Pension Envy & Lobster Traps

USA Today is reporting Pension gap divides public and private workers.

As the first wave of 79 million baby boomers heads to retirement, the nation is dividing into two classes of workers: those who have government benefits and those who don't. The gap is accelerating in every way — pensions, medical benefits, retirement ages.

Retired government workers are twice as likely to get a pension as their counterparts in the private sector, and the typical benefit is far more generous. The nation's 6 million retired civil servants — teachers, police, administrators, laborers — received a median benefit of $17,640 in 2005, according to the Congressional Research Service. Eleven million private-sector retirees covered by traditional pensions got $7,692.

Governments' generosity could have serious consequences for taxpayers and pensioners. Some states — including Illinois, Indiana, Michigan, New Jersey, Ohio and West Virginia — have troubled retirement systems that may require huge tax increases, spending cuts or even defaulting on promised benefits. The U.S. government has a bigger unfunded liability for military and civil servant retirement benefits ($4.7 trillion) than it does for Social Security ($4.6 trillion).

A sharp contrast

State and local governments have sweetened retirement benefits during the past decade at a time when corporations have soured on them because of their cost. Only 18% of private workers now have traditional defined benefit pension plans, compared with more than 80% of government employees.

Contrary to a widely held notion, the extra government benefits aren't compensation for lower pay. Most government workers are paid more than private employees in similar jobs, and the wage gap is growing.

A typical full-time state or local government worker made $78,853 in wages and benefits in the third quarter of 2006, $25,771 more than a typical private-sector worker, the Bureau of Labor Statistics reports. The difference was $7,604 in 2000. The compensation advantage holds true for all types of public workers, from teachers to laborers and managers. Better benefits for government workers is the biggest reason for the growing compensation gap.

"The government is in direct competition with us for employees. It's hard to compete against these benefit packages," says James Bellis, owner of Tree Tech, a 120-worker tree trimming company in Randolph, N.J. His company has a 401(k) plan that matches up to 2% of employee pay. By comparison, tree trimmers working for a government in New Jersey would get a pension benefit worth more than three times that.

Baby boomer retirements will force governments to confront the rising costs of civil servant benefits. The U.S. government's unfunded retirement obligation grew $200 billion last year to $4.7 trillion.

Unlike private pensions, though, the federal system still encourages early retirement. "The sweet spot for me is about age 56. When I run the numbers, the system almost forces me to retire" early, Nichols says.

Another big incentive to retire early: Most governments offer health insurance to early retirees until they qualify for Medicare at 65. Massachusetts spent $377 million on retiree medical benefits last year. The state's unfunded liability for such costs is $13.3 billion, nearly as much as its actual debt of $18.5 billion, which is counted separately.

Medical insurance may be the most vulnerable benefit because it has fewer legal protections than pensions, which often are guaranteed in state constitutions. Orange County, Calif., recently slashed promised retiree medical benefits, cutting its liability from $1.4 billion to $600 million. The county hasn't done anything about its pension problem.

"Pension benefits are like a lobster trap. You can get in, but you can't get out," says John Moorlach, an Orange County supervisor who has tried to reduce retirement benefits for government workers.

Taxpayers on the hook

Government pensions are, on average, in a similar condition as private pensions — about 20% below the assets needed to be properly funded. But some states, especially in the industrial Midwest, have severely troubled pensions. "The taxes needed to pay for these promises would push many of these states' economies into a death spiral," Chicago bankruptcy lawyer James Spiotto says.

Pension Envy

• 80% of government employees have defined benefit plans but only 18% of private workers do.
• The "sweet spot" for some government workers is as early as age 56.
• Some states, especially in the industrial Midwest, have severely troubled pensions. "The taxes needed to pay for these promises would push many of these states' economies into a death spiral"
• "Pension benefits are like a lobster trap [to state and local governments]. You can get in, but you can't get out".

Trouble Spots



The above chart shows results from the 5 worst states. For an interactive map of the US where you can see the results of your state, click on Cracked Nest Egg.

Note: those figures are as of June 30, 2004. A significant stock market rally may have reduced some of those deficits in some states. Then again, forward stock market assumptions are likely to be way off the mark and a mere 20% correction will put states way back in the hole.

More Public Pension Trouble Ahead?

Nationwide, pension monies currently promised to state and local workers and retirees total an estimated $2 trillion. But the shortfall in funds to pay this amount is estimated at $460-700 billion.

San Diego, dubbed "the Enron-by-the-Sea" in one New York Times headline, is the poster child for this problem. Now teetering near bankruptcy, San Diego has racked up $1.5 billion in pension debt, another $1 billion in retiree health care debt, and faces six conflict-of-interest indictments against members of its pension board, who cut deals to raise benefits while letting the city underfund its plans.

