Category Archives: Finance

Reader Alert: Another Jeremiad about Debt and Risk

Richmond Fed "Bailout Barometer" -- federal backing of total U.S. debt   increased another 0.7% in 2015 to reach almost 61%.

Richmond Fed “Bailout Barometer” — federal backing of total U.S. debt increased another 0.7% in 2015 to reach almost 61%.

Holman W. Jenkins, Jr., at the Wall Street Journal reminds us how countries around the world, including the United States, are doubling down on debt to stave off recession:

The Richmond Fed’s “bailout barometer” shows that, since the 2008 crisis, 61% of all liabilities in the U.S. financial system are now implicitly or explicitly guaranteed by government, up from 45% in 1999.

Citigroup estimates that the top 20 advanced industrial economies, in addition to their enormous, recognized public debts, also face unrecorded additional debts of $78 trillion for their unfunded pension systems.

Six years after a crisis caused by excessive borrowing, McKinsey estimates that even visible global debt has increased by $57 trillion, while in the U.S., Europe, Japan and China growth to pay back these liabilities has been slowing or absent.

No one likes recessions but they serve a useful purpose — they wring bad investments out of the economy and reallocate resources to more productive uses. But that’s not much consolation to a laid off Intel employee in the U.S. or a laid off cement-plant worker in China. So, politicians and central bankers around the world are doubling down on variations of the same strategy of spending, borrowing and financial repression (driving down interest rates to transfer wealth from savers to debtors) to perpetuate economic growth. When countries start experimenting with negative interest rates, the consequences of which no one can predict, you know that policy makers are desperate.

The global economy is entering a new phase: the end game in which democratic welfare states struggle to maintain massive entitlements in the face of aging populations and slowing economic growth. The United States is not as far down this road as some other countries, but absent major policy changes, deficits and the national debt are heading inexorably higher. Don’t believe me — believe the Congressional Budget Office.

Meanwhile, the four leading contenders for U.S. president are advancing platforms totally disconnected from reality. The cost of Bernie Sanders’ programs, if implemented, would cost $18 trillion over ten years, estimates the Wall Street Journal. Donald Trump’s tax-cut plan would cost $9.5 trillion over 10 years, says the Urban-Brookings Tax Policy Center, while the Ted Cruz tax plan would cost $8.5 trillion, according to the same group. The least fiscally irresponsible candidate, Hillary Clinton, would expand government spending by a mere $1 trillion over ten years, according to the McClatchy news organization

We can argue about the biases of the groups crunching these numbers, but that would miss the point. The odds are overwhelming that the next president of the United State will not be remotely serious about balancing the budget. Liberals argue that bigger spending can be paid for with taxes on the rich with little or no adverse impact on the economy, and conservatives can argue that the “dynamic” effects of tax cuts will stimulate economic growth and bring in more revenue than static models would indicate. Yeah, right.

Hither Virginia? There is little that Virginia can do to buffer its economy from these national and international trends, nor can state and local governments insulate themselves from collapsing tax revenue in the next recession. But they can protect themselves by maintaining AAA bond ratings and putting their public pensions on a sound footing so that when the crunch does come, they will be better positioned to meet long-term obligations without debilitating tax increases.

I am particularly worried about two categories of state-local debt. The first category is university debt backed by revenue from students. The higher ed bubble is unsustainable even during a period of modest economic growth. A recession will leave many institutions destitute, and a Boomergeddon-scale calamity could leave the entire industry in a shambles. A second category is debt taken on for “economic development” projects like sports stadiums, convention centers, golf courses, and other glittering objects that are best paid for by private investors trained in analyzing risk.

You can add a third category of long-term obligation: maintaining transportation services such as Washington-area metro, Virginia Beach light rail, Richmond bus rapid transit, and the like, which will require government subsidies in perpetuity. Could local governments support those services in a severe revenue downturn? Doubtful. Likewise, I am suspicious of toll-backed highway bonds assuming long-term traffic growth even as the evolution to more dense, mixed-use communities scrambles traditional commuting patterns, and as Uber, Lyft, Bridj, transportation-as-a-service enterprises, and self-driving cars seem destined to radically alter Americans’ driving habits.

