Friday, December 30, 2011

The World's Housing Markets: An Overview

Scotiabank has released its Global Real Estate Trends research publication for December 2011 and it contains some very interesting data and observations.

The author, Adrienne Warren, opens by noting that four factors are working against the global housing market; the slow pace of the economic recovery, weak consumer confidence, high unemployment and the sovereign debt crisis.  Of the real estate markets in the ten developed economies that Scotia bank tracked in the third quarter of 2011, average real home prices were below last year's levels in seven.  The best performing market was Canada and the worst was Ireland with the United States coming in at seventh place and the United Kingdom coming in at sixth place.  Let's take a more detailed look at several of the markets in the report.

1.) Ireland:  Here is a graph showing Ireland's real house price index since 1992:

Ireland, the worst performer among the ten nations, saw its year-over-year housing market down by 14.7 percent in real terms, adding up to a cumulative drop of 44 percent from its highs in early 2007.  This drop has pretty much negated the real estate price increases Ireland has seen over the past decade.  Between 1992 and 2007, house prices in Ireland rose by nearly 330 percent, largely as a result of massive growth in the country's economy (recall the long-extinct Celtic Tiger?).  This was both the biggest and longest housing boom.  With a drop of 44 percent, Ireland has now seen the largest downward price readjustment, however, its house prices still retain the largest cumulative price growth among the sample nations suggesting that the correction may not yet be over.  From the graph it is also apparent that the downward slope is still quite steep, suggesting that prices have not levelled.

2.) United Kingdom:  Here is a graph showing the United Kingdom's real house price index since 1995:

House prices in the U.K. are declining again after a short-term recovery in 2010 with real home prices declining by 6.7 percent on a year-over-year basis.  Over the period from 1995 to 2007, real house prices in the U.K. rose by 174 percent and fell 15 percent from the 2007 peak to the third quarter of 2011.

3.) Australia:  According to Demographia, Australia’s major cities suffer from some of the world’s least affordable real estate when prices are measured in terms of household income.  Australia’s median multiple (dividing median house price by median household income in that market) of 7.1 indicates that homes in the major centres are “severely unaffordablte.    Between 1996 and 2010, Australia saw its house prices increase by 125 percent.  The market suffered a 5 percent decline in 2010 on a year-over-year basis.

4.) United States:  Here is a graph showing the United States' real house price index since 1996:

Between 1995 and 2005, the United States saw real price growth of 50 percent in its housing market.  A sharp reversal in 2006 has resulted in cumulative downward price readjustment of 31 percent with a year-over-year drop of 7.5 percent in the third quarter of 2011.  Unfortunately, a stagnant job market, oversupply of foreclosures and unsold homes and tight credit conditions have led to a very moribund housing market.  Here is a graph showing the slump in the leading U.S. housing indicators:

With prices, home sales and housing starts moving sideways during 2011, one would think that demand for housing would be rising.  Unfortunately as I noted above, that is not the case despite the fact that home prices are now among the most affordable as valuations have fallen below long-term trends.  Weak income growth and weak employment gains are dragging the market sideways, resulting in consumers that are reluctant to purchase real estate.  As well, an oversupply of housing has kept new construction growth at a minimum with the number of vacant homes alone standing about 600,000 above its long-term trend.  One thing working in the favour of future housing price increases is the drop in American household debt levels as shown here:

Household credit has now fallen from its peak of 164 percent of household disposable income to 146 percent in the third quarter of 2011.  While still high, this readjustment is a marked improvement and if the trend continues, it could provide a boost to the housing market as consumers feel that their financial situation is more stable.

On top of these factors, annualized new housing construction is just over 600,000 units.  This is well below the long-term replacement value of 1.5 million homes per year.  This has resulted in a record low level of unsold new homes.  Should the aforementioned factors of employment, economic growth and household debt correct themselves, this dearth of new homes could quickly lead to a supply/demand imbalance which could push prices up quickly in some areas where there is not a massive inventory of foreclosures.

5.) Canada:  Here is a graph showing Canada's real house price index since 1998:

In the period between 1998 and the present, Canada has not seen a downward price readjustment, in fact, among the nations in the study, Sweden, Switzerland and Canada are the only nations that have seen steady price appreciation with prices at or near record highs.  Over that timeframe, Canadian real estate prices have risen by an inflation-corrected 85 percent, relatively small when compared to some of the European nations in the study.  On a year-over-year basis, prices rose by 4.8 percent in the third quarter of 2011 with some leveling off of prices in November due to economic uncertainty.  Canada’s housing boom is now in its 13th year, just behind Ireland and Sweden's 15 year boom.

