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 adviser, advisor, ancora, ancora west, ancora west advisors, bank balance sheet, Banking, Ben Bernanke, Bob Barone, bonuses, confidence, consumer debt, consumption, Debt, devaluing US dollar, economic policy, economics, fair value, FAS 157, FDIC, Federal Reserve, Finance, financial adviser, foreclosure, Home Prices, hostile attitued of FDIC, Inflation/Deflation, Josh Barone, Joshua Barone, mark to market, Matt Marcewicz, nevada, Obama, Recession, reno, retail sales, Robert Barone, shelia bair, small business, TARP, taxpayer, too big to fail, U.S. Treasury, unemployment 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 www.shadowstats.com).  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 Minyanville.com, November 29, 2010).  The table below shows the largest six federal budget items (see www.USdebtclock.org), total federal spending, and total federal tax revenues.

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 111^th 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” (www.youtube.com/watch?v=PTUY16Ck5-k), 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.

Conclusion

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

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February 15, 2011

Myth of the Wealthy Millionaire

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 adviser, advisor, ancora, ancora west, ancora west advisors, bank balance sheet, Banking, Ben Bernanke, Bob Barone, bonuses, confidence, consumer debt, consumption, Debt, devaluing US dollar, economic policy, economics, fair value, FAS 157, FDIC, Federal Reserve, Finance, financial adviser, foreclosure, Home Prices, hostile attitued of FDIC, Inflation/Deflation, Josh Barone, Joshua Barone, mark to market, Matt Marcewicz, nevada, Obama, Recession, reno, retail sales, Robert Barone, shelia bair, small business, TARP, taxpayer, too big to fail, U.S. Treasury, unemployment at 1:21 AM by Robert Barone

The last decade (2000-2010) has been one of the most tumultuous periods in the history of financial markets.  We had the technology bust, followed by the housing bust, followed by the stock market bust, followed by the commodities bust.  Many investors lost a significant portion of their savings in one or more of these debacles.

As our politicians debate measures to shrink our budget deficits, the rich usually become a bone of contention.  Folks on the right side of the political spectrum usually push for tax cuts, while those on the left typically call for higher taxes on the wealthy.   But what is wealthy?  Are the rich living lavish lifestyles while the poor suffer?

One common definition of wealth is the term millionaire.  The term is often tossed around when money is discussed.  Further, game shows abound with titles like “Who Wants to be a Millionaire”, “The Million Dollar Money Drop” and top selling books have titles like “The Millionaire Next Door”.   Clearly, amassing a million dollars is a common measure of success.  Let’s take a look at the income a millionaire would have at her/his disposal under various asset allocations.

To keep things simple, we have chosen a simple 50/50 stock/bond split, using low cost Vanguard mutual funds (VHGEX and VBTIX) as the most basic allocation.  We have also used recommended allocations/mutual funds from Morningstar.

The approximate current yield of each allocation is as follows:

The math is easy from here.  On a million dollar, conservative portfolio, an investor would receive a pre-tax income of roughly $28,500.  An “aggressive” investor would receive a measly $14,500 in income.  After taxes, a millionaire living off of the income of her/his portfolio, is receiving poverty levels of income.  And this doesn’t take into account advisor fees, which may actually leave the investor with negative income as shown in the last two columns.

Now, a couple of caveats.  First, it is said that an investor can often count on capital gains to add “income” to a portfolio.  This may have been true in certain periods in the past, and it may be true again in the future, but it wasn’t true over the past decade.  Whether you use 12/31/1999 to 12/31/2009, or 12/31/2000 to 12/31/2010, S&P 500 returns were negative (-16.1% for the former, and -7.7% for the latter).  So, an investor cannot count on capital gains.  In fact, to protect the principal, lower risk assets must be chosen, and this almost always means relatively low yields.  Secondly, a millionaire can consume principal to supplement the income from dividends and interest.  This is almost certainly the case today, as negligible rates, held down by the Fed, penalize those living on accumulated assets to the benefit of the financial sector.  So, in a sense, these “millionaires” are already being taxed to subsidize Wall Street.  Of course, any principal consumed has a large, negative impact on future income.  Using the 2.85% annual yield as a base, the table below shows how many years before the money runs out at various levels of consumption both with and without an advisory fee.

For someone aged 65, just retiring with $1 million in assets and with a life expectancy of 83 years, the table shows that, because 50% of these folks are expected to live beyond 83 years, more than half will run out of money if they take as much as $75,000 per year.  And, a significant percentage would run out before the end of their lives at $60,000. As is evident, most of these so called “wealthy” are clearly depending on social security and this places such folks solidly in the middle of America’s dwindling middle class, not at the upper end.  Thirdly, this assumes that we don’t suffer yet another burst bubble where even high quality assets get decimated.  In this case, the number of years to a $0 balance is even shorter.

