Over the past few years, without anyone debating it or publicizing it, America’s national debt has been converted to an adjustable-rate mortgage. That’s right – the moment after ARM mortgages went belly-up, the treasury decided that they wanted to get in on the game. How does the national debt become financed with an adjustable-rate mortgage?
To answer this question, we have to ask, what is an adjustable rate mortgage and why is it a problem?
An adjustable-rate mortgage is one where the person receiving the loan gets a low interest rate, but the interest rate follows the market rate year-to-year. In a fixed rate loan, if your rate is 6%, it will be 6% until your loan is paid off. For an adjustable-rate mortgage, your rate might be 3%, but then next year it might be 8%, all depending on the interest rate in the markets. The problem with an ARM is that people get used to the low rates, and they forget to plan on what will happen if the rates go up. If the rates go up even a little bit, it catches them off guard and they can’t pay.
So how does the government do this with its debt?
Well, the government finances its debt on the open market. So, for instance, it might sell a treasury bond. The treasury decides whether that is going to be a 6-month, 1-year, 10-year, or 30-year bond. Traditionally, the treasury has financed the debt using primarily longer-term notes – 10 to 30 years. This means that if interest rates fluctuate, we have some time to deal with it before we need to refinance. It prevents a crisis from interest-rate swings.
Well, 10-year bonds yields are at about 2.5%/yr, but the 1-year bond is only 0.1%/yr. Therefore, to save money temporarily, the government over the last few years has rolled over half of its debt into short-term notes! This has helped the bottom line for the current years. The problem is that it means that we have $8 trillion in debt which has to be refinanced every year. Now, at the 1-year rate, $8 trillion costs $8 billion a year in interest payments. However, if the 1-year rate were to go up to any historically normal interest rate, the government deficit would shoot through the roof.
Let’s say the interest rate shot up to 4%. That is still considered low, historically. What would happen? It would cost the government $320 billion in new interest payments. That would increase the deficit by about 30%.
This is life on an adjustable rate mortgage.