"Saturday night in a saloon, Craigville, Minnesota"
Ilargi: There will come a point in time, and in all likelihood it's already here, when wages for the working, and services for the community, will have to be drastically cut, not just because tax revenues plunge or because the overall economy is limping along, no, solely to pay out pensions to those who no longer work.
In other words, you will no longer be able to afford your children's college education (or any other, for that matter), which by itself will undergo severe cuts as well, because your parents and grandparents want to retire in comfort. Why? First, because their pension plans promise huge pay-outs, and second, because the pension funds have gambled away tons of money in the stock markets, as well as securities and other derivatives instruments.
Already, in Britain, those working in the private sector pay more towards pension systems for public sector workers than they pay towards their own retirement funds. Here's an example of how convoluted the "reasoning" surrounding pensions has become:
Britain’s $1,5 Trillion Pensions Timebomb• A Treasury spokesman insisted there was no looming funding crisis. He said: "The most important measure of public sector pension affordability is the Government’s ability to pay pensions as they fall due – the cost of pensions is projected to remain at under two per cent of GDP for the foreseeable future." And a spokesman for the Local Government Association said: "The supposed ‘black hole’ in the local government pension scheme would only occur if every single worker retired tomorrow, which is not going to happen."
Ilargi: Oh no, the black hole is very much there. It sounds better to make claims like these, but they're nonsensical. That $1.5 trillion present gap will have to be filled somehow. And it will have to come from taxpayers. The problem here is that these taxpayers ostensibly pay towards their own retirement, not that of others. Or that is at least what they would want, and think they do for that matter. Besides, the pay-out rates rise at a fast clip, something, as a even the most fleeting glance at baby-boomer demographics will tell you, that is certain to accelerate:
Britain's police pensions swallow 20% of total force budget• According to figures released by 48 of the UK's constabularies that agreed to reveal their pension costs in response to the requests, last year they paid out almost £2.1bn, up by 54% on the £1.4bn paid out in 2005.
Ilargi: How bad is all this promising to be? It's all in the term "contractual obligations", as Dan Froomkin states in the following Huffington Post article:
• [..] state taxpayers are contractually obligated to make good on the retiree benefits-- even as those promises threaten to crash headfirst into obligations to pay for schools, public safety, health care [..]
Ilargi: That is where the essence of the problem lies, and nobody volunteers anything even close to a solution. The best they can do is proposing "pension reform" that would give future employees less benefits. But that's not going to work. The problems have already grown beyond any such "solution".
'Something's Got To Give': Massive Pension Fund Shortfalls Threaten To Bankrupt States• [..] state taxpayers are contractually obligated to make good on the retiree benefits-- even as those promises threaten to crash headfirst into obligations to pay for schools, public safety, health care[..]
• [..] the cumulative shortfall from California's three giant pension funds alone is somewhere around $500 billion. Not only is that considerably more than the state is currently projecting, but it's almost six times the state's entire general fund budget. In other words, it would take California six years -- with no spending on education, public safety, health care or anything else -- to fill the gap.
• [..] the nation's 10 largest public pension funds have paid private equity firms more than $17 billion in fees since 2000, without reaping the rewards they were promised.
• [..] "The Trillion Dollar Gap" [report] from the Pew Center on the States last month called renewed attention to the pension shortfalls. The title reflects the gap at the end of fiscal year 2008 between the $2.35 trillion states had set aside to pay for employees' retirement benefits and the $3.35 trillion price tag of those promises."
But as NPR and others noted, that $1 trillion figure is unrealistically low. Experts like Joshua Rauh, an associate professor of finance at the Kellogg School of Management at Northwestern University, say pension funds are using exaggerated assumptions about investment returns. "Our calculation is that it's more like $3 trillion underfunded".
• [..] the General Accounting Standards Board, the accounting board for governments, is likely to force states to publicly adjust their calculations to reflect more realistic expected returns. "If the modifications are approved, many already cash-strapped states and municipalities would likely have to increase the amount they are supposed to pay annually to their pension funds to help cover the shortfall [..]"
Ilargi: To summarize: Britain has a $1.5 trillion pension gap, and the US has a $3 trillion one. Which seems comparatively meek. But then again, California's gap alone is half a trillion dollars.
California's $500-billion pension time bomb• Why should Californians care? Because this year's unfunded pension liability is next year's budget cut to important programs. For a glimpse of California's budgetary future, look no further than the $5.5 billion diverted this year from higher education, transit, parks and other programs in order to pay just a tiny bit toward current unfunded pension and healthcare promises. That figure is set to triple within 10 years and -- absent reform -- to continue to grow, crowding out funding for many programs vital to the overwhelming majority of Californians.
• For decades -- and without voter consent -- state leaders have been issuing billions of dollars of debt in the form of unfunded pension and healthcare promises, then gaming accounting rules in order to understate the size of those promises. As we saw during the recent financial crisis, hiding debt is not a new phenomenon. Indeed, General Motors did something similar to obscure the true cost of its retirement promises. Through aggressive accounting, for a while it, too, got away with making pension contributions that were a fraction of what it really needed to make,
• In California's case, past pension underfunding means reduced funding of current programs. This explains why pension costs rose 2,000% from 1999 to 2009, while state funding for higher education declined over the same period.
• What can we do about this? For the promises already made, nothing. They are contractual, and because that $500 billion of debt must be paid, retirement costs will rise dramatically no matter what we do. But we can reduce the sizes of promises made to new employees and require full and truthful disclosure so that pension debt can never again be hidden.
• Last summer Gov. Arnold Schwarzenegger proposed exactly that. Since then? Silence. State legislators are afraid even to utter the words "pension reform" for fear of alienating what has become -- since passage of the Dills Act in 1978, which endowed state public employees with collective bargaining rights on top of their civil service protections -- the single most politically influential constituency in our state: government employees.
• Instead of a government of the people, by the people and for the people, we have become a government of its employees, by its employees and for its employees. This explains why legislators fight harder to overturn employee furloughs than to reform pensions and elect to pay more in compensation to just 65,000 employees in one single department -- corrections -- than they spend on a higher education system serving 10 times as many people.
Ilargi: The issue is not just a general one for countries or states, it’s also one for specific fields:
Pennsylvania Schools Face Mounting Pension Crisis• Schools now paying the equivalent of 4.78 percent of the employee payroll [in required contributions to the employee retirement system] will see the rates rise to 8.22 percent starting in July, then to 10.59 percent in July 2011 before the leap to 29.22 percent in 2012.
• The Public School Employees' Retirement System, called PSERS, is a defined-benefit pension plan that's been in place for almost 93 years. A defined benefit means the members of the plan - school teachers, administrators and support workers - are guaranteed a certain monthly payment when they retire from work.
• [..] the major factor that seems to be beyond anyone's control - the performance of the stocks in which the fund is invested. Instead of returning healthy earnings as it did in bull market years - 19.7 percent in 2003-04 and up to 22.9 percent in 2006-07 - the fund lost 26.5 percent of its value in 2008-09.
It's also the main reason blamed for putting school districts in the position of having to boost their combined support from $616 million this school year to $4.2 billion in 2012-13. Schools have to pay more than $5 billion a year from 2014-15 through 2025-26, according to current projections.
• While the PSERS investment lost 26.5 percent of its value last year, the fund needs to regain that 26.5 percent plus the amount of positive earnings needed to keep the fund balanced. And this year PSERS needs to make up additional earnings that will be lost because the principal didn't grow last year. It's a function that could be called negative compounding, as opposed to the basic compounding of interest - an amount that grows each year - on a simple interest-bearing savings account. Because of the variety of factors affecting revenue and payments by PSERS, state Rep. David Reed, R-Indiana, said, there's no consensus among lawmakers on a legislative solution - if there is to be one.
• "The biggest thing that has occurred lately that has amplified the situation is the stock market going from 14,000 to 6,500 and the pension plan losing $30 billion in a year. That's really what has brought everything to a head. "
Ilargi: As unemployment is at near record highs, especially the long-term kind, pension payments surge to their own record highs. It would seem easy to call on Washington, right? Well, you might want to get in line for that one:
GM and Chrysler Pensions Underfunded by $17 Billion• The pension plans at General Motors and Chrysler are underfunded by a total of $17 billion and could fail if the automakers do not return to profitability, according to a government report released Tuesday. Both companies need to make large payments into the plans within the next five years — $12.3 billion by G.M. and $2.6 billion by Chrysler — to reach minimum funding levels, according to the report, prepared by the Government Accountability Office.
• If either company’s plan must be terminated, the government would become liable for paying benefits to hundreds of thousands of retirees. The effect on the government’s pension insurer, the Pension Benefit Guaranty Corporation, would be “unprecedented,” the report said. The agency manages plans with assets totaling $68.7 billion, less than the $84.5 billion in G.M.’s plan alone.
• The government spent $81 billion bailing out the companies and others in the auto industry. The report issued Tuesday said Treasury officials were confident that G.M. and Chrysler would earn enough to allow the government to gradually sell its stakes. But the report warned that the government could push the companies out of business, consequently terminating their pension plans, if their recovery efforts failed.
• “In the event that the companies do not return to profitability in a reasonable time frame, Treasury officials said that they will consider all commercial options for disposing of Treasury’s equity, including forcing the companies into liquidation,” the report said. In addition, the report said the government’s interests as a shareholder of G.M. and Chrysler could clash with those of pension participants and beneficiaries. “For example, Treasury could decide to sell its equity stake at a time when it would maximize its return on investment, but when the companies’ pension plans were still at risk,” the report said.
Britain’s $1,5 Trillion Pensions Timebomb• Taxpayers are facing a £1 trillion "black hole" in funding to cover the generous pensions of Britain’s army of public sector workers, business chiefs warn today. A damning report by the Confederation of British Industry calls on ministers to tackle the huge bill to look after millions of state employees in old age, which works out at a staggering £40,400 for every household in the UK.
• Campaigners say private workers pay more towards public sector pensions than [towards] their own, through taxes.
• Public sector pensions currently cost the taxpayer £14.93 billion a year, a rise of 38 per cent in a decade. But more than five million people, including civil servants, teachers, NHS staff and members of the Armed Forces, are in schemes for which no money has been set aside.
Britain's police pensions swallow 20% of total force budget• Fears that the burgeoning costs of Britain's public sector pensions will restrict the country's ability to cut its debts are underscored by new figures showing that police forces are paying out more than £2 bn a year to retired person
• At a time when the average age of a retiring officer completing full service has dropped to 51 and life expectancy rates are increasing, many ex-officers will enjoy pensions for longer than they have worked.
• The £2bn figure was obtained following a series of freedom of information requests made to all 52 forces by the Liberal Democrats, who said it showed that Britain's public sector pension costs were unsustainable. According to figures released by 48 of the UK's constabularies that agreed to reveal their pension costs in response to the requests, last year they paid out almost £2.1bn, up by 54% on the £1.4bn paid out in 2005.
•"No country can pay pensions for longer than people work, let alone Britain with its deep financial deficit."
• Unfunded pension promises made to past and present UK public sector workers now amount to almost £1.2 trillion, according to consultants Towers Watson – equivalent to almost £47,000 for every household in Great Britain.
Ilargi: To summarize, unless we see our economies produce record growth levels over the next ten years (they won't), we will live in a world where parents are pitted against their children, and neighbors versus neighbors. To understand that, look at the present funding gaps in all the pension systems, and combine that with the rate at which pay-outs increase, as well as the rate at which that rate increases.
It will become clear to the working population that the soon unprecedented amounts and percentages of their wages that will go towards pension plans, will not be used for their own retirement, but are needed for that of the generation before them. And that will happen at a time when downward pressure on wages by unemployment will be massive.
The only solution would be for the baby-boomer generation to voluntarily cut their own pensions by 50% or more, and return the remainder to the funds. That will not happen. Neither will there be politicians brave -let alone numerous- enough to force such cuts in any meaningful sense, not until the baby boomers are no longer the largest voting block in our societies, and rest assured, by then it will be way too late.
For those of you who are already retired or will soon do so, your pensions will be cut drastically within probably 5 years, and certainly 10 years. Think a 75% cut. For those of you under the age of 50, assuming you'd retire at 65, and this is something I’ve said many times before, there will be no pensions, period.
What there will be is enormous generational battlefields, both metaphorically and literally, in your families, communities and societies. A situation in which pensioners sit by their private pools while their grandchildren scavenge for food would never last long.
The age of entitlement is already over, but, except for the one in a million, you will be far too late in recognizing and realizing that. Let alone adapting to it.
Ilargi: Prior to our Summer Fundraiser, your donations are already welcome today as well, but of course, and our advertisers still yearn breathlessly for your visits, that why they're here. Clicking their ads carries no obligation to buy anything at all, don't worry. It does keep the Automatic Earth going, though. Much obliged.
Mighty America's 5 stages of rapid decline
by Paul B. Farrell
Jim Collins' danger signals: But can we halt the collapse of capitalism?
Imagine you're legendary business guru Jim Collins. Decade ago "Good to Great" and "Built to Last" made him the new Peter Drucker. He's a guy USA Today says would rather be rock climbing than helping companies learn the secrets of making "the leap to greatness." But that was nine years (and two brutal recessions) ago. Then, shortly after the Iraq War started, he was forced back to the drawing boards, and wrote "How the Mighty Fall." Why? His summary in BusinessWeek explains: "Some of the great companies we'd profiled ... had subsequently lost their positions of prominence," including the Bank of America.
Why do The Mighty fall? "If some of the greatest companies in history can go from iconic to irrelevant, what might we learn by studying their demise, and how can others avoid their fate?" Then fate did intervene, a call came that got his adrenaline flowing faster than hanging high on a rocky cliff: "Would like you to come to West Point to lead a discussion with some great students?" A seminar for cadets? No, "12 generals, 12 CEOs, and 12 social sector leaders ... and they'll really want to dialogue about the topic."
What topic? "America!" America? "What could I possibly teach this esteemed group about America?" A lot. The core issue became clear when the CEO of one of America's top companies pulled him aside: "We've had tremendous success in recent years," but "when you are at the top of the world ... the most powerful nation on Earth ... the most successful company in your industry ... the best player in your game ... your very power and success might cover up the fact that you're already on the path of decline?"
Hidden in the silent creep of doom, the seeds of failure
Yes, success is blinding. When everyone says you're the best, the leader, the most powerful player, when the press, your competition and your enemies all put you on a pedestal: "How would you know you're not already on the path of decline?" That CEO's questions inspired the new research, into what Collins calls "the silent creep of doom."
The problem: "Institutional decline is like a disease: harder to detect but easier to cure in the early stages; easier to detect but harder to cure in the later stages. An institution can look strong on the outside but already be sick on the inside, dangerously on the cusp of a precipitous fall." Happens to the best on Wall Street, Washington, Corporate America CEOs: You're on top, but "sick on the inside, dangerously on the cusp of a precipitous fall" ... but you don't even know it.
The wake-up call: "If a company as powerful and well-positioned as Bank of America in the late 1970s could fall so far, so hard, so quickly, then any company can," Collins discovered. "Every institution is vulnerable, no matter how great. There is no law of nature that the most powerful will inevitably remain at the top. Anyone can fall, and most eventually do." Collins sounds like anthropologist Jared Diamond in "Collapse: How Societies Choose to Fail or Succeed: "One of the disturbing facts of history is that so many civilizations collapse," sharing "a sharp curve of decline" that "may begin only a decade or two after it reaches its peak population, wealth and power." Yes, if it happened to Bank of America, why not America?
Collins research exposed the "Five Stages of Decline." Knowing them can help business, banking and government leaders "substantially increase the odds of reversing decline before it is too late -- or even better, stave off decline in the first place." Moreover, "decline can be reversed ... the mighty can fall, but they can often rise again." Here are his warning signs, and diagnostic clues, along the five steps of declining:
Stage 1: Hubris born of success
Imagine Collins as a psychiatrist diagnosing a patient on his couch: "Great enterprises can become insulated by success ... momentum can carry an enterprise forward for a while, even if its leaders make poor decisions ... Stage 1 kicks in when people become arrogant" ... insiders see "success virtually as an entitlement" ... like Wall Street banks today ... they "lose sight of the true underlying factors that created success in the first place" ... they "overestimate their own merit and capabilities ... The best leaders we've studied never presume they've reached ultimate understanding of all the factors that brought them success." If they do, "you just might find yourself surprised and unprepared when you wake up to discover your vulnerabilities too late."
Stage 2: Undisciplined pursuit of 'More'
The belief "we're so great, we can do anything" ... drives many to "more scale, more growth, more acclaim, more of whatever those in power see as success" and justifies mega-bonuses ... they make "leaps into areas where they cannot be great or growing faster than they can achieve with excellence ... investing heavily in new arenas where you cannot attain distinctive capability ... launching headlong into activities that do not fit with your economic or resource engine ... use the organization primarily as a vehicle to increase your own personal success -- more wealth, more fame, more power -- at the expense of its long-term success" ... and you'll "compromise your values or lose sight of your core purpose in pursuit of growth and expansion."
Sounds like Wall Street 2010, a community of addicts whose pledge of allegiance begins, "Greed is Good" ... amoral robots driven by a relentless commitment to the pseudo-capitalism of Reaganomics, blind to the impact on America's democracy.
Stage 3: Denial of risk and peril
Here Collins warns of our natural tendency to self-deception: "Internal warning signs begin to mount, yet external results remain strong enough to 'explain away' disturbing data or to suggest that the difficulties are 'temporary' or 'cyclic' or 'not that bad,' and 'nothing is fundamentally wrong.'... leaders discount negative data, amplify positive data, and put a positive spin on ambiguous data ... blame external factors for setbacks rather than accept responsibility" ... slogans and ideologies beat out "vigorous, fact-based dialogue that characterizes high-performance teams ... those in power begin to imperil the enterprise by taking outsize risks and acting in a way that denies the consequences" ... much as did Paulson, Wall Street's "too-stupid-to-fail' CEOs, Bernanke, Geithner and the Fed's toxic shadow banking system back in 2007-2008.
