This is a low probability event, and fund management companies would probably go to great lengths to avoid breaking the buck. But it happened once in 2008. If you are likely to need funds in a money market account in the near future, consider moving the necessary amount into a federally insured bank account in July if the debt ceiling mess remains unresolved.

Invest defensively. Now's not the best time to take a flier, except if you have mad money you can easily afford to lose. Note how the Nasdaq market has, in recent days, been falling proportionately faster than the Dow and the S&P 500. Many risk assets are falling, literally, out of favor. Be careful about diving into emerging markets. China's economy is slowing, and India's and Brazil's governmental yield curves are inverting (seen by some as a sign of impending recession).

Avoid unnecessary financial commitments. If you're thinking of making a major financial commitment, like buying an annuity or a whole life insurance policy, consider stepping back and waiting to see how things play out over the next few months. If, for example, you buy an annuity now, and Treasury yields rise sharply later this year because of a U.S. government default, you may effectively have lost money because you would have bought at today's low interest rates.

Line up credit lines now. Credit could evaporate if things go gonzo. While borrowing is to be avoided if at all possible during a financial crisis, there sometimes are pressing reasons to go into hock. Line up any loans you'll need. Since it's even possible a bank might terminate the unused portion of a line of credit if the sky falls, you may want to draw down on credit lines now if you are absolutely sure you'll need the money and have no other way to get it. Make damn sure you can repay what you draw down. And keep the loan funds in a bank account, not a money market fund.

All this may sound on par with suggestions to stock freeze dried food and bottled water, and to start a garden in your back yard. But we haven't had to rely on subsistence farming in more than a century. Just three years ago, credit was crunched and the financial system almost failed. As far as money goes, take nothing for granted.

An Omen of Financial Stress?

Something strange is happening in the short end of the Treasury securities market. Treasuries maturing in about 1 month are yielding around 0.01%. Just a couple of weeks ago, yields were above 0.10%. Perhaps this may all seem like peanuts (and it is, if you have, say, $10,000 invested). But a yield of 0.01% was last seen during the dark days of the credit crunch in late 2008 and in 2009, when the world's banking system faced a funding crisis. Such a low yield signified that no one trusted anything except the obligations of the U.S. government; that investors didn't care about getting a return. They just want to keep their money safe. The recent 90% plus drop in the short end of the Treasury yield curve in less than two weeks may be a sign that something is rotten somewhere.

Economists and other fortune tellers are raising their estimates for growth next year. Stock prognosticators are full of holiday cheer, predicting rosy returns for stocks in 2011. Consumers may be loosening their purse strings a bit for this year's holiday season. Recent tax legislation will widen the deficit for next year, ensuring that the federal spending spigot won't slow down. All systems are go, it would seem. What's to get stressed about?

Euro Mess. The European response to the Euro bloc sovereign debt crisis, generously assessed, has been tentative and muddled. The only clear impact has been to transfer risk of loss to European taxpayers and give the can a hard kick down the road. The continued uncertainty makes the U.S. greenback look good by comparison (once again demonstrating that it's easy to lose faith in America, until you look at the rest of the world). If you're going to dump Euros for dollars, it makes sense to buy the short end of the Treasury yield curve, where you're not competing against the Fed's quantitative easing program.

One group of potentially nervous investors would be money market funds that hold commercial paper of banks in shaky Euro bloc nations, like Greece and Portugal. Amazingly, in spite of the money market fund credit crunch in 2008, many money market funds bought this foreign issued commercial paper. (One wonders what happened to prudence, but then again prudence is something isn't brought up in polite company.) Those money market funds now may be quietly easing out of Euro bloc bank commercial paper and shifting into Treasuries before year end, when they'd have to disclose their holdings to investors.

