May 24, 2010

WOW!! Now That’s A Lot of Debt!

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 8:45 PM by Robert Barone

The markets are in turmoil because of the worry about the so-called PIIGS’ nations’ debts (Portugal, Ireland, Italy, Greece, and Spain).  In earlier writings (Fiscal Crises: The Next Shoe, March 14, 2010), I opined that Greece is just the canary in the coal mine and that when we look homeward, we have our own huge debt issues which are not significantly different from those of the PIIGS countries.  I believe that the only reason the European contagion has not yet spread to America is because of the dollar’s status as the world’s reserve currency.  That era is coming to an end, and it would behoove America to get its house in order.

A May 14, 2010 Barron’s piece entitled We’re Not Greece – Yet (D. Henniger) referred to a Royal Bank of Canada (RBC) study which concluded that “Although the states of California, New York, New Jersey, Massachusetts and Illinois are comparable in terms of economic output and population to Portugal, Ireland, Italy, Greece and Spain, RBC finds that states’ debt burden are nowhere near that of the PIIGS”.  This, “even after including unfunded liabilities for states’ employees’ pension and other benefits”.  As you will see below, I take issue with the above conclusion, and the first half of this piece will deal with why.  Basically, citizens of each U.S. state are responsible not only for the debt burdens of their states and localities, but they are also responsible for their proportionate share of the federal debt.  As you will see, the combination of the two produces debt ratios far in excess of those of the PIIGS.

Table 1 shows the PIIGS data that the markets are concerned with.

Table 1

Country Debt/GDP Deficit/GDP Unemployment Rate
Greece 125% 12.2% 10.2%
Italy 117% 5.3% 8.7%
Portugal 85% 8.0% 9.8%
Ireland 83% 14.7% 14.0%
Spain 66.3% 10.1% 20.0%

Source: Der Spiegel

Table 2 shows estimates (for fiscal year 2010) of the Population (1), State GDP (2),  State Debt/State GDP (3), Local Debt/State GDP (4), Unfunded Pension/State GDP (5), Other Unfunded Benefits/State GDP (6), Total Debt/State GDP (7), and Per Capita Debt (8) for the states mentioned in the Barron’s piece plus Michigan.

Table 2

(1)

Pop

(mill)

(2)

St GDP

(trill $)

(3)

StD/GDP

%

(4)

LclD/GDP

%

(5)

Pens/GDP

%

(6)

Oth/GDP

%

(7)

Tot/GDP

%

Per

Cap

($000)

CA 40.0 1.87 7.4 17.2 27.8 3.3 55.7 26.0
NY 19.5 1.16 10.6 15.7 0 4.9 31.2 18.6
NJ 8.7 .48 11.6 9.3 30.2 14.3 65.4 36.1
MA 6.6 .33 21.4 6.0 18.5 4.6 50.3 25.2
IL 12.9 .64 10.5 12.4 34.7 6.2 63.8 31.7
MI 10.0 .39 7.8 14.0 19.5 10.3 51.6 20.1

Sources: USgovernmentspending.com, Forbes, Pew Center

Using CA as an example, the population is rapidly approaching 40 million, the state’s GDP is estimated at $1.87 trillion, the State Government Debt/State GDP is 7.4%, Local Government Debt/State GDP is 17.2%, Unfunded State Worker Pension Liability/State GDP is 27.8%, Unfunded Other Health and Benefit Liabilities/State GDP is 3.3% for a Total Debt/State GDP of 55.7%.  Translating this into Debt Per Capita reveals that every CA citizen owes $26,000 for debt or liabilities contracted by their elected officials.  Looking back at Table 1, this isn’t too different than the Debt/GDP ratio of Spain.  And looking down the Total Debt/State GDP column of Table 2, it becomes apparent that both NJ and IL have Debt/GDP ratios equivalent to that of Spain.

But wait!  Citizens of the states in the U.S. are also responsible for the debt piled up in Washington, D.C.  So, to the debt of the states and localities, one must add the national debt.  The first three rows of Table 3 shows an average of all State (row 1), Local (row 2) and Federal (row 3) Debt/GDP and the Per Capita dollars owed by each U.S. citizen.

