That Light at the End of the Tunnel is a Train Coming

This blog post focuses on the next round of shock waves that are heading straight for the US economy. It examines the causes, symptoms, and consequences of the next crisis – a crisis that will make you wish for the pleasantries of the Fall 2008 economic crash.

But before we get into that, it is useful to step back for a moment and apply some scrutiny to what is already a bad situation, irrespective of what the next crisis might be. Once you digest the enormity of the fiscal challenges we currently face, you will inevitably gain an even greater understanding of why the next round of crises will be so catastrophic. In actuality, you will realize that even if we don’t have another crisis like 2008 in the short term (which I severely doubt), we are still in for an economic tsunami nonetheless (it will just arrive later). Heads you lose; tails you lose even worse.

Let’s assume for a moment that the current economic climate – 10% unemployment, stock market correction completed, relatively stable consumer prices – continues just as it is. Establishing that, let’s look ahead to some of the metrics regarding our national debt (how much total monies we owe to all our creditors combined) and the national deficits (the annual differential between what our economic activity brings into the country, and what we spend); note that the figures cited have been rounded off:

Debt = $12,000,000,000,000
Deficit for FY11 = $1,800,000,000,000
Projected Debt for FY15 = $24,000,000,000,000
Projected Debt for FY20 = $36,000,000,000,000

Current interest rate on our Debt = approx 3%, equating to:
Annual Debt Interest payment (current) = $300,000,000,000 (12 trillion x 0.03)

Let’s stop there for a moment. Think about all the taxes, fees, hidden taxes, benefits costs, et cetera that you pay now, in order to help Uncle Sam service its $300 billion interest payment. As it stands, this is not too pleasant for most middle class families, which are hit the hardest by most (if not all) of these taxes. (If you’re wealthy, you barely notice your tax payments because either you have a lot of money and the taxes don’t hamper your lifestyle, and/or you can afford the best accountants to hide your money from the IRS and thus pay less tax than people earning a fraction of what you earn. If you’re poor, you pay little to no taxes because you don’t earn enough [of course, if you’re poor you have other problems]. So the middle class suffers the worst from the tax code, and don’t let any government propaganda dissuade you from this fact. When the “wealthy” see tax increases, it’s really time for the middle class to turn its collective pockets inside out.)

So, if $300 billion interest payments don’t feel so great for the average middle class family, what will it feel like when those interest payments Uncle Sam owes start to rise? Let’s look at some more figures and analysis:

Assume our interest rate on the Debt starts to increase, as just about everyone following this situation expects. Why is it going to increase? Because as our dollar remains weak and grows weaker, it buys less, which means our creditors need more in the way of interest payments coming in to balance out the loss of their purchasing power with the US dollar. So let’s assume that by the year 2015, the interest rate we pay on the Debt has doubled to 6% (a modest figure considering it would happen gradually over the course of 5 years):

Debt in 2015 = $24,000,000,000,000
Interest rate on the Debt in 2015 = 6%
Interest Owed = $1,400,000,000,000 (24 trillion x 0.06)

So you can see, our interest payment approximately 5 years from now under the above stated conditions would climb to $1.4 trillion, or nearly a 500% increase from what we owe today. What do you think would happen to you economically if Uncle Sam needed 5 times the amount of tax revenue from you compared to what it takes today? I dare say this would be unsustainable for the average middle class family. But wait, it gets better…

Now let’s say that by 10 years from now, the current interest rate has tripled to 9%, and we then calculate what’s owed in interest based in the debt/interest metrics for the year 2020:

Debt in 2020 = $36,000,000,000,000
Interest rate on the Debt in 2020 = 9%
Interest Owed = $3,240,000,000,000 (36 trillion x 0.09)

So in 2020, under the stated conditions, the government would owe $3.24 trillion in interest, or nearly 1100% more than today. What would happen to you financially if the government required 11 times the tax revenue from you compared to today? Obviously, nothing good could come of this for the average American.

But unfortunately, the picture I just painted was intentionally semi-inaccurate, because I left out one major item: all of our entitlement programs. Let’s take a look at those:

All entitlements = approx $43,000,000,000,000 (based on 2008 figures), comprised of the following component expenses:
Social Security = $6,600,000,000,000
Medicare/Medicaid/Medicare Part D (prescription drugs for seniors) =$36,300,000,000,000

So the calculations I made earlier were actually devoid of the other $43 trillion dollar bill the government has racked up for the three major promises it made to us in the Social Security and Medicare/Medicaid programs. All of these programs begin to kick in earnestly around the 2017-18 time frame, and the spending just skyrockets from there. Needless to say, when you factor these conditions into the prior calculations, you get some very bad news if you happen to be a taxpayer in this country.

Suffice it to say before we move on the next part of this post, that the Congress’ orgiastic spending spree has bankrupted the country – you just don’t notice it yet because the bankruptcy is mostly on paper…for now. The fiscal challenge I outlined above is not speculation; it’s going to happen, the only questions are, how soon, and what agonizingly painful remedies will be instituted?

Having said all the above, we now move to the more short term crisis that looms ahead. There are a variety of factors that will/could potentially contribute to this crisis, but the most likely triggers lie (once again) in the now-familiar area of the housing market, and a new problem, that being the European debt crisis.

The European situation, which warrants greater analysis than I provide here, looks bad now, but has only just begun. The bailing out of Greece alone took abundant gnashing of teeth and then a $1 trillion aid package…all that for one country. What will happen in Europe and the global markets when Portugal, Italy, Ireland and Spain require similar treatment?