It is sad truth of today’s world that many Americans find it difficult just to make ends meet.  Saving significant sums of money to invest is even harder.   For those lucky few that have been able to either save or inherit a million dollars, it would seem that security has been assured.  Unfortunately, this is not the case.  Today’s low interest rates are destroying the incomes of people living off of past savings (never mind what they are doing to underfunded pension plans!).   For the small percentage lucky enough to retain a million dollars in assets, the reality is not as bright as it would seem.

Let’s hope that a tax assault doesn’t  further dismantle the American Dream.

Matt Marcewicz

Robert Barone, Ph.D.

February 10, 2010

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February 5, 2011

Fool’s Gold 4: Death of the Empire

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 adviser, advisor, ancora, ancora west, ancora west advisors, bank balance sheet, Banking, Ben Bernanke, Bob Barone, bonuses, confidence, consumer debt, consumption, Debt, devaluing US dollar, economic policy, economics, fair value, FAS 157, FDIC, Federal Reserve, Finance, financial adviser, foreclosure, Home Prices, hostile attitued of FDIC, Inflation/Deflation, Josh Barone, Joshua Barone, mark to market, Matt Marcewicz, nevada, Obama, Recession, reno, retail sales, Robert Barone, shelia bair, small business, TARP, taxpayer, too big to fail, U.S. Treasury, unemployment at 12:43 AM by Robert Barone

In the last two months, there has been a lot of hoopla in the media over municipal bonds.  If you have followed the Fool’s Gold series of articles that we published beginning in January, 2010, then the recent turmoil is not news to you (see www.ancorawest.wordpress.com, Fool’s Gold, 1/28/10, Fool’s Gold 2: Los Angeles, 4/22/10, Will Build America Bonds Save the States from Default, 6/4/10, and Fool’s Gold 3: The Empire Strikes Deals, 10/20/10).  On a recent 60 Minutes show, Meredith Whitney, the analyst famed for her calls on the impending implosion of the banking sector in 2008, predicted that the Municipal Bond Market could see 50 to 100 defaults amounting to more than $100 billion this year.   Needless to say, the municipal market has been reeling ever since.  In fact municipal mutual funds have seen more than $25 billion in outflows since Whitney’s TV appearance, according to the Investment Company Institute.  For her  prediction to have a chance of becoming reality, it appears to us that a large state would have to declare bankruptcy.  The most logical candidate for this would be California.

When we wrote the first Fool’s Gold article in January, 2010, California’s Long Term debt was about $59 billion.  Today, according to State Treasurer Bill Lockyer’s website, that long term debt is now $62.9 billion, about  7% higher.  But, that is only part of the story, as short term debt rose 30.5% over its 2009 level ($19.9 billion) to $25.9 billion.  Thus, total debt for California is $88.8 billion.   Furthermore, California currently faces a structural deficit of $25.4 billion, which newly elected Governor Jerry Brown proposes to close with $12.5 billion in spending cuts, and the rest ($12.9 billion) in tax increases. On January 20^th, California declared another fiscal emergency, as Jerry Brown’s budget hit snags from t special interests.

With this budget process looking like a repeat of last year’s when the budget deadline was missed by more than 100 days, it looks likes California will have to issues IOUs again.  This explains the strong language from State Treasurer Bill Lockyer in a recent Wall Street Journal article.  “We’ve never defaulted, not once in our entire history, including the Great Depression,”  he wrote and then goes on to affirm that making the debt service payment on the State bonds is the Treasurer’s second-highest priority, after debt service on school bonds.

The same day Governor Brown, announced his budget, the Illinois legislature, in a secret closed door session, raised its state income tax to 5% from 3% to plug its budget short fall.  Four days later Standards & Poor’s announced that there could be a surge in downgrades of bonds issued by state and local governments.  “We believe that continued revenue decreases for state and local government may increase fiscal strain on budgets, and monitoring of liquidity will be especially important in 2011,” said S&P’s credit analyst Gabriel Petek.  Mr. Petek could also be referring to Congress’s decision not to renew the Build America Bond (BABs) program that traders and analysts believed would save many states and municipalities when it was first introduced.  (See Will Build America Bonds Save the States from Default, 6/2/10)

With the ending of the back door BABs bailout of the States, it’s no wonder that there have been rumblings within Congress over legislation that will allow a state to file bankruptcy.  A recent New York Times article entitled State Bankruptcy Option is Sought (January 21, 2011) states, “Policy makers are working behind the scenes to come up with a way to let states declare bankruptcy and get out from under crushing debts, including the pensions they have promised to retired public workers.”  While there is no draft legislation at the moment for fear of a constituent backlash and/or a destabilizing impact on the municipal market, in a recent meeting on Capitol Hill, Senator John Cornyn (R TX) broached the subject of the impact of such bankruptcies with Federal Reserve Chairman, Ben Bernanke.

