July 22, 2013

Muni Investors Beware: Detroit Is Tip of Iceberg

Posted in Bankruptcy, Economy, Uncategorized tagged , at 9:43 PM by Robert Barone

When Detroit filed for bankruptcy protection last week, no one was shocked. It felt like it was inevitable. Now one has to ask whether analyst Meredith Whitney was correct but just early in her call in late 2010 on municipal defaults?
For Detroit, the real culprits in the bankruptcy were skyrocketing pension and health care costs, even though mismanagement and reduced state and federal aid also played a role.

Those same issues are at the root of most of the fiscal challenges faced by state and local governments. As I write, there is controversy over the legality of Detroit’s bankruptcy filing because state law prohibits such a filing if it contemplates a reduction in pension benefits.

That said, there is no doubt that Detroit, with more than $18 billion of debt, cannot pay its creditors. Of that debt, the city owes $3.5 billion to its pension plans. The answers that Detroit will deliver to the marketplace regarding the distribution of its assets will be based on forthcoming judicial decisions that will determine which group of creditors skates and which ones get savaged. Detroit may well become the model for how the courts treat the creditors of future municipal bankruptcies. The credit markets are certain to take note, and there are certain to be reactions and price adjustments as a result.

Detroit may be just the beginning of the spate of municipal bankruptcies that Meredith Whitney forecast more than two and a half years ago. In the last month, studies have shown that municipal fiscal problems are much worse than previously believed. Actuarial estimates of unfunded liabilities have risen, not only because governments have failed to properly fund the plans under the old guidelines, but because the guidelines have changed.

A couple of years ago, Morningstar estimated the funding status of each state’s pension program. The 2011 results ranged from 43.4% (Illinois) to 99.8% (Wisconsin). That study showed that only 30% of state programs were at least 80% funded. But now, those estimates have all changed as, in late June, Moody’s introduced new measurement methodologies. Not surprisingly, Illinois was still at the bottom. What is significant is that Moody’s found that the median state must now devote 45% of its annual revenue just to fund and catch up with its existing pension obligations.

At the same time that Moody’s concluded that retirement costs have been vastly underreported, the Government Accounting Standards Board (GASB) was introducing new accounting rules for municipalities to increase transparency and reduce that underreporting. Significantly, last September, a report by the U.S. Senate’s Joint Economic Committee (JEC) estimated that underfunding to be as high as $3.5 trillion.

Artificially low interest rates have a lot to do with pension underfunding. If actual pension plan investment returns are lower than the actuarial return assumptions, there won’t be sufficient assets to pay the retirees. In July, Moody’s reduced the return assumptions for CALPERS from 7.5% to 5.5%, causing the funding status of CALPERS to fall from 82% to 64%.
As you can imagine, the new studies and reporting rules are playing havoc with the interest rates that municipalities must pay. Much of the recent rise in rates in the muni markets have been blamed on Federal Reserve Chairman Ben Bernanke’s “tapering” pronouncements, which had a huge impact on the Treasury yield curve. But there can be little doubt that much of the recent increase in Muni-Treasury spreads was the result of the Moody’s study and the new GASB rules.

Although a financial meltdown was avoided in 2009, the crisis clearly isn’t over. State and local budget issues are going to have a significant impact on economic policy going forward. Their recognition may even delay the start of the Fed’s “tapering” program.

Muni investors, be forewarned: There is volatility ahead in the marketplace. As it turns out, the much maligned pronouncements on the health of state and local government finances by Meredith Whitney in late 2010 were actually prescient. Even the JEC agrees with her conclusions, as they reported that “some state pension funds will run out of assets in as little as five years.”

Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Barone or the professionals at UVA (Joshua Barone, Andrea Knapp, Matt Marcewicz and Marvin Grulli) are available to discuss client investment needs.

Call them at 775-284-7778.

