Fed President Says US on "Unsustainable Course"

Kansas City Federal Reserve Bank President Thomas Hoenig says U.S. fiscal policy is on an "unsustainable course" and the government must adjust its tax and spending programs or risk a crisis.

"The U.S. government must make adjustments in its spending and tax programs. It is that simple. If pre-emptive corrective action is not taken regarding the fiscal outlook, then the United States risks precipitating its own next crisis," said Hoenig.

"In time, significant and permanent fiscal reforms must occur in the United States."

Hoenig said a government faced with rising debt levels must come up with a credible long-term plan to reestablish fiscal balance.

That plan must be seen as fair, said Hoenig, and those who put it in place must be wiling to disappoint special interests.

"It means, for example, controlling budget earmarks, trimming subsidies to numerous economic sectors, and resolving our banking problems and the perception that Wall Street is favored over Main Street, all of which would otherwise foster mistrust and cynicism among the public," Hoenig said.

The Obama Administration recently sent Congress a $3.8 trillion budget blueprint, with a $1.3 trillion deficit, for fiscal year 2011. That follows a forecasted record deficit of $1.6 trillion in fiscal 2010.

Foreign Demand for US Treasuries Falls by Record Amount

Foreign demand for US Treasury securities fell by a record $53 billion in December.

China led the way, selling $34.2 billion in Treasury securities during the month. And it was the second consecutive month that China reduced its holdings.

The drop was significant since the old record was a $44 billion decline, set in April 2009.

China is saturated with US debt and signaled last year that it would begin reducing some of its holdings, which had doubled since 2007.

The size of China's holdings was so great that, as of September 2008, it had surpassed Japan to become the number one holder of US government debt. With $769 billion in holdings, Japan has now regained the top spot, while China dropped from $790 billion to $755 billion in Treasury holdings.

At the height of the financial crisis in 2008, many investors sought the perceived safety of US Treasuries. But the growing size of US deficits and the national debt may have changed that perception.

China is the biggest US trade partner and the sale of its goods here has helped to finance US deficits. So this selloff is politically sensitive. The US may now have to pay higher interest to compel foreigners to continue buying its debt. And the US can no longer rely on China, so it will have to look elsewhere for buyers.

Japan may not be the most reliable candidate since its debt is now 200% of GDP.

This sea change comes at a difficult time for the US; it now projects a $1.6 trillion budget deficit for FY 2010, which is 11% of GDP.

The trouble in European debt markets — due to the problems in Portugal, Italy, Ireland, Greece and Spain — has recently increased demand for US Treasuries, which could remain attractive as long as the crisis persists.

However, one questions remains: will the Chinese continue the selloff, or will they simply stop buying additional Treasuries?

Though it may just be posturing, two leaders in China's military have publicly called for their government to economically retaliate against the US for selling arms to Taiwan.

However, dumping its Treasuries would do as much damage to the Chinese economy as to the United States because it would further devalue the dollar. That would hurt China's ability to export to the US, and the Chinese economy is totally dependent on exports.

If the Chinese are willing to absorb a serious blow in order to punish the US, they hold an enormous amount of power and leverage. Further dumping of their Treasury holdings may amount to cutting off their nose to spite their face, but trying to understand or predict Chinese behavior may be futile.

The problem for the US is that it doesn't just need to sell Treasuries to finance its deficit spending; it needs to sell them to pay off the holders of maturing Treasuries. In other words, it needs to borrow from Peter to pay Paul.

In the absence of enough buyers, the Federal Reserve will simply conjure money out of thin air to pay the Treasury for its bonds. Such action increases the monetary supply and devalues all existing dollars.

That's the price all of us have to pay as China and others dump our bonds, and / or refuse to buy more of them.

2010: The Year of the Short Sale

The biggest US banks, including Bank of America, Wells Fargo, Citigroup, and JP Morgan Chase, are preparing to rid themselves of troubled mortgages by engaging in an aggressive program of "short sales," in which homeowners settle debts by selling their properties for less than the mortgage value.

