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Sunday, November 18, 2012

Financial Impressionism I

I value your comments, and some of them will come back to haunt us all in the final impressionistic masterpiece. For today, we will concentrate on the FHA actuarial evaluation of the MMI fund (the fund that insures amortizing mortgages). There is another reverse mortgage insurance fund, but we'll ignore that for now.

The report can be found here.  It's 235 pages, so we can guess that few journalists will bother to get past the executive summary, and thus, our Monte Carlo simulation predicts with some confidence that they will miss such gems as scenario V8, which begins on internal page 62 and external page 73. The dominant feature of this scenario is that incorporates not the Moody's forecast, which has interest rates rapidly rising, but what the Fed has PROMISED TO DO.

Now you may feel that using the Fed's promises to run simulations of estimated fund values is a hazardous effort, but in banking, it is the common practice, especially when the Fed has already begun doing that which it has promised to do and there is every evidence that they will be able to do what they have promised to do and the promise covers the near term period (i.e. the next two or three years). 

As the firm which did the analysis explains:
In a press release during August of 2011, the Federal Reserve Board announced its intention to keep the federal funds rate low for the next two years. On September 13, 2012 the Federal Reserve Board announced that “……the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.” Based on this new position, interest rates are likely to remain at their currently very low levels for an extended time.
Hence, for the third scenario we coupled the baseline home price scenario with an interest rate path that remains at the current very low level for another two years. Rates then gradually rise toward the long-term stable levels of Moody’s baseline scenario. This low interest- rates scenario is constructed to understand better the impact of the performance of the Fund with respect to a persistence of unusually low rates. Exhibit V-8 indicates that under this scenario the economic value of the FY 2012 Fund would be lower than the baseline by $17.58 billion, at negative $31.06 billion. This is similar to the 5th worst path in the simulation, which indicates a 5 percent chance the economic value can be lower than that of this low interest rate scenario.
So while our fearless analysts have earlier told us that there is an 80% chance that the current value of the fund is between -25 billion and +1.6 billion, or something very similar (I'm laughing so hard I can't focus my eyes well), now they are confessing that they get a dramatically worse result if they believe the Fed. This is like reading Chinese corporate financials. It also totally contradicts the executive summary, which is why you should never read the executive summaries. They exist to corrupt your mind.

On internal page 64 and external page 75, there is a nice summary chart which shows the results of various scenarios and Monte Carlo results. Two of these have the fund still negative in 2019. 

The current value has to center on the low interest (V8) to the extreme right for the beginning point. It's important to note that there are offsetting effects in rate assumptions. A protracted period of low interest rates reduces fund values by reducing investment returns, but it also tends to sustain housing values. Rapidly rising interest rates (ain't gonna happen) prevents prepayments to a high extent (controlling adverse sort), but it tends to suppress housing values, which increases expected losses.

The second highly meaningful variable is expected economic performance. In a few months, once the dust has settled in DC, we can say more about that. However, given my recession call I am somewhat more negative on that trajectory than the mean assumptions contained in this report.

The bottom line is that there is a very real chance that the MMI fund will be negative or marginally valuable in 2019. Right now this is unimportant, except that legislatively, the fund is supposed to add up to 2% of the book. So theoretically Congress has to intervene.

But the theory does not concern anyone, because under the current law, even if FHA has no capital reserves it has an open checkbook with the Treasury to pay claims. 

However in 2019 it should concern us, because that is past the event horizon when future federal borrowing becomes far more difficult. A legal right to something does not mean anything when the right cannot be exercised in the real world. 

So what you, the taxpayers, need is for this fund to come back into a meaningfully positive balance before 2017. If not, you will be forced to kick in the funds to make that happen considerably before 2019, because if investors get worried about the value of FHA insurance, a fan-excrement catastrophe occurs which will just crush the economy. 

The first-time homebuyer is a crucial part of our housing economy, but even well-qualified first-time buyers are going to be cash short for a long time to come. 

Student loans are a crucial reason. I know a young couple that are the "winners" in today's economy by any standards. They are both young, healthy, hardworking, intelligent and attractive. The guy graduated in 2010, and got a finance job as a trader. He has been quite successful and has since moved to another firm. He is earning in the six figures. She graduated this May and got a job. Their total gross income is definitely close to 150K. Both probably will have stable employment. They are very committed to each other and will get married eventually, but for now she lives at home and he does not have a car and lives in the city. They are trying to pay off their student loans before making ANY purchases, even of furniture or a second car. That's because their student loans are close to their pre-tax income.  It will take them years to pay them off, and then they will have to buy two cars before even considering saving to buy a home. 

Rents are high, but FHA loans are the only game in town for most first-time buyers. If you let FHA go down, you can kiss housing values goodbye, which paradoxically makes the FHA situation much worse. So this is one of the fundamentals of any reasonable future economy that does not look Greco-Spanish.

Monte Carlo simulations of journalists' reading habits? That gave me a much-needed chuckle.

Surely, Congress can squeeze $30B into a $1.2T deficit somehow this year.

