SNB on the Clock

As Tyler Durden pointed out the EURCHF fell off of a cliff two hours ago. I think there is a story here worth noting. First let me say that we are in no man’s land. Any part of the Swiss cross is a high-risk trade. Be guided accordingly. I doubt that tight stop losses will be executed if the SNB shows it’s hand.

Consider the timing of the collapse of the cross. It kicked off at 10:25. Why? Because “someone” knew that past 4:30 Zurich time the SNB was a no-show for the day. With that risk removed the “someones” sell hard and fast. Without the threat of the SNB the cross quickly corrects. It did it Sunday night in Asia. It did it NY yesterday. And today the cycle is being repeated.

This is a disaster in the making. The SNB has given the “someones” AKA the “market” a free ticket to coin money. The window is now open to trade around the SNB. If the door remains open, the players will continue to operate, the cross will go lower and there will be a crisis.

In September of 1992 George Soros (but really it was Stan Drukenmiller) broke the Bank of England. They made a bundle in the process. After that, the CB’s quietly agreed that they could not hand up winners to the market. By itself, it created a systemic risk. By making it profitable, it insured that there would a continuing “run on the bank” and the chaos that always goes with it.

The SNB has been doing exactly the opposite for nearly eight months. Their losses are FX player’s gains. It is a zero sum game in the short term.

I can’t imagine that this pattern can continue for long. There is no CB that is not watching this closely. They understand that this is a gathering storm. It is even more troubling that it is happening in a very similar fashion with the Yen crosses. The BOJ is just hot air. Like the SNB they are powerless.

If the CB’s want/need to stabilize speculative markets they have only one option. They have to re-establish two way risk. There has to be risks 24/7 that the CB’s will act. The CB’s have to step up and show they mean business and be active in all markets in large amounts.

This can only be accomplished if the intervention is done with a number of Central Banks and the activities are coordinated. It CAN NOT be accomplished unless the Fed is involved for it’s own account.

Should that be the result it would be the most significant leap in government involvement in the market since February-March of 2008. If initiated it would get the capital moving. There can be no certainty of what the outcome will be. These are the conditions where Black Swans appear.

I would not advise anyone to dabble in this water unless you are a pro. It is better to watch this play out from the sidelines. But do watch the Swiss crosses. There may be significant macro consequences from what will likely play out in the next few weeks. Either the attacks on sovereigns will dramatically accelerate, or the financial system will get “socialized” up another notch. A fair bit on the line.

New Boss at the FASB

Bob Herz, the Chairman at FASB quit last week. He will be gone by October. No explanation from anyone on the abrupt departure. My question is does this mean that there will be a change in the direction and pace that FASB is moving? IMHO FASB has been doing pretty well on the “direction” issue. The “pace” however has been glacial.

Two critical issues are on the table. The integration of international standards with US standards and the upcoming changes in lease accounting.

Leslie Seidman has been appointed the new Chairperson at FASB. She has excellent credentials. She knows FASB (been there since 2003). I liked what she said had to say in an interview with WEBCPA. She seems up to the challenge. Of interest/importance is that Leslie is also the point person on the changes to lease accounting. If she prevails on this one it will prove she is a tough cookie.

I think 95% of the S%P 500 hates the draft plans. The financials totally hate it. Big shots like GE are going to be hurt by this. The accountants don’t like it at all. It makes it more opaque. Why would an accountant want that? Finally, it is not clear to me that the SEC is behind the proposed changes.

I think the new rules make a lot of sense (but I am not an accountant). It relies on a PV method of evaluating a lease. The longer the lease, the greater the impact. A two-year lease has a much smaller balance sheet impact than a thirty-year lease. Seems simple. But it will have very significant BS consequences to some very big players.

Ms. Seidman will have some stiff opposition. I wish her well. Some cut and pastes from the interview:

CPA: Do you think there will be a lot of criticism of the proposal from companies that expect to take heavy losses or who are warning that it’s going to depress the market for commercial property leasing, that landlords are going to have to start re-negotiating leases with their tenants, or tenants with landlords?

LS: I accept that potentially putting amounts on the balance sheet can affect leverage and ratios and things like that. We understand that most investors have been trying to do a pro forma adjustment to put these things on the balance sheet, and so it’s a question as to how big a surprise these amounts are going to be.

BK: Oh boy! I hear all the time that “analysts’ have this figured out and there will be no surprises if and when the standards are adopted. Wanna bet? Here is an opportunity for the analysts. Answer this. If the standards are adopted what is GE’s pro-forma BS? An estimate to the nearest $200b will do. It is currently ~$650b. Will it go to $1 trillion? $1-1/2 trillion?

CPA: How do you think it’s going to affect the airline companies now that they’re going to have to start putting these leases on the balance sheet?

LS: If you have relatively long-term leases, then you will have potentially significant amounts.

BK: Don’t all airlines have long-term leases?

CPA: Is it possible that the leasing standards might be deferred for certain industries, say if the airline industry had a lot of problems adjusting to certain standards or the commercial property industry had problems adjusting? Would it be rolled out differently by industry?

LS: We’re very interested in hearing from all constituents about what they think of the proposal, how operational it is, whether they think it’s producing information that’s useful for their investors, etc.

BK: Gulp. I really wish she had answered this; “No”. Asking the “constituents" whether “investors” are going to get “useful” information is like asking a bank robber for financial advice. Opening the door for special groups (AKA GE) to get a hall pass on this would make it a joke.

Swiss Franc Tale

I will try to connect some dots on the Swiss Franc story. These are just dots, but there may be some short and longer-term currency implications. There is a EUR/DLR aspect to this as well.

Consider first an interview with Philipp Hildebrand President of the Swiss National Bank in the French language magazine L’Hebdo. Mr. H spells out the SNB currency intervention strategy as clearly as he can:

“Our mandate is very clear. It is one of the most explicit of all Central Banks:

The SNB provides price stability. In so doing, it takes account of changing circumstances. The SNB has no foreign exchange objectives.”

He leaves no room for misunderstanding of this simple mandate:

“That is what we do not stop repeating. And that is the yardstick that our actions must be judged.”

Okay we got it. The SNB will not intervene in the FX market UNLESS there is either inflationary or deflationary pressures. Hildebrand has been true to his word on this. On June 17 he said “The deflationary risk in Switzerland has largely disappeared.” This was a sign that the SNB would no longer intervene and sure enough the EUR/CHF collapsed. It was a wild ride but as of Friday the cross was at 1.31 after hitting a weekly low a tad under 1.30. True to their promise the SNB has been absent from the market.

What does this mean for the future? Again from the interview:

We in Switzerland have neither deflation or inflation. And the rate of growth should this year be one of the best in Europe. Approximately 2%.

So H crows that Switzerland is doing just fine and there is no deflation. To me this is a tip. Hildebrand can’t enter the FX market anytime in the near term and sell CHF and buy Euros. This would run counter to his very clear words from August 26 that he would not. He would look stupid if he did. My read: don’t be long EUR/CHF. That cross may get leaned on any day.


