The Dollar"s Reign As The Global Reserve Currency Is Running Out - Fast

The dollar’s hegemony over the global financial system can’t last forever. Like all things, it will eventually come to an end.

The only question left, as MacroVoices" Erik Townsend puts it, is whether we’re in the second inning and there’s going to be another hundred years of the dollar serving as the world’s global reserve currency? Or whether we’re in the bottom of the ninth and it’s all about to fall apart? Or maybe somewhere in between.

In an interview with Jeffrey Snider, CIO at Alhambra Partners, Luke Gromen, founder of Forest for the Trees, and Mark Yusko, founder and fund manager for Morgan Creek, Townsend explores the issue in greater detail. For many, the decline of the dollar as the world’s reserve currency is difficult to imagine. But the first blow to the petrodollar system has already been delivered: By refusing to accept oil payments in dollars, Venezuela has demonstrated to the world that an alternative system to the petrodollar is indeed possible. Furthermore, Latin America’s socialist paradise has begun publishing an oil-price index denominated in yuan. We"ve also highlighted reports that Russia, Venezuela and Iran - three countries that have trouble accumulating dollars because of Treasury Department sanctions - are considering launching a cryptocurrency backed by oil.

Townsend begins his interview with Gromen, who points out that, counterintuitively, the dollar’s rapid appreciation beginning in Q3 2014 has coincided with a drop in the share of global trade settled in dollars. Gromen predicts that this trend will continue to benefit the dollar – until it doesn’t.

I would probably say in the later innings. Certainly the last third of the game. Maybe the eighth inning.

 

The reason I say that is that, given the Eurodollar system as it’s structured, early on, if any nations or major parties wanted to move away from using the dollar for any number of reasons, ironically, what that moving away from the dollar would do would drive significant dollar strength. So, ironically, accelerating moves to dump the dollar in global trade usage, which in the long run is the most bearish development for the dollar, in the near term is the most bullish development for the dollar.

 

And so when we look back, we think, beginning in 3Q14 was when you started to see a marked acceleration in the dollar’s share loss in global trade. And, in particular, in energy trade centered between China and Russia. And so we think things began to accelerate in 3Q14 and, like we’ve said, the process of moving away from the dollar, or the dollar losing share in trade, is a big positive for the dollar – until it’s not.

However, Gorman believes an important shift happened in Q3 2016 when the dollar’s share loss in global trade started to accelerate. At that point, the dollar’s climb from 2014 and 2015 had already been unwound to a degree. Furthermore, Gorman posits that the dollar will weaken because it’s in the national security interest of the US for the dollar to weaken.

And then the “until it’s not” part of this movie began over a year ago now, in 3Q16. The reason we say that is because from 3Q14 until 3Q16 you saw a rising dollar, rising Libor, and a pretty traditional dollar strengthening cycle up to that point.

 

Where it started to become non-traditional relative to what pretty much any market participant trading in markets today – or even alive today – was when in 3Q16 rising dollar, rising Libor, drove a year-over- year decline in US tax receipts and therefore an increase in the US deficit as a percent of GDP. And it did this before you had a major emerging crisis.

 

This was the first time the US’s tax receipts declined before a major emerging market crisis, in a dollar-tightening cycle, in the post-Bretton Woods period.

 

And so, then, when you combine that with what has become effectively a system that requires as infinitum asset price appreciation in order to drive tax receipts for the US government, it sets up – beginning in 3Q16, where we started to get into late innings of this game. Where, not only are foreign creditors looking to move away from the dollar in trade usage for a number of reasons, but it also started to become a matter of national security for the

 

US government for the dollar to weaken.

Moving on, Townsend turns next to Jeff Snider, CIO at Alhambra investments. Snider explains how the Eurodollar system harms emerging-market economies and ultimately weakens the global financial system with each cycle of tightening.

The last tightening cycle, which lasted from 2014 through 2016, was particularly destabilizing, Snider explained, particularly for emerging markets like Brazil, Russia, and China. Many EM countries and corporations based in those countries issue dollar-denominated debt, which becomes more expensive to pay down when the greenback climbs.

But, for now at least, Snider expects the system to endure – if for no other reason than there’s nothing to take its place.

My position is that the dollar system, the supply of dollars in the global network of trade, continues to be a problem. But it isn’t a problem in a straight line. It’s not like it’s a straight-line decay from where you can draw a singular line from 2007 to 2013. Instead, it’s more of an intermittent type of thing where we have these alternating periods where things tighten up. Then they loosen up relatively.

 

But, as we go through each of these periods, the system is worse off for having gone through each one. And so the last tightening episode, starting in 2014 and lasting through 2016, was severe. Especially in emerging markets like Brazil, Russia, and China, the BRICs, because that’s where that part of the dysfunction was focused. More in FX and more into the Asian part of the system, as it has evolved since 2007 in that direction.

 

So, from my perspective, nothing has really changed except the system continues to get weaker. And I think right now where we are is we’re waiting for the next tightening event to start taking place. That there’s plenty of evidence that the system continues to decay, particularly with China and some of the other emerging markets.

 

So it doesn’t add up to a bullish position, necessarily. And I think that’s one of the things I want to define, is what exactly is a rising dollar? And it’s not bullish. And I’m certainly not of the position that most dollar bulls take, which is that the dollar goes up because the US is going to strengthen either economically, financially, or otherwise. I think that’s just not the case. So if we couch these in terms of the Eurodollar system and its continued decay, it’s not a bullish thing. But I think the dollar continues to go up, at least for the next little while. Because, frankly, there is nothing there to take its place.

 

So we’re kind of stuck with it.

Moving on, while Yusko didn’t feel comfortable attaching an expected expiration date for global dollar hegemony, he did draw some interesting parallels between the dollar and the British pound, the global reserve currency that immediately preceded the dollar.

You know, the interesting thing about world reserve currency is there have been lots of them over time. And I always joked that Americans are like Notre Dame football fans – they remember a past that never was. Notre Dame football fans think that we win all the time, which, clearly, we don’t. I was down in Miami. That was horrible.

 

And, you know, Americans think that we’ve always been the world reserve currency, for some reason. And we clearly haven’t. It’s only been since 1944. What’s interesting about that is the transition can last a long time. The sun never set on the British Empire for 70 years. They had the world reserve currency. They had the strongest navy.

 

And then in 1913 they invaded Mesopotamia, incurred a bunch of debt, the pound sterling collapsed, the dollar ascended. We, 31 years later, became the world reserve currency. And then in 2013, we (coincidentally) invaded Mesopotamia, incurred a bunch of debt, the dollar collapsed, and the Renminbi ascended.

 

Well, that hasn’t all happened yet. But I think it’s on its way to happening. And when I look around the world, I think it’s supremely clear that China has a plan. And for the last 50 years, their stated goal was a harmonious rise.

 

Doesn’t that sound poetic? It’s beautiful. It’s non-confrontational.

Ultimately, Yusko believes the Chinese yuan will replace the dollar as the world’s reserve currency sometime before 2050, the time by which Yusko expects China will become the dominant global power.

This contrasts with the consensus view, that, after the dollar, there won’t be one dominant currency, but several in separate spheres of influence.

The conversation is part one of a five-part series from MacroVoices exploring the dollar’s future as the world’s dominant currency.

Readers can listen to the whole conversation below:

Jamie Dimon Says Corporations Will Fund Buybacks With Tax Cuts And That"s "Not A Bad Thing"

For at least half a decade now (How The Fed"s Visible Hand Is Forcing Corporate Cash Mismanagement) we have warned about how the Fed’s flawed approach to monetary policy incentivizes corporations to fund share buybacks with massive amounts of debt...

…While the corporate sector has spent record sums on share buybacks...

Capex has experienced an unprecedented decline...

 

Of course, some Democrats have argued that the Trump tax plan will perpetuate essentially the same incentives as corporate tax rates are slashed and money brought back from overseas is spent on still more buybacks, instead of creating jobs and capital expenditures, like the Republicans argue it will be.

The flimsiness of the GOP’s argument was exposed a few weeks ago during a memorable gaffe involving NEC Chief (and former No. 2 at Goldman Sachs) Gary Cohn, one of two officials managing the tax bill on behalf of the White House – the other being Treasury Secretary Steven Mnuchin, also a former Goldmanite.

During an event for the Wall Street Journal"s CEO Council, an editor at The Wall Street Journal asked the room: "If the tax reform bill goes through, do you plan to increase investment - your company"s investment, capital investment?"

 

He asked for a show of hands.

 

Alas, as the camera revealed, virtually nobody raised their hand.

 

Responding to this "unexpected" lack of enthusiasm to invest in growth, Cohn had one question: "Why aren"t the other hands up?

