The 19th century belonged to Britain, the 20th century belonged to America and in the 21st century, China will rule the business world. Whether you like it or not, this transition is already underway and it will intensify over the coming decades.

Throughout history, no empire has managed to rule forever. Instead, empires rise to power, they prosper and spread their influence. Thereafter, they over-extend themselves and then break down in some fashion. In fact, all the glorious empires of history had one thing in common – a spectacular collapse.

Now, there can be no doubt that America ruled the economic world for the better part of the previous century. However, this powerful nation has now entered a terminal decline. The recent credit crisis and the failure of some of the largest American financial corporations is compelling evidence that the world’s largest economy is well past its prime.

Today, America finds itself heavily in debt and to make matters worse, its demographics are also worsening. Unfortunately, the American leaders are attempting to postpone the day of reckoning by taking on even more debt! It is noteworthy that over the past year alone, America’s federal debt increased by approximately US$2.1 trillion and its projected budget deficit over the next decade is now slated to be almost US$9 trillion! If this does not shock you, then consider the chart below which shows the total obligations of the US government.

Click here to read the rest of Puru Saxena’s article.

Everyone also knows that some of the key culprits behind this financial mess were the credit-rating firms like Standard & Poor’s and Moody’s Investors Service, which assigned top-tier “AAA” ratings to investments that were actually backed by subprime mortgages and other toxic debt.

Whether it was collusion or incompetence almost didn’t matter: The firms claimed that the credit ratings they issued were constitutionally protected free speech. With this First Amendment shield, S&P, Moody’s and others said they were protected from lawsuits or other liabilities.

But that’s about to change.

A federal court judge in New York last week stripped the ratings firms of that defense, a decision that could expose the companies to billions of dollars worth of liabilities from investors who were burned by the faulty ratings.

Let’s legal case involved three specific firms – two firms that rated collateralized debt securities, and an investment bank that sold the debt. Those three companies were:

• Standard & Poor’s, which is owned by The McGraw-Hill Cos. Inc. (NYSE: MHP).
• The Moody’s Investor’s Service unit of Moody’s Corp. (NYSE:MCO), which is 19% owned by Warren Buffett’s Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B).
• And Morgan Stanley (NYSE: MS).

This particular case had been brought against Moody’s and S&P by Abu Dhabi Commercial Bank PJSC and Washington State’s King County. The case involved losses suffered from an investment in a structured investment vehicle (SIV) called Cheyne Finance. Although the debt securities Cheyne issued were backed in part by subprime mortgages, they received ratings as high as “AAA.”

In return for the high rating, the companies received higher-than-normal fees.

The $5.86 billion Cheyne Finance SIV went bankrupt in August 2007. The plaintiffs claimed fraud. The suit is seeking class-action status on behalf of investors who were burned when Cheyne was forced to dump securities it had issued between October 2004 and October 2007.

Since lawyers for the plaintiffs say the ruling could be applied to any deal involving SIVs, it could have a substantive impact. Before the financial crisis caused the value of these asset pools to plummet, experts estimate there were $350 billion to $400 billion worth of SIVs in existence.

“There certainly will be other cases filed – that’s the future impact of this decision,” San Diego attorney Patrick Daniels told The Wall Street Journal.

Moody’s and S&P had sought a dismissal, citing their First Amendment protections. But U.S. District Court Judge Shira Scheindlin ruled on Sept. 2 that securities ratings that were distributed to a small group of investors don’t warrant the same First Amendment protections that are afforded to the widely circulated ratings of corporate bonds.

Judge Scheindlin acknowledged that ratings constituting “matters of public concern” are typically protected from liability. That’s especially true when the ratings are distributed to the general public. But it wasn’t the case here.

“Where a ratings agency has disseminated their ratings to a select group of investors rather than to the public at large, the ratings agency is not afforded the same protection,” Judge Scheindlin ruled.

The ruling will likely be appealed. And it could end up in front of the U.S. Supreme Court.

The case spotlights the biggest problem with the business of rating securities: The ratings firms are paid by the issuers to rate them.

When you get right down to it, ratings firms are in business not to rate but to make money for themselves by rating issuers and their securities. The surprise isn’t that the obvious lack of objectivity fostered abuses in the credit-rating process – it’s that the problem took so long to come to a head. The complexity of mortgage-backed securities (MBS),collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs) only exacerbated the investor risk.

The decision received widespread media attention. But it’s only half the story.

And the media missed the other half.

In an ironic twist that transforms the credit-rating firms into legal sacrificial lambs, the U.S. Securities and Exchange Commission (SEC) has in recent weeks acknowledged its own failure to protect the public from the same ratings firms that the federal agency mandates that investors rely upon.

This admission – combined with the legal assault on the constitutional protections ratings firms are used to hiding behind – could threaten the ratings firms’ very existence. It not only will further fuel investor ire, it could also provide litigants with additional needed legal ammunition. The ratings involve tens of billions – if not hundreds of billions – of dollars of failed securities.

