Advance Read on Q4 GDP

Big number due out on Friday morning. The 4th Q GDP is coming and it most likely will move the markets. The consensus read is for a big up number. Last I heard the Street estimate was for up 4.7%, more than double the annual rate of growth for the 3rd Q.

My own read of the numbers is for a slightly smaller number. Something a tad over 4% is my guess. But this number is not so easy to get right. Even worse, it will be revised a few times before we really know what happened. I look at this number and try to anticipate how the market will react if we get a surprise versus the consensus.

This number has potential to cause a stir if it comes in south of 4% or north of 5%. The numbers in the middle are ‘baked in the cake’.

If the number comes in at 3.5% (or less) I would expect:

-Stocks will fall.
-Bonds prices will rise.
-Gold will rise.
-The dollar will fall.
-A number of economists will be scratching their heads.
-There will be renewed talk of a ‘double dip, starting sometime in the 4th Q.
-Larry Kudlow will misread the number and will hail the day as a triumph of capitalism and the free market economy.
-The White House will make a statement that they are responsible for the turn-around.

If the number comes in at 5% (or higher) I think the following happens:

-Stocks will rise.
-Bonds will get crushed.
-Gold will be steady.
-The dollar will be steady.
-A number of economists will be scratching their heads.
-There will be talk of the economy over-heating; some will express concerns over inflation.
-Larry Kudlow will hail the day as a triumph of capitalism and the free market economy.
-The White House will make a statement that they are responsible for the turn-around.

I think a graph of the actual GDP numbers is helpful in trying to understand these big numbers. Note: The 4th Q number is a forecast based on the consensus estimate.

While I will be happy to see a big number tomorrow, you have to look at where we have come and where we are. Looking at this you see that the growth in the economy is about where we were two years ago. What did we pay to get back to 07? About $2 trillion in additional debt, the socialization of the financial system and the expectation for trillion dollar deficits as far as the eye can see.

A hypothetical question to ask might be, “What would we look like today if we had not had a train wreck in 08”. Another graph:

Of course we did have a wreck in 08, so it is sort of useless to play the game of “if coulda shoulda “. However there are hundreds of programs, retirement plans and dreams that are off track as a result. We will not catch up to where we might have been. We need to adjust to where we are, I can’t imagine how that can happen.

Some on the Street are putting 4Q GDP north of 5%. If we see a number with a five handle, take note of it. It will be the last time we see one that big for a long time.

Alan Blinder on Ben Bernanke – Phooey!

I understand that it’s a bit of a stretch for a low rent guy like me to take on a former Fed Governor and world class academic. But I’m going to try. Mr. Blinder wrote an Op-Ed in the Times today in support of his “friend and colleague” Ben B.

In a weak attempt at creating balance to his praise of the ‘man of the year' AB points to a few areas in the past where a mistake or two had been made. Possibly. He dismisses even those with a suggestion that it was Greenspan’s fault. On the failure of Bernanke to see the wave of problems before it was too late AB brushes it off with the excuse, “Who did?” Well Mr. Blinder, I did. I have been writing and talking about this for years. I saw Sub-Prime and 100% LTV ‘enhanced’ loans for what they were. Junk. I make investments and read prospectuses. I saw the crap that was being sold. I’m no oracle. There were thousands of us shouting into the wind when this was happening. I guess you did not hear us, being so isolated down in Princeton.

I loved this line:

“His job performance since October 2008 has been superlative.”

AB, I know you are ‘good buds’ with this guy, but really, “superlative”? What does that word mean in this context? Is that like a 10+? Why did you feel it necessary to write this Op-Ed? The answer is because your boy has not done a superlative job at all. There are Senators and Congressmen all over Washington that think he has not been superlative. There is a good many that have the academic status as you that think he has done a rather poor job. If this were put to a vote of the people your guy is finished. You think he is the guy that saved us. What you are missing is that more than half the population thinks he is the Prince of Darkness

AB: “He led the Fed to lower interest rates to virtually zero, and to hold them there.”

Please. What is hard about that? You make an announcement that says, “As of tomorrow we are lending at a ¼%”, and then you call the NY Fed desk to change the O.N. rate. Doing it is easy. Managing the consequences is a whole other matter. AB gives credit where none is due. I wonder if AB considered the consequences to people who are trying to save a few dollars? Unless you gamble in the stock market those savings have a negative future value because of the “0” stuff AB and BB are so fond of. Lousy incentive you are creating for a nation that needs savers.

AB: “(the Fed) breathed some life into the moribund MBS market”.

I’m sorry, what are you talking about? “Breathed some life?” The Fed has purchased $1.1 TRILLION of MBS. That is not a breath of life. That is a step that has no precedent in modern history. Your ‘best bud’ has just monetized $2 T bucks. Of course that is going to work. For a while. You throw gas on a fire, it burns. No trick to that.

AB: “The plain truth is that, as bad as the recession was it turned out less horrific than expected, and Ben Bernanke is one of the reasons”

Mr. Blinder is far too good a historian to make that statement and mean it honestly. Yes Ben wrote a biblical sized check. And yes that check avoided some things that would have happened. But it is far too soon to say that we have ‘won’. This comment reminds me of George Bush on the aircraft carrier with the banner “Mission Accomplished”. AB is drinking champagne a little early. Wait a few years until we see and feel the weight of what has been done. The easiest part of this was writing the check, paying it back could cripple us.

What prompted me (pissed me off) to post this was the last sentence of the Op-Ed. AB was clearly addressing his comments to just 100 people. The Senators who actually have a say in this. He reminded them that in 1983 there was a bit of a squeaker on the nomination of then Fed chairman Paul Volker. That vote went 84-16 in favor of Volker. Mr. Blinder concluded with:

“Those 16 Senators look pretty foolish in the eyes of history. There may be a lesson there.”

Mr. Blinder could have said it more bluntly, but left the same meaning:

“If you don’t vote for Bernanke you’re stupid and history will prove it so”.

Well the vote is in. 70 30. Some of those 70 were no doubt influenced by the kind words by AB. Thirty Senators stood up and voted against this nomination. In ten years history will not judge them harshly. This will not be a repeat of 1983. They will be looked at as the ones who made a vote at critical time and were ignored.  They will not look stupid as Mr. Blinder has suggested.  At some point I will remind Mr. Blinder that it is always a mistake to judge history before history has been made.

RE Bomb in Boise

RealtyTrac is out this morning with a year-end look at foreclosures. I think it is a terrible report.

There is the usual bad news from the worst hit areas.

-1 in 8 homes in Vegas was in foreclosure. How is it that the MSM has convinced us that things have gotten better there? They have not.

-Cali and Arizona are looking at ten percent default rates. And this has been going on for a few years now.

-A substantial part of South Florida has one home in ten in default. In Marco Island/Naples the rate is 6.5%. That blows my mind. I know this area. It is deep pocket. At least it used to be.

-The real shocker to me was Provo Utah and Boise ID. The default rates are up 100% from two years ago. This was not supposed to be happening in places like this.

There is a nationwide problem of defaults. The people in Boise are feeling the same pain as Stockton. Every time that a default happens it devalues other properties. I have real estate interests around the country and I can tell you that things are dead. There was a time when a buyer would look at a home and ask, “How big is the lot?” Today the question is, “Does the bank have title and are they desperate to sell?”.

There is not going to be a recovery in housing until the defaults have been stabilized at manageable levels. The broad economy is not going anywhere either. There is no plan on the table to stop what is surely coming. The government programs have delayed things by an average of nine months. That means that most of the millions of government sponsored ReFi’s from 2009 will blow up this year. We paid a bundle for those ReFi’s. They cost us last year, we will pay again for them this year. Little has been accomplished.

I know that there are many out there who will say, “Let price discovery rule!” You may be right. I don’t know anymore. We are paying a big price in time and treasure with what we have been doing. However, the policy of, “Let the chips fall” scares me. It is like a giant sucking noise. It is far away but getting closer.

Bernanke’s (new) Conundrum – Negative Convexity

The Atlanta Fed put out a report on the status of the Fed's purchases of MBS. The report confirms that 91% of the anticipated $1.25 Trillion of paper has been bought. This leaves about $110b of buying power left for the Fed. There is only nine weeks left until the anticipated time that this program will end. This implies an average of only $10b of intervention per week. The most recent purchase was for $16B. Look for that weekly number to fall pretty quickly from now on.

The following graph clearly shows the STEADY accumulation of Agency paper.

