Greenspan Panders for More Money

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market"(Aucontrarian.com, 2009)

Former Federal Reserve Chairman Alan Greenspan has once again received space on the editorial pages of the Financial Times. He does not deserve, so shall not receive, a rebuttal. But, it is probably still worth a moment to remind readers of the interests he continues to serve.

His intention, in "How Dodd-Frank Fails to Meet the Test of Our Times" (March 30, 2001), is to kill the Dodd-Frank Act's application to the banking industry. Greenspan, of course, was more circumspect, but he is not receiving the courtesy of careful interpretation here.

Greenspan still receives large fees to speak. These fees are paid by Too-Big-To-Fail banks and other tributaries of the financial juggernaut. His fees are reported to be lower these days. He used to receive $150,000 to $250,000. That is more than at least 90% of Americans will be paid during a single year of their entire lives. He is on John Paulson's payroll, the most highly compensated hedge fund manager of our times. Bill Gross at Pimco pays him a bundle, too. He was also hired by Deutsche Bank, a relationship that has not received much attention, so he may or may not be still serving DB's interests.

In the Financial Times, Greenspan warned that regulations in the Dodd-Frank Act would inhibit derivative markets, foreign-exchange trading (a market that exceeds $4 trillion a day), and "complex modern-day finance" that needs to be allowed to grow more complex - without interference from regulators "if we wish to maintain today's levels of productivity and standards of living."

For money, some people will say anything. The latest reminder of how finance contributed to America's welfare comes via Welling@Weeden, which published a 40-year study of American wages by Ron Griess (thechartstore.com). "Real" (meaning - adjusted for inflation) average hourly earnings in the U.S. were $20.86 in 1973. In February 2011: $19.33. Finance has grown from David to Goliath and sucked in money that has made billionaires of Alan Greenspan's current employers.

Greenspan warns that U.S. banks may leave for more favorable climates. This is the best recommendation yet for the Dodd-Frank Act. Go! Last week, some European bankers threatened their regulators with the same warning. It is doubtful any country other than North Korea would take the well-connected. That might be a fine place to send them all. Gibberish will not save a central banker or Too-Big-To-Fail banker in Kim Jong-il's paradise. Pak Nam Gi, North Korea's Head of Finance, was executed in March 2010 for inflating the currency. He was charged with "intentionally harming the country's economy." Two-Percent-Ben wears the charge like a bespoke suit.

Weimar Angst and the United States Today

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market"(Aucontrarian.com, 2009)

When Money Dies: The Nightmare of the Weimer Hyperinflation, by Adam Fergusson, was published in 1975 and became a best-seller in 2010. Federal Reserve Chairman Ben S. Bernanke's claim that "inflation expectations are contained" is refuted (once again) by this 35-year, dust-gathering incident, unless the public took a sudden interest in multiplying millions, billions, and trillions - a "delirium of milliards" - the phrase of soon-to-be-assassinated Weimar government minister Walter Rathanau.

Interest in the German episode (which peaked in 1923) was described by Professor Peter Bennholz, University of Basle, and author of Monetary Regimes and Inflation: History, Economic, and Political Relationships, published in 2003, and not yet matching Fergusson's sales, but out-of-the-money call options on a spike might be worth exploring. Bernholz, studying all 29 hyperinflations in history, does so to "point our attention to the time from which the public tries to escape the loss of money by reducing its use by a flight into other currencies and commodities." For his study, Bernholz uses the "arbitrary convention" that hyperinflation "has reached in at least one month 50 percent or more." It is not necessary for inflation to approach that astounding level for major dislocations to occur.

Some characteristics of Weimar Germany are apparent in the United States. Parallel observations are sometimes less than they appear (e.g., in both cases, the people enjoyed eating meat), but are striking. The German incident happened over four years (also arbitrary. It can be argued that any year from 1914 to 1921 was the point of departure.)

Similarities to the U.S. have been in motion for 30 years or so. These include: (1) a high concentration of wealth among those who leverage, (2) the middle- and lower-classes falling behind, but not understanding or knowing it (or - knowing it but not allowing themselves to think about it), (3) the rise of a gambling culture, (4) including financial speculation on the stock exchange, which spread to all ranks of the population, (5) the blossoming of a financial industry, with quantity crushing quality (Weimar bank tellers became financial advisers since most people were at a loss, and would take any advice, which was often horrible, but probably well-intentioned), (6) the "striking displays of luxury beside poverty" (quoting Fergusson), (7) a "growing lack of concern for one's fellow man" (the difference between greed and the attempt to survive is blurred), (8) values are distorted, in both senses, the one feeding the other: a wife selling her husband's gold watch for four potatoes, (9) the quality of goods (and services) collapses (an evolution with consequences to morale and personal dignity), (10) the denial by the central bank that it is in any way attached to the inflation.


Adam Fergusson discussed When Money Dies with radio host Jim Campbell earlier in March. I will talk about current complexities this Sunday, March 27, 2011. See below for details.

Streaming Live on the Internet - Click on:
http://wybcx.com/popup
"Business Talk with Jim Campbell"
Sunday March 27th @ 10-11am Eastern

Fred Sheehan
Contrarian Fed Expert
On "Quantitative Easing" & Fed Policies -

Are they working and the Threat of Inflation?