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

July 27, 2012

New Soap Opera: The Comedy of Euros

Posted in Banking, Bankruptcy, Economy, Europe, Finance, greece, Spain tagged , , , , , , , , , , , at 8:49 PM by Robert Barone

The term “European Theater” was first coined during World War II. Today in the financial markets, the term has come to symbolize an ongoing soap opera, where the audience is continually held in suspense as the bad actors (the politicians) promise actions and solutions to current crises, which have been created by their prior actions. Each time solutions are proposed, the audience breathes a sigh of relief (i.e., relief rally in the equity markets) only to be disappointed when they find out that the solutions won’t work or can’t be implemented.
As a result, the crisis and suspense continues, keeping the audience’s total attention (even while dinner on the stove at home is burning). Meanwhile, a new issue or crisis appears, it seems, on a daily basis.

Likely New Episodes

Daily we watch yields on Spanish and Italian debt move ever higher, now in zones where other countries have cried “uncle” and asked for bailout help. At the same time, the credit default swaps on Spanish and Italian debt have risen to record levels.
New Episode: Will the capital markets force a Spanish bailout by locking Spain out of the debt markets?
  • Spanish bank recapitalization: We have recently learned that the European Central Bank is willing to impose losses on the shareholders and junior bondholders of some of the Spanish savings banks. (When they bailed out Ireland, all bondholders were saved.) The draft of the document meant to give Spain’s banks 100 billion euros has this provision, but the periphery’s finance ministers are opposing it.
  • New Episode: Is 100 billion euros enough for Spain’s banks? The general rule of thumb appears to be that the ultimate amount needed is usually higher by a factor of at least two.
  • Spain’s regional provinces are now coming hat in hand for bailouts of their own. And those regional governments must refinance more than 35 billion euros in the near future.
  • New Episode: Are there enough resources in the European Financial Stability Facility (EFSF), the temporary bailout fund, and the European Stability Mechanism (ESM), the proposed permanent bailout fund, to bail out Spain and its regions? What about Italy?
  • The problematic link between Spain’s sovereign and its bank’s balance sheets has not been severed, as the audience was led to believe during the “Summit” episode.
  • New Episode: Will the ESM require the Spanish government to guarantee the bank capital? If so, will market reaction drive borrowing rates for Spain even higher, or lock them out of the capital markets altogether?
  • Greece now appears unable to produce an austerity plan acceptable to the Troika (EU Commission, ECB and International Monetary Fund). Greece has a 3.8 billion euro bond payment due in August. And the ECB just announced that it will no longer accept Greek government bonds as collateral for loans, thus locking Greece out of ECB borrowing.
  • New Episode: Will the Troika impose its own plan, or will it withhold bailout funding? Without access to the ECB, will Greece default again? And, will this lead to Greece’s immediate and disorderly exit from the monetary union?
  • Each monetary union country is required to put capital into the ESM. Italy will be required to pony up 20% of the ESM capital.
  • New Episode: What sense does it make for Italy to borrow at 7% when the ESM would offer a rate of return that is closer to 3%?
  • The ECB holds tons of Greek debt on their balance sheet at par (i.e., 100% of face value) (Portuguese, Spanish and Italian debt, too). If (when) Greece leaves the monetary union, they will renounce this debt, causing the ECB to need more capital to cover this loss.
  • New Episode: Will the remaining members be able to contribute even more capital? That will put additional pressure on the weaklings — again, Portugal, Spain and Italy will have to go to the capital markets to borrow at extremely high rates to meet their capital contribution requirements.
  • Will the ESM be allowed to purchase sovereign debt in the secondary market as promised in the “Summit” episode? This is meant to support Spain and lower the interest rate it has to pay to borrow. The Dutch, Finns and probably the Germans may say ‘Nein.’