Table 3

Debt/US GDP (%) Cumulative (%) Per Capita ($000) Cumulative($000)
Average State 7.9% $3.7
+Average Local 13.8% $6.5
+Federal 94.3% 116.0% $44.6 $54.8
+Agency 18.6% 134.6% $8.8 $63.6
+Private Debt 113.4% 248.0% $53.5 $117.1

Source: USgovernmentspending.com

Using the table, look at the  intersection of the ‘Cumulative (%)’ column and ‘+Agency’ row, which represents the recognized public debt of the federal government and its agencies and an average state and local burden. One can see that at 134.6% of GDP, debt burdens are higher than those of all of the PIIGS countries that have given the markets so much heartburn.  Table 4 substitutes the debts of the states shown in Table 2 for the ‘Average State’ and ‘Average Local’ and shows the indebtedness of the citizens of these states per capita and as percentages of both State and U.S. GDPs.  All of the states shown have Debt/GDP ratios significantly higher than that of Greece.

Table 4

State & LocalDebt Per Capita ($000) Fed & Agency Debt Per Capita ($000) Total Public Debt Per Capita ($000) Tot Debt/State GDP (%) Tot Debt/ US GDP (%)
CA $26.0 $53.4 $79.4 170% 168%
NY $18.6 $53.4 $72.0 150% 152%
NJ $36.1 $53.4 $89.5 162% 189%
MA $25.2 $53.4 $78.6 157% 166%
IL $31.7 $53.4 $85.1 172% 180%
MI $20.1 $53.4 $73.5 188% 155%

Now, I am not an expert on debt levels in European countries.  And, it could well be that citizens of those countries have taken on public debt which would be similar to U.S. State and Local debt that isn’t in the figures shown in Table 1.  But, because the absolute levels of the Debt/GDP shown for the PIIGS have been a cause for concern, then the debts of the citizens of the U.S., and, specifically those states shown in Table 4, should also be cause for grave concern.  For the most part, the European states are at least considering austerity measures.  And while some U.S. states are being forced into austerity because of their inability to print money, the major contributor to the indebtedness, the U.S. Congress, doesn’t seem all that concerned.  This is a major difference from what is occurring in Europe.

So far in this piece, I have only talked about public debt.  usdebtclock.orgusdebtclock.org as expanding; the other three categories of consumer debt are contracting.  I wish I could say the same about public debt!)  So, on top of all of the public debt, each U.S. citizen, on average, owes privately $53,525.  Adding the public and private debt together totals $117,181 per capita, or a total Debt/GDP ratio of 248% (see Table 3).  Wow! Now That’s a Lot of Debt! estimates total personal debt at $16.6 trillion, mortgage debt at $14.1 trillion, consumer debt at $2.5 trillion, and credit card debt at $848 billion. (Amazingly, of the 4 types of private debt, only consumer debt is shown at

Finally, as I have previously written (Overview – Economic Fundamentals Issues, The Ancora Advisor, Vol. 6, No. 1, January 19, 2010), the unfunded liabilities of Social Security and Medicare are nearly $109 trillion or about $352,000 per U.S. citizen (see www.usdebtclock.org/).  That number alone is a Debt/GDP ratio of 745% and is so outside the realm of rationality that I didn’t bother to put it in the table.  Clearly, the recipients of these promises cannot possibly hope to receive such benefits in current dollars.  Depreciation of the currency or significant cutbacks in the promises (or both) is inevitable.  The recognition of the real magnitude of these irresponsible promises should be enough to cause a loss of confidence in the dollar.  In my view, unless the U.S. moves to at least begin to address these issues, that day is closer than anyone might think.

All of the public debt was originated by governments and most of the private debt by banks or other financial institutions.  In feudal times, serfs owed a significant portion of their toil to their lords.  Have times really changed?  The lords are now the politicians and “Too Big To Fail” bankers.  Many ordinary people are serfs, highly indebted either voluntarily (private debt) or involuntarily (public debt).  Looking at debt in this way helps to explain the unholy alliance between Washington and Wall Street (see The Unholy Washington-Wall Street Alliance at https://ancorawest.wordpress.com/2009/11/) and why the “Too Big To Fail” and Washington politicians get richer and richer at the public’s expense.

