March 29, 2011

Fiscal Plight of the U.S.

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, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 7:50 PM by Robert Barone

Simple math is often revealing.  That is why what follows is so scary.  It’s about the debt of the U.S. and the near impossibility to fix the federal budget almost no matter what steps are taken today.  Unfortunately, even the difficult steps that must be taken, and that are being avoided by the political process, won’t solve the basic issue.

Let’s first look at the level of debt in the U.S.   The table below shows the level of personal debt, and the level of local, state and federal debt, all per capita, as currently estimated (2011) and what it would look like in 2015 if the growth of debt over the past year were to continue at the same pace (source:

2011 2015 CAGR
Personal Debt/Citizen $51,955 $45,339 -3.3%
Local Gov’t Debt/Citizen $5,512 $6,378 3.7%
State Debt/Citizen $3,757 $4,753 6.1%
Federal Debt/Citizen $45,791 $69,242 10.9%

Clearly, U.S. households are attempting to lower their debt levels.  And while it appears that state and local debt loads are still growing, public pressure, the balanced budget requirement in most states, a taxpayer revolt, and the inability to print money on the part of these entities will cause a significant slowdown in the growth of debt at these levels.  Unfortunately, this is not the case at the federal level.  As Stan Laurel often said to Oliver Hardy, “This is a fine mess you’ve gotten us into”.  The rest of this piece analyzes the “mess” that the federal government has put onto the American people.

U.S. Federal Budget Trends

The table below shows the rates of, and rates of growth of federal spending for the year ending in mid-March for the various years shown (source:  For example, the spending levels and growth rates for 2004 are from mid-March 2003 to mid-March 2004.  Using the latest actual data and growth rates (mid-March 2010 to mid-March 2011) the table projects what those spending levels would be in 2015.  The growth rates are shown in Compounded Annual Growth Rate form (CAGR).  Also shown are the levels of federal revenue collection, the implied deficits, and projected GDPs.  Because this table is based on actual revenues and expense trends in mid-March of each year, the deficit shown for 2011, $1.33 trillion, is lower than the current projections of $1.6+ trillion due to the extension of the Bush tax cuts and the temporary lowering of the social security tax on wage earners.  The 2004 deficit was actually $413 billion, higher than shown in the table, for the same reason, i.e., the table projects from mid-march 2004 based on the one year trend.  The column labeled CBO is the Congressional Budget Offices’ (CBO) 2015 projections.  While these are generally discredited, they add context to the debate.





CAGR (Bill$)  


CAGR (Bill$)  

CBO 2015



443.4 804.1 8.88% 1,111.2 8.42% 990.8 5.36%
Social Security 474.9 706.5 5.83% 817.2 3.71% 852.4 4.81%
Income Security 194.9 431.9 12.04% 328.4 -6.62% 284.3 -9.93%
Federal Pensions 130.3 202.7 6.52% 338.8 13.70% 227.3 2.90%
Defense 415.8 693.8 7.59% 791.2 3.34% 741.1 1.66%
Debt Interest 154.7 202.9 3.95% 345.6 14.24% 408.3 19.10%
Sub-total 1814.0 3,041.9 7.66% 3,732.4 5.25% 3,504.2 3.60%
Discretionary 375.3 467.0 3.17% 919.9 18.47% 520.9 2.77%
Total Spending 2,189.3 3,508.9 6.97% 4,652.3 7.31% 4025.1 3.49%
Revenue 1803.9 2,175.8 2.71% 2,454.0 3.05% 3,488.1 12.52%
Deficit -385.4 -1,333.1 19.4% -2,198.3 13.32% -537.0 -20.33%
GDP 11,135.9 14,622.3 3.97% 16,837.8 3.59% 17,464.8 4.54%
Rev/Expenses 82.40% 62.01% 52.75% 86.66%
Rev/GDP 16.19% 14.88% 14.57% 19.97%