Now look at the following graph. If you print this out and check with a ruler (I did) you will see that the lowest point on the brown shaded area is 1,200 and the upper band is at 2,400 (1,200 total). The legend states that brown are both Agency Bonds and MBS. From the report you get those numbers to be Bonds = $175B and MBS = $1.14T, for a total of $1.31T. Significantly higher ($110b) than you might have expected looking at the graph. There is a simple reason for the apparent discrepancy. It is called Negative Convexity.

A portion of all long term mortgages pre-pay prior to the stated maturity. There are many factors that influence this. People die, get divorced, send the kids to college and downsize. But the most significant factor in the amount of prepaid mortgages is prevailing interest rates. If rates are low on a historical basis, people who have good credit will refinance and achieve a lower monthly mortgage cost. These are the conditions that we are in today and have been for the past year. The MBS securities that the Fed has purchased are very diverse. They include primarily older, higher coupon mortgages. Ones more likely to prepay.

I asked a friend who does this type of thinking for a living to give me some thoughts on how quickly the Feds portfolio was shrinking due to natural prepayments that are occurring. I think his words are better than mine:

"Tough to say exactly how much paid down, but if we say GSEs have paid at 25% cpr in the past year (all pay differently and are well correlated to coupon, or WAC of borrower), then that implies 25% of principal is paid down over a year. You’re pushing 20% over 9mos…

typical speeds are in the low teens, if not high-single digits, except in times of high re-fi / default activity… I’d say you could feel good about using a 20-30% cpr weighted avg…. of course, they did not buy ALL their MBS 9mos ago – would have to weight that accordingly.

off the cuff, I’d say 10% principal back to them would be a good number….

From this professional you get a pretty good estimate of the prepay as being 10%. That would come to $110B. This estimate goes a long way toward explaining the discrepancy between what the Fed has purchased and what the principal balance is that they currently own."

Some thoughts on this phenomenon:

-My friend suggests that going forward the prepay could be as much as 20% PA. Well that would mean something in the order of $250B over the next year. That would, by itself, be a very deflationary force. It is too big a number. It would be happening at a very bad time. Pure economics would suggest that the supply of available mortgage credit would fall sharply as a result. The Fed does not need to do repo’s to suck up excess reserves. They just have to collect the prepays that are coming.

-If you buy into this you have to assume that the amount of prepays in the current month will be approximately $18b (1.1T * 20% / 12). The Fed is buying $16b a week or $64b a month. So in January the net is only $46B. Follow this dotted line and you will see that by early March the purchases net of prepays will be a negative number. This will be the starting date of the true reversal of the QE process. March is much sooner than people are thinking it will occur.

-The Fed will make Net purchases totaling $1.25T. But they will never have a portfolio of that amount. It has to be less. By the numbers they will end March with approximately 1.14 - 1.16 Trillion. And the portfolio will be shrinking by $20B per month thereafter.

This is a scary thought. This could well be the basis of a back door, Sneaky Pete “QE 2.0 Lite”. If the intention were to purchase and maintain a portfolio size of $1.25T they would have to make additional purchases of $100B and continue the buys on a monthly basis of approximately $20B. This would not be a change of policy (ahem). It would be refining and maintaining the existing policy. If the Fed tried to do that (I doubt they will) there would be uproar. But once Bernanke is back “in”, there really is no way to get him or his love of QE “out”.

The following is the language from the Fed on the Agency MBS purchase program. I draw your attention to two words. Total and Anticipating. I think there is wiggle room in this statement on some revisions to both the timing and amounts involved. Ugh!

“On September 23, 2009, the FOMC announced that the Federal Reserve will purchase a total of $1.25 trillion of agency mortgage-backed securities and gradually slow the pace of these purchases, anticipating they will be executed by the end of the first quarter of 2010.”


Side Story – We Get Humped

Please look again at the graph of assets from the previous discussion. Look at the brown section that represents the Fed’s holdings of BOTH Agency MBS and Agency Bonds. That line is not a steadily increasing number. It seems to go up and down quite a bit from the inception of the program to the end of chart.

A major reason for this is how the Fed conducts its activities and how they report them. On a weekly basis the Fed has accepted tenders for MBS. Of the amount tendered they report two numbers, Gross and Net purchases.

The Gross number is the one recorded in this graph and accounts for a substantial amount of the variable nature of that data. Most notable on the graph are the two obvious ‘humps and valleys’ in the March - April period. Behind these humps is this data. From March 19 – April 2 the Fed bought gross $196B, sold forward $94B and retained $96B. From April 16 – April 30 the Fed bought gross $175B, sold forward $100B and retained $75B.

As you can see the Humps are unique to the graph. There is a reason. March was a terrible month. Global GDP was in free fall. The stock markets were again hitting decade lows. We thought that Citibank and BoA were maybe going out of business. Bernanke has admitted that during this period he questioned whether the system would survive.

So anything that the Fed did during that terrible period that is out of trend is worth noting. What is the impact of these forward sales? The answer lies below the brown area. Look at the grey and dark blue levels. You see the reverse Humps. The forward roll transactions had the impact of temporarily absorbing the inventory of the primary dealers and the money center banks. It had the impact of creating liquidity for the PDs so that they could absorb some of the other things that were falling in price. (Stocks and bonds). The amounts were bite sized. My estimate is that these dollar rolls put $100b in PD hands for about six weeks. My guess is that the street got fat on the pricing.

Does this matter? Not really. That they Fed put some dough in the hands of the street when they needed it was probably the right strategy at the time. It was one of the many steps taken back then to calm things down. Any impact that it had, is long since gone.

I think this is just another of those ways that the Fed can maneuver things. They have extraordinary power. We don’t even understand what they can do. The Fed has full disclosure policy on most of what it does. They provide information on the forward rolls. Take a look and see if their explanation makes sense. To me, it as clear as mud.

"As the investment managers (NY Fed) conduct dollar rolls they simultaneously buy and sell agency MBS securities for different forward settlement dates. To date all sales for the SOMA have been associated with dollar roll transactions. These transactions have not represented any outright sales of agency MBS from the SOMA."

Yeah Ben. But why the big numbers in March? Answer: When the market needed a boost, you delivered.

A Way to Cut the Deficit? - Thinking "Outside of the Box"

The following discussion is an effort to describe a massive transaction that would have some significant impacts to the US financial picture. While it is theoretically possible to do this deal, it won’t happen. Mr. Geithner’s Treasury Department is too busy putting out political fires to do any deep thinking. Others, including those who believe that touching the Social Security Trust Fund is “Off Limits” will just rain criticism on this approach. I can’t wait. This idea has merit even if there are detractors. To even consider it we would have to think outside the box. That is not likely to happen.

I propose that we refinance $2.5 Trillion of the US debt. There will be a reduction in the cost of the debt to the taxpayers throughout the life of the transaction. The total savings, in the example provided, is $430 B. The transaction changes the ratio of Public to Intergovernmental debt outstanding. In my opinion the ratio is favorably impacted as a result.

In round numbers the US has $12 trillion of debt outstanding. Of that amount the public holds approximately $8T, the balance of $4T is held by government entities. The Intergovernmental total is equal to 1/3 of all our debt. This is a critical ratio. It is infinitely more desirable to have an increase in the Intergovernmental component of the debt than an increase in the Public side. The less we have to sell to the public the better.

In the 1960’s Congress passed a law that established the rules for the Social Security Trust Fund’s investments in US debt. The law established the method for setting the interest rates (short and long term) that the Fund’s investments receive. I do not have the details of these rules but it is easy to look at the results and conclude that the formula is based on averaging historical rates over a period of years. The result is a smoothing out of yearly ups and downs of interest rates. The following graph looks at ten-year Treasury yields from 1990 on. The red line is the yield that the SSTF has achieved on its investments. It is clear from looking at this graph that the TF has benefited substantially as a result of these rules. They are enjoying a much higher return today than they would have if they were obligated to invest at market rates.

Two recent examples of how the rules create distortions:

-In December of 2009 the SSTF invested its short-term surplus for 6 months at 2.875%. Actual market rates for Treasury bill yields would have resulted in a yield of no more than a ¼%. The Trust Fund got a great deal. They invested a total of $90.7B. The rate was 12 times higher than they should have received if market rates were applied. As a result the Fund will earn $900mm more than if the rate had been set at market levels.

-In June of 2009 the SSTF invested $153B in a fifteen-year maturity at 3.25%. That rate was 1% lower than market. As a result the TF will suffer from annual income that is $1.5B lower each year for the next fifteen years.