While U.S. citizens are drowning in debt, the political system appears incapable of reducing it.  In fact, the politicians continue to expand it in the erroneous belief that more debt will help.  There are only two ways out: years of austerity or currency devaluation/inflation.  The political system will not allow the former.  Buy Gold!

Robert Barone, Ph.D.

May 19, 2010

The mention of securities or types of securities in this article should not be considered as an offer to sell or a solicitation to purchase any securities mentioned.  Please consult an Ancora West Investment Professional on how the purchase or sale of securities can be implemented to meet your particular investment objectives goals. Investments in precious metals and similar securities or commodities are subject to risks.  It is important to obtain information and understand these risks prior to investing.

Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this formmay be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

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May 22, 2010

A New Paradigm for Community Banks

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 12:08 AM by Robert Barone

The banking landscape is rapidly changing. We had 126 bank failures in 2009, and, through May 7, 2010, there have been 68 additional closures. Sheila Bair, FDIC Chairwoman, has indicated that we can expect a significant number of additional failures for the next few years. The system that America got used to from 1990 through 2007 where credit was easy to get and consumption and investment grew as a result, has disappeared. In its place is emerging a system that is 180 degrees opposed. Those that are “Too Big To Fail” are getting bigger. Meanwhile, the small community bank, the source of working capital for America’s small businesses, is being choked by the regulatory system.

Ask any CEO of a community financial institution who he/she works for – the answer won’t be the Board of Directors or the Shareholders – inevitably, the answer will be the regulator (FDIC, OCC, Fed, OTS). It appears that, having failed to detect the sub-prime, housing, and derivative bubbles (which emanated from Wall Street), the regulatory agencies have decided to get tough on Main Street lenders. Never mind that community institutions didn’t participate in the sub-prime debacle, or didn’t sell synthetic securities to their clients while simultaneously taking short positions. And, ignore the $20 billion of capital that these institutions lost at the flick of the Treasury Secretary’s magic wand (FNMA and FHLMC preferred stock). If you want to figure out why the economy cannot find solid footing, look no further than the way the regulators are treating commercial real estate loans in community bank portfolios.

  • As presently enforced, federal regulations prescribe that all loans in excess of $250,000 that are secured by real estate must be periodically appraised in accordance with mark-to-market rules to determine value. For appraisals that show deteriorating property values, examiners, sometimes using arbitrary criteria, often impose write-off requirements, require additional collateral or demand cash payment for the difference between appraisal and the required loan to value ratio. These actions have set in motion “death spirals” in many communities based on fire-sale prices for assets which results in further market devaluations of other similar assets. Most borrowers in this economic climate cannot provide additional cash or collateral, and financing from an alternative source is simply impossible to get. The loan is classified even if the borrowers have made timely payments. The result is that the community bank has had to utilize its capital to create a reserve for any potential loss the examiner has determined, including loans that are not maturing for a considerable period of time. Under these constraints, most community banks do not have sufficient capital to expand their loan portfolios and finance local economic growth.
  • If a community bank adheres to Congressional pleas to assist borrowers who may have borrowed when interest rates were substantially higher by reducing interest rates to current market levels and bringing the loan in line with the established income of the borrower and/or the property in question, the regulators deem the loan to be “restructured and impaired” and compel the bank to create a reserve and write down the value of the loan. This occurs notwithstanding that the borrower can demonstrate that he and/or the property can sustain the payments at the restructured level. This policy penalizes the bank for assisting a borrower.
  • It is contradictory policy to have the Congress and the Administration urging community banks to lend more to stimulate economic growth and job creation while at the same time the banking regulators increasingly demand that banks build up their capital while substantially increasing their reserves to cover losses generated by the mark to market rules. Increasing capital and increasing lending activity are inconsistent goals in today’s market.

All market participants want “transparency”, i.e., want to know what is on a bank’s balance sheet, the market values of those assets, what other off balance sheet items exist, and how earnings are calculated. Transparency, then, appears both reasonable and necessary for market participants. On the other hand the function of a bank is to turn illiquid assets into liquid ones for its borrowing clients. Marking illiquid assets, which are not easily saleable in the best of times and which are not for sale and aren’t intended to be for sale, to fire sale prices makes little sense. The balance sheet assets of community banks are not there for a quick flip; they are managed over very long periods of time. The current requirement that they be marked to fire sale prices impacts community bank capital and the local economy that those banks serve.

