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December 26, 2010
Issue 128  -  Debt Tsunami
 
 
It finally looks like the 30 year bull market in bonds is over, and this is very bad news for the United States and probably the world.  In case you haven't been following interest rates, they have skyrocketed over the past six weeks.  I was eyeing up another refi for my house in the 3.875% range for a 30 year fixed rate, when all of a sudden:
 
 
The same company which was offering 30 year fixed mortgages at 3.875 is now at 4.75%. 
 
Interest rates have fallen since December 1981 when, believe it or not, mortgage rates topped out at a mind boggling 15.8%!  To give you an idea how high that is, on a $300,000 mortgage, the payment at the current 4.75% rates is about $1,565 and over 30 years you would pay nearly $565,000.  With a 15.8% rate, the payment would be $3,985 and total payments would top $1.4 million.  What do you think that would do to house prices?  Probably knock them down just a tad?  Yeah...probably.
 
So it is obvious to see that increasing rates will mean higher and higher interest rate payments on all debt.  The United States has a majority of it's debt in short term debt.  In case you're unfamiliar with bonds, they are all issued with a term.  After the term is up, the principal is returned to the buyer, or the debt is rolled over at current rates.  If interest rates are higher, then payments will go up.  We have lots of debt with less than 1 year until maturity.  The United States has been issuing LOTS of debt and most of it short term.  Why didn't we lock this debt up in 30 year bonds?  We couldn't/can't afford it.
 
The cumulative interest paid by Uncle Sam in 2009 was about $380 billion.  The average interest rate of all debt was about 3.25%.  For fiscal year 2010 (ended September 30th) the cumulative interest paid was about $415 Billion while the average interest rate was down to about 3%.  Interest rates have now spiked up nearly a percentage point while debt is increasing as fast as ever.  Just on the debt from 2010, the interest payments would jump to nearly $550 billion.  If interest rates don't stop rising, the interest payments jump to unsustainable levels very quickly.  Revenue in 2009 was 2.7 trillion which means interest would take up over 20% of all inflows.  Here is a chart of the projections:
 
 
 
 
If one leaves social security out of the inflow total, and it should be a stand alone system, the government take drops to about $1.8 trillion.  $550 billion is over 30% of income at that point.  A mere doubling of the interest rate would take debt payments up to roughly 45% of income.  This is ONLY interest.  That payment doesn't lower what we owe one cent.  In fact, we are scheduled to add more debt over the next three years.  We are adding more and more debt each year and are not paying any principal.  Unsustainable.
  
This is the box the Fed is in today.  The housing market is so weak that any increase in interest rates will have major effects .  Yet, interest rates must rise to compensate buyers of bonds for added risk.  Remember, as interest rates rise, the underlying bonds fall in price.  This is because new buyers of bonds will not give the old buyers the same price they paid.  If you could buy a new $1000 bond paying 5%, would you buy the old $1000 bond paying 4% at the same price?  Obviously not. 
 
So the years of too much debt is catching up to the United States.  Since we have the reserve currency of the world, we have been given much more rope than other countries such as Greece. 
  
Actually, the rope is snugging up, especially on municipalities:  (From Rick's Pick's)

Muni-Bond Market’s Descent into Hell

by Rick Ackerman on December 22, 2010
 
Just when it looked like the alleged economic recovery couldn’t get any weaker without extinguishing itself entirely, the municipal bond market has gone to hell. And just like in hell, there is no exit – at least none that we can imagine. Here’s why: Municipal and state borrowers who are on the ropes must pay a premium to continue borrowing; this drives their budgets deeper into the red, causing ratings downgrades that in turn raise borrowing costs even more. A vicious cycle, for sure, and it sounds just like much of Europe’s predicament doesn’t it?  Except that, for strapped U.S. cities and states, there is no IMF to pretend to bail them out.  And while Europe’s erstwhile deadbeats, the PIIGS, get plenty of time to work on balancing their budgets through measures of “austerity”  (Merriam-Webster’s Word of the Year, by the way),  U.S. cities and states must bring their budgets into at least a fleeting semblance of rectitude before the beginning of each new fiscal year.

We shouldn’t get our hopes too high that this recurring dog-and-pony show will work without eventually causing a taxpayer revolt. If you’ve been following the sordid bookkeeping tactics of such fiscal n’er-do-wells as California, Illinois and New Jersey, you’ll already know that austerity measures that would have been unimaginable just a few years ago have done little to eliminate structural deficits that keep returning like the slasher in a Wes Craven film. The big question is whether the lenders will continue to distinguish “good” borrowers from “bad.” At present they are doing so, charging, for one, the State of Illinois — the riskiest borrower of them all, with an A1-negative rating — 1.9 percentage points more than the broader muni market charges for 10-year bonds. For comparison, the borrowing spread for Nevada, which has been blighted by a real estate crash and severely depressed gaming revenues, is 0.80 percentage points, up from 0.50 in early November.

