Social Security - Trouble at Hand?

Mr. Steven Goss, the Chief Actuary of the Social Security Trust fund wrote a letter* on 9/15/2008. In that letter he included this graph:


On 2/12/2009 Mr. Goss wrote a letter* to Senator Robert Bennet. That letter contained this graph.


The two graphs describe a financial gearing ratio. Note that the data used in the 2008 graph shows a 'surplus' in this ratio through 2025. The updated 2009 graph shows that surplus is gone as of today. This represents a significant change in assumptions over the five month period. Mr. Goss is telling us something is coming. That 'something' is likely to be on the front pages and impacting the markets sooner than was thought.

The following is a link to a report produced by the Trustees of the Social Security Trust Funds (“SSTF”). http://www.ssa.gov/OACT/TR/TR08/index.html"

This is a status report on the health of America’s Social Security and Medicare system. The conclusions contained in this report should come as no surprise. The system is bankrupt. It is just a matter of time. The magnitude of the problem is enormous. The Trustees estimate that the present value of the unfunded portion is $13.6 trillion. It is virtually certain that unless the imbalances are addressed in the near future the U.S. Legacy Costs will destroy our economy.

The US is currently spending trillions of borrowed money to shore up a weakened economy. All of that money will be wasted. At best it will result in a resumption of economic growth for a few more years. By the end of President Obama’s first term the Social Security problem will already be a drag on the economy. By 2016 the damage will be impossible to reverse.
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The 2009 SSTF report will likely show a continued deterioration in the footings of the Fund. The dynamics that impact the SSTF include: economic growth, prevailing short and long term interest rates and the rate of payouts. All of these factors are working against the Fund currently. These impacts will foreshorten the day of reckoning.

This observer believes that it is folly to be spending trillions today when it is a given that the system will collapse in less than a decade. Every prior effort to address the looming crisis has been dismissed by DC. That is understandable. It is perceived that this is a problem that will be realized in 2032. That is not correct. The problem is already affecting us. The negative impacts to the broad economy began a few years ago.

The recession that started in 2008 will negatively affect the results of the SSTF. Should economic growth hover near zero for the next twenty-four months the drag from entitlements will become meaningful as early as 2011.

This is from the 2008 SS Trustees report:

"Social Security’s current annual surpluses of tax income over expenditures will begin to decline in 2011 and then turn into rapidly growing deficits as the baby boom generation retires. Medicare’s financial status is even worse."

The term used “current annual surpluses” requires a closer look. These surpluses have been a critical component in the success of our economy for the past 60 years. The SSTF has been a net saver since its inception. It currently holds $2.4 trillion of US Treasury IOU’s. That amount is approximately 1/4 of the entire US Public Sector Debt that has been accumulated since 1938. This pool of ‘savings’ helped finance the country’s ever growing deficit. The SSTF projected in 2008 that the annual surpluses would be eliminated by 2011. It is quite possible that this significant nexus has already occurred. Consider the following:

*The following graph shows a blue average trend line for SSTF cash flow. Above that a green line that describes the significant month-to-month variations from the mean. Notice that in all of the trough cash flow months there were none that resulted in an actual shortfall.


Not recorded in this chart is the fact that in August and October of 2008 and again in February of 2009 the SSTF ran monthly deficits. The total deficits amounted to $2 billion. These are the only negative monthly cash flows over the past decade. An ominous sign.

*The next chart shows the expense side of the Fund. The jump in outlays is due primarily to baby boomers who are just starting to enter the system. The March 2008-2009 rate of growth was 9.5%. The historical average is closer to 5%. This growth will compound at double-digit rates from now on.


*The final graph shows the average yield on the SSTF. The return has been in a long-term decline. This is largely due to the fact that for several decades we have been in a low interest rate environment. The levels of interest rates being set by the Federal Reserve today for short and long term Treasury paper are hurting the Trust Funds results. The Fund is earning a rate far less than the rate of growth of its expenditures. The interest rates used are set by a formula. As a result, the impacts of lower rates are felt with a significant lag. This lag affect will be realized on June 30th of this year.



The Trustees of the SSTF do not mince words on the seriousness of the problem:

“The financial condition of the Social Security and Medicare programs remains problematic. Projected long run program costs are not sustainable under current financing arrangements.”

It will be interesting to review the next Trustees up-date. My guess is that it will confirm that the economy is already being negatively influenced by the dynamics of the Social Security System. It could not be happening at a worse time. This could sucker punch an already weak system.

The reality is that the entitlement problem is a 2009 issue and not a 2032 issue. The Trustees of the fund recommend:

“The system could be brought into actuarial balance with an immediate increase in payroll tax revenues of 26 percent (from 12.4 percent to 15.6 percent) or an immediate reduction in benefits of 20 percent, or some combination of the two.”

A 26% increase in the payroll tax is out of the question today. Social Security payroll deductions totaled $637 billion in the past twelve months. On a tax adjusted basis this amount is equal to the entire two-year stimulus program recently enacted.




If SS payroll deductions were eliminated for one year the economy would bounce back to life. A one-year suspension would also kill the SSTF. But, the system is dead already, we just think it is asleep.

There is a bright side to this. The issue of the Social Security System is about to come onto the table. Exactly where it belongs. It will be a gut-wrenching process. The outcome of this debate will shape the economy for the next generation. It is possible that the result will be the foundation for an extended period of prosperity.

There is a solution. We must acknowledge that a significant amount of the Entitlement promises that have been made simply can’t be met. In addition we must dramatically change our health care system.

There are three possible outcomes:

(I) We do nothing today to address the imbalances. The result will be that we fall into a long period of economic decline. That decline may have begun already. It will certainly begin in less than five years. Lights out.

(II) We take action to address the visible issues with social security by raising taxes. Raising payroll taxes is no solution. It would just slow economic growth. That runs counter to the long-term interests of the SSTF. In addition, it is simply unfair to ask workers to pay more for a broken system. Lights out.

(III) We accept reality. We recognize that we are not as ‘rich’ as we thought we were. It is not necessary that all existing beneficiaries have their benefits curtailed. The following however is necessary:

a) All persons under age 60 will have their programmed benefits cut significantly.
b) There has to be a “means” test.
c) People under age 45 will lose most of what they have contributed.
d) The only lasting promise made is the availability of health care.

In return for these concessions American workers get back a significant portion of the $650 billion they are currently paying each year into a black hole. It is the only alternative that keeps the lights on. The good news is that the vast amount of American workers do not believe that they will ever receive SS benefits. Confirming that will come as no surprise.



*Link to Mr. Gross's letters and the charts:http://www.socialsecurity.gov/OACT/solvency/index.html

AIG-UGI: It's Over

Readers of this Blog are aware that I have been on a campaign against the Mortgage Insurance Industry. In particular I have been as loud as I can be regarding the continued participation of AIG – UGI in this business.

