Debt

GE’s Angolan Kwanza exposure

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Sell-side analysts rarely read through the fine print of an annual report. Hidden away in the prose, one can find some pretty eye-opening paragraphs. From GE’s 2017 Annual Report,

“As of December 31, 2017, we held the U.S. dollar equivalent of $0.6 billion of cash in Angolan kwanza. As there is no liquid derivatives market for this currency, we have used Angolan kwanza to purchase $0.4 billion equivalent bonds issued by the central bank in Angola (Banco Nacional de Angola) with various maturities through 2020 to mitigate the related currency devaluation exposure risk. The bonds are denominated in Angolan kwanza as U.S. dollar equivalents, so that, upon payment of periodic interest and principal upon maturity, payment is made in Angolan kwanza, equivalent to the respective U.S. dollars at the then-current exchange rate.”

On that basis the marked to market figure is actually another $250mn hole in 2017. One wonders what the exchange rate will be in 2020? Furthermore at what level will Travelex or Thomas Cook exchange that for? It would be safe to assume the ‘bid/offer’ spread will be horrendous. GE might find it more useful to run a Nigerian mail scam to hedge the expected losses. For a company as large as GE, potentially losing $850mn should look like a rounding error unless the company is bleeding as the monster is. GE took a pretax charge of $201mn on its Venezuela operations.

We shouldn’t forget that “GE provides implicit and explicit support to GE Capital through commitments, capital contributions and operating support. As previously discussed, GE debt assumed from GE Capital in connection with the merger of GE Capital into GE was $47.1 billion and GE guaranteed $44.0 billion of GE Capital debt at December 31, 2017. See Note 23 to the consolidated financial statements for additional information about the eliminations of intercompany transactions between GE and GE Capital.

As 13D Research noted, “GE spent roughly $45 billion on share buybacks over 2015 & 2016  despite the shares trading well above today’s levels all the while ignoring the $30 billion+ shortfall in its pensions. Management disclosed in a recent analyst meeting that it would have to borrow to fund a $6 billion contribution to its pension plans next year, as well as chopping capex by 26% in 2018.

As mentioned yesterday, there are some who have faith in the sustained turnaround in medical. Indeed it has seen some top line and margin improvement but management seems more concerned with focusing on cutting costs than pushing innovation. Efficiency drives should be part and parcel of all businesses but one must hope CEO John Flannery has far bigger hopes for its market share leading product line (which GE admits facing pricing pressure in some segments) than trimming the staff canteen cookie tin.

GE remains a risky investment. Flannery has it all to prove and to date his performances have been anything but inspiring. GE feels like a business suffering from the divine franchise syndrome synonymous with former CEO Jack Welch. That dog eat dog culture seems to be biting its own tail.

 

 

Cutting back on the Tesla staff cookie tin

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Where have we heard this before? When companies look to tighten the belt, bosses often pat themselves on the back by cutting back on ‘unnecessary expenses’ like staff coffee room biscuits. That somehow over a 12 month period a company hemorrhaging millions has saved $832.67 on cookie cutting. Maybe $1,239.31 on fewer newspaper subscriptions. Well it seems Tesla’s Elon Musk is getting tough on approvals. Well he might especially after claims he doesn’t need a capital raise and made wise cracks about going bankrupt on April fool’s day.

Musk tweeted that his finance team were going to be out to trim back on any expense deemed not vital to the cause. All $1mn approvals must be solely signed off by the CEO himself. Suchnis the extent of ‘production hell’ he has moved to 24-7 shifts to hit his slated targets.

His email also bragged,

It is extremely rare for an automotive company to grow the production rate by over 100% from one year to the next. Moreover, there has simultaneously been a significant improvement in quality and build accuracy…

Indeed it is extremely rare to have auto companies doubling production year over year because most companies never plan to improvise their manufacturing  methods to start with. Toyota doesn’t meet a week before starting a new vehicle build and have a thought bubble. “Tanaka-san, did you get hold of Fanuc to see if they have any spare robots they can install by Friday?” Moreover the quality improvements are also a celebration of dreadful moving to mediocre. These aren’t achievements in any manufacturers book. They’re a candid admission of ‘amateur hour’

Musk continued,

Any Tesla department or supplier that is unable to do this will need to have a very good explanation why not, along with a plan for fixing the problem and present that to me directly. If anyone needs help achieving this, please let me know as soon as possible. We are going to find a way or make a way to get there.”