In addition, state and local governments don't have a pension insurance system like the federal Pension Benefit Guarantee Corporation (PBGC) that guarantees private sector pensions. They must either raise taxes to cover their debts or float bonds, passing the interest on to another generation of taxpayers. And while distressed cities like San Diego can elect Chapter 9 bankruptcy to walk away from their pension promises, states have no such recourse.

Faced with these shortfalls, some states are following the private sector's lead and shifting their employees into 401(k)-style retirement plans:

• After estimating that its pension plan was short $5.7 billion, Alaska dropped lifetime pensions for new hires, offering instead a 401(k)-style plan. Alaska also reworked its health care benefits for state employees, shifting more of the cost onto workers and retirees.
• Michigan has done away with lifetime pensions for new employees.
• Oregon has taken the middle ground, capping some pension benefits for current employees and offering new hires cash-balance or "hybrid" plans instead.
• And California is talking about dropping pensions. Governor Arnold Schwarzenegger has seized on San Diego's plight to call for a statewide shift to 401(k)-style plans. If California, a bellwether state on social and economic issues, were to dump pensions, many other states could follow.

Good News for San Diego?

SignOn San Diego is reported January 13, 2007 that San Diego's pension gap apparently decreases to $1 billion.

San Diego must pay $138 million this year to keep up with the city's pension obligations, even as the overall deficit, after years of logging precipitous increases, fell to $1 billion.The fund had developed a systemwide deficit of at least $1.43 billion by 2005 – $1.4 billion of which was San Diego's responsibility.

Investment success in 2006, along with a new method of determining the system's fitness, led to the marked improvement, according to city and pension fund officials who reviewed the valuation report, which was released yesterday.

Yet Mayor Jerry Sanders, who warned this week that the city must endure significant budget cuts to meet its obligations was not celebrating. Sanders, said spokesman Fred Sainz, “wants to take a cautious approach to this” and will await an analysis from another expert hired by the city, before accepting the apparent improvement in the pension system's prospects.

The yearly amount owed to the pension was set at just over $160 million the last two years, but last year the city pumped in an additional $108 million. Much of that money came from San Diego's general fund, leading to substantial cuts in services for residents and job losses for city employees.

City Attorney Michael Aguirre, who is challenging the legality of some city benefits in an ongoing trial, dismissed the report immediately, and said retirement fund officials are "slicing and dicing, rather than showing what the actual shortfall is."

David Wescoe, the pension system's administrator, bristled at that accusation. "These numbers are solid and they're transparent," he said.

Several developments allowed some of its liabilities to be chipped away. The fund posted an 11 percent return on investments, leading to a $159 million gain. An additional $184 million boost was attributed to a change in the method of calculating system assets and liabilities.

Wescoe described the method as "widely accepted" in pension circles, but Aguirre called it "hocus-pocus."

The estimate, however, also doesn't reflect potential trouble. Individual pension checks are based on salaries, and earnings for about 6,000 city employees are set to rise July 1.

It's hard to say how much "hocus-pocus" is going on but if San Diego is taking on excessive risk to achieve those 11% gains while and counting on such gains deep into the future, there is going to be another crisis as soon as the stock market makes a significant correction.

Non-Farm Payrolls

Let's look at "Pension Envy & Lobster Traps" one last way.

A typical full-time state or local government worker made $78,853 in wages and benefits in the third quarter of 2006, $25,771 more than a typical private-sector worker, the Bureau of Labor Statistics reports. The difference was $7,604 in 2000. The compensation advantage holds true for all types of public workers, from teachers to laborers and managers. Better benefits for government workers is the biggest reason for the growing compensation gap.

If government was shrinking that might not be such a problem. So let's take a look at what is happening in practice.



The above chart was created specifically for this article thanks to Bart at NowAndFutures.

BLS Jobs Data

Since 2001 the US has added 4,386,000 total jobs.
Since 2001 the US has added 3,185,000 private non-farm jobs.
Since 2001 the US has added 1,201,000 government jobs.
Since 2001 the government accounted for 27.38% of job growth.
Note: 2001 uses year end 2000 numbers as a starting point for the calculation.

In 2006 the US added 2,468,000 total jobs.
In 2006 the US added 2,282,000 total jobs.
In 2006 the US added 186,000 government jobs.
In 2006 the government accounted for 7.48% of job growth.
Note: The 2006 numbers above were created by subtracting 2005 from 2006.

What seems to be happening is that government hiring steps up in a recession and/or government layoffs are less than layoffs in the private sector. Interestingly enough the last recession was the mildest ever yet it took nearly 6 years for the job picture to recover.