Nassim Nicholas Taleb writes about building “anti-fragile” enterprises and institutions — entities that are not merely resilient in the face of massive adversity but can thrive in adversity. Virginia can become anti-fragile if state and local governments, in the face of a global economic meltdown, can maintain the ability to provide core government services while other states and metros are falling apart. Talent and capital will migrate to the oases of stability. A handful of states will prosper. Will ours be one of them?

Mala Suerte, Puerto Rico

potential_derelictsby James A. Bacon

The U.S. territory of Puerto Rico, like several American states, has forged a facsimile of prosperity by borrowing and spending beyond its means. Earlier this year, independent bond-issuing authorities began defaulting on their debt. Investors fear the territory will fail to make payments on General Obligation bonds coming due in May and June.

Not surprisingly, Senate Democrats called for bankruptcy protection for Puerto Rico. Every Democrat in the Senate signed a letter in January, calling for “appropriate restructuring tools” available under bankruptcy law that would allow the territory “to respond to [its] economic and humanitarian crisis.” Virginia Senators John Warner and Tim Kaine signed the letter.

longer_range_risks2Congressional Republicans have been trying to devise some other means of devising default. One proposal has been to create a “control board,” which, though lacking the broad bankruptcy authority that territorial officials had sought, would facilitate some debt restructuring. (Bearing Drift has an excellent article describing the thinking of Rep. Rob Wittman, R-1st, who serves on the House Committee of Natural Resources, which has oversight of this issue.) Democrats maintain that tough measures usurping local control smack of colonialism.

All sides agree that there is no easy remedy. Either bond holders get stiffed, rattling municipal markets and creating fallout for the 50 states, or Puerto Rico must adopt draconian policies that will cripple the economy and hurt the poor. There is no happy ending here.

Why should Puerto Rico’s financial woes concern a Virginia-centric blog? Because whatever solution is devised for the territory will set a precedent for future bail-outs and, indeed, could accelerate the coming reckoning with reality of states in terrible fiscal shape like Illinois. Inevitably, there will be calls for more forgiveness in which fiscally disciplined states like Virginia will bail out improvident states.

safe_for_nowMichael Thompson, president of the Thomas Jefferson Institute for Public Policy, makes the following observation in his latest column:

Allowing Puerto Rico the unprecedented power of abridging [municipal] debt will come at a direct cost to Virginia and all the other states that rely on the bond market for financing. Once the market sees that ‘full faith and credit’ protections are faulty, borrowing costs will go up for states in accordance with the increase risk. … Likewise, the value of funds holding this debt, which are found in 401ks and other retirement nest eggs across Virginia and the rest of the country, will be severely shaken.

The importance of Thompson’s insight cannot be overstated: Once bond investors realize that the assurances they thought they were guaranteed are rendered null and void by political expediency, they will demand a risk premium on all other municipal debt. That will hurt Virginia, although probably to a lesser degree than states lacking our AAA rating. What the Senate Democrats overlook is that investors will demand the highest risk premium for precisely those states whose finances are in greatest disarray — the blue states of Illinois, New Jersey and California. A higher cost of debt would make Illinois’ currently perilous predicament even worse.

Now, it’s one thing for Congress to take a hard line toward Puerto Rico, a territory that no one quite considers a part of the United States, and a very different thing to take a hard line on Illinois, which has senators and representatives with voting rights in Congress. Should the unimaginable occur and Illinois default on its bonds, bailing out Puerto Rico will create a precedent that will make it harder to deny Illinois, and any other states that might follow it, similar consideration.

The country will immediately polarize between citizens of states that have acted prudently, made hard choices, and husbanded their resources and states that ducked fiscal reforms and borrowed more. Congress will face a terrible decision: whether to bail out the improvident, thus creating a moral hazard for the very behavior that got those states into the fix in the first place, or to hold the line, at the risk of having state governments failing to perform essential responsibilities, as we have seen, for instance, in the Flint, Mich., lead-poisoning crisis.

