Trailer Park Toronto

“There is a sucker born every minute” PT Barnum

Recent events in Toronto must be causing David Pecaut, to spin in his grave.

Over the past few months the legislative agenda at City Hall has imploded, throwing the political process into turmoil and imperiling the budgetary and planning imperatives. This ongoing political circus was temporarily upstaged by the Donald Trump circus, which moved into town briefly last week for the grand opening of the Trump Hotel and Condo Tower; a garish and undersold property development at the corner of Bay and Adelaide.

We then were treated to a story in Toronto’s tabloids about the owner of the Bunny Ranch bordello in Nevada declaring his intentions to expand his business into Canada.  Sixty-five year old, Dennis Hof, together with his business partner and pneumatically-gifted paramour, Cami Parker (twenty-five), told the papers in part that his establishment aimed for Toronto, will allow patrons to “dress up as Captain Kirk and play with Princess Leia.” Perhaps. But to me the thought of someone more than ten years older than me calling a woman that is younger than my oldest daughter, his “girlfriend” leaves me more than a little weirded out. Isn’t the general rule for these type of age-difference relationships “half your age plus seven years”?

No matter, the trailer park theme moved into absolute top gear when the issue of allowing Casinos into the City was again raised by a number of City councillors. Coincidentally, one of the casino supporters was past brothel-booster Giorgio Mammoliti who said that “Single mothers could hit the jackpot” with a Toronto Casino. Appearing as a guest on Mayor Rob Ford’s Newstalk 1010 show, Mammoliti floated the idea that a casino in Toronto could create “10,000 jobs” for residents. The idea appeared to get additional legs when “opinion surveys” of dubious provenance were trotted out to demonstrate that a small majority of Torontonians were in favor of the casino idea. Some councillors have even gone so far as to advocate extending tax breaks to Casino operators in order to attract them to Toronto.

The reasons why local politicians want to expand gambling as a form of industrial and jobs initiative is understandable on one level: Any new initiative which brings with it the allure of thousands of new jobs, expanded tax revenues and economic development can give the appearance of economic salvation. However, the degree to which this motivation is being exploited by gambling interests and their supporters and to where this could lead if the issue was left un-evaluated on its true merits is a serious matter that should concern all Canadians, and not only those residing in Toronto and environs.

Until recently, most research on the effects of gambling on local economies was conducted by special interests friendly to the gambling industry; or, in more brazen cases, by the very people and gaming companies in search of new places to exploit people through the legalized gambling mechanism. In fact, in 1999 the United States published a very comprehensive study of legalized betting in the United States. The Gambling Impact Study called for more research into what was then the largely unexplored area of the social and economic costs of legalized gambling.

Since then, a large body of evidence and data-based research has been established on the basis of years of experience with legalized gambling in the US, Canada and elsewhere which addresses in detail what the social costs and second order effects are, and why it is important not to just consider the jobs and spending parts of the equation in isolation.

Increased Bankruptcies

For example, with the exception of the cluster services associated with gambling, casinos tend to put pressure on surrounding businesses. In Atlantic City and elsewhere, small business owners testified to the loss of their businesses when casinos came to town. As evidence of this impact, few businesses can be found more than a few blocks from the Atlantic City boardwalk. Many of the “local” businesses remaining are pawnshops, cash-for-gold stores and discount outlets. One witness noted that, “in 1978 [the year the first casino opened], there were 311 taverns and restaurants in Atlantic City. Nineteen years later, only 66 remained, despite the promise that gaming would be good for the city’s own.”

In another example, bankruptcies in Iowa increased at a rate significantly above the national average in the years following the introduction of casinos. Nine of the 12 Iowa counties with the highest bankruptcy rates in the state had gambling facilities in or directly adjacent to them. After gambling was legalized in South Dakota, gambling become one of the leading causes of business and personal bankruptcies.

Data from other US states is consistent with this general profile and the bankruptcy phenomenon also prevails in Canada, as these pictures of downtown Niagara Falls which were taken after the Casinos moved in, will attest.

Increased Crime

According to the US National Research Council, “As access to money becomes more limited, gamblers often resort to crime in order to pay debts, appease bookies, maintain appearances, and garner more money to gamble.” In Maryland, a report by the Attorney General’s Office stated: “[c]asinos would bring a substantial increase in crime to our State. There would be more violent crime, more juvenile crime, more drug- and alcohol-related crime, more domestic violence and child abuse, and more organized crime. Casinos would bring us exactly what we do not need: a lot more of all kinds of crime.” Another study found that gambling behavior was significantly associated with multiple drug and alcohol use.

In a Canadian study casinos were positively associated with both rate of theft and robbery. And a recent RCMP investigation conducted in British Columbia found legalized and other forms of gambling intimately connected with gangs, the Mafia, money laundering, prostitution, drug addiction, robbery and extortion.

Obviously law enforcement costs escalate in these situations

Corruption

Once gambling enters a community, it has been established that the community undergoes many changes one of which is that local government becomes “a dependent partner in the business of gambling.” Politicians end up being beholden to the gambling industry whether explicitly or implicitly. In recognition of the problem of corruption, in some US states, it is now illegal for officials to accept contributions from gambling interests.

Homelessness increases

Individuals with gambling problems constitute a very high percentage of the homeless population. The Atlantic City Rescue Mission reported to the Commission that 22 percent of its clients are homeless due to a gambling problem. A survey of homeless service providers in Chicago found that 33 percent considered gambling a contributing factor in the homelessness of people in their program. Other data also substantiate this link. In a survey of 1,100 clients at dozens of Rescue Missions across the United States, 18 percent cited gambling as a cause of their homelessness. Interviews with more than 7,000 homeless individuals in Las Vegas revealed that 20 percent reported a gambling problem.

But what about these high-paying Gambling jobs?

The reality is that there aren’t many “high-paying” jobs. After the initial fillip to the economy provided by the construction of the facilities, casinos are far more eager to place slot machines into the building rather than to hire and train thousands of dealers and other casino employees. This is because each slot machine can bring in $100,000 per year of revenue and doesn’t demand a sick day, benefits or overtime and needs only the occasional dusting for maintenance. Casino workers pay averages around $24-30,000, not “high-paying” by any stretch.

Moreover, recent Canadian research has shown that Ontario casino workers are at exceptionally high risk for developing gambling problems and the attendant side effects. Employees’ gambling behaviors were found to relate to various workplace influences and employment variables. Casino employees in Ontario interviewed in the study exhibited problem gambling rates over three times greater than those of the general Canadian population.

Gambling Addiction has been recognized as a clinical psychological disorder. Today, millions of families suffer from the effects of problem and pathological gambling. As with other addictive disorders, those who suffer from problem or pathological gambling engage in behavior that is destructive to themselves, their families, their work, and even their communities. This includes depression, drug and alcohol abuse, divorce, homelessness, and suicide, in addition to the individual economic problems discussed previously. While the impact of these problems on the future of our communities and the next generation is indeterminable, it is clearly much larger than zero.

If you are a single Mom, do you now still crave those jobs as Mammoliti suggests you should?

