FedUpUSA

Archive for April 11th, 2010

The American Dream

By Ed Wallace

How Goldman Won the Over-the-counter Derivatives Poker Game Against All Investment Banks (CBS Videos)

There was a CBS exclusive the other day titled “Is Goldman Sachs Playing Fair” by Armen Keteyian. Below are the video segments: The Power of Goldman Sachs and Insight into Goldman Sachs. Basically how Goldman won the trillion dollar over-the-counter derivatives poker game against Bear Stearns, Lehman Brothers, Merrill Lynch et al, and the gap between Wall Street and Main Street.

Watch CBS News Videos Online

Watch CBS News Videos Online

In Game Theory, Greece Is the Start, U.S. Is the Endgame

Section 1: Co-ordination Failure as a Prisoners’ Dilemma
Mohamed El-Erian of PIMCO, writing in the FT (‘Why the Greek rescue isn’t going to plan’, April 7), spoke of Greece as a sovereign risk problem that is not going as planned. El-Erian indicated that it was because of what he referred as a co-ordination failure. He wrote

It is a classic co-ordination failure in game theory. Any first mover will become worse off. Indeed, it is in the interest of any single party to wait for others to move first. As a result, no meaningful progress is made, the problems fester, and the risks of a disorderly outcome increase.

This sounded exactly like the Prisoners’ Dilemma (PD) problem in classical game theory that shows why two economic actors may not co-operate despite it being in their best interests to do so. The dilemma is as follows:

Two crime suspects are taken in by the police. The police have insufficient evidence for a conviction. They separate both the prisoners, visit each of them and offer the same deal. If Prisoner A testifies (or defects against the other Prisoner) for prosecution against Prisoner B and the latter remains silent (and hence co-operates with Prisoner A), A goes free and B receives the full sentence of twenty years. If both remain silent, both prisoners are sentenced to a diluted sentence of five year as the more serious charge cannot be proven. If each betrays the other, each receives a ten year sentence. Each prisoner must either betray the other and testify against his partner, or remain silent and thus cooperate with his partner. Each one is assured that the other would not know about the betrayal or cooperation before the end of the investigation.

If such a game is played once and only once, defecting against the other prisoner is the rational outcome over co-operating. Irrespective of the actions of the Prisoner B, Prisoner A will always gain a greater payoff by choosing to defect. Similarly, Prisoner B will always gain a greater payoff by choosing to defect regardless of Prisoner A’s actions.

If the game is played repetitiously with each player (both of whom are aware as to how many times the game will be played and both of whom are in possession of the opportunity to punish the other player for previous non-co-operative play) it turns out that the rational outcome for the two players continues to be to defect again and again, irrespective of how many times the game is repeated.

Only when the players play the game an indefinite or random number of times, is it possible to enforce cooperation as a rational equilibrium outcome. Only in such a case, the incentive to defect can be overcome by the threat of punishment.

Section 2: Greece and Germany as Players in the Game

Greece and EU are playing such a one-shot (unrepeated) PD game.
Greece’s crime is that is did not heed the EU directives and put its fiscal situation in order in line with the Maastricht Criteria. EU’s crime is that it did not enforce the Maastricht Criteria and temporarily suspend Greece as punishment when it failed to follow the guidelines on fiscal debt.

Now that both the EU and Greece have been ‘caught’ by the Sovereign/Euro crisis, each is figuring out its best response. For Greece the optimal outcome, in the context of the prisoners’ dilemma, is to defect, while EU co-operates. Defection would imply that Greece does not rectify its finances and is instead bailed out by the EU. The optimal outcome for the EU in such a game is to force Greece to rectify its finances – Greece cooperates. Thus EU does not bail Greece out –in the context of game, EU defects.

If both the EU and Greece defect as is the optimal rational outcome in the game, both lose out somewhat. Specifically, Greece is likely suspended from the Euro region until it fixes its finances and the EU suffers a bout of credibility as markets begin to question the future of the Euro.

An IMF-led bailout in this context would be akin to both parties pleading guilty to partial charges. This again is not the rational equilibrium outcome and undermines the situation as a non-European solution. It would be somewhat of a co-ordinated outcome.