Thus, for community banks, there is a conflict between the desire and the need for “transparency” and the nature of their balance sheets. What could be done? For investors, the market values of assets and liabilities should be disclosed. But, because of the nature of a community bank’s balance sheet, rules for regulatory capital should not require write downs to prices where markets are clearly in turmoil. Regulators should use some measure of tolerance and allow community banks time to work their way through the current negative environment as they have successfully done in countless other economic contractions. Without community banks, who will lend to small business? And without small business expansion, how will we regain the 8.5 million jobs lost in this recession?

Under today’s regulatory regime, here is the new paradigm for community banking:

  • For the foreseeable future, perhaps as long as 3-5 more years, we will continue to see record numbers of community bank failures where the FDIC closes an institution and sells off the assets for pennies on the dollar;
  • For the surviving community bank institutions, credit standards will be quite tight. Loan to value ratios will be very low, and many businesses that got credit (and deserved to get it) in the last 20 years will be excluded. Community banks will shrink in asset size, and when they do start to grow, it will be at single digit rates;
  • The “Too Big To Fail” will get bigger; but, they haven’t been equipped to make loans to small business since they gave up that function in the 1980s.

The new paradigm for American banking is that the big will get bigger and the small will dwindle. But because it is the small institutions that lend to small business, and it is small business that create the majority of new jobs, this new paradigm means much slower economic growth and therefore a continuation of high levels
of unemployment.

Robert Barone, Ph.D.


Robert Barone is a Principal and an Investment Advisor Representative of Ancora West Advisors LLC an SEC Registered Investment Advisor. He is also a Registered Representative and a Registered Principal of Ancora Securities, Inc. (Member FINRA/SIPC).

Ancora West Advisors LLC is a registered investment adviser with the Securities and ExchangeCommission of the United States. A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II. A copy of this formmay be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

May 17, 2010

Europe’s TARP

Posted in Banking, Big Banks, Bonds, Capital, crises, Finance, investment advisor, investments, San Francisco, Uncategorized at 6:00 PM by Robert Barone

Part of the gloom sitting over the U.S. markets has to do with the uncertainty surrounding the fate of the world’s banking system should any of the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) default on their sovereign debt.  The European Central Bank’s (ECB) recent action to “save” Greece really wasn’t undertaken for the sake of Greece.  Rather, like the saving of AIG in 2008 by the Treasury via TARP, which was, in fact, a move to save Wall Street’s “Too Big To Fail” from the domino effect that would have resulted from their large counterparty exposure to each other, so too, the ECB’s bailout plan was done to protect the European banking system, especially Germany, the Netherlands, Belgium, and France.

In April, the Bank for International Settlements published a study showing the percentage of bank assets exposed to the sovereign debt of the PIIGS by country.  Canada, Chile, Panama, and Mexico had zero exposure.  The exposure of other major economies is shown below.  The first set of exposures appear to be minimal, with total banking exposure not a threat to the financial systems:

Australia: .08%;  Brazil: .198%; U.S.: 1.57%

The following exposures would imply that the country’s banking capital may be exposed:

U.K: 4.53%;  Austria: 4.84%;  Japan: 5.02%;  Germany: 6.18%;  Netherlands: 6.79%;  Belgium: 7.93%

Finally, these three appear to have significant issues if there is a sovereign default:

France: 10.40%;  Ireland: 13.50%;  Portugal: 14.08%

Several conclusions jump out from this data:

  • A default in any one of the PIIGS would likely cause the Irish or Portuguese banking system to collapse, and maybe even that of France.  This may have a domino effect on those systems with 4.5%+ exposures; thus, the logic for the ECB’s recent actions;
  • The Americas, both North and South, and Australia have little exposure and, besides stock market unease, are unlikely to have systemic banking risk as a result of a PIIGS sovereign default.

Individual bank data dealing directly with this issue is harder to come by as most banking systems still resist transparency.  Rochdale’s Richard Bove, in early May, tried to segregate loans by dollar value by major U.S. banks to the PIIGS by country.  His data, however, include both loans to sovereign governments and to the private sector.  Nevertheless, an examination of his data can lead to some conclusions about such exposure.  The table below shows five “Too Big To Fail” Wall Street institutions.  I have taken Bove’s data by country and aggregated it to the PIIGS as a whole. In addition, I show the data as a percentage of the institutions’ leverage capital.  That gives us an idea of how exposed the capital is to events in the PIIGS countries.