The Bottom line

Unfortunately, this is not where this sobering news ends. Research in the US indicates that for every dollar legalized gambling contributes in taxes, it usually costs the taxpayers at least three dollars. These costs to taxpayers are reflected in: (1) infrastructure costs, (2) relatively high regulatory costs, (3) expenses to the criminal justice system, and (4) large social-welfare costs. Another researcher, Professor Grinols, found that Casino gambling in the US causes up to $289 in social costs for every $46 of economic benefit. Put differently, Grinols said, “The costs of problem and pathological gambling are comparable to the value of the lost output of an additional recession in the economy every four years.”

Accordingly, several US state legislators have called for at least partially internalizing these external costs by taxing all legalized gambling activities at extremely punitive rates.

It is for all of the reasons enumerated above that Putin’s Russia outlawed gambling and casinos in 2009.

But aren’t Singapore and Nevada big success stories?

If there are all of these costs and negative externalities why is Singapore still a prosperous city-state with two mega-casinos located within its borders? Simple, this is because only foreigners can patronize casinos for free. Citizens and permanent residents must pay a $70 entrance fee or a $1400 annual pass to enter a casino. The hefty admission price, which is collected by the government, “discourages impulse gambling,” a Singapore official explained. To fill the casinos, promoters ferry in high-stakes gamblers, known as “whales,” from neighboring countries.

Nevada is also unique. Roughly 85 percent of Nevada’s gambling revenues come from out-of state tourists. Thus, Nevada receives the economic benefits of the dollars lost to gambling, while the attendant social and economic impacts of unaffordable gambling losses are inflicted on the families and communities in the states and countries from which those individuals come. Every gambling venue in Canada is far more reliant on spending by citizens in a far more concentrated geographic area and so would never be able to position itself to reap this kind of benefit unless it imposed Singapore-type disincentives on the local population (in which the case the known costs would still be inflicted on someone else, and more importantly the fundamental rationale gambling interests have for locating the Casinos in Canadian cities would evaporate)

A “destination gambling mecca” was never any part of David Pecaut’s vision for Toronto and it is hard to see how it is a part of any rational “vision” for the city or for Canada now or at any time in the future either. The promised benefits do not exist in the magnitudes advertised and are in any event significantly outweighed by the expected costs. Moreover, the predictable second-order effects of casino activity as described in the research are positively nightmarish.

Torontonians and all Canadians should not allow themselves to be buffaloed into a rash and unwise decision on this matter by the large-scale gambling interests and any venal, shallow-thinking facilitators that they might be connected with, and who are in positions of decision-making authority.

The facts are out there and it is time to consider them seriously.

Alex Jurshevski was intimately involved with the GBP 1500 MM acquisition of UK gaming company William Hill Bookmakers by Nomura International in 1997 and, far from being puritanical on the issue of wagering, is an avid poker, blackjack, bridge, backgammon and snooker player.

If anyone wants a full bibliography of the research material on which the forgoing article is based beyond the hyperlinks provided above, then please drop us a line.

Posted in Bankruptcy, Canada, Crminal Activity, Economy, Gambling | No Comments »

The Canary in the Coal Mine Part II

In our last blog installment we asked, given the present unsettled state of the world the real issue for clear-thinking people is: “What comes next after these “Occupiers” fade into the sunset?”

Well, here in Toronto the OWS has been dispersed, the “Library Yurt” in St. James’ Park has been dismantled and its “defenders” bundled off; and who better to provide some insight into that question than The Right Honourable Tony Blair, the former Prime Minister of Great Britain from 1997 to 2007 and since then the Official Envoy to the Middle East for the Quartet? 

Recovery Partners attended a dinner last week where Mr Blair was the keynote speaker. A key message that he delivered was that the world is shifting very fast, and it is more interdependent and interconnected than ever before. Following that theme, he said that today’s politicians must quickly get used to the fact that they have to make “Big Decisions” and they must the right ones and make them quickly or risk losing control of the situation the West confronts today. This message ran through his entire address.

As for the situation in Europe Mr. Blair strongly advised that leaders there must recognize that the Eurozone is shifting from the “Politics of the Grand Design” to the “Politics of the Grand Plan”. It is the Grand Plan that has eluded decision-makers there. Unfortunately for Europe, however, Mr. Blair emphasized that, in this regard, the Eurozone and its leaders cannot afford to rely on a strategy that makes incremental changes that lead to incremental gains. This requires that the current Eurozone leadership realize that the crisis there is not a situation to be “managed: Today’s leaders have to take Big Decisions at an Existential and Fundamental level (which in itself is an act that risks or provokes a collapse of the system unless the right decisions and plans are implemented). The key realization here is that the single currency crisis has exposed a need for reform, it has not created that need.

Mr. Blair went on to say that the true operative timeframe now for the Euro rescue must be measured in weeks not months if the Eurozone is to be saved. This means that everyone in Brussels and in the Euorzone countries needs to get behind the Euro. In the longer term decisions need to be taken about a European Fiscal Union and Fiscal Reform. There are clear flaws in the Monetary Union Project, but for now a crisis management solution must be implemented quickly.

Everything is preferable to a breakup as the consequences are serious for both creditors and debtors therefore people on all sides of the negotiating table should be motivated to find a decision. Based on the foregoing there is simply is no “middle course” according to Mr Blair.

Similarly, the US Economy requires dramatic decisions that the Leadership there has avoided. Mr. Blair enumerated several “huge challenges” facing the US including debt levels, deficits, needed reform of the tax code, and an urgent need to rebalance the economy in favour of a more equitable division of National Income. He was unequivocal in saying that needed decisions have been deferred and have been piling up for years and these imperatives can now no longer be ignored.

As noted above Mr. Blair has spent a good deal of time since leaving office preoccupied with events and developments on the Middle East. His main message here, following from above, was that the Arab Spring, the Israeli Palestinian conflict, and Islam’s relationship to the West are all not only interconnected, they are key agenda items.

While it has become obvious that a variety of  regime shifts have going on in the Middle East, it is less obvious to note that most lack stability. In many countries modernization has outstripped to ability of the economy and population to keep up. Here, the main difference between Eastern Europe and the Fall of the Berlin Wall and what is going on in the Middle East today, is that with the Fall of Communism there was: (1) Unity among the Eastern Bloc population on what they wanted to get rid of; and, (2) unity among those peoples on their desire to adopt a Western Way of life, its aspirations and values.

Mr. Blair explained that in this regard, today in the Arab world there is no cohesion around what the population would like to structure in place of deposed regimes and dictators. Therefore it would be a huge mistake for the West to assume that people there just want to move towards a stable democracy. The simple model of modernization conveniently ignores the deep influences or tribalism and religion in many of these countries.

Therefore it is not obvious what the outcome in many of these countries will actually be. That means that unless we take strong positive action to get people into the right frame of mind that there will be problems with the transition.

Many of the regimes outside the West are quite strong and resistant to “Arab Spring” type events. They afford a measure of political stability. The folks who are a serious threat to these regimes or the status quo in those countries are usually either co-opted or neutralized

To underscore this point Mr. Blair said that many prominent people in these countries are extremely nervous about making ANY move, let alone the RIGHT move….and that this is happening throughout the region. Therefore he emphasized that we in the West we have to stay engaged with these populations. Specifically he stated that we have to assist with change, help these societies cope with modernization and at the same time, challenge them. The West needs to demonstrate that democracy is not only about a constitution and right to vote, it is also about: (1) an attitude to life, (2) freedom of expression, (3) freedom of religion, (4) freedom to work and transact in open, transparent and fairly-regulated markets, and (5) the requirement to live with tolerance and diversity.