More dots. An interview with Pascal Couchepin in the influential newspaper, Neu Zuricher Zeitung (8/29). Mr. Couchepin is a long time Swiss pol. He was president in 2003 and 08. He led the bailout of UBS. He has no official position today, but it appears (to me) that he is looking for one. He has been a long time supporter of Switzerland integrating/joining the EU. The Swiss people have resisted joining the EU so far. There would be many advantages, but it would require that financial and political sovereignty would be lost. That is a Swiss no-no. From the interview:

"The accession of Switzerland to the European Union is currently politically" unrealistic.”

He explains further:

"People are only willing to take a big step if there is a crisis."

Here we have a guy who is committed to EU integration, who says it can’t happen unless there is a crisis. So the question to ask is; “What constitutes a crisis?” He tells us:

Such a crisis could be related to the Swiss franc. Until now we have had success with the interventions of the National Bank. What happens if the franc against the euro climbs further and further?

A possible scenario emerges from this. Assume that the CHF does resume appreciating. The comments from Hildebrand last week suggest that it will. FX markets rarely undershoot. Should we see a 5-7% appreciation of the CHF versus the Euro the Swiss export/tourism industry and (the all important) farmers will be screaming. Couchepin will have his crisis and some very powerful political forces in Switzerland will attempt to elevate the debate on whether Switzerland should join the EU.

A debate like that would last a few years, but from the first day that this gets to the MSM the CHF is going to explode. The market will immediately recognize that if Switzerland would consider a link with the Euro the rate of initial conversion would be at a level much lower than we are looking at today. EUR/CHF at 1.10 comes to my mind. If the market agrees with this assessment we are off to the races.

If you follow the logic of: “A strong CHF leads to joining the EU”, then you have to ask the question, “What is the politics at the SNB on this issue?” If the powers to be actually believe in the foregoing logic then they have every interest to see that the Franc gets stronger. An interesting conflict of interest.

I don’t know what Hilldebrand is thinking. I do know that the number one issue that the Swiss are concerned with is losing their currency to the Euro. On that issue Hildebrand had this to say:

L'Hebdo: Can Switzerland keep the franc in case of membership?

Hildebrand: Some member countries have this type of arrangement. Nothing makes it impossible. But it is a question that should be put to Mr. Barroso (President of the EU) and Ms. Merkel (German Chancellor) ...

This response blew my mind. Did Hildebrand suggest that the door might be a crack open if Merkel and Barroso would let Switzerland keep the Franc? The implication is that if the Swiss joined the EU they would keep the Franc as a local currency, but adopt the Euro for cross border trade and finance. Again, for this to be even considered as a compromise the EUR/CHF has to be much lower.

In my opinion Merkel and Borroso would like nothing better than to have Switzerland join the EU. If the price to pay is that there is a bastard float of the currencies for a while that would be a small price to pay.


There seems to be some energy developing for yet another big jolt in EUR/CHF. I doubt the article in the NZZ will be missed by too many on the Bahnhofstrasse. The NZZ headline leaves little to the imagination:

Strong Swiss franc could force Switzerland to EU

In a strong Franc versus Euro market environment the dollar has typically moved higher against the Euro. It is shaping up to be an exciting fall.

China to Globe: “No More Rare Earth”

Bloomberg reports that China is cutting back 72% of its exports of Rare Earth metals. China has said that environmental issues are the reason for the cutbacks.

72% drop in availability of any commodity is important. RE’s are important. I am no expert in this but I believe that RE metals are needed in most things we make and consume. From cars to cell phones. Some more informed comments on the importance of RE would be most welcome.

Japan and the US are already protesting the ban. The rest of the world’s manufacturing base will soon follow. This could become an interesting row.

And all those folks were saying that China would be the world’s economic growth engine. Not.

CBO Clears Things Up

Douglas Elmendorf, the Chief Honcho at the Congressional Budget Office has a blog. (Doesn’t everyone?) He uses his site to introduce/discuss new reports from the CBO. The reports are often long and tedious; Doug’s summaries are pretty good.

He had a post last week regarding the economic impact of ARRA, (09 stimulus). In his blog Elmendorf went out his way to defuse a political bomb. I doubt he was successful. We will hear more on this in the next two months.

The report touts the success of ARRA. The CBO made the following claim:

CBO estimates that in the second quarter of calendar year 2010, ARRA’s policies:

Increased the number of full-time-equivalent (FTE) jobs by 2.0 million to 4.8 million

My first thought on this was that you could drive a truck through those estimates. But if you use a mid estimate of 3mm you would have to conclude that ARRA was a pretty big success. But then you read on:

CBO’s estimates differ substantially from the reports filed by recipients of ARRA funding. Those recipients reported that ARRA funded nearly 750,000 FTE jobs during the second quarter of 2010

Wait a minute. How many jobs were saved? Is it 750k or is it 4.8mm?

I happen to know a lady who runs a health center. Big one. On behalf of the clinic she applied for ARRA money and got it. They bought needed equipment and hired people to use it. The reporting requirements for the money were rigorous. She had to document the number of jobs created before during and after. Failure to do so meant money did not come.

Based on this I conclude that the reports from the ARRA recipients is very accurate. These are the numbers the White House collected. But Doug does not like the results. He just blows them off:

The law’s overall effects on employment requires a more comprehensive analysis than the recipients’ reports provide.

So there are hard numbers and there are soft numbers. To be fair, ARRA was much more than a jobs program. It funded unemployment benefits and some tax breaks. I can’t imagine how 4-5 million jobs get created from that.

If you are an “In” you can say that you were part of a Congress that passed legislation that saved nearly 5 million jobs. You can wave a CBO report to prove it.

If you are a “Wanna Be In” you can say that the “Ins” failed miserably. They spent $820 billion to create a lousy 750k jobs. That comes to $1,100,000 per job! And you can wave the Recipients of the ARRA Funding reports to prove it.

Ain’t America great….

Krugman’s Solution – Nitro

Interesting read by Krugman in the Times today. He makes the clear case for some quarters of negative growth in the future, but his view is that a double dip is irrelevant. I agree with him.

While it may be hard to forecast a double dip it is now a slam-dunk that we are going into a longer period of sub par growth. That outlook is even worse than two quarters of negative growth followed by six quarters of anemic recovery. If we go two years with growth around 1% our fiscal books will be in the tank. We would be so far off on the critical issues of total debt, debt service to GDP, debt to GDP, deficit to GDP, employment and unemployment that I can’t envision how we could dig ourselves out of that hole. If we don’t grow we die.

Krugman says that we should throw everything we have got at the problem. It was clear that he was angry at the lack of action at the Fed and the Administration. I got a sense of trepidation in his words. Here are his suggestions of what should be done:

The Administration can use Fannie Mae and Freddie Mac, the government-sponsored lenders, to engineer mortgage refinancing that puts money in the hands of American families.

