$700 Billion Bail-Out of the US Economy

It’s hard to know what to make of this proposition – yes, it’s needed, yes, it’s wanted in some quarters, but in the end it is government intervention in the markets, which means it’s not capitalism.

This is the big problem for the $700 billion Federal Reserve bail-out of Wall Street; that 133 Republicans & 95 Democrats are so into the ideals of capitalism, they are willing to ride this collapse all the way through to a depression.

The key problem for capitalists is that, with the government being the chief regulator of the economy, it will cause a massive conflict of interests when the same people who will have to audit every company in the market, then have to manage their assets against the very companies they are regulating.

They will have an unequalled access to the accounts of their competitors, and are then meant to make a profit for the taxpayers whose money they are managing, but without using the knowledge they have gained through regulation. This ‘Chinese walls’ situation is so unrealistic that it has long been decided that for governments to be effective in regulation, and seen as being impartial, they should never join the market as a player.

Another sticking point in this rescue package for both Democrats & Republicans in Congress is that they have an election coming up in November, and none of them want to be insisting to their constituents that they shoulder the hurt from the state of the economy, while Wall Street gets all the money their constituents are told they can’t have, because of the damage it would cause.

To make matters worse, it seems that Morgan Stanley after being one of the chief contibutors to this market collapse would get a $1 Billion contract to manage and distribute the $700 Billion rescue package. Having made huge personal sums of wealth getting the US economy into this mess, Morgan Stanley are then going to get paid more tax-payers money to save their own arses. A situation that beggers belief is the only term that comes to mind. How can they be trusted with anyones cash after being a leading culprit of this disaster in the first place?

On top of that, both Henry Paulson and Morgan Stanley are going to have one of the strongest positions of patronage ever witnessed. As everyone has to come to them for help, they will effectively become untouchable, as no companies will want to risk their own slice of this $700 billion bail-out pie by critisising either one of these players in the coming months. The terms of Henry Paulson’s original deal were so stacked in his favour (such as no oversight, no limits, no checks and a free hand to spend this cash) these terms alone were enough to outrage Congress and wider America.

Not only has Paulson overseen this whole mess, now he wants unpresedented power to spend as he sees fit. Even the American tax-payers can tell that being in charge of a mess like this should mean you get the sack, not the patronage to spend $700 billion helping out your mates on Wall Street, while the rest of Americans lose their homes, jobs and savings.

The Banking Collapse

On the 7th of September Fannie Mae and Freddie Mac moved out of private ownership and were de-facto nationalised through a process the US Treasury calls ‘Conservatorship‘. This means that the US Government has now guaranteed a $5.3 Trillion companys debts and taken them on as part of the national debt. Furthermore any new trading of mortgage-backed bonds by Freddie & Fannie will also need to be backed by the government.

This action started the Credit Default slide that Alex Ritson warned about back in July; that the failure of Freddie & Fannie would constitute as a default. This meant that all other companies involved with Freddie & Fannie would come under pressure from 2 possible sources. Either they would have to lose vauable cash paying out on any default swaps that deliver returns with the collapse of Freddie & Frannie, or they would have to devalue any mortgage backed assets, that were backed by Freddie & Fannie.

This then created a problem, as not only did banks and insurers find they had no cash left after making default payments, the devaluation of their MBS (Mortgage Backed Securities) meant that many companies overall market vaue was significantly reduced. This then means that when Lehman Bros., AIG, Merryll Lynch and HBOS most need to raise cash against the value of their businesses, that overall value has come down so much that they can’t get any more money from the markets.

Unfortunately for Lehman Bros. the consequences of not being involved with the commercial (home/personal loans) banking sector meant that they were exposed to the markets (and practices such as ‘Short Selling’ of banking stocks) without any money to fight anyone off, and most significantly with no government support as a safety net. The stock markets anywhere in the world treat weakness as a chance to make easy money, and where there’s easy money there’s always a broker.