Bankruptcy could be a the best option for a state like California, as it could permit it to alter its contractual promises to its current pensioners, and break current union contracts.  David A. Skeel, a law professor at the University of Pennsylvania, said in an article in The Weekly Standard (“Give States a Way to Go Bankrupt“), that it was possible to envision how bankruptcy for states might work by looking at the existing law for local governments.  Called Chapter 9, it gives distressed municipalities a period of debt-collection relief which they can use to restructure their obligations with the help of a bankruptcy judge. Unfunded pensions would become unsecured debts in municipal bankruptcy and may be reduced. However the biggest surprise may await the holders of a state’s general obligation bonds.  Through widely considered the strongest credit of any government, they can be treated as unsecured credits, subject to reduction, under Chapter 9.  While this is one way Congress could go, another would be modeled on the Municipal Assistance Corporation, which dealt with New York City in 1975.  That entity acted as an oversight agency in the restructuring of New York City’s debt.

In our opinion, in California’s case, there are really only two options: the state could go bankrupt, or seek a bailout from the Federal government, a move that will be resisted by House GOP members.  In bankruptcy, the losers are the bondholders, a group that has, so far in this economic crisis, escaped nearly unscathed (except in the Chrysler bailout), while a general bailout falls on all of the taxpayers and would likely be financed with yet more federal debt. While bankruptcy would allow the state to fully fund public services like education, police and firefighters, and health care, it could cost the state more in the long-run as new investors, sensitive to the fact that their preferred status had been removed, would require higher rates of return on newly issued debt.

Both of these alternatives will result in significant pain in the municipal bond market.  Bankruptcy, where bondholders take a discount, would be more disruptive to the markets than a general federal bailout, and if one state uses it, it is likely that others would follow.  But, in our view, bankruptcy would be preferable, as it establishes the fact to investors that there is risk in these investments and spells out to politicians that the ‘free lunch” of taxpayer bailouts has ended.

Robert Barone, Ph.D.

Joshua Barone

January 27, 2011

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December 16, 2010

2011 – Could It Be A Repeat of 2010?

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 adviser, advisor, ancora, ancora west, ancora west advisors, bank balance sheet, Banking, Ben Bernanke, Bob Barone, bonuses, confidence, consumer debt, consumption, Debt, devaluing US dollar, economic policy, economics, fair value, FAS 157, FDIC, Federal Reserve, Finance, financial adviser, foreclosure, Home Prices, hostile attitued of FDIC, Inflation/Deflation, Josh Barone, Joshua Barone, mark to market, Matt Marcewicz, nevada, Obama, Recession, reno, retail sales, Robert Barone, shelia bair, small business, TARP, taxpayer, too big to fail, U.S. Treasury, unemployment at 5:38 PM by Robert Barone

Many pundits in the business media are signaling that the economy will perform much better in 2011 than it did in 2010.  Here are 9 reasons, forecasts, if you will, why 2011 will look a lot like 2010.

v  U.S. economic growth will remain anemic. There is still a small probability that there will be a double dip in 2011. The recent policy shifts by the Obama Administration to continue the Bush era tax rates and to reduce the social security tax on individuals for a year makes a double dip less probable, albeit this is occurring at the expense of fiscal discipline, something the bond vigilantes clearly do not like.  David Rosenberg, the Gluskin-Sheff economist, has stated several times in his daily blog that he thought 2010 consumption has been buoyed by folks who had stopped paying their mortgages but remained in those homes “rent free”.  Rosenberg has opined that a high percentage of what used to be their mortgage payments likely found their way into consumption.  So, a significant rise in “Strategic Defaults”, as discussed above, will likely have a similar impact in 2011.

But it is because of the job situation that economic activity will continue to be anemic. Job creation is all but non-existent.  The headline monthly jobs report emphasizes the number of jobs created.  That number is estimated by the Bureau of Labor Statistics (BLS) from a survey of large businesses called the “Establishment Survey”.  We’ve all come to realize that, in this economic environment, it is the small businesses that are suffering most.  So the “Establishment Survey” of large business appears to be biased to the upside.  The “Household Survey”, on the other hand, comes from a large sample of U.S. households and is probably a much more accurate gauge of the health of the labor market.  In November, the number of jobs in this survey fell by 173,000 after falling 330,000 in October.  According to BLS, in the 12 months ended in November, the number of employed people in this country rose from 139.132 million to 139.415 million, or by a grand total of 283,000.  Furthermore, we’ve come to look at the BLS data with a jaundiced eye.  According to John Williams of Shadowstats.com, who is an expert in the way BLS measures the data, “the overstatement of the level of payrolls as of November, 2010, is about 610,000 jobs” (see Shadow Government Statistics – Commentary No. 337).  Mr. Williams also indicates that “BLS continues regularly to overestimate growth in payroll employment by roughly 250,000 jobs”  each month due to its biased assumption that in today’s economy, small businesses, which are not in its samples, are actually adding jobs, an assumption that we know is not accurate.

