The overwhelming majority of Americans are relying exclusively on Social Security and Medicare to provide a comfortable retirement in their old age.
When interviewed, they say they think the systems are going to go bust, but they do not change their behavior and save more. They save less. Today, household saving as a percentage of household discretionary income is negative. Americans are borrowing to maintain their lifestyles.
Most Americans now live 15 years or more after their Medicare payments begin and 14 years after their Social Security payments begin. As longevity increases, and as Medicare payments keep people alive in the final six months of their lives, which are the most expensive phase of their lives, medically speaking, these two systems will go into red ink status. The generally accepted estimate for this is 2017 for Medicare. Social Security may take a decade longer. The United States government is now something in the range of $75 trillion in the red for these two programs. Most of this is Medicare. I report on these figures in a free department on my Website. You can verify there what I am saying here.
This means that over the life of the two programs, the Federal government will have to find $75 trillion to make the payments that it has committed to make to all Americans in their retirement years. This assumes, of course, that this liability does not increase as a result of even greater life expectancy.
Whether or not Americans live longer, this gigantic figure is guaranteed to increase. Why is this? Because the programs are not being funded today. For every year that the expected liabilities are not being covered by money set aside that will produce a guaranteed return (guaranteed by whom?), the principal that is not paid is tacked onto the total debt owed. If, this year, as is certain, $2 trillion are not set aside in income-producing assets, this $2 trillion will be tacked onto the $75 trillion obligation.
None of the investments are funded by investments in income-producing assets. The trust funds of both organizations are exclusively invested in nonmarketable, long-term United States government debt. There are only four ways to ecape. First, the government can increase workers’ taxes. Second, the government can reduce the payments. Third, the government can borrow from the capital markets. Fourth, the government can borrow from the Federal Reserve System which will create the money out of nothing to purchase additional debt.
Because the government already refuses to lay aside sufficient tax money to pay off these debts, we know what the government will do. It will either cut back on payments, or it will borrow additional money, either from the private capital markets or from the Federal Reserve System.
A WAY TO UNDERSTAND WHAT IS HAPPENING
The government is borrowing money today with a promise to pay off the loan later. This “later” can best be understood by watching Judy Garland sing “Someday, over the rainbow (way up high).”
For movie buffs, the best still image is W.C. Fields, with his top hat, dealing cards in My Little Chickadee. His motto: “Never give a sucker an even break.”
For moving images, any scene by Groucho Marx will work fine. But I recommend the scene in The Coconuts, where he is selling Florida real estate. Chico asks what the houses are made of. Groucho answers, “You can get them in wood. You can get them in stucco. Boy, can you get stucco!”
Economically speaking, our best example of what we are facing is to think of ourselves as bankers who have lent trillions of dollars to borrowers. The borrowers are officially retirees, but legally speaking, there is one borrower: the U.S. government.
Think of Social Security and Medicare as long-term mortgages. The big question is this: Which type of mortgages?
We have all heard of subprime mortgages. Very few people had ever heard of them a year ago, when the international capital markets began to break down as a result of these mortgages. The banking industry trusted them. The financial industry sold hundreds of billions of dollars of these toxic waste investments to their investors. No one knows how to recover the losses that these stupid loans have inflicted onto tremendously naïve investors, which include hedge funds and European banks. These loans are still inflicting losses on investors.
In addition to subprime loans there are also Alt-A loans. These loans, a year ago, were considered to be medium-risk loans. They are the next loans up on the risk level from subprime loans. Now, they are regarded as what would have been regarded as a subprime loan one year ago. They, too, are likely to go into default to the tune of hundreds of billions of dollars.
Then there are the ARM mortgages. These are adjustable rate mortgages. I have warned against these loans continually.
These loans adjust the overall interest rate structure for relatively short-term loans. This means that the borrower does not know what he is going to be paying a year or more from now.
If rates rise, his monthly payment will rise. If they fall, his mortgage payment will fall.
Then there are the least-known mortgages. They are called pay option mortgages. These are the mortgages most like Medicare and Social Security. Twenty years ago, they were called backward-walking mortgages.
