James Saft

James Saft is a Reuters columnist. The opinions expressed are his own.

HUNTSVILLE, Ala. — Housing in the U.S. is in the midst of a double dip in prices, a threat to the economic health of banks, households and the country itself.

S&P Case-Shiller will release on Tuesday their house price index, which will likely show a fall to a new post-bubble low, with prices now back to where they were in the middle of 2003.

House prices have hit a new post-bubble low, down almost a third from their 2006 peak, according to data released on Tuesday by S&P Case-Shiller.

Pending home sales, released last week by the National Association of Realtors, fell by 27 percent in April compared to the year before, an 11.6 percent fall in the month.

Given that we are supposed to be in the Spring home selling season, the outlook for the rest of the year is not good.

There are, in the current market, very few normal buyers; many are swamped by negative equity in their current house and those who are not are reluctant to commit their own capital to a falling market.

Given tighter underwriting standards someone who now owes more than their house is worth faces a double burden if they choose to buy a new one; cut one fat check to their existing lender to cover the shortfall and an additional one for a chunky down-payment for the new house.

And while mortgage rates remain low, and may well fall from here, underwriting criteria, outside of some government-backed programmes, are tight.

The pressure from sales of foreclosed homes is one of the prime forces driving prices lower. Banks are far more willing to cut prices to get a sale done than homeowners and many foreclosures are in poor condition, requiring further discounts to entice buyers.

The foreclosure system is overwhelmed, even despite a drop in new foreclosure starts and delinquencies. A scandal and lawsuits over improper foreclosure procedures has slowed the process, and it may be that banks are deliberately holding properties back so as not to further erode prices. At the current rate of sales it will take more than four years for banks to sell off their existing inventory of foreclosed or seriously delinquent houses. More than 40 percent of delinquent mortgages have been delinquent for more than a year, according to Lender Processing Services. That makes arguments that housing has reached fair value irrelevant. Four more years of foreclosure sales makes the market unattractive to all except for cash buyers looking for cash flow from renting the property and willing to wait patiently for capital values to rise.

CHANGE OF OUTLOOK

The long fall of housing has three main impacts; on the banking system, on the economy and on the psychology of U.S. consumers.

Even after the crisis, real estate remains a huge exposure for the banking system, both in terms of “toxic” assets from before the crash and prime and near-prime loans.

The Markit ABX AAA 2007-1 index, a tradable derivative based on sub-prime loans, has fallen about 20 percent in just over three months, reflecting weakness in housing and the very poor recovery rates banks are able to get from foreclosed houses. The longer a house remains in foreclosure, the higher the chance that it enters the market damaged, meaning investors can end up with far smaller payouts as a percentage of their capital then they would have planned on in even the direst scenario planning session.

“We are looking at some sort of an echo of the credit crisis coming up here,” noted bond fund manager Jeffrey Gundlach, of DoubleLine Capital, told CNBC television.

“You have to wonder about how these recovery rates are gong to do anything but go down and that will lead to an awareness of strains in the financial system. who’s to say that we won’t get an echo that re-prices
risk?”

Bank shares are beginning to reflect that risk, having fallen about 5 percent since February and underperformed the S&P 500 .SPX by 10 percentage points since the beginning of the year.

The economic impact of housing is broad, with home building usually driving the business cycle. The lack of a broad recovery in housing, despite government life support, is one of the reasons that the recovery has been so weak. A sustained double dip in house prices will further depress home building and other allied activity.

The biggest impact may prove to be psychological. Americans have had a 60-year romance with real estate and have come to conflate housing consumption with real estate investment. This has driven them to take on more leverage, to own multiple homes and to take on ever more risk. That mind-set has been slow to erode, even in the face of four years of evidence.

If Americans begin to scale back their expectations, both of how much house they need and how much housing will appreciate, the double-dip may turn into a decade-long grind lower.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

James Saft is a Reuters columnist. The opinions expressed are his own.

HUNTSVILLE, Ala. — With just a month to go until the Federal Reserve brings QE2 to a close, most analysts are focused on the risks to markets if interest rates shoot higher when the government is no longer buying its own debt.

But an alternative is worth considering: what if this buying binge by the Fed is followed not by that fire but by the ice of sinking yields and another lurch towards deflation.