Currently (as of year end 2006) government jobs account for 16.14% of total non-farm jobs. On a wage and a pension basis most of those jobs are making far more than private sector jobs and the discrepancy keeps widening. The discrepancy in pay was $7,604 in 2000 and as of 3rd quarter 2006 widened to $25,771.

So how does the lobster get out of the trap? State governments are going to have a tough time in the next recession. The choice will be to cut services (jobs), or raise taxes or both right as the housing economy (and housing related jobs) collapse. Longer term, the discrepancy in benefits needs to be addressed.

This post originally appeared in Whiskey & Gunpowder.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

New Century Criminal Probe & Fantasy Land CC

MarketWatch is reporting New Century faces criminal probe

New Century Financial Corp. said late Friday that it's facing a federal criminal probe and will likely breach a major lending covenant with its financial backers, bringing into question the survival of the second-largest U.S. subprime-mortgage lender.

The U.S. Attorney's Office for the Central District of California is conducting a federal criminal inquiry into trading in New Century securities as well as accounting errors, the company wrote in a regulatory filing late Friday.

The Securities and Exchange Commission also is looking into the company, as is the regulatory arm of the New York Stock Exchange, New Century disclosed. The company added that it is complying with all three inquiries.

The mortgage lender said it expects that it won't report at least $1 of net income for the two quarters ended Dec. 31, as stipulated in covenants with its lenders.

"Subprime lenders without deposits depend on their warehouse lines," said Zack Gast, a financial sector analyst at the Center for Financial Research and Analysis, a research firm. "If New Century's lenders do not grant the requested waivers, the company is likely to be forced to sell or shut down."

Indeed, New Century warned that if it can't get waivers or covenant amendments from enough of its financial backers, the company's auditor, KPMG, will conclude "that substantial doubt exists as to the company's ability to continue as a going concern."

CNN Money is reporting New Century faces trading, accounting probes.

New Century said the Attorney for the Central District of California is examining trading in its securities and accounting errors in how much it set aside for loan losses.

It also said NYSE Regulation is reviewing trading prior to its Feb. 7 announcement of plans to restate results, and that the Securities and Exchange Commission has asked for talks on that matter. New Century said it is cooperating with investigators.

The company also said it expects to report a pretax loss for 2006, and that if it cannot obtain waivers from some lenders, its auditor may call into question its ability to survive.

In a post titled Finanacial Fantasy Land RodgerRafter made note of his observations on a conference call from February 2005:

After watching in disbelief how long the sub-prime ponzi scheme continued to receive the support of regulators, creditors and investors. It's amazing how rapidly New Century's house of cards has come crashing down. All at once:
Regulators are seeking to stop New Century from performing their primary business.
Creditors are considering cutting off short term credit to the company.
Stock Market Investors are beating the crap out of the stock.
Mortgage Backed Security Investors are beating the crap out of their securitizations.

I seriously doubt NEW will survive this attack from all sides. Just as Enron and World Com crumbled when creditors pulled the plug, so too (I expect) will New Century.

I listened to the New Century Financial conference call today, and I'm convinced the executives of that company are from another planet.

When the call started, the stock was already down about 3.7%, having missed their estimates for the first time in ages. As the call went on and one amazing revelation after another came out, the stock kept dropping and now is down about 10%. Among the things that were revealed:

1. They borrow $1 Billion for 1 day every quarter so that they can show that Cash on their balance sheet. The Billion dollars they borrow for a day is to help them "explain" their financial situation better. If they didn't borrow that money, then people might be confused and think they didn't have that much cash.

2. They sell mortgages to themselves because they can report higher gains on the sales than if they sold them on the open market.

They were especially proud of becoming a REIT and all the imaginary benefits that bestowed on their results. While selling mortgages from their lending unit to their REIT unit resulted in nice gains on their income statement, the gains weren't taxable because they weren't real. Talk about the best of both worlds!

3. They aren't assuming any losses on certain portions of their loan portfolios now because most defaults occur later in the life of the loans.
...
...
more

New Century Financial Chart
click on chart for a better view



Fremont Subprime Collapses

HousingWire is reporting Fremont’s Subprime Platform Collapses; FDIC Steps In.

Troubled subprime lender Fremont General (NYSE:FMT), said late Friday it will exit subprime residential lending, citing mounting pressure from loan repurchases and likely regulatory action. The company had first hinted at problems on February 28, when it said it would delay its fourth quarter and full year earnings.

The company said its decision to exit was prompted primarily by the receipt of a Proposed Cease and Desist Order from the FDIC on February 27.

According to Fremont’s filing with the SEC today, the FDIC order calls for the lender to make sweeping changes to both its subprime residential and commercial mortgage businesses, including an allegation that the company violated Section 23B of the Federal Reserve Act by engaging in transactions with its affiliates on terms and under circumstances that in good faith would not be offered to, or would not apply to, nonaffiliated companies. Fremont did not disclose in its SEC filing which transactions were involved in the FDIC allegations.