Looking at each line item, Medicare/Medicaid and Social Security are dependent on demographics.  With the baby boomers now entering retirement, the growth rates shown are likely to get larger over the next few years.  As is shown in the table, the CBO projects a growth rate of only 5.36% for Medicare/Medicaid.  Given the 7 year growth rate from 2004 to 2011 of 8.88%, the CBO estimate most likely assumed that Congress would take some actions to reduce the growth.  The growth rate in Social Security is higher under the CBO projections than the most recent growth rate observed and projected into 2015.  Income Security is composed of the unemployment and other social safety net programs, is currently 12.3% of federal spending, and is projected to fall to 7.8%.  As a benchmark, this item was 8.9% of the budget in 2004, so its 2015 projected level appears reasonable.  The growth in Federal Pensions appears extremely high, but this is not surprising given the recent brouhaha over government employee unions, wages and benefits.  Using the recent growth rates, the 2015 projections dwarf the CBO estimates.  The growth of Defense appears about in line with the growth of GDP.  Debt Interest is a wild card.  Because the method employed by simply projects the growth over the past year into the future, there is the growth in the debt itself, but no assumption of any increase in interest rates.  Thus, it is likely that the figure shown for 2015 is extremely low.  Even the CBO projects debt interest cost at over $408 billion in 2015.  There have been many blogs written on the potential explosive nature of future debt costs (see my blog, What Happens to the Cost of Debt if Interest Rates Rise? Minyanville, November 29, 2010).

The six categories discussed above have been “untouchable” by the last few editions of the U.S. Congress (except to add to them as was done under President G.W. Bush – prescription drugs) and represent 87% of Total Spending.  The other 13% is termed “Discretionary”, as the Congress can control this spending on an annual basis.  You can see how well they have done that over the past year, as those expenditures have risen at an 18.5% rate.  For the 7 years from 2004 to 2011, the growth rate was 3.17%, a somewhat more acceptable level.  The table also shows Revenues relative to Total Spending, and Revenues relative to GDP.  Using 2004 as a benchmark, the Revenue/Total Spending ratio was about 81% (deficit of about $413 billion) and Revenue/GDP was 16.2%.

Scenario 1 Scenario 2 Scenario 3
(Bill$) 2011 CAGR (Bill$) 


CAGR (Bill$) 


CAGR (Bill$)  




804.1 8.42% 1,111.2 8.42% 1,111.2 6.32% 1,027.4
Social Security 706.5 3.71% 817.2 3.70% 817.2 2.78% 788.4
Income Security 431.9 -6.62% 328.4 -6.62% 328.4 -6.62% 328.4
Federal Pensions 202.7 13.70% 338.8 10.28% 299.8 10.28% 299.8
Defense 693.8 3.34% 791.2 1.67% 741.3 1.67% 741.3
Debt Interest 202.9 14.24% 345.6 14.24% 345.6 14.24% 345.6
Sub-total 3,041.9 5.25% 3,732.4 4.61% 3,643.5 3.80% 3,530.8
Discretionary 467.0 0.00% 467.0 0.00% 467.0 0.00% 467.0
Total Expenses 3,508.9 4.59% 4,199.4 4.04% 4,110.5 3.31% 3,997.8
Revenue 2,175.8 6.14% 2,761.4 5.83% 2,761.4 7.20% 2,873.4
Deficit -1,333.1 1.91% -1,438.0 .30% -1,349.0 -4.17% -1,124.4
GDP 14,622.3 5.00% 17,773.5 5.00% 17,773.5 5.00% 17,773.5
Rev/Expenses 62.01% 65.76% 67.18% 71.87%
Rev/GDP 14.88% 15.54% 15.54% 16.17%

The Deficit Issue

The U.S. cannot operate much longer at the trillion dollar deficit level without dire consequences.  Some of these include 1) rapidly rising interest rates as bondholders lose confidence in the fiscal integrity of the Treasury; 2) loss of world reserve currency status of the dollar; 3) likely rapid inflation as the Fed creates the fiat money that the government can no longer borrow from the U.S. public or the world’s investors at rates that keep the deficit from exploding even further.

So, what is it that can be done on this issue?  I have developed 3 possible scenarios.  In Scenario 1, by 2015 the Bush tax cuts have expired ($132.6 billion according to the Tax Foundation), and all additional discretionary spending has been reduced to 2011 levels.  Given the current political stalemate, this scenario may seem optimistic.  In addition, I have made the extremely optimistic assumption that the economy has turned around and has averaged a 5% compounded annual growth rate with a commensurate increase in federal revenues.  (I assumed 12 million new jobs are created over the 4 years (250,000/month), and each job generated $14,500 in tax revenue via income and payroll taxes.  Under this scenario, because of the explosive growth in Medicare/Medicaid and Federal Pensions along with normal growth in Defense, the deficit is still hovering at more than $1.4 trillion.  In addition, the apparent unrealistically low costs of the Debt Interest remain.