Albert Edwards, a trenchantly bearish strategist at Societe Generale, maintains that Treasury yields are heading lower and that this will be accompanied by the mother of all busts on the stock market, taking the S&P 500, currently at about 1,325 points, to 400.

Yes, that’s right, 400.

“Despite fully acknowledging the ruination of the government balance sheets as years of excess private sector debt are transferred to the public sector, we still expect to suffer another deflationary bust that will take government bond yields to new lows before government profligacy and the Feds’  printing presses take us back to both double-digit inflation and bond yields,” Edwards said in a note to clients. “For now, we remain heavily overweight government bonds.”

The more mainstream concern is that the ending of the second round of quantitative easing will remove a key support for Treasuries and that few will be willing to buy when the Fed is not, especially given the uncertain outlook for the budget and inflationary pressure from commodities and energy.

At the same time QE2 is ending, Chinese and emerging market tightening may mean less natural appetite for Treasuries. If China decides to allow its yuan to strengthen to fight inflation, this will be exacerbated. China must buy Treasuries to recycle export dollars and keep its currency cheap. If China decides to ease up on that policy there will be fewer Treasuries purchased.

Edwards thinks, though, that this will be swamped by weak economic fundamentals and a sell-off in risk assets. Both of these forces would send Treasuries higher, even despite the absence, at least temporarily, of the Fed as a big buyer of government debt.

So, in this scenario, the money that was displaced by the Fed during QE2, money that poured into risk assets, particularly bonds, comes flooding back to Treasuries, driven by fear of an economic downturn and seeking safety from carnage in the corporate markets.

Mark my words, if Treasuries do rally after the end of QE2, even if they are rallying due to a recession, we can expect the Fed and the Treasury to immediately claim credit for having wisely earned the U.S. profits by buying up its own debt.

DEBT NEGOTIATIONS IMPORTANT

Treasuries could also get a boost, strangely enough, if the U.S. fails to raise the debt ceiling by the Aug. 2 deadline, sending itself into a semi-default. In this scenario, espoused by Rob Dugger of Hanover Investment Group, money would pour out of stocks and bonds of companies which would be hurt by a government shutdown, either via higher taxes or lower government expenditures.

While this money flows into Treasuries some may take a polite default by the U.S. as positive for longer term Treasuries, on the view it makes the politically difficult task of cutting expenditures and raising taxes that much more likely.

It would certainly be poisonous for stocks and corporate bonds, as indeed should be recent signs of weakening in the U.S. and global economies.

U.S. durable goods orders was the latest in a string of disappointing data points, as they showed the largest fall in six months, considerably worse than analysts’ forecasts, on weak orders for aircraft and autos. Adding to this are recent signs of faltering growth in Japan, China and Europe, all of which has doubtlessly been partly caused by natural and man-made disasters in Japan.

The trials and follies of the euro are another prime reason to consider a Treasury rally. First off, the austerity being imposed on Greece, Portugal, Spain and Ireland are a profoundly deflationary force in themselves, a dampening of demand and cheapening of production that in aggregate is important.

What’s more, the risk of a Greek default, much less it coming to reality, will surely send investors scuttling for safety. While Swiss and Canadian debt and gold may be more deserving havens, they are not nearly large enough and considerable money will flow where it always does in times of uncertainty and stress: to Treasuries.

None of this is to imply that Treasuries are a fundamentally sound investment. The risks of inflation and a foreign sell-off are real, and you can bet that a new economic downturn will be met by new policy errors, or perhaps just the same policy errors all over again.

At the time of publication James Saft did not own any direct investments in securities mentioned in this article.

James Saft is a Reuters columnist. The opinions expressed are his own.

HUNTSVILLE, Ala. — With QE2 set to end in five weeks and with Greece rolling downhill towards default, the world is not best placed to withstand a weakening economy.

That, however, is exactly what looks to be happening, as Asian demand is hit by a cooling China and a struggling Japan.

Let’s take a look at the evidence:

Japan’s economy shrank by 0.9 percent in the three months to March, battered by the earthquake, tsunami and ongoing nuclear fiasco.

The preliminary HSBC/Markit purchasing managers’ index for China fell to 51.1 in May from a final reading of 51.8 in April, holding in expansionary territory above 50 but amidst growing evidence that China is coming off the boil. Chinese demand for raw materials and semi-finished products has been one of the global economy’s principal supports, but now a monetary policy tightening campaign may be gaining traction.

