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The State of the States – A woeful picture of fiscal profligacy, Bankers take the bait again...hook, line and rusted old sinker, Plus, Bill Bonner on fudging the data to save the economy (and the planet), and plenty more... The Daily Reckoning | Friday, April 2, 2010 Demon Debt and the Dalliance of Denial Extreme Optimism" is back...but beneath the surface lurks the debts of a nation and its ultimate day of reckoning. Bill Bonner Bill Bonner, with today’s reckoning from Baltimore, Maryland... Stocks rose 70 points on the Dow yesterday. Gold went up $8. And oil is now selling for more than $85 a barrel. What are these numbers telling us? That there is a recovery? That inflation is increasing? That things are booming...? Every body is an optimist. House flippers are back in business. They’re not buying new houses this time. They’re standing in front of courthouses and buying houses that have been repossessed. Still, they think they can find buyers and make money... The day traders are back too. Now they’re trading currency! Apparently, trading currencies is a hot thing in Japan...where housewives make a little extra money (or lose some) by betting on the yen/dollar exchange rate... “Extreme optimism” is what Ned Davis Research calls it. That’s what his measure of investor sentiment registers. And not since 2007 have mutual funds had so little cash. But are these the real, deep trends? Or these just on the surface, hiding the real movement below? The states are in trouble. The New York Times reports: “New Hampshire was recently ordered by its State Supreme Court to put back $110 million that it took from a medical malpractice insurance pool to balance its budget. Colorado tried, so far unsuccessfully, to grab a $500 million surplus from Pinnacol Assurance, a state workers’ compensation insurer that was privatized in 2002. It wanted the money for its university system and seems likely to get a lesser amount, perhaps $200 million. “Connecticut has tried to issue its own accounting rules. Hawaii has inaugurated a four-day school week. California accelerated its corporate income tax this year, making companies pay 70 percent of their 2010 taxes by June 15. And many states have balanced their budgets with federal health care dollars that Congress has not yet appropriated.  “California’s stated debt — the value of all its bonds outstanding — looks manageable, at just 8 percent of its total economy. But California has big unstated debts, too. If the fair value of the shortfall in California’s big pension fund is counted, for instance, the state’s debt burden more than quadruples, to 37 percent of its economic output, according to one calculation.  “The state’s economy will also be weighed down by the ballooning federal debt, though California does not have to worry about those payments as much as its taxpaying citizens and businesses do. “In January, incoming Gov. Chris Christie of New Jersey announced that his predecessor, Jon S. Corzine, had concealed a much bigger deficit than anyone knew. Mr. Corzine denied it. So far, the bond markets have been unfazed. “Moody’s currently rates New Jersey’s debt “very strong,” though a notch below the median for states. Moody’s has also given the state a negative outlook, meaning its rating is likely to decline over the medium term. Merrill Lynch said on Monday that New Jersey’s debt should be downgraded to reflect the cost of paying its retiree pensions and health care. In fact, New Jersey and other states have used a whole bagful of tricks and gimmicks to make their budgets look balanced and to push debts into the future. One ploy reminiscent of Greece has been the use of derivatives. While Greece used a type of foreign-exchange trade to hide debt, the derivatives popular with states and cities have been interest-rate swaps, contracts to hedge against changing rates. “The states issued variable-rate bonds and used the swaps in an attempt to lock in the low rates associated with variable-rate debt. The swaps would indeed have saved money had interest rates gone up. But to get this protection, the states had to agree to pay extra if interest rates went down. And in the years since these swaps came into vogue, interest rates have mostly fallen. “ Wait until interest rates go up! They’ll catch the states...and catch households...businesses...and the US federal government. They’ll all be in trouble. There are two parts to the debt story. The first part is just the gross size of the debt. The second is the cost of carrying it. As the debts get bigger so do the potential problems. Those problems become acute when interest rates rise. Then, debtors can no longer afford to pay the interest. Today, we got a first-hand look at how that works. We invested in a project that needed to borrow to survive – a development project. The borrowing was just supposed to tide it over until the managers could get control. Instead, it dragged on for years. And now the debt is so large that the interest is more than the company’s revenues. Year after year, the company couldn’t pay its interest, so we added it to the principle of the debt. Of course, that just made the following year’s interest greater. And now, there is no way the business can survive...because it can never make enough money to pay its operating expenses and the interest.  