Deficit Reduction – Credible Solutions – Part 4: Investment Impact

Should a comprehensive deficit reduction program, as outlined in our entry titled, Deficit Reduction – Structural Deficit Quick Primer and detailed in the previous four entries this week, be adopted, we believe the following big picture items would improve:

  • Clarity for business on taxes and final demand
  • U.S. corporate international competitiveness
  • Outlook for long-term interest rates

In turn, we believe these benefits would translate into the positive investment developments shown below:

  • Higher stock prices, driven by both higher earnings and expanding price/earnings ratios
  • A relatively benign bond market for the recovery stage of an economic cycle
  • Many alternative investments would rise in attractiveness
  • Industrial commodities would likely appreciate
  • Precious metals, especially gold, silver and platinum, would initially sell off

Within the equity markets, consumer discretionary and a retail shares, as well as defensive shares would initially decline the most. The former would likely then rally strongly, as the benefits of the reformed tax code became more fully and widely appreciated. Consequently, we would suggest you now begin to identify the highest quality names in these sectors for addition to your portfolio on the anticipated weakness.

On the other hand, if Congress failed to send an integrated solution to the President by November, we would expect more of the same volatility the capital markets globally have experienced in the past 30 days. Given the current fragility of the U.S. economy and the near full blown crisis in Europe, the U.S. economy may quite easily slip into a more prolonged economic slowdown, with anemic GDP growth and rising inflation – the dreaded stagflation.

We strongly believe a solution that tracks the one we have outlined this week will be implemented. To us the only questions are how soon and how much pain will be felt before it is put in place.

What do you think? Let us know! Leave a comment or contact us at [email protected]

 

 

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Deficit Reduction – Credible Solutions: Part 3 – Reduced Government Spending

As noted in our primer on the structural deficit crisis, we noted that reductions in the growth rate of the largest entitlement programs and the size of the overall defense budget are the two areas of spending cuts that should be implemented in any credible deficit reduction plan. The current Congress and the Secretary of Defense, Robert Gates, respectively, have already embarked on efforts to reduce the defense budget. More can be logically accomplished without diminishing either the U.S.’s role in world affairs or its readiness to respond to any circumstances that may require the military’s role, in our view.

Our recommendations for the large entitlement programs (Medicare and Social Security) are straightforward. In brief, these social programs are maintained. However, benefit reductions and eligibility limitations are phased in.

First, existing recipients of Medicare and Social Security benefits are largely unaffected. Current seniors’ sacrifice will mainly come from the consumption tax and the loss of eligibility for those above a certain level of income, say $250,000 for a couple and $200,000 for an individual.

Those in their 50’s should also be means tested, with a lower income ceiling, of say, $150,000 for a couple and $100,000 for an individual. The retirement age for eligibility for both programs should be raised to 70 1/2 now all under the age of 60.

For those between the ages of 35 and 50, the benefit package should be reduced, as well as having a higher retirement age (75?) and means-tested eligibility at or below that of those in their 50s.

For those between the ages of 25 and 35, there should be a bare-bones benefits package, raised retirement age (75?) and means-tested eligibility lower than that of those in their 50’s.

There should be no program benefits for those under the age of 25. Instead, these people should rely on private income, retirement and health insurance. If necessary, the ceiling for the individual retirement account (IRA) annual contribution could be raised to $5,000 from the current $2,000. Though seemingly harsh to those under 50 years of age, most in this age group don’t expect either program to be there for them when they reach 65 years old anyway.

Medicaid’s benefit package is already less than ideal and is inherently means-tested. However, a modest co-pay from those at the top of the income eligibility range of say, $1 per visit, may be necessary.

We are somewhat indifferent to cuts in discretionary spending. Why? Because in spite of some obvious waste, most egregious at the defense department and with earmarks in general, eliminating ALL discretionary spending just doesn’t move the needle. This falls into the category of political sideshow for us.

Rather, the key objective is to reduce the government’s need to borrow/issue new Treasury securities in gargantuan proportions. In particular, it is the interest on that borrowing, at whatever level you choose, that is the real danger. This is because such interest expense on hundreds of trillions of debt will crowd out all other budget items. In turn, such a national fiscal state renders the nation much less credit worthy and retards economic activity. This begins a vicious cycle which leads to sustained levels of even higher unemployment than we have today and thus reduced demand. In other words, a prolonged period of sub-par growth at best and at worst, an extended economic slump for which there are few policy options to employ to reverse it. This outcome must be avoided at all costs.

In our next post, we will discuss the investment impacts of both the adoption of a comprehensive solution and the likely outcomes borne out of the failure to do.

What do you think?

 

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Deficit Reduction – Credible Solutions: Part 2 – Faster Economic Growth

A central benefit arising from the simplified tax code would be faster economic growth, one of the three key parts of the integrated solution we support. Faster economic growth generates more revenue through higher profits, employment and consumption. The lowering of the long-term deficit from higher revenues and lower spending will allow for long-term inflation and interest rates to rise more slowly during the recovery and expansion stages of the current economic cycle. This, in turn, potentially enables a virtuous cycle.

Such growth is underpinned by the broad tax reform outlined in our previous post. Of particular note are the positive impacts from a lower tax rate on business uncertainty. In turn, business activity is attracted back to the U.S from international operations and new investments. Domestic employment is likely to rise.  Consequently, the lower top individual tax rate and higher household incomes (from the newly employed) tends to increase consumer spending, once consumer balance sheets are mended and consumer confidence bottoms and starts to rise.

A critical question to be answered, as noted above, is the maintenance of the tax policy supporting residential housing. Persuasive arguments can be made by both sides of this question. However, this is not the topic of this post. Nevertheless, should the current policy be retained or even enhanced within the context of comprehensive tax reform, it could blunt the downward pressure on this important aspect of domestic economic activity.

The infrastructure bank, which would fund overdue and necessary repair, maintenance and future investment, could reduce unemployment right now, particularly of those in the construction-related industries that supported benefited from the expansion in the nation’s housing stock in the 2003 – 2007 housing boom. Higher consumer spending could ensue from this employment sector as well. Similar benefits could accrue from shifting a portion of the subsidies for the oil and gas industries to the clean energy industries, to support the development and expansion of a natural gas filling station or electricity charging station infrastructure.

These are just a couple of ways comprehensive tax reform fits into and enhances faster economic growth. There are undoubtedly others. Feel free to share your thoughts on those.

 

 

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Deficit Reduction – Credible Solutions: Part 1 – Tax Reform

In today’s installment of our series on credible solutions for the deficit reduction problem facing the U.S., we will share our views on comprehensive tax reform and raising revenues. As we have noted during this series, we are proponents of a multifaceted approach to resolving the fiscal gap, utilizing higher tax revenues, reduced entitlement and defense spending and faster economic growth.

Today we will tackle arguably the toughest one first – tax reform. Despite some beliefs to the contrary, especially on Capitol Hill to the right of the aisle, more revenue is as important a component of the long-term solution to reducing the long-term structural debt as are spending cuts to entitlements and defense and faster economic growth. All three are needed. Unless Medicare and Social Security are ended altogether or the country scales back its military commitments to addressing solely the defense of its borders, more revenues to the federal government are required. And just to answer the unasked question, there are not enough federal assets to sell to avoid addressing taxes, as Laurence Kotlikoff notes in his book, The Coming Generational Storm.