The Chicago Fed national index, derived itself from 85 economic indicators, came in at negative 0.45 in April compared to 0.32 in March. There are numerous signals of an industrial slowdown in the U.S., while the housing market continues to weaken, threatening financial stability and consumer spending.

Finally, in Europe the euro zone composite flash PMI, an indicator combining service sector and manufacturing purchasing, fell to 55.4 from 57.8. More worryingly, the headline manufacturing index had its biggest fall since Lehman Brothers failed, falling by 3.1 points to 54.8.

“All in all it seems to us that the odds are high that a domestic and global economic slowdown is already in place.  In the U.S. the slowdown is happening with only weeks to go before the end of QE2, a program that has been a major prop for even the tepid recovery we’ve undergone so far,” said Charlie Minter of fund managers Comstock Partners in a note to clients.

“For the stock market nothing seems to matter until, suddenly, it does.”

It has begun to matter recently to the stock market, which has fallen in recent sessions after a sustained rally. The bond market has already figured this out; since mid-April U.S. 10-year yields are down more than 12 percent to 3.12 percent. Given that the U.S. debt market faces a debt showdown and the end of QE2, both factors which should theoretically send yields higher, this slide in yields shows real doubts about future growth.

CRUEL SUMMER

It is worth noting that the euro zone’s woes were not this time concentrated in the weak peripheral states; this time Germany got whacked too. That may well reflect the wrench thrown into production from Japanese plant closings, which in itself will self-correct. It is also likely reflecting a slowdown in demand for German products from China. If you believe that Chinese demand was artificially boosted by very easy credit, and that Chinese demand in turn was driving global growth, then this is an indicator of a very busy and volatile summer in financial markets.

Global markets have ignored, more or less, the euro zone’s issues for more than a year, but did so in a very supportive atmosphere. The Federal Reserve was buying up Treasuries, sending cash into risk markets in waves, while China continued to grow at a blistering pace. It may be that China is important not just because its slowdown affects demand, but because it lets investors focus on the actual prospects in the euro zone.

Will Germany and France be as willing to foot the bill for Greece if their own manufacturing bases begin to shrink? It is possible but a lot less likely.

Meanwhile the crisis both builds and spreads, with a dispute over debt reprofiling (a sort of doe-eyed default) between the European Central Bank and European officials and a fantasy plan by Greece to raise 15 billion euros through asset sales.

Greece may turn out to be a minor worry; Belgium and Italy have been threatened with credit downgrades by Fitch.

So what happens from here? A palatable outcome would be a gentle decline in economic momentum followed by a strong second half. This makes absorbing the impact from Europe easier, and makes it easier for Europe to come to terms with itself.

A less likely, perhaps, but still possible scenario is that the manufacturing slowdown gains speeds just as Europe faces a contagion from the periphery, either to parts of the core, to the banking system of the core, or both.

At this point the Federal Reserve will have an ugly choice; does it extend and expand quantitative easing to support the newly weakening economy, or does it sit tight, brace for the recession and hope something else will turn up?

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

James Saft is a Reuters columnist. The opinions expressed are his own.

HUNTSVILLE, Ala. — While the U.S. will fight it kicking and screaming, the dollar’s upcoming fall from its central global role will be a blessing all round.

The World Bank on Tuesday predicted that the dollar will lose its place by 2025 as the principle global reserve currency, to be supplanted by a multipolar world where it, the euro and the yuan will share top billing.

First off, things have come to a sorry pass when the dollar is going to lose out to two currencies of which one, the euro, many people worry may cease to exist, and the other, the yuan, isn’t even properly convertible.

But beneath the ignominy lies a simple truth: being the world’s main reserve currency is a bit like being a pop star; there are lots of fringe benefits but it is very easy to end up in financial rehab.

There are several supposed central benefits to being the world’s principal reserve currency; lower funding costs, a home-field advantage in financial intermediation and better control over one’s own monetary policy. All three have been a mixed blessing, at best, for the U.S. and may yet turn out to be mostly malign.