Stage 4: Grasping for salvation
The earlier "cumulative peril and/or risks" now "assert themselves, throwing the enterprise into a sharp decline visible to all. The critical question is: How does its leadership respond?" Many make things worse. Instead of "getting back to the disciplines that brought about greatness" they "grasp for salvation:" Quick fixes ... a charismatic visionary leader ... a bold but untested strategy ... a radical transformation ... dramatic cultural revolution ... hoped-for blockbuster product ... game-changing acquisition ... other silver-bullet solutions. Initial results ... may appear positive ... do not last."
Next, a critical turning point: When "we find ourselves on the cusp of falling, our survival instinct and our fear can prompt lurching -- reactive behavior absolutely contrary to survival -- when we need to take calm, deliberate action, we run the risk of doing the exact opposite and bringing about the very outcomes we most fear ... leaders atop companies in the late stages of decline need to get back to a calm, clear-headed, and focused approach. If you want to reverse decline, be rigorous about what not to do."
America was at this critical historical turning point moment in the fall of 2008. We were not calm. The economy and markets were collapsing. Our leaders lost their cool. Former Goldman Sachs CEO Hank Paulson, then Treasury secretary, panicked like a frightened grad school kid, racing to Congress with a three-page demand that taxpayers bail out his old buddies, the same out-of-control greedy idiots who created the problem. Congress also panicked.
In short, at that crucial historic moment in history, democracy failed us. Yes, democracy failed: Our elected representatives surrendered our great American democracy while also ending Adam Smith's moral-capitalism, turning both along with the keys to the U.S. Treasury over to Wall Street's new soulless pseudo-capitalism.
Stage 5: Capitalization to irrelevance ... or death
"The longer a company," bank or nation "remains in Stage 4, repeatedly grasping for silver bullets, the more likely it will spiral downward. In Stage 5, accumulated setbacks and expensive false starts erode financial strength and individual spirit to such an extent that leaders abandon all hope of building a great future. In some cases the company's leader just sells out; in other cases the institution atrophies into utter insignificance; and in the most extreme cases the enterprise simply dies outright."
How can we return to greatness? What do the turnarounds have in common? "Each took at least one tremendous fall at some point in its history and recovered ... but in every case, leaders emerged who broke the trajectory of decline and simply refused to give up on the idea of not only survival but ultimate triumph, despite the most extreme odds. The signature of the truly great versus the merely successful is not the absence of difficulty. It's the ability to come back from setbacks, even cataclysmic catastrophes, stronger than before ... great companies ...great social institutions ... great individuals can fall and recover. As long as you never get entirely knocked out of the game, there remains hope." The key? Great leaders. New Churchill: Obama? Romney? Palin? Who?
Collins shines the light on several corporate revival journeys, ending with the familiar story of Churchill going from a 1930s "quagmire from which there seemed to be no rescue" to "Prime Minister at age 77, knighted by the Queen ... Churchill's simple mantra: Never give in -- never, never, never, never. Does America have a Churchill in the wings, a leader who knows "the path out of darkness begins with those exasperatingly persistent individuals who are constitutionally incapable of capitulation."
Many thought it was Obama, but now question his "capitulation" to Wall Street, concluding that this final, total Wall Street takeover of Washington will ultimately kill America's "financial strength and individual spirit to such an extent that leaders" whether Obama, Romney or Palin will abandon "all hope of building a great future, and just sell out," as indeed Obama has ... because we now have the answer to Collin's core question, "How The Mighty Fall" ... we see it unfolding rapidly every day on cable ... game over.
Debt fears hit government bond markets
Greek bonds weakened sharply on Tuesday on concerns about the details of an international rescue package, while gilts fell as UK traders braced for a month of market volatility following the announcement of a date for the general election. Bonds across Europe were sharply lower as traders returned from the Easter break. The sell-off came on a combination of a delayed reaction to US data and ongoing worries about the ability of debt-laden governments to meet their obligations. Greek bonds bore the brunt of Tuesday’s sell-off following news of eurozone disputes over how much to charge Greece if it taps the standby facility agreed last month by the currency bloc and the International Monetary Fund. Yields on the five-year notes that Greece issued last month were 29.5 basis points higher at 6.401 per cent. Ten-year yields added 23 basis points to 6.772 per cent.
Stocks in Athens were also lower, down 0.9 per cent at 2,077.41. That defied the general upbeat mood elsewhere, which saw the FTSE Eurofirst 300 up 0.4 per cent at 1098.8 – an 18-month peak. Greece’s most recent sales of euro-denominated bonds have attracted lower levels of interest and the government is now aiming to issue in dollars, targeting emerging market investors who are attracted by higher yields. Yields on German two-year notes were 3 basis points higher at 0.984 per cent by late morning, having reached 1.04 per cent as trading began. The benchmark 10-year bund was also weaker, pushing its yield up 5.1 basis points to 3.040 per cent. Last Friday, when European markets were closed, strong US payrolls data led US Treasury yields to jump sharply, pushing the benchmark 10-year yield above 4 per cent for the first time since October 2008.
However, it was UK gilts that led the sell-off among the bigger European countries as confirmation that the general election would be held on May 6 date served to remind investors of the uncertainty over the election result. “Markets’ worst fears are for a hung parliament and given the close race we can expect some volatility in gilts over the coming month,” said Gary Jenkins, head of fixed income research at Evolution Securities. Two-year yields were 5.4 basis points higher at 1.213 per cent while 10-year notes added 6 basis points to 3.983 per cent, off a high of 4.01 per cent. Traders said the the UK market was also positioning for Wednesday’s sale of five-year gilts. Typically, investors sell bonds ahead of auctions to improve the yield on the new paper. A series of sales of Treasuries this week were also weighing on the market following weaker demand for new paper last month. This week it will sell $72bn in a series of sales.
Where Are Rates Headed And Why?
by Barry Habib
So the Fed stopped buying Mortgage Backed Securities, and people are wondering if this will affect mortgage rates. There's been plenty of whistling past the graveyard, guesswork and denial, where so-called experts have been trying to tell us that there will be minimal - if any - change to rates. That pipe dream is just nonsense.
Let's look at what we can expect for mortgage rates and the overall Bond market in the months ahead. During the past fifteen months, the Fed purchased $1.25 Trillion in MBS, which represented 80% of the mortgage market. Prior to this program, mortgage rates were above 6%. Now that the Fed program has ended, it's reasonable to assume that mortgage rates will rise back towards those levels.
Just How Much Money is $1.25 Trillion?
In today's financial headlines - the word Trillion is often casually thrown around. So much so, that it's easy to lose perspective on how much money this really represents. Picture a stack of $100 bills. It might surprise you to know that it only takes a stack four inches high to be worth $100,000. So $1,000,000 would be a stack of $100 bills 40 inches tall. How about a Billion? Well, you would have to stack $100 bills up to the top of the Empire State Building...twice...in order to reach a Billion. So to picture $1.25 Trillion represented by a stack of $100 bills - that stack would be 850 miles high. If you could turn that stack on its side and were able to drive alongside it, it would take you longer than 14 hours to reach the end. If you laid those $100 bills down side by side, they would travel around the world 50 times. We're talking about a lot of money here.
The Fed's purchasing influence has been significant. And now in the absence of this safety net, Bond prices and mortgage rates will experience greater volatility and a gradual worsening. Adding to this is the fact that the Fed will, albeit gradually, begin to sell some of their mortgage holdings, as they reverse their quantitative easing measures. It doesn't take a rocket scientist to see that this will pressure Bond prices...but read on, because there are additional factors at play, which will influence Bond prices lower and mortgage rates higher.
What Moves Mortgage Rates?
Mortgage Rates are not pegged to the 10-year Treasury Note, as some have reported in the media. Those in the know do understand that mortgage rates are based on the pricing of Mortgage Backed Securities (MBS)...and these Mortgage Bonds are influenced by many different factors.
They respond quite well to technical signals as well as Stock market volatility, as money can be drawn from or parked into Mortgage Bonds. Certainly, the news and inflation implications also play a heavy role in influencing Mortgage Backed Securities.
And just like the aforementioned influential factors, Treasuries can also play a role in the price direction of Mortgage Bonds. Last year, the 10-year Treasury Note was at approximately 2.2% and has since moved towards 4%. During this time, mortgage rates have been virtually unchanged. But now, Treasuries are offering yields that are close to the current Mortgage Backed Security rates, which are offered to investors.
Let's take a moment to understand the difference between the mortgage rate a borrower pays and the coupon yield on a Mortgage Backed Security that an investor receives. If a borrower pays 5.25% on their loan, only 4.5% of that is passed on as a coupon yield to the investor. This is because the mortgage loan servicer (that's who you make your payment to) takes a piece of the action. Additionally - the aggregators of these loans, like Fannie Mae and Freddie Mac take a piece as well. And let's not forget the folks on Wall Street, who need to get paid for underwriting, securitizing and selling this paper.
We know that Treasuries are backed by the full faith and credit of the US Government and are free from state income tax. And the 10-Year Treasury Note, while clearly not pegged to Mortgage Backed Securities, does offer investors a competitive alternative with a similar maturity period to Mortgage Backed Securities. But because of greater safety and tax advantages, the 10-Year Note will always trade at a lower yield than Mortgage Backed Securities, and therefore put a floor beneath how low Mortgage Backed Security coupon yields and corresponding home loan rates for borrowers can go.
The US is spending at an unprecedented rate - and its spending money it doesn't have. This means that more and more Treasuries will continuously need to be auctioned off. And in order to entice buyers to keep absorbing this supply, yields will very likely need to continue higher, just as they have for over the past year.
Additionally - sovereign debt has come into question. Downgrades in the sovereign debt of both Greece and Portugal are a warning to the US that the same can happen here, which would drive the cost of borrowing much higher. Our government currently spends $1.49 for each $1.00 it brings in. Our debt is now 57% of GDP...and rising. Does anyone really believe that Treasury yields are headed lower? As Treasury yields move higher from their current levels, mortgage backed security coupon yields will also need to move higher in order for investors to want to purchase them.
The Ever-Important Carry Trade
While the Fed's end of the MBS purchase program and eventual selling of MBS - along with an almost certain move higher in Treasury yields - all tell us that mortgage rates are headed higher, there is another important element that could have an even greater influence in moving yields higher and prices lower throughout the Bond market. It's called an unwinding of the "carry trade." The low interest rate environment in the US has provided fertile ground for the carry trade, where large investors can borrow at very low rates, and leverage into higher yields, resulting in huge returns.
Let's take an example: An investor wishes to purchase $1M in Mortgage Bonds yielding 4.5%. This would provide $45,000 as an annual return. In order to make the purchase, the investor puts up only 10% of $1M, or $100,000 in cash - and borrows the other $900,000 at the Fed Funds Rate + 2%, for example - which would be a borrowing cost of 2.25% or $20,250. This investor receives a $45,000 return, but subtracts a $20,250 cost to borrow $900,000 - leaving them with a net return of $24,750. Remember, the investor needed only to invest 10% of the $1M purchase - or $100,000 in cash. This gives the investor a whopping 24.75% return on their investment in a boring little old Mortgage Bond. And of course, this "carry trade" can be used in other securities as well.
While the investor understands that there are always market risks at play - the juicy 24.75% yield cushion gives them much added comfort to stay in the trade. But the biggest risk for the investor is if their borrowing costs - which are based on the Fed Funds Rate - were to rise.
When the Fed starts to hike rates, it will signal the beginning of a tightening cycle. A few Fed hikes can cause the yield cushion to quickly evaporate...and the decline in Bond values from overall higher yields could turn the trade from highly profitable to highly costly in a very short period of time. So why do these carry trade investors have such a care free attitude and confident air? It's because Ben Bernanke and the Fed have assured them that there is nothing to fear. How did the Fed do that?
Via "Fed Speak," these carry trade investors hear that "conditions warrant exceptionally low rates for an extended period of time." Translation: your biggest fear - that a hike in the Fed Funds Rate, which increases your borrowing costs and wipes out your gains - won't happen anytime soon. It's this "extended period" verbiage that is keeping the carry trade in place. When the Fed removes the "extended period" language, this will signal that hikes will begin in the near future, and that risk will prompt investors to begin to "unwind" their carry trade holdings. This will include the selling of Mortgage Backed Securities, which will assuredly push yields higher still.
When will the Fed remove the "extended period" language? It may happen sooner than you think. Kansas City Fed President Thomas Hoenig has officially dissented to the "extended period" language at the last two Fed meetings. And recently, St. Louis Fed President James Bullard, while yet to officially dissent, has stated that he feels "extended period" is inappropriate language and should be replaced by "data dependent." And there have been grumblings from other Fed members, who are growing more concerned that leaving rates too low for too long can spawn asset bubbles or inflation down the road.
What It All Comes Down To
When all the factors are considered - the chances of higher interest rates are a virtual lock. And anyone in the market to borrow should consider acting sooner rather than later. With such low rates still in our hands...and all these various factors pointing at the inevitable fact of rates moving higher...you have to wonder what people sitting on the sidelines are waiting for?
It brings to mind the closing scene of the movie "Dumb and Dumber," where two good-hearted but incredibly stupid heroes Lloyd and Harry are hitch-hiking, when along pulls up a bus full of beautiful Hawaiian Tropic models in bikinis. The models tell Lloyd and Harry that they are looking for two "oil boys" to lube them up before each of their photo shoots on the tour. Lloyd and Harry explain that there is a town down the road, where they should be able to find two lucky guys to help them out. As the bus pulls away, Lloyd and Harry look at each other and declare that one day their opportunity will come - they just have to keep their eyes open.
Here's hoping you have your eyes wide open to take advantage of this fleeting opportunity...before it's gone.
'Something's Got To Give': Massive Pension Fund Shortfalls Threaten To Bankrupt States
by Dan Froomkin
State governments have already been slammed by the recession, but there's an even more massive financial threat looming in the form of immense projected shortfalls in public-employee pension funds -- in some cases so big there is literally no way the states can make them up anytime soon, even if they tried. Chronic underinvestment (particularly in the bubble years), poor management of assets before and during the financial crisis, and, in some cases, unfunded benefit increases have put many pension funds wildly out of balance.
But state taxpayers are contractually obligated to make good on the retiree benefits-- even as those promises threaten to crash headfirst into obligations to pay for schools, public safety, health care and the like.
"Something has got to give," says Joe Nation, the director of a Stanford University graduate program that is reporting today that the cumulative shortfall from California's three giant pension funds alone is somewhere around $500 billion. Not only is that considerably more than the state is currently projecting, but it's almost six times the state's entire general fund budget. In other words, it would take California six years -- with no spending on education, public safety, health care or anything else -- to fill the gap.
"What is so alarming is there is no way that the state will be able to meet these obligations," Nation tells HuffPost. "The odds are so heavily stacked against the state on this one. The question is how we dig out of this."
It's a profoundly grim situation across the nation, for everyone involved -- with the usual exception. A new analysis by the New York Times concludes that the nation's 10 largest public pension funds have paid private equity firms more than $17 billion in fees since 2000, without reaping the rewards they were promised. So that's where some of the money has gone.
Indeed, pension fund administrators, far from investing with great caution as would seem to befit their calling, have instead contributed greatly to the explosive growth of private equity firms -- the folks who the Times dubs the "kings of corporate buyouts." And now that times are tough, the pension funds are actually doubling down.
A report titled "The Trillion Dollar Gap" from the Pew Center on the States last month called renewed attention to the pension shortfalls. The title reflects the gap "at the end of fiscal year 2008 between the $2.35 trillion states had set aside to pay for employees' retirement benefits and the $3.35 trillion price tag of those promises."
But as NPR and others noted, that $1 trillion figure is unrealistically low.
Experts like Joshua Rauh, an associate professor of finance at the Kellogg School of Management at Northwestern University, say pension funds are using exaggerated assumptions about investment returns. "Our calculation is that it's more like $3 trillion underfunded," Rauh told NPR.
The Stanford report, for instance, reflects expected investment returns around 4 percent, rather than the current projections of 7.5 to 8 percent. (It also reflects the three California funds' $110 billion -- or 24 percent -- loss in portfolio value between mid-2008 and mid-2009. But if the portfolios have continued to more or less mirror the performance of the Dow, they have likely gained back much of that loss by now.) The Wall Street Journal reports that the General Accounting Standards Board, the accounting board for governments, is likely to force states to publicly adjust their calculations to reflect more realistic expected returns.
"If the modifications are approved, many already cash-strapped states and municipalities would likely have to increase the amount they are supposed to pay annually to their pension funds to help cover the shortfall," the Journal noted.
How have the states gotten into this mess? As the Pew report puts it, the predicament "reflects states' own policy choices and lack of discipline." Political pressure, in particular, often leads elected officials to cut payments to the fund during boom years, since they're doing so well. Then during a recession, when the funds' needs become more apparent, there's no political will to further worsen the budget picture by increasing payments.
And it's not just states, either. The Civic Federation, a Chicago-based group that keeps tabs on state and local government finances, recently determined that the shortfall for ten major Chicago-area public pension funds reached $18.5 billion in fiscal year 2008, or about $5,821 for every Chicago resident.
So what are states doing about it now? It's all over the map. Illinois just rushed through a massive pension reform bill, which dramatically cuts pensions for future employees (though it doesn't do much about the existing shortfalls); Connecticut State Comptroller Nancy Wyman is simply delaying $100 million in payments to the state pension fund to help make ends meet; Merrill Lynch said last week that New Jersey's pension fund (and other) shortfalls are so serious, its bond ratings should be lowered.
A major factor underlying these shortfalls is that state (and some local) governments are virtually the last refuge of the defined-benefit pension. Workers in private industry and the federal government generally get defined-contribution pensions, like 401(K)s, where money is put into a private account -- and whether its value goes up or down is the worker's problem. By contrast, defined-benefit pensions promise retired state employees a specific amount -- averaging somewhere around $20,000 for current retirees -- regardless of how well or poorly the economy and the market are doing.
And it is not fair to blame the employees, said Jon Shure of the Center on Budget and Policy Priorities. In fact, quite the opposite. "We have to fight to get economic security back for private sector workers, rather than have the debate be how can we take it away from the few people who have it in the public sector," he said. Worries about the shortfalls can be exaggerated, he said. "It's a big number, but it's not due right now," he said. Policymakers, meanwhile, should not "succumb to people who are using this as an excuse to promote less of a role for government in their workers' economic security."
So what should states be doing? "The alternative is not a very sexy alternative," Shure said. "It's to stop pretending you can meet all your obligations and cut taxes at the same time."