My anger on this topic comes in part because I saw with my own eyes how mortgage insurance was being misused. In my view a significant portion of our current problems come from the excess leverage and bad borrowers that were the result.

I am please to report to you that AIG – UGI is going out of business. The following is a link with the details:
http://www.bloomberg.com/apps/news?pid=20601087&sid=aacp8qhi44lk&refer=home

This is a positive development. It is the ‘right thing to do’. AIG is owned by the taxpayers. The taxpayers should not be in the high-risk mortgage business.

I would be interested to know how this decision was made. Either Mr. Lockhart at FHFA and the folks at FNM and FRE said, “We just can’t do this any longer. It looks bad", or Mr. Bernanke said, “Enough is enough”. It was certainly not a choice made by the company.

If AIG – UGI stops writing new business its ability to pay claims will be further impaired. No doubt but that the taxpayers will pay for the closing of this company. We already kicked in $2.8 billion in 2008 for UGI’s losses.

There should be a look back at the transactions that have been booked by AIG-UGI since the government intervention in AIG. Some bankers made some nice money taking advantage of UGI-AIG/Fannie Mae in the past nine months. That should not have happened.

I have had some ‘off the grid’ email regarding things that I have written regarding AIG-UGI. I understand that some may be angry with me. I am not responsible for the problems with AIG. I just write about them. I am however, not at all happy that some very good folks in Greensboro NC will be impacted by this.

Bruce Krasting

Stress Test Lite – An Update

Neither the Government, the senior management of the big banks nor the investors need a Stress Test to determine what is the financial status of the banks. Treasury and Fed investigators have been inside of the big banks for months now. The heads of the banks know where they stand as well. As for the market, it has long ago figured out that the Financials are in big trouble. In spite of the recent bounce back in stock prices Citi is still trading under $4. The market, as always, speaks for itself.

The Treasury Stress Test has only one real purpose. It was/is a publicity effort. It was supposed to demonstrate to the broad public that:

“The folks in Washington are on top of this. They are going to take a hard look. Those banks that are not 'up to snuff', they will fix. The other banks will be just fine.”

This publicity effort could flop. Treasury and the whole Stress Test process got a slap in the face in just the past 24 hours. Yesterday we got this:



Today we have this news:



The downside assumptions used to stress test the banks for 2009 include:

*A drop in the Case/Shiller Ten City housing index of 22%. The starting point for the index was set at 162. The ‘worst case’ twelve-month drop would bring the index to 127.

*A drop in GDP of not greater than 3.3%.

*Unemployment to remain less than 8.9%

We are off to a terrible start with the assumptions used in the tests versus the recently announced statistics behind those assumptions.

The Case/Shiller home price report yesterday showed a drop of 2.1% for February. This followed a drop of 2.6% in January. As of the end of February the index has fallen by 8 points in just the first two months of the reporting period. At the present rate of decline it will reach the Treasury’s down side target in September. On an annualized basis the two-month drop is significantly above the 22% benchmark set by Treasury.

The GDP report showed an annualized loss of 6.1%. Almost double the rate of decline used to test the banks. While there may be some green shoots around there is also a swine virus that will certainly dampen consumption in the coming months. Even if the economy stabilizes it will be difficult to get out of the first quarter hole. The 3.3% ‘downside’ will likely be exceeded based on the 1st quarter GDP report.

It is possible that the pace of the declines in housing prices and GDP will slow in the remainder of the year. That remains to be seen. What is clear is that the economy is currently performing significantly below the conditions under which the banks are being tested.

If the upcoming payroll report shows another significant jump in unemployment (it will) then all three metrics that Treasury has used to measure the viability of the banks will have been exceeded.

As these statistics are revealed and the economic implications of the numbers are felt by individuals the inescapable conclusion will be:

“The DC folks told us that the banks were okay provided things did not get worse than such and such. Well, things are much worse than that and therefore it must mean the banks are not safe. If the banks are going bust then I might as well stop paying my mortgage”.

Publicity stunts rarely work. It is unlikely that the Stress Test will prove an exception.

Flu Economics

The initial reaction to the outbreak of the flu has been to, “stay at home and watch TV”. The effects are noticeable. Some restaurants have closed due to lack of customers. The retailers have yet another thing to worry about. There is less traffic on the roads this morning.

Ask this question, “How much could the 'flu factor' impact private consumption? It would be easy to answer this question with “Possibly as much as 20% for a few months.”

GDP is in the range of $1.2 trillion per month. If we did see a reduction in consumption of 20% over a few months it would translate into a drop in GDP of as much as $500 billion. That reduction would offset the entire 2009 share of the stimulus program. The 2009 flu could have a similar impact on the economy as the drop in consumption that followed 911. That drop in private demand proved temporary. We are much more economically fragile today than we were in 2001.

It will take a long time to evaluate the social consequences of this flu. The economic impacts may be felt more quickly. It is possible that there will be a significant elevation in the flu story in the next 48 hours. For example, a decision to close NYC schools could trigger a nationwide response. The economic effects would spread more quickly than the virus.


On average, 36,000 Americans die each year from the flu. The initial evidence suggests that this flu will not produce more than average fatalities.

It is likely that this flu will not kill us. It may however scare the economy to death.

Re-write

For my readers: The blog preceding this one is a re-write of one from a few days ago. I re-did it as it was not published. I softened the case against Bush. It was published this am at Seeking Alpha.

http://seekingalpha.com/article/132884-u-s-mortgage-market-2000-2008-the-reason-we-re-in-today-s-economic-mess

Thanks.
Bruce

US Mortgage Market 2000–2008 – Follow the Money

The following is a chart that shows the growth of total US mortgage debt as percentage of GDP (“MD/GDP") for the period 1985 - 2008. From the end of to 2000 to 2007 the rate of MD/GDP rose from 67% to a peak of 106%.


The increase in the percentage of MD/GDP coupled with the aggregate growth of GPD created an explosion in the total value of mortgages outstanding. From 2000 to 2008 mortgage debt rose from $6.9 trillion to $14.6 trillion, an increase of 110%.

The dramatic change in the relationship between mortgage debt and GDP was a significant contributor to the economic expansion during the period. The doubling of mortgage credit fueled the building boom. It was the gasoline that led to the rapid rise in home prices. It is the source of the bubble in both housing and the broader economy. It is the reason that we are in such a mess today.

This chart shows the holders of mortgages in 2000.


The following chart updates the information for 2008. Only the percentage for the Pool category is significantly increased. The total government share of the Pool increased 120% to $5 trillion. It is difficult to conclude from this data that the private financial institutions were responsible for the over leveraging that took place.


This final chart shows the components of the Securitized Pool in 2008. 66% of the $7.6 trillion Pool has been issued and or guaranteed by either, Ginnie Mae, Fannie Mae or Freddie Mac. The increase in the Federal Pool category totaled $2.5 trillion during the eight-year period.


