Month: July 2018

InnOvation Capital & Management, LLC

IntelDigest

LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR

JULY 25, 2018

 

Contact Richard Power with comments or questions.   IntelDigest  is intended for the use of our clients and colleagues.  Material may not be reproduced, forwarded or shared without express permission.

 

 

Well, if you’re not thoroughly depressed by the discussion of “unfunded liabilities” last week, we will continue our series on  Debt  in this issue of  IntelDigest.

We have laid out the facts on the subjects of corporate  Debt and government  Debt.   We’ll talk about personal Debt today … Student Loan Debt, Consumer Debt, and Auto Loan Debt.  We begin with student loans, which will probably constitute the next “subprime” crisis.

 

Student Loans

Student Debt  is at record levels, amounting to more than $1.5 Trillion!  That is the second-largest source of household debt after home mortgages.  Much of the  Student Debt  has accumulated in recent years … total indebtedness doubled from 2009 to 2016.

The average college student graduates with more than $30,000 in  Debt, and typically racks up another $6,000 in credit-card  Debt in just a few years after graduation.  Compare that to median earnings for Americans aged 25-34 … $36,000-$40,000.

That means that many recent college graduates begin their adult lives with a personal debt-to-income ratio close to 100%!

The level of  Debt  assumed by our youth threatens to become another catastrophic bubble in the American economy.  This burden causes borrowers to forgo spending and other forms of borrowing, which restrains our economy.

One in every four borrowers is delinquent or in default;  42% of federally-owned student loans are not being repaid as expected or on-time.

According to the Wall Street Journal, 33% of student loans are held by subprime borrowers.  It is projected that as many as one-third of college graduates will likely default on their loans.

 

Consumer Debt

The Debt Crisis goes far beyond student loans and home mortgages.  American consumers now owe more than $1 Trillion on their credit cards, which carry interest rates as high as 15%, 20%, even 28%!

The Center for Microeconomic Data (CMD) Quarterly Report on Household Debt and Credit recently reported that:

“… total household debt reached a new peak in the first quarter of 2018, rising $63 billion to reach $13.21 trillion. Balances climbed 0.6 percent on mortgages, 0.7 percent on auto loans, and 2.1 percent on student loans this past quarter, while they declined by 2.3 percent on credit cards.

“Aggregate household debt balances increased in the first quarter of 2018, for the fifteenth consecutive quarter, and are now $526 billion higher than the previous (2008:Q3) peak of $12.68 trillion. As of March 31, 2018, total household indebtedness was $13.21 trillion, a $63 billion (0.5 percent) increase from the fourth quarter of 2017. Overall household debt is now 18.5 percent above the 2013:Q2 trough.

“Mortgage balances, the largest component of household debt, increased somewhat during the first quarter. Mortgage balances shown on consumer credit reports on March 31 stood at $8.94 trillion, an increase of $57 billion from the fourth quarter of 2017.”

 

Auto Loans

Most people have no idea how pervasive subprime loans have become in auto lending.

In the Good Olde Days, auto lending was a simple and safe business, just like home mortgage lending.  Local and regional banks (or finance companies) would provide loans to customers having good credit and a substantial down payment. The term of the loan wouldn’t exceed the useful life of the car.

Under these conditions, auto loans were extremely low-risk. Historically, losses on auto loans were extremely low … less than 2%.  Even during the Great Depression, auto loans performed well.

The Auto Lending train went off the rails around 2011, when Wall Street firms started buying up auto-lending groups.  They changed the terms:  extending auto loans up to 84 months, lowering down payments (on leases, they’re next to nothing), and radically lowering the credit scores required to qualify.

Now, more people than ever before are borrowing money to buy cars.  Americans now owe more than $1 Trillion on auto loans.  More than 40% of the adult population has an auto loan, some at interest rates are as high as 20%.  Nonprime, subprime, and deep-subprime borrowers owe 37% of this Debt.

