This will not end well...

Unprecedented unemployment, falling home prices, and insolvent banks have led to the federal government filling the gap via massive deficit spending.  The Obama Administration expects continued deficit spending in excess of $1 Trillion for the next decade.  Let’s explore this path and why deficit spending cannot continue at this pace for another decade.

Government balance sheets
Federal government tax receipts continue to decline year over year [1], [2], and state and local tax receipts don't look any better [3], [4], [5], [6].  While state and local governments slash their budgets and their staffs, federal government spending remains at or near record high levels as money from stimulus programs is deployed.  These two factors have put the federal government on pace for record deficits for fiscal year 2010 [7], [8], [9], [10].

As stimulus funds run out, budgeted spending in several other areas will cause deficits to remain in excess of $1 trillion. The FICA tax is no longer collecting enough to fund Social Security [11].  Military spending continues to expand out of control [12], [13].  Fannie Mae and Freddie Mac which I discussed in a previous post, will need a continual bailout as the housing bubble deflates  [14], [15], [16].  Social Security, Medicare, and Medicare will continue to consume a larger and larger percent of the Federal Budget [17], [18].  The FDIC is deeply in the red [19].  A large portion of municipal bond market will either default or require a bailout [20].  Public pension plans are severely underfunded and will require extreme tax increases, partial default, or a federal bailout [21], [22].  Oh, and if that isn't enough, the government is simply lost $98.7 billion last year [23].

The current budget deficits are adding to the an already bleak financial outlook for the federal balance sheet.  Federal deficit at the end of fiscal year 2009 was $11.45 trillion.  Using generally accepted accounting practices (GAAP) which includes liabilities associated with Social Security, Medicare, and Medicaid, the deficit is $63.6 trillion [24]. These numbers don’t include the cost of continuing to bailout Fannie Mae and Freddie Mac, new healthcare mandates, future bailouts of state governments, and bailout of public pensions.  When you add up all debts (public and private) they equal 850% of GDP [25].  Folks, this will not end well..

Sovereign Debt Crisis
With politicians in Washington unwilling or unable to do the math [26], the future solvency of the US government lies in doubt. There is already indication that we are buying our own debt to fund our spending and to maintain low interest rates [27], [28], [29].  This action is simply a poorly disguised way to print money.  While this policy may be tolerated over the short term, several bond experts expect interest rates to rise over the next two years [30], [31], [32].  Increasing interest rates will cause debt service to consume a larger and larger proportion of the Federal budget and U.S. GDP [33].

While attempts will be made to fill the deficit by increasing taxes [34], [35], this “solution” will only delay what I view as the inevitable conclusion.  In order to clear government debts at all levels, default is the only option.  While state and local governments may explicitly default on their bonds and slash their pension obligations by revoking promised benefits. The federal government is likely to take the least responsible and most painful path, outright money printing. From Bloomberg:

Nobel laureate Joseph E. Stiglitz said the prospect of a default by the U.S. or the U.K. is an “absurd” notion constructed in financial markets. Both nations “deserve to keep the Aaa rating” and “the likelihood of a default is so small, particularly in the U.S. because all we do is print money to pay it back,” he said in response to questions after a speech in London yesterday. “The notion of a default is so absurd, it’s another reflection of the absurdities in the financial markets.” [36]

Outright money printing will lead to a crisis in the bond market.  Sometimes a sovereign debt crisis quickly precipitates into a currency crisis.  Historically in this scenario, some citizens are able to escape the crisis by moving their assets into another country’s currency, but as the above figure shows, most of the governments in the developed world are insolvent [37], [38].  If a currency crisis is triggered in one major economy, it is likely to stretch across the globe.  Let me emphasize that this outcome is not yet a certainty, but my personal view is that politicians are unwilling to force the necessary sacrifices on the American people.  Therefore, unless behavior changes dramatically in short order, deficit spending will not sustained for the next decade because we will enter a sovereign debt crisis, and perhaps a currency crisis/hyperinflation.

