Bankruptcy

The day Elon Musk gets asked by…

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Elon Musk said in the FY2017 conference call today: “Super Bullish…What I find sort of interesting is that our competitors – the car industry thinks they’re really good at manufacturing. And actually they are quite good at manufacturing, but they just don’t realize just how much potential there is for improvement. It’s way more than they think…I went through this math I think on a prior earnings call, but like it sounds like some of the fastest car factories produce a car maybe every 25 seconds. That sounds fast. But if you think of a 5-meter long car, including gap, and a 4.5 meter car with a half meter gap or something, that’s only 0.2 meters per second. Like grandma with a walker can exceed the speed of the fastest production line we’re in, so really no that fast. Walking speed is one meter per second, so five times faster than the fastest production line on earth.”

Listening to commentary like this just shows how cavalier the processes at Tesla are. The day Tesla gets called in by other kings of industry for lessons on production techniques the comment will hold water.

Toyota, which has coined almost every manufacturing effficiency jargon over 50 years, was invited by Porsche to fix its problems in the 90s. Several years ago Toyota was called in to help Lockheed Martin streamline production of the F-35 Joint Strike Fighter because of the massive cost overruns. The day Boeing calls up Elon Musk for tips on how to belt out more 787s two slices of humble pie will be consumed immediately.

Seriously one has to question how this board can believe it has the potential to be worth more than all the other volume and luxury auto majors combined when they make such fictitious claims. Sounds like Sakamoto from Elpida promising endless dreams. Elpida went belly up because it failed to deliver. .

Healthcare in America – more hospitals going bankrupt

The Affordable Care Act (Obamacare) is often lauded by some as noble legislation. Yet according to bankruptcy lawyers, Polsinelli, the changes made to reimbursements that used to help cover hospitals who treated uninsured patients were pulled under ACA and have sent many hospitals to the bankruptcy A&E ward. The law firm said in its report,

The Health Care Services Distress Research Index was 223.33 for the third quarter of 2017. The Health Care Distress Index increased 15 points from last quarter. The index has experienced record or near-record highs in 5 of the last 6 quarters. Compared with the same period one year ago, which was a record high at that time, the index has increased 60 points. Compared with the benchmark period of the fourth quarter of 2010, the index is up over 123 percent…Unlike the public markets, the Polsinelli/TrBK Distress Indices include both public and private companies, creating a broader economic view and one which may show developing trends on Main Street before they appear on Wall Street….Health care distress is high and it seems to be getting worse…

…The business of health care is unlike other industries, such as manufacturing, real estate, or retail. Health care faces all the traditional business challenges, such as competition, the impact of technology on services, and increasing wages. But more, the health care industry is needing to adapt to increasing regulations, changes in reimbursement rates from government or private payors, and a shift from traditional fee-for-service to value-based models that impact profitability…There is unprecedented pressure of major systemic changes to the existing health care system, particularly the implementation of the Affordable Care Act over the last several years and the current status of the program, which is alternately being repealed, repealed and replaced, phased out, or simply defunded…The administration’s recent decision to terminate cost sharing reduction payments will also directly impact the health care market. Insurance companies may continue to provide insurance at a higher premium or decide to exit the markets. Eliminating these payments and the resulting premium increases may increase the cost to the government through premium subsidies.”

In short many Americans saw a doubling of premiums (an average increase of 113%) under Obamacare inside of 4 years causing many to forgo the insurance. The reimbursements under the old system (which helped compensate hospitals administering emergency treatment for the uninsured) that were stopped on the proviso people would take up ACA plans backfired. Not enough people signed up and more hospitals running on a days cashflow have been forced to close because the reimbursements designed to protect them against uninsured patients disappeared. When Jonathan Gruber, the architect of Obamacare, testified to Congress he candidly said,

The Affordable Healthcare bill was written in a tortured way to make sure the (Congressional Budget Office) did not score the mandate as taxes…If CBO scored the mandate as taxes, the bill dies, OK? Lack of transparency is a huge political advantage … call it the stupidity of the American voter or whatever … that was really, really critical to get the thing to pass … I wish … we could make it transparent, but I’d rather have the law than not.”

