Throwing Trillions Around Like Crazy

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
February 17, 2009

IN THIS ISSUE:

1. President Obama Gets His “Spendulus” Bill

2. Geithner’s Bank Rescue Plan Short On Details

3. Should The Government Nationalize The Banks?

4. Conclusions - Trillions of Dollars Being Thrown Around

Introduction

Today, President Obama will sign into law the enormous American Recovery and Reinvestment Act of 2009 - $787 billion – which was passed entirely by Democrats in the House and with the help of only three moderate Republicans in the Senate. Unfortunately, the final bill directs only about one-third of the money to tax incentives and apprx. two-thirds to spending projects. We will look at the highlights as we go along.

Treasury Secretary Timothy Geithner gave his much-anticipated speech on how the government intends to rescue the banking system and unfreeze the credit markets on Tuesday of last week. President Obama had led people to believe that Geithner’s speech would be long on details and substance. It wasn’t. In fact, Geithner has since been roundly criticized by the media.

There are those who now believe that it would have been better for the Obama administration not to have put out any information at all until they had the details. Certainly, the stock markets didn’t like Geithner’s speech; the Dow plunged over 400 points at one point just after the speech. In the pages that follow, I will summarize what little Mr. Geithner outlined last week.

While the latest Treasury rescue plan includes spending $2 trillion or more to rescue banks and get credit moving, there are some knowledgeable analysts that do not believe that will be enough to save the banks and financial institutions. As a result, we are hearing more and more about nationalizing the banks.

While I am NOT in favor of nationalizing the banks, I think we all should understand how and why it might happen. In the pages that follow, I will reprint a very informative analysis written by Dr. Nouriel Roubini. In it, he discusses why he believes that the latest bank rescue plan won’t work, and why he thinks the government will ultimately have no choice but to nationalize many of our largest banks. I think you should read it carefully, if for no other reason than to be informed.

President Obama Gets His “Spendulus” Bill

As you are no doubt aware, Congress passed the $787 billion mostly spending bill last Friday, and the president is expected to sign it into law later today. Unfortunately, the compromise bill includes only $281 billion (36%) for tax incentives and $506 billion (64%) in new government spending programs. Of the $506 billion, $198 billion is spending for programs such as unemployment assistance, Social Security benefits and added money for states to help with Medicaid for low-income and disabled Americans. The bill is loaded with pork.

In addition to the size of the spending in the bill was the concern that most of the money would not be spent until 2011-2012. We are told, however, that the compromise bill envisions spending at least half the money by the end of next year. But that remains to be seen.

The tax incentives in the final bill were further watered down to the point that most workers will see only an extra $8-$13 more in their weekly paychecks. Most of the other tax incentives were in the form of tax credits which won’t be received until they file their tax returns. All in all, I think it was a terrible piece of legislation, and there is no guarantee it will work.

Geithner’s Bank Rescue Plan Short On Details

Last Tuesday, new Treasury Secretary Tim Geithner unveiled the Obama administration’s latest “Financial Stability Plan.” For a week leading up to last Tuesday, President Obama had heralded the plan Geithner was to announce. Unfortunately, the plan outlined by Geithner last Tuesday was very short on substance and there were virtually no details. As the world watched and listened, the US stock markets plunged during and after the speech, with the S&P 500 Index down almost 5% for the week.

Here are some excerpts from Secretary Geithner’s speech. He began as follows:

Today, as Congress moves to pass an economic recovery plan that will help create jobs and lay a foundation for a stronger economic future, we are outlining a new Financial Stability Plan. Our plan will help restart the flow of credit, clean up and strengthen our banks, and provide critical aid for homeowners and for small businesses.

After these opening remarks, Geithner went on to describe the current financial crisis and how we have gotten to where we are. Thereafter, he began to describe the plan the Treasury has come up with. For starters, he said that US banking institutions would undergo a “comprehensive stress test,” essentially to determine which banks should go forward and which banks should be closed or merged with other stronger banks. Those banks that continue to operate would have access to funding from the Treasury.

Those institutions that need additional capital will be able to access a new funding mechanism that uses funds from the Treasury as a bridge to private capital. The capital will come with conditions to help ensure that every dollar of assistance is used to generate a level of lending greater than what would have been possible in the absence of government support. And this assistance will come with terms that should encourage the institutions to replace public assistance with private capital as soon as that is possible.

