Wednesday, December 14, 2011

US Treasury Outlays & Receipts

Is Gridlock bullish or bearish? In the past, it’s probably been bullish more than it has been bearish. After all, our constitutional system was designed by our Founders to disperse power among the Executive, Legislative, and Judicial branches of our government. Congress was designed so that special interest groups more often than not would be stymied from achieving their legislative agendas by resistance from “factions” with opposing interests. In Civics, Gridlock is called by the less pejorative name of “Checks and Balances.”

So the system seems to have worked exactly as it was designed (i.e., not to work) this year. According to the Congressional Record, this year through November, the House approved 326 bills, the fewest in at least 10 non-election years; the Senate passed 368 measures, the fewest since 1995. Conversely, the House passed 970 measures in 2009 and 1,127 in 2007, and the Senate for those years approved 478 and 621, respectively.

So far, that hasn’t been very bullish for the stock market. That’s because the legacy of all the lawmaking over the past few years has been to saddle the US economy with huge federal deficits and rapidly mounting federal debt. Various attempts to narrow these deficits have failed miserably. From this perspective, Gridlock is bearish. The outlook is for more of the same next year, and beyond depending on the election results on November 6, 2012.

How did we get to this sorry state? The special interest groups learned that they could achieve their goals through cooperation rather than conflict with one another. Most importantly, they figured out that the government’s budget isn’t a zero sum game if the resulting spending binge is deficit financed. The Constitution needs a Balanced Budget Amendment. European governments seem to be moving in exactly that direction as a result of their fiscal crises.

We monitor the latest developments and trends in the US federal government’s budget in our US Government Finance briefing book. Let’s have a look:

(1) A trillion here, a trillion there. Over the past 12 months through November, the federal deficit was $1.01 trillion. On this basis, it has exceeded $1 trillion since June 2009 (Figure 1). Federal government outlays totaled $3.6 over the past 12 months through November. That’s up 50% since March 2005. Over this period, receipts totaled $2.3 trillion, up 14.8% from the most recent cyclical low during January 2010, but still 11.1% below the previous record high during April 2008 (Figure 2).

(2) Lots more IOUs. Total US government debt outstanding rose to a record $15.1 trillion during November. It is up 50% since September 2008 and 100% since December 2004 (Figure 17). The per capita comparisons are shocking. The government’s debt divided by the labor force, which represents actual and potential taxpayers, rose to a record $9,819 in November, a 100% jump since the spring of 2004 (Figure 23). In October, the government’s debt was 1.6 times greater than a year’s worth of disposable income excluding government transfer payments. That’s a record high, and up from 1.0 during May 2008 (Figure 24).

(3) Tax revenues are up and down. Total federal tax receipts tend to be a lagging indicator of the economy (Figure 12). They rose to a cyclical high of $2.3 trillion over the past 12 months through November, led entirely by individual income tax receipts, which rose to $1.1 trillion (Figure 2 and 9). Corporate tax receipts have flattened at around $200 billion. That’s really puzzling given that corporate profits are at a record high; yet these receipts are about 50% below the record high of $382.3 billion during June 2007. It may be that US corporations are earning more of their profits overseas and aren’t repatriating them because of the high corporate tax rate in the US.

In the past, payroll tax receipts (so-called “social insurance and retirement receipts”) rose during economic expansions, and even during recessions. They’ve been falling since November 2008, when they peaked at $905 billion. They were down to $806 billion over the past 12 months through November (Figure 9). That’s because Washington has been cutting payroll tax rates in an effort to stimulate economic growth.

(4) No more PayGo. The problem with cutting payroll tax rates is that the result is a rapidly widening social welfare deficit in America. Our Social Security and Medicare entitlement systems were designed to be fully financed by payroll taxes, which was the case until the middle of the previous decade. But then the social welfare deficit ballooned to a record high of $402.3 billion over the 12 months through November of this year (Figures 13 and 14).

By the way, a “do-nothing” congressional session, which passes relatively few bills, does not necessarily mean that the power and scale of our government in Washington has been diminished. When Congress cannot approve multiple separate pieces of legislation in a timely fashion, it will often bundle the bills together into the scheme known as an “omnibus” spending bill--which often leads to billions of dollars in pork being wasted on congressional cronyism in one piece of legislation. 

