Thursday, February 23, 2012

Reply to Jack Point:: Economic Collapse

Jack Point said,
Some differences with the UK & US and Sri Lanka
1. The public debt in those countries has shot up recently because of the bailouts. UK debt was around 40% prior to the crisis.
2. They have already achieved a high standard of living. Even if they stagnate or decline, it is from a high base. We are still poor.
3. The public debt, apart from the bailouts has funded for the most part infrastructure and services of value. In SL it is being used to fund interest repayments, pay salaries (for which very little is delivered). What infrastructure has built gone to the pockets of cronies in building white elephants.
Will try to address your concerns by three sections,
a) the state of US economy,
b) impact of an economic crisis on US compared to Sri Lanka
c) White Elephants, Cronyism in the US.

State of the US/UK Economy
Jack Point, contrary to your thinking the large public debt In US has been in the making since the late 70's. During the last century the US (UK and west in general) have been by far the largest consumers of resources in the world. In the case of the UK, they were funded by their colonial enterprises; think shipping Indian cotton to Lancashire, manufacturing cloth in the UK and selling it back to India while making it a criminal offense for the Indians to spin cloth from their own cotton. For the US the funding for resources was economic colonialism in South America and also being the only major manufacturing economy in the world after World War II.

By the late 60's cracks in the funding for the world resources to maintain the US/UK standard of living had started to emerge. For the UK it was earlier with loss of the colonies and the aftermath of World War II. In the US the 60's was the heyday of its economy, regardless of the Vietnam and Korean wars. The height of Flower Power and bright future assured for the young adults at that time even if they took many years of time out from career paths to "find themselves" either by traveling or living in an Ashram in India or both.

Japan and Germany had regained manufacturing power (with the help of the US) and were making inroads into market share of US products, even though ideologically it appeared that the Old Soviet Union was the greatest threat. The net national income started to decrease and defecit borrowing was needed to purchase the resources to maintain the lifestyle and living conditions of the 60's. That was the time of the famous Reagans "Deficits don't matter". In the eight years between 1981 and 1988 the United States moved from being the world's largest international creditor to the largest debtor nation.

Then there was real reprieve and resurgence in the US economy starting from the mid to late 80's to the late 90's with advent of the PC Technology. Completely US innovation and of worldwide use. However, free market ideology and the pursuit of profits by multi nationals ensured that the technology was shipped offshore and and end products shipped back to the US.

In the US, the country's decline in National Income lead to deficits and increasing Public Debt. Similarly for US citizen the real incomes started decline, exacerbated by increasing oil prices. This necessitated the US public having to take on increased debt in the form of credit cards, mortgages and student loans to keep their current life style. Easy lending standards, low mortgage rates all fueled the public's debt spree. Some of the practices were illegal, but with rising asset prices not a Bank cared. The writing was on the wall, by 2005 there were quite a few who were warning of impending collapse of the Securitization market (Assets created from Mortgages, Credit card debt etc). Read Tanta's Let Loose the Dogs of Hell (and comments) for an idea what was foreseen for the Mortgage market. Read More than you ever want to know of Mortgage Securitization at Tanta's Uber Nerd collection.

Anyway it all came to head in 2008, with the collapse of Lehman brothers and AIG. If it wasnt for the Govt bailouts, it would have been total collapse of all the large Investment banks. Unhappily, the underlying problems have not gone away. Its still there allowed to be hidden away with repeal of certain accounting rules (FASB MTM). The comment in 2007 from Scratch and Dent Loans " that does imply's JPMorgan also implies that the Big Dogs have more cooties on the balance sheet than they're prepared to tolerate. Looks like total war to me" still applies. More on this in the Cronyism section.

Impact of an economic crisis on US compared to Sri Lanka
I have been thinking and reading about of the consequences of economic collapse in different societies for a few yeas now, 2005 to be exact when it was apparent the US housing market was going to collapse. Societal issues such as not having or just a skeleton police force is too long to be discussed in a single blog post. I'll just address loss of or expensive fossil fuel energy caused by economic collapse.

The Modern world (for humans) runs on fossil fuel energy on scale never before seen in history. One of famous examples is that "a planeload of tourists flying from Los Angeles to Cairo to see the Great Pyramid use more energy in that one flight than it took to build the Great Pyramid in the first place". So, economic crisis are also energy crisis (for the most part) and examining the role of cheap fossil fuel energy in the functioning of a society provides a measure of that societies vulnerability to an economic crisis.

