Pension Seizure Precedents

One of the problems with out of control government spending is the way it affects the behavior of government itself. Like any other junkie, the government convinces itself it needs "just one more" fix and will do anything to get it. Again like a junkie, the government will prostitute itself and steal from friends and family to keep the drug supply coming.

We see a glaring example of the later when governments simply grab private property in order to pay off their own debts. We have already seen the precedent for pensions being seized by government. Just last week in Hungary the government grabbed $14 billion in private assets. Over the weekend, the Irish government decided to take 15 billion Euros from the future pensions of its citizens to give to the banks. Now France is taking 36 billion Euros from the pension fund to keep its bloated and unsustainable welfare state afloat for just a little while longer.

People need to understand that the United States is not immune to the same financial pressures that caused Hungary, Ireland and France to take these desperate measures. If you are counting on a future pension from the state, you might wish to start making alternate plans. In most states, there is effectively zero chance that you will get everything promised - the state government pension funds are already over $1 trillion in the hole. The gap will only grow as additional obligations are incurred but little new money is available to meet them from the state budget side. It would be completely unsurprising if the more desperate and foolish states attempted to raid these pension funds to "invest" in more unemployment payouts or other attempts to fund general budget spending.

Of course we won't have that problem with Social Security since it is funded entirely by current taxes. Since no such pension fund exists, we don't have to worry about the government grabbing it. Of course that raises the question of which assets the will try to take since the same financial imperatives and the same junkie behavior are at work in Washington as in Budapest, Dublin and Paris. That said, we need to be vigilant for any sign that similar asset seizures are imminent here in the United States since the precedent has already been set. We have been warned by events across the pond.

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.

Some Key Questions

The most important question facing us today, both in the US and around the world is just how much of our supposed wealth is real and how much was part of the illusion generated by bubble-mania and the UDB. Most of the actions of various governments and CBs seem aimed at preventing us from answering this question accurately. In The Limits of Optimism we outlined the various elements of the capital structure and it should be immediately apparent why the stock market is the chosen instrument for conjuring chimeras. By coercing a larger and larger percentage of accumulated capital into stocks, Wall Street ensured a large pool of buyers to continue pushing prices higher in complete defiance of fundamentals. By allowing so much of our wealth accumulation to be attached to something so insubstantial, we have collectively ensured the destruction of much of that wealth. Something that falls as soon as anyone wants to sell isn't much of an investment.

Now we see some of the real world impacts of aggressively tying ourselves to the stock market. Once again, the secondary feedback effects may be greater than the primary impact. According to the WSJ:

At the end of 2007, companies in the S&P 500 had a combined pension-plan surplus of about $60 billion, The market selloff in the nine months to late September turned that into a combined deficit of about $75 billion...

Of course that was before October even started and we all know that things didn't go so well during that month either. Double digit declines were the rule for the month - pretty much across the board. The pension obligation and attempt to meet it by speculating in the stock market are yet another example of companies tying their fortunes directly to stock market whims rather than fundamental performance. It worked well for a while - allowing them to report higher profits than justified by actual results as speculative profits allowed them to pay less into the pension funds than a sensible and stable plan would have required. The reverse is now occurring and it's going to be nasty. This is yet ANOTHER headwind for corporate profits as they are forced to pay cash in to make up for speculative losses.

The lesson that should be learned here is "don't gamble with retirement money" but I fear few will choose to learn it until all other avenues have been exhausted. People can usually be counted on to do the right thing after all else fails.


Confirmed Reservations
Occasionally, I will encounter a supercilious restaurant host who will haughtily ask if we have reservations. When the right mood strikes the answer will sometimes be "yes, but we're planning on eating here anyway." In much the same vein, our prior reservations about the export economies and China in particular have been confirmed with a vengeance recently. Reuters reports that China's PMI hit 44.6 in October - indicating clear and serious contraction in factory output. This now makes three of the last four months down. In addition, recent BBC reports suggest that half of the toy factories in China have shut down since the start of the year.

Keep in mind that we expect a crash and burn in China's economy even if exports stagnate, much less roll over. Government action can partially ameliorate this but only to a small extent. We laid out the full case four months ago in China Syndrome. All of the elements preliminary requirements have now been met for this scenario to play out. The US is desperately trying to prevent a meltdown across the submerging markets with swap lines to exchange valuable dollars for garbage currencies like the Mexican Peso and the Brazilian Real. The temporary availability of dollars in those imploding economies has relieved the pressure from capital flight for the moment and perhaps even caused a small short squeeze for those who were looking for reality to catch up to those nations' financial system. But the banking systems overseas cannot sustain their credit expansion in the face of falling external demand and especially the collapse of primary commodity prices on which their economies rely heavily.