A series of internal reviews by the SEC – one reaching back to last year – has highlighted some of the abuses.

About a year ago – in July 2008, to be exact – the SEC concluded a 10-month examination of the ratings industry that uncovered “poor disclosure practices and procedures guiding the analysis of mortgage-related debt and insufficient attention paid to managing conflicts of interest.”

According to the report, there was an obvious degree of knowledge and complicity in playing the ratings game.

E-mail exchanges between analysts at “unnamed” ratings firms back this up. In one, an analyst said the firm’s ratings model didn’t capture “half” of the deal’s risk, but said that the security “could be structured by cows and we would rate it.” In a Dec. 15, 2006 missive, a manager wrote that the ratings industry was creating “[an] even bigger monster – the CDO market.”

Confided the manager: “Let’s hope we are all wealthy and retired by the time this house of cards falters.”

In July of this year, in testimony to Congress, SEC Chairwoman Mary Shapiro said she supported proposals to impose liability standards that would make it easier for investors to sue credit ratings firms. That’s a bit ironic given that the SEC is charged with supervising the ratings firms.

According to the internal investigation conducted by the Office of Inspector General, the SEC failed to exercise its duties as the nation’s watchdog of the same credit ratings firms that many large investors are forced to trust.

By law, certain investors must rely on the ratings of a handful of companies, known as  “Nationally Recognized Statistical Rating Organizations,” or NRSROs. In many cases, the NRSROs determine what are “eligible” or “appropriate” investments. And it’s the SEC that determines who is, or who can be, an NRSRO.

For instance, most state insurance regulators say that insurance companies can only invest in assets that carry one of the top four credit ratings. And it’s the NRSROs that certify those ratings.

Similarly, money-market funds can only invest in the highest NRSRO-rated securities.

Countless institutions – public and private, domestic and international – rely on rules that determine what assets are acceptable investments. And that acceptability is determined by financial due diligence and the resulting credit ratings – as determined by SEC-certified rating agencies.

It’s not clear that any of this is really protecting investors, according to a Feb. 15, 2008 “Review & Outlook” piece in The Journal. Drexel University Finance Prof. Joseph Mason took a look at CDOs that were “Baa” (an investment grade rating) by Moody’s. His finding: They were 10 times more likely to default than equivalently rated corporate bonds.

In that same article, an S&P spokesperson was asked if they actually examined the mortgage debt that made up the investment pools that make up a CDO.

The spokesperson’s answer was not confidence-inspiring: “We are not auditors; we are not accounting firms.”

Source: The Credit Rating Firms Are Running Scared – It’s About Time

A majority of those polled by Bloomberg think it’s great; 61% said they thought they economy had taken off and was flying high. Stocks are up. Commodities are up. And here’s another Bloomberg headline: “Global investors give Federal Reserve Chairman Ben S. Bernanke top marks…”

The recovery has won the approval of economists and the public. It has almost everything going for it. It just won’t fly!

Comes news this morning that the US economy is still on the runway. This report from the AP explains why:

“WASHINGTON (AP) – Consumers slashed their borrowing in July by the largest amount on record as job losses and uncertainty about the economic recovery prompted Americans to rein in their debt.

“Economists expect consumers will continue to spend less, save more and trim debt to get household finances decimated by the recession into better shape. Such behavior, though, is a recipe for a lethargic revival, because consumer spending accounts for 70 percent of economic activity.

“The Federal Reserve reported Tuesday that consumers in July ratcheted back their credit by a larger-than-anticipated $21.6 billion from June, the most on records dating to 1943. Economists had expected credit to drop by $4 billion.”

Hey, not bad… economists were only off by 440%. Consumers are paying down debt more than 4 times faster than they thought. Partly because they want to. And partly because they have to. They don’t want to borrow… and banks don’t want to lend to them anyway. Consumer credit is falling at a 10% annual rate, based on July figures. Credit card debt is going down at an 8% rate.

When they pay down a dollar’s worth of debt that is one dollar less in the consumer economy. But it’s also a dollar that is not borrowed. Where the consumer spent all his income two years ago… and borrowed more so that he could increase his consumption even further… now, he doesn’t borrow… and he doesn’t spend all his income either. Now, the money that used to pour into consumer spending leaks out.

As we reported yesterday, personal spending is dropping… the figures were down in 4 of the last 6 quarters – something that has never happened before, since they began keeping records in 1947. And the level of consumer spending is down 33% from a year ago – with discretionary spending now down to a level it hasn’t seen in 50 years.

Of course, that’s just what we’ve been saying. The great credit expansion began in 1945. It ended in 2007. Credit will contract for many years. One study, also reported here, suggested that consumers would spend 14% less – even after the economy was back on its feet. We estimate that the total level of debt must go down below 200% of GDP. If that’s correct, we need to pay down about $25 trillion of debt. That won’t be easy and it won’t be quick.