“Countries whose currencies are key in the international monetary system benefit from domestic macroeconomic policy autonomy, seigniorage revenues, relatively low borrowing costs, a competitive edge in financial markets, and little pressure to adjust their external accounts. It has also produced a potentially destabilizing situation in which (a) the world’s leading economy, the United States, is also the largest debtor, and (b) the world’s largest creditor, China, assumes massive currency mismatch risk in the process of financing U.S. debt,” according to the World Bank’s report titled “Multipolarity: The New Global Economy.”

“Another shortcoming of the current system is that global liquidity is created primarily as the result of the monetary policy decisions that best suit the country issuing the predominant international currency, the United States, rather than with the intention of fully accommodating global demand for liquidity,” it added.

Because people must buy dollars to make many financial transactions, and central banks choose to hold dollars as a store of value, the dollar is too strong, borrowing in dollars is too cheap and there are inadequate controls on unsustainable behavior such as running current account deficits.

IT’S BAD TO BE KING

The U.S., both as a nation and a collection of individuals, would surely have borrowed less and arguably would have invested more if lower demand for the dollar had made real interest rates higher. It has been all the easier to believe fictions like the idea that we can all grow rich by buying each other’s houses when money was so cheap. There is then a direct line between dollar supremacy and the serial bubbles.

That brings us to monetary policy and the supposedly huge benefits of being free to run it the way you see fit. This of course has not always been true, Chinese buying of dollars and Treasuries has meaningfully impaired the Federal Reserve’s ability to control the economy.

Even beyond that, being able to run unimpaired monetary policy is akin to allowing small children to decide exactly what they will eat; they are going to tend to overindulge in sweets and get sick. Now part of that is due to the “heads,  asset holders win, tails, they get bailed out” policies of the Fed, which has concentrated wealth and rewarded people for taking on too much risk. It is impossible to know how the Fed would have acted if the dollar were not king of the hill, but it’s a fair guess to say they would have placed less faith in the benign powers of debt and consumption.

As for having a competitive edge in financial markets, this perhaps has been the real disaster, as America has financialized itself into a place with greater structural risks (think too big to fail), greater income and asset inequality and a hollowed-out manufacturing base.

Now, if you want to know why the world will become financially multipolar you simply need to look at the growth projections the World Bank made for developed markets between now and 2025 — 2.3 percent annually — and the same figure for the emerging world — 4.7 percent. Power and centrality will follow the money.

The new world will not be perfect either. If China opens its economy fully we will see a huge bubble as capital floods in to make money. And if you are not in one of the main currency areas you will face new and complicated issues of volatility and risk.

The key point is that this transition must happen gradually. If the dollar’s reign does end the hard way, all of a sudden in a currency crisis, it will be in large part because of temptations inherent in being number one.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

James Saft is a Reuters columnist. The opinions expressed are his own.

There are signs that China’s stupendous debt-fueled boom is cooling, posing new risks for global growth and markets.

The People’s Bank of China on Thursday raised the bank reserve requirement ratio to a record 21 percent, a rise of a half a percentage point and the fifth so far this year. The move, effectively a tightening of monetary policy, comes as inflation at 5.3 percent remains high and industrial output slides, albeit to a still high 13.4 percent in the year to April.

China is an economy addicted to investment, a sort of fun house mirror of the U.S.’s addiction to consumption, with an astounding 93 percent of GDP growth in 2009 attributable to investment.

That’s a strategy that worked well for years, but China’s response to the global financial crisis, a sort of all-in push for lending and investment, has led to over-heating, uneconomic projects and possibly now a disruptive slowing of growth.

An estimate by Lombard Street Research of broad money growth, including various banking shenanigans, showed growth equal to 40 percent of GDP in 2010, but falling quickly to 23 percent of GDP in the first quarter. Those figures reflect the tremendous growth of money being pushed through the banking system and through a shadow banking system that grew rapidly last year as banks tried to evade government control. The slowdown is almost as striking as the still heady heights of the growth.

That money powered investment across China into infrastructure, industrial production and real estate, sucking as it did tremendous amounts of raw materials and industrial goods from elsewhere in the world.

If Chinese appetite cools, the effects elsewhere will be large, both in countries like Germany which supply goods and places like Australia which supply materials.

There are complex opposing forces in China, with the central bank applying the brakes but other government authorities deeply ambivalent about the implications of a slowdown in investment.

“Historically one of the key indicators that the high-growth investment-driven model has reached its limits as a wealth creator (i.e. is no longer allocating capital efficiently) is when we see an unsustainable increase in debt,” according to Michael Pettis, a professor of finance at Peking University.

