Leeds on Finance

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First, a correction…several of you dimwits wrote me to ask for a clarification of this paragraph in the last email:


12. The amount of debt of many of the large economies is growing at a much faster rate than developing markets.  From 2007 – 2010, the US and Japan have increased by approximately 30% and the UK has increased by 36%.  Germany increased 37.7%.  Germany only increased 12%.


I don’t know why, but some of you were confused by the idea that Germany increased 37.7% and Germany only increased 12%.  What I meant to say was that Greece increased 37.7% while Germany only increased 12%.  But, since Germany will eventually own Greece, technically I was correct.


Now, on to some other thoughts…


Busy Week

I had a busy week.  I did two small presentations.  I wrote another op-ed piece for a different newspaper.  Once it either gets rejected or published, I’ll share it with you.  In addition, I was interviewed about the difference between the US approach to our problems and England’s approach.  (They actually interview a lot of people when they are writing a story like this.) Once that article is published, I’ll write to you with my thoughts on that subject (since I had to spend time preparing).


Interesting Link

A friend sent me this link.  It’s really interesting.  If you watch, it will show you how unemployment rates changed in each county across the country over the past three years.


Politics

Today, I want to share one simple idea.  My goal is to irritate you as the weekend starts.


On Wednesday, I was giving a presentation and I told the group, “if you consider yourself to be a Republican or a Democrat, you’re part of the problem.”  I think that this is a really important thought.  If you think that one party is right and the other party is wrong, you are what is stopping us from actually resolving problems.  If you speak in sound bites without any evidence backing it up, you’re part of the problem.


I just saw a survey done by the Pew Research Center.  Here’s the link to the results.  But the big picture is that Republicans see Democrats as liberal and Democrats see Republicans as conservative.  It’s hard to compromise with someone who you think is very different (and must be wrong).  Here are their main findings:

I think some people were surprised that my editorial in the Statesman was defending a Minnesota Congresswomen who is Republican and associated with the Tea Party.  (If the Tea Party is going to be a third party, be very clear…if you consider yourself to be part of the Tea Party, you are also part of the problem.)  In my opinion, each party has issues that they are right about and issues that they’re wrong about.  I’m not going to lock myself into the wrong side of an issue because I consider myself to be part of one of these two or three extremist groups.


Here’s the quick example that I really want you to think about.  President Obama pushed through a healthcare bill this year.  We’ve all heard estimates of what it will cost.  I’m anxious to see (later this year) the actual estimate for the next 75 years.  It will be interesting to see.


Many of you crazy right-wing readers wrote to me when the bill was passed, complaining about the huge cost and telling me about these crazy liberal Democrats.  Here’s what I’m trying to figure out…how is this any different than President Bush signing The Medicare Prescription Drug, Improvement, and Modernization Act (aka the Medicare Modernization Act or MMA) in 2003?  Take a look at our current estimate of the present value of the unfunded liability from Medicare Part D (the prescription drug plan).  It’s $7 trillion!


Again, get perspective of the numbers.  We have approximately $8.5 trillion of publicly held debt outstanding.  If we were going to fully fund Medicare Part D, we would have to come close to doubling our outstanding debt.


Don’t get me wrong.  I want the elderly to have their prescription medication.  I want the uninsured to be insured.  I think we all want this.  But, I also want a $5 million house and a really expensive car.  Unfortunately, I can’t afford it.  The real difference between me and the politicians is that not being able to afford something actually stops me from buying it.  Of course, if I got the benefit of spending the money (i.e., votes) and was able to spread the cost to others, maybe I’d be living in a nicer house…


So here’s the point.  When I hear the Republicans say that the Democrats are fiscally irresponsible, I completely agree.  I’m fortunate though.  I know what fiscally irresponsible means because I had the opportunity to watch the Republicans be fiscally irresponsible for eight years.  We’re letting two powerful groups (the political parties) destroy our nation.

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Market Update – July 21

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Hi All,

I’m prepping for two presentations that I’m giving this week.  I’m mostly talking about our debt problems.  But, I spent a few hours today making notes from newspaper articles from the last week.  The articles are generally those that involve debt, taxes, states, budgets, etc.  In other words, these are newspaper articles related to all of the issues that I’ve been thinking about lately.

Below, you will find a summary of those articles.

Enjoy.

Sandy

The Situation is Dire

1. Greenspan said that “unless we start to come to grips with this long-term outlook, we are going to have major problems.  I think we misunderstand the momentum of this deficit going forward.”  He also said that reducing the deficit “is going to be far more difficult than anybody imagines after a decade of major increases in federal spending and major tax cuts.”


2. The two leaders of President Obama’s Debt Commission (former Republican Senator Alan Simpson and President Clinton’s Chief of Staff Erskine Bowles) made some dire comments about our situation.  Bowles said that Social Security, Medicare and Medicaid fully consume federal revenue.  Everything else (fighting two wars, homeland security, education, art, culture, veterans, etc.) is being financed by China and other countries.  Bowles also said that we can’t grow our way out of this problem and that the debt is a cancer.


3. Here’s a good chart from The Washington Post showing what our budget looks like. (SOURCE: White House Office of Management and Budget; GRAPHIC: Wilson Andrews, Jacqueline Kazil, Laura Stanton, Karen Yourish – The Washington Post)

Federal Budget

5. One of the big issues right now is whether we should let President Bush’s tax cuts lapse.  In order to get the cuts passed in 2001, Bush agreed that they would lapse in ten years.  Recently, Alan Greenspan said that we should let them lapse in order to cut the deficit.  He said that while this may slow the economy, the threat of the deficit is larger.  President Obama says that we should continue the tax cuts, except for those making more than $250K.