The World no longer revolves solely around the US and Europe regarding strategies and political imperatives based around territorial interests. In fact the West must understand that the main message it must represent going forward is a Way of Life: Freedom, Democracy, Justice, and Tolerance being but some of the watchwords. Through leadership and vision we should impress upon the emerging and newly middle income economies to come to the conclusion that they would do far better to emulate the West rather than if they did something else.

Mr Blair’s remarks were warmly received and appreciated. Clearly in command of the subject matter and charismatic, he could probably have gone on for several hours. From our persepctive his address was as much an observation on the current state of affairs as it a warning to all of us that unless a more constructive approach to our problems is pursued by politicians both in Europe, North America and elsehwhere, that the consequences could be extremely undesireable.

This week financial markets in Europe remained on a knife edge and the US political class again showed that it continues to behave in a manner that is completely unresponsive to market discipline. The indicatiors on the threat board continue to flash yellow and red.

I am reminded of a luncheon I attended in Tokyo shortly after the fall of the Berlin Wall, when the then Russian Foreign Minister, Andrey Kozyrev, was asked by a member of the press how things would turn out in Russia. His response was that “No one is in full control, any one of hundred outcomes are possible and most of them are ones that people really won’t like.” As events have shown since then, it appears that the world and Russia herself has largely lucked out.

We may not be so fortunate this time.

Posted in Crisis, EU, Economy, Middle East, OWS, USA | No Comments »

The Summer of Discontent

 ”The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design”

 F A von Hayek, “The Fatal Conceit”

 If Ronald Reagan, Milton Friedman, or even Boris Yeltsin were alive today they would be shell-shocked to witness the transformation of Western countries’ public debate and public policy in the last twenty odd years from a celebration of victory by Free Markets over Communism into an embrace of the Power of the State.

In Europe and the US, governments now own or control banks, car companies, mortgage lenders, property companies and other former private sector enterprises. On both sides of the Atlantic public policy is increasingly reflecting an interventionist, heavy handed meddling by Governments who appear mistrustful of free markets. The folks currently at the center of policy-making in Brussels and Washington also seem to believe that it is possible to legislate results, pass laws to coerce behavior and generally thwart market outcomes as it suits them.

You might think that we are living in the old Soviet Union.

Don’t like the fact that the markets are starting to question the stability of European banks? Contrive a “Stress Test to allay market fears. When that doesn’t work and bank shares continue to get hammered, outlaw short selling and talk tough like you mean it. Simple. Listen to Jean Pierre Jouvet, the head of AMF, the French Financial Markets Regulator,“They wanted to test French resistance. This is our response, as always very determined, and it will be so for all those who want to put us to the test.” We’ll see.

 

Don’t like the fact that a variety of Euro area bonds are selling off in response to justifiable market fears regarding the deterioration in sovereign creditworthiness and hence increased likelihood of sovereign default? Well, then instruct the ECB and EFSF to start buying up these credits with money that is magicked up on a keyboard. Never mind that in doing this, you (the ECB and EFSF), are asking government ciphers to match wits with the likes of Michael Sherwood and his crew at Goldman’s, Bill Gross at PIMCO and Louis Bacon at Moore Capital; and that therefore this doesn’t really stack up as a fight that the apparatchiks can ever hope to win. Never mind that in all of recorded history government schemes to manipulate traded markets have always failed. And that in their wake massive credit and trading losses have accrued to the public purse accompanid by economic upheaval.

In the United States certain politicians (Nancy Pelosi among them),  are telling voters that Unemployment Insurance actually stimulates the economy because people spend their dole checks on goods and services; and that the Food Stamp programs (Over 45,000,000 recipients being served and counting)  are similarly stimulative. In the US it is now impossible for businesses to offer free coffee and donuts to clients; Grandmas can’t make home-baked pies for church socials, and kids can’t operate a lemonade stand without risking a $500 fine, all because of new US Federal regulations and armies of regulatory brownshirts freshly hired to enforce them (employed at salaries that are roughly double what they might earn in the private sector we might add). The new rules, regulations and directives burdening US business number in the thousands. 

The budget management and deficit reduction talks among the twelve member Super Committee will be getting underway shortly South of the Border. The fireworks that we saw connected to the debt ceiling negotiations are just a foretaste of what is to come in this set of “talks”. The real negotiation is over control of the 2012 Presidential and Congressional Elections. Democrats will be looking to recover ground lost by Obama in his botched handling of the debt ceiling debate while Republicans will be looking to drive the knife home and kill off Obama’s re-election chances for good. The stage is thus set for even more of the “political dysfunction” that S&P alluded to in its recent decision to downgrade the US. And the drama will play out agonizingly slowly, but loudly, over the next several months. Not a pretty backdrop either for financial markets or for Main Street.

Through all of this the markets are starting to crumble. Most commentators have raised their forecasts of the probability of a renewed slowdown  to 1 in 3 or 1 in 2. Some, like David Rosenberg of Gluskin Sheff, are saying that slipping into negative growth is a certainty. It is undeniable that economic growth in both Europe and North America is slowing. European economies are all growing at 1% annualized or less. Japan just printed a negative quarterly growth number. The US is limping along with a raft of indicators pointing to a sharp slowdown. In only one dimension this puts at risk the entire EU/ECB strategy of kicking the can down the road and hoping that the PIIGS and other debt-laden Euro-zone countries can grow out of their problems.

It is in this environment that this weekend’s annual meetings of Central Bankers at Jackson Hole Wyoming is taking place. Last year in a decidedly more upbeat environment (recall that the mantra then was that the recovery had arrived) Bernanke hinted at the unveiling of QEII and the markets promptly took off.

With the ECB and Brussels going “All-In” to stem contagion in the Euro-zone, what can Bernanke pull out of his bag of tricks to help boost confidence and get the US economy growing again? The answer is: “Not Much”. There is no more stomach for debt-financed stimulus in the US given the need to at least pay lip service to the objectives of the Super Committee. At the same time the Administration and Congress will continue to clamor for “action” to create jobs and re-start the economy.  This means that there is huge pressure on the Fed to “do something”. And, whatever the Fed “does”, the central banks of the world must fall in line or get steamrollered.

Our view is that the Fed has already recently tipped its hand by announcing the continuation of ZIRP for the next two years. Should the data continue soft as we expect it will, we foresee that Bernanke will at some point in the next few months, also implement another round of QE. Bernanke will likely strongly hint at this in any speeches and announcements coming out of Jackson Hole. No matter that the inflation indicators already exceed policy rates in both the Euro-zone and the US, Bernanke and the Fed are pre-disposed to action, can only take action in one direction, and will do so with a determination that reflects an unshakeable belief in their ability to control the economy. In our opinion they are sadly misguided in this and further, that any possible benefit can come out of the course they have already set.

So, for the period following the meeting of super-bankers,  our  short term prognosis is as follows: Government and Central Bank balance sheets will bloat further, unemployment will stay stubbornly high, economic growth will continue to crawl along at or below stall speed, the EU will continue to try and bail out failing Euro-sovereigns, the ECB and EFSF will continue to gorge on Euro-area debt that nobody wants to own; the Super Committee will serve up a dog’s breakfast; and the Fed will goose things further.

