Social Security Funds as Government Milking Cow: Spain Edition

I previously pointed out what seems as Ponzi financing scheme where the Spanish government has raided its pension reserve fund in order to boost Spanish bonds or to lower bonds yields, by buying up to government debt up to 97% share of its assets.

For the cash strapped Spanish government, this hasn’t been enough, as they squeeze money from the social security fund to finance state pension.

According to a report from Reuters: 

Spain tapped its social security reserve fund for the second time in a month on Monday, the Labour Ministry said, to help with extra summer pension payments as unemployment and retirement costs deplete government funds.

The government turned to the fund for 3.5 billion euros ($4.6 billion) on July 1 then for a further 1 billion euros on Monday. Spanish pensioners receive two cheques in summer and two over the Christmas holidays.

Spain was forced to tap the reserve for the first time last year to help pay pension costs, using some 7 billion euros.

Record high unemployment, which hit over 27 percent in the first quarter, and a growing number of retirees on a state pensions have put an unprecedented strain on Spanish social security funds.

Social security or pension funds have become a favorite tap for governments, especially for the cash strapped variety. These funds are not only subject to to government’s predation, they can also be used as instruments to effect political agenda. For instance, in the Philippines, government retirement fund the GSIS has been used as a tool to promote the popularity of the incumbent government via stock market purchases. Not only does the GSIS intervene directly via actual purchases, they also provide signaling mechanism to the marketplace by pledging to buy stocks at certain levels.

And like the Detroit saga, if the Spanish government defaults on their debt, pension fund beneficiaries will get cleaned out.

It’s sad to know how government tapping of or dabbling with people’s savings would eventually lead to hardships.

Spanish Government’s Ponzi Financing Scheme

More signs why the European debt crisis is far from being over.

Spain’s pension fund has been loaded with debt from the Spanish government

From Bloomberg: (bold mine)

Spain’s pension reserve-fund ramped up its holdings of domestic debt last year, profiting from a rally across southern Europe and making it easier for Prime Minister Mariano Rajoy to raid the fund to finance his budget.

The so-called Fondo de Reserva de la Seguridad Social in 2012 increased its domestic sovereign debt holdings to 97 percent of its assets from 90 percent at the end of 2011, according to its annual report due to be presented to lawmakers today at 12:30 p.m. in Madrid and obtained by Bloomberg News.

The fund purchased about 20 billion euros ($26 billion) of Spanish debt last year, while it sold 4.6 billion euros of French, Dutch and German bonds. More than 70 percent of the purchases took place in the second half of the year, after European Central Bank President Mario Draghi pledged to do “whatever it takes” to defend the euro, boosting Spanish bonds.

Two insights from the above.

One, pension funds are subject to government’s predation, thus can’t be relied on.

Two, if the Spanish government defaults on their debt, pension fund beneficiaries will get cleaned out.

Yet more signs of increasing vulnerability of Spain’s welfare state. More from the same article: (bold mine)

Spain’s state-run social security system, also in charge of unemployment benefits, stopped registering surpluses in 2011. Its deficit was 1 percent of GDP last year, contributing to the nation’s total budget gap of 10.2 percent of GDP.

A recession is crimping contributions paid by workers and their employers. At the same time spending has increased due to a record jobless rate of 26 percent and a pensions’ bill, which has risen to 9 billion euros a month from 8 billion euros in 2004.

While the fund stopped receiving government contributions in 2010, its managers changed rules on July 17 to profit from returns from Spanish securities, according to the document.

The maximum amount that can be invested in a given security was increased to 35 percent of the total portfolio from 16 percent. At the same time, the fund raised to 12 percent from 11 percent its maximum share in the Treasury’s total outstanding debt. The Treasury’s debt stock was 634 billion euros in February, according to data on its website.

See why governments have used central bank inflationism to boost asset prices? Gains from asset arbitrages have been used to cover funding shortfalls!

