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Unavoidable Financial Collapses and Backfiring Government Actions

Politics / Credit Crisis Bailouts Oct 13, 2008 - 10:24 AM GMT

By: Money_and_Markets

Politics

Best Financial Markets Analysis ArticleOpen Letter to
Dominique Strauss-Kahn, Managing Director of The International Monetary Fund (IMF)

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


Dear IMF Managing Director Strauss-Kahn:

This past Saturday, October 11, at a joint press conference by world economic leaders, you said:

“Intensifying solvency concerns about a number of the largest U.S.-based and European financial institutions have pushed the global financial system to the brink of systemic meltdown.”

Further, in an attempt to prevent that potentially traumatic outcome, some of the world's largest nations have proposed a series of new steps, including massive direct injections of taxpayer capital into private-sector banks.

This brings us to a crossroads that can determine the fate of six billion people for decades to come, a dire reality that motivates me to write you today.

I am president of Weiss Research, Inc., an independent research corporation, and Chairman of the Sound Dollar Committee, a nonprofit, nonpartisan organization founded by my father in 1959.

The Sound Dollar Committee was instrumental in helping President Dwight D. Eisenhower achieve one of the only truly balanced budgets of the past half century. And in keeping with that tradition, we continue to promote fiscal responsibility, sound business practices, and prudent investing.

Over the years, we have learned how elusive these goals can be. And by the same token, I recognize the unusual difficulty of the current challenges you face.

However, it is undeniable that the new rescue proposals being made today go beyond the already-extreme efforts announced or undertaken previously, such as the $700 billion bailout package signed into law by President Bush ten days ago, the unprecedented $1 trillion in central bank liquidity injections during the prior week, and additional extreme measures by the U.K., Germany and other leading nations.

It is also undeniable that those efforts have not yet been effective, leading us to wonder if new efforts will be any different. Before implementing them, therefore, I believe it behooves us to consider some ominous trends:

1. Government interventions are backfiring.

Since the credit crisis burst onto the global scene approximately 14 months ago, each new government countermeasure seems to have backfired.

Rather than encouraging investors to make the rational choice of shifting assets to stronger hands, governments have inadvertently done precisely the opposite. They have promoted irrational complacency. They have encouraged imprudent inaction. They may have also prompted investors to shift some assets back to weaker hands.

Repeatedly, the authorities pursued a policy that made individual and institutional investors more confident than the circumstances warranted. This policy, in turn, prompted investors to buy more common shares in insolvent banks, more junk bonds in over-rated corporations, and more derivatives contracts based on unrealistic models — all despite abundant evidence that the banks' balance sheets were continuing to deteriorate.

Earlier, various government measures seeking to reduce the panic — such as coordinated central bank intervention — did buy some time by temporarily reducing investor fears. And during those quieter interludes, policymakers were able to artificially drive down the premiums charged by lenders for higher risk loans.

But this was accomplished despite the deterioration in balance sheets.

In other words, each time governments intervened, the cost charged for risk came down, but the level of risk continued to rise. Instead of bringing stability to the marketplace, the authorities created a dangerous discrepancy between the two — between price and reality.

Result: As soon as the immediate effects of the interventions dissipated, and as soon as symptoms of the true risk levels resurfaced, there were sudden, explosive market adjustments.

Investors seeking to avoid devastating losses dumped their high-risk assets. Other investors, who otherwise might have not been unduly impacted by the turmoil, suffered parallel losses. And the general public, previously less cognizant of the financial turmoil, suffered surging anxiety.

The authorities may have exacerbated the very panic they were seeking to avoid. And now, as the public begins to connect the dots between government actions and market reactions, the quiet time bought with each new intervention has diminished or even vanished.

2. Government actions are too little, too late to stem the debt crisis.

Kindly refer to our white paper submitted to the U.S. Congress on September 25, 2008, titled “ Proposed $700 Billion Bailout Is Too Little, Too Late to End the Debt Crisis; Too Much, Too Soon for the U.S. Bond Market .”

In it, we detail why the U.S. debt crisis alone was far larger than previously believed. As of the first quarter, it encompassed or affected

  • 1,479 banks and 158 thrifts at risk of failure with $3.2 trillion in assets, or 41 times the bank assets estimated at risk by the FDIC.
  • $14.8 trillion in residential and commercial mortgages, $20.4 trillion in consumer and corporate debt, plus $2.7 trillion in municipal debts outstanding.
  • $180.3 trillion in notional value derivatives, of which one single institution — JPMorgan Chase — held $90 trillion, or 49.9% of the total U.S. market share.
  • $465 billion in credit exposure to derivatives, up 159% from one year earlier.

Today, less than three weeks later, it appears that many of these debts and bets are falling like a house of cards. Moreover, in retrospect, it appears that many of the efforts to support or sustain them may have been futile, wasteful, or both.

3. Government actions are too much, too soon for the debt markets.

In its Fiscal Year 2009 Mid-Session Review, Budget of the U.S. Government, the Office of Management and Budget (OMB) projected the 2009 U.S. federal deficit will rise to $482 billion, a major burden on U.S. debt markets. However, that OMB projection was made before the recent bailout commitments were known or even imagined.

Since then, the expenditures and liabilities announced or proposed by the U.S. government have easily exceeded $1 trillion.