The existence of the rules that sets interest rates coupled with the fact that the US has been in a decade long secular decline in interest rates has created an interesting and exploitable opportunity. I did not create that. It just exists and I want to take advantage of it.

As of December 31st the SSTF was sitting on a massive accumulated surplus of $2.5 trillion. This surplus is fully invested in Treasury IOUs that have maturities that go out as far as 15 years. The average life of the portfolio is currently approximately 8 years and has an average yield of 4.7%.

I want to ReFi the entire SS portfolio. I want to do it at a rate of 2 1/8%. This rate happens to be the arithmetic average of the current 8-year and one year Tbills. It really doesn’t matter what rate is used. The 2.125% just happens to produce some meaningful results and it reflects current markets.

The Trust Fund Perspective

There is zero economic impact to the SSTF over the life of the transaction. Before they have a $2.5T portfolio yielding 4.7% after the transaction they have a $3T portfolio with a yield of 2-1/8th %. The Internal Rate of Return of the portfolio is identical. The Net Present Value is also the same when the discount rate is 4.7%. There is no consequence to the Fund as a result. There can be no opposition from either the Fund or those that believe the Fund should not be meddled with. After the one time ReFi of the Trust Fund portfolio the old 1960’s rules would be used to govern the pricing of future purchases and sales by the Fund. There would be no lasting consequence to this proposal.

The Impact to the US Budget Deficit

The transaction would result in significant annual cash flow saving to Treasury during the life of the transaction. Using again an 8-year average life you would get these results:

The Impact to the US Bond Market

Based on the average life calculation, the transaction would result in $50b of savings per year of for a total of $430B. This amount would not be sold as debt to the public market ever. It would stay on the Intergovernmental side of the ledger. Does $430 less debt in the public hands matter? I think so. It is more than half of what the Chinese currently own.

The Impact on the Unified Deficit:

Total debt will rise as a result of the transaction. However, the increase is in the Intergovernmental A/C. I am not sure that is relevant. The question is, “What is the debt service to GDP ratio. This proposal improves that ratio.

Total debt for the US is going to rise substantially this year and for at least the next five. We can’t stop that. The only question is, "Where are we going to find investors for this at a cost we can afford?" Borrowing from ourselves is far more desirable than borrowing from the Chinese. This transaction does not address the long-term imbalances. It buys us time to put our fiscal house in order. If we fail to take advantage of the window that this transaction creates we will deserve the consequences that will surely follow. Hopefully we will be able to capitalize on that opportunity.

Note:
The biggest source of opposition to thinking like this will come from those who think that SS is sacrosanct. It can’t be touched. They will say,"You are doing something different! You can't change the rules!" I say to that, “Hogwash”. This transaction is being done in small amounts every month. That has been the case for the past five years. There is nothing new to what I propose. I just propose doing it in a much grander scale.

The following is a slide showing the SSTF purchases and sales for the month of December 2009. The transaction I highlight is a sale by the Fund of a small amount of high coupon bonds for cash. This transaction resulted in a capital gain to the Fund of $12mm. Meaningless in the scheme of things. But if one takes the time to look at the Purchase/Sale report provided by the Fund you will see that they have repeated the pattern of this transaction (sell high coupon, replace with low coupon) to achieve a capital gain that adds to the principal balance of the Fund nearly every single month for the last five years.

To those that hate the idea of financial engineering I say, “I’m sorry you feel that way”. Look at this as if you were a homeowner with a 7% mortgage. You can now Refi at lower rates and achieve a real benefit for your household. This transaction would be the same, except that it has a lot more of zeros involved. An additional benefit is that we would owe this debt to our rich Uncle, (SSTF) versus a foreign Central Bank.

Tim and Barney - Adios!

When the history books are written and the causes of the problems that we face are discussed and debated one conclusion will be inescapable. The mortgage Agencies, Fannie Mae and Freddie Mac were central to the economic collapse of 2008. It would be unfair to blame all our ills on F/F. There were many bad actors in this show. But I don’t think the explosion that occurred in 2008 and the crisis in the economy that ensued would have been anywhere near as severe as it has been had it not been for the terrible decisions that were made at every level regarding the D.C. mortgage lenders.

I bring this up because quite frankly I am mad this evening. Two important things took place today regarding the Agencies. Both of them upset me. In the fray of a three-day, 5% drop in the market; I think the implications were lost.

The first came from our gutless Treasury Secretary, Tim Geithner who said of the Agencies future:

"I don't think we're going to be able to legislate that until that process can start, until next year, because it's just a complicated thing to get right."

That is not true. The Treasury Secretary has been telling people in the press for months now that the problems with the Agencies were going to be addressed in the first half of 2010. As of today that time frame has been pushed back a year. The reason is politics. The Agencies need the mother of all bailouts. They have already cost us $100 billion. They need another $400-500 to write their portfolios to a level that would make them viable. After this week’s election there is no support for another big bailout. Geithner knows he can’t go to Congress and say we have a permanent loss of a half trillion dollars.

Washington has been pounding the table of late saying, “We are going to get the people’s money back!” They have been beating up all the TBTF’s with one plan after another to show that they are getting tough. But when it comes to a problem in their own back yard they conveniently push it off another year with the excuse that it is, “Just a complicated thing”. That is a shameful statement. Geither has lost any credibility that he may have had left after this move.

The other oracle that spoke today was Congressman Barney Frank. He also said something brilliant. His words:

“His committee will be recommending abolishing Fannie Mae and Freddie Mac in its current form and coming up with a whole new system of housing finance.”

I have been studying the Agencies for nearly a decade. I started in the days of Franklin Raines. I knew he was lying about the books. I wrote everyone that I could that he was playing fast and lose. I was proven right. I saw their demise two years before it happened. I know the history of these two and how they became as powerful as they did and how they have played a critical role in the housing imbalances that have brought us to where we are. From my perspective there is no single person who has been as influential and central to the colossal blunders at the GSEs as Congressman Frank.

For Mr. Frank to now suggest that his Committee has concluded that what has been done for the past twenty years was a mistake and that his Committee would be “Coming up with a whole new system” is galling.

Mr. Frank is right; our system of housing finance is critically broken. An entirely new one is needed. But Congressman Frank should have nothing to do with the future of America’s mortgage finance system. His hands are dirty from the past. He has to accept his share of responsibility for the blunders that were made.

We need new leadership. It is not clear to me that we can recover from the mistakes of the past, but what is very clear is that we can’t repeat the mistakes of the past and have a chance of surviving.

The people of Massachusetts have done the country a favor with the recent election. They woke us up. They shook the tree. Now those same citizens have more work to do for the rest of us. They have to vote Barney Frank out of office.

Consequences of the Mass. Election

I was watching the election results from Mass. with some people who know history better than I. None of us could come up with a historical parallel to the development that took place this evening. This one is going to go down as one of those ‘water shed’ events that you hear about.

The TV guys are all talking about what this could mean to the health care legislation. At this point, I could care less. I thought it was dead before and I think it is deader now. What I care about is what this means for some of the other significant issues that we face.

In my opinion the vote in Mass was a vote against the status quo. It was a loud enough vote for everyone in D.C. to hear. If there was any doubt that Americans are sick of the "same old, same old", this was it. The message was clear to me, “If you want to keep your job as an elected official you have to do things differently.” This will force changes across the board. Some things outside of health care that I think may be impacted:

-The days where the Fed and Mr. Bernanke get to establish broad economic policy without taking into consideration the mood of the public is over. This is not to suggest that the Fed is going to jack up rates anytime soon. But to me it means that the possibility of QE2 is done. There was a time when you might have said, “The American people don’t understand their monetary policy and have know idea how much debt has been created in their name”.  Well that was then and this is now. Americans do understand how much debt there is. They are shocked, dismayed and angered. They’re a lot of everyday citizens who are well aware that the Fed printed 2 trillion in the last year or so. The vote in Natick Mass showed their dislike and distrust of Fed policy. While I don’t think this will result in Bernanke failing to get a second term in the upcoming vote, it just got a bit more uncertain. In many ways this election will tie Ben’s hands.

-There is has been some discussion on a second stimulus bill. Those like me who see weakness before this year is over were pushing for that. Some big voices in the public and private sector are going to be disappointed. There will be no second stimulus bill. Not in 2010 at least. There is no stomach for that any longer. There are many Congressmen and Senators who are up for reelection in ten months. They are not going to stick there neck out for something the White House wants and they know the people don’t. I doubt the administration will even ask for a stimulus bill after this shellacking.

