Under Seige From Every Direction

Even as the Obama administration and the main street media hype the recovery, the system known as the United States economy implodes. The housing crises catalyzed the recession, but free-falling home values are now only the tip of the iceberg. Over the next two years, we will see the default rate continuing to rise as option arms recast. But there is much more. Fannie Mae and Freddie Mac have accumulated over $6.3 trillion of debt not on the government balance sheet which is filled with toxicity. Commercial real estate is now a time bomb which has begun exploding. State governments are rapidly seeing revenue fall while deficits mount. Should the federal government not intervene, massive cuts in services and layoffs will follow. The alternative is more bailouts which would only postpone the day of reckoning and add to the national debt. As the government takes on more and more debt, the traditional source of funding - treasury bonds - becomes more difficult to find buyers. 

Just today, the Congressional Oversight Panel published their report on Commercial Real Estate Losses and the Risk to Financial Stability. Read the Conclusion below.

Conclusion

There is a commercial real estate crisis on the horizon, and there are no easy solutions to
the risks commercial real estate may pose to the financial system and the public. An extended
severe recession and continuing high levels of unemployment can drive up the LTVs, and add to
the difficulties of refinancing for even solidly underwritten properties. But delaying write-downs
in advance of a hoped-for recovery in mid- and longer-term property valuations also runs the risk of postponing recognition of the costs that must ultimately be absorbed by the financial system to eliminate the commercial real estate overhang. 

It should be understood that not all banks are the same. There are “A” banks, those who
have operated on the most prudent terms and have financed only the strongest projects. There
are “B” banks, whose commercial real estate portfolios have weakened but are largely still based on performing loans. There are “C” banks, whose portfolios are weak across the board. The key to managing the crisis is to eliminate the C banks, manage the risks of the B banks, and to avoid unnecessary actions that force banks into lower categories. 

Any approach to the problem raises issues previously identified by the Panel: the creation
of moral hazard, subsidization of financial institutions, and providing a floor under otherwise
seriously undercapitalized institutions. That should be balanced against the importance of the
banks involved to local communities, the fact that smaller banks were not the recipients of
substantial attention during the administration of the TARP, and the desire that any shake-out of
the community banking sector should proceed in a way that does not repeat the pattern of the
1980s. The alternative, illustrated by recent actions of the FDIC, is to accept bank failures, and,
when write-downs are no longer a consideration, sell the assets at a discount, and either create a
partnership with the buyers to realize future value (as was done in the Corus Bank situation) or
absorb the losses. 

There appears to be a consensus, strongly supported by current data, that commercial real
estate markets will suffer substantial difficulties for a number of years. Those difficulties can
weigh heavily on depository institutions, particularly mid-size and community banks that hold a
greater amount of commercial real estate mortgages relative to total size than larger institutions,
and have – especially in the case of community banks – far less margin for error. But some
aspects of the structure of the commercial real estate markets, including the heavy reliance on
CMBS (themselves backed in some cases by CDS) and the fact that at least one of the nation’s
largest financial institutions holds a substantial portfolio of problem loans, mean that the
potential for a larger impact is also present. 

There is no way to predict with assurance whether an economic recovery of sufficient
strength will occur to reduce these risks before the large-scale need for commercial mortgage
refinancing that is expected to begin in 2011-2013. The supervisors bear a critical responsibility
to determine whether current regulatory policies that attempt to ease the way for workouts and lease modifications will hold the system in place until cash flows improve, or whether the
supervisors must take more affirmative action quickly, as they attempted to do in 2006, even if
such action requires write-downs (with whatever consequences they bring for particular
institutions). And, of course, they must be especially firm with individual institutions that have
large portfolios of loans for projects that should never have been underwritten. 

The stated purpose of the TARP, and the purpose of financial regulation, is to assure
financial stability and promote jobs and economic growth. The breakdown of the residential real
estate markets triggered economic consequences throughout the country. Treasury has used its
authority under the TARP, and the supervisors have taken related measures in ways they believe
will protect financial stability, revive economic growth, and expand credit for the broader
economy. 

The Panel is concerned that until Treasury and bank supervisors take coordinated action
to address forthrightly and transparently the state of the commercial real estate markets – and the potential impact that a breakdown in those markets could have on local communities, small
businesses, and individuals – the financial crisis will not end.

As the trend of expanding debt continues, eventually the only option available for funding will be monetization. Before we reach this critical stage, expect the government to find ways to extract the remaining savings and wealth of the citizenry to prop up a dying bureacratic monstrousity. Taxes will be raised both through legislating  higher tax rates and stealth measures such as health care or environmental decrees. Retirement funds will forced to annuitize part of the portfolio into treasury bonds. At the lmicro levels, states, cities, and municipalities will hike fees and fines. Small businesses will shut down or opt out as they no longer can afford to stay profitable.