6. We spend too much time worrying about our “tax gap” – the gap between what we should collect and what we actually collect.  We’re all outraged by tax evasion.  But the reality is that it’s going to happen.  In 2012, businesses are going to have to start filing documents with the IRS for every vendor from which they buy more than $600 of goods and services from.  This will be a paperwork nightmare.


Politicians Are Horrible

7. The House has not passed a budget outline for the first time since 1974, when the current budgeting system started.  These budgets list revenues and expenditures for the next five years and allocate money to large categories (such as defense).  One of the problems is that many Democrats are facing tough campaigns – so some of them want to cut spending and others don’t.  The only resolution that the House passed is one which says that discretionary spending will be $1.12 trillion.  Republicans are placing ads saying that this is evidence that Democrats have no priorities and they can’t control spending.  Democrats are taking credit for the pay-as-you-go law that requires all new spending to be offset by cuts and by arguing that the Republicans got us into the financial mess.

Our International Problems

8. China’s State Administration of Foreign Exchange (SAFE) said that it would not use China’s foreign exchange investments as an “atomic weapon.”  China has reserves equivalent to approximately $2.45 trillion.


9. The IMF said that Europe’s weak economy is the central threat to global recovery.  The countries struggle with heavy debt, banks have low capital and growth is slowing.


The Global Economy

10. According to The Economist, the IMF identified some downside risks to the global economy: banks could curtail lending because of their exposure to impaired government debt, consumers and businesses could spend less because their confidence has been dented, deficit spending could suppress new growth, new financial regulations could damp bank lending, American property prices could fall further, and exchange rates could go haywire.


11. Apparently, the Fed is thinking about what to do in case our economy weakens.  One idea is to strengthen the language so that investors know that we’ll be keeping rates near zero for even longer than we already expected.  Another idea is to stop paying interest to banks for excess reserves – so there is more incentive to loan those funds out.  Another idea is to keep buying mortgage backed securities (as those that the Fed owns are paid off).


Other Countries Have Debt Problems

12. The amount of debt of many of the large economies is growing at a much faster rate than developing markets.  From 2007 – 2010, the US and Japan have increased by approximately 30% and the UK has increased by 36%.  Germany increased 37.7%.  Germany only increased 12%.


13. Interestingly, the UK is preaching austerity while the US is still spending.  The difference is that the UK’s new government has time while the US has upcoming elections.


14. Britain announced this week that their debt is approximately 4 trillion pounds – approximately four times higher than previously announced.  This total includes “off-balance sheet” liabilities – primarily public sector and state pensions.  Their National Institute of Economic and Social Research said that taxpayer should be paying approximately 30% more in tax in order to avoid passing the burden to the next generation.


15. S&P has told the UK that they are at risk of losing their AAA rating, despite their austerity measures.


16. Moody’s cut Portugal’s sovereign-debt rating two notches to A1.  In April, the Portuguese government announced their plans to cut their budget deficit from 9.4% of GDP (2009) to 8.3% in 2010 and 2.8% in 2013.  S&P already had Portugal rated A- with a negative outlook.  Fit rates them AA- with a negative outlook.


17. Spain just issued $3.8 billion of debt at 5.116%.  The market seems willing to buy risky sovereign debt.  One possible reason is that the US recovery doesn’t look particularly strong.


18. The EU is discussing how to encourage member nations to index retirement age to increasing life expectancy.


19. The global imbalances which were supposed to be corrected by the recent financial turmoil are back in full force.  China, Japan and Germany continue to have huge exports, save too much and spend too little.  The US, Britain and other European nations tend to import, save too little and spend too much.


Debt Issuance Will Be Huge

20. The IMF pointed out that European countries and the US will be competing to refinance $4 trillion in government bonds maturing in the second half of the year.


21. The US will sell approximately $2 trillion per year for the next two years.  This is a combination of refinancing and deficit issues.


22. Sovereign debt will have to compete with financial institutions.  Banks worldwide owe nearly $5 trillion to bondholders and other creditors that will come due through 2012.  Approximately $2.6 trillion of the liabilities are in Europe.  US banks must refinance $1.3 trillion through 2012.  The European debt is the bigger issue because the banks haven’t cleaned their balance sheets as well and are loaded down with sovereign debt that investors are worried about.


23. Bond issuance by financial institutions in Europe dropped to $10.7 billion in May.  In May 2009, it was $95 billion.  In January, it was $106 billion.  May was a time of crisis (with Greece) and the market seems to be recovering.


24. S&P said approximately $1.7 trillion in bonds are due in the next three years among the non-financial companies that it rates.  Much of this is not investment grade.


Municipal Debt and States

25. Thirty-five municipal bond issues (totaling $1.5 billion) defaulted in the first six months of 2010.  This is three times the typical rate but better than recent years.  Last year, 194 municipal borrowers defaulted on $6.9 billion of bonds.  In 2008, 162 issues defaulted on $8.2 billion of bonds.  The prior two years were impacted by Jefferson County (Alabama) and Lehman (which was not able to pay back on some Georgia bond guarantees).


26. On June 30, the cost of credit default swaps on municipal bonds hit $266,500.  This was the highest level since March 2009.  But, by July 15, this was back down to $223K.


27. Commercial banks hold $216.2 billion of municipal debt.  If there is downward pressure on these bonds, these banks will be hurt.  Municipalities are hurt by unemployment and dropping real estate prices.  Warren Buffet predicted a “terrible problem” for municipal debt when testifying before the Financial Crisis Inquiry Commission.  Lenders hold approximately 8% of the $2.8 trillion state and local government debt market and muni bonds are only about 2% of total bank assets (which makes them approximately 25% of capital).


28. Connecticut has been encouraging hedge funds to move from NY to Connecticut in order to avoid NY taxes.  NY is planning on taxing the carried interest of NY based hedge fund managers (who live out of state) at the top ordinary state tax rate.


29. Maywood California has fired all of their workers and outsourced everything.  Much has been outsourced to nearby cities.  Many city employees have been rehired as contract workers.  But, the 30,000 resident city is lowering costs.