-I read the election result as being dollar positive. Somewhere inside this vote tonight is a call for fiscal conservatism. We are going to hear rhetoric to that effect in the coming months and we will see legislative steps that at least give lip service to the idea that we aught to tighten our belt a few notches. To the extent that I am right by calling this dollar positive, you have to also think that it is a gold negative development. For those that love the yellow metal and hate the dollar take heart. Any positive impact to dollar will be short lived. The inability to put a second stimulus together will show up in all of our numbers by midyear. At that point it will be more clearly understood that the US is broke and there really aren’t any viable options that don’t entail a lot time and pain.

-Tim Geithner’s ship went down in Massachusetts. I am convinced that he now must go. The Administration will have to make changes after this vote. They have to show that they are being responsive. The beating the WH took tonight was biblical. So will their response be. It will take a month, but changes and heads will roll.

-I am sure that all the stock pundits are going to read this evening’s results good for the broad market averages. I have been skeptical of this for a while. But not any longer. The stock market looks six months ahead. It will soon be sensing the next economic slowdown soon. I would not say the market is a screaming short. It is not, yet. It just got closer however.

-I can see how some health care companies might see a pop in their stocks for a few days. This group I would short. The absence of a health care deal is actually bad for them in my opinion. Give that a week at best.

-There will be no fix on Social Security this year. Mr. Goss who runs that shop has said that the issues facing SS have to take a back burner to finding a fix to health care. Well, we have not found that elusive solution. And now it is farther away then ever. Mr. Goss will have to wait at least another year. That will prove to be a devastating delay.

-There will be no significant steps to address the problems at the mortgage Agencies; Fannie, Freddie and FHA. The reason is simple. If you wanted to address the problems with these dogs you have to owe up to the fact that it is a $500 billion dollar sinkhole. Who would want to put that bad news on the table after getting your ass kicked in a crucial election? The answer to that is that no one in Washington would. And no one will. Having said that, I would not be at all surprised to see an effort to cut the outrageously rich compensation packages for the big shots at Fannie and Freddie. There may have been some belief that these two companies were in the private sector where salaries have no caps. But now there will be those in Congress that want/need an election edge. What could be a better edge than to beat up on a bunch of fat cat D.C. bankers?

-We have several states that are on the edge of a fiscal crisis. I thought that there would be some form of Federal assistance for them this year. That may still come, but it is now much less likely. You can’t just help NY and Cali. Those States will simply have to cut their deficits the old fashioned way, by cutting expenses. There is no way the folks in Texas are going to let Federal dollars be used to bail out TBTF States. And no one in Congress is going to stand up to that.

-If you were a TBTF institution you just hated this vote. This is bad for the Citi’s and BoA’s, but it just downright terrible for the likes of GS. The more successful you are, the more crap that you will have to take. Washington knows that Americans hate their banks. Now Washington is going to take sides with the people and lean on the TBTFs even harder.

-The bailout mentality is over. If GM needed a handout today, they would not get it. If a company runs into difficulty in the future they will just go down. There is no will left for the bailout thinking. If you are a legislator and you support a bailout, you will lose you right to vote in Washington. The voters will take you out back and shoot you on Election Day.

Macro Impact of Census Hiring - Nada

A friend of mine is out of work, so I suggested that he apply to the Census Department. The news you read is that Census will be hiring 1,200,000 workers. The head of the Census, Robert Groves has said these will be temporary, but good paying jobs.

The creation of 1.2mm jobs at this point in the economy would be a very good thing. It wouldn't solve all our problems by a long shot. But it would be a big boost. Just looking at the headlines you might get the sense that the Census employment wild card could be a factor in the economy. After looking at it a little closer I have concluded that it is no big deal.

The critical questions are, How long will these temporary workers be employed? How many hours a week will they work? What hourly pay will they receive?

At the end of this piece is a flow chart of the Census process. You will see that the allocated time frame for hiring and employing the temporary workers is May – July. A total of only three months. There is a specific restriction on the hiring. There will be no overtime. Therefore assume that each worker works the full forty-hour week. The hourly wage offered by the Census Bureau will vary by region. They will offer workers a “competitive wage”. The BLS puts the average hourly wage for non -permanent workers in a range of $11-15 per hour on a national basis. I use the highest average number for the following calculation:

(number of hires) * (maximum number of weeks employed) * (maximum hours worked per week) * (Average Wage) = Total Compensation

(1,175,000) * (12) *(40) * ($15) = $8.64b.

The $8.64b number can’t be correct. It has to be lower than that. The GAO recently estimated the cost of the census at $14.7B (up from $11.5b estimate in July 09). There is no budget on this $15b that I have found. But I did see a reference to the IT portion of the cost being 25% of the total. The direct costs to the Census Bureau are also significant. Based on my review of the job that has to be done and the role that the temporary workers will contribute the cost of the Temps has to be no more than 1/3 of the budgeted total. My own guess on this is that the number will prove to be no more than 25%. But lets use 33% or $5,000,000,000 as the amount of Total Wages Paid by the Census Bureau.

If you use the $5b number and put it into the formula I used it results in:

(1,175,000) * (12) * (Hours worked per week) * ($15) = $5b

Working this backward you get Hours Worked Per Week = 24. After tax that comes to less than $300 per week per average worker. That is less than what unemployment pays. On a five-day week equivalent it comes to $60 a day. The impact of the Census hiring is not what it might first appear to be. Some observations on the broader impact based on the foregoing:

-Social Security will take 12.4% of these wages. That comes to $620mm. This is a big number, but the Trust Fund deals in very big numbers. In August of 2010 the Trust Fund will be paying our $60 billion in benefits. They will receive an extra $200mm in August as a result of the Census. That comes to about 8 hours of payments. In 2010 SS will pay out approximately $700 billion. The Census income amounts to .09% of the total.

-The IRS will take approximately 25% or $1.25B. That comes to .09% of the anticipated $1.4 trillion deficit. While someone might look at this as a positive we have to remember that it is costing us $15 billion. So we are getting back less than ten cents on the dollar. Net of SS and the IRS the Census will add $13 B to the Unified Budget Deficit.

-$3.15 b will be the net wages received by the temp workers. This comes to .03% of GDP. Not all of the wages will actually go to consumption. Therefore the impact to the broad economy is barely noticeable.

-The Census impact will only benefit the economy for three months of the year. Any benefits that it does bring will be reversed by August 1st. This is not good timing in my opinion. I think a lot of the other monetary and fiscal stimulus measures will be ending at about the same time. This is just another reason to expect the economy to hit a wall in the 3rd and 4th quarters of this year. By August 1st there will be another 1.2mm workers looking for a job.

-To look at the impact of the Census on employment I annualized its affect as follows:

Total hours of employment = Hires * Weeks * Hrs/week

1,175,000 * 12 * 24 = 338,400,000 Hours.

Once again that appears to be a lot of hours. However, consider that if you were a full time employee (40hrs/week) you put in 2080 hrs in a year. It takes only 162,700 full time workers to accumulate 338.4m hrs. The annualized contribution to employment is equivalent to only 150K – 200K jobs. We have lost 7mm jobs in the past two years. The census impact is equal to full time hiring of just 2% of those who lost work. There is no lasting benefit. Total employment in the US is 130mm currently. The 2010 Census impact is equal to only 1/8th of a percent.

I looked at the Census employment issue because I have been hearing in the MSM that the hiring of 1.2mm workers is imminent and it will impact the employment picture in a measurable way. Don’t listen to the MSM on this one. While I will be happy if my friend (and many others) get some part time work, the Macro economic impact of the census is negligible. Any positive benefits will have been reversed by the start of the third quarter.

Another 'Sneaky Pete'?

Fannie issued an 8k today confirming what Mike DeMarco at FHFA said yesterday regarding the Agencies involvement with a new program to finance home construction.

Basically Fannie and Freddie are going to be the new bankers for HFA (Housing Finance Agency ). Treasury is buying the debt for this, so the taxpayers are at risk. It is not that big a deal, yet. It starts out with a modest $28b.

This is a stimulus. Plain and simple. If you have any doubt whether this is intended as a stimulus consider the words of some of the big shots who put this plan together:

“Supporting the work of state and local HFAs is critical to the Administration’s broader initiative to stabilize the housing market, which is helping to keep mortgage rates low and mortgage finance flowing for American households across the country,” said Treasury Secretary Tim Geithner.