Indeed, federal tax revenue as a percent of GDP has averaged around 19% – 22% over the past 100 years, while spending has hovered around 18% – 22%. As a result of unprecedented government spending to stave off a complete economic meltdown in 2008 – 2009, government spending has spiked to 25% of GDP. Meanwhile, as a result of persistent tax cuts over the past 30 years, with the exception of the modest tax increase in the top individual tax bracket to 39% from 35% during the Clinton Administration, and the effective corporate tax management, federal tax revenues have fallen to 14% – 16% of GDP over the past few years.

As the economy recovery will presumably pick up steam at some point, the government spending to bridge that fragile activity into a self-sustaining expansion will likely fall way, allowing for overall government spending to decline back within the historic range. Nevertheless, there will still be a fiscal gap. This is due to federal taxes as a percent of GDP still being too low, even with more receipts flowing in from higher profits. In other words, to turn the House of Representatives Republican mantra on its head – ‘We DO have a tax problem, not just a spending problem.’

But don’t be fooled. This does not mean we are an advocate of only raising taxes on the rich (say those with incomes over $1 million) or the barely wealthy (those with $250,000 and above in gross income), as those left of the aisle and the chief and current resident of the White House espouse. Rather, what we think is needed is a substantial rewriting of the federal tax code, the first time in a generation.

In short, the tax code needs to:

  • Be simplified
  • Be fair and share the sacrifice
  • Support U.S. international competitiveness
  • Expand domestic employment
  • Generate more revenue than the current code

A few highlights on this list. In terms of fairness, those living on government assistance are currently paying no federal income taxes. However, whether you believe in the fairness of this purposeful exemption or not, the people receiving government assistance and those working but living below the poverty line do pay other taxes, just not federal income taxes. Given the need to have shared sacrifice, this group should pay something, somehow to the federal government.

Corporate tax reform should have the effect of sharing the sacrifice, supporting international competitiveness, expanding domestic employment and actually generating more revenue from these tax payers than the current code does. For instance, obsolete subsidies for mature industries (such oil and gas) should be abolished. Instead, these supports should be shifted, for instance, to those emerging sub-sectors in energy that will generate cleaner, domestic and job-creating revenues. These clean technology sectors are among the fastest growing sectors in the world and a place the U.S. needs to reassert is leadership and competitiveness.

Significant loopholes for corporations to avoid their tax liabilities need to be eliminated. Despite a top corporate tax bracket of 35%, many of the largest U.S. companies actually pay no taxes.

This top corporate tax rate also has the negative consequence of deterring incremental investment in the U.S. by both U.S. and foreign companies alike. In this way, job creation and faster economic growth are blunted at the margin.

Lastly, the most important goal of this tax reform must be to generate more revenue than the existing system. All of the above factors contribute to this result.

Tax Reform Specifics

We recommend a drastically simplified federal tax code. This reform would include a corporate tax rate of 20% – 25%, a permanent R&D tax credit, clean energy subsidies and an infrastructure bank. There would be no other deductions or credits. Additional job creation incentives would need to be passed separately, paid for by other revenues and expire upon a sustained reduction of the nation’s unemployment rate to under 7%, for instance.

The top individual tax rate would decline to between 25% – 30%, on a gradual basis as the economy expands. Finally, a consumption tax on all goods and services would be instituted at a rate of no more than 19%. This flat tax should probably be phased in as the top individual tax rate falls, in order to keep tax revenues from falling. By the way, it is here, that the working poor and those on government assistance pay their so-called fair share.

The only deduction that remains from the current tax code is the residential mortgage deduction, in order to provide support the depressed housing market. However, we would support its phased elimination over time. More on this in our next post.

We believe this kind of tax reform is fair, simple and should generate more revenues than the existing system. Indeed, we believe actual U.S. corporate tax revenues would rise despite the decline in the top tax rate. Additionally, and equally important, U.S. international competitiveness would likely rise. In particular, U.S. corporate tax rates would fall in line with those of key competitors for new investments. A lower tax rate would probably spur job creation among small business, despite the anticipated higher costs of health care reform.

What do you think?

In our next post in this series, we will address the 2nd component of the comprehensive approach to deficit reduction, faster economic growth.

 

 

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Deficit Reduction – Side Show and Economic Context

In our last post, we shared our view of the landscape upon which the deficit reduction debate should be held. We also noted what we saw as sideshows to the main event, to mix our metaphors. These included reducing discretionary government spending and any ‘sturm and drang’ over raising the debt ceiling. We ended that entry with the promise of offering some broad pathways of solutions to the long-term fiscal deficit in which we find ourselves.

Today we begin that discussion.

Generally speaking, our solutions can be described as comprehensive, interlocking and integrated. They also can be characterized as sparing no key groups and yet shifting priorities to support future economic growth. These approaches encompass spending cuts to the largest portions of the budget to address the so-called debt bomb. Our solutions alsoinclude a generational overhaul of the federal tax code. Lastly, these strategies provide spurs to accelerate and sustain faster economic growth.

A number of economists, including Laurence Kotlikoff, in his book the Coming Generational Storm, market observers, former Republican budget directors (David Walker and David Stockman), as well as current and former senators and congressmen all support a mix of the above three approaches in any credible long-term fix to these fiscal problems.

However, before we delve further into these solutions, we would like to address the side shows and share a few words on the economic context of this discussion.

The Side Show

As we expected, there indeed has been a tremendous amount of fairly useless political posturing and unnecessary drama surrounding the negotiations over raising the debt ceiling and changing the long-term direction of the budget deficit. It was useless due to the result – yet another round of kicking the can down the road, this time to a ‘super committee’ of 12 congressmen, tasked with coming up with $1.5 trillion in deficit reduction. To paraphrase William Shakespeare, from Macbeth, “…this has been a tale…full of sound and fury, signifying nothing.”

These negotiations resembled a management-labor dispute with the twist of a role reversal. The Democratic president assumed a centrist compromise with a single core goal of raising revenues, by offering a big concession to the other side. Meanwhile, the Republican leader of the House of Representatives was riding herd over a bombastic and often unruly rank and file, which was seeking all of their goals. Further, the usually staid G.O.P. employed dramatic tactics like walking away from the negotiating table. Fear-mongering was employed by both sides. This negotiation had all the trappings of theater. And, to us, it was only theater.

There were no cuts of any kind to the largest entitlement programs, nor any serious discussion, much less promises or action on, transformative tax reform to reflect the new realities internationally, much less to raise more revenue. What the two sides delivered was a reduction in discretionary spending and promises to automatically cut spending on defense and education if the new gang of six times 2 can’t agree on deeper, more meaningful deficit reduction by mid-November 2011. If the stakes weren’t so high, we would simply be bored by it all. With this type of decision-making, we can no longer presumptively criticize the Europeans on their handling (bumbling) of their rolling sovereign debt crises.

However it looks, this process is untimely and so far has not yielded the necessary results to generate meaningful change in the long-term structural fiscal deficit. This side show has, however, now captured the attention of the capital markets. Thus, it is now of greater near-term interest to us. Consequently our views on what we believe are the appropriate solutions to address the long-term deficit may now be helpful in evaluating whatever emerges from the ‘super committee’.

But first, the economic context.

Economic Context – Timing and Credibility are Key

In short, the U.S. economy appears too fragile to sustain and absorb the reduction of government spending in the short-term. In fact, the U.S. economy seems to be stalling and is thus vulnerable to any untoward shocks that might come from either higher taxes or reduced spending right now. On the other hand, bondholders and ratings agencies seem to require that any credible deficit reduction plan begin now. We put forth the notion that such a requirement is in lieu of a realistic pathway to future, enforceable action that reduces the long-term deficit. It seems to us that if such a plan was submitted and put into law, the timing issue goes away. Thus, credibility is the antidote to the timing problem.