In addition, the policies pursued by all levels of government for the past two decades have finally caught up to small businesses, the major job creator in the U.S.  With reduced income and cash flows, many such businesses can no longer bear the tax, fee and administrative burdens imposed.  In many localities, it is a nightmare to fulfill all of the government imposed requirements, file all of the paperwork, deal with the bureaucracy, and pay the fees just to open a small business.  Then there is the ongoing plague of fees, restrictions and regulations, many of which have arisen because of a few scam artists like Bernie Madoff, or simply because of a failure on the part of the regulators in the first place.  The American people are bearing a great burden in terms of cost for the actions of a very few.  And instead of really fixing the issues with straightforward solutions, every individual and every business is simply taxed or regulated in the name of political correctness.  This applies all the way from airport security to the newest set of Dodd-Frank regulations, to the daily pronouncements of federal and state bureaucracies in the form of ever more burdensome rules.

Big businesses have their own bureaucracy as anyone who has ever tried to call one knows. The internal staff is paid to cope with all of the rules, regulations, and burdens.  With small businesses closing in record numbers, the market penetration of big business is rising.  With small business being choked to death, even in an anemic underlying economy, like that in the U.S. today, big business has been able to prosper.  The overall economic pie in 2011 will be about the same size as it was in 2008 when measured by GDP, but big business’ share of it will have grown significantly.   This view goes a long way toward explaining large cap corporate profitability and rising equity prices along side of high unemployment and overall anemic private sector growth.

v  Housing will continue its downward spiral.  In 2011, foreclosures won’t be about those who lost their jobs or just can’t afford the payments anymore.  “Strategic defaults” will mount and accelerate in 2011.  The trend is already beginning.  It is no longer a stigma to walk away from an underwater mortgage, even if you can afford the payments.

v  Mortgage ‘Put Backs’ will become a national issue. FNMA and FHLMC purchased tons of low or no doc loans from Wall Street that likely were not entirely “truthful”.  When Congress finally addresses these two bankrupt behemoths, it will be hard to ignore this issue and stick the losses onto the taxpayers, especially after the results of the just past elections.  The large Wall Street institutions, which sold the majority of these “fraudulent” loans to FNMA and FHLMC, are likely to be held responsible.  Remember, it was Wall Street’s greed that led to the housing bubble.  Now that greed is going to come back to haunt them.

v  Europe’s debt crisis will intensify. First it was a bailout for Greece; now it is Ireland.  Portugal and Spain appear to be on the bond vigilantes’ radar.  When you hear the prime ministers of these countries publicly proclaim that they do not need a bailout, you know one is imminent.  For the European Union, Portugal can probably be rescued in the same manner as Greece and Ireland.  But Spain is simply too big.  Germany’s prime minister, Angela Merkel, is pushing the idea that by 2013, any government aid will have to be accompanied by a haircut for the bondholders.  If the bond vigilantes attack Spain, which is likely, that idea will have to be moved up to 2011.

v  State and local government finances remain in crisis. This is likely to go on for several more years.  Already, these governments are raising taxes on businesses and individuals which can’t be good for job creation.  These governments are large consumers of business products and services.  Last month, John Chambers of Cisco Systems shocked Wall Street by forecasting poor sales for this business segment.  These government entities must lower costs (layoffs) or raise taxes, or both.  All conceivable scenarios for state and local finances imply a much lower level of business activity.  In addition, 2011 will witness a significant increase in the number of local government defaults.

v  Debt Concerns will hit the U.S. 2011 could be the beginning of the end of the U.S. dollar as the world’s reserve currency. As I have blogged previously (Wow! That’s a Lot of Debt, TheStreet.com, May 5, 2011, and What Happens to the Cost of U.S. Debt if Interest Rates Rise? Minyanville.com, November 29, 2010), the debt situation in the U.S. is as ugly as some of the European weaklings.  In addition, there is another shoe that has yet to drop, but will when interest rates rise – the cost of the debt. As a result of the almost certain expansion of the deficit due to the tax “compromise” now being considered by the lame duck Congress, there has been a rise in interest rates.  This has happened despite the fact that it has been the Fed’s expressed intent to keep rates low.  Could it be that the bond market is more powerful than the Fed itself?  Could it be that bondholders are getting concerned about the rising deficit and are beginning to demand higher returns?  Could 2011 be the beginning of higher debt costs despite (or perhaps because of) what the Fed does?

