Financial Armageddon
By Michael J. Panzner
Copyright 2007, 2008 by Michael J. Panzner
Smashwords Edition
Praise for Financial Armageddon
“I may not always
agree with him, but ‘Armageddon’ Panzner is a brilliant analyst
and a great trader. He has a tremendous grasp of investment
principles.”
—Larry Kudlow, Host of CNBC’s Kudlow &
Co.
“A breathtaking
and coherent vision of financial disaster.”
—Edward
Chancellor, Author, Devil Take the Hindmost: A History of
Financial Speculation
“The end of the
credit bubble, derivatives excesses, unfulfilled government promises,
and the upcoming retirement squeeze will provide investors with their
greatest challenge since the 1930s. Financial Armageddon lays out the
blueprint for what will happen and how to best prepare
yourself.”
—David Tice, President and Fund Manager, Prudent
Bear Funds
“Wonderful,
entertaining, and easy-to-digest… Panzner has done a great service
to reveal the truth, which the overpaid Wall Street crowd and the
government have conspired to hide from the ‘workingman.’”
—Marc
Faber, Managing Director, Marc Faber Limited
“Financial
Armageddon alerts you to the painful scenarios that may lie ahead,
including the worst case outcome. It may not come to pass, but you
will not be caught off guard if it does.”
—William A.
Fleckenstein, President, Fleckenstein Capital, and Columnist, MSN
Money
“Panzner is one of
the few people I know who can deal with day-to-day Wall Street action
and yet have a big picture perspective—a picture he paints in
Financial Armageddon as one that should terrify us.”
—Bill
Cara, BillCara.com (Forbes Favorite, 2006)
“Timely,
accessible… Readers who follow Panzner’s advice will be among the
few who successfully weather the storm ahead.”
—John
Rubino, Co-author, The Coming Collapse of the Dollar and How to
Profit from It
“The definitive work on our economic future. Read it now or dwell on the consequences later.” —Bruce Stratton, SafeHaven.com
“An absorbing
report on the gruesome inner workings of the Frankenstein Finance
monster that is dragging the rest of our economy into a dark
future.”
—James Howard Kunstler, Author, The Long Emergency
“A magnum opus of
the facts and figures of the astounding monetary and fiscal
stupidities of the last decade… all perfectly intertwined with
timeless economic wisdom.”
—Richard Daughty, the Mogambo Guru
This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that neither the author nor the publisher is engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The opinions expressed are those of the author and do not necessarily reflect the views of any other individual or organization.
© 2007, 2008 by Michael J. Panzner
All rights reserved. The text of this publication, or any part thereof, may not be reproduced in any manner whatsoever without written permission from the author.
Hardcover edition of Financial Armageddon originally published by Kaplan Publishing in March 2007.
PART
ONE
THREATS
1.
Debt
2.
The Retirement System
3.
Government Guarantees
4.
Derivatives
PART
TWO
RISKS
5.
Economic Malaise
6.
Systemic Crisis
7.
Depression
8.
Hyperinflation
PART
THREE
FALLOUT
9.
Economic
10.
Financial
11.
Social
12.
Geopolitical
PART
FOUR
DEFENSES
13.
Planning
14.
Investments
15.
Relationships
16.
Lifestyle
Acknowledgments
References
and Resources
About
the Author
“Contained.”
Around the time that the hardcover edition of Financial Armageddon was first published, we started seeing and hearing this term being repeatedly bandied about in the mainstream media. Despite my prediction of the coming crisis, politicians, bankers, and Wall Street insiders argued that the troubles brewing in a formerly arcane corner of the financial world were limited in scope. They said the threat posed by a meltdown in the subprime mortgage sector, together with a bursting housing bubble, would not spread to other markets or cause any real collateral damage as far as the overall economy was concerned.
In other words, there was no reason for anyone to worry. The fundamentals were sound and everything was under control. “Trust us,” they intimated with their characteristic aplomb, because “we know best.”
Given what has happened since, including widespread upheaval in global credit markets, the worst housing crash since the Great Depression, and billions upon billions of dollars of losses that have cascaded through the U.S. and global economies, we now see that these so-called experts were totally wrong. Of course, what we can’t be sure of is whether those uttering such baseless reassurances were incompetent, ignorant, deceptive, or evil, or some combination of the above.
Unfortunately, we may never learn the truth. What’s more, we may never really understand why so many people put so much faith in central bankers, politicians, regulators, rating agencies, bond insurers, economists, strategists, traders, financial engineers, stock and commodity exchanges, monetary and fiscal policies, technology, academic theories, government safety nets, and anyone and anything else that contributed to the dangerous and often self-serving mirage that all was well in America—even though it was not.
But that’s not all. Odds are, for example, that we will not find out who is to blame for the fact that the country’s largest banks were permitted, à la Enron, to create highly leveraged off-balance-sheet “shells,” known as structured investment vehicles (SIVs), that obscured their true risk exposure. Or why financial institutions were given the go-ahead to value as much as half (or more) of their billions of dollars of shaky financial assets using inadequate models and a substantial amount of guesswork. Or why credit rating agencies were allowed to exert so much influence despite so many conflicts of interest.
Indeed, there will be many questions left unanswered in the years ahead. And plenty of guilty parties who probably won’t get what they deserve for their part in either creating, extending, or denying the economic and financial disaster that has been unfolding at a far faster pace than many thought possible. In truth, though, it won’t matter.
The reality is that we need a road map for the difficult times ahead. Financial Armageddon offers an understanding of what led to the current crisis, how to prepare for what’s ahead, and how to manage our personal finances and investments in fast-changing and increasingly treacherous conditions. We will have to adapt quickly and act boldly if we want to come to grips with an environment that few have encountered before.
Financial Armageddon predicted the current crisis. To understand what happens next, read on. Because whether we like it or not, what is set to unfold over the next several years will be anything but contained.
Our world is a riskier place than it used to be. Whether from escalating conflict in the Mideast, rogue nations brandishing nuclear weapons, random attacks against innocent civilians, ruinous natural disasters, the emergence of global pandemics, or the fallout from volatile energy prices, we are increasingly vulnerable to a host of threats. Most Americans seem aware of these dangers, if only cursorily. We are familiar with war, diseases, and earthquakes. We understand that certain groups seek to subjugate others militarily or economically. We recognize that many individuals despise our country and wish to destroy everything for which we stand.
