Extend & Pretend: Hitting the Maturity Wall

How long can the government continue to extend & pretend? How long can public policy endlessly ‘kick-the-can’ down the road without addressing the underlying causes? Such a critical point is often academically referred to as a ‘Tipping Point’ or what newsletter writer John Mauldin refers to as a ‘Finger of Instability’.  I am more pragmatic and as an investor, who is forced to call the timing, I refer to it as the Maturity Wall.

In a recent article entitled "Sultans of Swap: Fearing the Gearing!" I outlined that the US will require $4.2 TRILLION in new financing to accommodate loans of questionable viability, existing lending terms or loan to collateral value coming due. This analysis based on work done by Morgan Stanley, Fixed Income Research & Economics.

Since releasing that analysis the debt requirements may now have reached a level where it may be too high to be scaled and we will hit the Maturity Wall. This level identifies the critical requisite timing that all investors must be fully aware of.

 HIGH YIELD DEBT

On Monday March 15th Diane Vazza, head of global fixed-income research at Standard & Poor’s was quoted as saying "many companies whose debt matured in 2009 and 2010 have been able to extend their loans, but the extra breathing room is only adding to the bill for 2012 and after.  That is because the record number of bonds and loans that were issued to finance those transactions typically come due in five to seven years". (2)  The New York Times in "Corporate Debt Coming Due May Squeeze Credit states that the "result is a potential financial doomsday, or what bond analysts call a Maturity Wall. From $21 billion due this year, junk bonds are set to mature at a rate of $155 billion in 2012, $212 billion in 2013 and $338 billion in 2014”.

If we compare the current results to those reported by Morgan Stanley in Q4 2009, we are struck with the magnitude of the problem. The chart below graphically represents the Maturity Wall in the High Yield Debt line item alone.

What about the recently announced US Government debt financing needs? Also Investment grade debt?  Based on what has been reported only after a few months since Morgan Stanley issued their report, I minimally calculate the hurdle bar to be the following (without being able to add reliable Investment Grade debt figures for 2013 and 2014):

This table is also limited to the USA. The obvious question is whether there is sufficient global savings to accommodate this amount of US refinancing demand, plus the additional demands from the rest of the world.  There is little doubt it is going to be an Olympic record pole vault, being attempted in 2012, by then a very weary, debt challenged athlete!

"The world does not have so much money to buy more US Treasuries." Zhu Min

US GOVERNMENT DEBT

What has surprisingly received little media attention is that the US Government has been steadily reducing the maturity of its treasury portfolio to keep fiscal deficits down. Whether interest rates rise or it becomes a problem for the US Treasury to re-fund the ever expanding roll-over pools, both suggest a Maturity Wall is dead ahead. My analysis suggests it will occur no later than 2012, but it will likely be triggered earlier with the next financial default scare.

EVERYONE HAS GONE SHORT DURATION

Besides US government debt duration shortening, Interest Rate Swaps with durations less than one year is equally alarming. The rate at which this duration has grown over the last ten years for US banks is nearly parabolic. We now have $75T in Interest Rate and Foreign Currency Swaps in paper with less than 1 year duration held by US Commercial banks. If interest rates begin to move towards Morgan Stanley’s 2010 estimate of a 5.5% in the 10 Year US Treasury, watch out! You can expect dramatic market volatility when $75T in derivative instruments requires re-alignment.

THE 10 YEAR INTEREST RATE SWAP INVERSION IS HIGHLY UNUSUAL

Also getting little attention is the fact that the 10 year Swap rate has now gone negative. This is an extremely unusual occurrence. According to the Financial Times “historically, yields on government bonds have traded at a discount to the derivative as swaps are money market instruments whereas Treasuries reflect triple A sovereign risk. Funding a swap trade over time is more expensive than Treasuries, but constraints on balance sheets make it difficult for traders to implement such trades. Swap rates and Treasury yields have been converging in recent weeks, driven by high government bond supply, and increased demand by investors using swaps for meeting long-dated liabilities rather than committing capital to buying bonds.”

THE DEFUNCT SHADOW BANKING SYSTEM IS HAVING UNINTENDED CONSEQUENCES

I have been wondering for some time about the real unintended consequences of the collapse of the Shadow Banking System. I read that Morgan Stanley analysts are likewise concerned and see the inversion in the 10 year Swap spreads as an indicator. What seems to be going on here is that there is a mis-match in supply between what is on balance sheet as represented by US Treasuries supply and what is off balance sheet as represented by Libor supply. The ‘producers’ of low libor for years has been the supply from the Shadow Banking system through SIV’s (Structured Investment Vehicles)  which were heavily used by the banking industry for Capital arbitrage and which generated short term money. Sovereign deficits are causing growing sovereign debt supply growth; which is causing Swap Spreads to narrow and go negative; which will lead to increasing yields; which will see higher levels of both nominal and real interest rates.

Morgan Stanley states that “The issuance of UST debt is dwarfing Libor-related issuance. For example, we expect UST net issuance to be $1.7Tr and net issuance of MBS to be zero. Thus, the relative issuance of UST’s vs. Libor-based products mainly accounts for the inversion in swap spreads. This is a first sign of stress leading to higher UST yields and is not to be missed.”

ROADMAP

With $492 Trillion outstanding in the notional value of global Interest Rate Swaps it is reasonable to conclude that one of the counterparties in the trade WILL GET HURT when rates rise. This suggests there is going to be significant ‘hurting’ in a total global economy of only $45 Trillion.  All indications are that no later than 2012, the global economy is going to run headlong into a funding maturity wall.  Markets always anticipate events at least 6 months in advance. This barrier is so huge I doubt the market will wait and will likely begin adjusting 12- 14 months ahead!  All bets are off if we get another sovereign or possible American State government default scare. This would move our Maturity Wall even ‘closer in’.

For the complete research report go to: Extend & Pretend
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The last Extend & Pretend article: EXTEND & PRETEND - An Accounting Driven Market Recovery

Gordon T. Long

Tipping Points

Mr. Long is a former senior group executive with IBM & Motorola, a principle in a high tech public start-up and founder of a private venture capital fund. He is presently involved in private equity placements internationally along with proprietary trading involving the development & application of Chaos Theory and Mandelbrot Generator algorithms.

Gordon T Long is not a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While he believes his statements to be true, they always depend on the reliability of his own credible sources. Of course, he recommends that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, you are encouraged to confirm the facts on your own before making important investment commitments.

© Copyright 2010 Gordon T Long. The information herein was obtained from sources which Mr. Long believes reliable, but he does not guarantee its accuracy. None of the information, advertisements, website links, or any opinions expressed constitutes a solicitation of the purchase or sale of any securities or commodities. Please note that Mr. Long may already have invested or may from time to time invest in securities that are recommended or otherwise covered on this website. Mr. Long does not intend to disclose the extent of any current holdings or future transactions with respect to any particular security. You should consider this possibility before investing in any security based upon statements and information contained in any report, post, comment or recommendation you receive from him.