In our next post in this series, we will share our recommendations on comprehensive tax reform, arguably the toughest of the three solutions upon which to get all sides to agree.

What do you think?

 

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Deficit Reduction – Structural Deficit Quick Primer

Introduction

In our last post on deficit reduction, we offered the point of view that there were two budget deficits, one that is due principally to the stimulus packages and the other the long-term structural deficit. Further, we stated this structural deficit would be much harder to reduce and promised a quick primer in our next offering on this topic. This is that primer.

Source and Size of the Structural Deficit

Decades of benefit promises coupled with demographics are the sources of the structural deficit. When passed into law, first Social Security in 1935 and then Medicare in the 1960s, were all seen on the political right as immediate and persistent drags on the economy. However, those fears were unfounded. First, over the intermediate term for both programs, the number of seniors was small relative to the working population.  For instance, when Social Security was first passed, it covered only white males, while also excluding many categories of employment, like agricultural, domestic service, governmental, teaching, nursing and social work. De facto, most women and minorities were excluded from receiving benefits. Additionally, according to Laurence Kotlikoff and Scott Burns in their book, The Coming Generational Storm, life spans of most beneficiaries at the time of passage of these programs were just above the qualifying age, so many benefit dollars were never paid out in the early years of both programs.

The Pig in the Python

However, today, these demographic strengths have been turned on their heads and are now a pernicious cancer on the financial health of these programs. They are not only eating away at the viability of these programs, but also threatening to cripple the larger economy, if promises are to be met. Further, these demographics alone severely limit the solution set to correct these imbalances.

Specifically, Kotlikoff and Burns note that back in the 1960s, when the benefit plans were expanded, the number of workers under 30 were substantial. Additionally, they point out that the ratio of those receiving benefits from Social Security and Medicare to those paying into the financing of the programs, they call it the dependency ratio was quite low. In 2000 the dependency ratio had risen to roughly 20%. It is projected to rise to over 35% in the next 20 years, nearly a doubling.

As the baby boomers, this large pig in the python in the populations of the U.S. in so many ways, begins to retire in large numbers (projected to begin in 2012 – 2014), this ratio only worsens. This is due to, again a couple of demographic factors. First, the baby boomers drop out of the financing role and being to participate in the beneficiary role, literally swamping the existing workforce. Second, the number of workers under 30 continues to fall, due to the falling birthrates for the baby boomers and their children. Third, people are living longer. This trend is is expected to continue well into the future.

No Demographic Relief – Internal or External

A quick side bar. Many of you may be thinking, ‘Okay, like the Romans, as well as so many other societies after, we will just ramp up immigration, to generate the necessary workers to pay the payroll taxes to support the coming explosion benefit costs from the baby boomers retirement. After all, you may say, we need more scientifically trained workers (H-1B Visa issue), as well as those to do the ‘dirty jobs’ many Americans refuse to do.’ Not a chance. The numbers needed are just too large, even including all the currently illegal immigrants already in this country.

So How Big is the Problem?

The size of the combined deficit is mentally staggering. According to the Congressional Budget Office (CBO) latest projections in 2010, these future unfunded obligations, also known as the fiscal gap, amounted to $202 trillion – yes, trillion. As a point of reference for those of you not wobbly with vertigo, that’s over 15x the size of the U.S. economy ($14 trillion). It is 4x the size of the estimated total notional value of all the derivatives floating around in the global economy.

So what is this deficit, also known as the fiscal gap, composed of? The answer is the  unfunded future obligations of Medicare, Medicaid and Social Security. The largest and most difficult of the three to address is Medicare. Nevertheless, all three need to be addressed as they are inextricably linked.

This gap is calculated using generational accounting. Future obligations are subtracted from future tax revenues to arrive either a surplus or deficit/gap. This accounting methodology provides a more accurate picture of a country’s fiscal health than from its debt/GDP ratio, in its proponents’ view.

How Did This Happen? With Apologies to Pogo and Stan Lee

You are probably wondering (and perhaps actually asking out loud) ‘how did it get this bad?’ Well, to quote/paraphrase both Messrs. Kotlikoff and Walker, we did this too ourselves (‘I’ve seen the enemy and he is us’ – Pogo) through our ‘friendly, neighborhood’ congressman/woman and the last 10 presidents.

Indeed, every session of Congress and every president since FDR, regardless of political affiliation, has both expanded benefits explicitly or passively for these programs and has failed to pay for them – either by not raising taxes enough or worst yet, cutting taxes. All of this in the name of short-term political gain.

The political game is played as follows: the GOP, playing to those that feel like they pay a lot of taxes, cuts taxes to win their support; the Democrats, playing to those that feel they don’t get enough benefits, hikes spending and benefit expansion, playing for their votes. Notice, however, how neither side addresses the problem of how to pay for the programs? We think this is due to the fear of losing the support of the most reliable voting bloc in the nation: seniors (not surprisingly the key direct beneficiaries of these programs). This is one of the ‘third rails’ of national politics – touch it and you’re dead, politically speaking.

The U.S. adult population, particularly those retired, retiring or about to retire (the baby boomers) have welcomed all of these benefits expansions, as either good for their grandparents, parents or themselves. In doing so and not finding a way to pay for them, they have, at least tacitly, kicked the  invoice for all of this down the generational road for their children and grand children.

The Risks of Inaction are Downright Scary

The risks of this deficit are straightforward, substantial and disastrous. If these future benefits are not funded and yet delivered, the issuance of a vast supply of government debt will be required. This volume, plus the accompanying decline in the underlying creditworthiness of the issuer (the US of A) will in turn require much higher interest rates to attract buyers of these bonds. By the way, this is the positive scenario, in that buyers actually show up.

To go on, these higher rates and the size of the debt to be issued will likely overwhelm the government’s ability to do anything else but service the interest on the debt. In this scenario, the country will quickly not only lose its global position of primacy, but will become at least a second tier economy, with the commensurate loss of flexibility and freedom. This is not just a conceptual construct.

In real terms, domestic economy growth would slow sharply and painful recession would ensue. With it’s hands tied due to the loss of options (borrowing its way out of the decline, for instance, at low interest rates), the government would have no choice but to either 1) further devalue the U.S. dollar, 2) spark higher inflation or 3) formally default on its debts. All of these further limit the policy choices to revive the economy. Next to deflation, no one in government wants this result.

In this case, private sector borrowing would be crowded out, with the exception of the largest and financially strongest multinational companies that could raise capital both in the U.S. public markets and as well as on foreign exchanges. But for what opportunities? Capital flows to the highest returns with the lowest risks. In this scenario, it is not clear that that combination could be found in abundance in a U.S. drowning in debt to fund transfer payments in a high inflation, slow growth (at best) economy.

So What are the Solutions?

Unfortunately, there are no quick fixes or easy answers.  In our view, the current debate in Washington is more political than focused on the structural deficit. It is also the first ‘easy’ solution that won’t work. This current debate focuses on the 15% of the budget that is discretionary spending, which if cut to zero, has no effect on the structural deficit. It does, however, allow for a stage for the aforementioned political game to be played out.