This is a litmus test issue for me. Having railed against fiscal recklessness for years only to be told by many that I am an alarmist if not an outright right-wing whackjob, I have zero sympathy — no, in this brave new world of negative interest rates, I have negative sympathy — for any Virginia politician who caves on this issue. I will wage relentless blogfare against anyone who buckles. The spenders and borrowers need to get a strong, in-your-face message that states must mend their fiscal their ways because there will be no succor for them in the future. Tough luck, Puerto Rico. But better you than Illinois.

Buena Vista: the Canary in Virginia’s Fiscal Coal Mine

dead_canaryby James A. Bacon

The City of Buena Vista, which defaulted in 2014 on a $9.2 million bond issue to pay for a golf course that was supposed to spur growth in the city, has received some good news. It will be allowed to keep its city hall. For now. The office building, along with the police station and the golf course itself, stands as collateral on the debt.

Although ACA Financial Guaranty Corp., the bond insurer, still could take possession of city buildings, reports the Roanoke Times, it will not do so any time soon. “ACA is not currently interested in pursuing the option of foreclosing on the deeds of trust securing the bonds,” an attorney for the insurer wrote to the Buena Vista city manager.

The long-running controversy has harmed the ability of Buena Vista, a city of 6,500 in the Shenandoah Valley, to access credit markets. The Virginia Resources Authority recently rejected a request by the city for a loan to upgrade its public water system.

Maybe someone needs to call in Marc Edwards, the Virginia Tech professor who documented the lead poisoning in the water system of Flint, Mich., to make sure Buena Vista’s water is OK. I say that only partly tongue in cheek. The overlooked part of the Flint tragedy is the decades of fiscal mismanagement preceding the city’s takeover by state authorities that allowed the water system to deteriorate.

In Virginia, there is very much the idea that “it could never happen here.” But, in fact, it could, and Buena Vista is a case study. There are many other fiscally challenged cities, towns and counties in Virginia, where the old tobacco-textiles-furniture-and-coal economy has suffered comparable devastation to the Michigan automobile economy. Who knows what kind of hail-mary “investments” other local governments have pursued in desperate bids to revitalize local economies? Who knows the extent to which localities have deferred maintenance on their municipal water systems?

Buena Vista is so small that its plight has escaped the notice of the usual hand wringers, and I haven’t heard of any requests for bail-outs (although that’s not to say Buena Vista hasn’t been quietly looking for help.) At the national level, Puerto Rico is bordering on insolvency, and the entire state of Illinois is close behind. You can be assured that both will ask for help at some point to relieve them from the consequences of their bad decisions and dysfunctional political cultures.

Inevitably, Americans will face cruel choices — either bail out reckless and improvident governments or let their innocent citizens face more Flint-like calamities — and most likely Virginia will, too. To be sure, the Old Dominion’s finances are sounder than those of most states, but they aren’t as sound as we think, and not every jurisdiction has a AAA bond rating like Fairfax County, Henrico County of the City of Virginia Beach.

Are the End of Times Upon Us?

Big hands... Rest easy, America

Big hands… Gog (left), Trump, and Magog

by James A. Bacon

Surely we have reached the end of times of apocalyptic lore when the leading Republican candidate for president flapped his arms during a national debate and assured the American people that not only are his hands of respectable size but so is another part of his anatomy. “I guarantee you, there’s no problem,” said the inimitable Donald Trump last night.

Such is the state of the nation that rather than explicate how he proposed to “make America great again” — beyond building a big wall, bringing in “really great” people, and hammering China, Japan and Mexico on trade — Trump felt compelled to assure the public that the size of his genitalia is something the nation can be proud of.

While Trump is grotesque, he taps into a very real malaise across a broad swath of the electorate. The American people know that something is very wrong, and that the elites have rigged the rules of the game to their favor, although they’re really not sure how. Americans are appalled by political correctness, they’re appalled by Wall Street bailouts, and they’re appalled by big money in politics. They are enraged by the loss of jobs, many of them to competitors overseas, and they are demoralized by the increasingly difficult struggle to maintain a middle-class standard of living.