With home values continuing to drop across the US, leaving many mortgage holders underwater, short sales are expected to increase sharply this year.

The number of homes entering, or in, foreclosure is also expected to climb to a record 4.3 million, from 3.4 million in 2009.

By June, more than five million homes (or 10% of all homes with mortgages) are expected to drop below 75% of their mortgage balance,

That's the threshold at which the owner starts to seriously consider just walking away, even if he or she has the money to keep paying, according to a recent NY Times report.

“We’re now at the point of maximum vulnerability,” said Sam Khater, a senior economist with First American CoreLogic, the firm that conducted the recent research. “People’s emotional attachment to their property is melting into the air.”

Compared to foreclosures, banks can cut their losses by 20% with short sales.

BofA executive Matt Vernon says short sales are growing faster than REOs [real estate owned transactions], a positive development for banks.

Mark Zandi, chief economist of Moody’s Economy.com, forecasts short sales and deed-in-lieu transactions will total 20% of all distressed home sales this year, up from 15% last year.

In April, the Obama administration will launch a program that encourages homeowners, lenders and investors to complete short sales by providing up to $3,500 in incentives.

Such an effort will only increase and hasten the number of short sales this year. That will be good not only for banks, but also for prospective buyers.

Don't Hold Your Breath Waiting For A Housing Recovery

The problems in the residential housing market remain deep. Nationally, home prices are down by about a third from their 2006 peaks, creating millions of underwater borrowers.

Last fall, it was widely reported that one-in-four US mortgages had negative equity.

By various estimates, approximately 11 million to 14 million mortgages are underwater, and the problem is poised to worsen.

U.S. foreclosure filings rose 15 percent in January from a year earlier and exceeded 300,000 for the 11th consecutive month, according to RealtyTrac Inc.

The company predicts that bank seizures (known as REOs, or real-estate-owned) may rise to a record 3 million this year.

Modification programs that were designed to keep delinquent borrowers in their homes have failed and are expected to continue doing so.

That's largely because about 8.4 million jobs have been lost since the recession began in December 2007. The continuing job losses have led to growing delinquencies and foreclosures.

A rising supply of homes puts downward pressure on already slumping home prices. And sales could be slowed considerably when government support for housing, including the Federal Reserve’s $1.25 trillion purchase of mortgage bonds and a first-time buyer tax credit, ends as scheduled next month.

With foreclosure inventories on the rise, banks are rightfully worried. But, by lowering credit standards and unleashing a wave of speculative housing demand, the banks were the ones that helped drive home prices to unrealistic levels in the first place.

As a result, significant trouble still lies ahead for banks, communities, and homeowners.

Federal and state officials are bracing for the next tidal wave of foreclosures—adjustable rate mortgages (ARMs), particularly option payment ARMs.

Option ARMs let borrowers choose to make very low payments for the first five years. During that initial period, borrowers were allowed to pick their payment option, including just the interest.

Option ARMs became widespread starting in 2005, which is why the recasts and higher payments will pick up steam this year.

According to Fitch Ratings, 94 percent of option ARM borrowers elected to make minimum payments only. That portends the trouble that lies ahead.

Even though most option ARMs have not yet adjusted higher, many borrowers are already defaulting anyway. That's an ominous sign.

The bulk of option ARMs recast dates are spread out from 2010 through 2012, meaning the foreclosure waves could drag on for the next few years.

Deutsche Bank projects that 48% percent (or nearly half) of all US mortgages will be underwater by early 2011. That would affect some 25 million homes. If realized, such a projection would be a serious blow to the economy.

No one can be sure just how big the housing inventory really is. As of last August, 72% of foreclosures hadn't yet been put on the market because lenders were waiting to see how much additional loan modification assistance the federal government would provide.

With home prices having already declined by nearly one-third - peak-to-trough - since 2006, a glut of houses hitting the market will cause prices to fall even further. The concern is that they could stay depressed for years to come.

