The Outlook For Stocks And Bonds: Still Bullish

Let’s begin with the meta-phenomena: money and credit growth. At present, both are quite weak. Money is growing at 6% which is too slow, given the current rates of inflation and nominal growth. Credit growth, which was contracting for a long time after the crash, has finally turned positive at an anemic 3.5%. Household credit growth has turned the corner and is now growing at 1%, which doesn’t cut it, while business credit growth is doing well at 8.5%. Federal credit growth--which sustained the economy during the recession--has now declined to 6.5%, which is still supportive. The weak link is household credit, which reflects the wounded housing market. The picture is therefore one of positive but weak money and credit growth.

Next, the outlook for bonds. Bond yields have risen sharply since 2012 (from 1.5% to 2.8%), despite a decline in inflation from 2% to 1.1%. The bond market appears to have mistakenly assumed that QE would accelerate money growth, which it has not. Money growth has been steadily declining since QE3 was announced in September 2012. I see no reason for bond yields to rise any further, and I think that yields are vulnerable to negative shocks, such as weak employment or nominal growth. Consequently, I am bullish on bonds, which translates into being bullish on stocks.

Stocks are no longer the screaming buys that they were when the Dow was at 11,000 in October, 2011. The equity risk premium has declined as prices have risen by 45% since then. But stocks are still more rewarding than the alternative asset classes: bonds, cash, metals. Stocks still have an attractive forward earnings yield (6.3% on the S&P), which compares favorably to bonds (2.8%), cash (0%), and metals (0%). As corporate earnings continue to grow (in the single-digits) and bond yields decline, the equity risk premium should widen, making equities a bit more attractive. The Fed is still paying investors to hold stocks and penalizing them for holding cash, bonds or metals.

I don’t expect robust earnings growth this year, given 4% nominal growth. But I do expect some EPS growth, especially for those companies using free cash flow to shrink their float. While topline growth may be slow, overall profitability is high, which leaves plenty of room for return of capital to shareholders.

When the Dow was at 13,000 in December 2012, I said that it would go to 15,000 by yearend; in fact it overshot my forecast and went to 16,000. For 2014, I expect the Dow to close the year about a thousand points above where it is today. That would be in the range of 17,000 to 17,500.

I see nothing coming out of the Fed in the near-term that would change this calculus. Although Yellen is a dove, there is no evidence that she plans to shake things up. Like Bernanke, she will seek consensus and do nothing radical. Money growth, inflation and nominal growth will remain subdued. The real funds rate will remain higher than it should be. Nonetheless, the business cycle is on the upswing.

The Unsound Doctrine Of Sound Money

There is a dangerous economic philosophy which threatens both capitalism and freedom. Like most isms, it is not the product of centuries of encrusted tradition, but is instead, like communism and fascism, based upon a radical philosophy which casts aside most of human learning and seeks to restore an imaginary golden age.

The Austrian School

This philosophy is called Austrianism, or the Austrian School, after Ludwig von Mises, Max Weber, Murray Rothbard, and other ultra-libertarian economists (but not Milton Friedman, a monetarist). Austrianism can be described as radical libertarianism, the antithesis of marxism (in fact it is a reaction to marxism). It is predicated on the notion that markets are perfect, and that government intrusion is always an error from both an economic and moral perspective. It is extreme capitalism, what was known in the 19th century as liberalism.

One of Austrianism’s chief tenets is that fiat-money central banks are among the most pernicious aspects of government intervention, and should either be abolished or replaced with the gold standard, private currencies (Bitcoin) or, as a last resort, a zero-discretion policy of price stability (e.g., the ECB). In the Austrian view, discretionary fiat money central banks are the cause of economic and financial instability, not their solution.

Austrianism turns Anglo-American economics on its head. Austrians believe that everything that Anglo-American economists (Fisher, Keynes, Samuelson, Friedman, Krugman) have learned and taught about money policy over the past 80 years is wrong. The edifice that is the modern financial system--a central bank which controls the money supply, a regulated banking system, the financial safety-net, deposit insurance, moderate inflation--is rejected.