Although we’d like to believe that some miracle awaits to save the municipal bond market from disaster, it only gets worse. According to a report recently issued by the Congressional Budget Office, the revenue side of the equation – i.e., property taxes – is poised to decline because of downward reassessments across the length and breadth of America. Because homes are not reassessed every year, local property-tax revenues tend to lag behind falling home prices by about three years.  “Even small declines in collections could cause fiscal stress when the cost of providing public services is growing,” the report said. What this implies is more than mere belt-tightening in the years ahead. Since states and municipalities won’t be able to raise taxes much to cover the shortfall, we would predict either a hyperinflationary federal bailout with Funny Money; or, more likely, a deflationary wallow that will make the 1930s Depression look like Mardi Gras.

As much as I like Rick Ackerman, I strongly disagree that the more likely outcome is a deflationary abyss, and have almost certainty that the Fed will crank up the printing presses.  What the deflationists seem to discount is the true lack of thought and decency that these cretins possess.  They don't care if things collapse.  They just want to stay in power, regardless of the long term consequences.  A deflation is just too much pain to withstand.
 
The deflationists would have you believe that the Fed will just stand by as California drops into an ocean of debt?  I don't think so.  QE 3, QE 4, QE 27.....whatever it takes to keep the boat afloat, will be done.  This is going to take a LOT of printing.  How much?:
 
$2tn debt crisis threatens to bring down 100 US cities

Overdrawn American cities could face financial collapse in 2011, defaulting on hundreds of billions of dollars of borrowings and derailing the US economic recovery. Nor are European cities safe – Florence, Barcelona, Madrid, Venice: all are in trouble

More than 100 American cities could go bust next year as the debt crisis that has taken down banks and countries threatens next to spark a municipal meltdown, a leading analyst has warned.

Meredith Whitney, the US research analyst who correctly predicted the global

credit crunch, described local and state debt as the biggest problem facing the US economy, and one that could derail its recovery.

"Next to housing this is the single most important issue in the US and certainly the biggest threat to the US economy," Whitney told the CBS 60 Minutes programme on Sunday night.

"There's not a doubt on my mind that you will see a spate of municipal bond defaults. You can see fifty to a hundred sizeable defaults – more. This will amount to hundreds of billions of dollars' worth of defaults."

New Jersey governor Chris Christie summarised the problem succinctly: "We spent too much on everything. We spent money we didn't have. We borrowed money just crazily. The credit card's maxed out, and it's over. We now have to get to the business of climbing out of the hole. We've been digging it for a decade or more. We've got to climb now, and a climb is harder."

American cities and states have debts in total of as much as $2tn. In Europe, local and regional government borrowing is expected to reach a historical peak of nearly €1.3tn (£1.1tn) this year.

Cities from Detroit to Madrid are struggling to pay creditors, including providers of basic services such as street cleaning. Last week, Moody's ratings agency warned about a possible downgrade for the cities of Florence and Barcelona and cut the rating of the Basque country in northern Spain. Lisbon was downgraded by rival agency Standard & Poor's earlier this year, while the borrowings of Naples and Budapest are on the brink of junk status. Istanbul's debt has already been downgraded to junk.

Whitney's intervention is likely to raise the profile of the issue of municipal debt. While she was an analyst at Oppenheimer, the New York investment bank, in October 2007 she wrote a damning report on Citigroup, then the world's largest bank, predicting it would cut its dividend. She was criticised for being too pessimistic but was vindicated when the bank was forced to seek government support a year later. She has since set up her own advisory firm and is rated one of the most influential women in American business.

US states have spent nearly half a trillion dollars more than they have collected in taxes, and face a $1tn hole in their pension funds, said the CBS programme, apocalyptically titled The Day of Reckoning.

Detroit is cutting police, lighting, road repairs and cleaning services affecting as much as 20% of the population. The city, which has been on the skids for almost two decades with the decline of the US auto industry, does not generate enough wealth to maintain services for its 900,000 inhabitants.

The nearby state of Illinois has spent twice as much money as it has collected and is about six months behind on creditor payments. The University of Illinois alone is owed $400m, the CBS programme said. The state has a 21% chances of default, more than any other, according to CMA Datavision, a derivatives information provider.

California has raised state university tuition fees by 32%. Arizona has sold its state capitol and supreme court buildings to investors, and leases them back.