Random Stat

30. Interesting stat: approximately one in seven homeowners with loans in excess of a million dollars are seriously delinquent.  Only one in twelve mortgages below the million-dollar mark is delinquent.  The delinquency rate on investment homes where the original mortgage was more than $1 million is now 23%.  For cheaper investment homes, it’s 10%.

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Good Morning,


I wrote an Op-Ed for the local paper (The Austin American Statesman).  It’s on page A8 of today’s paper.  I’ve printed it below (my unedited version with a slightly different title than they used).  You can also read it online at this link.


I also want to thank David Wenger, Director of Communications at McCombs. It was his idea to write this. He edited my draft and he was the one who got it published. Thanks David.


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The Lockbox Myth (or “Sorry PolitiFact…There Ain’t No Lockbox”)


This past month, PolitiFact Texas helped perpetuate the false belief that the Social Security program is funded and that we have a mystical “lockbox” at our disposal.  While arguing that Minnesota Congresswoman Michele Bachmann made false statements about Social Security, PolitiFact stated that “in assessing the financial health of Social Security, it’s important to realize … it’s also built up a big trust fund that it can tap when necessary.”


Too many Americans are horribly uneducated when it comes to our government’s finances and our eventual debt crisis (which will be caused by deficits, Medicare and Social Security).  Comments like those made by PolitiFact compound this problem.  While Social Security is just one piece of our eventual debt crisis, it’s an important piece.  We all need to understand how this works.  Only then will citizens know the questions that they should be asking our politicians and then maybe we can stop kicking the can down the road.


I would urge all citizens to start by understanding two things: the amount of underfunding that Social Security faces and the fact that the $2.4 trillion in “our big trust fund” has already been spent by our government.  In addition, it would really help if we all accepted the fact that this isn’t a Republican or Democrat issue and it’s not a liberal or conservative issue.  This is a problem that we face as a nation – we don’t have enough money to pay retirees what we have promised to pay.


Start by understanding the numbers.  The reality is that Social Security is grossly underfunded.  We have $2.4 trillion in our “big trust fund.”  People who are currently in the Social Security system (anyone who is working) will put in another $19.1 trillion (in “today’s dollars”).  Unfortunately, current workers and retirees will take out approximately $37.7 trillion (in today’s dollars).  So we have $2.4 trillion, we’ll take in $19.1 trillion (bringing us to $21.5 trillion), but we’ll pay out $37.7 trillion.  We are short by $16 trillion!  It would be one thing to be $16 trillion short on a $900 trillion liability, but it’s particularly outrageous to be $16 trillion short on a $37.7 trillion liability.


At this point, you should realize that Politifact’s assertion that there is a “big trust fund” is like a parent who has saved $20,000 to pay for college for his ten children.  When asked how he’s going to pay for all that tuition, he points to his trusty lockbox.  The reality is that he may pay for the first child, but the rules are going to change for the rest of the children.  In addition, if Mom and Dad want to pay tuition for more than the first child, they’re going to need to cut their spending on other things or they’re going to need to raise their income (or sell assets).


Second, understand what happens with our “big trust fund.” By law, the Social Security Administration can do only one thing with these funds (the $2.4 trillion that they are holding for us)…they can invest them in special Treasury bonds.  In other words, by law, the only thing that they can do is loan the money to our government.


Our government needs to borrow the money because we run a deficit most years.  (When you’re good at something, stick with it.)  This deficit has been financed by Social Security, China and others.  Unfortunately, Social Security is going to need to be paid back in the coming years (as baby boomers retire).   Hopefully other lenders will not need their money back.


As Social Security redeems their Treasury Securities (because they’ll need their $2.4 trillion back), our government will have to pay this back out of our General Fund.  It would be great if our government ran a surplus and could use the surplus to pay Social Security back.  But, since I recently broke it to my children that there is no tooth fairy, I’ll also break it to you that it’s very unlikely that the Surplus Fairy is going to appear any time soon.  This means, that we’re going to have to convince lenders to step in and replace Social Security.


You have to ask yourself how long lenders will trust a government that is approximately $50 trillion underfunded (when you consider Social Security and Medicare combined).  Remember that lenders (outside of Social Security and other parts of are government) have only loaned us $9 trillion (to date).  We’re counting on our ability to turn to them for much more.


The bottom line is that we’re in trouble.  Social Security is woefully underfunded and Medicare is an even larger problem.  This is going to increase the amount that we’re going to have to borrow from investors – and there’s no certainty that investors will always be willing to lend to us.  Most importantly, we’re never going to solve these problems until the electorate understands the issues and starts to pressure our elected officials into making the hard (but right) decisions.  We’re not doing anyone any favors by convincing them that we have “built up a big trust fund.”


Leeds is a senior lecturer in the Department of ?Finance, McCombs School of Business, at the?University of Texas. He blogs on finance and market issues at leedsonfinance.com/.

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Today, I want to share a chart with you that I find amazing.  (This is the first time that I’ve posted some pictures.  I’m hoping this works through the blog and email system – I’m a technological idiot and many people would take out the word “technological” from this sentence.)


If you look back over the past 60 years, our federal tax revenue has consistently been around 18.5% of GDP.  Think about this…we’ve had high tax brackets, low tax brackets, etc.  But, regardless of the tax rate, the tax revenue has been very consistent.


The following chart comes from a great chart book (2010 Budget Chart Book) that is put out by the Heritage Foundation. 


“Tax Revenue”

Tax Receipts

Of course, a significant issue is whether lower or higher taxes impact our real GDP growth rate.  If they do, then you could argue that tax revenue may always be 18.5% of GDP, but GDP is higher under one particular policy (and 18.5% of higher GDP is a good thing).