But when do you figure this "event horizon" occurs? I was a bit shocked to do some projections and come up with Q1 2014.
Thanks for reading the report so I don't have to ;)

Although I guess I'll have to take a look at why Moody's is forecasting rising interest rates. Seems unlikely.
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2013 may be the watershed year.

I'm thinking XMAS '12 will disappoint and that'll cause DC to kick the can yet again. The "fiscal cliff" is possibly DC's last best chance to demonstrate any semblance of discipline and they will fail.

Rating's agencies will knock U.S. down a notch, and thereafter the Fed's grip on rates starts to slip.

We all know that any rise in rates will eviscerate home values and implode FHA/FNM/FRE. Only a matter of time.
TJ - it's anyone's guess. These things really tend to happen very suddenly.

You can safely figure that debt ratios will cause angst, but right now we are only at 72-73% for debt actually issued. Counting the federal retirements and SS we are over 100%, of course, but right now we are still pretending we have a plan.

Another significant recession would move us rapidly up over 80%.

I think what's been holding us up is the difficult situation in Europe rather than the Fed. However capital inflows rose sharply this summer and then declined, perhaps in a natural reaction.

Watching capital flows will be an important indicator. But then you have to wonder about the effects of the election. Won't there be a tendency for US persons to try to move assets out of the country?
Neil - Congress doesn't need to do anything at all right now. FHA has money - it's just that any reasonable projection of future payouts versus income shows a negative flow for years.

The event horizon really has to do with the overall US situation, and right now I don't think it can be pegged well. We are going to have to see what Congress does over the next few months.

I would say outside 2017, inside early 2015, but a lot of things could change that.

At some point the Fed will lose control over matters, but everything's relative, and what happens in Europe really affects our timing.

The only thing you can't currently predict is a middle road. Right now it looks like the US slumps into deflation (moderate the best case) or vaults into a destructive inflation which probably shoves us into deflation. There's not currently some middle trajectory I can foresee.
TJ - we have to wait a couple of weeks to be sure, but I don't think 2012 is going to be that good. So when GDP comes in, it will be below 3%.

Before the storm I was expecting 2.7%/2.8% (residual bling). Now that may be more like 2.5-2.6%.

But so much depends on Federal action that it is really impossible to predict Q1!


The "event horizon" I calculated is the point beyond which economic growth becomes impossible without repudiation of debt, no matter what tax, spending, and regulation policies are implemented. Not that you asked, but the assumptions that resulted in Q1 2014 were:

1) Fed-held debt doesn't concern investors, because the Treasury effectively pays no interest on it.

2) 75% of GDP is about as much debt as any country can handle.

3) GDP growth is going to be flat, at best, for the next few years.

4) No combination of tax rate hikes and spending cuts can appreciably reduce the deficit. The resulting GDP hit would cause enough unemployment so that entitlement spending increases to raise the deficit right back up.

Basically, I assumed that Congress and the Administration will not agree on anything that can decrease the deficit. Projecting forward the current rate of deficit spending less Fed printing, interest-bearing debt should reach 75% of GDP during Q1, 2014.

At some point soon after that, I assume we encounter either Scylla or Charybdis.


Oh, and about capital flight: Congress and the IRS have gone to great lengths to make capital flight difficult. Multi-national corps ceased to repatriate foreign profits years ago, so I wonder how much one can tell from capital flows.

If we're talking entitlements then what about those that don't have paper backing them? Walker puts those at several times GDP.

OTOH, if we're talking strictly DC-backed, privately held paper... what about outstanding GSE obligations?

Let's not even discuss the FDIC & PBGC; both would be blood red if not for mark-to-myth.

We're already past the event horizon, it's just nobody dares to officially say so.
Neil - capital flight can occur in many forms, the simplest of which is just investing in precious metals and burying it in the ground.

As to the event horizon in the form you mean it, there are two levels. If you are talking the structural level, we blew right past it in the last two years. To be more precise, what the collective population expects to get out of the system is now far more than can be taken out of the system, and yet their lives are predicated upon these withdrawals in such a manner that failure of these promises would produce strongly destructive economic effects.

But event horizons such as those are always passed long before active recognition. For example, in the US the housing market passed the event horizon in 2005, but no one realized it, so the results only began to become apparent in 2007, and full recognition of the effects was delayed until 2010/2011, as witnessed by Zandi's Nov 7th confession that Moody's forecast for homebuilding trough was very significantly erroneous.

The real world effects of the event horizon will start showing up during this next presidential term, but will not even be fully evident then.
TJ uh-huh. And pretty much any real compromise on the debt to deal with it without a market-forced recognition was just precluded by this election.

Thus Zandi's Nov 7th baseline forecast must be too positive.

Good points. It's true that the official debt/GDP passed the 75% point years ago--but that is mostly because of the present value of future entitlement obligations, which we can assume are effectively in default.