Dan Froomkin is senior Washington correspondent for the Huffington Post.
Pension Funds Still Waiting for Big Payoff From Private Equity
by Jenny Anderson
Private equity deal-makers, those kings of corporate buyouts, made billions for themselves when times were good. But some of their biggest investors, public pension funds, are still waiting for the hefty rewards they were promised. The nation’s 10 largest public pension funds have paid private equity firms more than $17 billion in fees since 2000, according to a new analysis conducted for The New York Times, as the funds flocked to these so-called alternative investments in hopes of reaping market-beating returns.
But few big public funds ended up collecting the 20 to 30 percent returns that private equity managers often held out to attract pension money, a review of the funds’ performance shows. Many public pension funds are struggling to recover from a collapse in the value of their portfolios, despite large private equity investments that were supposed to help cushion their losses. Fees are at the center of the debate over the divergent fortunes of private equity managers and their investors, because fees often make a big dent in any investment gains. That "raises the question as to why they accept to pay this level of fees," said Oliver Gottschalg, a professor at the HEC School of Management in Paris who conducted the study on private equity fees.
State and local pension assets declined by 27.6 percent from the end of 2007 to the end of 2008, wiping out $900 billion, according to the Government Accountability Office. Those poor returns have rankled some longtime private equity investors like the California Public Employees’ Retirement System, or Calpers. In September 2009, it "strongly endorsed" principles proposed by the Institutional Limited Partners Association, which represents private equity investors, to keep management fees in check and improve disclosure about fund performance. The funds vary in how they report their performance and calculate their returns, allowing a significant number to classify themselves as "top quartile," or the best performers.
"The fees paid to private equity managers has been a source of great frustration," Joseph A. Dear, the chief investment officer for Calpers, said in an interview, adding that the managers "shouldn’t be making a profit on the management fee. They should make money when their investors make money." Still, despite the high fees, he said the funds’ performance had been good. "We don’t expect 20 percent," he said. "We expect 3 percent more than public markets, net of fees." Private equity executives generally say their fees are justified by their market-beating returns.
Public funds pay a lot of money to managers of so-called alternative investments like private equity, venture capital, real estate and hedge funds. In 2009, the Pennsylvania Public School Employees’ Retirement System paid $477.5 million in fees — 20 percent more than it did in 2008 and 283 percent more than in 2000, the earliest year for which data was available. These funds generally charge fees totaling 2 percent of the money they manage and then take 20 percent of the profits they generate. And yet, even after paying hundreds of millions of dollars in fees, the Pennsylvania fund is ailing. It lost more than a quarter of its value during its latest fiscal year and is now worth less than it was a decade ago, although its performance has improved recently.
Private equity owes its explosive growth largely to America’s pension funds. Buyout funds raised $200 million in 1980 and $200 billion in 2007. According to Prequin, a financial data provider, public pension funds were the biggest contributors over that period and now have $115.9 billion invested in private equity. But these investments have not worked out as well as many had hoped. According to data from the Wilshire Trust Universe Comparison Service, the median returns for public pension funds with assets greater than $5 billion were negative 18.8 percent over one year, negative 2.8 percent over three years, and 2.4 percent over five years. Indeed, research conducted by several university professors challenge the private equity firms’ premise that returns beat the stock market over long periods of time.
Two professors, Steven Kaplan of the University of Chicago and Per Strömberg of the Stockholm School of Economics, contend that, after fees, many private equity investments just about match or even trail the returns of the broad stock market between 1980 and 2001. Additional research by Ludovic Phalippou of the University of Amsterdam and Mr. Gottschalg of the HEC School of Management shows that private equity funds underperformed the Standard & Poor’s 500-stock index by 3 percent annually from 1980 to 2003, after accounting for fees.
To be sure, private equity returns have beaten abysmal stock market returns over the last decade, helping to provide a cushion at some funds. For Pennsylvania’s public school workers, the 10-year return for private equity was 9.5 percent, even after deducting for fees, compared to 3.6 percent for all assets, including stocks and bonds. The largest pension fund investors put a significant chunk of their money in private equity during the bubble years, from 2005 to 2008, according to a separate analysis by Mr. Gottschalg. Of the top 10 pension funds, eight invested more than 45 percent of their total capital in private equity during that period.
Mr. Kaplan said that the funds started during the boom years, so-called vintage funds, were likely to disappoint investors. "The deals of 2006 and 2007 will not perform very well," Mr. Kaplan said, referring to mergers and acquisitions led by private equity firms that have not yet been cashed out through a sale. Some big funds are doubling down on private equity anyway. In November 2007, the Washington State Investment Board, whose $75 billion fund is among the most heavily invested in private equity, increased its commitment to that asset class to 25 percent, from 15 percent, and its real estate allocation to 13 percent, from 12 percent.
Others, however, are retrenching. As of last September, the Pennsylvania State Employees’ Retirement System, a $24.3 billion fund that is distinct from the school workers’ fund, had 23 percent of its pension investments in hedge funds, another 23 percent in private equity and venture capital, and an additional 8.4 percent in real estate — bringing its total in alternative investments to more than 54 percent. A spokesman for the fund, Robert Gentzel, said it was working to scale back those allocations to 12 percent for private equity and venture capital and 9 percent for hedge funds.
California's $500-billion pension time bomb
by David Crane
The staggering amount of unfunded debt stands to crowd out funding for many popular programs. Reform will take something sadly lacking in the Legislature: political courage. The state of California's real unfunded pension debt clocks in at more than $500 billion, nearly eight times greater than officially reported.
That's the finding from a study released Monday by Stanford University's public policy program, confirming a recent report with similar, stunning findings from Northwestern University and the University of Chicago. To put that number in perspective, it's almost seven times greater than all the outstanding voter-approved state general obligation bonds in California.
Why should Californians care? Because this year's unfunded pension liability is next year's budget cut to important programs. For a glimpse of California's budgetary future, look no further than the $5.5 billion diverted this year from higher education, transit, parks and other programs in order to pay just a tiny bit toward current unfunded pension and healthcare promises. That figure is set to triple within 10 years and -- absent reform -- to continue to grow, crowding out funding for many programs vital to the overwhelming majority of Californians.
How did we get here? The answer is simple: For decades -- and without voter consent -- state leaders have been issuing billions of dollars of debt in the form of unfunded pension and healthcare promises, then gaming accounting rules in order to understate the size of those promises. As we saw during the recent financial crisis, hiding debt is not a new phenomenon. Indeed, General Motors did something similar to obscure the true cost of its retirement promises. Through aggressive accounting, for a while it, too, got away with making pension contributions that were a fraction of what it really needed to make, thereby reporting better earnings than was truly the case.
But eventually the pension promises come due, and for GM, that meant having to add extra costs to its cars, making its prices less attractive to consumers and contributing to its eventual bankruptcy. In California's case, past pension underfunding means reduced funding of current programs. This explains why pension costs rose 2,000% from 1999 to 2009, while state funding for higher education declined over the same period.
What can we do about this? For the promises already made, nothing. They are contractual, and because that $500 billion of debt must be paid, retirement costs will rise dramatically no matter what we do. But we can reduce the sizes of promises made to new employees and require full and truthful disclosure so that pension debt can never again be hidden.
Last summer Gov. Arnold Schwarzenegger proposed exactly that. Since then? Silence. State legislators are afraid even to utter the words "pension reform" for fear of alienating what has become -- since passage of the Dills Act in 1978, which endowed state public employees with collective bargaining rights on top of their civil service protections -- the single most politically influential constituency in our state: government employees.
Because legislators are unwilling to raise issues that might offend that constituency, they have effectively turned the peroration of Abraham Lincoln's Gettysburg Address on its head: Instead of a government of the people, by the people and for the people, we have become a government of its employees, by its employees and for its employees. This explains why legislators fight harder to overturn employee furloughs than to reform pensions and elect to pay more in compensation to just 65,000 employees in one single department -- corrections -- than they spend on a higher education system serving 10 times as many people.
Simply put, the single most important step a legislator can take to protect programs and taxpayers is to embrace pension reform. There is no structural impediment to pension reform, and no initiative has forced legislators to issue all that pension debt. All of the damage has been caused by legislation, most notoriously SB 400 in 1999, which retroactively and prospectively boosted pension promises by billions of dollars without boosting contributions. Likewise, all the remediation can be accomplished by legislation.
Even the state legislature of Illinois -- a legendary poster state for pension misbehavior -- has now passed pension reform. There's no reason the California Legislature cannot do the same. Call or write your legislator about pension reform, and while you're at it, remind him or her that we are indeed a government of the people, by the people and for the people.
Pennsylvania Schools Face Mounting Pension Crisis
by Chauncey Ross
A surge in Pennsylvania schools' required contributions to the employee retirement system looms in two years. It's an increase that's likely to stress the budgets of school districts across the state, forcing school boards to raise taxes or forgo other expenses to make the mandated payments. Schools now paying the equivalent of 4.78 percent of the employee payroll will see the rates rise to 8.22 percent starting in July, then to 10.59 percent in July 2011 before the leap to 29.22 percent in 2012.
State lawmakers next week will open debate on the first of several bills with proposed fixes for the retirement system. Each bill is different in how quickly or effectively it could make the schools' burden more manageable. While many call the rate increase a spike, others consider it a plateau. A 176 percent increase in 2012-13 is a steep change, but it's followed by several years of rates in the upper 20-percent and lower 30-percent range, rather than a corresponding steep decrease. The reasons that the school districts' payments have to jump so high seem to be clear. The simplest, perhaps an oversimplified explanation, is the failure of the stock market and the need to make up for investment earnings that didn't materialize.
The Public School Employees' Retirement System, called PSERS, is a defined-benefit pension plan that's been in place for almost 93 years. A defined benefit means the members of the plan - school teachers, administrators and support workers - are guaranteed a certain monthly payment when they retire from work. Several factors figure into how the benefits are paid. Some are within each worker's control, such as the number of years they work, their age at retirement and whether they've withdrawn any of their own contributions to the system. Other factors are within legislative control - for example, the formula used to calculate the base payment.
The money comes from three main sources. The employees contribute a fixed share from their paychecks. Most teachers and school workers are paying 7.5 percent of their gross income. The employers - a combination of local school district money and a state subsidy - pay a share that changes each year, as controlled by the PSERS board. The share depends on the third source: earnings from investments. That's the major factor that seems to be beyond anyone's control - the performance of the stocks in which the fund is invested. Instead of returning healthy earnings as it did in bull market years - 19.7 percent in 2003-04 and up to 22.9 percent in 2006-07 - the fund lost 26.5 percent of its value in 2008-09.
It's also the main reason blamed for putting school districts in the position of having to boost their combined support from $616 million this school year to $4.2 billion in 2012-13. Schools have to pay more than $5 billion a year from 2014-15 through 2025-26, according to current projections. A local investment counselor said even if the stock market would immediately recover, the burden on school districts would be to cover more than just the earnings lost in one bad year.
"For example, if your investment earns 15 percent compounded three years, then loses 15 percent in the fourth year, your average rate of return drops to about 6 percent," said Larry Catlos, a financial adviser for Eagle Strategies LLC in Indiana. "Then what do you need in year five to get back to the 15 percent rate of return? It's about 42 percent. "Even more simply, if my $1 investment is down to 50 cents, I have to earn 50 cents to get back to a dollar. That's a 100 percent return in one year. And that's just to break even."
While the PSERS investment lost 26.5 percent of its value last year, the fund needs to regain that 26.5 percent plus the amount of positive earnings needed to keep the fund balanced. And this year PSERS needs to make up additional earnings that will be lost because the principal didn't grow last year. It's a function that could be called negative compounding, as opposed to the basic compounding of interest - an amount that grows each year - on a simple interest-bearing savings account. Because of the variety of factors affecting revenue and payments by PSERS, state Rep. David Reed, R-Indiana, said, there's no consensus among lawmakers on a legislative solution - if there is to be one.
"The big thing to remember is that the problem didn't happen overnight," Reed said. "It's really an accumulation of decisions that have occurred over 20 to 30 years. ... You can blame past and present governors, past and present legislators, past and present school board members, past and present teacher union negotiators. You can blame a lot of folks because everybody shares a part of the blame. "The biggest thing that has occurred lately that has amplified the situation is the stock market going from 14,000 to 6,500 and the pension plan losing $30 billion in a year. That's really what has brought everything to a head. "Regardless of who you blame, blaming people is not going to get a solution," Reed said. "All those groups are going to have to work together to get a solution that makes it workable in the future."
Joe Pittman, the chief of staff for state Sen. Don White, R-Indiana, said he became familiar with PSERS in the late 1990s when he served on the Purchase Line school board. "When the markets were doing well, the pension obligations for the school districts and the state were reduced," Pittman said. "Because the markets were doing so well, the pension fund was overfunded." In that decade, the district contributions fell from 19.7 percent in 1990 to 10.6 percent in 1997. Then the rates dropped off to as low as 6 percent. Pittman said it stood to reason that the rates would rise again, but schools were unable to make larger contributions to protect against future increases.
"It's a set percentage," he said. "The retirement fund says `here's your percentage contribution for the year, period.' School districts could have tried to set aside money on their own in anticipation of this potentially happening, but I don't know if that's a reasonable expectation." A school district with financial breathing room could have considered saving money to cover another jump in the contribution rate, but the schools really weren't given the chance, he said.
"When that occurred, under the Ridge administration, ... it was sold as additional subsidy," Pittman said. "The Ridge administration and Legislature said to school districts, `we're not giving you much additional subsidy, but we're cutting your pension contribution, which essentially is giving you more money.' So the school districts then naturally started incorporating those savings as part of their budgets. There was never any discussion about putting it into a `rainy day fund.' "And it wasn't necessarily like the rates were reduced with a heavy word of caution that some day they are going to go back up. It's only natural to assume they're going to go back up. But it was never sold that way."
The General Assembly passed three bills over the past decade that shaped the PSERS fund. Two were in response to the general economic climate. They served to delay an increase in the school districts' contribution rates in the wake of the recession that followed the Sept. 11, 2001, terrorist attacks. That was the year the employer contribution was its lowest, at 1.09 percent. The next year, according to PSERS, the contribution should have risen to 5.64 percent.
Act 38 of 2002 held the 2002-03 contribution to 1.15 percent and stretched the "smoothing methodology" for recognizing gains and losses from investments. Instead of spreading abnormal changes in earnings over three years, it spread them over five years. Act 38 also spread the amortization of the gains or losses to 10 years - again, a way to control the school district contributions. It worked by reducing the 2003-04 rate from 9.36 percent to 3.77 percent
When the recession continued into 2003 and further hurt cash flow for school districts, lawmakers passed Act 40 of 2003. The measure changed the amortization period for gains and losses to 30 years but raised the minimum employer contribution from 1 percent to 4 percent. In effect, it mismatched the amortization period and created an offset that expires with the 2012-13 school year. "What Act 40 has been doing is suppressing the rate," said Evelyn Tatkovski, a spokeswoman at PSERS. "Basically, once that suppression wears off in 2012, you will have the payback." At the time, the 2012-13 rate was expected to be 27.73 percent, but the resurgent stock market allowed PSERS to reduce that projection to 11.23 percent, Tatkovski said.
When the recession began in 2008, the spike had to be recalculated and is now set at 29.22 percent. The third and earliest piece of legislation dealt with the retirees' benefits calculation. Act 9 of 2001 changed one of the multipliers in the benefit formula. Put most simply, a retiring worker's pension is based on the average of his three highest annual salaries, multiplied by the number of years of service, multiplied by 2.5 percent. The product is the "maximum single life annuity," which is divided by 12 to arrive at the monthly pension check. But before Act 9, the multiplier was 2 percent.
"That doesn't seem like a major increase," Catlos said. "But that's a 25 percent increase in one of the factors in the formula. So we've had the perfect storm of that increase coupled with a bad 10 years in the stock market." There seem to be as many theories on solving the impending rate increase as there are reasons the hike became necessary. PSERS Director Jeff Clay has been making the rounds of legislative committees and education groups to explain the scenarios that could ease the burden that the schools face. Summaries of his presentations are available on the PSERS Web site, www.psers.state.pa.us.
"You'll see how the presentation shows options to resolve the rate spike," Tatkovski said. "We don't recommend or promote any of the solutions, but put them out there and explain what can be done." The choice, he said, "would be a legislative policy decision about how they want to address the funding of the system." So far, virtually identical bills have been introduced in the state House and Senate. Each proposes changes in the benefit calculation formula, creates a new formula for future school employees and sets up a defined-contribution retirement plan under which employer and employee contributions go unchanged over the years - a so-called hybrid plan. The amount paid out in retirement benefits to future employees would change, based on performance of the investments.
A bill sponsored by Sen. Gene Yaw, R-Williamsport, has been under review by the Senate Finance Committee since Feb. 3. The companion measure, sponsored in the House by Rep. Glen Grell, a Republican who represents part of Cumberland County, was sent to the House Finance Committee on Jan. 6. Rep. David Levdansky, D-Elizabeth, the chairman of the committee, has scheduled a series of public hearings on the pension issue to begin Tuesday.The first hearings will focus on the status of both the school employees' program and the State Employees' Retirement System (SERS), which faces the same imbalance as the school plan.
According to a state House Democratic Caucus worker, subsequent hearings will consider Grell's House Bill 2135 and other proposed solutions. Groups with interests in the system, such as the Pennsylvania School Boards Association, the Pennsylvania State Education Association and other employee unions, would be scheduled to testify before the committee. The Senate Finance Committee held a hearing March 17 on the pension problems, taking comment from Ron Snell of the National Conference of State Legislatures on the status of public pension plans across the nation. Stephen Herzenberg of the Keystone Research Center, Pat Halpin-Murphy and John Abraham, both of the American Federation of Teachers-Pennsylvania, and Gerry Madrid-David, of the National Public Pension Coalition, also testified at the hearing. The committee chairman, Sen. Patrick Browne, R-Allentown, has posted hearing-related documents on his Web site, www.senatorbrowne.com. The Senate now is in recess until April 12.
