Thoughts on 2010

"Today's increasingly bullish sentiment is consistent with a B (or 2) wave, which would imply a setup for the most destructive (for financial wealth and confidence) phase of a C-wave decline, lasting 2-3 years. "

What "BC" is describing is similar to the sucker bounce in the early 1930 after the stock market crash of 1929. Source

By mid to late 2010, we will have lanced the biggest boils of the global system. Only then, amid fear and investor revulsion, will we touch bottom. That will be the buying opportunity of our lives. Source

Will the Fed realize, before it’s too late, that the job of fighting the slump isn’t finished? Will Congress do the same? If they don’t, 2010 will be a year that began in false economic hope and ended in grief. Source

Warning: The Deficits Are Coming! (WSJ Sept 4, 2009)

The former head of the Government Accountability Office is on a crusade to alert taxpayers to their true obligations. By JOHN FUND

Washington, D.C.

David Walker sounds like a modern-day Paul Revere as he warns about the country's perilous future. "We suffer from a fiscal cancer," he tells a meeting of the National Taxpayers Union, the nation's oldest anti-tax lobby. "Our off balance sheet obligations associated with Social Security and Medicare put us in a $56 trillion financial hole—and that's before the recession was officially declared last year. America now owes more than Americans are worth—and the gap is growing!"

His audience sits in rapt attention. A few years ago these antitax activists would have been polite but a tad restless listening to the former head of the Government Accountability Office, the nation's auditor-in-chief. Higher taxes is what hikes their blood pressure the most, but the profligate spending of the Bush and Obama administrations has put them in a mood to listen to this green-eyeshade Cassandra. "He's so unlike most politicians," says Sharron Angle, a former state legislator from Nevada, "his message is clear, detailed and with no varnish."

Mr. Walker, a 57-year-old accountant, didn't set out to be a fiscal truth-teller. He rose to be a partner and global managing director of Arthur Anderson, before being named assistant secretary of labor for pensions and benefits during the Reagan administration. Under the first President Bush, he served as a trustee for Social Security and Medicare, an experience that convinced him both programs are looming train wrecks that could bankrupt the country. In 1998 he was appointed by President Bill Clinton to head the GAO, where he spent the next decade issuing reports trying to stem waste, fraud and abuse in government.

One way the Peterson Foundation wants to change that is to bring big numbers down to earth so people can comprehend them. "Our $56 trillion in unfunded obligations amount to $483,000 per household. That's 10 times the median household income—so it's as if everyone had a second or third mortgage on a house equal to 10 times their income but no house they can lay claim to." As for this year's likely deficit of $1.8 trillion, Mr. Walker suggests its size be conveyed thusly: "A deficit that large is $3.4 million a minute, $200 million an hour, $5 billion a day," he says. That does indeed put things into perspective.

YouTube Video
Peter G. Peterson Foundation

How Overpriced Is The S&P 500?

America's Fiscal Train Wreck by Richard Berner at Morgan Stanley (New York)

United States
America's Fiscal Train Wreck
July 06, 2009

By Richard Berner | New York

America's long-awaited fiscal train wreck is now underway. Depending on policy actions taken now and over the next few years, federal deficits will likely average as much as 6% of GDP through 2019, contributing to a jump in debt held by the public to as high as 82% of GDP by then - a doubling over the next decade. Worse, barring aggressive policy actions, deficits and debt will rise even more sharply thereafter as entitlement spending accelerates relative to GDP. Keeping entitlement promises would require unsustainable borrowing, taxes or both, severely testing the credibility of our policies and hurting our long-term ability to finance investment and sustain growth. And soaring debt will force up real interest rates, reducing capital and productivity and boosting debt service. Not only will those factors steadily lower our standard of living, but they will imperil economic and financial stability.

Familiar challenges. Sound familiar? Warning about these challenges has long been a staple for economists. Five years ago, for example, I summarized my concerns about our coming fiscal problems, along with the interplay among them and unexpected longevity, inadequate thrift and saving infrastructure, mediocre education outcomes, and inadequate energy policy (see America's Long-Term Challenges, May 21 and May 24, 2004). I was merely the latest in a long line of alarmists; for example, Pete Peterson famously noted more than 20 years ago that "America has let its infrastructure crumble, its foreign markets decline, its productivity dwindle, its savings evaporate, and its budget and borrowing burgeon. And now the day of reckoning is at hand" (see "The Morning After," Atlantic Monthly, October 1987). The Congressional Budget Office (CBO) has since 1997 - under directors from both sides of the aisle - carefully laid out ever-more depressing fiscal scenarios in its annual Long Term Budget Outlook, the latest of which appeared last week.