We know enough to be concerned about these risks and remain on the lookout for any signs of danger. We also realize that we may one day need to take action to protect ourselves and our loved ones.
But that is not the case with the devastating economic cataclysm that lies ahead.
Lacking the most primitive early-warning signal available to miners, we have no “canary in the coal mine” to raise the alarm over the broad-scale dangers of a toxic confluence of debt, derivatives, government guarantees, and unfunded retirement obligations.
There have indeed been voices in the wilderness warning of the dangers, but most have only highlighted certain aspects of this disturbingly vast labyrinth. Until recently, the majority of Americans have blithely assumed that with rules, regulations, and capital cushions in place, as well as our long history of muddling through difficult times, there is no real cause for concern. Yet when it all starts to go wrong, and the supposedly unimaginable evolves into a horrifying reality, it will be too late to react. It will then be clear ix x Preface that these four developments have formed an explosive mix that is too unwieldy, too complex, and too rife with conflicts of interest for any individual or organization to come to grips with. As with deadly carbon monoxide spreading quickly and insidiously in the depths of a mine, many will find themselves overcome with financial ruin before they know what hit them.
Financial Armageddon is a layperson’s guide to four threats and the far-reaching impact they are poised to have on our lifestyles, our economy, and our society. The first is a burgeoning tower of public and private debt wobbling precariously on a foundation of greed, overindulgence, and fraud. The second is a multitrillion-dollar house of cards to which all Americans are exposed, though few of us know it. The third is a vast array of largely hidden promises that will ultimately remain unkept. The last is a retirement mirage that will leave millions cast adrift or financially enslaved until the day they die. Each is a ticking time bomb—all ready to explode at once.
A book on these threats has not yet been written for a few reasons. Many potential authors who are otherwise up to the task lack a solid understanding of the big-picture risks associated with modern day financial products, relationships, and markets. Moreover, the vast majority of those who are aware of the problems are bankers, Wall Street operators, and industry insiders who do not wish to kill the golden goose of profitability. Or they have decided to adopt an ostrich-like professional posture about the systemic dangers, despite their personal misgivings.
With time running out, a tragedy is in the making, and every American must acknowledge, understand, and prepare for it— before it is too late.
“Disasters
never come alone.”
—Chinese proverb
When the unraveling is fully under way, there will be a flood of lurid headlines. Amid the avalanche of hearings, lawsuits, arrests, and trials, stories about violent strikes and protests will vie with news of plunging markets and businesses going belly up. Every day, tales of foreclosures and broken lives will blanket the airwaves. Many financial institutions will shut their doors, often with little warning. Rumor-filled bank runs will be commonplace. Finger-pointing will also be widespread, as politicians, regulators, and corporate chiefs scramble for cover in the face of increasingly hostile public opinion.
Meanwhile, Americans will scratch their heads and wonder how it all went so wrong so fast, or why they had not been aware of the dangers before. In reality, we should have seen it coming. Signs of impending doom were everywhere, plain for all to see, in the years leading up to the wide-ranging meltdown. Still, even if people had been aware of the gravity of the situation, it seemed that few cared all that much.
That certainly appeared to be the case when President George W. Bush and the Republican-controlled Congress, in a charade of sober concern, agreed to boost the federal borrowing limit to $9 trillion in the spring of 2006. This was an extraordinary increase of more than 50 percent from five years earlier. It was another regrettable, but now unavoidable, step to fund the latest in a long string of understated multibillion-dollar deficits.
Apathy was also in the air when the U.S. personal savings rate went negative for the first time since the Great Depression and total household debt exceeded 150 percent of disposable income. American consumers were not only spending what they earned but also a great deal of what they didn’t. And few noticed an April 2006 survey by Phoenix Management suggesting that two-thirds of U.S. lenders thought the country was in the middle of a real estate bubble, and half of them believed the bubble was about to burst—or already had.
Most Americans did not worry when the nation’s top auditor, Comptroller General David Walker, suggested that the United States could be likened to Rome before the fall. Or when he said that the nation was facing “a demographic tsunami” that “will never recede.” Even more surprising was the muted reaction to an article written by Boston University economics professor Laurence J. Kotlikoff for the July/August 2006 Federal Reserve Bank of St. Louis Review. He asked—rhetorically, it would seem—“Is the United States Bankrupt?”
After an initial flurry of concern, people also glossed over Warren Buffett’s warnings about derivatives, which he characterized as “financial weapons of mass destruction.” Yet he would eventually seem prescient after he wrote in Berkshire Hathaway’s 2002 annual report that “[t]hese instruments will almost certainly multiply in variety and number until some event makes their toxicity clear.”
Few paid attention to warnings from Eric Breval, the head of the $15.5 billion Swiss state pension fund, in a November 2005 Bloomberg report. He discussed plans to shift assets away from the United States and referred to the financial “time bomb” that the nation’s largest mortgage lenders, Fannie Mae and Freddie Mac, were sitting on. The same held true in April 2006, when Citigroup vice chairman William Rhodes told the Wall Street Journal, “We are in a situation similar to that which existed in the spring of 1997, when threats existed to market stability and a lot of people didn’t want to see it.”
Perhaps that’s it: Americans just didn’t want to know. Or maybe they actually didn’t see anything wrong or out of the ordinary. Everywhere you looked, policymakers, politicians, and pundits insisted that the financial system and the so-called Goldilocks economy were alive and well, and there was no reason for anyone to believe otherwise.
Then again, perhaps it was just too easy to believe the fairy tale that the good times could last forever.
To be sure, only scant evidence existed in early 2006 that the average Joe had put the brakes on spending, despite increasingly burdensome levels of borrowing and the fact that real—inflation-adjusted— wages had been stagnant for years. “Why call it quits now?” consumers argued. Indeed, Americans had carried on with their profligate ways far longer than many observers had expected.
This was partly because consumerism had become an end in itself. It was a new religion—a new American dream supported by an endless stream of advertiser-supported media.