I spent a little time looking at some academic papers and other sources concerning this issue.  Interestingly, there is little evidence that tax rates have a tremendous impact on GDP.  Even the research that supports lower taxes indicates that the gains in GDP are limited.  Obviously, it’s difficult to examine tax brackets as a “stand-alone” cause of high or low GDP growth. In addition, most of the research only involves small changes in tax rates.



Eliot Spitzer wrote an interesting article concerning this issue.  He also concluded that there is little direct relationship between tax rates and growth.  He showed this with a chart:


“Tax Rates and GDP Growth”

Tax Rates and GDP Growth

The main takeaway is that (in the absence of other evidence), GDP and tax rates don’t seem to be directly related. That means that we’re stuck with collecting taxes that equal approximately 18.5% of GDP and we probably can’t drive GDP much higher by lowering tax rates.


Right now (and I reserve the right to change my opinion!), this makes me think a few things:

1. I find it hard to believe that our tax system is going to change significantly – I have to believe that we’re going to keep collecting an amount of taxes that is somewhere close to 18.5% of GDP.




2. If you agree with point 1, then most of the argument about taxes is really about who is going to pay the 18.5% (who should we tax more and who should we tax less – a very politically charged issue).




3. The primary way to fix the budget (over the long term) is to spend less.  In other words, our spending has to get down below 20% of GDP.  Obviously, this is a difficult time to limit spending.  But, it needs to be a realistic long-term goal.




4. If we do increase taxes by a tremendous amount (because we’re going to need a tremendous amount of revenue if we don’t cut spending), I have to believe that it will be inflationary.  In addition, while I mentioned conflicting evidence, I do believe that if we have a HUGE increase in taxes, this could easily slow the economy.

In the next week or two, I’m going to have some short posts on where the government’s revenue comes from and where it goes.  I’ll just preface those comments by saying that if we can’t increase our tax revenue and our outflows are increasing, you have to be scared about the future.


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There will be one more blog this week (on Thursday or Friday).


Today is a short blog.  As I mentioned yesterday, I wanted to show you that:

1. The Social Security problem is much bigger than $7.7 trillion I mentioned yesterday.
2. As a result, Social Security is a more significant problem than we recognize.

In yesterday’s blog, I discussed an odd issue…the net liability (primarily from Social Security and Medicare) for the closed group is $52 trillion, but it is only $45 trillion for the open group.  (If you forgot the terminology, you can always look at yesterday’s blog online.)  But here’s a quick reminder: the closed group includes Social Security and Medicare participants who have already reached the age of eligibility as well as people who have been paying in, but have not reached the age of eligibility (current workers).  The open group includes future participants who have not even started paying in yet.


Think about this…when you add in people who have not entered the system (i.e., kids who don’t work yet or children who have not even been born yet, but they will eventually participate in the system), the net liability drops.  I thought that this was really odd.  At first, I wondered if there was already some sinister plan in place to tax future generations more and give them fewer benefits.  But, while that will eventually happen, that’s not what’s going on.


The reality is that the Trustees plan out 75 years in calculating this liability.  As a result, when we count in future participants, we’re counting a lot of people who have not been born and won’t start working for 20+ years.  During the next 75 years, many of them will be contributing but not taking out (i.e., people born more than 10 years from now will not reach retirement age during this 75 year period).  So, when we calculate the liability for the open group, the future participants make it seem like the system is in better shape!


In the case of Social Security, the net liability is $7.7 trillion when you calculate it for the open group.  But, a more realistic picture is given by the closed group (because this captures a fixed group of participants and all of the money that will go in AND all of the money that will go out).  If you just look at the closed group, the net liability is $18.5 trillion!


The open group net liability is only $7.7 trillion because the people who will eventually start working will throw in $18.1 trillion (in today’s dollars) and will only receive $7.2 trillion.  In reality, they will receive a lot more than $7.2 trillion.  In fact, they’ll receive a lot more than $18.1 trillion if the rules don’t change.  But, much of it will be received AFTER 75 years from today.


The point that I’m trying to make is that people often say that Social Security’s liability is $7.7 trillion.  But, that’s a lie. That’s low because it includes the money that will be deposited by future employees, but it doesn’t consider most of the money that they will take out.


I’ve also heard a lot of commentators say that the Social Security problem is minor and the real problem is Medicare. There is no question that Medicare is a bigger problem, but Social Security is also significant.  To see the significance of Social Security, it’s more realistic to look at the $18 trillion net liability.  This is a big percentage of our (approximate) $50 trillion unfunded liability.  It is smaller than Medicare.  But, it’s not a meaningless amount.  In sum, Social Security and Medicare are both huge problems.
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I’ve received loads of emails from people who are happy that the blog will be focused on the long term issues.  That’s great.  (Of course, I’m not sure that the people who are unhappy will bother writing me!)  I’m going to try to break some of the blogs into pieces – so that they don’t take you (or me) too much time.  In other words, I hope that they are easier to digest.


Today, I want to explain the $52 trillion unfunded liability that I always mention.  It turns out that I was wrong – as of this past year, it was probably $49 trillion.  But, we’ll see (later this week) that it’s higher!  Before we get to that issue (tomorrow), I want to show you where the numbers come from and also show you the discrepancy (I wasn’t looking at the unfunded liability, I was looking at the net liability – a very small difference, but one that I want to correct).


