Here Comes Trouble: Three Problems

The CBO's annual Social Security Update is out, and its pretty ugly:

This is pretty ugly; we were not supposed to have a negative income-to-outlay view on Social Security for another decade or so.

Well, the recession fixed that.  Tax receipts are in the toilet but outlays sure aren't. 

This is a major problem - everyone wants to point to the "zero hour" for Social Security when the "trust fund" goes negative, as is shown in this graph:

This, unfortunately, is terribly misleading.  The Social Security "Trust Fund" contains nothing other than IOUs.  That is, it does not contain money, it contains "special" Treasury Bonds that form part of the "public debt."

How much? According to Treasury, about $4.3 trillion dollars worth.

But here's the issue - those aren't bonds or bills that the Social Security system can sell as it sees fit.  They're what are called "intragovernmental holdings", with the key focus there being the last part of the first word: mental, which is what you have to be to do something like this.

Here's the issue: Since these are not marketable securities the Social Security system cannot sell them to raise cash.  It must instead "redeem" them with Treasury, forcing Treasury to cough up actual cash.  This in turn requires Treasury to sell more bills or bonds to the public, since Treasury is operating with a deficit running (at present) more than $1.5 trillion dollars annually.

So the correct view of when Social Security (and Medicare!) is in trouble is not in 2037 or whatever, it is now, because the cash flow requirements are going to force the government to sell even more bonds to the public in order to pay supposedly-guaranteed "benefits."

What happens when you sell bonds into a saturated market?  Yields go up.  Maybe a lot - which of course makes your interest payments go up.  This can quickly turn into a self-reinforcing cycle that does critical damage to the federal budget.  This can get rather interesting - fast.

That's bad.  Now let's add the other two issues to the mix for the "worse."

We'll start with China:

Aug. 21 (Bloomberg) -- China plans to tighten capital requirements for banks, threatening to curb the record lending that’s fueled a 60 percent rally in the nation’s stock market, three people familiar with the matter said.

The China Banking Regulatory Commission sent draft rule changes to banks on Aug. 19 requiring them to deduct all existing holdings of subordinated and hybrid debt sold by other lenders from supplementary capital, said the people, who have seen the document. Banks have until Aug. 25 to give feedback, said the people, declining to be named as the matter is private.

Let's be clear: The Chinese index has doubled over the last couple of months because the Chinese banking system has been handing out money like candy, much of it going directly into the stock market as speculators take out loans to buy stocks.  This is a major problem because China's market does not have the sort of formal margin controls and requirements that the US (and most other nation's) market has; there is no ability to short, for example.  As a consequence if the market were to dive (it has "corrected" some 20% off its recent high) it could bankrupt not only lots of individual investors but also the bank that made the loan, since the speculator will be wiped out and almost certainly has nothing else to collect from!

This lending soundness problem has been compounded by the Chinese banks selling securities to each other and then counting them against their second-level "Tier 2" capital.  In effect there has been no public sale and no actual cash changing hands for this debt; the banks have been practicing a circle-jerk of "liquidity", somewhat similar to what has happened in the US with Bernanke buying back Treasury issues less than a week later.  This of course is extraordinarily dangerous in that it creates an interconnected web of firms that can blow each other up if they fail, similar to what happened with Bear Stearns and Lehman.

It's amusing how the Chinese will chastise us for having inadequate controls over rampant speculation and derivatives, yet when it comes to their own banking system they let the party go on until a parabolic blow-off appears to be well underway before saying "heh wait a second - there's no real money in this game; everyone is passing bonds off to one another and pretending they're raising actual capital!"

Needless to say if this blows up it will have dramatic (and really ugly) consequences for the Chinese economy, and will filter over here.  Bet on it.

Finally, we have the Eurozone putting up a surprise this morning:

Aug. 21 (Bloomberg) -- The euro rose and European stocks gained after services in Germany and manufacturing in France unexpectedly expanded, reinforcing speculation that the global recession is easing. U.S. index futures advanced.

Well, yes.  But the futures advanced because of this:

The pattern of the last couple of months remains intact - Dollar dives, stocks go higher as "hot money" comes out to play.  The problem with this sort of move is that it is exactly backwards; a weak dollar isn't the siren call of good things, quite to the contrary.

If that nice pink line breaks there's little left to hold - there is a chop zone around 76 (where an island was left before) and then a final support level down around 71-72. 

Below that?  Nothing.  The dollar has never been there.

Worse, there's an argument to be made that the spike high at the end of 08 and into 09's market lows was a failed breakout - meaning that we're headed (at minimum) down to the 72 area.  A break under 72 could take the Dollar to 40, which would force oil prices upward dramatically, taking out the old highs with ease, instantly destroying any hope of economic recovery.

Tough choices here, although I would characterize it more as "damned if you do (tighten up liquidity) and defend the dollar, but doubled-damned straight to Hell if you don't."

We live in interesting times.....