The Treasury plans to borrow to fund entities that will buy up to $700B of mortgage-backed assets, which if marked to market, would bankrupt much more of the banking system.
Fed Chairman Bernanke breathed life into the faltering plan by explaining to Congress his perception of “fire sale vs. hold to maturity pricing”; intimating that the ultimate cost to taxpayers will be a fraction of this amount as the assets are held long term and sold as real estate and mortgage-backed securities prices recover. Banks currently holding these overvalued assets get the bailout cash and resume receiving loans from other banks, due to their reduced credit risk, and making new business and consumer loans. Mortgage assets originated on or after March 14, 2008 are eligible; and participating sellers will give to be determined equity stakes to the bailout operation. Since no government entity has anywhere near the cash to do this, the national debt limit has been correspondingly raised.
This approach cannot work because:
- It retains the bad assets on the economy’s balance sheet at inflated prices using fresh capital (while shifting them from the imprudent lenders’ balance sheets (who created them) and rewarding them with this capital). This compromises future growth and leads to further misallocation of capital at the hands of lenders with a losing track record.
- It does not address the prices/valuation of real estate, stocks and risky bonds; all of which will continue plummeting; further compromising the asset side of the US balance sheet while the liability side remains – and drives hundreds of billions more in net loan losses. The asset side will be further undermined by the collapse of commodity prices in the face of plunging global demand.
- It does nothing to induce marginal real economic activity/growth that is critical as the US and world economies face a deflationary depression.
- It stratospherically increases government liability at a time of plunging tax revenue from all sources, destruction of loanable capital, and growing liability to fund unemployment claims and the like. This liability can only be met by borrowing, taxing or fiat money creation – each of which has major negative consequences.
Clearly, the price paid to current lenders cannot be one that bankrupts them or forces them to look for so much dilutive and skittish capital that it cannot be quickly raised. Even with the Treasury’s cost of capital advantage over any other buyer; this requires over-paying far above current market prices or the plan cannot achieve its goal.
Not addressed is the potential fallout from rising delinquency and default rates of trillions in other consumer and corporate debt; nor the assumptions about the direction and extent of change in future home prices which back these and remaining unimpaired mortgage assets. The problem has been framed as a temporary asset under-pricing phenomenon to be corrected by maintaining private solvency and liquidity with government as the only market maker. In the case of mortgages, the debt is backed by physical structures which are both priced far below book value in the market and which require cash out flows to maintain, insure and pay taxes. To the degree that loans are paying neither interest nor principal, the holder must cover the cash outflows.
The fundamental assumption behind this plan is most curious. Some maintain that the ultimate loss may not exceed $250B – it is therefore to be believed that this amount is causing the havoc in the financial markets and the risk to economic growth. This should be viewed in context of the identifiable net tangible and financial assets of the US economy which include $32.4T of non-financial debt ($51T total debt), $19.4T of public equities value, $11.1T of net real estate value, $7T of foreign-owned assets producing domestic GDP, plus trillions more in public infrastructure, private company equity and net tangible assets; etc. which together with human capital generate our $14.4T annual GDP.
Is it plausible that less than .36% truly bad assets in relation to identifiable total financial and net tangible assets is causing the jeopardy we face? Or, is the impaired and rapidly becoming impaired human and capital asset base far larger than this; and so, poses a lethal danger to real growth?
1. The Government’s Incremental Liability and Negative Growth Effect
The liability of the Fed and Treasury incurred this year is not limited to the amounts so far lent or sought for problem loan buyouts; but extends to the full balance sheets of the entities it has taken control of including Fannie Mae, Freddie Mac, AIG…and the FDIC… up to the full $4.4T of insured bank deposits.
- Fannie Mae (FNM) + Freddie Mac (FRE): $5.4 trillion in on the books assets and insured loans sold to and held by others and in addition any derivatives exposure
- AIG (AIG): $1 trillion in assets plus off-balance sheet derivatives exposure
- Bear Stearns (BSC): $30 billion
- Asset Buyout Funding Sought: $700 billion
- Fed term lending and swap facilities (PCD, TAF, TSLF, Securities Lending, SFP and currency swaps): $535 billion
- FDIC additional funding exposure est. $150B on top of the $45.2B the FDIC has (of which as much as $24B could go to WaMu (WM) depositors alone) with little remaining to cover losses on the other $4.4T of insured deposits; leaving $2.6T of uninsured deposits. This leaves an FDIC capital to loss coverage ratio on insured deposits of .5%.
Approximate total asset exposure: $7.8 trillion (excluding insured deposits; and except to the degree to which the new $700 billion buyout facility would purchase some assets now pledged as collateral under the above Fed programs). The liabilities of these entities remain unchanged.
The net worth of the Fed, FNM, FRE and AIG combined is about $179B. The Treasury has negative net worth and depends solely on taxing, borrowing or creating money to fund its operations. The asset to equity leverage ratio of this rescue operation appears to be at least 43.5-fold (compare to AIG’s 13.5). This implies that an asset loss ratio of more than 2.3% wipes out all equity. For purposes of reference, the US banking system has assets of $11.03T, net worth of about $1.22T and cash and near cash on hand of $266B. The rescue operation must also meet cash outflows based on debt service and other costs while the inflows from assets held may be substantially less while they are held long term in hopes of sale at higher prices.
What is a fair value of the $7.8T in assets at risk? How much of those assets are performing (amortizing principal and paying interest)? … and for how long in a plunging global economy? – are all fair questions from the sponsoring taxpayers.