Every year, the Treasury Department puts out a report that turns the government’s financial statements into an accrual basis (rather than a cash basis) and makes them more like the financial statements we’re used to seeing (in corporate America).  The most recent one is titled “The Federal Government’s Financial Health: A Citizen’s Guide to the 2009 Financial Report of the U.S. Government.”  (Here’s the link if you want to see it.)  One of the things that you can find in this report is a description of the liability for the following programs:


1. Social Security

2. Medicare (Parts A, B and D)

3. Railroad Retirement (very small)

4. Black Lung Fund (tiny)


For each of the programs, the report describes the present value of the revenue that will come into each fund (in the future) and the present value of the payments that will go out of each fund.  More interestingly, they break the revenue and liability down into three components for each fund (other than Black Lung):

1. the amounts related to people who have already attained eligibility for the program (62 and over for Social Security, 65 and over for Medicare)




2. participants who have not yet attained eligibility (e.g., people who are working and contributing, but they can’t claim benefits yet)




3. 3. future participants

When the government (and the Trustees of each fund) calculates these numbers, they plan 75 years out.  So, “future participants” (Category 3) are people who are not working yet, but will start working in the future.  (This is a key idea that I’ll come back to…you’re getting excited aren’t you?)  Many of these future participants haven’t been born yet…some will be the children of our children.


Categories 1 and 2 (people who have already attained eligibility and people who are participants but have not yet attained eligibility) are combined and called “the closed group.” When group 3 (the future participants) is included, it’s called “the open group.” Again…this is going to be important both today and later this week.


Here are some interesting things you should know:

1. The present value of the liability (in excess of the present value of the revenues) is $52 trillion for the closed group.




2. The way we get to the $52 trillion is $32 trillion of revenue and $84 trillion of liability.  This is amazing.  It would be one thing to be $52 trillion short on a $900 trillion liability.  But, we’re $52 trillion short on an $84 trillion liability!




3. In the past, I have mistakenly referred to this as our unfunded liability of $52 trillion.  This is wrong. As I’ve had more time to review the numbers, this number ($52 trillion) does not include the money already set aside (the well-known “lockbox”).  We actually have close to $2.8 trillion set aside.  So, you could make a reasonable argument that the unfunded liability is really closer to $49.2 trillion. It’s not a huge difference, but I’ll try to use the correct numbers.




4. While I will sometimes talk about the $49.2 trillion unfunded liability in the future, make sure you realize that this $2.8 trillion has been loaned to the US government (and spent).  The trust funds have IOUs in their “lockbox.”  In other words, the federal government has spent the money and promised to pay it back to the Social Security fund.




5. Assuming we don’t cut Social Security benefits, since we’ve already spent the “trust fund money,” these funds will have to be replaced.  This $2.8 trillion will come out of our General Fund (in the future) or we’ll have to borrow the money.  Since I’m not expecting the Surplus Fairy to arrive anytime soon, we’ll have to increase our debt by $2.8 trillion.  In other words, Social Security (and other funds) is currently financing our government’s past deficits (by loaning the trust fund money to the government).  Those loans will have to be replaced…someone get China on the phone.




6. Our current debt outstanding to investors (not including the Trust Funds) is approximately $9 trillion. (When you include the trust funds and other government agency loans, our total debt is $13 trillion and rising.)  So financing this $2.8 trillion is going to be significant (ignoring all other annual deficits that cause us to issue more debt).  In other words, it’s hard to believe that the credit markets are clamoring for a 50% increase in the amount of Treasury bonds outstanding (if you look at the entire $4 trillion loaned by trust funds and other government entities).  This will happen during the next 20 years (approximately).  (Of course, issuance will increase much more because of other problems.)




7. Here’s something that’s really interesting…while the net liability is $52 trillion for the closed group, it is only $45 trillion for the open group. THIS IS REALLY INTERESTING…when we include future participants, it seems like we solve a bit of the problem.  As Lee Corso says, “not so fast my friend!”  This is a really interesting issue and will be the focus of another blog this week.  It leads to an interesting conclusion.

So, in the interest of keeping this short, let me show you the net liabilities of each of the Funds.  I’m going to use the open group (and the $45 trillion net liability):

Social Security -$7.7 trillion

Medicare Part A -$13.8 trillion

Medicare Part B -$17.2 trillion

Medicare Part D -$7.2 trillion

Railroad Retirement -$100 billion (this is relatively small)

Black Lung $6 billion (surplus)


NOTE: Railroad Retirement and Black Lung are in billions while everything else is trillions.


In conclusion, we have a huge liability. You see that this appears to be largely a Medicare problem.  Tomorrow, we’ll see that this is a little misleading. Social Security is actually a very significant problem.

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As many of you know, I’ve been writing (with the exception of a few months last year) for a couple of years now.  This newsletter / blog started out as a simple email list (with a PDF attached) and it turned into a website (with email service) for the past year.


I’ve learned a ton from this process.  I’ve learned by reading and writing and I’ve also learned a tremendous amount from emails that people have sent me.  All of this reading and writing has led me to one main conclusion: our country has a tremendous debt problem and we are headed for significant problems down the road.  I don’t know if it will be five years down the road or twenty years down the road, but the problems are coming (and we’re already experiencing some of them).


In sum, if you asked me to identify what I believe will be the most significant economic issue over the next 25 years, I believe that it will be the debt crisis.  The key data point that scares me the most is that the present value of our unfunded liability for Medicare / Medicaid, Social Security and Veterans Affairs is $52 trillion! In other words, to fully fund today’s value of our outstanding obligations, we would need to issue $52 trillion more debt.  As a reference point, we have $13 trillion of debt outstanding right now.


Realize that this $52 trillion figure is not some crazy Republican or Democrat “think tank” number.  This comes straight from our crazy government.  Our country is going to have to change significantly over the next several years.  Our taxation is likely to change and our “benefits” will certainly change.


I’ve given several speeches in the past two months and I’ve realized that the debt problem is something that I’m very passionate about.  It scares me for our country and it scares me for my children.  While scaring me, this issue also makes me angry – because we continue to kick the can down the road.


In addition to being a tremendous problem, the debt issue is something that most of us can’t even get our arms around.  There’s too much to know and to understand.  As a result, I’ve decided that I want to start to focus my work on this issue. I want to read about this issue, research this issue, write about this issue and speak about this issue.  I want to develop more expertise in this issue.  I also want to pass on what I learn about this issue.