Almost everyone was imbued with a get-it-now, live-for-today perspective, a kind of financial hedonism enabled and repeatedly over-stimulated by an aggressively competitive, rapidly innovating, but ultimately self-serving financial services sector. To that end, lenders and borrowers joined hands and helped create a massive real estate and mortgage market bubble, allowing consumers to “extract,” as the euphemism went, $2.5 trillion in debt-financed equity from their homes from 2001 through 2005.
There was a growing sense of entitlement, especially among the 78 million baby boomers—Americans born between 1946 and 1965—as well as a widespread desire for wealth without work. For many, engaging in excessive borrowing, self-deception, and a rejiggering of priorities to support a lifestyle they felt they needed and deserved was just the way life was. A quick read of history suggests this delusion is common among the citizenry of fading and failed empires.
Perhaps it wasn’t so odd, because almost everyone agreed on the script, that few gave clear thought to the dangerous indulgences and unsustainable financial imbalances that had built up over the years.
Of course, it didn’t help that many factors that spawned the multifaceted disaster seemed too complicated and far-reaching for most people to comprehend. Without the Benefit of sophisticated financial wisdom, the majority saw the various influences as unrelated to each other. Moreover, few Americans understood how and to what degree globalization, consolidation, innovation, and technology had altered the financial landscape. It was also hard to grasp the paradoxical idea that long periods of stability, which many viewed as inherently positive, were actually destabilizing.
As economist Hyman Minsky once noted, the good times tended to foster the complacency and risky behavior that lay the groundwork for upheaval.
Even those who sensed early on that the end was near might not have grasped the significance of certain developments, like changes in state and local government accounting rules for postemployment health care and other nonpension Benefits. First implemented by the Government Accounting Standards Board in 2006, these rules were seen as a way to ensure that municipal finances were more transparent than in the past. The new requirements were meant to hold politicians accountable for at least some of their “free lunch” promises.
It seemed like a great idea. But as with several other rules and reforms that came into play up to and after the stock market bubble burst, they would ultimately have unintended—and unwelcome— consequences. In this case, the scale of once-hidden promises to current and former workers would turn out to be $1 trillion dollars, according to an expert cited by the New York Times. Eventually, that revelation will spur widespread credit downgrades, leave many municipalities cut off from financing, force drastic budget cuts, and trigger an ultimately unsustainable push for higher taxes that will only add to the fallout from other catastrophes, including a rapidly deflating credit bubble, a systemic financial crisis, a collapsing economy, and an imploding derivatives market.
By then, the dangers that a few observers had foreseen—which were discounted, misunderstood, or overlooked—will be the only thing that growing numbers of Americans will be able to think about.
Part One
THREATS
Chapter 1
“A billion here, a billion there, and pretty soon you’re
talking real money.”
—Senator Everett Dirksen
Sometime during 2008, the flickering display on the national debt clock will almost certainly run out of room. The ever-increasing figure will not be able to fit the extra digit that will pop up when federal government borrowing breaks the $10 trillion dollar barrier. Unless, of course, the Durst family, who owns the clock in New York’s Times Square, decides to upgrade it or there is a sudden bout of fiscal responsibility in Washington.
Unfortunately, the odds of the latter are almost certainly nil.
More likely is that the United States will soon suffer the fallout of the live-for-today orgy of borrowing and extravagance that has already foisted an untenable economic and financial burden on future generations. Americans will also confront the daunting impact of what Albert Einstein once described as “the greatest mathematical discovery of all time”: the compounding of interest.
Barring major spending cuts or tax hikes, the combination of higher interest rates, the costly war in Iraq, and various other forms of public sector profligacy could help boost the national debt by another $3 trillion by 2010, according to experts cited by USA Today in November 2005 And that figure does not even take into account other obligations, such as Social Security and Medicare.
Like individuals and companies, governments have often relied on debt to make up for shortfalls when current income is lacking. Indeed, during more prudent times, borrowing is one of many valid financial strategies to acquire productive assets, which can generate decent returns and repay principal and interest down the road. Borrowed money can also make it easier to finance expensive but necessary projects or acquisitions, such as a public sewer system, a company warehouse, or a place to live, when upfront costs can’t be met with current resources. Even then, the amount of debt any individual or entity might take on has traditionally been constrained by old-fashioned prudence and a grown-up sense of responsibility.
But this dynamic has changed in the last few decades.
The Federal Reserve, whose stated mission is to ensure price stability, seemed to adopt a new mind-set during the 18-year tenure of Alan Greenspan, former chairman of the Federal Reserve, that was predicated on cutting rates at the drop of a hat and using monetary policy to try to eliminate normal cyclical downswings in the economy. Like force-feeding a duck to make foie gras, the Greenspan-led Fed appeared determined to stuff the U.S. economy with enough borrowed money to ensure that something of value was created—even if in the end it killed the bird.
In addition, the upbeat mood of the 1980s and the heady, go-go days of the 1990s convinced many Americans that circumstances would invariably get better, no matter what hiccups came up along the way. The United States had not seen a bone-jarring, consumer-led recession for more than 15 years, and one could argue that the optimism was justified. Why prepare for the worst by saving more or borrowing less if the occasional downdraft is unlikely to last long? Ever-growing investment returns, an endless housing boom, and the Federal Reserve had conditioned Americans to believe that, inevitable good fortune would eventually bail them out—should it even prove necessary.
The financial system had also undergone revolutionary change, both in attitudes about credit and in the way the lending process worked. Technological innovation increased efficiency and facilitated financial institutions’ offering people all sorts of products and services not previously available to them. Advanced communications, quantum leaps in computing capabilities, and the power and reach of the Internet enabled anyone to borrow money for almost any purpose. The same developments also made it easier than ever to seek out and tap those with funds to spare.
Modern financial engineering had also altered the prudent lending relationships that were a hallmark of days gone by. Bankers no longer relied upon getting to know their customers or on experience-driven gut instinct to assess a borrower’s willingness and ability to repay a loan. Instead, they used technology and credit “scoring” methods—FICO® being the most common—that are based on prior payment history and other seemingly relevant factors of future creditworthiness. Or else they simply looked at the collateral involved—regardless of a debtor’s ability to pay.
