Download `Tis Only My Opinion

'Tis Only My Opinion!
August 2009 - Volume 29, Number 8
The Stimulus Report Card
The recession is world-wide.
Despite the 2008 Stimulus package enacted under George W. Bush or the 2009
Stimulus package enacted under Barrack Obama, the world economy as well as
the U.S. economy continues to wallow in recession. The industrialized nations
are sharing the brunt of the recession while the low-cost manufacturing nations
with trade surpluses as well as the largely third-world subsistence nations have
not been affected as significantly as shown in the following chart.
With the world in recession, it is not surprising that world GDP in 2009 will be
less than in 2008 and the drop in world savings will fall even more as energy
prices have fallen despite OPEC's attempts to control them. The following chart
provides some comparisons that might be expected.
During 2008, the U.S. trade deficit and the cash-based federal deficit was $1.04
trillion or approximately 75% of world savings. With the Obama Administration
projecting a federal deficit of $1.8 trillion although the trade deficit may fall to
$350 billion, world savings may only be about $800 billion.
The big problem is that as the U.S. Treasury has managed to lower interest
rates, the current $2.2 trillion twin deficits are almost 3 times world savings and
that is before considering the roll-over of currently outstanding Treasury
obligations. Goldman, Sachs has estimated that the total funding needs for the
U.S. is north of $3.2 trillion during 2009.
The question before the house is whether the dollar can hold its value and
interest rates can remain at historically low levels when faced with a funding gap
of this magnitude. I seriously doubt it. As I said in December, I would not be
surprised to see the U.S. dollar index below 70 by the end of the year and the
yield on the 10 year Treasury note about 6%.
Recent tax collections at the federal level as the recession continues solidifies my
conviction. The following chart from the AP on August 3rd illustrates the huge
drop in both personal and corporate income taxes this year.
Globalization only reduces U.S. standard of living.
Globalization continues to show that high-cost producers will be replaced by lowcost producers. Technology and service-oriented providers will not be able to
retain any competitive edge when the education systems in those countries are
not up to the standards of the low-cost producers. For example, for years, the
best students in Japan and China were taught in the U.S. Until about 1988, a
large portion of those students graduated and remained in the U.S. staffing
many of our high-technology jobs in science, engineering and medicine. A shift
by the U.S. on visa's saw an increasing number of those graduates returning to
their home countries to work and teach. Today, the top students in Japan and
China remain at home and those that attend the U.S. can not get in the top
Japan and Chinese schools.
Gross domestic product as estimated by the CIA for 2008 is shown in the
following chart. Clearly, the USA is the dominant player although the growth
rate of both China and India is higher. But it will take several years for China's
GDP to rival the US.
The Mandate for the Federal Reserve System
The Federal Reserve was founded in 1913 by Congress and given several
mandates which were used to justify its formation despite the wording contained
in the Constitution. The major ones were:
to counteract inflationary and deflationary movements
to create a higher level of employment
to maintain a stable dollar
to provide for economic growth
to increase consumption levels
During the time the Federal Reserve has been in existence, we have moved from
a dollar backed by gold and silver to a fiat currency. The inflation targets of the
Federal Reserve have caused the value of the U.S. dollar to fall substantially as
shown in the following chart as well as a tremendous increase in the stated cash
debt of the U.S.
As the value of the dollar has fallen, the outstanding stated cash debt of the U.S.
has increased exponentially.
It would appear that just based upon the above two charts, the Federal Reserve
System has failed to achieve its stable dollar mandate. For an organization to be
almost a century old and with this track record, should not Congress perhaps
decide to at least require an audit of the private organization. Inflation is an
insidious tax and the Federal Reserve System is largely responsible for it. Of
course, U.S. citizens often fail to understand the relationship between inflation
and purchasing power. As the world's reserve currency since Bretton Woods, the
U.S. has been in a very unique position of tapping foreign capital at a very low
apparent cost.
A major portion of the U.S. growth is simply the illusion of the inflation factor.
To understand purchasing power, we can use the following example. In 1970, I
purchased a Chevrolet pickup with four tires, a spare, an 8 foot bed, a V-8
engine and it held 3 people for $2,800. In 2007, I purchased a GMC crew-cab
pickup with four tires, a spare, a 6 foot bed, a V-8 engine and it held 5 people
for $36,000. From a pure utility value, the gas mileage was about the same and
the top speed was better in the 1970 pickup. Still both cars were essentially just
transportation.
The Financial Crisis - A Review
As we began 2007, there were some indications that the economy was beginning
to slow down. The following chart of the 1-month LIBOR-OIS spread illustrates
the major events that caused the Federal Reserve to panic.
Before we try to understand what happened, it might be useful to take a look at
the economy as of June 1, 2007 just before the two Bear, Stearns hedge funds
blew up by using charts to articulate the situation.