Politicians in a Box

The bad actors in this soap opera, the politicians, know that if they attempt to do the right thing, they will be voted out of office by populations who value their entitlements more than anything else. Look at Greece and the near victory by the Syriza party (anti-austerity) in the last set of elections. And now, we see riots in Spain.
These bad actors have proposed so-called “fixes” that merely kick the can down the road, from bailouts (Greece, Portugal, Spain, Ireland) to a banking union in order to avoid addressing the core issues. The fixes enacted calm the audience for shorter and shorter periods. For example, the deposit flight from Spain’s banks now continues unabated, despite the capital plan for Spanish banks announced during the recent “Summit”.
This soap opera will continue to play out because liquidity does not produce solvency. The ECB and politicians can throw all of the money they can create at the problem, but, until debt restructuring occurs (i.e., dealing with the debt), the soap opera will continue. Debt restructuring means that some lenders won’t get repaid at all and others will have to take a haircut. Inevitably, some financial institutions (i.e., lenders) will fail. The game to keep them alive cannot go on forever.
Eventually, the markets will tire of the soap opera, lose confidence (as they appear to be doing), and close the capital market to these players. It would be much better to have an orderly restructuring than a disorderly one imposed by a panicky market. But, so far, no European leader has stepped up with such a plan (i.e., a plan to exit the weaklings from the monetary union).
Without such a plan, the stronger European nations (like Germany, Finland and The Netherlands) will soon have had enough and will leave the monetary union on their own, most likely, to go back to their old currencies.

The Final Episode?

It appears that many of the New Episodes described above will soon play out as the situation appears to be in endgame mode. Some sort of resolution acceptable to the capital markets is being demanded by those very markets. The roller coaster is at full speed and it appears the tracks are about to end.
What new games can the European politicians play to buy more time? Is there anything they can do, short of having a plan to exit the southern weaklings that can now save the euro? What can they do now to even buy more time?
Unfortunately, it appears that a market-imposed resolution, which means market panic and financial chaos for Europe with grave worldwide implications, is rapidly approaching.
Robert Barone (Ph.D., Economics, Georgetown University) is a Principal of Universal Value
Advisors (UVA), Reno, NV, a Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee.
Information cited has been compiled from various sources which UVA believes to be accurate and credible but makes no guarantee as to its accuracy. A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521. Ph: (775) 284-7778.

July 23, 2012

Time for us to make enlightened policies

Posted in Armageddon, Bankruptcy, debt, Economic Growth, Economy, Europe, Finance, Foreign, recession, Spain, Uncategorized, Unemployment tagged , , , , , , , , , , , , , , at 8:10 PM by Robert Barone

On July 6, the country received another disappointing jobs report. For the month, the establishment survey indicated jobs grew by 80,000; for the quarter, such growth averaged 75,000, about one-third of the 26,000 monthly average for the first quarter. Clearly, the worldwide slowdown in Europe, China, India, Brazil, etc. is having an impact here.
Deleveraging and slow growth
Let’s be clear. We are in the midst of a worldwide debt deleveraging (i.e., consumers are paying down debt instead of consuming). So, absent another round of sweeping innovation anytime soon (e.g. the Internet), in the natural course of things, economic growth is going to be painfully hard to come by. As a result, it is doubly important that economic policies promote the growth that is available.
Policies are key
Clearly, monetary policy has led with pedal-to-the-metal and unconventional therapies. On the fiscal side, the Keynesian remedies (huge deficits) have been applied. Together, however, such policies haven’t worked well enough to establish a solid economic foundation, as the recent data prove. For those who study economic history, it is clear that deficit spending alone doesn’t work if government is simply stepping into the role of debtor in place of households, as total debt owed has continued to rise.The scary part is the interest cost of the rapidly accumulating debt when interest rates rise. For those who don’t believe me, just look at Greece, Portugal, Ireland, Spain, Cyprus and Italy in today’s world. Rising interest rates (near 7 percent for the 10-year government issue) make it impossible for states to survive without bankruptcy, a bailout or financial ruin.

Policy failures
In times like today, when deleveraging is slowing economic activity, government should adopt policies that promote the private sector, because it is the private sector, not government, that is the engine of economic growth. Unfortunately, the following federal policies currently are negatively impacting the private sector:

• Taxes:
Uncertainty surrounding tax policy causes the private sector to take less risk, which lowers investment and job creation. For the last several years, Congress has signaled that significant tax increases are just ahead (currently referred to as the “fiscal cliff” due to occur on Jan. 1, 2013), only to push them back at the last minute for another short period. Nevertheless, the uncertainty persists, and economic hesitancy pervades.
• Corporate cash: America’s multinational corporations are flush with cash, and while the politicians chide them for not putting it to work at home, it is their very policies that are to blame. Sixty percent of that corporate stash is held offshore, and it won’t come home because, if it does, 35 percent of it will disappear in taxation. Policies that encourage the return of that cash and its investment at home would spur job creation and economic growth.