These charts and related information clearly demonstrate that the DC side of the mortgage mess is a much bigger component than the private sector. Expansion of the Government's roll in the mortgage market by this level of magnitude could not have been accomplished without the ‘Official Guidance’ of the White House.

Mr. Bush was clear in his mind on the issue of expanding home ownership.

President Bush, May 2002:
“I believe when somebody owns their own home, they're realizing the American Dream. I want that pride of ownership to extend all throughout our country. The goal is, everybody who wants to own a home has got a shot at doing so. We want 5.5 million more homeowners by 2010.”

While his goals appeared admirable the consequences will prove costly. Before this housing crisis is over it is likely that we will lose 5 million homeowners rather than gain that amount.

Mr. Bush understood where the money was coming from to support his housing goals. He knew how to unleash the power of the Federal Mortgage Agencies. He refers to Fannie Mae as the ‘Private Sector’ in the following comments. His Treasury Secretary in 2002, Paul O’Neill, was arguing for restraint in the Agencies role in the mortgage market. O’Neill was sacked six months later.

“I called upon the private sector to help us and help the home buyers. I'm proud to report that Fannie Mae has heard the call and, as I understand, it's about $440 billion over a period of time. Freddie Mac is interested in helping. I appreciate both of those agencies providing the underpinnings of good capital.”

Mr. Bush connected his zeal for expanded home ownership with his thinking on homeland defense:

“Economic security at home is just an important part of -- as homeland security. And owning a home is part of that economic security.”

With the benefit of hindsight it is easy to conclude that the absence of regulations and guidelines by Federal regulators contributed to the explosive growth of credit during the last decade. Mr. Bush set the tone for the lax regulatory framework with these words:

“The problem is the fact that the rules are too complex. People get discouraged by the fine print on the contracts. There's too many pitfalls. The Secretary is going to do is he's going to simplify the closing documents and all the documents that have to deal with home ownership.”

The $3.1 trillion increase in the Federal Housing Agency extension of credit during the seven years commencing in 2000 should be compared to the $800 billion two year stimulus bill that was recently signed by President Obama. The ‘stealth’ housing stimulus that occurred from 2000 onward came to an average of $400 billion per year, exactly equal to the 2009 ‘emergency’ stimulus program. Of importance was that this stimulus was not on the Federal budget, it was masked as the private sector.That mask came off when FRE and FNM went into Conservatership.

The expansion of mortgage credit has been a powerful engine for economic growth for sixty years. That engine was red lined for the last seven years. Now we need a new engine for growth. It is unlikely that it will be from an expansion of easy credit. The aggregate amount of mortgage debt outstanding actually declined $100 billion over the last nine months. If we were to return to the 2000 level of Mortgage Debt/GDP = 70% it would imply a reduction of credit in excess of $4 Trillion. The return to historic debt ratios will take many years. The outlook for a return to sustained economic growth of 3% while the debt market is contracting as a percent of GDP is unlikely. An extended period of sub-par growth is a more probable outcome.


Sources:

http://www.federalreserve.gov/econresdata/releases/mortoutstand/mortoutstand20090331.htm

http://www.federalreserve.gov/Pubs/supplement/2004/01/table1_54.htm

http://www.hud.gov/news/speeches/presremarks.cfm

AIG Mystery Trades - Who Knew?

I follow AIG stories. On March 11th I read an interesting piece regarding AIG in blog called Zero Hedge.

The essence of this blog was that AIG went to a number of big Street players and unwound significant amounts of outstanding CDS swaps. The suggestion was that these ‘unwinds’ were done at fire sale prices and that the banks involved got fat on the trades.

There were aspects to this story that I found to be very ‘plausible’. It occurred to me that if this were true it might give the bank stocks an opportunity for a dead cat bounce. I checked around with a few journalists and some friends in Town. Several had heard the same thing, but no one that I talked to could confirm it. I let it slide. Too bad for me, The BKX is up 50% since then.

This weekend, no less than the Barron, Alan Ableson brought up this story in his weekly column. Here are Mr. Ableson’s words:

As Zero Hedge explains, AIG, desperate to hit up the Treasury for more moola, decided to throw in the towel and unwind its considerable portfolio of default-credit protection. In the process, the badly impaired insurer, unwittingly or not, "gifted the major bank counterparties with trades which were egregiously profitable to the banks."

If Mr. Ableson is comfortable with this story then so am I. Unfortunately it does not matter any longer. The move in the BKX is over. I missed it. Now that the confirmation on this story is out, the market will finish the cycle and ‘sell on the news’.

Assume for the sake of discussion that the story is true. There is some related information. Mr. Liddy, the AIG CEO said before Congress in mid March, "The CDS book is at $1.6T, and it will take four more years to unwind." That struck me odd at the time. At one point the CDS book was reported to be as large at $2.7 trillion. Did Liddy confirm that as much as $1 trillion of the CDS book was eliminated?

In the absence of facts let me speculate. These large unwinds must have taken place early in the year. Probably January, possibly it started in December. If this took place it happened on direct orders from Washington. If my sense of timing is correct then Paulson was still involved. His role was transitional however. The decision makers on this had to have been Geithner, Bernanke and Summers. It is not possible that AIG would have done something this significant without the advice and consent of the Federal Reserve.

It is possibly that the DC foursome were looking at an AIG black hole. AIG was ‘too big to fail’ but its CDS book was sucking up huge amounts of liquidity. Potentially an amount greater than Congress was prepared to pay. A choice was made. The order to AIG was given: “Reduce the portfolio by 40%”.

One can imagine the conversations that must have taken place between AIG and its CDS counterparties:

AIG: “We need a price to close $150 billion of CDS on your books”

Counterparty: “Gulp. I will call back shortly with a very stinky price.”

If this story is true it will explain some of those mystery profits the banks have been reporting. There is a broader context in which this should be considered.

The credit markets have been contracting for nearly eighteen months now. The contractions have come in waves. Each wave has been more destructive then the last. It started with something relatively minor called Sub Prime loans. The subsequent waves caused by BST, FNM, FRE, LEH and AIG each caused another contraction of credit and an associate drop in equity values.

The CDS market facilitated the expansion of credit in the good times. CDS created the opportunity for low risk investors to fund high-risk pools of mortgages. Unwinding the large AIG CDS positions had to have a contractionary impact on the total market capacity to absorb credit risk. At its peak in 2007, the shadow banking system was $10 trillion. If it is correct that the AIG unwinds totaled as much as $1 trillion it would constitute a significant portion of the off balance sheet debt market. A contraction of this magnitude in a short period of time would, by itself, result in significant market volatility as the underling ‘risk’ is repositioned. Yet another wave.