Gov. Ed Rendell also is advancing a pension fund proposal as part of his 2010-11 budget package. His two-part plan calls for a "fresh start" approach to amortization of the pension system liabilities over 30 years, and an incremental phase-in of the school districts' contribution rates rather than a sudden, steep increase. An increase of 1 percent would take effect in 2010-11, then rates would rise to 3 percent each year for the next 10 to 11 years. "It takes longer to get to where you need to be," said spokesman Gary Tuma at the governor's office. "But you do get there and you avoid this jolt to the taxpayers. They're still going to have to pay more, but would avoid the huge spike."
If the stock market rebounds and investments bring strong earnings in the meantime, fewer steps would be needed to reach the needed contribution level, according to Rendell's budget outline. A spokesman at Browne's office said Rendell's draft proposal was submitted last week to legislative leaders, but it hasn't yet been sponsored or introduced as a bill. The proposals follow the possibilities Clay outlines in his presentations. "Fundamentally, there are only three ways to address the Pension Fund," according to Clay. The choices are to "increase the funding of the system, decrease or cut the costs and liabilities of the system or to defer the liabilities of the system."
Tatkovski said any changes to the retirement fund would have to be thought of in two ways. "The short-term issue is the rate spike in 2012-13, because even if you would change the system going forward, you would not have an impact on the rate spike,' Tatkovski said. "The liability is already there, the debt is already there and has to be paid - how are you going to pay that and what is a reasonable way to pay that debt back?
"The other issue is more of long-term policy - what is an appropriate retirement?" she said. "That's not just an issue for PSERS. You must look at it on a national scale, and you have to look at the private sector. What is retirement going to look like going forward for everybody? "You have some people that don't have any retirement, and people that have only a 401(k) plan. Is that the most effective retirement? That's a whole huge other policy issue that needs to be discussed."
GM and Chrysler Pensions Underfunded by $17 Billion
by Nick Bunkley
The pension plans at General Motors and Chrysler are underfunded by a total of $17 billion and could fail if the automakers do not return to profitability, according to a government report released Tuesday. Both companies need to make large payments into the plans within the next five years — $12.3 billion by G.M. and $2.6 billion by Chrysler — to reach minimum funding levels, according to the report, prepared by the Government Accountability Office. Whether the companies will be able to make the payments is uncertain, the report concluded, though Treasury officials expect the automakers will become profitable enough to do so.
If either company’s plan must be terminated, the government would become liable for paying benefits to hundreds of thousands of retirees. The effect on the government’s pension insurer, the Pension Benefit Guaranty Corporation, would be “unprecedented,” the report said. The agency manages plans with assets totaling $68.7 billion, less than the $84.5 billion in G.M.’s plan alone. The carmakers’ pension plans were jolted by the downturn, increased liabilities and other factors. G.M.’s plan was overfunded by $18.8 billion in 2008, and was then underfunded by $13.6 billion last year, the report said. Chrysler’s plan was overfunded by $2.9 billion in 2008 but underfunded by $3.4 billion last year. The plans cover about 650,000 people at G.M. and 250,000 at Chrysler.
The Treasury Department owns 61 percent of G.M. and 10 percent of Chrysler as a result of the emergency loans the carmakers received last year. The government spent $81 billion bailing out the companies and others in the auto industry. The report issued Tuesday said Treasury officials were confident that G.M. and Chrysler would earn enough to allow the government to gradually sell its stakes. But the report warned that the government could push the companies out of business, consequently terminating their pension plans, if their recovery efforts failed.
“In the event that the companies do not return to profitability in a reasonable time frame, Treasury officials said that they will consider all commercial options for disposing of Treasury’s equity, including forcing the companies into liquidation,” the report said. In addition, the report said the government’s interests as a shareholder of G.M. and Chrysler could clash with those of pension participants and beneficiaries. “For example, Treasury could decide to sell its equity stake at a time when it would maximize its return on investment, but when the companies’ pension plans were still at risk,” the report said.
President Obama has said he wants to sell the government’s stakes in the two companies as soon as is practicable. G.M. executives have said that a public stock offering could happen this year but that the company would need to be profitable and meet other criteria first. G.M. is scheduled to release its financial results for 2009 on Wednesday. Chrysler plans to provide an update on April 21.
Britain’s $1,5 Trillion Pensions Timebomb
by Padraic Flanagan
Taxpayers are facing a £1trillion "black hole" in funding to cover the generous pensions of Britain’s army of public sector workers, business chiefs warn today. A damning report by the Confederation of British Industry calls on ministers to tackle the huge bill to look after millions of state employees in old age, which works out at a staggering £40,400 for every household in the UK. It also claims that civil servants, teachers and NHS staff are being allowed to retire on unaffordable gold-plated schemes based on their final salaries, far more generous than those in the private sector.
Campaigners say private workers pay more towards public sector pensions than their own, through taxes. They also pay higher rates of National Insurance and retire later. Industry bosses want the timebomb of taxpayer-funded pensions to be a key issue in the General Election. CBI deputy-general John Cridland said: "The pensions black hole is over £1trillion and rising, and taxpayers cannot be left to make up the difference." Matthew Elliott, chief executive of the TaxPayers’ Alliance, called for urgent action. He said: "The generous terms of most of these schemes are unsustainable and are placing a stranglehold on public finances. They must be reformed, as ordinary taxpayers face the prospect of picking up the bill.
"Most private pension funds have moved away from final salary schemes but those in the public sector seem to think there is an endless pot of money." Researchers for the CBI found there was an annual unfunded public sector shortfall of £10billion, partly because staff contributions were "out of kilter" with unpredictable payout levels. Public sector pension benefits are on average worth 26 per cent of salary every year, far higher than private sector levels, and the costs are spiralling as people live longer.
To compound the problem, the state workforce has grown by almost a million over the past decade to hit 6.1 million, or one in five workers. The depth of the funding crisis was underlined by a separate study revealing that local authority deficits have soared to almost £60billion. The CBI wants an independent body set up to calculate the true cost of unfunded public sector pensions and work out how the rising bill can be met. Mr Cridland said: "Public sector workers deserve a good retirement but they and their employers should pay their own way.
"Guaranteed final salary pensions have entered the history books in the private sector but the state has not squared up to the issue for its own workers. A new government needs to acknowledge the problem, establish the true costs and let the taxpaying public decide what they are prepared to pay for." The CBI report, which is published today, suggests all public sector staff be moved off defined benefit schemes, which include final salary and career average pensions. Just 15 per cent of private sector workers now have final salary pensions, while 78 per cent of public sector staff are signed up to a defined benefit scheme.
Public sector pensions currently cost the taxpayer £14.93billion a year, a rise of 38 per cent in a decade. But more than five million people, including civil servants, teachers, NHS staff and members of the Armed Forces, are in schemes for which no money has been set aside. Philip Hammond, Shadow chief secretary to the Treasury, said: "An incoming Conservative government will ensure that public sector employers properly recognise the costs of the pension promises they are making. It is already widely accepted that reform is needed and we will work to achieve consensus to move forward."
A Treasury spokesman insisted there was no looming funding crisis. He said: "The most important measure of public sector pension affordability is the Government’s ability to pay pensions as they fall due – the cost of pensions is projected to remain at under two per cent of GDP for the foreseeable future." And a spokesman for the Local Government Association said: "The supposed ‘black hole’ in the local government pension scheme would only occur if every single worker retired tomorrow, which is not going to happen."
Britain's police pensions swallow 20% of total force budget
by Jamie Doward
Many ex-officers will draw their index-linked payments for longer than they have served
Fears that the burgeoning costs of Britain's public sector pensions will restrict the country's ability to cut its debts are underscored by new figures showing that police forces are paying out more than £2bn a year to retired personnel. The figure – a fifth of the Home Office's budget for the police forces of England and Wales – can largely be attributed to shifting demographics. At a time when the average age of a retiring officer completing full service has dropped to 51 and life expectancy rates are increasing, many ex-officers will enjoy pensions for longer than they have worked.
The £2bn figure was obtained following a series of freedom of information requests made to all 52 forces by the Liberal Democrats, who said it showed that Britain's public sector pension costs were unsustainable. According to figures released by 48 of the UK's constabularies that agreed to reveal their pension costs in response to the requests, last year they paid out almost £2.1bn, up by 54% on the £1.4bn paid out in 2005.
"Police officers now retire on average at 51, at a time when it can be expected that men will live for another 34 years and women for 37," said the Lib Dems' Treasury spokesman, Lord Oakeshott. "Many retiring police officers then get another job, but will draw their index-linked pensions for more years than they've served in the police. Meanwhile the basic state pension age is having to rise to 68. No country can pay pensions for longer than people work, let alone Britain with its deep financial deficit."
Among the forces to experience significant increases in pension payments were Cumbria, Leicestershire, Surrey, Tayside, West Midlands and Strathclyde. The Lib Dems estimate the forces' pension costs will continue to rise by a further 14% over the next three years. Over the past five years, the average annual pension for a retiring officer who has completed his full 35 years' service has jumped from £12,500 to £14,250. Before the Pension Act of 2006, full service was defined as 30 years' service. The lump sum paid on retirement has risen from £80,000 to more than £88,000.
In Wiltshire, Tayside, Norfolk, Derbyshire, Lancashire and Strathclyde, the average age of officers retiring after full service is now under 50. The financial burden has become so acute that the Home Office has been forced to plug a £500m gap in the police pension funds. The rising costs of public pensions is likely to trigger fresh calls for an overhaul of the public sector pensions system, which would provoke a furore among unions. But Oakeshott said there was no alternative. "Making public sector pension costs affordable for taxpayers will be an acid test for Britain's credit rating in the next parliament," Oakeshott said.
All three parties have indicated that public sector pensions are now in their sights. During the recent televised chancellors' debate, Alistair Darling said: "I think reform of public sector pensions is necessary… New entries… will get fewer benefits than predecessors had." His Tory shadow, George Osborne, pledged a public sector pensions audit within weeks of coming to power, while the Lib Dems' Vince Cable called for fundamental reform. The scale of the problem was highlighted in an independent report last month. Unfunded pension promises made to past and present UK public sector workers now amount to almost £1.2 trillion, according to consultants Towers Watson – equivalent to almost £47,000 for every household in Great Britain.
More Than 200,000 Americans Could Lose Unemployment Benefits This Week
by Arthur Delaney
Thanks to congressional inaction, more than 200,000 laid-off workers could lose access to unemployment benefits this week, and no flood insurance policies will be renewed or issued until Congress returns on April 12 -- despite record long-term joblessness and record rainfall. Congress failed to pass an extension of several programs expiring today, including Emergency Unemployment Compensation, the National Flood Insurance Program, and a 65 percent subsidy of COBRA health benefits before adjourning for a two-week Easter break on March 25.
It's a game of political chicken: Democrats and Republicans in the Senate are each gambling that the other side will look worse for the lapse. Senate Republicans blocked the Democrats' $9 billion proposal to extend the programs on an emergency basis (without a funding offset); Democrats rejected a Republican proposal to pay for the programs by raiding stimulus bill funds. Party leadership in the Senate had apparently negotiated a one-week stopgap extension with a funding offset, which Senate Republicans said House Democrats rejected.
By pushing its own version of the extension and voting against adjournment, the GOP has made a concerted effort not to repeat what happened in February, when Sen. Jim Bunning of Kentucky, without the support of Republican leadership, took a stand for deficit reduction and single-handedly blocked a similar temporary extension of jobless aid. Senate Republicans voted against adjourning for Easter, saying they would be happy to stay and argue through the break even though they thought they would lose a vote on the bill.
Congress enacted the Emergency Unemployment Compensation program to fight the recession. EUC provides up to 53 weeks of federally-funded benefits (broken into four tiers consisting of several weeks each) on top the 26 weeks of benefits provided by states. About 6.5 million Americans, comprising 44 percent of all the unemployed, have been looking for work for longer than six months. Some six million are relying on some form of federally-funded unemployment benefits.
The National Employment Law Project estimates that 212,000 people will lose eligibility for EUC benefits this week. And many more people will be told by state workforce agencies that unless Congress does something, they too will prematurely exhaust their benefits. "It is unacceptable that Congress has, for a second time, failed to extend the existing federal benefits programs with so many people counting on this assistance," said NELP director Christine Owens in a statement. "We have been down this road already and seen the turmoil it caused. Congress cannot continue to play games with people's lives."
Fortunately, any disruption to unemployment benefits should be brief. During the Bunning blockade, most state workforce agencies were able to operate as normal for one week on the assumption that an extension would soon pass. After reconvening on April 12, Congress will pass an extension of the programs that should apply retroactively, meaning laid-off workers should eventually receive any checks missed because of the lapse.
The same goes for flood insurance. The Federal Emergency Management Agency advised last October that a lapse in the program shouldn't cause too much trouble: "If there is a lapse in NFIP authorization, any hiatus period should be brief, and most of the nearly 5.6 million flood insurance policyholders nationwide will not be affected." But that doesn't mean the lapse won't cause lots of confusion and panic among people who are told their benefits will be cut off.
How to Manufacture a Recovery
by Graham Summers
Last Friday the Bureau of Labor Statistics (BLS) announced that for the month of March, employers added 162,000 jobs. This would be fantastic news… if it were true.
Let’s have a look at these 162,000 jobs.
Right off the bat, we know that 48,000 of them came from hiring census workers. I won’t completely put this down because these ARE new jobs. But they’re hardly sustainable (the census is a temporary employer) or productive: paying someone to count other people adds literally NOTHING to the US’s manufacturing or productivity base. If it did, we could simply start hiring people to count clouds or trees and have an incredible economy in no time.
So without census workers, we added 114,000 jobs in March.
Then there are the +81,000 via birth/death adjustments. This metric is so complicated that it’s not even worth trying to explain. In simple terms, the BLS tries to adjust the jobs numbers to account for the birth/death cycle of businesses. But the reality is that it is an "X" factor used to downplay job losses and boost job gains.
Without these adjustments, we added 33,000 jobs in March.
Then, of course, there are the weather adjustments. The winter of 2009-2010, was by all counts, a rough one. So the BLS made various adjustments to atone for the fact that for several chunks of 1Q10, people couldn’t even get to work, let alone hire. Now that the winter is over, the BLS is adjusting numbers upwards to make up for former downward revisions. The total number of jobs "created" by adjusting for the nasty winter? 100,000.
Without these adjustments, we LOST 67,000 jobs in March.
So, here we are, three years into the recession (really a Depression) and the only way we can get the monthly employment numbers into positive territory is because of blizzards, economic adjustments, and the hiring of census workers. The fact that we’ve spent trillions and are still losing jobs should tell you everything you need to know about how well equipped the economic advisors to the current administration are to handle this situation.
The employment situation gets even worse when you dig beneath the headline numbers.
For one thing, 9.1 million continue to work part-time for "economic reason." In plain terms, this means they want full time work, but can’t find it. In January this number was 8.3 million, so this means we’ve added 800,000 people to the "want work, but can’t get it" category in the last two months.
Then of course, there are the 2.3 million who are "marginally attached to the labor force." The BLS defines this group as individuals who "were not in the labor force, wanted and were available for work, and had looked for a job sometime in the prior 12 months. They were not counted as unemployed because they had not searched for work in the 4 weeks preceding the survey."
So basically, if you have looked for a job in the last 12 months, but not in the LAST month, you’re "marginally" attached to the labor force. I’m sure the "marginal" relationship provides "marginal" income to meet REAL needs.
Oh, and by the way, there are 200,000 MORE people in this category today than there were one year ago.
Finally, I’ve saved the worst for last: those who lose their jobs are staying unemployed for an extremely long time. All told, 6.5 million people have been unemployed for more than 27 weeks (more than six months). The March number for this group is up 400,000 from February’s 6.1 million. These people ALSO comprise a record number of the total unemployed. Today, 44% of ALL unemployed persons have been unemployed for six months. That’s a record high.
In plain terms, the primary manufacturing going on in the US economy today is occurring on the "accounting" side of things. Real employment continues to drop, people who want work can’t find it, those who lose their jobs remain unemployed for long periods, and Uncle Sam is pretty much the only one who is hiring.
This is hardly cause for celebration, but the market (which was closed on Friday) will likely jump this morning on the report. There is also the Manic Monday effect which I’ve written about numerous times before. So the market will likely move higher today. After that, who knows? The whole thing is detached from fundamentals so it’s all about something breaking down before bearish impulses take effect again.
New Update of 120-Year Property Series Suggests 22% Nationwide Fall Ahead
by Michael David White
The federal government has tried every manner of strange intervention to foolishly support the price of real estate. The trend in unit sales shows very little evidence of success (see below).
Setting aside for a moment the massive stupidity of trying to uphold pricing created by a delirious and mentally-retarded credit bubble, the feds have failed in one obvious area: They haven’t been able to make the monthly mortgage payment for 15 percent of homeowners.
This wildly high number of individual financial failures makes the typical inventory of homes for sale petite and pretty. The consequences for the prices of homes is obvious. Massive new supply leads to massive new losses (see below). I don’t know what fraud they are going to think up to try to cover this up, but I know it will be as dumb as what they have already tried.
The bubble began in 1990 meaning that 16 to 20 years of buyers bought a scam. How many homeowners in the United States of Mortgage Fraud are living in a make-believe world of income-not-required lending and name-your-price appraisers? When do we return to a 120-year price trend (see below)? When will trillions of unaffordable mortgage debt be written off? When do we stop sending fools in to buy both their first home and their first financial failure?
A credit bubble can be broken only one way. Burn up the fake debts. Slash the false prices. Fire sale the assets of failed banks. Rematch the price of housing to income.
We will not have a balanced economy until the massacre of debt is done. Time to get to work.
UK house prices face multi-generation bear market
The housing market may now be trapped in a long-term bear market and may not bounce back to the peaks it reached in 2007 for generations, a leading economic consultancy has warned. British property prices benefited from a 25-year bull market since the 1980s, pushed up by low inflation and real interest rates, and the influx of millions of younger less well-off buyers who were suddenly able to get hold of mortgages, according to Lombard Street Research. But the organisation has given warning that homeowners must prepare for what could be a similarly long period in which economic forces work in the opposite direction. The warning, from LSR's senior economist, Jamie Dannhauser, will cause particular concern, since it comes amid hopes that having slumped by around a fifth since the peak of the bubble, the housing market has now recovered.