This discretionary spending is essentially everything that’s not Defense, Social Security, Medicare, Medicaid or interest on the national debt. As noted above, if all of it was eliminated, that is those programs that both parties respectively cherish, including pork barrel spending and earmarks, it is just not enough to scratch the surface of the structural deficit.

Other so-called solutions, including those mentioned earlier and taxing only the rich, are also not enough, even when combined. So what is? There are three ways to cut the structural deficit of future unfunded benefits:

  • Higher taxes
  • Lower spending/benefits
  • Faster economic growth

Yet here is another place where ‘we the people’ send a decidedly mixed message. According to David Leonhardt of the Economix blog of the New York Times,(who we first discovered in a post at Calculated Risk) Americans appear to both recognize the need to do something about this deficit, but don’t want to bear the sacrifice a reduction in benefits. They would rather see tax increases, but not their taxes.

All three are needed. The risks of employing only one approach are two-fold: the problem isn’t solved and new problems are unleashed. In general, the new problems are imbalances that subvert the country’s economic health and threaten the social fabric and contract of the nation.

In fact, in our view an integrated and reinforcing set of policies driven by these three approaches is the solution. The problem is it requires political and individual will to sacrifice and say no. All stakeholders, not just bi-partisan political support and leadership, from the poor to the rich, from corporations to government employees, from tax payers to seniors all must be included in the solution and required to make sacrifices.

The president’s deficit commission (National Commission on Fiscal Responsibility and Reform) is a good first step. But their recommendations, to our way of thinking, fell short of the mark, and more importantly, were not well received in Washington, including by their sponsor, President Obama. One take of what we would propose is shown below.

An example would be a tax policy that:

  • Raises much more revenue
  • Minimizes regressive impact
  • Maximizes fairness
  • Stimulates economic growth
  • Ensures international competitiveness
  • Simple to understand and to comply with

In brief, this would appear to imply a combination of some sort of a consumption tax, the elimination of individual and corporate tax deductions, lowered corporate and individual income tax rates, as well as lowered FICA and payroll tax rates.

In the same vein, spending cuts would need to address:

  • Reduction of future benefits
  • Maximize fairness – everyone sacrifices
  • Incentives to maintain better health
  • Incentives to increase personal savings
  • Sacrifices across all segments of society
  • Reduction in defense spending

In our next installment of this series, we will delve a bit deeper into these potential solutions, how they might be mutually beneficial and reinforcing and how all of this will affect the investment environment and your portfolio.

What do you think?

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Deficit Reduction – A Tale of Two Deficits

There has been a lot of talk and no small measure of Sturm und Drang, over the U.S. budget deficit. Points of view from both sides of the political spectrum have been expressed on this contentious topic. Dean Baker, co-director of the Center for Economic and Policy Research and Sebastian Mallaby, director of the Maurice R Greenberg Center for Geoeconomic Studies at the Council on Foreign Relations to Kevin Hassert, director of economic policy studies at the American Enterprise Institute, among others, not to mention those of actual politicians, have been shared, sometimes in heated, breathless fashion. We would like to bring some calm and clarity to the discourse in a series of posts. First off, we would like to point out there are actually two budget deficits in the United States that need reducing.

Two Deficits: Stimulus-Driven and Long-Term Structural

One deficit was caused by the Bush and Obama Administrations’, respectively, responses to the financial meltdown and accompanying global economic collapse in 2008 and 2009.

The other deficit, decades in the making, is powered by demographics and unsustainable benefit promises of the key entitlement programs of Social Security, Medicare and Medicaid. This position has been amply covered in much greater detail and scope by Laurence Kotlikoff and Scott Burns in their book, The Coming Generation Storm, and by David Walker, the former head of the General Accountability Office (GAO) under Presidents Reagan, G.H.W. Bush, Clinton and G.W. Bush, in his book, Comeback America, so for further detail, please feel free to seek out these reference materials.

The ‘stimulus deficit’ is short-term and can be easily reduced, relatively speaking. The ‘structural deficit’, is, in our and others’ view, infinitely more challenging to address, will require broad political will and truly risks the future health of the U.S. economic and financial system. Dealing with the ‘structural deficit has been avoid assiduously by both political parties, despite the heated and sometimes hyperbolic rhetoric. This is because two of the three benefit programs are central to the well-being and comfort of the most consistent voting bloc in the United States, seniors. The Democrats have staked a claim on protecting benefits (higher spending) while the Republicans have chosen to support those footing the bill for the benefits, the tax payers (cut taxes).

It is very important to not get these two deficits confused in your efforts to understand them, their risks, solutions and impacts on your investment portfolio.

The ‘Stimulus Deficit’

This deficit is directly related to the short-term status of the U.S. economy. In short, if the domestic economic recovery indeed gains traction and exhibits self-sustaining momentum, the remainder of the monetary and fiscal stimulus applied during, and in the wake of, the financial crisis can be removed from the economy. Unfortunately, for the deficit hawks, the Obama Administration and the Federal Reserve are targeting a drop in the unemployment rate, as their respective indicator to begin to ‘safely’ remove this stimulus and related ‘emergency’ measures (such  as QE2). Others seem to agree, including Mr. Walker. But there are consequences to ‘waiting until we see the whites of their eyes.’

Risk Number 1 – Inflation

Unfortunately, unemployment is a lagging economic indicator. That is, this economic series does not lead, but rather lags the direction of economic activity.  Consequently the economy will likely be well into the expansion phase (the phase in the economic cycle that follows the recovery from the recession lows – the expansion phase is when the economy grows above the previous cycle’s peak) when this spending will be cut back. Politically, that may be preferable to some, particularly with a presidential election looming in the next 18 months, but economically it risks exacerbating the inflation we and others see emerging now in the developed world.

Risk Number 2 – Higher Interest Rates

Many observers and market participants expect a ‘crowding out effect‘ to occur in the bond market, with all of the government debt expected under the stimulus program and QE2. Our view is that risk has come and gone. Just the opposite has unfolded.  Actually, there has been a tremendous  bond issuance by top creditworthy corporate borrowers (including the 100 year bonds issued last fall by Norfolk Southern and the 10 year bonds issued by Johnson and Johnson which bore the same current yield as the 10 year Treasury bond) in the fall of 2010. This in the face of the Fed’s expansion of its balance sheet and the looming QE2. To us, there has been no crowding out.

However, we do see the risk of higher interest rates. First, the rising inflation we have seen, and expect to accelerate, will undoubtedly result in higher interest rates. Second, the longer the additional quantitative easing (QE2) remains in the financial system, further stimulating Asian inflation (despite Chairman Bernanke’s protestations), the more powerful the snap back in inflation and consequently interest rates later.  The one counterweight of substantial significance is a fundamentally strong U.S. recovery, which will likely result in a stronger dollar without higher interest rates. Nevertheless, we this as a timing issue – rates will rise.

The Significance of the Stimulus Deficit is Overstated

From the fiscal side, the key components of the stimulus spending center on three areas, bailouts, TARP and unemployment compensation extensions. TARP (Troubled Asset Relief Program) is breaking even, as many of the largest banks which took TARP money have repaid it, in part to avoid the compensation restrictions that came along with continuing to maintain that capital. The biggest bailed out companies (General Motors, American International Group and Citigroup) have all raised capital in the equity markets, are continuing to heal, either organically or through additional asset sales at higher prices than 2 or 3 years ago. Further, the federal government has reduced its ownership positions via these secondary offerings, generally at a profit.

