Friday, 10 July 2009

Great Pyramid of Geezer

An update by Karl Denninger at Market Ticker today got the old synapses firing. Denninger points out that pension plans are in trouble and cites a Wall Street Journal article strongly suggesting accounting fraud in public pension plans. The WSJ says:

Based on their preferred accounting methods -- which discount future liabilities based on high but uncertain returns projected for investments -- these plans are underfunded nationally by around $310 billion.

The numbers are worse using market valuation methods (the methods private-sector plans must use), which discount benefit liabilities at lower interest rates to reflect the chance that the expected returns won't be realized.

Last year we warned about the same phenomenon in private sector pensions in Some Key Questions and The Limits of Optimism. In every case the culprit was the same - overly optimistic assumptions about investment returns allowed a financially deficient structure to be sold to key constituencies as safe and sound. The wild optimism that causes managers to overreach like this and causes others to believe their literally incredible assumptions are part and parcel of the Universal Debt Bubble (UDB). Only in such a manic environment can such outlandish claims be regarded as anything other than the fantasies they are in reality. Even worse, a bubble atmosphere makes those assumptions even more dangerous than normal by burdening assets with inflated starting values, making the required price appreciation even less likely than usual. But as long as such tales are believed, a small sliver of capital can be made to support grand promises in the future.

Unfortunately, the credulous public has been misled in any number of similar ways. Robert Prechter of
Elliott Wave International recently described the process by which banks also shrank the capital supporting their balance sheets to a tiny fraction of what had previously been required and considered prudent:
In the early 1990s, the Federal Reserve Board under Chairman Alan Greenspan took a controversial step and removed banks’ reserve requirements almost entirely.

To do so, it first lowered to zero the reserve requirement on all accounts other than checking accounts. Then it let banks pretend that they have almost no checking account balances by allowing them to
“sweep” those deposits into various savings accounts and money market funds at the end of each business day... The net result is that banks today conveniently meet their nominally required reserves (currently about $45b.) with the cash in their vaults that they need to hold for everyday transactions anyway.

Sure or Insure
Yet the problems of inadequate capital hardly end there. Like pensions and banks, insurance is another area that succumbed to the ubiquitous optimism of the UDB. Insurance companies became so accustomed to capital appreciation well above the historic norm that they began to take them for granted. Many annuity policies and guaranteed investment contracts were written promising high fixed rates of return based on that experience. This has proven devastating for many insurers, who are now rushing to rewrite such contracts. This is a microcosm for the weak capital position of much of the industry as key asset classes for most life and casualty companies are stocks, bonds and real estate. Like every other leveraged institution out there, the insurers have taken a beating on those assets and their promises to deliver future benefits are increasingly in doubt. Which brings us to a similar structure with the biggest capital shortfall of all.

GovernMENTAL Institutions
For the most part, capital is literally a foreign concept in this sector. Few governments have significant reserves, much less any real capitalization. Except in regions where government-owned enterprises dominate the economy, the primary source of revenue for most institutions is taxes - on the private sector naturally. So instead of actual capital, governments have something even more volatile - a projected future revenue stream. As with every other sector we have examined so far, those projections about the future are subject to the psychological distortions that accompany large-scale financial manias. In an environment of historic extremes like the UDB, those distorted perceptions can easily become fatal. We see that today in the sad case of California - where the state is issuing IOUs because they are out of money. Having accustomed themselves to double-digit annual rises in tax revenue, Sacramento (and other state capitals) simply spent it all. Those projections and plans aren't working out so well anymore.

The US Federal Government is arguably in even worse shape. Borrowing this year is likely to approximately equal tax income. No entity can spend twice its income for long and hope to survive. The remnant optimism of the UDB has settled in one of its last-ditch redoubts: faith in government. In addition to the spending spree, Washington has also embarked on a series of empty promises that would make a serial polygamist blush. Not content to merely guarantee deposits through the FDIC, the Feds now do the same for bank bonds through TLGP. Fannie and Freddie debt is backed thorough a de facto nationalization and money market mutual funds are guaranteed by the Federal Reserve. Many trillions of government "guarantees" are piled atop the roughly $1 trillion of deficit spending for this fiscal year. These promises are lighter than a feather but certainly worth their weight in gold. In other words there is no way Washington can deliver but they are hoping nobody notices and that the empty promises will inspire "confidence" in the economy. Like many other sectors, various levels of government are attempting to cover huge obligations with inadequate resources.

Frankly, it's sad that so many people fail to see the little man behind the curtain putting up the front that is the Great Oz. These large and varied institutions have stretched themselves far too thin and are praying for another bubble to bail them out again. The title of this missive refers to those who will bear the brunt of the damage from our return to reality - those who bought into the promises of these institutional pyramid schemes and don't have the time to recover financially. The frenzy of financial pyramid construction certainly put the Egyptians' little excursion in stonework to shame. In reality, the old truths would have served us well, but like every bubble generation in history, ours has convinced themselves that "this time it's different" when it never really is. Like those who have gone before, we will learn the hard way when two things we all learned as children would have prevented much of this mess:
  • Never count your chickens before they hatch.
  • Save for a rainy day.

It seems so simple and most of us will never forget. With the optimistic assumptions that undergirded the psychology of the UDB evaporating, any program sporting the words insurance or guarantee must be treated with great skepticism.

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