The sorry state of public pensions that are about to explode

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Perhaps the most disturbing fact that so many are choosing to overlook is the level of pension underfunding. Promises upon promises have been made and the nest eggs so many were expecting to retire on are likely to disappear or in the best case scenario be a mere fraction of what was originally thought. What a nightmare to wake up to. Decades of hard work gone up in smoke due to pension administrators sticking to unrealistic returns. Last year I wrote, ” US Pension Tracker assumes that public pension funds have a market based unfunded pension deficit of $4.833 trillion. The actuarial base (using a discount rate of 7.5%) of the pension deficit is approximately $1.041 trillion. This assumes an unfunded portion of $3.8 trillion. Using the 2016 20-year US Treasury bond yield of 1.71% the market based pension deficit explodes to over $8.8 trillion or a $7.5 trillion unfunded portion equating to around $74,000 per American household. For California alone this would push the pension debt per person above $135,000.”

Zero Hedge provides an interesting update on the coming crisis:

“We’ve written quite a bit over the past couple of months about the pending financial crisis in Illinois which will inevitability result in the state’s debt being downgraded to “junk” at some point in the near future (here is our latest from just this morning: “From Horrific To Catastrophic”: Court Ruling Sends Illinois Into Financial Abyss).

Unfortunately, the state of Illinois doesn’t have a monopoly on ignorant politicians…they’re everywhere. And, since the end of World War II, those ignorant politicians have been promising American Baby Boomers more and more entitlements while never collecting nearly enough money to cover them all…it’s all been a massive state-sponsored scam.

As we’ve noted frequently before, some of the largest of the many entitlement ‘scams’ in this country are America’s public pension funds. Up until now, these public pension have been covered by stealing money set aside for future generations to cover current claims…it’s a ponzi scheme of epic proportions…$5-$8 trillion to be exact.

Of course, the problem with ponzi schemes is that eventually you get to the point where the ponzi is so large that you can’t possibly steal enough money from new entrants to cover redemptions from those trying to exit…and, with a tidal wave of baby boomers about to pass into their retirement years, we suspect that America’s epic ponzi is on the verge of being exposed for the world to see.

And when the ponzi dominoes start to fall, Bloomberg has provided this helpful map to illustrate who will succumb first…”

Toshiba should be left to rot as a warning to others like Captain Kidd. Sadly Japan Inc is Captain Kidding

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In the olden days, pirates and criminals were left to rot and die as a gruesome warning to others. Japan should adopt the same policy for corporates which no longer reserve the right to function. I once conducted a study that showed that Intel by itself made more net profit over 25 years in aggregate than the largest 20 Japanese technology firms combined over the same period. Yes, that is right Intel made 40% more net profit than Sony, Panasonic, Toshiba, Mitsubishi Electric, Nidec, Canon, NEC, TDK, Hoya, Nikon, Kyocera, Ricoh, Olympus, Konica Minolta, Sharp, Tokyo Electron, Advantest, Fuji Film, Ibiden, Fujitsu and Brother combined.

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Fuji Film once boasted that it was a better company than Kodak on the announcement of its bankruptcy. The reality is that as a shareholder the decade preceding Kodak’s bankruptcy had higher total returns (dividends, buybacks) than one who held Fuji Film. Not exactly a proud boast to say you’re superior only in terms of survival. That is the problem many corporates face. They do not properly understand the importance of shareholders.

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I have lived in Japan for too long to know that foreign investors remain right to hold such a negative outlook on corporate governance here despite the introduction of the Corporate Governance Code I wrote about in 2015. Toshiba is without a doubt a poorly run company that has become an uncompetitive mess of its own doing. It is decades of poor business decisions that has led to its demise. Not bad luck . The way the government is trying to protect Toshiba and its 200,000 employees is exactly why foreigners will stay away. All such rearguard actions do is send a strong message to all other large Japanese corporates that there is a safety net if they screw up.