However, Mr Dannhauser said that although house prices may continue to rise for some months, buoyed by short-term factors such as low interest rates and thin trading, the impact of the credit crunch may mean that the long-term direction of the market could take a turn for the worse. He said that although the past 25 years had been punctuated by two housing crashes, the long-term trend for house prices had been overwhelmingly positive. "There was a big 25-year adjustment that came through three factors, which are one off shocks – inflation, real interest rates and credit availability," he said. "The real story now is credit, and more specifically what is happening in the mortgage market. For people who are bullish on housing as a medium term investment, that is a big question. It seems highly likely that given this banking shock there's been a step change in availability of credit.
"My medium term view now is that real house prices over the next three to five years will be flat at best. But it's quite conceivable that the equilibrium level of real house prices of 06/07 will not be reached again." This implies that although nominal house prices may once again shoot through the levels they hit at the peak, the price when adjusted for inflation and the cycle may never again attain such a level. The warning came as LSR said that its housing affordability indicator, in conjunction with The Daily Telegraph, showed that house prices became marginally more expensive in the final quarter of 2009. The indicator, in which 100 points represents the average affordability level since the early 1960s and a higher figure means prices are undervalued, dropped from 118.6 points to 118.4 points, meaning homes became slightly more overpriced. The indicator compares house prices to families' incomes and mortgage payments, and was one of the most reliable yardsticks in the run-up to the recent slump.
Affordability started to deteriorate for the first time in the third quarter of 2009, as house prices began to pick up enough to compensate for the fall in mortgage rates. Although prices rose by more than most economists expected last year, Mr Dannhauser warned that this was partly a function of the fact that so few people were putting their homes on the market. "One reason prices have bounced back is because the volumes have been so thin. The effective level of housing demand is still way down on previous levels – particularly at the first-time buyer level." In the Budget last month the Government pledged to exclude first-time buyers from stamp duty up to a level of £250,000, in a move which is intended to draw more buyers into the market.
Bond Buyers Demand Record Downgrade Protection
by Bryan Keogh
Bonds with built-in protection against rating cuts are making up a record share of debt issues as investors hedge against a slowdown in the economic recovery. Anheuser-Busch InBev NV, the brewer of Budweiser and Stella Artois, is among companies issuing so-called step-up bonds, whose interest increases if a borrower is downgraded. Sales surged to $37.3 billion in March, or 12.4 percent of all debt issued, according to data compiled by Bloomberg. Most of the notes are sold in the U.S., where almost half of bonds rated as so-called junk or on the cusp of non-investment grade include the protection.
Investors are concerned that debt-laden companies are at increasing risk of being downgraded this year, even as the global economy emerges from the deepest recession since the 1930s and credit markets rally. Reductions in corporate ratings and credit outlooks outpaced increases by 150 percent in the first quarter, according to Moody’s Investors Service. "The recent use of step-ups shows some investors are still concerned about downgrade risks, despite a rally in corporate debt," said Sarwat Faruqui, a director of capital markets origination at Citigroup Inc. in London.
Step-up interest coupons are typically used by companies rated at or below Baa1 by Moody’s and BBB+ by Standard & Poor’s, two notches above non-investment grade. Sales of the bonds globally are up from $16.6 billion in February and $8.4 billion a year ago, according to Bloomberg data. In the U.S., such borrowers sold a record $32 billion of the debt last month, or 46 percent of all bond issuance, the data show.
Elsewhere in credit markets, the extra yield investors demand to own corporate bonds rather than government debt fell 2 basis points last week to 149 basis points, or 1.49 percentage point, as of April 1, according to Bank of America Merrill Lynch’s Global Broad Market Corporate index. That’s the narrowest spread since November 2007 and down from a record 511 basis points in March 2009. The cost to protect against non-payment on corporate bonds in the U.S. fell to the lowest in more than two weeks.
The Markit CDX North America Investment Grade Index of credit- default swaps, which investors use to hedge against losses on corporate debt or to speculate on creditworthiness, declined 1.5 basis point to a mid-price of 83.6 basis points as of 12:33 p.m. in New York, according to Markit Group Ltd. The index, which typically falls as investor confidence improves and increases as it deteriorates, dropped to its lowest since March 17, when it was 82.5 basis points, CMA DataVision prices show. A basis point on a credit-default swap contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.
Royal Bank of Scotland Group Plc is selling bonds backed by commercial mortgages of several borrowers in the first sale of its kind since June 2008, gauging investor demand for the debt amid climbing defaults. The $309.7 million offering, backed by 81 properties in U.S. states from New York to Missouri, includes $240.8 million in top-rated securities, according to people familiar with the sale who declined to be identified because terms are private. Of those properties, 78 are retail sites, the people said.
Demand for collateralized loan obligations is reviving with more deals planned this year, Citigroup analysts wrote in an April 1 report. CLOs, shunned for their role in contributing to $1.8 trillion of bank losses and writedowns during the credit crisis, buy leveraged loans and then use the payments as collateral for bonds. Citigroup priced $525 million of CLOs last month in the first new issue in a year. Investors are demanding more borrowers use step-up coupons in their bond sales because of the amount of debt on companies’ balance sheets.
"Companies are offering incentives such as step-up coupons and ratings commitment language in order to attract a broader range of investment-grade investors" that may otherwise be put off by their debt levels, said Mark Lewellen, London-based head of corporate origination at Barclays Capital. Step-up bonds offer a different form of investor protection from credit-default swaps in that they increase the interest spread should a company’s creditworthiness decrease. Credit- swaps, on the other hand, are a kind of insurance contract that pay out when a company defaults on its obligations.
Anheuser-Busch InBev, the world’s largest brewer, sold $3.25 billion of bonds with a step-up coupon on March 24, Bloomberg data show. The conditions require the Leuven, Belgium- based company to pay 25 basis points more in interest for every one rating notch it’s cut below investment grade, up to a maximum of 200 basis points, according to Bloomberg data. The brewer is rated Baa2 by Moody’s and one level higher at BBB+ by S&P.
The use of such bond conditions is increasing against the backdrop of a global economy that will grow 3.6 percent this year, according to a Bloomberg survey. Bond spreads are at their lowest in more than 2 1/2 years and issuance of notes of all ratings rose to $752 billion in the first quarter, compared with $583 billion in the previous period and following a record $3.18 trillion in the whole of 2009, Bloomberg data show. Even so, investors want the chance of "an additional premium" on the interest of a bond sold by a company at risk of a rating cut, said Dinesh Pawar, head of flow trading at Aviva Investors in London, where he helps manage 250 billion pounds ($380 billion).
More companies were downgraded or had their outlooks lowered by Moody’s than were upgraded for an 11th straight quarter between January and March. The New York-based rating company made a total 767 credit reductions against 309 upgrades in the period, according to data compiled by Bloomberg. Western European companies showed the most deterioration, with 213 cuts in rating or outlook versus 40 credit improvements. A total 309 borrowers were at risk of a downgrade, Moody’s said, almost four times the number poised for an upgrade. Step-up interest may also be triggered if an issuer fails to register the securities.
Mondi Ltd., Europe’s biggest manufacturer of office paper, included a step-up condition in its debut 500 million-euro ($675 million) bond offering on March 26. The interest rate on the notes will increase by 125 basis points if the Addleston, England-based company’s rating falls to below investment grade at both Moody’s and S&P, according to Citigroup’s Faruqui. Mondi’s notes are currently rated Baa3 by Moody’s, the lowest investment-grade ranking, and one step lower at BB+ by S&P.
Big Banks Dominate U.S. Banking System
by Shahien Nasiripour
Just 16 banks account for more than half of the assets in the nation's banking system, new data show. The banks -- all of which have more than $100 billion in assets -- control nearly 56 percent of all assets in the banking system, according to an analysis of fourth quarter Federal Deposit Insurance Corp. data by Dennis Santiago, CEO and managing director of Institutional Risk Analytics, a California-based consultancy. The concentration of power among the nation's megabanks is more than double what it was just nine years ago, and has more than tripled since 1995.
The consolidation among banks and the growth of the big ones is of particular concern to policymakers and economists who are pushing to fundamentally reform the nation's broken financial system. Leading voices like Federal Reserve Bank of Kansas City President Thomas M. Hoenig and U.S. Senator Ted Kaufman (D-Del.) want to bust up the megabanks, arguing that the firms played a big role in causing a near-meltdown of the financial system and the subsequent Great Recession. The firms benefit from their size by being implicitly -- if not explicitly -- backed by the U.S. government, giving them a huge advantage over traditional Main Street banks, which harbor no illusions about U.S. taxpayers possibly bailing them out.
The prospect of potential bailouts has allowed these firms to enjoy lower borrowing costs, allowing them to grab more market share and get bigger. In 2008, the firms were all bailed out by taxpayers. Meanwhile, small banks are failing at the fastest rate since the early 1990s. In 1999, there were eight banks with more than $100 billion in assets, Santiago's analysis shows. They had a combined $2.5 trillion in assets. As of Dec. 31, 2009, there were 16 banks with more than $100 billion in assets. Together, they have about $8 trillion in assets.
BlackRock warns on banks’ distressed mortgages
by Aline van Duyn
BlackRock, a leading US bond investor, says banks will have to take their share of losses on distressed mortgages before it resumes large-scale purchases of new "private-label" mortgage bonds, which are sold without government backing. The position taken by Curtis Arledge, chief investment officer for fixed income at BlackRock, who oversees $580bn of investments, marks the latest development in an ongoing tussle over who should bear the costs of the US mortgage meltdown.
The return of private investors to the US mortgage market, now mostly financed through government-backed agencies, could have a big effect on mortgage rates and the speed of the housing recovery. Efforts to restore confidence among investors have so far failed. Disputes between investors and banks have erupted over riskier second mortgages, also called home equity loans. Many US homeowners who are behind on their payments took out two or more home loans. First mortgages were typically packaged into securities and sold to investors, while second mortgages were often kept by banks.
These "second-lien" mortgages should take losses first, in theory. But the holders of such debts have not always agreed to absorb hits before "first-lien" mortgage holders. US government programmes to restructure such debts have been slowed by these complications. Mr Arledge told the FT BlackRock, which is primarily a first-lien investor, had focused on the interaction with second-lien holders in the US mortgage modification programmes. "If [modifications] are done in such a way that is not fair ... it will be a real challenge for the mortgage market to move forward."
Banks owning the second-lien mortgages also own many of the mortgage servicers that decide how losses are shared. "In many cases the person owning the second lien is also servicing the mortgage and running the [modification] process," Mr Arledge said. "There’s potential for conflicts of interest."
IMF targets banks with 'excess profits tax'
by Edmund Conway
The International Monetary Fund is poised to recommend an unprecedented new "excess profits tax" on banks worldwide. The Fund is expected to suggest the tax – which is effectively on banks' cashflow – as one of the best ways governments can raise significant amounts from banks without drastically distorting the financial system. The tax will be announced alongside the Obama-style banking levy, which the IMF will also rubber-stamp in its report, to be published at its spring meetings this month.
The IMF was commissioned by the Group of Twenty leading economies last year to investigate new taxes on banks. Although most attention initially was on so-called Tobin taxes, which levy small charges on banks' financial transactions (a model promoted by campaign groups as the Robin Hood Tax), the Fund is likely to rule them out as a serious prospect. The move is likely to frustrate Gordon Brown, who threw his weight behind the transactions tax in the early stages of the research. Most had assumed that this would mean the Fund would give its central recommendation to a form of balance sheet levy, which has already been implemented in Sweden, and which has been proposed by the Obama administration.
However, the Fund is also considering giving an equally-important recommendation to a less well-known type of tax which simply levies a charge on bank profits, beyond a certain level. The advantage of the balance sheet levy is that it should encourage banks not to build excessively large stocks of assets, as Royal Bank of Scotland famously did ahead of the crisis. The benefit of the excess profits tax is that it is thought to be the most efficient way to raise money from banks, and could in time replace regular business taxes as the best way of generating revenue from financial institutions.
Michael Devereux, director of the Oxford University Centre for Business Taxation, said: "Although this is effectively a tax on banks' cash flow, if I were the IMF, I would present it as an excess profits tax – additional to everything else and particular to banking because that is whom we would like to tax. "Unlike a balance sheet levy, it is not designed to change behaviour and stop them from doing silly things. It is a way of collecting money – the most efficient way we can do it."
The proposals, which the Government and the Conservatives have both indicated they would adopt, could represent a revolution in the way banks, and wider businesses, are taxed in the UK. Cashflow taxes are not used elsewhere in the developed world, except for an obscure system in Belgium. In some ways, a cashflow tax would be equivalent to VAT, since it would be levied broadly on bank activity.
Peter Spencer, economic adviser to the Ernst & Young Item Club, said: "The problem with an excess profits tax would be that it is very difficult to draw a dividing line between one kind of industry – which does pay the tax – and another that doesn't. Migration and effectively avoidance are the things which would make it very difficult. Also, the last thing you want to do is to deter people from making profits." Britain toyed with an excess profits tax during the Second World War, although the use of such a system in a specific industry would be unprecedented.
Fannie Mae, Freddie Mac Likely to Get Swaps Clearinghouse
by Scott Patterson
The regulator of Fannie Mae and Freddie Mac is on the cusp of making big changes to the market for interest-rate swaps, in a move that could potentially cut into Wall Street firms' revenues and generate new business for some firms that run exchanges. The Federal Housing Finance Agency, which oversees the government-owned mortgage giants, expects them to start using a clearinghouse to trade the swaps by year's end, according to people familiar with the matter.
The impending change away from private "over-the-counter" contracts has generated behind-the-scenes meetings among officials at Fannie and Freddie, the banks that now command their business and the exchanges that want it, according to the people. Each camp is posturing to protect its interests amid the shift. Fannie and Freddie are among the biggest buyers of interest-rate swaps. The swaps are two-way derivative contracts in which one party pays a fixed rate in exchange for a rate that floats along with the market.
For years, the mortgage firms have purchased the swaps from Wall Street banks to hedge their huge mortgage portfolios against rate swings. The banks, such as Goldman Sachs Group Inc. and J.P. Morgan Chase & Co., make money by structuring the deals and selling them to clients. With so-called central clearing, banks play a similar role but operate under the umbrella of a clearinghouse that guarantees the trade for both parties in case one side defaults. The guarantee is something that many felt was badly missing during the financial crisis. Then, markets seized up amid fears that some firms would falter and be unable to make good on their swap trades.
Officials at the FHFA have said they are hoping a clearinghouse will give them more information about prevailing market prices and also will help regulators gauge when firms are accumulating excessive risk. The move to central clearing is a step short of what some critics of the opaque derivatives market have pushed for this past year: trading on a public exchange. While a clearinghouse will provide a backstop for trades, the market will remain an exclusive club because the clearinghouse is expected to be open only to brokerage firms that become members.
Still, if a large percentage of trading volume gravitates toward central clearing, the playing field for swaps brokerage and trading could open to other firms besides now-dominant banks. Incumbents would still make money by brokering the deals, but with more competition and transparency, their margins might shrink. "The FHFA will write the new rules" on interest-rate-swap trading and clearing, said Richard Repetto, an analyst who tracks exchanges at Sandler O'Neill & Partners LP. Goldman Sachs Chief Executive Lloyd Blankfein has said the bank favors a clearinghouse. In a September speech, he said clearing of derivatives would "do more to enhance price discovery and reduce systemic risk than perhaps any specific rule or regulation."
An effort to move swaps and other derivative financial contracts to clearinghouses has been among the bigger pushes for changes in market structure since the financial crisis. That is because the woes of firms like Lehman Brothers Holdings Inc. and American International Group Inc. made regulators wary about contracts struck out of their sight. But like many other efforts to change the status quo in markets, so far regulation requiring a move to clearinghouses hasn't gotten very far.
Fannie's and Freddie's regulator seems intent on changing course regardless of the political winds. Martha Tirinnanzi, chairman of the FHFA's clearinghouse working group, said at an industry conference in March that Fannie Mae and Freddie Mac are "going to central clearing" even if current legislation that includes clearing mandates doesn't pass. There were $342 trillion of interest-rate swaps outstanding as of June 2009, according to the Bank for International Settlements. Fannie Mae and Freddie Mac have more than $2 trillion of interest-rate swaps on their books, according to public securities filings. Market experts say that share, while under 1%, is among the biggest if not the biggest held by any participant.
A number of exchanges are now vying for Fannie's and Freddie's clearing business, including Nasdaq OMX Group Inc. and CME Group Inc. J.P. Morgan officials favor the use of a London-based clearinghouse, LCH.Clearnet Group Ltd., according to people familiar with the matter. LCH, in which several U.S. banks including J.P. Morgan are stakeholders, has been the most active clearer of the derivatives, according to firm data.
Meanwhile, in recent months, the agency has been running tests with the International Derivatives Clearing Group, or IDCG, a clearinghouse operator majority-owned by Nasdaq. It also has been testing the systems of LCH.Clearnet and CME. The FHFA is likely to select more than one exchange, according to a person familiar with the matter. Some see the IDCG as a front-runner, since its clearing system has been operational since early 2009. A number of large brokerage firms have signed on to its platform, including Newedge USA LLC and MF Global Holdings Ltd.
The CME, meanwhile, has had some trouble getting its rate-swap system operational, according to people familiar with the matter. If the FHFA moves forward with its plans before the CME is ready, other exchanges could benefit from a first-mover advantage, Mr. Repetto says. The FHFA may choose not to give much business to LCH.Clearnet, some market insiders say, because the firm is based in the U.K., which has different bankruptcy laws than the U.S.
Greece to target US investors with 'emerging market' bond
by David Oakley and Kerin Hope
Greece will this month launch a multibillion-dollar bond in the US in its hunt for new investors, selling itself for the first time as an emerging market country as demand for its debt dwindles in Europe. Morgan Stanley is being considered to handle the deal after Goldman Sachs’ plans to sell Greek bonds to US and Asian investors this year fell through amid rumours that the Chinese had shunned Athens’ debt. George Papaconstantinou, Greece’s finance minister, would lead a roadshow to the US "after April 20" but in contrast with plans at the start of the year he would not travel on to Asia, one official said.
Greece is seeking $5bn to $10bn from US investors to help cover its May borrowing requirement of about €10bn to roll over maturing debt and meet interest payments. The issuance is Greece’s first in the US in nearly two years. Athens is deliberately targeting emerging market investors, who only buy debt that pays high yields, as demand has dropped markedly on successive bond deals in Europe. "Greece is looking to diversify its investor base with this issue, which means attracting emerging market funds as well as other investors," one official said.
