Posts Tagged: pensions

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16
Feb 10

Where Are We Now?

“Where Are We Now?” is my fiftieth blog post.  The purpose of a political and economic blog is to “connect the dots” looking for coherent patterns.  This post will attempt to do just that, warning you that the emerging pattern is disturbing.

Slow Motion Depressions

Policy makers in Washington and other western capitals are recently smug. They proclaim that, through coordinated monetary and fiscal response, we have averted the Second Great Depression.  More bluntly, all we have done is throw a lot of money at the problem through unprecedented monetary easing and a fiscal policy of bailouts and stimulus bills.  The core financial issue remains:  western countries and the US in particular have too much debt and insufficient income to service that debt.  Depressions have their own timetable. In my opinion, government intervention has only slowed the timetable, but definitely has not averted the event.

The Magic Act

Politicians and central bankers are a bit like magicians.  While an observer is firmly focused on the right hand we miss the left hand’s activities, which are hiding in plain sight.   Just look at current economic and financial trends:

  • Increasing Risk of Sovereign Debt Default – In late 2009 a problem arose with the financial solvency of Dubai.  Much like the subprime crisis in the US, financial pundits assured the public that the Dubai default was minor and self contained.  Yesterday, credit protection for Dubai rose to a record high exceeding the November peak. See Dubai CDS Hits 652, Ploughs Through November Highs As Gold Jumps.   Greece too is on the verge of sovereign debt default and is seeking a European Union bailout.  Portugal, Ireland, Italy and Spain are reportedly in dire financial trouble as well.  The United States, Japan and United Kingdom are not immune from talk of default.
  • Crisis at the State Level – The Center for Budget and Politics has projected 48 of 50 states will have budget deficits.  Cumulatively, the Center estimates an $180b shortfall for this fiscal year.  All states with the exception of Vermont have a balanced budget requirement.  Some assistance to the states has been proffered through the American Recovery and Reinvestment Act, but it is questionable whether this aid can continue. See Recession Continues to Batter State Budgets; State Responses Could Slow Recovery. It is more likely that states will follow the lead of newly elected Republican Governor Chris Christie.  Recognizing that the state is on the edge of bankruptcy, Christie has declared a fiscal “state of emergency” and intends to slash $2.2b from the budget. See Chris Christie Declares Fiscal ‘State of Emergency,’ Paving Way for NJ Spending Cuts. The crisis in municipal finance portends trouble in the municipal bond markets.  The unsuspecting public has purchased municipals in search of yield and instead may receive an unpleasant surprise.
  • National Fiscal Irresponsibility – President Obama signed into law a $1.9t increase in the debt ceiling, raising it to $14.2t. As the administration has predicted deficits out to 2020, this ceiling will rise each and every year. Also, it does not include the Christmas Eve bailout of Fannie Mae and Freddie Mac which provided “unlimited financial assistance” to these two entities. We will likely exceed our previous limit of $400b on financial assistance under emergency bailout provisions.  See US Promises Unlimited Financial Assistance to Fannie Mae and Freddie Mac.  Moreover, how can we continue to finance these deficits without an increase in interest rates?  However, such an increase in interest rates could put the US in a “doom loop,” as interest payments become the dominant budget line item crowding out other federal spending programs.
  • China – Recently China has made a number of financial moves that do not bode well for the US and world economy. First, China has ordered its currency managers to withdraw from any US dollar denominated risk assets, such as corporate bonds, equities and only invest in US guaranteed assets.  Second, it has raised its reserve requirements on its own banks to dampen an over-inflated domestic real estate market.   Speculation in Chinese real estate has reached the point that Jim Chanos, a respected investor, predicts an economic collapse.  See Jim Chanos: China Bubble Ready to Burst. Given the size of our deficits, the US desperately needs China to continue purchasing US government securities. The world needs China as a growth engine to continue world trade and prevent a second leg of the recession.

Harbingers of the Economic Unraveling

Before the next phase of an economic crisis there are often clues to impending problems. Some harbingers to consider:

  • Junk Bonds – The Greek crisis has spurred investors to sell junk bonds, highly risky assets, at the fastest rate since 2005.  As a result credit spreads are widening between treasury and higher risk corporate bonds. See Junk Bond Spreads Widening: A Canary in the Coal Mine.
  • Problems in a Treasury Auction – Last week’s US 30-year Treasury bond auction was considered a failure.  Indirect bids, that is, foreign buyers, dried up and the government had to offer a yield of 4.72% compared to an expected yield of 4.687%.  See Dismal $16b 30 Year Auction
  • Credit Card Problems – Capital One, a major credit card issuer, reports that in January delinquencies rose and that expected unrecoverable loans have risen to 10.41% from 10.14% in December. See Capital One: Credit -Card Delinquencies Rose in January.
  • State and Municipal Finance –In its upcoming July 1 fiscal year budget, California expects a $20b shortfall.  Illinois has a $61b pension shortfall, and is borrowing to make contributions.   Harrisburg, Pennsylvania, is contemplating a March 1 bankruptcy filing.  These stories are the proverbial tip of the municipal finance debt iceberg. See Illinois Pension Fund $61b Underwater; State Borrows Money for 2010 Contribution; California $20b in the Hole Again.