The problem, ironically, is that the day of reckoning hasn't come. This has seriously undermined doomsayers' credibility and, more importantly, it has made the electorate and elected officials complacent about the threat from unsustainable fiscal policies. Some even proclaimed that "deficits don't matter."

Fast forward to today. Yet the last five years have brought our ever-distant fiscal crisis rapidly forward. Some of the deterioration is obviously cyclical: Courtesy of the financial crisis and recession, aggressive fiscal stimulus, and ongoing military outlays, the federal deficit has ballooned to US$1.8 trillion or 13% of GDP in fiscal 2009. But the bulk of the threat is structural: The fiscal stimulus package included spending increases with minimal bang for the buck, leaving more debt than growth. In its FY2010 budget, the administration proposes to extend several tax cuts enacted in 2001 and 2003, provide relief from the alternative minimum tax, and increase both mandatory and discretionary spending compared with current law. Most important, by 2019 the full force of rising entitlement outlays and debt service will begin to hit the budget. No rosy growth scenario will provide sufficient resources to meet all the claims on future federal revenue. And while tax hikes or a broader tax base will likely be part of the solution, the real cure is to curb the growth of entitlement spending.

Against that backdrop, voters and politicians are nervous: Two recent polls suggest that Americans are more worried about deficits than healthcare by a ratio of 2:1. But despite voters' deficit anxiety, near-term action to reduce long-term deficits seems highly unlikely for two reasons. First, no one wants to endanger a still-fragile economy by raising revenues or cutting spending until they are sure of economic recovery. Second, while there is no shortage of fiscal scolds inside the Beltway, the political will to change popular entitlement programs is still absent.

Healthcare the main culprit. Analysis of those programs makes it easy to see why. The rise in federal healthcare outlays under Medicare and Medicaid is the main long-term factor boosting deficits. These popular programs create a safety net for the elderly and disadvantaged that has been a band-aid for our flawed system of financing healthcare.

The base is already large: In 2010, some 100 million Americans will be enrolled in Medicare, Medicaid and SCHIP (the State Children's Health Insurance Program), and outlays amount to 5% of GDP. Longer term, Medicare enrollment will rise significantly as the population ages. More importantly, future per capita cost growth for both programs is well in excess of per capita GDP, meaning that outlays for these three programs will double to 10% of GDP by 2035 and nearly double again by 2080. Translated into budget outcomes, according to CBO, these programs will account for virtually all of the likely growth in primary federal spending - total spending less interest on debt held by the public - in relation to GDP, and thus all the likely expansion of the deficit and debt. In contrast, social security cost increases will play a relatively minor supporting role.

There is no lack of options to alter the unsustainable path for Medicare and Medicaid outlays. At the end of 2008, for example, CBO analyzed 115 of them, any handful of which could significantly slow the growth of spending or find the means to pay for it. To name two: Raising the age of eligibility for Medicare by two years (to 67) starting in 2014 would save US$85 billion by 2019. Limiting the tax exclusion for employment-based health insurance to amounts below the 75th percentile for such premiums and doing the same for health-insurance deductibles for the self employed would net US$452 billion over 2009-18. Note that the second option would raise additional revenue, but would not address burgeoning entitlement spending. Yet the prospects for actually adopting any of these measures are dim. There is no serious discussion in Washington of, or appetite for, curbing eligibility for federal health programs. Nor, more important, is there the will to rein in the growth of per capita costs.