Toshiba tried to appeal to investors after the initial accounting scandal that a majority of independent directors would prevent it happening again. Reality is that they were completely ineffective. To that point the Japanese stock exchange (JPX) asked me to fill in a survey on what I thought of corporate governance and whether it should be made mandatory instead of ‘comply or explain’. 98% of listed corporates have volunteered to hire two independent directors so I asked why would you make law what almost all are already in step with? Talk about not understanding what the point of shareholder needs are from the exchange itself. It is embarrassing. I made the point that the “quality” of independent directors was most important. I wrote in the corporate governance report the following,

“Companies must focus on qualitative aspects when hiring independent directors over quantitative parameters. Soft options to meet minimum regulatory requirements to protect the status quo is a recipe for failure. Independent directors should not be viewed as an ‘unavoidable cost’ but as a ‘wise investment’ for firms. Which company would rationally choose inferior staff for its operations? Would an airline actively seek unqualified pilots to fly its passengers? That is not the way of sustaining good reputation in the long run.”

Toshiba is to all intents and purposes insolvent. It bit off way more than it could chew in nuclear. Westinghouse looked a huge boon at the time and many analysts fawned over the Japanese giant becoming a monster player in nuke power. Now the massive costs of building plants, the delays, the requirement for trained personnel to build them etc has become too much to bear,. Yet the government sees the banks propping it up through syndicated convoy support is the way forward.

I wrote in Jan 2016 about Toshiba as its market cap slipped below Y1 trillion.

“I once joked soon after Lehman shock that Apple’s overnight move of 5% was the equivalent of the vanquished Toshiba market cap. Now Apple only needs to move 1.29% to increase / decrease the equivalent amount of Toshiba’s mkt-cap. It shows just how far the Japanese tech giant (?) has slipped. When we look at reality, the accounting scandal, the appointment of 50%+ independent directors on the board and the likelihood of having to write down goodwill, the former tech giant faces further woes. Toshiba is in dire need of a ‘crisis’ manager to restore lost fortunes.”

I also argued in the same note:

“Toshiba may be trimming 16,000 odd staff into next fiscal year. Interestingly the decision to cut 6,800 employees from their overseas businesses highlights once again that domestic social harmony takes a front seat to shareholders. We’re not saying the action is not well intentioned but in a sense it is hardly the thing which will help get the supertanker turned around in the required time. Interestingly Nidec’s Nagamori has offered to hire software, communications and robotics engineers from Sharp and Toshiba to ‘help’. So the best engineers from Toshiba and Sharp will sign up for voluntary redundancy (aka tax effective bonus) and land a job with arguably one of the most profit focused Japanese tech companies, further gutting the ‘best assets’ from the ailing companies.”

Yet look at what Toshiba tried to do with fixing its ailing PC business. It’s independent directors voted to copy what abysmally failed in mobile phones, even worse teaming with an old partner. As I also wrote,

“One would have hoped that the independence of the majority of the board would lead to a heightened sense of urgency and crisis management. The recent news is that Toshiba is in talks with Fujitsu again to merge their loss making PC units where the two share 6% of the global market…There is a lot of precedent suggesting that this is a fruitless exercise. As one of my colleagues put it best, “two drowning men together don’t make a swimmer”. One would hope that Toshiba’s revived sense of corporate governance would see its board seek more severe action…

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“Japanese mobile handset makers have consolidated. Toshiba teamed with Fujitsu (surely a lesson in what a poor decision that has been), NEC with Casio and Hitachi, while Sony (albeit teamed with Ericsson until they merged) has had a rear guard action. Sanyo sold its handset business to Kyocera. Mitsubishi Electric just quit altogether in 2008. I remember a time when Japanese clam-shell phones were amazing. Friends from foreign lands would marvel at the designs, light weight and features versus the clunky Nokia and Motorola offerings of the time. They also were stumped at how these devices could get so much battery life. Alas, Japan kept them largely from overseas markets leaving them without the little scale efficiency from expansion abroad.”

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“As smartphones have caught on, Japanese handset makers have been left further in the dust. Sony has the highest global share among Japanese brands at 1.7% (Q1 2015), however even in the domestic market, Apple and Samsung command the leading shares. Japan’s market share in mobile phones globally has slid from 15% a decade ago to less than 4% in 2012. Japanese maker’s global share of flat screen TVs slump from 45% to around 20% over the same period. What magic can a Toshiba-Fujitsu PC alliance make?”

Alas Toshiba dithered and eventually knew that the government would throw out the emergency airbag to cushion its fall. How does throwing hands in the air and not taking more drastic action (selling cross shareholdings etc) sit with best in practice corporate governance and protecting shareholders’ best interests? Not a chance.