Mr. K we are doing that. The Agencies are 95% of the lending. One can still get a 96-1/2% LTV loan for heavens sake. QE-1 and now QE-2 have killed savers and brought mortgage rates to 50-year lows! With HAMP and HARP nearly anyone who has a chance of landing on their feet can get a trial modification. The FHA is lending $50k to people in default at zero interest and the loan is non-recourse and subordinated. What the hell is that?

Mr. K wants to turn up the dial on this? The only way to do that would be to drop lending standards. The stupidest thing that we could do. Bad lending got us into this mess. Bad lending is not going to get us out it. It will only ensure our demise.

The Fed can buy more long-term and private debt.

Private debt? Who’s private debt? GE’s? BP’s? Citi’s? AIG’s? This is over the top in my opinion. We have already socialized big parts of the financial system. Now Mr. K wants everything to be owned by the government. This is not an idea that will sell in America. There has already been too much intervention. If the Fed starts buying Wal-Mart bonds America is finished. And heaven help us if the buy common stocks. Japan started doing that 20 years ago. Their market is down 70%.

The Fed can raise its medium-term target for inflation.

What does that mean? Does the Fed come out with a statement that says, “Our old target for inflation was 2%, we have changed it to 4%”? There is only one way to achieve that goal. The Fed would have to print money. Trillions of it. The fed balance sheet would go to $5T. To me this is assured destruction. I don’t think we would get to $5t. The financial system would implode before we got there. America would look like Argentina in the 1980’s.

Treasury can finally get serious about confronting China over its currency manipulation.

I’m sorry but just shut up with this Mr. K. In the past 24 months the US has intervened and supported financial markets at levels never before seen in history. The Federal Reserve bought $1.75 trillion of fixed rate paper! Have you looked at the tape lately Mr. K? The yields you’re seeing are in no small part due to those POMO operations. And he wants to do trillions more? Talk about a double standard. When America actually stops the intervention in the global credit market it can then sit down with the Chinese and talk turkey. Before that it is the pot calling the kettle black. And Mr. Krugman knows it.

These steps are big gambles. The downsides are enormous, the upsides questionable. Krugman acknowledges this:

Nobody can be sure how well these measures would work, but it’s better to try something that might not work than to make excuses while workers suffer.

No one wants to see “workers suffer”. I think this use of words was a cheap shot. The fact is the steps Mr. Krugman is advocating could very well destroy most of the things we consider important.

Friday evening. The markets are up big. The weather is perfect. But there are big storms in the Atlantic and I am worried that we are dead either way.

My Ex Bonds and Ben Bernanke

Three-four years ago I had a nice bond portfolio. For a guy who should have know better I completely boinked it up. I fell prey to the worst of errors. I let disbelief guide my choices.

I had a bunch of high coupon NYS GO Muni’s. Almost all of them have been called. I had 5 and 5 1/2% Agency MBS. I knew that was subject to prepay, but I never expected to get 80% cashed out. The corporate’s were high yield so I kept the maturities short. Most have been paid off.

Net-net my fixed income is down a cool $150, 000. I have managed equities and at my age I am not going overboard on that. I think all preff stock is junk. I will not buy JNJ for a 3% yield and lose a 1/3 of my equity. And I am not going out far on the curve when there is no payback. So I am screwed. Losing this much income makes it hard to plan for expenditures. Relying on the equity market to earn a stable income is not possible.

So if you lose that much income what do you do? I cut fixed and variable costs.

-I left my high-end golf club. Saved $30k on that. Last I checked there were 70 out of 270 members looking to do the same thing. Talk about a leading indicator.

-I had my eye on a new A-6. Call that $30k with the trade. I nixed that plan so a few folks in Wolfsburg have a car less to build.

-My farm pickup has gone to work six days a week for the past 12 years. The help, the rust and the big loads have beaten it to pieces. I need something that will push snow, so that is another $40k. Screw that, we will drive the piece of crap until it dies.

-I was thinking of asking a lady to come with me for a few weeks to Europe. Saved at least $10k there when I never brought the topic up. Funny thing is, she’s there now with another guy. Possibly he does not have a “duration” problem.

-I have an endless list of trades working for me. Plumbers, carpenters, masons, electricians. I usually budget 30k for this. These guys are all calling me up to see if I am okay and do I have some work? I tell them, “Next year”.

-My apple orchard needs pruning and the tree guy came over to talk about it. I also told him next year. The risk is we have heavy wet snows and I will lose trees so I am taking a gamble. Another 10g saved.

-I give 10% of my income to various forms of charity. I am not doing so this year. $15k to the plus, but I don’t feel so good about it.

That adds up to $165,000. But I know something will break and I am hoping to come in at the $150,000 that I lost to the bond market. If nothing breaks I will find something “good” to do with the extra.

Ben Bernanke does not give a rat’s ass about me. Nor should he. There are plenty of situations that are screaming for help that are much more important than I am. I have no problem with those priorities.

Ben is probably going to be working on his speech as he flies out to Jackson Hole. It will be an important presentation that many will focus on. I am sure that he will acknowledge the weakness in the economy. He will point to the recent steps he has taken and he will promise to do more “as necessary”. In other words, ZIRP will be with us for a long time yet to come.

Bernanke has a better handle on the numbers than anyone. He knows we are hitting an economic wall. But he can’t figure out what to do so he looks in a college textbook and reaffirms his belief in Keynesian economics and voodoo monetary policy. The only medicine he understands: zero interest rates. The poor guy must be wondering why his efforts have failed so miserably. He is now looking at a questionable future. If he steps on the gas with QE2 and fails, he will go down in the books as the worst fed governor in history. I think is going to fail miserably.

How many people look like me? A million? Three million? Five million? It is many more than you might think. If it is 3mm then it translates to a drop in consumption of $450 billion or 3-¼% of GDP. So without the me’s of this country contributing to consumption we have a tremendous drag. We need 3-1/4% growth or the social obligations/debt will eat us alive in a few years. We’re not going to see that growth. QE is the culprit. And Bernanke does not get it.


Note: The NY Times had a front-page story by Sewell Chan that spelled out his thoughts on the dilemma Bernanke faces. He started the column with these words:

Bernanke to Offer Outlook as Fed Weighs Bolder Steps

On Friday Ben Bernanke will offer his outlook on the economy and explain the Fed’s recent modest move.

This is a dangerous understatement by Mr. Chan. Until very recently Bernanke and the bulk of the board members had been signaling that the next move in monetary policy was going to be a return to normalcy. The Fed’s recent move to initiate the first step in QE-2 is a 100% u-turn on what has been said/promised for the past year. There is nothing modest about that step. The markets have shown they don't like it. Every additional measure that Bernanke takes will lead to more dissatisfaction. Ben can’t connect these dots. He thinks the solution to our problem is to create free money so the commercial banks can generate big income to absorb the big losses. It is a dead end policy for the real economy.