Here is a graph showing how both the number of sales and how real estate prices in Canada have risen since 1990:

Let's just say that its been a good decade to be a realtor!

A great deal of this boom in Canada's real estate can be attributed to ever lower mortgage interest rates as shown on this graph:

Mortgage interest payments have fallen from just below 7 percent of household disposable income in the early 1990s to roughly 4 percent in 2011, largely due to the current ultra-low interest rate environment.  The peak of 7 percent in the early 1990s was due to mortgage interest rates ranging between 14 and 15 percent.  As mortgage payments as a percentage of household disposable income have fallen, purchasers have been lulled into thinking that the current low interest rate environment is the new norm and that their payments will never increase.  With today's far higher real estate prices, mortgage debt servicing could well become an issue if interest rates rose to even half of their two decade peak.  While Canada prides itself on its stellar banking industry, the balance sheets of Canada’s banks could look a bit less beautiful if interest rates rose and mortgage arrears rose in tandem. 

While I realize that some of the issues facing the real estate markets in other nations are specific to the economies of those nations and that they are unlikely to impact Canada' real estate market, one should never say never.  With Canadians facing record high household debt levels, the day of reckoning could be just around the corner if interest rates rise even modestly and consumer debt becomes less serviceable.  No one thought that the United States' real estate market would crash in 2006 - 2007, did they?  Apparently, they were very, very wrong. 

Wednesday, December 28, 2011

Iran: An Oil Giant

Updated November 2013

Back in late November, I posted an article outlining Iran's contribution to the world's natural gas resource base.  As you may recall, Iran is one of the world's leading producers of both natural gas and oil; it is OPEC's second largest oil producer and exporter after Saudi Arabia and, in 2010, was the world's third largest exporter of oil after Saudi Arabia and Russia.  In this posting, I will be taking a look at Iran's oil industry, particularly since they have threatened to shut down the Strait of Hormuz, a very narrow body of water near the exit and entry point of the Persian Gulf through which passes 15 million BOPD or one-sixth of the world's supply of oil.

Iran is a founding member of OPEC.  According to OPEC's website, Iran has the third largest oil reserves among the 12 nations that comprise the cartel as shown here:

OPEC's oil reserves of 1193 billion barrels make up 81.33 percent of the world's total oil reserves.  Among OPEC nations, Venezuela has the largest reserves totaling 296 billion barrels and Saudi Arabia has the second largest at 264 billion barrels.  With reserves of 151.17 billion barrels, Iran has 12.7 percent of the world's total oil reserves.  Iran is OPEC's second-largest oil producer and the world's third-largest crude oil exporter (or fourth largest depending on the source).  

Here is a map showing Iran's main oil and gas fields and pipeline infrastructure: 

Iran has 40 producing oil fields, 27 onshore and 13 offshore with medium sulphur content crude and gravities ranging from 28 to 35 degrees API.  Onshore fields comprise just over 70 percent of Iran's total oil reserves with over 50 percent of the nation's reserves confined to just six supergiant fields including its largest field, Ahvaz.  The vast majority of the fields are located in the northwestern part of the country adjacent to the Iran-Iraq border.  Data available from OPEC suggests that Iran exported approximately 2.438 million BOPD to Asian and OECD European nations; in comparison, the United States Energy Information Administration (EIA) estimates that Iran exported over 2.2 million BOPD in the first half of 2011.  As of 2008, Iran was producing an estimated 4.3 million BOPD of which roughly 3.8 million BOPD was crude oil.  At these rates, if no additional oil was ever discovered in Iran, the country's reserves would last for 95 years.  In 2008, Iran consumed 1.73 million BOPD of its own production; these levels are rising as the population grows since most of the domestic consumption is related to the use of both diesel and gasoline.  Here is a graph showing Iran's total oil production and consumption over the last 4 decades:

One of Iran's energy and fiscal problems relate to its high level of energy subsidy.  In 2009, Iran's gasoline price was approximately 10 cents per litre.  The Iranian government proposed removal of these subsidies which would have raised the price of gasoline to 40 cents per litre, a 400 percent increase.  Here is a look at other proposed energy price changes which were announced in December of 2010:

Here is a graph showing how rapidly Iran's gasoline consumption rose over the past three decades:

Interestingly enough, this energy-rich country had imposed gasoline rationing which began in 2007.  In the three years following rationing, the gasoline quota per individual was reduced from 120 litres per month to just 60 litres per month!