Other allegations in the proposed FDIC order claim that Fremont’s mortgage lending businesses engaged in “unsatisfactory” lending practices, operated with inadequate underwriting criteria as well as inadequate capital, and that the company did not have effective risk management policies for managing and reigning in the company’s subprime and commercial mortgage brokers.

The order also would charge Fremont with marketing adjustable-rate loans in an “unsafe and unsound” manner, and that the lender had operated in violation of recent inter-agency guidance on subprime lending programs.

Fremont Chart



Mortgages Via TIN

In other news US Rep John T. Doolittle introduced a plan in Congress to block mortgages for illegal aliens.

New legislation on Capitol Hill seeks to curb an increasingly popular mortgage concept: providing home loans to applicants using their Individual Taxpayer Identification Number in lieu of a Social Security number.

Taxpayer numbers are issued by the Internal Revenue Service to assist immigrant workers who do not qualify for a Social Security number -- but do have taxable income -- to report their income and pay federal taxes.

Dozens of banks around the country have begun offering home mortgages to undocumented immigrants using taxpayer numbers, but their programs generally have been low-key and small in volume. Bank of America stirred controversy earlier this month when it announced a pilot program in Los Angeles to provide credit cards to resident alien customers who lack Social Security numbers but have taxpayer numbers.

Some critics charged that the bank was seeking to profit by helping illegal immigrants who should be deported or prosecuted, not extended consumer credit. Bank of America said its program is legal and may be rolled out nationwide if the pilot is successful.

Now a bill has been introduced in Congress that would prohibit financial institutions from providing home mortgages to anyone who lacks a Social Security number. The bill (HR480), introduced by Rep. John Doolittle, R-Rocklin (Placer County), would amend the Truth in Lending Act to make mortgage lending using taxpayer numbers illegal.

Doolittle's office released a statement that said in part: "The government should not be in the business of creating incentives to encourage illegal behavior. Nor should companies be permitted to reward those individuals in clear violation of our laws."

Summary

• Fremont is out of the subprime business via Cease and Desist Order from the FDIC. Fremont was the 5th largest subprime lender.
• New Century Financial is fighting for its life and with the criminal investigation, it is doubtful they survive in any capacity. NEW is the 3rd largest subprime lender.
  
• Credit standards continue to tighten everywhere.
• Proposed legislation to block mortgages by Taxpayer Identification Number in lieu of a Social Security number has been introduced. This would block mortgages for illegal aliens and possibly some legitimate mortgages as well.

The noose continues to tighten around subprime lenders and borrowers as well. This will continue to put pressure on home prices as marginal buyers are forced out of the game.

Addendum:
Rodger Rafter asked me to make it clear that what he stated we knew over two years ago. In editing down his comments I inadvertently took out that explanation. For those with access to the Motley Fool here is the complete thread on New Century posted on my board on the Fool on 2/3/2005. Rodger Rafter's comments today... "We all saw this collapse coming long ago, when much of the damage could have been prevented, and analysts, regulators, investors and creditors should have seen it too. Why didn't they pull the plug two years ago is the real question. The answer has something to do with greed." Here is an additional post from the thread on The Market Traders made today, showing our thinking at the time.

The 2007/02/07 New Century Finance conference call is also quite interesting. This quote sums it up nicely: "The company expects that the errors leading to restatements constitute material weakness in its internal control over financial reporting for the year ended December 31, 2006. "

Is that "material weakness" or purposeful securities fraud?

LawersAndSettlements.Com has these comments on New Century Finance Securities fraud.

New Century and certain of its officers and directors are charged with issuing a series of materially false and misleading statements in violation of Section 10(b) and 20(a) of the Exchange Act and Rule 10b-5 promulgated thereunder. Particularly, late on February 7, 2007, New Century announced that it will have to restate its consolidated financial results for the first three quarters of 2006 to correct errors the Company discovered in its application of generally accepted accounting principles regarding the Company's allowance for loan repurchase losses.

Bear markets (and subprime lending is surely in one) expose all sorts of frauds and schemes for what they are. No one cared as long as share price was rising. Now that share price has completely collapsed and subprime lenders are imploding everywhere, lawsuits have started. Numerous people are likely to end up in jail over this.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Critical Spot for the Yen

Check out the descending triangle formation on the Yen.



Click on chart for a better view.

At the February 2005 peak in the Yen, the then current rage was that Buffett and Gates were short the dollar. The Yen then proceeded to collapse for two full years. Now after that collapse, here are a few comments from just the past several days.

"Worries about the end of the carry trade are absolute nonsense" according to Stephen Massocca, president and head of trading at Pacific Growth Equities as attributed by MarketWatch.