The Austrian golden age was the period before central banks and deposit insurance. Such a golden age was 19th century America, when the dollar was bimetallic, bank charters were sold like lottery tickets, deposits and bank notes were understood to be risk assets, the money supply was determined by the credit cycle, and the only role played by government was the minting of bullion into coins of a specified metallic content.

The Business Cycle Is Prophylactic

Less extreme Austrians, today’s sound money community (see: Bundesbank, WSJ, Rand Paul) accept much of the architecture of today's  financial system, except for the notion that an appropriate role for the central bank is to encourage growth, employment or financial stability. The sound money community argues that price stability maximizes long-run growth and employment, and that the business cycle (including financial crises) is natural, prophylactic, and necessary: the instrument of Schumpeter's creative destruction. The business cycle is seen as an essential element of capitalism. (Marx saw the business cycle as an inherent contradiction of capitalism: the periodic instability and depressions which impoverish the proletariat.)

In the realm of abstraction, I am agnostic on the sound money question. I understand the rationale, that the business cycle is necessary and prophylactic. How can I say such a thing, given what happened under Hoover? Because the US operated successfully with a hard money system from 1791 until 1933 (excluding the Greenback Era). From 1791 until 1933, the US experienced price stability (the dollar price of gold remained unchanged at $20) and also brutal decennial "business depressions". Despite these depressions, average economic growth rates were very high by any historical measure.

Those periodic convulsions were prophylactic, purged the system of inefficiencies, and made room for innovation and efficiency. Impoverished workers were the necessary collateral damage. Wages and prices were flexible, employment was volatile but tempered by wage flexibility. Instead of starving, workers worked for less. Victorian liberalism.

Of course, much of the growth of the US economy over this 140-year period can be attributed to immigration, continental expansion and the industrial revolution. But the fact remains that the US enjoyed strong growth in the face of hard money and periodic deflations. Real growth often exceeded nominal growth, something unimaginable today. The golden age of hard money really did exist. It wasn't a golden age if your family starved to death (as many did in the 1870s and 1890s), but society as a whole prospered.

Democracy And The Business Cycle

The problem with the golden age of sound money is that it was accompanied by increasing universal suffrage: the masses were increasingly allowed to vote, and they voted for inflation, wage stability and job security. By the mid-20th century, the masses had won almost all of their demands: a dual-mandate central bank, counter-cyclical monetary and fiscal policy, the right to bargain collectively, unemployment insurance and wage stability. American capitalism accommodated itself to the democratic revolution by producing the New Deal, which went a very long way towards addressing the marxist critique of capitalism, and staving off the communist alternative.

In 1947, Congress passed the Employment Act which ultimately led to the dual mandate for the Fed: not only price stability, but also economic growth (full employment). That is how we got to where we are today, when we expect the Fed to smooth out the business cycle and prevent depressions. Anglo-Americans live in a world in which the Quantity Theory is a given: by controlling the money supply, the central bank can determine the rate of nominal growth. All English-speaking central banks believe this.

Keynesians like Krugman, Summers and Obama believe that fiscal policy is an indispensable partner for monetary stimulus, but they do not discount the importance of monetary stimulus. Austrianism is almost nonexistent within the US economics profession, and--aside from a handful of Paulistas--almost nonexistent in Congress. The American debate is between the Keynesians (fiscal + monetary) and the monetarists (money alone). No one in America, besides the Austrians, is arguing for a single mandate which ignores growth and employment. To paraphrase Richard Nixon, "We are all monetarists now."

Germany Is Austrian

In Germany, it's different. In Germany, both monetarism and Keynesianism are not only discredited, but seen as heretical. Most German economists and politicians--on both the right and left--are Austrians. They believe that price stability (the hard Deutschmark) was an essential component of the postwar wirtschaftswunder, and that price stability will--over time--bring the rest of Europe up to German standards of discipline and prosperity. The Germans believe that what is happening in the eurozone is prophylactic, that the excesses of undisciplined fiscal and monetary policies are being squeezed out, and that the faster they are purged, the sooner Europe will start growing again. Hence Draghi's constant refrain that the resumption of growth depends on deeper structural reform.

What Germany wants to do is to to usher in a new golden age of sound money in which the business cycle is allowed to operate, wages are flexible, and parasitic state-dependency is abolished: Mellonism.