It is optimal for both Greece and EU to cooperate with each other and put forth a credible plan internally to resolve both the fiscal deficit situation of Greece (and to some extent rest of the imbalances amongst the PIIGS), and – as suggested by Martin Wolf – to stimulate aggregate demand in countries running surpluses (like Germany) for goods from countries with deficits (like Greece). This would prevent Greece from wading deeper into recession, and help preserve the Euro region in its present shape and form. However such an outcome is difficult to achieve as in the context of the game it is not a self-enforcing, rational outcome. Consequently, solutions suggested by Germany hover around a zero-sum world of beggar-my-neighbor policies in which a country attempts to play to its benefit alone by increasing market share from the rest of the region.

Expertise of Trichet notwithstanding, a currency union without a fiscal and political union is difficult to succeed as it distorts incentives for members to part take in the benefits of a monetary union without necessarily incurring all the costs such a union imposes.

Fig 1: Greek over German Spread at historic highs is making Greek Bonds as expensive to issue as Junk Bonds. Source: Bloomberg.

Section 3: A Similar Story

Greece’s actions are no different fundamentally than the actions of banks going into 2007. Banks took on excessively risky exposures, without allocating appropriate levels of capital, to increase potential profits as they implicitly, and correctly, assessed that, on failure, there was a reasonable likelihood of a potential bail out. Thus, they enjoyed the benefits of being the key actors in a subsidized payments system.

Similarly, Greece has enjoyed the benefits of the single currency without having picked up the costs that come with such a union, specifically in terms of strapping its expenses and putting its fiscal house in order.

Worse still, the situation is not getting better. On Saturday, Markit reported that CDS protection on Greece had become more costly than that on Iceland. Earlier, Iceland had to seek a $4.6 billion IMF-led bailout after its three biggest banks collapsed in October 2008.

Ironically despite their demonization, CDS markets have been helping Greek to continue to issue primary debt as CDS trading is providing an avenue to hedge Greek exposure. This has eased hedging concerns in the primary issuance market allowing it to work, albeit at costs of issuance similar to that of junk bonds. Such a prohibitive cost undermines Greek government’s ability to continue to fund itself in the coming months.

Figure 2: Cost of insurance for Greece touched that of Iceland, a country that was bailed out by the IMF. Source: Markit’s CDS Report, Courtesy Gavan Nolan

Figure 3: Cost of insurance for Western European Sovereigns is rising once again indicating possible spreading of concerns. Source: Markit’s CDS Report, Courtesy Gavan Nolan (Click to enlarge)

Section 4: That May Get Enroll More Players

El-Erian ended his FT article by emphasizing

…Greece is part of a wider, and historically unfamiliar phenomenon – that of a simultaneous and large disruption to the balance sheet of many industrial countries. Tighten your seat belts.

This brings to mind the remarks of CLSA analyst Chris Wood on CNBC (March 01, 2010) that

….Credit Crisis we saw in the West in 2008 and 2009 has simply been deferred, because 95% of the so-called government policy solutions to deal with this Crisis have simply been to extend government guarantees. So the problem has been transferred from the private sector to the public sector. It is just a matter of time before investors’ revolt against these sovereign guarantees. The crisis is going to happen first in Europe. The U.S. will be the endgame.

Two astute market observers may not be completely right but one may ignore them at one’s own peril.

A client comment on Greece – European Sovereign Debt Crisis. The note in pdf is available for Seeking Alpha readers here

Sunday Funnies

By Nathan Martin

The $2.3 Trillion State and Local Government Debt Monster – California Pension Systems on Unsupportable Path with $500 Billion Projected Shortfall. CalPERS, CalSTRS, and UCRS.

Posted by mybudget360

Much of the focus on government debt over the past few years has revolved around the federal government.  No doubt, this is a stunningly large amount.  Yet the government has the ability to finance this debt through the U.S. Treasury and Federal Reserve with a buffet of choices.  You have direct bailouts to Wall Street, quantitative easing, and systematically dismantling the U.S. dollar.  But one issue that is rising to the top is that of state and local government debt.  States do not have the ability to print money at the whim of any central banker.  And the state and local government debt market is up to a whopping $2.3 trillion.  At this point, trillion is the new billion.

Let us examine the growth of this debt over the last forty years:

The growth in local government debt has exploded since the 1970s.  We went from $295 billion in 1968 to $2.3 trillion today.  But as Greece is demonstrating, there is such a thing as having too much debt and at a certain point the markets no longer have an appetite for so much borrowing.  Average Americans probably have a hard time examining the large numbers being thrown around.  Yet state and local governments are now finding a hard time balancing their budgets.  In many cases, the ability to balance their budget goes in direct conflict with paying out pension distributions.  Or in many cases states need to raise taxes or cut services.