Geithner did not say how much money the Treasury is willing to make available to banks under this Financial Stability Plan, nor what terms and conditions would be placed on banks that take government money. There was nothing on whether the government would require equity from the banks. Some analysts expect Geithner will need at least $500 billion for this program.

Next, Geithner talked of a new “Public-Private Investment Fund” for purposes of making a market in toxic assets and removing troubled assets from the banks’ books. He said:

Second, alongside this new Financial Stability Trust, together with the Fed, the FDIC, and the private sector, we will establish a Public-Private Investment Fund. This program will provide government capital and government financing to help leverage private capital to help get private markets working again. This fund will be targeted to the legacy loans and assets that are now burdening many financial institutions.

By providing the financing the private markets cannot now provide, this will help start a market for the real estate related assets that are at the center of this crisis. Our objective is to use private capital and private asset managers to help provide a market mechanism for valuing the assets.

We are exploring a range of different structures for this program, and will seek input from market participants and the public as we design it. We believe this program should ultimately provide up to one trillion in financing capacity, but we plan to start it on a scale of $500 billion, and expand it based on what works. [Emphasis added, GDH.]

So there’s another potential trillion of new government spending. Geithner then went on to talk about the next part of the rescue program:

Third, working jointly with the Federal Reserve, we are prepared to commit up to a trillion dollars to support a Consumer and Business Lending Initiative. This initiative will kickstart the secondary lending markets, to bring down borrowing costs, and to help get credit flowing again. [Emphasis added, GDH.]

In our financial system, 40 percent of consumer lending has historically been available because people buy loans, put them together and sell them. Because this vital source of lending has frozen up, no financial recovery plan will be successful unless it helps restart securitization markets for sound loans made to consumers and businesses - large and small.

This lending program will be built on the Federal Reserve's Term Asset Backed Securities Loan Facility, announced last November, with capital from the Treasury and financing from the Federal Reserve. We have agreed to expand this program to target the markets for small business lending, student loans, consumer and auto finance, and commercial mortgages.

Assuming the Financial Stability Trust costs only $500 billion (doubtful), we’re up to $2.5 trillion for this giant rescue package. But that’s not all. Geithner continues:

Finally, we will launch a comprehensive housing program. Millions of Americans have lost their homes, and millions more live with the risk that they will be unable to meet their payments or refinance their mortgages. Many of these families borrowed beyond their means. But many others fell victim to terrible lending practices that left them exposed, overextended, and with no way to refinance.

…The President has asked his economic team to come together with a comprehensive plan to address the housing crisis. We will announce the details of this plan in the next few weeks. Our focus will be on using the full resources of the government to help bring down mortgage payments and to reduce mortgage interest rates. We will do this with a substantial commitment of resources already authorized by the Congress under the Emergency Economic Stabilization Act. [Emphasis added, GDH.]

Note that Mr. Geithner did not put a number on the amount of money the government may be willing to provide to help Americans stay in their homes, preferring to use the term “full resources,” and there were no details as to how this money will be made available. Apparently, President Obama will speak tomorrow (Wednesday) with more information on the housing part of this giant rescue plan.

There was considerable disappointment over Secretary Geithner’s speech last Tuesday. As noted above, the stock markets started to plunge before the speech was over and the Dow fell over 400 points at one point and closed down 381 on the day. The markets were not happy!

It remains to be seen what the markets will do this week as we (hopefully) get more details. We are dangerously close to hitting new lows in the major equity markets, and that could bring yet another large wave of selling. Let’s hope not.

Should The Government Nationalize The Banks?

With the economy worsening by the month, and the credit markets still frozen for the most part, we are hearing more and more calls to nationalize the banks. Personally, I am NOT for nationalizing the banks. But if the latest credit market rescue plan outlined in very broad terms above does not work, it would not surprise me to see President Obama opt for nationalization.

With more and more talk of nationalizing the banks, I have chosen to reprint a recent article written by Nouriel Roubini, PhD. Dr. Roubini is a professor of economics at the Stern School of Business at New YorkUniversity and is chairman of RGE Monitor, a well-known economic consultancy firm. Roubini is best known for having warned about the subprime crisis and an impending economic and financial crisis way back in late 2005.