"There are really few reasons to extend the yen rally. The economic backdrop of the carry trade hasn't changed. Japan still has low interest rates" said David Watt, senior currency strategist at RBC Capital Markets Inc. in Toronto, a unit of Canada's biggest bank by assets.

That last quote is from Yen Poised for Best Week Since 2005 on Exit From Carry Trades. Following are a few other opinions from the same article.

"The momentum still favors an upside move in the yen in the short term," said Todd Elmer, currency strategist at Citigroup Global Markets in New York. "Risk aversion is rising. It isn't clear whether this has run its course."

"We will probably see more unwinding of yen carry trade in the short term," said Lara Rhame, a senior currency strategist at Credit Suisse in New York. "You have to take some risks off the table."

"Given that valuations and positions are stretched in carry, we think the case for further follow through is compelling," London-based Lehman currency strategist Phyllis Papadavid wrote in a research note today.

Unlike February of 2005 it's hard to tell exactly what the prevailing sentiment is, or even if there is a prevailing sentiment, except to say that the carry trade players seem a bit more fervent in their support. Technically that chart pattern can break either way.

For some additional analysis on Japan, the Yen, and the Nikkei Index, there is an excellent article with many charts in the March 2007 Contrary Investor called Love Triangle? Following is one snip that I want to discuss:

A credit cycle underpinning more than a fair amount of global asset inflation over the past decade-plus as well as contributing to the dramatic lowering of risk premiums in many a financial asset class. We can assure you that the global central banking powers that be are critically aware of these circumstances. Moreover, Japanese institutions themselves have been big beneficiaries in this global liquidity expansion scheme in the modern day environment. Someday, somewhere, the Yen carry trade is going to turn on its benefactors. And given the enormous one-sided tilt in the carry trade arrangement, even partial unwinding of this "trade" could play havoc with many a financial asset price for a time. But, as always, the question is when? Let's try to be realistic here; will the .25% rise in Japanese short rates now spark global financial market Armageddon as a result of this monetary baby step? We doubt it. ... We also know many a global mover and shaker brought up the growth in global financial derivatives as a focal point at Davos recently. But does any central banker really want to see the golden goose of credit and excess liquidity driven asset inflation killed off? Not on your life. It's the markets themselves that will most likely actually initiate the evil deed at some point. Probably when it's least expected.

Maybe the key here is simply to watch the Yen and its response to monetary policy changes in Japan, if any near term. Again, we doubt the 25 basis point increase in short rates is going to cause the Yen to immediately rocket skyward, although some type of short term upward reaction is very possible. We believe the real problem for the carry trade would come if the G7 were to continue to be very vocal and ultimately put real pressure on Japanese authorities to raise rates.

Fundamental Factors

There can be no doubt that the credit cycle reached absurd levels in risk taking in subprime lending, leverage, derivative trading, yield spreads, and leveraged buyouts. Central bankers (at least some of them from Europe) seem to understand this. But every one of them embraced those activities. Whether or not Central Bankers want to see this end or not is now irrelevant. Credit speculation can only go so far before it blows up.

When it comes to the carry trade itself, those pointing out tiny hikes by Japan(so far) while concentrating solely on interest rate differentials are missing a big point. While it's true that interest rate differentials are the biggest factor in currency movements; it is also true that it is the rate of change in interest rates as opposed to the absolute difference that is likely to matter most.

Not only is Japan hiking but the US is on the verge of cutting. This has a potential to matter far more than any of those asking "should I get back into the carry trade now" seem to think. Perhaps that expressed desire to rush right back into the carry trade after what is nothing more than a small blip on the weekly chart may be telling from the standpoint of sentiment. Furthermore, the US markets seem far more overvalued than the Nikkei. This is supportive of capital exodus from US equities into Japan.

Summary

1. Technically we are at a spot where the Yen can break either way.
2. Sentiment for the Yen is difficult to read but arguably conviction seems to be in the camp of the carry trade players. If true, this is bullish on the Yen.
   
3. The rate of change in interest rate differentials strongly suggests a strengthening Yen.
4. An overvalued S&P compared to the Nikkei supports a capital exodus from the US to Japan.

In light of the above are "Worries about the end of the carry trade absolute nonsense", or was that comment itself absolute nonsense?

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Rose Colored Glass Award - February 2007

Nominations are in for the Rose Colored Glass Award for February 2007.
Here are the nominees.