As the country spirals into the abyss, politicians will offer plans. Some will suggest even more government spending. Others will demand austerity measures which will be confronted by the various groups affected by such proposals. As always, there will be no consensus and whatever changes are implemented the winners will be those with the most political clout.

I don't think there can be a political solution. The rule of law has begun to erode. The founding documents  designed to serve as the template for governance have largely been discarded. At some point, our system will no longer function effectively. Once that happens, Americans must find true leaders and work together to forge a system that works as our system once performed. Most likely, a slow devolution will devastate the country before the citizens finally recognize what happened.

A Nation of Debt Serfs

                                                                                                                                                                 Paul Craig Roberts recently wrote an article titled America - A Country of Serfs Ruled by Oligarchs. The article is not that long, and unlike most policy wonks and bureaucrats, Roberts speaks in plain English. I've copied the article below and added commentary.

America—A Country of Serfs Ruled By Oligarchs

By Paul Craig Roberts

The media has headlined good economic news: fourth quarter GDP growth of 5.7 percent ("the recession is over"), Jan. retail sales up, productivity up in 4th quarter, the dollar is gaining strength. Is any of it true? What does it mean?

The 5.7 percent growth figure is a guesstimate made in advance of the release of the U.S. trade deficit statistic. It assumed that the U.S. trade deficit would show an improvement. When the trade deficit was released a few days later, it showed a deterioration, knocking the 5.7 percent growth figure down to 4.6 percent. Much of the remaining GDP growth consists of inventory accumulation.

More than a fourth of the reported gain in Jan. retail sales is due to higher gasoline and food prices. Questionable seasonal adjustments account for the rest.

Productivity was up, because labor costs fell 4.4 percent in the fourth quarter, the fourth successive decline. Initial claims for jobless benefits rose. Productivity increases that do not translate into wage gains cannot drive the consumer economy.

Housing is still under pressure, and commercial real estate is about to become a big problem.

The dollar’s gains are not due to inherent strengths. The dollar is gaining because government deficits in Greece and other EU countries are causing the dollar carry trade to unwind. America’s low interest rates made it profitable for investors and speculators to borrow dollars and use them to buy overseas bonds paying higher interest, such as Greek, Spanish and Portuguese bonds denominated in euros. The deficit troubles in these countries have caused investors and speculators to sell the bonds and convert the euros back into dollars in order to pay off their dollar loans. This unwinding temporarily raises the demand for dollars and boosts the dollar’s exchange value.

Roberts points out that the statistics which have temporarily given pundits, investors, and citizens  cause for hope, and that the economy will soon rebound are illusory at best. The underlying problems that led to the recession still exist and new obstacles are about to present themselves. A renewed dollar strength is emerging, not due to economic strength, but rather to the unraveling of debt in areas of global weakness. This trend will continue for some time in the near future, but will reverse in the long run. At that time, US debt will unravel causing great stress on the dollar.

The problems of the American economy are too great to be reached by traditional policies. Large numbers of middle class American jobs have been moved offshore: manufacturing, industrial and professional service jobs. When the jobs are moved offshore, consumer incomes and U.S. GDP go with them. So many jobs have been moved abroad that there has been no growth in U.S. real incomes in the 21st century, except for the incomes of the super rich who collect multi-million dollar bonuses for moving U.S. jobs offshore.

Without growth in consumer incomes, the economy can go nowhere. Washington policymakers substituted debt growth for income growth. Instead of growing richer, consumers grew more indebted. Federal Reserve chairman Alan Greenspan accomplished this with his low interest rate policy, which drove up housing prices, producing home equity that consumers could tap and spend by refinancing their homes.

Unable to maintain their accustomed living standards with income alone, Americans spent their equity in their homes and ran up credit card debts, maxing out credit cards in anticipation that rising asset prices would cover the debts. When the bubble burst, the debts strangled consumer demand, and the economy died.

Here, Roberts describes the slide of our economic system over the past 25-30 years. As globalism took hold, capital moved offshore to take advantage of (or exploit if some cases) cheaper labor. Much of this transition was inevitable as other countries finally were able to rebuild an industrial base after their economies were destroyed by WWII, however policies such as NAFTA, and granting China the status of  "most favored nation" have contributed to the paradigm shift and sped up the process.  Beginning with the loss of market share to the Japanese cars, industry by industry moved offshore. Manufacturing of products from steel, to clothing, to semiconductors are done via foreign labor. To offset the lack of wages needed to maintain the standard of living Americans are accustomed to, Americans took on debt in the form of housing and transportation. Historically low interest rates which were engineered by the Federal Reserve and Alan Greenspan made it possible for Americans to take on huge levels of debt. In 2008, the party ended and Americans are now facing the reality that the erosion of the economy had been masked by a false sense of wealth, disguised as debt masquerading in the form of assets such as houses, boats, and vehicles. These assets were actually liabilities, and when the paper value declined, the true financial condition of American citizens became apparent.

