After reading Michael Lewis’ wonderful book The Big Short: Inside the Doomsday Machine, I recommended it to a friend. As my friend is a financial professional, I knew he would enjoy a book about how a few obscure hedge fund managers, and their clients, handsomely profited from the collapse of America’s subprime-mortgage market. This friend knew that, starting in June of 2005, I had written extensively about the United States’ housing bubble (see articles, here, here, here, here, here, here, and here). So the meltdown in the subprime-mortgage market came as no surprise to either of us; but it definitely caught Wall Street by surprise. Upon finishing the aforementioned book, my friend called me and asked a thought-provoking, two-part question: "What is the next big short and how do we profit from it?"

Sovereign debt certainly has been in the financial headlines in 2010; with Greece getting the lion’s share of attention. In the midst of Greece’s debt crisis, Standard & Poor’s downgraded Greece’s credit rating to "junk" status. S&P’s rationale for this rating reduction was straight forward: "The downgrade results from our updated assessment of the political, economic and budgetary conditions that the Greek government faces in its efforts to put the public debt burden onto a sustained downward trajectory." What is not stated by S&P is that by joining the European Union, Greece no longer has its own central bank so it can’t paper over its debt crisis by printing more money.

Conversely, the United States’ central bank loves to use its printing press and is actively purchasing U.S. Treasury bonds with the objectives of keeping interest rates low and spurring economic growth in the U.S.; which will not work. As of October 15, 2010, a 30-year Treasury bond was yielding 3.98%. In addition to the Federal Reserve’s monetizing of Uncle Sam’s debt, such a low yield has also come about as individuals and large institutions, including banks, perceive U.S. Treasuries to be a safe haven; hence they are lending to this "AAA" rated borrower in droves. As George Goncalves stated: "Treasury bonds are gaining u2018rock star’ status…" Considering the heady levels the bond market has attained, is it possible that a bond bubble has emerged in the United States?

The Big Short: Inside ... Michael Lewis Best Price: $0.25 Buy New $8.64 (as of 01:20 EST - Details)

Egon von Greyerz, of Matterhorn Asset Management, certainly thinks so. He believes, indeed, there is a bond bubble of global proportions. Here is what he stated in a recent article:

The bond market is the biggest bubble in financial markets worldwide, in our opinion. Investors around the world are worried about the state of financial markets and therefore believe that government bonds represent a safe haven. These investors will receive the most enormous shock on two accounts. Firstly, no government will be able to repay the debts outstanding. So there will either be government defaults, moratoria, or money printing that totally destroys the value of the bonds. Secondly, interest rates are likely to go up significantly to at least 10—15%, totally destroying the value of the bonds.

Financial-market luminaries, such as Marc Faber, Jim Rogers, and Peter Schiff do believe U.S. Treasury bonds are in a bubble. In fact, in this interview, Jim Rogers states he is considering shorting U.S. Treasury bonds. If Rogers is thinking about shorting bonds, you should too.

Presently, I do hold a short position pertaining to U.S. Treasury bonds. I have taken this position via an inverse bond fund. Here is a description of this mutual fund:

The investment seeks total return, before expenses and costs, that inversely correlates to the price movements of Long Treasury bonds. The fund employs, as its investment strategy, a program of engaging in short sales and investing to a significant extent in derivative instruments, which primarily consist of futures contracts, interest rate swaps, and options on securities and futures contracts. It invests at least 80% of net assets in financial instruments with economic characteristics that should perform opposite to fixed-income securities issued by the U.S. government.

I did not take this short position without undertaking appropriate research. In January of 2005, LRC published my essay titled Should the US Government’s Sovereign Credit Rating be Downgraded to Junk? Here we are, over five years later, and Uncle Sam’s financial condition is much "junkier."

When I wrote the above-mentioned essay, the U.S. Government’s balance sheet revealed a deficit net worth of over $7.7 trillion. As of fiscal year-end September 30, 2009, the U.S. Treasury is reporting that Uncle Sam’s net worth is a mind-numbing deficit $11.5 trillion — I have included the 2009 balance sheet, below, for your viewing displeasure.

(In billions of dollars) 2009 Assets: ` Cash and other monetary assets (Note 2) 393.2 Accounts and taxes receivable, net (Note 3) 90.2 Loans receivable and mortgage backed securities, net (Note 4) 538.9 TARP direct loans and equity investments, net (Note 5) 239.7 Beneficial interest in trust (Note 6) 23.5 Inventories and related property, net (Note 7) 284.6 Property, plant, and equipment, net (Note 8) 784.1 Securities and investments (Note 9) 93.1 Investments in Government sponsored enterprises (Note 11) 64.7 Other assets (Note 12) 155.9 Total assets 2,667.9 Stewardship land and heritage assets (Note 27) ` Liabilities: ` Accounts payable (Note 13) 73.2

Federal debt securities held by the public and accrued interest (Note 14)