What I'm looking for is the point where interest on the debt reduces federal free cash flow to the point where it begins to impact ongoing operations, even with the Fed's low! low! rates. The point at which the Fed's moderate rate of money creation (moderate, considering the low velocity of money) is not enough to fund existing entitlement obligations, no matter how they re-arrange the budget.

My reasoning is that with such high demand for savings, it's very difficult to get sustained inflation of anything other than money-substitutes. The only mechanism I can come up with for inflation is if the Fed is printing on a large scale and Treasury is sending the money directly to people who must spend it on the basics. In other words, printing money to cover entitlement checks.

I'm still not sure about this, but thanks for helping me clarify my assumptions.
The one thing I've taken away from the Euro mess is that the can will be kicked a lot farther than anyone expects it can be kicked. The price is that the eventual collapse will be all that much more devastating for the years of throwing good money after bad.

Seriously, compare how cheaply the Europeans could have gotten off in 2009 with how expensive the collapse will be now.

I begin to see the logic behind pre-2005 bankruptcy laws and the concept of jubilee.
I agree about the comment about the likelihood of assets moving out of the country. I think that and the renunciation of citizenship are going to increase dramatically.

The "rich" have figured out that they are going to get handed the bill for the liabilities tail of the welfare state and will quickly decide there are greener pastures elsewhere despite the cost and inconvenience of changing nationalities. Note yesterday's NYT oped on a wealth tax. That is something you are going to hear a lot more about once we get done soaking the "rich" and find out that we have only closed 10% of the budget gap. The Chicago boys will then turn to that rather than having the middle class pay for their entitlements.

Even if you only have a couple of million dollars, there are very fine places to live that will take you in over a relatively short period of time for a modest six figure sum which you can essentially satisfy through a real estate purchase. Once enough people figure this out, there will then be great confusion and consternation among the static scoring revenue crowd in DC about where all the rich people and their tax returns went.

You can already see this has started to happen through the real estate prices of the low tax enclaves like Singapore, HK and Zug. Obama's re-election and the full imposition of the Pelosi tax fantasy along with a can kick on entitlement reform will only accelerate the process.

Time to start thinking about this now if you have the means. There will be a limited number of seats on this bus when the music stops here in the US. You don't want to be playing the role of Chuck Prince when that happens.

The laugh-out-loud line in that NYT column:

"...the tax system would become simpler."

Seriously, a wealth tax is one of a short list of things that would actually have me house-hunting in Zurich.

There are now economists tauting the idea that the U.S. could never default on it's debt

Modern Money Theory

True or False?

Just like a household, government has to finance it's spending out of it's income or through borrowing?

The role of taxes is to provide finance for government spending?

The National Government borrows money from the private sector to finance the budget deficit?

By running budget surpluses the government takes pressures off interest rates because more funds are then available for private sector investment projects?

Persistent budget deficits will burden future generations with inflation and higher taxes?

Running budget surpluses now will help build up the funds necessary to cope with the aging population in the future?

All the above are false.

St. Louis Fed:

“As the sole manufacturer of dollars, whose debt is denominated in dollars, the U.S. government can never become insolvent, i.e., unable to pay its bills. In this sense, the government is not dependent on credit markets to remain operational. Moreover, there will always be a market for U.S. government debt at home because the U.S. government has the only means of creating risk-free dollar-denominated assets..."

Government can never run out of dollars. It can never be forced to default. It can never be forced to miss a payment. It is never subject to the whims of "bond vigilantes".

Here is their reasoning:

The noose is tightening around America.

"Department Of Homeland Security To Scan Payment Cards At Borders And Airports"


Brian - oh, I agree. I think this election will spawn a run on property elsewhere and move money out of the US.

If we are not willing to try to engage with our problems, it's ludicrous to expect the successful to make a bunch of sacrifices knowing that in the end, the system must crash.

If we were going to make a credible effort to deal with our fiscal imbalance, I think rich people would be more willing to pay higher taxes. But if we are going to tax the rich at ever-increasing rates only to fund a few more months until we run off the cliff, then they'd have to be stupid to let themselves be strangled to death only to put the country, eventually, in a worse position.
Oh, God. Modern Money Theory has reared its ridiculous head on my blog. Can the apocalypse be far behind???

There has never been anything more ridiculous than Modern Money Theory.

It's time to start honing the arguments against MMT. We're going to need something that fits on a bumper sticker, because we're going to be hearing a lot about it in a year or two.

Superficially, MMT is correct; just like all good philosophical fallacies. The USG can print as many dollars as it wishes, and the populace will be forced to continue relying on dollars as a store of value, at least up to a point. The IRS will come down like a ton of bricks on any business that behaves otherwise.

But, MMT is like any other law which goes against the grain of human nature (or Natural Law, or the Gods of the Copybook Headings, or any of the other names for it). Printing dollars willy-nilly destroys the link between money and value, and so reduces the utility of the dollar. At some point a black market will appear. If the IRS is successful at preventing businesses from adjusting to the black market, then those businesses will simply be destroyed, and we'll end up buying Al Capone Deodorant--"now with 20% less arsenic".

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