MasterPo says: This blog is about topics and issues that are of importance to me. I am not one of the countless blogging lemmings that are tripping over each other scurrying down the hill and off the cliff of blogging oblivion trying to write the greatest blog on the latest topic de'jour. Your comments are welcome.

April 29, 2009

Calling Our Bluff…I Mean Our Debt

It's very much in fashion these days to say "What if the Chinese or Europeans (et al.) call the American debt? What if they suddenly demand immediate repayment of American Debt?"

This is a topic that has been talked about in the financial and political news for decades. But it is even more imperative today as our illustrious President Obama has set the United States on a course for crushing debt that can only be financed through massive foreign support (and HUGE domestic taxation, but that's for another article).

By this it is meant that foreign investors who bought U.S. government Treasury bonds suddenly demand the bonds to be repaid back in full on the spot rather than wait until maturity. The concerns being first we don't have the money to repay all the debt (or even most of the debt) Johnny On the Spot. Secondly, these foreign investors won't buy any more U.S. government issued Treasury bonds and therefore the U.S. government will be hard pressed to finance operations, much less the grand schemes and programs we have come to know and love(?!) as well as new ones.

The latter is because the reality is that taxation simple does not collect enough money to pay for all the government programs, both at the Federal level as well as the state/local level. Issuing bonds is the only way these government programs and functions can get funding. Why it's grown to this bloated state is a topic for another article.

It is to the former point, however, this article is addressed – the demand for immediate repayment.

To explain why this is technically impossible we need to review some basic concepts that I'm sure are not taught in school finance unless you take very specific courses (which is yet another failing of the education system).

A "bond" is simple a loan. In financial technical terms it's known as "evidence of indebtedness". The bond itself describes what the load is for (in often general terms), who is asking for the loan, the amount of the loan (the principle), how long the loan is for (the term of the loan), when the loan is to be repaid (the maturity of the bond), and most importantly for the buyer of the bond (the bond holder) the terms of the repayment of the loan including the interest rate to be paid. Therefore, the person who buys a bond is making a loan to the person who is issuing the bond. So if you buy a $1,000 U.S. Treasury bond you are making a $1,000 loan to the U.S. treasury department (i.e. the American government).

Most bonds pay the buyer interest periodically (some bonds – zero coupon bonds - don't but that's a different subject) as well as principle. In terms of Treasury bonds the bond holder gets interest paid twice a year and the principle paid back at the end of the loan when the treasury bond matures.

"Calling" a bond means the issuer - not the buyer! – repays the principle of the loan early (i.e. pays back the loan early). The bond contains a "call schedule" which is a list of dates when the bond issuer can (but not required to) call the bond and repayment amounts the bond holder will receive if called on the dates. In general call features are uncommon in bonds and rare in government bonds.

To the point of this article: U.S. Treasury bonds are not callable!

Technically speaking it is impossible for the Chinese, Europeans, Russians etc. to call our debt (i.e. demand immediate repayment)! This is one of the biggest falsehoods being spoken of these days. The best they could do would be to sell the bonds in the market but that transaction doesn't involve the U.S. Treasury (bonds are bought and sold all the time).

(I say "technically" because in the world of politics any things is possible!)

What can happen, however, is these foreign Treasury bond holders can choose not to buy new U.S. Treasury bonds when their current bonds mature. In other words, when the bonds they are holding now mature, instead of using the proceeds of the maturity to buy new Treasury bonds they take them money off the table and go out it else where. That would be major trouble for the U.S. if no one (at least not enough) bought our government's bonds. The pool of money to finance the American government would dry up fast!

Can anyone spare a dime?

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