Ignorance and Opportunity

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market"(Aucontrarian.com, 2009)

Following are some of my remarks prepared for Allen & Company's Fifteenth Annual Arizona Conference. The discussion, "Munis and the Euro: Crises or Opportunities?", took place on March 8, 2011. The moderator was Senator Bill Bradley, Allen & Co., New York. Participants were Dick Ravitch, Ravitch, Rice & Company, New York; David Kotok, Cumberland Advisors, Sarasota, Florida; Uri Dadash, The Carnegie Endowment, Washington, DC.; and Frederick J. Sheehan.

The panel discussion was conversational, so less formal and more wide-ranging than what follows. I have written about much of the "Ignorance" in previous dispatches, so omit redundent notes here. The "Opportunity" will also be familiar to many readers, and so is repeated in truncated form at the end.

To the prepared remarks:

I will discuss four topics:

First, some background to current problems;

Second, why it is not wise to make predictions about the amount and size of defaults;

Third, some areas where municipal solvency and bonds are most vulnerable;

Fourth, the opportunities.

FIRST, THE BACKGROUND TO CURRENT PROBLEMS

I will start with some numbers:

In 1995, $153 billion of mortgage debt was borrowed by home buyers. In 2005, it increased $1.1 trillion.

As for municipal borrowing:

In 1996, states and municipalities retired a net $7 billion in debt. In 2007, they borrowed $215 billion.

At the same time, tax receipts were rising fast.

In 2003, State and Local Government Current Receipts were $979 billion. By 2007, receipts were $1,304 billion.

This all leads to the conclusion that municipal spending no longer concerned itself with the future - the spenders simply extrapolated their budgets and borrowing into a splendid future.

The link between real estate bubbles and municipal finance bubbles is as old as the hills.

I will continue with a quote:

A.M. Hillhouse, author of a splendid study of municipal bonds - Municipal Bonds: A Century of Experience, 1836 - 1936, analyzed the U.S. municipal bond market across that century. He concluded:

"[T]he major portion of overbonding by municipalities arises out of real estate booms."

Hillhouse, who considered his book a font of wisdom for future generations, wrote:

"There will be no justification for a city's coming forward [in the future] with the excuse that... its revenue has dried up in times of falling property values... [T]he cause of the debt trouble [must be regarded] as an unwarranted failure of the city to adjust its borrowing program to certain known facts."

His book, as you might expect, never went to a second printing. Nevertheless, there should have been no doubt that a municipal bust would follow the residential mortgage crash. I wrote a study, "The Coming Collapse of the Municipal Bond Market" in 2009. The title may or may not turn out to be accurate, depending on one's portfolio, but there was and is no doubt municipal extravagance had left us with a grave problem.

Current theories and books written about the Depression do not dwell on the 1920s real estate boom. Real estate lending in the 1920s might rival the recent debacle, in form, if not degree. There was a flight to the suburbs. Inflated civic conceit hired construction crews to build houses, roads, sewers, schools, skyscrapers, and highways that crossed the country for the first time. When Treasury "Secretary Mellon endeavored to cut back federal spending, state and local governments stepped up spending at a rate that more than offset the Mellon program...."

I will continue with some more quotes - my point being that it is not necessary to talk about the past two decades to understand why municipal finance is in disarray. The town librarian could have gathered previously documented warnings. In those locales where the library has been closed for lack of funds - and there are many - a moderate level of common sense would have noted the city elders had lost control, and possibly, their minds.

In March, 1933, Professor Herbert D. Simpson gave a lecture at the 45th annual meeting of the American Economic Association:

"Throughout this period - [he was speaking of the 1920s] - there was another form of real estate speculation, not commonly classified as such, but one that has had disastrous consequences. This is the real estate "speculation" carried on by municipal governments, in the sense of basing approximately 80 per cent of their revenues upon real estate and then proceeding to erect a structure of public expenditure and public debt whose security depended largely on a continuance on the rate of profits and appreciation that had characterized the period from 1922-29."

Per Hillhouse, Simpson tried to steer municipal financing from its dependence on house building and price appreciation:

"The financial difficulties of local governments in consequence of both the inflation and deflation of real estate values demonstrates strikingly the unwisdom of a revenue system concentrated so heavily upon real estate..."

This elicits a truism that was ignored in equal parts during our twenty-first century mortgage and municipal bubbles: When asset prices fall, the collateral falls, but borrowed money, linked to the original asset price, still needs to be paid back.

Simpson recounted the credulity with which the citizenry accepted heavier property taxes in the 1920s. Similar to our recent splurge, the Jazz-Age home dweller did not mind that property tax revenues, municipal borrowing and municipal spending were all inflating - at unsustainable rates. The forgotten professor went on:

"During this period of prosperity, real estate taxes were paid with little complaint.... [U]nder these conditions, public expenditures expanded and taxes were increased without protest; and public officials exploited the real estate groups as systematically and thoroughly as the real estate groups had exploited the rest of the public. The result has been a structure of public expenditure which has been difficult to curtail, and a volume of indebtedness whose solvency is now jeopardized on a large scale."