Seriously? It is a rather frightening prospect now that the CEO, whom took over the production floor several weeks ago, is sending a  crisis stations email to staff and suppliers.

His levels of lashing out of late seem somewhat concerning. Two weeks ago he accused the NTSB of lacking credibility by kicking off Tesla in the investigation panel into the recent death caused of a driver in California who had relied on autopilot Attaking the regulator is never a wise move. Worse, he blamed the driver in response to a lawsuit launched by the deceased’s family claiming he put too much faith in a system he champions as smarter than humans. Which is it?

Musk’s full letter to employees is here but perhaps he should take a lead out of the Riva Aquarama production line book. Carlo Riva built the Ferrari of yachts with excruciating attention to detail. All the different stages of production crew had different coloured jackets on. When looking out his window if he ever saw colours mingling he knew he had a problem.

Musk talks the confidence game but the pressure is bearing down on him. Senior departures, impending court actions and a production system that has been found wanting after such a short period of time that major changes need to be enacted because the original concept was so poorly thought out. So much for sensible factory capex allocation.

Elon Musk also made surprising remarks about the new found existence of sub suppliers. Musk can’t  lick his finger to find the direction of the wind forever. This is rookie level discovery. Frankly shareholders should be very concerned.

Waking up to a horror of our own creation

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Some will say I am a pessimist. I’d prefer to be called an optimist with experience. At only age 16 (in 1987) I realized the destructive power financial markets had on the family home. Those memories were etched permanently. We weren’t homeless or singing for our supper but things sure weren’t like they use to be. It taught me much about risk and thinking all points of view rather than blindly following the crowd. That just because you were told something by authority it didn’t mean it was necessarily true. It was to critically assess everthing without question.

In 1999, as an industrials analyst in Europe during the raging tech bubble, we were as popular as a kick in the teeth. We were ignored for being old economy. That our stocks deserved to trade at deep discounts to the ‘new economy’ tech companies, no thanks to our relatively poor asset turnover and tepid growth rates. The truest sign of the impending collapse of the tech bubble actually came from sell-side tech analysts quitting their grossly overpaid investment bank salaries for optically eye-watering stock options at the very tech corporations they rated. So engrossed in the untold riches that awaited them they abandoned their judgement and ended up holding worthless scrip. Just like the people who bought a house at the peak of the bubble telling others at a dinner party how they got in ‘early’ and the boom was ahead of them, not behind.

It was so blindingly obvious that the tech bubble would collapse. Every five seconds a 21 year old with a computer had somehow found some internet miracle for a service we never knew we needed. The IPO gravy train was insane. One of my biggest clients said that he was seeing 5 new IPO opportunities every single day for months on end. Mobile phone retailers like Hikari Tsushin in Japan were trading at such ridiculous valuations that the CEO at the time lost himself in the euphoria and printed gold coin chocolates with ‘Target market cap: Y100 trillion.’ The train wreck was inevitable. Greed was a forgone conclusion.

So the tech bubble collapsed under the weight of reality which started the most reckless central bank policy prescriptions ever. Supposedly learning from the mistakes of the post bubble collapse in Japan, then Fed Chairman Alan Greenspan turned on the free money spigots. Instead of allowing the free market to adjust and cauterize the systemic imbalances, he threw caution to the wind and poured gasoline on a raging fire. Programs like ‘Keep America Rolling’ which tried to reboot the auto industry meant cheaper and longer lease loans kept sucking consumption forward. That has been the problem. We’ve been living at the expense of the future for nigh on two decades.

