The U.S. Deficit and Rates: Two Ticking Time Bombs

Here's a little confession: I voted for Bill Clinton back in 1992. I voted for then-Gov. Clinton not because I liked him a whole lot better than George H. Bush but because he promised to fix the economy and reduce the deficit.

In retrospect, I have nothing but respect for the first President Bush. I think he did a commendable job winning the Persian Gulf War, and building a coalition of nations to fight Saddam Hussein. Historians, unfortunately, have forgotten that it was this Republican president who cleaned up the S&L mess, and re-regulated that once sleepy industry back to its core mission of providing home finance money to Americans.

As for the second President Bush, I can't say I'm a big fan, but I'm willing to give him a chance if he does what President Clinton did: reduce the budget deficit. Right now that looks like a tall order, but if the former governor from Texas wants to build any kind of legacy he will need to do something about the deficit.

For the fiscal year ending Sept. 30, the U.S. budget deficit was an eye-popping $413 billion, or 3.16% of the nation's gross domestic product. The highest deficit (as a percentage of GDP) is the 6% setback in 1983.

There are several schools of thought on the deficit. Some economists, particularly those leaning right, believe that as long as the deficit (in percentage terms) stays under 3%, it's really nothing to worry about. But a $400 billion hole in the ground is still a $400 billion hole in the ground no matter how much revenue is flowing through the Treasury Department.

What does the federal deficit have to do with the mortgage business? Large deficits in and of themselves won't necessarily drive rates higher, but if foreign investors stop buying our Treasury bonds because they can get a better deal elsewhere, then rates will rise.

The math works like this: the U.S. government funds the deficit through the sale of Treasury bonds (debt). The government stopped issuing 30-year bonds a few years back, leaving the 10-year as the long-term instrument of choice. Mortgages (as we all know) are priced off the 10-year.

If foreign investors won't buy T-bonds because they feel the yield isn't worth the risk (or they can find better, risk/reward investments elsewhere), then the U.S. Treasury will be forced to raise the yield on their offerings. If the yield on new 10-year debt rises, that can only mean that mortgage rates will rise as well.

Will this happen? It's happened before and it will happen again. The federal budget deficit wasn't exactly an issue in this past election. If you believe all the pundits and columnists, most voters carried about: terrorism, abortion and gay marriage.

I will submit that when you mention the phrase "federal budget deficit," most voters fall asleep. But I'm not one of those voters and I will assume, for argument sake, that most folks who make their living in residential mortgages care a great deal about the deficit and rates. Let's face it: mortgage banking lives and dies on where rates are.

But will President Bush and the folks in Congress do anything about the budget mess? No longer can Republicans blame the red ink on those "tax-and-spend liberals" in Congress.

So, how do we stem the red rink? We can cut spending, which includes entitlement programs like Social Security or we can cut spending at agencies like the Department of Defense (one of the biggest budget items), but don't hold your breath. There is one surefire way to reduce the deficit: raise taxes, especially on wealthy Americans. Upon winning re-election, President Bush said he had earned political "capital" and that he intended to spend it. If anyone in Washington can get away with raising taxes it's Mr. Bush. The ball is in his court. Will he shoot or dribble?

Paul Muolo is executive editor of both Mortgage Servicing News and National Mortgage News. He can be e-mailed at: Paul.MuoloThomsonMedia.com.

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