Exposure to PIIGS/Capital (%) Exposure to France, Germany, & U.K./Capital (%)
BankAmerica (BAC) 0% 0%
Citigroup (C) 35% 276%
JPMorganChase (JPM) 124% 758%
Goldman Sachs (GS) 11% 138%
Morgan Stanley (MS) 23% 147%

JPMorganChase (JPM) has the most direct exposure; the rest appear safe.  Remember, even in a default, the public sector debt is still worth something; no one expects the private sector loans to have a default rate even approaching 10% of exposure. (In a separate revelation, BankAmerica (BAC) has indicated a $193 million exposure to Greek sovereign debt and $1.1 billion to the Greek private sector.  Still, total exposure is less than .9% of capital.  Because of the small amount, Bove did not capture this in his analysis – once again speaking to the transparency issue.)  The real danger in the European theater arises if the contagion spreads to France, Germany, and the U.K., which all have significant exposures in their banking system as I indicated earlier. As you can see from the table above, everybody’s exposure, except apparently BankAmerica (BAC), would become quite significant.  Thus, the Fed’s recent actions to provide greenbacks to its European friends now makes sense.

As for the European major banks, HSBC (HBC), Credit Suisse (CS), and UBS (UBS) claim that they have little to no exposure to PIIGS sovereign debt.  My research shows that the three most exposed banks in Europe are Commerzbank (CBK.XE) of Germany with 88% of its capital exposed, Unicredit (UCG.MI) of Italy with 57% exposure, and Banco Santander (STD), with 55% exposure most of which is to Spain’s public debt (its home country).

Like the failure of the Bear hedge fund in July ’07, the Greek issue appears to be the canary in the coal mine.  And, like the actions of the U.S. Treasury, the Fed, and with delay, the Congress to shore up the financial system via the TARP, the ECB, after some months of delay, has followed suit.  There is more of this drama left to play out, and markets will show volatility along the way.

Robert Barone, Ph.D.

May 17, 2010

The mention of American or foreign securities in this article should not be considered as an offer to sell or a solicitation to purchase any securities of American or foreign countries mentioned.  Please consult an Ancora West Investment Professional on how the purchase or sale of securities can be implemented to meet your particular investment objectives goals.  Foreign securities not denominated in U.S. Dollars may be subject to foreign currency exchange risk in addition to market risks.

Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this form may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

May 10, 2010

Precious Metals for the Long Run

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 11:15 PM by Robert Barone

The potential, and, perhaps, inevitable meltdown of the European Union due to the overpromising of entitlements and habitual deficit spending speaks directly to the reasons that our advisory firm has remained so cautious, keeping client assets in defensive positions with lower than normal equity levels and higher allocations to precious metals.  During the Greek debt crisis, precious metals have moved to the upside toward historic high prices.  Our view is, and has been, that the U.S. is not immune from similar dire consequences of its own profligacy.  In fact, the country may have already passed the point of no return with regard to solutions.  The uncertainty surrounding the long term direction of taxes, fiscal policies, and monetary policies makes precious metals a natural long term hedge.

The financial industry generally ignores academic studies and conclusions.  But, every once in a while, a study, based on well documented historical data, reports conclusions so compelling that they cannot be ignored.  Reinhart and Rogoff’s 2009 book, This Time Is Different: Eight Centuries of Financial Folly made an impression on some business savvy folks regarding the fallacies of the use of debt to resolve a financial crisis.  Now comes along another study, this one relatively obscure, by Cecchetti, Mohanty, and Zampolli of the Bank for International Settlements (BIS) entitled The Future of Public Debt: Prospects and Implications, March, 2010, which concludes that the current and future state of fiscal policies and accumulated liabilities along with the lack of political will make future inflation and devaluation the most likely future scenario.  Below are some of the study’s observations as seen and focused through my lens:

  • The deficits in the U.S. are now structural, not cyclical.  Deficits are now present as far as the eye can see even after the economy recovers and taxes increase;
  • Reinhart and Rogoff indicate that, after a banking crisis, the debt/GDP ratio rises by 86%.  That rise is now projected to be 111% for the U.S. in 2011.  Furthermore, once debt/GDP rises to 90%, future economic growth rates fall significantly;
  • With little likelihood of robust growth due to structural unemployment issues, there is little hope that the debt/GDP ratio in the U.S. can fall anytime soon;
  • Age related public spending (Social security, Medicare, and the new healthcare legislation) is not included in the BIS study calculations, nor are the huge unfunded liabilities in state and local pension plans which are just now coming to light.  It is estimated that federal expenditures for healthcare alone, which today are 5% of GDP, will rise to 10% by 2035 and 17% by 2080.  And this doesn’t count the burden the federal government puts on the states to support the social entitlements;
  • Deficit issues are not unique to the U.S. and are present in most industrialized nations.  Greece and the other weak European Union members (Portugal, Spain, Italy, Ireland) as well as the U.K. are all in the same boat.  The authors conclude: “the data show that the current fiscal policy is unsustainable in 19 industrial countries studied”.

The authors looked at several sets of plausible assumptions about fiscal policy and spending and they conclude that under almost any set of assumptions, debt in the industrial world explodes.

Assumption Set 1: Non-age related spending/GDP stays constant at 2011 projected levels.

While most U.S. voters want the Congress to have fiscal restraint, perhaps with the return of “pay as you go” which requires Congress to find money through reductions elsewhere or new fees or taxes in order to spend on something new or increase funds for existing programs, because of entitlements already promised, deficits rise precipitously with debt/GDP exceeding 150% in the U.S. (300% in Japan, and 200% in the U.K.).

Assumption Set 2: The U.S. follows the Obama plan to bring its deficit down to 4% of GDP by 2015.

Once again, the vested entitlements catapults the debt/GDP ratio toward 300% by 2040.  “This suggests that consolidation along the lines currently being discussed will not be sufficient to ensure that debt levels remain within reasonable bounds over the next several decades”, the authors contend.

Assumption Set 3: Freeze the age related spending/GDP at projected 2011 levels. 

This would appear to be politically impossible.  But, even if it could be done, the debt/GDP ratio falls in some industrial countries, namely Austria, Germany, and the Netherlands, but not in France, Ireland, the U.K., or the U.S.

The authors calculate that, for the U.S. to get back to the 2007 debt/GDP ratio, it would have to run a surplus/GDP ratio of 8.1% for the next 5 years, 4.3% for 10 years, or 2.4% for 20 years.  Note that the 2010 projected surplus/GDP ratio is -11%, i.e. we have an 11% deficit/GDP ratio.  Given the low likelihood of significant improvement, what are the consequences?

  • As the debt/GDP ratio rises, interest rates rise because investors demand a higher risk premium; higher rates imply slower economic growth;
  • Excluding age related expenditures, in order to maintain a given level of public services, taxes must rise.  If tax rates rise, depending on where the country is on the Laffer curve (the U.S. is among the highest taxing countries in the world and is almost certainly to the point on the Laffer curve where tax rate increases are a disincentive to work) tax revenues are likely to fall;
  • The constant tapping of the credit markets by the government “crowd out” the private sector which leads to higher interest rates, less investment, and lower economic growth;
  • As debt rises, there is likely to be an increase in inflation or inflation expectations;
  • Rising debt puts political pressure on central banks to monetize the debt to keep rates low both to increase economic growth and to hold down the cost of the debt.  “History shows that countries that ran high public debts eventually ended up with high inflation because governments were unwilling to pay high interest rates.”

Conclusions

  • Fiscal problems confronting the U.S. and other industrial economies are more serious than official debt figures show due to age related liabilities which are not accounted for in official budget figures, and this doesn’t include the huge underfunded liabilities present in almost all state and local pension plans.  “As frightening as it is to consider public debt increasing to more than 100% of GDP, an even greater danger arises from a rapidly ageing population”;
  • Interest rates on government debt will rise as debt explodes making the deficit problem worse;
  • Long-term fiscal imbalances pose significant risks as central banks are pressured into direct debt monetization or governments succumb to the temptation to reduce the real value of government debt through higher inflation;
  • High levels of public debt drive down capital accumulation, productivity, and long-term economic growth.