On 15th September Lehman Bros. filed for Chapter 11 bankruptcy protection, which means thay are bankrupt. The combination of a falling stock price because of their inability to soak up anymore bad debt, the downward pressure of ‘Short Selling’, and the need of humans to flee a potential sinking ship, even if this reaction will make going down a certainty, meant that Lehman Bros. lost too much value and went bankrupt.

This finally reminded the financial system that it was a financial system (and not the fun end of a US government department) and the markets underwent the sort of correction that has been long overdue. Stocks went from 11421.99 to 10, 917.51 with a 4.42% loss, based on the fact that Lehman Bros. failure proved that failure itself was still possible. The great collapse would now begin. All stocks would fall, all companies relying on revenue and credit from the markets would eventually go into bankruptcy, and the cascade effect of bad debt would sweep the whole system.

With the the primary quake having now gone off with the collapse of Freddie, Frannie and Lehman Bros., next to hit were the aftershocks from the realisation that the constant growth from credit-fueled trading was over. Subsequently Merryll Lynch was purchased by The Bank of America, and the collapse took place of a well hidden keystone of the western financial system; AIG (American International group).

The $85 Billion rescue of AIG by the US Treasury on the 17th September 2008, which gave the US Treasury 79.9% overall control of the company, was a recognition by the US government that while it could live with the failure of Lehman Bros, some market players are ‘too strategic to go down’.

AIG holding everyone else’s loan protection policies (Credit Default Swaps), combined with so many financial companies now being reliant on AIG backed assets for market value, meant that the US government could not allow AIG to fail and devalue $400 Billion of assets held by other key market players.

AIG had one key failing in its revenue stream – it went mad on selling credit default swaps. It had sold this defacto insurance on so many US mortgage assets held by the wider market that its own failure would put the whole stock market at risk of collapse. This prompted the US Treasury to look at AIG in a different way to Lehman Bros, with the subsequent bailout of AIG delivered at a cost to the US Government of $85 Billion.

Next to go was Merrill Lynch, purchased by The Bank of America to aviod becoming the next Lehman Bros, and was joined with the takeover of HBOS (the UK’s largest mortgage lender) by LLoyds TSB for the same reason. Barclay’s decided to join The Bank of America in aquiring new assets, with its purchase of the US investment arm of Lehman Bros.

In both cases these rescuing banks themselves have been under pressure for resources recently, but seem to have played the psychology of the situation and made good on the idea that the best way to convince investors you’re not in trouble is to play it cool and flash the cash. It does begger belief that, once again, there are companies seemingly looking to spend their way out of trouble, but it may well work, and will undoubtedly secure them the backing of both the US Federal Reserve and the Bank of England.

This left only two investment banks, Morgan Stanley and Goldman Sachs. After the shares of both of these companies started to come under pressure on Friday 19th September, they organised over the weekend to change their banking status with the Federal Reserve from investment banks to become Bank Holding Companies. Not only did this mean that the banking crisis has discovered a problem in the housing market, the business model of investment banks had failed, starting with the collapse of Bear Stearns in March, and ending with the status switch of Morgan Stanley and Goldman Sachs.

As recognition of how the traders who ’short sell’ stock have contributed to the collapse in stock prices of most of the banks on the FTSE 100 & Dow Jones stock exchanges, on Monday the 22nd of September the UK’s FSA (Financial Service Authority) banned the practice of ’short selling’ until 16th January 2009.

‘Short Selling’ is so controversial because the traders borrow stocks in a target company (like Lehman Bros.) and then dump that stock onto the market. This causes the stock price to fall, at which point they then reacquire at the lower price the stocks they borrowed, and pocket the difference. They therefore make money when stock prices fall, and then pay no regard to the damage this causes as it reduces the market capitalisation of the the banks, building societies & insurance companies affected.

It’s at this point we can now consider what the US Treasury’s spending spree will cost. Although it may seem like a bottomless pit of finance, especially as oil is traded in your currency, but there is a limit set by Congress and the US Treasury has spent more than the US people ever expected they would need to borrow.

