Income Tax Rates Must Rise To Offset Higher Deficits? Not So Fast.

Per one’s request, my latest quarterly letter to Peridot Capital clients included a section on the current macro-economic outlook for the United States. The question they wanted me to address had to do with possible hyperinflation resulting from ever-increasing budget deficits at the federal level. As with any question like that I try to completely ignore everything I have heard and instead rely on what the numbers tell me to form an opinion. Numbers don’t lie, people do.

The latest set of numbers I have looked at are very interesting and so I thought they were worth sharing. The consensus viewpoint today is that higher budget deficits will ultimately lead to higher income taxes on Americans, which is likely to hurt the economy over the intermediate to longer term. Interestingly, historical data does not necessarily support his hypothesis. Let me explain.

Despite current political debates, which are more often than not rooted in falsehoods, the United States actually saw its level of federal debt peak in 1945, after World War II. Back then the federal debt to GDP ratio (the popular measure that computes total debt relative to the size of the economy that must support it) reached more than 120%. Even after a huge increase over the last decade, currently the ratio is around 80%. As a result, our federal debt could rise 50% from here and it would only match the prior 1945 peak.

Given all of that the first question I wanted to answer was “how high did income tax levels go after World War II to repay all of the debt we built up paying for the war?” After all, the debt-to-GDP ratio collapsed from 120% all the way down to below 40% before President Reagan spent all that money in the early 1980’s. Surely tax rates went up to repay that debt, right?

The reality is that the top marginal income tax rate went down considerably over that 35 year period and even if Congress maintains the top rate at 39.6% (up from 35% under President Bush) the rate will still be near historic lows since the income tax was first instituted nearly 100 years ago.

Below is the actual data in graphical form. All I did was plot the top marginal income tax bracket along with the federal debt-to-GDP ratio. This makes it easy to see what was happening with tax rates as debt levels were both rising and falling over the last 70 years.

taxratevsdebtratio

As you can see from the data, tax rates did not go up even as debt was paid off dramatically. As a result, it appears to be a flawed assumption that increased federal borrowing automatically means we will have to pay higher taxes in the future. Political junkies won’t like what this data shows, but again, numbers don’t lie.

Chrysler, Ford Riding Government Incentives to First Sales Gains in 2 Years

It is hard to argue with the success of the “Cash for Clunkers” automobile incentive program so far. With $1 billion already blown through, Congress is working on a $2 billion extension, despite most Republicans being against the program (probably because it was a Democratic idea, not because it is not working).

So far the average consumer is trading in their clunker for a new car that gets 9 miles per gallon more than the vehicle it replaced. The sales spike during the last week of July has led both Chrysler and Ford to report July sales gains, the first increase in 2 years for the domestic automobile industry. General Motors reported a 19% decline in sales, but still saw an enormous benefit from the program.

It remains to be seen if car sales will be sustained at higher levels, but the glass looks half full at this point. New car inventories are near all-time lows so inventory rebuilding in coming months should boost GDP pretty significantly, perhaps leading to a positive GDP print for the third quarter.

The car companies are not the only beneficiaries, however. “Cash for Clunkers” helps consumers and the country as a whole too. Higher fuel efficiency should not be understated. Consumers will save money by spending less to fill up their gas tanks, freeing up money for other things. In addition, less pollution from the new vehicles not only is safer for Americans but the environment in general as well.

Despite skepticism from many, this program does this show that smart government spending can stimulate the economy. In this case it does so in more ways than one, making the investment well worth the several billion dollars spent.

Full Disclosure: No positions in Ford or GM at the time of writing, but positions may change at any time

Investors’ Thirst for U.S. Government Debt Yet To Be Quenched

We have been hearing warnings for years. Just wait until China stops buying our debt… the borrow and spend cycle in the U.S. will come to a grinding halt. Since the Obama Administration has already spent about $1.4 trillion (~$800 billion on stimulus and ~$600 billion on a down payment for healthcare reform), these calls are growing ever more prevalent.