Similar to the fading days of the old Soviet Empire, the pressures for a financial collapse are building. Expect the outcome of the Jackson Hole meetings this weekend to add to, and not to subtract from, those pressures.

Posted in Bond Market, EU, Economy, Fed Policy, USA | No Comments »

Now is the Time for Stronger Balance Sheets

Q:Do you know what a banker is?

A: “A banker is someone who happily rents you an umbrella when the sky is clear but quickly demands it back again at the earliest threat of rain”.

Laugh if you will at this cynically humorous description, but having been a Corporate Lender at BMO for over 5 years earlier in my career I know there is more than a nugget of truth in this.

So, in this vein, let me offer a reminder. One which soon may prove timely given the recent build-up of toxic debt on central and commercial bank balance sheets and the growing scarcity of investment-grade opportunities for all the risk capital that’s out looking around for safe-harbours to park boatloads of ‘manufactured’ cash in:

The best time to:

(a) shop for umbrellas is before it rains,

(b) strengthen your dyke is before the spring run-off begins, and

(c) build your ark is before the flood waters come.

Why do I say this now? Well, given the ‘big storm clouds’ that appear to be forming over the global economy, I think there a real risk we’re all going to get ‘really soaked.’ So, if you’re smart you’ll get yourself prepared before ‘all hell’ breaks loose and time runs out for those excessively optimistic (particularly on the business front), for when the market changes, it will do so in a big rush!

Now, beyond the threat of government debt contagion building everywhere these days, many of the informed observers we and Recovery Partners have recently talked to have developed a realtively jaundiced view of the “economic recovery” story. The sense of deepening pessimism relates to a variety of factors: including recent anti-inflation-driven moves in Europe and China to higher interest rates, the realization tha there are many weak economies, demonstrably out of control borrowing by both governments and consumers and the seemingly conspicuous-consumption-led high level of demand for basic economic inputs that clearly is outpacing the global supply of easily-accessible (cheap) resources.

And, with private equity investors and investment and commercial bankers complaining about the lack of good investment opportunities, the globalization and computerization fed growth in corruption and fraud that has occurred in governmental and capital markets over the past 20 years, the high levels of un- and under-employment around the world and the growing realization that our earth better go ‘green’ quick before we all end up killing ourselves, it all makes one wonder just how far beyond sustainability have we been living in recent years.

So, for those with open ears and minds to listen, (and brains that recall the talk two years ago about what type of Great Recession recovery we should expect – ‘V’, ‘W’ or ‘VW’?), I suggest it’s time to pay attention to these ominous ‘rumblings of thunder’ for they portend the high risk that the global economic recovery will get washed out sometime all too soon.

Worse still (and God forbid) is that we might be facing a ‘monsoon beginning’ to a ‘flood of biblical proportions’ if the current ‘US federal debt / borrowing limit crisis’ mushrooms into an actual crisis of confidence in the US economy and downgrades the safe haven status of the US Dollar and US markets in times of global financial and geopolitical stress.

Notwithstanding all of the above, I believe it’s best not to despair (particularly those of you who are mindful and prepared to act). There are constructive things that can yet be done if you act prudently and soon. There are ways still available to cut your risk of getting swept away by the looming economic catastrophe that seems to be almost here.

For those with investable funds, two choices to consider are: (1) parking your money in high quality money equivalents (gold anyone?); and (2) buying Hi-Grade corporate bonds while you wait for (another?) once-in-a-life-time buying opportunity to develop.

And if you or your business are user of third-party capital, I’d say now’s the time to strengthen your balance sheet. And for those corporates with business performance or balance sheet issues, best you opt for as much permanent capital as possible because, should the economic storm I’m concerned about break, accessible capital definitely will be in very short supply, if it’s available at all.

To reitreate the main message, (because it’s always too late to figure out how to keep a leaky boat afloat when the downpour comes) the best time to:

(a) shop for (more third-party capital or) umbrellas is before it rains,

(b) (buttress your defences or) strengthen your dyke is before the spring run-off begins, and

(c) (look for more equity capital or) build your ark is before the flood waters come.

Tony Johnston

President

Compass North Inc.

www.CompassNorthInc.com

Compass North Inc. provides CEO / CRO / CFO transition management, consulting and investment banking transaction advisory services that maximize Client Company:

- revenues, profit & cashflow growth,

- debt & equity capital raised, and

- enterprise market value realized.

Posted in Banks, Bond Market, EU, Economy, Loan Losses | No Comments »

FATCA : The Empire Strikes Back

In this blog our friends at US Tax outline a key development in US tax policy as it affects US expatriates. Passed as a “stealth” component of the Hiring Incentives to Restore Employment Act of 2010 (”HIRE”), the Treasury and IRS hope to significantly increase expat tax payments and compliance rates. As Dr Thomas Walford and his colleagues Darlene Hart and Alan Cohen argue in this short note, there is substantial room to increase compliance rates and collections from the almost 7 million US citizens that live outside its borders…..Alex Jurshevski

What is happening?

Just over a year ago, we realized the impact that the new Foreign Account Tax Compliance Act (”FATCA”) legislation in the US  would have on the international community.   This requires all banks, finance houses, investment managers, insurance and trust companies to either:

1. send reports each year to the US IRS on those clients who are, or who have rights to, American Citizenship or are Green Card holders, or
2. suffer a 30% withholding tax on all income, dividends on any US Assets including US Dollars and the gross proceeds of sale of any US investment (equity or bonds).

To opt for the first, the financial institution needs to sign an agreement with the US Government which covers the reporting requirements and obligations necessary.

Why did the US do this?

After 2008/9 the US was left with a substantial deficit following the bail out of the banks and Insurance companies after the Lehman collapse and the sub-prime mortgage disaster.

In 2009, the IRS reported to Congress on the position of Non-resident Americans and their tax affairs.  Currently they are aware of 7,000,000 Americans who live outside the US, and each one needs and always has needed to complete a US tax return every year.  The US taxes on the basis of citizenship or residency.  In 2009 they received only 462,000 tax returns, a figure which represents only seven per cent of the total.  As a result we know that 93% of non-resident Americans are not tax compliant.

So why is it important?

The US taxes its people on Citizenship or Residency.  As a result anyone who has American citizenship (and income over $10,000pa) has to complete a US tax return each year and pay any tax that may be owing. 

If you are an US person, not completing a US Tax return is a criminal offence.

If the individual also lives in a country which has a Double Taxation Treaty with the US, then they can obtain a credit for the tax they have paid and only pay any premium over that amount to the US Government. As a result an employed person with no assets probably owes little in tax as income tax rates are higher in many countries than in the US.  However there are frequently situations where there are US taxes owing.

Is that all that is required?

No.  There are also penalties for anyone who has not completed a tax return form and submitted it within the correct timeframe.  These can amount to a substantial sum of money.  Up until 2009 it was rare for the US to assess penalties – but now in the new economic climate it has become quite regular.

Most non-resident Americans will operate a bank account in the country in which they live; probably more than one.  As part of the annual returns to the US Government American Non Resident individuals need to submit a Foreign Bank Account Form (FBAR).  If this is not submitted there is a minimum penalty of $10,000 per account per year that it has been missed.  If the US can show that the omission was deliberate or willful then the fine rises to $100,000 per account per year or 50% of the maximum balance.