1. "The one-month slump in activity in today's January [housing] report is not enough to offset the more favorable picture painted by other housing indicators." — Wrightson ICAP economists. Attributed by MarketWatch.
2. "Taking all the new data into account, there is really no material change in our expectations for the U.S. economy since I last reported to Congress a couple of weeks ago. We are looking for moderate growth in the U.S. economy going forward." Ben Bernanke - Attributed by MarketWatch.
3. "These [emerging] markets, on a price-earnings basis, are not highly expensive, and there's no good reason for a massive correction." - Mark Mobius of Templeton Developing Markets Fund. Attributed by MarketWatch.
4. "The situation is pretty benign globally. There's 'No good reason' for a global stock sell-off". - Mark Mobius of Templeton Developing Markets Fund. Attributed by MarketWatch.
5. "This is more a short-term deal rather than a long term deal and we're closer to the end of this correction than the beginning." - Jim Paulsen, chief investment strategist at Wells Capital Management. Attributed by MarketWatch.
6. "Worries about the end of the carry trade are absolute nonsense." - Stephen Massocca, president and head of trading at Pacific Growth Equities. Attributed by MarketWatch.
7. "Global equity markets should experience a constructive year." - Bob Doll, global chief investment officer of equities at BlackRock Inc. Attributed by MarketWatch.
8. "I think the worst is behind us. We are in the midst of a very significant inventory liquidation of unsold new homes." - Alan Greenspan. Attributed by the Toronto Star.
9. "Take a red marker and make a big X on Feb. 27 in your calendar. Make no other marks or notations. Then go about your regular business for the next 10 months." - Chuck Jaffe of Marketwatch. - Attributed by MarketWatch.
10. "Any risks the housing contraction could spark an economy-wide recession are fading fast. Further declines in construction spending should peter out toward mid year." - Freddie Mac on February 8th - Attributed by Reuters.

It is hard to pick a winner in this stunning collection. We hope to have polling up soon on The Market Traders until then please feel free to respond with your rationale.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Schwarzenegger wants $500 billion to rebuild California

Reuters is reporting California needs billions in bonds.

"I was at a meeting this morning where someone said, 'Look, we need $150 billion just for infrastructure and transportation.' It's true," Schwarzenegger told Reuters in an interview in a state office in San Francisco.

"We need $500 billion to rebuild California the way it ought to be," he added. "But this is of course too big for people to digest, so you don't talk about that."

Speaking about the total of $42.7 billion in general obligation bonds authorized by voters last year for public works spending, Schwarzenegger said: "This was only the foot in the door, to whet the appetite."

In the short term, Schwarzenegger acknowledged California could face lower tax revenues than projected in his January budget plan, but said he opposed new taxes.

"We have done tremendously with the revenue increases, but we do not want to do a tax increase."

He said he does not expect California to issue less debt if the economy slows. "I don't think we have to do that," he said.

This is so staggering that all I can do is repeat the sound bytes.

Sound Bytes

• $42.7 billion in general obligation bonds issued last year is "only the foot in the door, to whet the appetite."
• It will take $500 billion to "rebuild California the way it ought to be".
• $500 billion is "too big for people to digest, so you don't talk about that" even though he is talking about it.
• California needs $500 billion even though it has "done tremendously with the revenue increases".
• California will not issue less debt even if the economy slows.
• California "could face lower tax revenues" but he opposes tax hikes.

The US Census Bureau QuickFacts estimates the 2005 California population at 36,132,147 as the following table shows.



Let's do the math. $500,000,000,000 / 36,132,147 is $13,838 dollars for every man woman and child in the state. That might not sound so bad but I do not think many 5 year olds have that much cash lying around. Let's try the numbers again with the working age population (18-64). The working age population is 22,546,460 (calculated manually). That translates to a staggering $22,176 liability for every working age person. Married couples would need to pony up a mere $44,352 per couple to do it "the way it ought to be done", and remember those are after tax dollars.

But there are some other figures to look at, such as 13.8% of the California population is below the poverty level, and the median household income clocks in at $48,440. (QuickFacts shows those numbers are as of 2003).

This looks like fiscal insanity no matter how many years he wants to stretch this out over. The kicker is that Schwarzenegger thinks this can be paid for without increasing taxes, in the face of falling revenues, even if the economy heads into a recession. Mark my words California, your taxes are going to skyrocket if anything remotely close to this proposal passes.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Faber on liquidity, the Yen, and Gold

This is a must play video interview with Marc Faber.

Summary

• "Markets obviously peak out when everything looks best and bottom out when things look horrible"
• "In this sense we have the goldilocks outlook and things look fantastic. This is precisely the climate in which stocks can make a longer term high and start to decline"
• "At every market peak.. you have excess liquidity. At the present time a very significant part of what people call excess liquidity comes actually from the American current account deficit". That 800 billion dollars flows around the world and boosts economic activity.
  