Just prior to the Iranian Revolution, Iran's oil production was in the 6 million BOPD range.  Imposition of international sanctions and a high rate of decline in Iran's oil fields pushed daily oil production down to approximately 1.5 million BOPD by the early 1980s.  This has since risen to around 4 million BOPD and it is estimated that in 2011, Iran's crude production has been in the range of 3.6 to 3.65 million BOPD, above its OPEC target of 3.34 million BOPD.  Natural declines in Iran's aging oil fields are an ever-present problem; an estimated 400,000 to 700,000 BOPD are lost to natural declines on an annual basis.  To combat this, Iran's oil fields require massive infrastructure investment including enhanced oil techniques using injection of the nation's massive natural gas resources to repressurize reservoirs.

Most of Iran's oil exports end up in Asia.  Here is a chart showing Iran's top export destinations for 2010:

Iran's largest volume of exported oil is comprised mainly of Iranian Heavy Crude.  In 2010, Iran's net oil export revenues were approximately $73 billion, providing roughly half of Iran's government revenues.  For the first half of 2011, China, India, South Korea and Turkey have all increased their imports of Iranian crude as export volumes are reallocated to countries that have less stringent sanctions in place.  Here is a chart showing how export levels by country have changed (increased for Asia (excluding Japan) and decreased for Italy) for the first half of 2011 as compared to 2010 above:

A number of new oil discoveries have been made in Iran over the past 2 years.  The National Iranian Oil Company (NIOC) announced the discovery of light oil in the Khayyam offshore field in May 2011; the field has estimated recoverable oil reserves of 170 million barrels.  As well, at the same time, Iran announced the discovery of new onshore oil and gas fields in the south and west of the country that contain an estimated 500 million barrels of oil.

Development of the infrastructure necessary to produce oil from new discoveries is hindered by international sanctions.  The massive North and South Azadegan Fields (discovered in 1999) contain 26 billion barrels of proven oil reserves in a very complex reservoir.  China, through its China National Petroleum Corporation (CNPC), is developing the north portion of the field.  Japan's INPEX had signed an agreement to develop the southern portion, however, it pulled out of the project in October 2010 due to international pressures.  Guess who stepped in?  You're right - a subsidiary of CNPC!  China has agreed to invest $8.4 billion over the next 10 years.  As well, China's Sinopec has signed on to develop another promising field, Yadavarn, which should be producing up to 185,000 BOPD by 2016.  Overall, according to FACTS Global Energy, Iran's discoveries of crude oil and condensate totaled 10.7 billion barrels of oil in 2010 alone.

From this posting and my posting on Iran's natural gas resources, you can see that Iran is most certainly key to the world’s overall energy picture.  While they have become a pariah state in the eyes of many world leaders, their production contribution to keeping the world’s oil production levels at or above the overall level of demand cannot be denied.  With that in mind, it will be interesting to see how long it takes before the leaders of the developed world take matters into their own hands and enact measures that will result in regime change, all in an effort to control Iran’s massive energy resources.  As I've pointed out before, one thing will hinder their plans; it will take a massive effort to unseat China from their role as supplier of capital to the resource-rich pariah nations of the world.

The Government Accountability Office and Washington's Fiscal Future

The Government Accountability Office (GAO) recently released its 2011 Financial Report of the United States Government.  I actually like this report; since I have a business background, I find that it reads more like a corporate annual report.  In this case, the Financial Report provides the President, Congress and Main Street America with a comprehensive look at how the Federal Government is (mis)managing taxpayer dollars by outlining the Government's financial position, its revenues, costs, assets and future liabilities.

 Let's open with Timothy Geitner's introduction to the report:

"This report provides another sobering picture of our long-term fiscal challenges.".

That sounds, well, rather sobering, doesn't it, especially since it's coming from a former Fed President?

Here's a snapshot of the condition of America's finances at the end of fiscal 2011 compared to:

If you think of this as a report card for both the Presidency and Congress, one would have to think that any teacher would assign a letter grade of "F".  Now, let's break down the data a bit further.

Here is a graph showing the United States' budget deficits and net operating costs for the past five years:

The budget deficits of fiscal 2010 and fiscal 2011 were nearly identical at $1.294 trillion and $1.299 trillion respectively; a slight increase in revenue for 2011 and a decreased net cost (due to a drop in costs for federal employee and veteran's benefits and a decline in the cost of economic recovery programs) led to a drop in 2011 net operating cost to $1.313 trillion, down from $2.080 trillion in fiscal 2010.  Basically, it was the so-called "economic recovery" that reduced overall net operating costs; when the economy heads south again (as it surely will),  net operating costs will rise as they did between 2007 and 2010 as government tosses more stimulus dollars into the pot.

