The Bush
Bust of '08
“It's All
Downhill From Here, Folks”
By Mike Whitney
| "I
just saw a picture Bernanke stripped
to the waist in the boiler-room
shoveling greenbacks into the
furnace.” Rob Dawg,
Calculated Risk blog-site
|
On January 14, 2008
the FDIC web site began posting the rules for
reimbursing depositors in the event of a bank
failure. The Federal Deposit Insurance
Corporation (FDIC) is required to “determine the
total insured amount for each depositor....as of
the day of the failure” and return their money
as quickly as possible. The agency is
“modernizing its current business processes and
procedures for determining deposit insurance
coverage in the event of a failure of one of the
largest insured depository institutions.” (http://www.fdic.gov/news/news/financial/2008/fil08002.html#body)
The implication is
clear, the FDIC has begun the “death watch” on
the many banks which are currently drowning in
their own red ink. The problem for the FDIC is
that it has never supervised a bank failure
which exceeded 175,000 accounts. So the
impending financial tsunami is likely to be a
crash-course in crisis management. Today some of
the larger banks have more than 50 million
depositors, which will make the FDIC's job
nearly impossible.
Good luck.
It's worth noting
that, due to a rule change by Congress in 1991,
the FDIC is now required to use “the least
costly transaction when dealing with a troubled
bank. The FDIC won't reimburse uninsured
depositors if it means increasing the loss to
the deposit insurance fund....As a result,
uninsured depositors are protected only if a
bank acquiring the failed bank will pay more for
all of the deposits than it would for insured
deposits only.” (MarketWatch)
Great. That's
reassuring. And there's more, too. FDIC Chairman
Shiela Bair warned that “as of Sept. 30, there
were 65 institutions with assets of $18.5
billion on its list of "problem" institutions;”
although she wouldn't give names.
So, what does it
all mean?
It means there's
going to be an unprecedented wave of bank
closures in the US and that people who want to
hold on to their life savings are going have to
be extra vigilant as the situation continues to
deteriorate. And it is deteriorating very
quickly.
Right now, many of
the country's largest investment banks are
holding $500 billion in mortgage-backed
securities and other structured investments that
are steadily depreciating in value. As these
assets wear-away the banks' capital, the
likelihood of default becomes greater. This
week, Fitch Ratings announced that it will
(probably) cut ratings on the 5 main bond
insurers (Ambac, MBIA, FGIC, CIFG,SCA)
“regardless of their capital levels”. This
seemingly innocuous statement has roiled markets
and put Wall Street in a panic. If the bond
insurers lose their AAA rating (on an estimated
$2.4 trillion of bonds) then the banks could
lose another $70 billion in downgraded assets.
That would increase their losses from the credit
crunch--which began in August 2007---to $200
billion with no end in sight. It would also
impair their ability to issue loans to even
credit worthy customers which will further
dampen growth in the larger economy. Structured
investments have been the banks' “cash cow” for
nearly a decade, but, suddenly, the trend has
shifted into reverse. Revenue streams have dried
up and capital is being destroyed at an
accelerating pace. The $2 trillion market for
collateralized debt obligations (CDOs) is
virtually frozen leaving horrendous debts that
will have to be written-down leaving the banks'
either deeply scarred or insolvent. It's a mess.
There were some
interesting developments in a case involving
Merrill Lynch last week which sheds a bit of
light on the true “market value” of these
complex debt-pools called CDOs. The
Massachusetts Secretary of State has charged
Merrill with “fraud and misrepresentation” for
selling them a CDO that was "highly risky and
esoteric" and "unsuitable for the City of
Springfield.” (Most cities are required by law
to only purchase Triple A rated bonds) The city
of Springfield bought the CDO less than a year
ago for $13.9 million. It is presently valued at
$1.2 million---MORE THAN A 90% LOSS IN LESS THAN
A YEAR.
Merrill has quietly
settled out of court for the full amount and
seems genuinely confused by the Massachusetts
Secretary of State's apparent anger. A Merrill
spokesman said blandly, “We are puzzled by this
suit. We have been cooperating with the
Secretary of State Galvin's office throughout
this inquiry.”
Is it really that
hard to understand why people don't like getting
ripped of?