“Of course whether or not we have reached this point is still much debated, but I would argue that we started to see this at least five years ago. The surge in banking assets doesn’t give much comfort.”

BANKING ASSETS HIT RECORD

Total assets in the Chinese banking system grew to 2.39 times Chinese GDP last year, yet another record, driven by heavy state-instigated lending beginning in 2009.

There are also reports of widespread off-balance-sheet maneuvers last year and this by would-be borrowers seeking to raise funds while avoiding official control. The asset figure is likely a large underestimate of both assets and of the stimulative effect debt is having on the economy.

The real problem with the end stages of a debt-financed growth binge is that policy makers are trapped regardless of what action they take. If Chinese authorities stamp on bank lending they are sure to leave many projects halfway completed and in default, a serious blow to an already shaky banking system. If, on the other hand, they allow loans to continue to be made freely we will be looking at much froth and many projects with highly uncertain economic underpinnings and value.

So, if the money actually is slowing what will be hurt? Chinese bank shares are already underperforming western peers, perhaps discounting the possibility of loans going bad if sky-high property prices sag. This looks a distinct possibility: housing sales were down 40 percent in Beijing in the first quarter.

Again, the risk here is that the banking system goes from overdrive to credit crunch if it sees and fears bad loans.

Analysts at Societe Generale suggest that hard commodities, such as copper and iron ore, would be particularly hard hit. If the slowdown is mild we would likely see only the most frothy markets hurt, but in the event of a hard landing, probably not a central scenario this year, the impact would be both big and global.

Longer term the question for China is how it dismounts from the tiger of an investment- and export-oriented economy and makes the transition to one with more domestic consumption. Letting the yuan rise strongly against the dollar would help. A large one-time revaluation of the yuan would also obviously help to control inflation and so might be a possibility.

Unless the transition to a more balanced economy is very gradual it will be disruptive. China, having helped to fuel a bubble in many assets, may well be the catalyst for the corresponding crash.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

James Saft is a Reuters columnist. The opinions expressed are his own.

HUNTSVILLE — If you as an investor think that insider dealers like Raj Rajaratnam are a top concern then I have a bridge, or perhaps an intricate highly-structured investment vehicle, to sell  you.

Rajaratnam, the erstwhile billionaire and founder of hedge fund Galleon Group, was found guilty of 14 counts of securities fraud and conspiracy charges on Wednesday in a case that unveiled multiple instances of Rajaratnam obtaining and acting on inside information.

This has prompted all sorts of silliness to be asserted to the effect that the conviction will either restore investors’ faith in U.S. financial markets or stand as a testament to why investors don’t believe they will get a fair shake.

To be sure, much of the trial was genuinely shocking, not least allegations that Rajat Gupta, one-time global head of consultants McKinsey, and then a serving board member at Goldman Sachs, had called Rajaratnam within minutes of leaving board meetings. One call, which Rajaratnam was alleged to have acted on, took place 23 seconds after the meeting was gaveled. This is the Wall St. equivalent of finding out that the Pope leads black masses or seeing the Dalai Lama ringside at a dog fight.

Gupta, who denies wrongdoing, faces civil insider trading charges from the Securities and Exchange Commission.

While the prosecution is right and proper, and I look forward to many more similar trials, insider dealing is well down the list of forces that separate the average saver from what should be the fruit of his investments.

It is not the obvious problems, the things that are already crimes, that are the big issues, it is the outrages that are so normal we have all grown used to them, like executive compensation.

The average CEO makes 185 times the average worker in the U.S., having risen from just 35 times more in the late 1970s.

To make an understatement, shareholders have not shared fairly in the gains in innovation and efficiency they have bankrolled.

And in fact the times of worst excess in compensation are exactly the same times when shares are rising to unsustainable peaks, as in 2000 and 2007, as boards and executives play a cozy game of writing and cashing in share options. Now theoretically shareholders can oust boards and thereby impose pay discipline on executives, but the reality is that there are massive impediments to them doing so. Lucian A. Bebchuk, a Harvard Law School professor, went so far as to describe the idea of the power of the shareholder franchise as a “myth,” though given the way investors are treated like children perhaps the better term would be fable.