The population in Sri Lanka is mainly rural (80%) and the only really large city is Colombo with little over a million residents if Dehiwala/Mt. Lavinia and other suburbs are included. Imagine a situation where the complete supply of oil to Sri Lanka was cut off. Life will be difficult, but will not result in death amongst a large section of the population. The worst affected will be the urban, specially those living in apartments. Think, carrying water for daily use up many flights of stairs. Water even in urban area is readily available, even if it means walking about half a mile. House dont need to be heated. One literally light a fire on the floor for cooking purposes as all houses are made of cement (wooden shacks are in rural areas). Coconut oil lamps are not that much of a fire hazard like in the west with carpeting and wooden house. Financially the Sri Lankan population does not have much debt either.

Life in the west is almost completely fossil fuel energy dependent. Think Urban areas, high rise apartments, heating during the cold season and the necessity for cars in suburbia. The US is the second largest user, consuming about 19% of the worlds energy (China is the biggest with about 20.3% consumption of worlds energy). Note: energy usage of the US does not take into account, energy used to manufacture goods imported into the country. The US is about 80% self sufficient. In comparison China is almost 100% dependent on external souces for fossil fuels.

On the economic front in the US there are 13 million unemployed, 46 million people on food stamps and approximately 29% of the country's homeowners mortgages are under water (mortgage amount is greater than house value). Total mortgage debt of the US is 14 trillion and most of are booked on the Asset side of the large banks as mortgage backed securities (MBS). I am not even going into derivative of MBS (CDS and CDO' etc) and Asset Backed Securites (Credit Card Debt, Auto Loans and Home Equity Loans). US debt is 15 Trillion, a little over 100% GDP and growing very fast, with the deficits being about 1.3 Trillion since 2008. (And people think Sri Lanka has it bad)

I really cannot see any way out of the dilemma of the US economy. The only reason they have been able to avoid economic collapse is because foreign countries still think the dollar is a safe haven and proceed to fund the US deficits. Its much like an extremely rich person, who has become extremely indebted, but banks and people will still lend money thinking it will be paid back. Some extremely austere measures might work in bringing the deficit down, like one proposed in cutting the Federal Work force by 15% which would save 15 Trillion in 10 years. However, even if the political will was there (which is unlikely; see cronyism section), there would be negative feed backs that could lead to greater economic fallout. One such direct result would be that the laid off workers could no longer pay back mortgages decreasing the value of the MBS Assets held by the Too Big To Fail (TBTF) banks.

From the perspective of energy, the US is fairly self sufficient. However, when economic collapse occurs (notice when, not if), there should be mechanisms to provide the population locally produced fossil fuel at cost or moderate profit. I do not think this will occur, simply because
a) this would be against the ideology of free market
b) the energy company lobby (lobby is another word for bribery and corruption) is too strongly entrenched in US politics.
Providing energy at cost as against free market prices would probably enable wages to be reduced while maintaining same standard of living and while making US manufactured goods competitive because of reduced labor cost and energy cost. But then unhappily there is the free market ideology and energy lobby standing in the way of that idea.

So what was it again, wasnt this discussion about the disaster Sri Lanka was heading toward. So I'll end this section with an excerpt of a comment I made about Arujuna Sivanathan's "analysis" of Sri Lanka's economy.
As they say talk is cheap, and show me the money. So what is the money, (i.e people who stand to loose or gain based on Sri Lanka's economy) doing. Sovereign Yield spreads and CDS spreads on Sri Lanka indicate medium risk, and definitely nowhere near the Greece's CDS spreads. Another indicator that even the man on the street understands are foreign exchange black market rates and property prices. The difference between the Official exchange rate and the Black market is a about two rupees. Property prices are rising even in Jaffna. If the economy (and human rights) were so bad you would expect property prices to decrease and the black market exchange rate to increase. i.e. People desperately want to sell their property and move it out of the country by buying foreign currency in the Black Market.
You can also read about Life in Argentina after it defaulted and Life in Russia after the economic collapse. You can also read a tongue in the cheek article (initially emailed around 2008) on Mortgage debt (MBS) and the dynamics of the US-China economic relations Fannie Freddie and the Chinese: The IOU Laws

White Elephants, Cronyism and Corruption in the US
The World Trade Center and the JFK program to send a Man to the Moon were considered white elephants for many years. The World Trade Center property, home to hundreds of commercial and industrial tenants, property owners and small businesses were taken over by Eminent Domain. Large sections of the WTC could not be rented and was considered an eye sore in NYC.

