For those of you who haven’t been following the private-sector wing of the institutional collapse of the United States, as a result of several generations’ determination to collectively suck out far more than they put in, this has been an eventful week. Yesterday marked the third largest bank failure in history, as S&L IndyMac Bank was seized by federal regulators. “The collapse is expected to cost the Federal Deposit Insurance Corp. between $4 and $8 billion, potentially wiping out more than 10% of the FDIC’s $53 billion deposit insurance fund,” according to the Wall Street Journal. Meanwhile, rumors persisted that mortgage giants Fannie Mae and Freddie Mac might go under and be taken over by the federal government. Taxpayers will have to bail them out, a host of congressional representatives and pundits asserted, because if they went under the entire mortgage system would collapse, and the entire financial system with it.
Finally, there was this little article in Forbes, that asserted that public employee pension funds have invested in highly leveraged, high-fee (and rich overseer) “opportunity funds” in recent years, that these funds are hiding massive losses, and that government pension fund managers refuse to disclose such losses on the grounds that they have signed “confidentiality agreements” with the fund managers. “’Investors who refuse to enter these confidentiality agreements risk losing many of their best investment opportunities,’ says Thomas DiNapoli, New York State comptroller.” Those of you who read this post 18 months ago know that’s just what I want to hear.
I’m no financial expert, because if I were I’d have a lot more money of my own and would have lost a lot more money belonging to everyone else. But allow me to muse about each of these in turn.
What is the “deposit insurance trust fund?” What does it consist of? If you downloaded the spreadsheet attached to this post and looked at the detailed figures on federal revenues and expenditures as a share of GDP, you might have noted something interesting in row 196. In 1989 the federal government, net, paid out $406 per $100,000 of GDP, or about 0.4% of GDP, for deposit insurance. That figure would rise significantly in the early years of the first Bush Administration, as the Savings and Loan disaster was cleaned up, contributing to tax increases, spending cuts, and a lousy economy. In later years, however, spending on deposit insurance was negative — which is to say that after raising rates charged to banks, and with fewer bank failures (virtually none for the past decade as everyone enjoyed the debt party), the deposit insurance trust fund made a profit. That profit built up reserves for the coming wave of bank failures.
Or did it? If the trust fund consists of U.S. Treasuries, like the Social Security “Trust Fund,” than it is likely that all the extra money paid in by the banks in the past 15 years, like all the extra payroll taxes paid in by those born after 1960, is gone. Gone. Either substituted for other taxes the federal government would have collected, or spent on things the federal government would not otherwise have been able to afford. The banks gave the federal government money. The federal government spent it, and gave the deposit insurance fund IOUs that said someone someday in the future will pay it back, if it is ever needed to pay off depositors when banks fail.
And the future is now, because we are just starting a long run of bank failures according the press, with some suggesting the massive failures of the 1980s S&L crisis might be repeated — or exceeded. If the deposit insurance fund consists of phony treasury bonds, then rather than paying off depositors by simply taking money from a pile of cash lying there, which is what the “deposit insurance fund” implies, the federal government will have to pay off depositors by raising taxes (probably on younger generations), cutting spending (probably spending to benefit younger generations and not today’s seniors who have “entitlements”), or borrowing the money to spread out the pain by issuing real treasury bonds.
Those real treasury bonds would have to be purchased by people who save money, who will then own yet another piece of our nation’s future. Who are these savers? Not Americans. Chinese? Arabs? Will they get sick of lending money to a country going deeper and deeper into debt, in a currency that is losing its value? What will an additional $50 billion in federal debt do to the economy over the next 18 months or so? How about $300 billion? How about $1 trillion?
I sniffed around the FDIC website and was unable to find out what financial instruments the Deposit Insurance Fund consists of. But I can guess. What a sweet deal past Americans got for themselves over the past 25 years: take money for yourself now, with the promise that someone else will be sacrificed in the future to pay for it. The sexual revolution of the 1960s is nothing compared with the financial screwing that the 1950s and 1960s generations have left behind. The winners are those who are dead and gone, having taken the benefits and escaped the cost. There is a huge attempt to keep deferring those costs so that more of the winners will not be around to suffer the consequences.