Back in 2001, many laughed me out of court for arguing Greenspan would go down in history as one of the most hated central bankers. At the time prevailing sentiment indeed made me look completely stupid. How could I, a stockbroker, know more than Alan Greenspan? It was not a matter of relative educations between me and the Fed Chairman, rather seeing clearly he was playing god with financial markets.  The Congressional Banking Committee hung off his every word like giddy teenagers with a crush on a pop idol. Ron Paul once set on Greenspan during one of the testimonies only to have the rest of the committee turn on him for embarrassing the newly knighted ‘Maestro.’ It was nauseating to watch. Times seemed too good so how dare Paul question a central bank chief who openly said, “I know you think you understand what you thought I said but I’m not sure you realize that what you heard is not what I meant.”

We all remember the horrors of the collapse of Lehman Brothers and the ensuing Global Financial Crisis (GFC) in September 2008. The nuclear implosions in credit markets had already begun well before this as mortgage defaults screamed. The 7 years of binge investment since the tech bubble collapse meant we never cleansed the wounds. We would undoubtedly be in far better shape had we taken the pain. Yet confusing products like CDOs and CDSs wound their way into the investment portfolios of local country towns in Australia. The punch bowl had duped even local hicks to think they were with the times as any other savvy investor. To turn that on its head, such was the snow job that people who had no business being involved in such investment products were dealing in it.

So Wall St was bailed out by Main St. Yet instead of learning the lessons of the tech bubble collapse and GFC our authorities doubled down on the madness that led to these problems in the first place. Central banks launched QE programs to buy toxic garbage and lower interest rates to get us dragging forward even more consumption. The printing presses were on full speed. Yet what have we bought?

Now we have exchange traded funds (ETFs). Super simple to understand products. While one needed a Field’s Medal in Mathematics to understand the calculations of a CDO or CDS, the ETF is child’s play. Sadly that will only create complacency. We have not really had a chance to see how robots trade in a proper downturn. ETFs follow markets, not lead them. So if the market sells off, the ETF is rapidly trying to keep up. Studies done on ETFs (especially leveraged products) in bear markets shows how they amplify market reactions not mitigate them. So expect to see robots add to the calamity.

Since GFC we’ve had the worst post recession recovery in history. We have asset bubbles in bonds, stocks and property. The Obama Administration doubled the debt pile of the previous 43 presidents in 8 years. Much of it was raised on a short term basis. This year alone, $1.5 trillion must be refinanced.  A total of $8.4 trillion must be refinanced inside the next 4 years. That excludes the funding required for current budget deficits which are growing despite a ‘growing economy’. That excludes the corporate refinancing schedule. Many companies went out of their way to laden the balance sheet in cheap debt. In the process the average corporate credit rating is at its worst levels in a decade. Which means in a market where credit markets are starting to price risk accordingly we also face a Fed openly saying it is tapering its balance sheet and the Chinese and Japanese looking to cut back on US Treasury purchases. Bond spreads like Libor-OIS are already reflecting that pain.

Then there is the tapped out consumer. Unemployment maybe at record lows, yet real wage growth does not appear to be keeping up. The number of people holding down more than one job continues to rebound. The quality of employment is terrible. Poverty continues to remain stubbornly high. There are still three times as many people on food stamps in the US than a decade ago – 41 million people. Public pension unfunded liabilities total $9 trillion. Credit card delinquencies at the sub prime end of town are  back at pre-crisis levels. We could go on and on. Things are terrible out there. Should we be in the least bit surprised that Trump won? Such is the plight of the silent majority, still delinquent after a decade. No wonder Roseanne appeals to so many.

A funny comment was sent by a dyed-in-the-wool Democrat, lambasting Trump on his trade policies. He criticized the fact that America had sold its soul for offshoring for decades. Indeed it had but queried that maybe he should be praising Trump for trying to reverse that tide, despite being so late to the party. Where were the other administrations trying to defend America all this time? Stunned silence.

Yet the trends are ominous. If we go back to the tech bubble IPO-a-thon example. We now have crowd funding and crypto currencies. To date we had 190 odd currencies to trade. Of that maybe a handful were liquid – $US, GBP, JPY, $A, Euro etc – yet we are presented with 1,000s of crypto currency choices. Apart from the numerous breaches, blow ups and cyber thefts to date, more and more of these ‘coins’ are awaiting the next fool to gamble away more in the hope of making a quick buck. Cryptos are backed by nothing other than greed. Yet it sort of proves that more believe that they are falling behind enough such they’re prepared to gamble on the biggest lottery in town. One crypto used Wikipedia as a source for its prospectus.