Lessons from current events
You have certainly heard the news of the ongoing sovereign debt crisis in Greece.  While Greece may still get bailed out, this route is an option only because their economy is small [39].  Unfortunately, the other so called PIIGS countries are approaching the point where they too may enter a sovereign debt crisis.  Over the next three years, these countries will need to issue around $2 Trillion in bonds (debt) [40].  This money does not exist and will need to be printed.  On the other hand if governments decided to default, it would destroy major banks in both Europe and the US [41].  The precedent set by TARP is that the politicians will not allow the banks to fail.  The banks will return the favor and buy government bonds.  Unfortunately, this scenario continues the current trend [42].  It leaves little money to loan to private entities which should result in the further deterioration of small business and the overall economy.

Update: As I was completing this post, a nearly $1 Trillion (~750 Billion Euro) bailout package was put together by central banks are around the world to "stabilize" Europe and its banks.  As I stated, this money was created out of thin air. The U.S. Federal Reserve was responsible for ~$50 Billion of this package.

Hyperinflation: A Crisis of Confidence
While the exact timing of a US sovereign debt crisis is uncertain, you can predict this outcome by doing a little math. Simply look at the growth in debts versus the growth in GDP. Very soon, total debt will run grow too big be serviced by GDP (total incomes).  Eventually, the citizens will awaken to the fact the government is willing to print money to pay them back.  If citizens' confidence in US dollars fails, they panic and the rush into tangible assets begins.  Anything not invested in secure tangible assets or companies not relying on non-discretionary spending will undergo a dramatic fall in value.  Paper assets like annuities and government debt will be nearly wiped out because they will be priced in devalued US dollars.  Protect your family, protect your wealth, and protect your future, buy some tangible assets like gold and silver immediately.  Gold and silver are insurance against a total failure of the financial system.  You can read another excellent analysis of this topic here [43].

Timing of the crisis
Let me clear, the United States may not be the first major economy to fall.  Beyond the PIIGS countries, Japan is at risk of a sovereign debt crisis [44].  The U.K is also at risk [45].  These countries may try to implement all sorts of policies to avoid this outcome [46] including nationalization of citizens' assets (see Argentina 2008).  These policies will fail as those of the past two decades [47].  No amount of 'policy' can change the mathematics.  So while the timing of the failure is unknown, the U.S. government is now bankrupt [48].  We need to start making adjustments to our personal affairs and demand the federal government begin adjusting as well.  A sudden, forced adjustment due to a crisis in the financial markets would be catastrophic to our economy [49].

The financial crisis of Fall 2008 began quietly in spring 2007 with failure small subprime lenders.  Some believe, as do I, that the second wave of the financial crisis has now begun and will intensify through the rest of 2010 [50].  When this crisis will peak, no one knows, but the sovereign debt crisis in Greece and the recent shock to the stock market are clear signs of instability in the financial system.  Please prepare yourself and your family for tough economic times ahead.

God Bless,
Matt

Citizens, The government says I can lie to you. Sincerely, The Banks

In my last post, I illustrated that home prices are likely to continue falling and will lead to billions of dollars in mortgage defaults.  Regrettably, this problem does not exist in isolation and should be reflected in the balance sheets of our financial institutions.  Curiously, the big banks have reported massive profits for the past couple of quarters [1].  So the question that must be answered is: How are the banks turning a profit when they should be losing billions on loans?

Once again, they are obscuring the truth, and the government is complicit in the ruse!  Let me show you how.

From Reality to Fantasy
Last year, the Financial Accounting Standards Board (FASB) was pressured by several senators and congressmen to relax a rule related to marked-to-market accounting. Marked-to-market accounting forced banks to mark loans to the value at which they could sell them on the open market. However using this accounting method, many of the biggest banks in the country would have been insolvent and unable to pass the “stress tests” last spring. So FASB yielded to political pressure and relaxed the mark-to-market accounting the rules. The rule change allowed banks to price bad loans to whatever their computer model said it was worth.  Unsurprisingly, the banks said they believed they would recover 90% to 100% of a loan’s value.  This practice is what some folks now call “mark to fantasy” accounting because computer models can be made to say anything [2].