Andrew Mellon, Hoover's economist, saw the Great Depression as necessary and prophylactic, and saw no reason to interfere with it. The millions of unemployed were necessary to drive down wages (now termed “labor market flexibility”). Mellon may not have been aware that the US money supply was contracting on his watch, but he would have agreed with the Fed that this was a natural consequence of the cycle: there is less demand for money during a depression.

Our interwar experience was the opposite of Germany's. Germany experienced hyperinflation, while we experienced deflation. (Germany experienced deflation too, but doesn’t choose to remember it; it was deflation that destroyed Weimar, not inflation.) Hence, Germany is Austrian, while we in the Anglosphere are all monetarists and/or Keynesians.

The Anglos and the Teutons approach the macroeconomy from such different perspectives that we can barely talk to each other. Our universities teach economics differently, and we don’t translate enough literature into each other’s language. Germans don’t use our textbooks and vice versa. Bismarck was right about the language barrier.

The Fed's mantra is that it is doing everything it can to stimulate growth and employment, while the Bundesbank's mantra is that any attempt to use monetary policy to address the  current eurozone depression is dangerous and will destroy the progress that has been made and remains still to be made. Imagine Janet Yellen explaining to Congress that high unemployment is a necessary feature of her monetary policy! Weidmann and Draghi have no problem explaining that high employment is a necessary consequence (or predicate) of structural reform. Our economists inhabit different planets and respond to very different public expectations.

I won't say that Austrianism is wrong, per se, because it worked in the past and actually functions today in Hong Kong. What I will say is that, after the experience of the Thirties, those who desire to preserve capitalism and free markets must oppose Austrianism because it is the handmaiden of welfare socialism (Obamaism). Andrew Mellon thought that he was restoring the golden age, when what he was really doing was forcing the proletariat to choose between welfare socialism and starvation. The masses chose welfare socialism by a landslide, in five consecutive presidential elections.

The Anglosphere has learned the lesson that depressions feed welfare socialism; Europe hasn’t. Free market capitalism is being discredited in Europe today, as the masses are forced to endure penury in pursuit of “structural reform” and "labor market flexibility".  The ECB's debt-deflation policy is a very blunt instrument to use against market rigidities and fiscal indiscipline. Fiscal austerity and structural reform--if they are really needed--must be offset by strong monetary stimulus, such that NGDP and employment continue growing. (The higher the rate of inflation, the less fiscal austerity is required, which no one on either continent understands.)

Europe is (or should be) slowly learning what the Anglosphere learned 80 years ago: democratic capitalism requires prosperity and and a dampening of the business cycle. That means competent monetary policy which delivers moderate inflation and moderate nominal growth. Price stability in an environment of sticky wages is deflationary and leads to depression and welfare socialism.

The End Of Communism In Latin America

Cuba and Venezuela are failed states, and regime change in both is increasingly likely. Fidel Castro and his brother are nearing their demise, a challenge for a regime which relies on personalities for legitimacy. This dynastic challenge is not really news since all dynasties have the same problem. What is news for Cuba is what is happening in Venezuela, which has major implications for Cuba’s future history. This is because concessionary Venezuelan oil has kept Cuba alive since the USSR went away in 1991.

Venezuela has two main problems: bankruptcy and revolution. Either could result in a cutoff of aid to Cuba. Here’s what Moody’s says: “Should Venezuela no longer be able to provide this support [to Cuba] to such a great extent, it is likely that Cuba would experience a balance of payments crisis.”

Moody’s rates both Cuba and Venezuela at Caa1, a default level rating. However, Venezuela’s bond-implied rating is now C, which signals default with little or no recovery. Cuba has no bonds from which to imply a rating, only long-defaulted bank loans from imprudent European banks that were written off ages ago.

Moody’s has very little nice to say about the Venezuelan credit: “Rising government liquidity risk reflects the deterioration of market access indicated by a recent sharp rise in yields on Venezuela's external debt. Vulnerability to external shocks is increasing as well as the current account surplus continues to shrink while the capital account remains in deficit. Consequently, foreign exchange reserves have fallen to perilously low levels.” Moody’s concludes that “the risk of an economic and financial collapse has greatly increased.”

