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business newsIs Social Security a Ponzi Scheme?
By
John Mauldin
Sep 26, 2011 8:30 am
There are some very real issues that do not get addressed when Social Security is discussed. Here, a look behind the the rhetoric at the real numbers.
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Breathes there a man with brain so dead
Who never to himself hath said,
"Social Security looks like a Ponzi Scheme?"
-- With apologies to Sir Walter Scott
Today we look at Social Security. In the US, Texas Governor Perry touched the third rail of Social Security and called it a Ponzi scheme, which of course immediately made him the leading candidate in the "shoot the messenger" category. Behind the rhetoric, we look at some actual numbers. No, not the unfunded liabilities, that's too easy. Let's look at what a heartless, uncompassionate man President Roosevelt was when he started Social Security (and that's what many will call me after reading this!). Behind the tongue in cheek, there are some very real issues that do not get addressed when we talk about Social Security, but that need to be part of the discussion. And of course, we must start off with the results of the FOMC meeting, which has me feeling not at all amused. What are they thinking? Apparently, they are seeing the results from another, alternative universe. There is a lot to cover as I head off to London, where I will finish this letter.
But first a very important announcement. I am very excited to be able to introduce my readers to a new mutual fund offered by my friends Altegris Investments. This fund is a blend of five commodity trading advisors or CTAs. Normally, to access a CTA you be to be an accredited investor, with all the net-worth requirements and limited liquidity. But Altegris has figured out how to wrap a mutual fund around CTAs and create a fund of commodity traders with all the usual aspects of a mutual fund (daily pricing, liquidity, etc.).
I have long been involved in the commodity-trading advisor space (some 20 years) and am a proponent of CTAs as a way to diversify portfolio risk. I have written a detailed report on this fascinating sector in relation to the fund, and it is available for free here, along with more information on the fund (including the offering memorandum and important risk disclosures, which are also included at the end of this letter).
The fund has been very well received since its launch and has grown rapidly to over $1 billion. There has been very active interest in the professional community, as advisors and brokers are looking for simple and realistic ways to diversify their clients' portfolio risk, as well as a way that is truly noncorrelated to typical stock funds and many other asset classes. Whether you are a professional or individual, you really should take the time to research what I think is a very solid fund. My partners at Altegris have decades of experience in the CTA space, with the largest database of CTAs and long-term relationships with many of the managers (I actually started my investment career in the commodity fund space, so have more than a passing knowledge of the arena). Given the potential for volatility in the global markets, I think it makes sense to have some exposure to funds that can go both long and short (depending on their models). I urge you to read my report.
400 Billion Yellow Aspirins
My mother used to tell me, "John, if you can't say something nice, then don't say anything at all." So let's see if I can find something to nice to say about the FOMC announcement. How about: "At least they didn't cause TOO much damage"? As Rich Yamarone tweeted immediately after, they announced they would buy 400 billion white aspirins and sell 400 billion yellow aspirins. This was not something that should have been done, but thankfully they only did some $400 billion and not a few trillion, which could have really screwed (a technical economics term) things up.
With Operation Twist as part of their new mix, they announced they would sell short-dated and buy long-dated treasuries. This sent the ten-year yield down to 1.72% (yields were already dropping), although as I write it is back up to 1.79%, which without the recent action would be the all-time low. The 30-year is below 3%, at 2.85%, which makes those of us who have been predicting such an event for many years finally right. I think I will just savor the moment and not make any more predictions for a week or so. It was a long time coming. It would have gotten there anyway, even without this Fed action. Which makes what they did impotent and pointless. More below.
However, such low rates are not cause for merriment but for thoughtful pause, as low rates might be good for the government and for those looking for mortgages, but they threaten to wreak havoc on pension plans, as the bond portfolios on which they are built are paying less and less, and that means they are becoming more and more underfunded, and stocks are not helping. The problem pension fund trustees have is that lower yields require them to raise their assumption for future liabilities, which must be discounted at a lower rate. Lower bond yields, like falling share prices, increase funding gaps.