Morgan partner Dwight Morrow was not a fan of his New Era - the 1920s New Era. He knew the asset inflation would come to a bad end. Morrow wrote: "It is the social effect which is so dangerous. It transfers the habit of spending from those who have long experience of spending to those who have no experience."

Today, our state-of-the-art Federal Reserve is actively and explicitly promoting and feeding asset inflation.


SECOND, WHY IT'S NOT WISE TO MAKE PREDICTIONS ABOUT THE AMOUNT AND SIZE OF DEFAULTS: THERE ARE TOO MANY "DON'T KNOWS"

1 - We Don't Know if unions and municipalities will reach agreements over benefit reductions

2 - If they do not reach an agreement, and the decision goes to a court, We Don't Know how courts will rule. Union pension plans are legal contracts. Yet, pensions and benefits are unsustainable. How will judges rule?

It is worth keeping in mind that most, if not all, states have legal recourse to amend pensions under certain conditions. In California - I quote: "an employee does not have the right to any fixed or definite retirement benefits but only to a substantial or reasonable pension."

I am quoting Amy B. Monahan, law professor at the University of Minnesota, from a paper in which she addresses legal remedies available to states and used in the past to reduce pension benefits of public union workers.

[Amy B. Monahan, Visiting Associate Professor, University of Minnesota Law School and Associate Professor, University of Missouri School of Law. "Legal Limitations on Public Pension Reform," Presented at Vanderbilt University, conference on "Rethinking Teacher Benefit Retirement Systems," February 19-20, 2009]

By the way, recently there have been federal legislation initiatives floating around that would allow states to declare bankruptcy. There is at least an implicit intention, by some parties, to use this legislation to reduce public sector wages. This is unnecessary. If an agreement cannot be reached among the parties, the state courts have the authority to reduce benefits.

3 - We Don't Know what the federal government - including the Federal Reserve - will do if states and cities go into default. Treasury Secretary Geithner may copy Hank Paulson's bazooka maneuver with Congress. The Fed may, or may not, buy a trillion dollars worth of municipal bonds before the Senate Banking Committee puts Chairman Bernanke in the witness box.

3 - We Don't Know what cities and towns that rely on a certain level of state aid to pay the bills will do. This, of course, is a Don't Know only after We Do Know that a state has stopped or reduced local aid payments.

4 - We Don't Know if states and municipalities will tell the feds to fund their own mandates. That is, regarding state and local costs that were either signed into law or regulations imposed at the federal level, but were not funded by the federal government. We are seeing some opening salvos, here, in Arizona, which is making cuts to Medicaid. I think cities and towns will test the waters, for example, in schools - where, instead of laying off teachers, they may drop federally mandated requirements.

5 - We Don't Know, once this step is taken, the response of the federal government and the courts.

6 - We Don't Know if states and municipalities will raise taxes if they are unable to meet municipal bond payments.

Rating-agency and brokerage-firm literature publish statements such as the following:

"What makes general obligation bonds...unique is that they are backed by the full faith and credit of the issuing municipality. This means that the municipality commits its full resources to paying bondholders, including general taxation and the ability to raise more funds through credit."

This is only true on occasion. A good place to study the variety of decisions is with a paper written by Kevin A. Kordana, an Associate Professor of Law at the University of Virginia. ["Tax Increases in Municipal Bankruptcies," Virginia Law Review, September 1997, Volume 83, Number 6.]

7 - Another Don't Know is the level of ignorance in cities and towns, where it is too often the case that nobody understands the financial situation. An outsider who drops by city hall can be amazed at how little anyone knows.

8 - Finally, and most importantly, the decision - or indecision, as it may be - to break the cities' or towns' contractual obligation to pay its lenders includes a lack of will among the parties. Here, we will have to wait and see.

THIRD, SOME AREAS WHERE MUNCIPAL SOLVENCY AND MUNICIPAL BONDS ARE MOST VULNERABILE:

Disagreements about public employee benefits and payments are in the headlines, so I will start there.

I used to work with investment committees of corporate, union, and municipal pension plans, to design pension policies. This included analyzing assets and liabilities. Understanding future, annual cash flows - outflows to retirees - was important for duration- and cash-matching of assets to payments. I said to the pension committee of a town in 1989: "There will come a point when you won't be able to pay these benefits."

This was not a surprise at all. They knew that. They had no say in negotiations between the different union groups in the town and the selectmen who approved the benefits. There had been an increase in future benefits through improvements to the benefit formula almost every year for several years. And, there was a boost to the formula almost every year during the next decade.

The proportion of retirees to current workers was small back then. Plus, discounting the much higher future payments 20 or 30 years out produced tiny numbers, that, over time, have blossomed. Now, we have reached the point when the benefit payments are exploding as a percentage of costs for many municipalities.

A second problem is maintenance expenses for municipalities that went on a building spree. A rule of thumb is they are about 30% higher than the prior trend.

A third potential problem is that many cities and towns are dependent on continual access to the bond market. If Treasury rates jump 3% or 4% in a failed auction, the light bill may not be paid.

A fourth means by which municipalities have telescoped the future into the present is by raising money through General Obligation bonds that is supposed to be used for a specific purpose but, the money is instead used to cover current expenses.

