A Thaw Before the Storm or Another “Lehman Moment?”

The event caused one of the most severe, heart stopping shocks to our global economy. The pain is still being felt (just ask the people of Greece) and will be for years to come. Within four months of Lehman’s collapse the US economy lost more than three million jobs and the Dow Jones Industrial Average shedded more than 4,000 points. 401k’s became 201k’s, the wealth destruction was profound. Anyone reading these words felt it.

In my book, A Colossal Failure of Common Sense – The Inside Story of the Collapse of Lehman Brothers, I chronicle the rise and fall of this fabled bank.

There are so many lessons to take away from Lehman’s collapse, none more important than the one facing a country I love: America. It’s staring every American right in the face.

Debt can provide years of goodies and pleasant times but it’s a double edge sword. If abused, debt can be the ultimate grim reaper, the all-powerful checkmate. As a former Lehman trader, I know this all too  well. There was no Joy in Mudville bailout for Lehman Brothers shareholders. I wear the financial scars to prove it.

Hedge Fund legend David Tepper once told me the market can handle a few uncertainties at a time, “any more than three big ones all at once and we’re going lower” (in the markets). The FTSE All World Index is 8.9% off its recent highs with four colossal uncertainties causing investors to run for cover. A global economic slowdown led by the US, political unrest in the Middle East, a possible default in Greece and the debt ceiling drama coming out of Washington, DC.

The United States is steaming toward our congressionally mandated debt ceiling, which was most recently raised in February 2010 to $14.2 trillion dollars (including $4.6 trillion held by Social Security and other government trust funds). U.S. Treasury secretary Timothy Geithner has warned (if not threatened) that if Congress does not approve another debt ceiling increase between now and August 2nd, for the first time in our countries’ 125-year history, the US could default on our debt. It won’t be a hard default but a technical default or a possible delay in interest payments to US Treasury bond holders.

The impact of such an event could provide us all with a gut wrenching repeat of the Lehman induced financial crisis. Interest rates on bonds the US must issue to keep our way of life funded would jump sharply higher, putting the breaks on an already sluggish economic recovery.

To put this in perspective, you must understand every one percentage point move in the weighted‐average cost of capital for the US government will end up costing taxpayers $142 billion annually in interest alone.

According to a recent note from the sage of Dallas based Hayman Capital, highly respected Kyle Bass, a move back to 5% (2006 levels) in short term interest rates will increase annual U.S. interest expense by almost $700 billion annually. This is against current U.S. government tax revenues of $2.228 trillion (CBO FY 2011 forecast). Even if tax revenues were to reach their prior “hay day” peak of $2.568 trillion (FY 2007), the impact of a rise in interest rates is still staggering.

Where do things stand in Washington? It’s simple and complex all at once.

The Democrats, led by President Obama and Vice President Joe Biden, want to raise taxes and Republicans led by Speaker of the House John Boehner and House Majority Leader Eric Cantor want to cut spending. A look at  Greece makes one aware of some ugly truths. Greek government’s tax revenue is a monstrous 40% of GDP vs. only 15% in the U.S.

Needless to say, raising taxes in Greece has simply enabled reckless spending by incompetent politicians.

Case in point: last summer Greece raised its value added VAT tax to 23% from just 17% and today it’s teetering near bankruptcy. Think it might be a spending problem?

What Are They Doing in Washington to Protect America from a Similar Fate?

With approximately two weeks remaining before a self-imposed deadline, those involved in debt limit increase/deficit reduction talks have so far only agreed to offer a deal to the Republican and Democratic Caucuses for review.

A group led by Vice President Joe Biden met three times last week. They discussed discretionary spending Tuesday, spending caps and triggers Wednesday, and reviewing the status of negotiations on specific items on Thursday. Negotiators are expected to reach a preliminary deal within this first timeline, with the August 2nd default date on everyone’s mind.

My friends at DC Tripwire tell me Rep. Van Hollen (D-MD) has announced that if a deal cannot be worked out by July 1, the group will announce that they cannot bridge their differences.

Any deal is likely to disappoint hard-line “Tea Party” Republicans and Democrats who will be upset with the scope of deficit reduction and spending cuts, respectively. Vice President Biden continues to assert that the talks will produce roughly $4 trillion in cuts over an indeterminate budget window. A sober, Rep. Clyburn (D-SC) has suggested that negotiators are still discussing the “form” of an agreement, rather than “specific numbers.” To me it’s shocking. With so much weighing in the balance, we have so few hard specifics.

The group is expected to meet four times this week. All negotiations on specific items remain open until there is a comprehensive deal in place.

In a positive sign of a thaw before the storm, President Obama, Vice President Biden and House Speaker Boehner (R-OH) played a round of golf together this weekend. The president and speaker even shared the same golf cart and the president offered to drive. Reports say deficit negotiations were discussed but most of the banter was focused on the 111th US Open being played at nearby Congressional Country Club, in Bethesda, MD.

My friends at DC Tripwire tell me deficit reduction plans will be compared during upcoming talks. While the discussions have been closely guarded so as not to blow up a potential deal in its infancy, negotiators have examined at least four dramatically different deficit reduction plans side-by-side: The Ryan/House GOP Deficit Reduction Plan, President Obama’s budget; the President’s Simpson-Bowles Commission Plan; as well as the Rivlin-Domenici Deficit Reduction Plan.

Of course the final size of the debt limit increase is in hot debate. Negotiators still hope they can achieve the necessary spending cuts to enable Republicans to agree to a $2.4 trillion debt limit increase, thereby ensuring that another vote to raise the debt limit would not occur until after the presidential elections. Although many members are wary of multiple debt limit votes, the possibility of additional debt limit increases before the presidential election cannot be ruled out at this point.