As I write about the economic hardships created for Americans by Wall Street and corporate greed and by indifferent and bribed political representatives, I get many letters from former middle class families who are being driven into penury. Here is one recently arrived:

"Thank you for your continued truthful commentary on the 'New Economy.' My husband and I could be its poster children. Nine years ago when we married, we were both working good paying, secure jobs in the semiconductor manufacturing sector. Our combined income topped $100,000 a year. We were living the dream. Then the nightmare began. I lost my job in the great tech bubble of 2003, and decided to leave the labor force to care for our infant son. Fine, we tightened the belt. Then we started getting squeezed. Expenses rose, we downsized, yet my husband's job stagnated. After several years of no pay raises, he finally lost his job a year and a half ago. But he didn't just lose a job, he lost a career. The semiconductor industry is virtually gone here in Arizona. Three months later, my husband, with a technical degree and 20-plus years of solid work experience, received one job offer for an entry level corrections officer. He had to take it, at an almost 40 percent reduction in pay. Bankruptcy followed when our savings were depleted. We lost our house, a car, and any assets we had left. His salary last year, less than $40,000, to support a family of four. A year and a half later, we are still struggling to get by. I can't find a job that would cover the cost of daycare. We are stuck. Every jump in gas and food prices hits us hard. Without help from my family, we wouldn't have made it. So, I could tell you just how that 'New Economy' has worked for us, but I'd really rather not use that kind of language."

Policymakers who are banking on stimulus programs are thinking in terms of an economy that no longer exists. Post-war U.S. recessions and recoveries followed Federal Reserve policy. When the economy heated up and inflation became a problem, the Federal Reserve would raise interest rates and reduce the growth of money and credit. Sales would fall. Inventories would build up. Companies would lay off workers.

Inflation cooled, and unemployment became the problem. Then the Federal Reserve would reverse course. Interest rates would fall, and money and credit would expand. As the jobs were still there, the work force would be called back, and the process would continue.

This is the old paradigm that has been in play for at least 70 years. The jobs are no longer here and the debt level is such that even with historically low interest rates, credit cannot expand as consumers are tapped out and cannot take on more credit.

It is a different situation today. Layoffs result from the jobs being moved offshore and from corporations replacing their domestic work forces with foreigners brought in on H-1B, L-1 and other work visas. The U.S. labor force is being separated from the incomes associated with the goods and services that it consumes. With the rise of offshoring, layoffs are not only due to restrictive monetary policy and inventory buildup. They are also the result of the substitution of cheaper foreign labor for U.S. labor by American corporations. Americans cannot be called back to work to jobs that have been moved abroad. In the New Economy, layoffs can continue despite low interest rates and government stimulus programs.

To the extent that monetary and fiscal policy can stimulate U.S. consumer demand, much of the demand flows to the goods and services that are produced offshore for U.S. markets. China, for example, benefits from the stimulation of U.S. consumer demand. The rise in China’s GDP is financed by a rise in the U.S. public debt burden.

Another barrier to the success of stimulus programs is the high debt levels of Americans. The banks are being criticized for a failure to lend, but much of the problem is that there are no consumers to whom to lend. Most Americans already have more debt than they can handle.

Hapless Americans, unrepresented and betrayed, are in store for a greater crisis to come. President Bush’s war deficits were financed by America’s trade deficit. China, Japan, and OPEC, with whom the U.S. runs trade deficits, used their trade surpluses to purchase U.S. Treasury debt, thus financing the U.S. government budget deficit.

The problem now is that the U.S. budget deficits have suddenly grown immensely from wars, bankster bailouts, jobs stimulus programs, and lower tax revenues as a result of the serious recession. Budget deficits are now three times the size of the trade deficit. Thus, the surpluses of China, Japan, and OPEC are insufficient to take the newly issued U.S. government debt off the market.

If the Treasury’s bonds can’t be sold to investors, pension funds, banks, and foreign governments, the Federal Reserve will have to purchase them by creating new money. When the rest of the world realizes the inflationary implications, the US dollar will lose its reserve currency role. When that happens Americans will experience a large economic shock as their living standards take another big hit.

America is on its way to becoming a country of serfs ruled by oligarchs.

 Interestingly enough,  Narayana Kocherlakota, President of the Federal Reserve Bank of Minneapolis gave a speech (link) that hints at the financing problem the Federal Government faces in the future. Check out this quote from Kocherlakota's presentation:

Why might households expect an increase in inflation? The amount of federal government debt held by the private sector has gone up by over 30 percent since the beginning of 2008. This debt can only be paid by tax collections or by the Federal Reserve’s debt monetization (that is, by printing dollars to pay off the obligations incurred by Congress). If households begin to expect that the latter will be true—even if it is not—their inflationary expectations will rise as well.

