The Illinois debt clock is ticking. Unless the Governor and the General Assembly set a budget in place by June 30, 2017, and a correctly balanced budget, Wall Street ratings agencies are expected to quickly downgrade the state’s credit to junk status.
To give you a clearer idea of just how big Illinois’ pension shortfall is, if Illinois cut all additional spending (like education) by 10 percent or increased taxes by enough to earn 10 percent more revenue and committed all savings or new revenue to its pension shortfall, it might take 20 years to fully fund the state pension system.
S&P Global Ratings has cautioned the agency will probably lower Illinois’ creditworthiness to below investment grade if feuding lawmakers don’t agree on a state budget for a third consecutive year, increasing the amount the state must pay to borrow money for items like building roads or refinancing existing debt.
Illinois Debt Clock
The prognosis for a deal is not good as lawmakers meet in Springfield for a special legislative session remained deadlocked with the July 1 beginning of the new financial year approaching. That should alarm everyone.
The Illinois debt clock shows more than $154.5 billion in debt here.
The fundamental process by which states get in such severe financial distress are well established. Public sector unions give state politicians large campaign donations in exchange for big, irresponsible future pension benefits. The state legislature then underfunds those pensions, keeping the citizens from realizing any short term pain from unfunded pensions. Unions do not object to the underfunding since they understand the law protects their pensions however bad the situation gets. Eventually, you’re Illinois, with a pension shortfall equivalent of about eighteen months of overall state spending.
The agencies are concerned about Illinois’ massive pension debt, in addition to a $15 billion backlog of unpaid bills and the fall in revenue that happened when lawmakers permitted a temporary income tax increase to expire.
Bond investors base their decision on whether to buy Illinois bonds on what degree of risk they are willing to take, according to the bond ratings that rating agencies such as Moody’s assign.
With near junk-rated status in Illinois, Chicago Public Schools are now paying the nation’s legal maximum of 9 percent interest on some of the borrowing it’s relied on to keep the doors open. The school system’s choices for additional fiscal juggling keep shrinking.
A junk score means that Illinois is in a greater risk of not repaying its debt. Now, many mutual funds and individual investors – who make up over half of the buyers in the bond market – will not buy Illinois bonds. Those willing to take a chance, like distressed debt investors, will only do so if they’re getting a higher rate of interest.
After the state pays higher rates of interest, that is less money it can use to pay for government services, or to decrease the growing $15 billion backlog of unpaid invoices.
There’s also a chance of what Standard & Poor’s has characterized as Illinois entering a negative credit spiral.
While no other state has ever been put at junk rating status, counties and cities like Chicago, Atlantic City and Detroit have. Detroit saw its score increased back to investment grade in 2015 as it emerged from bankruptcy, an alternative that by law, states do not have.
The additional interest charges anytime Illinois sells bonds will be in the “tens of thousands” of dollars or more. The more money the state has to pay on interest, the less that is available for things like schools, state parks, social services and fixing roads.
The issue of public pension plans being underfunded isn’t confined to Illinois. Other states are in nearly as bad condition and thousands of cities and counties also have underfunded pension plans.
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A weekly Saturday financial show that attempts to predict market direction for the week ahead by looking at a variety of fundamental and technical charts. This week’s show features commentary on Janet Yellen and the Federal Reserve’s strange timing of a rate hike, how Obama Administration diverted FNMA money and investors dividends into Affordable Care Act to keep it solvent, and the collapsing pension funds across America.
Pension funds in the US could be close to a collapse. There is an estimated $1.9 trillion shortfall in U.S. state and local pension funds because of low-interest rates and a sideways US stock market. Even stocks falling overseas is a problem for pension funds.
Credit Suisse published the chilling chart below on the funding gap at the largest 100 US pension funds.
Pensions count on annual investment gains of more than 7 percent to cover much of the benefits that come due as workers retire. But public plans had a median increase of 1 percent for the year ended June 30, the smallest advance since 2009, when they lost 16.2 percent, according to the Wilshire Trust Universe Comparison Service.