Yet the media remains engrossed on trying to prove whether the president had sex with a porn star a decade ago, genderless bathrooms, bashing the NRA, pushing for laws to curtail free speech, promoting climate change and covering up crime rather than look at reporting on what truly matters – the biggest financial collapse facing us in 90 years.

There is no ‘told you so’ in any of this. The same feelings in the bones of some 30 years ago are back as they were at the time of Greenspan and Lehman. This time can’t be avoided. We have borrowed too much, saved too little and all the while blissfully ignored the warning signs. The faith and confidence in authorities is evaporating. The failed experiment started by Greenspan is coming home to roost. This will be far worse than 1929. Take that to the bank, if it is still in operation because you won’t be concerned about the return on your money but the return of it!

Worst Q2 start for S&P 500 since 1929

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ZeroHedge reported today that the S&P had its worst percentage 2nd quarter start since 1929 overnight. Both the Dow Jones Industrial Average broke below the 200 day moving average before an at the death rally to close above. Plunge Protection Team (PPT)? The broader S&P 500 failed to hold the 200 dma. All feels ominous. Awaiting the dead cat bounce. Short dated out of the money index put options continue to look ridiculously cheap relative to other asset classes. Gold also having a good day. Bitcoin showing its true value sliding below $7.000. Best to remember in a bear market the winner is the one who loses the least.

Credit card delinquency in America – nothing to see here?

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Waltzing through the treasure trove of data at the St Louis Fed, this chart intrigued. It shows delinquency rates on credit cards among the smaller banks. Presumably the smaller banks have to chase less credit worthy customers because they lack the ultimate battleship marketing cannons of the bigger financial instititutions. We’re back at times worse than the highest levels seen during GFC. Among all banks, we are still away off the $40bn of delinqient credit card debts we’re back at levels higher than those before Lehman’s brought financial markets to a grinding halt.

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Add to that the step up in interest rates as well to levels we saw before the whole edifice of cards came crumbling down.

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Then why worry when the number of financial institutions looking to tighten standards on consumer lending languishes at close to zero, the types of levels we saw ahead of the market collapse? Nothing to see here?

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Meanwhile American household savings languish at 3%. Similar levels as just before GFC  melt down. Not much in the rainy day funds. So when Trump’s new economic policy advisor Larry Kudlow starts telling us to back a strong dollar and weak gold, you know exactly what to do.

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Moral hazard was supposed to be contained at the private sector level. Looks as though this time around the government is joining the party.

Should we trust ratings agencies on US state credit?

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The Financial Crisis Inquiry Commission concluded in 2011 that “the global financial crisis could not have happened without the ‘Big Three’ agencies – Moody’s, Standard & Poor’s and Fitch which allowed the ongoing trading of bad debt which they gave their highest ratings to despite over three trillion dollars of mortgage loans to homebuyers with bad credit and undocumented incomes.” The table above tabulates the deterioration in US corporate credit ratings since 2006. The ratings agencies have applied their trade far more diligently.

As written earlier in the week, US state public pensions are running into horrific headwinds. Unfunded pension liabilities are running at over double the level of 2008. With asset bubbles in stocks, bonds and property it is hard to see how plugging the gap (running at over 2x (California is 6x) the total tax take of individual states) in the event of a market correction is remotely realistic. However taking a look at the progression of US states’ credit ratings one would think that there is nothing to worry about. Even during GFC, very few states took a hit. See below.

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Looking at the trends of many states since 2000, many have run surpluses so the credit ratings do not appear extreme. It is interesting to flip through the charts of each state and see the trajectory of revenue collection. A mixed bag is putting it lightly. Whether the rebuild after Hurricane Katrina in 2005, since 2008 revenue collection in Louisiana has drifted.

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Looking through S&P’s own research at the end of last year it included an obvious reference.