While Scenario 1 itself seems somewhat optimistic, it is my intent to show the true depth of the fiscal issues.  Scenario 2 takes the results of Scenario 1 and assumes that the Congress cuts the growth rate of Defense spending in half and somehow reduces the growth rate of federal pensions by 25%.  But, just as in Scenario 1, the deficit remains stubbornly high near $1.35 trillion implying that $0.328 of every federal dollar expended is either borrowed or, more likely, printed.

In the final scenario, Scenario 3, all of the previous actions of the other scenarios are accomplished plus the Congress has successfully modified the growth rates of Medicare/Medicaid and Social Security by 25% and has found enough new revenue sources (new taxes) to bring the Revenue/GDP ratio back to 2004 levels (16.2%).  To summarize all of the actions contained in Scenario 3:

  • Discretionary spending is held to 2011 levels;
  • The Bush tax cuts have expired adding $133 billion to government revenues;
  • GDP grows at an astounding 5% CAGR from 2011 to 2015, 12 million new jobs are created, and tax revenues grow commensurately ($174 billion – from new jobs and economic growth);
  • The growth in Defense spending is cut in half;
  • Federal Pension growth is reduced by 25%;
  • Medicare/Medicaid growth rates are reduced by 25%;
  • Social Security growth rate is reduced by 25%;
  • New revenue sources add $112 billion to government coffers (in addition to the revenues from the expiration of the Bush tax cuts and 12 million new jobs).

You are probably shaking your head by now, as the above task list appears impossible to accomplish in the U.S.’s political environment.  The point is that, even if all of these actions would come to pass, the deficit in 2015 is still $1.1 trillion!  And the deficit I am talking about doesn’t include a) a realistic cost of the debt and b) the off balance sheet borrowing needed and deficits created by FNMA and FHLMC nor the additional pressures in the borrowing markets from the FHLB system, the FHA, and the SBA.


The simple math tells us that we are on an unsustainable path.  There appears to be no political will to even get to Scenario 1, much less all the way to Scenario 3.  And what I have ignored throughout this analysis is what will happen to the interest cost of the debt should the U.S. continue along its current irresponsible path.  Easily, the debt costs could be $300-$500 billion higher than shown.  Just add that to the deficits in the three scenarios.

In their groundbreaking book, This Time is Different: Eight Centuries of Financial Folly, Reinhart and Rogoff show that, historically, once a country’s debt exceeds 90% of its GDP, either default or a rapid inflation usually occur.  The debt/GDP ratio in the U.S. is now approaching 100%, and it is clear that the debt will continue to grow at much faster rates than the GDP.  Investors would be foolish to believe that “this time is different”!

Robert Barone, Ph.D.

March 23, 2011

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.

This writing discusses the possibility of future events and outcomes based on a limited number of circumstances.  Ancora West makes no guarantee these future events or outcomes may occur to due other future circumstances that could not be considered in preparing this writing.

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.

March 2, 2011

The Bond Bubble – Sources of Pressures on U.S. Interest Rates

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, taxes, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 7:48 PM by Robert Barone

The conventional wisdom is that, after nearly 30 years of decline, U.S. interest rates have nowhere to go but up, and rising interest rates are bad news for bondholders, especially those who hold longer term maturities.  (As rates rise, bond prices fall with the severity of the fall directly related to time to maturity.)  This blog outlines existing upward and downward pressures on bond rates and outlines emerging issues which have the potential to turn into a dollar crisis.


Upward Rate Pressures

  • The financial media believes that the U.S. economic recovery is finally taking off.  Much of the data today indicate better economic performance, from holiday sales to better news on the jobs front.  Fourth quarter GDP likely rose 3.5%, and the momentum may push first quarter growth toward 4%.  The 2% social security tax cut for wage earners will likely help spur first quarter consumer spending (but after that, spending growth isn’t impacted until the 2% is taken away).
  • The world’s economy appears to be growing, especially in the BRIC countries (Brazil, Russia, India, China) and the emerging markets.  Added demand from a recovering U.S. economy will put upward pressure on resources, especially commodities, and is likely, at least initially, to put upward pressure on rates.
  • Rates also rose in 2010’s fourth quarter with the implementation of the second phase of the Fed’s “Quantitative Easing” program (QE2).  Bernanke, himself, indicated in his August address at the Kansas City Fed’s Jackson Hole meetings that one of the purposes of QE2, including the reinvestment of the cash interest payments and mortgage paydowns back into the markets, was to make sure Fed policy didn’t become passively tighter by allowing bank reserves to shrink when such cash payments were made.  In effect, Bernanke indicated that the upcoming QE2 program was intended to keep long-term rates near their low points to “stimulate” housing and the economy.  Today, with the run-up of more than 110 basis points (bps) (1.1 percentage points) in the 10 year Treasury, we know that QE2 did not accomplish that goal.  I suspect that while some rate rise could be attributed to increasing worldwide economic activity and better prospects at home, much of that 110 bp rise was also due to widespread criticism of a QE2 policy that is simply monetizing trillions of dollars of new federal debt.  More on this below.