A fifth problem is the next step in the misuse of General Obligation proceeds. There are cities and towns that raise enough additional money in the bond market to cover the projected rise in next year's operating expenses.


MY FOURTH AND FINAL TOPIC IS OPPORTUNITES -

Opportunities in municipal bonds will spring from ignorance. They already have. There may be a panic of indiscriminate selling when owners of munis understand a municipal bond is not simply "money good." Such ignorance has produced great buying opportunities in the past.

For instance, in May 1933, all City of Miami bonds (with yields ranging from 4-3/4% to 5-1/2%, and maturities from 1935 to 1955) were quoted at $26. In the mid-1970s, the same combination of ignorance and fear created great buying opportunities for New York City bonds. All bonds traded for $25.

It will be awhile before buyers should pile in, but the wait may be worth it. A bond veteran who traded municipals in the 1970s - one who actually understood the securities - told me that buying New York City bonds at the bottom was extremely profitable.

The Exponentiality of Municipal Costs (and Some Advice for Endowments and Foundations)

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market"(Aucontrarian.com, 2009)

The word in social media is "exponentiality" of growth. Webster's, American Heritage, and Microsoft Word do not acknowledge it, I don't know how to spell it, but this path-breaking discussion of rising municipal costs deserves a word from the future.

The pension costs of states and municipalities in years hence are often stated in a calculation of future liabilities. For instance, the future obligations of state and municipal pension funds are calculated (in frequently cited studies) at between $1.5 trillion to $3.5 trillion.

Among the reasons for this range are the assumptions used by the actuary who produces the pension valuation, an annual exercise that shows a pension plan's current state of affairs. The liabilities, which, in turn, become pension payments, extend out 50 years or more: until the last member of the plan and all plan dependents have died. The actuary chooses an expected rate-of-return that will apply over the lifetime of the plan. The actuary also makes assumptions about the retention rate of current retirees, since benefits usually increase by years of service; the correct actuarial life table (how long will members and dependents live); and combines these with several other probabilities. Different assumptions are a reason for the $2.0 trillion range of future obligations, shown above.

In general, the rate-of-return being assumed by states and municipalities is too high, often 8.0%. Thus, the discount rate for future payments is too high. (The discount rate is the same as the rate-of-return assumption in municipal plans. This is not true in corporate plans.) Projections of future payments by plans using such assumptions are unrealistic.

Whatever the trillions turn out to be, the number is not of much use to interested parties. It is more helpful to know how municipal contributions will increase over time. These exponentialities are as varied as the pension plans - and the municipal bonds - to which they are attached.

Be that as it may, following are figures from three different state pension plans that may help the layman form an impression of how a specific plan might cause municipal finance restructurings again and again in the years ahead. There are two ways to read an actuarial valuation: either at a glance or through hours of analysis. The former is chosen here, since that is enough to illustrate the exponentialities; but is inadequate to address them. (Anticipating the question, should someone want the latter, I will do so - at a price.)

Some notes:

Pension obligations apply to General Obligation bonds, not Revenue bonds, though the eccentricities of municipal finance are bound to confound such an absolute statement. There is no substitute for reading the documents for each bond.

The state or town makes a "contribution" to the pension plan. The Plan is composed of a portfolio of assets that is expected to rise in price over time. (Thus: the importance of the actuary's rate-of-return on investments.) Benefits are paid from this portfolio of assets. Future employer contributions (there may also be employee contributions) are what bondholders, taxpayers, and retirees need to monitor for potential default by the states.

Future increases of pension contributions are not the only exponentiality. Future health costs may be higher than pension assessments. The bond owner should read the municipalities' actuarial valuation for "Postretirement Benefits Other Than Pensions."

Maintenance costs; because of the exponentially greater square footage of schools, town halls, and panic rooms built over the past 20 years; have increased expenses of such expansively minded municipalities at double-digit rates, a rule-of-thumb is for costs being 30% higher than the previous trend of cost increases.

The examples below were chosen because Massachusetts is local, New York's statements are thorough and clear, and North Dakota is celebrated as an oasis of fiscal sanity. The population (the members) of the "The State-Boston Retirement System," as well as the municipal workers covered by other Plans, is a subset of what the name indicates. States and cities have several different pension plans.

#1 - The State-Boston Retirement System:

The State-Boston Retirement System (SBRS) was required to make a minimum contribution of $143 million in 2000. This was the employer contribution. Plan participants may have also been required to put a percentage of their paychecks into the Plan. The minimum required contribution increased to $257 million in 2009 and to $336 million for fiscal year 2010. The actuarial firm, The Segal Group, estimates the minimum contribution will be $484 million in 2020. The Segal Group is using an expected rate-of-return of 8.00% to 8.25% during that period, and all years after.

The actuary calculates a corridor of possible contributions, from a minimum to a maximum. The SBRS made the minimum contribution each year, which, all else being equal, means contributions in future years have been, and will be, higher than if it had allotted more. As municipal finance goes, the SBRS has been prudent. See: Illinois is No Peter Pan for the Eval Knievel approach to pension fund management.