This anecdote shows
that these exotic mortgage-backed securities are
real stinkers. They're worthless. The market for
structured debt-instruments has evaporated
overnight leaving a massive hole in the banks'
balance sheets. The likely outcome will be a
rash of defaults followed by greater
consolidation of the major players. (re: banking
monopolies) The Fed's multi-billion bailout
plan; the “Temporary Auction Facility” (TAF) is
a quick-fix, but not a permanent solution. The
real problem is insolvency, not liquidity.
The smaller banks
are dire straights, too. They're bogged down
with commercial and residential loans that are
defaulting faster than any time since the Great
Depression. The Comptroller of the Currency,John
Dugan--who is presently investigating commercial
real estate loans---discovered that commercial
banks “wrote off $524 million in construction
and development loans in the third quarter of
2007, almost nine times the amount of 2006”. The
commercial real estate market is following
residential real estate off a cliff and will
undoubtedly be the next shoe to drop.
Dugan found out
that, “More than 60% of Florida banks have
commercial real estate loans worth more than
300% of their capital, a level that
automatically attracts more attention from
examiners.” (Wall Street Journal) He said that
his office was prepared to intervene if banks
with large real estate exposure maintained
unreasonably low reserves for bad loans. Dugan
is forecasting a steep “increase in bank
failures.”
According
to Reuters: “Dozens of U.S. banks will fail in
the next two years as losses from soured loans
mount and regulators crack down on lenders that
take too much risk, especially in real estate
and construction," predicts Gerard Cassidy, RBC
Capital Markets analyst. Apart from the growing
losses in commercial and residential real
estate, the banks are carrying over $150 billion
of “unsyndidated” debt connected to leveraged
buyout deals (LBOs) which are presently stuck in
the mud. Like CDOs, there's no market for these
sketchy transactions which require billions in
cheap, easily available credit. They've just
become another anvil dragging the banks under.
On January 31,
Bloomberg News reported: “Losses from securities
linked to subprime mortgages may exceed $265
billion as regional U.S. banks, credit unions
and overseas financial institutions write down
the value of their holdings.” Standard and
Poor's added that “it may cut or reduce ratings
of $534 billion of subprime-mortgage securities
and CDOs as default rates rise.” Another blow to
the banks withering balance sheets. Is it any
wonder why the "new loans" spigot has been
turned off?
Surprisingly,
there's an even bigger threat to the financial
system than these staggering losses at the
banks. A default by one of the big bond insurers
could trigger a meltdown in the credit-default
swaps market, which could lead to the implosion
of trillions of dollars in derivatives bets. The
inability of the under-capitalized monolines
(bond insurers) to “make good” on their coverage
is likely to set the first domino in motion by
increasing the number of downgrades on bond
issues and intensifying the credit-paralysis
which already is spreading throughout the
system.
MSN Money's
financial analyst Jim Jubak summed it up like
this:
"Actually, I'm
worried not so much about the junk-bond market
itself as the huge market for a derivative
called a credit-default swap, or CDS, built on
top of that junk-bond market. Credit-default
swaps are a kind of insurance against default,
arranged between two parties. One party, the
seller, agrees to pay the face value of the
policy in case of a default by a specific
company. The buyer pays a premium, a fee, to the
seller for that protection.
This has grown
to be a huge market: The total value of all CDS
contracts is something like $450 trillion.....
Some studies have put the real credit risk at
just 6% of the total, or about $27 trillion.
That puts the CDS market at somewhere between
two and six times the size of the U.S. economy.
All it will
take in the CDS market is enough buyers and
sellers deciding they can't rely on this
insurance anymore for junk-bond prices to tumble
and for companies to find it very expensive or
impossible to raise money in this market." (Jim
Jubak's Journal; "The Next Banking Crisis is on
the Way", MSN Money)
Jubak really
nails it here. In fact, this is what Wall Street
is really worried about. $450 trillion in
cyber-credit has been created through various
off balance sheets operations which neither the
Fed nor any other regulatory body can control.
No one even knows how these abstruse,
credit-inventions will perform in a falling
market. But, so far, it doesn't look good.