Meanwhile, the current healthcare reform effort aims at the apparently conflicting goals of curbing costs and increasing access and quality. In the long run, those goals may turn out to be complementary. But in the near term, politics likely dictate that increasing access will take priority over cutting costs. And increasing access to today's health options will be expensive. For example, preliminary CBO estimates of Subtitles A through D of Title I of the proposed "Affordable Health Choices Act" indicate that expanding access to health insurance for 39 million Americans by granting subsidies will cost US$1 trillion over the next decade. Proposals to cut costs may yet emerge to fulfill the president's requirement that any healthcare reform be deficit-neutral. But political agreement will be hard to come by; witness the storm of opposition to a "public insurance plan" when the outline for any such plan is still vague. Thus, in the short-to-intermediate term, increasing access first means bigger deficits are likely. Pundits are describing the president's ability to deliver a healthcare reform package that improves Americans' lives and contains costs as a defining moment for his leadership. As I see it, it is also a bellwether for our willingness to tackle our fiscal challenges.

Deficit disorder. America's now chronically rising deficit will almost surely expand debt beyond the appetite of global investors to hold it without significant concessions in the form of higher interest rates or a big enough decline in the dollar to make it look cheap, or both. Soaring deficits and debt imply higher real interest rates. That hasn't happened in the current recession, of course, because of the weakness in private credit demands resulting from the collapse of corporate external financing needs and the deleveraging of the American consumer. But rates likely will rise significantly when recovery begins to lift private credit demands. Standard estimates suggest that a 20-point sustained increase in debt/GDP - what we will experience between 2008 and 2010 - will boost real rates by 70-110bp.

But many question whether rising deficits and debt will have significant longer-term market consequences. Optimists cite the example of Japan, where massive deficits boosted government debt to 160% of GDP with apparently no effect on interest rates. The comparison is not apt for two reasons. First, Japan's lost deflationary decade pulled down nominal yields, but there were serious consequences for real yields. Real 10-year JGB yields averaged 1.7% over that period, much higher than the 30bp of annual real growth experienced in Japan. Indeed, my colleague Robert Feldman points out that this positive gap between real rates and real growth clearly boosted Japan's deficits and debt unsustainably (see Fiscal Reform and the r-g Problem, June 17, 2005). Second, Japan's massive current account surplus, which averaged 3% of GDP, means that Japan has no need to rely on foreign saving inflows.

In contrast, America's budget deficits are worsening our persistent internal and external saving-investment imbalances. Our chronic external deficit has shrunk to 2.9% of GDP in recession, but rebounding oil prices and imports suggest it will grow in recovery. Even a coming sea change in consumer behavior and the incipient rise in our personal saving rate to 7-10% of disposable income (5-8% of GDP) won't be enough to offset federal dissaving. State and local governments are awash in red ink, now more than 1% of GDP and growing. Consequently, we still need sizeable inflows of saving from abroad to finance federal deficits.

Fiscal credibility deteriorating. Some are concerned that our reckless fiscal policy will trigger a downgrade of the US sovereign debt rating, making the financing of our burgeoning deficits more difficult. While worries that the US will default on its debt are illogical, global investors and officials are concerned about the credibility and the sustainability of our fiscal policies. So am I. They fear that we will adopt policies that will undermine the dollar and the domestic value of dollar-denominated assets through a combination of risk premiums and inflation. I worry about that too, although such policies probably would be accidental rather than deliberate. As a result, interest rates may have to rise significantly to compensate investors, including reserve portfolio managers and sovereign wealth funds, for such dangers. While the dollar will for now retain its reserve-currency status, such concerns put it at risk.

S&P 500 at Critical Point

The dashed line is the closing price today (May 20, 2009). The market is only off 42% from the peak.

The S&P has just turned down below its 200-day moving average. Not a good sign for the bulls!

New Mortgage Loan Reset / Recast Chart

Matt Padilla at the O.C. Register presents a new reset / recast chart from Credit Suisse: Loan reset threat looms till 2012

Credit Suisse is using recast dates for Option ARMs and reset dates for all other loans.

As Tanta noted: "Reset" refers to a rate change. "Recast" refers to a payment change.

Resets are not a huge problem as long as interest rates stay low, but recasts could be significant.

Note that Wells Fargo expects only a small percentage of their $115 billion "pick-a-pay" Option ARM portfolio they acquired via Wachovia (originally from World Savings / Golden West) to recast by 2012 (because Golden West had very generous NegAM terms). I'm not sure how that fits with this chart.