Of course, China will continue to have excess cash reserves that need to be invested, and they only own a fraction — less than 10 percent — of the total U.S. debt outstanding (contrary to the widespread belief that they effectively own the United States), but it is not unreasonable to think demand would drop a bit as we continue to borrow money. The interesting thing, however, is that demand for U.S. debt is showing no signs of slowing down.

Part of the reason the stock market is doing so well today (Dow up 150 with less than one hour of trading left to go) is because we got the results of yet another U.S. debt auction and it went very well. The U.S. successfully sold $27 billion of seven-year notes with strong demand.

Demand can easily be gauged by what is called the “bid to cover ratio” which simply tells you how many dollars of bids were submitted for each dollar of debt that was auctioned off. Today’s note offering registered a bid to cover of 2.82 so we received $76 billion of bids for only $27 billion of notes.

Are we paying through the nose for this money? Not exactly. The yield on the 10-year bond right now is around 3.5% or so. I wish I could borrow money for 10 years at 3.5%. Not only is the government trying to do so, but it is finding great success even in this fiscal environment. To me, that bodes well for the future of the United States.

U.S. Energy Department Paves Way for Nuclear Power Plants, Public Companies To Benefit

You may have heard that the U.S. Department of Energy is planning to offer $18.5 billion in loan guarantees for the construction of more nuclear power plants. Not only would additional nuclear capacity reduce greenhouse gas emissions, it would also help private energy companies boost their market positions. Federal loan guarantees will reduce the cost of capital and make expanded nuclear power an easier goal to attain.

This is good news for investors too, as four publicly traded companies will share the $18.5 billion raised. The companies include NRG Energy (NRG), Scana (SCG), The Southern Company (SO), and UniStar, a joint venture between France’s EDF and Constellation Energy (CEG). These utility stocks are already fairly inexpensive on a valuation basis, with high dividend yields, so new future growth opportunities will only make them even more attractive.

The growth will help some more than others (Southern, for example, is a huge power player already, so nuclear might not make a large dent in their business), but I believe ventures like these serve to identify the leaders in the energy transformation movement. As a result, investors may want to take a closer look.

Full Disclosure: Peridot Capital was long shares of Constellation Energy preferred stock at the time of writing, but positions may change at any time

Profit On TARP Repayments Only To Cancel Out Other Losses

Before we start jumping for joy that the government stands to make a nice profit on the $68 billion of TARP money that is now eligible to be repaid, let’s consider that the gains are only from relatively healthy institutions. By forcing each of the nation’s biggest banks to accept TARP funds, former Treasury Secretary Paulson essentially assured profits would be generated on some of the loans, but we really need to look at the big picture. In order for the taxpayer to come out ahead, the gains on the good investments need to cancel out the losses on the bad ones.

Do the profits on $68 billion of TARP capital do the trick? Hardly. AIG received $70 billion from TARP, GM and Chrysler got $17.4 billion, and another $30 billion in slated to fund bankruptcy proceedings for the auto makers. That’s more than $117 billion that the government has tied up in 3 firms. It will take years to get that money back, and in the case of AIG, it appears unlikely a full recovery is a reasonable expectation. So, while $68 billion coming back to us is a good thing, let’s not get carried away and start calling TARP a solid “investment” just yet.

Full Disclosure: No position in AIG or GM at the time of writing, but positions may change at any time (unlikely in this case, however)

Trucker YRC Applies for TARP Funds, Don’t Hold Your Breath

For those who don’t know, YRC Worldwide (YRCW) is the former Yellow Roadway. Here is some of what the Wall Street Journal is reporting:

“YRC Worldwide Inc., one of the nation’s largest trucking companies, will seek $1 billion in federal bailout money to help relieve pension obligations, the chief executive said Thursday. Chief Executive William Zollars said the company will seek the money to help cover the cost of its estimated $2 billion pension obligation over the next four years. Under a complicated system that Mr. Zollars labeled unfair, roughly half of YRC’s contributions to a multi-employer union pension fund cover the costs of retirees who never worked for the Overland Park, Kan., company.”