• Corporate tax rate:
Having one of the highest corporate tax rates in the world discourages investment at home and makes investment elsewhere more fruitful. Corporate taxes are paid by consumers via higher prices.

• Energy policy: 
Cheap energy is the No. 1 requirement for robust economic growth. Current policies appear to be designed to raise energy prices to spur the development of government selected industries. The result is great waste (e.g. Solyndra) and significantly reduced economic growth.

• Taxmageddon:
The U.S. has a joke for a tax code. Talk about a Rube Goldberg! High, and threatened increased taxes on capital and investment just discourage economic growth. The tax code needs to be thrown out in favor of a broad-based, simple, and fair system.

• The financial system:
Scandal after scandal show how pervasive lawlessness is among the world’s “too big to fail” institutions. So far, no U.S. banker has gone to jail, nor trial, nor has anyone been indicted. Regulatory policy encourages moral hazard (excessive risk taking backed by implicit taxpayer bailouts) and discourages lending to the private sector. All of this reduces economic growth.

Investing in a deleveraging world 

For investors, the markets will continue to show volatility, with market up-drafts occurring when there is a perception of a policy change. For example, the recent hope generated by the late June “European Summit” caused a large rally in the equity markets, as will the hoped for move by the Fed toward more stimulus when and if it occurs. Down-drafts occur when poor economic data cross the tape.
Implications for Nevada
The policy prescription doesn’t end at the federal level. It is also relevant at the state and even local levels. Nevada has been challenged to attract new businesses now that gaming is widespread.The tax system in Nevada could be such a strength, especially when compared to what is going on in California. CNBC ranks Nevada 18 in “Business Friendliness,” but 30 in “Cost of Business.” Two things are critical: 1) The Legislature must stop threatening new business taxation every two years when it meets. The uncertainty this breeds prevents businesses from relocating here.

2) Policymakers must identify those businesses that would benefit from such a philosophy. There might be several categories that would so benefit, but one immediately comes to mind (maybe because I have worked in it all my life) — financial and intangible asset firms. This category includes managers of investments, hedge funds, trusts, patents and trademarks, insurance companies and services, banking and subsidiary finance companies. While these firms are usually small, their salary levels generally are high. A University of Nevada, Reno study indicates that salaries in these firms average $88,000, twice the state’s average.

Jon Ralston, a political columnist and host of a daily political commentary show seen locally, recently criticized the Apple move, saying that they will grow “astronomical profits” but that the state won’t benefit much because the number of jobs is small. But its move, along with those of Microsoft (which now employs several hundred), Intuit (also a large employer), Oracle and others, appears to recognize that Nevada, indeed, has something to offer now. If the state attracts enough of these companies, there will be plenty of tax revenue generated. The state should play to its current strengths and make sure its policies protect and nurture those strengths.

Robert Barone (Ph.D., Economics, Georgetown University) is a Principal of Universal Value
Advisors (UVA), Reno, NV, a Registered Investment Advisor. Dr. Barone is a former Director of the Federal Home Loan Bank of San Francisco, and is currently a Director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Company where he chairs the Investment Committee.
Information cited has been compiled from various sources which UVA believes to be accurate and credible but makes no guarantee as to its accuracy. A more detailed description of the company, its management and practices is contained in its “Firm Brochure” (Form ADV, Part 2A) which may be obtained by contacting UVA at: 9222 Prototype Dr., Reno, NV 89521.
Ph: (775) 284-7778.