If the AIG unwinds were responsible for the great ‘sucking’ noise of credit that we heard in January and February then it is also likely that the big swoon in equities prices during that period were a consequence as well. The move down in stocks during this period caused a drop in values of $2.5 Trillion in less than 60 days. No one factor was responsible for that decline. However, it is possible that an unintended consequence of the AIG unwind was that it caused/contributed to/accelerated the broad decline in global equity prices.

At this point there are a handful of people out there who have the answers on this. They know if this happened, when it happened, what assets were involved and how big this was. There are large group of folks, including Mr. Abelson, and myself that do not have these facts.

It makes sense that the Fed and Treasury keep some of their activities out of the public domain. Tipping their hand would just cost the taxpayers more money. At this point the deals are done. The quarter has passed. The story in Barrons makes it half public. The Fed and or Treasury should clarify the facts on this matter. I, for one, would like to know if our leaders in DC inadvertently triggered a 20% hiccup in the global equities markets.

The Mortgage Mess – Blame Bush

The Federal Reserve issued a report on March 9th titled “Mortgage Debt Outstanding”. There is a lot of useful information.
Here is a link: http://www.federalreserve.gov/econresdata/releases/mortoutstand/mortoutstand20090331.htm

This report brings some clarity to the problems we are facing. For example, the Fed establishes the size of the mortgages outstanding. The Fed puts that number as of year-end 2008 at a whopping $14.6 trillion. There has been a lot of discussion lately about the rapid rise in Public Sector debt towards the scary 100% of GDP level. Well, private mortgage debt is already there.

In 1990 mortgage debt was 66% of GDP. In 2000 it was 68%. However, from 2000 to 2008 that rate jumped to 100+% of GDP. This represents an expansion of mortgage credit of $7.8 trillion, a 100% increase in outstanding mortgages in just eight years. There was a 50% increase in the Mortgage Debt to/GDP ratio in the first eight years of this decade. This surge in available credit led to the bubble in housing that is killing us today.

There has been a lot of finger pointing going on as to who is responsible for the economic problems that we face. The question, “How did we get into this mess?” is being answered with, “The reckless guys on Wall Street did it”. A review of the information provided by the Fed does not support that conclusion.

The Fed report includes data on Non Farm, nonresidential and Farm mortgages. This information is not included in the following analysis. Only the One-to four family residences and Multi-family residences are included. These two categories totaled nearly $13 trillion as of December 2008.

The major changes in the 2004 - 2008 period:


Mortgage pools and the Banks are the only notable categories. Of the $3.1 trillion in growth over the period $2.8 or 90% comes from Mortgage Pools. In this category are the SPIV’s, SIV’s, CDO’s and other toxic waste that turned this mortgage pool into a cesspool. The category, 'Federal/Agency' is a surprise number. It looks as if the DC share of the mortgage mess was negligible. The data suggests that this category represents less than 10% of the problem and that the Federal involvement grew at a rate less than GDP. Nothing could be father from the truth. The Agency and the Pool categories are intertwined.

The Fed provides information regarding the Pool that we are drowning in. $6.9 trillion of the pool is residential mortgages. Of that amount only $2 trillion is identified as ‘Private’. The balance of $4.9 trillion has been securitized, guaranteed and sold by either Ginnie Mae, Freddie Mac, or Fannie Mae. In other words, the Feds own 70% of the Pool.

If the Pool is tainted we aught to look at who has been peeing in it. In this case it is clear that the Private Sector financial contribution to the growth of the now problematic pool is minor when compared to the Government’s direct involvement.

The following chart summarizes the Mortgage debt to GDP ratio over 23 years. The level was relatively stable for the years 1985 to 2000. Thereafter it exploded. This dramatic increase in financial leverage is the fundamental reason for the problems that we face today. It is not possible that such a significant expansion of Government credit could have been accomplished without the direct involvement of the President.


Then President Bush spoke on the subject of expanding mortgage credit in June of 2002. The speech was given to a large HUD audience. The speech was met with applause. It is worth reading. Link to speech http://www.hud.gov/news/speeches/presremarks.cfm

His words establish his state of mind on the issue of expansion of mortgage credit. The following are some excerpts from that speech:

-I believe when somebody owns their own home, they're realizing the American Dream. I want that pride of ownership to extend all throughout our country. The goal is, everybody who wants to own a home has got a shot at doing so. We want 5.5 million more homeowners by 2010

-I'm going to do my part by setting the goal, by reminding people of the goal, by heralding the goal, and by calling people into action. It is essential that we stay focused on the goal, and work hard to achieve that goal. And when it's all said and done, we can look back and say, because of my work, because of our collective work, America is a better place. Out of evil came incredible good.

-The single barrier to first-time home ownership is high down payments. We can deal with that. It is essential that we make it easier for people to buy a home.

-The problem is the fact that the rules are too complex. People get discouraged by the fine print on the contracts. There's too many pitfalls. The Secretary is going to do is he's going to simplify the closing documents and all the documents that have to deal with home ownership.

-I called upon the private sector to help us and help the home buyers. I'm proud to report that Fannie Mae has heard the call and, as I understand, it's about $440 billion over a period of time. Freddie Mac is interested in helping. I appreciate both of those agencies providing the underpinnings of good capital.

-Economic security at home is just an important part of -- as homeland security. And owning a home is part of that economic security.


Well before this speech Mr. Bush initiated the steps that linked Congress, the Executive Branch, Treasury, Fannie and Freddie in his grand plan to achieve his Goal. He engineered the massive increase in the Mortgage/GDP ratio. His intentions may have been good. His actions have brought us to our knees.


Along the way Mr. Bush solicited the support of anyone he could to achieve his 'goals'.

Geithner’s Red Herring

I read a lot of Red Herrings. These are the, not quite final, versions of what will become a Prospectus. If you want to sell a security to the public you have to circulate a Red Herring and ultimately a Prospectus. It is how Wall Street works.

The Red Herring contains a great deal of the information that an investor would need to know before he wrote a check. They all look alike. There is always a section on Projections. In that section there is information that allows the reader to ‘stress test’ the deal. The information is always presented with Base, Best and Worst case assumptions.

I have Swiss blood in me so I go directly to the Worst Case and take a look. If an argument can be made that the Worst Case (a) will not happen and (b) even if it does it looks manageable, then I will take a deeper look.

Mr. Geithner has never written a Red Herring. It is interesting to look at his approach for stress testing.

On the matter of Projections there is a significant difference between the DC version and the Wall Street version. While Wall Street provides a Base/Best/Worst case Treasury provides only a Base Case and something called “More Adverse”. This is tricky Washington speak. The More Adverse standard is just an excuse to stress test the banks with something quite different than a Worst Case. This is Stress Test Lite. It looks more like a Red Alert than a Red Herring

There are three components to the More Adverse stress test, GDP, unemployment and home prices as measured by the Case-Shiller index.