My argument in Bacon’s Rebellion is that much of this malaise can be traced to the failure of core economic institutions. The health care sector, which comprises close to one-fifth of the economy, is plagued by the poorest record of productivity and quality of any economic sector, making the cost of health care increasingly unaffordable for all. Meanwhile, college tuitions have become even more burdensome, blocking a traditional path to a middle-class occupation. Both sectors have become captured by the leading players — hospitals, insurance companies, institutions of higher education — and are run to protect their interests, not the interests of the public. And don’t get me started on dysfunctional land use patterns, also the playground of special interests, which drive up the cost of housing and transportation.

How these complex systems work is poorly understood, so Trump personifies the enemy as illegal immigrants and Chinese factory workers stealing American jobs, while both Democratic candidates personify the enemy as cops killing innocent black men and deploring the United States as institutionally racist.

There is another contributor to this malaise, also poorly understood: monetary policy. I have addressed it periodically in Bacon’s Rebellion, although I only dimly comprehend the dynamics myself and assuredly speak with no authority on the subject. But Bill Gross, head of Janus Capital Group and one of the leading bond investors in the world, does understand it. And I will let him do my talking for me.

In the current issue of his monthly newsletter, Gross writes the following:

Our global, credit based economic system appears to be in the process of devolving from a production oriented model to one which recycles finance for the benefit of financiers. Making money on money seems to be the system’s flickering objective. Our global financed-based economy is becoming increasingly dormant, not because people don’t want to work or technology isn’t producing better things, but because finance itself is burning out like our future Sun.

What readers should know is that the global economy has been powered by credit – its expansion in the U.S. alone since the early 1970’s has been 58 fold – that is, we now have $58 trillion of official credit outstanding whereas in 1970 we only had $1 trillion. Staggering, is it not? But now, this expansion appears to be reaching an ending of sorts, at least in its current form. Private sector savers are growing leery of debt piled upon debt and government regulators have begun to build fences against further rampant creation. In addition, the return offered on savings/investment whether it be on deposit at a bank, in Treasuries/ Bunds, or at extremely low equity risk premiums, is inadequate relative to historical as well as mathematically defined durational risk. The negative interest rates dominating 40% of the Euroland bond market and now migrating to Japan like a Zika like contagion, are an enigma to almost all global investors. Why would someone lend money to a borrower with the certainty of getting less money back at a future date? …

Negative yields threaten bank profit margins as yield curves flatten worldwide and bank NIM’s (net interest rate margins) narrow. The recent collapse in worldwide bank stock prices can be explained not so much by potential defaults in the energy/commodity complex, as by investor recognition that banks are now not only being more tightly regulated, but that future ROE’s will be much akin to a utility stock. …

In addition to banks, business models with long term liabilities that depend on 7-8% future returns from risk assets are themselves at risk – not necessarily of bankruptcy but future profitability. … Same goes for pension funds. Puerto Rico follows Detroit not just because of overpromised benefits but because they cannot earn enough on their investment portfolios to cover the promises. Low/negative interest rates do that. And the damage extends to all savers; households worldwide that saved/invested money for college, retirement or for medical bills. They have been damaged, and only now are becoming aware of it. Negative interest rates do that. …

In addition, government policymakers seem to be setting up future roadblocks for savers. There is a somewhat suspicious uniform attack on high denomination bills of global currencies. Noted economists such as Larry Summers; respected journalists such as the FT’s Gillian Tett, central bankers such as Mario Draghi – all seem suddenly concerned that 500 Euro or 10,000 Yen Notes are facilitating drug dealers and terrorists (which they are). But what’s an economist/central banker doing opining on law enforcement? It appears that the one remaining escape hatch for ordinary citizens is being closed. Money in a mattress will heretofore be associated with drugs/terror.

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Your Federal Monetary Policy at Work

by James A. Bacon

Pension funds and individual savers aren’t the only groups finding it difficult to generate decent investment returns in the current near zero-interest rate environment. Data gathered from 812 colleges and universities show that participating institutions returned an average of only 2.4% (net of fees) in 2015, contributing to a decline in their long-term, 10-year average return from 7.1% to 6.3%.

“This year’s long-term return figure is well below the median 7.5 percent that most endowments report they need to earn in order to maintain their purchasing power after spending, inflation and investment management cost,” states the press release announcing the results of the National Association of College and University Business Officers-Commonfund study of university endowments’ financial performance.