This reminds me of Hyman Minsky’s Ponzi finance from his Financial Instability Hypothesis

Mr. Minsky defines Ponzi finance as (bold mine)

cash flows from operations are not sufficient to fulfill either the repayment of principle or the interest due on outstanding debts by their cash flows from operations. Such units can sell assets or borrow. Borrowing to pay interest or selling assets to pay interest (and even dividends) on common stock lowers the equity of a unit, even as it increases liabilities and the prior commitment of future incomes. A unit that Ponzi finances lowers the margin of safety that it offers the holders of its debts.

In short, Ponzi finance depends on asset values from which is used either as collateral for borrowing or for funding purposes through asset sales.

 

How Ponzi schemes implode, again from Mr Minsky

In particular, over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance.

Furthermore, if an economy with a sizeable body of speculative financial units is in an inflationary state, and the authorities attempt to exorcise inflation by monetary constraint, then speculative units will become Ponzi units and the net worth of previously Ponzi units will quickly evaporate. Consequently, units with cash flow shortfalls will be forced to try to make position by selling out position. This is likely to lead to a collapse of asset values.

The difference here is that Mr. Minsky refers to capitalist economies or private finance units as practitioners of Ponzi financing, whereas today it has been governments that rely on Ponzi finance via asset bubbles to sustain their welfare states.

And Spain’s Ponzi finance scheme shows why debt laden governments will unlikely resort to the “exorcise inflation by monetary constraint”, since this will “lead to a collapse of asset values”, thus extrapolates to the collapse of Spain's welfare state.

At the end of the day, what is unsustainable will simply not last, like all ponzi finance schemes, they will fail.

Markets in Risk ON mode on Easing of EU’s Debt Crisis Rules

It seems that global financial markets are in a RISK ON mode anew as EU officials come into an accord to ease debt rules.

From Bloomberg,

Euro-area leaders agreed to ease repayment rules for emergency loans to Spanish banks and relax conditions on possible help for Italy as an outflanked German Chancellor Angela Merkel gave in on expanded steps to stem the debt crisis.

After 13 1/2 hours of talks ending at 4:30 a.m. in Brussels today, leaders of the 17 euro countries dropped the requirement that governments get preferred creditor status on crisis loans to Spain’s blighted banks and opened the door to recapitalizing banks directly with bailout funds once Europe sets up a single banking supervisor.

The leaders struggled for consensus on reducing market pressure on Italy and Spain, where surging borrowing costs stoked concern among investors and global policy makers that the currency union threatened to splinter and risk damaging the global economy. They would be allowed access to rescue loans without relinquishing control of their economies.

“We agreed on short-term measures that should apply to Spain and Italy,” said Luxembourg Prime Minister Jean-Claude Juncker, who heads the group of euro finance ministers. “We will keep all options open to do the interventions that need to be done to calm the situation. There is a whole array of possible interventions and measures.”

Make-or-Break

The gathering marked at least the fourth time in the past year that the guardians of the euro faced a make-or-break summit to restore confidence in their 17-nation bloc. They have struggled so far in vain to contain the financial crisis that began in Greece in 2009. The turmoil claimed its fifth victim this week when Cyprus sought a bailout.

Rules are made to be broken in order to accommodate the interests of the political elites, so what else is new?

We have seen this story play out again and again.

1. Realization that the crisis hasn’t been resolved sends the market into a RISK OFF mode.

2. EU officials meet and make announcements (pledges to inflate, new accord, new rules, new lending and etc…) and the markets switches to a RISK ON mode.

3. Go back to stage 1.

The problem is that the positive impact from such political actions seems to be diminishing.

The article says that EU “have struggled so far in vain to contain the financial crisis that began in Greece in 2009”.

Well that’s because EU officials have been using politics (such as the above) as the main tool to solve economic problems in order to preserve the status quo, mostly through financial repression measures.

Instead, EU officials should adjust politics to conform with economic realities through economic liberalization reforms.

Denials and measures that bank on hope or short term patches won’t have any lasting impact. This only worsens the uncertainty and sets the conditions for magnified volatility.

Dealing with Today’s Uncertainty: Patience is the Better Part of Valor

Highly volatile markets will be the outcome of today’s treacherous geopolitical conditions. That’s what I have been saying all along.

Volatility in Both Directions but with a Downside Bias

So far my perspective has been continually confirmed: volatility on both directions with a downside bias, especially for the Phisix.