And, increasing amounts of subprime auto loans are being securitized and sold to other investors, just as happened with home mortgage lending in the years leading to the 2008 Financial Crisis.   Securitization  moves credit risk away from the car companies and finance companies, directly into the laps of investors.

As we all experienced during the 2008 housing bust, subprime lending becomes a major problem for the economy when it comprises too great a share of total lending.  Overall credit quality can collapse.  That scenario is playing out now in the auto loan business.

 

Summary

The United States has become the largest debtor in human history … such a  Debt Burden  is a poor legacy to leave for our children and grandchildren.

Too many Americans now die in debt, leaving burdens on the next generation and raising the likelihood of another Great Recession, or full-blown Depression.

Massive amounts of  Debt  now rest on the shoulders of the poor.  The debt load for the poorest 20% of Americans is up nearly 300% in the past 20 years.

Debt  of this magnitude cannot be financed normally.  Debt  that can’t be paid won’t be paid.  An entire generation of young Americans will suffer … many will have no hope of affording the “American Dream.”

 

Innovative solutions will be vital to our economy.  A number of writers are seriously contemplating a national “Debt Jubilee” … a mass forgiveness of  Debt, which would be a body-blow to lenders and other investors.

If things get that bad, we’ll tell you all about it in  IntelDigest.

 

 

 

InnOvation Capital & Management, LLC

IntelDigest

LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR

JULY 18, 2018

 

Contact Richard Power with comments or questions.  IntelDigest  is intended for the use of our clients and colleagues.  Material may not be reproduced, forwarded or shared without express permission.

 

We continue the “Summer of Debt” … actually, it’s just our series on  Debt, and the many problems coming to our economy as a result of  Debt … in this issue of  IntelDigest.

This week, we will address specific aspects of U.S. government obligations. Next week, we will discuss individual  Debt, including mortgages, credit cards, student loans, et al.

As we wrote last week, government borrowing has reached historic levels. Today, the U.S. government owes more than 21 Trillion Dollars.  As of today, the number is approximately $21.2 Trillion, equal to about 105% of Gross Domestic Product (GDP).

Add in state and local debt, which amounts to another $3.1 Trillion … the total government  Debt  in the U.S. currently stands at $24.3 Trillion, more than 120% of GDP.

However, those Trillions of Dollars represent only the “official, on-the-books” Debt.

 

Unfunded Liabilities

The “official” federal  Debt  does NOT include “Unfunded Liabilities” … promises made to many people WITHOUT putting aside money to pay for those promises.  In fact, Uncle Sam has made many many promises to many many people, with little regard for its future ability to fulfill them.

These, too, represent  Debt  of the federal government, piled atop obligations already appearing on the national balance sheet.  Worse, generations of American citizens have planned their retirements based on the government fulfilling those promises.

What happens to millions of our citizens If those promises are not met?

 

Social Security and Medicare

You may be thinking, “wait a minute … Social Security and Medicare have been funded through payroll contributions by both employers and their employees.  What about the trust funds full of those contributions?”

Those “trust funds” are really just an “accounting fiction.”  Social Security and Medicare tax payments are deposited in the general fund of the United States, and the government leaves an IOU in the “trust.”

Think of it this way:  You have saved $100,000 for your child’s college education.  BUT, you have borrowed all that money to pay for your car or mortgage or vacations.  You can pretend that the money is still there to pay for future college costs, but what do you do when the first tuition bill comes in?  You will have to make college payments out of your then-current income stream, or liquidate other assets.

That, in a nutshell, is the government plan for paying future Social Security and Medicare benefits.

It is true that the dedicated revenue streams from payroll taxes, and premiums paid in by Medicare recipients, have covered current expenditures to date, and built up some reserves,  However, those income streams are about to go negative.  Going forward, current income will not be enough to pay all current benefits.

With both programs going into negative cash flow, the U.S. Congress must now take action to provide additional cash to pay the promised benefits.  The annual trustee report has estimated that Social Security will run out of reserves in 2034, and the hospitalization part of Medicare will go dry in 2026.