If  Venezuela does succumb to bankruptcy or revolution, so will Cuba because Cuba will collapse without foreign aid.  Cuba is the Gaza Strip of the Carribean. Regime change could occur within Fidel’s lifetime, an event prayed for by Cuban exiles. Fidel and his wife du jour might even be the Nicolai and Elena Caucescu of Cuba.

The post-communist future of Cuba and Venezuela is very dark. Economies which lack the rule of law and enforceable property rights have difficulty making the transition from marxism to capitalism. They generally tend to export capital and to subsist upon official inflows and commodity exports. However, no marxist regime has ever succeeded in a successful export strategy, aside from China which is only nominally marxist. In China, the state does not wish to own the land or the means of production.

Both Cuba and Venezuela have completely scrapped their Spanish heritage of rule of law and private property (yes, Spain has rule of law). Nobody knows who owns anything, and no titles are enforceable in courts--such as they exist. Both countries will face the post-marxist challenge of adjudicating the legal claims of those whose property or businesses were illegally expropriated, a difficult and time-consuming process especially when the current owners have “legal” title.

It is likely that any American aid to Cuba will be contingent on the satisfactory resolution of expat claims, since so many of them are now Florida voters. The absence of a functioning and impartial Cuban judiciary may render this process impossible, as it is in other former communist countries.

My view is that the most likely outcome for both regimes after their collapse will be chaos and a Haitian-style humanitarian/refugee problem. Both countries’ geographic proximity to Florida will result in a massive refugee crisis for the US. The rich of Venezuela already have their Miami condos and bank accounts, but the poor of Venezuela will resemble their fellow Caribbean refugees. There is seldom a happy ending for the world’s Marxist experiments.

Ukraine: A Quarrel In A Faraway Country

"How horrible, fantastic, incredible it is that we should be digging trenches and trying on gas-masks here, because of a quarrel in a faraway country between people of whom we know nothing. However much we may sympathise with a small nation confronted by a big and powerful neighbour, we cannot in all circumstances undertake to involve the whole British Empire in war simply on her account. If we have to fight, it must be on larger issues than that." --Neville Chamberlain, 1938

In the 1930s, Germany sought to undo the unequal peace treaty imposed upon it at Versailles. The new German chancellor sought to reunify the German people and reconstitute the Reich by incorporating the Rhineland, Austria, the Sudeten, Danzig and the Polish Corridor. He did not want war; he only wanted the reunification of the German people. Since the basis for the redrawing of the European map after the war had been the principle of self-determination, it seemed reasonable to apply this principle to the German people as well. Should they not be allowed to live together in peace, and wasn’t peace more important than some recently-drawn borders? After all, no one wanted another war. As long as the Allies made the concessions demanded by Germany, peace was maintained. Some regions were remilitarized, some borders were erased or redrawn, some populations were expelled or liquidated, but that was a small price to pay for world peace. No one wanted another war.  

The messiness of the newly-drawn borders made them seem negotiable, especially since millions of Europeans had been left on the wrong sides in many cases. The mapmakers in Paris had done their best, but the ethnic complexity of Central Europe required shortcuts and omissions.

Making a few border corrections to suit Germany seemed to be the pragmatic thing to do, especially given the unfairness of the Versailles treaty. No one wanted to go to war over regions they had never heard of which had been buried for centuries deep within the German and Austrian empires. There was one thing everyone knew: border adjustments were preferable to another war. In the end, when it was revealed that Germany’s appetite for lebensraum went beyond its old borders, the Allies were forced to draw the line, and they got the war they should have prevented.

The situation in Europe today is analogous to that of the 1930s. Once again, a major Continental power asks to be allowed to make “corrections” in the map of Europe in order to draw borders more in keeping with the aspirations of the populations affected. Russia had been unduly deprived of a region which had always been an integral part of its empire. Ukraine was temporarily detached by the breakup of the Soviet empire in 1991, but this was an historical mistake. Ukraine had always been and would always be part of Russia.