Reality

Till now the policy direction of the Obama administration and other western leaders has been to “extend and pretend:”  we will ignore economic realities by permitting banks to suspend “mark to market accounting” and we will send various administration spokesmen to spread the fairy dust of “green shoots” to pacify an anxious public.  Essentially, we have an economic policy of faith and hope that willfully ignores reality.  Economics does respond to the laws of mathematics.  Like a termite that silently eats away the wooden supports of a house, excessive debt has eaten away the structure of the world economy.  There will be more troubled countries like Dubai and states like California before this Depression has run its course.

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Banking / Economics / Financial / Foreign Policy / International Finance / Media / Political — 0 Comments
27
Dec 09

Seven Black Swans a-Swimming

The holiday spirit lingers. With all due respect to the Twelve Days of Christmas, let’s see if we can predict seven potential black swan events for 2010.  But we have a conundrum. According to Nassim Taleb (author: The Black Swan: The Impact of the Highly Improbable), “black swan events” are high-impact, hard-to-predict and rare events that are beyond the realm of normal expectations, that is, statistical outliers. Thus, if we are able to predict them, they may not be true “black swan events.”

I will leave that issue for philosophers.  Let’s focus on possible “disturbances in the Force” which can render useless the carefully orchestrated Obama, Geithner, Bernanke engineered recovery.

Black Swan Event Gestation

The government and mainstream media have been extremely helpful in identifying “black swan events.”  These even have usually been hidden in plain sight and then reported by main stream media.  Then we have a noted academician or high government official contextualizing the event to make the public believe that the occurrence of the event is improbable or lunacy. Examples: Ben Bernanke reassures the public that sub-prime losses were well contained and no threat to the economy. Tim Geithner proclaims that the largest banks were well capitalized.

In the former Soviet Union the joke was that nothing was true until it was officially denied.

2010 Candidates for Black Swan Event of the Year

And now for an Academy Award moment, the nominees please:

  • The Dubai World default – We are again receiving governmental reassurance that the Dubai World is well contained. Hearing this has eerie echoes of the sub-prime crisis being well contained. Why? We live in a highly interdependent worldwide financial system: if a butterfly flaps its wings in Beijing… you know the rest.
  • The US defaults on its sovereign debt – The Obama administration provided financial guarantees to everyone from American Express to GE to money market funds to Citicorp.  More than 2 trillion dollars of new US Treasury debt will need to be financed in 2010.  Is there enough money in the world to fund these deficits? What if a Treasury auction fails; that is, there are not enough bids to cover the amount offered?  That is like having a garage sale and nobody coming by.
  • The FDIC runs out of money – One commentator believes that the FDIC ran out of money in October 2009.   The FDIC is trying to muddle through by not aggressively closing problem banks.  Yes, the Treasury could step in and loan the FDIC money, but review the second bullet above on the potential for sovereign debt default.  Also, modern day bank runs occur via the internet rather than through heartwarming scenes a la It’s a Wonderful Life.  There is no George Bailey and no honeymoon money to bail out the money center banks.
  • Commercial real estate implosion – Commercial real estate – office buildings, hotels, regional and strip malls and multi- family dwellings have had a price decline of 41% since 2007. Rents have declined in all categories. Commercial real estate heavily utilizes short-term financing which require frequent re-financing at three, five and seven year intervals.  Re-financing needs will double from 2009 to 2010. Already stressed regional banks financed much of the growth in commercial real estate. Next year could be the perfect storm as both public and private sectors tap a limited pool of capital.
  • State, county or municipal insolvency – Multiple states are nearly insolvent. The same problems exist at the county and city levels.  States cannot declare bankruptcy, but counties and municipalities can.  A cascade of these bankruptcies would tax state treasuries.  A series of state defaults would put pressure on the Federal government for another set of bailouts.  Municipal defaults would send shockwaves through all financial markets.
  • Pension Fund Failure – Public and private pension funds are massively underfunded.  See Underfunded Pension Plans: The Next Shoe to Drop. Next year could be the year of recognition.  PBGC has limited resources to bailout the private sector funds and there is no PBGC coverage for public pension funds.  Multiple pension fund failures loom on the horizon.
  • War in the Middle East – Iran has shown contempt for international efforts to stop its nuclear development program.  Israel or the United States may be forced to take military action.  Iran has threatened to retaliate by closing the Straits of Hormuz, the international oil shipment passage way for Gulf oil.  Oil prices could soar crippling the world economy.

