Wednesday, June 29, 2011

Social Security - Will it survive and will we recognize it if it does?

A recent study of the American Social Security program by the Brookings Institution in Washington, DC, was published in the June 2011 edition of the National Tax Journal. The author of the article entitled “Social Security Reconsidered”, Henry J. Aaron, outlines the issues facing Social Security, a subject that is of particular interest in this time of rising federal debt and deficits.

Social Security was designed to assure a basic income for those Americans who have retired (Old Age), death benefits to the bereaved (Survivors) and financial support for the disabled (Disability Insurance), all indexed for inflation.  This is coverage that is not and was not generally available in the private domain.  For the fiscal year 2011, outlays from the Social Security program are expected to reach $750 billion, the largest domestic spending program in the federal government.  In 2008, the recipients of funds from this entitlement program received half or more of their income from Social Security and a rather surprising 22 percent received all of their income from Social Security.  Some economists have determined that the impact of the Social Security "blanket" has wide reaching impacts on the economy by affecting the individual savings rate.  Obviously, it is a much used and greatly needed support program for Americans over the age of 65.  Unfortunately, in the future, it appears that the "security" part of this social program may well not exist.

When the Social Security Act was signed into law in 1935 by President Franklin Roosevelt as part of his New Deal program, it was decided to fund the program with payroll deductions (taxes) rather than from general government revenue.  This meant that early beneficiaries collected far more in Social Security benefits that they paid in taxes. Calculations show that beneficiaries born before 1935 have collected and will generally collect more in benefits than they paid in taxes; the difference being funded by those who were born after 1935.  The program is also designed with benefit caps; this provides annual benefits that are larger relative to earnings for low income earners.  On the other hand, high income earners tend to live longer on average than low income earners resulting in larger overall lifetime Social Security benefits (in 1982 this difference was 1.9 years for those who were 65; this rose to 5.3 years for those who were 65 in 2006).  This is somewhat countered by higher Survivor and Disability benefits that are paid to lower income earners.

Social Security actuaries project that spending on this program will rise by 1.2 percent of GDP between the years 2010 and 2030 and then fall by 0.2 percent between 2030 and 2050 as baby boomers die and are replaced by a smaller cohort of seniors because of the slow decline in the birthrate over the past 30 years.  The Congressional Budget Office sees the future slightly differently with Social Security payments reaching 1.8 percent of GDP between 2010 and 2030 and falling to 1.5 percent of GDP between 2030 and 2050.  To put Social Security spending into perspective, the program accounts for 20 percent of all non-interest government spending.  If the federal government wishes to reign in the debt-to-GDP level before it reaches a critical level, overall budget deficits must be controlled before 2030.  While there are proponents for cutting Social Security benefits as part of a package of cost control measures, the author feels that such cuts will not kick in quickly enough to stabilize America's debt-to-GDP level.  

Every year, the trustees of the Social Security program prepare a report outlining their projections for the future of the program that attempt to envisage outlays and revenues for the next 75 years.  These outlays and revenues are expressed as a percentage of payrolls that are subject to the payroll tax that funds the Social Security program.  In 2010, the report stated that revenues would average 14.01 percent of payroll and that outlays (benefits) would average 15.93 percent of payroll over the next 75 years.  Right off, one can readily see that Social Security will be paying out more than it is bringing in as payroll tax revenue by 1.92 percent of payroll.  Kind of reminds me of most government programs today, doesn't it?

Looking back, Congress attempted to close this funding gap back in 1983 through the use of legislation.  Unfortunately, the legislation set revenues to exceed outlays for only the first part of the 75 year projection with the plan of leaving a small residual reserve in the 75th year and deficits in the 76th year and beyond.  That is where the problem cropped up.  As the years have passed (28 of them since 1983), the number of deficit years has increased as the 75 year period rolls forward in time.  As each year passes, an additional deficit year is added to the end of the equation and one less surplus year is left behind at the beginning.  Approximately five-sixths of the gap in funding that is today projected for 75 years in the future is due to the rolling forward of the projection period.  The other one-sixth of the funding gap is due to economic factors, individual disability, new legislation and changes in demography.

Let's examine the role of Social Security in the overall budget deficit scheme.  The Social Security program is funded by a trust fund, a massive $2.6 trillion at the end of 2010.  Funds accumulated within the trust fund grow as their assets accumulate interest earnings.  For that reason, the Social Security trust fund reserves are projected to grow until the year 2025.  At that point, Social Security outlays will begin to exceed revenues from both interest earnings and payroll taxes.  The excess reserves will be exhausted in 2037 and at that point, the gap between what is spent on Social Security and what is taken in will reach 1.3 percent of GDP.  This gap in funding will then be added to America's debt-to-GDP ratio.

Discussions regarding the cutting of Social Security benefits are fraught with hints of political suicide.  Both the Republicans and Democrats have been able to agree on one thing; significant cuts in Social Security should not erode the benefits of current or soon-to-retire beneficiaries because they have less ability to save additional funds to comfortably retire.  It has already been proposed that maintaining current program benefits apply to everyone over the age of 45 or 55.  While this is comforting on one level (to retirees), it is disturbing because it means that it will take longer for funding balance in the Social Security program to take place over the decades to come This will result in less than meaningful reductions to the debt-to-GDP level.

Let’s look at possible changes that could be made to the Social Security program to ensure its future.  First, revenues and benefits must be set at levels that keep the trust fund in balance as shown here:  

1.) Revenues:  Over the next 75 years, the gap between benefits and taxes has a present discounted value of $5.4 trillion or 0.6 percent of GDP.  This compares to the Bush II tax cuts that equaled two percent of cumulative GDP over the 8 years of his Presidency. 