Last June, Deutsche Bank forecast that home prices – covering 100 U.S. metropolitan areas – would continue to decline through the first quarter of 2011, for a total drop of 42% from their 2006 highs.

Moody’s now forecasts that some home prices may not return to their pre-recession levels until 2030. This means that hundreds of thousands of Americans may find it impossible to sell their houses without paying off banks for underwater home loans.

At a minimum, Moody's says that many states (i.e. NY, IL, CA, FL) will not recover until sometime between 2018-2024.

Those waiting for a massive government intervention shouldn't hold their breath. It would cost about $745 billion, slightly more than the size of the original 2008 bank bailout, to restore all underwater borrowers to the point where they were breaking even, according to First American CoreLogic.

The fallout of the housing crash will be an ongoing process, and it appears that we are at least three years from a bottom. Brace yourselves.

Derivatives: The $595 Trillion Time Bomb

Derivatives, or credit-default swaps, were the primary reason for the financial crisis that rocked the U.S. in the fall of 2008. That financial crisis morphed into the great economic crisis that the U.S. — and the most of the world — is still trying to recover from.

These derivatives, or swaps, are basically bets between companies and banks. In essence, they are insurance policies that Wall Street uses to protect themselves from unforeseen financial calamities.

Brooksley Born, head of the Commodities Futures Trading commission (CFTC) from 1996-1999, realized that there were trillions of dollars of essentially unregulated over-the-counter derivatives in world markets. Because they weren't regulated, the government had no idea what was going on in those markets.

During Ms. Born's tenure at the CFTC, derivatives amounted to a $27 trillion market that was being traded out of sight. The enormous sums of money being exchanged surreptitiously gave her pause.

"My staff began to say how big this was and how little information they had about it," said Born. "We didn't truly know the dangers in the market because it was a dark market. There was no transparency."

Derivatives contracts are unregulated. They aren't traded on exchanges. They are entered into between private parties and there is no oversight. There is no record-keeping requirement imposed on participants in the market. There is no reporting.

It's the perfect environment for fraud, gross speculation and economic disaster.

All of this made Ms. Born wonder. "What was it that was in this market that had to be hidden? Why did it have to be a completely dark market? So it made me very suspicious and troubled."

With trillions of dollars being traded and promised in secret, if something goes terribly wrong, the high-stakes derivatives market could take down the entire financial system. The largest financial institutions can go down like dominoes.

Though she tried to regulate the derivatives markets, it was all in vain. Born was staunchly opposed by Fed Chairman Alan Greenspan, Treasury Secretary Robert Rubin, and Deputy Secretary Larry Summers. The power trio prevailed and squashed Born's attempts at regulation.

Then Long Term Capital Management started to collapse in 1998. Financial institutions that had bought derivatives believed they had insurance and wanted to collect their collateral.

What they didn't know, but soon discovered, was that many other parties were making the same claims on the same collateral.

Despite the implosion of Long Term Capital, which leveraged $5 billion into more than $1 trillion in derivatives, Greenspan and his cronies prevailed once again. There would be no regulation of derivatives.

By 2007, the OTC derivatives market had grown to $595 trillion. Yes, $595 trillion. It is a disaster of epic proportions waiting to happen.

Derivatives are insuring derivatives, which are based on yet more derivatives. The whole system is a huge Ponzi scheme just waiting to collapse. It was, and still is, a ticking time bomb at the center of the world financial crisis.

That crisis has been papered over by massive government and central bank intervention, but it has not gone away. It still lingers, hidden under the surface.

"I think we will have continuing danger from these markets and that we will have repeats of the financial crisis," says Ms. Born. "It may differ in details, but there will be significant financial downturns and disasters attributed to this regulatory gap over and over until we learn from experience."

Latest Oil Finds Amount to Spit In The Bucket

The oil industry was on a hot streak in 2009, making more than 200 discoveries on five continents.

On its face, that certainly seems like good news.

For example, a new field found in Uganda last year is anticipated to yield two billion barrels of oil.