7,582.7 Federal employee and veteran benefits payable (Note 15) 5,283.7 Environmental and disposal liabilities (Note 16) 341.8 Benefits due and payable (Note 17) 160.8 Insurance and guarantee program liabilities (Note 18) 166.2 Loan guarantee liabilities (Note 4) 69.4 Liquidity guarantee (Note 11) 91.9 Other liabilities (Note 19) 354.1 Total liabilities 14,123.8 Contingencies (Note 22) and Commitments (Note 23) ` Net position: ` Earmarked funds (Note 24) 752.7 Non-earmarked funds (12,208.6) Total net position (11,455.9) Total liabilities and net position 2,667.9

But the news gets much worse. It is important to understand Uncle Sam does not have "his" financial statement prepared according to generally accepted accounting principles (GAAP). Most notably, if you go to page 158 of the U.S. Government’s 2009 audited financial statement (Table 6), you will see that the net present value of future Social Security and Medicare costs is $107 trillion. Under GAAP accounting, it could be argued that such liabilities would be included in the U.S. Government’s balance sheet as accrued liabilities. One could confidently assert, therefore, that Uncle Sam’s liabilities exceed assets by over $118 trillion. How the rating agencies continue to rate the United States as a AAA risk completely escapes me. Uncle Sam’s financial condition is a train wreck. Without the Federal Reserve’s printing press, this confidence game couldn’t keep moving forward.

The Hyperinflation Sur... Swanson, Gerald Best Price: $4.58 Buy New $9.13 (as of 08:40 EST - Details)

For up-to-date information, with respect to the debt and liabilities the U.S. is racking up at warp speed, I suggest visiting U.S. Debt Clock.org. As of October 15, 2010, the national debt was approaching $13.6 trillion and unfunded liabilities were approaching $111 trillion. One would suppose even Alexander Hamilton would be alarmed at such surreal figures. Ah, but the bond market is forecasting tranquility and absolute safety for the next 30 years.

This is exactly why I like the idea of being short U.S. Treasury bonds. Wall Street analysts, for the most part, will not sound the alarm indicating a bond bubble has emerged. After witnessing the subprime-mortgage collapse and then the ensuing bailout of Wall Street, I have concluded Wall Street is a criminal enterprise designed to separate you from your money. So don’t expect any help from these crooks. As for the rating agencies, such as Fitch, Moody’s, and Standard & Poor’s, they won’t sound the alarm simply due to the fact that they are incompetent. After Enron, MBIA, and the entire subprime mortgage-backed securities disaster, who takes the rating agencies seriously anymore? So while institutions and individuals flee to the alleged safety of long-term U.S. Treasuries, AAA rating and all, the "shorts" properly view Uncle Sam as a subprime borrower; and have detected an opportunity to profit when the Treasury-bond bubble bursts.

Confidence Game: How H... Christine S. Richard Best Price: $2.07 Buy New $1.99 (as of 04:35 EST - Details)

As a quick tangent, I highly recommend Christine Richard’s book covering the downfall of MBIA. It is titled Confidence Game: How a Hedge Fund Manager Called Wall Street’s Bluff. This book masterfully details how a hedge fund manager skillfully dissected MBIA’s business model and financial condition; and then openly questioned its AAA rating via a critical research report. The backlash, against this hedge fund manager, was vicious. In the end, he was vindicated when MBIA was stripped of its AAA rating and imploded. The reward for his lonely battle, against Wall Street and the rating agencies, was over a billion dollars in profits for his investors via astutely purchasing credit-default swaps and shorting MBIA’s common stock.

Aside from the above-mentioned inverse bond fund, there are other vehicles available to short U.S. Treasury bonds. There are exchange-traded funds (ETFs) that appreciate as bond prices fall (examples linked here and here). There is also a mutual fund "that corresponds to one and one-quarter times (125%) the inverse (opposite) of the daily price movement of the most recently issued 30-year U.S. Treasury bond." To be sure, there are other vehicles for shorting Treasury bonds; but the purpose of this essay is to provide an idea allowing one to profit when the Treasury-bond bubble bursts — further research and risk assessment are up to you.

Without a doubt, I do see U.S. Treasury bonds as the next big short. Uncle Sam, after all, has a subprime financial condition yet is rated AAA. Keep in mind the hedge fund managers, who profited from the subprime-mortgage meltdown (as chronicled in The Big Short), waited several years for their positions to pay off; thus patience is a virtue when holding a short position in U.S. Treasury bonds. Even if interest rates rise and bond prices drop like a stone, the U.S. could ban the short-selling of Treasury bonds. Political risk, therefore, must be considered when taking a short position in T-bonds. Consequently, shorting T-bonds is not a risk-free proposition. This aside, I savor the idea of making money by shorting the long-term debt of the retarded, clumsy "debtaholic" known as Uncle Sam.

The Best of Eric Englund

The Best of Eric Englund