In the short to immediate time line, it's doubtful that the bond rate will rapidly soar and the Fed would resort to monetization. Before that happens, the Government will find ways to replace foreign purchase of Treasuries with domestic purchases. The idea has been floated that workers would be required to allocate a portion of their  401K's into bond funds that would be annuitized. At least for a year or two, such a scheme would allow the government to continue financing huge deficits. In the long run, this too will not be enough and monetization will likely be the end result.

Unemployment Primed to Accelerate

For the time being, employment losses have slowed and the official unemployment rate has firmed around the 10% level. The media offers encouragement that a slow recovery is underway. But now the focus is starting to shift toward large and growing state and local government deficits. Revenue continues to fall from previous levels leading to unprecedented budget shortfalls. The construction and retail sectors took their lumps over the past year. The next round of pain will result from massive layoffs in the public sector.

CNN Money reports that states are looking at a $180 billion budget gap for fiscal 2011, beginning July 1st for most states. To close the gap, state workers will face layoffs or cuts in salary and benefits.

States are looking at a total budget gap of $180 billion for fiscal 2011, which for most of them begins July 1. These cuts could lead to a loss of 900,000 jobs, according to Mark Zandi, chief economist of Moody's Economy.com.

Newly elected Governor Christie stated he plans to freeze $1.6 billion including $475 million in school aid. Citing a potential shortfall of $1 billion, Louisiana Governor Bobby Jindal is calling for the elimination of 3000 state jobs that would call for 1000 layoffs. In San Bernardino, a local school district plans to cut 110 positions to help slash $30.7 million of the budget.

Detroit mayor Dave Bing is lobbying the Obama administration for $500M-$1B in federal aid.

Detroit Mayor Dave Bing says he is seeking $500 million to $1 billion from the federal government for efforts to bolster job growth, eradicate blight and address illiteracy and poverty.

Good luck with obtaining that, Mr. former NBA guard turned politician.

As you can see, everyone needs (wants) federal money. Without a federal bailout, the alternative is to cut back on services and force public employees to hit the pavement - teachers, policemen, firemen, medical personnel, and social workers. The federal government must weigh the political decision of forcing states to  undertake austere measures necessary to get their budgets under control versus bailouts that add to the national debt. Zero Hedge posted a brilliant analysis on the impact of interest payments on the national debt as a function of interest rates. It's well worth your time to read this article.

If the federal government does not send billions of dollars to the states, it is clear that we will see an acceleration in unemployment numbers soon. However, if the federal government placates state governors, the cuts will not be made and we will find ourselves at the same place one year later.

For politicians, self-survival is paramount. Most likely, Washington will decline state overtures for now, as the public has grown weary of bailouts. As layoffs mount and media begin to focus on starving ex-teachers and ex-policemen facing foreclosure, I suspect the public will want to be given the same  handouts from Washington that banks and large corporations such as GM and AIG have received.  Obama will give an impassioned speech and Congress will pass an emergency rescue bill.

The Rule of 72

On February 1st, the New York Times posted an interactive chart of Obama's 2011 budget proposal. The chart provides a nifty feature which allows you to see the increase/decrease of specific budget items as you move your mouse across the screen. You can also compare the dollar amounts from 2010 to 2011 for any budget category.

Congress has discretion over how much money is spent on items such as education and defense, but is limited when it comes to the big entitlement programs. Without "reform" (translation: cuts), these programs will soon force the government into insolvency.

The chart shows that medicare spending increases from $462 to $498 billion, an increase of 7.8%. The rule of 72 implies that this amount would double in just 9 years to approximately $1 trillion in 2020! And that's using the 7.8% current rate of increase. Aging demographics and ever rising medical costs imply that the rate of increase will only go up.

Another area of concern in the budget is interest payments. In 2010 that amount shows $188 billion. In 2011 the estimated interest payments are $251 billion; an increase of 33.5%! As the national debt increases, combined with rising interest rates, at some point the government will be unable to service the debt.

It is imperative that the economy grows faster, or at least keeps pace with debt. Unfortunately, that isn't going to happen. In order for the government to survive long-term, Americans must be willing to forfeit the entitlements which have become institutionalized and depended on by most of the citizenry. That isn't going to happen either.

The current path simply is not sustainable, yet politicians will never make tough choices and the populace would never allow them to if they tried. How will it end? Default? War? Monetization leading to a hyper-inflationary depression? Anarchy? Revolution? The answers to these questions will be played out over the next decade. It will be an interesting ride.