Amazing piece by Bloomberg on the pension crisis which will soon be front page news.  This article is filled with excellent research, insight and analysis.  Bloomberg.com is a great resource for in-depth journalism.  Their Recipe for Famine series last December provided great insight on the economics (facts) behind global food shortages.

Like most problems left to politicians, the pension crisis has been avoided as long as possible.  As the market has declined and evaporated trillions of dollars of wealth for everyone, this issue has now been dragged out of the closet, naked and shivering for all the world to see.

Some of my favorite excerpts are:

Fund accountants resort to a grab bag of tricks to get by. They set unrealistically high expected rates of return to reduce governments’ annual contributions. And they use smoothing techniques to paper over investment reverses so they make losing years look like winners.

Accountants do that by averaging gains and losses, usually over a five-year period — sometimes for as long as 15 years of investment returns.

That means actual results of any one year aren’t used to calculate how much a state legislature contributes, which can delay governments catching up with losses for more than a decade.

Fund accountants using “smoothing” to distort reality.  It is this type of deliberate, fine-print deceit which all investors and taxpayers must be vigilant against.  This type of smoothing occurs even in “earnings” announcements by companies like GE, which is a major reason why companies “beating earnings” should always be taken with a grain of salt.

“What appears to be a riskless strategy is actually very risky,” says David Zion, director of accounting research for New York-based Credit Suisse Holdings USA Inc. “If the returns on the pension bond-financed assets don’t exceed the cost of servicing the debt, the taxpayers bear the brunt.”

As always, the taxpayer bears the cost of unrealistic government promises.

Finally, flat out stupidity by those “in charge”

The CTA concluded it could borrow $1.9 billion, paying an interest rate of 6 percent to bondholders, and invest the proceeds to receive its expected rate of return of 8.75 percent. Such an annual return would add $52 million a year to bolster the fund.

The CTA chose to ignore not only Illinois’s auditor general but also its own actuarial firm, Detroit-based Gabriel Roeder Smith & Co. The company had determined there was just a 30 percent chance of earning 8.75 percent.

“We executed the best transaction we could, given the legislative and political restraints,” says CTA Chairman Brown, who is also co-head of municipal finance at Chicago-based Mesirow Financial Inc.

Takeaway:  Everyone has an incentive for the market to go higher and let the good times roll.  This attitude manifests in numerous levels of opacity.  This opacity ranges from the fund manager who smooths earnings, to the politician making outrageous promises, to Joe Taxpayer who complacently watches and does nothing.  Only during a market downturn do these instabilities and crises manifest.  As a grown man or woman, arming yourself with An Accurate Model of Reality is paramount to developing a healthy sense of skepticism and uncovering the truth before it is too late.

Kudos again to Bloomberg for shedding more light on this future front-page story.

The Stress Test results were revealed last Friday after much anticipation.  The test and broadcast of the results were quite telling and there are several things we can learn from this.

My initial reaction of skepticism was confirmed when many reputable bloggers (with their own capital on the line) expressed similar qualms over the weakness of government’s test.  The two short articles I have quoted are well worth the read.

A former FX trader, “Dude”, suggests that the test is direly lacking real-world stress. He cites much more dire scenarios, which the government has not tested:

1) China didn’t show up at a Treasury Auction and bond rates jumped 3-5%
2) China started dumping US$s on the open market and our exchange rate dropped 10%
3) The Fed, under such conditions, had to raise the Fed Funds rate by 5% quickly
4) An act of war or natural disaster struck one of the big coastal cities, putting it entirely out of commission thus pushing GDP down 6-10% quickly

Admittedly, the Treasury is more interested in a longer view than I was, although given the highly leveraged derivatives positions, they might be well served to also inquire about substantial, discontinuous price changes.

I’m troubled that they don’t test for what the past suggests is possible.

What if Unemployment goes to 30% as it did in the 30s?

What if Inflation falls to -5% or rises to 12%?

What if Fed Funds goes to 17% as it did in the early 80s?

What if we can’t roll-over our foreign held debt, as has happened to most nations which have run up as large an external debt position as ours?

Karl Denninger at Market Ticker mentions:

According to The Fed’s “More Adverse” scenario prime delinquencies will reach 3-4%. Note that the PRESENT serious delinquency rate on Fannie’s credit book for single family homes is at 3.15%.  Nowhere in the “mainstream media” (e.g. CNBC, etc) has this been mentioned but it is literally right in your face while reading the Fannie quarterly report.

If we accept the above as true, we must logically draw one of two conclusions.

  1. The government knows that the stress the system could endure could be much worse.  They have decided to deliberately ignore or discount this data to assuage our fears and not report the full truth to us.  In other words, they are knowingly lying to us.  If this is in fact the case and if the government is trying to deceive us, Geithner, Bernanke and Obama should be held responsible for the misdeeds, regardless of political party.
  2. The government is ignorant of these facts that other individuals have adroitly discovered.  This would mean they are not the most intelligent or conscientious leaders to be running our financial system.  They are not fit to be in charge and should be removed as soon as possible, regardless of political party.