As in the Thirties, the Western response has been to begin with the premises that no one wants a resumption of the Cold War, borders are negotiable, and that things can be worked out if Western leaders keep calm and do not overreact. Some argue that this is a purely European problem to be solved by Europe, ignoring NATO and America's treaty obligations.

It would appear that the West does not intend to punish Russia for invading Ukraine, annexing Crimea, seeking to overthrow the Ukraine government, and breaking a number of treaties. This is a serious mistake. Permitting the absorption of Ukraine to be a fait accompli jeopardizes the independence of all of the former Soviet republics, particularly the Baltics, Georgia, and Azerbaijan. It reopens the map of Europe for further revision, and may ultimately permit Putin to reconstitute the Russian empire through military or other means.

Because Poland and the Baltics are members of NATO, and Georgia is a candidate member, Russia’s policy threatens a direct military confrontation with NATO. Deterring Putin now is safer than waiting for his next demand. NATO must resume the Cold War in order to prevent something worse. This will require a return to Cold War thinking (circa 1980) about such things as trade policy, weapons systems, arms control, missile defense and both strategic and conventional force deployment. Of course this is very distasteful, but appeasement carries significant future risks. Is NATO really prepared to allow one or more of the Baltics to suffer Ukraine's fate? Exactly where do we draw the line?

The advocates of Russian appeasement argue that Ukraine is an "integral part" of Russia, but by that logic so is Poland. And isn't East Prussia an "integral part" of Germany? None of these historical considerations should be relevant when speaking about the sanctity of internationally agreed borders. Under the rules of the postwar world, forcible annexation has been disallowed. Otherwise, 1920s-style irredentism will resume across Central Europe. Every Central European country has a school-room map showing its “Lost Territories”. Let's not start that game again--the map of Europe is not a menu, for Putin or anyone else.

A Note On US Foreign And Defense Policy

A discussion of US foreign policy cannot be reduced to one of isolationism versus “global responsibility”. It is one thing to advocate a continuation of the 60-year old policy of European collective security, and quite another to advocate endless interventions in Arab civil wars. It is possible to reconcile the desire for economy in defense spending while also maintaining strategic superiority. The best way for the US to contain its defense spending is to avoid unnecessary, prolonged and unwinnable counter-insurgencies. Strategic superiority is a bargain when compared with the cost of our pointless wars in Arabia.

A Note On European Energy Policy

Europe’s dependence on Russian gas limits the policy options available to NATO. Europe is dependent on Russian gas because it has dismantled its own energy industry. Europe’s policy is no nuclear, no fracking, no coal, no drilling and no oil. Natural gas production in Europe is bad for the environment, but natural gas production in Russia is acceptable. While China pollutes the planet by burning soft coal, Germany is decommissioning its nuclear power stations. If Europe chooses to remain dependent upon Russian gas, it may prove unable to deter future Russian adventurism.

Ukraine and US Nuclear Strategy

Readiness condition	Exercise term	Description	Readiness	Color
DEFCON 1	COCKED PISTOL	Nuclear war is imminent	Maximum readiness	White
DEFCON 2	FAST PACE	Next step to nuclear war	Armed Forces ready to deploy and engage in less than 6 hours	Red
DEFCON 3	ROUND HOUSE	Increase in force readiness above that required for normal readiness	Air Force ready to mobilize in 15 minutes	Yellow
DEFCON 4	DOUBLE TAKE	Increased intelligence watch and strengthened security measures	Above normal readiness	Green
DEFCON 5	FADE OUT	Lowest state of readiness	Normal readiness	Blue

source: Wiki

For the first time since the Yom Kippur war, the US and Russia have maneuvered themselves into another major superpower confrontation. In 1973, Brezhnev threatened to intervene militarily in order to prevent Israel from moving further into Syria and Egypt. Nixon ordered our strategic forces to Defcon 3 and also told Israel to pull back. War was averted, and Nixon was soon able to visit Cairo and meet Sadat. It was another Nixon foreign policy triumph.