And it will mean high levels of joblessness for a long time. Already, two out of five working-age Californians are unemployed. The other three are working the shortest workweeks in history. No wonder; with spending dropping, sales are falling. So businesses don’t need so many people to make, ship, sell and service their products. Then, of course, when they lay off workers to cut expenses, the unemployed workers have to cut spending!

How is it possible for a consumer economy to grow when consumers are spending less money? Of course, it’s not. This is not a genuine recovery… it’s an imposter. A fraud. A recovery impersonator.

While the private sector is paying down debt, the public sector is adding debt at a ferocious pace – about $150 billion per month. Public spending isn’t the same as private spending. It is usually spending for things that people wouldn’t buy if they had a choice. And it comes with a whole new risk attached – the risk that the feds will inflate their way out of debt rather than pay it off.

Government spending does not bring a durable, real prosperity. (If it did… think how easy it would be to make people rich; governments love to spend money!) It may look like a recovery. It may have shiny wings and spiffy-looking stewardesses. But it won’t fly.

*** The World Economic Forum has taken the US down from the number one position. America is no longer the world’s ‘most competitive’ economy. That title goes to Switzerland.

Meanwhile, the US banking system is rated #109 in the world – just below Tanzania. US banks became leveraged casinos during the bubble years. They’ve still got a lot of leverage… and are still trying to relive those glory days when players lined up to spin the wheel… and free drinks flowed by Niagara Falls.

*** “Keeping up with children is a full-time job,” said Elizabeth last night. “There is always at least one of them who needs help. Sometimes more than one.

“Sometimes I wonder if we shouldn’t devote ourselves more fully to helping them. That’s our main project, isn’t it? It’s the thing that is most important, isn’t it?

“So… shouldn’t we go to where they are… and give them advice… help them get their careers and families established? I mean, we’re in Europe. Our children are mostly in the US. Shouldn’t we go back so we would be available to help them? Maybe we should rent a house in Los Angeles and stay there until Maria’s acting career is on a more solid footing, for example. At least, she’d have somewhere to go for Thanksgiving…

“The prevailing view in America is that children leave the nest when they are 18 or 21… and then, they’re on their own. But that’s not the view here in Europe. In Paris, I know lots of parents who stick with their children all their lives. They spend their vacations together. The parents buy an apartment for the children. They direct their careers… and pass judgment on marriage prospects. Not that the children always listen, but one generation is not left to its own devices. That’s why inheritance is such a touchy issue in France. People aren’t expected to make it on their own… they’re expected to get as much support from the family as possible…

“Sometimes I think we should take the same attitude. And we do to some extent… Still, I’m not sure the children would appreciate our help. I’m not even sure our help would really be much use. Sometimes they just need to make their own mistakes…

“Besides, we have our own projects… our own lives. I just don’t know what is best…”

Source: A Recovery Impersonator

It all boils down to COLA — the government’s cost-of-living adjustment. Since consumer prices are — in theory, at least — deflating, the Social Security administration announced this weekend that they do not plan on a COLA for the next two years. Should that forecast come true, it’ll be the first time that’s happened since at least 1975, when automatic increases were first implemented.

That will probably equate to a net monthly loss for millions of beneficiaries. Medicare prescription drug premiums are on track to bump up a few bucks next year — a major cost for most retirees. And until the Obama administration jams through their health care reform, medical expenses will continue to rise, as well. Who knows… they might go even higher after Obamacare. Either way, tens of millions of seniors are about to face stagnant income and rising monthly costs… could get politically interesting.

Source: Seniors Beware: Deflation Hits Social Security

For starters, Guaranty Financial of Texas went belly up late Friday and secured a spot in the history books. With $13 billion in “assets,” the bank is the third largest to fail this year and tied for the 11th biggest bank failure in U.S. history.

Even more interestingly, the FDIC brokered Guaranty’s assets to Banco Bilbao Vizcaya Argentaria, a bank from northern Spain. We’re surprised on two fronts here: 1) That a bank from Spain — strapped with double-digit unemployment and a wretched housing bust — wants to bring their euros to I.O.U.S.A. 2) That BBVA already has a huge presence in Texas. With this acquisition, they will be the fourth largest banking chain in the Lone Star State. That could be an interesting trend to watch.

Three other banks failed along side Guaranty: CapitalSouth, First Coweta and ebank. That brings the yearly total to 81.

This should put the FDIC’s deposit insurance fund on its last legs. At the beginning of 2008, the FDIC’s bank failure war chest had over $52 billion. At the end of the March 2009, the last time the FDIC has given us a look into the DIF, they had $13 billion left. 60 banks have failed since, including Guaranty and Colonial, which by themselves took out half of that remaining $13 billion. Only the FDIC can say with accuracy if there is any money left, but this chart gives you a pretty good idea of how the trend is shaping up:

The DIF does have a source of income — it taxes member banks a significant “insurance fee.” But we have to think that the DIF is still in bad shape, perhaps even empty… and that the FDIC will soon be hitting up someone (Tim Geithner, Joe Taxpayer and/or U.S. banks) to refill their coffer.

