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Monday, February 23, 2009

An Alternative Unofficial SOTU: 2009 Edition

President Obama is scheduled to deliver his first address to a joint session of Congress on February 24, 2009. Though not formally promoted as such, the speech will essentially be interpreted as a State of the Union report to Congress and the American people aimed at outlining efforts to be initiated in the coming months to address a litany of dire, vastly complicated and highly interrelated problems facing the country.

So what is the state of the union? A pretty frightening picture emerges from examining trends in just three key areas -- finance, housing and war.


The first major legislation enacted in the Obama Presidency committed $787 billion dollars over two years to stimulate the economy via spending on a variety of projects at the federal and state level and tax cuts for individuals and corporations. Ignoring the political debate over the need for a stimulus, the size of the stimulus or the nature (spending versus tax cuts) of the stimulus, the impact of the plan on the nation's larger fiscal balance sheet has gone largely unanalyzed.

According to a July 2008 estimate, the Federal deficit for fiscal 2009 (October 2008 through September 2009) was forecasted to be around $482 billion dollars. (#1) Kinda makes you nostalgic, doesn't it? A mere $482 billion. Since those rosy days of July 2008, the following items have been tacked on the nation's credit card:

* $80 billion dollars for Iraq and Afghanistan (only 6 months of war spending was included in the July 2008 estimate)
* $700 billion for the October TARP bailout, half of which is already spent and the other half likely to be spent in the next few months
* $15 billion dollars for immediate cash flow relief to Ford, GM and Chrysler
* $393 for the first half of the two year spending of the $787 stimulus package

That puts the 2009 Federal deficit at $1.67 trillion dollars and the total national debt at $12.47 trillion dollars and doesn't include the cost of the next round of automotive bailouts for Detroit, a mortgage relief bailout for consumers or the next round of bailouts for major banks.

The REAL picture on that debt emerges after a quick review of interest rates on US Treasuries in 2008 and 2009 (see #2 and #3). Interest rates on 30-year T-bills have varied from 2.69 to 4.77 percent and are currently sitting at 3.56 percent. Interest rates on 1-year T-bills have varied from 0.34 percent to 3.17 percent and are currently sitting at 0.64 percent. Short term rates were driven lower in part due to a flight to (relative) safety as investors attempted to sell out of a falling stock market and find a safe place to put their cash.

What's the true cost of this borrowing? For 2008, interest payments on the national debt were $412 billion, nearly a third of the yearly budget. That's an effective interest rate of about 3.8 percent which implies most of the debt has been shifted back to longer term Treasuries since the 30-year bond was re-introduced in 2006. The extra $1.67 trillion (and counting…) in spending will add another $59.4 billion in interest payments for a single year.

A more enlightening picture emerges looking at debt as a percentage of Gross Domestic Product, as show in the graph at Wikipedia. (see #4) In that graph, the 1970s marked the low point of debt as a share of GDP. Ah, the 70s. Weren't those the bad old days of stagflation, oil shocks and high unemployment? For over a quarter century, we've been told that low-tax, pro-business policies were the solution that jolted us out of that funk. The graph of debt as a function of GDP would appear to clarify exactly where the solution came from -- our children's pockets. Only now, it's becoming apparent that solution produced a great deal of phantom growth, in the form of fictitious "financial sector" profits which have been completely erased by the losses over the past two years and an asset bubble in real estate that's destroyed the equity of probably 10 to 15 percent of all homeowners in the country. If the value of that phantom portion of GDP was erased, the percentage of debt as a function of REAL GDP would be skyrocketing even faster.

Finally, there is absolutely zero assurance that American's megabanks will behave predictably and wait to collapse until Congress and the President have time to haggle over a coherent, rational strategy for properly recapitalizing those in trouble. In fact, between February 20 and 22, the US dollar dropped five percent against most currencies over rumors Citi was privately asking the Treasury to provide emergency injections of capital to avoid a collapse. (#5)

Without any exaggeration, the financial condition of the United States is in dire shape. Debt incurred over the past quarter century hasn't improved the competiveness of our manufacturing, hasn't maintained our roads, sewers, bridges and power grid, and encouraged highly speculative business models which have collapsed at the same time the consequences of our mis-investment have made us even more dependent upon the availability of continued credit.