• "Credit standards are now tightening. That leaves the consumer in the United states vulnerable ... and consumption in the US will hardly grow this year, which means the trade deficit in the US will not expand therefore international liquidity while still plentiful will not grow at an accelerating rate ... therefore markets may come off quite a bit more than the typical portfolio manager now expects"
• "We can easily have a correction of 10-15% on the S&P ... followed by a summer rebound but I doubt that we will make new highs as the economy deteriorates towards the end of the year that will get another big selloff in equity markets around the world"
  
• India and China can easily drop 30-40% before they become buying opportunities.
  
• Prefers Japanese Equities over other markets on an relative performance basis
  
• The Yen is very undervalued
• The moment other markets weaken, carry trade money will flow back to Japan and strengthen the Yen
  
• Prefers agricultural commodities like cotton and sugar over industrial commodities
• Likes gold on a pullback of 5-10% but always holds some gold
• "The gold bull market will end when there will be lines of people in front of gold shops buying gold because they want to move out of cash... when they really become afraid that paper money loses all its value."
• "I don't by gold for jewelry purposes, I buy it as cash, as a currency whose supply is very limited"
• "Certainly you don't want to [store] any gold in the United states because if I am right and the price of gold goes up as much as I think it will, I would imagine that at time in the US they will expropriate gold"
• Everywhere else money supply is growing rapidly, in the US, Europe,and all major countries. "Debt growth is very strong".

That was a great interview. Play it.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

A satirical look at tougher lending standards

The basis for the following discussion is a February 27th announcement by Freddie Mac Tougher Subprime Lending Standards To Help Reduce The Risk Of Future Borrower Default but any number of such announcements from a variety of lenders would likely have served the purpose equally well.

Inquiring minds may wish to read the above link for what was officially said before reading the following satirical interpretation of the above announcement:

Uncle Fred is pleased to announce that effective September 1, 2007 we will cease buying subprime mortgages that have a high likelihood of excessive payment shock and possible foreclosure. Our goal is not really to protect consumers from default, but rather our goal is self preservation. We want to protect ourselves against massive losses that other lenders are seeing.

Second, the company will limit the use of low-documentation underwriting for these types of mortgages to help ensure that future borrowers have the income necessary to afford their homes. Why we allowed such loans in the first place can be summed up in one word: greed.

We will implement these new investment requirements for mortgages originated on or after September 1, 2007 to avoid market disruptions (such as a sudden hit to loan volume) which might cause investors to panic.

To help lenders better serve borrowers with impaired credit, Uncle Fred is also developing fixed-rate and hybrid ARM products that will provide lenders with more choices to offer subprime borrowers. We are doing this to not as a favor to anyone but in desperate hope of keeping volumes going. Honestly, we don’t think this will work, but what else can we do?

Uncle Fred continues to play a leading lagging role in combating predatory lending and putting families into homes they can afford and keep. Proof is in the pudding. We let subprime abuse continue for years and did nothing about it. We took the loans knowing full well they were garbage. Simply put, we wanted our fair share of the graft. But in the wake of 27 subprime lenders blowing up, the market forced us to react. Better late than never we always say.

Uncle Fred’s new requirements cover what are commonly referred to as 2/28 and 3/27 hybrid ARMs, which currently comprise roughly three-quarters of the subprime market. Specifically, the company is requiring that borrowers applying for these products be underwritten at the fully- indexed and amortizing rate, as opposed to the initial "teaser" rate. Quite frankly we got tired of being a tease, not for moral reasons, but out of fear for our stock options.

We will no longer purchase "No Income, No Asset" documentation loans and will limit "Stated Income, Stated Assets" products to borrowers whose incomes derive from hard-to-verify sources, such as the self-employed and those in the "cash economy." Obviously we should have done this long ago. Honestly, we really don’t know what we were thinking. If you know what we were thinking, please tell us.

In addition, Uncle Fred will require that loans be underwritten to include taxes and insurance and will strongly recommend that the subprime industry collect escrows for taxes and insurance, as is the norm in the prime sector. Because the maintenance of escrow accounts is not widely used in the subprime sector, Uncle Fred does not believe it is practical to unilaterally mandate it as a purchase requirement at this time. This is consistent with our policy to be a market follower and to react only when the market forces us to.

"Escrowing for taxes and insurance clearly provides an added layer of consumer protection. It is our hope that this universal practice in prime lending today becomes the universal practice in subprime lending tomorrow.” We reduced to hoping that someone does what needs to be done while we wait for that to happen.

Our official policy is clear:
"There’s no time like the future to do what we think needs to be done today".

