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Biggest Debt Bomb in History

Recommendation to Congress Not to Spread Financial Panic

Interest-Rates / Credit Crisis Bailouts Sep 22, 2008 - 01:04 PM GMT

By: Money_and_Markets

Interest-Rates

Diamond Rated - Best Financial Markets Analysis Article Martin D. Weiss writes: The proposal before Congress for a $700 billion mega-bailout is far too little to repair the damaged debt and derivatives markets ... and, at the same time, far too much for investors and taxpayers who must put up the money.

How big is the problem, really?

In the past, Congress has repeatedly asked us for data and analysis on these issues, and we have provided it in Congressional testimony and white papers. In that same tradition, below is a partial first draft of a white paper we will be submitting on this matter:


Why the Magnitude of the Mortgage, Debt and Derivatives Crisis Overwhelms The $700 Billion Bailout Plan Now Under Discussion in Congress
(Partial First Draft of Weiss Research's Submission
to Congress and Federal Banking Regulators)

Last week, the President, the Treasury Secretary and the Federal Reserve Chairman announced their view that Congress must get to the root of the debt crisis in America by providing a broad solution that truly puts the crisis to an end.

However, the magnitude of the crisis afflicting mortgages, other debts and derivatives clearly overwhelms the $700 billion bailout proposal currently under discussion. To better understand the magnitude of the problem ...

First and foremost, we urge members of Congress to disregard data based on the list of troubled banks maintained by the Federal Deposit Insurance Corporation (FDIC).

The FDIC's list has only 117 institutions with $78 billion in assets. But given the current proposal for a $700 billion bailout, it is clear that Administration officials tacitly recognize that the FDIC list understates the problem. There are many more financial institutions at risk or in need of assistance with their toxic paper.

How many more? We believe a more accurate count comes from our analysis of: (a) the derivative risks assumed by major banks, (b) the mortgage holdings of the largest regional banks and (c) all banks and thrifts with TheStreet.com's financial strength rating of D+ (weak) or lower. Based on this analysis, we believe:

  • 1,479 FDIC member banks are at risk of failure with total assets of $2.4 trillion.
  • In addition, 158 savings and loans are at risk with $756 billion in assets.
  • In sum, banks and S&Ls at risk have assets of $3.2 trillion, or over 36 times the assets of banks on the FDIC's watch list.

These numbers alone indicate that the $700 billion contemplated for the bailout plan could be severely inadequate.

Second, Congress should seriously consider the facts in the Federal Reserve's Second Quarter Flow of Funds Report .

In this report, released on September 18, just one day before the President announced the Administration's $700 billion bailout proposal, the Fed estimates that the nation's mountain of interest-bearing debts has now grown to $51 trillion.

Plus, it provides critical additional insights regarding the breadth of the debt problems facing the nation, as follows:

1. The ownership of residential mortgages is dispersed among many different sectors. There are $12.1 trillion in mortgages on single- and multi-family homes in the United States. But these are not held only by banks and S&Ls. They are spread among a wide variety of institutions and individuals, all of which could have similar claims to federal assistance.

Specifically ...

2. Fannie, Freddie and GSAs are still at risk. As a first priority, the plan would have to expand the recently announced bailouts of Fannie Mae and Freddie Mac in order to properly secure the residential mortgages held by government-sponsored enterprises (GSEs) and agencies (GSAs). These now total $5.4 trillion, according to the Fed.

Plus ...

3. Private sectors and local governments also own residential mortgages in substantial quantities. The bailout plan would also have to cover:

  • Investment banks and others that issue asset-backed securities, now holding $2.1 trillion in mortgages,
  • Nonbank finance companies ($426 billion),
  • Credit unions ($332.4 billion),
  • State and local governments ($159 billion),
  • Life insurance companies ($61.6 billion), plus ...
  • Private pension funds, government retirement funds and households themselves.

4. Commercial mortgages are now going bad as well. The current debate seems to focus exclusively on residential mortgages. But at many regional and super-regional banks, much of the risk is currently in the commercial mortgage sector, where recent data denotes many of the same difficulties as the residential sector. To truly get to the root of the problem, Congress cannot exclude these either.