Potential defaults could also hit Florida, whose booming real estate industry burst two years ago, said Guy J. Benstead, a partner at Cedar Ridge Partners in San Francisco. "We are not out of the woods by any stretch yet," he said.

"It's all part of the same parcel: public sector indebtedness needs to be cut, it needs a lot of austerity, and it hit the central governments first, and now is hitting local bodies," said Philip Brown, managing director at Citigroup in London.

In Europe, where cities have traditionally relied more on bank loans and state transfers than bonds, financing habits are changing. The Spanish regions of Catalonia and Valencia have issued debt to their own citizens after financial markets shut their doors because of the regions' high deficits. Moody's cut to the rating of the Basque country on Friday left it still within investment grade but noted "the rapid deterioration in the region's budgetary performance in recent years". It said it expected it to continue over the medium term.

In Italy, Moody's and S&P have threatened to downgrade Florence, while Venice has been forced over the past few months to put some of the palazzi on its canals up for sale to fund the deficit.

"Cities are on their own. Governments won't come to their rescue as they have problems of their own," said Andres Rodriguez-Pose, professor of economic geography at the London School of Economics. "Cities will have to pay for their debts, and in some cases they will have to carry out dramatic cuts, such as Detroit's."

California crunch

Vallejo, a former US navy town near San Francisco, is still trying to emerge from the Chapter Nine bankruptcy protection it entered in 2008.

The city, now a symbol of distressed local finances, is still negotiating with the unions, which refused to accept a salary cut plan two years ago. Paul Dyson, an analyst with the Standard & Poor's credit agency, said Vallejo, which is mostly a dormitory town for Oakland or San Francisco employees, did not have enough local industry to sustain its finances and property tax – a major source of local income – plunged with the collapse of the real estate market. The S&P credit-rating agency has a C rating on the town – the lowest level.

With a population of about 120,000, Vallejo has $195m (£125m) of unfunded pension obligations and has to present a bankruptcy-exit plan to a Sacramento court by 18 January. Since 1937, 619 local US government bodies, mostly small utilities or districts, have filed for bankruptcy, Bloomberg News recently reported. US cities tend to default more than European municipalities as they usually rely on bonds issued to investors, which enter into a default if the creditor misses payments. European towns, by contrast, traditionally depend on bank loans and government bailouts.

Over 100 cities????  $2 trillion?  That will be a definite drag on things won't it?  Most states have a balanced budget law so cuts will have to be made.  I expect the cuts to start eating into "core" services, This chart shows the price of municipal bonds.  It looks like they are crashing:
 
 
 
The municipal bonds are what are used for funding various bond referendums and covering budget shortfalls.  The higher the interest rates demanded, the worse the budgets get.  If the breakdown in the above chart continues, it will mean deep trouble as the funding of the local governments will require much higher debt payments.  This just can't be sustained with decreasing state revenues.
 
Not much can be done at this point except to position yourself in hard assets.  That won't stop the idiots in government from trying.  In fact Bernanke is quite confident he can stop inflation were it to start:
 
  
 
In case you didn't watch, he said he is 100% sure they can stop inflation.  When you judge what someone says, it is a good idea to see how their predictions have worked out before.  Let's take a look: 
 
 
 
 
That's right, his past pronouncements and predictions have been pretty much a complete FAIL!  He's actually a complete idiot who doesn't understand the way things work, never ran a business, never held a real job, or lived in the real world.  Don't worry though, it's not like he's in charge of anything important.
 
 
 
Positions
 
Goro  (closed at $27.81, up $.81, average price paid, $6.10) 
  
Mexus Gold  (closed .23, down 4 cents, average price paid, $0.20)   
 
GORO June 11, call options, strike $20 (closed at $9.00, up $0.50, average price paid, $5.60)
 
SLW options  March 2011 expiration
        40 strike (closed at $2.40,  down $.70, price paid $2.75)
        45 strike (closed at $1.23, down $.41, price paid $1.62)
 
The following positions are now down to a point where they are almost worthless.  I'm continuing to hold them in case the London source from King World News is correct.  If gold goes up over $100 in the next 5 weeks these options would actually be up.  I can't recommend that you buy them now, but if I were going to try and play the rumor, I would buy a much later month.  If these options don't recover, it is a prime example of how volatile these are and why you don't put any money you can't afford to lose in them. 
 
Call Options, gold stocks, January 2011 expiration
       AEM - 90 Strike (closed $.17, down $.11, price paid $1.45)
       GG - 50 Strike (closed $.11, down $.12, price paid $.57)
       NEM - 65 Strike (closed $.38, down .13, price paid $1.12)
 
I'll close this week with a video in the spirit of the season, unconditional love.  This viral video has been viewed over 60 million times.  Happy New Year!