While Cohn’s dismay at the lack of enthusiasm for his tax plan was obvious and embarrassing (the clip was in heavy rotation on CNBC for much of the next day), the fact that corporations will spend the windfall created by the tax bill isn’t necessarily a bad thing, according to JP Morgan Chase CEO Jamie Dimon.

Of course it wouldn’t be “a bad thing” – for Jamie.

When it comes to the rest of us…well…maybe not so much.

Dimon, who was speaking at a conference in Ann Arbor, Michigan hosted by Axios, according to CNBC.

According to Dimon’s logic, repatriations enabled by the tax plan could swiftly lead to more than $1 trillion being brought back from overseas. It doesn’t matter where that money goes, the point is there will be more capital sloshing around the domestic economy…and that will eventually manifest itself in the form of capex, job creation and higher wages…

"You need a competitive tax system ... companies will retain more capital and start to use it over time," Dimon said Wednesday in response to a moderator question at the Axios Smarter Faster Revolution event in Ann Arbor, Michigan.

 

"Some will raise wages. Some will buy companies. Some may do dividends and buybacks. Don"t act like that is a bad thing. That is their money. Think of it as a QE4. That money gets recirculated in the American system."

Dimon said tax reform "simply needs to be done," and should have happened 15 years ago. And while the benefits aren’t “going to be immediate”, they will accelerate growth “cumulatively over time."

JPMorgan"s Jamie Dimon: Tax reform bill will result in more jobs from CNBC.

 

After the bill passes "probably a trillion dollars will come back from overseas," he added. "Cumulatively over time that will accelerate growth in the American economy." That effect will resemble something like QE4, though we’re not sure that’s the best comparison...

The real question is: Will the tax bill somehow prevent the Federal Reserve from needing to launch QE4 before the end of Trump’s first term. If you believe a recent Treasury Department analysis of the Senate tax plan released earlier this week.

That plan calcuated that the tax cuts would bolster US economic growth to an average rate of 2.9% real growth over the next 10 years...

...which would make the current economic expansion the longest in modern history...

...But then again, if you believe that, then we have some condos for you to buy.

Tax-Reform Opponents Blast Treasury Report As "Nothing More Than One Page Of Fake Math"

Yesterday, we highlighted a one-page report prepared by the Treasury Department which claimed that – in what was perhaps one of the most unrealistically optimistic budget projections to ever be produced by the US government agency - the Senate’s version of the Republican tax plan would, somehow, bolster GDP to a 2.9% real growth rate over 10 years.

The report – a transparent attempt to distract from the plan’s elimination of more than $1.5 trillion in total receipts, while emphasizing its potential pro-growth aspects – relies on a scenario where the economy achieves a baseline of 2.9% GDP growth over the coming decade, compared with the Treasury’s previous projection of 2.2%.

This additional 0.7 percentage point of annual growth, the report claims, will lead to an increase in tax revenue of $1.8 trillion. Treasury "expects approximately half of this 0.7% increase in growth to come from changes to corporate taxation, while the other half is expected to come from changes to pass-through taxation and individual tax reform, as well as from a combination of regulatory reform, infrastructure development, and welfare reform as proposed in the Administration’s Fiscal Year 2018 budget."

To transform these projections into a reality, the US economy would need to achieve the longest cycle of uninterrupted growth in US history.

Unsurprisingly, the report has elicited howls of outrage from Democratic lawmakers and academics, who blasted Treasury Secretary Steven Mnuchin – a former Goldmanite – for the obviously bogus report, as Reuters reported.

Even Mnuchin’s fellow Republicans joined in the outrage pow-wow: Case in point, the Committee for a Responsible Federal Budget, a conservative fiscal watchdog in Washington, claimed the report, which was prepared by Treasury’s Office of Tax Policy, “makes a mockery of dynamic scoring and analysis."

Meanwhile, Senate Minority leader Chuck Schumer said the Treasury analysis was “nothing more than one page of fake math."

Of course, when the next recession hits – which, if the past is any guide, should happen before the end of 2019 - the yield curve will be steeply negative, crushing the financial sector. Government tax revenues will plunge and government-borrowing will soar. In a scramble to monetize the explosion of debt before it snowballs into one of the most severe debt crises in modern history, the Fed will launch QE4 at a time when interest rates are still low by historical standards and the central bank’s swollen, post-crisis balance sheet may not yet be fully unwound.

In what was perhaps the report"s most entertaining paragraph, Mnuchin & Co. engage in what could be construed as a little light-hearted trolling of the economic community.

We acknowledge that some economists predict different growth rates. OTP projects that at approximately 0.35% of incremental annual GDP growth, Treasury tax receipts would generate approximately $1 trillion of incremental revenue. Neither JCT nor Treasury has released a score showing increased tax receipts from the House plan, though we would not expect the results to be materially different.

As Reuters points out, the Wharton Business School at the University of Pennsylvania also issued a report on Monday, which found that the plan approved by the full Senate would add $1.5 trillion to the national debt over 10 years, “even with assumptions favorable to economic growth."

One week ago, in its latest assessment of the current state of tax reform in the aftermath of the Senate"s passage of the tax bill, Goldman analysts calculated that, while the growth impact from tax reform would increase fractionally to around 0.3% in 2018 and 2019 "reflecting the slightly larger amount of tax cuts in the Senate plan following revisions, and our expectations regarding the eventual compromise", there would be a very modest - if any - boost to US economic growth from tax reform.

Notably, the sparring over economic forecasts came as Republicans resumed efforts to reconcile two tax-overhaul bills, one approved by the Senate and one by the House of Representatives.

Regardless of whether its projections are based on sound numbers, Republicans probably won’t hesitate to use it as a cudgel to beat back deficit hawks who are threatening to delay the tax plan by demanding that Republicans rein in cuts to stop the plan from blowing out the deficit and piling on the debt.

Senate Tax Debacle: Certain Pass-Through Entities Face Marginal Tax Rates Over 100% Under Current Bill

As the House and Senate continue to try to reconcile their two versions of a tax plan, the taxing structure for pass-through entities (s-corps, LLC"s, etc.) continues to be somewhat controversial, if not completely nonsensical. As we pointed out last week, the Senate bill somewhat randomly chose to exclude pass-through entities organized as family trusts from tax cuts which would ultimately leave them on the hook for much larger tax bills due to the elimination of other deductions. It"s unclear whether this bizarre exclusion was just an oversight or an intentional political hit on an easy target that no one in Washington DC would dare defend publicly: rich families organized as trusts.

Now, a new note from the Tax Policy Center lays out some scenarios whereby the marginal tax rate for high-income pass-through entities could soar to over 100%.  Of course, while two rational people can debate the impact of a ~40% tax rate on a person"s desire to work, we"re almost certain that a taxing structure that takes more than 100% of your marginal income will be a slight disincentive.  Here"s an example of how it works from the Wall Street Journal:

Consider, for example, a married, self-employed New Jersey lawyer with three children and earnings of about $615,000. Getting $100 more in business income would force the lawyer to pay $105.45 in federal and state taxes, according to calculations by the conservative-leaning Tax Foundation. That is more than double the marginal tax rate that household faces today.

 

If the New Jersey lawyer’s stay-at-home spouse wanted a job, the first $100 of the spouse’s wages would require $107.79 in taxes. And the tax rates for similarly situated residents of California and New York City would be even higher, the Tax Foundation found. Analyses by the Tax Policy Center, which is run by a former Obama administration official, find similar results, with federal marginal rates as high as 85%, and those don’t include items such as state taxes, self-employment taxes or the phase-out of child tax credits.

As Joseph Rosenberg of the Tax Policy Center notes, the penalty is greatest for high-income pass-through entities in highly taxed states. 

Consider the example of a married couple whose entire income is “specified service” income generated by a pass-through entity and who claims the standard deduction. At an income of $524,000, the couple could take an $87,000 deduction (17.4% of the couple’s taxable income “without regard” to the deduction) that would reduce their taxes by $30,450 (since they are in the 35% tax bracket), but the deduction is entirely phased out at an income of $624,000. On average, that amounts to more than a 30% surtax on top of the 35% statutory tax rate over that range of income.

 

The actual phase-out is much more complicated, as the bill’s text released Monday night makes clear, because the deduction continues to apply even as its benefit is phased out. (If that sounds convoluted, it’s because it is.) The couple’s marginal income tax rate would jump to 61.375% at $528,541 of income. And it would rise to 73% until their income reaches $624,000 and the deduction is fully phased-out, at which point their marginal tax rate would return to the 35 percent ordinary income tax rate. (Note that these calculations do not include the additional 3.8 percent in self-employment payroll tax or the net investment income tax).

