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Subprime Losses Already Outweigh The Great Depression

Stock-Markets / Credit Crisis 2008 Feb 13, 2008 - 04:50 PM GMT

By: Adrian_Ash

Stock-Markets

Best Financial Markets Analysis Article"Time somebody did something, right...?"

IN 1984 THE BANK of ENGLAND saved Johnson Matthey Bank – a horribly over-geared subsidiary of the centuries-old gold dealer – with an emergency buy-out costing just £1. The debts covered by the Bank of England, however, totaled $309 million on one estimate. They took 10 years to clear from the Bank's balance sheet.


The Swedish government then stepped into the Scandinavian banking crisis of 1992, buying the 13% of Nordbanken shares that it didn't already own at a 10% premium. That defended investors as well as depositors.

Washington even managed to contain the US savings & loan crisis of the late 1980s, protecting savers but letting more than 1,000 finance companies go under.

The direct cost to the US taxpayer was $124.6 billion, according to the General Accounting Office's report – right about the total bank losses in the subprime collapse so far.

All told, the S&L crisis cost "more than the cumulative loss of all US banks during the Great Depression, even after adjusting for inflation," as Jean-Charles Rochet, then a visiting professor at the London School of Economics, put it in a speech on banking crises of 2002.

Whereas, by its end, the current banking crisis will see total mortgage-credit losses of $400 billion according to Goldman Sachs' latest guess-timate. So "let's be clear and honest," as Housing & Urban Development secretary Alphonso Jackson said when launching Project Lifeline this week.

"One action alone will not solve every problem in the housing market," Jackson said as he gave US home-buyers an extra 30 days to try and stall foreclosure. He could just as easily have been talking about the entire banking industry.

One action alone won't solve it – not even if that one action does come from Warren Buffett. Or the White House. Or the Federal Reserve.

But altogether?

And what if we throw in an extra $3.3 trillion of foreign government finance, pouring out of the oil- and export-rich sovereign wealth funds of Arabia and Asia ? Might that be enough to wipe the world's greatest-ever credit bubble from history?

"So far, institutions have raised nearly $75bn of capital from sovereign wealth funds and public sources," notes Joseph Mason, associate professor of finance at Drexel University and a senior fellow at the Wharton School , in the latest market note from his private consultancy, Criterion Economics.

"[But] while the seemingly unconstrained supply of capital has, thus far, been a blessing, it is not clear that the flow can continue. Recent events suggest that private capital sources may be reaching their limits, at least with respect to riskier institutions."

Citigroup just managed to raise funds at 5% interest. It is the world's largest bank, after all. But MBIA, the biggest "monoline" bond insurer, was forced to pay 14% on its AA-rated debt as Mason gasps.

"Ambac canceled their most recent recapitalization attempt," he adds, "ostensibly because the cost was even higher."

So step forward Warren Buffett! The stock market initially rallied – and rallied hard – on the idea that the Sage of Omaha might buy up bonds currently insured by bond-insurance giants MBIA, Ambac and FGIC. Yet as Buffett told CNBC, he only wants the municipal bonds these firms insure, and nothing else.

Because – get this – municipal bonds are currently cheaper to buy if they come with insurance than without!

A "classic kind of mispricing" for the Sage of Omaha to exploit, as John Authers notes in the Financial Times , this arbitrage also shows just how horrified the entire investment world has become by the "monoline" insurers, thanks to the very same junk that Warren Buffett will not step in and save.

Clearly, Buffett's offer makes great news for US towns and states wanting to raise fresh capital to fund their core services. With his prime-beek cherry Coke check-book at the ready, there's no need to repeat Sept. 1933 – when 28 American cities went into default – nor the Orange County default of 1995.

Especially not if the Federal government were to stand behind Buffett standing behind the municipals. Right?

Buffett himself, however, was quick to point out that his offer "doesn't do anything" for the subprime bonds, collateralized debt obligations (CDOs) and leveraged debt pushing down on the bond insurer's credit ratings.

Indeed, "I'm not sure anything is going to do much for the CDOs," he said. That doesn't mean state agencies and central banks won't try, however. "Direct government bailouts are gaining in popularity," as Prof. Mason notes for Criterion.

He's not kidding!

Here in London, the British government has told the two remaining bidders for Northern Rock – the top-five mortgage lender, hit by a banking run in Sept. '07 and now supported by £26 billion ($46bn) of tax-funded loans – that it's on the verge of full-scale nationalization.

Northern Rock was moved onto the British state's official balance sheet last week.

Germany's IKB, currently 38% owned by the state, may see the government-run KfW development bank raise its stake to 50% – effectively nationalizing the subprime-hit lender – because private-sector investors are unwilling to back a new capital raising.

In France , the state-controlled postal bank La Poste is rumored to be joining the government-owned Caisse des Dépots in developing a bail-out package for Société Générale. The country's second-largest bank, SocGen managed to lose $3 billion on subprime investments – a little-known fact given the $7 billion it lost to "rogue trader" Jerome Kerviel.

This week SocGen raised capital by offering new shares at a 39% discount to its stock market price – itself already offering a near 42% discount from this time last year.

And in Switzerland , UBS – due to report its first loss in history on Thursday, worth some 4.4 billion Swiss Francs for 2007 as a whole ($4bn) – may gain financial support from the Swiss government if shareholders reject the capital restructuring proposed by the Singapore government. Along with an un-named Saudi investor, Singapore 's Government Investment Council (GIC) has offered to put up 13 billion Swiss Francs ($11.3bn) without demanding a seat on the board.

But the GIC would take a controlling stake, however, since "on average, 30% of shareholders turn up to vote at the AGMs," as one UBS shareholder told FinanceAsia this week.

"Somebody controlling one-third of that" – and the GIC-Saudi investors would hold 10% of the total between them – "effectively controls the company."

Does it matter? Maybe. "The investment arms of foreign governments appear to have saved the day for American financial institutions," says Steven M.Davidoff for Deal Book. They've also piled into the biggest banks in Europe too, saving Western governments some $75 billion so far.

On one day alone last month, some $19 billion was raised by Citigroup and Merrill Lynch tapping the convertible bond markets – and Citi's funding "included investments from sovereign wealth funds in Singapore and Kuwait, alongside Prince Alwaleed bin Talal, the bank's second largest shareholder," reports Financial News US .

Whatever the Asians and Arabs can do, Washington can do better of course, starting with the little guy right at the bottom of the subprime pyramid – the over-indebted home buyer himself.

George Bush might have watched 226 mortgage lenders go kaput since late 2006 (the latest count from ML-Implode.com), but he just signed that $168 billion tax-rebate bill, hoping to stop the current slump in US house prices becoming a genuine depression.

Not enough, grumbles Senate majority leader Harry Reid. The package is "far from a panacea," he says, getting ready for a Democrat White House no doubt.

"Much more should be done. Another stimulus package or two."

Or three. Or four. You just keep writing the checks, Senator – and get the Federal Reserve to keep US interest rates way below inflation.

We'll just keep Buying Gold outright – with no default risk – and store it in privately-owned, ultra-secure gold vaults, far outside the world's banking system.

By Adrian Ash
BullionVault.com

Gold price chart, no delay | Free Report: 5 Myths of the Gold Market
City correspondent for The Daily Reckoning in London and a regular contributor to MoneyWeek magazine, Adrian Ash is the editor of Gold News and head of research at www.BullionVault.com , giving you direct access to investment gold, vaulted in Zurich , on $3 spreads and 0.8% dealing fees.

(c) BullionVault 2008

Please Note: This article is to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it.

Adrian Ash Archive

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