Billions of dollars now seem like small sums compared to the total of $11.3 Trillion, which is what Henry Paulson has just asked Congress to lift the national borrowing limit to, as a way to cover the cost of his new $700 billion bail-out plan, on top of the purchases of Freddie, Fannie & AIG.

The problem with all of this borrowing is that on the government books it will cause the dollar to crash as the value of the US economy is reassessed by the markets. This devaluation will see inflation rise as America’s love of imported goods ensures that they either end up spending more on imports to recieve the same volumes of goods as they did last month, or they get less for their dollar. Either prices go up or consumption goes down and jobs with them, a real lose-lose situation, with possibly both happening at the same time.

To counter this collapse in the dollar and rapid influx of inflation into the economy, and to maintain the US Treasury’s long standing committment to a strong dollar, Interest Rates will have to be lifted. Lifting interest rates will strengthen deposits in the banking sector as a whole because the rates of interest offered will now be stronger than the returns offered on the stock markets.

As this switch will be into very low risk saving accounts it will seem very attractive to large organisations like pension funds and mutuals. The overall effect will be to make less money available to the markets and more held as savings, and so reducing consumption, especially that based on borrowing, and allow inflation to fall back to the 2% target level.

The problem with this solution is that while you’re waiting for inflation to start to decrease you have both high inflation, high interest rates and a low dollar. With reducing consumption you will have economic contraction in GDP and more companies will repost reduced profits and lose share value. This may then cause the start of the next wave of businesses coming under pressure over liquidity linked to their market capitalisation.

There is no mistaking however, this $11.3 Trillion debt the US Treasury and Federal Reserve have presided over will cost the US economy dearly. During this housing crash the lift in interest rates alone will take some absorbing. This then will be disturbingly combined with the affects of the gold rush in housing (from November 2005) coming back to haunt the US housing market, as huge numbers of home owners come to the end of their 3 year fixed rate introductory offer mortgages in November 2008.

The subsequent surge in prices due to a high base interest rate will cause a new round of mortgage defaults, and almost guarantee that all the toxic assets the US Treasury purchase through their rescue package will be proven to be as worthless as the rating agencies had made out, causing them to be offloaded in the first place.

It seems that there’s no escaping the fact that the bad debts are going to hurt someone, and the US bail-out will ensure that it’s the American tax-payers that suffer most with the prospects of a recession becoming a depression before the economy hits bottom and GDP growth once again returns, along with rising house prices.

The US Treasury Have Thrown Good Money After Bad

It’s so obvious this would be the end result of the US Governments decision to provide a $167 Billion stimulus package, it’s hardly worth saying, yet I just can’t help but cover the point.

President Bush in May and June provided the US economy with his teams solution to a huge credit binge lasting years; he went on a credit binge and threw some cash at the economy. This ’spend your way out of trouble’ idea was poor at best, and today we find that it has in fact failed. It has failed because the problems that have brought about the looming recession have not been dealt with, and as the latest retail data shows, it has had a marginal affect on the economy. Not only has that mild effect worn off very quickly, it had no follow-through with either more cash or a resolution to the underlying economic problems.

It must therefore be seen for what it is, a crude economic stunt with only political benefits and as my title suggests, it has ended up throwing good money after bad.

In generating extra borrowing it has in fact weakened the US economy, but ,worse still, it has wasted some of the precious money that was still available to the US Treasury. With nearly all the major Dow Jones companies now declaring losses (AIG being today’s latest) and failing to generate profits that the US government loves to tax, the limited resources that the US Government had at its disposal should have been better spent, rather than being wasted on a politically motivated forlorn hope.

It is now assured that in a period of declining US Government revenues, this one- off stunt was a definite waste of money.