Well, do we have any evidence to that these loans are worth less (err...worthless)? Yes, we do. The FDIC has closed over a hundred banks over the last twelve months and has had to find someone to take over these businesses. FDIC has been taking losses equal to 25% or more of the bank’s on entire asset portfolio [3].  Furthermore, delinquency rates in excess of 35% are being reported for many residential mortgage backed securities (RMBS) [4]. These two pieces merely imply that something is amiss within the banks.  Let me be more specific. The biggest four banks have $448 billion dollars of second liens and/or home equity lines of credit (HELOC) on their books [5], [6].  Many of these loans are on homes which are underwater on their first mortgage.  If the first lien is worth less than 100% then many of these loans are worth exactly zero, yet they are being reported at 90+% of value on banks’ books. Still, many of the losses are still hidden in their financial statements. The Federal Home Loan Banks [7] and Wells Fargo [8] are a prime examples of this type of accounting.

Bottom Line: The valuation of these loans are a fantasy.


Setting Up Crisis 2.0
Recently, it has been reported what set off the failure of Lehman Brothers and the financial crisis of 2008. Lehman Brothers was manipulating their quarterly reports using complicated financial instruments to make it appear they had billions in cash when they actually owned billions in bad loans [9], [10]. In reality, Lehman Brothers had almost no cash, and many on Wall Street knew it for months in advance.  It is also clear this kind of financial instrument continues to be used to this day by the banks, and since FASB has effectively legalized accounting fraud, they don’t have to tell you they are losing money [11], [12]. The banks know they are insolvent, and for this reason many corporations have curtailed tax payments in order to hoard cash [13], [14].  The cash hoard now totals over $1.2 trillion [15], and the banks will need it for the coming flood of foreclosures.  The other companies will need it as loans become more difficult to obtain.

Conclusions
The U.S. federal government spent several trillion dollars to bail out the financial system and clear toxic assets.  By all accounts, very little of bad debt has been cleared, and what remains on banks’ balance sheets gets more toxic by the day.  Our government’s failure to take meaningful action has allowed our financial system to remain broken.  The banks are unable or unwilling to make new loans which will severely limit both small business growth and job prospects going forward.  Furthermore, another liquidity driven financial crisis is likely to occur in the future due to losses in residential and commercial real estate markets.  This crisis will put most major asset classes (e.g. stocks, bonds, etc.) under extreme pressure as banks are forced into further deleveraging.  Serious measures should be taken to guard against risks imposed by the banks' implicit insolvency.  I will attempt to address these measures in a future post.

Giving away money fixes everything!

In my last post I illustrated that much of information that you need to plan your financial future is either distorted or isn’t discussed in appropriate detail.  I will continue on this theme by looking at how the government giving away money has given the false appear that our economy is recovering.  I will illustrate this point by looking at the “stabilized” housing market.

I pose to you the following question: Has the housing market hit the bottom or have we merely seen the biggest step down?  Below I will argue that while housing may have hit bottom regionally or locally, the national housing market isn’t even close to hitting bottom.

First, let’s look at the historical cost of housing.

The above figure shows you that the cost of housing peaked at around 200.  However, the long term historical average is roughly 105, and as of November 2009, the index sits around 134.  (For details see the data in this Excel File [1].)

Clearly, housing prices have corrected, but prices normally will fall back near historical average which means housing prices should fall a minimum of another 20%.   A way to check this estimate is to look at ratio of the median home price to the median household income.  Historically, it takes between 2.5 and 3.5 years of the median household income to purchase a home.  Using a little data from the Census Bureau, I find the median home price (November 2009) is $215,000 and the median household income (2008) is $52029.  Doing a quick calculation, we can see the ratio stands at ~4.1.  Furthermore, this calculation confirms that home prices should fall significantly from here.