Greece attracted demand of more than €25bn for its first bond sale of the year in January, yet order books rose to only €6bn for its last bond syndication at the end of last month. As Greece’s bond yields, or borrowing costs, are much higher than those of many developing world countries such as Brazil, Mexico and Poland, and about the same as Hungary, bailed out by the International Monetary Fund last year, analysts say it makes sense for Athens to tap emerging market funds.
"Greece is an emerging market and a Balkan country, and the fact that it’s a eurozone member is not a contradiction. It’s an issue of performance, not belonging," Nikos Mourkogiannis, a London-based economist and restructuring consultant, said. Greece’s 10-year benchmark yields are about 6.5 per cent compared with Brazil’s at 4.9 per cent, Mexico’s at 4.8 per cent, Poland’s at 5.5 per cent and Hungary’s at 6.6 per cent. Greece last raised money in dollars in June 2008 when it issued $1.5bn of five-year notes.
Greek banks hit by wealthy citizens moving their money offshore
by Harry Wilson
Greek banks are being hit by a wave of redemptions as the country's most wealthy citizens and corporations look to move their money offshore or to international financial institutions perceived as safer homes for their assets. Wealthy Greeks and companies have been clamouring to move their cash deposits to banks such as HSBC or France's Société Générale, which operate large branches in the country. They are among those to have received several billion euros of new money in recent weeks.
HSBC's private banking in the country is understood to have been flooded with business, while the local operations of several other major international banks have already seen large inflows of money. A spokesman for HSBC declined to comment. Eurozone countries are still at loggerheads on bailing out the southern European nation, with Germany believed to be in conflict with other countries in the single currency over how much interest to charge on the emergency loans package. Germany wants interest rates of 6pc to 6.5pc, with other countries willing to accept 4pc to 4.5pc interest.
More than €3bn (£2.6bn) of deposits held by Greek households and companies left the country in February, while in January about €5bn of deposits were moved out, according to the latest figures available from the Bank of Greece. Switzerland, the UK and Cyprus have been the largest recipients of the money, with the wealthiest Greeks looking to move their deposits to Swiss banks accounts to escape the more punitive tax measures many fear will be introduced in the wake of the country's economic crisis.
John Raymond, a banks analyst at CreditSights, said that on a visit to Athens last week capital flight was the number one issue worrying most Greek bankers. "The banks themselves are concerned by it because they can't get funding elsewhere at the moment," he said. "Greek banks won't be able to increase lending volumes if deposits don't increase, and a continued deterioration in their deposit base will lead them to cut back lending even more, stifling real economic growth."
Recent bond issues by the Greek government have struggled to find much demand and fears are growing that the country could become the first Western nation to default on its debt, stoking fears among Greeks over the stability of not just the country's banks but the entire economy. "Most bankers say they are worried about the stability of Greece and Greek banks. This combined with the tax issue is making many people nervous about keeping their money in domestic banks or within the country," said Mr Raymond.
What Do We Have to Show After a Year of "Extend and Pretend"?
by Gonzalo Lira
In 1982, many of the banks hit by the Latin American debt crisis were effectively insolvent. Paul Volcker, as the then-Chairman of the Federal Reserve—charged with overseeing the banking system—effectively cast a blind eye on this banking insolvency.
Volcker’s reasoning seems to have been that the US banks were not broke—they were just getting temporarily squeezed. Volcker seems to have concluded that time would heal the balance sheet wounds caused by the Latin American defaults. Therefore, to hold the banks to the letter of the accounting rules would likely drive one or more of them broke, to no useful purpose—and it could potentially cause a bank panic and general financial crisis. But to pretend (for a while) that all was right with the US banks would avoid a potential panic—so long as the crisis sorted itself out and the banks repaired themselves by writing off and renegotiating their toxic Latin American debt.
Volcker gambled, and won: The US banks indeed took the Latin American debt hit, but grew their way out of their hole. None of the large American banks were pushed to bankruptcy in 1982, and by 1983, the worst had passed. By 1984, the biggest chunks of Latin American debt had either been renegotiated or written off—so far as the American banking system was concerned, the crisis was over, with not a single name bank going broke. And most importantly, stability and calm reigning all the while. Score for Volcker and what we could say was the Volcker Call.
In 2008, when Lehman went bankrupt because of all the "toxic assets" on its balance sheet, the severe credit crisis that happened as a result was because everyone realized that Lehman was the canary in the coal mine. All of the American banking system was insolvent, for more or less the same reason: Assets on their books simply were not worth anything close to their nominal value. These assets were clustered around CDO’s, mostly in the real estate and commercial real estate markets.
To relieve the credit crunch that peaked in September, 2008, the Federal Reserve Board opened the money spigots—all kinds of lending windows were opened, with a dizzying array of acronyms, all of them doing basically the same thing: Lending out wads of cash at zero interest to the American banking system, all in an effort to keep it from going broke. Between September, 2008, and March 2009, the Fed backstopped the entire US banking system—but it still wasn’t enough. The losses were too great, the holes in the balance sheets too big.
So on April 2, 2009, a key FASB rule was suspended: Specifically, rule 157 was suspended, related to the marking of assets to market value—the so-called "mark to market" rule. Essentially, the mark-to-market rule means marking an asset to the value it can fetch in the open market at the date of the accounting period. If I own a share of XYZ stock which I purchased at $100, but today it’s quoted at $60, I mark it on my books at today’s market price—$60—not at the purchase price—$100. The reason is obvious: By marking the asset to market value, I’m giving a realistic picture of the financial shape of my company or bank.
However, ever since April 2, 2009, when the FASB rules were suspended, the American banking system has been floating on nothing by air. By suspending rule 157, none of the banks have had to admit that they’re insolvent. With the suspension of mark-to-market, accounting rules are now basically mark-to-make-believe. Why was FASB rule 157 suspended? Geitner, Bernanke and Summers seem to have been trying to duplicate what Volcker did so successfully in 1982. This period since March 15, 2009, when the suspension of the rule went into effect, has been called "extend and pretend". Has it worked?
Prima facie, it would seem so. The banks seem to be stable, and have been raking in the big bucks ever since the rule was suspended. The markets—from their March ’09 lows—have rocketed onward and upward. In fact, Citigroup stock has quadrupled, Goldman Sachs has doubled—everything is wonderful! Nothing hurts! However, the basic problems in the banking system remain: The banks are still broke, because of the same reason—the toxic assets on their books.
The banks have taken "extend and pretend" to heart—they have lobbied to extend the suspension of FASB, while they have pretended to repair their balance sheets, when in fact, they have not. In fact, compared to the write-off mania of ’08, the banks have not written off any of these non-performing assets. They sit like dead weight on the balance sheets of the banks—we still do not have a clear grasp of even how much of this garbage is still lurking out there, like turds in the Venice canals, because of the obfuscation of the basic accounting rules—an obfuscation which the banks insist on perpetuating. The banks still have the holes in their balance sheets which caused the crisis in 2008.
But then, how have the banks made such staggering profits during the last year? By trading. Instead of being banks, since March of ’09, the Big Six US banks have effectively become hedge funds. They have been trading themselves into profitability. Worst of all, these banks qua hedge funds have been making money by trading with each other. Price-to-earnings ratios bear this out—their general upward trend, across sectors and industries, even as the economy has been severely weakened, is indicative of a speculative bubble. A massive bubble—the kind that makes the Hindenburg look puny.
All of the markets have risen from their March ’09 lows because of what I would term musical chair trading—everyone makes money so long as the music doesn’t stop. The "music" of this metaphor is a combination of Uncle Ben’s easy money, relative calm in the world, and good ol’ "extend and pretend", courtesy of FASB. But when the music does stop, the banks are going to realize that it’s not that there’s one less chair in the circle. There are no chairs left. That when the next crisis will hit—when the music stops, and everyone rushes to get out of their musical chair trading positions.
To continue with the analogy, when will the music stop? When will everyone rush to find a seat—and find that there are none left? My guess is, it will be something from left field, something in-and-of itself not particularly earthshattering: A punitive Israeli airstrike against Iran, say, or Somali pirates sinking a big oil tanker. A lousy consumer sentiment number, or a surprise burst of unemployment. Why hasn’t Team Obama’s version of the Volcker Call worked? Simple—because Paul Volcker made it clear to the banks in ’82 that he would declare them insolvent, if they didn’t repair their balance sheets. Volcker scared the bankers, scared them enough to make then do what was necessary—which was to clean up their balance sheets.
What did Team Obama do 27 years later? Did they twist bankers’ arms, and force them to write off the garbage on their balance sheets? No they did not. Instead, they bowed and scraped at the banksters, as if they were truly Masters of the Universe, instead of what they really are—scum of the earth dressed up in really nice suits. In 1982—unlike 2009—the banks had a reason to try to renegotiate and write off the bad Latin American loans: Volcker was breathing down their collective necks, and the banks were scared of him. Volcker had a credibility then that Team Obama today does not have now—Volcker showed himself willing to bring the entire US economy to a halt, in order to purge inflation. What was putting a few big banks out of business, compared to that? Nothing—catnip for Volcker.
But Geitner, Bernanke and Summers have shown themselves willing to do anything for the banks—they’ve become twisted around, and come to think of the banks as ends-in-themselves, rather than means-to-ends, within the economy. What should have happened starting in March of ’09 was for the banks to take the suspension of mark-to-market and used it to purge their balance sheets of all the crap they are still carrying. But they did not. Nor will they. Because no one is forcing them to. No one forced them in April of ’09, no one is forcing them now in April of ’10.
Therefore, once the era of Musical Chair Trading ends with some ridiculous non-event that will send everyone panicking, the banking sector will be right back where it was on Septmber 18, 2008—the only difference, of course, being that Bernanke has already shot his wad, and politically, it will be impossible to pass another TARP. That’s when the world ends—the second crisis will be loads worse than the one in the fall of ’08. Loads worse, even, than ’29. When will it happen? I don’t know. Then again, I don’t know when the Yankees will next win the Pennant—but I’m pretty sure it’ll happen.
"Extend and pretend" could have been used to do what Volcker did in ’82—the Volcker Call. But Geitner, Bernanke, Summers, and ultimately Obama himself lacked the will or the gumption to force the banks to do what needed to be done—clean up their balance sheets. Write off all that crap. So get ready: The countdown to oblivion was paused by "extend and pretend"—but it wasn’t suspended, much less averted. I don’t know if the end will be hyper-inflationary or mega-deflationary—all I know is that it’s gonna really suck.
How Washington Abetted the Bank Job
by Susan P. Koniak, George M. Cohen, David A. Dana and Thomas Ross
A few weeks ago, two Republican House members asked Ben Bernanke, the chairman of the Federal Reserve, whether the Fed knew — before Lehman’s bankruptcy examiner revealed it — about the bookkeeping scam at Lehman known as "Repo 105." This scam allowed Lehman to disguise how much debt it was carrying, right up until it collapsed. Lehman got new loans to pay off old loans, pretended the new loans were "sales," and through a complicated series of steps made both the old and new loans disappear just in time for its quarterly reports.
Mr. Bernanke said the Fed had known nothing about this. After all, he explained, the Fed wasn’t Lehman’s regulator — the Securities and Exchange Commission was. The Fed had placed some people at Lehman — not as many as the S.E.C. had — but they were there only to ensure that Lehman paid back money it was borrowing from the government. Can’t lay this on him. Meanwhile, the S.E.C. insists that it could not have known what Lehman was up to because it was "understaffed" and "ill-suited" to run a voluntary oversight program. But, the commission says, since the Lehman bankruptcy examiner’s report it has sprung into action, investigating whether other banks might also have cooked the books.
Any minute now, expect to hear that the Treasury, the Office of the Comptroller of the Currency, the Office of Thrift Supervision and the Federal Deposit Insurance Corporation — our other federal bank regulators — were just as shocked that Lehman used make-believe sales to hide its ocean of red ink.
Well, the truth is this: The collapse of Enron back in 2001 revealed that the biggest financial institutions, here and abroad, were busy creating products whose sole purpose was to help companies magically transform their debt into capital or revenue. At the time, there were news reports about Merrill Lynch pretending to buy Nigerian barges from Enron, JPMorgan Chase dressing up its loans to Enron as commodity trades and Citigroup disguising Enron debt as profits from Treasury-bill swaps.
This went well beyond Enron. Our banks had gone into the business of creating "products" to help companies, cities and whole countries hide their true financial condition. Consider the recent revelations about how Goldman Sachs and J. P. Morgan helped Greece hide its debt. Now we discover that our banks not only were raking in huge profits helping others hide debt, they also drank their own Kool-Aid. As a chief executive of Citibank said in 2007 about financing dangerously leveraged deals, "As long as the music is playing, you’ve got to get up and dance."
Our bank regulators were not, as they would like us to believe, outside the disco, deaf and blind to the revelry going on within. They were bouncing to the same beat. In 2006, the agencies jointly published something called the "Interagency Statement on Sound Practices Concerning Elevated Risk Complex Structured Finance Activities." It became official policy the following year. What are "complex structured finance" transactions? As defined by the regulators, these include deals that "lack economic or business purpose" and are "designed or used primarily for questionable accounting, regulatory or tax objectives, particularly when the transactions are executed at year end or at the end of a reporting period."
How does one propose "sound practices" for practices that are inherently unsound? Yet that is what our regulatory guardians did. The statement is powerful evidence of the permissive approach bank regulators took toward the debt-dissolving financial products that our banks had been developing, hawking and using themselves for years. And it’s good reason for Americans to be outraged by the "who me, what, where?" reaction of Mr. Bernanke and the S.E.C. to the revelation of Lehman’s Repo 105 scam.
Since the financial crisis struck in 2008, many have bemoaned the supposed inability of bank regulators to coordinate their efforts. That assumes a joint effort would somehow have helped. In fact, our regulators could coordinate, and did, and thereby contributed to the crisis. Their cooperation began in the early 2000s, when the regulators decided they had to say something about how our banks helped Enron conceal its debt through complex transactions and how financial institutions were devising ever more complex instruments. In 2004, the agencies issued their first proposed statement on these practices.
This proposal was not quite "regulation" (in the sense of a set of new binding rules), but rather more like a position paper that set forth safeguards the regulators thought the banks should adopt. Mild really, given what Enron had exposed. Still, the plan included significant hurdles that the regulators wanted banks to clear before selling or using potentially dangerous financial instruments. The focus of the 2004 proposal was complexity itself; it would have applied to all new complex products developed by banks.
That focus was right. Complexity was what made it possible to hide debt, avoid capital requirements and evade taxes. Thus the statement said that banks should document their reasons for concluding that each complex instrument developed and sold would be used for a legitimate purpose and not to evade the law. It also said that financial institutions should ensure that the buyers of complex instruments understood how they worked and what risks they entailed.
The financial industry would have none of that. It bombarded the agencies with comments denouncing the proposal. Banks did not want the responsibility of explaining to customers the risks inherent in these instruments. And, while banks couldn’t say it directly, how they could document that products that were valuable specifically because they could get around laws were not being bought for that purpose?
Moreover, the banks understood that the statement threatened the virtually regulation-free zone they had won for other forms of complex structured finance, particularly collateralized debt obligations. So the industry condemned the 2004 proposal, and the regulators caved. They agreed to think it over — for two more years. Hence the interagency statement on "sound practices" of 2006 we described earlier, which was greeted with effusive praise from bankers, their lawyers and accountants. Gone was the requirement to ensure that customers understood these instruments and that the banks document that they would not be used to phony-up a company’s books.
The focus on complexity was also gone, as was the concern over transactions "with significant leverage" — that is, deals with little real cash underneath, another unfortunate deletion because attending to excessive leverage would have served us well. Instead, the only products that the banks were asked to handle with special care were so narrowly defined and so obviously fraudulent that suggesting that they could be sold at all was outrageous. These included "circular transfers of risk ... that lack economic substance" and transactions that "involve oral or undocumented agreements that ... would have a material impact on regulatory, tax or accounting treatment."
Just as troubling, at least in retrospect, the new statement specifically exempted C.D.O.’s from the need for any special care because they were akin to other "plain vanilla" derivatives, in that they were "familiar to participants in the financial markets" and had "well-established track records" (yes, the same C.D.O.’s backed by bundled mortgages that financial firms and the government are now stuck trying to value and absorb, the infamous "toxic assets").
Only two years later, these same regulators were explaining that the complexity and opaqueness of instruments like C.D.O.’s had contributed significantly to the economic collapse. And it is now common wisdom that many of the bankers themselves did not understand the risks of these "familiar" instruments. Moreover, the collapse was characterized by institutions supposedly healthy one day and on the verge of collapse the next, due in no small part to their extraordinary debt burdens — debt burdens that complex instruments magically removed from the books.
To this day, that final interagency statement (which was adopted in 2007) has not been repealed or replaced. It can still be found on the S.E.C. Web site, along with the letters from industry representatives praising the 2006 draft. The site also has a single letter begging the agencies not to adopt that draft statement — a letter the four of us wrote. Our position was simple: products having no economic purpose except to achieve questionable accounting, tax or regulatory goals; or that raise serious concerns that customers will use them to issue materially misleading financial statements; or that meet any of the other bullet points in the 2006 statement’s list, should, at a minimum, be labeled presumptively prohibited.
The final statement notes and rejects our plea, saying that if any firm determined that its participation in a complex financial transaction "would create significant legal or reputational risks for the institution," it could "take appropriate steps to manage and address these risks." As Congress now considers reforming the financial industry, it needs to take into account how abysmally our regulators performed when they coordinated their efforts and how insular their decision-making has been on matters that affect the entire economy. Congress needs to recognize that "regulatory capture," in which an agency becomes a pawn of the industry it is supposed to oversee, is real.
Ideas like the proposal by Paul Volcker, the former Fed chairman, to prohibit traditional banks from trading on their own accounts, will do little to improve the situation so long as enforcement is left up to regulators’ discretion. Passing piecemeal fixes to outlaw each fraud-inviting instrument — like the provision slipped into the recent jobs bill that outlaws a derivative that had been designed by the industry to allow individuals to evade paying taxes on their stock dividends — will never be a substitute for restoring civil liability for abetting securities fraud. Innovation can too easily outstrip specific rules.