As a consequence of purchasing bad mortgages, the Treasury must fund on-going maintenance, insurance and taxes stemming from a bailout portfolio; which, at say 4% of book value (check the costs related to your own home as a percentage of value) could amount to $28B/year which would exceed the cost of the borrowing at 3% or about $21B. This cash outflow of about $49B would be somewhat mitigated by interest and principal amortization from the bad asset portfolio – which is minimal; or it would not be for sale. Meanwhile, the $700B bailout funds could have been invested in real economic value producing activity earning at least 5% or $35B; resulting in a real annual loss to the economy of up to $84B/year – assuming no net capital loss on the bad assets and not counting management fees.
Compare this to ideal real GDP growth of 3% or $432B per year on a $14.3T nominal economy. The cost of this part of the bailout interventions alone is at least a 20% reduction in real potential GDP growth.
The government has taken on this incremental liability at the precise time of plummeting tax revenue from all sectors, destruction of loanable capital, and rapidly rising unemployment claims liability. The likelihood is that prime and Alt-A mortgages will continue to sour; as will the $2.6T of consumer, $2.2T of state and local, and $10.9T of corporate debt. Loans made by American banks to foreign entities have no better prospects considering the well-publicized home appreciation rates in Europe and its faltering growth prospects.
The Fed Chairman and Treasury Secretary as well as government economists have failed to see the largest financial crisis since the great depression coming: first denying a crisis was imminent as recently as the turn of the year; then repeatedly claiming it was contained and solved after a string of government interventions. Also, encouraging FNM and FRE to continue lax lending and mortgage insuring operations just months before taking them over. This is not to single out our leadership, because very few private forecasters saw this one coming either.
There is no evidence that the crisis was foreseen, or that even now its scope, nature, and solution are understood and known. Has leadership credibly changed? Have new and proven tools emerged to enable the leadership to deal with this crisis?
3. The RTC, GDP and Financial Markets
In August of 1989 government created the Resolution Trust Co. to liquidate some $394B of bad S&L assets at a loss of between $85B and $125B; implying a 27% loss on book value. These assets were not purchased, however, but assumed for liquidation. Nominal GDP was $5.5T at the time; compared with $14.4T today.
By Q3 of 1990, the economy entered five quarters of the severest recession since 1980. In early August of 1990, Iraq invaded Kuwait and the price of oil briefly spiked. The stock market held nearly flat from Q3 of ’89 to Q4 of ’90 before rising sharply. However, the marginal income tax was cut from 38.5% to 28%; thus boosting asset valuation, and the corporate tax rate was cut from 46% in 1986 to 40% in 1987 and 34% in 1988 – thus driving after-tax profit higher and reducing new investment hurdle rates. Tax policy was already providing strong tailwinds to the economy. According to OFHEO, real estate prices were rising coming into the RTC formation and essentially held stable for the several years following. Case-Shiller shows same house prices rose 8% in the year before the RTC formation; held steady for some months, then fell 8% in the three following years. There was nothing like the price appreciation preceding the current state of housing prices.
It is very likely that the US is in recession now and that the relationship of total bad assets to GDP is far higher. No action that affects either asset prices or real economic activity has even been discussed.
The author expects the near contemporaneous global further collapse of all major asset classes: stocks (earnings), risky bonds (higher risk spreads), real estate (return to constant real valuation and effects of recession, loanable funds dearth), oil (demand fall), gold (deflation) – and most other commodities (demand). Especially hard hit will be export-dependent nations (China, Lat Am, Russia (the latter two due also to collapse in the price of oil)), and India. If the US government continues to panic and pursue ineffective policies this is unavoidable. The money supply inflation option, if pursued, would destroy the dollar (if not equally matched abroad), further crush equities, increase bond yields and the nominal cost of debt and boost gold.
This assessment rests in part on an estimate of the amount and degree of impaired financial, tangible and human capital in the economy, its trend, and the lost return on these assets compared to potential real GDP growth.
Those interested in asset valuation are invited to research Required Yield Theory.
Historically, global financial crises spawn large wars.
5. The Only Solution
The only solution to this worsening global crisis is to immediately and simultaneously boost asset valuation and growth while writing down bad assets to market. Assets are valued based on a required, expected, real, after-tax return. Cut taxes on investment gains to immediately boost or mitigate the decline of asset prices. Cut taxes and regulatory costs on real economic activity to spur its formation.
- Eliminate all gains taxes on real estate and cut state, local and school property taxes. Offset lost revenue, which anyway is plummeting, by firing non-essential state and local workers (who are supported by tax dollars and generate dubious real economic value) so that they may be redeployed in the private sector.
- Eliminate capital gains, dividend and interest taxes on stocks and bonds; cut the marginal tax rate on gains in tax-deferred plans (currently the income tax rate). The cost of debt and equity falls/prices rise or declines are mitigated.
- Do not attempt to inflate the money supply since financial asset prices will collapse more because investors price assets so as to obtain a real, after-tax return.
Contractionary forces must be met with expansionary measures:
- cut the corporate income tax; thus lowering new investment pre-tax return rate hurdles and spurring investment
- eliminate the minimum wage; thus increasing return on investment and spurring hiring
- reduce regulation impairing internal and cross-border trade
- Fed Funds Rate: this rate is economically meaningless as there is compelling evidence that the Fed has to follow the market, which sets the short-term rate. Based on the current 3-month Bill rate; the Fed must soon cut massively - which will be a mere formality.
Allow banks with poor assets to fail. Let the insured deposits shift to well-run banks that allocate capital prudently. If this is made clear, uninsured deposits will quickly flee the bad banks; exposing them as surely as WaMu was. The market will bid on the assets of these failed banks; not taxpayers.
Long term, pass legislation qualifying only citizen taxpayers to vote – those who have an economic interest in the success of this country and in the prudent allocation of their taxed earnings by their elected representatives.