The GAO is quite concerned about the long-term fiscal challenges facing the United States.  Here is a graph showing the GAO's frightening fiscal projections for overall spending both including and excluding interest on the debt and revenue to 2086 as a percentage of GDP:

You will note the massive increase in net interest spending as time passes.  The cost of the debt is expected to rise as a percentage of GDP even if both federal government spending and receipts remain at a relatively stable 20 percent of GDP.  Net interest costs alone will ultimately reach over 15 percent of GDP due to increased debt levels, a scenario that is most likely unsustainable.

Now, let's look at government revenues for 2011.  First, the level of corporate profits rose in fiscal 2011 but at a slower rate than in fiscal 2010.  Despite the rise in corporate profits, corporate tax revenue dropped by $4.5 billion (or 2.5 percent) on a year-over-year basis as shown on this graph:

As I've posted previously, you will notice how corporate tax receipts declined in 2011 despite the fact that the economy was improving.  As well, corporate tax receipts are less than half of their level in 2007, prior to the beginning of the Great Recession.

The level of personal income tax revenue rose by nearly $133 billion from fiscal 2010 to fiscal 2011, an increase of 7.7 percent.  Personal tax revenue is now at 90 percent of its pre-Great Recession peak in 2008 compared to corporate tax revenue which is at only 48 percent of its pre-Great Recession peak in 2007.  Perhaps corporations really do need a cut in the 35 percent levy!  What I find interesting is the 7.7 percent year-over-year rise in personal tax revenue when one considers that the job market is hardly what could be termed as robust; U3 unemployment was stubbornly stuck in the 9 percent plus range all year and more comprehensive unemployment statistics showed unemployment levels well in excess of 15 percent as the Shadow Government Statistics website shows here:

Now, let's take a quick look at where Washington spent its windfall.  Here is a pie chart that breaks down where government allocates your tax dollars:

The bulk of spending is in three areas, Department of Health and Social Services, Social Security Administration and the Department of Defense.  Each of these consumes between 20 and 24 percent of Washington's revenue.

Here is a graph showing Washington's assets and liabilities:

Washington (or rather, taxpayers) owns about $2.707 trillion in assets comprised mainly of property, plants and equipment ($852.8 billion) with the remainder in paper including net loans receivable, those lovely mortgage-backed securities and other investments ($985.2 billion).  The problem with government assets like property and equipment is that their value is often difficult to accurately assess; for instance, what is the value of a National Park and is there a even a market for such a property?  On the liability side of the ledger, Washington has $10.174 trillion worth of debt securities outstanding (Treasuries plus accrued interest), Federal government employee post-employment benefits and veteran's benefits totaling $5.792 trillion and other liabilities of $1.526 trillion for total liabilities of $17.493 trillion.  Doing the arithmetic results in net liabilities of $14.785 trillion.  On top of this debt, there is intragovernmental debt which occurs when one part of the Federal government "borrows" from another; this debt totals $4.7 trillion.  This represents government debt held by government trust funds including the Social Security and Medicare Trust Funds which are required to invest excess annual receipts in Federal government debt securities.  Because these are liabilities of the Treasury and assets of the Trusts, they cancel each other out.

From the report,  here is a graph showing the projected non-interest spending by the government for the next few decades:

The difference between non-interest spending and what the government takes in is termed the primary deficit or primary surplus.  You will notice the black line showing Washington’s total revenue as a percentage of GDP; where the coloured portion of the graph rises above the black line, there is a primary deficit (remembering that the primary deficit excludes interest owing on the debt).  The primary deficit soared in 2009, 2010 and 2011 as the government bailed out the economy (i.e. TARP et al).  During those 3 years, the primary deficit reached nearly 10 percent of GDP both because of increased spending and decreased tax revenues.  That is expected to drop to the point where there is a small primary surplus between 2015 and 2019 as the spending reductions in the Budget Control Act kick in.  The primary surplus ends in 2020 as spending on Social Security, Medicare and Medicaid rise; the primary deficit is expected to peak at 1.3 percent of GDP in 2035.  You will notice that this projection does not include the possibility of another Great Recession that would require a massive federal government bailout as was the case in 2009 - 2011.  That is why the black line and the coloured areas are so smooth as we move into the future.  Looking back, one can see that the recessions of the early 1980s, 1990s and 2000s resulted in far higher primary deficits than would have been projected prior to their arrival.  The same holds for the future with one difference; the increased spending on entitlements will mean that the Federal government is starting from a primary deficit rather than a primary surplus, making the fiscal situation even more difficult to control.

