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The Daily Reckoning | Monday, August 2, 2010 The next subprime: why municipality can-kicking is not the answer, Jobs, consumer confidence, housing and other unhappy econo-tidbits, Plus, Bill Bonner with thoughts on the recovery that never was and some Japanese bargains... ------------------------------------------------------- Free Presentation: Tiny Canadian Penny Stock Discovers a MASSIVE $172.5 Billion Oil Field! Harvard geologist Byron King just released this new online video presentation. Watch it to hear about a tiny Canadian penny stock potentially sitting on $172.5 billion barrels of oil... Because this company is so small, this huge discovery could mean a potential 3,577% gain for fast movers! Click here now to watch Byron's presentation instantly. Inflate Your Debts Away The "American Way" of dealing with insolvency Bill Bonner Reporting from Ouzilly, France... The Daily Reckoning has moved to its Summer Schedule. Which is to say, your editor is working only half days. The rest of the time, he is painting shutters and fixing tractors. We arrived on Friday at the family place here in the Poitou-Charente region of France. A wedding drew us hastily hither on Friday. But now we have settled into our familiar August pattern. Three out of six children have already arrived. One other will come in a week or so. Friends and other family members will trickle in for the next few days. Since we're on our holiday schedule, we'll make these Daily Reckonings short and to the point. The stock market in the US was flat on Friday. Gold rose $13. China edged out Japan to become the world's second largest economy. Bonds rose. And the dollar fell. The Bloomberg report: The Institute for Supply Management-Chicago Inc.'s business barometer rose to 62.3 this month, exceeding the median forecast of economists surveyed which anticipated the measure would drop to 56. The June reading was 59.1 and figures greater than 50 signal expansion. The Thomson Reuters/University of Michigan final index of consumer sentiment declined to 67.8 this month from 76 in June. A preliminary measure issued earlier this month was 66.5. The Standard & Poor's 500 Index fell 0.1 percent to 1,100.07 at 12:12 p.m. in New York. The yield on the 2-year Treasury note drop to 0.55 percent from 0.58 late yesterday and touched a record-low 0.546 percent. The worst US recession since the 1930s was even deeper than previously estimated, reflecting bigger slumps in consumer spending and housing, according to the Commerce Department's annual revisions also issued today. The world's largest economy shrank 4.1 percent from the fourth quarter of 2007 to the second quarter of 2009, compared with the 3.7 percent drop previously on the books, the report showed. Household spending fell 1.2 percent in 2009, twice as much as previously projected and the biggest decline since 1942. Consumer Slowdown Consumer spending, which accounts for about 70 percent of the economy, rose at a 1.6 percent pace last quarter, compared with a 1.9 percent rate the previous three months that was smaller than previously estimated, today's report showed. Job gains have been slow to take hold, curbing household purchases. The economy lost 8.4 million jobs during the recession that began in December 2007, the biggest employment slump in the post-World War II era. So far this year, company payrolls grew by 593,000 workers, according to Labor Department figures earlier this month. More than 7 out of 10 Americans say the economy is still mired in recession, and the country is conflicted over how to balance concerns over joblessness and the federal budget deficit, according to a Bloomberg National Poll. Just like the experts, Americans are torn about whether the federal government should focus on curbing spending or creating jobs, the poll conducted July 9-12 shows. Seven of 10 Americans say reducing unemployment is the priority. At the same time, the public is skeptical of the President Barack Obama's stimulus program and wary of more spending, with more than half saying the deficit is "dangerously out of control." At this stage in the typical post-war recovery, the economy should be steaming along with GDP growth of about 6%. The latest reading, alas, came in at only 2.4% for the second quarter. Growth has been cut in half from the end of last year. The recovery - if there ever was one - is now faltering. Of course, you, Dear Reader, know that there never was anything resembling a real recovery. You can recover from a fall. You can recover from a broken heart. You can recover from a head cold. You cannot recover from death. You can only become a zombie. The US economy merely became more zombified, after the crisis of '07-'09. Houses are underwater. People are living on food stamps and unemployment compensation. The feds control major industries. Banks are kept alive with tax money. And GDP 'growth' was pushed up by boondoggles, bamboozles and bailouts. But now, even the zombies are beginning to shuffle. They need more flesh...more blood... In this regard, Federal Reserve Governor Bullard has let the cat out of the bag. He says the best remedy at this stage would be further doses of quantitative easing. He's right - at least within the strange context of central banker thinking. If your goal is to get the zombies moving...you need to give them some juice. And when you've already cut your rates to zero (the current rate is actually 0.25%), and you've run a deficit of $1.5 trillion, what else can you do? You've got to print money, right? There are some very smart people who believe inflation rates are going up - soon. They're urging investors to dump the dollar and US bonds. Their logic is very clean and very solid: The US government owes more than it can pay. When a debt cannot be paid by the borrower, someone else must pay. Typically, it's the lender who pays when the borrower defaults. But the US government doesn't have to default. It has