The enormity
of the derivatives market ($450 trillion) is the
direct result of Greenspan's easy-credit
monetary policies as well as the reconfiguring
of the markets according to the “structured
finance” model. The new model allows banks to
run off-balance sheets operations that, in
effect, create money out of thin air. Similarly,
“synthetic” securitization, in the form of
credit default swaps (CDS) has turned out to be
another scam to avoid maintaining sufficient
capital to cover a sudden rash of defaults. The
bottom line is that the banks and non-bank
institutions wanted to maximize their profits by
keeping all their capital in play rather than
maintaining the reserves they'd need in the
event of a market downturn.
In a deregulated
market, the Federal Reserve cannot control the
creation of credit by non-bank institutions. As
the massive derivatives bubble unwinds, it is
likely to have real and disastrous effects on
the underlying-productive economy. That's why
Jubak and many other market analysts are so
concerned. The persistent rise in home
foreclosures, means that the derivatives which
were levered on the original assets (sometimes
exceeding 25-times their value) will vanish down
a black hole. As trillions of dollars in
virtual-capital are extinguished by a click of
the mouse; the prospects of a downward
deflationary spiral become more likely.
As economist
Nouriel Roubini said:
“One has to
realize that there is now a rising probability
of a 'catastrophic' financial and economic
outcome, i.e. a vicious circle where a deep
recession makes the financial losses more severe
and where, in turn, large and growing financial
losses and a financial meltdown make the
recession even more severe. That is why the Fed
has thrown caution to the wind and taken a very
aggressive approach to risk management.” (Nouriel
Roubini EconoMonitor)
"In the fourth
quarter of 2007, new foreclosures averaged 2,939
a day, double the pace of a year earlier." (RealtyTrac
Inc.) The banks are presently cutting back on
home equity loans which provided an additional
$600 billion to homeowners last year for
personal consumption. Bush's $150 billion
“stimulus package” will barely cover a quarter
of the amount that is lost. As consumer
spending slows and the banks become more
constrained in their lending; businesses
will face overproduction problems and will have
to limit their expansion and lay off workers.
This is the downside of “low interest”
bubble-making; a painful descent into deflation.
Capital is now
being destroyed at a faster pace than it is
being created. That's why the Fed is looking for
solutions beyond mere rate cuts. Bernanke wants
direct government action that will provide
immediate stimulus. But that takes political
consensus and there's still debate about the
gravity of the upcoming recession. The pace of
the economic contraction is breathtaking. This
week's release of the Institute for Supply
Management's Non-Manufacturing Index (ISM) was a
shocker. It showed steep declines in all areas
of the nation's service sector---including
banks, travel companies, contractors, retail
stores etc—The Business Activity Index, the New
Orders Index, the Employment Index, and the
Supplier Delivery Index have all contracted at a
“historic” pace. Everyone took a hit.
“The numbers are so terrible, it's beyond
belief,” said Scott Anderson, senior
economist at Wells Fargo & Co.
The $2 trillion that has been wiped out
from falling home prices, the slowdown in
lending activity at the banks, the loss $600
billion in home equity loans, and the
faltering stock market have all contributed
to a noticeable change in the
public's attitudes towards spending. Traffic
to the shopping malls has slowed to a crawl.
Retail shops had their worst January on
record. Homeowners are hoarding their
earnings to cover basic expenses and to make
up for their lack of personal savings. The
spending-spigot has been turned off.
America's consumer culture is in
full-retreat. The slowdown is here. It is
now. We are likely to see the sharpest
decline in consumer spending in US history.
Bush's $150 billion will be too little too
late.
America's place in the world has been
guaranteed not by what it produces but by
what it consumes. The American consumer has
been the locomotive that drives the global
economy. Now that engine has been derailed
by the reckless monetary policies of the Fed
and by shortsighted financial innovation.
When equity bubbles collapse; everybody
pays. Demand for goods and services
diminishes, unemployment soars, banks fold,
and the economy stalls. That's when
governments have to step in and provide
programs and resources that keep people
working and sustain business activity.
Otherwise there will be anarchy. Middle
class people are ill-suited for life under a
freeway overpass. They need a helping hand
from government. Big government. Good-bye,
Reagan. Hello, F.D.R.
The Bush stimulus plan is a drop in the
bucket. It'll take much, much more. And,
we're not holding our breath for a New Deal
from George Walker Bush.
