Volume X, No. III

We're in the middle of Passover with Easter just around the corner, about a quarter of the way through 2010. So far this year, we've been looking at the impact of business and personal debt on America and on our personal lives.

We showed how businesses and individuals have begun rebuilding their balance sheets after the financial crisis of 2008. We even glimpsed a future where we all spend less and save more. And we questioned the reality of a prosperity built up while many of us ingested debt steroids for so many years.

But that's all in the past. While we don't know exactly where the new frugality will take us in the coming years, there's still one huge part of the old world of borrowing and spending that refuses to die: government. At every level – federal, state, county, city, and town – government spending continues on its merry way. Brace yourself as we continue our journey starting with:

• How Our Cities and States Kept Up the Appearance of Prosperity For So Long
• What This Will Mean To Us In Coming Years
• Who Will Benefit – and Who Will Be Hurt
• Why You May Need To Reassess Investing in Municipal Bonds

But first some important news from our friends at the IRS...

Yes, you read that right: good news. The IRS reports that tax refunds are up. They're running 9.6% ahead of last year, averaging $3,232 so far this year, vs. $2,770 for last year. Will this happy trend put a few extra dollars in your pocket this April? We hope so.

What's that you say? They're going to raise taxes next year? But that's not until 2011. For now, just enjoy the good news while it lasts. After all, a little indulgence in the good things of life works wonders for the spirit.

In fact, now that we think about it, 2010 hasn't been such a bad year so far. Especially if you consider how New Year's Day kicked off the year in grand fashion with the appearance of a silver rose around 9:20 PM.

It was almost 24 hours after the great crystal ball had descended on Times Square to mark the beginning of 2010. We were all at the Met Opera watching the second act of Der Rosenkavalier unfold. Octavian, a young knight, carrying on an 18th century custom, presents a silver rose to Sophie, on behalf of the Baron to whom Sophie has been betrothed. Unfortunately for Sophie, the Baron, a fat, pompous, older man isn't the apple of her eye. It turns out Octavian is. So naturally, when the apple's eyes meet Sophie's as he presents the rose, it's – you guessed it – love at first sight. You'll see what all this has to do with government debt in a moment.

First you have to understand that the "Presentation of the Rose" is one of those sublime moments in opera. Later on, we'll provide a link to a really arresting performance of the duet between Octavian and Sophie so you can judge for yourself. But for now, let's look at how the scene relates to our topic of the day.

You see, for everyone else witnessing the presentation of the rose in Sophie's home that day, the rose appears to seal her betrothal to the Baron (as arranged by her father). But in reality – for Sophie and Octavian as well as the sold-out audience of 4,000 at the Met – the rose has become the symbol of their love.

And it's the idea of appearance vs. reality that will connect us with government debt. (Listen. Even if you think it's a bit of a stretch comparing Der Rosenkavalier and our massive government debt, we think you'll thank us for bringing all this up when you get to the Youtube link at the end of the letter.)

Now let's cut from the Met Opera to...

Rather than dramatically build up suspense here, the answer is debt. Massive borrowing has done a pretty good job – at least until now – of keeping things looking, well, rosey (sorry, couldn't resist). Not that you should be surprised if you've been reading our recent letters.

As we said above, while the financial crisis of 2008 seemingly shook people and businesses out of a false vision of prosperity built on mountains of ever-growing debt, that same message hasn't caught on with government yet. Even as businesses and individuals have cut down on spending and paid down debt, government debt at every level is simply exploding.

Of course, growing government debt isn't news. But, as you'll see, we've never had anything approaching the current levels of government debt. In fact, let's take a look right now...

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We like this chart because it shows total debt relative to something else – in this case gross domestic product. That's important because the numbers thrown around today – you know, all those trillions – pretty much make our heads spin. In fact, all those trillions almost become meaningless unless we use them with some sort of reference.

So with that in mind, look at the first big spike. It shows government debt during the Great Depression. The second taller spike is now. You can see why we said we've never had anything approaching the current levels of government debt.

Now, you have to understand that all this debt has its defenders, those who say that we need government spending to avoid a terrible economic downturn. Whether you happen to believe government spending saved us then or is saving us now, the important point is that the reasons given for the debt back in the Great Depression are the same sorts of reasons we hear now. To sum them up: spend or die.