Monday, November 21, 2011

Credit Insurance Fraud Industry

Who is to blame for this mess? I’ve accused the Credit Insurance Fraud Industry (CIFI) of causing the financial crisis that started in the US subprime mortgage market during 2007 and has now spread to the European sovereign debt market. This industry expanded dramatically during the previous two decades by selling credit insurance derivative products that magically transformed subprime mortgages, junk bonds, liars’ loans, and other trashy debts into AAA-rated credits. This financial engineering was a great business while it lasted. But it was all mostly a huge fraud.

In the June 9, 2009 Morning Briefing, I wrote: “Before the crisis started in 2007, the fastest growing business was the Credit Insurance Fraud Industry. This industry emerged following the Basel Accords of 1988. The banking regulators of the major industrial nations agreed to impose uniform capital requirements on banks. Risky assets required more capital. The credit insurance fraud industry employed an army of financial engineers whose innovations magically transformed the most dodgy loans and bonds into AAA securities. Many of these products were defective. Fraud was rampant in the industry. The worst offenders were the credit rating agencies that had awarded triple-A ratings to thousands of CDOs.”

Lloyd Blankfein, the chief executive of Goldman Sachs, wrote an article in the February 8, 2009 FT titled, "Do not destroy the essential catalyst of risk." He observed that it should have been obvious that there was something not right about CDOs: “In January 2008, there were 12 triple A-rated companies in the world. At the same time, there were 64,000 structured finance instruments, such as collateralised debt obligations, rated triple A. It is easy and appropriate to blame the rating agencies for lapses in their credit judgments. But the blame for the result is not theirs alone. Every financial institution that participated in the process has to accept its share of the responsibility.” Mr. Blankfein, who is still the CIFI’s capo di tutti capi, should be asked the following three questions under oath: “When did you know this? Why didn’t you alert us sooner? How much money did your firm make selling these bogus instruments to your customers while shorting them at the same time?”

The CIFI’s financial alchemy can create the illusion that trash has been turned into gold, but it’s all hocus pocus; it’s not real. We all know how the CIFI messed up the US mortgage market. Let’s consider its major contributions to the Euro Mess:

(1) The euro transformed Greek debt into German debt. Prior to the introduction of the euro on January 1, 1999, bond buyers required higher yields on European bonds issued by “weak” credits such as the government bonds of Greece, Italy, and Spain versus the much lower yields on German bonds. Indeed, during 1992-1994, the Greek yield was over 20%. It plunged below 4% in June 2003, matching the German yield. The government bond yields of all the other members of the euro zone also converged to equal the German yield.

The euro had converted the junk debt of some of the members into AAA credits. But not for long, given that now the Greek yield is 25%. That yield soared after a new Greek government revealed in late 2009 that the previous one had fraudulently understated the size of its fiscal deficit. In other words, governments can be involved in the CIFI.

The Bond Vigilantes became much less vigilant and stopped doing their due diligence on the credit quality of what are now called the “peripheral” countries of the euro zone. So, the buyers of the bonds willingly bought into the fraud and enabled the CIFI to expand like mad. Besides, is it really necessary to do any credit research at all on any bond if you can protect against its default by purchasing the CIFI’s insurance policies against such “credit events?” The answer to this question should have been, “Yes, it is!”--especially after AIG blew up. Instead, European banks loaded up on euro-denominated sovereign debt as though it was all issued by Germany.

(2) The Euro Mess may be morphing into AIG-2.0. The October 16, 2008 issue of BusinessWeek had a very good analysis of how AIG brought down the European banks: "How AIG'S Credit Loophole Squeezed Europe's Banks." Before the financial crisis hit, AIG did a booming business in credit default swaps. The biggest buyers were European banks, whose deals during 2007 with AIG totaled a staggering $426 billion. “But the banks didn’t always buy the swaps as insurance against defaults--they often used them to skirt capital requirements… By owning credit default swaps, banks could make it appear as if they had off-loaded most of the risk of a loan to AIG or another firm, thereby reducing their capital needs. The perfectly legal ploy allowed banks across the Continent to free up money to make more loans. It was part of the game taking place across the global financial system. During the boom, firms seemingly created money out of nothing, propelling the markets to unsustainable heights. Such excessive risk-taking has brought down several European lenders.” The European banks had set aside only 1.6% of a loan's value, rather than 8%. When AIG imploded on September 15, 2008, European banks suddenly found themselves up the creek without a paddle. That’s where they are again now.