Investment returns were down for all asset classes: domestic equities, alternative strategies, fixed income, international equities, and short-term securities/cash. This is what comes of a Federal Reserve Board policy of quantitative easing that has driven down interest rates to near-zero levels for more than seven years now. There has been too much money chasing too few sound investments, creating asset bubbles around the world that now are deflating — along with financial returns. While Fed policy benefits the world’s largest borrower, the United States federal government ($19 trillion in debt and counting), it punishes savers, which includes state pension funds, private pension funds, insurance companies, and Americans saving for retirement.

For every percentage point shaved off the interest rate curve, Uncle Sam saves about $190 billion a year. (Other borrowers benefit, too, such as buyers of houses and cars.) But savers are punished. That’s a major reason state pension funds are in crisis. They’re always playing catch-up to ever-falling investment yields.

America’s universities are another victim of Fed policy. Collectively, their endowments hold assets valued at $528 billion. A 0.8% decline in return on investment amounts to $4.5 billion. Translated into Virginia terms, an 0.8% decline in return on the $16 billion in Virginia university endowments amounts to almost $130 million. That’s right, Fed policy is costing Virginia universities $130 million a year — and nobody knows about it, and nobody talks about it.

““FY2015’s lower average 10-year return is a great concern,” NACUBO President and Chief Executive Officer John D. Walda said. “On average, institutions derive nearly 10 percent of their operating funds from their endowments. Lower returns may make it even tougher for colleges and universities to adequately fund financial aid, research, and other programs that are very reliant on endowment earnings and are vital to institutions’ missions. ”

Higher ed bears most of the responsibility for runaway costs and tuition, but it isn’t responsible for declining investment returns. Next year is not likely to get any better. The U.S. stock market is down, international stocks are down, commodity prices are down, and interest rates remain depressed. Even hedge fund managers are losing money.  Most likely, Virginia colleges and universities will take another hit, and it doesn’t take a Larry Sabato to predict that they will respond by boosting tuitions and begging the General Assembly for more money.

Threading the Needle on Long-Term Debt


Graph credit: Virginia Debt Capacity Advisory Committee

by James A. Bacon

Virginia has more than tripled its tax-supported debt over the last decade, according to the December 2015 report of the Debt Capacity Advisory Committee, but the state still has enough capacity to support the issuance of another $603 million per year in added debt in Fiscal years 2016 and 2017 without undermining its AAA bond rating.

Long-term debt is necessary to pay for long-lived assets such as public buildings, university facilities and transportation projects, but higher debt payments, a fixed expense, make it difficult to respond to economic downturns and address other budgetary needs. It has been Virginia’s policy to limit debt payments to 5% of blended revenues.

While other states have been somewhat constrained in their borrowing in recent years, Virginia has continued to add to its debt. Net Tax-Supported Debt (NTSD) as a percentage of personal income increased to 2.8% — higher than the national median and 19th highest among the states.


Graph credit: Virginia Debt Capacity Advisory Committee

Against this backdrop, Governor Terry McAuliffe has proposed issuing $2.43 billion in bonds for higher-ed R&D initiatives, Virginia ports, corrections, state parks and the environment. Assuming the bond issuances are staggered over four years, they would soak up the state’s projected added bond capacity over that period.

Complicating matters, McAuliffe has an appetite for even more spending that requires long-term financing. The administration’s signature transportation initiative is a $2 billion upgrade to Interstate 66, a key transportation artery in Northern Virginia. The project as currently envisioned is dependent upon highly unpopular tolls and toll-backed debt to finance the project. Unless offset by the maturation of old transportation debt, issuing bonds for the project could accentuate the crowding out of other priorities. As the committee report states:

Currently, debt service on debt paid by the TTF (Transportation Trust Fund) exceeds 5% of TTF revenues. Accordingly, to the extent the 5% measure is exceeded, capacity derived from the general fund is being utilized. This does not mean that general fund dollars are supplementing debt service payments on TTF debt; rather, it means that capacity derived from the general fund is being used to keep overall capacity for all tax-supported debt under the 5% target.