March 13, 2012

Greece Default Declaration Stabilizes CDS Markets

Posted in Banking, Bankruptcy, Big Banks, Bonds, credit default swap, debt, derivatives, Economy, Europe, Finance, Foreign, government, International Swaps and Derivatives, investment advisor, investment banking, investments, ISDA, Nevada, sovereign debt tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 3:10 PM by Robert Barone

NEW YORK (TheStreet) — The determination by the International Swaps and Derivatives Association that Greece officially defaulted on its debt when it invoked its recent legislatively passed “Collective Action Clause” to force investors to take losses is actually good news for the other so-called troubled European sovereigns like Portugal, Spain, Italy and Ireland.

The ISDA determination assures private sector investors that if they buy the so-called troubled foreign sovereign bonds, hedge them with credit default swaps and a Greek style default occurs, they will be paid at or near par value.

If the CDS payout had not been triggered, the private sector investors would view the purchase of such sovereign debt as having significantly more risk, and that would result in a much higher interest cost of that sovereign debt to the issuing countries. In addition, it would throw the whole CDS concept into confusion, potentially impacting even the higher quality sovereigns like, Germany, the U.K., Canada, Australia, and even the U.S.

According to the ISDA, about $3.16 billion of Greek debt is covered by the CDS (4,323 swap contracts). On March 19, an auction will be held which will set the “recovery” value on the Greek bonds. The difference between that recovery value and par will be the payout of the CDS.

For example, if the auction results in a recovery value of 20%, then the CDS payment will be 80%, or about $2.5 billion. This is not a large amount in the context of world markets, and it would be a surprise if any viable CDS issuer will be greatly impacted, although it does appear that Austria’s KA Finanz, the “bad” bank that was created in 2008 when Kommunalkredit Austria AG was nationalized and given all of the “distressed” assets, will be stuck with CDS losses in excess of $550 billion which will require the Austrian government to step up with a significant capital injection.

The “non-eventness” of the CDS payouts is a result of the fact that there has been a long lead time for the issuers to adjust their risk portfolios to deal with the likelihood of a Greek default. Over the past year, the amount of Greek debt covered by the CDS has halved. Compare this to the Lehman default of $5.2 billion where there was almost no lead time between the emergence of the Lehman issue and its bankruptcy filing.

It was the lack of such a lead time that caught CDS issuers, like American International Group(AIG), with no time to adjust their risk portfolios, and required government intervention to prevent a domino default effect. With Greece, no such domino effect is expected although there is always the possibility (albeit low) of a surprise. We will know that soon after the March 19 auction when settlement must occur.

This is not to say that the world is now safe from financial contagion, as, in the context of world markets, Greece’s default is an expected and well prepared for event. The real worry should be if Spain, with a debt of about $1 trillion and/or Italy with a debt of about $2 trillion default.

In addition, the CDS market is not transparent, and no one knows where the CDS obligations lie. While a Portuguese and/or Irish default would have about the same individual impact as that of Greece (economies slightly smaller and not as indebted), we should worry that a rolling set of smaller defaults would eventually cause a major CDS insurer to fail due to the cumulative impact of the several defaults.

After all, it is likely that the CDS insurers who dabbled in Greek CDS, are also involved in CDS insurance of the other high debt European countries. And, if a significant CDS insurer defaults (e.g., an institution similar in size and stature to AIG in 2009), we could, indeed, have contagion.

February 8, 2012

Avoiding The Austerity Death Spiral

Posted in bail out, Banking, Bankruptcy, Ben Bernanke, Big Banks, Economy, Federal Reserve, Finance, government, investment advisor, investment banking, investments, Senate Banking Committee, taxes, Unemployment tagged , , , , , , , , , , , , , , , , , at 8:19 PM by Robert Barone

Over the past four years, the slow creep of government into the private sector has become a gallop.  Unfortunately, a high level of structural unemployment is the unintended consequence of social engineering, picking winners, over-taxing and over-regulating every aspect of the business process.

The conventional wisdom is that a balanced budget will be a magic solution to the sluggish economy and the employment situation, but if it is done with just austerity and tax hikes but without relief from an overbearing set of governments on the business sector, what we will get is an “austerity death spiral.”  Federal Reserve Chairman Ben Bernanke said as much to the Senate Banking Committee on Tuesday.

Intervention is the Norm

We now live in a world where government intervention in the business process is expected.  When any sort of economic issue arises, government is now expected to fix it.