Uncle Fred apologizes for its role over the last few years in failing to prevent predatory lending and rising foreclosures. From now on (and we mean it this time… maybe) the following polices will be enforced strictly encouraged:

• refusing to do business with institutions that engage in predatory lending practices (except of course we are willing to overlook such things like enormous prepayment penalties for up to 3 years)
• not investing in mortgages that require mandatory arbitration (except for major homebuilders like Lennar, KB Homes, TOL, and well everyone else too... at our at our discretion of course)
• refusing to invest in high-rate or high-fee mortgages as defined by the Home Ownership and Equity Protection Act of 1994 (HOEPA), as well as mortgages with single-premium credit insurance or subprime mortgages with prepayment penalty terms of more than three years. Three years is all our conscious can bear at this point in time. Besides, three years covers almost all of these offerings anyway. This makes it look like we are really doing something when we aren't. Prepayment fees are very lucrative. We don't want to shut off that gravy train prematurely.
• requiring that lenders provide complete credit information about borrowers to all the credit bureaus and reporting agencies (This requirement is so basic that it should be a given. But we needed to pad our bullet point list a bit).

Finally we would like to wash our hands for our role in the ongoing housing collapse. We are doing that with superficial programs such as FredSmart®, and Don’t Borrow Trouble. We readily admit that such programs will be about as effective as warning teenagers about premarital sex but what the heck? These catchy sounding programs just might stop a lawsuit sometime down the road.

Uncle Fred is a stockholder-owned company established by Congress to support homeownership and rental housing. Uncle Fred fulfills its mission by purchasing residential mortgages and mortgage-related securities, which it finances primarily by issuing mortgage-related securities and debt instruments in the capital markets.

Our new truth in lending policy requires us to point out that these debt instruments are often packaged as AAA government bonds (even though they shouldn't be rated AAA nor are they really government bonds in the first place). We sell these debt instruments to unsuspecting pension plans, hedge funds, and foreign investors who do not fully understand the risks of a housing implosion (and/or are simply too greedy to care).

Over the years, corporate insiders at Uncle Fred have profited tremendously from our quasi-government relationship. We are acting as best we can to smooth earnings (and with regulators breathing down our necks this is getting more difficult every passing day). We hope that superficial announcements like this will keep our stock prices high, stock options flowing, and insiders (us) happy.

As stated at the outset, the above article is purely fictional. No one really knows what any of these lenders were thinking when collectively the subprime mess was allowed to get out of hand as it did. What we do know is that corporations are reacting after the fact. We also know that it took over 20 subprime lenders to blow up before some companies reacted at all. This is not a slam directed specifically at any particular lending institution per se but rather a satirical look at the entire mortgage lending business.

How big is the subprime market?

The answer to that question, as well as a non-satirical look at subprimes, can be found in Nouriel Roubini's article Is the Sub-Prime “Garbage” 6% or Rather 50% of the Mortgage Market?

Now even mainstream media and mainstream analysts regularly speak of the sub-prime “meltdown” or “carnage” and refer to these sub-prime mortgages as “garbage” or “trash”. Since most of these sub-prime mortgages were junk that should have never been originated in the first place, now the new spin in financial markets is to minimize the nature of the problem by making two arguments: first, sub-prime loans are only a very small fraction of the housing market, specifically only 6% of it; second, sub-prime problems are a niche problem that is not affecting other parts of the mortgage market. Both arguments are utter spin without any basis. Let us see why.

Where did the Mortgage Bankers Association (MBA) get the “sub-prime is only 6%” figure that it is spinning around in every possible media? Their trick is to consider all homeowners, even the 35% of homeowners who do not have any mortgage and then argue that only 6% of homeowners are sub-prime borrowers. Why is this spin and why is the actual figure for “garbage” mortgages actually closer to 50% of the flow of new mortgages in 2005-2006 rather than the “6%” being spinned around?

Let me elaborate:

1. Sub-prime are now 13% of the stock of mortgages, not 6%.
2. Sub-prime mortgages were at least 20% of mortgage originations in 2005 and 2006.
3. The same “monster” lending practices used for subprime mortgages were also used for most “near-prime” and “prime” mortgages.
4. Many pseudo “near-prime” mortgages (such as Alt-A) are undistinguishable from sub-prime ones and have now sharply rising default rates
5. What is defined as sub-prime is subject to highly cosmetic accounting by banks: the rule that FICO scores of 660 or below are sub-prime is often diluted down to 630 or even 620 to exclude many mortgages from a sub-prime classification.
6. Counting all of the categories above, subprime-like mortgages accounted for almost 50% of all originations in 2005 and 2006 not the 6% figure spinned by the industry lobbies.

From the above, it is clear that the barn doors are being closed by "leaders" long after most of the damage was done. A plethora of lending institutions are finally refusing to do something they never should have been willing to do in the first place: originate garbage. Worst yet, they seem to be bragging about this as if it was some sort of accomplishment, even as junk loans with prepayment penalties as long as three years are still being accepted.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/