2.) Benefits:  When looking at the level of benefits, the ratio of United States Social Security benefits to cash earnings ratio is in the bottom quarter of 18 of the OECD nations and only two-thirds of the OECD average.  Despite having one of the highest wage levels among 18 OECD nations, the pension wealth associated with the Social Security program finds the United States in 17th place with Social Security pensions falling 40 percent below the 18 nation OECD average.  On top of that, Social Security benefits have grown less rapidly than total earnings because of the ceiling placed on taxable earnings; the increases in earnings above the ceiling of $106,800 has risen sharply and are exempt from Social Security payroll taxes.

For balance to be achieved, a cut in benefits of approximately 15 percent for all Americans or an increase in payroll taxes of 2 percentage points or a combination of the two would result in balance between revenue and benefits on the average over the next 75 years.  Another option, raising the normal retirement age, would act as a cut in benefits.  Unfortunately, as in the case of the 1983 legislation, in actuality, the gap would still remain at about half of its projected size in year 75 because buildups of funds in the early years would only offset deficits in the later years and would not solve the problem after the 75th year.

Mr. Aaron proposes the following:

1.) Vertical Redistribution:  Since life expectancy has risen more rapidly for higher income earners and earnings inequality has increased, total benefits paid over a lifetime also increase, particularly to high income earners.  In this proposal, Mr. Aaron suggests that cutting benefits for high income earners would assist in balancing the funding gap.

2.) Variation in Benefits by Age: Benefits are currently indexed to ensure that purchasing power is constant.  Some economists recommend reductions in the indexing so that pensions would not rise as quickly as inflation.  Unfortunately, this would work against those who are extremely elderly since they would have more years of less-than-indexed pensions.  As well, these are the very people that may well have outlived their savings.

3.) Raise the Age of Initial Eligibility: This would change the Social Security balance situation very little since early savings in benefits paid are offset by later increased retirement benefits.  On the other hand, delaying retirement has other more noteworthy impacts on the economy and raising the age of initial eligibility may intensify this, particularly since the labour force participation level among older workers has increased.  This increased labour force participation increases tax revenues, boosts GDP and may result in the lowering of government spending on benefits for retirees.

4.) Raise the Wage Base: Growth in the wages of high income earners since 1983 has meant that the proportion of earnings that is subject to payroll taxes has been reduced to 84 percent, down from 92 percent in 1937.  If the wage base were raised, this would result in the immediate generation of additional revenue, particularly if benefits were not raised in conjunction with the higher wage base.

In conclusion, unless changes to the Social Security program are made soon, the problem becomes increasingly worse as the years pass meaning that swift action is imperative.  This issue will become increasingly difficult to solve as demographic changes result in fewer and fewer young Americans paying into the system that is being used by more and more baby boomers.  The author, Mr. Aaron, notes that the structural deficit inherent in the system is most easily resolved by increasing revenues rather than by decreasing benefits.  Unfortunately, raising taxes is something that is regarded as extremely unpalatable, particularly when the increased revenue will be used to fund a program shortfall that many Americans will not live to see.

Here's a quote from President Franklin Roosevelt:

“We put those payroll contributions there so as to give the contributors a legal, moral, and political right to collect their pensions and their unemployment benefits. With those taxes in there, no damn politician can ever scrap my social security program”

We shall see.

Friday, June 24, 2011

Land Use Overregulation: Is it to blame for America's housing market debacle?

The National Centre for Policy Analysis recently released its analysis of the Great Recession and accompanying housing crash in a report entitled "The Housing Crash and Smart Growth".  In this report, the author, Wendell Cox, a scholar with the National Centre for Policy Analysis and a visiting professor at the Conservatoire National des Arts et Metiers national university in France, discusses the housing bubble, how it formed and how the magnitude of the issue varied across the United States and how it relates to urban planning.

Mr. Cox opens his report by acknowledging that the Great Recession was worsened by the bursting of America's housing market which, in large part, reached "bubble proportions" due to the relaxation of mortgage loan standards which allowed many Americans to buy homes that they simply could not afford.   It was this massive increase in demand that drove home prices into the stratosphere.

From 1999 to 2006, housing prices seemed to ride a never-ending escalator upwards.  This created a feeling among many homeowners that prices would never drop resulting in many Americans taking equity out of their homes in the form of additional mortgages.  Homeowners regarded home ownership as a risk-free venture; prices would always rise allowing endless extraction of equity.  Low interest rates combined with creative lending strategies by banks and other lending institutions resulted in the issuance of both subprime and variable interest loans to households with poor credit ratings.  This resulted in a marked increase in the demand for homes which, in turn, resulted in an increase in price and that resulted in an increase in supply.  Homeownership in America rose steadily after World War II; in 1940, only 44 percent of households owned their own homes, this rose to 62 percent by 1960, 65 percent by 1995 and peaked at 69 percent in 2006.  Accompanying the increase in home ownership level was an increase in the average size (and price) of America's single family dwellings; in 1973, an average home was 1525 square feet, this rose by 47 percent to 2248 square feet in 2006.  I find that statistic particularly interesting in light of my own life experience; as a baby boomer, most of my peers were raised, quite comfortably, in 1000 square foot bungalows (often with 3 or 4 children in a family).  This is certainly not the case today.

Mr. Cox notes that during the years between the end of World War II and the early 1970s, the median selling price of an average American home was less than or equal to three times the median household income in most markets.  This ratio began to break down during the 1970s in certain states that began to impose stronger real estate development regulations.  This median price to median income ratio accelerated markedly during the 1990s and 2000s when the median price rose far faster than household incomes which were basically stagnant.  On a nationwide basis, the gross value of United States housing stock doubled from $10.4 trillion in 1999 to $22.7 trillion in 2006 as shown on this graph:

From the peak of housing stock value in the fourth quarter of 2006, values have dropped by more than $6 trillion.  There goes that "wealth effect".