Boeing’s Albatross

In my year-end forecasts for 2010 I predicted:

-Boeing will finish a few Dreamliners but they will face many delays and problems.

Looks like I am going to be wrong again. There is a now a question if any of these troubled planes will be put into service this year. The latest problem is not with the body of the plane. It is the engine that is supposed to keep this beast in the air.

Bloomberg reported today that on August 2 the Rolls Royce Trent 1000 engine literally blew up while being tested.

The explosion resulted in “limited debris” being released into the test facility,” Rolls-Royce spokesman Josh Rosenstock said.

Uncontained failures are “extremely rare” said Paul Hayess, safety director at U.K. aviation consultants Ascend Worldwide.

Think of this engine blowing up. It is the size of a cement truck.

RR is attempting to make this development a ‘no big deal’. But three weeks after the explosion the testing facility has not be reopened. So how big was that explosion? From the Bloomberg article:

Rolls-Royce could switch testing of the Trent 1000 to other locations around the world, according to a person familiar with the programs, who declined to be identified because the information isn’t public.

Earlier in August Boeing said that the first deliver of the Dreamliner to All Nippon Airlines might be delayed to sometime in 2011 due to “flaws with the structure”. Now we know that the engines may explode.

Boeing built a plane made of fiber that has structural flaws and an engine that took out the test sight. Do you want to fly in this plane? I don’t.

Ah! Well a-day. What evil looks

Had I from old and young,

Instead of the cross, The Albatross

about my neck was hung.

The Rime of the Ancient Mariner

Samuel Coleridge

What’s Your Home Worth? Ask FHFA

The Federal Housing Finance Agency (“FHFA”) publishes its own monthly home price index. I think it is inferior to the Case-Shiller index in terms of measuring what is actually going on month over month. However, the FHFA gets its data from their own pool of mortgages. Given that FHFA represents more than 50% of all mortgages (Fannie+Freddie+FHLB=$5.9 Trillion) they have a unique database. The good news is that they have packaged this up on their website so that anyone can check out trends on both a city by city or a state by state basis. Amassing this database has/will cost the taxpayers at least $400 billion (about $3000 each) so I would encourage you all to get your money’s worth. Link

The following are some graphs of individual states. I plugged in the start period as 2006 and a $1mm price tag (the site lets you use any variables you like). The results are not surprising. “Sand” did very poorly. The upper mid-west is bleeding. Snow resorts seem to have been clobbered. Texas did pretty well. I could find only one other bright spot in all the country that not only sustained value but also saw prices rise. This RE winner shone while most other parts of the country were tanking by 30+%. Guess where that is? The District of Columbia, of course. I believe that there is a direct correlation to the results in D.C. and the rest of the country. Washington is flourishing while the rest of the country withers. Not a surprise to me.

I found the site useful. I was able to confirm that the disagreeable relative who said, “RE is stable here in San Diego”, was full of crap. Prices in that zip code were down YoY for the past four years. I was also able to disabuse a RE agent in Naples, Florida who told me, “Prices are down at most by 20% from the high, they are already starting to recover”. They are actually closer to 40% off that high water mark and they continue to fall.

Note: In my neck of the woods (N. of NYC) there was a lousy selling season (ends August 1). It was better than 2009. There is still a tremendous overhang of properties. Increasingly, bank owned REO is a factor. There are many “must sell” homes. A number of these have quietly dropped the asking price another 10%. There does not seem to be elasticity of demand. There are cheap mortgages and cheap houses and no demand. I have to believe that this is occurring in other parts of the country. The graphs from the FHFA are headed lower. Except the one for D.C.

On SSTF - Let's Go Back to 1956

I want to make a case that we are paying far more than we should be to borrow money from the Intergovernmental Accounts (“IG”). I will try to make this argument based on a review of the Social Security Trust Fund and then expand on that to the entire IG.

In 1983 the master fixer, Alan Greenspan, put the SSTF on a long-term path to build a big surplus. Thirty years ago it was obvious to anyone looking at the problem that SS would face an enormous bulge of expenses as the baby boomers began retiring. The plan was to increase SS revenues in order to create a surplus. When the boomers aged the surplus (savings) would be eaten into. After the boomers died the surplus was to have been depleted. At that point (around 2035) the system would go pay go.

It was a pretty good plan. The surpluses were created. The excess cash earned interest on the Special Issue Treasury Securities investments. As a result, we find ourselves today where the SSTF is sitting on $2.5 Trillion of government debt. Three times what the Chinese and the Federal Reserve currently own. The surplus is derived from two sources. The principal or excess cash flow on an annual basis and interest on the principal.

The following graph shows the annual cash surpluses from 1983 through 2010. Notice that for 2010 the number is negative $40b. The TF expects that 2010 was an aberration; that the surpluses will resume in 2011. I am one who doubts that.

The following graph looks at the cumulative total balance of the Fund (blue) and the contributions of both the cash surplus (green) and interest (red). The cumulative interest income is equal to $1.4 trillion. Therefore 54% of the total surplus is interest.

I have no problem with SS or any other Agency earning a reasonable return on their Trust Fund assets. I do have a problem if the calculation on how interest is determined is far from reasonable. The interest that the Trust Fund earns is based on a formula that was created and enacted by Congress in 1960. The description from SS:

The average market yield on marketable interest-bearing securities of the Federal government that are not due or callable until after 4 years from the last business day of the prior month (the day when the rate is determined). The average yield must then be rounded to the nearest eighth of 1 percent.

Notice that the formula excludes short date and maturities up to 4 years. That is very convenient. The Fund earns a yield that is the average of 5 through 30 years. They have reaped the benefit of a steep yield curve. They have avoided the investment death of ZIRP. They have been doing that on a mountain of short-term investments for the past 27 years.

The 1960 formula replaced one that had been established in 1956. The older language read:

The average coupon rate was computed for all outstanding marketable obligations, with no limitation on the maturities. In addition, the rounding formula called for rounding to the next lower multiple of one-eighth of 1 percent.

This includes all maturities. It therefore includes short-term yields as part of the formula. I love that they even rounded the result down.

How much of a difference does this change in the formula make? Given the number of zeros and years involved in this equation, even small changes in yield produce significant long-term results.

An example: In January of this year the SSTF bought a net of $35b of five-month bills from Treasury. The yield was set 3.5%. At the time that this was done the market return for this investment was 25 basis points. That yield difference comes to a tidy $474 million. Keep in mind that this goes on nearly every month and every year for the past quarter century. That adds up. Which state or city could not use an extra half bil?

The average yield on the Trust Fund portfolio is a very desirable 4.76%. The average maturity is 8 years. As of today the market yield for this would be 2.2%. The Fund is enjoying a yield that is 2.5% over market or 220% over the current yield. Bill Gross over at PIMCO would die for this book.