The FDIC will provide their second-quarter report tomorrow, which among other things will include a look into the DIF and their infamous bank “problem list”… could get ugly. We’ll keep you up to speed.

“Recent bank failures remind us of the problem loans festering on small and regional bank balance sheets,” writes Dan Amoss, “and that many of them are marking loans at fantasy levels. The secondary market value for some of the worst loans, like construction loans, is 20 or 30 cents on the dollar.

“There’s a backlog of at least a few hundred insolvent banks that need to be shut down and sold into stronger hands. Bank stock bulls are ignoring the credit losses yet to be recognized, so there are lots of shorting opportunities in the sector. Many banks will not be able to “earn their way out” of their credit losses.

“The problem is, there aren’t many strong buyers with lots of capital out there. Those that are, like private equity groups, are buying only after the FDIC agrees to eat most of the credit losses, and the buyer is gifted with the remaining shell — the profit-making engine of spread lending.

“It’s understandable that the FDIC doesn’t want much publicity about the Deposit Insurance Fund; it wants to maintain the public’s confidence that it can ‘insure’ all deposits with just a few basis points of capital reserves and skimpy premium income. The fund is clearly not adequate to cover the bank failures still in the pipeline, so we’ll see another ‘special assessment’ imposed on all other banks, which will ultimately be passed on to depositors via lower interest rates.”

Critical banking analysis has been one of the hallmarks of Dan’s Strategic Short Report. His brand of scrutiny gave readers 162% gains betting against Allied Capital (NYSE:ALD), 220% on PNC Financial and the whopping 462% winner shorting Lehman Brothers. Today is the last day we are offering his latest financial short play for just $1. Capture this truly rare opportunity by clicking here… midnight tonight, the deal’s off.

Source: The Banking Crisis Cometh

In the last two years, I’ve:

• Gone long the dollar when it was in the tank…
• Shorted oil near its peak…
• Shorted the big move to Treasuries on the heels of the credit crisis…
• And, most recently, shorted gold at $918 an ounce.

At the time of recommendation, each trade was extraordinarily unpopular, prompting some folks to flat out question my sanity. And yet, taking the dissenting opinion made money each time (the jury’s still out on the shorting gold trade.)

How’d I find the wherewithal – and nerve – to do it?

David Dreman – The Father of Contrarian Investing

I’ve been under the tutelage of David Dreman, known as “The Father of Contrarian Investing,” for many years.

Dreman literally wrote the book on contrarian investing. (If you don’t own a copy of his latest work – “Contrarian Investment Strategies: The Next Generation” – get one!)

In the book, he lays out his straightforward, time-tested investment philosophy to consistently outperform the markets: choose cheap investments that other investors hate.

Sounds too simple to be true, I know. But like any trading genius, Dreman’s track record underpins his investment philosophy…

• Since inception in 1988, his flagship large-cap value fund’s average annual return of 9.2% beats both the S&P 500 and Russell 1000 Value index by a full percentage point. His small-cap value fund has performed even better.
• Since inception in 2003, it has trounced the Russell 2000 Index (the benchmark for small-cap investments) and the S&P 500 index by more than seven percentage points.

Investing in Small Caps Predictions Ring True…

Recall, in January I predicted small cap investing would shine this year because they always do coming out of recessions. And this time has been no exception.

• From the March 9 bottom, small-cap stocks are up 50%, compared to 40% for large-caps stocks.
• And using history as our guide, we can expect more of the same ahead – small caps to trump the gains of their larger-cap peers for at least three more years.
• Thus, not capitalizing on this disparity would be foolish.
• Furthermore, the recent rally has increased stock valuations virtually across the board, so finding winning stocks will require increasingly more investment skill.

And that’s where Dreman comes in… No one on earth is better at unearthing small-cap value investments than he has been.

So how does he do it?

• First, he exploits the fact that the U.S. stocks with the lowest 20% of price-to-earnings ratios returned 16.8% per year from 1920 to 2004 – four percentage points better than the market as a whole. He buys nothing but such undervalued stocks.
• That said, he doesn’t just focus on the “cheapness” of a stock to determine its worthiness. “We don’t like dogs,” says Dreman, adding that, “All our stocks are financially strong, have high yields and earnings growth faster than the market.”
• He pays great attention to the stock filtering process, as well. Specifically, Dreman looks for companies with market caps between $300 million and $2.5 billion. Those are then screened based on their respective P/Es.
• Stocks with P/E ratios greater than the market get discarded, immediately (Dreman is innately opposed to paying a premium for growth). And the remaining companies (those with P/E ratios below the industry median) must possess an above average dividend yield, low leverage, low price-to-book and price-to-cash flow ratios, strong management teams and a catalyst that could spur future growth.