Madoff PBS Frontline

Mortgage Rate Resets (2010 + 2011)

Still heavy Option Arms + ALT A in 2010 and 2011

The Quiet Coup (Simon Johnson MIT/IMF)

{T]he global economy continues to deteriorate, the banking system in east-central Europe collapses, and—because eastern Europe’s banks are mostly owned by western European banks—justifiable fears of government insolvency spread throughout the Continent. Creditors take further hits and confidence falls further. The Asian economies that export manufactured goods are devastated, and the commodity producers in Latin America and Africa are not much better off. A dramatic worsening of the global environment forces the U.S. economy, already staggering, down onto both knees. The baseline growth rates used in the administration’s current budget are increasingly seen as unrealistic, and the rosy “stress scenario” that the U.S. Treasury is currently using to evaluate banks’ balance sheets becomes a source of great embarrassment.

Under this kind of pressure, and faced with the prospect of a national and global collapse, minds may become more concentrated.

The conventional wisdom among the elite is still that the current slump “cannot be as bad as the Great Depression.” This view is wrong. What we face now could, in fact, be worse than the Great Depression—because the world is now so much more interconnected and because the banking sector is now so big. We face a synchronized downturn in almost all countries, a weakening of confidence among individuals and firms, and major problems for government finances. If our leadership wakes up to the potential consequences, we may yet see dramatic action on the banking system and a breaking of the old elite. Let us hope it is not then too late.

U.S. Total Credit Market Debt by Sector: 1929-2008

Nice chart from Morgan Stanley breaking down total U.S. credit market debt as a percentage of GDP since 1929. The differences in the debt’s composition from the 1930s to today are striking, with households, not corporates, being the credit problem children today.

Dark Musings (Steve Waldman @Interfluidity)

The news of today is the Geithner plan. I think this plan might work very well in terms of repairing bank balance sheets.

Of course the whole notion of repairing bank balance sheet is a lie and misdirection. The balance sheets we should want to see repaired are household balance sheets. Banks have failed us profoundly. We want them reorganized, not repaired. A world in which the banks are all fixed but households are still broken is worse than what we have right now. Too-big-to-fail banks restored to health are too-big-to-fail banks restored to power. The idea that fixing legacy banks is prerequisite to fixing the broad economy is a lie perpetrated by legacy bankers.

I think that critics of the Geithner plan are missing some of its tactical brilliance. My guess is that behind the scenes, Geithner has arranged a kind of J.P. Morgan moment. You know the story. During the Panic of 1907, J.P. Morgan locked a bunch of bankers in a room and insisted they lend to stave a panic. We've already seen one twisted parody of this event, when Henry Paulson locked a bunch of bankers in a room and insisted they borrow money from the Treasury. This second one is more clever. I don't think the scandal of the Geithner plan is going to turn out to be the subsidy to well-connected investors embedded in the non-recourse loan put option. On the contrary, I think that Treasury has already lined up participants for the "Legacy Loans Public-Private Investment Fund" and persuaded them to offer prices so high that despite the put, investors will expect to take a major loss. My little conspiracy theory is that the Blackrocks and PIMCOs of the world, the asset managers who do well by "shaking hands with the government", will agree to take a hit on relatively small investments in order first to help make banks smell solvent, and then to compel and provide "good optics" for a maximal transfer from government to key financial institutions.

Consider a hypothetical asset manager, PIMROCK. PIMROCK reviews a pool of loans held by the bank J.P. Citi of America, and its analysts determine they are worth 30¢ of par value. The bank holds them at 80¢ on its book. PIMROCK agrees to put down $10B to purchase loans from the pool at 82¢ thrilling stock markets everywhere. It was all just a bad dream!

Under Geithner's plan, PIMROCK's $10B permits a $10B equity investment from the Treasury. Then the FDIC levers the whole thing up, providing $6 of debt for every one dollar of equity. So, $140B of bad loans are lifted from J.P. Citi of America, nearly $90B of which is sheer overpayment to the bank.

Of course, as cash flows evolve, PIMROCK's $10B is wiped out entirely, as is the Treasury's investment. The FDIC gets repaid in a bunch of securities worth about $50B, taking a $70B loss. But, as Calculated Risk, likes to say "Hoocoodanode?" These were real market prices, Geithner or his successor will argue. Our private partners lost everything. There was no subsidy here.

Meanwhile, taxpayers will be out around $80B.