My estimate on the average benefit to the Fund from the 1960 formula over time comes to 1-2%. Using a middle estimate of 1.5% the cumulative effect is $485 billion dollars or 19% of the assets of the Fund. The conclusion is that SS is costing our economy much more than we think. This interest bill is killing us.

The SSTF is just one component of the IG account. The following is a partial list of Trust Funds that hold Special Issue Securities. The total in this group comes to $3.7B or 150% larger than the SSTF. Therefore, if you gross this analysis up for all of these accounts, the excess annual interest cost comes to a whopping $55B a year. And you wonder why our fiscal accounts look so bad. The excess interest is 10%+ of future projected (CBO) budget deficits. We can’t afford this any longer.

The 1960 law that started this all off should be reconsidered. At a minimum it should be understood. Treasury knows this problem full well. They publish a report on it daily. The IG account is equal to 1/3 of our total debt, yet the IG account costs us 50% of our debt service.

If the 1960 rules were revisited and adjusted for reality (the 1956 formula would be fine with me) SS would look much different going forward. The funding gaps would be accelerated from the current thinking of 2037 to a year that is much closer to today. That would imply that very significant cuts would have to be made to scheduled benefits to keep the system solvent. So really there is no solution. But masking the problem with a 50 year-old formula is just that. Masking the problem.

On balance 56’ was a pretty good year. I think we should go back to that year as far as calculating interest on the Trust Funds. No more “off market” pricing. Yes this would starve the Trust Funds. Doing so would force other changes. But those changes are badly needed.

 

How Much Debt Does the S&P 500 Have?

About 25 years ago I worked for a few months with a team of deep thinkers who were trying to convert Capital Leases into Operating Leases for tax and accounting purposes. The objective was to get the most optimal treatment; (1) tax deductible amortization of the asset and (2) keep it off the balance sheet so as to hide the true debt level and therefore improve balance sheet ratios. There were strict rules that were supposed to avoid this. But is was a goldmine idea if it could be done. This was early derivative days. Make something look different than what it actually was. I thought it was a dumb idea, so I quit and went to sell junk bonds at Drexel. Turns out the folks involved figured it out and made a bundle selling it. I am still glad I was not involved.

Now, a quarter century later, the regulators are catching up to this. It is possible that changes will be made. If they do, it will have very significant implications. The Economist has an article that sums things up pretty well. Here is the link, some sections of the report:

This new rule, proposed on August 17th by the two regulators (IASB and FASB), has shocked companies everywhere.

The change will make a lot of firms look wobblier: a survey by PricewaterhouseCoopers, an accounting firm, found that it would add about 58% to the average company’s interest-bearing debt.

Many companies are close to their maximum debt limits, and the new rules could push them over the edge. Small wonder they are howling.

Other companies will see their apparent return on capital plunge. Many firms will see their debt-to-equity ratio rise and their ability to borrow fall.

You can look at each company's BS and estimate what the impact of the new rules will be. The article suggests that airlines and retailers will be hard hit. The list of companies with Operating Leases is endless. I would imagine that most of the S&P 500 will be impacted one way or the other. I did look for macro information on total outstanding operating leases and did not find a source. I think we are talking a trillion or so. Does anyone have a source for the big picture?

Watch for a big fight over this issue. Look for GE to be the biggest opponent to any changes. I think they have the most to lose in this.

It makes me laugh/cry to see that it took them 25 years to come to the conclusion that lease accounting was being abused.

Hello, We Lost Track of $25 Billion?

I have been keeping an eye on the monthly numbers for the Social Security Trust Fund for some time. The 2010 revenue numbers have been terrible. They are running 3% below last year’s very crummy results. I was anticipating that the 2010 top line would look like 2009. Unemployment has been steady at just below 10% for a long time. There was no logical explanation for the continued drop in YoY payroll tax receipts. So I was confused.

Two important sources have “explained” this drop. Both the SSTF and the CBO have confirmed that somehow there was a miscount over at Treasury for $25-29 billion.

The explanation from the CBO today:

Receipts from social insurance taxes are also expected to decline this year—by $29 billion (3.2 percent) from last year, mostly because of an adjustment by the Treasury to correct for the allocation of receipts in earlier years.

The explanation from the SSTF in their August report to Congress:

The estimated decline in trust fund income from 2009 to 2010 is due to the economic recession and to an expected $25billion downward adjustment to 2010 income that corrects for excess payroll tax revenue credited to the Trust Funds in earlier years.

Some thoughts on this:

-This is not supposed to happen. In the monster numbers the government tosses around this is not a big deal. But $25b is still a lot of dough. It is equal to the GDP of Vermont.

-There is not an adequate explanation of what has happened. What the hell does “earlier years” mean? (Note the common language by both CBO and SSTF)

-By the rules of the TF this money was invested in Special Issue Treasury securities. It earned interest on those securities. So Treasury created the $25b and gave it to the TF in cash, then the TF invested it back with Treasury. But there was no money. It was a double count. One would have thought that Treasury actually balances and confirms its cash accounts from time to time. This gets back to the question how long this error has been going on.

-In my opinion the SSTF has misrepresented its financial condition to the public and to Congress for more than eleven months. Faced with an embarrassing $25billion restatement what do they do? They bury the loss. They have artificially reduced reported monthly payroll tax receipts by approximately $2b per month for all of 2010.

That is not how a loss of this magnitude should be handled. A public announcement and a one-time loss would have been the appropriate way to account for it. What standard should we hold SS to? At least that of a listed public company (I would argue a much higher standard).

If a public company played fast and loose with top line earnings to obfuscate a bottom line loss there would be hell to pay. The market would take the stock out in the woods and shoot it. The SEC would fine them 10% of what they hid. The press would have a field day and anyone near the cover up would be forced to resign. But this is D.C.

-I am now assuming that the SS top line number will make a $2b YoY jump in October. That would have been the tip off for me and others who watch this puzzle. It would have implied a few million new workers in the month. As that will not happen the increase would have been a red flag. So disclosure on this was necessary before 9/30 (they pre-release solid estimates on PR receipts). Disclosure was made in the recent TF report. Here’s the link(pdf). If you’re not looking for the quote from above, the disclosure is not so obvious, nor is it complete.

Let BABs Die

The Sunday talk show economic topic was what to do with the Bush tax cuts that expire at the end of this year. I thought I heard a unanimous voice from the likes of Zandi, Corzine, Tyson and (surprisingly /importantly) Senator Corker (R.Tenn.) that Congress should act quickly to agree to do nothing on those tax increases for at least another year. Look for that terrible choice to be made sometime in the next month.

There is another government program that is headed for the sunset New Year’s Eve. The Build America Bond (“BAB”) subsidy program was one of those “emergency” measures taken back in 09. The program was part of the ARRA stimulus legislation. This deal has Wall Street "deep thinking" all over it. I think it is a legacy idea from Hank Paulson. Geithner probably took some notes at a meeting in 08 and a year later it was law.