Here is how the overall tax rate schedule for pass-through income would look:

“This is a big concern,” said Scott Greenberg, a Tax Foundation analyst. “It would be unfortunate if Congress passed a tax bill that had the effect of making additional work and additional income not worthwhile for any subgroup of households.”

Of course, in the end, this type of taxing structure just raises the returns on "gaming" the tax system in every way possible.  “I would expect a huge tax-gaming response once people fully understand how it works,” said Mr. Gamage, a former Treasury Department official, who said business owners have an easier time engaging in such tax avoidance than salaried employees do. “The payoff for gaming is huge, within the set of people who both face these rates and have flexible enough business structures.”

Not surprisingly, lawmakers are looking at changes to prevent this debacle from happening as they attempt to reconcile Senate and House versions of the tax bill this week. The formal House-Senate conference committee will meet on Wednesday, and GOP lawmakers have said they may unveil an agreement by week’s end...though they seem to consistently miss their own self-imposed deadlines.

But you shouldn"t worry about these issues too much as a spokeswoman for the Senate Finance Committee assured the Journal that as "with any major reform, there will always be unusual hypotheticals delivering anomalous results...The goal of Congress’s tax overhaul has been to lower taxes on the American people and by and large, according to a variety of analyses, we’re achieving that."

QE Unwind is Really Happening: Fed Assets Drop To Lowest Level In Over Three Years

Submitted by Wolf Richter of Wolf Street

The Fed’s balance sheet for the week ending December 6, completes the second month of the QE-unwind. Total assets initially zigzagged within a tight range to end October where it started, at $4,456 billion. But in November, holdings drifted lower, and by December 6 were at $4,437 billion, the lowest since September 17, 2014:

“Balance sheet normalization?” Well, in baby steps. But the devil is in the details.

The Fed’s announced plan is to shrink the balance sheet by $10 billion a month in October, November, and December, then accelerate the pace every three months. By October 2018, the Fed would reduce its holdings by up to $50 billion a month (= $600 billion a year) and continue at that rate until it deems the level of its holdings “normal” – the new normal, whatever that may turn out to be.

Still, the decline so far, given the gargantuan size of the balance sheet, barely shows up:

The Fed is unloading its Treasuries alright.

As part of the $10-billion-a-month unwind from October through December, the Fed is supposed to unload $6 billion in Treasury securities a month plus $4 billion in mortgage-backed securities (MBS) a month.

The Fed doesn’t actually sell Treasury securities outright. Instead, it allows some of them, when they mature, to “roll off” the balance sheet without replacement. When the securities mature, the Treasury Department pays the holder the face value. But the Fed, instead of reinvesting the money in new Treasuries, destroys the money – the opposite process of QE, when the Fed created the money to buy securities.

This happens only on dates when Treasuries that the Fed holds mature, usually once or twice a month.

In October, the big day was October 31, when $8.5 billion of Treasuries on the Fed’s books matured. The Fed reinvested $2.5 billion and let $6 billion “roll off.” Hence, the amount of Treasuries fell by about $6 billion from an all-time record $2,465.7 billion on October 25 to $2,459.8 billion on November 1.

In November, there were two big maturity dates:

• November 15, about $11 billion in Treasuries matured. The Fed allowed $3.4 billion to “roll off” without replacement.


• November 30, about $7.9 billion matured. The Fed allowed $2.5 billion to roll off without replacement.

For all of November, the balance of Treasuries fell by $5.3 billion to $2,454.5 billion, in line with the plan, and the lowest level since October 8, 2014:

Mortgage-backed securities are a different animal.

As part of QE, the Fed acquired residential MBS guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae. Now, as part of its $10-billion-a-month QE-unwind, the Fed is supposed to shed up to $4 billion a month in these MBS. And?

At the beginning of October, the Fed held $1,768.2 billion in MBS. The balances then jumped up and down on a weekly basis and ended October at $1,770.6 billion, or $2.4 billion higher than at the beginning of the QE-unwind.

Same scenario in November, though they have started to edge down overall just a tiny bit to $1,767 billion, the lowest by a smidgen since March 8, 2017:

Residential MBS differ from bonds. Fannie Mae et al. regularly pass through principal payments to MBS holders as underlying mortgages get paid down or get paid off. Thus, the principal shrinks until the remainder is redeemed at maturity.

To keep the MBS balance steady, the Fed, via the New York Fed’s Open Market Operations (OMO), buys MBS in the “to-be-announced market,” or “TBA market.” This is a trade where the actual MBS is not designated at the time of the trade but will be announced 48 hours before the established settlement date, which can be two to three months later.

But the Fed books its MBS holdings on a settlement-date basis. So there is a mismatch between the date the Fed receives principal payments and the date reinvestment trades settle. Hence the jagged line in the chart above.

So when will the $4-billion-a-month in MBS reductions show up on the Fed’s balance sheet?

The first MBS reinvestment trades under the QE-unwind plan were conducted in October. Given the lag to settlement date of two to three months, the first visible impact on the balance sheet would start no earlier than December. This is where we are now, on the verge of seeing it.

The line in the MBS chart will always bounce up and down due to the mismatch between the date the Fed receives principal payments and the date reinvestment trades settle. But the line should start trending down, with noticeably lower lows and lower highs.

For the first three months, the QE unwind only removes about $10 billion a month, a negligible amount, given the vast markets and excess liquidity. But it picks up steam every three months. By October 2018, if the plan is still on, the QE unwind will remove $50 billion a month from the markets. This process will do the opposite of what QE had done: it will gradually destroy some of the $3.6 trillion that the Fed had created during QE. And by that time the broader effects of QE – asset price inflation – should also start to reverse.

Iraqi Militia Says Trump"s Recognition Of Jerusalem Is A "Legitimate Reason" To Attack Americans

In the latest sign that Trump’s decision to recognize Jerusalem as Israel’s true capital has put American lives at risk, Russia Today is reporting that Shia paramilitary group Harakat Hezbollah al Nujaba has declared that the US’s violation of the holy land status quo is a “legitimate reason” to attack American troops in Iraq.

“Trump"s stupid decision... will be the big spark for removing this entity [Israel] from the body of the Islamic nation, and a legitimate reason to target American forces,” said Akram al-Kaabi, the Iraqi organization’s leader, as cited by Reuters.

Of course, militia leaders aren’t the only ones speaking out against Trump’s decision. Heads of state and other senior officials in the governments of Turkey, Saudi Arabia, Jordan and – of course – the Palestinian territories have denounced the declaration. Meanwhile, the embassy’s impending move to Jerusalem will probably only further infuriate much of the Muslim world. One Palestinian official said Trump’s declaration has effectively precluded the possibility of a two-state solution.

The Israelis claim all of Jerusalem as their capital, while the Palestinians hope to make east Jerusalem the capital of a future Palestinian state.

According to the latest update from the US Defense Department, there are 5,200 US troops in Iraq, mostly special forces “advisers”. Officially, the Iraq War “ended” in December 2011, when the military pulled the last US ground troops out of the country.   

Al Nujaba, a militia group mostly made up of Iraqis, has about 10,000 fighters, according to Reuters. Being a part of the Iran-backed Popular Mobilization Forces (PMF), the group is believed to be one of the most important militias in Iraq.

In November, Ted Poe from the US House of Representatives proposed imposing “terrorism-related sanctions” on Nujaba. The text of the document says Nujaba is “an affiliated faction” of the US-designated foreign terrorist organization Kata’ib Hezbollah, which also fights with the PMF.

And there"s good reason to believe the group will follow through on its threats.

Nujaba’s leader Akram al-Kaabi was earlier sanctioned by the Treasury Department “for threatening the peace and stability of Iraq.” As a former insurgent, it’s believed Kaabi took part in “multiple mortar and rocket attacks” on the Green Zone in Baghdad in 2008.

Shortly before making his announcement, Trump acknowledged that the move would cause dissent, but he also insisted it would help solve the Arab-Israeli conflict.

A number of world powers, including Germany, Turkey, and Russia, expressed grave concern over the Trump administration’s decision.

US decision to recognize Jerusalem as Israel’s capital may become a “legitimate reason” to attack American troops in Iraq.
 

China Slams "Wrong" US Sanctions Against North Korea-Linked Trading Firms

A day after China’s state-run airline closed its last remaining routes to North Korea – a decision the airline’s executives blamed on a sharp decline in business travelers due to restrictive UN Security Council sanctions – Communist Party spokespeople slammed new US sanctions targeting Chinese traders doing business with North Korean businessmen, calling them “wrong” while reminding the US that China has vigorously enforced the UN sanctions.

