Agora Financial’s Rude Awakening

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Laguna Beach, California

• Bonds hammered, dollar slammed…and other “good” news,
• Calling GM’s demise like only a non-politician could have done,
• When reputations fail to make the repayments and plenty more…

Eric Fry, reporting from Laguna Beach, California…

The US stock market is enjoying one of those delightful episodes when all news is good news. The Dow Jones Industrial Average jumped 221 points yesterday to 8,721 – lifting the Blue Chip index to within a whisker of a positive year-to-date performance.

Let’s give credit for the rally to good news… and also to bad news, because that’s also good news. In fact, let’s just give credit to news in general.

Topping yesterday’s headlines was the “news” that General Motors had formerly declared bankruptcy. The automaker’s de facto bankruptcy of the last several years finally yielded to the de jure variety. That’s good news, because now we taxpayers get the chance to increase our charitable giving. We get the opportunity to write a $50 billion check to one of America’s largest and most beloved nonprofit organizations.

But wait, GM’s bankruptcy wasn’t the only good news to cross the wires yesterday. Stock market investors celebrated the following stories as well:

1) Treasury bond prices plummeted, exacerbating the bond market’s worst January-through-May performance in 32 years.

2) The Dollar Index slipped to a fresh seven-month low.

3) Activity in the nation’s factories fell for the 15th straight month.

Curiously, there were also a few news items yesterday that the stock market blithely ignored…like the news that our largest foreign creditor is becoming increasingly nervous about supplying fresh credit. On the eve of Treasury Secretary Timothy Geithner’s goodwill mission to China (OUR goodwill, not theirs), Yu Yongding, a former central bank adviser, remarked, “I hope Geithner’s visit can soothe our nerves. The Chinese public is worried about the safety of its foreign-exchange reserves.”

China is the largest foreign holder of U.S. Treasuries – with almost $800 billion worth in its national piggy bank. Understandably, therefore, the Chinese are not thrilled to see Treasury prices plummeting, while America’s budget deficit is soaring. Seventeen of twenty-three Chinese economists polled in connection with Geithner’s visit said holdings of Treasuries were a “great risk” for their nation’s economy.

“It will be helpful if Geithner can show us some arithmetic,” said Yu. Regrettably, basic arithmetic would produce more consternation than comfort. No matter how you line up the numbers, the sum will always be an enormous, gigantic, colossal NEGATIVE number.

No, Geithner does not need arithmetic; he needs a miracle…or a printing press. Without some sort of miracle that converts liabilities into assets, America’s debt is already larger than national cash flow would support. We would be broke already, were it not for two convenient facts: 1) Our creditors keep lending us money; 2) Even if they didn’t, we can print for ourselves the money with which we must re-pay our debts.

So it’s probably safe to say that America will not default on its debt. But it’s also probably safe to say that the dollars our creditors receive in the future will be worth much less than the dollars they loaned us in the first place.

“We are committed to bringing our fiscal deficits down over the medium term to a sustainable place, to a sustainable level,” says Geithner. “We believe in a strong dollar. A strong dollar is in the U.S. interest.”

China’s Yu Yongding does not seem to believe him.

Says Yu: “I wish to tell the U.S. government: ‘Don’t be complacent and think there isn’t any alternative for China to buy your bills and bonds.’ The euro is an alternative. And there are lots of raw materials we can still buy.’’ To sharpen the point, Yu continued, “Some people say the euro is very weak. Okay, weak is good, we’ll buy very cheap.’’

Geithner promises that America will keep its spending under control. But the promise rings hollow from a leading member of an economic team that will produce a $2 tillion deficit in its very first effort to “control spending.” The Obama Administration did not invent deficit spending, but it has quickly mastered the art.

“The borrower should keep their promises,” China’s Yu insists. “The U.S. should be a responsible country.”

It should be, but it’s not. The nearby chart, based on data provided by Shadow Stats, tracks the explosive growth of America’s national indebtedness over the last few years. This chart presents America’s indebtedness in terms of both cash-based accounting and GAAP-based accrual accounting. The latter of these two methods is the one that every corporation in America must use. As such, GAAP is real-world accounting, which would include things like the present value of the Social Security liability and the Medicare liability. At $12 trillion for year-end 2009, the cash-based deficit is bad enough; but at $74 trillion, the GAAP-based numbers are a catastrophe.

$74 trillion is about five times GDP, which is a ratio that would put America well within emerging market parameters. The only problem is; we aren’t emerging. We are submerging…at least from the standpoint of national indebtedness.

These data points should frighten any student of financial history. Therefore, these data points should terrify every holder of dollar-denominated assets. The good news – and remember, it’s all good news right now – is that Rome wasn’t destroyed in a day.

There may be a way out of this mess – we certainly hope so – but America’s current fiscal plight reminds us of General Motors. For many, many years, General Motors survived on its reputation. Despite the company’s obvious financial distress and obvious inability to book a profit selling cars, investors continued to buy the company’s bonds and to bid its shares higher. Thus, GM racked up liabilities far in excess of what it could ever hope to repay.

Sound familiar?

Your editor’s here at the Rude Awakening began fearing for GM’s terminally ill balance sheet more than four years ago…and we stated as much on several occasions. One of those occasions was the February 11, 2005 edition of the Rude Awakening, entitled, Major League Debtors. We are re-publishing this column today as a “Rude Classique,” not to rehash GM’s demise, but to make a very timely point: Reputation does not service the debt.