Awfully presumptuous of him, don’t you think, applying as a trucking company without any indication Treasury would ever widen TARP to include any U.S. corporation? I would be shocked if this were approved, and if somehow it is, TARP would be completely out of control.

“Mr. Zollars declined to comment on YRC’s specific strategy in seeking the funds, other than to say the company shouldn’t be forced to pay the pension benefits of employees who never worked for YRC.”

This seems like an odd explanation. I don’t know the details of the “complicated, multi-union” pension plan in question, but it strikes me as probable that if half of YRC’s contribution goes to people who didn’t work for YRC, then the other truckling companies are in the same boat and are paying for some of YRC’s former employees. Does Zollars want to stop paying for non-YRC pensions while still having his competitors subsidize YRC’s pension obligations? The whole thing is bizarre, to say the least.

Full Disclosure: No position in YRCW at the time of writing, but positions may change at any time

U.S. Bank Stress Test Cheat Sheet

All we’ve heard about this week has been the stress tests, so I figured I would summarize the important aspects for everyone. Hear is what you need to know if you are following the large cap U.S. financial sector.

Capital Ratio Requirements: Banks must have enough capital to maintain the following ratios:

*Tier 1 Capital of 6.0%

*Tangible Common Equity (TCE) of 4.0%

Deadlines: For banks that need more capital, here is their timeline:

*Articulate plan for raising capital by June 8th, 2009

*Implement plan by November 9th 2009

*Maintain target capital ratios through December 2010

Sources of Additional Capital:

The regulators have indicated that raising private capital is the preferred source of raising capital. The banks may also choose to sell certain assets and use cash earnings to reach the targets. If those options are not sufficient to reach the desired capital levels, the banks may convert their TARP preferred capital into mandatory convertible preferred stock, which can be converted, on as needed basis, into common equity in order to boost capital levels to the needed levels.

Here are the results:

As for individual stocks, I have long been writing positively about COF, PNC, and USB on this blog. COF and USB passed and PNC needs to raise the least of all the banks, a meager $600 million. These results are not surprising to me, and I continue to like all three stocks long term.

Full Disclosure: Peridot Capital was long shares of COF, PNC, and USB at the time of writing, but positions may change at any time

Credit Cardholder “Bill of Rights” Looks Like Sensible Regulation

One of the biggest concerns from conservatives since President Obama’s election has been the possibility of new, overly burdensome government regulation on various aspects of the economy and financial markets. While this should be a real concern, it is unfair to assume new regulations will be over-the-top before any of them are actually drawn up, passed, and enacted.

Among the first is a credit cardholder “bill of rights” which is supposed to protect consumers from unfair and deceptive credit card issuer practices. The U.S. House of Representatives overwhelmingly passed its version of the bill (the Senate is working on possible modifications), so I thought I would go through the summary of its contents to see how reasonable it is. Below are the details:

Interest Rate Increases

1) Limits interest rate increases on existing balances to those cardholders who are late with their payments, have a promotional rate expire, or have a card with a variable rate

2) Requires card issuers give consumers 45 days notice to any interest rate changes or significant contract changes

Credit Limits

1) Lets consumers set their own fixed credit limit

2) Prevents over-the-limit fees for consumers who have set a limit or for “hold” transactions

3) Limits (to 3) the number of over-the-limit fees issuers can charge for the same transaction

Penalties for On-Time Payers

1) Ends “double cycle” billing – interest charged on balances that were paid on time

2) If cardholders pay on time and in full, prevents issuer from charging left-over interest fees

3) Prohibits additional fees for paying over the phone or internet

Allocation of Consumer Payments

1) After the minimum amount due, payments must be allocated proportionally to high interest and low interest balances, not exclusively to the lowest interest rate debt

Due Dates

1) Billing statements must be mailed 21 calendar days before the due date, payments received by 5pm local time on the due date must be considered “on time”

2) Extends the due date to the next business day if the due date falls on a day the card issuer does not accept or receive mail