European leaders have fashioned three Grand Plans (GP) so far. All three seem to have turned their sovereign debt problem into a full-blown banking crisis. The first Greek rescue plan (GP-1.0) was approved on May 9, 2010 and established the EFSF. By July 21 of this year, a second rescue plan (GP-2.0) was needed. It included voluntary haircuts of 20% and increased the size of the EFSF. In the third plan (GP-3.0) on October 27, lenders were forced to accept a voluntary 50% haircut on their Greek debt. The latest plan is shaping up to be AIG-2.0 because banks holding European sovereign debt can no longer be sure that the CDS contracts they purchased to insure against defaults will be honored. So, they’ve been selling their bonds. In principle, the EFSF was expanded again under GP-3.0 to buy these bonds, but the details remain in limbo.

(3) The EFSF is a CDO-Squared. On Friday, ECB President Mario Draghi hit back at the European leaders who have recently called on the ECB to clean up the Euro Mess for them. Instead, he insisted that they implement their bailout fund: “We are more than one and a half years after the summit that launched the EFSF as part of a financial support package amounting to 750 billion euros or one trillion dollars; we are four months after the summit that decided to make the full EFSF guarantee volume available; and we are four weeks after the summit that agreed on leveraging of the resources by a factor of up to four or five and that declared the EFSF would be fully operational and that all its tools will be used in an effective way to ensure financial stability in the euro area. Where is the implementation of these long-standing decisions?,” he demanded to know in a speech at the European Banking Congress, "Continuity, consistency and credibility," European Central Bank (November 18, 2011).

The EFSF has slammed into a brick wall because it is based on the faulty premise that Europe’s non-AAA debtors can join together with the AAA-rated ones to form a triple-A-rated rescue fund that can borrow on behalf of the debtors who need to be rescued. That sure sounds like the super-senior tranche of a CDO. The assumption is that the fund will remain AAA-rated even if it is expanded. That assumption held up after the EFSF was increased to €440 billion on July 21, but the non-AAA guarantors of the fund (i.e., Italy and Spain) were downgraded because they thus became exposed to more liability. When the EFSF was expanded in principle again on October 27 to over €1 trillion--in effect, a CDO-Squared--the details of how this would be done were omitted to avoid a downgrade of France’s AAA rating, which would have forced the rating agencies to lower the credit rating of the EFSF.

Note: This is an excerpt from today’s Morning Briefing for our subscribers.

Thursday, October 27, 2011

Home Alone: Update on the Homestead Act

Everyone knows that housing was the epicenter of the previous recession and that it is the biggest drag on the recovery. President Barack Obama wants to help by allowing homeowners to refinance their mortgages at record low interest rates even if the values of their homes have fallen below the amounts they owe.

The majority of the FOMC wants to help too. That’s why they voted to implement Operation Twist at their meeting on September 20-21, despite the objections of three cold-hearted dissenters. Last week and early this week, three of the do-gooders on the FOMC said they are ready to do more good and are considering a third round of quantitative easing that would include purchasing mortgage-backed securities again.

I don’t understand why no one in Washington is pushing for more targeted policies that would simply reduce the huge overhang of unsold homes. Doing so would take the downward pressure off of home prices. Actually, it should boost home prices by convincing would-be homebuyers to stop waiting for better deals and jump in and buy a house.

That’s the objective of the Homestead Act that Carl Goldsmith and I proposed this past summer. It would provide a matching down payment subsidy of up to $20,000 for anyone purchasing a home as their principal residence for two million houses. It would provide tax-free rental income for 10 years to anyone who purchases a house to rent for another one million houses. That would eliminate the current overhang of unsold homes completely.