When the growth in the value of housing stock is compared to household incomes between 2000 and 2007, the gross value of the stock of houses in America rose a staggering $5.3 trillion more than household income.  This number alone explains a great deal of why there was such a flurry of foreclosure activity once the impact of the Federal Reserve's tightening in the early part of 2004 and throughout 2005 and 2006 took effect.

While house price increases were very steep in some markets, others noted relatively minor price increases.  For example, house prices in the 10 major real estate markets with the greatest price increases compared to income, rose by an average of $275,000 relative to income.  In contrast, major markets with the least rise in prices saw house prices rise by only $5000 relative to income.  In general, house prices rose the most on the East and West coasts of the United States and the least in "Middle America".  As well, house prices rose most in metropolitan areas that are encumbered with heavy land use regulations (i.e. New York, San Diego and Miami) and least in less restricted cities (i.e. Houston and Atlanta).

Now let's take a brief look at what happened to mortgage debt during the same period from 2000 to 2007.  During that period, the gross value of residential mortgages in the United States rose $4.8 trillion more than household incomes.  Mr. Cox states that "...assuming that the distribution of mortgages tracked escalating prices, 83 percent of the rise in house values occurred in the 20 markets with the greatest escalation in housing costs relative to income..." and "...these markets account for only 26 percent of the nation's owner-occupied housing stock...".  Basically, he is suggesting that there were other factors in play that created and then destroyed the housing bubble; liberal lending policies alone were not to blame for all of today's housing market woes.

Mr. Cox goes on to discuss how land use regulation can artificially create housing supply shortages.  Certainly, nature plays a role in limiting housing developments; one need only think of the presence of mountains or bodies of water as barriers to further development.  Land use regulations can artificially suppress the amount of land available for residential development; as the supply of developable land is decreased because of regulation, the price of available developable land rises.  Land use regulation can take two forms as follows:

1.) Prescriptive regulation: regulations are designed to stop or contain the spread of urban areas into rural areas in an attempt to force travel by public transit in more compact cities.

2.) Responsive regulation: regulations are designed to allow development to take place based on market preferences.

In normal regulatory situations, land and associated regulatory costs amount to 25 percent of the cost of building a house.  A study of the land and regulation costs for new homes in 11 major United States markets shows a very wide variation.  The study assumes that any house price that is more than 125 percent of its actual construction costs is likely due to excessive land and regulation costs.  In general, housing prices were far less affordable in markets with a prescriptive regulatory environment that attempted to control development; the three worst markets in the United States being Portland, Oregon with added land costs of $76,200, Washington-Baltimore with added land costs of $90,700 and San Diego with added land costs of $239,100.  Not surprisingly, housing markets with the more onerous prescriptive regulatory environments accounted for 89 percent of the rise in house values.  Interestingly enough, 25 percent of America's homeowners live in responsively regulated major markets which accounted for only 11 percent of the aggregate increase in house values.  This is even further proof that the "wealth factor" associated with homeownership was not evenly spread throughout the United States.

Now let's look at what happened as the bottom fell out.  Losses in the value of homes was even more concentrated geographically than price increases.  House values in prescriptively regulated markets accounted for 94 percent of all value losses between 2007 to the fall of 2008 for an average loss of $97,000 per house.  In comparison, houses in responsively regulated markets lost just 6 percent of their value for an average loss of $12,000 per house.

To close, I would like to take a brief look at Mr. Cox's summary of the markets that have suffered the most since the fall of 2006.  Between 2000 and 2006, most of the house price increases in the United States were found in 11 major markets.  These included Los Angeles, San Francisco, San Diego, San Jose, Riverside-San Bernardino, Sacramento, Las Vegas, Phoenix, Miami, Tampa-St. Petersburg and Washington, D.C. (notice the sun connection excluding Washington?).  These very heavily regulated markets accounted for 56 percent of the increase in aggregate house values across the nation as prices were rising before 2006 but have only 28 percent of America's homeowners.  In the period from the peak in 2006 to the fall of 2008, average house values in these markets dropped an average of 25 percent and accelerated after the sudden demise of Lehman Brothers and the "launching" of the Great Recession in 2008.  Despite these massive downward price adjustments, in the first quarter of 2010, the median house price in San Diego (a prescriptive regulatory market) was $380,000 which would require 35 percent of the median income of a household.  In comparison, a median house is priced at $140,000 in Dallas-Fort Worth (a responsive regulatory market), requiring only 15 percent of the median income of a household.

It is interesting to view the American housing market debacle from a planning viewpoint rather than simply blaming lax lending policies and the role of speculation.  While the latter two played some role in the run-up of housing prices, it appears that land use over-regulation is at least partially to blame for the housing bubble in certain markets.  Some changes in land use regulation may have prevented such a dramatic run-up in prices in certain markets (basically California) during the period up to 2006, increasing the supply of homes at a pace that was closer to the increase in demand that resulted from laxity in lending practices.  Apparently, once again, it is the old supply and demand story.

There just has to be some way to blame the Fed for this!

Wednesday, June 22, 2011

An Military Examination of Climate Change

In perusing the web, I stumbled on this very interesting paper on climate change.  While most media coverage is either strongly supportive of the concept of climate change or very strongly against the concept, this research paper comes at the issue from a completely different viewpoint than any that I have seen before.  

The paper entitled "National Security and the Threat of Climate Change" was released back in 2007 by the CNA Corporation, a Virginia-based "nonprofit institute that conducts in-depth, independent research and analysis" and has done so for more than 60 years.  That's pretty much boiler-plate think-tank talk.  The report was an attempt to answer the call made by President George W. Bush in his 2007 State of the Union address where he stated that help was needed " confront the serious challenge of global climate change...".