Interest rates for both 90 day T-Bills and 10 year Treasuries had climbed steadily
for almost two years as the Federal Reserve continued to increase its discount
rate. The rise had been much more pronounced in the short-term bills but the
longer note yields had also increased.
The following chart shows some of the changes in the 10 year note yield since
the Democrats took Congress in November 2006. In six months the yield on the
10 year note had increased 50 basis points and stood at the highest level since
August 2006.
The DJIA continued to move higher after a brief correction in February 2007 and
was making new record highs. However, the economy in the 1st Quarter of
2007 saw GDP growth fall to 0.6%, a worrisome sign given the stock market
level.
There were some analysts concerned over the reset of $ 1 trillion in adjustable
rate mortgages but in general, no recognized government official was raising
warnings in either Congress nor the Bush administration over the impending ARM
resets. Nor were the possible problems to be caused if counter-parties defaulted
on collateral default swaps a concern. Why did not everyone have insurance and
besides "those trillions of derivatives were not worth regulating" according to the
former Federal Reserve Chairman Alan Greenspan?
Derivatives had removed risk from the market
As of June 1st, the federal funds rate stood at 5.25% and the risk premium in
the market had all but disappeared as shown in the following chart. The market
was in an Alice in Wonderland phase.
It was a unique time in history ... declining GDP growth, interest yields nearly
level across the yield curve and markets near record high levels. Something was
about to cause reality to show up.
Bear Stearns can not save two small hedge funds.
The flash point for the financial crisis began when rumors about the viability of
two relatively small, highly-leveraged hedge funds managed by Bear Stearns
began in June 2007. The Bear Stearns funds purchased collateralized debt
obligations (CDO)'s of 'AAA' rated tranches of subprime, mortgage-backed
securities using leverage to increase the return. The funds then used credit
default swaps (CDS's) as insurance against movements in the credit markets.
The problem became that the credit markets began to destabilize when
delinquencies on mortgages began to increase. As leverage at the funds was
large, a small increase in the delinquency rate caused the funds to experience
large losses.
To help its High-Grade Structured Credit Fund, Bear Stearns provided in June
$1.6 billion to meet margin calls from the funds creditors. By July 17, both the
High-Grade Structured Fund had lost 90% or more of its value and another Bear
Stearns High-Grade Structured Credit Enhanced Leveraged Fund had lost
virtually all of its investors funds.
Moreover, the increasing losses in the funds caused the their creditors to
demand additional cash collateral for their loans, i.e., a margin call was made. It
soon became apparent that there was no ready buyer for these CDO's and the
value plummeted compounding the problem for not only Bear Stearns but also
other investment houses and hedge funds. Merrill, Lynch put the secured assets
up for auction and withdrew them three or four times in one day as the bids
were between 10 & 30% of face value and no-one wanted to discover what the
market-to-market value of these instruments were.
For it was a shell game. Using market-to-model accounting, both parties to a
transaction could use a different model to price these instruments and could thus
book a "profit on the transaction." Of course, elementary accounting debunks
this nonsense. The FASB adoption of "mark-to-market" accounting changed the
"mark-to-make-believe" world which many financial institutions were using to
generate profits on the securitized instruments.
On July 31, 2007, these two funds filed for Chapter 15 bankruptcy and the die
was cast. The effect of the collapse can be clearly seen in the following graph
slowing the collapse of the share prices of both Bear Stearns and Freddie Mac.
Fannie Mae would look almost the same.
The financial sector continued to struggle until in January 2008, the Federal
Reserve brokered a fire sale deal with JP Morgan Chase to acquire Bear Stearns
of $2/share whereas just a few month earlier, the stock was at $70/share. The
Bear shareholders began to raise major objections and threatened to expose
some of the problems influencing the JPM transaction and were ultimately given
$10/share at the closing. To close the transaction, the FED provided $30 billion
to acquire certain toxic assets of Bear Stearns and another $25 billion in
additional funding to JPM/Bear.
In a sweetheart transaction, Barclays was able to buy the profitable Bear Wagner
Specialists for only $30 million. Bear had bought Wagner for $625 million in
2001.
Although Congress investigated the transaction, no one was willing to state the
obvious. The real risk to the financial system was not the failure of Bear Stearns
but the fact that JPM was the counterparty to the majority of Bear's positions.
JPM could have failed if the deal did not close. One analyst feels that the
eventual cost to either the FED or the taxpayer in the Bear takeover is in excess
of $125 billion.
2008 - Don't forget the Bush Stimulus package
With the economy faltering, Congress sent the first stimulus package to George
W. Bush and he signed it on February 13, 2008. The focus was upon stimulating
individual spending and was billed as a tax rebate to individuals. It was designed
as a booster shot to an ailing economy. It provided a one-time tax rebate of up
to $600/individual taxpayer and $1,200 for couples, plus $300 for dependent
children. The White House expected 128 million American households to receive
checks beginning in May 2008.
