A simplistic but we believe quite accurate perspective of how we got here was through a massive credit expansion over the last 25 years to support consumption that could not be afforded otherwise. According to the latest Fed Flow of Fund report, US Debt outstanding is over $50 trillion or about 350% of GDP. Private sector credit market debt to GDP has gone from 120% throughout most of the 90s to over 170% in 2008. Of course none of these figures include accruals for future Medicare and Social Security liabilities (after all the US is not required to report according to GAAP) nor the deficits currently budgeted for the next several years. A lot of focus was on the perceived healthy growth statistics all around (GDP, asset prices, household net worth, etc.) with very little regard to the liability side of the ledger (ponzi scheme # 1).
Let’s put things into perspective. Household debt/income peaked at 139% in 08 from under 100% in 00and around 60-70% for most of the 60s, 70s and 80s. Household deleveraging has yet to begin. Household net worth is declining at record rates – close to 15% as of recently (in the last 60 years, we only saw declines of around -6% in 01 low single digits once in the early 70s). Combine this with payrolls shrinking at the unprecedented rate of around 600k/month – we would bet on double digit optimistically reported BLS unemployment levels in the double digits – and now people are becoming truly scared. The logical reaction (and despite opinions to the contrary we believe a healthy one) will be to dramatically curtail consumption, increase savings and reduce leverage. Household savings rate was 12% in the 80s and has been around zero to negative in recent years. With the consumer at a record 70% of GDP, were he to pull back to 5-10% savings that would mean a 3-7% reduction in GDP, not to mention the multiplier effect of taking that capital out of circulation. The impact on the US economy as a whole of a consumer behavior switch going from a 25-year borrowing and spending binge to a savings mentality will be profound (shoe #1).
We were amazed when in the brief course of a few months in 2008, the Fed’s $800 billion balance sheet went from almost 100% treasuries to under 50%. Well, here we are in early 2009 staring at a balance sheet already well north of $2 trillion (and it ‘ain’t’ all treasuries if we need to say it) and this does not include the latest trillion or so stimulus. It is unclear to us that the unprecedented “quantitative easing” (we love the new name for printing money it sounds so, technical – “No honey, I am not selling the family silver to feed my addictions! I’m just going through a quantitative easing phase…”) will cause inflation or when this will happen or if it will only mitigate the onset of deflation. Budget deficits as a % of GDP are “budgeted” to go to high single digit and maybe double digit in the next few years. Let’s pause to consider that the worst deficit in the last 30 years was of around 6% in 83! Given that most of the net purchase of treasuries over the last several years has been from other sovereigns who now face their own sets of challenges, the logical step, which has just begun, is for the US to in effect print money to buy its own obligations (ponzi scheme #2).
This brings us down to the State level where the combined deficits are already over $100 billion. Again for perspective, the worst ever in the last 30 years was around $60b in 03. Of course no one mentions that State budgets have expanded quite dramatically in the last 5-6 years with California’s, for instance, increasing by about 40% over that period. Fixed expenses rising at or above the rates of a variable revenue line… anyone see a management problem?
We thought once home prices stopped falling we might start seeing some semblance of normalcy return. We now believe this is only one of the elements that needs to find a bottom. According the the Case-Shiller index it would still take another 15-20% drop from Q408 levels just to get back to trend line, assuming no overcorrection on the way down. As of recently, over 10% houses were in arrears on their mortgages from a prior peak 7% in 85… this will only get worse as unemployment rises and the resets keep coming in while we hit new highs on credit tightening by financial institutions. Not to mention the 23 year high inventory of new and existing single family homes currently on the market (at around 10 months-worth) – US consumers was sold a bill of good with the dream of home ownership which took off in the mid 90s with the affordable housing push from around 64% home ownership rate to a peak in the high 60s. Asset markdowns are far from over as home prices (and all its derivatives) continue to fall, we start seeing increasing real problems in credit card and auto debt and, and we haven’t really begun to see markdowns in several illiquid asset categories (i.e.; commercial real estate and private equity) that today make up such a big component of many alternative portfolios is pension funds, endowments, etc. This wave will probably hit the shore later this year (Shoe #2). Public pensions in the US had total liabilities of around $2.9 trillion in late 2008 vs total assets of about $2 trillion or 30% less. This underfunding has only been growing as many large pension funds still expect rates of return of around 8% while their results for the past decade ending last year have been in the 2-3% range. Funding gaps have been made up by the issuance of bonds which by the way have coupons that exceed the returns on investment of the proceeds by a fair margin. As happened in the housing market, what seems to be unsustainable usually is. As we cannot imagine public pensioners giving up entitlements, this will inevitably result in a combination of higher debt and taxes going forward. The perennial hope of public officials is that these problems only become apparent long after their departure (think of Medicare, Social Security and the current stimulus programs, sounds familiar?) (ponzi scheme #3). Similar issues seem to lurk on the balance sheet of many insurers, especially the whole life ones. Analysts have estimated that life insurance industry losses could be in the vicinity of 20% of total assets while their total amount of capital is of only around 10% of assets. The difference is of around $250 billion (Shoe #3)
We confess that while we see many problems and disagree with many actions being taken, it is very difficult to have a comprehensive point of view. However, three thoughts do come to mind. First, significant credit induced consumption over the last quarter century seems to have finally runs its course but it doesn’t sound right that substantially more leverage is the way out. Second, policies that seem more about redistributing income than creating it don’t seem like an obvious path to raising national wealth. Third, substantially expanding the role and cost of government doesn’t seem like a sensible way to raise national wealth (unless of course you believe that the return on capital of projects chosen by legislature is superior to those of the private sector). There may yet be something to the notion of taking the bitter medicine and letting the correction truly run its course. Unlikely to happen in an economy that isn’t used to having to go through pain and insofar as elected officials are making the decisions.