Can it be a coincidence that the periods of fastest growth in executive pay coincide so neatly with periods when it would have been foolish to buy shares?

DEATH BY 2 AND 20

Or take fees paid for investment management, that eternal example of the triumph of hope over experience. There is no solid evidence that money management is a skill that can be sustained over time, much less that you or the person you will pay to pick a manager can identify who will turn out to be a winner.

John Bogle, the founder of index fund giant Vanguard Group, and one of the great proponents of the philosophy of buying, holding and keeping the fees you pay low, points out that in the 40 years ending in 2008 $10,000 put into an S&P index tracker would have yielded more than $346,000. Actively managed domestic equity funds returned just over $200,000 in the same period. That’s a lot of fees, a lot of trading, a lot of lunches and client seminars.

The amazing thing about investment is that, as in fashion, it is usually the rich who get played for the worst fools. The aging fashionista spending tens of thousands for a haute couture outfit and the well-heeled investor listening uncomprehendingly over a nice lunch to a pitch for a hedge fund-of-funds, which piles fee totteringly upon fee, are siblings beneath the skin.

There is, again, no good evidence that hedge funds, or for that matter private equity vehicles, pay off in aggregate. There are plenty of people out there who would have made you rich, but perhaps more who would have left you poorer than if you had simply bought passive funds and sat on your hands.

The money lost in wasted fees must surely dwarf the money lost to crooked trading in scale, and the remedy is so cheap and so readily available.

So by all means, let’s go after Rajaratnam and his ilk; they’ve always been with us and always need controlling. Let’s not, however, confuse a capital market that is acting in accordance with the law with one that is functioning properly.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

James Saft is a Reuters columnist. The opinions expressed are his own.

Greece cannot be saved without debt relief, and debt relief for Greece may mean what amounts to a mass Jubilee with debt write-offs and recapitalizations needed for weak banks and nations across the euro zone.

Little wonder that officials delay, deny and only belatedly try to negotiate openly with reality.

Greece’s credit rating was downgraded by Standard & Poor’s to B on Monday, taking it two steps further into junk territory, just days after a secret meeting of euro zone finance ministers  gave rise to rumors that the country would soon leave the common currency zone.

EU officials have said a new aid package for Greece (and Ireland) is on the way, and S&P foresees commercial creditors paying their share too, which even if it is only an extension of the maturity of the bonds is tantamount to a default.

“Although an extension of maturities with no principal discount would likely imply a recovery greater than 50 percent, our projections suggest that principal reductions of 50 percent or more could eventually be required to restore Greece’s debt burden to a sustainable level, given trend growth potential of the Greek economy,” S&P said in explaining its action.

This brought on a fit of scoffing from Greek officials, who said there had been no deterioration since S&P’s last evaluation in March. Gentle notice to officials: ratings agencies are famous not for being always wrong, but for being behind the curve. When they are downgrading you furiously it means everyone else already knows you are a poor credit.

For evidence of this you need only look at financial markets, which have been busily downgrading S&P in hard currency terms. Greek two-year debt is currently yielding north of 25 percent, while Greek debt overall is trading at levels that imply a 40 percent discount.

The overall message from the hard-hearted financial markets is that austerity without meaningful debt relief will not work. As odious as it may be to German and Finnish taxpayers, Greece is not going to be able to bear the load if its economy carries on shrinking. The same is self-evidently true for Ireland and Portugal. Spain’s saving grace, if you can call it that, is that it is so big and important that by the time we get to imposing conditions on it we will have moved to a far more radical game plan, one involving significant debt relief.

A GRAND RECAPITALIZATION

The European quest to maintain the fiction that the debts will be repaid fully is particularly quixotic, in that the ECB is strenuously acting to keep a lid on inflation, most recently by lifting interest rates by a quarter of a percentage point. While U.S. policy is not above its own polite fictions, at least it is consistent; they are still playing the same game of inflating spending by inflating asset prices, hoping that eventually inflation will eat gently away at the debts.

The ECB will hardly emerge unscathed from a restructuring of Greek debt, at least from one bold enough to lift the country out of its problems. The ECB is profoundly exposed to Greece, not just directly through bonds it has purchased, but also as a massive (91 billion euro) lender to Greek banks. And what are those loans collateralized with? Much of it are loans issued by or guaranteed by the Greek state.