Of course, the “debt crisis” includes a lot of issues, such as Medicare, social security, the trade deficit, our broken political system, demographics, taxation, state budget issues and other topics.  I plan on learning more about all of these issues (particularly as the relate to the debt crisis) in the future.  (Of course, I would argue that even the issue that I discussed in my blog this week about the Chinese government was impacted by our debt crisis.)


This blog has served (and will continue to serve) as your window into the issues that I’m thinking about on a daily basis.  My interests change over time, although I think that this will be an important issue to me for a long time.  I hope that you will read the blog over the next few weeks and see if it’s still interesting to you.  I think that you’ll find it highly relevant and (hopefully) educational.  But, if you don’t, you shouldn’t feel funny unsubscribing.  (I’m convinced that unwanted email is a tremendous drain on our productivity.)


I titled today’s blog “A Midlife Crisis” because my change in focus has a lot to do with my career.  If you can’t tell, I love what I do.  I get a lot of enjoyment and meaning out of my work.  Lord willing, if I maintain my health, I hope to work another 25 years.  My goal is to continue teaching and to couple that with addressing a meaningful issue.  I want to understand the upcoming debt crisis and I want to help others to understand it.  I want my work outside of the classroom to have as much meaning to me as my work inside the classroom.  Maybe it’s a midlife crisis.  (I’ve also been thinking about getting a hairpiece and a convertible.)  (Jenny would love for me to also look for a second wife, but no such luck for her.)

A Few Random Issues

Jeff Immelt (GE’s CEO) made some interesting comments about China.  You can read about it here.


For those of you in Houston…there’s a documentary that is playing in Houston this week that looks great.  It’s called Restrepo.  Here’s a link to where it’s playing – the Anglelika Houston.


I’m a huge fan of documentaries and I happened to see a story about this in the middle of the night (when I should have been sleeping).  This documentary is about an incredibly dangerous outpost in Afghanistan – they get attacked daily.  Whether or not you support the war, I think (hope) that we all support the people fighting it.  I enjoy seeing these documentaries because it’s a reminder of what people are doing for all of us.  It’s a great reminder of how easy most of us have it.

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For those of you who have heard my presentations over the past six months, I frequently mention Liu Xiaobo.  Liu Xiaobo is a Chinese dissident.  He had the audacity to write Charter 08, a document which called for free elections in China, the recognition of human rights and the abolition of subversion laws.  After a lengthy two-hour trial, he received a sentence of eleven years.  He was sentenced on Christmas day – something that many commentators believed was an intentional message to the United States.


I speak about Liu Xiaobo for several reasons.  First, this is an important reminder that China is very different than us.  This is significant because we have become deeply indebted to China – they are the largest owner of our Treasury securities.  Second, it’s just another example of what happens when a country becomes indebted – we’ve lost our ability to lecture the Chinese.  Finally, I think (unfortunately) that it’s another indication that we’ve lost our moral compass.  I would argue that when I was younger (I’m 46), we used to care more about issues like this.  We used to think about these issues and talk about them.  But, we don’t seem to care any more.


We see China as a huge market and that’s all that matters.  Interestingly, if you look at rankings of countries based on respect of human rights, in 2007 (the best ranking I could find) China was below Iraq, Cuba and Afghanistan.  In other words, if they weren’t such a huge market, we wouldn’t trade with them.


Now, things have become even worse.  On July 4^th (another interesting selection of days), a Chinese court sentenced Xue Feng, A US CITIZEN, to eight years in jail for attempting to traffic in state secrets.  Very few of the accusations were made public (we’re dealing with China), but it’s been widely reported (including by the BBC and The Wall Street Journal) that he was trying to purchase a COMMERCIALLY AVAILABLE DATABASE of information about the Chinese oil industry.  (At first, I wondered if he had been arrested for trying to buy this database since the Chinese government would have simply stolen it, but apparently this wasn’t the case…)


(Mr. Xue attended the University of Chicago and is a naturalized citizen.  His family lives in Texas and he was working on behalf of a Colorado company (IHS Inc.).)


To make matters worse, Mr. Xue was arrested in 2007 (so even if he is eventually released and deported, he has been in jail for three years).  He was not allowed to contact the US Embassy and his whereabouts were unknown for several weeks.  He claims that he was tortured (burned with cigarettes and hit over the head with an ashtray) and has supposedly shown evidence of this to the US Embassy.  (Personally, I don’t need much evidence to believe that the Chinese government would do this.)


President Obama sent a personal appeal to China prior to the sentencing.  Our ambassador to China attended the sentencing hearing.  Our Chinese embassy said that Washington is “dismayed” at the sentence.  Here in Austin, I’m “dismayed” that we’re bullied by China’s government and that we don’t talk about these issues on a regular basis.  The Chinese government is evil.  Period.  Why do you think that their human rights ranking was below Afghanistan?  The reason is that they have even less respect for human rights than the taliban does.


Before any of you start writing me to tell me that we’ll change China by trading with them, realize that China is already the largest exporter in the world.  So, I’m not sure that I’m seeing our impact.  And don’t start writing me to tell me about things that the US government has done.  China’s act is a deliberate message to the US – it’s not a mistake or an act of negligence.  Finally, I realize that the US arrests spies all the time, but there have not  been any spying allegations made here.


In the past seven months, China has executed four Japanese citizens and one British citizen – all for drug smuggling.  We can argue about whether harsh drug laws are appropriate or not.  But what you should realize is that Britain pleaded with China not to execute their citizen (partly because they said he suffered from mental illness) and China refused.  China executed him at the end of Britain’s Boxing Day weekend.  What does it say about a government that is executing foreign citizens and sentencing foreign citizens on holidays in those foreign countries?  How can anyone disagree that we are dealing with an evil government?


