Green Taxi

I do not see how it can get any better. Let me explain using rough numbers.

Obama’s budget for 2011 calls for $3.8 trillion in spending, with only $2.3 trillion in revenue (ie. taxes).  The current GDP is roughly $14.5 trillion. Thus, we will have a deficit of $1.5 trillion for 2001, or 10.6% of GDP.

The deficit for 2009 and 2010 are on roughly similar levels. To get a sense of how ugly that  is, let’s look at one of the ugliest charts I’ve ever seen.

Yes, that clearly shows how not only our spending increasing massively, but the amount we are bringing in decreasing quickly.  This new budget does not plan to tighten that gap next year.

However, the budget does plan to bring the deficit down from 10.6% of GDP to only 3% by 2015.  How?  Close our eyes and pray.

“Economic recover alone is expected to reduce the deficit-to-GDP ratio to 5% by 2015,” said White House Budget Director Peter Orszag.  So, it’s like the housing market, where we are just hoping it will go back up and everything will take care of itself?!   OH FUCK.

The budget cuts and tax increases are getting the headlines, but it really means nothing. The over-hyped bank tax on the front pages is supposed to raise $90 billion over 10 years. That is $9 billion per year, or roughly an impact on the deficit of 0.06% of the GDP.

Well, maybe the economy will recover and we’ll all be saved. Please explain to me how that can happen?

Who’s Gonna Pay For It

Over the past year, the Federal Reserve bought roughly $1.2 trillion in mortgages, part of a plan to support the housing market. Effectively, that buying financed the US government fiscal deficit, albeit indirectly. As John Mauldin explains,

“It seems that funds and banks that sold the mortgage securities turned around and bought US government debt or put the cash right back at the Fed. Foreigners (note: Chinese being the largest) bought about $300 billion of the $1.5 trillion in new government debt. The rest came from the US, courtesy of the Fed buying mortgages.”

Unfortunately (or, rather, fortunately), the Fed is just about done buying mortgages. Their program officially ends in March, meaning from then on, someone else has to buy the extra $1.2 trillion in federal debt, not counting the growing state and local debt.

As Bill Gross explains, the Fed’s mortgage buying, and in effect deficit covering, was behind the markets rally in 2009.

“The fact is that investors, much like national citizens, need to be vigilant, and there has been a decided lack of vigilance in recent years from both camps in the U.S. While we may not have much of a vote between political parties, in the investment world we do have a choice of airlines and some of those national planes may have elevated their bond and other asset markets on the wings of central bank check writing over the past 12 months. Downdrafts and discipline lie ahead for governments and investor portfolios alike. While my own Pollyannish advocacy of ‘check-free’ elections may be quixotic, the shifting of private investment dollars to more fiscally responsible government bond markets may make for a very real outcome in 2010 and beyond. Additionally, if exit strategies proceed as planned, all U.S. and U.K. asset markets may suffer from the absence of the near $2 trillion of government checks written in 2009. It seems no coincidence that stocks, high yield bonds, and other risk assets have thrived since early March, just as this ‘juice’ was being squeezed into financial markets. If so, then most ‘carry’ trades in credit, duration, and currency space may be at risk in the first half of 2010 as the markets readjust to the absence of their ‘sugar daddy.’”

To cover the deficit this year, the US government needs about 8% of the GDP from other sources, primarily it’s citizens. “That means that consumers and businesses will have to save an additional 8% of GDP just to finance federal government debt,” John Mauldin explains.

Considering most individuals balance sheets, I do not see that coming from new savings. Which means it has to come from somewhere else. Expect the stock market and other high risk markets to drop this year as we as a nation reallocate our savings into government bonds.

Real Estate Double Dip to Begin

Lastly, let’s look at the other side of the Federal Reserve coin. Their program to stop buying mortgages will not only hurt the Treasury, but also the real estate market.

