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Wanna Bet the U.S. Bails Out Argentina???

Saturday, July 26, 2014

The chickens are about to come home to roost.

In his recent book, Stress Test, former Treasury Secretary Tim Geithner makes his case for bailing out the major banks during the last financial crisis.  The main thrust of his argument is that "bond holders" had to get 100% of the face value of their bonds, instead of taking what the bond market calls a "haircut."

Hang on, hang on...  Don't go screaming into the night (or clicking out of here) just yet.  We can actually push past the nonsense I am really starting to think is set up on purpose to keep ordinary people like you and me from asking inconvenient questions of the 'experts'.

A '10 year 16 oz. Bottle of Coke Bond'

I'll reprise an example I use in my book and in an earlier post here on my blog.  Let's say I pop my head over the cubicle wall you and I share at work and ask "Can I borrow two bucks to get a Coke from the break room?"

"Sure" you say.  You begin reaching for your purse or wallet.

"Uhhhh, the only thing, though," I add, "Is I'll have to pay you back 10 years from now."

You stop, raise your eyebrows a bit and think about it for a second.  But you're good at math, so you figure it out pretty quickly.

"No worries...You'll just have to pay me 10% each year.  And then when the 10 years are up, you can pay me back the two bucks."

Here's what's happening here.  You think about that 16 oz. bottle of Coke for a second.  What do you think it will cost you 10 years from now?  You settle on four bucks pretty quickly as a reasonable estimate.  Right now, you figure, your two bucks is 100% of the 'purchasing power' needed to buy that Coke.  10 years from now, though, with that Coke costing four bucks, your two bucks will only be one-half (that's 50% for you jocks out there - don't say I don't help you guys out) of the 'purchasing power' to buy that Coke.

So you put 10% terms on this little loan.  10% of $2.00 is $0.20, of course.  So you'll collect $0.20 each year from me for 10 years.  So at the end of those 10 years you will have collected another two bucks.  Add that to the original two bucks I'll return to you at the end of those 10 years, and you have the four bucks that bottle of Coke will cost you then.  You have protected your purchasing power.

This is how the bond market works.  A bond is a loan where you only pay the interest during the term of the loan.  At the end you pay back the full amount of the loan.  Those annual $0.20 payments are called 'coupon' payments.  Paying the original two bucks back at the end of the 10 years is 'redeeming' the bond 'at par' (100% of the original amount) when it 'matures' (the end of the 10 year period).

But let's say we get to the end of the 10 years... and I can't pay you back because I am overloaded with 'coupon' payments to other 'bond holders' whose bonds have not yet 'matured'.  Two things can happen at that point: Either I 'default' on the '$2, 10 year, 16 oz. bottle of Coke' bond I 'sold' to you over that cubicle wall, or you agree to 'take a haircut'.

I owe you the full two dollars, but can only afford to pay you one dollar.  You figure it is better to get one dollar rather than nothing if I default, so you agree to take a '50% haircut' (accepting one-half of what I owe you - $1 instead of $2).

The Next Bailout

This is what is happening right now in a Manhattan federal courthouse.  Argentina is negotiating with a group of bond holders led by NML Capital - an investment company who bought Argentina's bonds.  While other bond holders have agreed to take a haircut on their Argentina bonds, NML (and a few others) is refusing to do so - insisting that they are entitled to 'par' - 100% of the face value.  The problem for Argentina is that if NML Captial gets par for its bonds, Argentina's prior agreements with the other bond holders to accept a 'haircut' will then be challenged by those bond holders.

Either everyone takes a haircut, or Argentina will be forced to default on all of its bonds.

So why would NML Capital and the other few bond holders take such a hard line in these negotiations?  If Argentina defaults, they may get nothing at all.  Why not just take the haircut like everyone else and walk away?

Because when 'Junior' was at the helm of the Treasury (see here if you don't get the reference), he made it very clear that the U.S. would not allow those holding bonds sold by the banks which were failing to be forced to take a haircut.  By his rationale, to do so would only make the crisis worse by scaring off the remaining investors and any future investment.  And in his book he persistently derides those who warned what this would do going forward as "moral hazard fundamentalists" demanding "Old Testament" justice.

We are about to find out why he was wrong.  The chickens are about to come home to roost.

'Sovereign' bonds like those sold by Argentina are an even more 'systemic' form of debt than were the bonds sold by the banks.  If it is the policy of the U.S. Treasury not to force bond holders to accept a haircut on bank bonds, the calculation is that the U.S. Treasury will have to take the same approach to sovereign bonds like those sold by Argentina.

So why, then, would NML Captial accept a haircut when the Treasury has already put itself in a box on this matter?  If you felt you someone would step in to bail me out so I could pay you both of your original two dollars, why would you accept only one?

Stay tuned to the news.  And whatever you do, please don't switch the channel when you hear a story about the International Monetary Fund (IMF) - which is funded largely by the U.S. - and Argentina.  The chickens are due on July 30th.  And there is really only two possible outcomes: Either Argentina will be bailed out - largely by us - or they will default.

And if Argentina is bailed out, this will expose Junior's lie that doing what was done during the financial crisis would enable us to avoid having to do it again.

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