David Einhorn

Excerpted from his presentation to the Ira Sohn Investment Research Conference on May 26, 2010

I have titled today’s talk Good News for the Grandchildren. By that, I mean that I do not believe that there is a need to worry that today’s debts will be passed on to our current youth…I believe the government response to the recession has created budgetary stress sufficient to bring about the crisis much sooner. Our generation – not our grandchildren’s – will have to deal with the consequences. If we do one thing, let’s stop bemoaning the fate of our grandchildren on this topic. We might take the issue more seriously if we realize that our own future is at risk.

According to the Bank for International Settlements, the US’s structural deficit – the amount of our deficit adjusted for the economic cycle – has increased from 3.1% of GDP in 2007 to 9.2% in 2010. This does not take into account very large liabilities the government has accepted by socializing losses in the housing market. We have not seen the bills for bailing out Fannie Mae and Freddie Mac and even more so the Federal Housing Administration, which is issuing government guaranteed loans to non-creditworthy borrowers on terms easier than anything offered during the housing bubble. Government accounting is done on a cash basis, so promises to pay in the future – whether they are social security benefits or loan guarantees – do not count in the budget until the money goes out the door.

A good percent of the structural increase in the deficit is because last year’s “stimulus” was not stimulus in the traditional sense. Rather than a one-time injection of spending to replace a cyclical reduction in private demand, the vast majority of the stimulus has permanently increased the base level of government spending. A very large amount was dedicated to preserving government jobs. How different is the government today from where General Motors was a decade ago? Government employees are high cost and difficult to fire. Bloomberg reported that from the last peak businesses have let go 8.5 million people or 7.4% of the workforce while the government has only cut 141 thousand workers, or less than 1%.

Public sector jobs used to offer greater job security but lower pay. Not anymore. According to a 2009 CATO Institute study the average federal civilian salary with benefits totals $119,982 compared to $59,909 for the average private sector worker and the disparity has grown enormously over the last decade.

The situation at the state and local levels is no more comforting. The excellent superintendent of the public school in the town next to mine just “retired” at age 58. He had a fully vested public pension but was not interested in quitting work. So, in addition to beginning to collect his pension, he moved to New Jersey to take a similar job and to begin earning a second public pension in that state. While there is no reason to begrudge him for operating within the system, there are consequences to arrangements such as this. His is not an isolated story – articles describing “retire and rehire” of public officials can be found in many local newspapers around the country.

There has been a lot of scoffing in financial circles about Greek civil servants earning 14 months of pay for 12 months of work. While the details are different, civil servant pay appears to be as big a problem here as well. I doubt it will be easier to reform this than other government entitlements. And, there are so many government workers that they are an important voting block that helps elect officials who won’t challenge the current arrangement.

The question is how long can we travel down this path without either changing direction or having a crisis. The answer lies in two critical issues; first, how long will the capital markets continue to fund government borrowings that may be refinanced but never repaid on reasonable terms, and second, to what extent can obligations that are not funded through traditional fiscal means be satisfied through central bank monetization of debts – that is, by the printing of money?

The recent US credit crisis came in large part due to capital requirements and risk models that incorrectly assumed AAA rated securities were exempt from default risk. We learned the hard way that when the market ignores credit risk, the behaviors of borrowers and lenders become distorted.

It was once unthinkable that “risk-free” AAA rated institutions could fail, as they recently have. Their CEOs probably didn’t realize when they crossed the line from highly creditworthy to eventual insolvency. Surely, had they seen where the line was, they would to-a-man have stopped on the solvent side.

Our government leaders are faced with the same risk today. What is the level of government debt and future commitments where government default goes from being unthinkable to inevitable, and how does our government think about that risk?

I recently posed this question to one of the President’s senior economic advisors. He answered that the government is different from financial institutions because it can print money and statistically the United States is not as bad-off as some other countries. As an investor, these responses do not inspire confidence…

Modern Keynesianism works great until it doesn’t. No one really knows where the line is. The government doesn’t know, nor do the credit rating agencies. One obvious lesson from the crisis should be that we get rid of official credit ratings that inspire false confidence and, worse, are pro-cyclical. Congress has a unique opportunity in the current effort of regulatory reform to eliminate the credit rating system. For now, it does not appear interested in taking sufficiently aggressive action. The big banks and the big bond buyers have told Congress they want to continue the current ratings system. As Bill Gross put it in his last newsletter:

Firms such as PIMCO with large credit staffs of their own can bypass, anticipate and front run all three [rating agencies], benefiting from their timidity and lack of common sense.

Given how sophisticated bond buyers use the credit rating system to take advantage of more passive market participants, it is no wonder they stress the continued need to preserve the Status Quo.

It would be better to have each market participant individually assess credit-seeking entities. Certainly, the creditworthiness of governments should not be centralized in the hands of a couple of rating agency committees.

Consider this description about the sovereign rating process an S&P analyst offered in an interview aired by the National Public Radio Morning Edition earlier this month:

S&P analyst: For any country we have two analysts who go to a country for that rating. Never send just one person because you need a second pair of eyes.

NPR interviewer: I think there are people listening to this who would say “just two?” Shouldn’t you be sending seventy to rate a country’s government?

S&P analyst: To be fair, what we are looking at is fairly narrow. Can you pay your debt fully and on time? What is your ability and willingness to do so? You know, I think two people…this has been our practice. It has worked well.

NPR reported that after interviewing some government officials, business people and journalists for a few days, the S&P analysts fly home and write a report. A five person rating committee debates the issue and holds a vote of hands.

S&P analyst: We always want an odd number because we don’t want to have a tie and do the whole thing again.

NPR interviewer: How long does that take?

S&P analyst: Even if you are doing like a Canada which is [a] relatively boring rated AAA, you still have to go through all the steps. So two hours is sort of average.

That is about as long as it takes to watch a hockey game.

We have just watched the pro-cyclical behavior of the ratings agencies foster a private sector credit crisis. By continuing the official use of this system, public sector borrowers will experience the instability caused by rating agencies at the worst possible moment. Now, European leaders are learning the hard way that it isn’t a good thing to have rating agencies declare that things are stable even as risks build and then, as problems reach a critical stage, accelerate the loss of confidence by declaring that things are not so good after all.

When Secretary Geithner promises that the US will never lose its AAA rating, he chooses to become dependent – effectively putting all of his eggs in one basket – on the whims of the S&P ratings’ committee rather than the diverse views of the many participants in the capital markets. It is not hard to imagine a future crisis where just as the Treasury Secretary seeks buyers of government debt in the face of deteriorating market confidence, a rating agency exacerbates the problem with an untimely downgrade, triggering massive additional sales by existing bondholders. This has been the experience of many troubled corporations, where rating agency downgrades served as the coup-de-grace.

The current upset in the European sovereign debt market is a prequel to what might happen here. Banks can hold government debt with a so-called zero risk weighting, which means holding it requires no capital. As a result, European banks loaded-up with Greek debt and sold sovereign CDS and now need to be bailed-out to avoid another banking crisis. As we first saw in Dubai and now Greece, it appears that the response to Lehman’s failure is to use any means necessary to avoid another Lehman-like event. This policy transfers risks from the weak to the strong – or at least the less weak – setting up the possibility of the crisis ultimately spreading from the “Too-Small-to-Fails” like Greece to “Too-Big-to-Bails” including members of the G7.

To be continued tomorrow…

David Einhorn
for The Daily Reckoning

David Einhorn

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