Carl and I reached out to various political leaders in Washington on both sides of the aisle. Congressman Gary Ackerman liked the idea well enough to instruct his staff to work on a bill. The problem is that our plan would lower the corporate tax rate on repatriated earnings to 10%, using the proceeds to pay for the subsidy. The Congressional Budget Office scores these tax revenues as though they will be raised at the 35% tax rate even though such a high rate has been a major obstacle for such repatriation. So, we’ve hit a road block, though we are still pushing for the plan as best we can.

Thursday, October 20, 2011


In my opinion, China’s success of the past three decades is mostly attributable to the exploitation of Chinese workers. That’s right, the world’s largest communist country has been exploiting its workers! There are an estimated 120 million migrant workers in China. These are not people from other countries. They were all born in China, mostly in rural villages. Yet, they are restricted from living and working freely in their own country.

Many of them have no siblings because their parents were limited by the one-child population control policy instituted during 1978. When they were teenagers, they swarmed out of the impoverished rural areas to the urban centers on the east coast of China, finding jobs in the booming export manufacturing industries.

These migrant workers provided the cheap (exploited) labor that transformed China into the world’s top manufacturer and exporter. Their pay was low, and they received few, if any benefits. They were second-class citizens subjected to the household registration system known as the “hukou,” which defines where people are officially registered to live and whether they are considered urban or rural residents. The distinction is crucial, because rural migrant workers who move to cities to work in factories and on construction sites are not eligible for many social benefits, including education for their children.

Many migrant workers are now young adults, who are very unhappy about their status and their standard of living. They are starting to demand better treatment. The government responded at the beginning of the year by raising the minimum wages by 15%-20%, and by promising that the next Five Year Plan will focus on improving the lives of Chinese workers. The resulting jump in labor costs has been exacerbated by a shortage of young exploitable new entrants into the labor force as a result of the one-child policy.

Higher nominal wages and rising labor costs have pushed the CPI up by 6.1% y/y through September, led by a 13.4% increase in food prices and a 12.3% increase in fuel prices. Anecdotal evidence suggests that inflation may actually be higher than shown by the official data. That explains why monetary and credit authorities have been tapping on the brakes since early last year. M2 (in yuan) rose 13.1% y/y through September, the slowest since May 2001. Bank loans are up 14.3%, the slowest since November 2008.

Small firms are getting squeezed by rising labor costs and much tougher credit conditions. They are being forced out of business. The authorities are scrambling to provide credit to them, fearing that rising unemployment along with erosion in the purchasing power of recently raised wages will exacerbate social unrest. No wonder that the Chinese stock market is down 15.7% ytd, among the worst performing in the world.

Thursday, September 22, 2011

The Twist

Monetary policy is twisted. Operation Twist is supposed to push bond yields closer to zero, which should reduce mortgage rates and revive housing activity. QE-1.0 was supposed to do the same thing. But it didn’t work. Housing remains in a depression even though the Fed purchased $1.24 trillion in mortgage-related securities from November 25, 2009 through the end of March 2010. Operation Twist is supposed to force investors to buy riskier securities, especially stocks, with the expectation that will somehow stimulate economic growth. QE-2.0 was supposed to do the same thing. But it didn’t work either, which is why the Fed is doing the twist.

Ten-year Treasury yields and mortgage rates were already at record lows before yesterday’s Operation Twist announcement. Yet housing remains depressed. The mortgage applications index for both new and existing home purchases remained at the lowest levels since 1995, based on 4-week average. It is actually 8% lower than a year ago and 42% lower than two years ago despite the drop in mortgage rates. The housing problem can’t be fixed with record low mortgage rates.

Actually, the Fed isn’t sure how Operation Twist will work to boost the economy. And how do we know this? The Fed said so in its FAQs: “The maturity extension program will provide additional stimulus to support the economic recovery but the effect is difficult to estimate precisely."