This time, forty years later, Putin has decided to invade Ukraine on the pretext of protecting ethnic Russians. In reality, this is Russia’s Monroe Doctrine concerning the former USSR. NATO has zero conventional capabilities in the region and is unable to protect Ukraine from Russian invasion. Thankfully, Ukraine is not a member of NATO--otherwise the situation would be even more serious, given NATO mutual defense obligations. We have the strategic option of allowing Russia to invade Ukraine, as we did with Georgia. That is a luxury.

Putin evidently intends to either annex the eastern Ukraine, to forcibly change the regime in Kiev, or both. PM Medvedev expressed today the intention of regime change: "Russian Prime Minister Dmitry Medvedev said that Ukraine's leaders had seized power illegally, and predicted their rule would end with "a new revolution" and new bloodshed." Russia is in violation of a long list of treaties and, more threateningly, may be in the process of moving Russian forces to NATO's eastern border which is strategically reckless.

Russia controls the ground in this confrontation and has free reign to do whatever it wishes militarily. The challenge for NATO is how to respond, at which point I ask: “What would Nixon do?”. The answer is a long list of things, but which would definitely include raising the state of our strategic readiness to Defcon-3. This would require the Pentagon to move to a war-preparation footing and would bring the triad (ICBMs, strategic bombers and nuclear subs) to a higher alert level. Going to Defcon-3 is called saber-rattling, which can substitute for a lot of empty words and UN resolutions. Most importantly, it forces Putin to confront the reality of US strategic superiority in the event of war with NATO.

The US has enjoyed global strategic superiority since 1945. Despite Sputnik, Gagarin and the “missile gap”, the US has maintained this superiority for almost 70 years. We now know that, during the Cuban confrontation in 1962, Russia had a very small and unreliable rocket capability--which Khrushchev knew and Kennedy didn’t (no more U-2s). When Kennedy called Khrushchev's bluff, he had to back down because the entire population of the eastern bloc was at risk of annihilation. Kennedy was a reckless gambler, but he won, because even then we had more rockets. Throughout the history of US-Russian relations, our strategic superiority has played a crucial role: Taiwan in 1950, Korea in 1953, Berlin in 1961, Cuba in 1961 and 1962, Vietnam in 1973, Europe in 1983, numerous mideast conflicts, and now once again.

Today, both Putin and Obama have a pretty good idea of each other’s strategic capabilities. I believe that, when Obama is briefed on Russia’s nuclear arsenal, he will learn that it is old, creaky, unreliable and subject to serious command-and-control problems. Putin has a nuclear arsenal, but it is antique and no match for ours. Our rockets will fire and hit their targets. His may or may not: it’s 1962 again.

Since the earliest days of the Cold War, the Soviet strategy has been to try to take nuclear weapons off the table via the anti nuke movement, the peace movement, the CND, the freeze movement, etc. By removing America’s strategic superiority, Russia would regain military superiority--and huge leverage over Europe.

Reagan ultimately bankrupted the USSR by raising the nuclear stakes to a level where Russia could no longer afford to play (SDI). The collapse of the Soviet Union was a huge setback to the modernity and readiness of Russian’ strategic forces, with submarines rotting, bombers rusting and electronics remaining in the analog era. The Russian defense budget declined sharply, undoubtedly doing damage to its strategic capabilities. How old are Russia’s warheads? How accurate are its guidance systems? Can its MIRVs still MIRV?

US strategic policy since the end of the Cold War has been prudent, but a bit naive. Our strategy has been to maintain an effective arsenal and to rely upon the quality instead of the quantity of our weapons, thus allowing additional arms control treaties. In view of what happened today, I think those treaties are now obsolete and should be abrogated. Nonetheless, the still US enjoys overwhelming strategic superiority over Russia, and Putin knows it.

President Obama takes a very sophisticated view of US foreign policy and its limits. He understands the questions, and has an unemotional set of criteria for finding answers. His non interventionism and hostility to adventurism are admirable. However, his expressed desire to eliminate strategic weapons via treaty is naive and counterproductive. His statements to Medvedev regarding arms control flexibility were naive. Obama needs strategic superiority, especially this week. He needs to learn from this crisis. An unarmed US is Belgium. The US has been able to contain potential aggressors around the world because of strategic superiority. It is crucial that we maintain strategic superiority as a way to contain Russian and Chinese adventurism while preventing global war.