The same seemed to hold true for many who invested in fixed-income securities. If a bond had an appropriate credit rating from an agency like Moody’s, or if it was guaranteed by Fannie Mae or an insurer like MBIA, or if it was secured in some way, then it was worth owning, despite other considerations that once might have raised red flags.
And when it came to the U.S. government, few Americans contemplated the possibility of default when shelling out for Treasury bills or bonds. To use an old cliché, most people assumed that their money was “as safe as houses,” which is ironic given the havoc a bursting real estate bubble will eventually wreak on government finances. Yet in decades past, investors might have balked at financing the debt of a nation with a current account balance—the difference between what it consumes and what it produces—of close to 7 percent of output, as well as other obligations that seemed to grow exponentially. Even investors outside our borders, who should have known better, were oblivious to the realities of an American economy gone bad. By 2006, foreigners owned over 42 percent of outstanding Treasury securities, up from 30 percent only six years earlier.
Unlike boring, old-fogy bankers, those putting up the money didn’t seem to have the same degree of concern about whether they would get back their principal.
Part of their reasoning undoubtedly came down to securitization— a process whereby loans or other assets are lumped together and essentially resold, with the payments from debtors often sliced into many pieces with different coupons, maturity dates, and risk parameters to suit the multifaceted needs of various end investors.
In a simple example, XYZ Bank convinces prospective home buyers to arrange their mortgages through the lender. Once the paperwork is complete and the funds paid out, the bank sells the newly created loans to a “special-purpose vehicle,” or SPV, for the face value plus a fee. At the same time, investment bankers arrange to have these SPVs issue debt—in much the same way an established company might—that could then be sold to institutional fixed-income money managers, such as pension or mutual funds, or even directly to retail investors.
The mortgage-backed securities, or MBSs, would usually be comprised of several classes, or “tranches,” with the higher-rated securities having first dibs on the proceeds flowing into the SPV from the mortgage-paying homeowners. The riskier tranches would, however, be designated for a larger share of the interest received than would the more stable variety. Typically, the lower-rated tranches would be structured in such a way that they would be the first to suffer losses if some of the homeowners whose loans were in the “pool” defaulted on their mortgages. By tradition, the riskiest slice is called the “equity tranche.” The yield for each tranche would vary, with the overall average working out to less than what the underlying mortgagees were paying. The difference would go to cover the fees of those involved in the securitization and later sale to investors, as well as any legal and administrative costs. Anything left over after making good on loan losses would go to the equity tranche holders.
In the end, the bank would be back where it started—albeit with a quick profit on its original loans—ready to originate another round of new debts and add to the total amount of credit outstanding. Meanwhile, investors would hand over cash to purchase the mortgage-backed securities issued by the SPV and would receive interest payments in return. Eventually, as the underlying mortgages were paid off, the proceeds would flow back to the MBS owners as principal.
And everyone, it seems, would be happy. This is most likely why more than half of all U.S. residential mortgages were incorporated in mortgage-backed securities by 2006, according to the Bank for International Settlements.
Of course, the assumption is that most homeowners whose loans are in a pool will actually make their payments on time—and will eventually repay all of the original principal. This belief has already proved fanciful in the wake of a bursting property bubble and the 2007 meltdown in the subprime mortgage financing sector. It will be further undermined when the economy abruptly flips from modest growth to sharp contraction. All of a sudden, large numbers of believers in the American dream will find themselves out of a job, owing more on their homes than their properties are worth, or both. At that point, homeowners will either be unwilling or unable to hand over what they owe.
Making matters worse are the many other obligations that Americans acquired during the credit-bubble years. Of course, the scale of exposure will not have seemed quite as daunting as it will when everything goes wrong. By then, however, the straitjacket of debt will prove to have an extraordinary impact on every aspect of economic life.
Still, economic catastrophe should not be such a rude awakening. Anyone could have anticipated that our attitudes about debt, the widespread availability of borrowed money, and low U.S. interest rates would encourage Americans to borrow first and ask questions later. It was so easy, in fact, that the ratio of total debt to gross domestic product, a measure of U.S. economic output, rose to more than 300 percent by 2005, exceeding the record of 290 percent last seen just prior to the 1929 stock market crash. And net external debt, which measures the difference between what we owe the rest of the world and their obligations to us, reached more than $3 trillion, having been in surplus only a few years before.
According to the Federal Reserve’s triennial “Survey of Consumer Finances,” more than three-quarters of American families owed money in 2004, while the overall debt load of borrowers surged by 33.9 percent in a three-year span. The spree continued in 2005, as household debt rose 12 percent, the fastest rate in 20 years. It wasn’t just that the percentages were large; the raw numbers were also mind-boggling, with the tally adding up to over $8.8 trillion in mortgage debt, $2 trillion of consumer debt, and a cool trillion in home equity loans and second mortgages.
Borrowing money was fast becoming the bad habit of choice for American consumers, many of whom were finding it hard to “just say no” or were oblivious to the longer-term consequences of boosting debt exposure to hitherto unseen levels. Households spent a record 13.75 percent of their after-tax income on servicing required interest and principal payments during the last quarter of 2005.
Americans borrowed so carelessly because they focused only on the payments involved. When it came to obtaining financing, the number that always stood out was the monthly carrying charge, or “nut.” That amount was usually highlighted in big, bold letters, unlike other important details, such as the total that was owed, including interest, or the penalties that would accrue if the loan was not paid on time.
Automakers had long relied on this strategy to get buyers to sign on the dotted line. Yet when higher rates made it difficult to offer monthly terms that were palatable, Ford, General Motors, and others would eventually extend the maturity dates of the agreements by 50 percent or more. Or they would push leases where, in essence, monthly payments covered only the interest and part of the principal—in exchange for 0 percent of the ownership. In March 2005, for instance, Edmunds.com reported that 19.8 percent of all vehicles were leased rather than bought, the highest rate since 2001.
In fact, a variety of intermediaries did all they could to ensure that even those who lacked the financial wherewithal got their share of borrowed money, especially when it came to property-based lending. In the spring of 2005, reports indicated that around 10 percent of homeowners had zero-to-negative equity in their homes whereas nearly 30 percent of buyers had none. That figure was not surprising given how easy it had become to acquire a property with no money down.