The General Assembly money committees have more than budgets to discuss this year.

Slaying the Debt Dragon – or Feeding the Beast?

slaying_debt_dragonby James A. Bacon

There aren’t many things that almost everyone across the ideological spectrum agrees about, but one of them is that indebtedness from student loans is out of control. Here in Virginia, about one million students owe roughly $30 billion, according to the Richmond Times-Dispatch — or about $30,000 each on average.

The loan burdens can be difficult enough for students who graduate with degrees, but the debt can be devastating for those who don’t complete their degree requirements and don’t achieve the earning power they expected. Commenting on the Richmondsunlight website, Ruth Hall asks:

What about a person who becomes disabled before completing their education? Where is the concern for them regarding paying back student loans when their only source of income is social security disability? My daughter has a rare disease (as defined by the NIH) that struck her in her early 30’s. She is unable to work, but her social security disability check is garnished to pay her outstanding student loans. Already living in poverty with an income of $1000 a month, losing $150 a month to student loans affects her ability to provide for herself. Student loans never go away and she will never be able to finish college or return to earning a living due to this rare disease.

But not all debtors inspire the same degree of sympathy. The Times-Dispatch quotes one student griping about the $250,000 cost of his education, including the interest on the $190,000 he borrowed to attend the University of Virginia and the University of Richmond Law School. Is his complaint really with the debt and interest — or with the outrageous cost of higher education? The young man worries that he might have to sacrifice his career in public interest law. Perhaps he should have considered the consequences such a massive debt before embarked upon that particular goal!

Another student said she didn’t realize she owed $32,000 for a nine-month medical assistant diploma from Corinthian College, which she says turned out to be worthless, until it showed up on her credit report. She said she had been told grants and scholarships would cover her costs. “I still to this date have never received a bill” or documentation, she said. Either she was defrauded, in which case she should collect damages in a civil suit, or she was negligent in understanding the obligations she was incurring, in which case it’s hard to muster much sympathy.

Regardless of the circumstances of individual loans, it’s clear that thousands of Virginians have a problem. The question is, what do we do about it?

Sen. Janet Howell, D-Reston, and Del. Marcus Simon, D-Falls Church, are lead patrons of SB 52 and HB 400 respectively, identical bills that would create a Virginia Student Loan Refinancing Authority. The Authority would be tasked with creating a program in which Virginia students with educational loan debt “may receive a loan from the Authority to refinance all or part of his qualified education loans.”

Where would the money come from to refinance the student loans? The Authority would issue bonds. However, the Commonwealth of Virginia would take on no financial risk. The bills explicitly state: “No bond of the Authority shall constitute a debt or pledge of the full faith and credit of the Commonwealth or any political subdivision of the Commonwealth and each bond shall be payable solely from the revenues and other property pledge for such payment.”

Bacon’s bottom line: Howell and Simon deserve credit for devising an innovative approach to the problem of student indebtedness. I have major reservations, but I think their idea deserves deserves thorough airing and debate. The devil, of course, is in the details.

Investor appetite for the Authority’s bonds will determine how much money the Authority will have to work with and how many students it can help. I would like to know how prospective bond underwriters would evaluate the quality of the debt, what interest rates they would demand, and what flexibility the Authority actually would have to offer students better loan terms. I presume that the bonds would be classified as tax-free municipal debt, which would be cheaper than private-market financing. On the other hand, participating students , presumably those with the greatest need, pose a higher-than-normal risk of default, which could push interest rates higher.

Currently, the federal government assumes the risk for student loans gone bad. A Virginia student loan authority would assume that risk for the debt that it restructures. The transfer of risk needs to be examined very carefully. Even if the state’s full faith and credit weren’t on the line, bond defaults by the Authority would be a debacle for the state.

Otherwise, my main reservation is that creation of a Virginia Student Loan Refinancing Authority is only a palliative. This proposal would not address the underlying causes of the problem — out-of-control costs at Virginia colleges and universities, and indiscriminate lending by the federal government regardless of a student’s likelihood of repaying their debt. That’s what got us into this predicament, and anything that dulls our laser-sharp focus on those realities only delays addressing them.