Takeaway:  There is a simple theme we can learn from the stress test and it comes from Buddha.  He says:

“Believe nothing, no matter where you read it or who has said it, not even if I have said it, unless it agrees with your own reason and your own common sense.”

Ben Bernanke has made statements such as:

“It is not the responsibility of the Federal Reserve – nor would it be appropriate – to protect lenders and investors from the consequences of their financial decisions.”

(Freddie and Fannie) “…will make it through the storm”, “… in no danger of failing.”,”…adequately capitalized”

We’ve had a $700 billion bailout and numerous corporate-welfare financial programs (CPFF, TLGP, PPIP, CPFF, TARP, etc.).  Fannie and Freddie have been nationalized.

Karl Denninger has published his remarkably accurate predictions publicly (2008, 2009) and stood by them.  People might think you’re a fool for believing a blogger, rather than an MIT-educated expert.  Look at the evidence and track-record and decide for yourself. Just because someone is a popular leader (religious, business, political) or has a popular title doesn’t mean they are any more thoughtful, intelligent or honest than someone without popularity.

For more on the crisis, read here.

If you have a mom, give her a call or a hug and thank her for the job she did raising you.  She’ll appreciate it.

Take a moment to think about what it would be like to grow up without a loving mother.  That’s reality for too many kids and, as a result, they grow up without a strong sense of right and wrong.  Having a loving mother is something we should take the time to appreciate.

Happy Mother’s Day!

At work last week, I was looking at a bond and realized I forgot how to use the Rule of 72 to get a rough idea of the value of the bond.  I realized the only time I ever used the Rule of 72 was in college; over five years ago.  The Rule of 72 is a rule which I have had no use for and I did not practice.  As a consequence, I forgot it.

After this humbling experience, I realized that if you don’t use your skills, you lose them completely.  This applies for all skills:  love, charity, music, learning, and all others.

It takes a concerted effort to exercise skills that you value having.

Over the last few years, I’ve tried to practice more life-affirming skills in my daily life and it has made my life more enriching.  Work, especially work with no tangible byproducts, can often suck us dry and make us resort to eating rich foods, drinking alcohol or other activities to avoid dealing with reality that what we’re doing is forgettable.

A year ago, I was walking around my neighborhood in my old city and I spotted a man who needed help moving a mattress.  As I helped the man move his mattress, it brought back memories of helping people and doing something I enjoyed doing.  That act of helping the man with the mattress still sits with me today.  It was probably the first time in three years that I could actually say my actions helped someone else.

Volunteering has given me peace of mind and comfort knowing that I’m not just trading financial reports for food, shelter and a “lifestyle”.  As little as I have contributed to this world, helping someone smile or avoid pain is something I definitely enjoying getting back in touch with.  I sometimes fear that if I don’t make these types of connections a priority, the desire will slip away.

Takeaway:  If you don’t use your skills, you lose them.  This applies for all skills:  The Rule of 72, love, charity, music, learning, and all others.  What skills do you want to own?  Are you practicing them?

As a child, I always used to take note of coupons and mailings which had the word “FREE” on them.  I would mistakenly believe that these items represent value, rather than an attempt to move stale merchandise or lure in customers who would eventually spend more.  While kids fall for this trick, adults know there is no such thing as a “free lunch”.

As we mature, we realize nothing worthwhile comes easy.  Just as an alcoholic has to struggle through the shame and humiliation of addiction and the superstar athlete has to struggle through off-season practice, individuals can only grow and strengthen through facing pain.

Nature also teaches us that nothing is free.   The Law of Conservation of Energy and The Law of Conservation of Mass state that all energy and mass are conserved.  They may be redistributed, however, they are neither created nor diminished.

On a national level, we cannot escape our economic problems pain-free either.

Here are a handful of financial problems we are facing:

The answers from our leaders have been to buy more time, borrow more money and avoid reality as long as possible.  The sleight of hand of verbal obfuscation (Congressional grandstanding, Fedspeak) and cheerful optimism will not fix these underlying issues.  Debts need to be repaid or defaulted on, they cannot be rolled over forever at favorable interest rates.

The flood of new money and credit is not prosperity, it is a sugar high that is not sustainable.  Like a marathon runner who vomits with exhaustion and dehydration, we cannot expect a packet of sugary government goo to provide us with meaningful sustenance.

When will this painful “growth” of financial sanity occur?  When will this reality be faced?  When will the veneer of prosperity via interventionism be ripped off?

Takeaway:  We only grow when we challenge our worldviews, struggle, and exit our comfort zone.  Comfort and complacency is the enemy.

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