Another way around the problem was to dilute underwriting standards or make the terms more “affordable,” especially for buyers with spotty credit records or income that was hard to prove on paper. Many of these “subprime” borrowers discovered that by taking on adjustable-rate mortgages, or ARMs, which featured ultralow introductory rates instead of the traditional 30-year, fixed-rate loans, they could tap into the American dream and own their own home. Some had to stretch even harder than that, but bankers were only too willing to oblige. They began offering other nontraditional products, including interest-only loans, with the entire principal payable at the end of the term, and payment option ARMs, whereby borrowers had the choice of remitting less than the interest and principal due in any given month.
Unfortunately, this kind of affordability had a downside known as “negative amortization,” which leaves many “owners” owing more on their property than they did when they initially purchased it. They would then be, to use the vernacular of the industry, “upside down.” Many also didn’t quite realize that having adjustable mortgages meant just that—that their rates and payments could go up, perhaps by a lot. According to a 2006 Fed study, 41 percent of homeowners with ARMs didn’t have any idea about the maximum interest rate that they could be charged.
But the risks didn’t seem to matter. By 2005, 13.4 percent of outstanding mortgages were classified as subprime, up from 2.1 percent in 1999, according to the Mortgage Bankers Association. In addition, half of the mortgages underwritten in 2005 and 2006 were ARMs, while nearly 10 million mortgages—a quarter of the total outstanding—carried adjustable interest rates. And from 2006 through 2008, up to $2.5 trillion of those loans would be “reset,” meaning payments would spike from their initial low levels after more than two years of interest rate hikes by the Federal Reserve.
It was going to be ugly, that’s for sure.
Not all of the borrowing was for the purchase of new homes. According to the National Association of Realtors, a record 39.9 percent of the properties that Americans bought in 2005 were for vacation or investment, with many owners counting on a buoyant rental market and continually rising prices to keep the juggling act going. Regardless of the reasoning behind the purchases, house prices had outstripped income growth by a factor of six over five years, according to a Harvard University study, helping to create an unsustainable real estate bubble of epic proportions.
Property-related borrowing also played other roles in the economy. Refinancing activity that tapped home equity—the value of property less any debt owed on it—grew to represent a sizable slice of the overall market. Enabled by surging home prices and heavily marketed by banks and other lenders as an alternative to unsecured but high-rate credit cards, “cash-out refis” became an increasingly popular way to raise funds for property owners—and even some prospective purchasers who didn’t have quite enough money for a required down payment.
The numbers turned out to be huge. From 2001 through 2005, the sum total of mortgage equity withdrawals, or MEWs, was estimated to be around $2.5 trillion, according to the Weekly Standard. Some analysts suggested, in fact, that MEWs may have accounted for a substantial share of U.S. economic growth over the five-year period.
Along with the direct economic impact, however, developments in the credit markets dramatically altered the distribution and structure of interest rate and default risk in the American financial system. For a start, with the gradual move from unsecured towards secured lending, debtors assumed a greater financial burden in the event that they could not pay their bills. Although a substantial proportion of assets has traditionally been available to pay off creditors following a filing for bankruptcy, debtors once had been able to “affirm”—agree to keep paying—secured debts to shield at least some of their equity interest from credit card and other unsecured lenders. In addition, many states allowed certain property, including homes, to be excluded from the pool of assets that could be used to satisfy existing creditors.
The shift toward variable-rate debt has also altered the impact of a change in yields. In the past, bankers’ bottom lines tended to be adversely affected when interest rates moved higher. But with adjustable-rate mortgages and the like accounting for a significantly larger share of a market that comprises 45 percent of total nonfinancial debt, borrowers—individual Americans—will increasingly feel the heat. It is not just the mortgage market that has been affected. According to Bankrate.com, by early 2006, approximately two-thirds of all credit cards carried variable interest rates, a noticeable increase from the 55 percent level only 12 months earlier.
As lenders aggressively courted business with an almost singular focus on generating fees and turnover, many invariably acted foolishly. The Federal Bureau of Investigation, for example, estimated that lenders had been ripped off to the tune of $1 billion in mortgage-related fraud in 2005 alone. Still, there were plenty of willing participants in the ever-expanding credit bubble, many of whom already found themselves under the gun even before things began to unravel. By 2005, for example, there were more than two million bankruptcies, up from 616,000 in 1989, though the surge was certainly abetted by a rush to file ahead of October’s implementation of the extremely debtor-unfriendly Bankruptcy Abuse Prevention and Consumer Protection Act.
Homeowners and consumers were not the only ones who leveraged up—corporate America did the same, though many businesses were also Benefiting from what William “Bill” Gross, chairman of bond fund powerhouse PIMCO, called the “finance-based economy.” During 2005, gross issuance of international bonds and notes by U.S. entities rose by 8 percent to $836 billion, while net issuance increased almost threefold to $114 billion, according to the Bank for International Settlements. In contrast, reported The Economist, the profits of financial firms in America had risen from 4 percent of the overall total to more than 40 percent since 1982, with the industry accounting for almost 25 percent of total stock market capitalization.
The corporate side also benefited from the frantic urge to boost volume that was rippling through the consumer lending market, with creditors falling over themselves to offer overly generous terms and conditions. In April 2006, for example, the Wall Street Journal reported that lenders were mandating fewer covenants— performance hurdles—for business borrowers to clear. Such accommodation helped boost the annual rate of growth of nonfinancial company borrowing to its fastest pace in five years.
Meanwhile, borrowing for speculation, investments, arbitrage, and corporate finance–related activity had been growing sharply as well. In sophisticated, lightly regulated, and often actively traded investment pools known as “hedge funds,” assets under management, often boosted many times over through aggressive leverage, were estimated to have reached $1.5 trillion for the entire industry.
Activity was also surging in the “private equity” sector, which used large dollops of borrowed money to acquire what were deemed to be undervalued companies. During early 2006, according to Forbes, 2,700 funds were raising half a trillion dollars to invest, which could then “bankroll them for $2.5 trillion in deals, given their penchant for putting $4 (or more) of debt leverage atop every dollar they put in.” Intense competition also forced many to lower their standards, with some evaluating and accepting deals on multiples of seven times EBIT—earnings before interest and taxes—versus multiples of four or five only a few years earlier.