After announcing that the US would once again designate North Korea a state sponsor of terrorism due to its missile and nuclear tests and its trading in illegal arms with terrorist groups and unsavory governments, President Donald Trump revealed that the Treasury Department would be rolling out new sanctions over the next two weeks, the US’s latest volley in a "maximum pressure campaign" against Kim Jong-Un"s regime, AFP reported.

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As had been expected, the US Treasury Department announced on Tuesday that the list of North Korean and Chinese companies targeted by existing US sanctions has been expanded. It was this decision that angered the Chinese.

Only last week, Trump returned to the US from a five-nation tour of Asia with assurances from Chinese President Xi Jinping that China, the North’s primary benefactor which is responsible for 90% of its trade, would do more to economically pressure its restive neighbor.

 

Treasury sanctions trading, labor, and shipping companies and vessels
to further isolate North Korea and disrupt illicit funding of its unlawful nuclear and ballistic missile programs. Targets include one individual, 13 entities, and 20 vessels: https://t.co/CT9hMx3d6p

— Treasury Department (@USTreasury) November 21, 2017

 

The Treasury has added to a list of 10 Chinese companies believed to be doing business with the North in violation of international sanctions.

In response, a Chinese spokesman reiterated that China rejects unilateral sanctions against its companies and North Korea, saying these issues should be worked out through the Security Council.

"We consistently oppose any country adopting unilateral sanctions based on its own domestic laws and regulations and the wrong method of exercising long-arm jurisdiction," foreign ministry spokesman Lu Kang told a regular news briefing.

The sanctions are a sign that, despite Xi’s assurances, many doubts remain about China’s efforts to contain the North’s nuclear ambitions.

The spokesman called on Washington to provide "any solid evidence" that Chinese companies have violated the UN sanctions, according to AFP.

 

He added that if any companies or individuals have violated domestic laws, "we will severely deal with that in accordance with our laws and regulations".

While China has backed the Security Council sanctions – which it easily could’ve blocked with a veto – the country has been reluctant to take the more drastic step of cutting off oil supplies through a pipeline to North Korea"s lone refinery, fearing that regime collapse could lead to a flood of refugees and chaos on the China-North Korea border.

Still, US authorities believe some Chinese banks and trading firms continue to do business with the North in defiance of UN sanctions, US threats of unilateral action and warnings from the Chinese government.

Since the verbal standoff between Kim Jong Un and President Donald Trump began shortly after the latter’s inauguration, China has pressed for dialogue between the two countries, saying this week that "more should be done" to hold talks to resolve the crisis. Specifically, both Beijing and Moscow have pushed for a "dual track approach" which would see the US freeze its military drills in South Korea while North Korea would halt its weapons programs. Ultimately, the Chinese hope the US will remove its THAAD missile defense systems from South Korea, since the Chinese see the purportedly defensive systems as a potential offensive threat.

A Chinese special envoy also wrapped up a four-day trip to the North on Monday, during which the two sides discussed regional concerns but made no direct statements about the nuclear standoff.

US Treasury Secretary Steven Mnuchin said the sanctions would not only increase Pyongyang"s isolation but also expose "its evasive tactics."

"These designations include companies that have engaged in trade with North Korea cumulatively worth hundreds of millions of dollars," Mnuchin said.

 

"We are also sanctioning the shipping and transportation companies, and their vessels, that facilitate North Korea"s trade and its deceptive maneuvers."

In all, the new measures add one individual, 13 trading entities and 20 ships to US sanctions lists.

Any property or assets of the firms involved found to be in areas under US jurisdiction are to be frozen, and Americans are banned from trading with them. Three Chinese firms - Dandong Kehua Economy and Trade, Dandong Xianghe Trading Company and Dandong Hongda Trade - are said to have sold computers, minerals and ore to North Korea. Chinese businessman Sun Sidong and his company Dandong Dongyuan Industrial are accused of exporting vehicles, machinery, radio navigation and "items associated with nuclear reactors.” A woman who answered the phone at the company said it was not doing business with North Korea and suggested that the firm had halted its operations.

"We are not operating," she said.

Another woman at Dandong Kehua Economy and Trade denied knowing about the sanctions.

"We have temporarily suspended (trading)," she said.

In a surprise move, in addition to slapping sanctions on firms and North Korean ships, the Treasury added the Korea South-South Cooperation Corporation to its sanctions list. The firm is alleged to have sent North Korean guest workers to China, Russia, Cambodia and Poland. Foreign workers are a major source of income to the regime. Trump has repeatedly exhorted the US’s allies to expel North Korean guest workers, whose remittances provide a vital source of foreign currency to the regime.

Ironically, the stringent sanctions are being applied even as North Korea has, at least temporarily, ceased its missile tests. The North hasn’t launched a missile test since Sept. 15 – more than two months ago.

Some believe the North’s reticence is due to Chinese pressure. If this is accurate, we imagine Xi’s government might loosen its grip.
 

White House Declares North Korea A State Sponsor Of Terror

Following comments by the White House last week that the administration would soon bring more pressure on North Korea, President Donald Trump has confirmed as much to a crowd of reporters, adding that, as of today, that North Korea would once again be designated a terror sponsor.

Trump cited the killing of North Korean leader Kim Jong-Un"s estranged half brother in a Malaysian airport earlier this year, as well as the North’s horrific treatment of Ohio college student Otto Warmbier, as justifications for the sanctions.

“North Korea has supported acts of international terrorism, including assassinations on foreign soil,” Trump said.

“As we take this action today we think of Otto Warmbier and the many others affected by north korean opporession."

During remarks at the start of a cabinet meeting at the White House, Trump said the Treasury Department will announce on Tuesday additional sanctions against North Korea, describing the moves as “a very large one.” The sanctions will be imposed over the next two weeks, Trump said.

Trump demanded that the North cease its nuclear program and stop aiding terror groups across the world.

Trump called the move a long overdue step and part of the U.S. "maximum pressure campaign" against the North...

 

United States designates North Korea as a state sponsor of terror.

Pres. Trump: "Should have happened a long time ago, should have happened years ago." pic.twitter.com/3GC5Umcd4S

— Dan Linden (@DanLinden) November 20, 2017

 

North Korea was last on the U.S. list of state sponsors of terror in 2008, when the country was removed in a bid to salvage a deal to halt its nuclear development. Iran, Sudan and Syria are also designated by the U.S. as state sponsors of terror, the Associated Press pointed out.

The designation had been debated for months inside the administration, with some officials at the State Department arguing that the North did not meet the legal standard to be relisted as a state sponsor of terrorism.

Officials said there was no debate over whether the slaying of half brother Kim Jong Nam was a terrorist act. However, lawyers said there had to be more than one incident and there was disagreement over whether the treatment of Warmbier, who died of injuries suffered in North Korean custody, constituted terrorism.

While North Korea is being added to the list, last week, Deputy Secretary of State John J. Sullivan said the United States was willing to consider removing Sudan, which has been on the list since 1993.
 

Record Number Of Americans Expected To Renounce Citizenship In 2017

Perhaps some of the disaffected Hollywood elites who threatened to leave the country after Hillary"s staggering 2016 election loss have actually followed through on their childish temper tantrums after all...

According to a Bloomberg note today, a record 6,800 Americans are expected to renounce their citizenship in 2017, a 26% increase YoY and nearly 7x the pace set just 5 years ago.

In the third quarter of this year, 1,376 Americans renounced their U.S. citizenship, putting the annual tally on track to top 2016’s record, data from the Treasury Department show.

 

If this year’s fourth quarter mirrors that of 2016, when 2,365 people chose to expatriate, 2017’s annual tally would be 6,813. That’s a 26 percent rise from 2016’s total of 5,411—which was itself a 26 percent jump from 2015.

Of course, the uptick, unfortunately, has nothing to do with disaffected Hollywood elites but rather corresponds with Obama"s passage of a 2010 law requiring foreign banks to disclose U.S. citizens.

"To some degree it is President Obama’s fault. It was Obama and the Democratic Congress that passed a law in 2010 that forced foreign banks to disclose U.S. citizens," says Mitchel.

 

When the law was passed, it appeared to be aimed at fat cats who sought to hide money in secret Swiss bank accounts. But today, it could affect nearly any of the 7 million Americans, who Mitchel says live abroad—many of whom are people of modest means.

As Fortune pointed out, the United States, unlike almost every other country in the world, taxes people on the basis of citizenship rather than residency.  So even if you spend all of your adult, wage-earning years on a remote tropical island with a 0% tax rate, if you were born in the United States, you still owe Uncle Sam your "fair share."  So, when all those sunbathing tax evaders had their Swiss bank accounts exposed in 2010 they started to renounce their citizenship in record numbers.