Muni Mess. The muni market has fallen, about 5% in the past month. That may not sound like much, but if you held munis and it was your 5%, you'd be peeved. The future for munis isn't pretty. The federally subsidized Build America Bonds program turns into a pumpkin at the end of this year, and there won't be a fairy godmother for it next year. That means states and municipalities will face the harsh winds of the muni market without a quick fix from Uncle Sam. Many financially troubled states are still struggling with their budget problems. To make things worse, questions over states' pension accounting could compel larger state contributions to employee pension funds. Muni investors with battered portfolio syndrome may be seeking a port in the growing storm and heading for the safety of Treasuries.

Bond Mess. The bond market has fallen since early November, when the Fed formally announced its quantitative easing program. Investors who bet that QE would extend the 30 year bull market in bonds may now suspect that this time, things really are different. Those that aren't ready for the quicksands of the stock market may be parking at the short end of the Treasury curve, waiting to see whither the winds blow.

It's unclear that any of this will push the financial system back into the septic tank. Any analysis of that question would require information about who's holding what exposures in the derivatives markets. (Query: are major banks holding the hot tamale because they took the wrong end of the wrong credit default swaps?) But those markets are as opaque as ever, notwithstanding the enactment of the Dodd-Frank financial reform legislation this past summer. All we know is that the short end of the Treasury yield curve is at 0.01%, and the last time that happened, canaries in the mine were gasping.

Banks Get Murkier

Just as an incipient credit crunch lurks in Europe's weeds, the financial condition of major banks is getting murkier. Spain's credit crisis is mostly a matter of banks being overleveraged (its government isn't in bad fiscal shape, compared to many Western nations). Some Spanish banks may not be marking their real estate assets to market. Spain's government is merging banks rather than liquidating them, which might obscure rather than illuminate the financial weaknesses of the banking sector (kind of like the way grocery stores mix good string beans in with the crappy ones to make lazy shoppers buy some, well, crap).

In the U.S., Citigroup and Bank of America have admitted to misclassifying in financial reports repo transactions (which are loans) as asset sales. This echoes the infamous Repo 105 strategem used by Lehman Brothers to reduce reported leverage levels. Both Citi and B of A claim the amounts were immaterial and that the misclassifications were errors. Nevertheless, billions of dollars of transactions were involved, and a curious investor might wonder, in light of the magnitude involved, how sound the banks' internal controls were.

U.S. banks continue to benefit from accounting rule changes made by regulators last year under political pressure from Congress, which loosened requirements to mark assets to market. It's possible that the major U.S. banks hold hundreds of billions of dollars worth of hinky assets that are carried at valuations above market prices. With residential real estate wobbly and commercial real estate falling, the banks can't continue indefinitely to wear rose-tinted glasses when compiling their financial statements.

One reason why the stock market goes on volatility frenzies is that investors are ambushed by surprises. The sovereign debt crisis began with Greece 'fessing up last fall to having a lot more debt than it had previously acknowledged. Things went downhill from there as it became clearer that various EU members had debt problems. Spanish and other European banks are having trouble selling or rolling over commercial paper in the U.S. Credit default swaps protecting against defaults on bank debt have been rising in price. While many failures contributed to the current problems, a failure of proper accounting was among the most important.

"Garbage in, garbage out" is a time-honored axiom from computer science. It also applies to the financial markets. Bad or inadequate information results in poor pricing. When the truth comes out, abrupt shifts in valuation can be expected. When bank accounting goes hinky, the soundness of the financial system can be endangered. Taxpayers must then gird themselves for more bailouts. Bank regulators don't always encourage transparency, in the fear that the truth will spark runs on troubled institutions. But in today's computerized, Internet-connected world, there are no secrets. At least, not for long, and when the word belatedly gets out, the run is all the more panicked. Full, fair and timely accounting and disclosure by banks, nations and other debtors is essential to a healthy financial system. Such should be a primary goal of financial regulatory reform in the U.S., Europe and elsewhere. Expediency, however, militates in the other direction. Sunshine is the best disinfectant, but human frailty the greatest source of continued infection.