We decided to take it out into the back yard and shoot it. Get it over with. We diddle-daddled long enough. Instead of cutting the losses at $1 million, we waited until they reached $7 million. This happened under the watchful eye of a group of supposedly competent, cynical, experienced businessmen. Imagine what goes on in households run by psychologists! Or businesses run by Democrats. Imagine what goes on in enterprises where management takes Tom Friedman seriously? Or sends its employees to a “Get Motivated” conference with Sarah Palin, Rudy Giuliani and Colin Powell as speakers? We don’t want to think about it. Debt sneaks up on you. Before you know it, it has taken over. It becomes too large to manage. You can’t cut costs enough to stop it. You can’t raise revenue enough to pay for it. You can’t do anything but admit that you’ve been an idiot. That’s not easy for people to do. They’ll try everything else first. Then, with no other way out, they go broke... The Daily Reckoning Presents Down to the Sea Again... Bill Bonner Every line in the financial world has a hook on it.  And at the end, sooner or later, is a banker with the wit of a tuna. Back in the early ‘00s, the Fed cast out a line, urging member bankers to lend more money.  Dallas Fed chief Robert McTeer had bad advice for consumers too:  “Buy a Hummer,” he said, before the price of oil went over $100.  A few years later, Alan Greenspan caught the entire financial sector in a net.   Financial derivatives, he said, helped spread the risk and helped make the system more stable.  Last week, the Bernanke Fed, along with the Federal Deposit Insurance Corporation, told bankers to maintain larger stocks of “unencumbered highly liquid assets...readily available...during the time of most need.”  What exactly did they have in mind?  US Treasury securities. The timing couldn’t be better.  Last week, the US Treasury market began to crack.  And this Wednesday, the feds’ $1.25 trillion program of buying mortgage-backed securities came to an end.   On the 25th of March, the 10-year T-note reached a yield of 3.91%.  Long bonds – 30 year Treasury bonds – traded at a yield of 4.75%, up from what now seems to be the bottom in November 2008 at 2.5%.  Technical analysts think they see a big head-and-shoulders formation, marking the end of a major trend.  Fundamental analysts wonder why it took so long.   Here at the Daily Reckoning, we’ve called the top in the bond market on at least three occasions in the last 7 years.  Our feelings wouldn’t be hurt if this one turned out to be another Elvis sighting too.   But now that the feds have banks on the line, rising bond yields must be almost a sure thing. Long bond yields hit a high of 15% back in 1981.   Since then they have been going down.  That they would eventually find a bottom would surprise no one.  But that the bottom would be found in March 2010 would inconvenience practically everyone.  Never before have so many borrowers counted on such low rates.  And ‘never again,’ lenders might soon tell one another, will they be willing to fund such huge deficits for so little nominal return. In 1981, consumer price inflation was running at about 9%, leaving a net, real return of about 6%.   But that was also when Paul Volcker was tightening the screws on the whole financial system, toughening up credit rules to bring inflation under control.  It was also at a time when the US balance of trade was still positive...when the US was still a net creditor to the rest of the world...when the national debt was only 33% of GDP (it is close to 80% today) and when the deficit was only $57 billion (today, it is 25 times that amount).  No one at Moody’s was studying the balance sheet of the US government back then.  There was no need to.  Its triple-A credit rating was not in doubt. Much has happened between then and now.  But of all the many changes since the Reagan Era we can’t think of a single one that actually improves the credit quality of the US government.  Thirty years ago, not only were US finances much more solid than they are today, so were its demographics, and its politics.  In 1980, the baby boomers were just reaching their prime earning and spending years; now they’re beginning to shuffle and stoop.   The stated mission of the Reagan administration was to reduce government’s role in the economy.  “Government is the problem, not the solution,” said the Reaganites.  “Government is the solution,” says Obama’s team. The US administration just pushed through a $1 trillion health care overhaul.  This was on top of $1 trillion deficits as far as the eye can see.  This year alone, the federal government will sell some $2.4 trillion in securities.  Judging from these facts alone, you would wonder who would be dumb enough to buy US bonds now?  The bankers, of course.  