What Japan Inc should do is allow it to fail. Let the free market decide what assets they want. If Westinghouse is worth something to Hitachi or some other maker then so be it. Sharp was sold to a Taiwanese maker.  If Toshiba’s NAND flash business is only worth X to a foreigner or Y to a Japanese then that is reality. The market is there to match buyers and sellers. Somehow I fear that there is a ‘Hinomaru’ type structure that will form to absorb the chip businesses of several Japanese companies to form a burdensome partnership to appeal to social goals.

The government must understand that listed corporates are not there for national service. If that is the wish of the state then it should nationalise Toshiba. I’m sure the BoJ will be glad to add more toxic waste to its massive balance sheet which even dwarfs America. There is no way that foreign investors can glean any hope for true reform if protecting zombified atrophied elephants continues.

Japan is a shame culture. How is it that it doesn’t see that protecting Toshiba is in fact seen as so shameful to foreign investors and increasingly Japanese taxpayers.

Toshiba has till March 14th to find a solution before it gets put on the scheduled for delisting board. That I’d argue is even more embarrassing.

Dallas bankruptcy looms. What would JR Ewing would give to have Jeannie?

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Who would have thought that the home of JR Ewing could be facing bankruptcy? The rate of outflows from the Dallas Police and Fire Department pension fund is so high the fund needs a billion dollars in funding this year alone, equal to the entire city budget, just to keep up. Dallas’s mayor, Michael S. Rawlings, testified this month to a state oversight board that his city appeared to be “walking into the fan blades” of municipal bankruptcy. JR must be praying to shape shift into the set of “I dream of Jeannie” to right this mess.

Bank in September I wrote:

“The beauty of pension accounting is that slight tweaks can make a large unfunded liability seemingly disappear or at the very least shrink it to “she’ll be alright mate” levels. However if a pension fund plays the game of understating its risks for long enough then eventually it catches up, especially if performance is consistently poor. This is what we are starting to see in vivid colour among state and local (S&L) governments in America. Reality is biting”

Now it seems that The Dallas Police and Fire Pension (DFPF) System, once applauded for a diverse investment portfolio finds itself needing to dig out of a deep hole. A $1.2 billion change last year in the difference between the value of its assets and what the pension owes retirees left the $2.6 billion fund with just 45 percent of the assets needed, down from 64 percent at the end of 2014. The pension, which was 90 percent funded a decade ago, could be out of cash in 15 years at the current rate of projected expenditures. The pension’s former real estate investment manager, CDK Realty Advisors, was raided by the FBI in April 2016 and the fund was subsequently forced to mark down their entire real estate book by 32%.

The fraud at the DPFP left the fund over $3bn underfunded and its board of directors with no other option but to seek a $600mn infusion from taxpayers to keep the fund afloat.

Zero Hedge writes, “Well, it seems as though Dallas police officers are catching on to the ponzi and rushing to withdraw retirement funds as quickly as possible before the whole system goes bust. As reported by a local ABC affiliate, Dallas police officers are retiring at a record rate and opting for full cash withdrawals of their pension benefits as opposed to equal monthly distributions for life (apparently they don’t think the fund will be around long enough to pay them for very long).”

While this is partially crumbling because of fraud, there are many other pension funds which are way underfunded. In the public sector alone in America, pension funds are unfunded to the tune of $9 TRILLION. In the current investment environment, no amount of tricky actuarial accounting can wriggle out of this.

This will be a recurring nightmare for Main Street. Something that should make even Freddie Krueger cling onto his mother. We’ve already had some previews from the 2008 financial collapse. Small scale maybe but the lessons are real and this time round the effects are likely to be far larger and quantum levels more painful.

I wrote in August that the State of California’s pension fund (CalPERS) has unfunded pension liabilities of $412bn, or 3x the annual tax collection for the entire state. Rewind to 2008. The municipality of Vallejo, California filed for bankruptcy. It wasn’t just the evil banksters that caused financial markets to collapse that made tax revenues shrivel. Sadly the city of Vallejo was living high off the hog. Bloated pensions and fat cat salaries for public servants ruled by stubborn unions created a scenario where it couldn’t bail water fast enough when the crash hit.

