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US Government Rescue Plan is Too Little Too Late as the Liquidity Bubbles Burst

Stock-Markets / Liquidity Bubble Jan 28, 2008 - 04:30 PM GMT

By: Money_and_Markets

Stock-Markets Best Financial Markets Analysis ArticleFor politicians, the government's $150 billion stimulus package is a no-brainer. But for investors, it's a bomb that could greatly intensify the flood of disasters now unfolding. In my open letter below, I explain why. And in the days ahead, we will give you step-by-step instructions for an ark of protection that would make Noah proud. — Martin


From:

Martin D. Weiss, Ph.D.
Chairman of the Sound Dollar Committee

To:

Mr. Ben Bernanke
Chairman of the Board of Governors of the United States Federal Reserve

Congresswoman Nancy Pelosi
Speaker of the United States House of Representatives

Sec. Henry M. Paulson, Jr.
United States Secretary of the Treasury

Re:

Your recent responses to U.S. economic decline and market turmoil

Dear Mr. Bernanke, Ms. Pelosi, and Mr. Paulson:

I am Chairman of the Sound Dollar Committee, a nonprofit, nonpartisan organization founded a half century ago to promote a stable economy and sound monetary-fiscal policy.

Back in 1960, when we mobilized millions of American citizens to help President Dwight D. Eisenhower balance the federal budget, we won a great national battle.

However, in the years that followed, we lost the war: Balanced budgets have become a faint memory; the strong dollar, a lost dream.

Indeed, it distresses me to say that America's day of financial reckoning is not just coming. In some ways, it has already come and gone.

The breakdown of the greatest asset bubble of all time — the recent housing boom — began over two years ago .

The fires of the subprime mortgage crisis, which quickly enveloped much of the $14 trillion U.S. mortgage market, began over one year ago.

And the credit crunch, strangling new financing to millions of debt-addicted consumers and corporations, began over six months ago.

Today, U.S. home builders are already mired in their greatest depression since the 1930s.

Major money-center banks have already suffered some of their largest losses in modern times.

Consumers have already snapped shut their pocketbooks.

Investors are already stampeding to safety.

Therefore, despite the best intentions, the steps you've taken — along with any you still plan — may already be too late to prevent economic decline, too late to stop financial turmoil, and too late to break the vicious cycle now emerging between them.

Let's not forget: In every major recession since World War II, financial stresses of the magnitude we're witnessing today appeared only after the economic contraction was in its final stages. That's when corporations finally threw in the towel and filed for bankruptcy. That's when consumers did the same.

This time is very different.

This time, defaults are surging even before the onset of a recession ... even before millions of Americans lose their jobs or see their net worth sink.

So this begs an urgent question:

If we're already seeing blatant and abundant signs of financial stress or distress now , what can we expect in the recession?

In its front-page analysis last week, " Worries That the Good Times Were Mostly a Mirage ," The New York Times explained it this way:

"Everyone from first-time home buyers to Wall Street chief executives made bets they did not fully understand, and then spent money as if those bets couldn't go bad. For the past 16 years, American consumers have increased their overall spending every single quarter, which is almost twice as long as any previous streak.

"Now, some worry, comes the payback.

"Martin Feldstein, the éminence grise of Republican economists, says he is concerned that the economy 'could slip into a recession and that the recession could be a long, deep, severe one' ...

"First, Wall Street hasn't yet come clean. Even after last week, when JPMorgan Chase and Wells Fargo announced big losses in their consumer credit businesses, financial service firms have still probably gone public with less than half of their mortgage-related losses, according to Economy.com ...

"'Part of the big uncertainty'," Raghuram G. Rajan, former chief economist at the International Monetary Fund, said, 'is where the bodies are buried.'

"The second problem is that real estate and stocks remain fairly expensive. This shows just how big the bubbles were: Despite the recent declines, stock prices and home values have still not returned to historical norms ...

"The price declines will also lead directly to the third big economic problem. Consumer spending kept on rising for the last 16 years largely because families tapped into their newfound wealth, often taking out loans to supplement their income. This increase in debt — as a recent study co-written by the vice chairman of the Fed dryly put it — 'is not likely to be repeated.' So just as rising asset values cushioned the last two downturns, falling values could aggravate the next one."

In short, we are facing a vicious cycle more powerful than anything we've seen in the half-century history of our Sound Dollar Committee:

  • Debt troubles sinking our economy, and ...
  • The sinking economy triggering more debt troubles.

Free Markets or Gambling Casinos?

Your predecessors have promoted free markets, and you have done the same. We commend you.

But why have you allowed those same free markets to be transformed into history's greatest gambling casinos?

I'm not referring merely to the credit card marketing frenzy that trapped millions of Americans into 18% debt.

I'm not even stressing the subprime mortgages debacle that's destroying our economy.