“We applaud the successful completion of the HFA Initiative. Freddie Mac is proud to provide an essential financial link to the nation’s state and local HFAs that will support affordable homeownership and rental housing and help stimulate America’s housing markets,” said Freddie Mac CEO Ed Haldeman.

“These bond proceeds, combined with the $7.7 billion in retail housing bonds the Initiative requires state HFAs to issue, will allow HFAs to finance more than 200,000 affordable homes, while generating jobs and tax revenue for the economy,” said Susan Dewey, president of the National Council of State Housing Agencies (NCSHA)”


Okay, so we all agree that this deal was hatched up to create a stimulus to the housing market. Maybe that type of thinking and action is justified. I disagree with it, but that is not relevant. I do however feel strongly that if these meddling steps in the economy are taken there should be a discussion about it and a vote should be cast.

There was no discussion about this. There was no vote. How quick was this thing rammed down our throats? Real fast according to FHFA Director Demarco:

“Their (Fannie/Freddie) successful execution of over 125 separate transactions, all in the final month of 2009, was an impressive achievement.”

So how is a program of nearly $30b in federal subsidies not put on any budget? How is it there is no vote on this much money? This is substantially larger than California’s deficit. If Treasury wrote a check to cover California without a vote there would be hell to pay.

The answer is sadly easy to find. The reason is simple. It is right in the information from the FHFA and confirmed By F/F. It is the very last line:

“The Initiative is expected to come at no cost to the taxpayers and to the Government Sponsored Enterprises.”

So when you ‘expect no losses’ you don’t need a vote. It doesn’t have to show up in a budget.

But here is the problem. The same people who are today saying this is not going to cost the taxpayers a cent are the same ones who tomorrow will tell you that Fannie and Freddie will cost us more than $500 billion.

I am very disappointed at the Administrations efforts to create stimulus programs outside of the budget process. The ‘openness’ thing sounded so good. Nothing has changed. Each Administration has used the Agencies as a quiet form of intervention and stimulus. In the process they wracked up $7 trillion in off balance sheet financing.


NOTE:
A side comment, directed to Director DeMarco. What is the cost of issuing an 8k for Fannie? More broadly the question is what is the cost of maintaining a public float and all of the related costs that are required? How many SEC lawyers do you have under you that are involved with all of the documents/disclosure required? Is that cost (F/F) more than $50mm? Is it more than $100mm? Are you aware that the shares of F/F are just trading fodder for computers? The owners of those shares don’t care anymore about 8k’s.

WH's Romer on Street Bonuses - "Simply Outrageous"

I’m feeling a bit like a puppet on a string. I got sucked into watching the bank big shots get grilled by Congress. At one point I thought they were actually squirming a bit. Even that new guy, what’s his name from BoA? He had nothing to with any of this. He still looked he was doing the bowing and scraping thing.

At the same time the Boss gathers all of the financial troops (was Volker there?) onto a stage and announces Beaucoup new taxes on the nasty bankers.

A one two punch. It looked impressive. I think it was just show.

The big banks have a gajillion of tax loss carry forwards and plenty more losses to take as they please to minimize taxes. Don’t look for this to add a dime to the till until after the next presidential election.

As for that squirming and tough questions stuff, I think it was just an act. The “Boys” had to do a lay down on this one. They wanted to look beaten, taxed, and humbled. They had to. They had no other choice.

There are two powerful reasons for this theatre. The first is there is a very high level of awareness of how much dislike America currently has for it’s financial institutions. That is a troubling development. If you walk down that road it ends up in a very bad place. We most certainly are ‘walking’ at this point. They question is, does the ‘tongue-lashing’ and ‘big new taxes’ get anyone to turn around and go the other way?

The second reason is that it was intended to blunt the criticism that will surely follow when the banks provide the full details on 2009 compensation.

Last Sunday Christina Romer, the Chair of the President’s Economic Advisors was on “This Week”. Their words

STEPHANOPOULOS: ““Do you see any sign that the big banks are going to demonstrate the kind of fundamental constraint the president has called for?

ROMER: I sure hope so, because, you know, the American people…


STEPHANOPOULOS: But you're shaking your head, "No."

ROMER: ……the idea that, as the financial system heals, they just go back to business as usual is -- is simply outrageous.


Well Ms. Romer did not get her wish. The banks are paying out a record $145 bil. This will cause a stink. The theater looked good, for a few days at least. But it isn’t going to work for long.

So much for form, we need some substance.

I'm No Chicken Little

I wrote a piece on the 2009 results that were published by the SSTF. Some of my assumption and many of my conclusions have come under criticism. Mr. Bruce Webb, a well-respected fellow, suggested that I was “peddling crap”. He went on to suggest that I was in collusion with two leading economists, Mr. Briggs and Mr. Hassett of the American Enterprise Institute (AEI). There is no truth to that. Right or wrong I have come to my observations on the Fund on my own. I have written a total of 11 pieces (out of 180) on the SSTF in the past year. They have all been published outside of my blog. I am not that new to this debate.


Dale Coberly (another well respected guy) at Angry Bear did a piece that discussed all of this. Mr. Coberly took me to task on my views. Argued with my analysis. Disagreed with all of my conclusions. Fair enough. I think that is what blogs are for.

I have never met Coberly or Webb. I am not sure why they took the approach they did. The Angry Bear site has a link to Webb’s blog on the banner. So they speak as one voice. One says that I am colluding with people from AEI (in my view he lost any respect he might deserve with that silly assertion) the other approaches this with a tone and style that makes me think of a sandbox.Their piece and my thoughts:


The Sky Is Falling Before Schedule. Again.
by Dale Coberly

Bruce Krasting tells us The sky is falling the sky is falling Social Security has run out of money 30 years before it was supposed to happen. The words here are mine, the tone is his:

BK-I never said anything of the sort. As you say, you make up words. Why do you feel it is necessary to do that? I did say the following and I stand by it:

"I think that the recession of 08 and 09 and the anticipated high unemployment (low employment) in 2010 has crippled the Fund. Nothing short of a major overhaul can turn it around at this point. The damage has been too great."

BK-Yes, a major overhaul is necessary in my opinion. From the SS Trustee’s 2009 report to Congress,


“Under current law, the cost of Social Security will soon begin to increase faster than the program’s income….. . Based on the Trustees’ best estimate, program cost will exceed tax revenues starting in 2016.”


FICA and SECA taxes were less than benefits paid for the first time in history in 2009. That is a significant milestone. Mr. Webb points to adjustments to this basic ratio including tax on benefits and RR expenses and overhead. His calculation was for this to result in a surplus of $8b. Fair enough. By that calculation the Fund covered expenses 1.012X. The ratio I point to is .9924X. These are rounding errors. The break even point has been functionally achieved. It will be exceeded in 2010. The Trustees predicted that this would happen in 2016. In will come six years earlier. You see no sense of urgency in that?

He tells us the Trust Fund has a surplus of 2 and a half trillion dollars. That's 2,500 billion. Yet he is convinced that a 5 billion cash shortfall this year "has crippled the Fund." Other things being equal (they are not), that 5 billion shortfall would take 500 years to deplete the Fund. The Fund will run out of money long before that for other reasons... but those other reasons were understood and planned for a long time ago.

BK: Yes, if you divide 2.5 trillion by 5 billion you get 500. But we both know that is an irrelevant calculation. You think that math adds to this debate?

Krasting may be alluding to those other reasons when he argues with Bruce Webb that the small cash deficit this year will keep on growing, but he doesn't really say so. The deficit might keep growing or it might not. The recession could end, and then cash flow would go positive again, at least for a while.

BK: Yes the recession will end. It already has. But we have 10% unemployment and few prospects for job creation. If we started getting increases in NFP of 700k per month, I might back off. But we are still losing jobs. I think that net of census hiring we will lose jobs for the full year. I am not alone in that view of employment. What is your outlook for jobs creation? Are you looking for 10mm net new hires this year? If not, you might want to consider the implications to the Fund.

The other reasons the Trust Fund will eventually "run out of money" (almost) will still be with us. Fortunately, they don't matter either. Social Security will not be "broke." The Trust Fund was designed to "run out of money" (almost). When it does, Social Security will return to pay as you go (almost) at perhaps a slightly higher tax rate to pay for the longer life span of the generation paying the tax.

He claims that there was a negative COLA. There wasn't. He seems to think the difference between the December and January total outlays represents a "decline in monthly checks." It doesn't.