The state and local equivalent of this federal nightmare is the public employee pension funds, where those generations awarded themselves richer pensions without contributing more by simply assuming richer returns, and then shifted money to riskier assets such as hedge and opportunity funds that promised those returns. Rather than just invest in assets such as mortgage bonds and construction loans (a bad enough decision in the housing bubble), many of them make leveraged investments in these leveraged assets meaning they would be wiped out by a small decline in value. And in case you didn’t notice, the collateral backing those real estate bonds and loans has declined by more than a little from bubble highs, even if those values were not inflated by fraudulent appraisals.
Here’s a couple of more choice quotes from the Forbes article.
“For small investors all across America whose retirement pools poured 1% to 5% of their assets into opp funds, heavy losses–only beginning to surface–could be a sizable blow. If the setbacks for pension funds are severe enough, it could force state governments to raise taxes to cover shortfalls and induce companies to cut back on dividend payments to shareholders in order to set aside additional money for their private workforce pensions.”
“Something–mystique, desperation for better returns, fear of being locked out of the deal flow–keeps pension funds coming back. New York Common owns $2.3 billion worth of opportunity funds (1.5% of its assets); the Pennsylvania State Employees Retirement System has $583 million (1.7%). Washington State Investment Board has $2.2 billion (2.6%), and Virginia Retirement System owns $643 million (1.1%). Even tiny Chicago Teachers' Pension Fund has $300 million invested in opp funds (2.5%). In most cases they're willing to pay opp fund managers the standard 1.5% a year of money under management plus 20% of profits over an 8% minimum "hurdle rate" return.”
Ie., the Hedge Fund managers get a piece of the big gains, but the public employee pension funds take all the losses. Gamble away! Note that according to the article, New York has been snorting some of its own supply. So how has it turned out?
“’We know funds are sitting on investments that have gone totally belly-up,’ says Nori Gerardo-Lietz, whose Partners Group in San Francisco advises pension funds like Calpers on real estate investments. Barring a miraculous resurgence in values, she predicts opp funds will produce poor returns and a few devastating writedowns of pension fund investments in the coming year or two. ‘They're trying to hold on, so they get debt extensions,’ she says. This month Gerardo is publishing her ‘Lake Wobegon Revisited’ report, so called because it questions the impression that all opportunity funds, like the children in Garrison Keillor's mythical Minnesota town, are above average. Adjusting for leverage, however, opportunity funds bombed out and trailed low-cost ‘core’ real estate funds in 7 of the last 11 years.”
And those low cost funds aren’t going to do so well either.
Moving on, why can’t Fannie and Freddie be allowed to collapse? Because other financial institutions, like banks and insurance companies, hold the bonds that these organizations issued, and if these organizations collapse it could cause banks, insurance companies, and pension funds to also go under. And if the banks can’t lend, businesses can’t borrow, and all the whole S&P 500 could go under. All those holding existing wealth in paper assets — stocks, bonds, etc. could see those assets decline in value massively, as everyone and everything went through a kind of Chapter 11 or was nationalized. People who today have substantial wealth might have little more than what the earnings from their future labor would provide, and whatever benefits the government could provide them — like most young and working class Americans. Some “ownership society.” When, in the history of the United States, was the distribution of income and wealth the most even? In the aftermath of the Great Depression.
So as the bailouts come along, as taxes are increased, public services and benefits are cut, pay is reduced in business, prices rise for consumers, and even more money is borrowed, all due to “circumstances beyond our control,” just remember how well people have made out in the past on both the public and private side in the past. Those who made out are now holding pieces of paper that say we have an obligation to serve them in the future. Don’t we? Not all those “free market” types who suddenly see the wisdom of government bailouts of all kinds.
I’ve actually saved, and hold some of those pieces of paper myself, but my views of what to invest them in over the next 18 months are as bleak as my expectation of state and local finance over the same period. We are facing a very difficult situation, and lots of people got very rich, or got very rich retirement benefits, or both putting us there. The mess is public, corporate and personal, Republican and Democratic. To me it is cultural, and generational — and thus beyond debates about business and government. You see the same thing everywhere.