Goldman Sachs Guru Warns of War-Debt Failure

Monday, July 30

Is America becoming a global credit risk? How to get back on track

By Paul B. Farrell, MarketWatch
Published: 07-30-07

Will Moody's downgrade America's debt next? Actually, that's already happening; our credit rating is collapsing with the dollar.

Foreign banks are dumping dollar reserves, while we gorge on , cheap toys and bad pet food. Actually, our biggest "terrorist" threat is internal: Distorted values are downgrading our nation's "creditworthiness." We're like out-of-control kids with stolen credit cards, spending our future with no plans to repay.

Recently Robert Hormats, vice chairman of Goldman Sachs (International), appeared before the U.S. House Budget Committee to "discuss an issue of great economic, financial and national security importance to our country -- the growing dependence of the United States on foreign capital." Currently we import $1 trillion new debt annually, with no repayment plans. That's a historic break from over two centuries of American policy.

Hormats was in Washington with warnings from his brilliant new book, "The Price of Liberty: Paying for America's Wars." He traces the history of American wartime financing from the Revolution through the War of 1812, the Civil War, the two World Wars and the Cold War to the present.

Conclusion: "One central, constant theme emerges: sound national finances have proved to be indispensable to the country's military strength" and long-term national security.

1776 to Iraq, national security demands fiscal responsibility
America's long tradition of war financing began with Alexander Hamilton: "In January 1790, Hamilton, by then the country's Treasury secretary, confronted the American people with a stark fact: the nation had run up a huge debt fighting the Revolutionary War. This debt, he wrote, was the 'price of liberty,' and the new government had to repay it.
 

The future creditworthiness of the United States, and ultimately the security and ability to finance future wars, would depend on how successfully and faithfully this was done."

Hamilton's principles have kept America's credit strong through every war since the Revolution ... until the Iraq War. Since then, "although U.S. leaders have warned that the war against terrorism could last for decades, the country lacks a multidecade financial strategy to address the challenge."

Iraq tossed the lessons of history out the window. Hormats says that despite the oft-repeated remark that 9/11 "changed everything, in the area of fiscal policy, however, it changed nothing. The country is pursuing a pre-9/11 fiscal policy in a post-9/11 world." That assessment comes from someone who worked inside Washington for over a decade before joining Goldman Sachs in the 1980s.

Unsustainable debt is weakening national security
America's new faith-based guns-and-butter policy is hurting both guns and butter. The war is costing us $12 billion a month. Hormats examined the Congressional Budget Office's projections for domestic costs: "In 2006, spending on Social Security, Medicare, Medicaid and interest on the federal debt amounted to just under 60% of government revenues" and "if they continue on their current path, they will account for two-thirds by 2015."

• Social security from $550 billion to $960 billion
• Medicare from $372 billion to over $900 billion
• Medicaid from $181 billion to $390 billion

Worse yet, these commitments will continue skyrocketing in later decades. The CBO projects the federal debt rising from 40% of GDP to 100% in the next 25 years: "Continuing on this unsustainable path will gradually erode, if not suddenly damage, our economy, our standard of living, and ultimately our national security."
Hormats warns of the risks of this gross departure from Hamilton's principles: "Of late, the precedents and experiences of past generations have been cast aside. The 9/11 attacks were seen by many legislators as a license to spend more money on non-security programs, and Americans have not been called to make sacrifices. Tax cuts and spending increased on politically popular security-irrelevant domestic programs have been enacted as if there were no expensive defense programs to be funded."

Turning point in Iraq, where 'deficits don't matter'
In my opinion, the turning point occurred in late 2002. Remember, the Afghan War was hot. America was in recession and a bear market. The surpluses of the 1990s rapidly disappeared. Corporate scandals were damaging our global standing. Washington was pushing a second round of tax cuts. And the Iraq invasion was imminent.

Treasury Secretary Paul O'Neill, true to Hamiltonian principles, warned the White House of a coming fiscal crisis. The vice president retorted: "Reagan proved deficits don't matter." (Hormats tells me Reagan never said that.) Soon after, Cheney "fired" O'Neill ... and Hamilton's principles of sound war financing were dead.
Unfortunately, Washington's radical new faith-based financing is sabotaging national security. America's unsustainable deficits are making us extremely vulnerable to terrorists whose goal is to "attack the United States, perhaps with chemical, biological, or nuclear weapons capable of killing enormous numbers of people and seriously disrupting the American economy," targeting a "major port or transportation center."
Hormats says America is now "relying on faith over experience, hoping that sustained growth will erase deficits and that the ballooning costs of Social Security, Medicare and Medicaid will be manageable in the coming decades without difficult reforms."

