Saturday, December 18, 2010

Spending Down

            Spending down.  We think of spending down when someone who has lost his job, and is running through whatever savings he has.  Or we think of a spend thrift relative rifling through his inheritance.  Usually before you can spend down first you need a pile to spend down.
            The 1990s provided such a mountain of paper wealth when stocks had the trajectory of a Cape Canaveral launch, and everyone was flush.  According to Robert Shiller’s spreadsheet, the S&P 500 hit an all time high PE (Price to Earnings Ratio) of 44, an over-pricing perhaps only equaled in the Tulip Mania of 1637 or the Mississippi Bubble of 1719.  Even in the bull year of 1928-29, the PE only hit 33.  Or to put it in perspective, the talented trader Steve Cohn said all you had to do in the 1990s was “show up.”
            The value of housing was beginning to move up, but not as rapidly.  That had to wait for the low interest rates of the early 2000’s and the innovations of mortgage market.  No money down loans, interest only loans, balloon mortgages.  But for most folks, equity in the home has been, and still is, the most important source of wealth.  So, when people re-financed their homes and took down some of the equity in their homes, they knew they were spending down. 
            Though this was in an environment where houses were increasing in value every year, and, it was argued, they weren’t making it anymore (that is, land).  You still had a job with benefits, or a job that paid pretty well, or at least you had a job, and with property values still increasing, which you could check on, and would increase momentarily to make up the equity you took out.  It was easy to maintain the delusion that you weren’t really denting your savings.
            So when the home-as-ATM hit full stride in the middle part of the first decade of the new century, it should have come as no surprise when the personal savings rate went negative in 2005 and 2006.  We knew as a nation we were not sacrificing for the future anymore.  And once we started re-financing our home to pay bills, we knew we were spending down.  That was followed by the sinister television ads with Robert Wagner telling us how easy it was for seniors to get all the equity out of their houses in monthly installments to get funds to live on.
The realization of how bad things had gotten was forestalled by Bush and Greenspan.  Bush distracted us with a war against terrorism, and when we expected taxes to go up to pay for the war, they went, inexplicably, down.  Meanwhile, Greenspan kept us at Home Depot and our local car dealer with unbelievably low interest rates.  It was right in this time frame that zero percent car loans started to appear.  Seth Glickenhaus, the octogenarian investment manager, told us in an interview in Barron’s, they’re stealing demand from future years.
And now the future years are here, and demand for autos is weak, and demand for houses practically non-existent.  You have to reach back to the 1940s to find housing starts at the current low levels.
            But it’s not just individuals, in 2004, the City of Chicago started to spend down when it leased the Chicago Skyway to an investor group for 99 years for $1.83 billion to help bridge a current budget shortfall.  This sale of the city’s jewels meant that no more regular annual income will come from that source.  Daley also tried to lease Midway Airport, a sale which fell through, but then cut a deal to lease the street meters the street meters to another investment group for $1.16 billion for 75 years.  Is it any wonder that Daley has decided not to run in 2011?  The financial problems facing the City of Chicago are staggering, and he’s running out of assets to sell.
            But in Illinois the problems are not confined to Chicago, the Illinois Teachers’ Retirement system announced in August that it will need to sell $3 billion of its investments, or about 10% of its $33.1 billion in assets, to pay pension benefits.  The Illinois State Universities Retirement System expects to sell $1.2 billion from its $12.2 billion of assets, again about 10%.  And the Illinois State Board of Investment, which funds state employees’ pensions, could sell $840 million of its $9.9 hoard to pay benefits, on the same order as the others.  All of this selling is the result, in part, of the State of Illinois not making its contributions to those pension plans.
            The State of Illinois itself is a disaster, borrowing $13 billion out of a budget of $26 billion.  And according to Messrs. Robert Novy-Marx of the University of Chicago and Joshua D. Rauh of Northwestern University, you would need 7.2 years of the current tax revenue in Illinois to fund the pension gap to date.  Tax increases on this order are not feasible.  They will have to double just to break even on current expenditures.  Moreover, it seems that the deal that was struck years ago will find voters unsympathetic.
            That deal was that the pay for teachers and firemen and policeman was low, so the pension made up for that.  In the present situation, those pay levels no longer appear to be so remarkably low, and voters are also aware that there has been a lot of mischief going on with pay levels and pensions.  For example, what voter is unaware that pay levels are routinely increased in the last years of employment, so that workers will get the maximum pension?  For every offensive Goldman Sachs employee selling mortgages for big money, there is a municipal employee sitting at his desk figuring out how to game the pension system.  A president of the village of Bellwood, Illinois, augmented his pension by saving up a year’s worth of vacation, and applying it at the end of employment. 