These are the GDP assumptions that are being used by Treasury for the More Adverse analysis:


Let’s hope that things turn out this way. The forecast calls for a resumption of growth by the end of the year. It assumes that we will be returning to ‘Trend Line Growth” next spring.

This forecast is not out of line with a lot of well respected economists. These same economists have missed the boat on their forecast of economic activity for the last year and a half. While the Treasury More Adverse assumptions are defendable they have nothing to do with stress testing the banks on a Worst Case basis. In my view a legitimate stress test for the banks would have used a GDP forecast of flat growth for the whole year. The idea that the ‘down side’ is defined as a return to normal economic growth in just twelve months seems a tad optimistic.

The assumptions used for unemployment are for an average of 8.4% for 2009 and 10.3% for all of 2010. The unemployment rate is currently 8.1% and rising rapidly. The 8.4% assumption for unemployment will almost certainly be exceeded. Unemployment is a lagging indicator and will likely rise in 2010 even if the economy stabilizes. In the post WWII period US unemployment exceeded 10% only once. That was in 1982. During the Depression unemployment topped out at 25%. That is not going to happen again. However, in the ten year period from 1929-1939, the unemployment rate averaged 15%. The post war history of unemployment at less than 10% will be tested in the next year. We may not be having a depression, but this is the mother of all recessions.

The More Adverse case for housing prices relies on the Case-Schiller index. In this most critical area the Treasury appears to have chosen an aggressive litmus test. The assumption used is that the National Housing index will fall by less than 20% from the levels of January of 2009.

One would think that an additional drop of 22% could not be possible. However the same index has fallen by more than 30% in less than two years. We are now at 2003 levels for housing prices. If we fell to 2000 prices it would exceed Treasury’s down side benchmark. More troubling is that the Treasury analysis has the drop in home values leveling off in less than one year.

The Case–Shiller index has accurately described what is going on in the real estate market. However, the stress test should have been based on the 20 City report versus the National Average. The 20 City report is more likely to drop by 20% than the national report.

On balance, the Treasury Department did an okay job of establishing the criterion for their stress test. They very deliberately chose not to provide a set of Worst Case Results. They are only stressing the banks to a standard of More Adverse. If they had chosen a stricter set of standards for this test it just would have meant that more banks would have failed the test. There is no more TARP money to speak of so the standards must be driven by the available capital to fix the problem banks that result from the test.

On May 4th Treasury will release the results of their efforts. This is what they will say:


I would read their announcement differently. I would read it to say:


Of course you will never see that. You just might however see GDP declining for longer than anticipated. Unemployment looks like a lay up to exceed 10.5%. If those conditions are what we will be looking at, then it is not too hard to forecast an additional 20% drop in RE prices on a national basis.

The conclusion is simple. Either we get out of trouble pretty quickly or we will be in a lot of trouble before too long. Let’s hope Keynesian economics will work one more time.

Geithner’s China Flip-Flop

These two headlines speak for themselves. Geithner spoke forcefully at his confirmation hearing on January 24. Now, only 90 days later he reverses himself. Some thoughts on this development:

*If one was ever wondering what the perfect example of a Flip-Flop in American politics is, this is it.

*Mr. Geithner has apparently misspoken at his confirmation hearing. His comments at that time lead to a market hiccup. Later on the Premier of China and the Chinese Finance Minister went public with some nasty comments on the soundness of the US economy. No doubt those remarks were prompted by Mr. Geithner’s tough talk on the Yuan exchange rate at his confirmation hearing. Tit for Tat.

*Mr. Geithner took a hard approach on China at his confirmation hearing because he wanted to deflect attention from his tax ‘computation errors’.

*Mr. Geithner has misled a Congressional Hearing regarding his intentions regarding China. At some point he will back on the Hill and I am sure that he will be reminded of his words at that time. That will be interesting to watch.

*Mr. Geithner should take care to avoid these types of policy flip-flops in the future. The financial system appears to be forming some sense of stability. The last thing we need are ‘surprises’. America loses financial credibility when these types of things happen.

*It is good that the US has come to its senses and has decided not to start a trade war with China. Imports are down from 20-40% depending on the category. The urgency of the problem when the economy was hot has abated.

*Currency manipulation never works for long. The Chinese will pay a price for maintaining an undervalued currency. Market forces and the impact on the domestic money supply will ultimately force the Chinese to act. Rhetoric from DC just makes the Chinese position more difficult. If they were to have responded to the Geithner pressure they would have looked weak. Therefore there was never a chance that strong-arm tactics would have influenced them.

*It is very difficult for the US to point fingers at the Chinese currency policy. The Swiss National Bank recently announced a new policy to manipulate the Swiss Franc to a lower value versus the Euro. I have not heard the Treasury Secretary blast the Swiss for their moves. The Russian Central bank intervened heavily in their own currency market throughout the fall. They spent $250 billion. Many other countries have been forced to intervene or devalue their currency over the past six months. The idea of singling out one country, when there are plenty of violators out there, is just a bad fight to pick.

*The US has been lily white on the matter of currency manipulation over the past year and a half. We have let the market sort this out. No doubt that is the correct policy choice, However, The Federal Reserve has been intervening on a very regular basis in the US Treasury Bond market. The Fed will be buying up to $300 billion of paper that Mr. Geithner at Treasury will create. The polite word for this is ‘quantitative easing’. The less polite description is, ‘dirty float’. Manipulating interest rates is as old as the hills, but direct purchases of Treasury securities is brand spanking new. Each country is doing what they believe they have to do in order to get by The US has taken unprecedented and extraordinary steps in the past year. Not a single, ‘market based’ solution has been implemented. It is difficult to accuse China of manipulation while we have been so massively intervening in our own economy.

*There will be much talk about the Treasury decision. I would expect that there will be a statement from Treasury that says, “Decision on China not influenced by their US bond Holdings. Nothing could be farther from the truth.

*This is not a win for the US. It is not a tie either. It is a loss. It is never good to make concessions to creditors. Once you start it does not stop. We just made a big concession. That we did will not go unnoticed by all those other holders of US Reserves.

The End to Systemic Risk?

The following is a five-year chart of the Wilshire 5,000. It clearly shows the amount of capital destruction that took place in the 08-09 period. The 18-month peak to trough represents a loss of wealth of nearly $9 Trillion.


The one-year chart shows that the bulk of the losses took place in just six weeks. From September to October 2008 the equities market gave up $6 Trillion. The November 08 low is V shaped. The more significant March 09 low is shallower in slope. More stock was traded. It looks convincingly like a legitimate low.