What is different about this report are the names that appear on the Advisory Board.  There are 11 retired military personnel named; four Generals, one Lieutenant General, four Admirals and two Vice Admirals.  I'd say that's pretty unusual.  Each of these men brought decades of first-hand experience in various parts of the world to the table, in fact, the section of the report entitled "Regional Impacts of Climate Change" are divided into subsections that are entitled "Voice of Experience" where each member offers his perspective, from his military experience, on the potential impacts of climate change on the national security of the United States over the next 30 to 40 years in an attempt to allow the military to adapt to the world's new reality.  When one thinks of national security, climate change is probably one of the last things that most people associate with any type of "code red" alert.

Here is a selection from the introduction to the report, directed to the readers:

"During our decades of experience in the U.S. military, we have addressed many national security challenges, from containment and deterrence of the Soviet nuclear threat during the Cold War to terrorism and extremism in recent years.

Global climate change presents a new and very different type of national security challenge.

Over many months and meetings, we met with some of the world’s leading climate scientists, business leaders, and others studying climate change. We viewed their work through the lens of our military experience as warfighters, planners, and leaders. Our discussions have been lively, informative, and very sobering...

The nature and pace of climate changes being observed today and the consequences projected by the consensus scientific opinion are grave and pose equally grave implications for our national security. Moving beyond the arguments of cause and effect, it is important that the U.S. military begin planning to address these potentially devastating effects. The consequences of climate change can affect the organization, training, equipping, and planning of the military services. The U.S. military has a clear obligation to determine the potential impacts of climate change on its ability to execute its missions in support of national security objectives.

Climate change can act as a threat multiplier for instability in some of the most volatile regions of the world, and it presents significant national security challenges for the United States. Accordingly, it is appropriate to start now to help mitigate the severity of some of these emergent challenges. The decision to act should be made soon in order to plan prudently for the nation’s security. The increasing risks from climate change should be addressed now because they will almost certainly get worse if we delay."

Whether or not you believe in the concept of global climate change (and I happen to), it is certainly sobering to read these words from a group of men who have had "their fingers on the button".

On to the report.

The report was structured to answer 3 main questions:

1.) What conditions are climate changes likely to produce around the world that would represent security risks to the United States?

2.)  What are the ways in which these conditions may affect America’s national security interests?

3.) What actions should the nation take to address the national security consequences of climate change?

The Advisory Board acknowledges that there is some discussion among scientists as to the veracity of climate change and its extent. They state that the potential consequences of climate change are so significant, that now is the time to assess which courses of action, if any, should be taken, particularly from a military security standpoint.  They also acknowledge that as military leaders, their perspective is different from that of the science community, the media and government policymakers since they look at the issue of climate change through a range of estimates and degree of risk that is involved.  The Board feels that it is most unwise to wait until the scientific community has reached 100 percent certainty in its climate change projections before any action is taken.  They refer to "low probability/high consequence" events, those events that occur rarely but have devastating effects when they do (think tornados or Hurricane Katrina); the Board is concerned that with inaction, climate change could well become a "high probability/high consequence" event.

Since the report hits too many points for this posting, I'll try to pick out a few salient points.  

The first issue that concerns the Board is how climate change will affect access to supplies of fresh water.  Climate change could impact rainfall and snowfall distribution and amount and will impact glacial melt rates, a source of drinking water for 40 percent of the world's population.  This is of particular concern in the Middle East (which, by extension, means that it is of particular concern to the United States and its security) where there is already geopolitical tension over already scarce fresh water supplies.  It is predicted that large parts of the India, Pakistan, South Africa and China will experience water shortages by 2025, even without the impact of climate change, because of accelerated glacial melting in the Himalayas.  It is those areas in the world that have marginal water supplies at the present time that will be most impacted by climate change and it is likely that these impending shortages will ultimately lead to military conflict over access to potable water.  Unfortunately, many of the areas of the world that are experiencing and will experience tension over access to fresh water are already breeding grounds for terrorism.

Climate change will also impact the spread of infectious, water-borne diseases.  The spread of vector-borne diseases such as malaria are already being noted and in the jet-age, diseases that were once eradicated in certain areas of the world, can become newly endemic, particularly as climates change.  As well, a growing lack of clean water in heavily populated countries can lead to the spread of diseases including cholera.

Changing climate will also impact humans that live either near coastlines or near sea level.  Rising sea level will result in the contamination of fresh water wells with saline water, affecting the ability of the land to sustain life of any kind.  One need look no further than Bangladesh where a great proportion of the country's residents live at or near sea level.  Rising sea level in Bangladesh has already resulted in the loss of productive arable land and has threatened the nation's food supply.  Damage and destruction of infrastructure is projected to displace tens of millions of people in Bangladesh by the end of the century.  The experience of Hurricane Katrina showed that even the United States is not immune from the impact of severe weather-related events that may be connected to global climate change.   While developed nations may have the resources to cope with world-wide sea level changes, poorer nations will most likely find themselves at the mercy of nature.

If the availability of fresh water and access to productive land are threatened, mass migrations could result and it is often these mass migrations that lead to geopolitical conflict, particularly where migrations take place across international boundaries.   The report estimates that by 2025, 40 percent of the world's population will be living in countries that are experiencing chronic shortages of water.  This alone will force populations to resettle in areas that can sustain a reasonable quality of life.  As well, the need for emergency assistance by military forces around the world may be required by nations that are unable to support themselves during a climate-related crisis.  This will impact those nations like the United States that are able to supply manpower and materiel in times of need.  To date, the cause of the world's many conflicts has not been directly associated with shortages of potable water, however, that issue could well create a future military conflict that will require intervention by outside nations.  One need look no further than the water issues facing both Israel and Jordan where increasing water scarcity is impacting government policy.  As well, the issue of scarcity of arable land has been the cause of unrest in areas of Africa and South Asia over the past few decades and this may well increase as the pressure of changing climate impacts agricultural output.

