It's Time For a U.S. Sovereign Investment Fund

In the previous post I wrote that the strategy of patching holes that Fed is pursuing is not working, as every time one bank is bailed out or closes, two more get into trouble. We are seeing evidence of this now with Morgan Stanley (MS), Goldman (GS) and WaMu (WM) in the crosshairs..

Saving AIG (AIG) might in isolation seem like a good idea – they have a viable main business, the loan provided by the Fed is secured by the assets so taxpayers should not lose (and might even make) money, while the bail-out temporarily saves whatever banks and hedge funds were using AIG as CDS counterparty. However, it does not in any way solve the biggest problem: lack of confidence in the system. And this problem is snowballing. Non-finance people on the streets talk about how they will put all their money into gold. Companies are drawing down on their credit lines afraid that the banks will not have cash on hand tomorrow. I get calls from my friend abroad saying he read an article that Bank of America (BAC) is the next one in the failure line.

With every day this sentiment is increasing and we're approaching a tipping point: not failure of one major CDS player, but systemic bank runs that spelled doom in the Great Depression. Some might argue that we have the FDIC now, so people won't rush to the bank. I think that is wishful thinking. A third of deposits are not insured, people do not want to wait in huge lines to get their money back, some are increasingly growing wary of the government's promises and some do not know about insurance (I saw a figure of 30% although that seems too high).

I suggest a two-tiered approach. First you need to shift the headlines away from nose diving stock prices. A drastic measure (in which US government can follow the Russian leaders) is to shut down trading altogether for a few days. This will give some breathing room to implement measures that will improve the overall outlook rather than racing from one failing institution to the next.

Step two, (take a deep breath), is the formation of a US Sovereign Investment Fund. This fund can then provide equity capital injections into each one of the major U.S. banks – not just WaMu, not just Wachovia (WB), but every one. Why should the Singapore Sovereign Fund or Chinese government be able to use the current environment of fear and lack of private capital to get the best of U.S. financial institutions like Morgan Stanley at fire sale prices? The formation of a U.S. investment fund can prevent the spread of the panic, but also prevents a huge wealth transfer from the hands of U.S. people to foreign entities. The private U.S. players are simply too scared to risk the capital these days, and the government must act.

How much money will that fund need? Not that much more when compared to the $150B stimulus check, $85B loan to AIG, $29B gift to JPMorgan (JPM), and substitution of half of the Fed's $800B balance sheet for junk assets. The lower end of credit losses for U.S. banks according to the IMF estimates is ~$600B. Total figures of twice the IMF amount have been floated, so maybe they're around $1TR, with around $350B having been raised already.

Because banks are generating incomes (credit writedowns aside), and because the losses are spread out, if everything was left as it stands, the banks would probably be able to keep their capital ratios at adequate levels by using incomes excluding writedowns to offset the credit losses. However because the margin of error is relatively slim – even the latest analyst reports, which are generally more optimistic that investors these days, contemplate that Bank of America might just have to raise some capital to offset losses on its loan portfolio. And that was prior to the Merrill (MER) acquisition that may bring an unknown amount of suspicious assets to Bank of America's books.

Given that the margin of error on even the largest U.S. bank is small, it's no wonder everyone is starting to panic about others. Raising the capital ratios by 30% should do the trick of allaying investor fears. That means injecting roughly $200-300B into the U.S. banking system. This may seem like a large figure, but the consequences of no action can be much more dramatic.

Comments

[Dan Walker:]

Are you one of the idiots bill clinton raised? We are broke, spud. End of discussion.

2008 Sep 19 10:36 AM

[icandoitdon:]

clinton's been out of office 8 years, "spud." get over it. this disaster occurred on george bush's watch.

2008 Sep 19 11:04 AM

[Sailaway:]

hey dan walker, how is spending hundreds of billions to buy default mortgages cost less? sounds like you weren't raised but born an idiot.

2008 Sep 19 11:12 AM

[bbzz24:]

sovereign wealth fund..... funded with 'treasuries'. HAHAHAHAAAA

2008 Sep 19 11:15 AM

[buyitcheap:]

I've got a $20. That would buy 3% of FNM at current value, right?

2008 Sep 19 11:36 AM

[Chris B:]

If foreign SWFs think these investments are dumb, why should a US SWF purchase them? Blind nationalistic pride?

When did it become the government's job to ensure that investments such as bonds, stocks, and real estate never lose money?

In the case of these bailouts, the investment losses of the foreign SWFs were shifted to American taxpayers, but of course the foreign SWFs get to keep whatever gains they had over the years. Why would your own govt. put all this debt on you for the benefit of foreigners?