As I mentioned earlier, the GAO is concerned about the changing demographic that will impact the fiscal picture in the future; America’s aging population will result in persistent growth in Medicare, Medicaid and Social Security costs.  Here’s a quote from the report:

"Largely as a result of the provisions in the Budget Control Act of 2011,4 the fiscal outlook has improved. However, rising health care costs and the aging of the U.S. population continue to create budgetary pressure. The oldest members of the baby boom generation are now eligible for early Social Security retirement benefits and for Medicare benefits. In addition, debt held by the public continues to grow as a share of the economy; this means the current structure of the federal budget is unsustainable over the longer term." (my bold)

According to the Medicare Trustees' Report, spending on Medicare alone is expected to rise from 3.7 percent of GDP in 2011 to 5.6 percent in 2035 and 6.2 percent in 2085.  The Hospital Insurance Trust Fund is expected to remain solvent until only 2024 after which time, tax income will only cover 90 percent of benefits,  declining to 76 percent in 2050.  Social Security costs are expected to rise from 4.8 percent of GDP in 2011 to 6.2 percent in 2035 and declining to about 6.0 percent by 2050.  The Social Security Trustees' Report notes that the annual Old-Age, Survivors and Disability Insurance Trust Funds (OASDI) income will exceed annual costs until 2023 at which point it will be necessary to begin drawing down the trust fund assets until assets are exhausted in 2036.  After funds are exhausted, tax income will cover only 77 percent of benefits in 2036 and 74 percent in 2085.

Let’s look at what happens to growth in the primary deficit as a percentage of GDP if health care cost growth is more rapid than projected:

If Medicare and Medicaid expenses grow just 2 percentage points faster than the GAO projects, the primary deficit (excluding interest on the debt) reaches 20 percent of GDP by 2085.  This doesn't sound like much until you put the number into perspective.  Right now, the entirety of Federal government spending as a share of GDP, once again excluding interest on the debt, is 22.6 percent.  To put the deficit into dollar terms, the 75 year present value fiscal imbalance of this 2 percentage point increase in Medicare and Medicaid spending is a rather scary $66.5 trillion or just over 4 times the current level of the entire federal debt. 

When we take all of this data into consideration along with projections for interest rates and GDP, here is what we end up with:

Over the next 75 years, the debt-to-GDP ratio is projected to rise to 283 percent, down markedly from the projections of 352 percent in last year's Financial Report, largely because of spending reductions called for in the Budget Control Act of 2011.  While this may appear to be a meaningful improvement, a projection is just that, a projection.  From the graph showing what happens when spending on Medicare and Medicaid increase by just 2 percentage points, you can see how sensitive the projections are to small increases in spending or declines in revenue.

The sooner Congress makes meaningful progress towards fiscal consolidation, the less painful it will be for America.  If reform begins in 2022 rather than immediately (assuming an immediate reform of 1.8 percent of GDP), the primary surplus must be raised by 2.2 percent of GDP, by 2032, the primary surplus must be raised by 2.8 percent of GDP just to keep the debt-to-GDP level in 2086 equivalent to the level in 2011.  The increased cost incurred by delaying is a result of rising interest on the rising debt level.  

Let’s close this rather lengthy posting with one last quote from the report:

"If a higher debt-to-GDP ratio increases the interest rate, making it more costly for the government to service its debt and simultaneously slowing private investment, the primary surplus required to return the debt-to- GDP ratio to its 2011 level will also increase. This dynamic may accelerate with higher ratios of debt to GDP, potentially leading to the point where there may be no feasible level of taxes and spending that would reduce the debt-to-GDP ratio to its 2011 level." (my bold)

Friday, December 23, 2011

It's Not a Christmas Story But....'s entertaining, nonetheless.

I just wanted to wish all of my readers, followers et al a Merry Christmas and Happy New Year.  I'm not certain that I'll be posting any further diatribes over the Christmas break so I'll leave you with this rather interesting "Not Christmas" news item.  I just thought that it would be a nice change to post something that wasn't quite so "intense", unless of course, you happen to be the lady involved.

According to this case report by Doctor Oliver Richard Waters that I found on the BMJ website (formerly known as the British Medical Journal), it seems that a 76 year old female presented with weight loss and diarrhoea.  Other than that, she was in good health.  She underwent a sigmoidoscopy (a rather fun procedure if you haven't had one!) and the physician noted that she had severe diverticulosis or small bulges in the inner lining of her large intestine.  A CT scan of her abdomen showed a linear foreign body located in her stomach as shown here:

After questioning her further, the patient recalled that, 25 years earlier, while she was inspecting a spot on her tonsil with a pen, she slipped, fell and swallowed the pen.  Her husband, a general practitioner, dismissed her story because x-rays done at the time showed up nothing.  Her 21st century physician performed a gastroscopy (another one of those fun medical procedures!) and extracted a plastic felt-tip pen.  The pen was subsequently removed and, surprisingly, still worked as shown here:

Notice that the first words that the pen "spoke" after seeing the light of day for the first time in 25 years was a much relieved "hello"?