another alternative, the aforementioned quantitative easing - monetary inflation, in other words. Instead of defaulting on its debts directly, the federal government can inflate them away. We have no real argument with this line of thinking. We have a hunch, however, that it won't work out that way. It's too obvious. Instead, we see the zombies staggering on for years... This Time Next Year, You Could Be Living Your Dream Your own cottage on a quiet beach...a grand apartment in a city vibrant with concerts and cafes...a mountain villa where the air is crisp...a vineyard amid gently rolling hills...maybe a full-time maid...plenty of time and funds to travel... Whatever your ideal retirement looks like, we can help you make it happen. For as little as $649 a month. For more information or to reserve your seat, please click here. Live & Invest Overseas Conference September 16-18, 2010 * Las Vegas, Nevada The Daily Reckoning Presents Son of Subprime AddisonWiggin In 2007, the writing was on the wall. The famous "perfect storm" had gathered above the US housing market, its eye hovering over subprime loans. As you know, the storm came...and it rained, and rained, and rained... Ultimately, it washed away trillions of dollars in investor wealth. Now in an entirely different sector - probably the last place you'd look - the clouds are turning black once again. Strip out the finer details, and you'll find the very same mechanics that brought the subprime market from boom to bust: Widespread investor acceptance Complicated derivatives Intense incentives for banks to make deals Boneheaded assumptions of endless return on investment Underqualified borrowers Stunning amounts of leverage and debt A loosely regulated multitrillion-dollar market Overstated credit ratings from Wall Street Social and political pressures to maintain growth This crisis-yet-to-be is...municipal bonds Munis have been a long-standing pillar of stable return. Only bonds from sovereign governments and blue chip corporations have a better reputation for credit-worthiness than munis. So when a city or state sells bonds to build a new school, sewer or stadium, investors form a line around the block. In the history of the union, only one US state has ever defaulted on its debt (Arkansas 1934). A few cities here and there have also done so. In other words, munis have performed admirably over the years. But reputations, as this credit crisis has taught the world, no longer mean jack. Ask debt holders of "blue chip companies" like GM, or "sovereign" states like Greece. Investors are learning an old lesson the hard way: No asset class - not one in the history of the world - is a sure thing. Though vast and complicated, the root of American municipalities is like any business or household: Money goes in, money goes out. Done right, a municipality takes in more money than it pays out. Money comes in mostly from taxes and revenue streams such as utilities and tolls. Money goes out to finance municipal government payrolls and public works programs. Cities and states sell bonds when they either can't pay upfront for such needs. No big deal...at least, it wasn't a big deal until recently. In this era of high unemployment and shrinking economies, municipal revenues are hurting. Tax revenue tends to be lower with 15 million Americans out of work. Just the same, they use less power, drive through fewer tolls. Pay that parking ticket? I don't think so...not this year. Not surprisingly, municipalities are struggling to cut spending in line with lost revenue. But their biggest expense of all is untouchable - pension plans. California offers a telling example. A recent Stanford study concluded that the state pension fund program is underfunded by roughly $500 billion. The researchers urged Gov. Schwarzenegger to inject $360 billion into its public benefit systems - right now - to have an 80% chance of meeting 80% of obligations over the next 16 years. Facing a $20 billion state budget gap, what can he possibly do? It's precisely this pickle that undid Vallejo. The San Francisco suburb declared bankruptcy in 2008. Tax revenue had collapsed, a major shipyard closed and all of a sudden the city found itself paying 90% of its annual budget to retired public employee pensions. 90%! The problem, just like with subprime, is an irrational form of leverage. In essence, municipalities borrow current earnings of public employees in exchange for some of the most favorable retirement plans in the world. That borrowed money is invested aggressively, just like a private-sector employee would in his 401(k). Except if the fund loses money, which they all have over the last 10 years, pension funds don't adjust payouts. The social and political pressure to maintain the status quo - keeping our public employees comfortably retired - is just too strong. So municipalities kick the can down the road. New employees buy into the funds. Fund managers maintain their projections of endless 8% annual returns. Retirees keep taking out the funds they were promised...and no one pays the tab. And it's not just California. Orin Cramer, chairman of New Jersey's pension program, estimates a national funding gap around $2 trillion. The municipal bond market is roughly $2.7 trillion. If Cramer is on target, that's a total liability about the size of France and Britain's annual GDP - combined. Therefore, in yet another subprime redux, Wall Street has found a way to make the muni bond problem even worse. Like the mortgage market, the municipal bond market has morphed into its own new era of highflying finance, adjustable-rate loans and complex securities. For proof, read "Looting Main Street," a recent Matt Taibbi expose in Rolling Stone. How could a $250 million sewer project leave taxpayers on the hook for $5 billion? Easy - if you're a Wall Street bank and you engineer a "synthetic rate swap" deal. It brought Jefferson County, Alabama, to its knees: The county got the stability of a fixed rate, while paying