The result is typically three to four stocks in each industry group, with only one or two making the final cut.

Collectively, Dreman uses this investment process to construct a portfolio of 95 to 100 stocks from 50 different industry groups, with a 1% weighting to each. Such a small position size means that a single security can’t sour the overall portfolio performance. Which adds another layer of downside protection. (Deep-value stocks are inherently less risky than high-flying, high P/E growth stocks, anyway).

So clearly, Dreman does much more than simply buy small cap companies that investors have discarded, or ones in the midst of tough times. As he puts it, “We look for reasonably strong companies on the whole.”

But to really put his words into perspective, let’s consider a recent purchase…

Dreman Invests In Small-Caps With Aaron’s Inc.

Last year, Dreman added Aaron’s Inc. (NYSE: AAN) – a small-cap company that allows consumers to rent-to-own plasma TVs, household and office furniture and computers, without any credit checks.

Most investors looked at that business model, cringed and sold the company’s stock, causing it to lose 33% in 2007. After all, could you get any riskier than catering to consumers with poor or no credit during a credit crunch?

Dreman, of course, is too smart to fall for that. This guy can sniff out his prey from a mile away. He knew the current credit freeze was about to push previously credit-worthy buyers away from Best Buy and right through Aaron’s front doors. And with the stock trading at a historically low valuation below 11 times earnings, it was a no-brainer.

Sure enough, with an uptick in demand, Aaron’s earnings jumped a solid 19% last year alone.

And the stock defied the market, rallying 39% in 2008 while everything else took a bath. This year, it’s tacked on another 25%, thanks to a 55% jump in earnings in the first quarter.

Bottom line, small cap stocks can be some of the most profitable investments in any market. Should this market pull-back continue, consider this another great opportunity to pick up some attractive small caps.

But like Dreman, I recommend you stay away from dogs at any price.

Source: Investing in Small Caps: Why it Pays to be Contrarian

The stock market crashed in ’29. The market then bounced. After a few months almost everyone was persuaded that the “worst is over.” But the worst was just beginning. It wasn’t until 1932 that the stock market finally hit bottom. By then, it beginning to seem like a depression… and only years later did economic historians tag it as a ‘great’ depression.

This depression is still wet behind the ears… We’re still in the bounce phase. On Friday, the Dow went 113 points higher. And as the bounce continues, more and more investors will come to believe that stocks are in a new bull market and that the economy is back in growth mode.

Neither will be true.

The stock market is in a bear market rally, not a genuine bull market. The economy is entering a long depression… possibly a ‘great’ one.

How can we be so sure? Well, we’re not sure of anything. But all the signs point in that direction. Household debt as a percentage of disposable income hit a low of about 2% just at the end of WWII. It’s been going up ever since. By 2005 it nudged against 15% — 7 times higher than it had been 60 years earlier. Household debt represents spending that has been taken from the future.

But you can’t take an infinite amount from future earnings. You reach a point when the future can’t handle it. As more and more future earnings are absorbed by past consumption, pretty soon there’s not enough left to live on. At some point, so much of earnings are devoted to paying the interest and principle on past borrowings that the poor householder cannot to pay his expenses. And imagine what happens if his disposable income goes down.

Guess how many jobs the US private sector has added over the last 10 years? Almost none. Private sector employment is back to levels of 1999. There are more jobs in restaurants and health care… but many fewer in manufacturing. Net gain: zero.

The only job gains have been in the parasite sector – government. On the evidence, this trend is going to continue. Now, the feds have a new post called “pay czar.” As near as we can tell this is a busybody who undertakes to control salaries in the industries that the feds have bailed out.

There will be a lot more jobs running the regulatory/bailout apparatus. Then, too, there are all the make-work jobs of the shovel ready boondoggles the feds began in an effort to replace private spending.

Back in the private sector, 72 banks have failed so far this year. And a record 34 million Americans are getting food stamps.

Naturally, incomes are falling. Now, imagine the consumer… he’s already paying 15% of his disposable income to debt service… and then his income is cut in half! This means that 30% of his remaining income must be used just to service the debt. Impossible to do without big cuts in spending…

The poor consumer hit the wall in 2007. He was spending all he earned… and paying more of his income in debt service than at any time in the last 60 years. He couldn’t continue to live on future earnings – there just weren’t enough of them. That is why the finance industry has topped out. It loaded Americans up with enough debt already.

And it’s why the credit cycle has turned. All of a sudden savings rates are back up to 7%. Consumers are cutting back… raising chickens in their back yards… driving less… planting gardens and squeezing their nickels. The private sector is de-leveraging. And there won’t be any durable economic boom or lasting bull market on Wall Street until this process is finished.

How long will that take? Read on…

*** Harvard professor Ken Rogoff says it will take 6-8 years for households to reduce their debts to a more sustainable level. Let’s see. We reported on Friday that the big upswing in credit over the last 60 years added about $35 trillion in excess debt to the system. But not all of that is private debt.