These fines can amount to an extremely large sum.

So who does this apply to?

Anybody who has US Citizenship, a right to US Citizenship or Green Card Holders.  This means that it will include all people who:

• Were born in the US
• Have taken up American Citizenship
• Green Card Holders
• Anyone who has one parent who is American and lived in America for 5 years after the age of 14.

It does not matter if you have dual citizenship or live in another country.

Why is it important to Canada?

Canada has the largest proportion of Americans in the population compared with any other country in the world.

Analysis of number of Non-Resident Americans

                               
Population Stats from http://en.wikipedia.org/wiki/List_of_countries_by_population

Number of Americans from National Taxpayer Advocate 2009 Annual Report to Congress

Is there any way out?

Yes – the US Government has announced a voluntary disclosure Initiative (OVDI). This allows people to come forward who may not be in compliance and, if accepted, pay a fine and with immunity from criminal prosecution.  The fine is calculated as 25% of assets and they need to pay the back tax owed over the last 8 years.  Under certain circumstances the fine can be reduced to 5% for non -resident Americans who are Tax compliant in the country in which they live.

This scheme is only open until 31^st August 2011.  There is a 90 day extension if necessary and once accepted into the scheme, to complete all the tax returns required.

Any one who comes through the OVDI will be fully up-to-date with their tax responsibilities and hopefully will have an easy job in finding financial institutions to represent them.

What has changed?

The tax obligations of US persons has not changed.  What has changed is that the US Government may now receive a report of all US persons who are clients starting on 1^st January 2013 from any financial institution which opts to avoid the 30% withholding tax.  Most financial institutions are expected to do so.

What should US persons do?

They need to get their tax affairs up to date urgently.  Otherwise they risk being a named as a criminal and subjected to possible arrest and detention.

Who can help?

US Tax and Financial has an office in Tel Aviv and provides tax advice and consultancy services to individuals, companies and trusts as well as financial institutions.

US Tax has offices in London, Zurich Geneva and Tel Aviv and as such can help with a wide range of issues.

Please consult

Dr Thomas Walford

Telephone +44 20 7357 8220 or Cell +44 7769 707020

t.walford@ustaxonline.com

www.ustaxonline.com

 

Posted in Economy, Regulatory, USA | No Comments »

Fun With Numbers

“I am concerned about the fact that the recovery that we’re on is not producing jobs as quickly as I want it to happen,”  POTUS Barack Obama

President Obama has recently been chastising Americans for being too pessimistic about the future while at the same time continuing to push his high-spending agenda down the nation’s throat. Continued reliance on PR spin and blaming George W Bush for the country’s ills is no substitute for substantive steps to stem the red ink and deterioration of financial risk profile that his and his various predecessors’  policies have produced. Unfortunately, it is not only Obama, but perhaps the entire US leadership of the two mainline parties that have been ignoring the grim reality of the situation unfolding around them.

It is therefore of no surprise to us that Austan Goolsbee resigned several days ago as Obama’s Chief Economic Advisor in the wake of a slew of troubling economic numbers  (To which we might add, “Mr. President: What “recovery” are you referring to?”)

In this blog we examine some interesting statistics that we came across recently that these folks might do well to reflect on. For example, the unofficial number (based on the 1980’s calculation methodology) for the Misery Index at 25.3%, is now higher than it was under Jimmy Carter (21.8%) . Other statistics show that the US Government is now spending almost all tax revenues on entitlement programs while (ominously) financing the balance of its budgetary obligations by printing money. Paranthetically, no mention is being made by this Administration, or anyone else inside the Beltway, of the lack of Congressional spending authority for the warfighting operations in the Libyan quagmire and the newly disclosed “secret” operations in Yemen.

Here we go:

So now, less than five years later, you can go up on a steep hill in Las Vegas and look West, and with the right kind of eyes you can almost see the high-water mark—that place where the wave finally broke and rolled back.” — Hunter S. Thompson (Fear and Loathing in Las Vegas)

 

Posted in Bankruptcy, EU, Economy, Fed Policy, Hockey, IMF, USA | No Comments »

Disappointment is Sinking In

Last week we were interviewed on the European debt situation a number of times. You can view the interviews on our webpages in the Newsroom section here and here.

As serious as the situation in Europe is, it is merely a distraction from the much bigger debt crisis now unfolding in the United States. Ominously, the latest jobs numbers and other statistics show that the US economy might be rolling over again. Without the boost provided by the 206,000 jobs magicked up by the birth/death hand-adjustment, the May jobs figures would have beeen minus 153,000 workers. Not only are the jobs numbers weak, real wages are shrinking as well, providing scant reason for any optimism that the consumer can support the economy going forward. In fact, retail sales are arguably showing negative growth (as is the real economy) if we were to adjust the nominal numbers using inflation statistics from the MIT Billion Prices Project (running at 7% annulaized in the last 3 months) rather than the deflators normally applied by the Commerce Department.

Moreover, in the last few weeks we have seen data that show hoouse prices falling to new lows, weakness in bank lending and a drop off in consumer sentiment. This and other soft economic numbers is probably why Ben Bernanke in a speech today suggested that monetary policy was likely to remain ultra-loose for some time.

Unsurprisingly, a number of establishment economists such as Paul Krugman are now calling for yet more fiscal and monetary stimulus in order to “create” more growth. What these folks and their many acolytes do not seem to undestand is that there is no shred of data that supports the idea that fiscal stimulus can produce any type of predictable growth response in the economy at all (this is most eloquently argued by our friend Steve Hanke in a recent piece in the FP). Moreover, mainstream economic thinking also ignores the corrosive balance sheet effects of large deficits and monetary experiments that involve neophyte bond traders – Ben Bernanke -  laying down fixed income risk positions that amount to a non-trivial share of US GDP in terms of nominal size. The bottom line is that this situation will contribute to a continuing impasse in the US as regards needed fiscal reform and consequent inertia in reining in an out-of-control deficit picture. Finally, the probability of a QE3 to follow a short time after the conclusion of the current highly experimental QE2 monetary stimulus program has now become almost a certainty – as we have been predicting for some time now.

 Buckle up. The ride is going to get bumpy again

Posted in Bankruptcy, Crisis, EU, Economy, Fed Policy, USA | No Comments »

The Large Print Taketh Away and the Fine Print Giveth

“AAA/A-1+’ Rating On United States of America Affirmed; Outlook Revised To Negative

We have affirmed our ‘AAA/A-1+’ sovereign credit ratings on the United States of America.

The economy of the U.S. is flexible and highly diversified, the country’s effective monetary policies have supported output growth while containing inflationary pressures, and a consistent global preference for the U.S. dollar over all other currencies gives the country unique external liquidity.

Because the U.S. has, relative to its ‘AAA’ peers, what we consider to be very large budget deficits and rising government indebtedness and the path to addressing these is not clear to us, we have revised our outlook on the long-term rating to negative from stable.

We believe there is a material risk that U.S. policymakers might not reach an agreement on how to address medium- and long-term budgetary challenges by 2013; if an agreement is not reached and meaningful implementation is not begun by then, this would in our view render the U.S. fiscal profile meaningfully weaker than that of peer ‘AAA’ sovereigns.”