Nevertheless, Fannie Mae and Freddie Mac remain unaddressed. However, proposals from the Obama administration are apparently forthcoming.

The unemployment compensation spending is diminimous in relation to the stimulus package that has been authorized but not spent. Indeed, despite all of the talk on both sides of political spectrum, most the $800 billion in stimulus spending has not been spent, although pledged. What remains unspent is by law to be used for deficit reduction.

Next Steps

In our view the next events stemming from the ‘stimulus deficit’ are living with and then taming inflation, lifting the national debt ceiling by Congress and an expanding domestic economy which brings down the unemployment rate. To us, the reduction in the stimulus deficit is a sideshow to the main event – addressing the long-term structural deficit. As such, talk and action on the stimulus deficit is potentially only a short-term trade-able event at best, and not a likely investable development.

In our next post we will give a quick primer on the long-term structural deficit – its size, scope, sources, accelerators and potential solutions.

What do you think?

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China’s $1.5 Trillion in Strategic Investments – Our Generation’s Sputnik Moment?

Introduction - A Bit of History

In 1957, the dissonant combination of complacency and unease in the United States was as widespread as they it now. Then, suddenly, on October 4, 1957, the world became less comfortable. The Union of Soviet Socialist Republics (USSR), which had just developed the hydrogen bomb and became the U.S.’ de facto challenger for world supremacy, launched a rocket into space with a satellite named Sputnik. This on its face was truly remarkable, as it was the first time humans had successfully launched an artificial satellite into orbit. One month later, on November 3, 1957, Sputnik II was launched, a heavier version of Sputnik I, and this time, with a passenger, a dog named Laika.

This was viewed in the U.S. as a  threat to American national security. Specifically, part of the reason the U.S. and its allies had won World War II was due to their dominance of the skies. The fact that the USSR had launched not one, but two satellites in rapid succession with heavier than expected payloads alarmed the general public, the military and political establishments that the United States’ new enemy could deliver its recently developed nuclear weapons to the heartland of America. In short, to those Americans in 1957, their way of life seemed threatened.

The American response, initially awkward and flatfooted, evolved into the space program and the creation of the National Aeronautics and Space Administration (NASA) in 1958. Furthermore, a substantial change took place in America, with an emphasis on science and technological research. This massive endeavor generated unheard of technological innovations and economic benefits. Not only was America’s geopolitical prestige and confidence restored, but a slew of profitable and meaningful new products and services were developed, from new foods to advances in semi-conductors, communications and medicine to name a few. In many ways, this effort was instrumental in the U.S. becoming a global economic power in the 1960s.

Today – China’s Challenge to U.S. Global Economic Pre-Eminence

Today the situation seems different. The U.S. , despite the real and perceived damage from the financial crisis of 2008, is still the global leader economically, politically and militarily. China is our economic partner and a friendly competitor, right?

Not so fast. Its a bit complicated. China is also a tough competitor and often a difficult political and economic adversary. Objectively speaking, they have their own agenda. They are not a client-state nor an economic supplicant. China is, however, a complex competitor for natural resources, trade, finance and investments. For instance, China is the leader in cleantech investments and is pushing even more capital into the sector in 2011.

On December 3, 2010, it was announced that China was mulling the investment of $1.5 trillion over 5 years in 7 strategic industries. To us, with this announcement, China  clearly establishes itself as a direct economic and technological competitor to the United States. These industries are, to our minds, all key sectors of not only current economic growth, but the sources of future economic success and global pre-eminence.

What are These Industries?

Here are the seven strategic industries:

  • Alternative energy
  • Biotechnology
  • Next generation information technology
  • High-end equipment manufacturing
  • Advanced materials
  • Alternative fuel cars
  • Energy-saving/environmentally-friendly technologies

Interestingly and not coincidentally, the U.S. is or is among the current global leaders in all of these sectors. Equally disturbing, there has been scant discussion or reporting on this, short of repeating the China Daily story under their own banners by western media outlets, and a passing set of comments on Fareed Zakaria’s GPS program on CNN, a week after he announcement. Finally, just over half of these sectors are viewed as central to sustainable and green investing, as well as positive areas of investment for sustainability investing.

Crisis: A Dangerous Crucial Moment When Something Changes

The Chinese word for ‘crisis’, ‘wei-jin’, has been long misunderstood in the West as meaning both danger and opportunity. An apparent more accurate definition of ‘wei-jin’ is a dangerous, crucial moment when something changes. We believe this announcement is a such a moment, a Sputnik moment in modern vernacular. America and its business and investment communities can ignore this shot across the bow of U.S. business interests (danger) or they can move to exploit a major opportunity to accelerate innovation and development in these ‘strategic’ industries (moment when something changes).

We see two ways to address this dangerous crucial moment when something changes:

  • Service the Chinese effort
  • Develop and innovate in these sectors domestically

We suspect the U.S. business community will do both. We view all of these sectors as critical areas for investment via venture capital, private equity and publicly-traded industries, as well as through public-private ventures, especially for the medium and long-term time, depending on your risk tolerance, time horizon and specific investment objectives.

Are your advisers talking to you about these long-term investment opportunities?

Posted in Economic Views, Green Investing, Investment Themes, New Ideas, Sustainability Investing, Uncategorized, views on news | Leave a comment

The Gathering Inflation Storm Hits Western Shores

We last opined on this topic in August. To briefly review, we stated inflation would break out in the West sooner rather than later. We said its sources would be both from Asia and from the unprecedented fiscal and monetary stimulus unleashed to combat the global financial crisis in 2008 and its continuing effects on the West’s economies and financial systems, such as the sovereign debt crisis in Europe.

In our August post we asked the question if the data points we were seeing then were ‘random, false positives or the nascent signs of a return of inflation in the West.’ The evidence, in our view, is now quite clear: Inflation has returned to the West, in pretty much the fashion we expected. Today we will highlight the significant recent data supporting our view.

Full Blown Inflation Storm in Asia

Inflation in China continued to build since the summer of 2010. For instance, China’s inflation rate jumped in November to 5.1%, the fastest rate in 28 months. Moreover, Chinese consumer inflationary expectations are also on the rise. In Hong Kong, which sources its food from China, the inflation rate increased to 2.9% in November, the highest level in three months, on the back of rising rental, commodity and food costs. Capital flows to Asia, fueled by the recent U.S. quantitative easing and the mild appreciation of the Yuan, were also cited as contributing factors.

In response, the Chinese financial authorities delivered a Christmas morning surprise, raising two key interest rates, the one-year lending and deposit rates by 25 basis points each. These were the second such increases since mid-October. Again, the issue of future inflation expectations came up, this time as the key target of the increase in rates. This appears to be reflected in the returns of Chinese fixed income securities. In particular, Chinese bonds undeperformed in 2010, rising just under 2% in 2010.

Indeed, inflation accelerated throughout Asia during the 4Q of 2010, as well, from India (6.3% in November) to Vietnam (11.75% in December up from 11.09% in November). The common factors are rising food and commodity prices and weak currencies, the latter in part to exploit opportunities for international customers versus the mildly appreciating Chinese Yuan.

This week, December and full year 2010 economic growth and inflation figures were released in China. GDP grew faster than in 2009, 10.3% versus 9.2% and December’s inflation rate eased to a still rapid 4.6%. As the December 2009 inflation rate was from a higher level than November 2009, it is expected that January’s inflation rate will be higher than December’s. Either way, these figures support the idea of future quickening inflation and monetary tightening in China.