Taking the period of the bubble years, in 2000 total debt in the US came to $26 trillion. Now, it’s twice that amount — $52 trillion, of which $38 trillion is private… or more than 2 and a half times GDP. At this level, the private debt absorbs roughly one out of every 7 dollars in consumer earnings – in interest and principal payments.

If the private sector undertook to reduce debt back to 2000 levels, it would mean eliminating all the debt accumulated during the bubble years – or about $19 trillion. How long will it take to pay down, write off, inflate away and otherwise shuck $19 trillion?

Well, inflation is running below zero – so that is not now a source of debt reduction. Between write-offs and pay-downs, about $2 trillion has already been cut – over, very roughly, the last 2 years. At least the math is easy. At that rate, it will take 19 years.

Now, let’s go back and look at the Japanese. How long have they been deleveraging. Gosh all mighty… 19 years. From 1990 to 2009.

Are we looking at a 20-year period of on-again, off-again deflation… of bear market rallies followed by real bear markets… of weak employment and weak or no growth? That’s what we argued, along with Addison Wiggin, in our first book, Financial Reckoning Day. Then, the stock market took off… and the bubble years came. It looked like we were dead wrong. Maybe we were just early. Or maybe those bubble years were just a feint… a fake-out that convinced the entire world to invest in stocks and property, just before the biggest crash in history.

In that book, we guessed that the crash in the tech sector marked the beginning of the end. By 2005, it didn’t seem at all as though we were in a down-cycle. But adjusted for inflation, stocks never beat their January 2000 high. And outside of government, the economy has no more jobs than it did in 1999. We’ve had wars against terror, bubbles in practically every sector, trillion-dollar boondoggles, bailouts, bamboozles and Michael Jackson’s tragic cooling… but what is the only durable thing to come out of the last 10 years? Just Google and debt.

*** “When you have a big family there is always someone in the family who is in trouble,” said another friend.

“I thought that when the children left home to go to college, we’d be more or less free from problems. They’d be on their own. We could turn our attentions to other things.

“Well, it didn’t turn out that way. There’s always one of them that has a problem. And we spend a fair amount of time worrying about them… even if there’s nothing we can do to help. Or trying to help them if we can…

“And then the grandchildren come… and then we worry about them. It just goes on and on. It’s not disagreeable, of course. I’d rather have children and grandchildren to worry about than not have them. But there doesn’t seem to be any end to it… ”

Source: Still in the Bounce Phase

The first public retirement pension scheme was created by Otto von Bismarck in 1880 Germany. Fifty years later, during the Great Depression, Franklin Roosevelt followed suit in the United States. As we’ve seen, the number of people expected to reach the retirement age of 65 was not considered to pose a threat to future funding. Life expectancy in 1935, in the United States, for example, was 76.9 for men. Workers relying on the plan for retirement would not receive much each month and were not expected to live long enough to drain the system.

When Social Security was founded, the typical U.S. worker at age 65 could expect to live another 11.9 years. But if today’s official projections are right, by the year 2040 the typical 65-year-old worker can expect to live at least another 19.2 years. If the normal retirement age had been indexed to longevity since 1935, today’s worker would be waiting until age 73 to receive full benefits and tomorrow’s workers even longer.

In a report called “Demographics and Capital Markets Returns,” Robert Arnott and Anne Casscells argue that the crisis is not in Social Security, but in demographics. “When an entire society ages,” suggest Arnott and Casscells, “…the thing that matters most is the ratio between the workers to retirees. Unfortunately, the aging of the baby boom generation, which is a significant bulge in population, will cause a dramatic increase in the ratio between workers to retirees, one that will put enormous strain on society and cause friction between generations.”

In the United States, as in other developed countries, the unfunded benefit liability for public pensions amounts to 100 percent to 250 percent of GDP. It is a “ hidden debt ” far greater than official public debt. Unlike in the private sector, these debts are not amortized as expenses over 30 to 40 years. 21 And it may be worth pointing out that under normal conditions economies do not run such crushing deficits. They only do so in crisis mode.

The annual cost of Social Security benefits represented 4.4 percent of GDP in 2008 and is projected to increase to 6.2 percent of GDP in 2034, and then decline to about 5.8 percent of GDP by 2050 and remain at about that level.

A Bubble in Health Care

And to the retiring boomers’ other doubts and insecurities, we might add that U.S. health care costs are expected to rise by 7 percent of GDP over the next 40 years—a rate that is more than twice as fast as other developing nations. The “old old,”—those aged 80 and over—are predicted to rise sharply through 2050 and will dramatically increase long – term care costs as well as disability, dependence, and health care expenses.

In fact, by official projections, in 2030, the U.S. government will be spending more on nursing homes than it spends on Social Security today. “Although people justifiably worry about Social Security,” says Victor Fuchs, an economist who studies the health care industry, “paying for old folks’ health care is the real 800-pound gorilla facing the U.S. economy.” 23 Adding projections for Medicare and Medicaid ’s expenditures to those of Social Security could raise the total cost to more than 50 percent of payroll taxes.