Roubini does not believe that the government’s rescue plans announced by Secretary Geithner last week will save the banking system, and he believes the system will have to be nationalized at some point, at least those banks that are insolvent. Whether you agree or not, I suggest you read the following closely, if for no other reason than to be informed.

QUOTE:
“Nationalize Insolvent Banks
by Nouriel Roubini

A year ago I predicted that losses by U.S. financial institutions would be at least $1 trillion and possibly as high as $2 trillion. At that time, the consensus was that such estimates were gross exaggerations--the naïve optimists had in mind about $200 billion of expected subprime mortgage losses. But, as I pointed out, losses would rapidly mount well beyond subprime mortgages as the U.S. and global economy spun into a severe financial crisis and ugly recession.

I argued that we would see rising losses on subprime, near-prime and prime mortgages; commercial real estate; credit cards, auto loans and student loans; industrial and commercial loans; corporate bonds, sovereign bonds and state and local government bonds; and massive losses on all of the assets--collateralized debt obligations (CDOs), collateralized loan obligations, asset-backed securities and the entire alphabet of credit derivatives--that had securitized such loans.

By now, write-downs by U.S. banks have already passed the $1 trillion mark (my floor estimate of losses), and institutions such as the International Monetary Fund and Goldman Sachs predict losses over $2 trillion (close to my original expected ceiling for such losses).

But if you think $2 trillion is already huge, our latest estimates at RGE Monitor suggest that total losses on loans made by U.S. financial firms and the fall in the market value of the assets they are holding will be, at their peak, about $3.6 trillion. The U.S. banks and broker-dealers are exposed to half of this much, or $1.8 trillion; the rest is borne by other financial institutions in the U.S. and abroad.

The capital backing the banks' assets was just $1.4 trillion (last fall), leaving the U.S. banking system some $400 billion in the hole, or close to zero even after the government and private-sector recapitalization of such banks. Thus, another $1.4 trillion will be needed to bring back the capital of banks to the level it had before the crisis, and such massive additional recapitalization is needed to resolve the credit crunch and restore lending to the private sector.

These figures suggests the U.S. banking system is effectively insolvent in the aggregate; most of the U.K. banking system looks insolvent, too, and many other banks in continental Europe are also insolvent.

There are four basic approaches to a clean-up of a banking system that is facing a systemic crisis:

No. 1: Recapitalization together with the purchase by a government "bad bank" of the toxic assets;

No. 2: Recapitalization together with government guarantees--after a first loss by the banks--of the toxic assets;

No. 3: Private purchase of toxic assets with a government guarantee and/or--semi-equivalently (a provision of public capital to set up a public-private bad bank where private investors participate in the purchase of such assets--something similar to the U.S. government plan presented by Treasury Secretary Timothy Geithner for a public-private investment fund);

No. 4: Outright government takeover (call it nationalization--or “receivership” if you don't like the N-word) of insolvent banks, to be cleaned after takeover and then resold to the private sector.

Of the four options, the first three have serious flaws. In the bad-bank model (the first, above) the government may overpay for the bad assets, at a high cost for the taxpayer, as their true value is uncertain; if it does not overpay for the assets, many banks are bust, as the mark-to-market haircut they need to recognize is too large for them to bear.

Even in the guarantee-after-first-loss model (No. 2 above), there are massive valuation problems, and there can be very expensive risk for the taxpayer, as the true value of the assets is as uncertain (as in the purchase of bad assets model).

The shady guarantee deals recently done with Citigroup and Bank of America were even less transparent than an outright government purchase of bad assets, as the bad-asset-purchase model at least has the advantage of transparency of the price paid for toxic assets.

In the bad-bank model, the government has the additional problem of having to manage all the bad assets it purchased, something that it does not have much expertise in. At least in the guarantee model, the assets stay with the banks. The banks know better how to manage--and also have a greater incentive than the government to eventually work out such bad assets.

The very cumbersome U.S. Treasury proposal to dispose of toxic assets, presented by Geithner, taking the toxic asset off the banks' balance sheets as well as providing government guarantees to the private investors that will purchase them (and/or public capital provision to fund a public-private bad bank that would purchase such assets). But this plan is so non-transparent and complicated it got a thumbs-down from the markets as soon as it was announced. All major U.S. equity indexes dropped sharply.