Inflation Showers Arrive in Europe

These higher food and commodity prices in Asia have impacted European consumer prices. Specifically, higher food and commodity costs, as well as oil, have pushed up inflation in Europe. Inflation in Britain rose to a six month high of 3.3% in November, well above the official government target of 2%. Additionally, Eurozone consumer prices rose to 2.2% in December, again, above the European Central Bank (ECB) target of 2%. This was the fastest rate in more than two years. In the Eurozone, energy prices, which rose 11% in the last 3 months, were the largest component of the increase in the Eurozone inflation rate.

In Germany, consumer prices rose 1.9% in December, once again the fastest in more than two years and up from 1.6% in November. Of greater importance in Germany, to us, is that short-term inflation expectations jumped as well. Notably, the spread between conventional and inflation-protected bunds rose to the highest rate since the Greek sovereign debt crises in April.

Consequently, ECB officials, from Jean-Claude Trichet to Axel Weber, expressed concerns over inflation in Europe. Mr. Trichet has placed inflation back on the ECB agenda despite the immediacy of the sovereign debt crisis in Ireland, Portugal and Spain. Mr. Weber, an ECB council member and the head of Germany’s central bank, the Bundesbank, expressed concern over the medium term for rising inflation risks.

Inflation Clouds Begin to Darken Skies in the U.S.

Meanwhile, in the U.S., the rate of inflation in December surprised the consensus to the upside. The theme seen overseas persisted here – higher commodity costs, especially food and energy paced the increase in consumer prices in the last month of 2010. The Consumer Price Index (CPI) increased .5% in December, more than the .4% estimate of economists polled by Bloomberg News. Despite these facts, the consensus continues to hold the view that prices are subdued.

Sidebar – CPI Understates Inflation

In general, this can be the topic of a separate blog entry. Nevertheless, two quick points need to be made. First, the charge of understating inflation has been leveled at the Bureau of Labor Statistics and CPI for decades. This was raised initially to point out the benefits of such governmental understatement of inflation, according to investment manager Stephen Harrington, President of Scientific Advisors , LLC. He stated it appears to proponents of this point of view that to save money on the cost of living adjustments (COLA) on social security benefits, the government has been slow to adjust the weightings of the components in the CPI to more accurately reflect actual consumer inflation. The COLAs, by way, have been discontinued for the last two years, owing to the financial crisis.

Mr. Harrington doubts an outright conspiracy but rather notes that institutional inertia is more likely to blame. Nevertheless, he points out that benefit still accrues to the government. Specifically the U.S. Treasury has issued a tremendous amount (over a half a trillion dollars) of Treasury Inflation-Protected Bonds (TIPS) since 1997, arguably among the fastest growing type of government-issued debt. He noted it would be in the best interests of the government to keep inflation low. If inflation rises and stays high through the maturity of these bonds, not only are additional payments to be made to the bondholders for interest, but principal as well.

Second, the nature of the understatement is significant. We believe and concur with Paul Sloate, an economist and hedge fund manager at Green Drake Partners (as well as other observers) who points out the CPI severely understates or distorts the actual price activity in the U.S. economy, whatever the reason. This is accomplished principally by underweighting and poorly tracking key economic activity in the index.

Two examples should highlight the issue, with thanks to Paul Sloate. First, health care costs are underweighted. In the October 2010 release of the CPI, health care is shown to have a weighting of 7%, despite that fact the Department of Health and Human Services uses a 13% weighting in its calculations, and that most economists state health care spending is in the mid to high teens as a percentage of U.S. GDP. Second, housing is overweighted. In the CPI its weighting is 42%, while the Mortgage Bankers Association states that consumers should spend no more than 28% of their disposable income on housing in order to qualify for a mortgage loan.

Examples of poorly tracked activity are housing and transportation. In the October 2010 CPI, the cost of housing was shown to be down 2%. Arguably this is true for actual home prices, at least in direction if not magnitude. But a broader measure of housing costs would have to include rental renewal rates, as measured by EQR, a large REIT specializing in apartments and corporate housing. These rates are running about 5%, as many are now renting rather than owning.

For transportation, the October CPI showed an increase of 4.8%. Seems accurate, right? At least in the right direction? Well, for the same time period the EIA showed gasoline prices rose 9.1% and airline yields (a proxy for ticket prices) rose in the low to mid teens. Mr. Sloate has calculated that the true year over year inflation rate in October 2010 was 4.6%, not 1.2% as calculated by the BLS.

Consequently, many money managers use a number of other measures to try to get a better handle on domestic inflation, including the producer price index. But most are generated by the government and thus potentially suffer from the above challenges. Needless to say, we believe inflation is much higher than the .5% rate for December. Stated differently, when the CPI rises to 3% – 4%, the actual rate of inflation, and more importantly, future inflationary expectations, will be much higher and therefore harder to contain.

Possible Counterweights to Higher U.S. Inflation

There are a couple of potential headwinds to a full blown inflation storm in the U.S. this year. The first is the single family housing market and the second is government spending cuts. Let’s take a brief look at each in turn.

Single family home prices are still falling in the U.S. Further, the consensus outlook is that housing prices will continue under pressure for the remainder of the year, and in fact for years to come. Additionally, the foreclosure documentation scandal has slowed the clearance of excess inventory in the housing market. Lastly, mortgage lending has also been slow to snap back.

However, a contrarian view is that household formation is the key demand driver of the housing market, This view holds that as unemployment falls for those young people who have postponed family formation by moving back home with their parents, they will return to the market as first-time home buyers. Nevertheless, currently housing is a counterweight to sharply rising inflation in the U.S., in our opinion.

The rising populist discontent and anger over being either left out of government bailouts or being left to pay for others irresponsible behavior, brought in a wave of new, apparently frugal, members of the House of Representatives in November. Coupled with a growing general concern with both removing the fiscal and monetary supports and addressing the unfunded future Medicare/Medicaid and Social Security mandates, one can easily assume fiscal restraint will be the order of the day this year. If so, it should provide yet another powerful headwind to a spike in domestic inflation.

However, the new Congress has been in office for less than a month and already the newly Republican-controlled House of Representatives is signaling a pullback on their campaign promises and rhetoric of immediate and substantial deficit reduction. Perhaps a more meaningful gauge of potential spending restraint for the new Congress is the vote to lift the debt ceiling in a few weeks.

To us, at best the jury is still out on true spending cuts. The situation must be monitored, however, as we believe conditions are fluid. We therefore put this factor in the neutral camp until more clarity is available.

Additional Sources of Higher Prices on the Horizon

First, future bailouts. We have already seen Ireland’s biggest bank bailed out by the Irish government with the help of the IMF and ECB. Now Portugal and Spain are under pressure again. In the U.S., there has been a fierce debate over whether a number of states are, or will be, in need of federal support, and indeed, if so, whether they will get it. A number of members of the new Congress have vowed to oppose any such bailouts to the states. If allowed to fail, these would be counterweights to higher prices. But we think such defaults will be managed in an orderly fashion to avoid the deflationary impacts.

Second, falling unemployment in the U.S. due to rising private sector hiring. The tone of economic activity appears to have improved over the  past few weeks. Certainly anecdotal comments from business leaders and economists have been decidedly more positive. However, as employment is a lagging economic indicator, monitoring labor as a predictor of future inflation will be of little help in controlling future domestic inflationary expectations. Further, as the Fed has both indicated this will be a key parameter for them to reduce its stimulus and that instead, they have a bias to increase inflation in the U.S., say it all to us: The Fed will allow inflation to rise before attempting to combat it.