Misleading Terms

1) Establishes standard definitions for terms such as “fixed rate” and “prime rate” so as to ensure clarity in marketing materials

2) Gives consumers who have been “pre-approved” for a card the right to reject the card prior to activation without negatively impacting their credit score

High Fee, Subprime Cards

1) Prohibits issuers of subprime cards (cards with fixed annual fees that exceed 25% of the card’s credit limit) from charging those fees to the card itself, which often results in consumers going over their limit

Issuance to Minors

1) Prohibits card issuers from knowingly issuing cards to individuals under 18 who are not emancipated minors

After reviewing this “bill of rights” I was pleased to conclude that none of these measures, in my view, would be considered excessive regulation by the federal government. I think we all need to take more responsibility for our actions and our financial situations, and empowering the consumer with information and the ability to avoid certain products if they choose to can only aid in that process. Kudos to Washington on this one (hopefully the Senate doesn’t mess with it).

Paulson Threatened To Remove Ken Lewis If He Backed Out Of Merrill Lynch Deal

Some people are worried that President Obama is going to try and run the banks and credit card issuers but how about this little tidbit from the Wall Street Journal:

Then-U.S. Treasury Secretary Henry Paulson threatened to remove Bank of America Corp. Chief Executive Kenneth Lewis and the bank’s board of directors if the bank backed out of its merger with Merrill Lynch & Co. last year, New York Attorney General Andrew Cuomo said.

Mr. Lewis had informed Mr. Paulson on Dec. 17, 2008, that Bank of America was planning to invoke a material adverse event clause in the merger agreement that would allow it to call off the deal, Mr. Cuomo said. Three days before, Mr. Lewis had learned that Merrill Lynch’s financial condition “had seriously deteriorated at an alarming rate” since Dec. 8, 2008, Mr. Cuomo said.

The difference between this news and the ouster of GM CEO Rick Wagoner, of course, is that the government is a creditor of GM and without having lent them money, GM would have filed bankruptcy a long time ago. Forcing shareholder-owned companies to merge simply to prevent possible instability in the financial system is questionable at best and completely inappropriate at worst. I hope the Obama administration doesn’t repeat these types of things. Fortunately, pushing for a credit cardholder bill of rights, as discussed today in Washington, does not fall into such a category. Let’s cross our fingers it stays that way in the future.

Why I Have No Problem With The Government Firing Rick Wagoner

Call me skeptical that since the Obama administration’s auto task force ousted General Motors CEO Rick Wagoner it means the government is going to take over and ruin the auto industry. I think Wagoner’s list of accomplishments (or lack thereof) shows that he deserved to be gone long ago. After all, GM stock went from $60 to $2 under his tenure as CEO.

As for whether the government should have the right to force him out, why shouldn’t they have the same power that any other creditor or investor would have when trying to help a company avoid bankruptcy? Private equity invests in distressed companies all the time and as a condition of such investments always has a say in the turnaround plan, including replacing a chief executive. Having such power is the only way they feel comfortable that adequate changes will be made to somewhat protect their investment.

The government is unfortunately in the drivers seat in this case because nobody else will come to GM’s aid in its current form. By doing so, however, they should have the same rights as anybody else. No more, no less. Whether they should have even tried to prevent a GM bankruptcy is another question entirely, and a very valid one at that. I have no problem with someone arguing against that, but that really has nothing to do with the Wagoner situation.

The Obama team has decided to continue the public aid that the Bush team started, probably to try and avoid further destabilizing the financial system and economy. Reasonable minds can (and are) disagree over whether that is the right thing to do or not, but Rick Wagoner had to go regardless. Don’t forget, under his leadership, even when the economy was booming GM North America was in the red.

What about Wagoner’s replacement, Fritz Henderson? Well, I don’t think the government had a hand in choosing him. He openly and proudly announced that he was a lifelong GM’er and that Rick Wagoner was his mentor. Yikes, I guess the jury is still out on whether that is change we should believe in or not.

Full Disclosure: No position in GM at the time of writing, but positions may change at any time (I don’t expect this to change in this case)