Rather, I'm focusing on the gambling casinos that are many times larger — and potentially riskier: The markets for derivatives.

My concerns are many ...

Concern #1. Off the Charts

If these derivatives were just a sideshow in the financial arena, any flare-ups could probably be contained.

But nothing could be further from the facts: By the third quarter of last year, just the derivatives held by U.S. banks alone ballooned to $172.2 trillion in notional value, according to the latest report of the U.S. Comptroller of the Currency .

How did our government let these debts and bets grow so large?

Also by the third quarter, credit default swaps — bets on bond defaults and corporate bankruptcies — surged to nearly $14 trillion. These hardly existed five years ago. And now their notional values are as large as the outstanding value of the entire U.S. mortgage market?!

Concern #2. Off the Radar

If most of these derivatives were traded on regulated exchanges — with standard oversight of each player — they might not be quite as alarming.

But the reality is that 95% of the derivatives are traded over the counter. In other words, they're off-the-radar, one-on-one contracts between two trading partners and no one else.

So I ask:

Do you know where the bodies are buried? Does anyone know?

Do you know what to do — or even what is likely to happen — when trading partners can't pay up on their debts?

Do you recognize the full nature of the threat to the system of a single major default? What about multiple defaults at approximately the same time?

The best metaphor is a street bookie taking daily bets from dozens of high rollers. If just one of his customers doesn't pay up, everything can blow up — not just for the bookie, but for the bookie's bookies as well. That's why he hires hit men to impose discipline.

But in the market for credit swaps, it's each to his own. Regulators have few tools — let alone guns and cement boots. How do they impose the needed discipline? Do they even know who owes what to whom?

Yes, in 1998, when just one derivative player collapsed, the Federal Reserve was able to orchestrate a bailout. But what are you doing about the many big players on the brink of collapse today? How could you possibly rescue them all — not to mention their trading partners? And how could you do it quickly enough?

Concern #3. The Global Derivatives Bubble

I assume you've been coordinating closely with other governments around the world on this crisis, because, globally, the mountain of derivatives is triple the size of the pile-up held by U.S. banks alone.

Instead of just $172.2 trillion, it's $516.4 trillion, according to the mid-year 2007 stats from the Bank of International Settlements .

And globally, credit default swaps are also three times larger than those in the U.S. alone. Instead of $14 trillion, it was $42.6 trillion by mid-year, probably over $45 trillion by year-end.

Even if you are coordinating efficiently with foreign governments, what good is it if no one has a handle on the current state of affairs? What good is it if we have neither the knowledge nor the power to prevent defaults or their consequences?

Concern #4. Safety Nets Failing

Pivotal players in the credit default market are the big U.S. bond insurers such as Ambac and MBIA. When issuers default, these insurers are supposed to provide a tamper-proof safety net.

If these bond insurers were not at risk of losing their triple-A ratings, it might not be of such urgent concern.

But the fact is, Ambac has already lost its triple-A rating from Fitch — a prelude to similar downgrades for other insurers and by other rating agencies. Last week, this already began to set off shock waves that threatened the credit markets. Are you ready for what might come next week or next month?

Have you calculated how much it would take to bail out the bond insurers? Do you realize that, if default rates surge in a recession, it could cost almost as much as you're planning to spend on the entire economic stimulus package?

Plus, do you not see the relationship between bond insurance and credit default swaps? They're essentially the same animal. If one goes down, so does the other.

A key point: The main reason so many big players have been willing to take so much risk with potentially shaky trading partners in the past five years was because they figured they had their backside covered. They had credit default swaps. They had bond insurance.

But if these hedges and insurance policies themselves are going sour, then what?

Are you going to be the insurer of last resort?

And have you considered the fact that the very act of bailing out private companies — driving inflation and interest rates sharply higher — could set off the tripwires on still more defaults?

I have just one fundamental word of advice with respect to all of these questions: Don't do it. It's too risky.

Don't let the U.S. government get dragged down into the quicksand. It's too deep.

Don't bail out the banks, the bond insurers, and the thousands of other gamblers in the derivatives casino. They're too big.

Don't get entangled in the giant web of bets and debts they've created over the years. It's too complex.

Yes, help orchestrate work-outs and coordinate clean-ups. But don't squander taxpayer funds.

If you do, you'll sacrifice the most precious resource we have left — the ultimate viability of the U.S. dollar and credit rating of the U.S. government.

Instead, wait until the excesses of recent decades have been mostly washed out. Then focus your efforts on helping to bring about a true recovery.

No matter how dire the situation may be, it's not the end of the world. We've survived worse, and we're still here. We'll survive this crisis as well.

Sincerely,

Martin D. Weiss, Ph.D., Chairman
Sound Dollar Committee

This investment news is brought to you by Money and Markets . Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com .

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