So here’s what I’m wondering.  If I’m a CEO, is it ethical for me to send my employees to China?  If they do market research, they can be imprisoned.  All I know is that Jenny and I are not going over there and our kids aren’t going either.  The other thing that I know is that if we were China’s largest creditor (rather than debtor), we probably wouldn’t be in this situation.


RANDOM THOUGHT

Can one company pay enough to make the entire Gulf Coast whole?  When I think about all of the people who have lost their income (e.g., fishing, tourism, shops in towns that are hurting, etc.) and the fact that this is a multi-year problem, it is hard to understand how BP will be able to finance this.
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Today, I pulled data from articles about the EU (and member countries).  When the  EU announces the results of their “stress tests” and gives us a “boost of confidence,” here are some things to be thinking about…

Part 1: Greece is Still in Trouble

1. Greece has debt of $371 billion (300 billion euros).


2. In mid-June, Moody’s cut Greece’s credit rating four notches to junk status (from A3 to Ba1).  They cited substantial risks to economic growth from the austerity measures.


3. Many think that Greece will restructure its debt once it gets its house in order.  Their debt will be 150% of GDP and the interest costs will be burdensome.


4. Credit default swaps on $10 million of Greek debt (for five years) reached $1.1 million (per year).  Apparently, these prices imply a 69% chance of default over the next five years.    Greece is now considered the second riskiest sovereign borrower in the world, behind Venezuela.


5. Greece should not have to sell bonds for at least two years due to the EU bailout.  Greece has a $135.6 billion funding package in place which covers their debt needs for the next three years.


6. Greece expects their GDP to shrink 4% this year and 2.6% next year.  This past year, their deficit was 13.6% of GDP.


7. There is fear that tourism will be slow in Greece this summer and that will cause large problems.  It’s odd that tourists wouldn’t want to visit a country that is implementing austerity measures and is constantly striking.


8. This week, Greek unions held their fifth general strike of the year.  They are protesting the government’s plan to cut pension benefits and loosen labor laws.  Companies will be allowed to fire five percent of their workers.


9. Greek pensioners (on average) receive 96% of the salary that they had when they worked!


10. The Greek pension system consumes 12% of national output.


11. A recent poll showed that 64.8% of Greeks believe that their sacrifices will not save their pension system.


12. Juergen Stark (an executive member of the ECB) said that the ratings agencies acted irresponsibly in downgrading Greece while the IMF was negotiating with Greece.  My view is that Stark needs to get a clue.  Ratings shouldn’t be based on potential deals or the disruptive effect of these deals.  A rating can be conditional and a rating can be upgraded if a deal is made.  But, we should have learned from the financial crisis that we want the ratings agencies to be proactive.


13. The IMF’s head of their Greek mission said that Greece will overcome their debt crisis with the austerity plan.




Part 2: Germany Is Doing Well and Supporting the EU

14. Germany is expected to account for 27% of euro-zone GDP.  Industrial production is up 13.9% YOY.  Unemployment is down to 7.7%, the lowest since December 2008.  Annualized growth could hit 5% in Q2.  Germany is being helped by the weak euro.  In addition, companies and individuals are not overleveraged.  They are the only sovereign issuer that has not had their AAA status questioned by investors.


15. Germany contributed approximately $1 trillion to the EU bailout.


16. Paul Krugman criticized Germany’s austerity measures.  He also criticized the head of the German central bank.  Krugman has been a big fan of “spend now, worry about the debt situation later.”


17. George Soros said that Germany’s fiscal tightening could lead to deflation and ultimately endanger the EU.




Part 3: The Rest of the Euro-Zone (Much Of It is In Trouble)

18. A Fitch report said that the euro-zone problems were caused by:

A. economic imbalances

B. skepticism over the ability of economies within the eurozone to adjust in the absence of monetary and exchange rate flexibility

C. concerns about fiscal solvency given large fiscal deficits and wak economic growth prospects

D. doubts over the political commitment to the eurozone in the aftermath of the hesitant and reluctant support given to Greece



19. For years, Europe had a model of high taxes, but a complete safety net (medical care, retirement, housing) for your whole life.  Now, these benefits are being cut.


20. We have the EU implementing austerity measures while China is also trying to slow growth.

21. Loans to private businesses increased .2% (YOY) in May in Europe.  While commentators have been noting the acceleration of credit, this is still a very low rate.  In addition, realize that there wasn’t much lending in the public markets…


22. The volume of bonds sold in Europe in the first half of 2010 fell 29% to $1.2 trillion.  European companies led the decline with a 63% decline from the same period in 2009.  These numbers are a little unfair because the first half of 2009 was particularly strong.  Many countries and companies took advantage of the strong markets last year.  With that said, the drop also reflects investors’ fear about Europe.


23. According to the IMF, the three countries that must raise the most money this year are Italy, Belgium and France which all have to raise more than 25% of GDP.


24. Ireland’s GDP shrank 7.1% last year and is still in recession.  Unemployment is above 13%.  This is what happens when you have austerity measures.  Last year, their deficit was 14.3% of GDP.  This is a country that has a debt-to-GDP ratio of only 77%.


25. Spain is trying to change their labor laws: reducing severance pay to 25 days pay per year worked (from 45 days), making it easier to lay off workers temporarily during bad times and simplifying contracts.  They have 20% unemployment.


26. Spain’s banks took possession of large inventories of homes, building and land two years ago in order to avoid defaults.  They basically made a bet that the market would come back.  Now, they need to get rid of these assets.  So, some of the banks are offering 100% financing.  Keep kicking the can down the road…


27. France is going to raise the legal retirement age from 60 to 62 by 2018 (not a particularly bold move).  They are also going to raise the top income tax rate from 40% to 41% and increase the taxes on capital gains.  They plan on balancing their pension fund by 2018.  But, most people don’t trust this…the fund is supposed to become underfunded again after 2018.  France’s deficit is 8% of GDP this year and their debt-to-GDP is 85%.