v  Precious metals likely to continue to rise in value. If U.S. economic growth remains anemic, higher deficits (now a reality given the tax “compromise” the lame duck Congress is now ”enhancing”).  This implies a weaker dollar and a rise in the dollar price of most commodities (including precious metals).  If, on the other hand, U.S. recovery is robust, the world economy will thrive and the prices of most natural resource inputs (including precious metals) will rise due to demand.  But China could be the fly in the ointment.  Rule #9 of Bob Farrell’s, (former Merrill Lynch economist), 10 rules for investors is: “When all the experts and forecasts agree – something else is going to happen”.  So, what can possibly happen?  Answer: A dramatic slowdown in China’s growth.  If that were to occur, demand for natural resources and manufacturing inputs would fall, and, of course, the markets would over react to the downside.  Because of its rapid growth, many view the Chinese centrally planned economy as efficient, much like some viewed Russia’s in the 60s and 70s. But, history hasn’t produced a single centrally planned economy (including that currently in the U.S.) that has worked efficiently.  Lately, there have been many commentators who have pointed out imbalances in China’s economy (empty  buildings, a real estate credit explosion, rapidly rising real estate prices, rapidly rising consumer prices …).  It is inevitable that sooner or later China’s economy will misfire.  Will that be in 2011?  I don’t know – but precious metals investors ought to be cognizant of this risk.

v  Federal deficit will rise, not fall, in 2011. The actual 2010 deficit exceeded $1.5 trillion.  As a result of the tax “compromise” which is now being debated and “enhanced” in Congress, 2011’s deficit will likely exceed 2010’s.  In a previous blog (What Happens to the Cost of U.S. Debt if Interest Rates Rise? Minyanville.com, November 29, 2010), I indicated that the four major social categories in the federal budget (Medicare/Medicaid, Social Security, Income Security, and Federal Pensions) along with Defense/Wars and Debt interest consume 86% of that budget.  All of these items will have significant upward pressures in 2011 and beyond.  The recent elections will only begin a long process of getting the structural deficits under control, and the success of that is far from a certainty.  The “compromise” reached between the Democrats and Republicans in the lame duck Congress is clearly a budget buster, and that has implications for interest rates (rising) and the dollar (falling).  The bond vigilantes have already reacted as interest rates rose rapidly after the “compromise” announcement.

v  The Stock Market will remain range bound. Twelve years ago, the S&P 500 index was right where it is today.  Given the state of the economy, that performance is likely to continue.  While the large multinational corporations may see modest profit growth, much of this will likely be at the expense of small businesses which will continue to suffer from over taxation, over regulation, and rising input costs.  And without jobs and the lack of availability of easy credit, consumption is not likely to be robust.

Just as in 2010, while the economy may do poorly, big business will do just fine.  The stock market will be held back by a lack of job growth, all of the federal, state and local and household debt issues, debt issues in Europe, a continued slump in housing prices, mortgage defaults and “put backs”, and a weakening dollar.  Buoying it will be decent large cap corporate earnings.

Robert Barone, Ph.D.

December 9, 2010

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December 1, 2010

Wow-II! That’s A Lot of Interest!

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 adviser, advisor, ancora, ancora west, ancora west advisors, bank balance sheet, Banking, Ben Bernanke, Bob Barone, bonuses, confidence, consumer debt, consumption, Debt, devaluing US dollar, economic policy, economics, fair value, FAS 157, FDIC, Federal Reserve, Finance, financial adviser, foreclosure, Home Prices, hostile attitued of FDIC, Inflation/Deflation, Josh Barone, Joshua Barone, mark to market, Matt Marcewicz, nevada, Obama, Recession, reno, retail sales, Robert Barone, shelia bair, small business, TARP, taxpayer, too big to fail, U.S. Treasury, unemployment at 5:42 PM by Robert Barone

Recent events in Europe have once again focused the markets on the huge overhang of debt in the high debt European economies with Ireland now effectively joining Greece on life support from the EU and IMF.  Can Portugal (Spain) be far behind?  (Most Americans and Germans would have a fit if they knew how much of the IMF commitments were borne by them!)  During that first European debt crisis last spring, I blogged about the level of debt in the U.S. (see “Wow! That’s a Lot of Debt!” at TheStreet.com 5/21/10).  Now, with QE, QE2, and trillion dollar structural deficits as far as the eye can see, I wonder how many people recognize the potential devastating costs of the national debt as deficits continue, especially if interest rates start to rise as many pundits believe is fairly imminent.