The way to maintain strategic superiority is to modernize the entire nuclear warhead and delivery arsenal (which will require underground testing), to bring the potential of SDI to fruition-- and not just against Iran, and to abrogate our obsolete and counterproductive arms control treaties which limit our superiority. This is the cheapest way to keep the peace. Strategic superiority is more important than the size of the army or navy, and much cheaper. The essence of deterrence is the certainty of an annihilating response to an attack. That certainty takes war with the US off the table as an option for Russia, China, Iran, Kim and others.

Strategic Defense
SDI will play a crucial role in the maintenance of US strategic superiority. Someday it may even offer complete immunity from nuclear attack. In the meantime, it erodes the credibility of the enemy's strategic capabilities; it is asymmetric. The mere existence of the program adds to our strategic superiority. Opposition to SDI plays into Russia's hands and weakens our superiority.

Puerto Rico And Its Underwriters Appear To Be In Noncompliance With SEC Rule 15c2-12

Puerto Rico’s underwriters intend to sell $2-3 billion in new securities to the public--including retail--despite the fact that it is chronically noncompliant with SEC Rule 15c2-12, which requires timely financial reporting.

Here is what the SEC says:

“An underwriter shall not purchase or sell municipal securities in connection with an offering unless the underwriter has reasonably determined that an issuer of municipal securities has undertaken in a written agreement to provide annual financial information.”

Here is what Puerto Rico says:

“In light of the Commonwealth’s continuing difficulties in the timely filing of the Comprehensive Annual Financial Report notwithstanding the establishment of the policies and procedures described above, the Commonwealth is reviewing how to improve such policies and procedures to ensure timely compliance in the future with its continuing disclosure obligations.”

Here is Puerto Rico’s explanation of its noncompliance with SEC Rule 15c2-12:

The Comprehensive Annual Financial Report for fiscal year 2012 was filed by the Commonwealth on September 16, 2013, which is after the Commonwealth’s May 1 deadline, established in its continuing disclosure undertakings pursuant to SEC Rule 15c2-12. The Commonwealth was unable to finalize its audited financial statements on time due to (i) delays in the audit of such financial statements as a result of the government transition process, (ii) the adoption of new government accounting pronouncements, (iii) the restatement of the financial statements of the PRPA, a discretely presented component unit of the Commonwealth, and (iv) the failure of the University of Puerto Rico, a discretely presented component unit of the Commonwealth, to finalize its audited financial statements. The Commonwealth is evaluating the implementation of measures to ensure future timely filings of its audited financial statements. The Commonwealth has entered into several continuing disclosure undertakings in accordance with SEC Rule 15c2-12 in connection with its bond issuances. Although the Commonwealth has filed all the reports and financial statements required to be filed, some of these filings have been made after the Commonwealth’s filing deadline, which is normally May 1.

Puerto Rico has acknowledged that its financial reporting is noncompliant with SEC Rule 15c2-12. One might think that this would preclude the marketing of $2-3 billion in new debt securities. The underwriters for PR’s upcoming bond sale are Barclays, RBC and Morgan Stanley. It is not entirely without interest that Barclays is also a major creditor of PR. Would that not be a small conflict of interest? Wasn’t that the whole point of Glass-Steagall, to prevent banks from unloading their bad loans on retail investors?  

How can an underwriter sell bonds of an issuer whose financial disclosure  is 18 months old? How can a fiduciary buy the bonds of an issuer with no current financials?

It is amazing to me, a person who has been a market participant since 1978, that nothing ever changes, and that the Madoffs and the Enrons are as much in business today as they were in 1978. I am not advocating another Dodd-Frank; I am advocating the enforcement of existing law, and that the SEC should protect retail from buying dreck, which was the whole point of the Securities Act of 1934.

Why Puerto Rico Resembles Enron

Remember Enron? Enron financed its huge negative cashflows with debt it could never repay. It was a story of unconsolidated subsidiaries financed with layers of debt, extremely creative accounting and--toward the end--a deal that would solve everything.