A week ago, the Phisix got slammed early but the bulls worked their way to cover on the lost ground, and by the end of the week, losses had been trimmed to less than half[1].

The opposite scenario occurred this week: the Phisix had a strong opening carried mostly by the initial torrent from Spain’s bailout, but bulls eventually succumbed to the bears by the week’s close.

Technically speaking, in spite of all the volatility, the Phisix has been rangebound.

Volatility has been global.

In seeming defiance of gravity where bad news conventionally extrapolates to lower markets, today, bad news IS good news.

It is ironic to see central bankers scream for blood[2], yet global equity markets trekked higher. That’s because market participants have been conditioned to the Bernanke Put or expectations that central bankers, led by the US Federal Reserve, will like a knight in shining armor, ride to the rescue.

News of the $125 billion Spanish bailout prompted for a one day euphoria which quickly faded. It was evident that markets saw through the flaws of the proposed bailout[3]. However as the week progressed, the spate of bad news gave way to intensifying speculations, which has been further fuelled by promises[4] of renewed interventions by central bankers.

Except for ASEAN bourses which posted mixed showing, major global indices registered modest to significant gains over the week.

China’s Loan Growth and Chart Patterns

China’s loans unexpectedly jumped in May, according to news reports[5]. This has prompted the Shanghai index to post a modest advance of 1.13% over the week.

Most of the growth in China’s credit markets seems to have been driven by State Owned Enterprises (SOE). This means that China may have embarked on a furtive state based stimulus rather than a nationwide program.

Unfortunately SOE’s which have played a prominent role in the expansion of China’s highly fragile shadow banking system and which has already been encumbered by questionable loans, may have limited actions for further expansion. But of course, given that SOEs are government owned firms, restrictions may be circumvented to advance political goals.

Yet given the moderate gains exhibited by China’s equity markets on such development, investors must have remained cynical to the sustainability of China’s bailout policies.

Nevertheless surging bond yields have not posed as a burden to global stock markets in heavy anticipation of central bank steroids. In spite of Spain’s bailout, Spain and Italy’s bond yields soared[6].

A week’s action cannot be read as a sustainable trend, thus we must continue to observe how prices in various markets will react to China, as well as to the developments in Europe, particularly the Greece moment and in the US.

Many have crowed about the bullish potentials of the US stock market through the reverse head and shoulder pattern, which they think may have a spillover on the Philippines.

As I pointed out in the past, patterns don’t make prices, people’s actions do.

It will be actions of central bankers that will determine the directions of the marketplace rather than chart patterns. I pointed out last year that the death cross in the US S&P 500 in August of 2011 signified a false alarm[7] (false positive error) and was eventually validated four months after[8].

So far, US money supply M2 seem not supportive of a sustained rise by the S&P 500 owing possibly to the US Federal Reserve’s offsetting of the “flight to safety” inflows coming from the EU and from the closure or winding up operations of Operation Twist as discussed last week[9].

It would likely take the FED another ramping up of their balance sheet expansion to rekindle the monetary accommodation.

So the bullish chart pattern may play out its trend if the Fed will ease further, otherwise, the chart pattern will likely fail.

Buy the Rumor, Sell the News

Global financial markets have relied heavily on the “buy the rumor” from central banking rescues.

These are likely to have two short to medium term outcomes.

One, if central bankers FAIL to deliver in accordance to market’s expectations, then we will likely see another huge bout of downside volatility in global equity markets.

The Phisix, whom has not been immune to contagion, may breakdown its recent support level at 4,863, a level which represents nearly 10% from the peak. But a breakdown may not necessary lead to a bear market.

Yet such market turmoil may likely serve as fulcrum for the next batch of intensive interventions. Nevertheless, under such conditions, it would be best to wait and see until volatilities in the financial markets (stocks, commodities, bonds) subside, before considering to reposition.

On the other hand, if markets may be temporarily satisfied with REAL actions of central banks (e.g. $1 trillion bailout) then we should see a minor or a slight “sell on news”. But this should be seen as opportunities to RE-ENTER the markets incrementally.