So why does the chart show home prices have stabilized around 134?  It has stabilized here because giving away money fixes everything!   At least that is what the government would like you to believe. The government’s credit for first time home buyers has brought people to the market at these prices, and delays in processing foreclosures have stopped thousands of homes from coming on the market [2]. However, the inventory of homes entering foreclosure continues to grow [3], [4]. Therefore, the obvious conclusion is that home prices have been artificially held up by temporary stimuli.

Can this last? Of course not! There are simply too many factors working against prices holding here.  As of January, 13.68% of Fannie Mae and 8.52% of Freddie Mac loans were delinquent [5].  As of February, ~10.5% of all homes were delinquent or in foreclosure [6], and these numbers are continuing to grow [7].   With the latest numbers showing that 7.9 million home owners are not paying their mortgages [8], the outlook for home price is anything but rosy.

As if this isn’t bad enough, several factors will cause the foreclosure numbers to hold at these high levels. First, the banks will eventually have to process the foreclosures they have delayed. Second, at these price levels, approximately 1 in 4 homeowners is underwater on their mortgage, and continued price declines will lead many people to simply walk away from their home. Third, mortgage interest rates will likely rise from these historically low levels. Finally, thousands of Alt-A [9] and Option ARM [10] loans will reset of over the next several years and lead to higher mortgage payment for these homeowners.

Obviously, these factors will help push home prices down further, and, therefore, the outlook for U.S. home prices is downward until these issues clear out of the system. When the unprecedented number of foreclosures is considered along with high employment, it would not be surprising if home prices fell another 40% to near to their historic lows seen during the Great Depression.

For another brief review of the problems facing the housing market, please look here [11].
For anyone considering the purchase of a home, I would recommend you listen to the recent Mark Hanson interview [12] at King World news.

Smoke and Mirrors

Two of the most important things to do when planning for the future are to understand the current state of affairs and to be a good student of history.  For the next couple of posts I will focus on understanding our present economic situation and throw in some salient historical items as needed.

Smoke and Mirrors?
Unfortunately, some of the most critical economic statistics published by the US government hide the truth of our economic situation.  How do they do this you ask?  Let me give you a couple examples, and from these we can draw some initial conclusions.

Unemployment
The government reports the unemployment rate (also known as U-3) and job losses/gains every month just a few days after the month’s end.   This initial report is what you see in the headlines, however, what is covered by the mainstream press masks reality. How is it masked? These initial numbers are merely an educated guess, and the press rarely explains how much these numbers change after the headlines. So how do they calculate this number?

One of the factors used to calculate (un)employment numbers is the Birth-Death model. This model estimates the number jobs created by small businesses because the government simply can’t survey every small business owner.   In theory, most people would agree that this is a reasonable process, however, its application is another matter.   From April to December 2009, the government’s model claimed that small businesses created almost a MILLION jobs! [1]  Thus, the unemployment numbers reported to you for the past few months were artificially lowered because the government was creative and imagined (or if you prefer, hoped and changed) jobs into existence.  This nonsense continues to this day.

Furthermore, the unemployment numbers are later revised once more complete data arrives [2].

Lately, the initial report has been foolishly hopeful. As of February 2010, official revisions of initial unemployment reports from 2009 have registered an additional 824,000 jobs losses [3].  But have you heard these numbers discussed in the mainstream news?

Another way to make government numbers look rosier is to change how you define terms.  For example, a key factor in calculating the unemployment rate is how you define who is unemployed. Please watch the brief video to see an entertaining (though slightly exaggerated) explanation of how the government determines a person’s employment status [4].



As the video demonstrates, the narrow definition of unemployment underestimates the unemployed and leads to the U-3 unemployment number which distorts reality. When people get so discouraged they quit looking or only work a few hours a week, they are simply no longer counted in the unemployment rate [5].  Fortunately, the government does calculate the U-6 unemployment rate that counts these people, but it is rarely mentioned because it currently stands at 17%.