The same day the 2009 stimulus plan was signed into law, an additional $50 billion dollar plan was proposed to reduce the number of foreclosures driving home prices down even further. Again, seeing the real picture behind the debates about the plan requires digging out a calculator and doing some basic math. Over 274,000 borrowers received foreclosure notices in January of 2009. (#6) Monthly foreclosures throughout 2008 were probably in the 220,000 range each month so that would reflect roughly 2.69 million mortgage defaults for the past 12 months. The $50 billion dollar plan amounts to $18,587 for each of those mortgages. That sounds like a significant amount but what if the economy worsens? If unemployment worsens and another one million jobs are lost triggering another one million foreclosures, the amount per mortgage drops to $13,550 or about one year of mortgage payments.

Analyzing the impact of the $50 billion program requires an attempt at answering two key questions:

1) for individual borrowers, what exactly is the core problem being faced and how big is it?
2) does a micro level solution provide any synergy to help our macro level problems?

For question #1, borrowers face at least one of two problems -- an interest rate jump on their loan that pushes their monthly payment beyond their means or a job loss or other major event that eliminates their ability to handle ANY mortgage amount. Assuming each loan is an average FHA mortgage of $175,000 (#7) with a 30 year term, the monthly payment with a 5% rate would be $939.44. For those facing a rate hike jumping from maybe 3% to current market rates, the monthly dollar jump might be about $240 per month.

A $50 billion dollar program clearly has the potential to keep current borrowers on the bubble of foreclosure from dumping their homes on an already depressed market -- for at least a few months. If the current economic downturn was going to only last 12 months and home prices could stabilize at current prices, we might have a winner. Unfortunately, a twelve month downturn is a long shot. Unemployment may continue to grow for 12 to 24 months and economic output may continue to decline for the same period. If that holds true, the program would only defer the inevitable for a larger portion of loans and continue to prop up home prices at unsustainable levels. At that point, more analysis of the macro impacts of the plan is required.

If a $50 billion program isn't the right answer to the foreclosure problem, maybe we're targeting the wrong problem. If the 3.69 million at-risk borrowers are 15 percent of the overall mortgage pool, that still means there are 20.91 million other homeowners who ARE able to keep their homes in the downturn. Curiously, those homeowners are the real problem. Why? Because they are smart enough to look at the current distorted market and avoid it until prices stabilize and they see neighbors' homes sell in less than nine months. Even families who can afford their current home, afford a new home, and afford to move are unlikely to risk a capital loss on their existing home, risk an additional loss on a new home by buying before the bottom and risk having to pay two mortgage payments while they wait for their existing home to sell.

Stated concisely, the problem is not a meltdown in 15 percent of the mortgage market, the problem is a complete freeze in the other 85 percent. It's worth stating explicitly this is NOT a "psychological" problem that exists merely in the heads of these qualified buyers. This reluctance is a sign of rational thought on their part in an otherwise broken market. The only thing that will return these buyers to the market is stabilization of home prices and a return to more normal velocity in home sales. Unit sales shouldn't return to 2005 levels but inventories should drop well below nine months for "regular" homeowners to consider getting back into the market.


We're still fighting two wars. After seven years of effort, more than $600 billion has been spent, more than 4903 American troops have been killed and it is becoming more difficult to answer a single question.

What are these wars really about?

The answer?


We are literally fighting wars about nothing. Afghanistan is a prime example. The country is landlocked with no beaches, ports or major rivers and the terrain is austere and mountainous, making travel difficult and modern farming virtually impossible. The climate doesn't make anyone's list of vacation resort hot spots. The culture is tribal, Islamic and famously hostile to all outside parties. Though it has some potentially valuable natural resources, the other elements mentioned previously have inhibited any serious attempt to begin leveraging those resources. As a result, modern nations have virtually no economic, cultural or political interest in engaging the country. It might as well disappear from the map.