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The next update will be sent on Wednesday morning.


Today’s update has some of the data that I’ve recently come across related to the housing market.

Part 1: The Data

New home sales hit a record low in May. Sales of new homes declined 32.7% from April to May!  Only 28,000 new units sold in the month, the lowest May total ever and the lowest seasonally adjusted annual rate since the data series started in 1963.


You could argue that new home sales don’t matter. New home sales are approximately 8% of home sales.  With that said, there’s no reason to believe that the new home sales results are much different than existing home sales.  In addition, because of the way that existing home sales data is collected (see below), new home sales data is more current.


Existing home sales are also dropping. Existing home sales in May dropped from April, but since existing sales are counted at the time of closing (rather than signing), this was actually falling before the credit expired.

Existing homes are approximately 15% – 20% cheaper than new ones.


The National Association of Realtors said that completed resale’s of homes in May were down 2.2% from April, an increase of 19% from a year earlier.  The SAAR is 5.66 million units.  This index measures completion of sales, most of which were based on contracts signed in March or April.


Mortgage applications for home purchases are now at a 13-year low.  Purchase applications have decreased for six of the past seven weeks.  They are down 30% from April.


May construction starts on single-family homes fell 17% to an annual rate of 468,000, the lowest level in a year.  Building is slowing because May and June sales have been horrible.  Residential investment (home building) is just 2.4% of GDP.


The anecdotal evidence supports the idea that the market continues to be very weak. Many firms have estimated that home purchases are now down approximately 20% from a year earlier.  We don’t have the stats yet, but brokerage firms are telling us this.


There is anecdotal evidence that many more real estate deals are falling apart. Buyers are more demanding.  They feel that sellers must be desperate and should be willing to do anything to sell.


The drop in home prices has been continuous. Home prices (Case-Shiller) have declined for six consecutive months.


Interest rates are very low. The average rate on a 30-year fixed-rate mortgage fell to 4.69% this week from 4.75%.  This is the lowest level since Freddie Mac started tracking the data in 1971.  We’re seeing that low rates don’t always drive the real estate market.


Housing is more affordable now. Falling prices and historically low mortgage rates have lowered monthly payments to approximately 15% of household income – down from 21% in 2007.


Expectations are dropping. MacroMarkets monthly report found that 56% of the 106 economists and other analysts surveyed expect home prices to decline this year.  That is up from 40% a month ago.


In some areas, there are a lot of people underwater. Approximately one-third of the seven million California households with a mortgage are underwater.


Economists from the New York Federal Reserve Bank calculated that only 15% – 19% of Las Vegas homeowners have any equity left in their house.  In San Diego, the number is between 35% and 39%.




Part 2: California Legislation

Interesting California legislation. California is considering a bill that would prevent lenders from suing borrowers for the amount that they originally borrowed.  In other words, it would mean that the amount of your original loan was non-recourse.  Currently, California is basically a non-recourse state UNLESS you have refinanced.  If you refinanced, you can be pursued for the deficiency (the difference between what you borrowed and what the house is worth).  Part of the justification for this law is that it doesn’t make much sense to penalize homeowners for refinancing.


In reality, lenders in California rarely pursue deficiency judgments.  But, the threat of this litigation is an important negotiating tool in loan modification negotiations and short sales (selling for less than the house is worth).


The problem is that passing this law could lead to more strategic defaults.  The bank lobby wants to limit this law to new loans. Otherwise, the law will be altering existing contracts.


In effect, the bankers are facing off with the borrowers and real estate agents. Bankers are pushing to hold borrowers liable for their debt.  Real estate agents are pushing to have the debt released – so that the homeowners will return to the market.




Part 3: Strategic Default

There is a huge fear of strategic default becoming a contagion.  As a result, the government is trying to discourage it. Fannie Mae said that it would “lock out” borrowers from getting a new loan for seven years if they strategically default (defaulting on a mortgage that they could afford to pay).  Clearly, this shows the fear that strategic default is starting to cause.  They also said that they are going to pursue deficiency judgments in states where this is allowed.  Approximately 25% of homeowners with a mortgage are underwater.  A Morgan Stanley report said that approximately 12% of all mortgage defaults in February were strategic.


Previously, Fannie would not make loans to borrowers who had been foreclosed upon in the last five years.  Now, unless you can document “extenuating circumstances” must wait seven years to get a loan.  If you can show a hardship or that you attempted a workout with the lender, you can get a loan in three years.  This is probably making the rules EASIER for many people (who can show job loss, etc.).  If you complete a short sale or do a “deed in lieu of foreclosure”, you can get a loan again in two years.


There has been strong demand for Fannie, Freddie and Ginnie debt. Thirty-year agency bonds yield approximately 1.5% more than Treasury bonds.  Central banks have become big buyers because it seems like the government has guaranteed this debt.  In addition, banks can borrow cheaply and buy this debt.  In addition, there is a shortage of new debt being issued.  There is also less prepayment risk, since homeowners have already refinanced.  Some buyers are looking at this as an overbought market.




Part 4: Final Thoughts

1. The tax credit simply shifted the time in which people bought houses.


2. The short-term future does not look promising (although I personally believe that real estate will prove to be a good long-term investment from these levels).  We have huge inventory levels because of overbuilding and huge foreclosures.  We have millions underwater.  Unemployment is 9.7%.  The tax credit didn’t change any of this.


3. It’s amazing to see the market so weak when mortgage rates are so low.  This shows the effect of uncertainty in the job market, damaged credit ratings and the home-for-clunkers program that we just finished.


4. With 25% of homeowners (with mortgages) underwater, it won’t take much to push more people under water (in other words, there are many who are close) and to push the “already underwater” to the point at which they consider strategic default.

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