Wall Street firms and traditional lenders, of course, were reaping the rewards of the borrowing boom, especially in the real estate sector. By 2005, mortgage-related activities accounted for a record 62 percent of commercial banks’ earnings versus 33 percent in 1987. Financial institutions were heavily geared to the property market in other respects, too. In a spring 2005 speech addressing proposed commercial real estate (CRE) guidance by U.S. banking agencies, Susan Schmidt Bies, Federal Reserve governor, noted that average CRE exposure for certain midsized banks was near 300 percent of capital, a level double that of the late 1980s and early 1990s.
Still, when it came to playing the game of modern-day finance, few firms could match Fannie Mae and Freddie Mac in their use of leverage or their lopsidedly bullish exposure to the fortunes of the real estate market. Together, the two government-sponsored entities, or GSEs, held nearly $1.5 trillion in loans and mortgage-backed securities and guaranteed $2.4 trillion of MBSs owned by banks and other investors as of the first quarter of 2005. This created tremendous vulnerability in the financial system. Some banks, for example, had exposure to Fannie and Freddie securities amounting to more than 100 percent of their capital.
In the public sector, it was not only the federal government and the GSEs that were on a borrowing spree. During 2005, issuance of new state and local bonds hit an all-time high of $405 billion, up 13 percent from 2004, with more than $2 trillion worth outstanding. Indeed, the amount of debt raised in the capital markets in recent years has been staggering. The Bond Market Association, an industry trade group, reported that overall U.S. bond issuance reached $5.52 trillion in 2005, led by a record-setting $1.1 trillion for asset-backed securities such as MBSs.
The problem with all of this borrowing, of course, is that much of it was taken on in the hope that the economy, borrower income levels, or the assets that backed many of the debts would be sufficient to secure repayment. This assumption, as it turns out, will prove seriously flawed.
Chapter 2
“Sooner or later everyone sits down to a banquet of
consequences.”
—Robert Louis Stevenson
By the time all the numbers are tallied and reported, at least some people will paraphrase Shakespeare. They will suggest, with more than a hint of seriousness, that it’s time to “kill all the accountants.”
But those numerate types with the green eye shades won’t be to blame. Rather, it will be leaders of the public and private sectors who put off an accurate assessment of what the future held, even though they knew a day of reckoning would come. When promises worth trillions of dollars made by American chief executives, state and local officials, and politicians in Washington are finally brought to light, figuring out how to pay for them all or, more realistically, how much should be paid will be a truly Herculean task.
Certainly no small number of leaders and policymakers were somewhat aware that a difficult future beckoned. Most private pensions were governed by reporting guidelines and other requirements established under the Employee Retirement Income Security Act of 1974, or ERISA, meaning that a few concerns had already seeped into the open. Moreover, some shortcomings of the federally administered social safety net had been at least partly addressed by the introduction in 1982 of a new payroll tax following concerns raised by the National Commission on Social Security Reform about the system’s going broke.
But few Americans are knowledgeable about the absolute scale of their long-run financial exposure, largely because of the way retirement-related promises had—legally, in most cases—been accounted for in the past.
Historically, pension and other postemployment Benefits, or OPEBs, including medical coverage for retired workers, have barely been acknowledged. Risks and liabilities were frequently buried deep in footnotes or in hard-to-decipher reports and were not ordinarily listed as line items in financial statements. Aside from being “off balance sheet,” many of the liabilities were obscured through the use of nebulous accounting practices and unrealistic assumptions about future interest rates, investment returns, and health care inflation. Another problem with the vast majority of OPEBs is that they were accounted for on a pay-as-you-go basis, where only current-year program revenues and expenses were recorded. That made it difficult to grasp the full extent of what is referred to as the “Benefits gap,” or the difference between the present value of what had been promised versus what had been set aside.
But in the post-Enron era, there is a growing —though admittedly not altogether successful— emphasis on illuminating what was once obscured. That view took on greater urgency with the prospect that poor investment returns following the collapse of the 1990s stock market bubble might add to existing shortfalls.
At the municipal level, where a history of financial opacity and a never-ending series of blue-sky promises have been the norm, the need for change was obvious. For politicians who often measure careers in two-or four-year cycles, trading “free” promises involving pensions and other long-term Benefits to unionized public sector workers in exchange for lower but politically palatable pay increases was usually too good an opportunity to pass up.
When the Government Accounting Standards Board (GASB) amended its rules in 2004, however, it created a ticking time bomb. GASB 45 mandated that governments and agencies, in a staggered rollout beginning December 15, 2006, estimate the “actuarial liability” of their OPEBs—the net cost in current dollars— and the amortized equivalent over 30 years. Suddenly, decades of generous promises would be placed under a harsh light—and the results were not going to be pretty. Based on early estimates, the annual costs of postretirement health care Benefits could turn out to be up to 20 times as large as expected. According to one expert cited by the New York Times, the tab for all state and local governments will be as much as $1 trillion.
Add to that more than $300 billion—or, according to Barclays Global Investors, $800 billion if more conservative private-sector accounting methods are used—of underfunded municipal pension plans. Nearly all of these plans are traditional defined-Benefit schemes under which retirees are guaranteed a set payout for life and sponsors bear the investment and other risks.
In one fell swoop, the financial health of state and local government will have taken a gargantuan turn for the worse, and talk of a massive taxpayer bailout will increasingly fill the air. This will lay the groundwork for a firestorm that will only be made worse by a crumbling economy, unraveling financial markets, and fewer new workers replacing older ones. Already stretched precariously thin in many locales, municipal finances will come under relentless attack as state and local government authorities are forced to take such drastic steps as cutting spending, raising taxes, and attempting to borrow additional funds. The sum of these endeavors will come to naught.
While revelations about the financial position of state and local governments will be a growing cause for concern, awareness of an even greater threat will finally dawn on investors, foreigners, politicians, and individual Americans after years of largely ignored warnings: U.S. government finances are also in a complete shambles.