While few are mentioning this aspect, Spencer Jakab of the Financial Times sent me this note:
"A sensitivity study by Credit Suisse done in mid-August shows how big an impact this can have. The underfunding for S&P 500 members was then an estimated $390bn. A 25 basis point fall in discount rates would have inflated the deficit to $435bn – about the same as 4 percentage points of investment underperformance this year. In August alone the deficit among the broader S&P 1500 widened by some $75bn, Mercer Consulting found. Slumping equities and bond yields brought the deficit from 12 to 31 per cent since April alone."
Not to mention what low rates do to people who are trying to live off their savings. How can you survive on 1% yields from a small income portfolio? That means you start reaching for yield in places that are not as safe or liquid, which is precisely what we do NOT want our retirees to be doing. Wrong, wrong, wrong. An unintended consequence of this Fed policy is that retirees are being put at serious risk. And it is an important consequence. So many retirement plans were formed ten years ago, assuming they could safely withdraw 5% a year. Now that is difficult, at least if we're talking "safely." There is going to be a plethora of schemes to entice retirees with "safe" higher-yielding investment programs. Please, remember that there are no free lunches. If you are getting above-market yields, you are taking above-market risks.
Now, let's look at what the Fed is actually likely to do. They have indicated their actions will occur over the next nine months. This also means they will sell most of their short-term treasuries and increase their duration, but not necessarily their risk. It is still US government debt. These projections are from Bridgewater.
Treasuries the Fed will likely sell:
On average, $400bn at 1.5-year maturity
Treasuries the Fed will likely buy:
Rates have already moved in anticipation, as seen below.
One has to go out beyond five years to get more than a 1% yield. Who is buying this stuff? Any pension plan doing so is locking in low returns and underfunding for that period. This is just a disaster in the making in the pension and insurance world. If you couple that with a recession, a Muddle Through Economy, and a secular bear market, it is a prescription for a pension-funding train wreck of epic proportions, which means that the large companies will have to start writing checks, which will be a hit on earnings.
Note: Adding to pension concerns about the stock market, the ECRI weekly leading indicator has been down for six of the last seven week. More evidence that we are in for a real slowdown, if not a recession, sooner rather than later. This just in from Bob Sechler of the Wall Street Journal:
"Providing fresh evidence of weakening global trade, FedEx Corp. said Thursday it is cutting capacity and trimmed its full-year earnings forecast amid weaker demand, mainly due to slowing sales of consumer electronics made in Asia.
"The news comes as a slide in Asian air cargo traffic that started in July has shown no immediate signs of abating. The slowdown extends to the makers of perishable foods, high-end apparel and automotive and industrial parts that fill the holds of planes flown by FedEx (FDX) and rivals such as United Parcel Service Inc. (UPS) and Cathay Pacific Airways Ltd.
"'The consumer just doesn't have an appetite' for spending more, Chief Executive Fred Smith said during a post-earnings conference call. As a result, he added, 'we don't anticipate a significant peak [shipping season] this year.'"
But that's just it. What happened with QE2? The money went into commodities and stocks (for which Ben Bernanke again took credit), giving us inflation and a good feeling. But the economy, in terms of jobs, hours worked, incomes, and GDP, went south or sideways. Where was the carry-through? I somehow don't remember that the stock market was part of the dual mandate, yet Bernanke listed its rise among the results of QE2. My bet is that with QE off the table, that will come to be seen as a temporary rise. A sucker's rally.
And now that we have used that QE bullet, where are we? The stock market is tanking, as are commodities. Bond yields are making new lows. The dollar is getting stronger. Can someone tell me why we went through this exercise? It seems we are right back where we were, yet with even more uncertainty. And now we start something that my Dad would call a piss-ant (a small, rather noxious and foul variety of Texas ant) program called Operation Twist, which has no real hope of doing anything that will help the dual mandate. It simply creates the illusion the Fed is doing something.
I said at the time of the second QE that the main problem I had was that we were wasting a bullet that we would (and now do) need when the next liquidity crisis came. And we have now kicked inflation up. As Rob Arnott wrote me in a private message, when you look at the next four months, which will "drop off" the year-over-year rate of inflation, it's not pretty. Core could easily run up to more than 2.5%. The Fed may have handcuffed itself at the very time we need some liquidity. QE2 was a very bad and ill-conceived move, as is the current one. It is not smart to mess with Mother Market. (Can anyone say Fisher for Fed Chair?)