Financial Crisis

To start this months post I would first like to make a mention of a great blog I read every week that I consider to be well worth a look;

It’s written by Alice Cook and is called UK Bubble

The second artice I would like to recommend is from Alex Ritson (14/07/08), a reporter with the BBC’s Newsnight program. The contents of his article are so powerful and awe-inspiring that this is one situation that would never be allowed to play out. Titled ‘The US Economy’s Next Bad Thing?‘ it is essential viewing.

Even the most conservative of approaches to market intervention would still be put aside to prevent this meltdown from taking place. The scary part is that this is not some doomsday scenario, but is in fact a very real situation that will take some skillful and careful economic management from all western governments to avoid it becoming the worst economic collapse ever.

To prevent the situation identified by Alex in the above article, no bank will be allowed to fail, especially the two most precarious of giants, Freddie Mac and Fannie Mae. If you wanted to know what the gun being held to the US Treasury’s head looks like, the Credit Default Swap market is that gun. The US Treasury looks like being handed a choice between nationalising Freddie & Fannie and taking the US national debt from around $3 Trillion to $9 Trillion, or allowing them to collapse and starting the cascade effect of Credit Default Swaps being paid out by the banks that issued them.

The problem is that these banks can’t cover the payments they are meant to make and will therefore collapse. The big problem with banks collapsing is that these Credit Default Swaps are in fact insurance policies, and, to ensure they will never have to be paid out by any bank, they secured most of them on the safest assets they could find – big banks mortgage products.

When the two biggest banks in the market fail, and all the policies are paid out by the surrounding banks, then those banks paying out may also collapse. Then, the next wave of CDS’s (Credit Default Swaps) pay out on the next set of banks to fail, and, before you know it, you’ve got a cascade effect going right though the system ripping $62 Trillion out of banking.

In the UK the exposure of British banks to this problem was mentioned in Alex’s article as being unknown due to it being hidden amongst a package of credit derivatives. Notably however, the two banks that have recently been inexplicably trying to raise shareholder finance, Barclay’s and RBS, have the biggest exposure of any UK banks at £2.5 & £2.4 Trillion respectively. Is it any wonder then that they are desperately trying to raise their capital holdings?

One further notable problem connected to Fannie & Freddie is the fact that one of the biggest takers of their sub-prime related bonds are the Chinese government. If, in avoiding a Credit Default Swap situation, the US government does have to nationalise Freddie & Fannie and bankrupt its investors, this will wipe out any holdings by China.

This would really represent a Bush administration encouraging China into investing in the US economy, only to find that the US government has taken their cash and run. It’s not like the US government will have much choice, but that will still be a hard pill for the Chinese to swallow, and may discourage them from fueling any similar fires in US housing in future.

Henry Paulson, US Treasury Secretary

Having seen this week Henry Paulson’s latest words of wisdom, “Later this year, I expect growth will pick up.” (Paulson sees end), I declare he is a guy stood in the eye of a hurricane proclaiming that the worst of it is over. I’d have thought after spending $150 billion he would have managed to buy a clue, but then I remember that he’s give up on serious economics, and now wants to give this recession a political makeover so that his boss, President Bush, isn’t blamed for causing this mess.

This idiot actually thinks that not only can America spend its way out of trouble, but that the turn around will be seen well before the worst of the recession has even got underway. I’ve heard of stupid blind optimism before, but this lack of understanding can only be put into context by knowing he won’t be around to deal with this situation much longer, so its open season for any and all stupid comments.

I mean, its well known for being a strategy that works; as you enter a big recession try and spend your way out of it, because its not like a spending binge got you in this mess in the first place.

Besides the fact that this gamble won’t work, and will only make matters worse, he lacks any incentive to be truthful because he won’t be around to live with the aftermath. As far as this genius is concerned its a win-win strategy.