Downward Rate Pressures

  • U.S. Economic Growth faces headwinds:

o   While the official headline unemployment rate (U3) is 9.4%, a more comprehensive definition (U6) puts the rate closer to 17%.  And, using consistent definitions from the early 90s would put the rate closer to 22% (see  While there appears to have been better news on the labor front of late, it is hard to see significant economic growth as long as such high levels of unemployment continue.

o   To further exacerbate this, the new, GOP controlled, House of Representatives has spending restrictions as a major agenda item, which will slow economic activity by some multiple of the spending reduction.

o   There is no longer any doubt that residential real estate is entering a second dip.  Rising 10 year bond rates over the past 3 months have raised mortgage rates and made homes less affordable.  The Case-Shiller index of home prices shows a definite downward movement in prices, and Shiller himself has indicated that the next leg down could be as large as 20%.  Such a price movement will do two things: a) cause a negative “wealth effect” for continuing homeowners (this may amount to hundreds of billions of lost value), and b) it will accelerate the already rapidly rising trend in “strategic” defaults (people who can afford their mortgage payments who choose to walk away anyway).

o   There remain huge fiscal issues at the state and local government levels.  Most states are facing current budget deficits, but the poster child for kicking the can further down the road remains California.  It prefers temporary patches, hoping that things will soon return to “normal”, i.e., pre-2008.  Like the City of Chicago which sold its parking meters to Wall Street and some sovereign wealth funds for what appears to be significantly less than fair value, California is selling its state owned office buildings to raise some cash to partially patch its current deficit.  The selling price appears low relative to the lease terms, but worse, the legislature is not dealing with the structural causes of the deficit.  As a result, deficits are bound to reappear in future fiscal years.  Wonder what happens when all of the salable assets have been sold?

o   Clearly, more layoffs of state and local employees are coming.  If not layoffs, then lower wages and benefits.  In either case, this implies lower, not higher, levels of consumer spending.

o   Finally, no one has addressed the huge level of unfunded liabilities in state pension plans.  Because insolvency of the plans is not imminent, the politicians aren’t dealing with it.  New Jersey’s governor, Chris Christie, who has done more than any other governor in pushing his state toward fiscal responsibility, has said that he simply has no idea about how to deal with the magnitude of the unfunded liability.  Even if the current budget bleeding stops, it will be years of fiscal austerity and high levels of taxation to work out of these situations.

o   Food costs have gone up rapidly in the U.S. (and in the rest of the world causing worries about social unrest in some underdeveloped countries).  Gasoline prices, too, have risen rapidly in the past couple of months.  And each cent takes some billions of dollars out of consumer disposable income.  Higher food and energy prices will stunt economic growth and put downward pressure on rates.

  • The World’s economy may slow.

o   China has raised reserve requirements on their banks and put in other restrictions on real estate to try to deflate a growing real estate bubble.  Today, if China sneezes, the rest of the world catches cold (we used to say this about the U.S.).  And, if China slows, so will all of the commodity producers (Australia, Canada, Brazil, Russia …)

o   The European debt crises is about to enter its third act – Portugal (Greece was Act I, Ireland was Act II).  The debt crisis and the adoption of austerity throughout the continent will surely slow economic growth there.  Furthermore, if the opposition party in Ireland wins the March elections (currently leading by 20 points in the polls), they have vowed to fix the sputtering Irish economy by removing much of the austerity via a “debt restructuring” (shorthand for “default”).  If that occurs, it is likely that the rest of the European weaklings will follow suit.  Surely, panic would spread worldwide, the dollar would strengthen, and interest rates would fall.


Given these headwinds, it is my view that if left to strictly market forces, deflation still has the upper hand.  It may be several quarters or even years before the private sector of the U.S economy is healthy enough to grow on its own and for there to be upward pressure on interest rates generated by the domestic private sector.


The Flies in the Ointment

However, we no longer live in a world where the U.S. economy is dominant and unaffected by global events and conditions.  A huge worry involves the seemingly wrongheaded monetary and fiscal policies currently being pursued in America.  In an earlier blog, I commented on the level of debt and federal structural deficits  (see “What Happens to the Cost of U.S. Debt if Interest Rates Rise?”, at, November 29, 2010).  The table below shows the largest six federal budget items (see, total federal spending, and total federal tax revenues.