Implications for Investors

Ask yourself how confident you are that the U.S. Congress could soon accomplish any one of the three sets of assumptions, i.e.: 1) hold non-age related spending at 2011 projected spending levels; 2) follow the Obama plan to reduce the deficit/GDP ratio to 4% by 2015, especially in the face of high structural unemployment; or 3) freeze the age related spending/GDP ratio at projected 2011 levels, especially given the new health care legislation.  Given the spending track record of the Congress under both Republican and Democratic leadership since 2001, one should have little confidence that 1) or 2) could be accomplished.  And 3) would take political will not seen in our lifetimes.  Yet, even if any one of these is accomplished, the authors conclude that the U.S.’s debt/GDP ratio would still reach at least 150%.  It thus appears inevitable that the dollar will lose purchasing power (even if it doesn’t fall vis a vis other currencies due to those countries’ debt/GDP ratios) against hard assets.  Finally, history shows that it is politically more palatable for politicians to choose inflation, rather than higher interest rates, as the way out.  Increased portfolio allocations to inflation hedges (precious metals), then, would seem to be the rational long-term response.

Robert Barone, Ph.D.

May 5, 2010

The mention of precious metals and similar investments in this article should not be considered as an offer to sell or a solicitation to purchase any investments or securities mentioned.  Please consult an Ancora West Investment Professional on how the purchase or sale of such investment can be implemented to meet your particular investment objectives goals.   Investments in precious metals and similar securities or commodities are subject to risks.  It is important to obtain information and understand these risks prior to investing.Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this form may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

Cash Flow – The Ultimate Margin of Safety

Posted in Banking, Big Banks, Bonds, Capital, community banks, crises, derivatives, Finance, Forward thinking, government, investment advisor, investment banking, investments, local banks, municipal bonds, San Francisco, Stocks, Uncategorized tagged , , , , , , , , , , , , , , , , , at 11:07 PM by Robert Barone

Cash is King

The intrinsic value of a stock is considered to be the discounted value of future cash flows.  But, it is free cash flow (defined as cash from operations less capital expenditures) that is used for paying dividends, paying down debt, and buying back shares, actions that create value for shareholders.  The more robust and secure the cash flows, the safer the investment.  As an added bonus, the more free cash flow produced per dollar invested, the higher the expected return.   On the flip side, the more leveraged and fragile the cash flows, the more risky an investment becomes.  Even for fixed income, cash balances and cash flows determine whether or not timely interest and principle will be paid on an investment.  As such, an investor should constantly monitor the source and stability of cash resources.

Universal Truth

The same logic that applies to business applies to personal finances.  Income that comes from a salaried position at a quality company would typically be more consistent than a commission based job in a cyclical industry.  A person with inconsistent income and high personal debts would be in a more precarious financial position than someone with no debt and millions of dollars in liquid assets, especially in an economic downturn. 

Extrapolating this thought process to the national level, it is clear that countries that have stable incomes and low levels of obligations have the ability to sustainably provide services to their people while keeping taxes low so that business and investment can flourish and grow.  Those that don’t have reliable revenue more often than not make up for it with increased debt loads and higher taxes.   If tax rates rise faster than business revenues and personal incomes, the system crumbles (as we are now witnessing in Europe).  The other approach to high debt is money printing.  This is often used as a politically less offensive way of paying for accumulated debt.  The resulting inflation can be blamed on greedy businesses or previous regimes.   Either way, the system is hit with hardship. 

While the simple concepts outlined above seem obvious, the core lesson seems to be eternally lost upon the financial markets, politicians, and the voting public. George Bernard Shaw once said, “Hegel was right when he said that we learn from history that man can never learn anything from history.

Quality of Earnings

In investment circles and the media, much of the focus is placed on earnings.  Each quarter’s earnings release is awaited with baited breath.  If the company “misses” the collective analysts’ expectations, then the stock sells off.  If the company “beats the street”, then the stock rallies.  Despite the fact that cash flow may be declining and debt rising, the markets are often happy if “earnings” go up.

The actual meaning of “earnings” is often missed, and often has no bearing on the amount of cash that a company generated or burned.  Remember, you can’t pay back debt or pay dividends with earnings.  It is the cash that counts.  While this article is too short for an elaborate explanation of earning vs. cash flow, suffice it to say that the difference is often large.  Further, executives that mismanage companies often spend a significant amount of time on spinning or even manipulating earnings (e.g. Enron, Madoff,…) .  Over the long term, it pays to understand the difference between earnings and cash flow, and to focus on the source and sustainability of the cash flow.