The Sky is Clouded with Black Swans

Given the nature of black swan events, I cannot predict that any will land. It is even more difficult to determine whether or not they are even black swan events at all.  Other worthy candidates: dollar collapse, earthquakes and volcanoes, sovereign debt default in Portugal, Spain, Italy, Ireland, Greece, the United Kingdom (or all these countries), Euro collapse, depression in China, constitutional crisis in the United States.  The list is long and fraught with possibility.  Or the black swan event could be that nothing happens at all.

Still hope spring eternal, keep checking the skies and Happy New Year.

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Financial — 0 Comments
8
Sep 09

What are the Unintended Consequences of Low Interest Rates?

The Federal Reserve has announced that it intends to pursue a low interest rate policy not only now, but for years to come.  The CNBC cheerleaders mindlessly applaud the Fed for pursuing such a policy.  Let’s play devil’s advocate and examine the heretical position that low interest rates are destroying the US economy.  Let’s look at two classes of investors and examine the unintended consequences of a low interest rate policy.

You retired from a large company sometime in 2005 at age 65 with a final salary of $125k with stay at home spouse.   Your lump sum pension, 401k and personal savings have allowed you to accumulate $2m in investable assets.   With interest rates at 6 percent you plan on $120k in income plus a maximum social security benefit of approximately $27k.  In other words, you can relax and look forward to a financially secure retirement with your assets generating $150 k per year of income.  But after the financial crash, we are in “Bernanke World” where interest rates on 3 month T-bills drop to .1 percent.  Our new retiree shops around and finds 12 month CD rates of .90 percent.  Suddenly, $150k annual income drops to approximately $50k of income including social security payments.  Our retired couple has gone from a life of 3-4 great vacations, visits to the grandchildren and dining out several times a week to barely being able to afford housing, food and supplemental medical insurance.

A couple of observations about the plight of our hypothetical couple: the standard response heard in the media is that our couple can just go back into the workforce.  What workforce would that be? Statistics demonstrate that one of the hardest hit groups in this recession is workers over 50.  What employer is clamoring for our now 69-year old couple to re-enter the workforce?  It seems there are just so many Wal-Mart greeter positions.  They are not particularly high paying positions, at least not enough to make up our hypothetical $100k income shortfall.  Further, my guess is that applicants significantly outpace available jobs.

Where is the political support for our couple?  Where is the vaunted AARP?   Where is the AARP’s famed lobbying machine to make the case that bankers (and quite undeserving ones at that) are being favored over thrifty, hardworking retirees? Where is the Congressional response to the plight of our couple?

Other investor constituencies negatively affected by low interest rates are defined benefit pension funds (the classic pension benefit) and insurance companies.  These groups have a basic goal of matching long term liabilities, e.g. pension payments, annuity payments and life insurance payouts with long term assets that will out earn these liabilities.  This is a pretty simple business model with the insurance company or pension fund keeping the excess earning in the form of a profit or a surplus. In the case of a pension fund this surplus or reduce future funding costs for the sponsor, i.e., a company, university or governmental entity.  Insurance companies and pension funds live in an actuarial world of an assumed return on assets.   Insurance companies were guaranteeing that annuities written in the past several decades would earn in excess of 4, 5 or 6 percent.  Pension funds projected that earning on assets would be between 7 to 9 percent.  These aggressive projections moved ever upwards as the 25-year long bull market gave a false sense of confidence to actuaries and financial executives.  Both the pension and insurance company projected earnings levels are now confronting the reality of a low interest rate world.

In a low interest rate world this patented formula is virtually destroyed.  Bridled by fiduciary concerns limiting risk taking, there is a large potential shortfall between projected and actual earnings.  The ramifications are enormous.  Insurance company earnings will be negatively impacted, corporate sponsors of defined benefit pension plans will be negatively impacted as companies by law will be required to make additional contributions affecting net income and cash flows and states and municipalities will be required to increase taxes to meet funding shortfalls.  The Federal Reserve is forcing fiduciaries to take even greater risk to try to catch up with past underperformance.  The autumn 2008 debacle in the financial markets does not auger well for increased risk taking at this point in the economic cycle.

I do not purport to know what the real rate of interest should be, but neither does the Federal Reserve.  I do know that artificially pegging an interest rate at an artificially low number has numerous unintended consequences, two of which are described above.  Driving investors to greater level of risk taking has never ended well.  Get the Federal Reserve out of the equation and let the free market decide the level of interest rates.

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