 

The Semantics of Assumptions

Having already “borrowed” all the money in the Social Security and Medicare trust funds, the federal government is being disingenuous in projections of “running out of reserves” in 2034 or 2026.  The government has already used all “reserves,” and will have to pay future benefits out of then-current income.

But, as an academic exercise, let’s play the “assumptions game.”  How did the government determine that the Social Security “reserves” will last until 2034, and Medicare reserves until 2026?  These estimates are based on lots of assumptions.

To estimate revenue, government economists must know how many workers are in the United States, their wages, and at what rates those wages will be taxed.  To estimate expenses, they must know how many retirees will be drawing benefits, the amount of those benefits, and how long the retirees will live to receive them.  They also have to assume an inflation rate on which the cost-of-living adjustment is based.  A small deviation in any of those can have huge long-term consequences.

The government estimates that Social Security has a $13.2 Trillion unfunded liability over the next 75 years.  That is the amount of benefits which the government expects to pay, minus the revenue expected to come in.

Medicare projections require even more assumptions:  what kind of treatments the program will cover, how much treatment senior citizens will need, and what those treatments will cost.  All these could vary wildly, but the “official” assumptions put the Medicare 75-year unfunded liability at $37 Trillion.  It could be vastly more.  Or, if medical science finds ways to keep us healthier in the future, then healthcare costs could be less, as could the total unfunded liability.

But, the current assumptions indicate total unfunded liabilities of approximately 50 Trillion Dollars!

Of course, this scenario depends on government assumptions being spot on (unlikely), and the United States averting wars and other political conflicts which could blow these assumptions out of the water!

Economist Laurence Kotlikoff and financial columnist Scott Burns addressed these issues in their book, The Clash of Generations: Saving Ourselves, Our Kids, and Our Economy.  They take a rather dim view of our elected representatives, writing that the “… only truly bipartisan cooperation in Congress is that both sides lie.”  And, that any time a politician talks about putting a “lock box” around Social Security or Medicare trust funds, he or she is either staggeringly ignorant or lying.

By the way, Professor Kotlikoff estimates the unfunded liabilities to be closer to $210 Trillion!

 

Summary

So, at a minimum, we can probably assume that Social Security and Medicare add another $50 Trillion of Debt on top of the $21.2 Trillion (and growing) on-budget federal  Debt.

By the way, none of the foregoing discussion includes civil service or military retirement obligations, or the federal government backing for some private pensions under the Pension Benefit Guaranty Corporation, or open-ended guarantees like FDIC, Fannie Mae, et al.

What solution will Congress provide for angry retirees who think they have already “paid” for their benefits?  Can they make strategic modifications (benefit cuts) to these so-called “entitlement” programs to extend their efficacy?

In reality, arguing over whether it’s a $50 Trillion or $200 Trillion problem is pointless.  Congress will have to act … rather sooner than later … to cut spending or raise taxes, or some combination of both.

 

 

 

InnOvation Capital & Management, LLC

IntelDigest

LAW – POLICY – FINANCE – MARKETS
INFORMATION FOR THE ENTERPRISE AND INVESTOR

JULY 11, 2018

 

Contact Richard Power with comments or questions.   IntelDigest  is intended for the use of our clients and colleagues.  Material may not be reproduced, forwarded or shared without express permission.

 

We continue our series on  Debt, and the many problems coming to our economy as a result of  Debt, in this issue of  IntelDigest.

As we have written in recent weeks,  Debt  has been much too easy to amass over the last 20 years.  It has artificially boosted asset prices, and will become a serious drag on growth in the near future.

Making matters worse, many lenders (investors) are now more highly leveraged than they were ten years ago.  Many have bought their corporate bonds with borrowed money, confident that low interest rates and low defaults would keep risks manageable.

 

Rolling Over the Debt

According to Wells Fargo Securities, Four Trillion Dollars of bonds in the U.S. must be refinanced over the next five years.  This amounts to over 65% of all outstanding corporate debt in this country.