The pay option ARM mortgage allows a borrower to pay a minimum monthly payment. This minimum monthly payment is not a complete payment in order to amortize the mortgage over a specific period of time. Whatever portion of the monthly obligation that does not cover the full amortization of the mortgage is added to the principal owed by the borrower. So, if he would normally have to pay $1500 a month, but he decides to pay only $500 a month, $1000 is added to the principal owed.
The person who elects to do this is never going to catch up. He has such poor understanding of debt that he signed the papers. He put no money down. He thought he was securing his future. He was securing his eviction.
Here is a summary of these loans, written 2007, by someone who maintained an air of neutrality about these loans. The author writes as if the kind of people signing these loans were careful evaluators of risks and rewards. In fact, they were mostly first-time buyers. This sort of article was common until a year ago. They are all over the Web: “Pay option mortgages.”
There are an estimated $500 billion of these loans, 60% in California. They are now about to come due. The mandatory trigger points for increasing monthly payments will start the default process rolling in the second half of this year, as the graph on the page makes clear. The first re-sets are just now beginning. They will escalate, month by month, until August, 2011. Then they trail off for a year.
This wave of unstoppable foreclosures will hit the housing market for three more years, accelerating month by month.
The borrowers who took on these loans are generally ignorant people who know nothing about finances. These people are guaranteed defaulters. There is nothing Congress can do about this.
These loans were supposedly justified as being only for sophisticated borrowers. This was utter nonsense from 2002 onward, when they first appeared. Only misguided people borrowed by using a pay-option mortgage. These mortgages were touted as a rational option for lenders. By November, 2007, no institution was making them. This was reported in the New York Times.
If they were wise loans, why aren’t lenders offering them any longer? Because they were always bonehead loans. Brokers who were being paid large commissions made these loans to people who they knew would default. Then they sold these loans to pools of investors assembled like lambs to the slaughter by Wall Street firms and major banks.
There were a few warnings in 2005. No one took them seriously. The experts made excuses for them. The experts were dead wrong. Experts will baptize any screwball investment offered by idiots in the final stages of a boom fostered by central bank monetary inflation.
One of the large banks that promoted these loans is the fast-sinking Wachovia. One site that has summarized these loans — after no one was making them — quotes a page from Wachovia’s Website. (This page has been dropped from Wachovia’s site.)
At Wachovia, we understand the importance of flexibility and choice when it comes to choosing a mortgage. That’s why we’ve teamed up with our affiliate, World Savings Bank, to provide you with a mortgage solution that lets you choose the monthly payment you’re most comfortable with.
The Pick-a-PaymentSM Adjustable Rate Mortgage (ARM) offers you payment choices that allow you to take control of your finances. You have up to four different payment options each month — Minimum Payment, Interest Only, Full Principal and Interest, or 15-Year Payment Option.
With the Adjustable Rate Pick-a-Payment, you could:
Make a lower monthly payment and temporarily increase your cash flow so you can free up cash for:
Retirement savings Paying down high-interest debt Funding college tuition Make higher payments and pay offyour home loan sooner
Keep mortgage payments low during the initial years of your loan
Control your budget based on your individual financial needs
It sounded so good. That was then. This is now.
The experts never see economic disaster coming. They go with the flow. If something worked yesterday, it will work tomorrow . . . and ten years from now. Here is a classic example. Alan Greenspan offered this sage advice on ARMs in 2004:
Calculations by market analysts of the “option adjusted spread” on mortgages suggest that the cost of these benefits conferred by fixed-rate mortgages can range from 0.5 percent to 1.2 percent, raising homeowners’ annual after-tax mortgage payments by several thousand dollars. Indeed, recent research within the Federal Reserve suggests that many homeowners might have saved tens of thousands of dollars had they held adjustable-rate mortgages rather than fixed-rate mortgages during the past decade, though this would not have been the case, of course, had interest rates trended sharply upward.
Bill Fleckenstein immediately said this advice was a mistake, but who was he, compared to Greenspan? A nobody. He was right, but it did not matter.
With respect to pay option ARMs, there is a site on-line that sells these mortgages — or says it does. Here, we read: “With an understanding that pay option arms are as important and respected as any mortgage product in the market place today. Take the time to see if pay option arms is the right path for your primary home, a vacation get a way or, an investment property.” Respected? In 2008? I don’t think so.
For a video analysis of the coming pay-option ARM implosion, see this by “Mr. Mortgage,” who used to sell them.