Over the past 2 years, the US home mortgage market has been nationalized without anyone noticing. The Fed now owns $1.25 trillion in mortgages that it bought off of banks and funds.  In the meantime, almost all new loans are being made by the government. As Andy Miller explains in an interview with David Galland of The Casey Report,

“Last September, reportedly over 95% of all new loans for single-family homes in the U.S were made with federal assistance, either through Fannie Mae and the implied guarantee, or Freddie Mac, or through the FHA. If government support goes away, and it will go away, where will that leave the home market? It leaves you with a catastrophe.

Why am I so certain that the federal government will have to cut back on its lending? Because most of the financing is done via the bond market, through Ginnie Mae or other government agencies. And the numbers are so big that eventually the bond market is going to gag on the government-sponsored paper.”

In other words, more forms of government bonds, of which virtual financing is drying up as the Fed stops their mortgage purchases (remember, the Fed bought mortgages from people who turned around and bought government debt, such as these). There is now no natural buyer of nationwide home mortgages. Add the massive market supply and percentage of homes underwater, and we realize the real estate market is in still grave trouble.

CRE’s Turn to Crash

It is not just the housing market, either. The commercial real estate bomb is about to drop.  Andy Miller believes it will come during the second quarter of 2010.

“The reason I say second quarter 2010 is a guess is that the Treasury Department, the Federal Reserve, and the FDIC can influence how fast the crisis unfolds. I think they can have an impact on the severity of the crisis as well – not making it less severe but making it more severe…they can influence the speed with which it all unfolds, and I’ll give you an example.

In November, the FDIC circulated new guidelines for bank regulators to streamline and standardize the way banks are examined. One standout feature is that as long as a bank has evaluated the borrower and the asset behind a loan, if they are convinced the borrower can repay the loan, even if they go into a workout with the borrower, the bank does not have to reserve for the loan. The bank doesn’t have to take any hit against its capital, so if the collateral all of a sudden sinks to 50% of the loan balance, the bank still does not have to take any sort of write-down. That obviously allows banks to just sit on weak assets instead of liquidating them or trying to raise more capital.

That’s very significant. It means the FDIC and the Treasury Department have decided that rather than see 1,000 or 2,000 banks go under and then create another RTC to sift through all the bad assets, they’ll let the banking system warehouse the bad assets. Their plan is to leave the assets in place, and then, when the market changes, let the banks deal with them.  Now, that’s horribly destructive.”

Thus the banks are back where they began.  Free from writing down problem mortgages and allowed to lend without any capital usage.

The Big, Scary Picture

So, let’s take a step back and look at this from afar. We have a deficit of $1.5 trillion for 2009, 2010, budgeted for  2011, and “planned” to slowly decline from there going forward. The Fed covered most of that deficit in 2009, but will be stopping soon. Meanwhile, the mortgage market has been nationalized. The mortgage financing must come from somewhere, and it is not coming from the Fed after March. The government will try to sell bonds, but we do not know who will buy them any more.

We have a deficit that we will struggle pay for and mortgages for which our government will soon lack financing. How do we get out of this? Well, we cross our fingers and hope that the economy will recover, according to Obama’s Budget. If the economy grows, so will our tax revenues.

In the meantime, our government will avoid cleaning up any existing risk. First, the Fed bought $1.2 trillion in mortgages to buoy the real estate market and bank industry and prevent true clearings of either market. At the same time, the FDIC is allowing banks to continue to hold risky assets without marking them down, thus preventing them from failing and letting the market clear.

This is a ticking time bomb that is growing with each misstep. Personally, I hope the bomb goes off in the second quarter of 2010. We need to begin to go through the pain (as they are in Colorado Springs) or or the bomb will continue to grow. Can we make it through to 2015 or 2020 with steady economic growth that will pay for all of our problems? Yes, but the odds are massively against us. I’d prefer not to bet on Optimism at this point. The main risk is that nothing clears this year or the next and we have a gigantic bomb go off in 2013 or 2014 from which we cannot recover.

This is scary as hell and I am not embarrassed to admit it.

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