The US Government Is in the "No-Money-Down" Mortgage Business
The Fed was very clear in its statement that it wants mortgage rates to go down. But anyone with a pulse knows that the problem in the housing market is not that rates are too high. Dropping rates another 25-50 basis points is not going to help all that much if you can't get the 20% down you need to finance a house, let alone get a nonconforming loan or, God forbid, a jumbo loan. With banks feeding into the market "REO" homes they get from foreclosures, it will be several years until we get close to a bottom in housing. But new homes are being built. So what gives?
This week I went to a fund presentation on new-home construction and sales. I was invited by a very knowledgeable real estate consulting firm (John Burns), and I was interested to know, how do you raise money in this market for new-home "spec" construction? The numbers and the company sales history they presented looked very impressive, but I could not figure out how they were closing the rather significant number of homes per development they did. No one else I knew of was close, from what I have seen (I watch these things). When the person who presented sat down, I looked at the mailer they send out by the millions. They send it to apartment renters. It says, "Why would you rent an apartment when you can buy a new home for $699 a month with NO MONEY DOWN?" And at very low rates, I might add.
These are starter homes, smaller but quite nice. (Note: a lot larger than the houses I grew up in with three siblings!) But they are on the outskirts of town, and that triggered a thought in the back of my head. Joan McCullough had tipped me to this.
"Are you using USDA financing to get the no-money-down?" The short answer was yes, along with FHA (3% down) and VHA. And what, you may be asking, is USDA financing? And how do I get some?
The USDA is the US Department of Agriculture. They currently have $24 billion they can use for government-guaranteed financing of homes (up from $12 billion last year). This is not Fannie or Freddie, this is the good old US D of A. As in farms and stuff (and food stamps and housing and… basically they got all these odd mandates long ago, when congressional agricultural committees wanted to expand their power). From Real Estate Economy Watch:
"Founded in 1949 to spur home sales and development in rural areas, the US Department of Agriculture's popular direct and guaranteed rural housing loans today are one of the few places in America you can still get a mortgage with no money down at competitive rates.
"Borrowers don't have to be lower income; in fact they can make slightly more than the median. To qualify for the government guaranteed loans, borrowers can earn up to 115 percent of the median income for the area. Nor do they have to buy in a rural area. They can live relatively close to a major urban area or in a popular resort community, however qualifying areas were recently redrawn to comply with the program's rural mandate.
"Best of all, no down payment is needed to get financing through approved lenders, which makes the USDA program more attractive to borrowers who qualify than FHA." (emphasis mine)
And there are actually subsidies available, so that you might not need to make the entire payment. Now, you can't use this to buy a McMansion. You have to be in a rural area, which has come to be defined as outside the city limits (except in certain areas). There are income limits. The program does attempt to help lower-income families, and I am not trying to be snarky here, but these are government-guaranteed loans (read: taxpayer-guaranteed) at 100%, being handed out in areas where in the city homes are going into foreclosure and need someone to live in them, yet right outside the city you can buy this cute new home. Which is a situation more or less guaranteed to keep home values down in the rural outskirts, yet we want first-time buyers to snap these up!
The intention here is all well and good. And the buyers are seeing it as a way to reduce their monthly payment, and a house is still the American Dream. And, over time, it will be. If they stay in them long enough and don't need to move, etc. I just think the unintended consequences (there are those words again, as we're talking about a government project) are likely to be larger than anyone thinks.
I invite you to go here. Look around. Notice that four of the first five press releases on the home page have the words job creation in their titles. Plus a lot of other current buzz words, like energy, environment, etc.
This whole side trip got started with our analysis of the Fed and its recent actions. Let's quickly return, before moving on to Social Security. This week's action is not useful. It falls under the category of "Let's do something to show we know there is a problem." It will provoke suspicion or opposition among those of a conservative monetary bent, probably hurt small and medium-sized banks (as it drives down the yield curve, which bankers depend on to make money), and lower interest rates for savers.
No positions in stocks mentioned.
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