The cause of the defections, which led the U.S. to say so long last quarter to everyone from Jonathan Abbis to Anna Zwirner, is primarily the U.S. tax system.

 

When it comes to taxes, the United States is an outlier because, unlike nearly every other country, it taxes people based on nationality rather than residency. While U.S. citizens can claim credits with the IRS for what they pay to foreign tax authorities, those amounts are not always enough to offset what they owe.

 

U.S. expats also face the burden of annual filings with the IRS with the prospect of stiff penalties if they fail to comply.

 

According to international tax attorney Andrew Mitchel, those who deliberately fail to report foreign accounts to the IRS can face a fine of $100,000 or half the value of the account—whichever is greater. Meanwhile, there are a range of other penalties for small business owners abroad and for those with assets of more than $30,000.

 

"The IRS has been very gracious in saying they won’t take more than 100% of your money," says Mitchel, ironically. "These people are terrified they will go bankrupt because of the United States. They just want to get out of the U.S. tax system."

And while we know many of you will be disappointed that our disaffected celebs aren"t the key driver of the data above, we encourage you to keep an eye on this IRS list of American quitters...perhaps Lena Dunham"s name will show up on there yet.

Default Time: Venezuela Announces It Will Restructure All Debt After Tomorrow"s Final Payment

One week ago, we and many others wondered, if the time has finally come for Venezuela, which was facing a "no grace period" $842 million principal payment for bonds issued by state-run energy company PDVSA, to default on its billions of unrepayable obligations. As we reported then, the liquidity crisis for Venezuela was especially acute because even if it did make the first PDVSA payment, it was facing a second, even larger one today, when PDVSA had to make another $1.121BN payment.

Well, despite a several day transfer delay, Venezuela did make the first payment, however it was not clear if Caracas would also make today"s payment, although as Reuters reported earlier, "markets remained optimistic that President Nicolas Maduro’s government will make the payment, though investors expect delays. PDVSA last week struggled for days to deliver funds for a separate bond payment amid confusion over which banks were charged with transferring the money."

PDVSA bonds were down slightly in early trading on Thursday, while Venezuelan bonds were mixed, according to Thomson Reuters data.

However, as we previewed again last week, and as Reuters confirmed today, "most economists say a default is increasingly likely in the medium term as Venezuela’s collapsing socialist economic model has left the once-prosperous population destitute and led to deterioration of the OPEC nation’s vital oil industry."

It now appears that that is indeed the case, and the long overdue Venezuela default, which has been speculated ever since 2014, is finally nigh, because during a nationwide TV address, Venezuela"s socialist president Nicolas Maduro said the country will seek to restructure its global debt after the state-owned oil company makes the PDVSA payment due at midnight. Maduro blamed a financial blockade that is preventing the nation from rolling over its debt, according to Bloomberg.

“I decree a refinancing and restructuring of all foreign debt and all Venezuelan payments,” Maduro said. “We’re going to a complete reformatting. To find an equilibrium, and to cover the necessities of the country, the investments of the country.”

“We have had to face a real global financial persecution,” Maduro said, adding that OPEC member Venezuela had paid $71.7 billion in debt since he came to power in 2013, despite losing $100 billion in revenues to falling oil income. Too bad he didn"t blame the "speculators" for the collapse of his socialist paradise.

“If Venezuela wants to refinance one of its bonds, it is prohibited by the global financial dictatorship,” Maduro added according to Reuters, warning that “they will never suffocate us. We will never surrender to the U.S. empire,” he added, also criticizing Colombia for allegedly blocking a shipment of medicines under U.S. pressure.

The good news is that bondholders of the PDVSA bonds maturing Thursday will get paid in full: according to Maduro, the government will make the last $1.1 billion PDVSA principal payment due overnight. The bad news, is that everyone else is about to get a big, juicy haircut, or as Bloomberg reports, "from there on out, the nation will renegotiate its debt with banks and investors, he said in a national address."

Of course, since there is no such thing as a "unilateral restructuring" in the world of debt, and since the country has effectively previewed it will be haircutting its creditors few if any of whom will agree to Maduro"s terms, another way of putting what Maduro just said is that Venezuela is - finally  - about to default.

Now this is a problem for Venezuela"s creditors because, well, they are owed a lot of money.  In total, Venezuela has $143 billion in foreign debt owed by the government and state entities, with about $52 billion in bonds, according to Torino Capital, even as Venezuela"s international reserves - including the nation"s gold - have sunk to just $10 billion, a 15 year low. The table below shows only the upcoming coupon and maturity payments:

What is bizarre is that unlike most of its Latin American neighbors, during 18 years of socialist rule, Venezuela has always paid its foreign debt on time, including during the recent crippling economic crisis that has spurred widespread food shortages. Or rather had.

Maduro made the announcement in a televised address in which he emphasized that Venezuela has always honored its obligations, and had the money to continue doing so, but was being hampered in its efforts by the financial penalties the U.S. imposed this year for what it said were anti-democratic moves by his administration.

He may have a point:  In many ways the default was inevitable. Financial sanctions imposed by Donald Trump in August made it virtually impossible to raise money from many international investors, and led to a collapse in Venezuela oil exports. Those sanctions, which prohibit U.S.-regulated institutions form purchasing new bonds, will also limit the current regime from sitting down with U.S. investors to restructure its debt. It’s an unprecedented situation for bondholders, who have limited recourse to negotiate for payment as long as sanctions are in effect.

Vice President Tareck El Aissami - one of the individuals targeted in the sanctions - was named by Maduro as head of bond restructuring efforts. He will convene bondholders of all international debts owed by the sovereign and PDVSA. But wait, there"s more, because earlier this year, the Treasury Department alleged that the same El Aissami - who was elevated to vice president in January - protected drug lords and oversaw a network exporting thousands of kilograms of cocaine.

El Aissami spoke on TV, saying that the "refinancing", by which he probably means default, will allo Venezuela to invest in social functions, and added that Euroclear has blocked Venezuela"s payments.

Meanwhile, as a long-awaited Venezuela default is now reality, there are those - including economists such as Ricardo Hausmann - who will be delighted by the country"s aggressive move to impair its creditors, having urged the government to stop payments on its bonds. They say the debt load is unsustainable, and sending dollars to foreign investors while cutting back on imports of food, medicine and basic goods for the Venezuelan people is immoral. In the hyperinflationary banana republic case of Venezuela, they just may have a point.

Venezuelan bonds trade at an average price of 36 cents on the dollar due to widespread investor concern that the nation was headed for default. Benchmark bonds due in 2027 have plunged from about 50 cents on the dollar a year ago to 38.7 on Thursday.

As for whether or not Venezuela is about to default, from a purely technical CDS and ISDA standpoint, any distressed restructuring of debt - which is what is about to take place - is equivalent to a credit event. Which means all those who loaded up on CDS in the past three years are about to have a long-overdue payday.

Paul Manafort Indicted On 12 Counts In Mueller Probe, Surrenders To FBI

 Update: President Trump on Monday called for the focus to be shifted to Hillary Clinton after his former campaign chairman Paul Manafort turned himself into the FBI after being indicted on 12 counts, including conspiracy against the United States."Sorry, but this is years ago, before Paul Manafort was part of the Trump campaign. But why aren"t Crooked Hillary & the Dems the focus?????" Trump tweeted. "Also, there is NO COLLUSION!"

Update: Sources close to the White House have released what appears to be an unofficial statement: "This has nothing to do with the White House."

The statement alludes to the fact that Manafort"s alleged misdeeds took place before he joined the Trump campaign.

Source close to the White House: "Today has zero to do with the White House"
(Still no official statement, though) https://t.co/KLdpJRIBUA

— Meg Wagner (@megwagner) October 30, 2017

Update: Messages of support from Republican Congressmen for the Mueller probe are beginning to trickle in...

1/ Months ago I & many other Republicans vowed to support Mueller investigation & allow it to work its way through process to get the facts

— Jim Banks (@RepJimBanks) October 30, 2017

2/ In light of today’s indictments we must continue to support and allow the integrity of the process to work

— Jim Banks (@RepJimBanks) October 30, 2017

Update: In an apparent attempt to pre-empt criticism of the Mueller probe from President Trump, Nancy Pelosi and Chuck Schumer have both released statements defending the investigation...