It was referred to as "unquestionably the largest onshore discovery made in sub-Saharan Africa in at least 20 years.”

And the Jubilee oil field, discovered off the coast of Ghana, is estimated to hold between 650 million and 2 billion barrels of recoverable oil. The find was viewed as so important that Exxon put up $4 billion for a stake in the field, the oil giant's biggest investment in a decade.

And last September, oil was discovered in the deep waters off the coast of West African nation of Sierra Leone. It is believed that more oil fields are yet to be discovered and developed of the West African coast, perhaps yielding as much as one billion barrels.

Advances in drilling technologies and exploration strategies are allowing for the discovery and extraction of deep water oil that would have previously been unrecoverable. Twenty-five years ago, oil companies struggled to operate in seas deeper than 600 feet. Now technological innovations mean they can pump crude in waters 6,000 feet deep.

But, as difficult as it is to get to oil as these depths, the rising price of oil and diminishing onshore oil fields have made it worthwhile and cost-effective to go after deep-water oil. That said, these oil fields are still extremely expensive to develop.

But the most striking elements of these finds — cumulatively totaling five billion barrels of oil — is this: the U.S. alone uses 21 million barrels of oil every day. That amounts to 7.7 billion barrels annually. And U.S. oil consumption has been rising at about two percent annually.

And, as a whole, the world uses 85 million barrels of oil daily.

The point is, despite the seemingly good news, the latest finds amount to spit in the bucket. In no way will they make an appreciable difference in the supply/demand ratio.

Recent oil discoveries have been far too small to offset the world's growing population and rising demand for oil.

Just this week, Dubai excitedly announced the discovery of a new offshore oil field, though its size was not revealed. The UAE sits on the world’s fifth largest proven oil reserves, amounting to 97.8 billion barrels of crude oil. But, according to the UAE government website, Dubai’s oil reserves, mostly offshore, are expected to be exhausted within 20 years.

Dalton Garis, of the Abu Dhabi-based Petroleum Institute, warned of the possibility that "prices would have to go above 80 or 90 dollars a barrel for [the new discovery] to be commercially viable."

And last month, a new pool of oil was discovered in southern Egypt that is proving to be more productive than the currently producing zones. The new discovery has a natural flow to surface rate of 220 barrels of oil per day; with artificial lifting, the maximum rate is 1300 barrels per day. That's all. And it's more productive than currently producing zones.

You get the picture.

New oil discoveries totaled about 10 billion barrels in the first half of 2009, according to IHS Cambridge Energy Research Associates. It was quite a pace, as the industry desperately seeks new discoveries in an attempt to keep up with peaking oil fields and rising world demand.

That's why oil companies are searching beneath the ocean floor, even though drilling and extracting are much more difficult and expensive there. With oil currently at $71 per barrel, the price makes such difficult exploration feasible. Some deepwater wells can cost up to $100 million, yet only 30 to 50 percent of exploration wells find oil.

That leaves us in quite the conundrum; we need high oil prices for the industry to maintain deep-water exploration. And if the price falls due to the weak economy and a slumping demand, then exploration will cease, resulting in diminished supplies and higher prices in the future.

The chief executive of the French oil giant Total and the secretary general of OPEC have expressed exactly these concerns.

Ultimately, the recent discoveries do not come close to matching the massive discoveries of previous decades. The last truly substantial discovery was the Kashagan field in the Caspian Sea, which was discovered in 2000. It is estimated to hold over 20 billion barrels of oil.

To put that in perspective, last year the global rate of oil consumption reached 31 billion barrels.

Despite the fact that more than 10 billion barrels worth of oil were discovered last year, the industry's recovery rate — the share of oil that gets pumped out — averages just 30 to 35 percent.

The best hope is this: Shell Oil estimates that 300 billion barrels — and maybe more — might be squeezed out of existing fields, much of it once thought beyond retrieval.

And Peter Jackson of Cambridge Energy Research, has reviewed data from the world's biggest fields and concludes that 60 percent of their reserves remain available. It would be nice if he's right.