Senate Majority Leader McConnell (R-KY) echoed the arguments of other negotiators that any eventual compromise must satisfy not only the Republican and Democratic Caucuses, but also the American people, foreign investors and credit rating agencies.

Nevertheless, there is skepticism in many quarters about whether a compromise will truly result in $4 trillion in cuts. DC Tripwire makes the point that at this point negotiators have examined all significant areas of the Federal budget for potential savings. Last week, Vice President Biden noted, “we have gone through a first serious scrub of each of the categories that make up the total Federal budget,” adding, “and the really tough stuff that’s left are the big-ticket items.”

The Thaw Before the Storm and the Cantor-Biden Lovefest

Last week, with all the horrible headlines out of Greece there were actually some encouraging signs in Washington. Office of Management and Budget Director Jack Lew, sounded upbeat on Wednesday: “Conversations continue to be in the same constructive spirit. Everyone’s very focused on the importance of the work we’re doing.”

Majority Leader Cantor described himself as “very impressed” with Biden’s leadership in the talks and said that he has “kept the ball rolling.” Vice Presient Biden returned the kiss Thursday night, telling reporters that he’s “really enjoyed working with Eric Cantor – for real.”

“I mean, it’s been a great, pleasant surprise for me,” Biden gushed. “The guy’s smart as hell. I don’t want to ruin his reputation; I don’t want to hurt him. But he really is. He’s smart, and he’s been totally, completely straightforward and sincere.” In other words, this time I’m really not full of bologna.

So Much Distrust They Can’t Even Agree on the Date?

On a sobering note last week, one surprising question mark has been over whether the Aug. 2 deadline set by Treasury Secretary Timothy Geithner is a real firm date. Led by Sen. Pat Toomey (R-Pa.), a group of more than 100 House and Senate Republicans has been vocal in its skepticism of a possible default if the ceiling isn’t raised by then. The Democrats and the White House have pushed back aggressively and often against that argument.

And another bit of a curve ball emerged last week; the Obama administration’s suggestion that this year’s 2% slice in Social Security payroll taxes, due to expire at the end of the year, should be extended. If that cut were included in the package, Republicans can argue that they won lower taxes. Likewise, adding credence to the possible payroll tax cut extention, former White House economic adviser Larry Summers was vocal in a Financial Times Op Ed last week. Sounding like a Reagan era economist, Summers said “without payroll tax cuts negotiated last Autumn we might be looking at a double dip recession.”

Real Wild Card: The Tea Party

The biggest threat to the stock and bond markets might just be aggressive Tea Party activists in Congress. These conservative House Republicans have not made negotiations any easier for Speaker Boehner. Last week, 103 House Republicans demanded that deficit/debt negotiations cut the annual deficit in half by next year. The Congressional Budget Office estimate for the U.S. deficit in 2011 o be $1.5 trillion, up from $1.27 trillion in 2010. So cutting the deficit by “half” would be an ambitious $750 billion slice.

The Tea Party players in Congress also want to cap Federal spending at 18% of GDP and include a vote in both chambers on a Balanced Budget Amendment.

The letter did not go so far as threatening to withhold votes on a debt limit increase unless those conditions were met. While some conservative Senate Democrats have proposed a 22% GDP spending cap, either an 18% or 22% GDP cap on federal spending is a difficult sell among the larger Democratic Caucus. Several conservative members met with Alan Greenspan last week, who argued that the Treasury might have more wiggle room than it has suggested by imposing an Aug. 2 deadline on talks – although a “concerned” Greenspan later clarified his comments and said that a debt limit increase might be necessary before Aug. 2 as well.

Tea Party power broker Jim DeMint stirred up the pot last week when he threatened action on any GOP turncoats. DeMint said, “If we have folks who go the wrong way on that (debt ceiling), it’s going to be pretty hard for me to sit still.” In other words, hold off re-election support funds for GOP members who jump the fence. He went further to say, “If you want to lose those people who elected us last November, if you want to deflate that new base that believes that they have the power to change things, if you want to destroy the conservative movement in America and push a third-party candidacy at all levels, then fold on this one (debt ceiling).”

Ultimately this Debate will come down to Big-Ticket Items: Tax Increases and Medicare Cuts

Although lawmakers moved closer this week to closing so-called tax loopholes, the parties remain firmly divided on the issue of tax increases. Democrats continue to push for revenue increases as Republicans firmly maintain that tax increases will not be part of any deal. However, the notion of what constitutes a tax increase remains unclear. Although some Republicans have argued that closing tax loopholes without offsetting tax decreases is a de facto tax increase, this position is being increasingly resisted in the Republican Caucus.

For now, at least, my friends at DC Tripwire tell me Medicare cuts are very much alive – just don’t call them cuts. Like the definition of a tax increase within the Republican Party, Democrats continue to debate the meaning of “Medicare cuts.” While numerous Democrats in both chambers have threatened to vote against any package that includes Medicare cuts (and even House Budget Committee Chairman Ryan (R-WI) has walked back from his own plan), Democratic negotiators have promised to put together a Medicare reform package that will be broadly acceptable to them. However, such a plan may include items like drug price negotiations that Republicans are expected to resist. The Democratic proposal may also include conditions of participation and drug rebates for so-called “dual eligibles.” Medicaid cuts are also on the table. Specifically, negotiators are looking at repealing state maintenance of effort mandates, which have strapped many state budgets and helped stymie state-level attempts to find areas of cost containment.

The Lehman legacy is one of a colossal failure of common sense. I hope members of Congress are listening for the sake of our country. All the warning signs are there. We can ill afford another “Lehman moment.”