Impacts and Outlook

We are in the camp of expecting a stronger economy, a stronger dollar, higher inflation and rising interest rates this year. These expectations frame our view of the investment environment for 2011.

We would expect to see a correction in the domestic equity markets, as leadership shifts, fueled by inflation concerns and valuation, from industrial  and material cyclicals and growth technology to consumer cyclicals, financials and economically-sensitive technology stocks (particularly those leveraged toward financial institutions). We would not be surprised to see some emerging markets correct as adjustments to more restrictive monetary policies take place.

Obviously, as noted in our previous post on Treasuries, intermediate and long-term Treasury bonds would be viewed as less attractive to us. As the economy strengthens,  the yield curve steepens, and the Treasury carry trade erodes, banks are more likely to expand their lending activities, albeit at higher, more profitable rates. This should benefit private equity funds that recently completed capital raises and are seeking to finance transactions with a more conservative mix of debt and equity capital.

We are less enthusiastic about commodities, as we have been very bullish in early and mid 2010. This is primarily due to the substantial appreciation in most commodities in 2010. Long-term, we continue to be positive about energy, agricultural and precious metals commodities, owing to secular trends already underway.

What do your advisers think?

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Fannie Mae and Freddie Mac – Into the Death Spiral

As the new century dawned, Fannie Mae and Freddie Mac continued to follow the Wall Street brokerage houses and the mortgage bankers further away from their core competencies and deeper into the sub-prime mortgage market. At the same time, conditions supporting the lax behavior by almost all participants in the housing credit market moved toward a crescendo.

In the wake of the terrorist attacks of 9/11/01, the Federal Reserve Bank and U.S. government provided support to the economy to mute the impact on the recession. The Fed had lowered lowered interest rates and eased monetary policy in the first half of 2001, to respond to weakening economic activity. The U.S. economy was already in a mild recession at the time of the attacks. The Fed simply eased credit further to prevent a financial panic and provide liquidity to the financial system.  The Bush administration combated domestic fears at home by encouraging the populace to go about their business as usual, and spend going into the Christmas season, lest the terrorists win. Internationally, the administration launched the war on terror and dramatically upped military spending. This tone and action persisted right through the beginning of the Iraq War in 2003.

One of the results was that even easier credit for mortgages was provided. Lower interest rates hurt those dependent on safe, interest-bearing investments. A voracious global search for yield ensued from those in retirement to major public, private pension plans and institutional investors around the world. These conditions also attracted the less savory participants amongst the support infrastructure of the housing market, in particular, appraisers and mortgage bankers. Additionally, the lure of greed drew and blinded otherwise judicious elements in the brokerage business to encourage and benefit from potential and real fraud in the system.

A Quick Side Bar About Housing Market Fraud

According to Arthur Lewis, former mortgage banking executive and now principal at Get Smart Leadership, fraud in the housing market started long before the 1999 – 2000 period. Indeed, Mr. Lewis said this type of fraud first began in the early 1980s. He said it ranged from what he called ‘well-meaning fraud’, such as document violations like subletting homes and using internal family members income to supplement the borrowers income, to fraud for profit. Examples of fraud for profit, according to Mr. Lewis, included disguising (inflating) the true value of the property and disguising the true ownership of the property.  Notably, these abuses tended to not become widely known due to repeated waves of refinancing that washed over the industry during the 1980s and 1990s. He opined that up to 20% of the “A” loans alone underwritten during this time had some aspect of fraud associated with the documentation. He said refinancing masked these fraudulent loans, and tended to have the same affect as money laundering. He said during the 2002- 2007 time period fraudulent loans simply expanded from the pre-existing levels of the 1990s, particularly into the sub-prime segment, due to confluence of capital, demand for yield by investors and loose and poorly (or unmonitored) underwriting standards.

One example touched upon in Michael Lewis’ (no relation to Arthur Lewis) book, The Big Short, was the expansion of mortgage loans to immigrants. In brief, these individuals had a couple of aspects to their mortgage applications that were prized by those creating collateralized debt obligations (CDOs) – attractive but thin credit files with attractive FICO scores. Their credit files showed no negative reports, but were incredible light on general activity. But the underwriting models of both Wall Street and the GSEs focused more on the FICO scores and the lack of negative reports rather than the longevity of credit activity.

Rising Toward the Unsustainable Peak,

Emboldened by these ‘successes’ and motivated by the high demand for high-quality yield in a lower interest rate environment, Wall Street brokers and mortgage bankers alike moved to increase the flow of mortgage loans in the sub-prime sector of the housing market.  Following upon the thin FICO files from immigrants, new products began to be introduced, such as no document (verification) and no income-no job, to go along side the prior generation of loosened underwriting standards, such as no down payment and collateralized down payment products for higher income, higher FICO score borrowers. Mr. Arthur Lewis said reasonably managed risks for a select group of borrowers was  allowed to expand to a marketplace where the risk couldn’t be managed, including alt-a and sub-prime. These loans in turn would be packaged into securitized loan products, such as CDOs, to be sold to yield-desperate investors. This by way, completely separated the borrowers from the ultimate lenders, sometimes by continents.

Mortgage brokers sought out Fannie Mae and Freddie Mac to buy and implicitly guarantee these mortgages, by both approving the products and actually buying them to be repackaged and resold as mortgage bonds under their names. These two GSEs, now quite comfortable and confident in their new underwriting models and looking to grow their earnings, complied.

Notably, the other checks and balances in the system by the early 2000s were also badly infected with perverse incentives to ignore the risks and seek profit as well. According to Arthur Lewis, some mortgage originators were earning 50 to 300 basis points (.50% – 3.00%) per transaction based solely on how it was priced to the borrower, without regard to the quality or integrity of the loan. Consequently, the originator could earn more money making questionable loans than using higher underwriting standards. Appraisers were incented to do the same.

Internal Machinations Create Vicious Cycle with External Pressures

Dysfunctional incentives were also at work within Fannie Mae and Freddie Mac. The first was in executive compensation. The congressional reform legislation passed in 1992 (the Federal Housing Enterprises Financial Safety and Soundness Act of 1992) that also created the Office of Federal Housing Enterprise Oversight, mandated ‘pay for performance’ as a key component of these two GSEs’ executives’ compensation.  Second, the implicit guarantee of the U.S. Treasury to make good on any losses on the two GSEs bonds, the underlying mortgages upon which they are based or the mortgages purchased from originators, and other special privileges they enjoyed proved powerful incentives to use to maximize company profits. The incentive to maximize shareholder value as publicly-traded entities completed the package of dysfunctional motivations, providing a legitimate veneer. Together, Fannie Mae and Freddie Mac’s managements were incented to use the implicit guarantee and their exemptions from fees and costly regulation to issue significantly cheaper debt than other participants in the residential mortgage funding market and buy increasingly riskier mortgages. Mortgage bankers and Wall Street were encouraging the GSEs to do so, lest they lose market share and profits.

By 2003, management risk-taking crossed too many lines. Freddie Mac was accused of and revealed it illegally managed earnings over the previous number of years. Specifically, they stated they moved earnings growth forward to smooth out future earnings streams, by almost $5 billion. In 2004, Fannie Mae was found to have engaged in similar widespread accounting errors, to the tune of over $6 billion.