Yes, we can lay Lehman’s Repo 105 and the proliferation of dangerously complex instruments at the feet of the Fed, the S.E.C. and the other signatories to the watered-down interagency statement. Years earlier, after Enron collapsed, they learned all they needed to know about the bogus structures banks developed to conceal financial instability. Yet by backing down and giving in, the regulators encouraged them. We are paying for those mistakes today.
Susan P. Koniak is a law professor at Boston University. George M. Cohen is a law professor at the University of Virginia. David A. Dana is a law professor at Northwestern University. Thomas Ross is a law professor at the University of Pittsburgh.
Canadian dollar hits parity with US dollar
The Canadian dollar rose to parity with the US dollar for the first time in nearly two and years on Tuesday. The Canadian dollar hit a high of C$0.9991 against its US counterpart, its strongest level since July 2008 and taking its gains to more than 24 per cent during the past 12 months. Camilla Sutton at Scotia Capital said on almost every measure the Canadian economy was strong. “Economic fundamentals are better than both economists and the central bank anticipated: inflation is firmer, job gains are larger and growth is running well above expectations,” Ms Sutton added. Furthermore, she said Canadian sovereign risk was low, which in the current environment was a major concern for global investors. “Sentiment is bullish for both the Canadian dollar and Canadian based assets,” she said.
Adding support for the Canadian dollar was increasing expectations that the Bank of Canada would join other central banks from commodity-producing nations and start to raise interest rates from their current ultra low levels and normalise monetary policy. David Watt at RBC Capital Markets said the Canadian employment report, due on Friday, should show strong gains in March, but, unlike last week’s strong US employment figures, would be less due to technical or one-off factors. “Canadian [employment] gains are expected to reflect broad-based hiring as the relatively robust economic recovery continues, further emphasising why the Bank of Canada will need to hike much earlier and more aggressively than the Federal Reserve during the early stages of the normalisation process,” he said.
The interest rate market has moved to price in a 7-per-cent chance that the Bank of Canada raises interest rates in April and a 70-per-cent chance that the first rise comes in June. Mr Watt said interest rate expectations were not the only factor supporting the Canadian dollar, however, with rising risk appetite and rising commodity prices also supporting the currency. He said with global equities rebounding to reach cyclical highs in recent weeks and oil prices climbing to their highest level in eighteen months, risk sensitive currencies such as the Canadian dollar should receive support. “Momentum remains on the Canadian dollar’s side,” he said.
Gavin Friend at National Australia Bank said the Canadian dollar was benefiting as part of a large group of pro-growth currencies, which have been outperforming the US dollar since disappointing US non-farm payroll figures in February. “We call this group ‘Ninja’ as as it constitutes North American Free Trade Area members, India and non-Japan Asia,” he said. Mr Friend said the disappointment of the February US employment report had prompted investors to differentiate between “old world” currencies, such as the dollar, euro, pound, yen and Swiss franc and Ninja currencies, which have either an Asian or emerging market focus. “As a group Ninja currencies are holding just beneath multi-month highs against the dollar,” he said. “This performance will hold as long as stocks continue to rise and risk appetite holds up.”
Can the SEC Get Its Street Cred Back?
by Martin Z. Braun
The Securities & Exchange Commission was criticized by lawmakers for failing to uncover Bernard Madoff's $65 billion Ponzi scheme and other investigatory lapses. So a crackdown on abuses in the $2.8 trillion U.S. municipal bond market would be a welcome development right about now at the SEC. Chairman Mary Schapiro is counting on an associate director in the agency's Philadelphia office to deliver the goods. That would be Elaine Greenberg, a 20-year SEC veteran who is leading one of the most ambitious municipal bond market investigations since the 1990s.
Now she's looking into whether banks, such as JPMorgan Chase and Bank of America , colluded with brokers to artificially lower the promised return of proceeds raised in municipal debt offerings. She's also looking at public officials who hire political contributors as investment advisers—and local governments that fail to disclose their true financial condition. "There's some very egregious conduct that goes on," says Greenberg, whose late-'90s probe into improper Treasury-bond price markups in the muni market led to 21 firms paying $170 million in penalties.
Greenberg, 49, was tapped in January to head the SEC's municipal securities and public pensions unit, one of five task forces created after the global credit crisis. The 2008 collapse of the $330 billion auction-rate securities market left governments and investors with debt they couldn't trade. States and cities are now dealing with more than $1 trillion in budget and pension deficits. Municipal securities enforcement "was terribly neglected in recent years," says Arthur Levitt, SEC chairman from 1993 to 2001. "Fraud in the municipal market and incompetence, which in some ways is worse than fraud, has never been greater," he said. (Levitt is a director of Bloomberg LP, parent of Bloomberg News.) Some 70% of the debt in the municipal market is held by individual investors.
A graduate of Temple University and its law school, Greenberg is looking into possible price collusion by brokers that allowed banks to pay municipalities artificially low interest rates on the cash they raised from bond sales. The commission has informed companies including JPMorgan Chase, Bank of America, UBS, Wachovia, and General Electric Capital's Trinity Funding Co. unit (all of which declined to comment) that it determined sufficient wrongdoing occurred to warrant civil charges.
The SEC has also stepped up enforcement of a rule barring securities-firm executives from making political donations to win municipal business. It said on Mar. 18 that the so-called pay-to-play ban applies to corporate officers after it found an unidentified JPMorgan Chase vice-chairman had raised funds for former California Treasurer Phil Angelides in 2002, less than two years before the bank's securities unit underwrote $15.8 billion of state bonds. JPMorgan Chase consented to the inquiry's conclusions without admitting or denying wrongdoing, the SEC said.
In November, two former JPMorgan Securities managing directors were sued by the SEC for alleged pay-to-play deals that allowed the New York-based bank to get $5 billion of bond and interest-rate swap business from Jefferson County, Ala. The transactions nearly bankrupted the state's most populous county. The bankers have asked the judge to dismiss the case. Greenberg says the municipal market deserves regulatory scrutiny since federal law exempts state and local issuers from the disclosure required of companies, putting public-bond holders at a disadvantage. "When a municipality or a state or any local issuer goes out and seeks to raise money, it's critical they adequately disclose their liabilities," Greenberg says.
The Fed: Invasion of the Inflation Doves
by Peter Coy
Picture the horror-movie scene in which the terrified family barricades the door to keep the murderer out, only to discover he's already inside. Federal Reserve Governor Kevin M. Warsh evoked that scary image in a speech on Mar. 26 to describe the threat to inflation-fighting central bankers from economists who are, in his view, insufficiently hawkish on inflation. Said Warsh: "Not all of the threats to central bank independence come from outside the walls of the Federal Reserve. Some pressures, however well-intentioned, like in the clichéd scary movie, may come from inside the house."
Emotions must be running high when bland central bankers start casting disagreements over interest-rate policy in terms that are more familiar to fans of Freddy Krueger. The charged language may be further evidence of a growing divide between hawks and doves over how strenuously the Federal Reserve should fight inflation. This isn't a drawing-room debate. The outlook for growth and inflation depends on how quickly the Fed rolls back the emergency monetary easing it put in place to combat the worst economic downturn since the Great Depression.
Until now, the rate-setting Federal Open Market Committee has been remarkably unified under Chairman Ben Bernanke. Even the committee's inflation-phobic hawks have mostly gone along with lowering the federal funds target rate to a basement-floor zero to 0.25% and flooding the banking system with excess reserves to encourage lending.
But the hawks' grumbling is getting louder. Thomas M. Hoenig, president of the Federal Reserve Bank of Kansas City, broke ranks at meetings in January and March, dissenting from the FOMC's determination to keep the federal funds rate at "exceptionally low levels" for "an extended period." Hoenig loses his FOMC vote next year, but two other hawkish regional bank presidents are scheduled to become voting members of the FOMC: Richard W. Fisher of Dallas and Charles I. Plosser of Philadelphia.
Monetary hawks argue that over the long run, very low and predictable inflation is the best condition for growth. In his Mar. 26 speech, Warsh attacked an idea that particularly frightens the hawks: a proposal that central banks should try to make inflation rise a bit to a long-term average of around 4%. (Inflation in personal consumption expenses, excluding food and energy, is all of 1.3% over the past year.)
The 4% idea was raised on Feb. 12 in a widely noted paper by Olivier Blanchard, research director of the International Monetary Fund. Blanchard suggested that higher average inflation would make it easier for central banks to stimulate growth in a recession by cutting interest rates. The idea is that cutting borrowing costs to below the inflation rate encourages expansion by effectively paying people to take out loans. Thus, cutting interest rates to zero can be more stimulative when inflation is 4% than when it's just 2%. That's a dangerous idea, Warsh said. "Central banks that desire just a little more inflation may well end up with a lot more."
Here's where the horror-movie plot thickens. Blanchard, as a pillar of the economics Establishment, may well have been the threat "from inside the house" to whom Warsh was referring. Then again, Warsh may have meant a true Fed insider, John C. Williams, research director of the San Francisco Fed, who wrote a paper similar to Blanchard's last September. But Williams isn't quite the foe hawks might imagine. In an interview on Mar. 29, he said he understands Warsh's misgivings. He added that while there are theoretical advantages to a 4% inflation target, the risks of confusing the market by moving to a higher target now might be unacceptably great. Confused yet? Don't worry. The main plot line is still hawks vs. doves. And as the U.S. economy recovers haltingly, that fight isn't going away.
For Consumers, Time to Shop (Until the Mortgage Drops)
by Paul Jackson
Here’s a provocative thought: what if ‘extend and pretend’ within our nation’s troubled mortgage markets is actually providing a lift to consumer spending? It’s not as far-fetched as the idea might initially sound, and it might help explain some interesting data we’ve seen as of late — and it also might explain why the statistical recovery we’re seeing now doesn’t really feel like a recovery to most Americans.
And, if I’m right, it also explains why we may very well slip right back into the throes of recession all over again as we head into 2011.
Let’s start with what we know. We’ve got 7.4 million non-current loans in this country, according to data source Lender Processing Services, Inc. — that’s an awful lot of households still living in a house, without a mortgage or rent payment draining their available disposable income. And the mortgage or rent borne by most households has historically been one of the most significant capital commitments any household makes, relative to other purchases.
In fact, as I’ve shown in previous columns, most Americans behind on their mortgage have gone more than a year without making any payments. The average age of a loan in foreclosure is now 410 days delinquent, after all, according to LPS; and that’s just the average. Many delinquent borrowers are able to stay in their homes for even longer than that.
We know from emerging credit data at Equifax and from other credit bureaus that Americans are now more likely to stop paying their mortgage first relative to other debts, meaning that they will continue to pay their credit cards, auto leases and other financial commitments. And why not? Miss a few payments on the car, and the repo men are there to claim that shiny Lexus within weeks; miss a few credit card payments, and dinner Saturday night is immediately disrupted.
But miss a mortgage payment? The consequences here are now so far off into the future and so vague, and layered under numerous government assistance programs, that any future penalties are tough for a consumer to accurately assess when faced with making a choice on how to best manage their debts. (I’d even argue that for many consumers, given the current environment, it makes logical sense to default on their mortgage first.)
So we’ve got millions upon millions of consumers in the U.S. meeting their shelter needs for free, even if only temporarily; and what’s becoming of any extra disposable income, since no rent or mortgage need be paid? Is this money being saved? Of course not. We’re Americans — we don’t know how to save (and neither does our government, apparently).
Instead, we’re seeing consumer spending head northward, and for five straight months, too. This data has many economists touting a nascent economic recovery, but I think the data instead paints a very sinister picture.
Put simply: people are spending their mortgages.
Consider the following individual as a case study — an actual ‘HAMPlicant’ at one of the nation’s larger servicing shops, as highlighted in a guest post at the Calculated Risk blog. They had an $1,880 monthly payment on their mortgage they’d defaulted on, yet their bank statements for the past 30 days included the following expenses:
- visits to the tanning salon
- visits to the nail spa
- some kind of gourmet produce market
- various liquor stores
- A DirecTV bill that involved some serious premium programming or pay-per-view events
- Over $1,700 in retail purchases, including: Best Buy, Baby Gap, Brookstone, Old Navy, Bed, Bath & Beyond, Home Depot, Macy’s, Pac Sun, Urban Behavior, Sears, Staples, and Footlocker
Here’s one household that’s clearly doing their part to ensure that consumer spending stays strong. And any sane person should be asking themselves: How many more people like this are out there among the 7.4 million delinquent loans we now have? And how many more ’spenders’ are there among the 5 million or so currently underwater homeowners — many of whom may at some point decide to default on their mortgage, too, but dutifully continue spending at Best Buy and eating at the Cheesecake Factory?
And the zinger: what happens when these people eventually find themselves, at some point in the future, saddled with rent or a mortgage payment?
Even if you assume that just half of the current 7.4 million currently delinquent mortgages fit this sort of ’spending profile’ (that is, they are spending their mortgage) and you assume a $1,000 median monthly mortgage payment for most U.S. homeowners — you get a $3.7 billion boost per month to consumer spending. It’s certainly enough spending to matter in the overall scheme of things.
A colleague I respect immensely, John Mauldin, has as of late been hammering a simple economic identity we all should be familiar with:
GDP = C (consumer and business consumption) + I (investments) + G (government spending) + E (net exports)
Regardless of how you see it, the dominant variable in the GDP equation above is consumer spending (C); it’s roughly 70% of GDP historically, including health care costs (half of which are actually a government expenditure, but let’s stay out of the minutiae of how data is reported for now). Which means, in the end, that as consumer spending goes, GDP generally goes.
Mauldin sees the risk of recession in 2011 as a 50-50 proposition, largely due to concerns over government stimulus spending and taxation (G). He argues that we must get our deficits under control. But if I’m correct in asserting that there is a ‘delinquency effect’ embedded in our current personal consumption figures, as well, we have even more troubling cause for concern — because shrinking government deficits while simultaneously watching consumer spending tank all over again is a recipe for significant economic pain.
The alternative — government spending its way into oblivion, and headlong into a sovereign debt crisis — isn’t exactly a rosy picture, either. My advice? Plan accordingly, whether for your business or your household.
Let the Short Sales Begin
by Diana Olick
Today the Administration's Home Affordable Foreclosure Alternative Plan takes effect, offering incentives to borrowers, servicers, investors and second lien holders to push short sales through the system. Yep, everyone gets a cut of government funds to get these troubled borrowers out of their homes and get them sold, even if the sale price is less than the value of the loan. I find it interesting that before the plan even went into effect today, the Administration upped the incentives a week ago, doubling the amount of cash to $3000 offered as borrower "relocation expenses" and juicing the payoffs to the others as well. Of course they want to push short sales because of course they know that their modification program isn't working as planned.
But the biggest impediment to the plan is the lenders themselves, who have to weigh what's going to save them the most money and cause them the least bleeding on their books. Is it a short sale or a foreclosure sale?
We're already seeing inventories shrinking way down out West, where banks are holding on to foreclosed properties and manipulating prices to their advantage. I'm also starting to hear rumblings among the number crunchers that the wave of foreclosures we keep hearing about is about to hit with a thunderous roar.
Servicers are ramping up the mod process and pushing those who don't qualify out the door more quickly than ever. A big jump in inventories, which we already saw last month, right in the midst of the Spring market will turn home prices on their heels. Don't get me wrong, I'm loving the jump we saw today in the Pending Home Sales Index, but there was just something a little too hesitant in the Realtors' report. They seem to be talking about hints and hopes, rather than real change.
Ilargi: Americans keep having a hard time wrapping their heads around the realities of the EU and its member states. The New Yorker's James Surowiecki here compares the EU attitude vi-à-vis Greece with The United States governemnt letting 8 states go broke in the early 1840’s. Well, if you need to go all the way there in order to make your point, perhaps it’s time to retrace your steps and see where it was you came from in the first place. For Surowiecki, that seems to be la-la land:
The refusal of European countries (especially Germany) to bail out profligate neighbors, although perfectly understandable, has increased the chances that Europe as a whole will suffer a double-dip recession. In the U.S., by contrast, federal aid to the states softened the impact of the recession, allowing the economy to start growing again; while states still had to cut thirty-one billion in spending, the stimulus aid saved hundreds of thousands of jobs.
by James Surowiecki
Another year, another crisis. If we spent last year worried that big banks were going to fail, the fear of the moment is that entire governments may go under. The anxieties about "sovereign debt" have been most acute in Europe, where the infelicitously named PIIGS countries—Portugal, Ireland, Italy, Greece, and Spain—have huge debt burdens, and where Greece in particular is in dire need of assistance. (It owes four hundred billion dollars, against an annual G.D.P. of around three hundred and forty billion and shrinking.) And now people are wondering if American state governments are headed for their own Greek tragedy. Last week, the Times suggested that the states could be plunged into a debt crisis, and the Wall Street Journal asked, "Who Will Default First: Greece or California?"
It’s not an outlandish question. Besides great climates and lovely beaches, California and Greece share a fondness for dysfunctional politics and feckless budgeting. While American states are typically required to balance their budgets annually, that hasn’t stopped them from amassing a pile of long-term debt by issuing municipal bonds. And, like Greece and other E.U. countries, states have used accounting legerdemain to under-report the amount they owe, even while accumulating huge, unfunded pension obligations. Just as a default by Greece (whose bonds are held by many big European banks) would have nasty ripple effects across the European economy, a state-government default would have all sorts of unpleasant consequences, as state bonds have traditionally been considered a thoroughly safe investment.
For all this, though, the comparison has been overblown. Our states’ debt burden, while sizable, is far more manageable than that of the PIIGS, which owe three times as much relative to G.D.P. as American state and local governments. And though states will certainly have to cut their budgets again this year, the cuts will be smaller (and therefore more politically palatable) than those of, say, Ireland, which is cutting government spending by almost nine per cent. Most important, the states have a fundamental advantage over euro-zone nations: they’re part of a country, not an ill-defined union, so they can count on help from the federal government.
Much of the assistance that the states get from Washington is close to automatic: in normal times, the government sends almost half a trillion dollars in aid (for everything from Medicaid to highways and education) directly to the states. And it can generally be counted on to step up its efforts in a crisis; last year’s stimulus sent more than a hundred and fifty billion dollars to state and local governments. There’s a long-standing tradition of this: one of the federal government’s first acts was to assume the debts that states had run up during the American Revolution. This meant that frugal states had to help pay the debts of profligate ones. But the assumption was that closing gaps between the states by some measure of redistribution was in the national interest. The theory is that we hang together in times of trouble lest we all end up hanging separately.