Overlaid on the Enron story was the parallel saga of Enron’s external auditors, who slowly evolved from being an enabler into Enron’s nemesis. During the course of 2001, the external auditors came to realize that Enron’s reported financials bore no relation to the underlying economic (or legal) reality. They had been lied to. This led to delays in the release of financials. As news of the fraud began to dribble out, market confidence collapsed, Enron’s ratings were downgraded, its debt was accelerated and the firm went bankrupt with high loss severity. Enron sought to stave off its demise by promising to merge with another firm which would assume its huge debts. The deal was always “next week” until the end.

I don’t want to overdraw the analogy, but there are hints of Enron in the Puerto Rico story.

PR is a highly complex credit with multiple SPVs financed with debt, very large operating losses, and financial disclosure that is so late as to be useless. Puerto Rico’s most recent audited financials are from June of 2012. All subsequent financial reporting is unaudited. PR has repeatedly failed to comply with its commitments with respect to the timeliness of financial reporting. The financial reporting subsequent to the last audited report has not included a consolidated balance sheet, and instead consists of lists, tables and prose. PR’s principal financial unit is an unregulated “bank” which does not provide timely or adequate disclosure. The auditor’s most recent report (June, 2012) for the bank contains cautionary language regarding the collectability of the bank’s loans to the commonwealth and its borrowing vehicles and specifically mentions liquidity risks arising from rating downgrades (this was in 2012).

In fact, PR’s ratings have subsequently been downgraded and, as with Enron, the downgrades have triggered covenants permitting acceleration or additional collateral demands adding up to almost $1 billion. The government is trying to get the counterparties to waive these requirements. Nonetheless, the government is already experiencing cashflow problems:

“These factors have resulted in delays in the repayment by the Commonwealth and its instrumentalities of their loans to GDB and, at the same time, caused the Commonwealth and its instrumentalities to rely more heavily on short-term financing and interim loans from GDB and other lenders.”
The government's plan to resolve its liquidity crisis is to sell more debt into the previously nonexistent junk muni market.

As with Enron, the challenges associated with analyzing Puerto Rico as a credit are epistemological: what do we really know, and how do we know it? To borrow a phrase, we must sort out the known knowns, the known unknowns, and the unknown unknowns.

I would argue that everything we “know” since June of 2012 is based on unaudited information provided by the issuer. If PR was a corporation, its stock would have been delisted and its ratings downgraded long ago for this reason alone. (In municipal disclosure, everything is different--and inferior to corporate disclosure.) It is difficult to analyze a credit with unreliable financial information. Here is what the government has to say on the subject:

“In light of the Commonwealth’s continuing difficulties in the timely filing of the CAFR and the Commonwealth Report notwithstanding the establishment of the policies and procedures described above, the Commonwealth is reviewing how to improve such policies and procedures to ensure timely compliance in the future with its continuing disclosure obligations.”

Here are some of the “known unknowns”:

1. Consolidated monthly cashflows for 2014.

2. A current detailed balance sheet (consolidated and consolidating)

3. Consolidated monthly schedule of debt maturities.

4. Status of the negotiations with holders of accelerated debt or collateral receivable as a result of the rating downgrades.

Puerto Rico proposes to market a multibillion-dollar bond offering next month on the basis of its mid-2012 audited financials, and in the midst of a cash crisis. One hopes that the underwriters do not plan to market these securities to nonprofessional retail investors, but that hope is probably misplaced. Concerns regarding “suitability” are so old fashioned.

Enron was a huge mess to resolve, and a huge mess to prosecute. If Puerto Rico ever does default, it will make Enron look like a traffic case. Each entity will have to be resolved, each revenue stream will have to be fought over, each class of creditor will have to fight over venue and preference, on top of which there will be the legislature and the people of Puerto Rico. There is no legal precedent for any of this, which will vastly complicate the resolution.

Nothing like this has ever happened in the United States (or anywhere else), and when it’s over the legal documents will fill the Pentagon. It would make sense for the US to step in and help to resolve this mess, but that would be politically unpopular since Puerto Ricans pay no federal taxes and have no congressional delegation. Also, this would require placing a sovereign people under receivership, which would be difficult.

Will Puerto Rico do to munis what Enron did to merchant energy and what WorldCom did to telecom? That's an interesting question.