Assets = Liability owners + Equity owners
so...
Government = Foreign creditors + Taxpayers

Thus, government is partially owned by the people we owe debts to. These bailouts are a sign that they now have a majority stake.

2008 Sep 19 11:36 AM

[Reinko:]

To bbzz24:

Ha ha, that is a great idea!
Just like the FDIC fund that is funded with (still) AAA rated Treasuries...

2008 Sep 19 12:35 PM

[User 265700:]

US soverign funds? are you kidding me? are you going to fund it with more IOUs funded by our positive cash flows starting in 2100?

2008 Sep 19 02:10 PM

[Shiv139:]

I do not believe a US Sovereign Investment Fund is the answer; a nation in surplus I can understand; a nation in deficit; maybe not.

I can see next steps being required as including:

1. An RTC type vehicle to hold and sell assets of failed banks.
2. Nationalization as in the case of FNM/FRE/AIG.
3. Combination to create a stronger entity post acquisition like BAC/MER.
4. Active marketing of new capital requirements to SWF’s and nations with budget surplus.

Everyone has a responsibility to act; this crisis may have started out in the US, but its impact has and will continue to be felt the world over. How bad it gets depends on how early and how actively the world engages in seeking a solution.

Escalating deficits from the rescue packages will cause an elevation of inflation; this will hurt the world. In my view nations which can look at risk from a multi-decade perspective will need to engage in providing a solution.

2008 Sep 20 10:07 AM

[I weep for ...:]

AIG was not bailed out by the Government, the Government took them over. There was no need to take the 80% interest in the company. That was a throw in. AIG just needed time to sell its assets a bridge. The core company (the international and domestic commerical insurance) is doing great, in fact operating at a bigger surplus than any other insurance company in the world. The non core can be sold for at least 180 billion. The Government, however, had AIG over a barrell on Wed with company facing bankruptcy because they could not raise the capital quick enough for the rating agencies and thus the government decided not only to loan the money but to also steal the company because they could. Now the shareholders rather pay back the loan to the FED and get the company back from uncle Sam. Also, that bad unrealized debt that AIG insured which caused the need to raise capital in such a hurry in the first place will now go away pursuant to the bailout so it will actually be a surplus rather than a debt for AIG. That debt will never be realized Thus, whomever gets control of AIG will have control of one of the best companies in the world.

2008 Sep 20 11:38 AM

[hwood007:]

I need someone to explain how a public owned company is allowed to give away company money to a politician? On which company disclosure form does that appear? I thought this was stock holders money and management was hired to run the firm in the interests of the stock owners, not the interests of any politician they like.

It would also seem to be a conflict of interest for GSE type companies to give money to the election funds of any government politicians and a conflict of interest for politicians to receive such money. GSE firms were setup to take care of taxpayers but seem to be taking care of those who are charged with GSE oversight and why is it that the liberal politicians are at the top of the recipients list of GSE funds?

I remember several years ago someone tried to offer a bill to control the GSE firms and I also remember that a Senator who received large donations to his election fund was instrumental in blocking the bill. Anyone remember who?

2008 Sep 20 01:03 PM

[icandoitdon:]

hwood007....

the collapse of FNM/FRE was a symptom...not a cause of the broader financial collapse, which is a work-in-progress because of a critically overleveraged financial system in both the consumer and commercial sectors of our economy. the overleveraging occurred because of too many years of cheap and plentiful credit made available by the dysfunctional policies of both our elected officials...republican and democrat...and their appointed proxies.

if you want to defend the role republicans played in this disaster, have at it if you can. you can start with that great republican "free-marketeer" alan greenspan, a reagan appointee, who never met a bailout or adjustable rate mortgage he didn't like, and never made an interest rate cut that he didn't defend, no matter how many economists say it was indefensible of him to push the fed funds rate to 1% and hold it there in the aftermath of 9/11. then there is dick cheny who contributed his knowledge of economics by saying that "deficits don't matter." then there is george bush who adopted the reagan mantra that "government regulation is the problem, not the solution." until now, that is. and then there's the republican candidate for prez, good ole boy "deregulation john mc cain," who early in the week opined that the economy is "fundamentally sound" but changed his mind when advisers told him that if he couldn't come up with anything more intelligent than that he would talk himself right out of the white house. now i guess he thinks the economy is in the shitter. no kidding. and anyone who thinks it's over because of this proposed taxpayer bailout is absolutely clueless.

wake up.

2008 Sep 20 02:29 PM