Yet economists now estimate these entitlements can only be "reformed" by either a cut in benefits or an increase in taxes greater that 40%. In short, today's faith-based economics is failing us.
The current Treasury secretary also appears to be supporting this new approach: Henry Paulson, former Chairman and CEO of Goldman Sachs, recently told Fortune that "this is far and away the strongest global economy I've seen in my business lifetime."

Well, that sure sounds to me like yet another rejection of Hamiltonian principles in favor of the new faith-based policy, which assumes that global economies will always be strong and, therefore, foreign capital will indefinitely bankroll America's war machine at a low cost.

The danger is, it also assumes that American taxpayers will be able to indefinitely pay the interest costs of our burgeoning foreign debt ... on top of exploding unfunded domestic entitlements in Social Security and Medicare.

Time to rediscover 'Hamilton's gift' of war financing
Hormats was being much too diplomatic in summing up his warning to the House Budget Committee: "If government debt continues to pile up, deficits rise to stratospheric levels and heavy dependence on foreign capital grows, borrowing the money will be very costly. If America remains on its dangerous financial course Hamilton's gift to the nation -- the blessing of sound financing -- will be squandered."

The truth is, America's leaders have already squandered "Hamilton's gift," and along with it, more than two centuries of experience, replacing it with a new "faith-based" policy: "Deficits don't matter."

No wonder Main Street Americans have a "gut instinct" that we're a disaster waiting to happen. Not only are we "transferring an inordinate burden to future generations," says Hormats, Washington's undisciplined spending and total lack of a financial repayment plan is undercutting our national security and exposing America to the worst-case scenario: Another domestic terrorist attack that would trigger a "massive disruption of our economy" and a meltdown of America's credit rating throughout the world.

The truth is, America desperately needs a new "Hamilton" who understands that in calculating "the price of liberty," not only do deficits matter, Americans must have a plan to repay our debts ... if we want a strong credit rating that insures our national security for future generations.

Link to article here.

Controversy erupts over leaser of U.S. toll roads
Foreign firm part of public-private partnerships funding highway network

By Dr. Jerome Corsi
World Net Daily
July 20, 2007

Investment analysts in New York and Australia charge that Macquarie, the Australian conglomerate leasing U.S. toll roads, is a "house of cards" that has made billions by spinning off the highway assets into over-valuated investment trusts controlled by the bank.

Macquarie has been an active participant in the "public-private partnerships" sponsored by Mary Peters when she was head of the Federal Highway Administration.

As documented on the FHWA website, Macquarie recently concluded long-term leasing deals on the Chicago Skyway and the Indiana Toll Road.

In both projects, Macquarie has partnered with Cintra Concesiones de Infraestructuras de Transporte, S.A., the Spanish investment consortium also involved in financing and leasing the Trans-Texas Corridor.

The criticism of Macquarie can be traced to a paper published last year by John L. Goldberg, an honorary associate at the School of Architecture, Design Science, and Planning at the University of Sydney in Australia.

Titled "The Fatal Flaw in the Financing of Private Road Infrastructure in Australia," the paper argued equity investors in Macquarie investment trusts are likely to suffer heavy losses by excessive valuations Macquarie makes of financed toll roads that are packaged together to be sold to pension funds and other institutional investors.

Goldberg also argued that government guarantees on Macquarie projects are often buried in the confidential part of toll road "comprehensive development agreements," such that the public taxpayer liability only comes to light when a toll road project fails.

Jim Chanos, a founding principal in the New York investment firm Kynikos Associates, has been equally critical of Macquarie.

Kynikos, founded in 1985, specializes in short-selling the stock of companies the firm believes are overvalued by the financial markets and likely to fall in price. Chanos distinguished himself as one of the most active critics of Enron prior to the company's fall.

In a May 30 radio interview with Australian talk-show host Mark Colvin, Chanos charged that the "Macquarie model" was seriously flawed.

"The bank scours the world buying assets," Chanos told the radio audience, "buying assets, everything from toll roads to bowling alleys and selling them into separate trusts that the bank controls. This generates triple fees for Macquarie Bank: one for the up-front purchase; a second for selling the assets into the trust; then ongoing management and performance fees from the funds."

Chanos charged that the loser in the scheme was the investor.

"If you look at the financial accounts of the trusts," Chanos explained to the Australian talk show, "you'll see that in almost all the cases the companies are using Australian re-valuation accounting which is legal under [Generally Accepted Accounting Practices] in your country to write up the value of the asset annually and put that through operating income and into equity."

Chanos argued that the practice only works in a financial environment in which cheap credit is readily available and valuations for infrastructure projects are generally rising.

"You need a credit environment that looks the other way, or you need a credit environment where the people lending are just lending on reputation or not numbers," Chanos said.