Now it seems like there is a run on the Dallas Police and Fire Pension as employees try to claim benefits before the system becomes insolvent.
Rhode Island plans to scale back its investments in hedge funds by more than $500 million over the next two years, and reallocate those funds to more traditional investments with lower fees.
Pension funds like Rhode Island are starting to be more defensive and are hunkering down. The problem though is that defensive US Treasury bonds mean way below 7 percent returns which means more shortfalls in funding are coming.
There’s no way pension funds can stay above water in an environment with low-interest rates and with equity markets at valuations that are sky high.
But wait, Democrats say everything is good, just look at consumer confidence that came out this week at 104.1.
There is massive offshoring of good paying US jobs, stagnant wages, soaring costs of health care and education, contraction in manufacturing, falling retail sales, and consumers pensions are dangerously close to collapse. Meanwhile, consumer confidence is hitting multi-year highs? Consumer confidence is starting to look like just another tool of public manipulation that’s out of touch with reality on the street.
Deutsche Bank may be on the verge of collapse. Last week Deutsche Bank reported Q2 2016 earnings of 20 million euros which is a 98% drop in earnings year-over-year.
In 2015, Deutsche Bank announced its first full year of loss since the 2008 recession.
Deutsche Bank’s stock is down -60% over the last year meaning that the bank is close to collapse.
Deutsche Bank’s shares now trade for two-thirds less than their tangible book value, a steeper discount than even during the depths of the financial crisis.
Beyond Germany, few stock traders care if Deutsche Bank collapses. The problem with Deutsche Bank collapsing is its enormous derivatives portfolio valued at 42 trillion euros! To put in perspective, the entire EU (all 28 member states) has an estimated GDP value of 14.3 trillion. Deutsche Bank’s 42 trillion euro derivatives portfolio is about three times the size of the entire EU!
One might think that with such a high exposure to the derivatives market, Deutsche Bank would have already collapsed. The reason Deutsche Bank has not collapsed is because of something called netting. For every derivative position Deutsche Bank holds, they hold another position in the opposite direction, so they roughly cancel each other out. At least that’s what Deutsche Bank is reporting that they are doing. Whether that is true or not remains to be seen. Why would anyone hedge their longs with shorts in a 1:1 ratio? You would never make any money from trading, and you would slowly lose on slippage. The OCC tracks netting on U.S. banks and does, in fact, show that even with netting, net current credit exposure (NCCE) has been rising rapidly since 2014.
When Deutsche Bank collapses, it is going to be the explosion heard around the world, and it will be a disaster many times greater than the collapse of Lehman Brothers in 2008.
US Derivatives Exposure
The big U.S. banks have higher exposures to derivatives than Deutsche Bank. As of June 30, 2016, below are U.S. banks with the largest derivative exposures.
Citigroup has amassed the largest stockpile of interest-rate swaps as they bet on central bank rate changes.
Five U.S. banks hold 93% of all derivatives: Citigroup, JPMorgan Chase, Goldman Sachs, Bank of America, and Morgan Stanley. The total value of these derivatives is $247 trillion (notional).
Morgan Stanley has $31 trillion in derivatives with $1.6 trillion (notional) in credit derivatives. What is scary is that Morgan Stanley is back to speculating in the same credit derivatives market that took down AIG in 2008. I don’t think Morgan Stanley necessarily wants to speculate in credit derivatives but with revenue flat the last few years, they may be getting more desperate to prop up their stock price. Morgan Stanley’s stock is down more than -25% over the last year.
Most traders in the U.S. don’t care about Morgan Stanley’s risky credit derivatives portfolio, but they should. Morgan Stanley has more than 15,770 retail brokers managing $404 billion of other people’s money (mom and pop savings, retirees, pensions, retirement accounts, etc.cause). Morgan Stanley’s risky credit derivatives position poses a huge threat to the investing community in my opinion.
Banks and Financial Firms Will Not Disclose Information Until It’s Too Late
If you are waiting for banks and financial firms to disclose risks and even how much they were bailed out from the last time they made risky credit derivative bets, don’t.