            Voters also perceive that a defined benefit pension is no longer the standard in the country.  If federal employees only get a 401k, and all big corporations offer anymore is a 401k, they why will they vote for a cushy pension for state and local employees?
            What really brings this home is that the mother of all defined benefit programs, Social Security, is in its first year of reverses.  2010 will mark the first year in which Social Security receipts are expected to be less than payouts, by about $29 billion.  This was not expected to occur until 2016.  Supposedly, there exists this thing called the Social Security Trust Fund where there sits a huge balance above two and half trillion dollars, but the Trust Fund loans the money to the federal government.  So, the government only goes to market to sell bonds when it needs additional sums.  To get at the so-called trust funds, the government would have to borrow the two and a half trillion dollars, which will surely become more of a problem after all the massive borrowing the government has already done, and may have to do to fund the new healthcare initiative.
            The Republicans would probably have made a lot more progress with the privatization of Social Security if they had recast it by saying something like, “a real account with real money, not just a government accounting entry.” 
If the Social Security Trust Fund really meant something, you could say the federal government was spending down to pay benefits.  But the reality is that the system is a pay-as-you-go program, and the government, ultimately, will have begun borrowing this year to pay benefits.  It will go into the market this year to borrow the $29 billion shortfall in receipts to pay benefits.
            Sooner or later, the federal government will have to cheat us, fair and square, and raise the age you can collect benefits, and, possibly, they will have to cut benefits.  In fact, the whole entire concept of retirement is in jeopardy.  It could be, in the future, retirement will be viewed as a twentieth century scheme which occurred because personal savings rocketed during World War II when everyone was working around the clock for the war effort.  And that was followed by a freak population anomaly, which began with the baby boom of 1940s, and created a huge wave of cash, allowing the parents of the boom babies to retire.  When the wave crested and then ebbed, the baby boomers themselves, who had been paying their parents’ benefits, found themselves with no wave of payers for their own benefits.  And with this realization, the concept of retirement folded its tent and stole away in the night.
            This development may welcomed by some, retirement only caused grief for many who found aimless hours hard to fill.  But, as a practical matter, if this scenario plays out, then government planners and economists will be faced with the same problem they had in the Great Depression.  Many more people chasing jobs than there are job vacancies to fill.  Already, it is apparent to any thinking person that while it might be nice to cut the military budget to cut the deficit, but that would mean adding hundreds of thousands or a million more to the unemployment lines.
            “Lies, damn lies, and statistics,” attributed to Mark Twain, who apparently stole it from Benjamin Disraeli.  To anyone looking for work, it is pretty straight-forward that the government has systematically provided statistics which are not reflecting the situation.  Unemployment may be 9.5% by the definitions the government is currently using, but if you compare our current employment situation in an apples-with-apples comparison with the 1930s, which you can find at, our unemployment likely stands at 23%, comparable with the Great Depression of 1930s.  The chief difference in the statistics is that now the government doesn’t count people who gave up looking for work, who were defined out of the mathematical expression in 1994.
            The struggle between generations is at work, even if it is unaddressed, when the Illinois Teachers Retirement system draws down 10% of its assets.  You have to think: how many years can they do this?  Ten, eleven.  And what that means is that those who are benefiting now from the draw-down will do so at the expense of those who would expect to get something later.
            And the psychology of the nation has changed in the past fifty years.  There was this planning-for-the-future mindset that is missing now.  It is almost as if all people were expecting they are at ground zero, so they may as well spend it.  How can we compete with the Chinese?
            What Robert Wagner doesn’t tell the listener when he does those reverse mortgage commercials is that your parents won’t be leaving you very much.  The family homestead will be gone, eaten up.  But what can the parents do?  Medical expenses are much greater than before.  People are living longer, 30 years longer than a hundred years ago.  Medical procedures are working better than before, even the dreaded chemotherapy and radiation are working better, and drugs are keeping heart patients alive longer.  All of which is making retirement longer and more expensive, and eating up assets that would have been transferred.