Nikola G Swann, Standard and Poor’s 18^th April 2011

The “bombshell release” yesterday by Credit Ratings Agency Standard and Poor’s was greeted by most media as a “Wake Up Call”, that a “Government Bubble was targeted” and that the Ratings Agencies “now mean business when dealing with the US Government and its spendthrift ways”.

In reality the announcement yesterday seems to us more of a giant PR wheeze that doesn’t necessarily mean that anything much will change at all. In fact, in our opinion, the intent of the entire exercise is to allow the can to be kicked a little further down the road rather than to initiate substantive action.

For starters, there was nothing in the report that is new information as far as the US fiscal situation is concerned. Nor does the report set out what would constitute grounds for a return to stable ratings status other than some vague language about “deficit cuts greater than $4 Trillion”. This is an obvious soft target for politicians on both sides of the House and Senate to aim for and hit at some pint in the next three years.

Secondly a variety of academic studies have shown that credit ratings have and announcements of ratings changes tend to have almost zero predictive power. Typically these announcements are made after the event and tend to confirm what the market is already reflecting in terms of relative risk. What is surprising here is that the markets have held up as well as they have to this point.

Thirdly, the US Government has been on negative ratings watch before. Fitch put U.S. debt on a “negative ratings watch” in November 1995 until spring 1996, and Moody’s put some U.S. government bonds on review for a possible downgrade in January 1996.

Fourthly, The Chinese for their part laid down the gauntlet in November 2010 when Dagong Credit Rating Agency downgraded the US to A+ with a negative outlook. “Who listens to Dagong?” one might ask. The answer is that they only need one client – the Chinese Government – and if the ratings threaten to fall below single “A” (the typical investment cut-off for central banks and Governments); what that client does or what it tells the market in intends to do with its holdings of US dollars and US Treasury debt is of vast significance. We already know that the Chiness have cut back on their Treasury holdings. What this tells us is tha the largest offshore holder of Treasuries thinks that they have already turned into a bad deal, not that they someday might.

Fifthly, having been myself involved in Sovereign Ratings negotiations as a Sovereign Debt Manager I can assure our readers that much of what was announced yesterday and the reaction to it by Treasury and Fed officials was long planned and stage-managed in advance through a cooperative effort between the US Government and the Ratings Agency in question. Typically nothing is left to chance – in this case including the opportunity for Treasury and Fed spokespeople to flood the airwaves AHEAD of the S&P annoncement with their views on US creditworthiness. 

What we also find hugely risible (if were not so deadly serious) is the references the S&P makes to “effective monetary policy” and “unique external liquidity” in the US. The reality is that QE is an untested experiment that has been shown to feature a variety of unanticipated second order effects, some of which are contributing to various asset bubbles and civilian unrest; and that by itself, QE poses a huge re-entry problem for the Fed and US Financial markets (if not a treadmill to financial oblivion). Moreover, US “liquidity” is simply the ability of the Fed to print money at will. What S&P is really doing here is lending its credibility (or what is left of it) to supporting the massive money printing that the Fed has engineered. This policy is attracting huge and unprecedented criticism, even from within the Fed, but we are supposed to beleive that this is “AAA” finacial leadership for the world?

The practical effect of the announcement was thus designed in many ways is to provide positive support (through the imprimatur of the S&P analysts for a continuing AAA rating) for the current financial posture of the US rather than to apply a rational, transparent analytical framework to US finances and come up with a coldly objective assessment of creditworthiness. If the S&P had done the latter, they would undoubtedly have come to the same conclusion as the IMF did almost one year ago when the economists on 19th Street concluded that the US needed a fiscal adjustment on the scale of Ireland or Greece to stabilize matters, rather than some nebulous level of deficit cuts “above $4 Trillion”. Ireland is rated BBB+ (also a wheeze – they are bankrupt) and Greece is rated BB- The latter just auctioned 2 year bonds at yields in excess of 20%.  Note that the US fiscal position has measurably eroded from one year ago as has the economic outlook.

In view of the foregoing one must ask whether the country still rates an “AAA” rating by any conceivable rational and objective yardstick.

Some two weeks ago at a Euromoney Conference here in Toronto, our friend Barry Allan, Founder and President of Marrett Asset Management, summed up his views of Credit Ratings Agencies thusly:

“I don’t understand the reason for the existence of these organisations. In the first place they operate from a privileged position because any borrower who wants a rating needs to pay them to obtain one. This opens up the whole process to significant risk of professional conflict. And then, if the ratings provided are shown to be too sanguine by subsequent developments (and they frequently have been), there is no financial or other sanction assessed against the Ratings Agencies for the misdiagnosis and consequent losses to investors. This does not conform to any other rational business model that I know of.”

Posted in Banks, Bond Market, Crisis, Economy, Fed Policy, IMF, Sovereign Debt, USA | No Comments »

The Men Who Killed the Greenback

“We have met the enemy and they is us”    Pogo

When German finance minister, Wolfgang Schaeuble, called US monetary policy “clueless” in early November of 2010, he opened a new chapter in the World’s response to the decades-old control that the United States of America has enjoyed over global economic policy.

European criticism of American politics is not new. After all, the elites of Berlin, Paris or Rome have a history of voicing their opinion on American matters. But the fact that a European political heavyweight essentially calls an entire government and one of its revered institutions “clueless” sets a new standard and amounts to a direct attack on the trio of Fed Chairman Bernanke, Treasury Secretary Geithner and President Obama — the three individuals that been have advertised by the mainstream media as saviors of the global economy. (the fact that Bernanke and Geithner were at the controls well before the crash occurred and that they therefore share some blame for the crisis itself is conveniently ignored).

In past decades, one could not imagine a senior European political leader so openly attacking the US, but Obama’s “Yes, We Can” approach seems to  invite criticism and challenge to US hegemony. Not in the least, these new attitudes are gaining traction because the world must now struggle through the consequences of American policy-making that fomented the madness of giving mortgages to American “NINJAs” ultimately transferring the credit risk associated with insane balance sheet management decisions onto the backs of taxpayers around the world, including the those in the US.

Increasingly, political leaders around the globe have come to the conclusion that blame must be accorded the United States of America for causing the biggest collapse the global financial system has ever seen. There seems to be a new desire to challenge the United States in its hence undisputed global leadership role and to emancipate the rest of the world from the American ideal and its grip on World affairs. None of this portends a rosy or even stable future path for the world economy and the evolution of geopolitical relationships.

Misguided US Policy

Mr. Schaeuble is right in calling American policy clueless. Printing money and creating more liquidity is not ever going to solve America’s own economic or fiscal problems.

Quantitative Easing has not worked in round one, as can easily be seen in the slow recovery of the U.S. economy. Yes, the liquidity created by the Fed in QE1 has made financial markets happy, creating plenty of liquidity to drive asset prices higher, but it certainly has not produced any jobs. Nor has QE2.

 The monetary policy stance has simply blown new bubbles in a variety of global markets and convinced market participants the that “Bernanke put” is still operative. However the raw numbers do not lie. While wealthy America enjoys better times on Wall Street, the unemployed or underemployed America continues to suffer from the protracted slump on Main Street.

