Friday, July 17, 2009

The Price of Ponzi

Faking Bank
First let's be clear that prices for the majority of asset classes around the world are unsustainably high. This is an obvious corollary to the very inflated state of the global financial system and economy due to the excessive leverage that we have commented upon many times. It bears repeating that central banks (CBs) have little actual power, they merely serve as rallying points and fetish-totems for optimistic, true-believing speculators. The evidence is quite clear that CBs often fail to accomplish their goals, in recent cases despite extraordinary actions to "inspire confidence" - i.e. reignite speculation.

If the CBs were as powerful as most think, they could not possibly fail to accomplish their goals. Like voodoo, it is the BELIEF of the victim that causes the damage - a negative application of the well-documented placebo effect. While they have succeeded in restarting speculation to some extent in equities and commodities, they have utterly failed to do so in most of the securitization and especially the re-securitization markets. Other than the Fed itself, there is very little demand for MBS and ABS. CDOs have fallen flat on their face and can't get up. The investment bankers' efforts to re-securitize garbage and get it rated as AAA again have largely met with derision. Assets in the real economy are seeing no increase in demand at all to this point. Housing, commercial RE, private businesses, capital equipment and others are all in the doldrums with hardly any positives even in the second derivative.

Flee(t)ing Confidence
Take note of which asset classes are seeing speculation and which are not. It is only those that can be sold instantly with a mouse click that are getting any action - equities and commodities which trade as futures on an exchange. The exceptions are revealing. Iron ore, which requires long-term contracts instead of futures isn't going up and in fact is going down, with users essentially buying at spot by refusing to commit to L-T deals. Assets that are theoretically liquid but actually trade by appointment only are seeing little help. This would include the aforementioned MBS and ABS. Those that require a real commitment and have payback periods measured in years continue to crater. Basically, the only confidence at this time is the confidence of the daytrader.

Yet we now see speculation among economists that there could be a return to growth in the next four quarters and actually, it's hard to disagree that such a thing is technically possible. The key here is the massive amount of deficit spending by governments around the world. Official US Treasury estimates place the FY 2009 deficit at $1.8 trillion but $2 trillion is more likely. The DEFICIT will likely represent 14% of GDP this year. China is in a similar situation, with a "stimulus" package of nearly $600 billion in a $4.4 trillion dollar economy - which works out to just under 14% of GDP. Hmm, that number sounds familiar.

Large segments of both economies are ponzi schemes, though China's most vulnerable sectors are both larger and more leveraged relatively speaking. In the US, the most affected sector is finance; in China, construction and fixed investment. Consider for a moment that both governments are spending enormous sums of money they don't have - effectively borrowing it from the future to spend now. Once again hoping to ignite a chain reaction of speculation and a new bubble.

We actually expect a slight positive print in US GDP in early 2010, with a larger collapse to follow as soon as the government can no longer borrow cheaply. This is the inevitable result of spending twice your income (tax revenue) just to keep the current illusion alive. When the bond market cuts off this foolishness, the portion of the economy that is unsustainable without a bubble dies and all of the capital spent to keep it alive dies with it - a complete waste. Instead of a mere depression, we have a depression compounded with the destruction of capital that should have been preserved to start rebuilding afterwards.

Pricing Ponzi
If you think about it, both the US and China are expending one-seventh of their respective GDPs to support a lie. Another way to think of it is the rate of return the market (in the form of speculators) demands to continue to invest in the ponzi schemes. In effect, the government's best guess at the required RoR is 14%. Antal Fekete has written about the falling marginal productivity of debt. In other words, the debt-based ponzi scheme is becoming less and less effective. As a result the sponsor of the scheme (governments) are having to increase the amount pumped into the bubble to keep the speculators in and prevent a UNIVERSAL recognition of the failure that has already occurred. This is typical of late-stage ponzi schemes where a critical mass of investors become suspicious and demand their money. The sponsor has to come up with it somewhere and in this case they can conveniently pledge their citizens' future income (taxes) as collateral for more loans.

It is impossible to calculate the precise cost but we can look at deficit and "stimulus" spending as a good first approximation of the price to keep the ponzi scheme rolling. If 14% of GDP can be spent and not even produce a single quarter of positive numbers then the decay is even larger and more advanced than we have previously postulated. As an example, the latest Personal Income Report from the BEA showed the scale of government attempts to manipulate the economy. Wages dropped sharply but personal income rose 1.4%. The money quotes:

Private wage and salary disbursements decreased $12.4 billion in May, compared with a decrease of $0.7 billion in April.

Personal current transfer receipts increased $162.6 billion in May, compared with an increase of $59.1 billion in April. The American Recovery and Reinvestment Act of 2009 provides for one-time payments of $250 to eligible individuals receiving social security, supplemental security income, veterans benefits, and railroad retirement benefits. These benefits boosted the level of personal current transfer receipts by $157.6 billions at an annual rate in May.

Once the long-end of the Treasury yield curve resumes its upward march, the financing will get more difficult. If short-term money ever becomes expensive for the US government then the deception is over. But for right now we may get further upticks in optimism as long as the government can continue to create doubt and obscure the real state of the economy. In the near term, it's all in the hands of the speculators and their mood swings and isn't that a sad commentary on the state of the world.