U.S. state and local governments can use pension obligation bonds (POBs) to address the unfunded portion of their pension liabilities. In certain cases, POBs can be an affordable tool to lower unfunded pension liabilities. But along with the issuance of POBs comes risk. The circumstances that surround an issuance of POBs, as well as the new debt itself, could have implications for the issuer’s creditworthiness. S&P Global Ratings views POB issuance in environments of fiscal distress or as a mechanism for short-term budget relief as a negative credit factor.”

Perhaps the agencies have learnt a painful lesson and trying to stay as close to being behind the curve as possible. It doesn’t seem like public pensions are being factored at levels other than their actuarial values. Marked-to-market values would undoubtedly impact these credit ratings.

As mentioned in the previous piece on public pensions, a state like Alaska has public pension unfunded liabilities equal to $145,000 per household, treble the 2008 figure. It is 3.5x annual tax collections. The state’s per capita operating budget of $13,728 per person is way above the national average of $6,826 per person. Alaska relies on oil taxes to finance most of its operating budget, so a sudden drop in oil prices caused tax revenues to sharply decline. The EIA’s outlook doesn’t look promising in restoring those fortunes in any scenario. So S&P may have cut Alaska two places from AAA in 2015 to AA in 2017.

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While pension liabilities aren’t all due at once, the last 8 years have shown how quickly they can fester. It wasn’t so long ago that several Rhode Island public pension funds reluctantly agreed to a 40% haircut, later retirement ages and higher contributions with a larger component shifted from defined benefits to defined contributions raising the risk of market forces exerting negative outcomes on the pension fund.

In 2017, despite a ‘robust’ economy, 22 states faced revenue shortfalls. More states faced mid-year revenue shortfalls in the last fiscal year than in any year since 2010, according to the National Association of State Budget Officers.

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Pew Charitable Trust (PCT) notes in FY2015 federal dollars as a share of state revenue increased in a majority of states (29). Health care grants have been the main driver of this. FY2015 was the 3rd highest percentage of federal grants to states since 1961.

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By state we can see which states got the heftiest federal grants. Most states with higher federal shares expanded their Medicaid programs under Obamacare (ACA) and got their first full year of grants under the expanded program in FY2015.

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PCT also wrote “At the close of fiscal year 2017, total balances in states’ general fund budgets—including rainy day funds—could run government operations for a median of 29.3 days, still less than the median of 41.3 days in fiscal 2007…North Dakota recorded the largest drop in the number of days’ worth of expenses held in reserves after drawing down almost its entire savings to cover a budget gap caused by low oil prices. It held just 5.4 days’ worth of expenditures in its rainy day fund at the end of fiscal 2017 compared with 69.4 days in the preceding year… 11 states anticipate withdrawing from rainy day funds under budget plans enacted for fiscal 2018

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Looking at the revenue trends of certain states, the level of collection has been either flat or on the wane since 2010 for around 26 states. As an aside, 23 of them voted for Trump in the 2016 presidential election. The three that didn’t were Maine, NJ and Illinois.

Optically US states seem to be able to justify the credit ratings above. Debt levels aren’t high for most. Average state debt is around 4% of annual income. Deficits do not seem out of control. However marking-to-market the extent of public pension unfunded liabilities makes current debt levels look mere rounding errors.

Considering stock, bond and property bubbles are cruising at unsustainably high levels, any market routs will only make the current state of unfunded liabilities blow out to even worse levels. The knock on effects for pensioners such as those taking a 40% haircut in Rhode Island at this stage in the cycle can only feasibly brace themselves for further declines. This is a ticking time bomb. More states will need to address the public pension crisis.

A national government shelling out c.$500bn in interest payments on its own debt in a rising rate environment coupled with a central bank paring back its balance sheet limits the options on the table. Moral hazard is back on the table folks. Is it any wonder that Blackstone has increased its short positions to $22 billion?