JP Morgan estimates that a 50 percent reduction in Greek debt obligations would cost the ECB 32 billion euros, or about 40 percent of its member central bank’s reserves and capital.  Such a haircut might be withstand-able, though it would likely wipe out the capital of the Greek central bank, but such a haircut, when it happens, will not happen in isolation.

“We need a very comprehensive solution very fast, not only for Greece but for the other problem countries,” Peter Bofinger, one of the German government’s wise men economic advisors told Reuters Insider television.

“If we don’t reach this solution I am not sure that the euro area will remain intact for the next 12 months.”

Greek banks will need to be recapitalized, for a start, not a terrifying prospect, but so too quite likely will many banks outside Greece, and not solely due to losses on Greek credits.

While authorities may want to put off a Greek restructuring until 2013, when new measures to handle bailouts come into force, they’d be far better off addressing the multiple bailouts that are needed, including of banks, all at the same time.

That’s because a  Greek restructuring will speed contagion to Spain, to Portugal, to Ireland and to banks. If that restructuring is inevitable, and it looks as if it both is and is coming soon, then better to have an orderly debt Jubilee, with taxpayers and shareholders sharing the pain, than to allow the markets and that old enemy, events, to set the agenda.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

James Saft is a Reuters columnist. The opinions expressed are his own.

HUNTSVILLE — What happens when you combine a recession, an unwillingness to pay your way, and unrealistic expectations of how much you can make in the stock market?

For U.S. state employee retirement funds, the answer is you end up with an underfunding of $1.26 trillion, a shortfall that will cause political strife and personal misery.

That misery, however, may extend beyond those whose pensions and benefits are slashed or taxes raised, as the issue has at its heart a fundamental miscalculation that is also embedded in many company and personal retirement plans.

A study by the Pew Center on The States found the $1.26 trillion shortfall, which is split roughly evenly between a lack of money in state employee pension plans and un-funded retired employee future health benefits.

The shortfall, which is as of fiscal 2009, is a 26 percent increase on the year before. And lest you think it’s all caused by the recession, partial results for 16 states show an additional increase in the level of underfunding in fiscal 2010.

Public sector retirement funding is a failure with many fathers, including an unwillingness to tax to meet obligations, spiraling health care costs and, to be fair, an awful recession that slashed revenues and left many states even less willing to stash away the needed funds.

At its heart, the underfunding issue is substantially governed by the actuarial assumptions used to calculate how much the plans need to salt away every year to have enough to meet their promises.

Those actuarial assumptions, in turn, have embedded into them an assumption about how much investments will earn in future. The more money you expect to earn on your investments, the less you need to save. State funds generally use an 8.0 percent assumption, which seems high but is incredibly convenient if you are a state official and don’t want to (a) raise taxes and commit political suicide, or (b) slash benefits and commit political suicide.

That 8.0 percent may be highly optimistic. If the state plans used the the lower target of a high quality corporate bond yield, about 5.2 percent, as their investment target then the deficit balloons all the way out to $1.8 trillion.

Should you decide to be even more conservative and pencil in returns equal to 30-year Treasuries — about 4.3 percent — then the states face a collective $2.4 trillion shortfall.

POST-WAR ABERRATION

But why should we expect to earn 8.0 percent?  In part, this is because pension investing developed during the post-World War II-era, a time when equities did much better than they should have based on dividend and earnings growth.

There are many who think that equity returns in the post war period were higher than could be explained by the fundamentals, and thus higher than what we should expect going forward.

Eugene Fama and Kenneth French found that the U.S. equity risk premium — the amount of extra return investors got for taking ownership risk – during 1951-2000 was far larger than you would expect looking at earnings and dividend growth.

It may be that this period was simply a good time for stocks — after all it included the rebuilding after the war and a period of dropping inflation. It may even reflect the build up of savings made by the baby boomers, so much of which was funneled into equities.

Generally equity returns are linked to the growth in earnings, which in turn is linked to the growth of the overall economy. It is hard to see strong reasons for economic growth to suddenly take off in the developed world. Nor should we expect an increase in the share of GDP that corporations are able to capture as earnings. After a blip during the recession that is back to levels that are close to an all-time high.

If we add into this demographically-driven selling, as retiring baby boomers begin to eat their savings, the outlook for a return to the 20th century glory days of stocks looks even more remote.