Unemployment – A Brief Aside
While I am on the topic of unemployment, I want to bring up a few additional numbers.  About 70% of US GDP is driven by consumer spending, and so one might wonder how our economy is growing with so many people (aka consumers) being unemployed.  A partial answer is unemployment insurance benefits.  The government has now extended unemployment benefits up to an additional 72 weeks beyond the standard 27 weeks.  Tragically, roughly of 40% of people have been unable to find work in 27 weeks, [6], [7], [8], and while initial unemployment claims have slowed, those individuals on emergency unemployment claims (EUC) have skyrocketed. The latest unemployment insurance numbers can be found here [9].

Finally a fun fact for those of you who help produce a product, you are now outnumbered by government workers [10].

Consumer Price Index
The Consumer Price Index (CPI) is a measure of how the price of goods change over time.  For this reason, the government and many corporations use the CPI to determine cost of living adjustments (COLA) for benefits (e.g. Social Security) and/or salaries. What most people don’t know is that government has changed how this number is calculated several times since 1980, and the calculation now grossly understates the rise in prices as shown below. These stealth changes have allowed the government to short change retirees on Social Security payments and have allowed the prices to far outpace the increase in one’s salary.





I hope this brief discussion has shown you that the government is distorting their statistics in an attempt to make you believe our economy is stronger than it is.  Additionally, I hope these insights spur you to look beyond the facade so you can begin to construct a more accurate view of the world.

Digging Deeper
To aid you in getting a more realistic view of our economy and our government, I want to encourage you to look at John Williams’ Shadowstats.com.  Mr. Williams uses the data published by the government and uses it to reconstruct government statistics based on the original methodology (e.g. CPI, Unemployment, etc).   (Note: He explains his reasoning for these changes on his site.)  His calculations begin to lift the veil of manipulation from government economic reporting, and it allows you to reconcile government fantasies with what you hear from friends, family and neighbors every day.

Rather than ramble on further, I will simply present a few more charts for Mr. Williams’ site with minimal commentary and will provide a permanent link to his site on the side of this blog.



As a consequence of CPI being understated, GDP growth has been overstated.  Once adjusted, it becomes clear the United States has experienced little growth for the past two decades.



Inflation is defined as a growth in the money supply.  After the money supply grows, CPI usually increases (i.e. price inflation) about 1-2 years later.  Unfortunately, Mr. Williams' adjusted numbers don't even capture the whole picture [11].

Fannie and Freddie are just the start...

The following is a email that I sent to a few of my friends and family via email on December 31, 2009:

To my friends and family,

For those of you who haven’t heard, government backed companies Fannie Mae and Freddie Mac have already been bailed out to the tune of 100+ billion taxpayer dollars. Until recently this bailout was limited to $400 billion, but the Treasury Department has now declared that these companies will receive an endless bailout [1]. However, I believe this is only the beginning of the story. Despite the talk of economic recovery, mortgage defaults are increasing [2]. Furthermore, defaults are on track to increase in 2010-2012 as thousands of mortgages rates reset. These resets will cause the mortgage payments of financially stretched homeowners to increase dramatically [3]. Add to the mix that the employment situation is not improving as millions of people are moving over to emergency unemployment claims [4], and you can see that significantly more mortgage defaults and more bank losses are likely.

So who is going to bailout the banks and mortgage companies once again? The American taxpayer will of course! [Late addition: As of this morning, we now own a majority stake in GMAC [5].]  Over the next several years, the federal government will be forced to increase its deficit spending to pay the billions (or more likely trillions) in guarantees it issued to banks and companies like the Fannie and Freddie.  Furthermore, community and regional banks will continue to fail as more people default, and FDIC will have to cover these losses.  Unfortunately, the FDIC is or will soon be insolvent [6] and will have to use their credit line with the US Treasury Department. But with tax revenue down, where will the US Treasury get the money to bailout Fannie, Freddie, and the FDIC?   Someone will have to loan the government money by buying US Treasury bonds, but who?

Over the past decade, a large portion of government deficit have been financed by foreign governments buying US Treasuries. However, this trend has been changing the past few years, and it is not initially clear who is picking up the slack [7].  As this article discusses, it appears that our central bank (the Federal Reserve) is simply printing up money to covertly buy US Treasuries. Any student of history will find this policy extremely alarming (see Weimer Germany, Zimbabwe 2006-2009 , Argentina 1991). Still, I don’t expect you to believe me or any of my resources. I urge you to do your own research.