DEFAULT IS COMING
Mortgage debtors who cannot make their payments have two choices: (1) stop paying and walk away; (2) stop paying and sit tight. By far, the second choice is best for them. It is also best for lenders. Empty house are targets.
There are hundreds of thousands of owners in this second class. They are no longer paying at all. They are sitting in their houses, rent free, waiting for the lending agency to foreclose. Recently, Freddie Mac extended the foreclosure date to 300 days from the last payment, up from 150.
So, someone with a $1000 month mortgage can get another $10,000 of free rent. Maybe he can gum up the system by making one payment on day 299, and get another 300 days.
In any case, lenders have been hit with hundreds of billions of dollars in losses. They can pretend that these losses do not exist, but they do exist. The lenders are sitting on top of hundreds of billion dollars of uncollectible mortgage debt. They are doing their best to avoid admitting to the auditors that these are nonperforming loans. They are doing their best to keep these loans from being written down to zero. They are therefore not foreclosing on homes rapidly.
On the homes that they have foreclosed on, they are not holding auctions in which buyers can submit any bid they want, with the low bid winning. Instead, lenders are establishing a lowest-bid minimum, and this minimum is above any bid that a rational investor or buyer is willing to submit. So, the lenders buy back 95% of these properties each time they list these properties for sale. These shadow sales constitute as much as 40% of the homes sold in California. This makes it look as though the housing market is not in a state of collapse in California. It looks good, but it is a gigantic delusion.
FEDERAL DEFAULT IS COMING
As surely as holders of pay option mortgages will default, so will the U.S. government default. But there is a huge difference. Mortgage lenders can evict mortgage holders in default and gain ownership of their houses. There is no way that “lenders” to the U.S. government can evict the government for non-payment.
This relieves today’s politicians from having to make payments above the minimal required payment to be re-elected. Year by year, month by month, day by day, the government is adding to principal owed to future retirees by not setting aside funds to pay the beneficiaries of the two old-age programs. The funds are immediately spent by the government. Any funds not paid out to today’s growing army of elderly recipients is borrowed by the Treasury and spent. The Treasury issues IOUs to the two trust funds, but these IOUs are not counted as part of the official on-budget debt.
This is deception. The voters don’t understand. Congress likes the results: deferred day of judgment.
You may think: “Why don’t people in charge blow the whistle?” Only one senior official ever did. He is David Walker, the Comptroller General of the United States until early this year. He resigned to head Peter G. Peterson’s newly created foundation, which is devoted to warning the voters about the looming bankruptcy of the government.
[Note, as is true of so many Websites, the outfit allowed the Website designer free reign. Like all programmers, he is young, has a huge screen, and has chosen as his default rate 1024×768 pixels, which produces small print. So, anyone who is older — I am one — who uses maximum resolution of 800×600 cannot easily view the Website.]
Almost no one in authority warned bankers and Wall Street firms against subprime mortgages, Alt-A mortgages, and pay option mortgages. The experts assume that the deal-makers know what they are doing. The deal-doers don’t know. As Warren Buffett has said, there are three phases of the cycle. Each is dominated by one group: (1) innovators; (2) imitators; (3) idiots. We are in phase three.
A year ago, the capital markets were hit by a crisis. Losses are now estimated at $450 billion. That crisis continues. It is likely to get much worse, as leveraged investments — borrowed short, lent long — produce more losses.
Almost nobody warned the public. The experts would not have listened. They never do.
Yet, without warning, the capital markets seized up. This is what happens to capital markets. Things go well for years. Then there is a crisis. Everyone in power says, “We had no warning.”
The Federal government today can still sell its debt. There is a rush for liquidity in a recession period. But there will come a time when, just like the capital markets in August 2007, there will be an unforeseen lock-up of the market for Treasury debt. The Federal Reserve will then have to inflate by buying this debt.
The bankruptcy that is guaranteed by the two pay option mortgages known as Social Security and Medicare will be paid off in a wave of inflation. This inflation will begin long before the trust fund of Medicare goes into the red in 2017.
There will be a default. That default will be mass inflation. The on-budget debt of the United States government will force the FED’s hand before the off-budget debt does. But if it doesn’t, the backward-walking mortgage of Medicare will force the default.
We will have to take our medicine earlier or later. I predict earlier.
August 6, 2008
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