Both of these lows were head fakes. In November there was a fairly broad perception that the lights were rapidly going out in the global economy. Mr. Bernanke has since acknowledged that even he was not certain that the system would survive during that period. The actions by UK’s Gordon Brown turned things around when he took steps to make direct investments in British banks. The rest of the world quickly followed suit with a massive recap of the public sector financial institutions. TARPing worked. It took the, “We are falling into a hole” issue off of the front page.

By March of 09 the economic numbers were catching up with what the market was telling us in the Fall. In the first two months of the year there was evidence from every corner of the globe that private consumption was dropping at double-digit annual rates. That led to the Depression talk. At the same time there was the mistaken belief that Citi and a number of other major US financials were going to disappear. Fortunately, Mr. Geithner spoke forcefully and said, “No major banks are going under”. At the same time it became clear that virtually every major country was initiating a significant stimulus program. China, the US, EU and a number of others are throwing big money at the demand problem.

As of today the market has recovered $2 Trillion since the March low. All stocks benefited, but it was really just a massive turnaround in the financials. By way of example C is up nearly 400% off its low.


The chart of the past six months shows that we actually have been pretty flat for the period. For sure there were some big swings and percent changes but net-net a lot of stocks are not much changed in price from mid-October.

The question is what will happen next? A lot of risk has been taken out of the market. (A) We are not going to collapse into a global depression. (B) The major financial institutions that we need to weather this storm are not going to go away. Many of the systemic risks that we were worried about appear to have been addressed.

If those two statements are correct then the market has a lot of opportunities in it. Those opportunities are probably not in the stocks that have both collapsed and then surged in the last six months. Those opportunities are not in the stocks of companies whose franchises have been destroyed by the sea-changes in the economy. Those opportunities are probably in the stocks that are trading at or near their mid-October 2008 levels. I suspect there are a lot of them. That makes this a ‘stock pickers’ market. It is unlikely that the ‘buy and hold’ will make money.

Supporting the market of late is a lot of ‘green shoots’ blah blah. The talking heads are looking everywhere for ‘good news’. Even the President is seeing favorable signs. Much more important is that the folks who go to work everyday to invest money are seeing the same things, and they are putting money to work. The buy side, outside of the mutual funds, is significantly under invested at this point.

Investments should not be based on one's highest expectations or one's worst fears. Those extremes never happen. Either you take no risk and make no money or you take too much risk and get killed. Having said that it is worth keeping an eye on what could be the ‘worst case scenario’.

By my count the Treasury must raise close to $3 Trillion in the next eighteen months. This amount includes the deficits, the unfunded portion of the TARP, The TALF funding requirement, The FDIC guaranteed paper, the supplemental expenditures for Iraq and Afghanistan and a substantial portion of the debt of the Agencies. If these green shoots people are talking about actually sprout then there is going to be a problem for Treasury to raise this much money. Keep in mind that not only does Treasury have to sell this staggering amount of paper, they have to do it at historically low yields.

The Treasury bond market is now officially a ‘dirty float’. The Federal Reserve is intervening directly in the bond market on a weekly basis. They have bought paper at auctions and they have bought off the run issues in support of the yield curve at more or less the current levels. The have pledged to buy up to $300 billion of Treasury Securities. In addition they will buy up to a Trillion of Agency and Guaranteed MBS.

For now, the bond market is just looking at this new phenomenon and scratching its head. Technically the Fed has spoken for more than a third of the funding requirement. That still leaves close to $2 Trillion that has to get sold to the public. I, for one, cannot imagine who will buy this unless rates are allowed to rise to levels that would attract the money. A 2.8% taxable return on the ten-year has to be one of the dumbest investments around if you believe that the worst is behind us.

My guess is that this apparent standoff will not end softly. The intervention in the bond market that is working today will not work for long. The Fed buys $15 billion while at the same time Treasury sells $90 billion. Before too long the ten year bond market is going to make a new test of the 3% level. If the Fed meets that with increased weekly purchases it will result in only a temporary standoff. People are counting every penny that is being spent on this intervention. When that number reaches $150 billion the talk will grow that, “They are running out of ammo”. This raises the possibility that at some time in the future the Treasury has an auction and not enough people come. Either the yields will have to rise to levels that will kill the housing market and the rest of the economy or, even worse, the Fed will just buy everything that is issued in order to keep rates low. It is hard to imagine that stock prices will do well if those are to be the market conditions that we will face.

For the past eighteen months the markets have forced the policy makers hand at every turn. We created a free market system and now that same system is eating our lunch. It is unlikely that the markets are going to be suddenly tamed by Bernanke’s limited ability to intervene and control pricing.

The bond market will determine if we land softly. This is an awesome responsibility for a market whose players wake up every morning with a pessimistic outlook. If and when the ten-year yield gets to a level of 3.1% the sparks will start to fly. If at that time the Fed is unable to control the market without using up a substantial portion of its buying power we will have a new-new paradigm in the making. This is all shaping up to take place before the end of Summer, so keep your seat belts on.

This observer doubts whether the bond market will allow Mr. Geithner and Mr. Bernanke to have their cake and eat it too.

Ben Stein – Nobody’s Business

Ben Stein wrote a piece on Sunday called, “When a Cure Fights Itself”. Mr. Stein is always worth reading. The link to his article is at the end of this page.

There is nothing in Mr. Stein’s article that I agreed with.

Mr. Stein starts by making light of a new social phenomenon in the US called ‘Tea Parties’. Tea Parties are public gatherings where folks get together and bitch about things like taxes and the economy.

Mr. Stein is confused by this development. He says, “These Tea Parties strike me as off base.”

Read the papers Mr. Stein. Tea Parties are not some spontaneous event in America. This is a well-orchestrated effort by an outfit called Freedomworks. Conservative Dick Armey runs this shop. I hope this info clears up your confusion.

Mr. Stein says, “I don’t get the taxation uproar. As far as I know no new taxes have been enacted.”

What? You must be kidding right? You live in California. State taxes are going up $13 Billion. You must have heard about that. State income taxes, property taxes, school taxes and all manner of fees are going up in every community in America. You probably have an accountant and do not really look at the minutia. If you looked, you would see that you are paying increased taxes on everything you do.

Mr. Stein connects the dots between the Tea Parties and an economic theory and concludes that consumers aren’t spending because they are afraid of the future. They should save less and spend more.

Mr. Stein, it is not just fear of the future that is restraining spending. You are missing the picture. People are out of work. We have been losing 600,000+ jobs a month. Malls, car dealerships, restaurants, retailers of all sorts are closing. There are new layoffs by our biggest companies every week. There are foreclosure sales everywhere. We lost $11 Trillion last year! The theory of “Rational Expectations” is of questionable relevance today. We have never been 'here’ before. It is hard to act rational in uncharted waters.

In a push to get people spending Mr. Stein wrote, “The stimulus program is like borrowing from our grandchildren, without their permission, so we can buy now”. That is a heinous suggestion.