Investors would be justifiably concerned … combine unprecedented amounts of borrowing with interest rates rising steadily, and corporate balance sheets approach a tipping point.

As our economy enters recession, many companies will lose their ability to service their debt.  Several Trillions of Dollars of corporate Debt are scheduled to “roll over” in the next few years.  As interest rates rise, that Debt becomes more expensive to extend.

When companies can no longer service their  Debt, they have to cut back.  They will do so by laying off workers, reducing inventory and investment, or selling assets.  All of these actions reduce growth.  If reductions spread across the country, we get economic contraction, and  Recession.

 

The Scourge of Debt

Taxation is an arrangement by which government takes money from our pockets … theoretically, to provide services for our benefit.  However, when government incurs  Debt, it is taking from our children and grandchildren.

Government borrowing has reached historic levels.  Today, the U.S. government owes more than 21 Trillion Dollars.  That is approximately $180,000 for each American taxpayer.

A 2014 Harvard study provides perspective on the problem (dollar figures have been updated to 2018 levels):

If the federal government provided NO operations, and spent its annual revenues exclusively on debt reduction, it could pay down its debt in three or four years. Or, the government could pay down the debt in one blow if it simply took more than $65,000 from every person living in the U.S., including children, the elderly, and the unemployed.  (As mentioned above, the figure would be approximately $180,000 per taxpayer, if children and the elderly would get a pass).

If the government had to pay even 6% interest on its debt, it would cost roughly $1.2 Trillion per year.  And, that’s just to pay the interest on the debt.  The entire government brings in approximately $3.3 Trillion in taxes every year.

 

Debt Addiction

Adding up all of our government, corporate, and consumer debt, America owes roughly $70 Trillion … that would be approximately $836,000 per American household

This is truly a “debt addiction.”  Instead of learning from the mistakes that crippled our economy in the 2008 Financial Crisis, the U.S. has created more bubbles which have the potential to implode our economy.

The largest threat is the U.S. corporate bond market, particularly junk bonds.
There has never been a bigger bubble in U.S. bonds.

In recent years, the difference between the yields on junk bonds and the yields on investment-grade bonds has been very small.  Credit was more available than almost ever before for small, less-than-investment-grade companies.  The last time that credit was that widely available … at such low costs … was 2007.

We know where that led.

A collapse of the bond market in the next two years would be far worse than the 2008 Financial Crisis.  U.S. monetary policy since 2008, as implemented by The Federal Reserve (The Fed), has featured ultra-low interest rates and The Fed spending Hundreds of Billions of Dollars to purchase Treasury securities and mortgage-backed debt.  This has driven the huge Bull Market in bonds.  As The Fed bought bonds, bond rates fell, forcing other buyers of bonds to buy riskier debt which (historically) offered much higher yields.

When panic hits the corporate bond market … perhaps as early as next year … the average price of non-investment-grade debt (junk bonds) could fall as much as 50%.  Investment-grade bonds would also take a tumble, perhaps by 25%.

This would wipe out a huge amount of capital.  Junk Bond expert Martin Fridson has projected that $1.6 Trillion of bonds and loans will default.  That would be three times as many debt issuers as defaulted in the last recession.

This would have already happened, according to Fridson, but the government has kept interest rates artificially low, making it possible for many at-risk debt-issuers to refinance their debt at a lower interest rate.  That delayed an inevitable wave of defaults in the junk- bond industry, but only temporarily.

 

Exit Strategy

Right now, it’s better to have a defensive mind set than an offensive one.

We will reiterate our opinion on the markets, which we have stated on several occasions … it is important to devise an Exit Strategy for each and every asset in your portfolio.  We recommend establishing a Stop Loss level for each asset;  the Stop Loss is the exit price where you will sell your position if the price drops that low.  The Stop Loss can be a specific dollar price, or a percentage loss from the highest price which a stock has attained.

By setting Stop Losses and executing them without emotion, one can methodically cut losses, while allowing winners to ride.

 

More on the coming  Debt Crisis  next week.