The police captain was paid over US$300,000 while his lieutenants were on c.US$250,000. The average fire fighter took home US$170,000. The police and firefighters pay and conditions sucked up three-quarters of the budget much more than the 55-60% of most municipalities. That $80mn budget suddenly faced a $17mn black hole.

The city was forced to fire 40% of its 260 police officers and told its residents to be judicious with calling 911. Crime rates unsurprisingly jumped above the state average.

Vallejo didn’t sort its pension obligations to CalPERS during its bankruptcy negotiations which ended up becoming its largest budget hole by a considerable margin. Even in 2011 when the city came out of bankruptcy the pension time bomb ticked away. Moreover the declaration of bankruptcy prevented access to bond financing making budget gap filling even more complicated.

Scroll to 2016, the anaemic (and slowing) economic growth around the world is putting stress on pension funds ability to payout retirees and fund future pensions. Pensions funds set “return targets” which actuaries set to ensure the fund stays solvent. However pension funds need to be diversified with a mixture of cash, bonds and equities. With equities reaching more outlandish valuations and bonds moving further into negative yield territory (capital appreciating at least) pension fund returns are undershooting. When pension funds undershoot then the unfunded liabilities keep growing. As more baby boomers retire the more outflows are required putting more pressure on the unfunded portions.

Vallejo was small fry but the risk of more cities declaring bankruptcy in coming years is something that isn’t even on investor, national government or central bank radar screens. We’re fed more of the same tripe that all is ok and they’re in control.

San Bernadino, California also filed for bankruptcy after GFC carrying $140mn in unfunded pension liabilities including $50mn in debt it had raised to fill the pension hole. Yes! It was borrowing money to plug a pension hole. Sort of like buying groceries on the credit card you can’t pay off.

San Jose spends 20% of its $1bn budget on healthcare and pensions given the generous offer following 30 years service in police or firefighting. They net 90% of final salary every year to see out their retirement. Those sweet deals are now being contested in court giving people the option of the same deal with much higher contributions or accept a higher retirement age with a lower payment.

Take Detroit, Michigan. It declared bankruptcy around this time three years ago. It’s 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.

What we are likely to experience is more city and potentially state bankruptcies this time round. With over-inflated assets which aren’t producing returns and cash rates effectively zero or negative in the US, EU and Japan portfolio diversification gets more complicated pushing real returns lower and unfunded liabilities higher. There is no easy out. Printing more money will not help fill the hole. Even if it managed to keep nominal payments broadly unchanged the buying power would be severely diminished. What we can say is serious problems are being stored up and likely to arrive at the least opportune moment where realities will have to be faced and the blame game taken to new levels. It is truly a frightening prospect that once again Main Street will be left to carry the can!

As I have said repeatedly. Whoever wins the US presidency would be lobbed a hand grenade without a pin. Testing times ahead.

Intriguing quote in Deutsche Bank’s funding sheet. What if all of a sudden there is a run?

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By now most people know that Germany’s once gargantuan Deutsche Bank is trading at all time lows. Over the weekend Angela Merkel said the German government saw no grounds to bail it out although I’m sure if it comes to it Germany will be under so much international pressure to save it because of the systemic risks that a failure would pose to global financial markets. Europe’s fashionable bail-in concept means the ultimate victims are those that have lent to it – whether individual depositors or wholesale lenders. Is it any wonder Italian PM Renzi is ignoring the EU rules and likely to bail out the world’s oldest bank?

Deutsche’s most recent funding blurb says the following:

“Diversification of our funding profile in terms of investor types, regions, products and instruments is an important element of our liquidity risk management framework. Our most stable funding sources come from capital markets and equity, retail, and transaction banking clients. Other customer deposits and secured funding and shorts are additional sources of funding. Unsecured wholesale funding represents unsecured wholesale liabilities sourced primarily by our Treasury Pool division. Given the relatively short-term nature of these liabilities, they are primarily used to fund cash and liquid trading assets…

…Credit markets in 2015 were affected by continued political uncertainties in the euro zone, the ongoing low interest rate environment as well as the implementation in a number of jurisdictions, including Germany, of measures intended to reduce the levels of implicit sovereign support for banks, with a consequential impact on bank senior ratings. Our 5 year CDS traded within a range of 61 to 110 bps [trading at 247bps today], peaking in July. Since then, the spread has slightly declined and as of year-end was trading at the higher end of the range for the year…

…In 2016, our base case funding plan is up to € 35 billion which we plan to cover by accessing the above sources, without being overly dependent on any one source. We also plan to raise a portion of this funding in U.S. dollar and may enter into cross currency swaps to manage any residual requirements. We have total capital markets maturities, excluding legally exercisable calls of approximately € 22.4 billion in 2016.”