The report then goes on to assess the impact of climate change to five regions of the world - Africa, Asia, Europe, the Middle East and the Western Hemisphere.  The report assesses the specific threats to each region and how the indirect impact of climate change in other regions will impact that particular region (i.e. migration from Africa to Europe).  I don't wish to go into the specifics of each region in this posting but may touch on them in a future posting.

The last section in the report is entitled "Direct Impacts on Military Systems, Infrastructure and Operations".  This is where the military looks at the impact of climate change on its own operations.  I'll summarize their findings briefly.

The authors, being militarily inclined, are concerned about the operation of military equipment in extreme environmental conditions since this can impact the working life of equipment; for example, a stormier North Atlantic would increase the risk of equipment fatigue, hamper flight operations and lengthen trans-Atlantic travel time.  When major storms approach the east coast of the United States, military ships leave port and flight operations are moved inland.  Increasing temperatures in the Middle East would affect the ability of flight crews on aircraft carriers to launch aircraft because of crew fatigue.  Some United States military bases around the world are located very close to sea level; these will have to either be moved inland or decommissioned.  Either scenario will cost the already strapped American taxpayers dearly.

The military is particularly concerned about operations in the Arctic.  Climate changes in the Arctic are magnified and this has resulted in much greater increases in overall average temperature than any other part of the world.  A Navy study from 2001 concluded that an Arctic that was ice-free would require more vigilant monitoring.  Increased year-round accessibility will bring with it increased international competition for the resources in the area including oil, natural gas and minerals; this could lead to escalating military tensions.  The Russian Federation has already made it quite clear that they regard the area up to the North Pole as sovereign Russian territory and have been charting the seabed to discover the extent of their Lomonosov shelf.  This has led to increased surveillance by both Canadian and United States Coast Guard and military.  As year-round ice becomes a thing of the past, the cost of increased military oversight and vigilance in the Arctic region will stretch existing resources.

While the concept of global climate change is dismissed by a significant number of politicians, lay people and scientists, it is most interesting to see that the United States military has spent some time examining the repercussions and impact of climate change on its operations and on national security.  In conclusion, I'd like to quote from the final section of the report:

Recommendation 2:

The U.S. should commit to a stronger national and international role to help stabilize climate changes at levels that will avoid significant disruption to global security and stability.

All agencies involved with climate science, treaty negotiations, energy research, economic policy, and national security should participate in an interagency process to develop a deliberate policy to reduce future risk to national security from climate change.

Actions fall into two main categories: mitigating climate change to the extent possible by setting targets for long-term reductions in greenhouse gas emissions and adapting to those effects that cannot be mitigated. Since this is a global problem, it requires a global solution with multiple relevant instruments of government contributing.

Recommendation 3:

The U.S. should commit to global partner- ships that help less developed nations build the capacity and resiliency to better manage climate impacts.

Some of the nations predicted to be most affected by climate change are those with the least capacity to adapt or cope. This is especially true in Africa, which is becoming an increasingly important source of U.S. oil and gas imports. Already suffering tension and stress resulting from weak governance and thin margins of survival due to food and water shortages, Africa would be yet further challenged by climate change. 

That sounds like a rather pragmatic approach to global climate change. 

Friday, June 17, 2011

The World of Oil According to BP - 2010 In Review

BP has once again released this year's version of its Statistical Review of World Energy.  This publication is widely used by energy industry analysts and employees and is considered by many to be the energy industry standard.  Let's take a brief look at how 2010 looked for the world of energy according to "Beyond Petroleum".

BP notes that global energy consumption rose by 5.6 percent on a year-over-year basis, the largest annual growth since 1973.  This is an interesting statistic considering that average oil prices for the year were the second highest on record.  Coal prices were high in Europe but weak in both North America and Japan and natural gas prices were strong in the United Kingdom and weak in the United States where unconventional gas drilling (shale gas and other tight gas lithologies) flooded the market with natural gas.

Many recent projections of longer term global energy use propose that the so-called developed nations of the OECD will see their energy consumption drop over time as their economies become more energy efficient and that the bulk of the growth in future energy use will come from the non-OECD nations of Asia.  This was not entirely the case in 2010.  OECD consumption grew by 3.5 percent, the highest growth rate since 1984 and is now roughly at the same level as it was in 2000.  Non-OECD energy consumption grew by 7.5 percent year-over-year and is now up a rather astounding 63 percent since 2000.  China is now the world's largest energy consumer, using 20.3 percent of the world's total, up 11.2 percent year-over year.

Now let's take a look at the year that saw oil prices rise to levels that have only been seen once before, just prior to the Great Recession of 2008.  Let's look at the demand side of the equation first, followed by supply and then price.

On the demand side, globally, oil is the world's most used fuel, commanding 33.6 percent of the world's total energy consumption.  During the two previous reports for 2008 and 2009, BP noted that oil consumption declined on a year-over-year basis.  Not so in 2010.  Oil consumption reached a record 87.4 million barrels, up 2.7 million BOPD or 3.1 percent.  Interestingly enough, while this growth is rather robust, it is actually the weakest growth among all fossil fuels.  OECD oil consumption grew by 480,000 BOPD and non-OECD consumption grew by a record 2.2 million BOPD or 5.5 percent with China's consumption alone rising by 10.4 percent or 860,000 BOPD. Growth in net imports from China (growing at 14.6 percent) and Japan (growing at 7.1 percent) led the world.