The Segal Group (in the person of Kathleen A. Riley, FSA, MAAA, EA, Senior Vice President and Actuary, who signed the valuation), and all other related parties who have an interest in achieving a compound, 10-year return of at least 8%, may find the minimum required contribution in 2020 will be much higher than the present estimate. Since such estimates, as well as health cost projections, are the base from which budgets are built, as well the foundation for rating-agency reviews, we might hope the reigning authorities have the good sense to cut the return assumption in half. And, if pigs could fly.

#2 - The New York State and Local Retirement System:

The New York State and Local Retirement System (NYSLRS) made a contribution of $164 million in 2000. In 2009, that had risen to $2.4 billion. What the future holds is a mystery: these numbers are from the March 31, 2009 Comprehensive Annual Financial Report, not the actuarial valuation. There are signs that the contributions will only go up. From the text: "[I]n 1999, benefit payments were approaching $3.5 billion, while this year's payments totaled $7.3 billion." Note: these are the actual dollars paid to the retirees, not the Plan's contribution.

There is a graph in the NYSLRS Financial Report (p.21, for holders of New York State General Obligation Bonds) that shows a steady rise of the number of retirees over the past 10 years. The salaries of those retiring today are much higher than those a decade ago. Since the pension received is usually a function of the final salary and years of service, payments will rise.

#3 - North Dakota Teachers' Fund for Retirement:

The North Dakota Teachers' Fund for Retirement (NDFR) popped out in a search for a North Dakota state plan. The Peace Garden State (as every school child knows) was chosen because it is often mentioned as an exemplary fiscal citizen. This choice was intended to show the condition of a pension plan with rock-solid management.

Contributions (in this case only, the number includes both employer and employee contributions) rose from $54.5 million in 2001 to $78.1 million in 2010. The Unfunded Actuarial Accrued Liability (the lower, the better) changed from a surplus of $21 million in 2000 to a deficit of $546 million in 2009, then plunged to a shortfall of $795 million in 2009.

This is an example of the havoc wreaked by the markets in 2008, though, as noted, the method here is glance-and-write. A full examination would elicit other developments, such as (among many possibilities) a generous boost to the retiree benefit formula. Similar damage can be seen from 2009 to 2010 for the SBRS, above.

This may cause a fatal blow to such plans if we suffer another such period. Many university endowments and foundations are similarly strapped. The funding ratio of assets to the Actuarial Accrued Liability (the higher, the better) fell from 109% in 2000 to 82% in 2009 to 55% in 2010. The Fund's initial descent followed the dot.com crash, when the same ratio fell from 96% in 2001 to 85% in 2003. (Because of timing and smoothing, pension valuations reflect past market booms and busts with a lag.) Yet, it can be roughly stated that the funded ratio fell by half (109% to 55%) over a period when stock market returns were approximetly zero.

Solely from inference, experience, and intuition (not knowing the asset mix employed, etc, etc.), it was not so much the negligible returns of the past decade, but the bust-boom-bust-boom pattern that probably did more to leave the Plan in such poor condition. The growing unfunded liability - that needs to be funded - will place a larger financial burden on the employer, at a time when not much is going right.

Back to the actuary's long-term, 8% rate-of-return: this could be fulfilled, yet, a 50% loss in the interim could sink the Plan. In the current environment - of unprecedented government interference, thus instability in the markets - pensions, foundations, and endowments should pay insurance, the simplest example being put options on indexes. Insurance costs money and reduces returns - until the moment it may save the pension fund or institution from an incapacitating blow. A university that can no longer afford its physics laboratories, a museum that sells its Goyas, a hospital that slashes its clinical education budget, is not the same institution.

There has been a trend, encouraged by some consultants, for pensions, foundations, and endowments to borrow money (for instance: borrow 100% to 200% the value of plan assets, at a 4.5% - 5.0% interest rate) and to invest the funds with the intention of earning a higher return while paying off the loan. Not knowing the future, this is a reckless strategy, even though, to a committee of trustees, it may be presented, and may sound like, the most sensible solution given a deteriorating situation.

The government and its appendages want stocks to trade at an inflated level. The objective of Quantitative Easing (QE), called "money printing" by the plebiscite, was stated by Brian Sack, head of the New York Federal Reserve Markets Group, on October 4, 2010: QE will "keep asset prices higher than they otherwise would be." Keeping asset prices higher than they otherwise would be ensures that, at some unknown time, asset prices will trade at a lower price than they should be.

Alan Greenspan Auditions on Comedy Central

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market"(Aucontrarian.com, 2009)


"There is no question at this stage that the momentum of this economy, leaving out the oil price issue, leaving out the Euro problems that have emerged, and very specifically leaving out the budget problems, this economy is really beginning to pick up momentum. The fascinating issue for forecasters is how do you factor in all of the negatives."


-The King Report, March 8, 2011, quoting from former Federal Reserve Chairman Alan Greenspan's "Guest Host" appearance on CNBC (also known as The Comedy Channel), March 9, 2011

Former Federal Reserve Chairman Alan Greenspan
waiting offstage before his CNBC comedy act.

Yellen and Khaddafy - Studies in Paranoia

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market"(Aucontrarian.com, 2009)


The continued existence of the Federal Reserve System is both the greatest threat to national solvency and an insult to the American people.

