Archive for July, 2008

The Top Five Financial Issues for the Coming Decades

July 23, 2008

With all the turmoil in investment markets, I have found it useful to try to estimate major financial issues that will influence the American economy over the next few years and several decades.  This will summarize my current findings ranked in order of total dollar value.  All of these problems need to be resolved for the future viability of our way of life.  I think it is obvious that if the biggest problem is not solved, what we do with the other four will be of little consequence.

Issue #5:  The estimated asset write-downs resulting from the 2007-2008 credit crisis.  The International Monetary Fund has estimated this to be $1.1 trillion.  Less than half of this has been realized to date.  The time frame for this to be totally realized is one to three years.  The potential for this estimate to be too high is limited to a couple hundred billion at the most.  The potential for this estimate to be too low depends on whether or not we see an extended downward spiral in home prices and the associated worsening of credit markets.  Worst case scenario is probably another $1 to $1.5 trillion, corresponding to defaults on 20% to 30% of home mortgages.

Issue #4:  U.S. national debt of $4.4 Trillion.  This figure is obtained from the “Long-tern Financial Outlook”, U.S. Government Accountability Office, Jan. 2008.  Government estimates envision a balanced budget by 2013.  If you believe this, I would like to sell you a well known bridge over the East River.  However, I will use that to project the national debt to grow to $5.9 Trillion in the next five years.  The probability that this is too high an estimate is extremely low.  The probability that the national debt will be larger than $5.9 Trillion in 2013 is very high.  Furthermore, I am skeptical that a balanced budget will be achieved, not only in five years, but even in 10 years.  The risk is high that the national debt will continue to grow through deficit spending for many years to come.  I do not have a rational way to estimate an upper limit for the national debt in five years or beyond.

Issue #3:  The unfunded liabilty of the Social Security System is estimated to be $6.7 Trillion (Government Accountability Office, Jan. 2008).  This number could be higher with inflation above the report estimate – approximately 3%.  The time frame for this figure is several decades.

Issue #2:  The unfunded liability of Medicare is estimated by the Government Accountability Office to be $34.1 Trillion.  Again, higher inflation could raise this estimate.  The time frame is several decades.

Issue #1:  The cost of imported oil.  Many sources have estimated the 2008 cost for imported oil to be approximately $800 Billion at an average price of $120 to $130 per barrel.  The estimate for the hidden cost of oil – added military expense, environmental expense, health care expense, infrastructure degradation, etc – was approximately $825 Billion per year in 2006.  See the following website for details on the hidden cost:                                                               . 

If we assume the 2006 hidden costs and the estimated 2008 purchase cost to be applicable for the next 30 years, the cost of importing oil over that time frame is approximately $48.7 Trillion.  The likelihood that this too high an estimate is extremely small.  To lower the cost not only does the price of oil have to stay at or below current levels, the amount of oil we import must stay at or below current levels and there must be no inflation for 30 years.  With that scenario, the present value of a cash flow of $1.6 Trillion per year is $45 Trillion at a discount rate of 5%.

It is much more likely that the annual cost for imported oil will rise from the $1.6 Trillion per year.  If the cost rises by 10% per year (probably too small a figure), the present value of the cash flows over 30 years is approximately $58 Trillion.  The cost of continuing current energy policy is somewhere between $45 Trillion (an unrealistic lower bound) and something larger than $58 Trillion.  Half of this money is paid to entities outside of our economy and can only return to us by purchase of our assets.  A lot of the hidden cost remains within our economy, but none contributes to higher productivity.  The hidden costs are basically maintenance expenses.


Can a Margin Call Instantaneously Double the National Debt?

July 11, 2008

Rumors abound that the U.S. government will, one way or another, step in to guarantee the debt held by Fannie Mae (FNM) and Freddie Mac (FRE), the mortgage underwriters for the country.  Why has this possibility arisen?  These mortgage corporations hold $3 trillion in mortgage paper.  This has been written with a leverage of 100+ to 1.  In otherwords, these corporations have put up about $30 million (stock holders equity) and borrowed about $2.97 trillion within the U.S. financial system (which includes international lenders) to buy the mortgage obligations.