Much of the problem stems from a failure of leadership and the inherent flaws of a system where politicians must constantly curry favor with special interest groups. Still, the nation’s demographic profile certainly made matters worse. Americans have been growing old quickly, and 78 million baby boomers will soon draw upon the wealth of younger Americans. People are living longer, too; the average life expectancy increased from 75.4 years in 1990 to an all-time high of 77.6 in 2005—two years in less than a generation. By 2030, twice as many people will be 65 or older as there are now. And by 2040, one out of every four Americans will be in that age bracket.
That means only one thing: barring any dramatic changes in Benefits, the already large cost of the social safety net will expand rapidly. But our means to support it and the working-age population that underwrites it are not growing. In 1942, seven years after Social Security was first established, there were 42 workers for every beneficiary. By 2002, the ratio was down to 3.3, and by 2030, it is expected to drop by another 50 percent to 2.2.
Municipal finances will also feel the strain of an aging population. So will private-sector pension plans, especially in industries such as steel, autos, utilities, and airlines, which once employed hundreds of thousands of workers.
For many people, hardest to swallow will be the realization that American prosperity is no longer limitless. A number of safety-net commitments began when the United States and much of its industry were market leaders and world beaters. Back then, a majority of Americans accepted that the wealth of the nation should not only be shared with those who helped create it but also with those who were less fortunate. Before Medicare was established in 1965, for instance, many older Americans found it difficult to cover the cost of health care, and widespread sentiment held that society owed them more for their troubles. In recent years, however, actuaries have increasingly warned about the rapidly rising cost of entitlement programs, such as Social Security, Medicare, and Medicaid, the largesse of which have grown over time.
Undoubtedly, complacency has played a part. The United States has successfully weathered other so-called fiscal storms in The Retirement System 19 the past. America thrived in the years leading up to 2006, even though we consumed far more than we produced and spent much more than we earned. But as the economic and financial tide turns, what had once fallen on deaf ears will almost certainly turn deafening—and investors, businesspeople, foreigners, and many others will grow increasingly fearful.
In 2006, University of Pennsylvania risk management professor Kent Smetters and Jagadeesh Gokhale of the Cato Institute estimated that, because of entitlement programs, the gap between projected federal spending and income might be as high as $65 trillion. Economist Laurence Kotlikoff puts the total of unfunded liabilities nearer to $80 trillion, over seven times the value of the gross domestic product (GDP), the nation’s output of goods and services. To make up the difference, Smetters and Gokhale have warned that Social Security and Medicare payroll taxes would “need to double immediately,” according to the Christian Science Monitor. The problems will grow even more intractable if health care spending exceeds the nearly 10 percent annual increases of recent decades, or if Washington adds other entitlement programs, such as the Medicare prescription Benefit, which alone contributed more than $8 trillion to the total.
These numbers do not even take into account that Social Security has not been treated as the discrete “trust fund” many assume it to be. Rather, it has generally been viewed as just another taxpayer cash cow that could repeatedly be tapped by lawmakers in exchange for government IOUs that obscure the true state of the nation’s budget morass. If Washington reported the finances of the United States using Generally Accepted Accounting Procedures— the methodology that public companies are required to use—instead of recording a $318 billion deficit in 2005, the federal budget gap would have been $3.5 trillion, or more than ten times as much, according to USA Today.
Hence, when the same newspaper noted that “[t]he nation could soon face its worst fiscal crisis since at least 1983, when Social Security bordered on bankruptcy,” the federal entitlement system clearly had become a cancer, growing more dangerous with each passing year. Standard & Poor’s warned, in the summer of 2006, that if current fiscal trends prevail, the U.S. sovereign credit rating could easily decline from AAA to A or BBB in the decade ahead.
Yet efforts at reform, including attempts by the George W. Bush administration to privatize Social Security, have gone nowhere. This failure partly reflects the reality that those who benefit from an all-encompassing social safety net are growing in numbers— and political clout.
Ironically, the retirement-related concerns in the private sector seem almost inconsequential in comparison. Nonetheless, they are another layer on an ever-growing fiscal disaster, a burden that must ultimately be paid for in one way or another. Like the public sector, corporate America has significant exposure to retiree health care costs. According to one estimate, two-thirds of the S&P 500 companies have some OPEB obligations, to the tune of about $300 billion—in addition to $150 billion of underfunding for employee pensions. At one company in particular, the numbers are indeed astonishing. As of early 2006, General Motors’s unfunded pension promises were estimated to be as much as $31 billion—despite the company’s claims to the contrary—while other postemployment Benefits were thought to total more than twice as much, or $70 billion, according to some analysts.
Despite the similarities, there is a key difference between corporate America and the public sector when it comes to retirement-related liabilities. The private sector generally has more freedom to deal with future promises. It can alter the terms, either by watering down Benefits or eliminating so-called perks like health care coverage for retirees. Companies can also “freeze” plans so that current employees cannot accrue any more Benefits than they already have.
Many firms have shifted away from defined-Benefit plans altogether in favor of others, such as 401(k) plans. Named after a section of the Internal Revenue Code and first introduced in 1979, 401(k) plans are a tax-deferred savings scheme that companies The Retirement System 21 have readily adopted as a “defined-contribution” alternative to traditional pensions. Under such an arrangement, the amount of money paid into the plan, rather than the payouts at retirement, is fixed. In essence, investment, actuarial, and other risks are shifted from the sponsor—in most cases, the employer—to the employee.
As with the broad shift to floating-rate borrowing fostered by mortgage and other lenders, the rise of 401(k) plans indicates that ordinary Americans have increasingly begun to shoulder risks traditionally assumed by businesses and governments. By cutting Benefits and moving away from defined-pension arrangements, a sizable slice of corporate America moved large numbers of employees into programs that are far less costly for the corporate bottom line. In 1985, there were approximately 22 million active participants in single-employer defined-Benefit plans. Seventeen years later, there were 5 million fewer, despite the fact that the overall U.S. workforce had increased significantly.
