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On The Cliff

  • Written by Syndicated Publisher No Comments Comments
    October 3, 2012

    Absent some earth shaking event between now and November, Obama is going to win, the House will remain in the hands of the Republicans and the Senate will continue to be equally divided. The war between Reds and Blues will be just as bad as it was a year ago. The day after the election, the fight over the fiscal cliff will commence. I expect it will be ugly.


    -I think there is zero probability that all of the issues now on the cliff will be pushed off to some future period. (Ultimate-can-kicking) Some of the cutbacks/tax increases that are now scheduled, will happen.


    -I put the odds on falling off the cliff without any compromises at 40%. This scenario comes about if the Reps and Dems can’t agree on anything. If that is the case, we fall very hard on January 2. (No-can-kicking)


    -Therefore, I see a 60% chance of a compromise that softens the consequences of the fiscal cliff, but does not eliminate it entirely. (Semi-can-kicking, but still kicking ourselves in the face)


    If there is to be a compromise, it will be interesting to see who gets what, and who gives up what. It might play out with the following results:


    I)              The 2% reduction in FICA taxes is history. As of 1/1/13 every worker is getting hit with a 2% tax increase. This is a very regressive tax increase.



    II)            The Bush tax cuts for those making more than $250k are gone. This is a very Progressive tax increase.


    III)          The Bush tax cuts for those making less than $250k will be retained. This “centrist”compromises is the result of the “give” on #s I and II. Both sides will be able to claim that they did their best for “Middle Class Workers”.


    IV)          The Alternative Minimum Tax will be adjusted for inflation and will be fully phased in over a period of three years. This tax will hit 40m taxpayers (up from only 4m today). This is most definitely a middle class tax increase.


    V)            The capital gains tax rate is going to go up to at least 25%.



    The result of I – V is that everyone who works, or has investment income is going to be paying more. No one will escape higher taxes.


    Then there is the spending side of the ledger. The so-called, “sequestered” amounts. Here is where the real horse-trading will happen. Keep in mind that the timing of this critical argument debate will be in November and December. What else will be happening in those months that will influence the budget compromises? Talk of War.


    It is almost certain that post the election, Iran is going to be front and center. Israel has promised to hold off on an attack of Iranian nuke facilities until after America votes. After November 6, the headlines will be about war. There will be big NATO/US Navy activity all over the Straits of Hormuz. This will shape the debate on military cutbacks.


    With this as a backdrop, I don’t see the mandatory cuts for the military sticking. Most of the promised cutbacks will get eliminated, or pushed forward. Obama would welcome this, as it would allow him to trade more military spending for a deferral of the cuts in non-defense spending.

    We will get a half loaf of spending cuts and increased taxes. The results will not significantly change the trajectory of the deficit, it will create an additional drag on the economy.


    If all of the tax increases/spending cuts now pending are allowed to happen (we fall off the cliff) it will result in a drop in economic activity of at least 1.5%. It will bring about a recession that will last a minimum of six-months. The compromises that I outline above will still result in a contraction of economic activity. If we get (more or less) of what I see coming, then ¾% of annual GDP will be lost; for a long time.


    What does a lousy ¾% mean? It means sub-stall speed. It means GDP will be well below 2% for 2013 and beyond. It could mean that growth falls below 1%. (Functional recession; unemployment up, tax receipts down)



    There are two issues related to the “cliff” that are of interest to me. These are  minor matters (in the scheme of things). They are Wall Street related. They go by the odd names of:






    Grant Anticipation Revenue Vehicle (GARVEE) bonds are tax free, issued by states and are backed by anticipated future revenues from D.C. for dedicated highway construction. The Fed backing (not a guarantee) makes these bonds trade rich relative to straight state debt.


    The federal money to pay Garvee bondholders is at risk. Future payments from Washington are part of the sequestered amounts that will be on the negotiating table come November 7.



    The rating agencies have been downgrading Garvees because of the risk of repayment. There is only $10B of Garvee bonds outstanding. I think this problem will be patched up (it’s too small a matter to cause muni defaults). I also think that there will be no more Garvees issued. The fiscal cliff showed the flaw in the construction of these “bullet proof” bonds.


    Build America Bonds are taxable state debt issues. This hybrid security was a child of the crisis of 2008. It died in 2010 after $180B of BABs were issued. Republicans hated BABs, Democrats (led by Tim Geithner) loved BABS.


    There is an odd feature to BABs; they become callable if sequestration takes place:



    BABs were issued in the terrible days of 2009/10. Recall that the likes of Meredith Whitney were calling for massive muni defaults back then. As a result, the $181b of BABS that were issued all had nice fat coupons on them. The States would love to call that paper at par; they could replace it with much cheaper debt today. The losers would be the bondholders. They would see their nice yielding bonds called away. No one cares about bondholders anymore, so BABS are dead.


    Garvees and BABS are inventions of Wall Street. They are structured financial transactions that allow states to borrow more money by accessing different investor bases (tax vs tax exempt). In the end, Garvees and BABS will be throwaways in the horse trading. Their loss does not add up to much.  However, if you are thinking that the solution to America’s economic problem is a major infrastructure build out,forget it.


    A program big enough to create a few million jobs and modernize our roads, bridges, seaports and airports can’t be done with more federal borrowing. It has to come from the states. Shutting down BABs and Garvees is also saying “no” to that infrastructure plan.


    The worst case outcome would be that there are no compromises; and we fall off a fifty-foot cliff, and die. The best case is that we fall off a twenty-five foot cliff, and only suffer a few broken bones and a concussion. Options that were once available to the country to dig out of an economic hole will have been lost. A long period of economic mediocrity is the most likely outcome.



    Images: Flickr (licence attribution)

    About The Author – Bruce Krasting

    I worked on Wall Street for twenty five years. This blog is my take on the financial issues of the day. I was an FX trader during the early days of the ‘snake’ and the EMS. Derivatives on currencies were new then. I was part of that. That was with Citi. Later I worked for Drexel and got to understand a bit about balance sheet structure and corporate bonds from Mike Milken. I was involved with a Macro hedge fund later. That worked out all right, but it is not an easy road. There was one tough week and I thought, “Maybe I should do something else for a year or two.” That was fifteen years ago. I love the markets. How they weave together. For twenty five years I woke up thinking, “What am I going to do today to make some money in the market”. I don’t do that any longer. But I miss it.