Otherwise, the world will need to focus on conservation, efficiency, and alternatives such as natural gas, wind, solar, and advanced battery technology.

One of the ironic outcomes of the Great Recession is this: U.S. oil consumption dropped by 9 percent over the last two years. That may be the only good news resulting from our economic malaise, but it is something we'd be hard pressed to continue hoping for.

Federal Budget & Deficits Unsustainable

How ingrained is deficit spending in Congress? Consider this: Over the forty years ending in 2008, federal revenues averaged about 18.3 percent of our economy, while spending averaged over 20.6 percent, resulting in an average deficit of about 2.4 percent.

The federal government's long term “fiscal exposure” — the sum of all the benefits, programs, debt payments, and other expenses — will cost taxpayers huge sums in the future, regardless of whether or not it cuts discretionary spending.

In the first eight years of this century, that fiscal exposure has grown from $20.4 trillion to $56.4 trillion — a 176 percent increase. That is a financial obligation of unimaginable size and scope.

For decades, government revenues have not kept up with spending. Or, perhaps it's best to say that government spending has continually, and significantly, exceeded government revenues. As a result, the government has borrowed vast sums of money — and pays huge sums interest — to make up the difference.

Based on the GAO’s latest long-range alternative budget simulation, within about twelve years, our interest payments will become the largest single expenditure in the federal budget. By 2040, all of our federal tax revenues will add up to cover only our two biggest expenses: interest on our debt plus Medicare and Medicaid. Everything else — Social Security, defense, education, road building, you name it — will fail to be funded.

The Republicans and Democrats are all acting as if they've suddenly found religion as it applies to spending and debt. Last week President Obama proposed freezing one-sixth of the federal budget in order to bring government revenues in line with spending.

While it's a nice gesture, it's largely symbolic and will be ineffectual since it doesn't address the real problems.

We've reached a critical mass where government spending on the military and entitlement programs is literally out of control.

Benefits payments are the biggest chunk of the government’s massive obligation, and total defense spending has increased in recent years as the military fights two foreign wars.

In addition, the government has added new and prodigious resources for homeland security. The U.S. now spends more on its military than all of the other nations on the planet — combined!

Healthcare is one of the biggest drivers of our persistent deficits, since Medicare costs are an enormous piece of the federal budget. At present, healthcare is 18 percent of our GDP, and growing. With an aging, overweight, sick population, there is no end in sight to this problem.

For example, diabetes has become an epidemic, and a very expensive one. The annual cost for treating diabetes now approaches $200 billion.

The U.S. budget deficit is currently 10 percent of GDP. This means that healthcare and deficit spending alone are eating up 28 percent of GDP. And the 2011 budget deficit is projected to be 11 percent.

We will not experience nearly enough economic expansion to grow our way out of this debt problem. Our problems are structural and they run deep.

It is clear that — like it or not — tax increases are coming, as well as cuts to entitlement spending. Means-testing must be introduced, so that richer Americans only get back what they put into the Social Security system, and nothing more.

According to the Social Security Administration, life expectancy at birth in 1930 was just 58 for men and 62 for women, But men who were 65 in 1935 could expect to live another 12 years, while women faced an average 13 more years. Meanwhile, the retirement age was set at 65.

However, life expectancy has now reached an average of 78 years (76 for men; 81 for women). And life expectancy at age 65 is now 17 years for men and 20 years for women. This means that by retirement age, men and women can now expect to live to 82 and 85, respectively.

The Social Security payroll tax and wage base were much lower when most current retirees were working and contributing to the system. For example, back in 1960, the maximum amount of payroll tax for one earner was just $288. In 1972, it was only $419 a year. And as recently as 1975, it had only risen to $1,650, annually.

The reality is that many older people paid in relatively little compared to their current benefits. As a result, most retirees get back significantly more than they contributed. Obviously, the system was not designed to support this burden.