This is a blog about the cost of the national debt.  But, to set the table, let’s look at some data.  The national debt currently stands at $13.7 trillion, and, under the most optimistic Congressional Budget Office (CBO) projections for 2015, it is projected at $17.4 trillion (based on 4.9% GDP growth between now and 2015).  More likely, unless economic growth improves dramatically, the debt will rise to $20 trillion, perhaps $22 trillion in the next five years.  The Federal Budget is nearly $3.5 trillion (23.9% of GDP) and CBO projects a Federal Budget of $4.2 trillion (22.8% of GDP) in 2015.  Tax collections for 2010 are expected to be $2.1 trillion, of which $894 billion are from income taxes.  CBO projects total taxes to rise to $3.7 trillion by 2015 (an 11.7% annual growth rate), and for income taxes to rise to $1.9 trillion (16.1% annual growth rate!).  Clearly, such projections occurred prior to the recent elections. Today, for every dollar spent by the Federal Government, nearly $.39 is borrowed.  USDebtClock.org indicates

Six Largest Federal Budget Categories

* Includes Supplemental Security Income, Earned Income Credits, Unemployment Compensation, Nutrition Assistance, Family Support, Child Nutrition, Foster Care, Making Work Pay.

that the six budget categories shown in the table account for nearly 86% of the Federal Budget.

The six categories shown account for nearly $3 trillion of spending and are 140% of total tax collections indicating the nature and extent of the structural deficit.  A few of these six categories have become “sacred cows” with any politician or would be politician attempting to “fix” any of the four “social” categories (Medicare/Medicaid, Social Security, Income Security, and Federal Pensions) subject to vicious political attack.  It also appears that these four are also subject to fierce upward spending pressures as the population ages, the recession continues, and federal employee wages remain significantly above those available in the private sector (and rising!).  As long as the U.S. continues to fight two wars and must defend itself against the war declared on it by the jihadists, upward pressure on the defense budget will continue.  That leaves Interest on the Debt.

The website USTreasuryDirect.gov has a wealth of data concerning the national debt.  As of October 31, the official debt was $13.689 trillion consisting of $8.497 trillion of marketable debt and $5.192 trillion of non-marketable.  Debt held by the public (including foreigners), which consists of most of the marketable debt plus a few minor items (like savings bonds), was $9.07 trillion.

The remainder of this paper investigates what happens to the cost of the debt if interest rates rise?  It isn’t a simple answer because the debt matures issue by issue on widely different dates.  If a maturing issue, for example, has a coupon higher than current market conditions require, the total cost of the debt would fall.  So, changes in interest rates take time to work their way through the debt maze.  To analyze what happens to the cost of the debt, I made the following assumptions: a) the shifts in the yield curve would be parallel shifts; b) a maturing issue would be reissued to its original term (for example, an issue that matures on 11/15/10 that was issued on 11/15/2000 (i.e., a 10 year Note) would be reissued on 11/15/10 at current market interest rates to mature 11/15/20); c) the marketable debt ($8.497 trillion) is a close proxy for the debt held by the public ($9.07 trillion).  While the “cost” of the $13.689 trillion is a number in the $325 billion range on an annual basis, the real cost of the debt is the cost of the portion held by the public because that is the net amount of interest to be paid out; the rest is just intra-governmental transfers.  Some may argue that the budgets of those agencies must reflect the interest that has to be paid, but for this analysis, I have used the “net” debt concept.  The existing marketable debt (Bills, TIPS, Notes, and Bonds) has a weighted average maturity of 4.9 years and a current cost of 2.41%.  The base yield curve used is the yield curve for Treasuries and the yield curve for TIPS on 11/15/10 as shown in the following table:

11/15/10 Yield Curves

The table below shows the percent change (from current costs) in the cost of the marketable debt in 1, 3, 5 and 10 year periods using parallel shifts in the base yield curve of between 0 and 700 basis points (bps).  As the table shows, the longer the yield curve stays where it is (or goes lower), the better it is for the cost of the existing debt.  For example, under the constant yield curve scenario (0 bps change), because the issues maturing have a higher coupon than newly issued debt, the cost of the existing debt falls.  So, if the 11/15/10 yield curves exist for the next year, the cost of the debt would fall by 5.2%, or approximately $10.6 billion.  And, over 10 years, the annual cost reduction would be quite significant.  Under the parallel shift of 100 basis points scenario, the cost of the existing marketable debt rises 7.3% (approximately $14.9 billion) after 1 year.  Under this scenario, things stabilize and actually improve between the 5 and 10 year marks.  However, as the table shows, as rates rise more than 100 basis points, things deteriorate.  For example, at a 200 basis point rise, 5 years out the cost of the existing debt will have risen 37.4% (approximately $76.5 billion).  So, if the economy begins to experience inflation, or if we simply cannot place the maturing debt without higher coupon yields, the cost of the existing debt becomes a significant issue.  Using the 5 year column, the cost of the existing marketable debt for rises of 300 and 500 basis points is 66.0% ($135.0 billion) and 123.2% ($251.9 billion) respectively.