The main problem with the Treasury plan--that in some ways may resemble the deal between Merrill Lynch and Lone Star--is the following: Merrill sold its CDOs to Lone Star for 22 cents on the dollar. Even in that case, Merrill remained on the hook in case the value of the assets were to fall below 22 cents, as Lone Star paid initially only 11 cents (i.e., Merrill guaranteed the Lone Star downside risk). But today, a bank like Citi has similar CDOs that, until recently, were still sitting on its books at a deluded value of 60 cents.

Since the government knows no one in the private sector would buy those most toxic assets at 60 cents, it may have to make a guarantee (formally or informally) to limit the downside risk to private investors from purchasing such assets. But that guarantee would be hugely expensive if you needed to convince private folks to buy at 60 cents assets that are worth only 20--or even 11--cents.

So the new Treasury plan would end up being again a royal rip-off of the taxpayer if the guarantee is excessive in relation to the true value of the underlying assets. And if, instead, the guarantee is not excessive, the banks need to sell the toxic assets at their true underlying value, implying that the emperor has no clothes [i.e. – large bank failures].

A true valuation of the bad assets--without a huge taxpayer bailout of the shareholders and unsecured creditors of banks--implies that banks are bankrupt and should be taken over by the government.

Thus, all the schemes that have so far been proposed to deal with the toxic assets of the banks may be a big fudge--one that either does not work or works only if the government bails out shareholders and unsecured creditors of the banks.

So, paradoxically, nationalization may be a more market-friendly solution to a banking crisis. It creates the biggest hit for common and preferred shareholders of clearly insolvent institutions and, most certainly, even the unsecured creditors, in case the bank insolvency hole is too large; it also provides a fair upside to the taxpayer.

Nationalization can also resolve the problem of the government managing the bad assets: If you're selling back all the banks' assets and deposits to new private shareholders after a clean-up, together with a partial government guarantee of the bad assets (as was done in the resolution of the Indy Mac bank failure), you avoid having the government manage the bad assets.

Alternatively, if the bad assets are kept by the government after a takeover of the banks and only the good ones are sold back, through a reprivatization scheme, the government could outsource the job of managing these assets to private asset managers. In this way, the government can avoid creating its own Resolution Trust Corp. bank to work out such bad assets.

Nationalization also resolves the too-big-to-fail problem of banks that are systemically important, and that thus need to be rescued by the government at a high cost to the taxpayer. This too-big-to-fail problem has now become an even-bigger-than-too-big-to-fail problem, as the current approach has led weak banks to take over even weaker banks.

Merging two zombie banks is like having two drunks trying to help each other stand up. The JPMorgan Chase takeover of insolvent Bear Stearns and WaMu; the Bank of America takeover of insolvent Countrywide and Merrill Lynch; and the Wells Fargo takeover of insolvent Wachovia, all show that the too-big-to-fail monster has become even bigger.

In the Wachovia case, you had two wounded institutions (Citi and Wells Fargo) bidding for a zombie, insolvent one. Why? They both knew that becoming even bigger than too big to fail was the right strategy to extract an even greater bailout from the government. Instead, with the nationalization approach, the government can break up these financial supermarket monstrosities into smaller pieces to be sold to private investors as smaller (better) banks.

This "nationalization" approach was successfully undertaken by Sweden, while the current U.S. and U.K. approach may end up looking like the zombie banks of Japan that were never properly restructured and ended up perpetuating the credit crunch and credit freeze.

Japan wound up with a decade-long near-depression because of its failure to clean up the banks and the bad debts. The U.S., U.K. and other economies risk a similar near-depression and stag-deflation (multi-year recession and price deflation) if they fail to appropriately tackle this most severe banking crisis.

So why is the U.S. government temporizing and avoiding doing the right thing, i.e., taking over the insolvent banks? There are two reasons.

First, there is still some small hope (and a small probability) that the economy will recover sooner than expected, that expected credit losses will be smaller than expected, and that the current approach of recapping [recapitalizing] the banks and somehow working out the bad assets will work in due time.