Thursday, August 18, 2011

The New Homestead Act: Update

President Barack Obama recently promised that he has a plan to create jobs, which will be disclosed in September, after he takes 10 days off in Martha’s Vineyard. I certainly hope he comes up with a good plan. If he needs one, how about the one that Carl Goldsmith and I proposed at the beginning of August? [1] I met with my congressman, Gary Ackerman, last Tuesday to pitch the plan. He liked it well enough to issue a press release on Wednesday of this week endorsing it and promising to introduce the “Homestead: Act 2” when Congress returns from its August recess.[2]

The Act aims to reduce the huge overhang of unsold homes by offering a matching down payment subsidy of up to $20,000 for homebuyers, who do not currently own a home, and exempting newly acquired rental properties from taxation for 10 years. The cost of these incentives would be offset by the tax revenues collected by lowering the corporate tax rate on repatriated earnings to 10%.

Congressman Gary Ackerman is presently serving his fifteenth term in the US House of Representatives. He represents the Fifth Congressional District of New York, which encompasses parts of the New York City Borough of Queens and the North Shore of Long Island, including west and northeast Queens and northern Nassau County. Ackerman serves on the powerful Financial Services Committee, where he sits on two Subcommittees: Financial Institutions and Consumer Credit as well as Capital Markets and Government-Sponsored Enterprises (of which he is the former Vice Chairman). The stock market rose sharply after March 12, 2009, when Mr. Ackerman, during a congressional hearing, leaned on Robert Herz, the head of FASB, to suspend the mark-to-market rule. FASB did so on April 2. I had brought this issue to the congressman’s attention in a meeting we had during November 2008.

[1] Carl Goldsmith & Ed Yardeni, “The New Homestead Act” (August 16, 2011 update)
[2] Congressman Gary Ackerman, Press Release on “Homestead: Act 2” (August 17, 2011)

Sunday, August 14, 2011

The New Homestead Act

In the August 1 issue of the Morning Briefing, I started to float an idea for fixing the economy that was suggested to me by Carl Goldsmith, the chief investment strategist at Delta Management in LA. We believe that our “New Homestead Act” would quickly revive the US housing market and our economy (1). It turns out that Puerto Rico already implemented such a program with great success. According to this weekend’s WSJ (2), “A stimulus program on the island, long ripe with vacant houses and condos, has sent sales of new homes surging 80% and sales of existing homes up 24% in the past 10 months from a year earlier, even as the market in much of the U.S. mainland is dead.” The program includes a bunch of tax breaks for both buyers and sellers of residential and commercial properties. It was rolled out by Gov. Luis Fortuño as part of his effort to revive the Commonwealth’s economy.

Here are the key elements of the Fortuño initiative: “One of the incentive program’s popular provisions offers qualified buyers down-payment assistance for homes purchased with a mortgage, as well as a second mortgage of as much as $25,000 that can be used to make down payments and pay closing costs. Buyers of new homes also pay no transfer taxes when a property changes hands, escape paying property taxes for five years and future capital-gains taxes, and pay no taxes on rental income for 10 years. Sellers don’t have to pay capital-gains taxes on profits.” This is very similar to the plan Carl and I have been promoting for the US mainland.

Last Wednesday, the Obama Administration announced it is seeking input from investors on how to rent homes owned by Fannie Mae, Freddie Mac, and the Federal Housing Administration (3). The goal is to turn thousands of government-owned foreclosures into rental properties to help boost falling home prices. Carl and I have proposed a 10-year tax exemption for rental income, which is one of the features of Gov. Fortuño’s program.

The WSJ embraced the Administration’s initiative this weekend (4): “This is positive news if the Administration is finally ready to accept market-based solution to our housing problems. The Wednesday document encouraged ‘investment of private capital’ and welcomed input from market participants with ‘the technical and financial capability to engage in large-scale transactions.’ Could it be that the Administration is courting hedge funds and private equity to scoop up foreclosed homes? We can only hope so.” The Journal recommends setting up a new Resolution Trust Corporation, similar to the one set up by George H.W. Bush, which worked so well to clear out the overhang of real estate in the early 1990s. Carl and I second the motion.

(1) Carl Goldsmith & Ed Yardeni, "The New Homestead Act" (August 16, 2011)
(2) Puerto Rico Fires Up Housing Market," WSJ (August 13, 2011)--requires subscriptions
(3) "FHFA, Treasury, HUD Seek Input on Disposition of Real Estate Owned Properties," US Treasury Press Release (August 10, 2011)
(4) "Foreclosure Brainstorm," WSJ (August 13, 2011)--requires subscription