We don't know about you, but we still find this a heck of a lot of debt to try and wrap our minds around. So for the sake of brevity and sanity, we'll just look at state and local government – a small percent of total government debt – this month. Another name for state and local government debt is "municipal" debt. So now let's look at total U.S. municipal debt.

If you remember the charts we used in our recent letters, we showed how both personal and business debt began to rise dramatically starting around 1980. That's exactly what we see in total government debt above. And, lo and behold, municipal debt also started dramatically increasing starting around 1980. Here's U.S. municipal debt outstanding from 1981 through 2009 (courtesy of the Wall Street Journal):

For the 17 years between 1981 and 1998, total municipal debt increased 28%. For the 9 years between 1998 and 2007, it increased another 55%. And even with the financial crisis that started in 2007, and which at one point dragged the value of some municipal debt down almost 20%, the total still increased.

Why are municipalities taking on so much debt? The simple answer: to keep up with spending. Taxes aren't doing the trick.

Remember, as opposed to individuals and businesses, who typically earn money in some way, the only way government "earns" money is via taxes. So if a government doesn't take in enough in taxes to pay for its expenses, it has to borrow. Basically, it's spending more than it earns.

What's all the spending about? Just as the federal government provides services (national defense, social and "entitlement" programs, internal security, all those government agencies, etc.), so municipal governments (states, counties, cities and towns) provide services: local roads, bridges and tunnels, public schools, trash collection, water and sewage services, police and fire protection, etc.

Most of these are necessary expenses. (Yes, we know, in many cases, there's a lot of fat that could be trimmed. But let's keep this simple for now.) The fact is, even though some services have been "privatized," government – state and local – still provides the bulk of these services in some way.

Now all of this doesn't count the pensions many of our municipal employees get. State and local employee pensions have been enhanced – to put it mildly – over the years, especially in states like New York and California. As a result, these two states – and many others – face large future obligations to pay pension benefits to their retirees. Once you start counting the pension obligations – current and future – you start coming up with some pretty astounding numbers like this: the unfunded pension liability for all the states right now stands at around $2 trillion.

Oh, and let's not forget Medicaid. Remember, the states, with some help from the federal government, have to fund that program. A survey by the Kaiser Family Foundation says that in fiscal 2009 the states estimated that Medicaid enrollment grew by an average of 5.4%, the highest rate in six years. It's expected to increase 6.6% in 2010. A 1/28/10 paper by the Center on Budget and Policy Priorities says that total state budget shortfalls for 2010 and 2011 are estimated at $350 billion including gaps already closed and gaps projected for the future. Even after taking into account the federal Recovery Act dollars that should remain available for fiscal year 2011 ($40 billion), states will still have to close shortfalls of some $260 billion for fiscal years 2011 and 2012 combined.

As you might imagine, we could continue piling on more numbers at this point, but let's stop for minute to catch our breath and look at all this while using our common sense.

The fact is, it's nothing new that municipalities can't raise enough money in taxes to pay their way. Since the 19th century, they've been raising money by issuing bonds – municipal bonds.

Now, borrowing's not the worst thing in the world. After all, most of us borrow to buy a home. But as many of us have seen, when the borrowing gets out of hand, trouble begins. And that's pretty much what's brewing for municipalities – trouble.

There's certainly some recognition of the problem. After all, cuts have begun in earnest in some states and cities. The difference between the trouble brewing for municipalities and the trouble we've seen in the case of some individuals and some businesses in the last couple of years is that municipalities have more ways of hiding their troubles – or at least giving the appearance that things aren't all that bad.

Not that individuals and businesses can't fool you sometimes too. Companies fiddle with their books and fool their lenders, shareholders and employees from time to time. Remember Enron?

Individuals also can fool us – for a while. Witness more and more McMansions in foreclosure these days – symbols of wealth that never really existed. Now they stand abandoned, empty shells built by borrowed money, no longer adorned with those shiny, expensive leased cars or filled with all that furniture and various trinkets bought with high-limit credit cards.

But municipalities can fool us more and for a lot longer. And that may be what's going on right now, as they continue borrowing in the face of ever-declining revenue. But why be surprised? When you look at the increases in municipal debt we outlined above, you see they've been keeping up appearances for years now. The question is: is there any limit? Put another way, will reality ever set in? Will municipalities continue to borrow more and more or will investors start to scratch their heads and wonder how they'll ever be paid back?

