Friday, October 30, 2009


In November 2007 we wrote an article entitled “Surreality Check… Dead Men Walking”, in which we discussed the early warning signs of the impending credit crisis and highlighted companies that were looking particularly troubled to us at the time.

We identified General Motors with a book value of negative $74 per share that boasted a market cap of $15 billion. (Ask your friendly neighborhood Chartered Financial Analyst to explain that one to you). Two years later? Following a $50 billion government injection, GM declared bankruptcy on June 1, 2009 and reemerged on July 10, 2009 with new owners consisting of: the US Treasury (60.8%), the Crown in Right of Canada (11.7%), previous GM bondholders (10%) and the UAW Health Care Trust (17.5%). GM stock went to zero.

We identified Fannie Mae, which, at the time, had a market cap of $40 billion and owned/guaranteed $2.7 trillion of mortgages - or about a quarter of all residential mortgages in the United States at the time. Fannie’s leverage ratio was a sobering 67:1. Two years later? Fannie Mae and Freddie Mac have both been nationalized. On September 7th, 2009, the US Treasury announced the two mortgage giants were being placed into a conservatorship run by the FHFA and pledged up to $200 billion each to back their crumbling balance sheets.
We highlighted Citigroup as a candidate for collapse under the weight of its subprime portfolio. One year later? $25 billion from the TARP program, a massive US government guarantee on $306 billion in residential and commercial loans and a cash injection of $27 billion into Citigroup for preferred shares. It was a de facto nationalization.

Why the walk down memory lane? The equity market performance in November 2007 masked the underlying problems plaguing the financial system at the time, and it’s blindingly apparent that it is doing the same again today. The government has assumed most of the financial system’s liabilities in a giant game of ‘kick the can’. The calls for a new bull market are coming fast and furious. Market participants are bidding up the stocks of companies that are demonstrably bankrupt, and government balance sheets have ballooned to unforeseen levels. As respected market commentator David Rosenberg recently wrote, “the stock market is divorced from economic reality”.1 It’s time for another surreality check, but this time it isn’t the publicly traded companies that deserve attention, it’s the governments that have saved them. Make no mistake – the dead men are still walking – they’re just a lot bigger now than they were two years ago, and they don’t generate earnings – they print money and tax their citizens.


In case you failed to catch it in our previous articles this year, we thought we’d state it outright for our readers this month: the United States Government is on a trajectory to default on their obligations. In its current financial condition, it will not be able to fund its forecasted budget deficits and unfunded Social Security and Medicare promises on top of its current debt obligations. This isn’t official yet, and we don’t know when the market will react to it, but there is no longer any doubt about the extent of their trajectory. There simply isn’t enough taxing power, value creation or outside capital willing to support its egregious spending.

Stating the obvious may be construed by some as fear mongering, ‘talking up our book’ or worse, but our view is not as severe as you might think. In the Federal Reserve Bank of St. Louis’ Review from July/August 2006, Lawrence Kotlikoff stated that “partial-equilibrium analysis strongly suggests that the U.S. government is, indeed, bankrupt, insofar as it will be unable to pay its creditors, who, in this context, are current and future generations to whom it has explicitly or implicitly promised future net payments of various kinds.” 2 He went on to suggest that the US should immediately close the Social Security program to reduce future liabilities (could you imagine?), use a voucher system for Medicare to limit costs, and replace personal, corporate, payroll and estate taxes with a single federal sales tax. All this, published in an article from 2006, well before the credit crisis and subsequent meltdown had even begun!

Three years later, the financial condition of the US government is completely untenable. The projected US deficit from 2009 to 2019 is now slated to be almost $9 trillion dollars.3 How on earth does anyone expect them to raise this capital? As we stated in a previous article, in order to satisfy US capital requirements, all existing investors would have had to increase their US bond purchases by 200% in fiscal 2009. Foreigners, however, only increased their purchases by a mere 28% from September 2008 to July 2009 - far short of what the US government required.4 The US taxpayer can’t cover the difference either. According to recent estimates, tax revenue from all sources would have to increase by 61% in order to balance the 2010 fiscal budget. Given that State government income tax revenues were down 27.5% in the second quarter, the US government will be lucky just to maintain its current level of tax revenue, let alone increase it.5

The bottom line is that there is serious cause for concern here – and don’t be fooled into thinking
this crisis will fix itself when (and if) the economy recovers. Just how bad is it? Below we outline the obligations of the US Federal Government from 2004 to 2009. We present two sets of numbers, as government accounting can vary widely depending upon the source. In column A, we outline the Total US government Obligations, using actuarial reports from the Social Security Administration and the Medicare Trustees Reports. In column B we identify Total Federal obligations according to GAAP accounting provided by Shadow Government Statistics, calculated on a US fiscal year end basis with estimates for 2009. The differences in the absolute amount of total obligations ($114.7 trillion vs. $74.6 trillion in 2009) are a function of timing, the calculation timeline for Social Security and Medicare, and other obligations included under GAAP rules. Either way we choose to calculate it, the total number is preposterously large. From 2004 to 2009, US unfunded obligations increased by an average of almost 50% over this six year period under both calculation methods, while US government revenue increased by only 12%.6 No company or government can increase its liabilities by more than four times the rate of its revenue and stay solvent for an extended period of time. And as the numbers imply, the hole that the US government is digging is getting deeper by the minute. On a GAAP basis, US government unfunded obligations increased by more than $9 trillion from last year alone! That represents ten years of projected deficits added in a mere twelve months. How can this be happening? The numbers are surreal, and we must ask ourselves how much longer the world will continue to support this spending frenzy.

The Federal Deposit Insurance Corp. is another major problem for the US. The FDIC’s Deposit
Insurance Fund, which had $10.4 billion at the end of June, has spent so much covering bank failures over the last three months that it is now completely out of money. This means there is no capital set aside to insure the $4.8 trillion of deposits and $320 billion worth of FDIC-guaranteed debt that US banks and other financial companies have issued. The real shocker that we discovered some time ago is that the FDIC ‘funds’ were never even held in a segregated bank account – the fees collected from the banks are accounted for as a part of the government’s general revenues that go towards military spending, bailouts, interest costs and other government programs. The FDIC ‘fund’ merely consisted of IOU’s from the general revenues accounts. And now that the Deposit Insurance Fund balance as of September 30, 2009 is negative13 the FDIC wants the institutions to prepay their assessments for all of 2010, 2011 and 2012. In effect, the FDIC wants to borrow money from the banks it provides insurance for. Does this not strike you as surreal? Why would anyone have any confidence in anything the FDIC guarantees?

To see the full report: UNITED STATES MARKETS