While I am optimistic about investment prospects for the next year or two, I am keeping a very close eye on the coming crisis. I have described the coming crisis a number of times since the beginning of 2008. Here is a thumbnail sketch. Three negative trends are converging in 2015 (plus or minus 2 years): the US Government will borrow $5 Trillion or more; and, Social Security system will be spending more than it receives; and, State & Municipal pension plans will not contain enough money to pay their promised benefits. I continue to believe we must watch these three trends closely. I ran across an article that discusses what happened the last time States & Municipalities could not pay their bills and defaulted. It is interesting reading:


When States Defaulted: 1841

Land values soared. States splurged on new programs. Then it all went bust, bringing down banks and state governments with them. This wasn’t America in 2011, it was America in 1841, when a now-forgotten depression pushed eight states and a desolate territory called Florida into the unthinkable: They defaulted on debts. Deputy WSJ Money & Investing Editor Dennis Berman explains why history shows higher taxes are highly probable as states cope with defaults on their loans.

This was an incredible step, even then. Fledgling U.S. states like Indiana and Illinois were still building credibility on global debt markets. They rightly feared “a prejudice so deep and wide” that they could never sell bonds in Europe again, said one banker.

Their paranoia would be familiar to the shell-shocked California and Illinois of 2011. Each is beset by budget problems so great that some have begun debating default or bankruptcy. These worriers may draw comfort from the state crises that raged and retreated long ago. Most of the states eventually paid off their debts, and changed their laws to safeguard their finances, helping make U.S. states some of the world’s best credits.

Congress, meanwhile, helped set a precedent that still holds: In 1843, it rejected an elaborate plan for a bailout, with one critic later observing it would “cause recklessness and extravagance” among the states. Surely, someone will dust off those ideas in 2011.

Yet for all their similarities, there was an ominous difference from now: Leaders and citizens of the 1840s were more willing to accept new taxes to pay for the infrastructure and to defend, in the earnest words of the time, their “moral duty” of meeting debts. In Indiana and Ohio, property taxes went up eightfold in the early 1840s. New York, Pennsylvania, Maryland, and Massachusetts all installed state property taxes, the first in 40 years for Pennsylvania.
“People didn’t want to raise taxes but they did,” says John J. Wallis, a University of Maryland economic historian. He traces our current states crises back to those defaults in 1841, after which legislators amended constitutions to clamp down on new borrowing. Over time, these rules have been perverted by politicians, meaning that “constitutional rules have made it harder to raise taxes than to raise expenditures,” he says.

There were differences between today and 19th century. Then, expensive state programs weren’t for government pensions or Medicaid. They were for roads and canals. And in today’s slow-growth economy, raising taxes won’t solve all of the states’ fiscal woes. Any real solution will require wholesale cuts in government programs and spending, too.

When the defaults began in January 1841, investors dumped state bonds, pushing yields above 12% in early 1841, and to nearly 30% by 1842. The consequences of those defaults would last for decades: Among historians, the rule of thumb is that U.S. states would pay interest rates one percentage point higher than Canadian issuers the rest of the 19th century. To this day, Mississippi hasn’t paid back some of those bonds, even after a 100-year English bid to collect.

The defaults weren’t crippling. U.S. states went back into the public markets in the railroad boom of the 1850s, most of them armed with stronger safeguards for creditors and new constitutions.

Could states default today without causing another 1841? Randall Kroszner, a former Fed governor and University of Chicago professor, calls it as a long shot. “Only if there were a clear legal framework, and a clear way in which people would be treated, and not interminable delays through the courts,” he says. “States should be very averse to defaulting.”

For Mr. Wallis, the lessons of the 1840s are bracingly clear. Taxpayers and politicians have lost the connection between borrowing and costs. So taxpayers must be willing to approve tax rises as a direct part of new borrowing plans.

“There is nothing wrong with raising taxes to support government services that voters want and are willing to pay for,” he says. But government needs to be set up “so that both voters and legislatures are forced to make decisions about taxing, spending, and borrowing simultaneously.” (Source: The Wall Street Journal)

Question:

I refinanced my home mortgage last year; and, I paid 2 points (2% of the mortgage balance) in order to reduce the mortgage rate. Are the points I paid deductible on my income tax return?