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Major League Debtors, Revisited
By Eric J. Fry

The ranks of BBB- credits are a lot like AAA baseball teams.

Both groups include “players” that aren’t quite Big League material – either because their talents are diminishing or because their talents aren’t yet fully developed…or perhaps, because they never really possessed much talent in the first place.

In other words, the ranks of BBB- credits and AAA ball clubs contain both “has-beens” and “up-and-comers.”

In the AAA, for example, 30-something former big leaguers play side-by-side with 20-something prospects. BBB- credits include an equally diverse – if not motley – collection of players. Thus, we find in the ranks of BBB- credits the curious juxtaposition of General Motors and the Russian Government. These two borrowers may be BBB- “teammates,” but we doubt they’ll be on the same team for long.

General Motors, the has-been of our metaphor, once boasted a formidable AAA credit rating, just like the U.S. Treasury itself.

Throughout the 1970s, while GM was busily responding to the Arab oil embargo by churning out yacht-sized Cadillac Fleetwoods, the automaker was able to borrow money at preferred AAA rates. In 1981, however, the company’s downward slide “officially” began, as S&P dropped GM’s rating to AA+.

Today, the beleaguered American icon’s debt rating sits just one downgrade away from “junk” status.

By contrast, the Russian government had never managed to earn an investment-grade rating…until a few weeks ago.

Like a career minor leaguer, the Russian government’s credit rating bounced around in the junk ranks for several years. Then, in 1998, this troubled borrower validated its lowly rating by defaulting on its sovereign foreign debts. (Hence the “SD” rating, displayed in the chart below).

This ignominious event – otherwise known as the “Russian debt crisis” – marked the nadir of Russia’s post-communist economic odyssey. But it has been recovering steadily ever since. Aided by a doubling of the oil price, the Russian economy has clawed its way back to international respectability, finally garnering an “investment grade” rating from S&P late last month.

But what lies ahead for Russia and General Motors? Which of these two marginal credits will advance to the big leagues and which will fall even deeper into the minors?

To formulate a guess, we’ll need to take a brief look…under the hood of the General Motors Corporation. [Eric’s note: In Part II of this column we examined the credit-worthiness of Russia].

GM’s debt load is massive and growing. Its net debt outstanding has doubled over the last four years to $244 billion. In addition, GM’s balance sheet contains a towering pension liability of $102.4 billion and a $67.5 billion liability for other post-employment benefits (OPEB), primarily health care, insurance and other benefits that the company is committed to providing both current retires and active employees. These already-considerable costs seem certain to grow.

Unfortunately, a peak inside GM’s recent financial results provides no comfort whatsoever to bondholders. Over the last two years, the automaker has earned very little money selling autos. Instead, the company’s finance unit, GMAC, has produced three quarters of the entire company’s net income. And in the final quarter of last year, the finance unit produced ALL the net income. Equally disconcerting is the fact that GMAC’s mortgage division has produced more net income over the last two years than all of GM’s worldwide auto operations.

These facts are not so surprising when one considers that GM’s North American market share eroded last year from 27.4% to 26.7%, despite the fact that GM spends more than $4,000 per vehicle to “incentivize” buyers to drive one of its cars off the lot.

Net-net, GM seems fully deserving of its “near junk” rating and seems likely to trend from bad to worse…The adverse trends plaguing GM might simply continue, in which case this BBB- borrower could slip into a kind of junk-credit abyss – paying ever higher interest rates, while struggling to satisfy ever-growing liabilities.

Some players simply don’t belong in the big leagues…General Motors may be one of them….

Joel’s Note: Just quickly here, did you receive Byron King’s Gold Report last Friday afternoon?

Put simply, we don’t have much faith in the U.S. dollar. As Eric pointed out above, all manner of catastrophic scenarios are lining up for a “GM-style” breakdown of the world’s reserve currency…and possibly even the entire U.S. economy itself.

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[Rude Endnote: World markets staged mixed responses to yesterday’s stellar/delusional rally on Wall Street. Maybe they see a shrinking U.S. economy as, uh, a bad thing?

Here in Asia Hong Kong’s Hang Seng index was the day’s biggest loser, snapping three straight days of gains to end the session down 2.6% on profit taking. Japan’s Nikkei 225 and China’s CSI 300 edged slightly higher, up a quarter percent by the closing bell. The Aussies faired quite a bit better, ending the day up 1.5% on the All Ordinaries Index.

Over in Europe London’s troubled FTSE was down 0.8% last we checked while France’s CAC and Germany’s DAX had barely budged from where they started the session.

The real news, of course, has been over in the commodities pits. While everyone was paying attention to GM’s funeral procession, crude quietly snuck up to near $70 a barrel again. It’s a long way from $147, to be sure, but it’s certainly a start. And gold, well, right in time for the release of Byron’s Gold report our favorite shiny metal rocketed all the way up to $980 per ounce. She’s settled back a few bucks to $977 this morning.

We hope you enjoyed today’s Rude Classique. We’ll be back with more musings on the morrow.

Until then…

Cheers,

Joel Bowman

The Rude Awakening
aussiejoel@the-rude-awakening.com