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Financial Black Holes Destroying Capital

Stock-Markets / Credit Crisis 2009 Jan 17, 2009 - 06:03 PM GMT

By: Money_and_Markets

Stock-Markets

Best Financial Markets Analysis ArticleMike Larson writes: When I was a kid, black holes fascinated me. The idea that you could have an area of space so massive … so dense … that it could suck in and absorb ANYTHING that got too close — even light — seemed ludicrous. Like pure science fiction. But they're real.

These days, black holes aren't so fascinating. But unfortunately, they are very, very real. And they keep popping up throughout the financial sector …


Bear Stearns. Lehman Brothers. AIG. Fannie Mae. Freddie Mac. Subprime residential mortgages. Alt-A loans. Conventional home loans. Commercial real estate loans. Student loans. Credit cards.

The Federal Reserve and Treasury Department keep coming up with new whiz-bang “solutions” to deal with these black holes. They keep opening up Washington's checkbook, allowing our tax dollars (or newly minted ones) to spiral toward their center.

But every time they do, another market or institution implodes somewhere else. Suddenly, there is a new, giant money-sucking black hole to focus on!

In fact,

I see three right now that are opening up — and that could torpedo the markets and the finances of our nation …

Black Hole #1 Federal Home Loan Banks following Fannie, Freddie, private banks over a cliff?

Unless you follow the banking industry closely, you probably haven't heard of the Federal Home Loan Banks. But the FHLBs are vitally important as a source of funding for U.S. banks both large and small. There are 12 of them spread around the country — in Atlanta, Boston, Chicago, Cincinnati, Dallas, Des Moines, Indianapolis, New York, Pittsburgh, San Francisco, Seattle, and Topeka.

You've probably never heard of Federal Home Loan Banks. But after the federal government, they're the biggest borrowers in the country!
You've probably never heard of Federal Home Loan Banks. But after the federal government, they're the biggest borrowers in the country!

FHLBs sell debt into the capital markets to raise money, using their AAA ratings to borrow cheaply. They use that money to make advances to banks that are members of the system and take collateral in exchange — often mortgages or mortgage-backed securities.

The banks use the money they get from the FHLB, along with cash raised elsewhere from their own debt sales and depositors, to make loans. The banks are required to own stock in the FHLBs, and that stock helps capitalize the regional FHLBs.

So what's the problem?

The FHLBs own billions and billions of dollars worth of mortgage backed securities. Those securities have plunged in value. So just like their banking customers, FHLBs are facing potentially huge write-downs on their portfolios. They may also be losing money on derivatives they employ.

And that's what is stressing the system.

Specifically:

  • The Seattle FHLB just warned that it may miss one of its capital targets. It may be barred from paying dividends on the stock member banks hold in it, potentially impacting those institutions counting on the money.
  • The San Francisco FHLB also said earlier this month that it was facing impairment charges, and that it wouldn't pay a fourth-quarter dividend as a result.
  • Moody's recently warned that eight out of the 12 FHLBs could ultimately face capital problems thanks to losses on their $76 billion of mortgage securities not backed by Fannie Mae and Freddie Mac.

Now here's where it gets really interesting: While many investors have never heard of the FHLBs, they collectively have roughly $1.25 trillion — with a “T” — in debt outstanding. That makes them the biggest borrowers in the U.S.— behind the federal government!

If you thought it was expensive to bail out Fannie Mae and Freddie Mac (The Treasury has pledged to inject up to $200 billion in capital into the two of them), just you wait. Should the FHLBs need a bailout, there's no telling how much it will cost!

In other words, we're looking into the maw of yet another gigantic black hole!

Black Hole #2Insurance industry's capital and surplus cushions are eroding fast …

It's not just the banks that are in trouble. The insurance industry is taking a pounding, too. Losses on residential mortgage securities, commercial real estate investments, and other holdings are hammering capital levels throughout the sector.

The insurers are also getting hit because they guaranteed minimum returns on variable annuities — and the market subsequently tanked.

Take the life insurance sector …

The industry's so-called statutory surplus, or difference between assets and liabilities — plunged 24%, or $76.8 billion, last year to $237.3 billion, according to research firm Conning & Co.

In an effort to rescue their collapsing balance sheets, some insurance firms are trying to get government bailout money by buying up teeny-tiny thrifts and banks.

For example, Lincoln National, an insurance firm with $173 billion in assets, is purchasing the miniscule Newton County Loan & Savings of Indiana (total assets: $7 million). That transaction could give Lincoln access to $3 billion in TARP assistance.

But that's mere peanuts compared to what the ultimate cost may be …

One estimate says the insurance industry may have to raise up to $50 billion in capital. Unless market conditions ease up, that kind of money just won't be available from private investors. And that means we're staring square in the face at yet another black hole— one that Washington is already being called upon to fill.

Black Hole #3Pension funding picture deteriorates dramatically …

Then there's the dismal picture for the nation's pension funds.

States, corporations, municipalities … they've all promised benefits to retirees based on assumptions about the returns for various asset classes. But those returns are being blown to smithereens, causing funding shortfalls of epic proportions.

The PBGC is $11 billion in the red. And with so many companies in bankruptcy, it may need a government bailout to rescue failed pension plans.
The PBGC is $11 billion in the red. And with so many companies in bankruptcy, it may need a government bailout to rescue failed pension plans.

The consulting firm Mercer recently estimated that the pension funds of big U.S. companies are underfunded to the tune of $409 BILLION! At the end of 2007, they were running a $60 billion surplus. That huge swing could drive up corporate borrowing costs and drive down corporate earnings.

It could also lead to reduced business investment as companies are forced to divert money from equipment and facilities budgets to their pension funds. Advisory firm Watson Wyatt recently estimated that U.S. corporations will have to boost pension fund contributions to $111.2 billion in 2009 from $50.5 billion last year.

Now it's true that the government-backed Pension Benefit Guaranty Corporation (PBGC) insures the basic benefits for more than 29,000 plans. But with so many companies falling into bankruptcy these days, it's increasingly likely the insurance premiums the PBGC receives won't be enough to cover its obligations.

The agency was already running a deficit of more than $11 billion as of September 30. And that number is poised to rocket higher.

Result: Yet ANOTHER black hole the government will have to fill somehow, either by bailing out the PBGC or bailing out corporations.

So at this point, I think it's reasonable to ask three simple questions …

  1. Can the government continue its policy of bailing out anyone and everyone?
  2. Can the Fed and Treasury afford to keep filling black hole after black hole, without a heck of a lot to show for it … except more black holes? Heck, even the black holes they thought they had filled are opening up again! Just look at Bank of America. The firm got a whopping $25 BILLION in bailout money several weeks ago, and now it's back in Washington begging for billions more!
  3. At what point are policymakers just going to have to give up and let more banks fail, more companies fail, and more asset markets trade down to where they are going to go anyway, rather than waste hundreds of billions of dollars trying to retard the process?

Some food for thought the next time you hear yet another speech out of Washington promising the sun, the moon, and the stars — if only we bail out (fill in the blank).

Until next time,

Mike

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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