This situation has resulted in what is comparable to a margin call.  When an investor buys stocks on margin, he puts up part of the purchase price and borrows the rest.  U.S. security laws have a margin requirement, a limit on the percentage of stock value that can be borrowed.  If the stock purchased on margin falls far enough below the purchase price, the percentage of stock value financed by the margin loan can rise above the maximum value permitted by law.  When this happens, the investor receives a margin call.  He must then immediately provide more cash or the position will be liquidated by the broker/dealer.

The situation with FRE and FNM is similar in concept to the margin call, but is different the details.  The conceptual similarity is that these corporations have bought mortgages, effectively, on margin.  Investors around the world have provided the money for the margin, which totals approximately $2.97 trillion.  Many of these mortgages have been written with loans at 80% to 100% of the purchase price.  Currently, the market value of some of these mortgaged properties have fallen as much as 20% or even more.  Thus some of these mortgages are “under water”, i.e. the balance owed by the homeowner is more than the current market value.  This produces a situation where the balance sheets for FRE and FNM should show negative net worth.  In other words, these corporations should be bankrupt.  Technically, they can not be proven bankrupt because there is no transparent market for the mortgages they own. The market value can only be estimated.  It should be obvious, however, that the value of each mortgage can not be more than the market value of the underlying property.  I compare the current situation to a margin call because it is possible that the market value of mortgaged homes has fallen by more than $30 billion (1%) plus the aggregated down payments.  Therefore the $2.97 trillion in borrowed money is probably backed by negative equity.  In other words, to adequately secure the debt, more capital must be raised or the debt must be sold to repay the lenders.  I refer to this as the FNM/FRE margin call.

What can happen now?   One possiblity is nothing.  This would be disaster for the reeling U.S. financial system.  It would effectively cause a collapse because no one would have the confidence to lend to a system that ignores its obligation to honor its debt.  This will not be allowed to happen.

Another possibility is that FNM and FRE would be provided access to the Fed discount window.  In other words, these corporations could obtain capital by putting up their mortgage paper to secure loans by the Fed.  This would solve the problem if the bottom is close in housing prices.  However, if housing prices were to continue to fall, this action would be like a bandaid on a severed limb.  A total decline in house prices of 30% to 40% could require as much as $900 billion to $1.2 trillion in Fed financing.  This is in excess of the money in circulation under the Fed.  In order to provide liquidity, the Fed would need to have the Treasury issue more debt in order to obtain the necessary money to keep the Fed window open.  Thus, the national debt would be increased.  There would be some offsetting assets (value of mortgaged properties).  The major problem, however, is capital, not liquidity.  Therefore, this use of the Fed discount window would be outside the stated purpose of the facility. 

Another possibility is the abolishment of FNM and FRE with the assets and liability assumed by the U.S. government.  Instantaneously the national debt would be increased from the current value (approximately $3 trillion) to a new level of approximately $6 trillion.  Unless our economy collapses, this increase in national debt is offset by approximately the same value in assets, the mortgaged properties.  The problem is that, absent the huge mortgage financing vehicle represented by FNM and FRE, home mortgage financing would be reduced to a very low level.  Absent the ability to obtain mortgages, buyers would not be able to buy homes.  The housing market would dry up and home values could easily fall precipitously.  In that event, the national debt would be permanently increased by the loss in home values.  Therefore, if this option is pursued it would be necessary for the government to operate the mortgage underwriting business that FNM and FRE have operated in order to hold down the potential escalation of the national debt.

Inaction is not a possible solution.  Some form of action will be taken by the government.  The best result will have a mortgage market continue in the future.  The best result will not be fractured if housing values drop another 20%.  Preserving equity for FNM and FRE stockholders should not be a primary objective of the government action.  It is most likely that government action will be to offer some form quarantee to FNM and FRE issued debt and to keep these corporate agencies operating, probably with more regulatory oversight.