  • Financial institutions in trouble?  No problem – the taxpayers, via the government are expected to bail them out!
  • Domestic auto companies historically made awful decisions around retiree medical and pension issues and, as a result, can’t compete and are staggering toward bankruptcy.  Again, no problem.  Ask the government to shore them up, even if it means trampling on bondholder contract rights like in the General Motors case.
  • Some homeowners can’t, and others don’t want to make their mortgage payments.  That’s easy.  Ask the government to intervene, stop or slow the foreclosure process, and, perhaps, even require the lenders to reduce principal balances! This deal is in the works now with the government prepared to offer big lenders like Citigroup, Bank of America, Wells Fargo and JPMorgan Chase money to offset losses on short sales.

The markets now expect intervention.  When the government intervenes in an economic issue, the markets rise.  If the government doesn’t, it falls precipitously. On September 29, 2008, the Dow Jones Industrial Average (DJIA) fell 778 points when Congress failed to pass the initial TARP legislation; From the time QE1 began in November, 2008 until it ended in March, 2010, the DJIA rose 28% or  2,378 points.

QE2 elicited a similar market response, 1,199 points (10.7%) from November, 2010 to June, 2011, even more if you go back to August when Bernanke articulated the strategy in Jackson Hole, Wyo.

In late November, 2011, on the day when the Fed gave unlimited swap lines to the European Central Bank (ECB), the DJIA rose 490 points; it rose 337 points just before Christmas when the ECB opened its lending facility to 540+ European banks.

I suspect we will see similar market reaction if the Fed goes through with its hinted at QE3.

Unintended Consequences

Unfortunately, nearly every government intervention carries with it unintended consequences, and, if such interventions interfere with the free market processes, they have long-term negative implications on economic growth. Recent examples in the U.S. include the Keystone Pipeline and the National Labor Relations Board’s attempt to block Boeing from opening a plant in South Carolina.

Nearly every economic malady that exists today is directly traceable to the unintended consequences of government interference in the economic process or via its attempt at social engineering:

  • Sub-prime and housing crisis:  It is widely recognized that this was caused by three concurrent factors: 1) an extended period of low interest rates engineered by Greenspan’s and Bernanke’s Fed; 2) the social engineering goals of the Community Reinvestment Act (CRA); 3) the political and monetary aspirations of Fannie Mae and Freddie Mac executives and sponsors;
  • Social Security and Medicare unfunded liabilities: As the baby boomer generation reaches retirement age, unfunded liabilities will increase by more than $3.5 trillion each year.  To show how absurd this is, the payroll tax reduction, in effect since January 1, 2011, and currently an issue in the Congress, simply puts the Social Security system ever deeper into debt that cannot be repaid without hugely inflated dollars;
  • Unfunded pension liabilities:  While some private sector corporations have unfunded pension liability issues, the bulk of the problem lies at the local, state and federal levels;
  • High structural unemployment: As alluded to earlier, impediments to business from all levels of government, but especially from the federal government, are a huge issue.  Recent legislation, including Sarbanes-Oxley, Dodd-Frank, and Obamacare, is crushing small business.  In addition, business must be confident that the future environment will be friendly.  So, the notion of a “temporary” tax reduction doesn’t reduce business uncertainty, as businesses invest for the long-term.

This last item is particularly poignant.  In a three part op-ed series published by Bloomberg in mid-January, Carl Pope, former chairman of the Sierra Club, bemoans America’s loss of manufacturing jobs.  “It’s not the wages, stupid!”, he says.  If wages were key, how is it that Germany, where wages are higher and unions stronger, enjoys a growing manufacturing base?

For the auto industry, which in 1998 had over 70% of the U.S. domestic auto market but now has 44%, it was the health care and pension costs of its retirees that caused the industry’s economic crisis, he says.  Since the turn of the century, America’s manufacturing base has shrunk by one-third, not because of wages, which are similar to wages paid in the rest of the world, but the lack of support or even outright hostility on the part of government.  (When even the Sierra Club recognizes that government is choking free enterprise, the issue must be terribly obvious!)