Pair that bleak picture with the US housing market. Recall for a moment that in 2008, the softening and then collapsing housing market was a major contributor to the economic misery that followed. At that time, one of the primary instigating factors was the subprime mortgage market, which comprised approximately 2% of all mortgages on the balance sheets of various banks. However, today there are other insidious categories of mortgages that are about to become popular in the news: the Alt-A and Option ARM (adjustable rate mortgage). These kinds of mortgages comprise closer to 30-40% of all the mortgages on the banks’ balance sheets (depending on whose estimates you read). Obviously, considerably more exposure lies in these kinds of mortgages versus the subprime variety. (There's $2.4 trillion tied up in Alt-A mortgages alone.)

Let’s take a closer look at Alt-A and Option ARMs. What are they? Essentially, they are less reliable than “prime” loans, made to the most financially stable customers, and more reliable than “sub-prime” loans, made to the least financially stable individuals. In both cases, the key aspect for the sake of our discussion in these mortgages is the fact that the interest rate attached to the loan is variable (a “teaser rate”), and at some future date, will reset to a new amount, depending on the prevailing interest rates at the time and/or the conditions of the original mortgage agreement. (In many cases, the whole point of these loans was to lure an individual into the agreement with a low interest rate, and then make up for the abnormally low interest later by raising the interest rate – hence the term “teaser rate”). Most of these loans were made in the 2005-06 time frame, with resets occurring around the 5 year mark. Therefore, these loans will see their interest rates reset in 2010-11.

Essentially, this means that at some point, the mortgage holder will see his or her mortgage amount increase at some point in the future. If you are an average middle class family, holding one of these mortgages, and your monthly mortgage rises from $1500 to $2000 or higher, what will this do both to your finances and to the overall economy? Well, from the family finances standpoint, the increased amount will obviously impact the remainder of the budget, and may be prohibitive to pay in and of itself. On top of this fact, if you’re already under water on your home (you owe more than the house is worth), you may very well be incentivized to simply walk away from your home and instead choose to rent. (Estimates abound that by 2011 at least half of US homeowner will be under water. Just last week data came in showing 1 in 7 homeowners is underwater and may be headed for foreclosure.) If you did this, you would effectively be telling the bank that lent you the money (and then possibly packaged your loan into an overall securitized investment and sold it to some other financial institution/investor) that you would be defaulting on the loan and no longer planned on sending in anymore mortgage payments. Clearly, this would quite negatively impact the banks, particularly if it occurred on a nationwide scale.

The other impact that this higher mortgage payment will have lies in the external consequences to the overall economy. If 30-40% of US families holding these resettable mortgages suddenly experiences a spike in their monthly mortgage obligation, it translates into a decreased degree of spending elsewhere. (Post-2008 crisis, it’s likely most families will not opt to continue spending on credit, as they’ve experienced a shift in mindset from the last time this happened and taken to increased saving habits.) This decrease in spending will send ripples through the rest of the US economy, which is based heavily (approximately 70%) on consumer spending and service-oriented industries (versus industries that create items to be sold/exported, such as manufacturing).

Thus, as the housing market softens and possibly collapses (again), and banks begin to witness mounting losses on their balance sheets in the mortgage area, and the consumer once again tightens his belt to deal with the crisis, the economy will experience a massive seizure based on the inability of banks to lend or extend credit and the service sector of the economy experiences large scale reductions in spending, thus reducing profit margins and creating waves of layoffs. This vicious cycle would clearly result in higher unemployment, deflated prices and business profits, and an imploding housing market and banking system. In essence, from a fractal perspective it would look like the 2008 crisis, but the actual implications financially and economically would be far more devastating. (Nassim Taleb discusses the use of fractals in understanding potential black swan events in his book The Black Swan – definitely worth reading.)

Combine the above prognostication with the beginning portion of this post. What if the crisis of 2010-11 occurs as I described (or something close to it), but at the same time the US government is in the middle of an accelerating debt crisis and needed to raise more revenue through taxes? The pairing of an economy in freefall with rising taxes is simply unconscionable, as it would be the final coup de grace for any semblance of the standard of living we enjoy today. If the government didn’t raise this money through taxes, it would only have one other place to get the money (assuming that borrowing more and thus raising the debt/interest payments higher was no longer a viable option): inflation (printing money). Unfortunately, the amount of inflation required to pay this bill is so incredibly high, there is almost no conceivable way it wouldn’t produce massive inflation, and possibly hyperinflation, leading to prices soaring astronomically (see 1920’s Germany for the endless examples of buying a loaf of bread for millions of German marks, etc).

As you can see, the road ahead is bleak for the US, no matter what permutation of specific scenarios you use. Somewhere along the line, and that sometime is in less than 10 years, taxes must be raised a lot, or government spending has to be reduced to spendthrift levels (is that even possible for this reckless Congress?) and entitlements must be reduced substantially (is that politically possible in this country?), or some moderate combination of both. But all of these attempted remedies carry great consequences, and would absolutely demand that an American people now used to the government caring for it in old age/retirement/unemployment would be left holding the bag. Losses of retirement, medical, and unemployment benefits due to the worsening economy and reduced government spending would exacerbate the problem by leaving more Americans jobless and no longer spending their money in an economy that requires spending to function (recall the 70% figure). In other words, the effects produced by these economic realities are exponential and have a cascading dimension to them, which means each year the situation could become drastically worse than the year before (making 2012 much worse than 2011; 2013 making 2012 look enjoyable; 2014 making 2013 look like an economic paradise…you get the picture).