To survive the 2007-2009 Wall Street crash, Morgan Stanley received an injection of $9 billion from the Japanese bank, Mitsubishi UFJ Financial Group; a $10 billion injection from the U.S. government and over $2 trillion in secret, cumulative, below-market-rate loans from the Federal Reserve. According to data obtained by Bloomberg News following a multi-year court battle to obtain the information from the Federal Reserve, Morgan Stanley’s one-day secret outstanding loans from the Fed peaked at $107.3 billion on September 29, 2008.
The public would have never known about these secret loans shoring up Wall Street’s reckless conduct and hubris and obscene bonuses except for the court battle of Bloomberg News and legislation secured by Senator Bernie Sanders of Vermont requiring a Fed accounting.
Credit Derivatives Exposure On the Rise In the US
The Office of the Comptroller of the Currency reports some scary facts in their most recent quarterly OCC report.
– Insured U.S. commercial banks and savings associations reported trading revenue of $5.8 billion in the first quarter of 2016… $1.9 billion lower (24.9 percent) than a year earlier. [In my opinion, when trading revenues are down, trading divisions take on more risks in a desperate attempt to meet quotas like buying riskier credit derivatives as the data points below confirm].
– Credit exposure from derivatives increased in the first quarter of 2016. Net current credit exposure (NCCE) increased $65.1 billion, or 16.5 percent, to $460.1 billion.
– Notional derivatives increased $12.0 trillion, or 6.6 percent, to $192.9 trillion.
– Derivative contracts remained concentrated in interest rate products, which represented 76.3 percent of total derivative notional amounts.
Measuring credit exposure in derivative contracts involves identifying those contracts where a bank would lose value if the counterparty to a contract defaulted. The total of all contracts with positive value (i.e., derivative receivables) to the bank is the gross positive fair value (GPFV) and represents an initial measurement of credit exposure. The total of all contracts with negative value (i.e., derivative payables) to the bank is the gross negative fair value (GNFV) and represents a measurement of the exposure the bank poses to its counterparties.
GPFV increased by $0.8 trillion (26.6 percent) in the first quarter of 2016 to $3.8 trillion, driven by a 29.9 percent increase in receivables from interest rate and FX contracts. Because interest rate contracts make up 76.2 percent of total notional derivative contracts, changes in interest rates drive credit exposure in derivative portfolios. Declines in interest rates tend to increase exposure. This effect has increased in recent years, as the maturity profile of interest rate derivatives has increased, making credit exposure more sensitive to changes in longer-term rates.
Credit risk exposure increased a whopping 26.6% in Q1 2016. Much of that increased credit risk exposure is coming from bets on Federal Reserve rate hikes. If interest rates go up, credit risk exposure in derivative positions goes down. If interest rates go down, credit risk exposure goes up. In other words, most of the bets in the derivatives market are on interest rates rising. Better hope Janet Yellen doesn’t have to lower interest rates!
Credit Default Swaps Dwarf All Other Forms of Derivatives
Credit default swaps dwarf any other form of credit derivative trading.
The notional amount for the 54 insured U.S. commercial banks and savings associations that sold credit protection (i.e., assumed credit risk) was $3.6 trillion, up $206.4 billion (6.0 percent) from the fourth quarter of 2015. The notional amount for the 50 banks that purchased credit protection (i.e., hedged credit risk) was $3.8 trillion, $224.9 billion higher (6.3 percent) than in
the fourth quarter of 2015.
It is interesting that many people are reporting having received a letter from their credit card company informing them that their interest rate is going up from 19.9% to 25% in August 2016. Some people have even reported receiving credit limit increase letters too. How kind of these bankers to go long credit default swaps while raising your credit limit and interest rate to insane levels at the same time.
Folks derivatives are dark financial products that cause excessive risk taking that ultimately leads to disaster. I have little doubt that the next global financial crisis will, at its core, once again involve speculative derivatives betting.