Why would PIMROCK go along with this? Because they feel it is their patriotic duty to work with the government for the good of the financial system, even if that involves accepting some sacrifices. And because they hold $100B in J.P. Citi of America bonds, and they've received assurances that if we can get the nation out of the financial pickle it's in, there will be no haircuts on those bonds. "Shaking hands with the government" means that nothing ever has to be put in writing.

Welcome to America, 2009. Change we can believe in.

China has more to worry about than its Treasury holdings

Premier Wen ...“[w]e have lent a huge amount of money to the U.S. Of course we are concerned about the safety of our assets. To be honest, I am definitely a little worried.” He called on the United States to “maintain its good credit, to honor its promises and to guarantee the safety of China’s assets.”

Citibank Nationalized Commercial

The New F***ing Citibank - watch more funny videos

Mysterious Plans by Paul Krugman

At the top are a bank’s assets. Below are its obligations to various parties, with decreasing seniority from left to right. I’ve drawn it to embody a pessimistic assumption about the bank’s finances, because those are the cases we’re interested in: the bank’s assets aren’t enough to cover its debts. Nonetheless, the stock, both preferred and common, has a positive market value. Why? Because of the Geithner put: the bank is protected from collapse, keeping the creditors appeased, but stockholders will get the gains if somehow things turn up.

What Treasury now seems to be proposing is converting some of the green equity to blue equity — converting preferred to common. It’s true that preferred stock has some debt-like qualities — there are required dividend payments, etc.. But does anyone think that the reason banks are crippled is that they are tied down by their obligations to preferred stockholders, as opposed to having too much plain vanilla debt?

I just don’t get it. And my sinking feeling that the administration plan is to rearrange the deck chairs and hope the iceberg melts just keeps getting stronger.

Nationalizing Bad Banks to Save the Rest!

Use this Video Link not the Play Button above.

Yves Smith, editor of The Naked Capitalism blog, thinks it's just a matter of semantics and that nationalization is nothing new. "We already do nationalization in this country. It's called the FDIC resolving banks," she says on Fast Money.

And she tells the traders “nationalization could be a good alternative,” once the government clarifies what nationalization really means. But “we must fix the banks to get out of this economic crisis” and nationalization does the trick.

With nationalization looking more like a question of when – and not if – investors poured into Treasuries and gold briefly pushing up prices to $1000 an ounce before settling lower.

Cumulative Bank Failures Over Time

How The World Almost Came To An End At 2PM On September 18

LiveLeak has caught a scary moment of previously undisclosed insight by Paul Kanjorski where he reveals some facts that have not been captured by the media previously. At 2 minutes and 20 seconds in the video below, Democratic Representative Kanjorski explains how the Federal Reserve told Congress members about a "tremendous draw-down of money market accounts in the United States, to the tune of $550 billion dollars." According to Kanjorski, this electronic transfer occurred over the period of an hour or two. And it gets worse. Kanjorski paraphrases the following disclosure by Bernanke and Paulson:

On Thursday (Sept 18), at 11am the Federal Reserve noticed a tremendous draw-down of money market accounts in the U.S., to the tune of $550 billion was being drawn out in the matter of an hour or two. The Treasury opened up its window to help and pumped a $105 billion in the system and quickly realized that they could not stem the tide. We were having an electronic run on the banks. They decided to close the operation, close down the money accounts and announce a guarantee of $250,000 per account so there wouldn't be further panic out there.

If they had not done that, their estimation is that by 2pm that afternoon, $5.5 trillion would have been drawn out of the money market system of the U.S., would have collapsed the entire economy of the U.S., and within 24 hours the world economy would have collapsed. It would have been the end of our economic system and our political system as we know it.

We are no better off today than we were 3 months ago because we have a decrease in the equity positions of banks because other assets are going sour by the moment.

Interestingly, Kanjorski, and likely more and more Democrats, are starting to shift to the camp that more time is needed to make a correct decision this time (which may explain Geithner's decision to postpone the "bank-rescue" announcement by one day to Tuesday), instead of rushing into another half-baked plan. Very scary stuff.

Rise & Fall of U.S. Mortgage & Credit Markets

The Paulson Funds 2008 Yeard End Report

PBS Frontline February 17, 2009 Preview