Right now, we'd have to say there's very little scratching going on. Admittedly, we're a bit on the conservative side, so it shouldn't surprise you that our view isn't universally accepted - that too many municipalities have borrowed way too much money. But, really, California and New York – with their budget deficits in the tens of billions – continuing to issue municipal bonds and investors continuing to lap them up…Are we really the crazy ones?

Maybe it simply comes down to two related issues: the search for return and a belief that the federal government will ultimately save the day.

If there's one thing we've learned these last ten years or so as interest rates on CD's, money markets and bonds plummeted , it's that the search for return will cause people and institutional investors to take some pretty crazy risks to get a return on their money. As for the belief that the federal government will save the day, Henry Thornton described it this way in 1802: a central bank will be called on to bail out insolvent banks in order to avoid a wave of defaults. In 1878, Walter Bagehot, then criticizing the Bank of England, gave it a name: moral hazard. Like we said before, it's nothing new.

We're running out of space this month, but there's a lot more we can talk about next time. So next month we'll just continue with:

• What This Will Mean To Us In Coming Years
• Who Will Benefit – and Who Will Be Hurt
• Why You May Need To Reassess Investing in Municipal Bonds

For now, with Passover and Easter pressing in on everyone's time, we'll finish up with our promised link to the Presentation of the Rose – right after this

Personal Note...

Passover and Easter are pretty close together this year. When I was growing up, I liked it that way. We lived in what would today be called an "ethnic" neighborhood filled mostly with Irish, Italians, Polish, Jews, and some Germans. We all had our own traditions but we also shared them from time to time – like when Easter and Passover came together.

My Mom would share her pizza grana with some of our neighbors and either Mrs. Rosenfeld or Mrs. Guttmann (I forget which) would bring us something they made for their Seder – usually gefilte fish. I wasn't a big fan of gefilte fish, but I always enjoyed eating some with my Mom and Dad. Somehow the taste mattered less than the fact that we two were able to share something together that our Jewish neighbors had shared with us.

It's funny that I can't remember which of these two ladies would bring us the fish. They couldn't have been more different. Mrs. Guttmann was large and loud with a thick German accent. Mrs. Rosenfeld was short and petite, American born and bred. Mrs. Guttmann always made her points whether you wanted to hear them or not. You always had to strain a bit to hear what Mrs. Rosenfeld had to say.

From time to time one or the other would ring our bell and come in and sit with my Mom. I had no interest in what they talked about, so I'd usually go about my own business. But whatever they talked about, my Mom always enjoyed their brief visits. And since my Mom liked them, so did I.

When you grow up Italian-American, you learn that food is more than just fuel. But we weren't the only ones who understood this. That's why sharing food was so special. It helped me to recognize that we're not made to live alone in this world. We were made to live with one another. Which brings me back to the Presentation of the Rose. Now, before you click the link – in case you're not an opera fan – you should know that Octavian's role was written for a soprano, but while it's sung by a woman, the character is a young man. It's just an old technique opera composers sometimes use when they want to blend voices a certain way – artistic license and all that. So don't read anything into it.

Anyway, I picked this particular link because one of the sopranos, Joyce DiDonato (who plays Octavian), introduces the scene a lot better than I can. It's a concert version, so there's no scenery and costumes. But the two sopranos act the scene out pretty well. You'll see the "love at first sight" when Octavian and Sophies's eyes meet. And I hope you feel the love captured in the unforgettable music and singing.

I don't know if either Mrs. Guttmann or Mrs. Rosenfeld were opera fans. And of course we certainly didn't all love each other in our apartment building the same as Octavian and Sophie. But I am sure that it was some kind of Love that bound us all together then, in spite of our differences. The Love symbolized by the silver rose was in some way the same Love that we shared with our pizza grana and gefilte fish.

Here's the link.

Wishing you all Happy Easter and Happy Passover,

P.S. – Find out why "professionals" are driving much of the current stock market rally or how the government is planning to tax the poor. All this and more at my blog.

Richard S. Esposito, ChFC
Lighthouse Wealth Management LLC
405 Lexington Avenue, 26th Floor
New York, NY 10174
Tel: 212-907-6583/Fax: 866-924-1952

Email: resposito@lighthousewm.com