Of course, the direction of gold prices, as well as, prices of general commodities, will serve as crucial indicators in determining the strength of the trend.

While gold’s price trend has significantly improved, there have been little signs of progress in the oil market (WTIC) and the general commodities (CRB).

Finally as caveat, I would like to reiterate that should markets continue to rise in ABSENCE of REAL actions from central bankers, we cannot rule out that the markets could fall like a house of cards (fat tail risks) or what I would call a Dr. Marc Faber event[10].

The market’s deep addiction to stimulus will eventually seek REAL stimulus more than just promises or in central bank lingo, signalling channel. Reversal of expectations can become violent.

As a side note, I find it ridiculous for people especially so-called experts to assert that today’s problems have been caused by lack of confidence, as if confidence has been randomly determined, and not in reaction to changes in the environment or in response to interactions with people. People have been not confident with the markets because of the persistent problem of insolvency and price artificiality and price distortions from political meddling. It’s a severe mistake to interpret effects as THE cause.

Bottom line: Global financial markets, including the Phisix, remains in a state of limbo. Uncertainty still governs. Under current conditions, the best guiding principle would be; patience is the better part of valor.

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[1] See Expect a Continuation of the Risk ON-Risk OFF Environment, June 11, 2012

[2] See Central Bankers Talk Doom, Markets Surge, June 16, 2012

[3] See Why Spain’s Bailout may NOT Work June 12, 2012

[4] See Talk Therapy boost US Markets, June 15, 2012

[5] See China’s New Loans Unexpectedly Surged in May, June 12, 2012

[6] Danske Bank, All eyes on Greek election June 15, 2012 Weekly Focus

[7] See How Reliable is the S&P’s ‘Death Cross’ Pattern?, August 14, 2011

[8] See US Equity Markets: From Death Cross to the Golden Cross, December 31, 2011

[9] See Expect a Continuation of the Risk ON-Risk OFF Environment, June 11, 2012

[10] See Dr. Marc Faber Warns of 1987 Crash if No QE 3.0, May 11, 2012

Why Spain’s Bailout may NOT Work

Author and derivatives analyst Satyajit Das at the Minyanville.com has an insightful dissection of why Spain’s bailout will not likely succeed (all bold emphasis mine)

1. Spain’s bailout package overlooks the requirements of larger banks

The amount -- 100 billion euros or more depending on the independent assessment of the needs of Spanish banks -- may not be enough. On the surface, the amount appears around three times the 37 billion euros the International Monetary Fund says is needed. The capital requirements of Spanish banks may turn out to much higher -- as much as 200 billion to 300 billion euros.

The IMF assumes only the smaller Spanish savings banks (the Cajas) will need help. In reality, the larger Spanish banks may also require capital.

Spain’s banks have over 300 billion euros in exposure to the real estate sector, mostly through loans to developers. Around 180 billion euros of this exposure is considered “problematic” by Spain’s central bank.

Estimates suggest that there are about 700,000 vacant newly built homes, but including repossessed properties the total could be as high as 1 million or even higher. At current sales levels, it will take many years to clear the backlog, which will be compounded by more properties being completed and coming onto the market. Housing prices have fallen by 15% to 20% but are forecast to fall eventually by as much as 50% to 60%. A severe recession and unemployment of 25% means that losses on Spain’s over 600 billion euros of home mortgages loans are likely to also rise.

2. The bailout excludes sovereign debts

The proposed amount also does not include any provision for write-downs on holding of sovereign debt. Local banks are estimated to hold over 60% of outstanding Spanish government bonds.

3. The conditions of Spain’s bailout may prompt for a domino effect or demand for changes in the conditions or covenants of existing bailouts by other crisis affected EU nations.

The bailout will be provided with no conditions, which creates its own problems. The lack of conditions may lead to Greece, Ireland, and Portugal seeking relaxation of the terms of their assistance packages. The lack of conditions also prevented the IMF from contributing.

4. The bailout lacks the discipline of keeping the house in order, unlike crisis affected Asian economies during the 1997 Asian Crisis.