Mr. Stein presents all of this in the context of “When the recession is over”. Here again I think Mr. Stein is not in touch with what is going on. We are not going to go back in time to 2006 where he thought everything was peachy. That is not going to happen for another generation. Hopefully two generations.



For some reason Mr. Stein chose to mix his thoughts on Tea Parties with a cheap shot at Larry Summers and Hank Paulson. His gripe is that they both lead successful private sector lives. He suggested their judgment might be influenced by that fact. Mr. Stein, what are you talking about?

That Mr. Summers is a success is a plus on his resume, not a minus. We need people like him who will work for peanuts and address the problems we face. As for Paulson, Mr. Stein is dead wrong. If Paulson had not acted as he did in the fall of 2008 the economic lights would be out today. He took one for the 'team' and we owe him.

The link to Mr. Steins article:
http://www.nytimes.com/2009/04/12/business/economy/12every.html?ref=business

S&P on the Mortgage Insurance Industry – Trouble

S&P reported on the Mortgage Insurance Industry ‘MI’ recently. It wasn’t pretty. You have to hand it to S&P on this one. They dealt the industry a blow. At the same time they have forced some critical choices by FHFA Director Lockhart.



There are six principals in the MI business. Here is what S&P had to say about them:

*AIG -United Guaranty Residential Insurance Co to 'BBB+' from 'A-' .
*Radian Guaranty Inc. to 'BB-' from 'BBB+'.
*PMI Mortgage Insurance Co. (PMI) to 'BB-' from 'A-'.
*Genworth Mortgage Insurance Corp. (GMICO) to 'BBB+' from 'A+'.
*Mortgage Guaranty Insurance Corp.'s (MGIC) 'BB" ratings were affirmed.
*Republic Mortgage Insurance Co. to 'A-' from 'A'.

Triad Guaranty a former member of MICA is currently in default.

Fannie Mae commented on the MI ratings dilemma in its 2008 annual report:


FHFA and the Agencies have played fast and loose with their own rules governing activities with the PMI providers. The revised ratings by S&P and other ratings agencies will make it impossible for this to continue. The MI industry has outstanding a total of $460 billion of insurance in force with FNM and FRE. This represents a risk to the Agencies of more than $100 billion.

It would be a mistake for those that have a voice in this matter to stay silent. This story will almost certainly have an unpleasant ending. The following are possible outcomes:

-FHFA, FNM and FRE could bury their heads in the sand and continue to do big business with insurance entities that are rated substantially lower than the guidelines that they have previously set. At some point in the next six months the GSE’s will need more capital. Congress will have to approve at least an additional $200 billion. Having a hand out while at the same time breaking reasonable credit guidelines that result in taxpayer losses and more foreclosures will make the next round of capital for the GSE's a harder sell.

-Mr. Lockhart at FHFA could, “do the right thing” and enforce the existing guidelines. This could trigger a host of problems. If the MI companies are shut out of the income from new business with the Agencies they will have lost a major revenue source. Without that revenue they have limited ability to pay claims. This would result in larger losses for the GSE’s.

More than 20% of the Agencies new mortgage activity in 2008 was enhanced with MI. If this 20% were substantially eliminated the resulting reduction of available mortgage credit could produce another downward leg in the housing crisis. Obviously this runs counter to the Administration’s stated objectives.

Neither of these possible outcomes appear to be attractive. No doubt there are some folks in DC who are trying to come up with Plan B. The usual solution is at hand. Washington will have to TARP the MI companies. Director Lockhart put that thought on the table in a recent letter to the MI industry lobbyist, MICA:


Mr. Lockhart will no doubt continue to stand behind the MI industry. He does not want to lose 20% of his new business activity. On the other hand, Mr. Bernanke and Mr. Geithner will have a difficult time supporting a plan that puts more tax dollars at risk to junk insurers. The optics of the MI story are not good. Bernanke and Geithner risk their credibility if they 'fold' on what looks like an obvious call.

If the discussion on MI is elevated to the White House it is likely that Mr. Summers would see both the pro's and con's and he would lean toward another, "short-term socialization to protect the broader economy" approach. Mr. Volker may have the final voice. As an old Wall Street guy who knows credit my guess is that he will say, "Enough is enough".

MICA - You Can See Through It

Treasury Secretary Geithner recently said that he was going to be the new Sheriff when it comes to mortgage fraud. If Mr. Geithner is truly interested in addressing the malpractices of the mortgage industry he should first look very close to home. He is sitting on a conflict of interest with AIG and the Agencies that he has know about for a long time. It is costing the taxpayers billions.

MICA stands for Mortgage Insurance Companies of America. MICA is the industry spokesman for the players in a very troubled side of the mortgage industry. In February of 2009 MICA members had outstanding insurance guarantees on $950 billion of mortgages. Almost of all of those enhanced mortgages were sold to Fannie Mae and Freddie Mac. The mortgage insurance industry has played a substantial role in the over-leveraging of the housing industry that has now brought us to our knees.

The corporate players behind MICA as of 12/08 include:

-AIG-United Guarantee
-Mortgage Guaranty Insurance Corporation
-Genworth Mortgage Insurance Corporation
-PMI Mortgage Insurance Co.
-Republic Mortgage Insurance Company
-Radian Guarantee

Follows a quote from MICA’s brochure describing their activity:


Read ‘traditional lenders' to mean Fannie and Freddie. The definition of a conforming loan for the Agencies calls for a minimum of a 20% down payment. PMI allows individuals to buy homes when they have little or no down payment. FNM and FRE report that MICA members have enhanced an average of 25% of their combined portfolios.

MICA is well aware that no money down loans creates bad borrowers. Their words:


Studies? Forget the studies. Look at the facts. Fannie Mae reported in December of 2008 that its “Seriously Delinquent” rate for ‘Conforming’ mortgages was at 1.4%, the rate for ‘Enhanced’ mortgages was at 6.42%. MICA enhanced mortgages have a default rate 5 Times that of conventional mortgages.

When a mortgage goes into default and the home is foreclosed on the result is a devaluation of all of the homes in the neighborhood. This phenomenon has been sweeping through areas of the country for the past year. Foreclosures have been accelerating the downward spiral in housing prices. MICA’s members are responsible for a portion of the decline.

MICA provides a report on the loss rate for its insured loans:


2004 and 2005 were the ‘best of times' for the residential real estate market. During that period of time the industry was making money. But even during those years the loss rate was equal to 37% of the premium income. This has always been a high-risk business where high default rates are anticipated. In 2007 and 2008 the defaults on MICA mortgages exploded. The financial results crippled the industry, the housing market and the economy. It was a big factor in sending Fannie Mae and Freddie Mac into receivership.

AIG brags of a 13% market share in this industry. They lost $2.5 billion in 2008 writing PMI insurance. Their defaults and losses are mounting in the first quarter of 2009. The taxpayers are footing the bill for every penny of this. FNM and FRE are also suffering losses from the same AIG enhanced loans. The resulting foreclosures are continuing to push all real estate values lower.