            Grappling with the pension issue now could help stand the country upright again.  Most voters know the facts.  By now everyone knows that when Social Security started 13 people contributed for everyone one receiving benefits, and now that ratio is more like 2 to 1. 
By now most everyone knows that the rust belt companies were made uncompetitive by unions targeting the weak sister of the auto companies, for example, and extracting contracts for welfare and pension programs, which ultimately went beyond the ability of companies to pay (especially when combined with incompetent managements).  Corporate America has all but abandoned defined benefit pensions because the costs are not predictable, and have become especially prohibitive as investment income yields have vanished.  Defined benefit plans were fine as long as you could get your expert actuaries to hedge and use the best possible assumptions on investment income, often 8%.  But those assumptions have been, in fact, destroyed by Allan Greenspan and Ben Bernanke, who have kept interest rates low to get business going, but such medicine has the side effect of destroying the income of pensioners.
             The total liability that has accumulated for unfunded pensions according to Novy-Marx and Rauh is estimated at nearly $2 trillion.  Some of this occurred with the stock market decline, some of this is because the money earned on pension assets based on treasury rates are so very low now.  The conservative strategy would be for the states first of all to stop defined benefit pensions, and change to contribution plans, which has been the way for most of America over the past twenty years.  At least pensioners might know better what to expect when states make no payments to pension funds.
            But pensions cannot just be completely shucked.  Some workers were not included in the Social Security system.  Illinois Governor Quinn recently denied workers a chance to join that system because it was cheaper to opt out.  Something will need to be paid to pensioners, exactly what will have to be negotiated, between the young and old pensioners, between taxpayers and pensioners, though if taxes, for example, have to be doubled in Illinois just to meet current obligations, it would seem there is little room to move.  An economy top heavy with taxes will not aid the recovery.  So, as always, it’s a bit of a trick this thing with taxes, especially if citizens and companies have mobility.  The governor of Indiana has let it be known it is getting a lot of new businesses from Illinois.
            And it may be a matter of national security to start paying down the debt, Admiral Mike Mullen, chairman of the Joint Chiefs of Staff, said during the summer that our quickly growing debt is "our biggest national security threat."  Certainly, it is axiomatic that a weak economy will not be able to support military actions, and that is the Admiral’s point.
            As a practical matter, if an individual is spending down, he ends up in bankruptcy court or on the government dole.  In the case of governments, both federal and state, the ultimate arbiter is the bond market.  When the State of Illinois, for example, cannot borrow 50% of its budget anymore, then tough decisions will need to be made.
            The federal government has been a little like the home borrower of the recent past in that investors around the world have found money for U.S. bonds the way banks used to find money for home buyers.  The flow to “safety” has been in such large amounts that it hides the government’s deteriorating investment security.  Some investors, like Bill Gross of Pimco, have been recommending that investors look at German bonds, and lighten up on American bonds.  If this sentiment spreads, interest rates will head up, and the Federal Reserve will have to pull in its horns.
            It would be a happy event if the government’s finances could be solved before an unhappy bond auction, perhaps with bids covering only 1.2 times a bond issue, instead of the 3.7 times of a recent auction.  But recent budget suggestions of the bipartisan committee headed by Alan Simpson and Erskine Bowles met with a “simply unacceptable” from Nancy Pelosi, and "two thumbs down" from Jim DeMint.
            But look for trouble the next time the Congress is asked to raise the nation’s debt ceiling perhaps in April of next year.  Republicans are sure to make their mark by raising a stink about the borrowings, but whether they will halt the government in their zeal remains to be seen.

    You Know You’re Spending Down When:

  1. You take less expensive vacations, or just stay home for a week as a vacation.
  2. You know all the take-out places where you can buy a meal for around $5.
  3. You transfer money from savings to checking.
  4. You have to think about going to the movie, because a ticket is $8, and now popcorn costs $4.
  5. You get your rental DVD’s from the library for free.
  6. You nurse your car long instead of replacing it.
  7. You alienate a pretty girl because you don’t have the money to take her out.
  8. Credit card invitations decline.
  9. You get shoes repaired. 
  10. Your representatives raise the National Debt Ceiling to pay for stimulus spending.

c2010 Thomas Barnard