There are $2.6 trillion in commercial mortgages outstanding in the United States. As with residential mortgages, these are also dispersed widely beyond the banking sector — $644 billion held by issuers of asset-backed securities, $263 billion held by life insurers, $65 billion at nonbank finance companies and $37 billion at Real Estate Investment Trusts (REITs).

5. Mortgages are less than half the problem. Although it is true that the current debt crisis in America originated in the mortgage market, it is not accurate to say that the root of the crisis is strictly in this one sector. Rather, the debt crisis has multiple and varied roots, with excessive risk-taking in credit cards, auto loans and virtually every other form of private-sector debt.

There are currently $14.8 trillion in mortgages in America. But beyond mortgages, there is another $20.4 trillion in consumer and corporate debt. This means that mortgages represent only 42% of the private-sector debt problem in America.

6. Local governments are a higher priority. Overlooking the debt problems of state and local governments would also be a big mistake. Indeed, given the essential nature of their services, including the pivotal role they play in homeland security, it could be argued that their credit challenges take priority over those faced by banks, S&Ls and Wall Street firms.

Currently, the Fed estimates $2.7 trillion in municipal securities outstanding, most of which have been reliant on a bond insurance system that remains on the brink of collapse.

In short, to truly get to the root of the problem as the President is requesting, Congress' new bailout plan would have to cover a lot of ground beyond just the banking industry.

Third, we urge Congress to get a better handle on the enormous build-up of derivatives in America, beginning with a thorough review of the OCC's Quarterly Report on Bank Trading and Derivatives Activities, First Quarter 2008.

Although derivatives were originally designed to help reduce risk, it is widely acknowledged that their volume and usage have reached such an extreme level that they have become, instead, speculative bets which greatly increase the systemic risk to financial global markets.

And although regulators have few details about these derivatives, most officials now realize they may be at the root of the panic that began to spread throughout the global banking system in the wake of the Lehman Brothers bankruptcy on September 15.

Therefore, it should be well understood by all members of Congress that, to ward off possible renewed waves of global panic, the bailout plan would also have to address the following facts:

  • The notional (face value) amount of derivatives held by U.S. commercial banks is $180.3 trillion.
  • The credit exposure to derivatives (risk of default by trading partners) is $465 billion, up 159% from one year earlier.
  • U.S. banks with the greatest credit exposure to derivatives are HSBC (with $7.21 in risk per dollar of capital), JPMorgan Chase (with $4.11 in risk on the dollar), Citibank ($2.79), Bank of America ($2.15) and Wachovia ($.77).
  • Further, after Bank of America's merger with Merrill Lynch, which reports $4 trillion in derivatives, and after a possible Wachovia merger with Morgan Stanley, which holds $7.1 trillion, these exposures will likely be intensified.

Congress must go into its deliberations with its eyes open, recognizing that any bailout plan that does not include these banks and other players in the vast market for derivatives could leave a gaping hole through which financial panic can spread again.

Fourth, for all of these debts and derivatives, a bailout plan would, in normal circumstances, require (a) realistic estimates of the amount that is already delinquent or in default, and (b) a reasonable forecast of how many more are likely to go bad in a continuing recession.

However, the only estimates currently available are those reflecting actual write-downs recognized by large, global financial institutions — over $500 billion. That figure does not include the thousands of other institutions which are among the sectors we cite above. Nor does it include losses incurred but not yet properly booked — let alone losses not yet incurred.

To date, no government agency is providing such estimates. But without them, any budgetary planning for this bailout is next to impossible. No one will know, except in retrospect, if the bailout truly removes the cancerous debts from the economic body or leaves most of them to fester and spread.

In sum, there should be no illusion that the $700 billion estimate proposed by the Administration can actually provide anything approaching a total solution to America's current debt crisis. It could very well be just a drop in the bucket.

Too Much, Too Soon for the U.S. Government Securities Market

There should also be no illusion that the market for U.S. government securities can absorb the additional burden of a $700 billion bailout without traumatic consequences.

In its Fiscal Year 2009 Mid-Session Review, Budget of the U.S. Government , the Office of Management and Budget (OMB) projects the 2009 federal deficit will rise to $482 billion.