What possible value could such a country be to anyone on the planet? Well, such countries are of great value to two particular types of groups which thrive in such vacuums --- drug dealers and terrorists. Wouldn't you know it, that's exactly what we have in Afghanistan. In fact, we have terrorists participating in opium production which makes up nearly a third of the country's economy to produce funds to aid terrorist activities. Call them narco-Islamic terrorists. A trifecta of trouble. Pashtun areas of Pakistan exhibit many of the same traits and threaten to topple an actual nuclear power

The former Soviet Union spent ten years fighting in Afghanistan and lost 14,453 troops attempting to combat forces using insurgent tactics with conventional tactics. Sadly, America has never been particularly adept at learning from the mistakes of others and the Soviet invasion of Afghanistan would have been a particularly valuable lesson to learn. The Soviet misadventure in Afghanistan was more than an object lesson in the danger of fighting insurgent forces in a desolate climate. It was also a lesson in military jujitsu and the defeat of an enemy by sucking them into a war they were not prepared to fight. What most Americans don’t know is that America actually played a lead role in sucking the Soviet Union into that war. Under a Presidential order, the CIA began conducting propaganda operations against the Communist puppet government months before the full Soviet invasion. (#8) The National Security team for President Carter viewed Afghanistan as a trap waiting to snap on the Soviet army. It did and played a major role in the final demise of the Soviet Union. Yet only twelve years after the Soviets lost and withdrew in 1989, America launched its own war in the same country trying to root out bad guys who actually got their start via American aid during the war against the Soviets.

We are at a crucial point in our battle against terrorism. It took three and a half years for the military to acknowledge we were losing in Iraq and using the wrong tactics. A better mix of tactics was used in Afghanistan but we still shorted troop levels and jeopardized the effort and drove the enemy into neighboring Pakistan, further destabilizing that country as well. We have burned out our military and have contributed over $600 billion to the country's debt load for absolutely zero perceptible benefit to date.

The Coming Social and Economic Ctl-Alt-Del

In prior posts, I've used the idea of an economic and social "Ctrl-Alt-Del" sequence being applied to correct some of the problems we face. The analogy is very apt. In many regards, the United States as an economy and a society is acting like a home computer riddled with viruses, spy-ware and other parasitic processes. We have a tremendously powerful society and economy with virtually unlimited potential yet flaws in our "operating system" are allowing parasitic processes to run inside the machine. For years, despite a few billion dollar glitches like Enron or Worldcom, enough of the system's behavior appeared normal and didn't trigger any major concerns. However, the effects of the parasitic processes have become so ingrained in the larger system, we have lost track of what "normal" is and have failed to realize the degree of impairment.

With computers, rebooting halts everything running in the machine, takes the system back to a known, clean starting point, then reloads the original operating system to allow normal functionality to return while programmers attempt to fix the code before similar inputs produce a similar lockup. Of course, like parasites in nature, many computer viruses poison this reboot process to ensure they get re-installed and remain running. Many of the parasites affecting our society and economy will attempt the very same thing, whether in the form of special tax favors, special regulatory exemptions or entitlements for "one-time" emergencies that somehow become permanent.

The arrival of a "Ctl-Alt-Del" is not really an "if" question at this point. The only question involves the nature of the changes that will result from the reboot. To avoid having the viruses and worms of our economy re-establish control over our rebooted society and economy, Americans need to be re-educated in some of the basic mechanics of a sound business, sound industry and sound regulatory environment. Perhaps the best way to start is for President Obama to create a calendar of topics for the next two months and dedicate a week to a single topic, ranging from personal and government finance, infrastructure, transportation, energy and taxation. Our problems weren't created by 535 people in Congress or 10,000 people on Wall Street. They were created by 300 million Americans, partly out of misplaced optimism but mostly out of ignorance or willful suspension of disbelief.


#1) http://www.npr.org/templates/story/story.php?storyId=93018389

#2) http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml

#3) http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield_historical_2008.shtml

#4) http://en.wikipedia.org/wiki/United_States_public_debt

#5) http://finance.yahoo.com/news/Govt-reportedly-mulls-taking-apf-14434394.html

#6) http://www.realclearmarkets.com/news/ap/finance_business/2009/Feb/12

#7) http://mortgagedataweb.blogspot.com/2009/01/fha-average-mortgage-amount-plateaus.html

#8) http://en.wikipedia.org/wiki/Soviet_war_in_Afghanistan