On February 25, 2011, Federal Reserve Vice Chair Janet L. Yellen explored new depths of dishonor. (For an earlier depth, see:Liquidate the Fed.) At a University of Chicago Business School forum, the life-long academic claimed: "I'll highlight the role of central bank communications in bolstering the effectiveness of unconventional monetary policy." [All Yellen statements are in italics.] The title of Yellen's speech was: "Unconventional Monetary Policy and Central Bank Communications." It was dishonest from beginning to end.

After the preliminaries, Yellen expounded her theme: "In the remainder of my remarks, I will present some evidence regarding the effectiveness of these policy tools..." Among the "unconventional" policy tools mentioned by Yellen were purchases by the Federal Reserve of mortgage-backed securities and "longer-term Treasury securities." The reason to buy longer-term Treasuries was "to depress term premiums and longer-term interest rates."

Chairman Ben S. Bernanke, the leading practitioner of mendacious central-bank communications, explained the Fed's plan to buy long-term Treasury securities in the Washington Post on November 4, 2010. He claimed the purchase of these bonds would drive their prices up; hence, their yields would drop. As a consequence: "[L]ower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment." [My bold - FJS]

Bernanke could not have been more wrong. On the day his communication was published, 10-year U.S. Treasury bonds yielded 2.33%. Today, they yield, 3.4% - a rise of 46%. Mortgage rates generally mimic Treasury yields. Over the same period, the 30-year Freddie Mac fixed mortgage rate has risen from 4.10% to 4.95%. House prices are falling again. In January, 2011, median, existing houses sold for $158,000 - the lowest level since April, 2002. Since the housing bubble was so great, the renewed decline is trampling more bystanders. From David Rosenberg, head economist at Gluskin, Sheff, in Toronto, on February 7, 2011: "The [U.S.] labor force has plunged an epic 764,000 in the past two months.... People not counted in the labor force soared 753k in the past two months.... [I]t looks like real weekly earnings contracted in January for the third month in a row."

Vice Chair Yellen went on: "My reading of the evidence, which I will briefly review, is that both unconventional policy tools - the use of forward guidance [that is - her contorted communication of unconventional policy to the public] and the purchases of longer-term securities - have proven effective in easing financial conditions."

With no more discomposure than Colonel Khaddafy, the academic stated: Last August [2010], the FOMC announced that it would begin reinvesting principal payments on agency MBS and agency debt into longer-term Treasury securities.... Consequently, when the Committee announced in early November that it intended to purchase an additional $600 billion in longer-term Treasury securities, that decision was largely anticipated by financial market participants, and it occasioned only minimal market response."

Certainly, the announcement in August put money in motion, but "only minimal market response" pretends interest rates have been stable since. Her "reading [that] the purchases of longer-term securities - have proven effective in easing financial conditions," is as great a distortion as the paranoid claims by the bedraggled Libyan dictator.

This is, in fact, the position in which Yellen and the other Fed apologists now operate. As in the last furlongs of the Soviet Empire, the Federal Reserve is a paranoid body that finds every action fails, and its only hope to retain legitimacy is to establish untruths and hope the prestige of the office smothers opposition.


Hear one-hour interview of Frederick J. Sheehan by Dr. Stan Monteith from Radio Liberty - February 17, 2011

A Municipal Score Card

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market"(Aucontrarian.com, 2009)

Meredith Whitney has kicked up a storm with her 600-page, municipal-bond report. She was one of the first analysts on Wall Street who warned the banks were going to topple well before they toppled. (Standard & Poor's downgraded Bear Stearns three notches - to BBB - on March 14, 2008, two days before J.P. Morgan acquired Bear's carcass.) Whitney told 60 Minutes on December 19, 2010: "You could see...50 to 100 sizable [municipal] defaults.... This will amount to hundreds of billions of dollars' worth of defaults." The municipal bond CABAL (issuers, fund managers, analysts, the municipalities) denounced Whitney and her predictions.

In concert with the times, the debate is superficial. It is not even a debate but a tryout for the Society of Mind-Numbing Auctioneers. The drift on Bubble TV goes something like this:

Bubblehead announcer: "You there - at the other end of the camera! Wha' da' you think of Whitney's hundred defaults?"

Muni Expert #1: (everyone on Bubble is an Expert): "No. That's extreme. Municipalities are having their problems, but they know it and are taking action..."

Bubblehead Announcer: "So - how many - 10?

Muni Expert #1: "It is hard to put a number on it, but I estimate [pause] none."

Bubblehead Announcer: "Yo! Number two! - Zero or 10?

Muni Expert #2: "Between zero and 20."

Bubblehead Announcer: "I have 20 defaults, 20 defaults, 20 defaults, He-e-e-re! Hey, producer! [Offstage] Will you give me 30? No? [Turning to the camera] There you have it folks. Whitney is a scaremonger who is trying to make money off your fears!"