BK: This is a valid criticism. It would have been more correct if I had said:

“The December to January benefits number fell by $475mm ($6b annualized). The first time ever absence of a COLA adjust may have contributed to this unusual phenomenon. In the past decade there has not been any years where this has occurred. The percentage change in the past few years were 06/07 = + 2%, 07/08 = + 1%, 08/09 = + 5% and 09/10 = -1%. A big swing in direction for 2010."


I look for numbers that change from a ‘predictable’ direction. When that happens there is often consequences. Sometimes those consequences create opportunities to make and lose money. That is why I watch for them. Coberly and Webb have unique knowledge of the workings/numbers of the Fund. They could turn that into an opportunity to make a buck. They should try it. It is rewarding in many ways. But I doubt that they see the forest for the trees.


He seems to think that a 100 billion dollar surplus is a deficit because it's not a 190 billion surplus. Time to run in circles, scream and shout, because we only came out a 100 billion ahead this year instead of the 190 billion we predicted before the recession. The whole point of the Trust Fund is to bridge cash shortfalls due to things like recessions. What Krasting is screaming about is the Trust Fund doing what it was designed to do. See, you build up surpluses when times are good, and you spend them down when times are bad.

BK: That was not a little rain shower we just went through. That was the storm of the century. Yes we have eaten into the surplus. In 2010 we may start to ‘live off the interest’. And this ship is far from being turned around.


Yes, I do think a miss of 45% on a basic measure of the Fund’s performance is material. If a public company missed by 45% on the bottom line we would take the stock out back and shoot it.

He seems alarmed that Social Security is not able to lend money to the Treasury. This is like your forty year old son getting mad at you because you can't afford to "lend" him a hundred bucks this week like he expected because he has gotten so used to getting it. The purpose of Social Security is to provide benefit checks to the people who pay the payroll taxes. The purpose of Social Security is NOT to support Congress' deficit spending.

BK: You have me right on this point. I am alarmed. While I agree that this is not an issue for the SSTF, it most certainly is an issue for the entire fixed income market. In prior years the SSTF acquired Treasury IOU’s for as much as 50% of the total deficit. In a few years the Fund will be a seller versus a buyer. Do you really think that is not a significant development?

So because Social Security has reached the long planned for point where the surpluses have to be called upon to do the job they were designed to do, Krasting wants to call a "deficit commission" and steal the benefits from the people who have paid for them. And subject them to "means testing," i.e. "welfare," which Social Security was specifically designed not to be.

BK: The fund has proposed either a 2% increase in payroll taxes or a 13% cut in benefits (or some combination). The 2% solution proposed by the Fund would increase payroll taxes by $115 billion annually. That number would rise each year thereafter. Please point me to the economist, Senator or Congressperson who would sign up for that. I think the voters in the States that they are from would be anxious to hear about that. You have my email. Send me the list and I will publish it.



The Trustees said that ‘creative thinking’ would be required. I don’t see you two putting anything new on this table. There are 160mm people paying into the system, there are 55 million getting benefits. That is two thirds of the population and most of the adults. Not one of them would support an increase in their taxes and/or a decrease in benefits. What I offer is politically doable. The alternatives will create a debate that will make health care and tea parties look like small beer.


A question. You have two choices, which do you choose?


1) You reduce the check to Bill Gates’s and a widow from Alabama’s by 20%.
2) You eliminate Bill’s check entirely and keep the widow with her old benefits.


Would your really go for #1? If so, I suggest you ask Bill (or me). We would disagree with you. #1 is not the ‘right thing to do’.


Mr. Coberly has already answered this question. He stated yesterday, “Bill Gates will get his check” He is correct, under the current law Mr. Gates will get money he does not need or want. But if it becomes necessary to cut benefits, Mr. Gates will have his benefits reduced by the same percent as the widow. In 2010 the mindset of the people is not in agreement with this thinking.

It also needs to be pointed out that Social Security has nothing to do with the deficit. Not the current debt nor any future deficit. Social Security was carefully designed to be paid for by the people expecting the benefits. It is not paid for by general revenues, taxes on the rich, or government borrowing.

BK: I want to focus on the statement that, ‘SS has nothing to do with current debt.’ This is correct. But things are happening now that affect who owns the debt. On a month to month basis a small portion of the debt has been shifting back and forth between that held by the public and that which is intergovernment. I want to demonstrate a troubling trend that I see. Some data.

The monthly shortfalls are reversed at the end of the quarter (except Q 3) and we see the annual surplus number. There is no YoY negative shift in the Public vs. Government holdings. (It continues to be positive)


However, for the months of Feb., May, July, August, Sept., Oct., and Nov. the SSTF did reverse repo transactions with Treasury to provide the liquidity to cover the monthly shortfall. The offset is that for that month the Treasury has to increase it’s sales of Treasury bills to the public to generate the cash to cover the deficit. In 2009 those shortfalls had three affects. 

1) It reduced the amount of investable funds and therefore the ability of the Fund to earn income and,
2) It cost the Fund +/-$125mm in interest to fund the monthly shortfalls. 
3) It caused the Treasury to issue additional short term debt in the public market. Some of that additional debt extended beyond one quarter.



I acknowledge that these monthly amounts are negligible in the scheme of things. But now you have to acknowledge something. In 2008 there were 3 deficit months. In 2009 there were 7 deficit months and the sum of those was $24.2b. As historians of the Fund’s performance you will confirm that these negative cash flow months have not been seen in the Fund’s numbers over the past twenty years. A troubling development if it were to sustain itself. I believe that it will.


Now consider the 4th Q 2009 surplus of only $13.6 b. Compare that with the surplus in 2008 of $52.3 b. A YoY decline of 75%. I believe there is a very real possibility that the 4th Q 2010 number will be a full quarter deficit number based on the trend from 08 to 09 and the assumption that there will no meaningful additions to the number of contributors. I expect the 3rd Q to repeat the 09 performance.



You would say of this development, should it happen, that it is no big deal and of no lasting significance. From the perspective of the Fund you might be right. But you have to look ‘outside the box’. There will be a market consequence to this. And that is what my readers and I care about. Should the 4th Q 2010 prove to be a net negative you will get this headline in the Wall Street Journal:

Treasury Forced to Sell More Debt to Public as SSTF Turns Negative for Second Half 0f '10

Bond market spooked, yields rise. Gold rallies, stocks and the dollar down.

You may be experts on the Fund. But I know a thing or two about markets. A six month deficit for the Fund is not “priced in”. Unless something is done (or we get extraordinarily lucky and create 8mm new jobs) this development will take place in the next two years. When it does it is not going to go over well at all.

Finally, let us suppose that Krasting were right (he is not) and that we have depleted the Trust Fund. Would this be a catastrophe? Would Social Security be "broke." Would we see a crippling burden on the young?No. Social Security would return to pay as you go... as it was always intended to be.

BK: I never said the Trust Fund was depleted. I said that it needs a fix ASAP. You say I am wrong about something I never said. Do you think making these false claims supports your position? There are a lot of smart folks who read this stuff, they will see through this fog you are trying to create.

It would continue to pay benefits out of current payroll taxes.Because of the size of the baby boom, the missing Trust Fund income would have to be replaced by a small tax raise. That raise would be on the order of one percent of payroll for each the employee and the employer, probably phased in over ten years. This was going to happen anyway... starting in about 2026...because the next generation is going to be living longer than the last. All an immediate collapse of the trust fund (not going to happen unless Congress steals it) would do would be to advance the date of the first one tenth of one percent tax increase.

Krasting does not understand what he is talking about, but he is getting encouragement from people who do. They know he is wrong, but they are happy to let him do the "sky is falling" screaming for them. It accomplishes their purposes, which is to panic the people into letting them cripple Social Security.

BK: Okay. I don’t know what I am talking about and Mr. Webb and Mr. Coberly, are the experts. Mr. Webb has stated his views, “nothing needs to be done, maybe a tweak in twenty years”. I think he is way off on that call.


We shall see who is right or wrong. I say that SS is at a nexus. I say we should address the issue before it gets to a point where the fix is more than we can bear. They suggest that we should just sit back and assume that this is all going to work out fine. Sorry to disappoint you. You can’t put your head in the sand and hope this goes away. It will not.