So, while equities, which are at the heart of pension savings, will likely beat other asset classes over the longer term, they may not beat them as soundly as they did in the past. That matters, a lot, because it will make even worse the underfunding.

So, how will this play out? Once the shortfall is so large it cannot be ignored, states will try and cut benefits, as they have in Wisconsin, while at the same time taking on ever more risk in hopes of out-earning their problems.

Look for the snake-oil salesmen to be on the spot offering private equity, structured products and hedge funds, all promising better than equity returns and all with high embedded costs to the investor.

The sooner we cut our expectations, the better.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

James Saft is a Reuters columnist. The opinions expressed are his own.

HUNTSVILLE, Ala. — If bank failures and deflation frighten you, we are managing the economy in the right way, but if you worry about drops in output and investment, we’ve not made much progress.

In other words, policy makers are very good at re-fighting the Great Depression, but may have simply reallocated the damage.

A study of the interaction of credit, the economy and financial crises by economists Moritz Schularick and Alan Taylor looked at the period between 1870 and 2008, casting a shadow over the usefulness of modern activist central banking.

“The impact of financial crises was more muted in the postwar era in absolute numbers, but of comparable magnitude relative to trend,” according to the study, authored in 2009 but presented last month at a conference hosted by the Atlanta Federal Reserve.

“Measured by output declines, financial crises remain severe in the post-1945 period. The maximum decline in real investment activity was somewhat more pronounced before WW2, albeit with a sharp bounce back after 4 to 5 years.”

Schularick and Taylor looked at 14 developed economies over the 138-year period, examining the growth of bank loans, bank assets and money supply and how they compared to overall economic growth. What they found is that credit creation has become unmoored from the creation of money, allowing for an ever larger banking system.

In an earlier era that ended in 1939, money and credit jumped around a great deal, reflecting the more laissez faire attitude of the authorities, but they tended to have a reasonably stable relationship to one another. That meant difficult periods of balance sheet contraction and deflationary pressure.

After World War II, however, bank assets and loans grew strongly relative to both the economy and to money supply. This happened, most likely, because banks leveraged up, borrowing heavily to lend more heavily than their deposit base would allow. Non-banks, such as investment banks, grew even more strongly, as we know.

Under our current system, much credit is created by the financial markets, giving them a more central role in the economy’s health but also making it subject to the whims and crazes of investors. This explains the Fed’s determination to support asset prices, but it also underlines the way in which the Fed, and the rest of us, are hostage to confidence and successive bubbles.

SHADOW OF THE DEPRESSION

Central bankers learned the lesson of the Great Depression, in that they eased more aggressively in the post-Depression period. That has meant that we’ve not seen the collapses in money supply and grinding deleveraging that characterized many old school recessions.

While that has arguably led to fewer failures in the financial system and has seen off long periods of deflation it actually hasn’t improved the economic impact of financial crises.

That may be unfair, partly because we don’t know how bad the modern-era crises would have been if the Fed and other central banks had not eased quickly and aggressively. After all, the more heavily financialized an economy is, presumably the worse a crisis centered in the banking system will become if no circuit breaker is applied.

That’s just where the madness of the current system becomes apparent; we ease to avoid a depression, but in doing so we fertilize the financial sector which grows so large that we are ever less able to face up to allowing it to suffer. Ultimately, as in 2008, we feel we have no choice but to apply blanket guarantees. The important point is that the financial system has not grown because it is successful, or based on demand, but because it enjoys protected and favored status.

All the while, at least based on the data, the damage to trend growth is about what it used to be. Interestingly, the data covers not just the highly banked English-speaking world, but many other economies as well, and is pretty consistent.

While the benefits of the system of insurance and Fed guarantee are questionable, some other effects are not. It has created a much larger financial sector in the U.S., as well as in the rest of the world, and this has grown alongside economic inequality. In this light it is wrong to look at growing inequality, and all it brings, and conclude that this is the result of a market system rewarding winners and punishing losers.

Increasing inequality may well be the fruit of a system of government intervention in markets, as whomever can get closest to the spigot of warm cash flowing from the government guarantees does best.

This system also, inevitably, breeds bubbles and crises which are tending to get larger and larger and which must eventually overwhelm states’ ability to underwrite them.

The fun is in guessing what the next bubble will be, but at some point that particular game will be up.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)