Here is the summary of the case report:

"This case highlights that plain abdominal x-rays may not identify ingested plastic objects and occasionally it may be worth believing the patient’s account however unlikely it may be."

Once again, have a Merry Christmas and please keep all of those plastic pens away from your tonsils!

Wednesday, December 21, 2011

Canada's Hidden $80 Billion Public Pension Debt

Updated April 2013

Some months ago, I wrote a posting about both federal and state pension plans, the funding gap between their current balances and their future liabilities and how this was going to impact American taxpayers who are on the hook for the shortfall.  Thanks to the C.D. Howe Institute, a Canadian think-tank, we now have a brief entitled "Ottawa's Pension Gap: The Growing and Under-reported Cost of Federal Employee Pensions" which outlines how the issue will impact Canadian taxpayers.  Let's dive in and see what the authors, Alexandre Laurin and William Robson, had to say.

Canada's public servants are beneficiaries of defined benefit pension plans (DB).  Three of the largest federal government DB pension plans are provided to the Public Service, the Canadian Forces and the RCMP.  On top of that, Members of Parliament and federal judges have special plans; those of MPs are considered by many to be the ultimate in gold-plated pensions since they qualify for the MP pension after just six years of service which they can collect at the advanced age of 55.  How many of us could say that?  According to the Canadian Taxpayers Federation, the current DB pension plan requires taxpayers to fork over $5.50 for every $1 contributed by any given MP.  For your illumination, here is the Canadian Taxpayers Federation calculations for pensions and severance payments owing to the MPs that were defeated in the May 2011 General Election.

Back to the C.D. Howe brief.  In the private sector, DB pension plans must calculate the difference between their future obligations and assets using actual market yields.  Not so for public sector pension plans.  Public sector plans are allowed to use made-up rates of return to value their plans.  Unfortunately, generational lows in interest rates have made these assumed rates of return unreasonable, resulting in growing unfunded liabilities.

Let's take a look at the pension data supplied by the Canadian Government for fiscal 2010 - 2011 in its Public Accounts annual publication:

Canada's public sector pension assets total $54 billion in 2011, future accrued obligations total $213.3 billion and unamortized estimation adjustments total $13.2 billion for a total future liability of $146.1 billion.  However, if one replaces the government's current smoothed liabilities of $213.3 billion with a fair value approach that better reflects market rates of return that are currently available.  Right now, the government is using a real assumed rate of return of 4.2 percent (note, that's the nominal or posted interest rate plus 4.2 percent for inflation) on all fund assets for benefits that were earned since 2000.  The government also uses a moving average of past nominal yields on 20 year federal bonds in its calculations, again, these rates are well above what one would expect in the past few years.

If an individual Canadian wanted to set up a pension plan that mirrored the plan available to Canada's public sector workers, they would have to index their savings to inflation.  The best measure of this index is a Canadian government real return bond.  This is where the problem crops up.  As noted in the previous paragraph, Ottawa is using a real return of 4.2 percent; unfortunately, the actual return on the real return bond is now just over one-half percent.  According to the Bank of Canada website, real return bond yields have ranged from a high of 3.76 percent in December of 2001, falling to 0.53 percent in December 2011 with an average of 2.07 percent over the 10 year period.  Here is a graph showing all of the data:

We can now readily see that the 4.2 percent real return is highly optimistic.  The C.D. Howe recalculated the assets that would be required to fund Ottawa's pension promises using a "fair value" 1.15 percent yield and finds that Ottawa's obligations would rise from $213.3 billion to $285.2 billion.  If one subtracts a new assets fair value of $58.6 billion, the unfunded pension liabilities rise from $146.1 billion to $226.6 billion, a difference of $80.5 billion.  If one substitutes the current 0.5 percent rate on real return bonds, the future funding shortfall is even greater.  Since the Canadian taxpayer will ultimately be responsible for these shortfalls, the $80.5 billion should actually be added to Canada's debt. According to Statistics Canada's latest economic and financial data report, Canada's accumulated federal debt reached $568.140 billion as of September 2011.  If we add in the realistically calculated unfunded public sector pension liabilities, the debt rises by 14.2 percent to $648 billion.  Since, in fact, this $80.5 billion shortfall was accrued over a number of years, the surpluses of the past decade were actually smaller than reported and the deficits were larger.  For example, the 2010 - 2011 deficit would have risen from its reported value of $31 billion to almost $47 billion, a rather significant change.