One of the many risks to the economy back then was whether the municipalities across the country would be able to access the capital markets to fund big ticket projects like schools, water treatment and other infrastructure investments. BABs addressed the problem by allowing the municipalities to fund in the taxable market. The audience for taxable bonds is very big. BABs opened the door for muni’s to issue taxable debt. However, when issuing taxable debt those same borrowers faced a much higher cost than if they had issued tax-exempt securities. Muni’s trade about 20% richer (historical) to taxable because of the tax break. To offset this cost and to encourage local governments to borrow and spend Uncle Sam has agreed to rebate the borrower for 35% of the interest expense.

I expect that the BABs legislation will be rolled into the Bush tax roll-over and they will both be extended for at least another twelve months. Shame on us. BABs should die because:

-This was an emergency measure. It was deliberately keep on a short time frame. This stopgap measure is no longer needed economically. But more importantly we need to get off the federal life support and see how the patient is breathing.

-Tax-exempt muni yields have collapsed. Even California bonds have been a big winner. Their five-year yields have fallen from the 4’s to the 2’s. A graph of the price action:

There is no justification for extending BABs looking at this graph. There is no shortage of demand for municipal bonds.

-Since the program began $123b of long term BABs have been issued. The average coupon was ~5%. That comes to $2B (and growing) per year for a very long time. This is just a stupid way of spending spare federal dollars.

-The Muni market is about $2.8T. It is a very large and well-developed market. The BABs issuance has competed with the traditional tax exempt issuance. If allowed to continue there will be two negative consequences. (1) The depth of the Muni market will be negatively impacted. (2) Taxable issuance of Muni’s will compete with the corporate bond sector. The latter is a non-issue today. But wait a year or two and watch the pendulum swing.

-BABs enables municipal borrowing. This is at the heart of the matter. Should we have policies that encourage more debt? With few exceptions, the “deciders” would say “yes”, more debt is good. It is true that DEBT=GROWTH. And we all know the deciders are desperate for growth.

-Possibly the most compelling argument against extending the BABs legislation is a review of who is supporting it. High priced lobbyists paid for by the big shots on Wall Street. From The Bond Buyer:

According to congressional lobbying records and interviews with market participants, 78 organizations have either hired lobbyists or lobbied on their own for BABs, and as many as 202 lobbyists have taken on the issue since the taxable stimulus bonds were created in February 2009. But activity spiked most noticeably this year, as muni market participants began pushing for a BAB extension

Goldman reported in March that it earned $54 million to underwrite $34 billion of BABs and charged slightly higher fees for BABs than for tax-exempt bonds.

Bank of America NA, Citigroup Management Corp. and Goldman have all reported BABs in lobbying records since last fall.

Wasn’t FinReg supposed to fix this stuff? Nah…

Ackman Suckers Fannie and Freddie?

William Ackman at Pershing Square Capital is a very savvy guy. I would not bet against him. He is making a play for a monster busted real estate deal. I am sure he has if figured out. I can’t make sense of it.

NYC’s Stuyvesant Town was bought by Tishman Speyer back in the good old days (2006) at a big price of $4.3b. It went into default last year and the equity and Mez debt got taken to the cleaners.

There was a $3b senior mortgage. $1.5b was taken down by Wachovia and later put in a $7b CDO. The other $1.5 billion was taken up by our pals at Fannie and Freddie.

This a political deal and a business deal. There are many rent controlled apartments in Stuy Town. The city of NY will not let anyone walk on those people’s rights. And Ackman wisely got ahead of this issue with a plan he made public last week. (NYT and NY magazine) He made it clear that he was not going to mess with that problem. Any of those renters with subsidized apartments were welcome to stay. With that issue defused the only remaining questions were (1) what was the price Ackman was willing to pay and (2) how was he going to finance it.

The price Mr. A put on it is $3b. Exactly equal to the outstanding 1st mortgage. The way to pay for it? Simple. The existing lenders would restructure the notes and stay in the deal for a very long time.

Well done Bill. You plan to buy one of the largest properties in NYC with next to no money down. Here are some of my problems with this transaction.

I asked The FHFA (the regulator for Fannie and Freddie) sometime ago about this deal. I will rely on their responses to make some points.


The Stuy Town property is not worth $3b. Fitch recently valued the property at $1.8 billion. When I asked about this the FHFA responded:

BK: Comment on Fitch value of 1.8B?

FHFA:This is Fitch’s estimate. Other firms estimates place the values between $1.6 and $2.2 billion depending on the cap rate.

That’s interesting. The lender thinks their loan is underwater. But Bill Ackman thinks it is money good. So Fannie and Freddie love Bill. He is going to bail them out of a problem. He is going to force F/F to lower the mortgage to a much lower rate and the loss on F/F’s books will just be moved down the road for a decade or so. Everyone will be happy. Except me and few hundred million other taxpayers who have to support it.

It does not have to be like this. The value of the Stuy Town property does not have to be artificially inflated. F/F do not have to jump through hoops to avoid an accounting loss. They had credit protection on their holdings of Stuy Town debt:

BK: Did F/F have other credit enhancement?

FHFA: F/F had enhancements for this deal that were typical for large loan deals. Other investors had the same enhancements.

Color me shocked. They had “enhancements”. In other words they either had some form of CDS or they put the bonds in a CMO/CDO and took back senior tranches. They did not do the latter:

BK: Did F/F put the securities in a larger CMO transaction?

FHFA: No, they did not put the securities into a CMO. The GSEs approached this as typical investors.

So they have a CDS or insurance contract that protects them from some or all of the losses relating to Stuy Town.

If F/F can get out whole today there is no reason for them to stay in this deal. They never should have been in this transaction in the first place. There was a fat coupon on this, but we now know that that the coupon was not enough to compensate for the risk. It was a bad deal from the time it was signed. The evidence of that is the fact that F/F and “other investors” sought credit protection. The real motivation for F/F was the “low income housing credits” that the Agencies needed to fulfill their Congressional obligations. On that subject:

BK: Did F/F do this to get low-income housing credits?


FHFA: They did receive housing goals credits and did so in the context of meeting their standard securities investment criteria.

The silly game of housing credits and the GSE is one of the reasons were are in a decade long housing crisis. It is/was a bankrupt concept. It no longer exists. There is no excuse for F/F to roll over and stay in the Stuy Town transaction.

This is a “story deal” that is going to come to a head in the next few months. Wilbur Ross is also a player; but he is keeping his cards close. If Ackman wins this one it will prove once again that he is force to be reckoned with and that the taxpayers are suckers.



Note: I would love to know if those “enhancements” came from AIG. Wouldn’t that be a kick in the head?

Another Man’s Opinion

The problem with guys like me (and hundreds of others) who write/talk about markets is that if any of us really had a lock on the future the last thing we would be doing was writing about it. We would be trading it and getting rich.