The fiscal kickers of health cost inflation and political demand for more long-term care benefits threaten to raise public spending dramatically in the United States. Between 2005 and the fall of 2008, we spent two and a half years chronicling the efforts of David Walker, the former comptroller general of the United States, and Bob Bixby, executive director of the Concord Coalition, to reign in reform and shore up the Social Security and Medicare systems. The project yielded a feature length documentary film, which earned us a trip to the Sundance Film Festival in January of 2008 and another to the Critic’s Choice Awards in Los Angeles a year later. We published a best-selling companion book of the same title in late 2008. You’re encouraged to delve into the numbers we presented in the film and book. They’re truly mindboggling. But in many ways the project was dated the moment we released it to the public.

The credit crisis that reached a fever pitch developed in 2008 pushed the date of insolvency of these programs ever closer. On May 13, 2009, the Medicare Trustees warned that the fund they tap to pay for beneficiaries’ hospital care will be insolvent by 2017—two years earlier than trustees had predicted the year before. The program has been paying out more than it collects in taxes and interest since last year, in part due to a recession well underway. 25 Medicare would have to deposit $ 13.4 trillion—$ 1 trillion higher than last year’s estimate—into an interest-earning account today in order for the hospital fund to pay its scheduled benefits over the next 75 years. The program’s total unfunded obligation, which includes doctor and prescription drug benefits, is $37.8 trillion. The trustees estimated that in coming years, Medicare spending will rise faster than workers’earnings or the economy as a whole.

Trustees say that while the financial standing of Social Security decreased more sharply than Medicare last year, the health program remains at greater risk of insolvency. The financial difficulties facing Social Security and Medicare pose serious challenges, the report concluded.

For Social Security, the reform options are relatively well understood but the choices are difficult. Medicare is a bigger challenge. Its cost growth can be contained without sacrificing quality of care only if health care cost growth more generally is contained. But despite the difficulties—indeed, because of the difficulties—it is essential that action be taken soon, particularly to control health care costs.

After the revised Social Security and Medicare announcement the world began to wonder: Can the U.S. hold onto its AAA credit rating?

“The U.S. government has had a triple-A credit rating since 1917,” David Walker, now president and CEO of the Peterson G. Peterson Foundation, commented in the Financial Time s following the release of the Trustees report, “ but it is unclear how long this will continue to be the case. In my view, either one of two developments could be enough to cause us to lose our top rating.

“First, while comprehensive health care reform is needed, it must not further harm our nation ’ s financial condition. Doing so would send a signal that fiscal prudence is being ignored in the drive to meet societal wants, further mortgaging the country’s future.

“Second, failure by the federal government to create a process that would enable tough spending, tax and budget control choices to be made after we turn the corner on the economy would send a signal that our political system is not up to the task of addressing the large, known and growing structural imbalances confronting us.”

Of course, we must note that the whole credit rating biz is…well…corrupt. The agencies that are responsible for dishing out sovereign credit ratings (S & P, Fitch, and Moody’s) are the same ones that left us all out to dry in 2007. (Of course, mortgage – backed securities get a AAA…housing prices never fall!) Rest assured, if Wall Street can buy its way into AAA, Uncle Sam surely can, too.

But even Moody’s is starting to hedge their bets. They’ve since created three subdivisions within their AAA rating: resistant, resilient, and vulnerable…a corporate way of saying the good, the bad, and the ugly. While the United States isn’t in the worst of the bunch, it’s certainly not the best.

Regards,
Bill Bonner and Addison Wiggin

Source: Excerpt from ‘The Hard Math of Demography’

Since the Great Depression, a period marked by widespread runs on banks, the FDIC has done a good job of fulfilling its mandate. So how are they doing in this crisis?

In a nutshell, they are in trouble.

The FDIC insures 8,246 institutions, with $13.5 trillion in assets. Not all of them are going bankrupt, of course. Yet as of late July, a disturbing 64 banks had gone belly up this year – the most since 1992 – costing the FDIC $12.5 billion. At the end of Q1, the agency was already asking for emergency funding.

And worse, much worse, is likely yet to come. The following chart shows the total assets on the books of the FDIC’s list of 305 troubled banks. The list doesn’t include the biggest banks that are considered too big to fail, as they are being separately supported with bailouts. By contrast, if the banks on this list fail, the FDIC is on the hook to have to step in and take them over and, of course, make depositors whole.

Other measures of how serious the losses at banks are becoming can be seen in the chart below, which shows charge-offs and non-current loans at all banks. You can see that the Net Charge-offs remain stubbornly high, with banks charging off almost $40 billion in bad loans in the last two quarters alone. And the number of non-current loans – loans where payments are not being kept up – is soaring.

Together, these measures indicate the potential for more big failures and more big bailouts coming down the pike.