Saturday, July 11, 2009

Great Pyramid of Geezer

An update by Karl Denninger at Market Ticker today got the old synapses firing. Denninger points out that pension plans are in trouble and cites a Wall Street Journal article strongly suggesting accounting fraud in public pension plans. The WSJ says:

Based on their preferred accounting methods -- which discount future liabilities based on high but uncertain returns projected for investments -- these plans are underfunded nationally by around $310 billion.

The numbers are worse using market valuation methods (the methods private-sector plans must use), which discount benefit liabilities at lower interest rates to reflect the chance that the expected returns won't be realized.

Last year we warned about the same phenomenon in private sector pensions in Some Key Questions and The Limits of Optimism. In every case the culprit was the same - overly optimistic assumptions about investment returns allowed a financially deficient structure to be sold to key constituencies as safe and sound. The wild optimism that causes managers to overreach like this and causes others to believe their literally incredible assumptions are part and parcel of the Universal Debt Bubble (UDB). Only in such a manic environment can such outlandish claims be regarded as anything other than the fantasies they are in reality. Even worse, a bubble atmosphere makes those assumptions even more dangerous than normal by burdening assets with inflated starting values, making the required price appreciation even less likely than usual. But as long as such tales are believed, a small sliver of capital can be made to support grand promises in the future.

Unfortunately, the credulous public has been misled in any number of similar ways. Robert Prechter of
Elliott Wave International recently described the process by which banks also shrank the capital supporting their balance sheets to a tiny fraction of what had previously been required and considered prudent:
In the early 1990s, the Federal Reserve Board under Chairman Alan Greenspan took a controversial step and removed banks’ reserve requirements almost entirely.

To do so, it first lowered to zero the reserve requirement on all accounts other than checking accounts. Then it let banks pretend that they have almost no checking account balances by allowing them to
“sweep” those deposits into various savings accounts and money market funds at the end of each business day... The net result is that banks today conveniently meet their nominally required reserves (currently about $45b.) with the cash in their vaults that they need to hold for everyday transactions anyway.

Sure or Insure
Yet the problems of inadequate capital hardly end there. Like pensions and banks, insurance is another area that succumbed to the ubiquitous optimism of the UDB. Insurance companies became so accustomed to capital appreciation well above the historic norm that they began to take them for granted. Many annuity policies and guaranteed investment contracts were written promising high fixed rates of return based on that experience. This has proven devastating for many insurers, who are now rushing to rewrite such contracts. This is a microcosm for the weak capital position of much of the industry as key asset classes for most life and casualty companies are stocks, bonds and real estate. Like every other leveraged institution out there, the insurers have taken a beating on those assets and their promises to deliver future benefits are increasingly in doubt. Which brings us to a similar structure with the biggest capital shortfall of all.

GovernMENTAL Institutions
For the most part, capital is literally a foreign concept in this sector. Few governments have significant reserves, much less any real capitalization. Except in regions where government-owned enterprises dominate the economy, the primary source of revenue for most institutions is taxes - on the private sector naturally. So instead of actual capital, governments have something even more volatile - a projected future revenue stream. As with every other sector we have examined so far, those projections about the future are subject to the psychological distortions that accompany large-scale financial manias. In an environment of historic extremes like the UDB, those distorted perceptions can easily become fatal. We see that today in the sad case of California - where the state is issuing IOUs because they are out of money. Having accustomed themselves to double-digit annual rises in tax revenue, Sacramento (and other state capitals) simply spent it all. Those projections and plans aren't working out so well anymore.

The US Federal Government is arguably in even worse shape. Borrowing this year is likely to approximately equal tax income. No entity can spend twice its income for long and hope to survive. The remnant optimism of the UDB has settled in one of its last-ditch redoubts: faith in government. In addition to the spending spree, Washington has also embarked on a series of empty promises that would make a serial polygamist blush. Not content to merely guarantee deposits through the FDIC, the Feds now do the same for bank bonds through TLGP. Fannie and Freddie debt is backed thorough a de facto nationalization and money market mutual funds are guaranteed by the Federal Reserve. Many trillions of government "guarantees" are piled atop the roughly $1 trillion of deficit spending for this fiscal year. These promises are lighter than a feather but certainly worth their weight in gold. In other words there is no way Washington can deliver but they are hoping nobody notices and that the empty promises will inspire "confidence" in the economy. Like many other sectors, various levels of government are attempting to cover huge obligations with inadequate resources.

Frankly, it's sad that so many people fail to see the little man behind the curtain putting up the front that is the Great Oz. These large and varied institutions have stretched themselves far too thin and are praying for another bubble to bail them out again. The title of this missive refers to those who will bear the brunt of the damage from our return to reality - those who bought into the promises of these institutional pyramid schemes and don't have the time to recover financially. The frenzy of financial pyramid construction certainly put the Egyptians' little excursion in stonework to shame. In reality, the old truths would have served us well, but like every bubble generation in history, ours has convinced themselves that "this time it's different" when it never really is. Like those who have gone before, we will learn the hard way when two things we all learned as children would have prevented much of this mess:
  • Never count your chickens before they hatch.
  • Save for a rainy day.

It seems so simple and most of us will never forget. With the optimistic assumptions that undergirded the psychology of the UDB evaporating, any program sporting the words insurance or guarantee must be treated with great skepticism.