Wall Street enjoys exploiting this fact because they actually loot the public sufficiently with golden parachutes and ridiculous bonuses that they never need any sort of pension.  Yet the truth is, many of the gold plated pensions are just another side of the Wall Street mentality coin.  That coin relies on having others pay for your bailout or extended retirement.

Now Wall Street has implemented the biggest transfer of wealth in history with the $13 trillion in bailouts and backstops.  But many pension funds also bought into what Wall Street was pushing.  Let us examine the California state pension systems.

California Pensions – $500 Billion Underfunded

The Stanford Institute for Economic Policy Research issued a stunning report on the three largest pension systems in California.  The report was titled Going for Broke and what we find is a rather daunting mountain that California has to climb if it seeks to remedy their pension system.

Let us look at the three largest systems:

In total these cover 2.6 million of California state workers.  These are CalPERS (the largest), CalSTRS, and UCRS.  But if you look at the funds performance through the crisis, all of the funds saw 23 to 25 percent declines.  These declines only exacerbate the shortfall of the system.

The odds of shortfalls are virtually assured for all systems.  We are now entering a stage where many workers will be retiring and drawing into the system.  Expectations for deficits are large:

Part of this stems from the notion that markets will always return a standard rate.  As we have seen with the massive market volatility, markets are largely unpredictable especially when they become casinos for the wealthy.

As the report finds, these funds do not have the flexibility required in an unpredictable market:

“A public employee’s pension constitutes an element of compensation, and a vested contractual right to pension benefits accrues upon acceptance of employment. Such a pension right may not be destroyed, once vested, without impairing a contractual obligation of the employing public entity.”

It becomes a matter of law to pay even if the economy has rendered a new reality.  As Greece is showing, having very early retirement rates with generous packages is not supportable with a younger generation that isn’t having larger families.  The math doesn’t work but good luck changing that.  Some will argue that people contribute into these systems.  This is true but not anywhere to cover the actual payout over time:

In other words, there is a shortfall of coverage and a market decline only pushes the problem to the surface for all to see:

“As mentioned earlier, the pressing nature of California pension shortfalls is due in part to the losses CalPERS, CalSTRS, and UCRS sustained in the mar­kets over the past 18 months. CalPERS expects an average annual investment return of 7.75 percent, CalSTRS targets 8.00 percent, and UCRS expects 7.50 percent.”

Those expected rates of return are simply too optimistic.  These funds are expecting 7.5 to 8 percent annual returns in a market that is giving 0 percent rates to savings accounts and 4 percent for 30 year fixed government debt.  Instead of realigning to this low yield environment fund managers went all in to the market and gambled on Wall Street:

It is amazing that many fund managers look at the above as “safe” but it is anything but safe if you are losing 23 percent.  Part of the bets were flat out risky:

“(LA Times) SACRAMENTO — The value of residential real estate investments owned by the country’s largest public pension fund has plummeted 35% — a paper loss of $3.3 billion for current workers, retirees and their state and local government employers.

The California Public Employees’ Retirement System reported Wednesday that in the year ended June 30 its real estate portfolio declined to $6.08 billion from $9.36 billion, based on 461 independent appraisals of its investments in 288,000 housing units across the country.”

Housing, both residential and commercial has not recovered.  So these losses are still likely part of the funds new reality.  The massive rise in equities probably has helped but it is a long way from that 7.5 to 8 percent annual return:

Past performance is no indication of future returns especially when more and more retirees are going to draw from the system:

“In 1999 California passed Senate Bill 400 (SB400), substantially raising benefit factors and lowering retirement ages for public employees (see Table 3). Based on a National Institute on Retirement Security report, average monthly public pension benefits in California were $2,008 in 2006, the eighth highest nationwide.”

Now that $2,008 monthly benefit does not factor in additional healthcare benefits which cost a lot and are also provided.  Just do the quick math, let us assume someone retires at 55 and lives to 85 and receives that $2,008 monthly benefit:

$2,008 x 12 = $48,192 x 30 = $1,445,760 in total paid out

We are also assuming no COLA adjustments which some of these plans have.  We aren’t adding the added healthcare cost which an older retiree will be using up.  Something tells me that a state worker did not even come close to putting in $1.4 million over their working career.  And you wonder why these pension funds combined are projected to have a $500 billion shortfall?  And good luck if the stock market turns lower or simply remains stagnant for years.  California is only one example of many.