These discussions do not enlighten. The typical municipal bond investor - and that is to whom the following is addressed - is older, may or may not still be working (the following will be directed more towards the retiree), has accumulated a pool of assets, and that pool is heavily weighted towards municipal bonds. This investor depends upon coupon income as a major source for spending. Municipal bonds are often preferred by this cohort because the stream of income is usually not taxed at the federal, state, or local level. Also, it is a top choice because investment advisers tell old people this is the safest investment. That statement is probably correct, historically, but then, "House prices have never gone down across the U.S." was the pitch line into 2007. (The demise of the house market is intertwined with the drum beat to destiny in the municipal bond market, for obvious reasons. But members of the CABAL ignore this.)

Newspapers are filled with stories of towns running out of money, municipal employee layoffs, reduced services, and taxes being raised. The resolution to these disputes will be as varied as the municipalities engaged in such struggles.

There are helpless cases, probably those identified by Whitney. She is an excellent analyst. Whether her forecast for the size and timing of defaults is accurate does not matter other than to a municipal bond insurer and credit-rating agency. It is whether the retiree receives the expected coupon payment from a specific bond or portfolio of bonds that is of first consequence.

There are four competitors in this struggle for municipal funds; the battle among them will potentially deny the bondholder full payment. It would be convenient if the parties could be split into four pieces of a pie, the pie being of a fixed size. There are two means, however, by which the pie may inflate, meaning new cash inflows that could delay the immediate prospect of defaults. These will be discussed next, after which the fixed pie will lie center stage.

First of the two is the bond market. Municipalities will continue to issue bonds until they cannot. Currently they can, notwithstanding some recent problems of specific issuers.

Today, many bonds are issued to meet not only current expenses (vs. capital expenditures), but also projected expenses in future years. This evolution is presumably not stated in bond offerings, but is known sotto voce. (Friendly city hall clerks are good sources for such information.) Municipal bonds were traditionally floated for capital requirements: construction, for instance. It was considered reckless, if not illegal, to sell bonds to pay this month's salaries. Today, it should be assumed that a cash-poor city will use bond proceeds for immediate needs - if it can get away with it. This is fraud. See the Miami Herald from February 17, 2011 "Audit: Miami Misused Millions in Public Works Funds."

Second, is the federal government. There has been talk of federal bailouts for states and cities. If the federal government is to pick up expenses for Illinois; California; New York City; Harrisburg, Pennsylvania; and a hundred others, the cost will be enormous. The federal government has plugged non-federal gaps at an increasing pace since the $787 billion stimulus bill was passed in 2009. It has also established avenues to keep paying state and city bills after the $787 billion is depleted.

This will not be sufficient though, so let us assume a Big Bailout Bill is proposed. This may or may not pass. If it passes, the pie (flows to the mendicants) will grow. This should help boost the municipal bond market, but it should be remembered that we will live to see the moment when yields of 10-year, U.S. Treasury bonds double, possibly precipitated by such a reckless Bill as this. When yields double (this is not a question of "if"), municipal bondholders may satisfy themselves that coupon income will still be paid, but that will only be of momentary consolation given the chaos of a broken bond market.

If such a Bill does not pass, Federal Reserve Chairman Ben Bernanke may buy a trillion dollars worth of municipal bonds before Congress acts. Some congressional committee would then interrogate this unaccountable public servant, doubting the legal authority for his purchases. Bernanke; in his vague, impenetrable mien; will claim he had authorization and cannot reveal which securities the Fed bought since disclosure would endanger the solvency of the parties involved. ("Parties" - including the balance sheet of the Federal Reserve.) The New York Federal Reserve Bank will publish 12 papers, simultaneously, with both historical and legal justification for the Fed's purchase of municipal bonds. That will be that. Assuming the bond market shuts down (it will, at some unknowable point) and the Feds, as well as the Fed, do not inflate the pie, the fixed pie with the four parties can be viewed as follows. (Eventually, the deleverging U.S. economy will shrink this fixed pie. Tendencies during the time when America is miniaturizing will probably resemble those discussed below.)

#1 - Bondholders - want to be paid interest and principal. (General Obligation bonds are addressed here. The distinction from Revenue bonds is explained on page 20, footnote 20 of The Coming Collapse of the Municipal Bond Market.) Aside from not being paid, most bondholders do not want to be scared. ("Most" - because some thrive on these fears.) Fears can be precipitated by potential default. Prices are likely to fall when default threatens. For example, see six-month charts of California and New York State municipal bond funds. Very few bonds in California have defaulted, possibly none in the funds. Therefore, all interest and principal payments may be current. There are many investors who will not be reassured (and, already, in California and New York are dismayed) should the market value of their investments fall 20%.

The fact that many municipal bond investors are not sophisticated, and look to these assets as their source of retirement income, means this market could be particularly subject to panic. On the other hand, the highly vulnerable investors may be too petrified to act.

Default may mean no more than a few missed payments that will be paid later. (A technical default means no missed payments at all, but it would be surprising if the Bubble media is able to explain this material distinction to its viewers and readers, who may be deaf to legal talk when their remaining assets are plunging in value.) The holder of a bond in default may not listen to promises that missed payments will be paid in the future, no matter how likely. The sales pitch is often that "municipal bonds are the safest of all investments." These investors have heard this before (stocks, houses), so may have lost heart.

Therefore, the bondholders are not interested in grievances of public employees, the loss of municipal services, or, a tripling of tax rates to avoid default. The municipal investor being discussed needs this money.