Answer:

Yes, but not all in one year. The deduction of the points is spread evenly over the life of the mortgage. For example, if the new mortgage is a 20 year mortgage, then only 1/20 of the points are deductible in each year. NOTE: points paid on a mortgage used to BUY the house are fully deductible in the year the house is purchased.

“The difference in winning and losing is most often…
not quitting.”

Walt Disney

“Two out of three” is not bad in most sports. In the NFL, my three favorite teams in order of my favoritism are: (1) Pittsburgh Steelers, (2) Philadelphia Eagles, and (3) New York Jets (goes way back to Namath but has been recently reinforced by my son-in-law Matt Petrozelli and his family). Well, two of these three teams have made it deep into the play-offs and only 2 wins away from the Super Bowl. The only negative I see right now is that it is conceivable, but not likely, that the two remaining teams, the Steelers and the Jets, will play each other January 23 – but, wait a second, that would be a great game. Go Steelers! Go Jets!

The economy continues to give us mixed signals but there were more positives than negative developments last week. Here is a detailed list of these signals:

Positives:
1) Unemployment rate falls to 9.4%
2) ISM services best since May ’06
3) ISM Manufacturing best since May ’10
4) Euro Zone PMI highest since Apr
5) Euro Zone Economic Confidence highest since Oct ’07
6) 16 yr high UK PMI

Negatives
1) Dec Retail comps below expectations
2) New high Portugal yields, 10 yr high in Spanish yields, Italy and Belgium under pressure too all ahead of supply of new bonds next week
3) CRB food sub-index and Journal of Commerce industrial commodity index both at record highs

If the first week of 2011 is any indication, the stock market is raring to go and also a little afraid to do so.

Stocks began January with a 1.1% pop—its best day since the first days of December—that quickly gave way to second guessing and buyers’ remorse. Those scouring December’s economic data for corroboration got only mixed signals, with the service sector growing at the fastest pace since 2006, but tentative employers hiring just 103,000 new workers.

The enthusiastic start hews to a 2010 pattern and shows money managers anxious to buy—or at least anxious not to get left behind. The Standard & Poor’s 500 index gained 142.5 points in 2010, and 133.5 of those came on the first trading days of each month. Is it any wonder? Only 21% of mutual funds had outperformed the S&P 500 last year, with cautiously positioned money managers often doing better when the markets slipped but lagging whenever the market surged. Throw in a central bank hell-bent on inflating asset prices, and a growing consensus that our economy is improving, and the anxiety not to miss rallies grows more acute as 2011 begins.

Momentum has also been a force. The S&P 500 hasn’t closed beneath its 50-day average in more than four months —a feat seen just once in the past decade, in 2003. The U.S. stock market ended 2010 with a 12.8% gain but is up 20% in the year’s final four months. The past 30 years or 120 quarters have produced only 16 quarters where the S&P 500 rallied 10% or more, and two of those lined up back-to-back in the latter half of 2010. And after more than two years of steering money from stocks toward bonds, investors have put more than $6.5 billion into stock mutual funds since mid-December, as they yanked $4.7 billion from bond funds. Two weeks do not a new trend make, at least not yet, but it complicates the logical decision to pull back from stocks.

Meanwhile, there are unmistakable signs of froth. Exhibit A is China Shen Zhou Mining & Resources (ticker: SHZ). Who, you ask? All you need to know is the company has a Beijing address and owns fluorite and copper mines in the Mongolia region, and shares listed at the American Stock Exchange have nearly quadrupled since December. Meanwhile, surveys show investors becoming more bullish, and more fully invested mutual fund managers with less dry powder at their disposal. And have you heard the giddy swirl of takeover gossip lately?

Investors also seem anxious to take profits, at least in the short term, which could create a scramble for the exits should the selling begin. December sales rose 3.1% at 28 retailers tracked by Thomson Reuters, less than the 3.4% forecast but not at all bad considering the blizzard that blanketed the Northeast after Christmas. Yet you’d never know from the 1.5% drubbing meted to retail stocks Thursday, compared to the S&P 500’s 0.2% ebb. Auto parts retailers, another of 2010’s big winners, pulled back 5% to start this year (Source: Barrons Online).