In the E.U., things are very different. For all the lip service paid to "Europe" as an entity, local interests consistently trump continental ones, as evidenced by the fact that it took Europe months to agree to help if Greece finds itself unable to finance its debts. Despite the large economic imbalances between the E.U.’s members, there are few tools for correcting them. The E.U. does have structural subsidies for weaker economies, but they’re quite small, and there is no obvious mechanism for channelling aid to countries that get in trouble. (Indeed, the E.U. constitution explicitly includes a "no bailout" clause.) Worse still, the single currency means that struggling countries like Greece and Portugal can’t devalue to boost exports and create jobs.
Their only option is to slash budgets to the bone. Countries like Greece and Ireland need to learn to live within their means, of course. But in the middle of a severe recession steep spending cuts and tax increases can be disastrous. The refusal of European countries (especially Germany) to bail out profligate neighbors, although perfectly understandable, has increased the chances that Europe as a whole will suffer a double-dip recession. In the U.S., by contrast, federal aid to the states softened the impact of the recession, allowing the economy to start growing again; while states still had to cut thirty-one billion in spending, the stimulus aid saved hundreds of thousands of jobs.
All this aid comes at a price, of course: it increases moral hazard, and it increases the national deficit. But the federal government is able to borrow money at exceptionally cheap rates, and, at a time like this, when the economy is still trying to find its feet, forcing states to cancel building projects and furlough teachers and policemen makes little economic sense. (Indeed, there’s a strong case to be made that more of the original stimulus package should have gone to state aid.)
The European model would do more harm than good, as American history shows: in the early eighteen-forties, after the bursting of a credit bubble, many states found themselves in a debt crisis. The federal government refused to bail them out, and eight states defaulted—a move that cut off their access to credit and helped sink the economy deeper into depression. The U.S. did then what Europe is doing now, putting the interests of fiscally stronger states above the interests of the community as a whole. We seem to have learned our lesson. If Europe wants to be more than just Germany and a bunch of other countries, it should do the same.
Why Folks Are WAY Too Sanguine About The Possibility Of Bailing Out Basket Case US States
by Megan McArdle
In the new issue of the New Yorker, James Surowiecki has an article comparing the debt problems of our states to the member states of the EU. Surowiecki points out that unlike European states, our states get "automatic fiscal stabilizers" from the federal government, which eases the problems.
But for all that, I think he's rather too sanguine about the fortunes of American states. For one thing, while it's true that the US government has greater institutional capacity to transfer money from feds to states, Europe may have a larger incentive. If a member state defaults, the euro may well go under, causing havoc across the eurozone as their currency falls apart, and lenders start demanding currency risk premia. If California defaults . . . well, a bunch of other states will get the fish eye from the financial market, but this probably won't translate up to the national level.
Perhaps more importantly, I think he dramatically underweights the risk of moral hazard:All this aid comes at a price, of course: it increases moral hazard, and it increases the national deficit. But the federal government is able to borrow money at exceptionally cheap rates, and, at a time like this, when the economy is still trying to find its feet, forcing states to cancel building projects and furlough teachers and policemen makes little economic sense. (Indeed, there's a strong case to be made that more of the original stimulus package should have gone to state aid.) The European model would do more harm than good, as American history shows: in the early eighteen-forties, after the bursting of a credit bubble, many states found themselves in a debt crisis.
The federal government refused to bail them out, and eight states defaulted--a move that cut off their access to credit and helped sink the economy deeper into depression. The U.S. did then what Europe is doing now, putting the interests of fiscally stronger states above the interests of the community as a whole. We seem to have learned our lesson. If Europe wants to be more than just Germany and a bunch of other countries, it should do the same.
The moral hazard involved is no small thing. We've already introduced quite a lot of it into the banking system, but at least the CEOs of those banks got the sack, and the rest have some genuine fear that regulators will get more involved in their business. The Federal government is constitutionally prohibited from the kind of prudential regulation that would be necessary in the wake of bailouts.
This is particularly worrisome because of the nature of the state problems. This is not a classic sovereign debt issue, where there's a giant overhang of high-interest bonds that can be renegotiated at a haircut, or bought down by money from outsized sources. What the states have is a bunch of other obligations, especially to current and past employees. I don't see how these can be bought down, and there are substantial legal and political (not to say moral) issues with asking, say, current pensioners to "take a haircut".
If the feds bail out these states, they're assuming an ongoing obligation--and encouraging other states to let their fiscal problems get as big as possible, so Uncle Sugar will have to pay off. Leaving aside any ideological questions about robbing Peter to pay Paul, and the proper size of government, the federal government simply cannot afford to take on all these new obligations--and if it did, its ability to borrow money would rapidly becaome unsustainable.
Sure, there's nothing wrong with giving states temporary assistance to keep the recession from hitting too hard--but we're approaching the point where that's not really what we're talking about. We're talking about letting states make big promises without bothering to find sustainable sources of revenue with which to pay for them. That's not something the federal government can afford to encourage.
California and Kazakhstan - just who is the underdog?
by Spencer Jakab
Maybe Bill Lockyer "not make benefit glorious state California"? Taking a page out of Greece's playbook, the peeved treasurer of America's largest state fired off letters this week to the chiefs of Goldman Sachs and other banks questioning their marketing of credit default swaps on California's debt. The instruments, he complained, "wrongly brand our bonds as a greater risk than those issued by such nations as Kazakhstan".
Insulting indeed, but who exactly should be insulted? Home to Hollywood, Californians may derive their hazy image of Kazakhstan from Borat, Sacha Baron Cohen's satirical take on a country where he claims the main forms of entertainment include the "running of the Jew". The real Kazakhstan, although not problem-free, looks fairly solid compared to California and many other states - a fact that should spook investors in America's $2,800bn municipal bond market.
On paper, California's debt of $85bn supported by 37m citizens and the world's eighth largest economy looks more manageable than Kazakhstan's near-$100bn heaped on its poorer population of 16m. Go beyond headline figures though and Kazakhstan, with the world's 11th largest oil reserves, an economy that grew more than 8 per cent annually from 2002 through 2007 and unemployment of just 6.7 per cent looks positively vibrant next to the Golden State's joblessness of 12.4 per cent.
And Kazakhstan's modest budget deficit and $25bn rainy day fund make it a paragon of fiscal virtue compared to a state forced to pay bills with IOUs last year and possibly again this summer. Unlike US states, Kazakhstan has its own currency and central bank. If it were to raise taxes or cut public services, wealthy Kazakhs could hardly defect to Kyrgyzstan the way Californians, already facing some of the highest levies and worst schools in the nation, might decamp to, say, Utah.
But such head-to-head comparisons do not even begin to spell out the relative woes of American states compared to many developing nations. In addition to their headline borrowings, equal to nearly a quarter of national output, states and cities have made billions more dollars in promises to current and future retirees. Pensions are nominally underfunded by an already scary $1,000bn according to the Pew Center for the States, but that uses their own rosy actuarial assumptions. Former Social Security administrator Andrew Biggs reckons the shortfall would be up to $3,500bn if calculated using a more conservative private sector methodology. Tack on another thousand billion or so for unfunded health benefits and America's states appear to have dug a hole so deep no amount of austerity could fill it.
Demographics, too, favour developing countries. Even with a relatively restrained birthrate, the median Kazakh is four years younger than the median American and will live 10 years less, cutting down the country's dependency ratio. And while California's innovators may or may not crank out future iPods, Kazakhstan will soon export even more oil as its giant Kashagan field and pipelines to booming China come on stream.
States' borrowing costs are supported by a minuscule historical default rate on traditional municipal debt but also by the distortion of being tax exempt. Lacking this feature, taxable California "Build America Bonds" given a direct federal subsidy yield 6.3 per cent for a 2022 maturity, some 2.4 percentage points above comparable US Treasuries. A more modest spread than Greek bonds over Germany's, to be sure, but then Greek credit protection is also pricier.
After resorting to Hellenic-style fiscal sleight-of-hand to plug this year's budget hole, it is alarming to hear California's officials blame the messenger in similar style. They must grasp that markets don't lie and creditworthiness is unrelated to superficial wealth. For example, Californians who illegally employ Mexican migrants as maids or gardeners might be surprised to learn that swaps traders consider its poor southern neighbour about half as risky a borrower as their state. Jagzhemash!
L.A. controller warns that city could exhaust general fund next month
by Phil Willon and Maeve Reston
Los Angeles Controller Wendy Greuel on Monday said she expects the city’s general fund "will be out of money" by May 5 and that L.A. will likely deplete its reserve funds and be in the red by June 30. Greuel alerted Mayor Antonio Villaraigosa and the City Council of the city’s dire financial situation after the head of the Department of Water and Power stated he would oppose sending $73.5 million in utility revenue to the city treasury. Interim General Manager S. David Freeman said the council’s vote to block a proposed electricity rate hike last week threatens to put the utility in a deficit.
Greuel urged the council and mayor to immediately tap the city’s reserve funds so that city has enough cash to cover payroll. "This is the most urgent fiscal crisis that the city has faced in recent history, and it is imperative that you act now. That is why I am asking you to immediately transfer $90 million from the city’s reserve fund to the general fund so I can continue to pay the city’s bills, and to ensure the fiscal solvency of the city," Greuel said.
Councilman Greig Smith said the decision by the DWP had put the city in a "very risky" situation. "Our reserve fund was already very marginal to begin with. This could push it over the edge," Smith said. "That would mean we would have nothing in the tank on June 30," at the end of the fiscal year. Smith said he could not envision a scenario in which the city could recoup that much money before July 1. Even additional layoffs could not be processed that quickly. "The question is what are we going to do next? That I don’t know," Smith said.
N.Y. Budget ‘Shell Game’ Hides Deficits, Report Finds
by Michael Quint
The state of New York’s history of budget manipulation is contributing to its chronic deficits and cash squeeze, Comptroller Thomas DiNapoli said. "New York needs to stop playing games with the deficit," DiNapoli said in a statement. By shifting money between accounts in a "fiscal shell game," state officials and lawmakers "cover cash shortfalls and avoid making the difficult decisions needed to align spending with revenues," DiNapoli said.
In the year ended March 31, the state used $6.4 billion of funds shifted and borrowed between accounts, and rolled $3 billion of payments into the current year, which began April 1, the report said. Lawmakers haven’t agreed on a plan to close a deficit of more than $9 billion this year in a $135.2 billion budget proposed by Governor David Paterson. "We agree with much of the Comptroller’s report," said Matt Anderson, a spokesman for the Division of Budget. "That’s why we are focused on recurring spending cuts to close deficits instead of one-time transfers," he said. Paterson has said he wants 75 percent of the budget gap closed by reoccurring cuts that would also shrink future deficits.
The Division of Budget’s summary of spending begins with the state operating funds budget, which was $79.3 billion last year, "to help avoid the confusion of transfers with the general fund," Anderson said. The general fund budget was $54.2 billion last year, and the all-government funds, a measure that includes capital spending and federal aid, was $134 billion. The state’s short-term investment pool, which holds unused money from various agencies and was intended as a kind of credit line for "episodic shortfalls," is "now used to cover built- in and permanent structural deficits," the report said.
Thirty-six separate accounts didn’t receive enough revenue to pay their bills and operated with continuous loans from the investment pool amounting to $331.3 million as of March 31, 2009, the report said. New York has 720 so-called special revenue accounts that are supposed to collect funds for specific programs, such as cigarette taxes for health care, according to the report. Over the past 10 years, $2.9 billion was shifted from those accounts for budget relief. In the last three years, transfers totaled $1.8 billion. New York’s Dedicated Highway and Bridge Trust Fund, which handles fuel taxes and other transportation-related fees, has been used for operating expenses such as snow removal and bus inspections, instead of paying for capital projects as originally intended, DiNapoli said.
Since being created about 20 years ago, only 35 percent of the fund’s $33.2 billion of revenue has been spent on capital construction, compared with 38 percent for state agency operations and workers’ fringe benefits, the report said. The state pays more than $1 billion annually on interest and principal for bonds sold in past years to pay budget deficits, the report said. Total debt costs this year are estimated at $6.4 billion, up 14 percent from the prior period. About 36 percent of the increase is the result of 2005 financings that reduced bond expenses that year, according to the state’s capital plan.
New York has $54.8 billion of debt, second only to California, and plans to market $5.9 billion of bonds this year, according to budget documents. The Local Government Assistance Corp., which sold bonds backed by sales tax in the 1990s to pay for accumulated deficits, has about $3.64 billion of outstanding debt, according to budget records. The Tobacco Settlement Finance Corp., which helped close gaps in 2003 and 2004 by selling bonds backed by payments from tobacco companies to settle lawsuits, has $3.26 billion in debt, budget documents show.
Budget Crisis Sparks 40 Days of Prayer, Fasting in Missouri
by Eric Young
Though the 40 days of fasting may have concluded for those who chose to engage in one for Lent, it’s only just begun for many in and from Missouri who are seeking divine intervention for their state amid a budget crisis. Thousands from and throughout Missouri are engaged in a 40 Days of Prayer and Fasting campaign for their state in the time leading up to May 7 – the deadline that lawmakers have to cut millions of dollars out of the current version of the budget before the presentation of the final one to Gov. Jay Nixon.
Though states across the nation are facing economic woes, the people of Missouri decided to embark on a prayer and fasting campaign after the state’s budget crisis "woke them up," according to ministry leader Anne Graham Lotz, who helped kick off the effort last week at a gathering in front of the Missouri Capitol Rotunda. "I believe the ‘alarms’ are going off in our world today," said Lotz, pointing to "alarms" such as the 9/11 attacks, the recent slew of big-scale natural disasters, and the economic meltdown.
"And I believe God is trying to wake us up. And He’s trying to tell us that there is danger ahead, that we need to get right with Him to prepare for what’s coming," she added. "But my concern is that we have been sleeping through the alarms. Which is one reason I want to tell you I am so honored and humbled and thrilled to come to Jefferson City in Missouri because I believe you all may be the first ones to start waking up."
Last week, State Budget Director Linda Luebbering announced that 2010 fiscal year-to-date net general revenue collections declined 13.3 percent compared to fiscal year 2009, from $5.40 billion last year to $4.68 billion this year. And last month, after reviewing the preliminary February revenue figures, Gov. Nixon announced that even as Missouri’s economy begins to rebound, state revenues will continue to lag for a prolonged period of time. "It is my hope that we can continue to work together in a bipartisan fashion to not only balance next year's budget, but also keep our state on sound fiscal footing for years to come," he said.
Lotz, whose ministry is actually based out of Raleigh, N.C., said she's hoping for the "Show Me" state will show the rest of the nation through the revival campaign that it's time to "wake up and get right with God." Throughout the 40 days, Lotz will be sending out daily e-mail to guide participants in the effort "so that God's people all over the Nation can join and be guided in the 40 days of prayer and fasting, focusing on the One who holds the future of Missouri - Jesus Christ." Lotz's ministry, AnGeL Ministries, undergirds her efforts to draw people into a life-changing relationship with God through His Word.
Peak oil man shifts focus to peak price, demand
by Barbara Lewis
Colin Campbell discovers economics, says oil price to stay below $100
Retired petroleum geologist Colin Campbell, who worked for major oil companies as well as smaller firms, has long been associated with the belief the world's oil supplies are dwindling. He does not waver from that and dismisses the argument of the so-called optimists that technology will manage to keep eking out more and more oil to keep pace with rising demand. What has changed is his opinion of the price impact and implications for fuel consumption after the spike of July 2008 to nearly $150 a barrel was followed by world economic recession, a deep drop in fuel use and a crash in oil futures to just above $30 in December 2008.
"I have changed my point of view about future prices," said Campbell, who used to think the peak in conventional oil production, which he believes happened in 2005, would lead to a relentless price surge. Instead, the record rally led to a peak in demand in the developed world. "Peak oil drives prices up in the first place. It has its own mechanism. We're sort of at peak demand right now," Campbell told Reuters from his home in the village of Ballydehob, West Cork. "I think presently the price limit is about $100."
For those who have painted alarming pictures of civil unrest as the world economy is forced to move away from conventional fuel and pay high prices for it in the interim, an inbuilt price mechanism to limit demand and move the world to other forms of energy should be a good thing. "We have no alternative but to go green," Campbell said. But he does not think reduced demand is enough to offset the gravity of peaking supply. He still sees a possibility of social anger as millions are forced to change their lifestyles in a too-sudden structural shift from economic growth driven by cheap conventional fuel.
Campbell's theory, which he developed from studying first Colombia's oil reserves and then analyzing global data on the world's oilfields, applies to conventional oil. The peak for difficult-to-extract, non-conventional sources, including oil sands and polar oil -- for instance, in Arctic regions of Russia -- is three years later, in 2008. The problem is non-conventional oil only "ameliorates the decline" and relies on high oil prices to be viable. "They are no substitutes for what we have built the economy on so far," said Campbell, whose oil depletion theory has been published in books and through the Association for the Study of Peak Oil, which gave its first workshop in 2002.
Since then, the peak oil theory has nudged its way further into the mainstream and was widely publicized around the 2008 price spike, but it is hotly contested by many in the oil industry, including OPEC, which argues the world will rely on fossil fuels for decades to come. Campbell's analysis of data questioned reporting of reserves by the Organization of the Petroleum Exporting Countries, whose members' upward revisions, he said, were not credible. "It's absolutely implausible new discoveries would absolutely match that produced," he said.
He takes the view the reporting of higher reserves was designed to ensure higher output targets for individual OPEC members -- targets, he said, were increasingly irrelevant. As OPEC heads toward its 50th anniversary in September this year, for Campbell the producer club has lost its "raison d'etre." Prices, he argued, were likely to stay sufficiently high as supplies dwindled naturally and the danger for OPEC was the market would embark on another rally that could further focus attention on the pursuit of alternatives to oil.
"OPEC's purpose is to limit production to hold prices up. It no longer has any need to do so," he said. The counter argument is OPEC's output discipline helped to drive the market higher from its low-point in December 2008 to prices around $85 a barrel now, although the group's compliance with agreed limits has dwindled to only around 50 percent.