Another point of concern is the growth in the funding gap.  Here's how the growing gap between reported pension obligations and the fair-value estimate has looked over the past decade:

The authors suggest that the Canadian government has two ways to fix this mounting problem:

1.) Eliminate the final-salary-based DB plan and replace it with a career-average-salary plan and eliminate the early retirement option.

2.) Raise contribution rates to ensure that actual money inflow matches entitlements.  

In summary, the rising gap between Canada's public service pension assets and its future liabilities should concern every Canadian since we are all ultimately responsible for the shortfall.  Just as Canada's private sector employees are looking to retire, they may find themselves paying much higher taxes to fund their country's public sector pensions.  That will most likely be a terribly unpalatable prospect.

Tuesday, December 20, 2011

United States and Canada - More Pragmatic Debt Ratings

Over the past few months, I am always amazed when I see how the world's major bond ratings agencies view the current level of sovereign debt.  In particular, I have been shocked that the debt wall facing the United States has garnered very little in the way of a downgrade, perhaps a slap on the fingers with a wet spaghetti noodle at most.  Thus far, the downgrade and warning have provided very little impetus for Congress and the President to meaningfully change their spend more and then tax less philosophy.

Fortunately, however, there is a very small ratings agency located in Jupiter, Florida, that takes a far more pragmatic view of America's debt problems.  Weiss Ratings, an independent ratings agency, uses far tougher standards than other ratings agencies because they are primarily a consumer oriented agency, providing risk-adverse consumers with a means to better understand investment risk.  They have a reputation as a very conservative ratings agency and use a different letter grading system that is more intuitive than a series of A's, B's and plus and minus signs.  Weiss rates banks, insurance companies, and credit unions so that consumers can avoid depositing their hard-earned money with companies that are financially weak.  Fortunately, Weiss also rates sovereign debt, the subject of this posting.

Here is a screen capture showing how Weiss's ratings scheme compares to Best, S&P, Moody's and Fitch:

As I mentioned before, Weiss's ratings scheme is far more intuitive since most of us passed through elementary school at one time or another and have very clear memories that E's and F's were very bad and were probably going to get grounded, D's weren't so hot, C's meant you had some problems that would require extra homework and A's and B's meant that you were doing well.

Here is a screen capture showing what Weiss's ratings mean:

Now let's get down to the specifics of Weiss's ratings for sovereign debt.  Weiss analyzes data from the IMF and other government sources to determine a country's rating.  They look at four factors:

1.) Debt Index:  The debt index measures the country's reliance on debt and deficit financing in proportion to its population and the overall size of its economy.

2.) Stability Index:  The stability index measure the country's strength in terms of its currency, reserves, status as a world reserve currency and default history.

3.) Macroeconomic Index:  The macroeconomic index measures the long-term sustainability of the economy including GDP growth, unemployment and inflation.

4.) Market Acceptance Index:  The market acceptance index measures the ability of the government to raise additional debt on the world's bond markets.

Here are their ratings for sovereign debt:

A - Excellent - The country's finances are in excellent shape with good budgetary and debt management.  It has a strong economy with good ability to raise additional funds in global markets as required.  Risks to bondholders relate to interest rate and exchange rate fluctuations only.

B - Very Good - The country's finances are in good shape with at least good scores in all four factors.  Most risks to investors involve interest rate and exchange rate fluctuations as noted above.

C - Fair - The country's finances are in fair condition although in the event of adverse economic conditions, it may encounter difficulties in maintaining its financial stability.  Investors in bonds from these countries face potential losses if there are sustained declines in the country's medium- or long-term government securities that exceed those that are strictly related to rising inflation.  Losses could also be incurred from a serious decline in a nation's currency.

D - Weak - The country is in a weakened financial condition with poor results on at least one of the four factors.  It could have a heavy debt load, inadequate reserves, poor economic growth or an inability to raise additional funds on the world's bond markets.  Risk to investors includes the threat of default.  Sovereign debt investments in C-rated countries should be considered speculative.

E - Very Weak - The country has very severe financial weaknesses that make investment in its securities highly risky.  Investors face very high risk of loss of investment capital because of bond price declines, currency collapses or default.  Sovereign debt investments in D-rated countries should be considered extremely speculative.

That's enough background.  Now let's look at what Weiss has to say about the United States and Canada.

