I O U, America

by Ouida on April 21, 2010


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LetsGetFiscal started following me on Twitter and the follow reminded me that I need to get back on track talking about the budget.  Our country is on a dangerous course on many levels: 1).  We have adopted the policy of taxing high income households to pay for the benefits that every citizen will enjoy 2).  We are really not talking honestly about the future of our major entitlement programs, Social Secrurity, Medicare 3). We are increasing our levels of indebtedness to pay for budgetary shortfalls. 4) Debate about the budget has gone down the Partisan sewer when both parties are equally responsible for creating the mess we are now in and, truth is, they know it.

I actually have the 2009 unified income statement for the United States on my hot little hard drive.  The document is over 200 pages long, but most of that is the citizen’s guide and it is pretty easy to read.

My financial adviser, Kim Butler, at Partners4Prosperity always reminds me that I should think micro-economically to understand macro-economics.  In other words look at how I handle money on a small scale to understand how the government does it on a large scale.

Eventually these posts are going to contain images taken directly from the unified income statement for the United States, but for right now, I am only going to discuss general principles.  First a basic example we can all relate to.

Imagine a college kid.  He finishes college and graduate school with $60,000 in debt.  His loan is at 8% and it will be financed over 10 years.  When the loan goes into re-payment the payment amount will be $727.97.

While he was in graduate school, he got a job paying $30,000 dollars per year and decided he needed a car.

Even though he will have an outstanding debt of $60,000 with a payment due of $727.97, while he is in graduate school or qualified post graduate training, his student loans will be in deferment.  Because he is not actively paying on the loans, present day creditors will not consider the loans which represent future debts when deciding whether or not to loan him money for a car today. His student loans are in essence an unmet obligation.  They aren’t due now, but they will be due at some future date.  He knows he has to plan for them, but he has no sense of urgency.

He gets a car for $15,000 at 8% for a payment of $304.15.  Remember his income is $30,000 per year.  That means that his gross take home pay (before taxes) is $2500.  There is a general rule that total debt obligations should be no more than 36% of gross monthly income and housing debt should be no more than 28% of gross monthly income.  The general rule of thumb is that the lion’s share of that maximum total debt obligation will go to housing.  Whether you are renting or buying a home these total percentages are the total percentages.  You can’t just say I’ll run up the cards until my debt is 36% of my gross pay, no you always have to factor in housing because you need a place to live.

36% of $30,000 is $10,800 dollars or 900 dollars per month.  See the problem?  Because no one was looking at his student loan debt, our student was able to get a car loan for $304.15 per month.  But when his student loans come due, he will suddenly be well over the maximum debt load for his income and he still doesn’t have a place to live!

Our student will only have 5 options:1) increase his income, 2) sell his car  3) default on his loans 4) renegotiate his debt  5) reduce current spending

Okay, now imagine our student is actually the US federal government.  Take student loans out of the picture and substitute the entitlement programs of Social Security and Medicare.  From our earlier post we know that the unmet obligation is $46 trillion dollars.  Remember our government’s income is only about $2 trillion dollars. Our government has the same options as our college student:1) it can increase its income through tax increases. Only an extremely naive person would believe that all necessary revenues can be obtained by taxing the top 2% of income earners. 2) it can sell it’s assets 3) it can re-negotiate its debt.  Actually our government already does this by issuing new bonds and using the revenue generated to cover budgetary shortfalls and to pay off other bond holders. 4) default on its debt.  There are plenty of articles on the web that discuss the possibility of US debt being downgraded. 5) reduce both present and future spending.  What this would look like is tackling fewer new social programs and reducing benefits promised through established programs such as establishing a means test for Social Security.  What this would mean is that Social Security benefits would be tied to a person’s post-retirement income, no matter how much they contributed during their working years.

I’ll stop here and ask you to please comment.

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I O U America Part 2
April 23, 2010 at 8:34 pm

{ 2 comments… read them below or add one }

Ruth T. Vincent April 26, 2010 at 9:12 am

I’m trying to fully understand the Matgnetar scenario:

Based on what you said, the toxic CDOs included a few of the Bs and Cs, but the makeup would not have turned the trench into non-toxic? How could they take out insurance on Bs and Cs they did not own? What as I missing?

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Ouida April 29, 2010 at 8:24 pm

Exactly!

See the problem with the CDS market (credit default swaps) is that it is completey unregulated and private. No one knows who owns what until the owner of a CDS goes to the issuer of the CDS and wants payment.

So here is the deal. It was perfectly legal for investors to take out insurance on tranches they did not own. It would be like your neighbor taking out insurance on your house and they do it because they know you are a smoker and they are betting that you will one day torch your own house down, and, to increase the probability that you will do that, your neighbor supplies you with cigarettes and alcohol. Except of course your neighbor cannot take out insurance on your home because the insurance industry is regulated.

There was a further problem. S&P rated the top tranches as triple A: “good as money”, the bottom tranche was basically junk.
So investors bought the top tranches, reassured by the triple A rating and only the bottom tranche was considered toxic waste.

Magnetar used its influence with CDO managers, however, to make sure only the poorest assets were included in the entire CDO to increase the likelihood that the top rated tranches would default.

The bottom tranches are worth only pennies on the dollar because they truly were considered junk but the top tranches cost investors hundreds of millions of dollars because they were triple-A rated. Sooooo Magnetar was able to, for a small insurance premium, take out insurance (CDS) on tranches they did not own but were worth considerably more than the bottom tranches they did own.

There is one final thing. When an investment bank creates an investment and cannot sell all of it to other investors, they have to keep what they do not sell on their books. No one wanted to keep the bottom tranches of CDOs on their books, they were junk and as early as 2005 CDO managers realized that markets were cooling off and defaults were on the rise.

Magnetar revived the CDO market by making it clear that they would buy the bottom tranches removing the fear from investment banks that they would get stuck holding the junk tranches after they created the CDO.

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