Category Spending Rate (Mill $)
Medicare/Medicaid $793,134
Social Security $701,645
Defense $692,799
Income Security $433,682
Debt Interest $202,593
Federal Pensions $198,464
Total $3,022,317
Total Federal Spending $3,490,905
Total Federal Tax Revenue $2,156,022


These top six spending categories are centered around entitlements ($2.13 trillion), defense ($.7 trillion), and debt interest ($.2 trillion).  The entitlements have been “untouchable” and Congress has kicked the can down the road on these issues for years.  Currently, they seem to be ignoring the recommendations of Obama’s own Debt Commission.  These six represent 86.6% of total federal spending, and 140.2% of total federal tax revenue.  Even if all other discretionary spending were eliminated (about a 0% chance!), the structural deficit is $866 billion.  Thus, the GOP proposals to ax $100 billion in spending (likely to be compromised downward significantly) barely makes a dent in the structural deficit.  Given the tax “compromise” reached on Capitol Hill during the lame duck session of the 111th Congress, it appears that the structural deficit is growing, not shrinking.  The question its, how long will the world be willing to finance these trillion plus dollar deficits at current interest rates?  Most likely answer – not much longer unless Congress convinces investors that they are serious about spending and deficit reduction, and they can only do that by addressing the heretofore “untouchable” spending categories and by taking the Obama Debt Commission recommendations seriously.

The Fed, too, despite warnings from most of the world’s major central bankers and respected economic historians, has embarked upon monetary policies that have failed every time they have been tried.  I am referring to the explosion of the Fed’s balance sheet which has led the huge levels of bank reserves and a monetization of almost all new Treasury debt.  If you haven’t already viewed the You Tube rendition of “Quantitive Easing Explained” (, you should do so.

The Fed is not a true government agency.  It is owned by the banking system and the Wall Street banks own the largest share. (So, it isn’t any wonder why the Fed was so anxious to save those institutions in ‘08 and ’09.)  At the end of 2010, The Fed had $54 billion in capital.  They recently announce net income of about $80 billion, of which $78 billion was returned to the Treasury. Their capital represents less than 2% of their assets (now approaching $3 trillion).  In the U.S. banking system, once capital reaches 2% of assets, the Fed and the other regulatory agencies close the institution!

Given $1.25 trillion of mortgaged backed securities purchases in ’08 and’09, and the QE2 operations in the 4-7 year treasury maturity range, it appears that we can safely assume the Fed’s portfolio has at least a 5 year duration.  Given that it would be nearly impossible to hedge a $3 trillion portfolio (market size), what would happen to the Fed’s finances if rates rose 100 basis points in the 5 year area of the yield curve?  If the Fed had to “mark to market”, using the duration rule of thumb that for every 100 bp rise in rates results in a percentage fall in portfolio value equal to the duration, using $3 trillion as the asset size, the value of the portfolio would fall by $150 billion.  Even if the Fed kept the entire $80 billion in profits, when added to its capital (about $51 billion at the end of ’09), it would still show negative equity.

Today, the Fed is not subject to public scrutiny and most likely doesn’t mark its portfolio to market.  Enter Ron Paul.  Paul is the new Chairman of the House Financial Securities subcommittee that oversees the Fed and monetary policy.  It is no secret that he believes the Fed itself is unconstitutional.  Herein lies the danger.  Rates rose 110 bps from early November through early January in the 5 year segment of the curve, so significant damage may already have been done to the Fed’s capital.  If the public audit advocated by Mr. Paul occurs and it shows that, on a mark to market basis, the Fed is insolvent, there may be a significant shift in attitude toward the dollar in the rest of the world, causing rates to rise with significant implications for the dollar as the world’s reserve currency, with negative implications for the domestic economy.



The probabilities are that interest rates will rise, not because of U.S economic expansion, but because of the disastrous fiscal and monetary policies that have been and are currently being pursued.  Higher interest rates will occur as investors lose confidence in America and Treasury securities as a stable investment.  The resulting rising interest rates will only make economic growth more difficult to achieve.  History has shown that added debt and money printing have never reversed the effects of a debt bubble.  Apparently, those in power in Congress and at the Fed either haven’t studied history, or actually believe that “this time is different”.


Robert Barone, Ph.D.

January 11, 2011

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.


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.