On the supply side, global oil production rose by 1.8 million BOPD or 2.2 percent.  Looking back one paragraph, you'll note that production growth fell short of the growth in consumption.  In 2010, OPEC nations produced 41.8 percent of the world's oil.  Production by OPEC nations rose by 960,000 BOPD or 2.5 percent with production growth from Nigeria and Qatar leading the pack.  Production by non-OPEC nations rose by 860,000 BOPD or 1.8 percent, the largest increase since 2002.  Production growth was led by China, Russia and the United States.  Production decreases were most notable in Norway and the United Kingdom.

Now that we've looked at supply and demand, let's look at something that concerns all of us that consume oil (which is all of us) - the price of the commodity.  Brent crude (Europe's benchmark crude) averaged $79.50 per barrel over the year, still nearly $18 per barrel below the highs hit in 2008 but up 29 percent from its level in 2009.  In large part, production allocations by OPEC led to supply constraints and helped Brent reach a peak of $94 per barrel on the year.  For your information, Brent reached a high of just over $125 per barrel back in April 2011 and is trading in the $115 per barrel range now.  By comparison, West Texas Intermediate, North America's benchmark crude, was trading at just over $90 per barrel at the end of 2010 and reached a high of $114 per barrel in May 2011.

As a geoscientist, I am prone to flip to the reserves-to-production (R/P ratio) page because I find that it tells me the macro picture of the world's oil industry.  According to BP, the world's proven oil reserves reached 1383.2 thousand million barrels and were sufficient to meet the world's oil demand for 46.2 years.  This is down from the previous year, largely because the world's oil consumption rose rather dramatically (as noted above) and its proven reserves rose only slightly.  One note of interest is the change in Venezuela's official reserve estimates.  This revision drove the country's R/P ratio to 93.9 years from its previous 40 year life.  Venezuela now has the world's longest reserve-to-production life, surpassing that of the Middle East as shown in this graph:

Venezuela claims that they now have 15.3 percent of the world's proven oil reserves just behind Saudi Arabia at 19.1 percent and well ahead of third place finisher Iran with 9.9 percent.  To compare, the United States has only 2.2 percent of the world's oil reserves and Canada has 2.3 percent.  

Let's take a brief look at what the International Energy Agency (IEA) had to say in their monthly Oil Market Report released on June 16th, 2011.  The IEA predicts that global demand will reach 89.3 million BOPD by the end of 2011.  Global oil supply rose to 87.7 million BOPD in May after dippling to  87.4 million BOPD in April 2011 with OPEC supply rising by 210,000 BOPD to 29.18 million BOPD.  This is still 1.25 million BOPD below the level prior to the Libyan crisis.  China's oil consumption is expected to reach 9.9 million BOPD by the fourth quarter of 2011 and is expected to average 9.7 million BOPD over the entire year compared to 9.1 million BOPD in 2010 and 8.1 million BOPD in 2009.  That works out to a 19.75 percent increase in demand over a two year period.  Non-OECD nations will see their demand rise from 41.8 million BOPD in 2010 to 43.3 million BOPD in 2011.  Both demand numbers are up from 39.5 million BOPD in 2009.  With these statistics in mind, it is apparent that unless China's economy implodes, they will be the country that drives future oil demand and price.

As I have stated in other postings, I feel that the reserve-to-production (R/P) number or reserve life index is the key to the future of oil production and consumption.  As shown in the graph above, this number has remained static since the late 1980s despite ultra deepwater drilling, drilling in increasingly hostile environments, the growing exploitation of oil sourced from tar sands and the massive upgrade to the volume of recoverable oil in Venezuela.

In my estimation, the reserve life index number is telling us that peak oil is on our doorstep….or behind us.  Only time will tell.

In a future posting, I’ll examine the world’s natural gas situation, particularly in light of the massive shale and tight lithology exploration and exploitation that has taken place in many of the world’s sedimentary basins.  It is most interesting to think that natural gas may be the fossil fuel that bails the world out of a very sticky energy situation.

Wednesday, June 15, 2011

Mr. Bernanke's Game of Congressional Chicken

In light of Mr. Bernanke's recent comments about playing a Congressional game of chicken with the debt ceiling, I thought that a brief look at the latest Monthly Budget Review for the month of May 2011 from the Congressional Budget Office would be in order.

For the first 8 months of fiscal 2011, the federal budget deficit reached $929 billion, $6 billion higher than the deficit for the first eight months of fiscal 2010.  Outlays rose by 6 percent and revenues rose by 10 percent on a year-over-year basis.  The deficit for the month of April alone was $40 billion and is estimated to be $59 billion for the month of May.  Outlays dropped by $48 billion compared to May 2010, however, most ($42 billion) of this drop is due to reduction in outlays for TARP.  The $6 billion difference from the previous fiscal year sets the United States on track for another $1.5 trillion deficit, the third year in a row that the deficit has exceeded $1 trillion.

Let's look at the revenue side of the ledger first.  On a year-over-year basis, Treasury receipts grew by $139 billion (10 percent) for the first 8 months of fiscal 2011 to $1485 billion.  Individual income taxes rose by a rather stunning 28.5 percent from $546 billion to $702 billion.  On the other hand, corporate income taxes rose by a rather paltry 4.8 percent from $81 billion to $85 billion.  Who said that Main Street Americans aren't paying more than their fair share!  Most impressively, everyone's friends at the Federal Reserve contributed an additional $9 billion to the American Treasury, based mainly on increased earnings on their larger portfolio (of QE Treasuries?).  

Now let's look at the spending side of the ledger.  Outlays for the first 8 months of 2011 rose 6 percent or $132 billion to $2414 billion.   Spending on unemployment benefits dropped the most, decreasing by 22.9 percent on a year-over-year basis largely because of declining unemployment (shocking!) and lower average benefits (not shocking!).  The largest spending increase on a year-over-year basis was on net interest on the public debt which should surprise no one.  In the first 8 months of fiscal 2011, net interest rose by 16.1 percent to $176 billion, nearly what the federal government spends on Medicaid.  Social Security spending was up 3.6 percent to $478 billion, Medicare spending was up 3.8 percent to $303 billion and Medicaid spending was up 5.4 percent to $189 billion.