Percent (%) and Dollar Changes (Bill $) in the Cost of Existing Marketable Debt

Under Parallel Shifts in the Yield Curve

Of course, this does not tell the whole story, as the U.S. continues to run significant budget deficits, and each added dollar of debt results in increased interests costs.  The CBO has projected the national debt at $17.35 trillion in 2015.  That is $3.68 trillion more than now exists.  Given the current deficit estimate of $1.27 trillion for fiscal year 2011 (which began October 1) after $1.56 trillion of red ink in fiscal 2010, and an economy clearly in low gear, the CBO number is clearly optimistic.

In the table below, I show the change in the cost of the marketable debt using the CBO $17.35 trillion of total debt, and adding more realistic $20 and $22 trillion columns (I note that on June 9^th, the Treasury projected the 2015 deficit at $19.6 trillion).  Besides the assumptions used in the table for the existing debt, the following assumptions were added to create the estimates for higher levels of debt: a) all of the new debt created is marketable; and b) the term structure of the total marketable debt would not change from what it is currently.  As can be seen from the table, deterioration in the cost of the debt is rapid, even if interest rates rise only slightly.  For example, even at a parallel shift in the yield curve of only 100 basis points, at $20 or $22 trillion of debt, the cost rises 63.8% ($130.5 billion) or 81.2% ($166.0 billion) from current levels.  The cost of the debt, which is currently 5.7% of the Federal Budget, would rise to 11.1% under CBO projections and to 13.4% or 15.1% of the Federal Budget under the $20 trillion and $22 trillion scenarios at the more “normal” interest rate levels represented by the 300 basis point shift row in the table.  While that is daunting, the rest of the table is truly terrifying, especially if the Fed’s QE programs end up putting the U.S. economy into a 1970’s type inflation.

Percent (%) and Dollar Changes (Bill $) in the Cost of 2015 Marketable Debt

Under Parallel Shifts in the Yield Curve

It is a fine line the Congress and Federal Reserve is walking.  Given the structural nature of the deficits and the difficulty of slowing or reversing defense costs or the costs of the “social” categories, even small upward changes in interest rates toward “normality” will exacerbate the deficit and economic growth issues.

Robert N. Barone, Ph.D.

November 29, 2010

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October 28, 2010

QE2: More Harm Than Good

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 adviser, advisor, ancora, ancora west, ancora west advisors, bank balance sheet, Banking, Ben Bernanke, Bob Barone, bonuses, confidence, consumer debt, consumption, Debt, devaluing US dollar, economic policy, economics, fair value, FAS 157, FDIC, Federal Reserve, Finance, financial adviser, foreclosure, Home Prices, hostile attitued of FDIC, Inflation/Deflation, Josh Barone, Joshua Barone, mark to market, Matt Marcewicz, nevada, Obama, Recession, reno, retail sales, Robert Barone, shelia bair, small business, TARP, taxpayer, too big to fail, U.S. Treasury, unemployment at 9:24 PM by Robert Barone

With voters up in arms about unconscionable federal and state deficits and likely to change the ability of the federal government to add even more “stimulus” in the next Congress, all eyes are now on the Federal Reserve (Fed).  QE2 (Quantitative Easing 2 – government speak for money printing) has been promised by various Fed documents and Federal Open Market Committee (FOMC) member public speakers, including Chairman Bernanke himself.  The equity markets have responded.  Priced in is a large stimulus with the expectation that it will lead to an increase in the anemic rate of economic growth, and, hopefully, a lowering in the rate of unemployment.  Any disappointment is likely to have a significant impact on the equity markets.

But, beyond the transitory impact on the equity market, is QE2 good public policy?  A good, question, especially since QE1 did not produce any measurable economic growth.  Some folks argue that QE1was a success in the sense that it saved the credit markets from complete collapse and likely saved several large financial institutions.  However, the issue today isn’t the functioning of those markets.  In fact, new debt issues have no trouble finding buyers today.  The issue today revolves around an economy that cannot find traction.

Hope?

So, what does the Fed hope to accomplish by bloating up its already pregnant balance sheet?  It is pretty clear that the economy is in a liquidity trap.  That is, like the 1930s, the banking system already has an extremely high level of excess reserves and there appears to be no demand for borrowing.  On the contrary, because consumers have too much debt, they are now foregoing consumption and borrowing despite historically low interest rates (Mohammed El-Erian’s “New Normal”).  Thus, on a monthly basis, we continue to see significant loan contraction.  The actual implementation of QE2 (the buying of bonds and notes in the open market) adds reserves to the banking system, and lowers interest rates on the part of the yield curve in which the purchase operations take place, with, perhaps, some trickle down to the rest of the yield curve.  Given the level of excess reserves already in the system, the Fed certainly can’t be hoping that these actions will spur loan growth.  And, given the already historic lows in interest rates, they can’t be foolish enough to think that the lowering of rates by a few basis points will have a significant impact.  Then, what can the Fed possibly be hoping for in this round of money printing?