INBOX: @NancyPelosi on the Mueller indictments: pic.twitter.com/DCvmIg1GOj

— Ed O"Keefe (@edatpost) October 30, 2017

 

INBOX: @SenSchumer on Mueller indictments: pic.twitter.com/k0ZqDD5yuh

— Ed O"Keefe (@edatpost) October 30, 2017

Update: The Justice Department has released the Manafort/Gates indictment. The indictment contains 12 counts total, and the big one appears to be conspiracy against the US. They are also facing charges of tax fraud, money laundering and giving false statements.

The two men are expected to appear in court at 1:30 am ET.

In total more than $75,000,000 flowed through Manafort"s offshore accounts, according to the Mueller indictment. Manafort allegedly laundered more than $18 million which was used by him to buy property, goods and services in the US, income that he concealed from the US Treasury, the DOJ and others. Gates was instrumental in helping Manafort move the money form his illict foreign accounts into the US, and eventually transferred more than $3 million to accounts he controlled.

According to the indictment, between at least 2006 and 2015, Gates and Manafort acted as unregistered agents of the Government of Ukraine, the Party of Regions (a Ukrainian political party whose leader Victor Yanukovych was President from 2010 to 2014), Yanukovych, and the Opposition Bloc (a successor to the Party of Regions that formed in 2014 when Yanukovych fled to Russia). The two men generated tens of millions of dollars in income as a result of their Ukraine work. In order to hide Ukraine payments from United States authorities, from approximately 2006 through at least 2016, they laundered the money through scores of United States and foreign corporations, partnerships, and bank accounts.

Manafort and Gates used money from their Cyprus accounts to finance lavish lifestyles. Manafort spent more than half a million dollars of it on clothes from stores in Beverly Hills, and $20,000 on housekeeping. Gates spent the money on his mortgage, personal expenses, tuition payments and  an interior decorator for his Virginia home.

Manafort spent $1.3MM on home automation, lighting and entertainment, $849K on men"s clothing, $655K on landscaping, $934K on antique rugs pic.twitter.com/mXJgbBqeWZ

— zerohedge (@zerohedge) October 30, 2017

  Read the indictment in its entirety below, whose highlights are below, courtesy of Bloomberg:  

•    Both men hid their work for the former Ukrainian president Victor Yanukovych, his Party of Regions and the Ukrainian government from 2006 “through at least 2016,” according to the indictment.


• Manafort alone laundered more than $18 million to finance what the indictment called his “lavish lifestyle,” which included millions of dollars in real estate, luxury cars, antiques, clothing, landscaping services and home improvements. He also defrauded banks that loaned him money, prosecutors said, and failed to file reports to the Treasury Department declaring ownership of foreign bank accounts.


• After news reports surfaced in August 2016 about Manafort’s work in Ukraine, he and Gates “developed a false and misleading cover story” to distance themselves from their activities, the indictment said. This included “false and misleading letters” in November 2016 and February 2017 to the Justice Department, which was trying to determine whether they had acted as “foreign principals” under the Foreign Agents Registration Act. Prosecutors charged them with false statements for those two letters.


• They lobbied members of the U.S. Congress and worked with two other Washington lobbying firms, identified in the indictment only as Company A and Company B, according to the indictment. Manafort and Gates directed the work of those firms on Ukraine and paid them more than $2 million from the offshore accounts, it said.


• To hide their assets, the men controlled dozens of business entities in Cyprus, Grenadines and the U.K. that masked their ownership, the indictment said. They also owned U.S. entities in Delaware, Virginia and Florida.


• Prosecutors seek the forfeiture of four Manafort properties, including a Brooklyn brownstone, a Lower Manhattan condominium, and homes in Arlington, Virginia, and eastern Long Island.

* * *

Update: The Washington Post reports that Manafort was seen entering the FBI"s Washington field office Monday.

* * *

Update: Manafort has been hit with several charges, including tax fraud, WSJ reported. He"s expected in federal court in Washington later Monday, a person familiar with the matter said. Meanwhile, Rick Gates is also reportedly turning himself in.

* * *

Update: CBS News confirms a photojournalist has captured images of Manafort leaving his home this morning with his lawyer.

*  *  *

Surprise, surprise. The New York Times is reporting that the first indictment in Special Counsel Robert Mueller"s probe into possible collusion between the Trump campaign and Russia has been unsealed.

And the target is none other than Paul Manafort, who briefly served as chief executive of the Trump campaign last summer before reports about his work for Ukraine"s former leader Viktor Yanukovich forced him out. Manafort has reportedly been asked to surrender by the FBI, sparing him an embarassing perp walk.

Manafort"s former deputy Rick Gates has also been asked to surrender.

The charges against the pair weren"t immediately clear. But they do represent an escalation in the probe that has loomed over President Trump"s first year in office.

Gates is a longtime protege and junior partner at Manafort"s firm. His involvment in the probe was revealed in the spring. His name appeared in documents linked to a Cypriot firm Manafort set up to receive payments from Eastern European politicians like Yanukovich, who purportedly paid Manafort with money looted from the Ukraine state.

Manafort had been udner investigaiton for violations of federal tax law, money laundering and whether he failed to properly disclose his foreign lobbying.

As we"ve noted, since these charges mostly stem from Manafort"s work before he became involved with the campaign, they leave ample room for Trump to declare victory.

As far as impact to the market - so far nothing - and as KBW’s Brian Gardner explains, none is expected, despite expectations for much sound and fury and told-you-so"s from the left.

Special Counsel Robert Mueller"s indicting former Trump campaign manager Paul Manafort or former National Security Adviser Michael Flynn over activities separate from Trump campaign/administration would be "mostly political noise," and would not significantly affect markets.

However, Gardner notes that any unsealing of indictments may dominate the week’s entire news cycle, drowning out coverage of tax legislation and monetary policy.

Now, we watch for the administration"s response.

Here"s the indictment:

Draining the Swamp: Credit Scores and Housing Finance Reform

News that Senator Bob Corker (R-TN) is retiring from the Senate was not welcome news for advocates of reform in the government-controlled world of housing finance.  "A big loss," said John Thune (R-SD). "He"s always been a guy who"s really about trying to find solutions, common ground, and getting results."

Corker was indeed somebody who would work with his colleagues across the isle, but he was also willing to work period on difficult and contentious issues like housing, something few members are willing to do.  His departure leaves a considerable vacuum in terms of the capacity of Congress to engage on the issue of housing finance, much less pass legislation.

As the mortgage finance industry heads into the last quarter of 2017, we are still running about 30% down in terms of lending volumes compared to last year, the result of the post election pop in yields for US Treasury bonds that killed the declining refinance market.  No amount of innovation, quantitative easing from the Federal Open Market Committee, or new, more accommodating credit scores can make up for this sharp decline in production of mortgage loans. 

Meanwhile in Washington, the prospects for ending the decade-long conservatorship of Fannie Mae and Freddie Mac are dim at best.  In his statement to Congress last week, Melvin L. Watt, Director of the Federal Housing Finance Authority, said “ that these conservatorships are not sustainable and they need to end as soon as Congress can chart the way forward on housing finance reform.”  But nobody on Capitol Hill seems to consider the status quo a problem when it comes to Fannie Mae and Freddie Mac.

Watt is headed for a potential confrontation with the Trump Administration and Congress over the issue of maintaining minimum capital for the GSEs, but ultimately he must blink.  In his remarks, the former congressman from North Carolina seemingly made clear that he is preparing to modify the “sweep” of profits from both enterprises to the Treasury to prevent one or both from becoming technically insolvent, an eventuality that would require support from the Treasury. Watt stated:

 “Like any business, the Enterprises need some kind of buffer to shield against short-term operating losses.  In fact, it is especially irresponsible for the Enterprises not to have such a limited buffer because a loss in any quarter would result in an additional draw of taxpayer support and reduce the fixed dollar commitment the Treasury Department has made to support the Enterprises.  We reasonably foresee that this could erode investor confidence.  This could stifle liquidity in the mortgage-backed securities market and could increase the cost of mortgage credit for borrowers.”

While by law the Treasury’s ability to support the GSEs with new capital is limited, bond market investors and the credit rating community accords “AAA” ratings to Fannie and Freddie because of the fact of the conservatorship and the presumption of unlimited credit support from the United States.  Whether such confidence is reasonable given the current posture of Congress and the Executive Branch when it comes to the GSEs and federal debt more generally is another matter entirely. 

Watt is aware of this market reality and what a repeat of the 2008 bond market debacle would mean to the mortgage market and US taxpayers.  Yet despite his tough talk, it is not safe to assume that Watt will direct the GSEs to start accumulating capital. He said in blunt terms:

“FHFA has explicit statutory obligations to ensure that each Enterprise ‘operates in a safe and sound manner’ and fosters ‘liquid, efficient, competitive, and resilient national housing finance markets.’  To ensure that we meet these obligations, we cannot risk the loss of investor confidence.  It would, therefore, be a serious misconception for members of this Committee, or for anyone else, to consider any actions FHFA may take as conservator to avoid additional draws of taxpayer support either as interference with the prerogatives of Congress, as an effort to influence the outcome of housing finance reform, or as a step toward recap and release.  FHFA"s actions would be taken solely to avoid a draw during conservatorship.”