At the end of last week I wrote that the dollar would be on the weak side for the balance of the month. That the bad news from the US would trump the bad news elsewhere. That proved to be a dumb idea. Having been humbled once again, I looked at the screens and confided to myself that I really could not make a compelling case on either side of the bond, stock or currency markets. So I sought out the thoughts of a friend who actually buys and sells paper for a living. He does not write about it. He just does it. His thoughts:

We’re digging an ever deeper hole here, the EU problems have not gone away by any means. And after I saw the amount of sov debt the European banks own, I have conviction the EURUSD rally is a headfake. Those banks will go down as they are forced to take the haircuts on the sov debt… unlike in the US, where the gov’t could borrow to bail out the losses on private securitized debt, the Euro banks’ ‘toxic problem’ is the gov’t debt itself… it’s a tight closed loop… or spiral, as it were…

Stocks are nearly out of accounting tricks, imo…. The final demand is not there and won’t be. Trading on fwd P/E when the ‘E’ is pure fantasy will not end well. Everyone seems to say “stocks have gone nowhere in 10 years” as the ultimate sign of how poor stocks have done…. actually S&P is down over 25% in the last 10yrs. And it continues as we de-lever.

If we think fund flows into bonds / out of stocks are significant now, just wait til we get another big leg down in stocks this fall… I think we see banks (and individuals to a lesser, but significant degree) go all in UST… every day there’s less and less hi-quality, non-UST bonds – eventually, if it has not already happened, the yield premium for taking incremental risk in high-grade f/i over USTs withers to a level that is not meaningful, and the UST bid from banks and mom/pop begins, and then feeds itself… the proverbial towel will be thrown in.

We sell a lot of product to banks. Community banks used to own a large amount of USTs outstanding – today they own almost nothing – but that is beginning to change. From a bank portfolio perspective, you’re just not getting ‘paid’ to try to outsmart the market in anymore… (the one exception is the non-agcy mbs mrkt, but they are not making those anymore; it’s dying…) GSE MBS is rife with headline/pre-pay risk from executed and potential gov’t ‘fix’ programs/experiments – it used to be that the ‘base-case’ scenario in GSE MBS was the ‘worst-case’… today it’s the ‘best-case’ and if the stars don’t line up, you can get SMOKED. Just ask holders on GSE MBS that saw 70-80% cpr during the buy-out months this spring and summer… and for taking on this ‘the rules can change at anytime’ risk on your massively negatively convex portfolio, you’re barely getting paid 1% over UST… risk >>> reward… look at it this way: in a GSE ‘modification’ or ‘principal reduction’ or whatever program, the investor receiving immediate par back on mbs holdings with a $108 book price is a BIG hit – 8 points will take 3-4yrs to recoup at today’s rates…

My fear was that a potential big QE2 would give another huge leg up in stocks etc and drag this out…. But over the last 3-4 weeks, it’s amazing the sentiment change – I think the market sees straight thru another QE program and says “oh shit – it’s as bad as we feared”….

I’ve said since many months back 2.25% 10y and 7000 DOW by 12/31…. My only change from that thought is that the trend continues in 2011 – and we see 1%-handle 10yr and 2%-handle 30yr at some point. And yea, I’m aware that we are building a fiscal hole we’ll probably never get out of – and we’ll deal with the huge consequences of that down the line, no doubt… but for now, the US situation is the worst, except for all the others.

Lender Liability at the FHA?

Lender liability is a tricky legal question. Above my grade. The case law is pretty clear that when a lender uses unscrupulous or illegal methods to get a borrower to sign a piece of paper the lender loses his rights. There is a grey area in this where the lender may also lose their rights to repayment if a fiduciary relationship can be established between borrower and lender. In this later example the lender has a responsibility or an Obligation to not do things that conflict with the best interests of the borrower.

The conditions for establishing this fiduciary status are as follows:

In Waddell v. Dewey County Bank, the court attempted to define the elements of a fiduciary relationship between lender and borrower as follows: 1) the borrower must have faith, trust and confidence in the bank; 2) the borrower must be in a position of inequality, dependence, weakness or lack of knowledge; and 3) the bank must exercise dominion, control or influence over the borrower's affairs.

HUD announced a new program today to assist struggling homeowners. They are going to lend up to $50,000 to families in trouble. These are bridge loans so that the owners can continue to service the existing debt and pay property taxes. The individual loans will be made at a zero interest rate. $1 billion of these loans will be made.

My question is, does the FHA have a fiduciary responsibility to the borrowers, and if so is this billion-dollar loan program just a way to print more money and kick the can down the road?

On #1. The lender is the US Government. One would assume the borrower has faith and trust that they are not being led down a debt hole for political purposes.

On #2. Each borrower will have a different profile. However two condition to get the $50K:

Be at least three months delinquent in their payments.

Be at risk of foreclosure and have experienced a substantial reduction in income due to involuntary unemployment, underemployment, or a medical condition.

Do these two mandatory conditions meet the lenders description as “weakness”? Yes is my answer. You have to be up against it to qualify. By definition one is in a weak position. Same for “dependence”. Without these loans many of the people would be foreclosed on.

On #3. There are many strings attached to these loans. The restrictions include that the proceeds must be used to pay existing installment debt. No second homes. Limitations on indebtedness. Reporting requirements. There is no question but that FHA has dominion and control of the borrowers affairs.

Case closed.

The new FHA loans are not collectable. They would not stand up in court. The FHA is well aware of that fact. They have no intention of collecting on these “loans”. Some additional terms of the bridge loans to nowhere:

zero percent interest, non-recourse, subordinate loan.

So they get no return on the money, but they also make it non-recourse and they subordinate it to any existing first or second liens on an obviously underwater property? If it is non-recourse you can just walk away. They won’t even call you. They can take the house but the first liens come first so the FHA gets the big goose egg. This is not a loan. It is a gift.

60% of all mortgages are owed back to Uncle Sam. On paper this means that at least $6b of mortgages on the government’s books will be artificially kept alive for another 24 months as a result of this. After two years all of them will just go poof overnight and the taxpayers will have a bigger pill to swallow. In this case FHA will be taking back bad paper and in exchange it will keep a portion of its loan book current. The conflict of interest is obvious to me

By definition a loan should have a source of repayment that is predictable and adequate collateral. These new loans by FHA do not meet those standards. This program will cover only 20,000 borrowers. A billion dollars is meaningless when the problem is measured in trillions. It is a “nothing” policy. It is another show pony. While there may be 20k folks in the country who will end up voting for the Dems as a result of this, I am certain that another few hundred thousand will line up to vote against them just because the bailout mentality will not stop.

In the worst days of mortgage lending back in 2006 some terrible loans were made. But not one of them was made that was non-recourse and subordinated. The FHA just announced it will be making the very worst loans in history. Something to celebrate for the boys over at HUD.