They give their money to the feds for less than a third of the interest yield they demanded 29 years ago.   What mutation happened in the human gene pool accounts for it?  None at all, is our contention.  They were fools then...and fools still.  A generation of rising bond prices simply changed what they were foolish about.  But this time it is different.  This time the feds have put the harpoon into the whole economy.  First, they exchanged the toxic, mortgage-backed assets of the financial industry for US Treasury bonds.   Then, they set up a carry trade to make it easy to finance their deficits:  the banks borrow from the Fed.  But with such low interest rates the banks don’t lend the money to the private sector; they lend it back to the US Treasury.  The public sector is flush but the private economy remains locked in irons. This was very similar to what happened in Japan 20 years ago.  The banks began to go under, dragged down by their own mistakes.  The government tossed them a line.  They were saved...but at a price – two “lost decades” in the Japanese economy.  Instead of lending to business, banks were urged to buy government bonds to finance runaway fiscal stimulus programs.  This kept the GDP above the waterline, but the ‘growth’ was nothing but a fata morgana – a vision of the damned, financed with debt.   Now, the banks own so much government debt that a downturn in the bond market (such as caused by real growth) would undermine their reserves and sink them all.  US banks, led by the Fed, follow them down to the sea.  Bill Bonner for The Daily Reckoning Joel’s Note: Bill will be heading up an all-star cast of presenters at this year's Agora Financial Investment Symposium in Vancouver. The list of speakers includes - in addition to Bill, Eric, Addison and the rest of our "in house" gang - a Moscow- based fund manager, a beltway "insider" and the guy who will bring Brazil's massive offshore oil discovery to fruition. For more info on joining us in Vancouver from July 20-23, click here. Bill Bonner On World "Improvers" Bill Bonner Bill Bonner with the rest of today’s reckoning from Baltimore, Maryland... Professor James Lovelock, creator of the Gaia concept, says trying to save the planet is ‘a lot of nonsense.’ Lovelock, 90, was the first to describe the earth as a single organism. Now, he notices that the earth sciences profession has sold out – just like economists before them: “Scientist have moved from investigating nature as a vocation to being caught up in a career path where it makes sense to ‘fudge the data.’ He’s talking about Al Gore’s scientists...and all the scientists with a dog in the “global climate change” fight. Instead of merely observing and trying to understand nature, they’ve decided to try to change the earth’s climate themselves... Why? Because there’s money in it. Al Gore has reportedly made millions from his various investments in ‘green’ technology. Hundreds of millions more have been spent on subsidies for alternative energy projects, ethanol, solar energy and various other boondoggles – all of which gave scientists a way to make some money. This was not exactly the same – but similar – to the way economists sold out in the ‘20s and ‘30s...and thereafter. Economists were observers too. They watched the way an economy worked and tried to understand it. But then, they found that they could provide a service to governments – by first helping to predict changes in economic outcomes and second by offering to improve the outcomes before they came out. This was the bold offer made by the Keynesians in the ‘30s...and repeated ever after ....that they could eliminate the most disagreeable features of capitalism, by controlling the down part of the business cycle. Ever since, they have been working their way up the chain of power from mere advisors to powerful people...to becoming the most powerful figures in government themselves. In some cases, they made money – by offering their services to the large banks and consulting agencies. But they also gained power and prestige. It was no accident that Hillary Clinton stood beside Alan Greenspan at her husband’s inaugural. And it is no accident that Ben Bernanke gets his face on TIME magazine as the Man of the Year. Economists now are movers and shakers, not just observers. While the earth scientists offer to improve the world’s climate....economists offer to improve its economy. Trouble is, there is no evidence whatever that any of their moving and shaking has ever done the world one bit of good. Instead, it merely distorts the delicate price information that guides investment, sales, and growth. Give them the wrong signals – such as a mistaken idea of how much demand is available or the cost of investment capital – and they make the wrong decisions. That is when the economists really shine. After having made a mess of the world, they then offer to save it. This they do in the worst possible way – by sending out even more phony and misleading signals, distorting the markets further, and setting up the economy for more mistakes and more losses. Regards, Bill Bonner, for The Daily Reckoning