Forget misleading comparisons with the relatively straightforward RTC bailout in the early 90's. The toxic debt dump plan, it is becoming increasingly clear, is a way of paying way over the odds via 'reverse auctions' for RMBS and other mortgage derivatives in order to surreptitiously recapitalize the banking system at huge public expense.
There will be an angry political backlash against this, and Congress is already waking up to the populist implications. The dictatorial powers being demanded by the Treasury and Fed, with minimal democratic oversight and no legal recourse, are quite outrageous, regardless of the gravity of the situation.
What seems clear right now is that the ideologically and lobbyist driven financial deregulation of the past two decades has proved an economic disaster, from the repeal of the Glass-Steagall Act to the 2000 law that exempted financial swaps from CFTC scrutiny after intensive Wall Street lobbying. In particular, the separation of loan origination from repayment risk via securitization has opened a Pandora's box for the financial system. The explosion in financial engineering creating so called 'structured products', many of them off exchange (or OTC) and thus inherently illiquid and opaque, has seen a level of arcane balance sheet complexity develop beyond the comprehension of bank CFOs, auditors, and regulators, let alone shareholders, and has undermined the resilience of the entire shadow banking system.
This latest in a series of euphoric relief rallies should be seen in the context of those preceding it; there is no magic bullet to kill a huge credit contraction, and the fallout from the latest panic measures will be profound both politically and economically. Bernanke and Paulsen told Congress last week that we were days away from economic cataclysm, a total seizure of the credit, money market and commercial paper systems that would cripple the real economy.
Does that stunningly grim situation make you want to run out and increase your equity exposure? Were stock markets discounting this possibility at their low point last Wednesday? If you answer yes to those questions, please go take a deep breath in a dark room. You'll thank me for it. Credit markets were certainly beginning to; bonds in even the safest banks like HSBC were trading at huge discounts to par and credit spreads in financials were at all time highs. The yield on the 90 day T-Bill hit a Japanese style big fat zero.
When I forecast on my blog that the US would see $1trn deficits within a couple of years, many readers felt I was surely exaggerating. As it turns out, I was too conservative, we will see that shocking level next year, based on the $600bn committed to existing bailouts, plus this latest 'toxic debt dump' wheeze; $700bn is just a down payment on the existing subprime RMBS write offs; Alt-A and Prime mortgages are now seeing soaring delinquencies as well, and commercial real estate is crumbling; this may cost US taxpayers $2-3 trillion over the next few years. Warren Buffet's derivatives 'time bomb' has exploded right under the pillars of US prosperity.
With the debt ceiling to be raised for the second time this year to $11.3trn (against a $15trn economy), the US will now be the world's third most indebted nation, after Japan and Italy (those two great models of economic dynamism). Crucially, unlike Japan, the US needs a constant flow of foreign capital to finance its fiscal and trade deficits.
There is now a serious risk of foreign investors balking at the scale of US financing needs (and certainly at anything like current yield levels), and the country losing its crucial AAA credit rating, as Japan did in 1998. After calling a dollar rally way back in June, I'm afraid it's now well and truly over, and the fundamental outlook for US government bonds, already poor, has now become downright appalling. Stepping back from the immediate crisis, two disturbing economic trends have brought us to this point.
Firstly, real household incomes have stagnated in the US for well over a decade, and lifestyles have been maintained only by massively increased levels of household debt, whether by refinancing housing or expanding personal credit. The savings rate was negative in 2006, and is still only 3%. It is striking that the US spends 2% of GDP on consumer advertising, and Europe just 0.5%, or that the average house has increased in size 40% in 30 years while household size has decreased; the entire economic system has been geared to pushing unsustainable levels of consumption (hitting 71% of GDP in 2007) financed by unbearable levels of debt.
Secondly, under the Greenspan Fed, the illusion grew that the economic cycle could be fine tuned so as to make recessions obsolete, but that overlooked their crucial role in curbing inevitable speculative excesses and reallocating capital productively. Cyclical recessions are a necessary part of the capitalist system, and by using recklessly expansionary monetary policy to avoid one in the last 16 years, the Fed set us up for something far more destructive. A hugely important economist who should be read by all members of Congress urgently, and who predicted the evolution of the current US economy, dominated as it is by sequential asset bubbles and chronic overleverage, was the late Hyman Minsky who wrote that 'over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance.'
In other words, capitalism, and markets, tend to excess rather than some happy equilibrium if left to their own devices and doped up on cheap money. If Greenspan had been a devotee of Minsky instead of the ubermensch drivel of Ayn Rand, we might not be in this mess.
One thing seems inevitable; as the dust settles on the implosion of US financial capitalism, and taxpaying citizens realise the enormity of the costs they now face, there will be a fearsome political backlash against the whole laissez-faire economic paradigm predominant since the Reagan/Thatcher era in the 1980's.