Quality of GDP

As stated above, the economic reality of a nation’s finances are not fundamentally different from that of an individual or a business.   Most pundits measure the financial strength of the economy by looking at Gross Domestic Product, or GDP.  (For a review of GDP, see my November 10, 2009 blog “Is the Recession Really Over?”)    Much like the earnings of a company, GDP can be of high or low quality.  For example, GDP is of low quality if consumption growth is currently funded by a massive run-up in debt.  Ditto for government spending.  The short term GDP gain will have to be paid for with principal and interest, potentially turning the short term gain into a long term drag.  Keeping up with the Joneses doesn’t work well for families, or governments, if long term stability is the goal.

Similar to earnings, GDP has little to do with cash flow.   The Government gets its revenues from taxes, and to a lesser extent, fees.  If there is a deficit, debt issuance and/or money printing is used to make up the shortfall.   If one wanted to assess a government’s ability to pay its obligations, it would be more instructive to compare that government’s debt to tax revenue with an eye towards stability of the tax source, than to GDP.  (With regard to the stability of the tax source, for example, the capital gains tax can generate a large amount of revenue in years where the stock  markets are booming, but usually contribute much less in most years.  1999’s tax revenue would have looked different without the taxes generated by stock options and day trading.)

Suffocating the Golden Goose

Contrary to the pronouncements of U.S. government officials, cash flow, not credit,  is the lifeblood of the economy.  If it is not nurtured, the entire system suffers.   In the U.S., Japan, and much of Europe, debt levels are ballooning in relation to cash flows.  Most of the recent U.S. GDP gains were created by the unprecedented use of credit, for both consumption and real estate development.  To fix the debt problem, governments have decided to run deficits.  The thought is that by deficit spending (adding debt), we can help debtors get out of debt.  This sounds ridiculous in theory, and it hasn’t worked in practice.  Nevertheless, our leaders continue to try to cure the economic hangover by administering more booze.  

The current level of debt is having a negative impact on business cash flows and will have a bigger impact when interest rates rise from their historically low current levels.  And we are now finding out that state and local pension plans (and many business pension plans) are significantly underfunded.   The first political reaction to all of this is to raise taxes.  For example, in the U.S., a value added tax is being considered, not as a substitute for the byzantine income tax system, but in addition to it.  Taxes and fees are being raised at every level of government (e.g., public parking fees, licensing fees, transportation fees, bridge fees, sales taxes…).  Taken in the aggregate, higher taxes slow down business.  Lower business revenues mean lower cash flows.   Lower cash flows mean lower salaries, and fewer jobs.  People that make less money, and pay higher taxes, will have less to spend.  It is easy to see that this negative cycle makes debt burdens larger.  If business taxes rise, their cash flows will suffer.  As those cash flows suffer, so will their investors’ returns.  

Hard Choices

What can we do about it?   Unfortunately, the only way out of this is to cut government budgets, reduce pension payments, and or print a large amount of money.  There is no easy solution, and few politicians are willing to be honest with their voters.  All of these solutions will have negative outcomes.  Budget cuts will bring reduced services and transfer payments country wide.  Reduced pension benefits will lower many people’s incomes, wreaking havoc on their lives and lowering consumption.  It may even lead to social unrest, as is currently the case in Greece.  Money printing, and the resulting inflation, has always been a painful process.   Many people’s life savings are impacted, and middle and lower class people are hit particularly hard. 

Investment Implications

While the solutions are hard to swallow, there is no other way to solve these problems, problems borne of over promising entitlements and from habitual deficit spending.  Investors need to protect themselves against the probable outcomes of slower economic growth, lower investment values, and higher interest rates.  Stock investments should be of the highest quality.  Look for companies with strong balance sheets, hefty cash flows, and entrenched products.  Fixed income should be of the highest quality, with a bias towards the short end of the curve.  A gold hedge would be prudent for most investors.  A margin of safety is always smart when making an investment, but today, it may be more important than ever.

Matt Marcewicz

May 5, 2010

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