The Bush administration in 2000 expressed concern over some of the GSEs business practices and the House of Representatives Banking Subcommittee of Capital Markets, Securities and Government-Sponsors Enterprises held hearings on Fannie Mae. A number of factors, including a shift in the federal government’s focus in the wake of the terrorist attacks in 2001, as mentioned earlier, blunted this effort. Equally important, to many observers, was the substantial lobbying effort by the two GSEs. This was capped by illegal campaign contributions from 2000 and 2003, to both Republican and Democratic members the House Financial Services Committee. by both Fannie Mae and Freddie Mac This is one of key panels that can affect Fannie Mae and Freddie Mac.

The combination of the incentives within the GSEs to growth their balance sheets and the external pressures from both their shareholders, customers (mortgage originators), competitors and founding stakeholder (the U.S. government) drove the expansion of the GSEs’ market share of residential mortgages to the 45% – 50% level by 2004.

Government Pressure Yet Again Rachets Up

In 2004, the Department of Housing and Urban Development issued an edict to Freddie Mac to provide more support to the sub-prime borrower market. Specifically, HUD instructs Freddie Mac to ‘do more’ in this segment of the housing market. Further, in that same year, rules put in place in 1999 that disallowed risky, high cost loans from being credited toward affordable housing goals set by HUD, were rescinded. Thus, these high-risk loans were again counted toward the affordable housing goal.

Private Sector Sub-Prime Lending Expands – the GSEs Don’t Keep Up

Given the above conditions and coupled with lax enforcement of existing regulations, it is no surprise that private mortgage lending expanded sharply. The boom in sub-prime lending was at its height from 2004 – 2007. Federal Reserve System data shows the following facts:

  • 84% of sub-prime mortgages in 2006 were issued by private lending institutions
  • Private firms made nearly 83% of sub-prime loans of low and moderate income borrowers that year

Furthermore, President George W. Bush’s Working Group on Financial Markets reported the turmoil in financial market was clearly ‘triggered by a dramatic weakening of underwriting standards for U.S. sub-prime mortgages beginning in late 2004 and extending into 2007.

From 2004 to 2006, the period in which sub-prime lending was accelerating to its peak, Fannie Mae and Freddie  Mac actually lost substantial share of the sub-prime loans sold into the secondary market. Most of the riskiest loans were used to create the some of the most toxic CDOs during the period.

Nevertheless, Fannie Mae and Freddie Mac, while not leading the charge into these risky loans, did willingly follow Wall Street and the mortgage bankers fully into the sub-prime mortgage fiasco, despite new management after the scandals of 2003 -2004. Specifically, the GSEs, while not buying the actual mortgages of the most risky sub-prime loans, did buy sub-prime mortgage-backed CDOs from Wall Street, in order to continue to meet their affordable housing goals set by HUD; Freddie Mac more so than Fannie Mae.

The End Begins

In 2006, housing prices peaked. This event was generally not noticed, as they didn’t fall; rather home prices just stopped rising. But in selected markets around the country, home prices did begin to fall. Some observers have said  immigration-driven demand for mortgages also slowed, in the face of heightened enforcement activity against illegal immigrants. This potentially cut into that source of ‘acceptable’ thin FICO score applications that were feeding the securitization machine. Additionally, some outrageous frauds were uncovered. Some sub-prime borrowers begin to default on their first payment due, as they had no job or income with which to  make the payment. The great assumption in this raging bull market for residential real estate was that housing prices would forever rise, if not by 5% per annum, at least they would never fall. Yet, in the summer of 2007, in more markets, prices indeed began to fall.

There are a number of possible reasons for housing prices to have peaked in the summer of 2006 and fallen the next summer; we believe they were all at work to halt the generally accepted and expected rise in home prices. These reasons fall into the general category of there were fewer buyers of homes than sellers. This resulted in more supply (homes on the market) than the market could clear at higher prices, so prices had to fall to move that inventory.

We believe it was a bit more pernicious than that. For example, without the sub-prime borrower and the yield-hungry investor in securitized mortgage bonds, prices would have peaked sooner and at lower levels. But with the above market participants, prices continued to rise, exacerbating the problem. The continued ascent in prices from 2004 – 2007 encouraged direct investors to buy and sell homes at even higher prices. These non owner-occupied borrowers are simply investors, and can simply walk away from the mortgages if they fail to sell the home to pay off the loan and gain a profit.

Additionally, many sub-prime loans were adjustable rate mortgages. After the teaser rates expired and the interest rates reset,  particularly for those loans underwritten in 2004 pressure mounted suddenly on many borrowers. Some of these borrowers may have been unable to continue to service the loans, leading to default, foreclosure and a rise in housing inventory on the market in 2006 and 2007. This rise in foreclosed inventory from just these two sources, has a multiplied negative effect on neighborhood home prices, more so than typical economic supply and demand parameters would indicate. Still, the failure of prices to continue to rise revealed the final and deadly false underpinning to the housing boom: prices can rise indefinitely.

At the same time, the cost of insuring collateralized debt obligations jumped sharply. Steven Gjerstad and Vernon Smith reported in the Wall Street Journal article ‘From Bubble to Depression?’ that “the cost of insuring  a $10 million AAA rated mortgage backed security tranche jumped from $68,000 to $900,000 from July 3, 2007 to August 7, 2007″. In turn, sub-prime originations dropped sharply as well, effectively draining liquidity from the housing financing market.

By early 2008, more sub-prime borrowers were moving into foreclosure. Foreclosure rates had already started to rise in 2007, as noted earlier. This was highly unusual. Typically, foreclosure rates rise during recessions, the trigger being substantial job losses. However, the foreclosures in 2007 were happening during a fairly robust economic expansion. This time the rise was due solely to the nature of this particular housing boom.

As Fannie Mae and Freddie Mac were implicit guarantors on many of these defaulting and soon to default loans, they were on the hook to make good on them to the now frequently distant mortgage holders. With market liquidity and new mortgages dropping, the end of Fannie Mae and Freddie Mac had begun.

As mortgage bankers got into trouble and went bankrupt, the availability of privately sourced residential mortgages began to contract. By the time the nation’s largest residential mortgage originator, Countrywide Credit, was forced into the arms of Bank of America, these two GSEs were pretty much the only sources for residential mortgage loans. Their market share had risen in just 2 years from 50% of all residential mortgages in the U.S. to 97% by early 2010. This was due to both previous underwriters leaving the market (by choice or involuntarily through bankruptcy) to an unwillingness of new entrants to issue housing credit to anyone other than the most pristine and highest rated borrowers without the implicit guarantee of Fannie Mae or Freddie Mac. And from just before conservatorship through today, these two GSEs underwriting standards have once again become tighter, new loans from the private sector have still been brought to Fannie Mae and Freddie Mac, due to market fear and uncertainty couple with the existence of the implicit guarantee.

Two articles which offer clear reviews of the last months of the crisis leading up to conservatorship are The Reckoning – Pressured to Take More Risk, Fannie Mae Reached Tipping Point by Charles Duhigg of the New York Times and From Bubble to Depression? by Steven Gjerstad and L. Smith in the Wall Street Journal.

Knowing how these two GSEs got to this point is critical. Only from that knowledge and the policy goals going forward for the nation’s housing market can both a resolution to their outstanding obligations and their future role, if any, can be properly determined. For investors this is not only the difference between identifying potential future winning and losing investments, but the nature and viability of a large chunk of the U.S. credit markets.

In our next post on this topic, we will share our opinions on the possible solutions to the above.

Let us know what you think!

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