1.) United States:  To open, Weiss quite clearly states that they are not big fans of the AAA ratings assigned by the major ratings houses to United States sovereign debt.  Here is a quote:

"We believe that the AAA/Aaa assigned to U.S. sovereign debt by Standard & Poor’s (S&P), Moody’s and Fitch is unfair to investors and savers, who are undercompensated for the risks they are taking. An honest rating for U.S. government debt is urgently needed to help protect investors and support the collective sacrifices the U.S. must make in order to restore its finances."

Weiss definitely does not go out of its way to be kind to the United States.  They rate United States' sovereign debt as meriting a grade of C, putting them in 44th place out of 47 nations in terms of its debt burden primarily because of its consistently large deficits, 32nd place for its international stability due to its low reserves, 27th place for economic growth because of the swings in its economic growth pattern and 6th place for its ability to borrow in the international bond marketplace, largely because the United States dollar is regarded as the world's reserve currency.  Overall, the United States comes in 33rd place out of the 47 nations in Weiss's ratings "world".

Here is Weiss's summary of their reasoning behind their assessment:

"The C rating signals that the current fiscal condition of the United States government is far inferior to that implied by its AAA/Aaa rating from other agencies. At the same time, it means that the U.S. retains enough borrowing power in the marketplace to give it the opportunity to take remedial steps. Still, there are grave risks for policymakers and investors, including the possibility of a vicious cycle that includes severe declines in U.S. bond prices and the U.S. dollar.

Although our opinion of U.S. sovereign debt contradicts the AAA/Aaa rating assigned by the U.S. credit rating agencies, it is supported by a large body of new research published by governmental and international organizations. Moreover, in creating its sovereign debt ratings, Weiss Ratings ensures fairness by avoiding conflicts of interest and focusing exclusively on objective, quantifiable criteria without cultural or political bias."  

Weiss feels that the AAA/Aaa ratings assigned to United States sovereign debt securities is misleading investors because it fails to warn investors of the true risk involved, meaning that investors are undercompensated for the risk that they are taking when holding United States Treasuries.  Most importantly, Weiss also notes that:

"The AAA/Aaa U.S. debt rating has continually fostered political resistance and gridlock in Washington. If an appropriate rating had been issued years ago, it could have played a pivotal role in helping lawmakers and policymakers take earlier remedial steps." (my bold)

Perhaps Weiss is correct; until there is a meaningful downgrade in the rating of United States sovereign debt, action on the part of Washington will not be forthcoming.  After all, until you are punished, you have no incentive to change your behaviour!  One need look no further than the recent example of the Eurozone to see what has happened when the major ratings agencies downgraded the debts of several European nations by several steps at a time.  Certainly, the Eurozone's problems are far from over but at least discussions are being held and modest headway is being made.  The same cannot be said for the United States where vitriolic partisan politicking takes the place of meaningful fiscal change.

2.) Canada:  Weiss downgraded Canada from C to C- on December 19th, 2011.  Weiss states that Canada is expecting slower-than-expected economic growth and rising unemployment which will make it increasingly difficult for Canada's government to balance its budget.  As well, due to close economic ties with the United States and Europe, Canada is in the line-of-fire and cannot possibly hope to sidestep the world economic slowdown as it relates to the Eurozone debt crisis.  Weiss also notes that reduced government receipts will make it difficult to achieve fiscal balance.  This assessment is not that far off from what Canada's Parliamentary Budget Officer noted in his appraisal of Canada's chances of fiscal balance in his most recent PBO Economic and Fiscal Outook in November 2011.

To put these ratings into perspective, Weiss rates Austria as a C+, Belgium as a C-, the United Kingdom as a C-, Turkey as a C-, Ireland as a D-, Spain as a D+, Portugal as a D+, Brazil as a C, Greece as an E and Australia as a C+.  Austria, Belgium and Turkey have all noted declines in their ratings in recent months due to deteriorating conditions in the stability of their financial markets.  It is interesting to see Canada and the United States dwelling in the Eurozone debt transgressors neighbourhood, isn't it?  Weiss's A-rated nations include Switzerland, Singapore, China and Malaysia.

As a hobby economist, I really like the Weiss ratings system.  Not only is it easier to understand for lay people, I think that it better reflects the true situation of the fiscal stability of both Canada and the United States.  While the governments of both nations just love to strut about and proclaim that their debt has among the world's highest credit ratings, their grasp on reality is tenuous at best.  Weiss's grasp of the real issues that will ultimately impact the creditworthiness of nations seems to be far more compelling.  After all, one cannot go on making a dollar and spending a two dollars forever.  The folks at Weiss seem to be aware of that fact.  Unfortunately, our politicians do not.