Naturally it presents an interesting question. If you are lending to DB how much faith do you put in the government to bail it out? Even if you weight the chances as high on a “too big to fail” argument (which is becoming somewhat hard to justify on grounds of market cap) premiums have to go up to compensate which at the ridiculous rates we are at has a far greater relative impact on profitability. I’m not sure how much of the € 22.4 billion in 2016 has been funded already but I’m sure those with money due in 2017 will have to take a longer look.

But we shouldn’t worry. Deutsche’s CEO is on record as saying “funding is not on the agenda”. I always love the way banks talk about their risks. Who could forget former Goldman Sachs CEO and Treasury Secretary Hank Paulson in March 2008 before GFC:

“We’ve got strong financial institutions . . . Our markets are the envy of the world. They’re resilient, they’re…innovative, they’re flexible.”

Of course banks always push the denial line when in trouble. They have no choice. No doubt the internal emails at DB have a”message” to staff – where what is written doesn’t resemble anything like the reality faced everyday by the minions. That is the folly of working in an investment bank – the internal politics get ever nastier until there are no more lifeboat passes left and no life jackets to give.

Throw in a good Trump performance tonight and global markets will be even more skittish – then again it might be they are finally waking up to the reality of the disaster central banks have put the world into.

US public pension hole would swallow 100% of state taxes to fill

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The beauty of pension accounting is that slight tweaks can make a large unfunded liability seemingly disappear. However if a pension fund plays the game of understating its risks for long enough then eventually it catches up with them. The risk of state and local (S&L)governments going bust is becoming a reality. I wrote on the S&L bankruptcies to date in the US last week. It is a nightmare for Main Street.

The US Federal Reserve has an interesting set of data on state and local pensions tucked away in its vaults. The unfunded pension liabilities as a % of GDP are truly worrying. As I pointed out with CalPERS, the generous return profile it states but isn’t achieving means its unfunded proportion is much higher in reality.

The Fed reported in 2013 that the State of California had an unfunded pension liability status equivalent to 43% of state revenue. However if marked-to-market with realistic discount rates we estimate that it is equivalent to 300% of state revenue or 7x as great. Going back to 2000, California had an unfunded liability less than 11% of tax collections. As a percent of GDP it has grown from 2% to 9.7%. If our estimate is correct, the mark-to market reality is that California’s unfunded state pension (i.e. for public servants only) is around 18% of state GDP!

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The State of Illinois is even worse. The unfunded pension liability is around 24% of state GDP. In 2000 the unfunded gap to state revenue was 30% and in 2013 was 126% in 2013. Alaska is at 20% of GDP up from 0.27%.

On a gross country level, the US Fed reports that aggregated S&L unfunded pension amount of $1.35 trillion in 2013 from $94.8bn in 2000. As a percentage of GDP it has climbed from 0.9% of GDP to 8.19% over that same period. If the FT is right in assuming a $3.4tn pension funding gap today then the impact should be 2.5x higher or 20% of US GDP.

Putting unfunded liabilities as a % of state tax collections under that scenario and we would effectively see 100% of state budgets across America be required to close the gap. Of course the entire gap doesn’t require immediate action (because all retirees aren’t happening at once) to get it to zero but getting it to a point where it could safely cover future liabilities on realistic returns over the long run would still  require significant injections. Such injections would crimp S&L services causing retrenchment of staff, public services and so on.

Perhaps more alarming is that with asset prices so artificially inflated we must question the mark-to-market pension assumptions should equity and bond markets collapse, leaving even larger unfunded liabilities with the ensuing economic impacts crushing tax collection creating an even more vicious circle. As Caroline Burnham said on American Beauty, “You cannot count on anyone but yourself!”