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Truly sickening US Public Pensions data

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Following on from the earlier post and our 2016 report on the black hole in US state public pension unfunded liabilities, we have updated the figures to 2016. It is hard to know where to start without chills. The current state of US public pension funds represents the love child of Kathy Bates in Misery and Freddie Krueger. Actuarial accounting allows for pension funds to appear far prettier than they are in reality. For instance the actuarial deficit in public pension funds is a ‘mere’ $1.47 trillion. However using realistic returns data (marking-to-market(M-2-M)) that explodes to $6.74 trillion, 4.6-fold higher.  This is a traffic accident waiting to happen. US Pension Tracker illustrates the changes in the charts presented.

Before we get stuck in, we note that the gross pension deficits do not arrive at once. Naturally it is a balance of contributions from existing employees and achieving long term growth rates that can fund retirees while sustaining future obligations. CM notes that the problems could well get worse with such huge unfunded liabilities coinciding with bubbles in most asset classes. Unlike private sector pension funds, the states have an unwritten obligation to step up and fill the gap. However as we will soon see, M-2-M unfunded liabilities outstrip state government expenditures by huge amounts.

From a layman’s perspective, either taxes go up, public services get culled or pensioners are asked politely to take a substantial haircut to their retirement. Apart from the drastic changes that would be required in lifestyles, the economic slowdown that would ensue would have knock on effects with state revenue collection further exacerbating a terrible situation.

CM will use California as the benchmark. Our studies compare 2016 with 2008.

The chart above shows the M-2-M 2016 unfunded liability per household. In California’s case, the 2016 figure is $122,121. In 2008 this figure was only $36,159. In 8 years the gap has ballooned 3.38x. Every single state in America with the exception of Arizona has seen a deterioration.

The following chart shows the growth rate in M-2-M pension liabilities to total state expenditure. In California’s case that equates to 3.2x in those 8 years.

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Sadly it gets worse when we look at the impact on current total state expenditures these deficits comprise. For California the gap is c.6x what the state spends on constituents.

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Then taking it further,  in the last 8 years California has seen a 2.62-fold jump in the gap between liabilities and state total expenditures.

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This is a ticking time bomb. Moreover it is only the pensions for the public sector. We have already seen raids on particular state pension funds with some looking to retire early merely to cash out before there is nothing left. Take this example in Illinois.

Sadly the Illinois Police Pension is rapidly approaching the point of being unable to service its pension members and a taxpayer bailout looks unlikely given the State of Illinois’ mulling bankruptcy. Local Government Information Services (LGIS) writes, At the end of 2020, LGIS estimates that the Policemen’s Annuity and Benefit Fund of Chicago will have less than $150 million in assets to pay $928 million promised to 14,133 retirees the following yearFund assets will fall from $3.2 billion at the end of 2015 to $1.4 billion at the end of 2018, $751 million at the end of 2019, and $143 million at the end of 2020, according to LGIS…LGIS analyzed 12 years of the fund’s mandated financial filings with the Illinois Department of Insurance (DOI), which regulates public pension funds. It found that– without taxpayer subsidies and the ability to use active employee contributions to pay current retirees, a practice that is illegal in the private sector– the fund would have already run completely dry, in 2015…The Chicago police pension fund held $3.2 billion in assets in 2003. It shelled out $3.8 billion more in benefits to retired police officers than it generated in investment returns between 2003 and 2015…Over that span, the fund paid out $6.9 billion and earned $3.0 billion, paying an additional $134 million in fees to investment managers.”

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To highlight the pressure such states/cities could face, this is a frightening example of how the tax base can evaporate before one’s eyes putting even more pressure on bail outs.

This problem is going to get catastrophically worse with the state of bloated asset markets with puny returns. Looking at how it has been handled in the past Detroit, Michigan gives some flavor. It declared bankruptcy around this time three years ago. Its pension and healthcare obligations total north of US$10bn or 4x its annual budget. Accumulated deficits are 7x larger than collections. Dr. Wayne Winegarden of George Mason University wrote that in 2011 half of those occupying the city’s 305,000 properties didn’t pay tax. Almost 80,000 were unoccupied meaning no revenue in the door. Over the three years post the GFC Detroit’s population plunged from 1.8mn to 700,000 putting even more pressure on the shrinking tax base.

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