Let's take a quick look at the "Debt to the Penny" number for today just to put things into perspective:

Certainly, as the world's number one central banker has recommended, Congress could stop playing politics and raise the debt ceiling for the umpteenth time once again, making the current debt ceiling the new debt floor.  Unfortunately, that is like sticking another finger in the fiscal dyke.  It solves nothing.  It is interesting to note that, on the spending side for fiscal 2011, the largest year-over-year increase was on net interest on the public debt despite ultralow interest rates.  Should the Federal Reserve raise interest rates to historical norms (as they no doubt will eventually do), more and more of the tax dollars that are remitted to Washington by working Americans will be spent on debt interest payments rather than entitlement programs.  Ceaseless additions to the total federal debt will have the same effect and will eventually constrain government's ability to fund much needed social programs.  As well, let us not forget the looming $100 trillion shortfall for the aforementioned entitlement programs as noted here.

Fortunately for Mr. Bernanke, he is highly unlikely to ever need to avail himself of Medicare, Medicaid or Social Security.  The same cannot be said for those Americans who live on Main Street.

Tuesday, June 14, 2011

America's Housing Market - As the Fed Sees It

It's always interesting to see how our very best friends that dwell in the rarified air that is the Federal Reserve, deal with the ways that their policies are affecting those of us who live in the real world.  A speech in June by Janet Yellen, the Vice Chair of the Board of Governors of the Federal Reserve System given to the Federal Reserve Bank of Cleveland Policy Summit does just that.  The title of Ms. Yellen's speech is "Housing Market Developments and Their Effects on Low- and Moderate-Income Neighbourhoods", in other words, an examination of the housing markets where most of us live...except those of us that just might happen to be central bankers.

I'm going to select a few salient points from Ms. Yellen's speech.  In particular, I will be selecting the most interesting statistics that might be of interest to my readers.  I am also mindful that many of you are part of these statistics but sometimes quantifying the issues facing America's housing market makes us all realize just how grim things are for many of our peers, friends and neighbours.  As well, much of this data can be found if one is willing to wade through scattered sources but to me, this appeared to be a very compact summary of America's housing market issues.  Think of this as "one stop shopping" for all you need to know about what is happening in the housing market.

Ms. Yellen opens by noting that prices in the housing market have been dropping for the past six years and that only 15 percent of households in America expect that house prices will increase over the next year and, looking further down the timeline, only 50 percent expect that house prices will increase over the next five years. (my bold)  That is a truly frightening statistic because, as we all know, the market often predicts its own trajectory.  For instance, if people (and the media) believe that the market will decline, it quite often does.

Ms. Yellen goes on to state that the fall in house prices and the accompanying stubbornly high rate of unemployment resulted in 4.5 percent of mortgages in the United States currently falling into foreclosure with an additional 3.5 percent falling behind by three or more payments.  In 2010 alone, 2.5 million foreclosures were initiated and that number is expected to be repeated in 2011.  The flood of foreclosures on real estate markets across the United States has depressed prices even further than what might have been anticipated.  Many of these foreclosed homes sit empty for months and fall into disrepair which further depresses prices and has the unfortunate result of creating "collateral damage" to the value of neighbouring homes.

As if foreclosures weren't causing enough market disruption, it is estimated that in the first quarter of 2011, there were nearly 2 million vacant homes scattered across the United States.  While this is down from the 2008 highs, it is still a whopping 60 percent higher than the average vacancy level over the 20 years between 1988 and 2008.  With 2.5 million anticipated foreclosures for 2011, it is unlikely that the rather ample supply of vacant homes is going to disappear any time soon.

Ms Yellen also discussed the issue of tight credit in the housing market.  Commercial banks are starting to open the credit spigots for credit card and consumer loan debt but she notes that the credit score required to access mortgage funds has risen from a median of 740 in 2005 - 2007 to 780 since mid-2010.  To make matters worse (for both banks and the real estate market), demand for mortgages has been very weak, partly a response to a weak economy where potential buyers are uncertain about the stability of both their jobs and the future value of any home that they may buy.  Many Americans have watched their net worth plummet over the past 4 years with one-quarter of all homeowners seeing their net worth drop by more than 50 percent.  As well, with approximately one-quarter of all homeowners "underwater", mortgage holders cannot refinance, cannot easily sell and are more likely to default if they should find themselves unemployed or underemployed.

Now let's take a brief look at the main subject of the speech, the impact of the housing disaster on low- and medium-income neighbourhoods.  According to research by the Fed, house prices in low- and middle-income neighbourhoods rose more during the boom of the 2000's and fell more during the bust of the late part of the same decade than their high-income counterparts.  A study by CoreLogic reveals that from 1998 to 2006, house prices rose an astonishing 11 percent annually in low- and middle-income neighbourhoods compared to 9 percent in their high-income counterparts.  In contrast, during the price bust from 2007 to 2010, house prices in low- and middle-income neighbourhoods dropped at an annual rate of 8 percent compared to 7 percent in high income neighbourhoods.  As well, mortgage application rates differed greatly across social lines.  Between 2003 and 2006, there was a surge in mortgage lending in the lower income neighbourhoods with applications up 60 percent between 2003 and 2006 compared to a rise of only 20 percent in higher income neighbourhoods.  When the market started to collapse, applications contracted by 65 percent in lower income neighbourhoods and by only 50 percent in higher income neighbourhoods.  This had the consequence of leaving twice as many lower income homeowners underwater since they held a greater portion of prime mortgages and, since they had a greater portion of their overall assets tied up in the declining value of their residential real estate, they were far more likely to default on their mortgages.  Statistics show that 13 percent of mortgages that were held by residents of low- and middle-income neighbourhoods were 90 days or more overdue in Q1 2011 compared to only 6 percent in higher income neighbourhoods.