Watt may seem willing to make changes in the way that the GSEs compensate taxpayers for the continued sovereign credit support given to both enterprises, yet is unlikely to act.  But he continues to be skeptical of calls for FHFA to allow alternative credit scores when underwriting loans covered by insurance in the GSE market. “FHFA has received overwhelming feedback from the industry that it would be a serious mistake to change credit scoring models before the Enterprises implement the Single Security in mid-2019,” Watt told Congress, reflecting the view of many mortgage market participants.

The incumbent consumer credit bureaus – Experian, TransUnion and Equifax – have been pushing a weaker credit score as an alternative to the incumbent credit scoring monopoly held by Fair Issaac’s FICO model.  Huge amounts of money have been spent to promote the alternative scores, so far with little in the way of commercial success. Indeed, most media organizations are cowed into silence by the vast amounts of money flowing from Washington c/o Equifax and the other members of the credit score triopoly.

“We have looked deeply at these issues, and this process has raised additional concerns,” Watt noted in a barely disguised rebuke for the consumer data triopoly.  “For example, how would we ensure that competing credit scores lead to improvements in accuracy and not to a race to the bottom with competitors competing for more and more customers?  Also, could the organizational and ownership structure of companies in the credit score market impact competition?”

There are certainly legitimate concerns about competition in the consumer credit market, yet the more important issue is how a change would impact the primary and secondary markets for mortgage credit.  The bond market in particular is very opposed to any change in how default risk probabilities are measured, including both investors and the credit rating agencies that serve institutional investors.

The fact is, the bond markets like having one benchmark for measuring default risk, a fact that seems to elude advocates of "competition" in credit scoring.  Having multiple benchmarks is not about competition but rather intellectual chaos.  And as the old saying goes, be careful what you wish for, you may get it. 

Fact is, were FHFA to allow for the use of multiple credit scores in underwriting loans that back Fannie Mae and Freddie Mac securities, investors and credit rating agencies would be compelled to “score” the different models. Based on what we know today about the respective credit score products, the alternative score being pushed by the three incumbent consumer credit repositories would almost certainly trade at a discount to the FICO score used in most default models.

Watt’s comments make clear that he understands that “competition” in credit scores is really about opening the credit box to higher risk borrowers.  But thanks to the benevolence of central bankers, such worries are very distant from the minds of people who live and work in Washington. 

For the past decade, the FOMC has wrapped such concerns as market liquidity and default risk with a comforting blanket of cheap money.  When banks and the GSEs come to grips with the hidden default risk currently embedded inside trillions of dollars worth of new mortgage production, the conversation about housing finance reform may take on a bit more urgency and seriousness.  But sadly, Senator Corker will have left the building.

"You May Be Hopping Mad When You Finish Reading This"

Submitted by John Mauldin of Mauldin Economics

Uncle Sam’s Unfunded Promises

Here’s a surprisingly profound question: What is a promise? Dictionaries offer various definitions. I like this one: “An express assurance on which expectation is to be based.”

That definition captures the two-sided nature of a promise. One party offers an assurance, which the other converts into an expectation. You deposit money in your checking account, and the bank assures you that you can have it back on demand. You expect that the bank will fulfill its promise when you visit an ATM.

Governments likewise make promises, but those are different. Government is the ultimate enforcer of promises, but we have no recourse if it chooses to break them – except at the ballot box. As we’ve seen in recent weeks regarding public pensions, that’s ineffective when the promises were made long ago by officials who are no longer in office.

The federal government’s keeping its promises is important for everyone in the US, because almost all of us are part of the largest public pension system: Social Security. We pay taxes our whole working lives and expect the government to give us retirement benefits. But what happens if it can’t?

Three weeks ago we visited the problems with local and state pensions. Last week we looked at European pensions. This week we are going to take a hard look at the unfunded liabilities and debt of the US government. And even though the federal unfunded pension liabilities dwarf those of state and local pensions, I want to make it clear that I believe the state and local problems will be far more intractable.

I have to warn you: You may be hopping mad when you finish reading this.

* * *

Doubled Debt

In the United States we have two national programs to care for the elderly. Social Security provides a small pension, and Medicare covers medical expenses. All workers pay taxes that supposedly fund the benefits we may someday receive. That’s actually not true, as we will see in a little bit.

Neither of these programs is comprehensive. Living on Social Security benefits alone is a pretty meager existence. Medicare has deductibles and copayments that can add up quickly. Both programs assume people have their own savings and other resources. Nevertheless, the programs are crucial to millions of retirees, many of whom work well past 65 just to keep up with their routine expenses. This chart from my friend John Burns shows the growing trend among generations to work past age 65. Having turned 68 a few days ago, I guess I’m contributing a bit to the trend:

Limited though Social Security and Medicare are, we attribute one huge benefit to them: They’re guaranteed. Uncle Sam will always pay them – he promised. And to his credit, Uncle Sam is trying hard to keep his end of the deal. In fact, he’s running up debt to do so. Actually, a massive amount of debt:

Federal debt as a percentage of GDP has almost doubled since the turn of the century. The big jump occurred during the 2007–2009 recession, but the debt has kept growing since then. That’s a consequence of both higher spending and lower GDP growth.

In theory, Social Security and Medicare don’t count here. Their funding goes into separate trust funds. But in reality, the Treasury borrows from the trust funds, so they simply hold more government debt.

The Treasury Department tracks all this, and you can read about it on their website, updated daily. Presently it looks like this:

• Debt held by the public: $14.4 trillion


• Intragovernmental holdings (the trust funds): $5.4 trillion


• Total public debt: $19.8 trillion

Total GDP is roughly $19.3 trillion, so the federal debt is about equal to one full year of the entire nation’s collective economic output. In fact, it’s even more when you consider that GDP counts government spending as “production,” even when Uncle Sam spends borrowed money. Of course, that total does not count the $3 trillion-plus of state and local debt, which in almost every other country of the world is included in their national debt numbers. Including state and local debt in US figures would take our debt-to-GDP above 115%. And rising.

You can quibble over the calculations, but there’s no doubt the numbers are astronomically huge and growing. And we haven’t even mentioned the huge and growing private debt.

Just wait. We’re only getting started.

Yes, Trillions

We in the business world put a lot of faith in accountants. We trust them to count the beans honestly and give us accurate reports. We may not like the numbers (I was certainly distraught with my final tax numbers this year!), but we mostly believe them. Nothing will make a company’s stock drop faster than accounting irregularities will.

Government accounting is, well, different. The government doesn’t need to make a profit, but we expect it to spend our tax money wisely and to deliver services efficiently. That’s not possible unless there is reliable accounting. But reliable accounting is the last thing most politicians want – it constrains them from promising things they can’t deliver. So we have to take all government numbers with many grains of salt.

However, there is one chink in the politicians’ armor. An old statute requires the Treasury to issue an annual financial statement, similar to a corporation’s annual report. The FY 2016 edition is 274 enlightening pages that the government hopes none of us will read.

Among the many tidbits, it contains a table on page 63 that reveals the net present value of the US government’s 75-year future liability for Social Security and Medicare. That amount exceeds the net present value of the tax revenue designated to pay those benefits by $46.7 trillion. Yes, trillions.

Where will this $46.7 trillion come from? We don’t know. Future Congresses will have to find it somewhere. This is the fabled “unfunded liability” you hear about from deficit hawks. Similar promises exist to military and civil service retirees and assorted smaller groups, too. Trying to add them up quickly becomes an exercise in absurdity. They are so huge that it’s hard to believe the government will pay them, promises or not.

Now, I know this is going to come as a shock, but that $46.7 trillion of unfunded liabilities is pretty much a lie. My friend Professor Larry Kotlikoff estimates the unfunded liabilities to be closer to $210 trillion. When presidential candidate Ben Carson last year quoted Kotlikoff’s numbers, the Washington Post, New York Times, and other mainstream media immediately attacked him. Of course, the journalists doing the attacking had agendas, and none of them were economists or accountants. None. Zero. Zip.

Larry responded in an article in Forbes, since Carson was using his data:

The fiscal gap is the present value of all projected future expenditures less the present value of all projected future taxes. The fiscal gap is calculated over the infinite horizon. But since future expenditures and taxes far off in the future are being discounted, their contribution to the fiscal gap is smaller the farther out one goes. The $210 trillion figure is based on the Congressional Budget Office’s July 2014 Alternative Fiscal Scenario projections, which I extended beyond their 75-year horizon.