However, this projection was made before the bailouts of Fannie Mae, Freddie Mac and AIG and before the White House's $700 billion bailout proposal.

Even assuming no budget overruns beyond the $700 billion, these bailouts threaten to double or even triple the federal deficit.

The OMB seeks to minimize its $482 billion deficit projection by stating it will be only 3.3% of estimated GDP, which it deems manageable. However, after adding the cost of announced and proposed bailouts — approximately $1 trillion — the federal deficit could be between 8% and 10% of GDP.

No reasonable person could deny that such a dramatic increase in the deficit will have an equally dramatic impact on interest-rate levels. To attract investors, the U.S. Treasury will have to pay much higher rates ... and these higher rates, in turn, will drive up rates on mortgages, credit cards and nearly all borrowing.

Recommendations for Congress

In light of these facts, we have four recommendations:

Recommendation #1. Before passing any bailout package to patch up certain sectors of the debt markets, consider the impact of massive government borrowing on all sectors of the debt markets, and on the value of the U.S. dollar.

History proves that far less dramatic increases in government borrowing have crowded out millions of private borrowers, driven up interest rates and greatly damaged the economy as a whole.

So it's reasonable to assume that the massive increases in government borrowing required for a bailout of this magnitude would put unprecedented upward pressure on interest rates, greatly aggravate the debt crisis, sink the U.S. dollar, and cause even more damage to the economy than in the past.

To avoid these consequences, we recommend that Congress reject the Administration's $700 billion bailout proposal and shelve any related legislation, moving forward instead with our recommendation #4 below.

Recommendation #2. If, despite the risk of causing much higher interest rates and a sharp decline in the dollar, Congress is determined to pass legislation creating a new government agency to buy up bad debts as proposed, we recommend that the new agency pay strictly fair market value for those debts, including a substantial discount that reflects their poor liquidity.

Further, it should be clearly understood that:

  • Due to the recent sharp declines in market values and market liquidity, many of the bad debts on the books of U.S. financial institutions are currently worth only a fraction of their face value.
  • When the government buys these debts at fair market value, it will still leave most of these institutions with severe losses.
  • Many of these institutions do not have the capital to cover their losses and will fail despite the bailout.

Recommendation #3. Congress must clearly disclose to the public that:

  • There are several significant risks to the financial system that the government is unable to address with any new legislation, including defaults on other large debts and derivatives, which could trigger a chain reaction of corporate failures.
  • Whether the bailout legislation is adequate or not to stem the debt crisis and prevent financial panic, the government will need to prioritize the protection of its own credit and seek to ensure the stability of the U.S. dollar.
  • The private sector, in turn, will need to handle any further spread of the debt crisis largely without government financial assistance.

Recommendation #4. Rather than focusing primarily on a safety net for imprudent institutions and speculators, Congress should devote more effort to bolstering the safety nets for prudent individuals and savers. These include:

  • The FDIC, which insures bank depositors, but has inadequate funding and staffing to handle a large wave of bank failures.
  • SIPC, which supposedly covers brokerage firm accounts, but, in practice, does not compensate investors for losses in most circumstances.
  • State guarantee associations, which promise to cover insurance policyholders, but which have repeatedly failed to live up to their promise when large insurers fail.

Unless Congress approaches its monumental task with enormous caution, it could produce the worst of both worlds: A failure to resolve the current debt crisis plus the creation of a new set of crises that merely spread the panic and prolong the pain.

Recommendations for Investors

Most investors have unrealistic hopes and expectations regarding what Washington can accomplish. Even if Congress moves swiftly to enact legislation for the government to buy up bad debts from financial institutions, at best, the government will pay far less than face value.

Banks will continue to suffer losses and fail. Uninsured depositors will continue to lose money and investors will continue to see their shares lose all or nearly all value.

Therefore, regardless of what Congress decides in the coming weeks, investors should continue to seek the safest havens for their money and pursue investment strategies designed to build wealth in a crisis.

For more details, see our 1-hour video, " Plague to Pandemic ," before it goes offline early this week.

Sincerely,

Martin D. Weiss, Ph.D.
President, Weiss Research, Inc.
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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Biggest Debt Bomb in History