The cronyism and corruption that has occurred in the US (I have not really followed the UK) is on a scale unparallelled in history. Read the article Why isnt Wall Street in Jail from the Rolling Stone magazine for a good overview.

Another couple of examples not in the Rolling Stone article.

a) The Too Big To Fail (TBTF) banks, by excess and at times illegal risk taking almost caused the US economy to explode and had to be bailed by tax payer money. For all that hard work, the US government allowed the CEO and Senior executives to continue collecting billions as bonuses since 2008.

b) Treasury Secretary Henry Paulson told his pals from Goldman Sachs and some other Hedge fund managers the rescue of Fannie Mae/Freddie Mac would entail wiping out common stock. Now that is golden information, with a couple of thousand dollars in put options you could make about a million when the Fannie Mae/Freddie Mac stock price nose dived. Oh wait, isn't that what is called Insider Trading, that little thing for which Raj Rajaratnam went to jail. Not quite, apparently no such rules for Govt officials.

c) George Bush purchased in 1989 for $600,000 a 2% share of the Texas Ranger team. The land for the stadium was seized by eminent domain and the stadium built with tax payer funds. Then in 1998 the Rangers were sold and Bush got 14.9 million for his share. There were issues of insider trading as well, you can read them up in wiki link.

c) MF Global used customer account money to pay of its Trading debts. John Corzine who was the CEO authorized use of this money. Think Golden Key and Kotelawela. So do you think John Corzine, ex CEO of Goldman Sachs, ex Governor of New Jersey and ex US Senator is going to be prosecuted. I think not, because that might set a bad precedent of sending highly connected people to jail.

d) Hiding of financial information. After 2008 Financial Accounting Standards Board (FASB) has allowed Level III assets to be valued at cost or purchase price, and not current market prices. So what are Level III assets; they are mostly MBS and ABS. If you recall those pesky assets made up of home mortgages and credit card debt etc on the TBTF Bank balance sheets. So you may well ask whats the issue with carrying at cost. When you think of a MBS made of five 200,000 mortgages then original cost for simplicity is 1 million. So one of the mortgages has defaulted and there is zero recovery. That means the MBS asset is now really 800,000 but under FASB rules you allowed to book the MBS at 1 million till all the mortgages have paid up or the MBS is sold. Now is that hiding or what. You may well ask who cares. It probably means that these banks will require further bailouts down the line, while the CEO etc continue to collect billions in Bonuses and compensation. I have just skimmed the surface.
It just becomes worse, with all eyes on Level III assets, some of those assets have been moved to level II where indirect methods/models are used for valuation.
Then it becomes a little harder to do back of the envelope like I did in 2008 for Goldman Sachs
Assets 1,081,773.00
Liabilities 1,036,174.00
Equity 45,599.00

# of shares 395.44
i.e. Book value /per share = 45,999/395.0 = 115.00
Thats the price Warren Buffet bought at.

We know that level 3 assets are 70 billion
i.e. 7% of assets (70,000/1,081,773)

Does not sound a big deal, right ?

Say now your Level 3 assets are over valued.
Value needs to be reduced by 30%, i.e approx 20 billion (30% =20 billion/70 billion).
30% haircut on Level 3 assets is very optimistic, more likely 80% right now.

You equity is now 45,599.00 - 20,000 = 25,599
i.e. Book value /per share = 25,999/395.0 = 65.00

And thats still optimistic. If its 80% GS is insolvent. !!

e) Finally, you can read about fraud or gross negligence in paperwork ((equivalent to Sri Lanka transfer of deed and recording in Land Registry) when mortgage loans were transferred. US: Cautionary Tale of deregulated Banking

Regards "Even if they stagnate or decline, it is from a high base. We are still poor." then reading The Collapse of Complex Societies: by Joseph Tainter (or even the Amazon reviews) coupled with reading of the the blogs on life in Russia and Argentina might be enlightening and probably make your outlook of Sri Lanka more optimistic.

He then lays out his theory of decline: as societies become more complex, the costs of meeting new challenges increase, until there comes a point where extra resources devoted to meeting new challenges produce diminishing and then negative returns. At this point, societies become less complex (they collapse into smaller societies). For Tainter, social problems are always (ultimately) a problem of recruiting enough energy to “fuel” the increasing social complexity which is necessary to solve ever-newer problems.
Cruel Windfall: Hows wars plagues, and urban disease propelled Europe’s rise to riches can also be quite enlightening

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