The paper lays out a few suggestions including higher contributions, a hybrid 401k/403b system, and safer investments but also a tiered system.  In reality, Wall Street has not wanted to deal with reality and has used the taxpayer as a bailout for their wealth protection.  Now that taxes are being talked about including a value added tax (VAT) people are getting angry.  You didn’t think bailing out Wall Street was free?  The same reality will hit the state pension systems.  Younger workers are going to enter a tiered system where they have to pay out more with no future guarantee while they watch older workers take on funds that they will never see.  I’m sure that is politically going to go over well.

By Joel S. Hirschhorn

 Would you choose being wealthy and paying income tax or making little enough to escape income tax?  Americans have a far greater chance of being in the latter group.

 Sometimes there are statistics that you really need to meditate on for awhile.  They open the door to critical thinking about American society.  They shed light on a host of hot political and public policy issues.  This is especially true for rich versus poor issues, taxes, justice and equality.  First, note the number of households in the United States: now at 115 million, which equates to an average of 2.6 people per household.

 Now, think for a few moments and guess the answers to this question: What fraction of households have assets of $1 million or more and what fraction will pay no federal income tax for 2009?

 Take a moment, think seriously about what these two fractions might be.  To have net assets of $1 million or more certainly signifies people at the top of the economic ladder, but is a far greater number than the superrich, because a million bucks is not what it used to be.  A lot of ordinary people seeing themselves as middle class, but making good incomes and probably older, even with lower house values, can have wealth at this level. 

 And to pay no federal income tax certainly covers people at the bottom of the economic spectrum, but not necessarily just the very poor.  They too may see themselves as middle class or, for some, the working poor.  For example, for 2009, a family of four with two children under 17 could have made $50,000 and escaped paying any federal income tax because of various tax credits and other benefits.  Many two income households could avoid paying federal income tax, because of low but rather typical salaries.

 Here are the answers to the above question.  Households with $1 million or more in net assets number just 7.8 million or 6.8 percent of the national total.  Households that will pay no federal income tax for 2009 number 54 million or 47 percent of the national total.

 Thus, there are about seven times as many households paying no federal income tax, nearly half the nation’s households, than having $1 million or more in assets.

 If a high income rather than assets is considered, then note that about 16 percent of households have annual incomes of $100,000 or more.  This means that a lot of households with pretty high incomes have not accumulated the wealth level of $1 million in assets.  Households with incomes of $250,000 or more, however, number just under 2 percent of the nation’s total.  This is the group that will see higher taxes from the new health care reform legislation and now pays about half of all taxes.  This group equates to about 2.3 million households and 6 million people that really are rich in terms of both wealth (assets) and income.  These people can afford to pay more taxes because they have benefitted disproportionately from past tax cuts and probably are not hurting much in this recession.

 All these numbers shed some light on the considerable economic inequality that has gotten steadily worse in recent years.  Yes, the rich have become richer, the poor poorer, and the middle class devastated, probably worse than ever, because the current Great Recession for millions of people is really just as bad as the Great Depression – financially and psychologically.  Over the past 30 years the lowest income people are actually making less now, after adjusting for inflation, and CEOs at the largest companies went from making 35 times to over 300 times more than their average workers.

 Take away the no income tax and high asset households and you have about 46 percent left or 53 million households with about 138 million Americans.  This is a better view of the shrinking, at-risk middle class, households trying to survive in a cruel society with high economic insecurity.  These people should be more worried about sinking into the lower class, no income tax paying group, than dreaming about rising up into the wealthy high tax paying class.  The bitter truth is that upward economic mobility has largely become a myth, like the American dream, more like winning the lottery than a reasonable expectation from working hard.

 Maybe all this explains why there are so many angry, anti-government Americans attracted to the tea party movement, and firmly entrenched independents fed up with both major political parties because they more serve corporate rather than public interests.   With an enormous national debt, high unemployment that will not go away, and increasing number of people losing homes and needing free food things are likely to stay bad or get worse for a lot of people.

 Dwell on this: Do you really think that voting in different Democrats or Republicans will return the nation to a healthier condition?   And this: Does having a positive attitude about the future require delusional thinking, or heavy drug use to avoid thinking about it?

 [Contact Joel S. Hirschhorn through delusionaldemocracy.com.]