In their posts yesterday Mr. Webb/Coberly went out of their way to establish that they were in fact the experts on this. The word Hubris came to mind when I read:


“I am an expert on this part of Social Security. Bruce is an expert on a part of it that is larger than but not entirely overlapping my part. There are a few other experts around. But in general you cannot trust people who bill themselves as "non partisan experts."
Dale Coberly





Note:
On November 20, 2007 I was on the FOX “Scoreboard” show with David Asman. On that show I said, “Fannie and Freddie will go bankrupt. The stockholders will be wiped out, the bondholders will all be spared”. I took a lot of criticism for saying that. All the ‘experts’ were saying it could not happen and guys like me were lunatics. Less than a year later I was proven correct. I did well with that call.

SS is no Fannie or Freddie. There will be no explosion. But the ins and outs of SS are equivalent to 13% of GDP. Anything that affects SS will have an impact on the real economy one-way or the other. When that happens there will be both risk and reward. My guess is that this is about nine months off from become an issue that starts to move markets. If anything, it will be less.

Gun Play in Caracas - Where do the Bullets Land?

Some interesting developments in Venezuela over the weekend. The government of Cesar Chavez devalued the Bolivar, twice. The official rate was devalued from 2.15B/$ to 2.6B/$, a change of 21%. This is of little consequence. The official rate is not used for any significant transactions.

They established a new exchange rate regime as well. There is now a two-tiered official rate. The second rate was set at 4.3. This rate is intended for “Non Essential” imports. There is supposed to be a list forthcoming of 430 items. The list will include all luxury products. This is something that will not go over too well in Caracas.

But that step is probably irrelevant as well. As of last week the “Parallel Market” (AKA Black Market) was trading the Bolivar at around 6 to the dollar. President Chavez announced new plans to crack down on speculators. It was not clear if he was referring to the currency traders or the shopkeepers who have been driving up prices at a torrid (30+%pa) pace. Probably both.

I would put no faith in the numbers that are available from Venezuela. By way of example the following chart is derived from info from the CIA World Fact Book. This chart makes me think there should be no problems. What can go wrong when you have a $39B Current Account surplus?

This chart is from Banco Central De Venezuela. The information only covers through March of 2009. But looking at this it is very difficult to believe that the $39b surplus forecast by CIA was realized.

I have lived through a few dozen Latin American financial crises’. This one does not look so different from those in the past. A natural resource dependant country gets financially clobbered when the resource they are peddling falls dramatically in price. My guess is that actual reserves at the Central bank have fallen to dangerously low levels. (less than $10b. Down from $40b in 08) The black market and the dramatic actions by the government prove that they must have been getting close to an empty cupboard. The two-tiered currency regime will not work. It never has in the past. It encourages speculation and hoarding. It will lead to shortages of all manner of goods. It will prove to be socially disruptive.

In the scale of importance to the rest of the world I would give this a 2 out of 10. Really no big deal by itself. We all knew that Venezuela was a basket case so who cares?

But now look at this report prepared by the Bank for International Settlements:

We see from this that the problems in Venezuela are soon to be the problems in Spain. Not only are their banks exposed to the trade credits outstanding but the exporters must have been making a fair buck in selling the stuff to Venezuela that are behind these credits. So the sovereign risk story in Venezuela is soon to become a sovereign risk story in Spain.

The great sucking noise of credit contraction is continuing. Today it is Viet Nam and Venezuela; tomorrow it will be with those that trade with the weak ones. Sooner or later there will be no strong ones left. As this process progresses it will rise to the top.


Note: I went to Caracas for business a number of times in the 80’s. I found nice people, good restaurants and interesting things to capture my attention. I liked it, but would not have suggested it as a destination. My last trip was in 1988. I was there shortly after a spat of domestic violence that brought the military out. At night I heard shooting throughout the city. I asked someone what this was about. The explanation was, “The people who are angry shoot guns in they sky.” I wonder if they are still shooting off guns at night in Caracas. I am sure there are plenty of angry people.

Errata

In the piece I posted yesterday titled, "Tim Out - Sheila and Debt Relief In?" I made a mistake.

I confused the names of Mr. Neil Barofsky with Mr. Neel Kashkari. Mr. Kashkari has moved from Treasury to PIMCO. Mr Barofsky continues as the Special Inspector General for the Troubled Asset Relief Program.

My apology to both you gentlemen.

bk

Maynard Keynes on Japan – “Very Disastrous”

“In an era of declining population, demand tends be below what is expected and a state of over-supply is less easily corrected. Thus a pessimistic atmosphere may issue; and although at long last pessimism may tend to correct itself through its effect on supply, the first result to prosperity of a change-over from an increasing to a declining population may be very disastrous.”

John Maynard Keynes
General Theory - 1937



 And now in 2010 we get the following headlines:

I will leave you to conclude whether Keynes’s forecast for Japan will come true. Keynes wrote his thoughts on population in the context of equity prices. Generally speaking, the Nikkei has been down for the last twenty years.

There are many components to the make up of population. The death rate and immigration are factors. But the big one is the fertility rate. Some fuzzy math: If each female has 2.3 children in her lifetime the population will be steady. (.3 mortality). If each female has 2.6 children, then the population is growing.

The CIA provides updated information on fertility rates for most countries. The information is interesting. There may be some clues in it if you believe Keynes. The link is here. A few highlights:

-The EU has a broad based problem. Germany’s fertility rate is 1.41, the UK at 1.66.

-The US is at a ratio of 2.05. Well below the rate for indigenous population growth. Our numbers look better when the death rate (declining) and immigration (legal and illegal) are taken into consideration. It will be interesting to see this year’s census data. I think the illegal population is way down. The US looks good compared to most other industrial countries.

-Russia is at 1.41. This country does not do well on the longevity statics either. Good thing they have tons of oil. Hint - buy Resources not Retailers if you want to invest here.


-Afghanistan and Iraq have fertility rates of 6.5 and 3.9 respectively. They are having lots of babies. Iran on the other hand had a fertility rate in 2009 of just 1.71. That probably confirms something we already know about the domestic situation in this country. If you were calling the shots in Iran and were looking at this number, you might just conclude that it would be better to make a 'move' sooner versus later.

-India is a standout. Not only do they have a big population, they are having babies. The fertility rate is 2.72. The population is climbing steadily. This will continually boost domestic demand.

-China was the big surprise. The fertility rate is one of the lowest. It stood at 1.79. The UN has a forecast that it will remain at 1.8 for the next fifteen years. China is trying to create demand domestically as they have lost a lot of exports. They do that with deficit spending, but it is not supported long term by the fertility rate.

-Japan is near the bottom of the big countries at 1.35.

-Brazil looks good on this list at 2.4.  This country keeps popping up when you think of where money should go.


I’m not sure of the importance of this. It certainly does not mean anything in a given month or a year. But over the longer-term these are powerful forces. The fertility rates have come down in almost all countries on a steady basis for the past 25 years. We are still growing globally, but at a lot smaller pace. It’s hard to assume that “productivity” is going to make up for these declines. It’s easier to conclude that average global growth in the next twenty years will be lower then it was in the priort two decades.

Tim Out - Sheila and Debt Relief In?

In my piece “What’s in Store for 2010” my number one prediction was:

-Tim Geithner will resign as Treasury Secretary. Sheila Bair will replace him.

The odds of getting any of these types of predictions correct are probably 20 to 1. Given what has happened in the past few days I would now say that the ‘swap’ of Sheila for Tim is an even money bet.

Mr. Geithner has outlived his usefulness. He is too connected to the bailouts of 08. Bear, Lehman, AIG, TARP and even QE are all part of his legacy. That makes Tim a lightening rod. Too many Americans hate that part of our history.

I don’t think the current flap relating to the deliberate ‘non-disclosure’ of information relating to AIG is that big a deal. When the full history of this period is finally told (it will take awhile yet) this particular transgression of Mr. Geitner will look small by comparison. The things that we do not yet know about that we 'agreed to' during the 'crisis period' are going to cause us to roll our eyes and bow our heads when all is said and done.

Those that had their hands on the tiller were firmly of the belief that the western world financial system was shutting down. They left no stone unturned in trying to save the patient. They committed future generations for Trillions in additional debt. Every step available to calm market fears was taken. Even withholding information. When you are at war, and you think you are losing, you do what you have to do. If you later win the war and someone criticizes you for using WMD so be it.

I will take a stab at writing the President’s statement on this:

“I have today accepted the resignation of my Treasury Secretary Tim Geithner. One year ago the global economy was facing the biggest challenge in history. Tim and a small handful of dedicated individuals took the steps that were considered necessary at the time to first stabilize a collapsing system and second put the economy of the US and the globe on a path that would lead to recovery.”