#2 - Municipality - the state, town, county, or other administrative district does not want to change its mode of operation. It would like to continue building monuments to folly, hiring campaign workers in permanent jobs, awarding higher benefits to employees, and selling bonds since tax receipts do not meet this largesse. See: Illinois is not Peter Pan.

Some, of course, know better and are cutting expenses and attempting to corral employee benefits. Some were always managed well. But those in the headlines pretend to address current circumstances with no intention of balancing their budgets. They have more to lose by doing the right thing - such as, laying off workers, or, halting the construction of a new $100 million high school that is intended to provide 3,000 union construction jobs. Often, this is the reason schools, stadiums, museums, and other white elephants have been built.

The ostriches with their heads in the sand can not conceive of a time when the bond market will shut down. They have little motivation to close funding gaps. The ostriches are also very American; specifically, the vintage of Americans who have been swept into the post-modern guise that everything will work out well. In this case, the federal government will fill the gaps. They may be right, but for how long?

Municipalities hold a trump card that has not received much attention. Many state and city expenses are mandated by the federal government. Congress imposes new regulations that include more school administrators, demand access ramps, the expansion of health benefits, and on it goes, but the Feds do not fund these declarations of magnanimity. In 1970, Medicare cost the states $2 billion. The estimate for 2008 was $158 billion. Some state or city is bound to tell the Feds "you pay for it, or we're stopping it." From a spectator's point-of-view, the scuffle that follows will be engaging.

#3 - Employees - want to keep what they have and many want more. The United States is a large country so it is hard to generalize about the stubbornness on either side. Recent histrionics in Wisconsin, including the juvenile comments by President Obama, represent the aggressive union position. The unions will not budge. In such situations, when the negotiation of benefits and pay fails, court decisions will intercede. Bondholders are the least of the unions' concerns. In such circumstances it is prudent for bondholders to expect the sort of vilification heaped on the owners of General Motors' debt.

As a reminder, the Obama administration and the unions accused hedge funds of forestalling justice. The greedy Greenwichites claimed General Motors' bonds were a contractual arrangement (a bond being a contract). This would not do and a ukase was imposed on hedge fund managers that satisfied the President, a graduate of Harvard Law School.

Crucial to the propaganda campaign was the false representation that hedge funds owned most of the bonds. In fact, a large contingent of GM bondholders fit the profile of the municipal investor. General Motors' bondholders wanted their day in court.

The Family and Dissident Bondholders group was denied official status to represent bondholders by the bankruptcy court. [In re General Motors Corp., 09-50026, U.S. Bankruptcy Court, Southern District of New York (Manhattan).]

The group was overwhelmed by the machinery of the state. A spokesman for the Unofficial Committee of Family & Dissident GM Bondholders said: "The committee members today simply lack the resources needed to mount an effective appeals process on the accelerated basis that would be required here." The "accelerated basis" indicates the Dissident Bondholders were denied Due Process, a potential hazard to municipal bondholders.

Peter Kaufman, president of the Gordian Group LLC, an adviser to the Family and Dissident Bondholders, stated: "It's a tragedy. Twenty-seven billion dollars of bonds, many if not the majority of which are owned by mom and pop, have been essentially wiped out."

Not many municipal bond managers and brokerage firms have considered such a reoccurrence when municipal workers tread the same path. The mom-and-pop holder of a Wisconsin general obligation bond should be prepared to sell in a hurry. In fact, mom and pop should not own Wisconsin general obligation bonds today. Wisconsin sold 10-year bonds in January, 2011, with a yield-to-maturity of 3.75%. Given our state of affairs, which includes Ben Bernanke's campaign to ruin the dollar, the entire structure of interest rates will double at some point. Consumer inflation is at least double the 10-year yield today - 7.5%. Mom, pop, grandma, and grandpa are not being paid an adequate yield given the risks, and given that these securities only repay a fixed amount of dollars. Bonds do not go Verticalnet.

The militant public employee and compromised court scenario is the worst case. There are many municipalities where pay and benefits remained within reason. There are other states and cities with more important troubles. There are some with no problems.

#4 - Taxpayers - are not happy. Homeowners are often paying more in property taxes now than before house prices fell 10% - 50%. States have also raised sales taxes and imposed fees on the most basic services. The citizenry is awakening to the mismanagement and criminal racketeering that created the fiscal abyss Meredith Whitney so ably quantified.

Taxpayers grit their collective teeth as they are learning of outrageous pension and health benefits awarded to their neighbors, the contractual skullduggery between city officials and parking-garage managers, and the fleecing of the taxpayers through incompetence that is barely conceivable to any bystander with an IQ above 70. To all appearances, the taxpayer is facing an infinite tax bill since general obligation bonds are sold with the promise that the issuing authority will "in good faith use its taxing power as may be required for the full and prompt payment of debt service."

This belief is another reason legislators are slow to act and that some public-sector unions are unwilling to negotiate pay and benefits. This is in contradiction to the workers best interests, but they will be the last to accept the Deleveraging of America. Taxpayer resentment is building, a pustule with the ulceric properties that may corrode this mountain of municipal malpractice.