In an opinion piece in the Financial Times, Jin Liqun, chairman of the supervisory board at the China Investment Corporation, pointedly noted the contrast between the treatment of European and Asian countries.

Viewed from China, the management of the eurozone debt crisis offers a stark contrast to the handling of the 1997-98 east Asian crisis. In that episode, Thailand, South Korea and Indonesia were all forced to implement tough austerity programmes imposed by the International Monetary Fund.... Unlike many of today’s Europeans, the people of east Asia did not have the luxury of large relief funds from outside their countries. The people had to tolerate hardship...In a poignant case, the Korean people contributed gold and household foreign exchanges to the government to help ease fiscal pressure.

Amen to that.

Western politicians think that they can elude the laws of nature. Markets will eventually prevail.

5. The bailout overestimates on the sources for funding.

Future international support, either bilateral or through the IMF, may be difficult.

The funds will come from either the European Financial Stability Fund or the still to be approved European Stability Mechanism. Since 2010, the eurozone has committed 386 billion euros to the bailout packages for Greece, Ireland, and Portugal. In theory, the EFSF and ESM can raise a further 500 billion euros, beyond the commitment to Greece, Ireland, and Portugal, allowing them to contribute the 100 billion euros for the recapitalisation of the Spanish banking system. The EFSF/ESM also assumes that it “can leverage resources." The reality may be different.

For a start, Finland has indicated that it may seek collateral for its commitment, an extension of its position on Greece which the European Union ill-advisedly agreed to.

As Spain could not presumably act as a guarantor of the EFSF once it asks for financing, Germany’s liability will increase further from 29% to 33%. France’s share also increases from 22% to 25%. The liability of Italy, which is in poor shape to assume any additional external financial burden, rises from 19% to 22%.

The EFSF’s AA+ credit rating may now be reduced. Irrespective of the rating, the EFSF and ESM will have to issue debt to finance the bailout. Support for any fund raising by these instrumentalities is uncertain.

Commercial lenders have been reducing European exposure. Emerging market members with investible funds lack enthusiasm for further European involvement. Lou Jiwei, the chairman of China Investment Corporation, the country’s sovereign wealth fund, has ruled out further purchases of European debt: “The risk is too big, and the return too low."

6. Spain’s bailout will worsen Spain’s financial ratios which could likely dissuade participation from the private sector.

The bailout also does not address fundamental issues.

The funds will be lent to the Spanish government, probably its bank recapitalisation agency Fondo de Reestructuracion Ordenada Bancaria (FROB), rather than supplied directly to the banks because of legal constraints. This will add 11% of GDP to Spain’s debt level. The transaction will do nothing to reduce the country’s overall debt level -- over 360% of GDP before this transaction.

Spain’s access to capital markets or its cost of debt is not addressed. The last auction of Spanish government bonds saw yield around 6.50% per annum with the bulk of bonds being purchased by local banks. Spain and its banks also face pressure on their own ratings, which are now perilously close to becoming non-investment grade.

The bailout may actually adversely affect the ability of Spain and its banks to funds. Commercial lenders are now subordinated to official lenders. Based on the precedent of Greece, this increases the risk significantly, discouraging investment.

The European Union has stated that it believes that these measures will help the supply of credit to the real economy and assist a return to growth. This optimism is unlikely to be realised.

Restoring the bank’s solvency will not result in an increase in credit. The capital will allow existing bank debts to be written off. Spanish banks have limited access to funding. They are heavily reliant on the European Central Bank for money, a position which the assistance does not address.

Interventionism begets more interventionism which substantially deepens the distortions of the markets, through more misallocations or malinvestments and which consequently aggravates the problems.

Policymakers do NOT have the KNOWLEDGE and the RESOURCES to deal with the worsening crisis.

The basic 'commonsense' solutions are to keep the proverbial house in order through fiscal discipline “austerity”, allow unsustainable institutions to fail or for the markets to clear and to induce competitiveness by removing structural political and regulatory obstacles (e.g. labor market reforms).

Yet commonsense has been disregarded for wishful thinking.

The current path of policies of sustained bailouts only increases the risk of MORE inflationism which serves as the fundamental reasons to be bullish on gold and commodities.