“For this, the American people owe Tim our thanks. He worked tirelessly during one of the darkest periods of our history. And he succeeded. Today the economic crisis of one year ago has receded. Our economy has stabilized and growth has resumed. Our financial institutions have also returned to health. The financial support provided them through the TARP program has worked. We see the evidence of this as those banks who took assistance a year ago are now paying it back with interest.”


“Our country continues to face serious economic challenges. Unemployment remains stubbornly high; we face a protracted period of large fiscal imbalances. A critical weakness continues to be with homeowners who are unable to meet their financial obligations.”

“I have appointed Sheila Bear to replace Tim Geithner. Sheila will bring to the Treasury Department her proven leadership and administrative skills. She has both the knowledge of the core issues and the compassion that is required to address the problems that are at hand.”

“Sheila has set the standards and seen to the implementation of the Nations efforts in restructuring home mortgages. The guidelines for refinancing troubled homeowners that she established have been accepted by virtually every public and private sector lender. Much more work needs to be done in this area. Many homeowners are still facing default. This reality causes human suffering and is adding to our economic problems. I am looking forward to working with Ms. Bair in this critical area as well as all of the other challenges we face.”


Okay, so that was BS. But if it does go this way, the Boss will say words to this effect. He will just do it better.

My sense is that this would be a very significant development. I believe that Ms. Bair will introduce a very large program of PRICIPAL debt relief for borrowers. This program will start with the D.C. mortgage lenders Fannie, Freddie and FHA. It will be forcibly extended to the private sector lenders. (They already have significant reserves on a lot of this.)

I hate this development. But I think it is the ‘right thing to do’. The inequity of it will cause great divides. The cost will be astronomical. The total could go as high as $800 billion. A significant portion of that would be born by the Government lenders. My guess for the taxpayer tab is $500 billion. I do not see any realistic alternative however. If we let the problem fester it will cause us to lose a decade of growth. Better we deal with it now.

A muse of all of this is that the money to accomplish a half trillion dollars of debt relief has already been made available to the D.C. mortgage lenders. Mr. Geithner saw to that on Christmas Eve when he did the ‘Sneaky Pete’ announcement of a virtual blank check for the Agencies. For me, that was a much more serious offense than the disclosure issues with AIG. That was then, this is now. I thought that this, by itself, would have proved to be a significant enough gaff to take him down. As it turns out, that straw on the camels back may well prove to be the critical step that insures that the next Treasury Secretary will have the ‘Bazooka’ that is necessary to address the problem. Funny how things work. It almost looks like it was planned.


Notes:

-I do think that Sheila Bair would make an excellent T. Secretary. She has the skills and experience. She also has a vision that we desperately need. She is no lightweight. She will fight very hard and she has a lot of ‘chips’ in her pocket. The fact that she is a woman is helpful. In my opinion it is high time that a woman took this job. Lets face it. The ‘Guys’ have screwed this up for decades.


-If all this happens and Tim G. ends up at PIMCO or with Wilbur Ross structuring investments in “Distressed Debt” as Neel Kashkari and James Lockhart have, I am just going to puke.

Fugly Farms Friday

For the better part of two decades I sat at a desk at 8:30 on the first Friday of the month and waited for the Non Farms Report. That was a long time ago. Nothing has changed. There are still thousand of people who will put on a seat belt and wait for the numbers to come.

The ‘market significance’ of these numbers is very high. Quite often they drive the chitchat for weeks. It always makes some mention on the evening news.

I have always hated this data series. If you have a book you are ‘at risk’ at 8:29. If you don’t have a book there is no chance to make money. It stacked up a lose-lose.

There was a time that I got so frustrated with this process that I hired a few big shot economist to give me an edge. I paid them serious money for a year. The results were slightly worse than tossing a coin. To hell with the economists.

Tomorrow’s numbers have the potential to light some fires. The expectation for the payroll number is either side of flat. That would be boring if it turns out that way. Even with that, there will be two camps. The first will say”

Golly this is GREAT! A year ago we were losing 700k jobs a month and now we have broken even!!

The other camp will cry:

This is crap! We need 250,000 new jobs a month to sustain a recovery! This lousy number at this stage of the cycle is a sure sign of a double dip in six months!

If we get a breakeven number tomorrow the Vol's in the things we trade are going to make a jump and the computers will make some dough but I don’t think it will mean much for the rest of the month. Too much else to worry about to get agita over a neutral number.

The worst feeling is when the number comes and it is a blow out. Being on the wrong side of a blow out leads to sphincter issues.

For tomorrow, I will say that anything that is outside of plus or minus 250,000 is going to cause a stir that will last for a bit. If it is on the ‘over’ there has to be a mighty hit to the bond market. A very ‘hot’ number coupled with the big calendar next week will take the ten year close to 4% by the end of the day. On the flip side, if the number is a big downside surprise the dollar is going to get whacked and gold will be up $25.

My gut tells me that the economy is stronger than we think. I believe there is going to be a big 'upside' tomorrow.

Can’t wait.

SS Trust Fund - 2009 Full Year Results - Ugh!

The Social Security Trust Fund issued their November and December reports today. They also provided the payment data for January 2010. I think there is some significant information.

From my writings on the Trust Fund I have received many comments from those who believe that the SS is a bankrupt Ponzi scheme. That is not correct. The SSTF did an admirable job in a very tough year. They paid a total of $675 billion in benefits and ended the year with an even $100 billion surplus. On December 31st they were sitting on $2.5 Trillion of US Treasury IOU’s.

That said there are some very disturbing trends at the Fund. First a Macro Economic thought:

There was a onetime negative COLA adjustment that kicked in January 1. Rather than the usual increase, beneficiaries are getting smaller checks. The difference between the December and January payments comes to $475 million. That re-base means a reduced outlay for the full year of $6 billion. In the scheme of things that is peanuts. But this is going to be felt most in the Sunbelt states where the bulk of the beneficiaries reside. I believe that a significant percentage of SS payments goes right into consumption. Given that fixed costs are actually rising for this group of consumers (the hell with COLA) the 65+ set might not be going to the Wal-Mart in Boca as much as they used to. A year ago we were talking of ‘green shoots’. This ‘shoot’ is decidedly brown.


On the Fund itself:

I think that the recession of 08 and 09 and the anticipated high unemployment (low employment) in 2010 has crippled the Fund. Nothing short of a major overhaul can turn it around at this point. The damage has been too great.

In the 2009 Trustee Report to Congress (signed by Chairman Tim Geithner) the following information was provided:

Now look at the reports released today. Total tax receipts were less than the disbursements. This was not supposed to happen until 2016. It happened last year.

There was a $100 billion surplus for the year. But compare that to the $190 Billion surplus in 2007. We have lost $90 Billion in just two years. But this number should be much higher than the 07 surplus. It was assumed that the Fund would have larger and larger surpluses for years to come. The 2008 Trustee Report (signed by then Chairman Hank Paulson) provided a set of Intermediate Assumptions for the Fund's surpluses looking forward. As you can see we missed the 2009 target of a $220b surplus by a cool $120 billion. As of 12/31/09 the funds assets are behind that 08 schedule by $155 billion.

In prior years the SSTF has financed up to 50% of the deficit through their purchases of Treasury paper. In 2009 that ratio fell to a measly 7% of the total new issuance. It will be a rounding error in a few years. At some point someone is going to look at this and conclude it is not a plus for the bond market.

We are in an election year. Any significant legislation on SS changes will have to be completed by June. After that no one will want to touch this. Given that Health Care is far from resolved and there is that thorny problem with the mortgages Agencies I can easily see that the problems at SS get buried for another year. It will be very difficult to fix this beast if we wait another year.

The most optimistic scenario is that out of the ether comes a bi-partisan effort to address the issue head on and make the necessary fixes. By my calculation that would require a 2% increase in payroll taxes and as much as a 20% reduction in benefits (over time). Taxes on benefits would have to increase as well.

Those combined actions are extremely deflationary. It would directly cut consumer demand. It would be another blow to the head of small businesses. This would not be a brown shoot. Think of this development as being Amber Waves of Grain. And that is the optimistic scenario.

My solution has always been a means test. If you have $100k in taxable income you don’t get paid. Finished. I’m not sure that is legally possible. But to me it is the only option. The alternative will impoverish those that are/will be dependent on SS benefits. Raising taxes on America’s 90 million workers and their employers is just bad economics. It should not be considered.

I am not the only one looking at these numbers. This issue will have to come on the table before June. The 2009 results of the Fund are like an elephant in a room. It's too big to ignore.