The journalists used a very poorly researched analysis, which fit their political bias (shocking, I know). Apparently they take that fabricated analysis more seriously than they do the views of 17 Nobel Laureates in economics and over 1200 PhD economists from MIT, Harvard, Stanford, Chicago, Berkeley, Yale, Columbia, Penn, and lesser known universities and colleges around the country. Each of these economists has endorsed The Inform Act, a bi-partisan bill that requires the CBO, GAO, and OMB to do infinite horizon fiscal gap accounting on a routine and ongoing basis.

Now why would 17 Nobel Laureates and over 1200 US economists, all listed by name at www.theinformact.org, including many, like Jeff Sachs, who lean to the left, and others, like Glenn Hubbard, who lean to the right, endorse infinite horizon accounting. Because they understand something that I told Michelle repeatedly and have also told Bruce Barlett repeatedly. The fiscal gap is the only measure of our fiscal position that is mathematically well-defined.

Every other fiscal measure, including fiscal gaps calculated over any finite horizon, such as the CBO’s 25-year fiscal gap Michelle references, are not mathematically well defined. The infinite horizon is mathematically well defined because it is the same number no matter what choice of internally consistent fiscal words we use to label government receipts and payments. Moreover, the infinite horizon fiscal gap is the only measure of our fiscal policy’s sustainability that puts everything on the books. It is also the only measure of our fiscal policy’s sustainability that is invariant to the choice of words.

Congress’s choice of fiscal labels determines what gets put on and what gets kept off the books. I told Michelle that her grandparents’ Social Security benefits, for which she is now paying taxes, are not on the books because the government chose to call those payments “transfers” paid in exchange for “FICA contributions” not “return of principal plus interest” paid in exchange for “purchase of government bonds.”

Every mathematical model of the economy’s dynamic transition path incorporates the infinite horizon fiscal gap, which is called the government’s infinite horizon intertemporal budget constraint. This constraint has to hold, which means the infinite horizon fiscal gap must be zero. Our country’s infinite horizon fiscal gap is far from zero. It would take an immediate and permanent 59 percent increase in all federal taxes or an immediate and permanent 33 cut in all federal expenditures (including official debt service) to eliminate our fiscal gap. The longer we wait to fix our fiscal system, the larger the adjustment needs to be. This means that (the journalist), and others her age, will need to pay even more for all the “assets,” including my own Medicare and Social Security benefits that have been left off the books.

Yes, something will have to give.

The $210 Trillion Gap

I will admit that I’m not worried about the $210 trillion in unfunded liabilities. Long before we ever get to having to fund those liabilities, the country will be in a massive crisis.

Using the CBO’s own numbers, the projected total US debt will be $30 trillion within 10 years, but the CBO also makes the rosy assumptions that there will be no recessions and that GDP will grow at a 4% nominal rate. Now, that’s possible; but I’m inclined to haircut it a bit.

If you asked me to bet the “over/under” on the debt in 2027, I would bet the over at $35 trillion. After the next recession the deficit will be $30 trillion within 4–5 years and then grow from there at a rate of anywhere from $1.5 to $2 trillion per year. Note: That is not the CBO’s projected debt. It does not count the off-budget deficit that still ends up having to be borrowed. Last year the deficit was well over $1 trillion – but we were told it was in the neighborhood of $600 billion. If any normal company tried to use accounting like the US Congress does, the SEC would rightly declare it fraudulent and shut it down immediately. .

Here’s another chart from the Treasury’s annual financial report, projecting government receipts and spending:

Note that this chart expresses the various items as percentages of GDP, not dollars. So the relatively flat spending categories simply mean they are forecasted to grow in line with the economy, or just a little faster. But the space representing net interest grows much faster than GDP does – fast enough to make total federal spending add up to one-third of GDP by 2090.

Obviously, this chart is based on all kinds of assumptions, and reality will be far different. I doubt we will make it to 2090 (or even 2050) without at least one global depression or other calamity that radically resets all the assumptions. Beneficial changes are also possible – biotech breakthroughs that reduce healthcare expenditures, for instance.

Still, looking at the demographic reality of longer lifespans and lower birthrates, it’s hard to believe Social Security can survive over the long run in anything like its present form. But any major change will mean that the government is breaking its promise to workers and retirees.

Well, guess what: They backtracked on that promise decades ago. Few people noticed it at the time, and even fewer remember it now.

Tax, Not a Promise

There’s a big difference between that federal government financial statement and similar ones from private companies. “Liabilities” for a business represent contracts it has signed – the long-term lease on a building, for instance. The company agrees to pay so many dollars a month for the next 20 years. That obligation is enforceable in court. Even if the company enters bankruptcy, the court will award creditors damages from whatever assets it can recover.

The federal government doesn’t work that way. It signs contracts all the time – but often with escape clauses that private businesses could never get away with. Social Security is a good example.

Many Americans think of “their” Social Security like a contract, similar to insurance benefits or personal property. The money that comes out of our paychecks is labeled FICA, which stands for Federal Insurance Contributions Act. We paid in all those years, so it’s just our own money coming back to us.

That’s a perfectly understandable viewpoint. It’s also wrong.

A 1960 Supreme Court case, Flemming vs. Nestor, ruled that Social Security is not insurance or any other kind of property. The law obligates you to make FICA “contributions.” It does not obligate the government to give you anything back. FICA is simply a tax, like income tax or any other. The amount you pay in does figure into your benefit amount, but Congress can change that benefit any time it wishes.

Again, to make this clear: Your Social Security benefits are guaranteed under current law, but Congress reserves the right to change the law. They can give you more, or less, or nothing at all, and your only recourse is the ballot box. Medicare didn’t yet exist in 1960, but I think Flemming vs. Nestor would apply to it, too. None of us have a “right” to healthcare benefits just because we have paid Medicare taxes all our lives. We are at Washington’s mercy.

I’m not suggesting Congress is about to change anything. My point is about promises. As a moral or political matter, it’s true that Washington promised us all these things. As a legal matter, however, no such promise exists. You can’t sue the government to get what you’re owed because it doesn’t “owe” you anything.

This distinction doesn’t matter right now, but I bet it will someday. If we Baby Boomers figure out ways to stay alive longer, and younger generations don’t accelerate the production of new taxpayers, something will have to give.

If you are depending on Social Security to fund your retirement, recognize that your future is an unfunded liability – a promise that’s not really a promise because it can change at any time. 

How Will We Fund the Deficit?

And now we come to the really uncomfortable part. Notice that Larry Kotlikoff said we would need an immediate approximately 50% increase in taxes to fund our future deficits. That’s what we would need to create a true entitlements “lockbox” with the funds actually in it. But surely everybody knows by now that there is no lockbox with Social Security funds in it. That money was spent on other government programs and debts. And so when the CBO doesn’t count the trust funds as part of the national debt, they are not only being disingenuous, I think they are committing financial fraud. The money that will actually pay for Social Security and Medicare down the road is going to have to come out of future taxes, just as for any other debt of the US.

So at some point – even though Republicans are jawboning hard about cutting taxes now – we are going to have to raise taxes in order to fund Social Security and Medicare. I personally think it will have to be done with a value-added tax (VAT), because the necessary increase in income taxes would totally destroy the economy and potential growth.

(And yes, I know some of you will write back and say we had much higher tax rates in the 50s and we had good growth then, but our demographics and productivity levels were completely different in that era. Plus, nobody actually paid the highest tax levels. I remember that in the 80s, before Reagan cut the tax rate, I had so many deductions that my effective tax rate was about 15%. The irony is that after the Reagan tax cuts, my total tax payments went up, not down – I lost all of my cool deductions! Aaah, the good old days…)

But the simple fact of the matter is that no Congress is going to fund Social Security and Medicare through tax hikes. Before they ever go there, they will means-test Social Security and increase the retirement age – which they should.

Of course, Congress could always authorize the Treasury Department to authorize the Federal Reserve to monetize a certain amount of the Social Security and Medicare debt, which is essentially what Japan is doing (and seemingly getting away with it). I think we should all be grateful to the Japanese for being willing to undertake such a fascinating experiment in monetary and fiscal policy.

Let me close with a quick sidebar note. I think the Fed’s mad rush to raise rates and reduce its balance sheet at the same time is unwise. I mean, seriously, is the Federal Reserve balance sheet making that much of a difference to the US economy? Perhaps when that extraordinary balance was created, it did – but not today. This is one of those times when I think our policy makers should go slowly and tread carefully. Just saying…