The first decade of the 21^st Century has seen official US federal debt cross the $10 trillion mark (this does not include the $50 odd Trillion of off-balance sheet commitments) which is being left to tick away like a debt bomb while the politicians convince themselves that they are being prudent and parsimonious. No wonder that the Fed and the Treasury are manipulating  interest rates by flooding the market with ever cheapening dollars. Debasing the currency is in fact an act of desperation, but it comes with the side effect of keeping the specter of higher interest rates at bay, while at the same time creating a ready demand for the vast supply of Treasury paper. This balancing act has been on a fuse from day one. Unfortunaltely the US leadership chooses to ignore this reality.

 How far removed American policy makers are from reality was further demonstrated by the 2012 budget that President Obama tabled just last week. According to the plan crafted by the White House, the United States will not see a balanced budget for another 15 years and will continue to pile up new debt at a rate exceeding $1trn per year. Obama seems to have replaced his “Audacity of Hope” message with an “Audacity of Desperation” when he publicly (and quite possible cynically) announced that the US Government would stop “racking up the credit card”. Not only is this statement an audacious misrepresentation in and of itself,  it also demonstrates a total lack of political leadership coming from this Administration that is truly appalling. How long this game can go on is anybody’s guess, but if history is any guide (and we have plenty of data on Sovereign default) we are already well into the danger zone.

To compound the complexity of the situation that the US authorities have created for themselves, there is now a widespread understanding of the  connection between QE and the unprecedented rise in commodity and food prices. In fact, the rising cost of basic food items denominated in US dollars renders the linkage between US monetary policy and the eruptions of unrest across the Middle East and parts beyond fairly obvious. 

In addition, no matter how much the White House and most leaders in the West cynically celebrate these revolutions as spontaneous “acts of liberation” by the people from repressive regimes and the first step towards a spread of democracy in the Middle East, a more sober view of recent events should focus on the geopolitical risks and on what instability in the Middle East means. For example, there is a non-trivial risk that we could see a repeat of post Shah Iran where elements of Islamo-fascism are behind or are planning to hijack the processes by which governments are being replaced or have been replaced in a number of these countries.  The Obama Administration must bear some responsibility for these unexpected developments both as a result of expansive monetary policy which has boosted food prices and incited the hungry masses to action, but ironically, also because of Obama’s early term kowtowing and proselytizing to these same masses which has encouraged America’s enemies in that part of the World.

America’s Decline and China’s Rise

Since emerging from WWII as the world’s strongest economy both militarily and financially, the United States have spent the better part of the last 60 years becoming the largest debtor country the World has ever seen. It hardly comes as a surprise that all of this encourages world leaders to question US leadership. Bernanke’s QE exploits and the perversion of the US bond auction process may well become the tipping point in a developing story where the greenback can no longer serve as the world’s only reserve currency. Chatter is increasing of central banks around the globe putting together a basket of leading currencies, logically including the euro, Swiss Franc, Remimbi and other emerging market tender, that can either supplement or even take over the role of the U.S. dollar.

 China has recently started opening the Remimbi as a trading currency across Asia. This is widely seen as a first step towards China asserting a larger international role for its currency. China is demonstrably on the path of securing long-term sustainability of its rise to global economic power. China also understands that it is in her best interest not to increase the trade deficit with the United States further but to soften its impact. While the US spends and prints money, the Chinese are prudently applying the economic brakes. If recent meetings of global leaders are any guide, it remains unclear whether prudence and restraint from the Middle Kingdom, and Europe for that matter, will be enough convince Washington to turn away from desperate and ill advised policies. However, this point may soon become moot as China discovers for itself the power a creditor can exert over debtors; a game which the US has practiced with impunity in the Postwar period – unitil now.

Loss of Leadership

After driving the world to the brink of financial collapse in 2008, the United States may indeed have lost both credibility and legitimacy as the steward of the reserve currency and global monetary system. Many see the creation of a new international currency system as the ultimate solution to monetary warfare and to stabilizing the world economy.  The United States may not like this infringement on their global dominance. In the best case the US authorities may come to realize that the creation of an alternative global monetary mechanism may allow them to share the burden that the global role of the Greenback signifies for America. This would be a World in which all nations, including the US, understood their role, their standing amongst peers and foreswore any attempts to exercise dominion over other countries and peoples. What a wonderful World that would be, would it not?

Unfortunately life is not that simple, and the US will not yield easily. The reserve currency debate spans across all major international organizations, reaching from the UN to the IMF and the G20. It has been a while since we have seen the world engaged so deeply in devising a new global monetary policy — and never before have we seen the United States not at the forefront of financial issues and leading the agenda. It could be that at a structural level, ossification has set in and US institutions are too wracked by political inertia to come to the correct decisions in a short enough period of time to be able to effectively deal with the various problems. This is certainly appears to be part of the issue. However personalities also play a role. And here we have to conclude that from President Obama on down, the individuals in key positions of authority and responsibility in this Administration simply are not “Men of the Moment”……and they are therefore not up to the task of fixing the problems that they have helped create.

How this will all play out is anybody’s guess.

 

By: Beat J. Guldimann, LLD

Posted in Bankruptcy, Crisis, EU, Economy, Fed Policy, IMF, Sovereign Debt | No Comments »

Hubris Meets Nemesis

“…….a central bank should always be able to generate inflation, even when the short-term nominal interest rate is zero …[this] more direct method, which I personally prefer, would be for the Fed to announce ceilings for yields on all longer-maturity Treasury Debt.   Ben Bernanke 2002

Last week Moody’s Investors Service said that the top Aaa ratings of key Western nations face new challenges that increase the possibility of a downgrade. Not one of the big countries was spared – the USA, the UK, France and Germany all came under the microscope for evaluation as to possible future downgrades. Specifically, the  ”distance to downgrade” for these four sovereigns has been reduced, the credit rating agency said in a statement, meaning their credit quality within that top category is declining. In addition a contrast was drawn between the key European states, who are pursuing deficit reduction strategies and the USA which for the time being is not.

By now the events in the US have revealed glimmers of the true picture previously hidden behind the avalanche of economic disinformation that has enveloped the country since the onset of the GFC. The average American is now very aware of the hardships of living in a nation being driven by policies that do not substantively address the very real weaknesses in the economy, and which have been obscured or soft-pedaled by the Government as well as the apologist economists associated with it. The population is also becoming increasingly aware of the dangers of not facing up to the issues that need to be addressed urgently in order to avoid  a slide into an even worse predicament.

However, the Obama Administration, for its part seems to disregard the fact that the economy continues to bleed cash and jobs. It professes to have saved the country by adding Trillions to the National Debt, by allowing many US banks to pretend that they are solvent, and that by following the “diktat” of its ultra-Keynesian advisors that taking on even more debt is the road to salvation. Ordinary Americans are being forced to pick up the tab for the bank failures, pick up the tab for the policy failures, fund insolvent institutions through the payment of net interest margins associated with “carry” trades and are being forced pick up the tab for ill-advised borrowing policies.

Whilst we agree with pretty much all of what the Moody’s reports have to say about the general picture regarding Sovereign default in the countries mentioned as well as elsewhere; we completely disagree with the focus of these reports as being on the “distance to downgrade”. As students of Sovereign Debt we observe that default is not a gradual process, much less one that can be accurately measured using “black box” algorithms or the like. The default process is one that moves akin to a step function: when one or more factors exert too much strain on the underlying structure of debt finance, the whole edifice comes tumbling down very quickly.