We’re In A Lot of Hot Water

It’s hot all over, including the Gulf of Mexico. I keep my eye on a single buoy, # 42001, 180 miles South of Southwest pass, LA. (Not too far from the oil spill). Yesterday the water temperature jumped to over 90 degrees. My unscientific approach is to keep track of these spikes in water temperature. This is what breeds the big storms. Another key factor is the El Nino/La Nina cycle. Storms are more likely to develop during El Nino conditions. Some data on the spikes:


-1975-1994. No readings over 90 degrees.

-1995. An El Nino year. 91.4 degrees reached on 8/18.
20 storms ending with Tanya. Luke was a Cat 4 that wrecked the Leeward Islands. The QE2 avoided this storm but was hit by a 95-foot rouge wave. Marilyn, a Cat 3 hit the Virgin Islands hard. Opel was a Cat 3 that hit Pensacola. The first hit in 20 years.

-1996-No reading over 90 degrees.

-1997. A La Nina year. 90.3 degrees reached on 8/18.
Five named storms. None of any significance. Little damage.

-1998-2001. No readings over 90 degrees.

-2002. A La Nina year. 90.7 degrees reached on both 8/1 and 8/23
No major storms make landfall.

-2003. An El Nino year. 91.4 degrees reached on 8/18.
21 cyclones, 16 named storms. Fabian hit Bermuda, the worst storm in 75 years. Isabel became a Cat 5. It hit NC as a Cat 2 and caused $4b in damage.

-2004. An El Nino year. 90.3 degrees reached on 8/21 and 8/23.
15 named storms. One of the worst years on record. 3,332 deaths $50b in total damages came from Bonnie, Charlie, Francis Ivan and Jeanne.

-2005. An El Nino year. 90.2 degrees on 8/10 and a record breaking 92.8 degrees on 8/22.
The most powerful season in history. 28 Tropical storms, 15 hurricanes, 7 Cat 3+. 4,000 fatalities, $140b in damages. Wilma was the largest storm ever observed. Katrina devastated a city.

2006-2009 No readings over 90 degrees.

2010. We have just crossed to a La Nina condition. 90.4 degrees on 8/9.

This is a look at the El Nino/La Nina cycle. That thin blue line that is just starting to appear on the right just might be timed to save us some headaches. But it is still weak and may not have the upper air currents that would break up hurricanes.

The hot water in the GoM has to go somewhere. Storms will form, in the process the heat energy will be converted into rain and wind. These might not be Atlantic hurricanes. They could be “home growns”. These can be just as dangerous. They form quickly. They would look just like the following developing storm. It will be passing over buoy 42001 next week. It will suck up a tremendous amount of energy along the way. It will probably have a name by then.

Above Trend GDP Growth for Ever - SSTF

The following graph looks at US GDP from 1930 to 2010. An amazing story. Look how steep our raw growth has been.

Now consider the following graph that includes the SS forecast for GDP over the next 75 years.

This is the same data as above. Notice that the red line is the 1930-2010 GDP. It now looks flatter than a pancake. That is what happens when 5% growth forecasts are used. GDP will grow from ~$15T today to 528T. It will grow non-stop by 3,600%. At the end of the period it will take only ten days to produce our current GDP. Now that is a success story. And if you believe that, I have a bridge for you.

The Fund also forecasts “real” GDP. Here are their numbers:

Two observations. First note the “happy” comeback in GDP for 2011-14. This is wishful thinking. It is also a critical assumption. When the first few years of a 75-year analysis is “missed” it substantially impacts the results all the way out to the 75th year.

The second is that the Fund is using a real growth rate for all of the 75 years that is greater than 2.1%. I have no idea if that is reasonable. I found this on the topic from the CRS. This paper suggests that a growth rate of GDP above 1.8% is not in our history. What does .3% (^17%) mean over 75 years? Trillions.

 

US Payrolls to Rise 1.1mm Per Month in 2011 – SSTF to Congress

The following is a graph that tracks percentage changes in GDP and the growth of SS payroll tax revenue from 1990 through 2010. While there is not a perfect correlation between the two data sets one can see that the lines do track each other. The exception is 2010. The economy has made a recovery from the 09 recession. But SS payroll receipts have actually fallen during fiscal 2010 (ends 9/30).

This is the dilemma facing the US economy. We are not creating enough new jobs. Based on history one could expect that job creation is not far off. But 2011 is unlikely to look like the past. I can’t think of a single economist or government-forecasting agency that believes we will see any significant job growth over the next twelve months. There is a very real (and growing) potential that we will actually see more net job losses.

The SS Trust Fund does not share this outlook on job growth. They think things are about to ramp up in a very big way. The following graph updates the prior one and shows a line in green that represents the Fund’s expectation for payroll tax receipts for 2011. They are expecting a YoY rise of $60b. This comes to an increase of 9%. That percentage increase has not been achieved in any year for the past 20 years. A slide using the projected data for 2011 from the SSTF 2010 Annual Report to Congress:

The data table from the 2010 SSTF report:

SS payroll tax is 12.4%. Therefore the $60b increase in 2011 receipts translates into $485b of increased total payroll. The question is how many jobs will this convert into. The answer is dependent on the average salary that all of the new workers will get. Average income in the US is $35,000 today. Using this number you back into the new jobs for the period 10/1/2010 to 9/30/2011 implied in the SSTF forecast is 13.8mm or about 1.1mm net new jobs a month.

The Trust Fund Report to Congress gave an overall rosy view of the future. By their calculation the net health of the Fund improved from 2009 to 2010. To arrive at that conclusion they relied on the recently passed health care legislation and a set of economic assumptions that are overly optimistic.

The TF is looked at under a 75-year microscope. I can’t look beyond a few months with any confidence. I don’t understand actuarial science. It makes me dizzy. But I do know that if you trip up on the first year of a 75-year compounded calculation the magnitude of the miss grows exponentially over time. Small miss today, big headache 25 years from now.

Should those jobs not appear as SS is anticipating and we find ourselves in 12 months with no net new job growth it will translate into a miss of $50b on the Fund's bottom line versus plan. The 2011 cash flow deficit would therefore be approaching $100b. This shortfall would have to be financed by Treasury. It would not increase total US debt, but it would cause the Debt Held by the Public to increase dollar for dollar (9% increase) with the SSTF shortfall. Just a bit more work for Tim Geithner and the Federal Reserve. Should be no problem, at least for a few more years.

SS hit a nexus point this past spring. It went cash flow negative at a trajectory that made it impossible to avoid a YoY cash flow loss. The first for the fund since Alan Greenspan “fixed” SS in 1983. The Fund estimates that this is a temporary phenomenon; that we have many more years of surpluses in front of us.

I don’t think those 14mm new jobs are going to be there over the next year. I believe that the TF will suffer another big cash loss in fiscal 2011. I don’t think we will ever again have a true surplus at SS unless they raise taxes and do it fast. That is not going to happen.

The Trust Fund did us a disservice by using an overly aggressive forecast. The evidence is clear to me at this point. It will be a matter of record in six months. So whom might you blame for this “blue skies” view? I would start at the top and blame the Managing Trustee. Guess who?