However, for the world's debt markets — the primary source of federal government deficit financing — the expectation of exploding federal deficits is damaging confidence. It may even be one of the factors responsible for the global paralysis of short-term credit markets. And it may also be one of the reasons why, this past Friday, October 10, we witnessed the worst-ever collapse of high-yield corporate bonds.

4. Government bailouts could endanger government credit and credibility.

The credit market contagion has spread in phases:

  • In the mortgage sector, it was initially confined to subprime mortgages. Then it reached the mid-level Alt-A mortgages. And now it has affected prime mortgages.
  • In short-term credit markets, it was first restricted to commercial paper issued by weak financial institutions. Next, it spread to the short-term paper of stronger financial institutions. And now it has hurt nonfinancial paper as well.
  • In bonds, it began with the most speculative junk bonds, then reached middle-tier bonds, and now has impacted most corporate bonds of all stripes.

Each time, frightened investors sought the safety of government paper. And each time, this fear factor drove up government bond prices while driving down their interest rates.

This may be giving U.S. Treasury officials the false impression that they enjoy strong investor demand for government securities and easy access to funds for more handouts to near-bankrupt corporations. But this influx of money may also be obscuring a frightening prospect:

Governments could be the next victims.

To the degree that the authorities pursue the purchase of bad bank assets, or to the extent that they go forward with the injection of government capital into a collapsing banking system, they may become subject to the same contagion of mistrust.

I implore you: Please do everything in your power to help prevent that from happening. If the governments' heretofore stellar credit is sucked into this crisis, it could

  • make it much more expensive for governments to roll over their maturing debts;
  • make it difficult to raise the cash needed to maintain government operations; and
  • ironically, deprive authorities of the last weapon they have to help bring about a subsequent recovery: The credit and credibility of the world's leading governments.

5. Government actions could aggravate, or even cause, the systemic meltdown they are seeking to prevent.

Reason should dictate that governments should do everything possible to liquidate insolvent institutions, quarantine the weakest institutions, fortify the strongest, and insulate the government's own credit from the scourge. Instead, it seems that U.S. and European authorities are doing precisely the opposite. They are engineering

  • shotgun mergers that sweep bad assets under the carpet of otherwise stronger institutions;
  • bailouts that create zombie banks and corporations, weakening the system as a whole; and
  • new, bigger and unaffordable FDIC-type guarantees of bank deposits that further obscure the difference between worthy and unworthy banks.

The long-term, fundamental affect of these actions is widely known: They are corrosive. They cause far more losses and pain in the end.

What's not so widely recognized is that the short-term consequences could be equally catastrophic: By

  • combining bad assets with good assets,
  • merging weak banks with strong banks, and
  • confusing risk with safety,

the authorities are merely making it more difficult for millions of savers and investors to discriminate between each of the above.

The result: Instead of shifting from riskier banks to safer banks, many people are exiting the banking system entirely.

Inadvertently, the authorities could be transforming what should have been a shift within the system to a run on the system.

Instead of a harsh, but ultimately manageable, collapse of the weakest institutions, they could be leading us toward the systemic meltdown you warned about this weekend.

6. Governments are squandering scarce capital that will be needed for a true recovery after any collapse.

No one wants a collapse.

We all abhor the tremendous hardship it will inevitably cause — not just for the few who have the most to lose, but also for the many who have lost hope of anything to gain.

But a financial collapse, no matter how dramatic, is not the end of the world. We have endured many such collapses before and we survived. We can survive this one as well.

Today, it seems the relevant debate is no longer whether or not a financial collapse is preventable. The collapse is already here.

Rather, the main topics worthy of discussion are how big the collapse will be, how long it will last, and what we can do today to maximize the chances of a healthy recovery in the future. Below, I provide my view on each of these topics separately:

The size of the collapse is not within our power to control. We cannot repeal the law of gravity; we cannot stop investors from selling. Nor can we turn back the clock to reverse the financial sins already committed. One way or another, the bad debts have to be expunged. And the events of recent weeks are telling us that a deflationary debt collapse may be the mechanism.

The duration of the decline depends on its speed. To the degree that we let the debt liquidation process happen naturally and manage it wisely, it should be short, fast and behind us soon; to the degree that we stop it from happening and sweep the debts under the rug, it could be long, slow and more tortuous.

It's in the nature of the subsequent recovery that I feel you can have the greatest influence today. If you protect the credit of the financially sound institutions, they can be powerful resources to help bring about a recovery. However, if you prematurely squander our precious resources now, then any subsequent recovery is bound to be weakened and delayed.

I have four recommendations, as follows:

First, cut back the bailout and rescue efforts.

Second, protect the credit and credibility of sovereign government debts.

Third, preserve public resources for (a) emergency assistance to those that are rendered ill or destitute during a secular economic decline, and (b) carefully planned economic stimulus after a secular decline.

Fourth, foster an environment of public trust by guiding consumers to research that can help them better distinguish between low- and high-risk banks, insurance companies, and other financial institutions.

I know it will be very difficult. I realize millions of people must make great sacrifices. But with the right guidance and leadership, I am sure we'll be ready to step up to the challenge.

Sincerely,

Martin D. Weiss, Ph.D.

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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