Debt Payment Is For Losers

Editor’s note: Today, Porter turns the Journal over to Distressed Investing analyst Martin Fridson. Marty spent years at leading firms like Salomon Brothers, Morgan Stanley, and Merrill Lynch – researching debt and how it’s collateralized.

Here’s Marty…

The U.S. doesn’t have a debt problem…

U.S. President Donald Trump recently tried to reassure the American public about the federal government’s fiscal health – but his message is likely to have the opposite effect on those who understand how sovereign borrowing works.

In an interview with Fortune, President Trump argued that the level of federal debt – currently $39 trillion – isn’t really as terrible as people are making it out to be. He said the total value of America and its natural assets, such as the Grand Canyon and the surrounding oceans, is “like hundreds of trillions of dollars.” According to his logic, the U.S. is “way under-levered.”

This reasoning would make sense if government finance worked like the real estate business, where Trump has spent most of his career. If the buyers of U.S. Treasury bonds lent against collateral, they’d escape financial ruin in the event of a default. They’d just sell off the Grand Canyon, a few national parks, and the Atlantic Ocean and recover at least a substantial portion of their principal. In reality, pledging assets in the manner of a real estate developer has historically occurred in the sovereign debt market only when a country was in dire financial straits.

The buyers of a government’s bonds must rely instead on the government’s ability and willingness to pay. If the country defaults, there’s no global bankruptcy court to go to for relief.

Ever since Alexander Hamilton did the financial engineering that made it possible for the United States to come into being (he got the national government to assume the states’ Revolutionary War debts), our nation has had an excellent reputation for the willingness-to-pay part. The U.S. has demonstrated a firm commitment to meet its obligations.

The ability-to-pay part, however, is showing some strain. It’s a question of whether, after deducting all the other costs of operating the government, there’s enough left over from tax revenue to cover interest on the Treasury’s debt.

The table shows that over the last five years, money available to pay interest on Treasury debt has fallen short of interest expense by an average of $2.2 trillion per year.

“What’s the big deal?” some may ask. “Scaremongers have been ranting about federal deficits for as long as I can remember, but the Treasury hasn’t yet failed on a single dollar of interest.”

Well, here are some things that have changed. In an earlier period, 1996-2000, revenue at least covered operating expenses every year. In the subsequent 25 years, that has happened only twice, the last time being in 2007. Every time there isn’t enough in the till to cover interest expense, the Treasury makes up the difference by issuing more bonds. (Have you heard a personal financial expert warn against trying to borrow your way out of debt?) This problem has become more severe in recent years, with the national debt doubling from $18.2 trillion to $37.6 trillion in just the last 10 years. The more debt the government takes on, the higher the interest bill goes.

One way the government could ameliorate the widening gap between interest costs and the wherewithal to pay them is financial repression. This consists of keeping Treasury-bond yields below market levels by fiat – penalizing investors, who consequently receive a lower return than the risk warrants. As part of this strategy, the domestic banks would probably be forced to continue buying U.S. bonds, even though they constitute a bad investment. But the government doesn’t have that power over foreign buyers, who hold about one-third of U.S. sovereign debt.

Another possible solution would be to raise cash by selling off federally owned land for private development. Although the government owns about 28% of the country’s total land area, the acreage occupied by national parks, military bases, and wilderness areas is not realistically available for sale. The most generous estimate of the value of land that could actually be sold, including mineral rights, is $5 trillion. Based on the numbers shown in the above table, the cash that could be generated by selling all of it would cover the interest coverage shortfall for only a little more than two years.

In light of this arithmetic, it’s no wonder that the U.S. Treasury no longer carries AAA credit ratings from Moody’s or Standard & Poor’s. They consider Microsoft (MSFT) and Johnson & Johnson (JNJ) more certain than Uncle Sam to pay their interest and principal in full and on schedule. Of course, those private sector borrowers don’t have the option sometimes used by financially strapped governments, namely, a massive currency devaluation. Under that solution, bondholders get paid back fully in nominal terms but take a beating in real terms.

There’s one final, if improbable, way out of a government debt spiral – exercising fiscal responsibility. The U.S. could increase taxes and reduce spending, such that the income remaining after operating expenses would suffice to cover interest on the debt. Unfortunately, it’s hard to think of a proposal more politically unpopular or less likely to get through Congress than raising taxes or cutting services.

This picture would be discouraging enough if the head of the whole operation weren’t proceeding on the basis of a false analogy with the real estate industry. To make matters worse, the self-proclaimed King of Debt’s perceptions may be skewed by the fact that he personally managed to remain very well set financially despite racking up six corporate bankruptcies in the course of his wheeling and dealing in land and buildings. Perhaps in President Trump’s mind, suffering consequences when debt payments can’t be met is for losers. If the Treasury ever defaulted, the losers would be those who relied on the full faith and credit of the United States.

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Martin Fridson
New York, New York