To make matters worse, the government spent the accruing Social Security surplus that had developed over the many years when there was more money coming into the system than going out. That should have been put in a "rainy day" fund for when the system faced growing demands, like right now. It's "raining" pretty hard at the moment, and it's going to get worse.

The Baby Boomers — all 76 million of them, amounting to 25% of our population — begin retiring this year, and will continue to do so for the next 18 years. However, a lot of their contributions have already been spent. Yet, they still expect the government to keep its promises.

From 1937 (when the first payments were made) through 2007, the Social Security program had expended $10.6 trillion. But in that same period, the program program received $13.0 trillion in income. The $2.4 trillion surplus was spent by Congress on other programs.

At best, it was a wildly irresponsible misappropriation. At worst it was a criminal theft from the taxpayers.

It's part of a long term pattern of reckless spending designed to appease special interests and to garner votes. The public hates taxes but loves spending programs. Not enough members of Congress are willing to stand up and speak the truth.

But the jig is up. The old ways will no longer work. The chickens are coming home to roost. Our debt is crippling.

In essence, our government is attempting to borrow its way out of a debt crisis. That is oxymoronic, thus it cannot work. The government cannot continue to borrow beyond its income without eventually going bankrupt. History abounds with examples of such failures.

Our government has been paralyzed by partisanship. Both sides give no quarter. Any success had by one side is viewed as a defeat for the other. All progress is thwarted for political reasons.

Spending benefits both sides. Constituents back home love projects and programs. So, the politicians bring home the bacon. Our leaders are more partisan than patriotic.

Republicans tout their passion for tax cuts. But what they don't admit is that budget cuts — the kind that their constituents feel — are very unpopular. Making deep spending cuts amounts to political suicide. So they ignore the fact that there is not enough revenue collected to pay for these programs.

The Republicans were oddly silent about the debt during the Bush years. Yet, they have suddenly found religion on the issue now that Democrats control the Congress and the White House.

Democrats love the same social programs that their constituents love. But they also understand that tax hikes to pay for these programs would be very unpopular, to the point of political suicide. So they ignore the funding problems.

It's six of one, a half-dozen of the other.

For nearly 30 years, our government has spent too much and collected too little. It's now coming to a head and reaching a crisis point. Both sides lack the political courage to be honest with the American people and to make the tough, uncomfortable decisions that are desperately and immediately needed.

All of this deficit spending has been financed through the sale of Treasuries, which have to be paid back with interest. And the Federal Reserve prints money out of thin air — increasing the money supply and devaluing the currency — to buy those Treasuries when there aren't enough takers on the open market.

The government is simply too big. This level of spending is unsustainable. Entitlements need to be immediately restrained.

The military budget needs to be cut in half. We'll still spend more than any other nation, and still maintain the world's most powerful military. But we need to recall most of the 500,000 military personnel, stationed on over 700 military bases, in more than 150 nations. Our footprint is far too big. We're bleeding ourselves to death.

We need to stop the knee-jerk reaction of calling all military spending "patriotic" and all cuts "unpatriotic." This is nothing more than irresponsible and dangerous rhetoric. We're going broke and we need to act. The Military-Industrial Complex that President Eisenhower so famously warned about has got us in a stranglehold.

The United States' continually weakening financial position is threatening our place in the world. It is threatening the very lifestyle that Americans take for granted. And it will threaten our ability to refinance our perpetually revolving debt in the not-too-distant future.

Right now, the future looks bleak. It will be replete with tax hikes, jarring spending cuts, rising interest rates, and rising inflation. We've been on this course for decades. Some, like David Walker, the nation's former chief accountant, were sounding the alarm. But there weren't enough like him. And no one in government seemed to be listening.

Our alleged leaders are crippled by politics and obsessed with grandstanding and gamesmanship. Each generation of politicians passed the debt problem along to the next, and just kept on spending like drunken sailors.

Now the bills are coming due. The size of our debts are staring us in the face and can no longer be ignored. The future is now, and it is going to be painful.