Wall Street to assume the risk of the variable rates on its bonds. That's the synthetic part. The trouble lies in the rate swap. The deal only works if the two variable rates - the one you get from the bank, and the one you owe to bondholders - actually match. It's like gambling on the weather. If your bondholders are expecting you to pay an interest rate based on the average temperature in Alabama, you don't do a rate swap with a bank that gives you back a rate pegged to the temperature in Nome, Alaska. That's the "beauty" of modern lending. This deal, struck by JP Morgan, allows a cash-strapped county to upgrade to a world-class sewage system it could otherwise never afford. The extra costs - the fees, adjustable rates and superfluous debts... That's a problem for the next generation. Just like the state pension fund. And as Taibbi also observed, banks pull in millions upon millions in fees for structuring these loans and swaps. Bonuses live and die by such deals. Just like the 2005 mortgage market, there is both intense demand for new age municipal financing - and remarkable incentive for Wall Street to "help out." Of course, what modern catastrophe is complete without a credit ratings debacle? According to the National Conference of State Legislatures, 34 states are projecting budget gaps for 2010. The total shortfall will likely exceed $84 billion. Yet only two US states, California and Illinois, are currently rated lower than AA by Standard & Poor's. Only four states have fully funded pension programs. Yet 11 have S&P's coveted AAA credit rating. Given all that we've explored above, and the ratings agencies' track record over the last 10 years, those AA and AAA ratings seem woefully optimistic. Insolvent is insolvent, not matter what the rating agency's say. For the conservative investor, therefore, our advice is straightforward: Avoid municipal bonds. For the speculating investor, check back in tomorrow to learn about a risky way to bet against the municipal bond market. Addison Wiggin, for The Daily Reckoning Joel's Note: Are you already part of Addison's "beta-test" list for his new Apogee Advisory service? If not, get yourself on the trial list, here. Watch the Presentation: Secret $200 Retirement Blueprint Last year $200 could have turned into $10.1 million following 5 simple steps revealed in this secretive retirement blueprint. It's happened before, but could it happen again and could it happen to you? Click here to watch the presentation now. (Turn your speakers on) Bill Bonner New Trade of the Decade Update: Japanese Stocks Looking Good Bill Bonner With the rest of today's reckoning from France... Hey... Here's someone who likes at least one side of our Trade of the Decade - long Japanese small cap stocks, short Japanese government bonds. Leslie P. Norton reporting from Barron's: EARNINGS IN JAPAN ARE outpacing expectations nicely, leaving Japanese valuations at attractive levels. Outside Japan, however, the picture in Asia is mixed, raising questions about the outlook for stocks as results are reported in August. In Japan, despite the strong yen, a host of big companies delivered upbeat results last week, including Sony (NYSE:SNE), Honda Motor (NYSE:HMC), Nissan Motor (TYO:7201), TDK (LON:TDK), Kyocera (NYSE:KYO), and Canon (NYSE:CAJ). "In my 20 years of covering Japan, I have never seen such a positively surprising earnings season, with banks, autos and electronics all leading the way," says John Vail, chief investment officer at Nikko Asset Management in Tokyo. In Japan, however, the P/E ratio for the benchmark Topix index is "as low as I've ever seen it," says Nikko's Vail. "The forward dividend yield is equal to the US yield, and nearly double the 10-year Japanese government bond. You have to have a very dramatic reversal in the global economy to justify the current low valuations." ------------------------------------------------------- Here at The Daily Reckoning, we value your questions and comments. If you would like to send us a few thoughts of your own, please address them to your managing editor at joel@dailyreckoning.com Three Out of Four Economists are Wrong The thing economists said was nearly impossible actually happened last week. Yields on 2-year US debt hit a record low just as the Treasury prepares for another record-setting deficit. The supply of Treasury debt and the demand for it hit new highs – together. Stranger things have happened. But the strangeness of this event has caused a furor loquendi amongst economists. Usually, there are only two major ways of misunderstanding current events. Now there are at least four of them. Housing Market Sinks Beneath the Waves How the Threat of Monetary Inflation Keeps a Currency Strong US Economic Outlook: Indebted to Death John Stepek at MoneyWeek.com, talking about the “European bank stress tests” that were “a whitewash, of course” said that it kind of reminded him of “one of Gordon Brown’s budgets.” My immediate reaction, of course, and speaking as a true American, is to ask, “Huh? Gordon who?” as a clever way of reminding these British guys that real Americans, like me, don’t know about anything, or care about anything, that is not about America and/or Americans and how it affects us, as Americans, but mostly me, personally, as an American. No Stopping the Money Creation Machine A Crude Display of How to Invest in Oil The Unemployment Nightmare in Greece According to the Organization for Economic Cooperation and Development (OECD), Greek unemployment is nearing 14 percent... but on-the-ground accounts peg joblessness closer to 90 percent in some regions. The Greek government belt-tightening, in the form of austerity measures, should bolster the long-term economic health of the nation. However, in the near term many regions are hard hit by the stalled economy, including a suburban dock area called “the zone.” Goateed Jon Stewart: Goldman Abolishing Swear Words, Now Makes Sweet Love to You More Rampant BIS Gold Swap Speculation