Eventually, he contended, the self-dealing between Macquarie and the Macquarie-controlled funds into which the infrastructure assets are sold is likely to crash.

"All I would tell your listeners," Chanos said in the radio interview, "is simply just go to the trusts, the financial statements, and simply extract out the asset re-valuation number, which is basically management's guess as to how much, what the asset's worth and just see what the cash flow looks like. In many cases, the cash flows are diminished or actually go negative. That's the simple litmus test to the Macquarie model."

Still, Chanos argued that despite the problem in the underlying cash flows, Macquarie makes hefty profits.

"Capital gains alone in the fiscal year 2007, just for flipping these types of assets into the trusts, accounted for half of the pre-tax income of Macquarie Bank," Chanos asserted.

Macquarie Bank has hit back strongly against both critics.

According to newspaper reports in Australia, Macquarie Bank executive Warwick Smith complained to University of Sidney Vice Chancellor Gavin Brown, demanding that the university dissociate itself from Goldberg over his critical research.

In response, Brown issued a statement clarifying that Goldberg is not an employee of the University of Sydney, though he has been given the title of honorary associate by the Faculty of Architecture. In his statement, Brown claimed Goldberg "speaks as an individual and the university accepts no responsibility for his comments which it does not endorse."

In the subsequent controversy that erupted in Australia, Goldberg was featured as a case study in "Silencing Dissent," a book critical of the administration of Prime Minister John Howard, published in Australia by Clive Hamilton, the executive director of a prominent Australian think-tank, and his co-editor Sarah Maddison.

In the book, Hamilton and Maddison charged that the Howard government used strong-arm tactics to challenge the tax status of non-government organizations and ruin the reputations of academics who were critical of governmental policies, including the sale of highway infrastructure leasing rights to private investment concerns in Australia.

Macquarie used a similar personal attack to discredit Chanos following the interview on Australian radio.

In a May 31 statement posted on the Macquarie website, the investment group charged that Chanos, "a hedge fund short-seller of equities," had an economic self-interest in advancing "incorrect claims" that could cause the stock price of Macquarie to fall.

When contacted for comment, Macquarie's New York representative referred WND to the company's online statement, in which Macquarie asserts that all assets acquired by funds controlled by Macquarie are valued directly from the market and subject to the approval of independent directors of the funds.

The published Macquarie response to Chanos also cited a May 25 Bloomberg report which quoted Chanos as saying Kynikos maintains a short position on Macquarie.

Short-selling is a Wall Street practice in which an investor borrows and sells stock the investor does not own, anticipating the stock will go down in value. The short-seller profits by buying shares at a lower price to replace the shares that originally were borrowed and sold at the higher price.

Short-sellers lose money if the price of the stock increases and the cost to purchase shares to replace those borrowed is greater than the price for which the borrowed shares were sold.

Macquarie Infrastructure Group is a separate subsidiary from Macquarie Bank.

The website of Macquarie Infrastructure Group bills the company as "one of the largest private developers of toll roads in the world."

Macquarie Infrastructure Group (MIG) is a worldwide toll operator and has bid to takeover several toll projects in TX including 121 in Dallas area and 281/1604 in San Antonio. Macquarie is also tied to Rudy Giuliani. The plot just got thicker as Jim Chanos, investor who was the first to expose Enron, calls Macquarie's business model a "house of cards" and "unsustainable." The fact that U.S. federal and state pension funds are beginning to make their way into these infrastructure deals that are more akin to a ponsi scheme than sound investments, Macquarie's model makes Enron look like child's play. Read on...


ABC Online

PM - Macquarie Bank model cannot last: Chanos

[This is the print version of story http://www.abc.net.au/pm/content/2007/s1938221.htm]

PM - Wednesday, 30 May , 2007 18:18:00

Reporter: Stephen Long

MARK COLVIN: Jim Chanos was the first big US investor to expose Enron as a fraud.
Tonight, he's told PM why he thinks that Macquarie Bank is a 'house of cards'.

Macquarie's staff have made billions by buying assets around the world and spinning them off into funds and trusts controlled by the bank. The bank collects fees all along the line.

But Mr Chanos says this economic model can't last. His key concern is that the Macquarie Bank funds pay their shareholders not out of income they earn, but from borrowed money.

They continually revalue their assets, then borrow against the asset values to fund payments to investors.

He also says the structure encourages serial overpaying for assets, and that Macquarie is relying more and more on unsustainable self-dealing between the bank and its funds to make money.

This report from our Economics Correspondent Stephen Long.

STEPHEN LONG: Jim Chanos has made a fortune picking stocks that are ripe for a tumble.

He was the first big investor to say Enron was a fraud.