Another Asset Bubble?

Asset inflation is one possibility.  And the announcement of QE2 has been, to date, successful in inflating equity prices.  The hope here appears to be that rising equity prices will cause a “wealth effect” – an increase in consumer confidence and more spending because of the perception of rising equity values.  All past studies of the “wealth effect” that I am aware of suggest that its impact on consumption is quite small compared to other policy tools.  Unfortunately, all of the other tools have already been completely deployed.

Inflation Expectations?

QE2 also increases the potential money supply, resulting in rising inflation expectations, and, ultimately resulting in a weakening dollar relative to other currencies.  In other blogs, I have discussed the “race to the bottom” in the world’s currencies (see “How the U.S. Should, But Won’t, Handle Job Creation”, Minyanville, 10/6/10).  Given the very strong deflationary pressures in housing and from record levels of unemployment, it appears that the Fed hopes to combat such pressures by influencing inflation expectations.  Again, the impact here doesn’t appear to be very robust.

Trade Deficit Reduction?

Finally, it seems that the Fed, by its QE2 announcement, must believe that a weaker dollar will improve the trade deficit and ultimately bring jobs back to the U.S.  This appears contrary to what Treasury Secretary Geithner says about a strong dollar, but there just isn’t any other possible interpretation.  Because other countries react by lowering the value of their currencies to protect their export industries, there doesn’t appear to be any benefit here, either.

Negative for Jobs

There are potential intermediate and long-term negative consequences of QE2.  One possible negative impact is on jobs, and is contrary to the objective of the QE2 program.  First, many companies have invested in plant and equipment overseas, so their commitment isn’t reversible in the short-term.  Second, most companies look for a business environment where they are comfortable, i.e., where there is visibility into the future tax and regulatory environment, something that the U.S. currently lacks.  Third, and what isn’t widely recognized, is that a weak dollar policy (QE2) drives dollars (capital) to other countries in the attempt to protect its value.  As dollars flow to places with more stable tax and regulatory environments, it is invested there, thus enhancing economic growth there, not here.  The dollars that do return to the U.S. are invested in very short-term investments (U.S. Treasury Bills and Notes) which, by their nature, are not invested in long-term projects (i.e., they finance current U.S. government deficits), and, therefore, do not create jobs.

Negative for Consumers

The intermediate and long-term impacts of QE2 is also likely to be negative for consumers.  Ever lower interest rates on consumer deposits and along the yield curve continues to remove income from savers and investors and transfers it to the large financial institutions and to the large publicly traded companies.  The lower cash throw offs from savings and investments causes lower levels of consumption.

In addition, the weaker dollar, as a result of QE2, has two more negative impacts on consumption:

• A weaker dollar means higher commodity prices in dollar terms (note the rise in the prices of gold, industrial metals, oil, and agricultural commodities since the announcement of QE2) which are inputs in the manufacturing process.  If they can, manufacturers will pass along these higher costs to consumers in the form of higher prices.  In this case, consumption will be negatively impacted unless consumer incomes rise faster than the prices (not likely with high unemployment levels).  In the more likely case that most of the increase in input costs cannot be passed on because of consumer resistance, corporate margins get squeezed.  Again, a negative result for economic growth.  Furthermore, some of these commodities are more important than others, e.g., oil and food.  After 40 years of dependence on foreign oil, we should be well aware of the negative impact on consumption of rising gasoline prices.
• Then, of course, there is the direct impact of a weaker dollar on the prices of imported goods.  Despite Walmart’s commitment to lower prices, because they are a huge importer of foreign manufactured goods, as the dollar weakens, even their prices will have to rise.

More Harm than Good!

Most of the large multinational firms can deal with a weaker dollar and new regulations.  For them, because they have significant sales in other currencies, a weaker dollar is beneficial to their overall dollar denominated income statements.  But small, domestic businesses are another story.  In this economy, they cannot pass on increases in their input costs due to a weakening dollar.  Furthermore, rising taxes and fees from federal, state, and local governments (e.g., the costs of Obamacare) and added regulations (e.g., new IRS 1099 reporting requirements) are overwhelming small businesses.  Small businesses create the vast majority of jobs in the U.S.  The weaker dollar implied by QE2 will further impact the already reeling small business sector.  There is only one conclusion to be drawn:  QE2 is likely to do much more harm than good.

Robert Barone, Ph.D.

October 25, 2010

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