Many companies with traditional defined-Benefit plans are dumping them onto the Pension Benefit Guaranty Corporation (PBGC). Once used solely as a last resort, shedding retirement obligations is now viewed as just one of many strategic options. Established in 1974 under ERISA following several high-profile Benefit program failures, the self-funded PBGC was envisioned as a government-sponsored insurance backstop to protect workers. Like many such programs, however, it had inherent structural flaws and unintended consequences. For one thing, the existence of the PBGC contributed to what is known as “moral hazard.” Many companies offered retirement Benefits that were overly generous and unsustainable in the long run, knowing full well that if the burden eventually became too great, they could walk away from their obligations and let others clean up the mess.
The fees that the Pension Benefit Guaranty Corporation charged also turned out to be too low, given the risks involved. Following several large corporate failures, including United Airlines, which swamped the agency with liabilities, PBGC found itself $23 billion in the red at the end of 2005. By some estimates, that amount could exceed $100 billion over 20 years in the absence of dramatic changes. Even that figure may be optimistic. At the end of 2004, the PBGC calculated that America’s single-company defined-Benefit plans were underfunded by as much as $450 billion, with nearly $300 billion of that total not reflected on company balance sheets, compared to a deficit of $164 billion only three years earlier.
Although the PBGC is not explicitly backed by the government, the federally sponsored agency’s insolvency would not necessarily eliminate the problem. Most observers expect that the pension insurer would have to be bailed out despite the political fallout.
Private-pension accounting also has a number of shortcomings, and it has become increasingly obvious that many companies offering such plans have been gaming the system for years. They either assumed that they would earn higher rates of return on their portfolios than was reasonable or underestimated the effects of inflation. Incredibly, some companies borrowed money when interest rates were near their lows after the stock market bubble burst and managed to convert the financing into an instant arbitrage profit. How? They assumed they would earn more on their investments than the interest they would have to pay out on the loans. Under the regulations, they could immediately book the difference as income.
Pension accounting rules also allowed companies to “smooth” returns to avoid creating excessive volatility in reported results. While the allowance had practical value, the methodology tended to obscure the poor state of many plans, especially following the collapse in share prices after March 2000.
This was one reason why the Financial Accounting Standards Board (FASB) stepped in. Similar in scope to the role of its sister agency, GASB, in setting state and local government accounting protocols, FASB decided to rework the rules to provide more insight into corporate America’s financial condition. The effort would be a two-stage process. The first step, effective December 15, 2006, requires companies to shift details on the net exposure The Retirement System 23 of pension and other postemployment Benefit programs from the footnotes to the balance sheet, directly impacting reported net worth, or assets minus liabilities.
Although in theory there will be no new revelations, the FASB rules will make the data more readily accessible. The hope is to cast a brighter light on poor planning and potential trouble spots. However, the sudden realization that many leading companies are in a precarious financial condition—which, again, should not be a surprise—will likely add to the pressures felt everywhere else. Investors will realize—belatedly—that numerous leading blue-chip companies are more or less insolvent.
The second of the proposed changes in pension accounting rules will be more wide ranging and controversial. Once fully in place, the amendment will bring a measure of consistency to the many assumptions that companies make about their pension plans and will likely phase out the smoothing of portfolio returns.
Taken together, all of the new rules will almost certainly have severe repercussions for the bottom line of many companies.
The accounting overseers aren’t the only ones making adjustments. In the summer of 2006, Congress and the Bush administration passed a 907-page pension reform bill spurred in part by the widely publicized losses at the PBGC and growing pressure for more accountability. But rather than strengthening the system, many observers believe the measure will do the opposite. Whether the changes will still allow too many loopholes for pension chicanery or spur companies into watering down or eliminating retirement programs, the eventual fallout will only add to the strain on the pension guaranty system and leave more Americans at risk during their twilight years.
For the defined-Benefit plans that remain in force, some proposed changes could trigger collateral damage. Budgeting pressures may inspire some pension managers to adjust the mix of assets in their portfolios to reduce swings in net exposure. According to the Committee on Investment of Employee Benefit Assets, the wholesale switch from a smoothing of returns to “mark-to-market” methods, where portfolios are valued based on current prices, could eventually cause $290 billion to be shifted from stocks to bonds, triggering shock waves in both markets. In addition, growing cost pressures will no doubt force many companies to further pare health care and other Benefits for retirees and current workers. Increasing numbers will also rely on “financial engineering” strategies or the bankruptcy courts to transfer their existing burdens onto the PBGC or employees.
While some companies will improve their outlook, the overall picture will likely grow worse. Although individuals will have a greater say in their retirement, they will, in reality, have less control over their destiny. One reason is that few people will have much to work with. According to a May 2005 report in the Washington Post, “The median account balance of 401(k) and individual retirement accounts combined . . . for households headed by individuals on the verge of retirement [was] $10,000.” That is—and will be—a far cry from what they would need to live on without other income, such as from a traditional defined-Benefit pension, to supplement it.
Many Americans will likely struggle to keep working well beyond the traditional retirement age, or they will try to turn to an overstretched or already failed social safety net for help. Some may have nowhere to go. Meanwhile, faced with a broad array of pressing financial concerns, state and local governments, as well as the federal government will also look to dump some of their no-longer-tenable promises. In the spring of 2006, the Wall Street Journal noted that many states had implemented rules requiring health insurers to cover the adult children of members still living at home. Massachusetts, meanwhile, introduced statewide health insurance funded by a mandatory fee on employers and individuals.
But in the end, such measures won’t bridge the gap. They will merely shift a portion of the burden to a different spot, like the air in a squeezed balloon. As the pressures from an unwinding debt bubble, a falling housing market, and a collapsing economy continue to grow, the retirement system and other wobbly towers of promises-to-be-broken will soon come tumbling down.
Chapter 3
“The
only sure thing about luck is that it will change.”
—Bret
Harte.
In 1968, Vermont enacted a ban on billboards and roadside advertising to protect its scenic views. According to the Concise Encyclopedia of Economics, one consequence “was the appearance of large, bizarre ‘sculptures’ adjacent to businesses.” These included a 12-foot tall, 16-ton gorilla clutching a real Volkswagen Beetle placed next to a car dealer, and a 19-foot genie holding a rolled carpet as he emerged from a smoking teapot, which was erected near a store that sold floor coverings.