He's not saying there are crooks at Macquarie Bank. Simply, that the model that's made the bank billions is unsustainable.

JIM CHANOS: I guess the heart of our criticism of the bank is the model itself, this so-called Macquarie model.

STEPHEN LONG: The Macquarie model is now world famous. The bank scours the world buying assets, everything from toll roads to bowling alleys, and selling them into separate trusts that the bank controls.

This generates triple fees for Macquarie Bank: one for the up-front purchase; a second for selling the assets into the trust; then ongoing management and performance fees from the funds.

There's been much discussion in Australia about whether this raises a conflict of interest.

Jim Chanos' critique is more fundamental.

JIM CHANOS: The underlying economics, in my opinion, are flawed. Being the top bidder for these assets and then flipping them into the trusts leads to an unsustainable economic engine at the trust level. And when that breaks down all of the fees and whatever's being paid begin to break down.

STEPHEN LONG: Macquarie's funds pay their investors out of borrowed money and that's one of Jim Chanos' key concerns.

They revalue the assets they own then borrows money against the re-valuations to fund the payments to investors, a strategy that could founder when, inevitably, the period of cheap credit and asset price inflation comes to an end.

JIM CHANOS: And this is the real crux of the problem on an ongoing basis. If you look at the financial accounts of the trusts you'll see that in almost all the cases the companies are using Australian re-valuation accounting which is legal under GAAP (Generally Agreed Accounting Principles) in your country to write up the value of the assets annually and put that through operating income and into equity.

STEPHEN LONG: And your worry then is that the payments to the stockholders are being funded essentially by debt and re-valuation not out of income.

JIM CHANOS: Re-valuating and borrowing against that stream. So you need willing lenders, you need a credit environment that looks the other way, or you need a credit environment where the people lending are just lending on reputation and not numbers.

STEPHEN LONG: The man who blew the lid on Enron has other concerns, too. He says the fee structure encourages serial overpaying for assets because Macquarie gets fees based on the size of the assets it spins into its trusts.

He says the Macquarie model relies increasingly on unsustainable self-dealing between Macquarie and its funds.

And then there's the huge levels of debt and leverage.

JIM CHANOS: Capital gains alone in the fiscal year 2007, the year ending March 2007, capital gains alone of Macquarie flipping these types of assets into the trusts and elsewhere accounted for half, roughly half, of the pre-tax income of the bank. And that alone should be enough to call into question the quality of earnings.

STEPHEN LONG: If we came to the end of this extraordinary period we've been in, of cheap credit and escalating asset prices, asset price inflation, where would that lead Macquarie in terms of those capital gains?

JIM CHANOS: Well, I think that they would be greatly diminished or non-existent.

STEPHEN LONG: Although they're perfectly legal and transparent, Jim Chanos says the techniques Macquarie Bank uses have some similarities to those used by Enron.

JIM CHANOS: Let's just say, Stephen, I'm apparently not the first one to make those observations. That's exactly what they appear to be doing.

STEPHEN LONG: Macquarie Bank's boss Allan Moss says short of complete disaster, people will keep driving on toll roads no matter what.

Jim Chanos says that misses the point.

JIM CHANOS: All I would tell your listeners, Stephen, is simply just go in to the trusts, financial statements, and simply extract out the asset re-valuation number which is basically management's guess as to how much, what the asset's worth and just see what the cash flows look like if you take that out.

In many cases the cash flows are diminished or actually go negative. That's the simple litmus test to the Macquarie model.

STEPHEN LONG: Well, Jim Chanos, how concerned should we be that pension funds in Australia are major investors in the Macquarie Bank trusts?

JIM CHANOS: Well, if I was a pensioneer, in your country and my pension fund accounts owned some of these trusts, I would urge the managers to look at the financial accounts closely and not just look at the yield they're getting but look at how that yield is being received.

Is it actually from the economic output of the assets or is it from asset re-valuation which is simply writing up the paper value of the assets and borrowing the money against it.

These pension funds, which are answerable to the pensioneers in your country, if they're comfortable with that, well, great. If I was a pensioneer I wouldn't be.

STEPHEN LONG: Plenty of people disagree. Brian Johnson of JPMorgan is Australia's top rating banking analyst. He says Jim Chanos will join a long line of people who've lost money betting against Macquarie.

BRIAN JOHNSON: A lot of money is being lost basically shorting Macquarie Bank over the years. And while the model is certainly not without risk, the fact is the size of this potential market is absolutely massive.

STEPHEN LONG: So take your pick. Macquarie is either poised to run the world or heading for trouble.

MARK COLVIN: Stephen Long.

We were told Macquarie Bank's Chief Financial Officer, Greg Ward, would respond to Stephen Long's story, but he is yet to call.