Into the battle against bank insolvency the Fed brings a level of reserves that can best be described as paper-thin. From almost $60 billion last fall, the FDIC’s reserves have been drawn down to only about $13 billion today, a 16-year low. A quick look at the FDIC’s own data shows us how inadequate those reserves are compared to the deposits they are now insuring.

The chart below says it all:

As you can see, the Federal Deposit Insurance Corporation currently covers each dollar on deposit with a trivial 2/10ths of a penny.

And even that understates the seriousness of the situation: the $4.8 trillion in deposits the FDIC is providing coverage on doesn’t include the expansion that now extends insurance coverage from $100,000 to $250,000 for normal bank accounts. That likely brings the exposure of the FDIC closer to $6 trillion. But that’s pretty inconsequential at this point: using any reasonable accounting method, the FDIC is already bankrupt and will require hundreds of billions of dollars in government bailouts just to keep the doors open.

So, given the dire shape of its finances, what measures is the FDIC taking, you know, to batten down the hatches and all that?

For starters, they are expanding their mandate by guaranteeing bank loans – $350 billion and counting at this point. And the government has tapped the FDIC to play a pivotal role in guaranteeing the loans issued to buy toxic waste through the government’s highly problematic and fraud-prone new Private Public Investment Partnership (PPIP). The FDIC’s commitment to the PPIP is and may become limited based on its resources.

It is hard to draw any other conclusion but that hundreds of billions in new funding will be required to keep the FDIC operating. Given the catastrophic consequences of the FDIC failing, starting with a bank run of biblical proportions, there’s no question it will get whatever funding it needs. By loading the new loan guarantee responsibilities and the PPIP onto the FDIC’s back, the administration will go back to Congress and ask for the next large bailout.

Of course, in the end, all of this falls on the taxpayer, either directly in the form of more taxes or indirectly via the destruction of the dollar’s purchasing power. Another bale of straw on the camel’s back, and another reason to be concerned about holding paper dollars for the long term.

Regards,

Bud Conrad

Source: The FDIC is in Trouble

U.S. gross domestic product (GDP) shrank 1% in the second quarter, following the first quarter’s 6.4% drop. The $787 billion Obama stimulus package, smaller decreases in business spending and slowing erosion of the housing market all helped to slow GDP contraction, according to the Bureau of Economic Analysis. A poll of 78 economists surveyed byBloomberg News showed a median estimate of a 1.5% decline in GDP.

“The recession is slowing but we still need to get households and businesses to start spending again,” said Joel Naroff, president of Naroff Economic Advisors, Inc.

With such a dramatic drop in the rate of contraction, the third quarter could sport the first expansion in more than a year. The last time the GDP grew was the second quarter of last year, thanks in large part to the $112.4 billion in stimulus payments to taxpayers.

Despite rising unemployment and a looming jobless recovery, Naroff is optimistic about consumer spending.

“Vehicle sales were actually up from the first quarter and are likely to be even better this quarter, so consumer weakness should not be a major concern,” Naroff said, adding that he’s optimistic that strong growth isn’t far off. “[GDP growth] could be either the third or fourth quarter and could approach 5%.”

Still, until there is real growth in consumer spending, any recovery will be difficult to sustain.

“We’ll get more support from government programs in the second half, but if you want a strong recovery, you need a strong consumer, and we are not seeing that,” Nigel Gault, chief U.S. economist at IHS Global Insight Inc. told Bloomberg.

A recovery may have to rely on business and government spending. Business investments, while still falling, slowed to a rate of 8.9% in the second quarter, a far cry from the first quarter’s 40% drop. The decline equipment and software purchases also slowed, falling a modest 9% compared to 36.4% in the previous quarter.

On the government side, federal officials – including U.S. President Barack Obama – say less than a quarter of the stimulus package has been spent so far.

“You just can’t push [funding] out that quickly, partly, not just because the federal government has to process applications but also because states and local governments have to gear up to get these projects going,” President Obama said in an interview with Fox News earlier this month.

Without consumer spending, which makes up more than two-thirds of the economy, any recovery will likely be agonizingly slow.

“We’re going from recession to recovery, but at least early on, it’s not going to feel like one,” said the chief economist at Moody’s Economy.com, Mark Zandi in an interview with The New York Times. “For economists, this is a seminal part in the business cycle, but for most Americans, it won’t mean much.”

Indeed, the unemployed or the underemployed struggling to make ends meet it’s hard to be optimistic, even as the markets, corporate profits and other economic data show improvement.

“At some point it becomes Obama’s economy, not Bush’s economy anymore,” said Dean Baker, co-director of the liberal research group Center for Economic and Policy Research told The Times. “He made a big mistake in overselling the first stimulus, and then in celebrating all the ‘green shoots.’ That just opens the door for people to say, ‘Where are my green shoots? I still don’t have a job.’ ”

Source: U.S. GDP Contraction Slows, but the Road to Recovery Will Be Rocky