However, I will outline the problems we face in the next few years.

1. The Obama Whitehouse has promised $1+ Trillion deficits for the next decade. These optimistic estimates are based on 4% GDP growth during this same period, yet the US has not experienced sustained 4% growth in the last several decades. Thus, I believe government deficits numbers will exceed these estimates. 
   
2. Government guarantees (FDIC, Fannie, Freddie, etc.) will cause the deficits to balloon further because the issues I raised above. Generational cycles will exacerbate this problem even further [8].
   
3. Foreign governments/investors don’t believe we will pay them back, and they will continue to limit their purchases of Treasuries. (They have their own problems to address.)
   
4. The Federal Reserve will either continue to print money to buy increasingly large quantities of US Treasury bonds to cover government debts, or they will stop printing and allow interest rates to rise. [Note: Rising interest rates make mortgage resets more painful.]

Conclusion: I don’t know what the future will hold, but it is clear to me the US government cannot continue on the current path [9]. Our government is insolvent and has avoided discussing the problem with the American people. We have now arrived at a point where the US government has essentially two choices: default on its debts and obligations or allow the US dollar to be destroyed via massive inflation.

Once again, please read, pray, and consider these things. I know this may raise more questions than provide answers, but be certain as I am that God will get us through whatever the future holds. Still, we must seek his wisdom to understand these times and prepare for what lies ahead.

May the Lord bless you and keep you in these difficult times,
Matt

Equilibrium Theory: An Introduction

AN INTRODUCTION
After much careful thought and deliberation, I have decided to start blogging about the ongoing economic crisis.  This blog is focused on the following:

1. Documenting the ongoing issues I see within our current financial and political systems
   
2. Understanding the potential outcomes as American society moves back into balance (i.e. the current systems fail and are replaced/reset)
3. Creating personal solutions which allow one to thrive as the economic crisis intensifies
4. Sharing these ideas with my friends and family

So what's with the name Equilibrium Theory?  Well, I am trained as a chemical engineer and a primary tenet of my education is that systems move towards or oscillate around equilibrium.  ...so what's equilibrium?  Simply put, equilibrium is a balancing of forces.  So when any system is not at equilibrium, there will be forces pushing the system back towards balance.  Naturally, our world never reaches perfect balance, but it should never stray far from equilibrium for very long.

This concept of balance is a fundamental part of the way the founders conceived our republic.  Checks and balances on power were meant to keep individuals or groups from accumulating power by illegal or immoral means.  Sadly, all levels of government now ignore these checks on their power.  They implement laws and regulations for special interests and corporations without concern for the natural rights for the individual.  This system of corporatist-fascist government must end.  Our economy is now on the brink of collapsing under the weight of the inefficiencies produced by boundless regulations and bureaucracy.  While many have not recognized it, the reset has been triggered.  The subprime mortgage meltdown and the resulting economic crisis is pushing us into balance, and the inefficiencies are being forced out the system.  However, our society has been out of balance for so long most Americans don't know what to expect.  This blog intends to identify many of the forces at work and determine where these forces are directing the future of the nation. 

WHERE DO WE BEGIN?
Over the past couple of years, we have experienced the economic shocks of the first wave of the mortgage crisis.  The US government has spent trillions of dollars trying to shore up the balance sheets of the banks and end the loss of jobs.  However, these actions have failed to address the larger fiscal issues, and our current financial system is still far out of balance and is breaking down.  This imbalance raises some pertinent questions.  How did we get here?  Are the government and the mainstream press presenting us the truth?  What are the potential changes required to bring our society back into balance?  How do these changes affect my lifestyle, my wealth, and my security?  What actions can I take to minimize negative consequences?


Through the next few posts, I will try to outline the data that demonstrates the dire situation we now face and will begin to formulate simple actions to take to reclaim our liberties and our financial security.