What I find particularly interesting about this speech is that it was given by a member of the Federal Reserve, the body that is in large part responsible for the current mess in the housing market.  With the Fed's easy and cheap money policy over an extended timeframe in the mid-2000s, one would think that they would have picked up on just where all that money was going.  Here is a graph showing what has happened to the Fed Funds Rate over the past 23 years:

Note that the prolonged period of near zero interest rates in the middle of the first decade of the new millenium coincides quite neatly with the massive rise in house prices as shown here:

I guess "Helicopter Ben's" money had to go somewhere!
To conclude, here is a direct quote from Ms. Yellen's speech:

"In making a decision about homeownership, prospective buyers need to consider the risks as well as the benefits--in particular, the possibility that house prices can fall and that such declines can have long-lasting effects on their financial well-being. The current decline in national house prices and the preceding run-up were, of course, unusually large even by historical standards. But even during times when house prices were rising nationally, prices fell steeply in certain local markets, such as Texas in the mid-1980s or Massachusetts in the early 1990s. And homeowners are not alone in their difficulty in predicting house prices: The record of industry analysts and economists is also mixed. Although many professionals understood that house values were high at the peak of the recent cycle--probably unsustainably so--there was no consensus about the extent or severity of the coming fall." (my bold)

When Ms. Yellen refers to the mixed record of "economists", I think she really meant to say "central bankers".

Thursday, June 9, 2011

How Underwater Are American Households?

In early June, CoreLogic released its analysis of negative equity data for the United States housing market.  In this interesting quarterly report, CoreLogic analyzes which residential real estate markets in the United States have the highest and lowest percentage of households with negative equity and quantifies the negative equity that borrowers in each state average.  The report also examines which states have what CoreLogic terms "near negative equity"; these are the households that have less than 5 percent equity in their homes.  For those of you who aren't aware, negative equity (also referred to as "underwater" are borrowers/mortgage holders that owe more on their mortgages than their homes are worth.  As CoreLogic notes, negative equity can result from either a decline in the value of the home, an increase in the total amount of mortgage debt or some combination of the two factors.  In many cases, the extraction of equity from homes through the use of home equity loans is to blame for the problem as we'll see later.

As background information, the CoreLogic study includes data from 48 million properties across the United States; this accounts for over 85 percent of the country's mortgages.  Data was only used for properties that were valued between $30,000 and $30 million which should cover most of us!

When compared to the first quarter of 2011, the negative equity situation was slightly improved.  In the second quarter, 10.9 million residential properties with a mortgage were in negative equity compared to 11.1 million in the first quarter of 2011.  This translates to 22.7 percent of all residential properties in Q2 compared to 23.1 percent in Q1.  In addition, 2.4 million additional borrowers had near negative equity (as defined above).  When the negative equity and near negative equity borrowers are summed, 27.7 percent of all residential properties with a mortgage are in deep trouble.

Now let's look at the state-by-state data starting with the three states that have the highest percentage of underwater properties, the percentage of those properties and the trend from the previous quarter.

1.) Nevada: 63 percent underwater, down 2.7 percentage points
2.) Arizona: 50 percent underwater, down 1.3 percentage points
3.) Florida: 46 percent underwater, down 1.3 percentage points

Now let's look at the three cities with the highest percentage of underwater properties:

1.) Las Vegas: 66 percent underwater
2.) Stockton: 56 percent underwater
3.) Phoenix: 55 percent underwater

Nationwide, the average negative equity mortgage holder was underwater by $65,000.  According to the study, this amount varied widely by state.  Here are averages for the three top states:

1.) New York: underwater by $129,000
2.) Massachusetts: underwater by $120,000
3.) Connecticut: underwater by $111,000

The three states with the lowest average negative equity are as follows:

1.) Ohio: underwater by $31,000
2.) Indiana: underwater by $34,000
3.) Minnesota: underwater by $38,000

The part of the study that I found very interesting was the data on mortgage holders that had borrowed against the equity in their homes, a very common occurrence when home prices were rising in the early to mid 2000's.  Nationwide, borrowers with positive equity in their homes had an average of only 1.2 loans per property.  On the other hand, borrowers with negative equity had an average of 1.6 loans per property and when negative equity rises to a loan-to-value ratio of 150 percent or greater, borrowers had over 1.7 loans per property.  Only 18 percent of borrowers with no home equity loans were underwater compared to 38 percent of borrowers with home equity loans.

Finally, let;s take a quick look at the default rates for various degrees of negative equity.  Where borrowers have a loan-to-value ratio of 150 percent or higher, they have a default rate of 12 percent.  This drops to approximately 7 percent for borrowers with loan-to-value ratios of between 125% and 149% and continues to drop to approximately 2 percent for borrowers with loan-to-value ratios of between 100 and 104 percent.

While the negative equity situation for borrowers has improved very slightly over the past quarter, data shows that it has improved very little over the past year.  Since the first quarter of 2010, borrowers with negative 25 percent or greater equity in their homes is firmly stuck at 10 percent of all homeowners.  Despite Mr. Bernanke's protestations to the contrary, unless the economy really takes off in the second half of 2011 and creates a massive number of high paying jobs, this situation is unlikely to improve in the foreseeable future.  The impact of negative equity households on America's real estate market will continue to keep prices from rising and, if the economy softens as it appears to be doing, it is likely to lead to even greater numbers of foreclosures entering the market acting as a brake on any housing market recovery.