What do our leaders in Washington think of MICA? They have been looking for ways to slow the default rates for nearly eighteen months now. One would have thought they would have looked to where most of the defaults are coming from. No such luck. FHFA Director Lockhart wrote to MICA recently. His words:




Vital role? Mr. Lockhart is suggesting that the business that got us into this mess is going to be our salvation. He is dead wrong. We have to stop creating more bad borrowers and more bad loans. We have to decrease the number of defaults and foreclosures. MICA is working against Mr. Lockhart in that effort.

Mr. Bernanke and Mr. Geithner are well aware of these facts. They know that part of the AIG TARP money was used to cover the PMI losses at AIG - United Guaranty. They know what the default rate is on the enhanced loans owned by the Agencies. They know that the default/foreclosure rate is killing the housing market and adding to the overall number of problem loans. They have both spoken on the urgent need for stronger lending standards. But, AIG and the other members of MICA still have a book of insured mortgages that total nearly $1 trillion. The majority of that is owned by the Agencies.

There is no justification for State owned entities like AIG, Fannie Mae or Freddie Mac to be involved with high risk mortgage lending. If they understood the issue the 'people' would object. If Mr. Lockhart and Mr. Geithner believe that they have to sustain AIG's role as an 'accepted provider' of PMI to the Agencies they should explain their rational. I for one would like to hear it.

Geithner Speaks to Lord Keynes

Timothy Geithner is asleep in his bed. A loud noise is heard. The rattling of a long and heavy chain. He is startled into consciousness. There is an apparition in his chamber.





TIMMY:
Who are you? Are you security? You do not look like security. You look dead!

LORD K:
I am dead. I am Lord Maynard Keynes. Do not be frightened. I mean you no harm.

TIMMY:
What are you doing here? It's three in the morning. I have to testify today!

LORD K:
You testify every day. This is important. Do you know who I am?

TIMMY:
Yeah sure. I had an economics class in Dartmouth once. You are the guy that said, “In the long run we will all be dead.”

LORD K:
Interesting that you should remember those words and so little else of my work. You have been taking my name, work and reputation in vain. There are penalties for that.

TIMMY:
I did that? Why are you here and what is that chain you are carrying around? And what do you mean about penalties?

LORD K:
The penalties will come to bear in the court you will face one day. As to the chains, they are my onus. For each $100 billion that the public sector has borrowed in my name a new link is formed. It is getting longer by the week. I am here to warn you that you are pursuing the wrong policies. These steps that you have taken may not succeed.

TIMMY:
Why not? We are doing everything you told us we should be doing!

LORD K:
That is not true. You and the other financial advisers to the President know that.

TIMMY:
Well, Goolsbee and Summers say that we have to follow your economic principals. We have established an “interventionist” approach. The goal of our economic policies will be to offset the drop in the economy with fiscal and monetary stimulus. We are spending a bundle on this! We are going to be building roads and schools and getting people back to work just like you said. What is wrong with that?

LORD K:
Re-read my work. My rules are simple. An economy is a living thing. At times it has energy to grow and at times it ebbs. It can spiral up too fast and it can spiral down. If either extreme is not met with intervention then the cycle will get out of control.

To stabilize the economy in 2009 I would have advocated that you meet the anticipated drop in private sector demand with an equal increase in public sector consumption. If you don't, the downward spiral will continue. The economy will suffer a drop in GDP of at least 6% over twelve months. That means a drop in demand of $1 trillion. Your stimulus is for only $800 billion over two years. You are spending less than half of what is needed.

In addition, I argued against infrastructure projects as a mechanism to provide short term stimulus. They take too long to implement and the spending is stretched over too long a period of time. Your policies create the risk that in twenty-four months the economy has not recovered and the downward spiral I described will continue. The negative pressure is self perpetuating.

TIMMY:
Gee wizz! We had a heck of a time selling the $800 billion deal. No way we could have asked for more. And if you are thinking that tax cuts are the answer you can forget about that. We are boxed into a corner on that issue.

LORD K:
Without tax cuts your plan will fail in the short run. Remember that President Roosevelt resisted my policies until 1938. Nine years after the start of the depression. You are at best eighteen months into this one. By 38' the economy's downward spiral had ended. My stimulus measures were well timed. Roosevelt only adopted my ideas because he was looking to Europe and the coming need for the the Lend - Lease program to support England. It was the build up to war that ended the depression. My policy merely created the mechanism to finance it.

My theories on economics worked in 1938 for special reasons. Economic intervention has worked well in all of the post-war economic cycles because the swings in GDP were much smaller in size than what you face today. You are almost out of policy options.

TIMMY:
Now you have me worried. What can we do?

LORD K:
America needs to re-think it's long term economic goals. The United States is a mature economy. An annual growth rate of 1% is a more reasonable expectation. You are attempting to re-establish the old average rates of 3%. That number is no longer the 'optimal' growth rate. You are attempting to sustain something that was not sustainable. The end result will be that you will have created a debt load that will sink the economy for decades.


TIMMY:
Holy smokes! A long term growth rate of 1% would kill the Social Security System and the other entitlement programs.

LORD K:
I never advocated these programs. Blame Roosevelt and Johnson for that. You can't achieve the necessary long term growth rate to pay for these programs. You will go broke in the next four years trying. If these social promises can't be met, you must address it now. These legacy costs must be reconfigured to reflect the reality that long term economic growth of 3% is unsustainable without a crushing debt load.

TIMMY:
Man, this is bad news. Have you talked to Ben Bernanke yet?

LORD K:
No. His sins are beyond my intervention. He is monetizing the debt. This will weigh heavily against him when he is judged.

TIMMY:
Whoa! That does sound bad. What about me? How am I going to be judged?

LORD K:
It is too soon to tell. You have already made many mistakes. Take this warning to heart and you may be able to save your future. However if your plan does not work and you blame the failure on Keynesian economics then your fate will be set. I must go now.

TIMMY:
Wait! Don't go! I have another question. What is it like where you are?

LORD K:
We want for nothing. We have little.

In my youth I led a gay life style. Later I married a prima ballerina. Much of my life was driven by social standing and appearances. There is none of that here. There is a peace to that.

TIMMY:
Huh. That is not what I thought Heaven would be like.


LORD K:
Hah! My judgment day lasted only a few minutes. They sent me straight to Hell. After all, I invented deficit spending. 'They' thought that was a terrible idea. It will ultimately cause much suffering. I must go!


The room is now empty of the Spirit.

TIMMY: (to himself)
I think I drank too much wine last night. I am going to pretend that visit did not happen. No one would believe me if I told them anyway. Maybe we will get lucky and this will all work out.

He turns the Lights Out.