Second, taking over the banks--whether you call it nationalization or, in a more politically correct way, "receivership"--is a radical action that requires most banks be clearly beyond the pale. Today, Citi and Bank of America look blatantly near-insolvent and ready to be taken over, but JPMorgan and Wells Fargo as yet do not.

But with the sharp rise in delinquencies and charge-off rates that we are experiencing now on mortgages, commercial real estate and consumer credit, even JPMorgan and Wells will likely look near-insolvent in six to 12 months (as suggested by Chris Whalen, one of the leading independent analysts of the banking system).

Thus, if the government were to take over only Citi and Bank of America today, wiping out common and preferred shareholders and forcing unsecured creditors to take a haircut, a panic may ensue for other banks, and the Lehman fallout that resulted from having unsecured creditors taking losses on their bonds will be repeated.

On the other hand, if, as is likely, the current "fudging" strategy does not work, and most banks--the major four and a good number of the remaining regional banks--all look clearly insolvent in six to 12 months, you can then take them all over, wipe out common and preferred shareholders and even force unsecured creditors to accept losses.

So, the current strategy--Plan A-- may not work, and Plan B (or better, "Plan N," for nationalization) may end up the way to go later this year. Wasting another six to 12 months may risk turning a U-shaped recession into an L-shaped near-depression.

The political constraints the new administration faces--and the remaining small probability that the current strategy may, by some miracle or luck, work--suggest Plan A should be first exhausted before there is a move to Plan N.

But with the government forcing Citi to shed some of its units and assets, and starting stress tests to figure out which institutions are so massively undercapitalized that they need to be taken over by the Federal Deposit Insurance Corp., the administration is laying the groundwork for the eventual, necessary takeover of the insolvent banks.

So while Plan A is now underway, the very negative market response to this Treasury plan suggests it will not fly. Markets were expecting a more clear plan, but also one that would bail out shareholders and creditors of insolvent banks. Unfortunately, that is politically and fiscally unfeasible. It is time to start to think and plan ahead for Plan N.” END QUOTE

Conclusions - Trillions of Dollars Being Thrown Around

As I have emphasized repeatedly over the last several weeks, the politicians in Washington, as well as our monetary officials such as Ben Bernanke, are scared to death about a “debt deflation” that could throw the country into a new depression – which would likely mean that they all lose their jobs! So they will stop at no lengths to avoid it. This is why we are seeing multiple trillions of dollars being thrown around.

The Geithner rescue plan announced last week, with almost no details to go along with it, would commit the government to at least another $2 trillion in spending, and maybe more. Add to that however much more spending President Obama is likely to announce tomorrow to rescue the housing market, which I expect to be up to another trillion.

Bloomberg estimates (based on government data they had to sue to get) that the government is already on the hook for $9.7 trillion in bailouts and various guarantee liabilities associated with the credit crisis – before the announcements over just the last week: 1) the $787 billion stimulus; and 2) at least $2 trillion in the Geithner plan. Not to mention what Obama announces tomorrow for housing.

We’ve never seen anything like this in the history of America, or even the planet for that matter. Making matters worse, no one knows if these efforts will work. And people wonder why the stock markets are going down.

Interestingly, I have been criticized over the last two weeks as I have written extensively about President Obama’s trillion-dollar “stimulus” package (if you add interest). I expect I’ll get more negative comments this week with the focus on the Geithner rescue package and Dr. Roubini’s piece on nationalizing the banks.

Some readers have complained that these are really just political matters that don’t belong in an economic/investment e-letter. I beg to differ – have you looked at the value of your investment portfolio recently? No one can argue any longer that politics don’t affect our investments.

Very best regards,

Gary D. Halbert

SPECIAL ARTICLES:

Obama’s Tainted Win
http://www.realclearpolitics.com/articles/2009/02/obamas_tainted_win.html

Obama Chose Urgency Over Transparency (this from a liberal)
http://www.slate.com/id/2210698/

Geithner Can’t Find Gun, Let Alone the Silver Bullet
http://www.bloomberg.com/apps/news?pid=20601039&refer=columnist_reilly&sid=aN_dadtIVMZo

Is Geithner Ready for Prime Time?
http://www.realclearpolitics.com/articles/2009/02/is_geithner_ready_for_prime_ti.html