I think this would be a good time for a recap on how well this guys superb predictions have stood up so far, so we can see what to make of this latest gem of wisdom:

22 October - “The consensus was that markets are better than in August,” said US Treasury Secretary Henry Paulson. “It has been slowly improving, but it is going to take a while.” (World economy now recovering)

3 December – “Mortgage lenders and regulators are close to finalising an aid plan for homeowners hit by the credit crunch”, US Treasury Secretary Henry Paulson said. (Mortgage aid close)

The length of time between these two comments = exactly 6 weeks. His latest comments are only 8 weeks and 2 days after the total collapse of Bear Sterns bank (17th March). He could have at least waited until the end of May when Americans had spent their governments cash, before he declared victory.

It seems that Paulson’s idea of how long this recession lasts will be 15 months, with it starting around July 2007 and ending between October and December 2008. This would mean that the economy has gone from prosperity and growth to the total collapse of one of the largest US banks, (with a $200 billion bailout for all the other banks and $150 billion for the domestic market) and back to prosperity and growth again, all in the space of 15 – 18 months.

If this idiot worked for anyone other than the guy who caused this mess then he would be sacked for such a stupid prediction, but alas he doesn’t and he won’t be.

The US Housing Market Problem

This is the situation as I see it: The economies in both the US and UK have enjoyed the longest periods of stability and growth ever recorded and have enjoyed a real boom. The big problem with that boom is that since around 2003 this has largely been based on borrowing that should never have been allowed. The moves by the Federal Reserve in setting interest rates down to 1% by 2005 allowed too many customers into the market, and made the cost of borrowing too cheap.

This move by the Federal Reserve to set interest rates low to stimulate growth in the economy did just that, but unfortunately, combined with poor regulation in the banking sector, that allowed mortgage lenders connected to banks to gain AAA lending status (the same as the banks of England), which resulted in a situation where customers with poor credit ratings could afford mortgages that were not properly risk-assessed and instead were seen as triple ‘A’ secured debts.

This had now created the perfect conditions for a housing boom where excessive demand led to an increase in every property’s value. This led to two destructive scenarios; customers selling up and trading up to a bigger homes with cheap mortgages they could afford for the initial introductory period, or banks offering customers the chance to increase the lending on their homes because the mortgage they had was only worth a fraction of the houses new value. These Equity Release Loans (or second mortgages) could then be invested in anything from holidays to renovations on the home, further increasing the value of the property and allow the owner to release more money from lenders, or trade up to a bigger home.

This cycle of lending was always going to end badly as its continuation was based on a constant level of high demand, which, in turn, created the constantly increasing prices. The big problem with this scenario is that at some point the demand will begin to fall and then so will the house prices. Demand will fall because cheap lending creates inflation (known as demand pull inflation) which is countered by increased interest rates ,which then removes cheap lending. At this point the Adam Smith effect of the invisible hand of the market kicks in, and the whole scenario is thrown into reverse with house prices returning to a more appropriate value for a property. This change is currently taking place in the US housing market, with everyone waking up together (banks, lenders and customers alike).

The problem that is left in the wake of this cycle is devastating. Customers are faced with mortgages they can’t afford and go into foreclosure, prices are still too high for first-time buyers to join the market and the loans available are too expensive to afford, so demand is further depressed.

The big sell begins with people unable to afford their properties now looking to sell, which results in far too many properties put onto the market at once, which further depresses values. In many cases customers are now in the negative equity trap paying for high value mortgages that are now worth more than the value of the property. If your bank is kind enough to allow you to sell the property at less that you paid for it, you are left with no home and have to keep paying back a loan on the loss you just made when you sold your house. If the bank forecloses instead then you are again left with no home, but this time the debt is for the full value of the home. As a regular salary or wage would not even cover the interest payment, and the debt will therefore only increase, declaring bankruptcy is often the only solution.

The main problems now are that with foreclosed properties being put on the market for sale by the banks at quick sale knockdown prices, customers not yet behind with payments but that need to sell up and reclaim the value of their homes before they get behind, can’t sell their homes because there are too many houses for sale to compete with, which keep dropping in price.

As is now evident in the US, the economic binge created by cheap credit has reached as far as the lending can reach, and the reality of poor choices at the top is being felt by the people on the ground.