 It takes knowledge, experience and judgement to identify the unique factors in each situation that are material to avoidance of the disaster scenario.  In the present case we can identify numerous risk factors that if they continue to be left un-managed or mis-managed could see the United States enter a default scenario or if not outright default, then a situation where a further, and more substantial, loss of geo-political and economic clout  becomes a reality. What follows is a partial list of these myriad danger signals:

Policy Misalignment

Judging by the comments of Bernanke, Paulson and others in the lead-up to the crisis, it is clear that the US authorities completely underestimated the extent of the economic crisis, failed to identify its causes and failed to devise and put forward appropriate solutions. Apart from not allowing the stimulus alternatives and other pieces of economic legislation to be debated by Congress, the Obama Administration has compounded the mis-diagnosis by clinging to the notion that the GFC triggered a cyclical /liquidity problem (which it is not) rather than a structural/ solvency problem (which is what it is).

 As another example of the implications of this error, according to a recent Flow of Funds Report, Washington has been piling on debt at an 18.5% annual rate since the beginning of the year while households have been reducing debt by around 2.5%. Since every dollar of government debt is a promise to tax the private sector in the future with interest, this orgy of public spending has swamped the rational and strenuous efforts of the private sector to return to a sustainable expenditure track and income/savings balance.

Tax Receipts Crashing

Government Tax revenues are slowing. According the Heritage Foundation the problem has some scale: US federal tax receipts are tracking at around 14.8% of GDP, compared to 20.6% in 2000 and a 30 year average of slightly over 18% of GDP.  The US Government is being squeezed between too slow a rebound in tax revenues and the limitations on how quickly it can realistically take its funding requirements to the US Treasury auctions. This cash management information is signalling trouble ahead simply because the economy is recovering much more slowly that what was assumed in Administration fiscal forecasts.

How can we credibly expect a rebound in tax receipts when employment patterns are so weak? The U-3 numbers are tracking just shy of 10% and the U-6 series is at 16.6%. No jobs means that taxes aren’t getting paid.

State and Local Governments are Bankrupt or Going Bankrupt

Slowing revenues at the Federal level are also reflected at lower levels of government. Moreover, Investment in State and Local issuance has completely dried up. As a consequence States and cities across America are amassing scary, yet non-market fundable, budget shortfalls in record time. California as a whole is best known for being on the verge of debt default, but California is not the only State with a Government and its cities on the brink. Moreover, according to the Economic Policy Journal, 32 states are now technically bankrupt, and are borrowing money from the Federal Treasury (read “printed money”) just to keep up with unemployment benefits. The National League of Cities has reported that U.S. municipalities will come up short on debts to the tune of up to $80 billion this year.

Readers, please note that the recent $26 Billion “State Aid Plan” passed by Congress a couple of weeks ago does not actually give the States the money. It merely mandates that they have to match-fund any federal transfers in order to receive them in the first place. In other words the “rescue package” adds to the States’ fiscal burden, it does not reduce it (See “Policy Misalignment”)

 Insolvent Banking System

Readers of this blog know that we have estimated the number of insolvent and/or severely impaired banks in the US to be well over 2000 institutions, far higher than the 800 or so that were supposedly on the FDIC watchlist earlier this year. April 2^nd, 2010 marked the first anniversary of the date when FASB 157 was suspended and with it came the abolition of “mark-to market” accounting. The Administration left FASB no choice but to change their guidelines using the notion that this move was a temporary deferral of the rules, instituted in order to allow time for the banks to adjust to the toxic assets on their books. What progress have banks made in moving assets off of their books in the “Extend and Pretend” environment?  How much closer are these banks to regaining financial health? The answer is: “No one knows for sure”, because the problems have been swept out of view as a consequence of the removal of the `mark-to-market` rules.

The bottom line here is not only that the entire response to the banking debacle in the US wrongheaded, it is also a violation of the Prompt Corrective Action Law which mandates that the regulatory response to financial institution failure must be decisive, transparent, economically rational and that it be implemented in the early stages of a problem situation.

Housing Market  Near Death

The US housing market, a key driver of domestic consumption and wealth accumulation in the Post WWII period is all but dead and is not showing any signs of imminent re-animation. The full force of the plunge in US housing activity after the expiry of the homebuyer tax credit was revealed today in the form of a massive 27.2% decline in existing home sales in July. Sales are now 34% below April’s tax credit-induced peak, well below the previous cycle low back in November 2008 and at a level not seen since June 1993. At the current pace of sales it would now take 12.5 months to erase the inventory overhang, well above the 7 months that has historically been consistent with stable prices. Mortgage applications for home purchase remain close to their recent 14-year low. All of this is happening despite record low mortgage rates. Most observers now concede that weak housing activity is constraining the already fragile and tenuous growth prospects for the general economy.

Debt Issuance  Patterns

 Usually, a Sovereign debt management strategy features limits on issuance of short term debt in order that the debt portfolio not become too sensitive to rate resets and liquidity conditions in the funding markets. Thus, a typical issuance strategy for Sovereigns would be to seek 80% fixed rate term debt, perhaps 20% in floating maturities and perhaps a small portion in inflation indexed stock. In addition, debt managers try to aim for an average maturity of the overall portfolio that will shield it from interest rate volatility usually by aiming for a duration range of 4-6 years. Stable borrowing strategies also feature a diversification of funding sources.

The current situation in the US reflects anything but this. The Chinese and Japanese who together own about 40% of the Treasury stock held offshore are limiting their purchases of Treasuries. China has in fact sold down some of its holdings recently. Britain another large holder is in no position to support the Treasury’s borrowing program. It is not probable that this behavior will change in the future.

The upshot of this is that in the recent US Government fiscal year over 70% of issuance has been in the one year and under (i.e. short dated and floating) portion of the maturity spectrum. Issuance in the 10 year and over maturities has so far constituted less than 7% of the funding requirements. As the deficits projected for the next few years are very large, this disproportionate short-dated issuance will vastly increase the vulnerability of the US Government Budget to rising rates and market funding conditions, placing pressure on the Fed to maintain low rates and possibly imperiling the Dollar as reserve currency should it come under speculative attack. The focus on short-dated issuance in a situation where gargantuan deficits are in store is a very significant risk factor. Ironically, a key risk factor affecting the US dollar is precisely the debt managment connundrum described above.

Off Balance Sheet Federal Government Liabilities

At last count these amounted to around USD 52 Trillion or around 4 times larger than annual GDP. There is no further comment needed here.

Hanging by a Thread

The situation in the United States is reaching a critical point. Key economic indicators are signalling a weak activity profile, Fed and Treasury  policies have not worked and more of the same tonic might in fact prove very dangerous, and offshore investors and trading partners are growing increasingly nervous and unsure of the economic stewardship of the World’s still-largest economy and that whose currency is the principal reserve asset for the Global Financial System.

Given the foregoing it is not be surprising that there are reports of significant stress between members of the FOMC coming out of the Beltway and the growing difficulties that Bernanke is having riding herd on this increasingly restive group of Senior US Central Bankers. However much stress and nervousness there might be at present, to us it seems that, given the results so far, the real difficulties, dangers, and hard choices unfortunately still lie ahead.

Posted in Banks, Bond Market, Canada, Crisis, Economy, Fed Policy, Restructuring | No Comments »