The financial crisis escalates
2008
Sept 7
Sept 11
Sept 14
Sep 15
Sept 16
Sept 17
Sept 19
Major Event
Fannie Mae, Freddie Mac placed in conservatorship, putting a
liability of $5 trillion of mortgages facing the taxpayer.
Lehman Brothers shares drop 45% in a day as traders believe
that the company will fold.
Bank of America to buy Merrill Lynch for $29/share, or $50
billion, after turning down Lehman Brothers.
Lehman Brothers files for bankruptcy. Largest in U.S. history
at $639 billion.
The FED provides $85 billion to AIG as an emergency loan in
exchange for about 80% of AIG's equity.
Barclays' buys Lehman's North American Banking Division for
$250 million.
Bush Administration via Treasury Secretary Paulson and
Federal Reserve Chairman Bernanke asks Congress for broad
new powers to buy toxic debt and bad mortgages. Bill is
expected to cost billions.
Goldman Sachs and Morgan Stanley are approved by the FED
Sept 21 to become bank holding companies. The transition allows GS
and MS access to the FED's discount window.
Bernanke and Paulson testify before Congress. Bernanke
asserts, "If financial conditions fail to improve for a protracted
Sept 23
period, the implications for the broader economy could be quite
adverse."
Washington Mutual becomes largest savings and loan failure
with $307 billion in Assets. JP Morgan Chase agrees to pay
Sept 26
$1.9 billion for banking operations but does not take ownership
of the holding company.
Citigroup acquires Wachovia's banking operations in a deal
brokered by the FDIC for $2.1 billion in stock. Also, several
Sept 29
European banks are nationalized or infused with large amounts
of cash to prevent their bankruptcy.
Paulson ramrods TARP through Congress.
As the financial crisis failed to recede with the failures of IndyMac and the
conservatorship of both Fannie Mae & Freddie Mac, the failure to provide a
lifeline to Lehman Brothers (a major competitor of Goldman Sachs) saw the Bush
administration and particularly, the U.S. Treasury facing a major test. The credit
markets around the world were seizing up and the 1 month LIBOR-OIS spread
had begun to go parabolic. The commercial paper market was in dire straits and
had seized. When AIG went down, the financial system was in serious trouble.
Within days, Washington Mutual and Wachovia were on the ropes and Treasury
Secretary Paulson (a former Chairman of Goldman, Sachs) in September 2008
was asking Congress for $700 billion to be spent as he saw fit in a bill only 3
pages long. Entitled the Emergency Economic Stabilization Act of 2008 (or
TARP), the $700 billion was to purchase distressed assets, mortgage-backed
securities, and to make capital injections into both foreign and domestic banks.
Before Bush signed the bill, another $150 billion was added for unrelated pork
spending. Bush signed the law on October 3rd, 2008.
However, in just two weeks, Treasury Secretary Paulson announced that the
TARP program would be revamped and a $250 billion Capital Purchase Program
(CPP) would make direct capital infusions into primarily the money center banks.
The Paulson three page bill was now something much different.
Emergency Economic
Stabilization Act of 2008
Original Authorization for EESA, or
Amount in
billions
$700
TARP
Less: Capital Purchase Program
(CPP)
$250
Amount available for Distressed
Asset purchases
$450
Added: Congressional Pork Barrel
spending
$150
Total TARP authorization
when signed
$850
The estimated population of the U.S. as of July 1, 2008 was 304.059,074. Thus,
the EESA legislation amounted to a stimulus package of about $2,795 per capita
which was substantially greater than the first Bush stimulus package.
To avail themselves of access to the Treasury bailout, Goldman Sachs and
Morgan Stanley, two of the largest remaining investment banks and others
petitioned the Federal Reserve for conversion into national banks to qualify for
the bailout money. The move along with the easing of collateral rules on lending
by the FED in essence prevented the sudden collapse of both funds as their
funding model -- using short-term collateralized loans in the repo market -- had
become untenable. Goldman Sachs and Morgan Stanley were facing bankruptcy
as money market mutual funds (the primary supplier of short-term collateralized
loans) had broken the dollar and were now retreating to safer assets.
The Federal Reserve takes AIG
AIG problems were caused primarily by its writing of CDS swaps. It was the
largest writer of those instruments and Goldman Sachs was thought to be the
largest buyer of AIG CDS swaps. To save the financial system, Chairman Ben
Bernanke and Treasury Secretary Paulson decided that the Federal Reserve
System needed to take AIG over. Although there have been several hearings
about the problems at AIG, the acquisition of AIG by the FED was significantly
different than the conservatorship of both Fannie Mae & Freddie Mac. The
reason for this structural change has never fully been explained to the public in
any of the hearings and basically, has been downplayed by many in the press
and government.
It is my assertion that AIG was the largest writer of CDS swap positions held by
the banking system and other entities. You have to understand that the Federal
Reserve System is not a governmental organization but rather a private
institution controlled by bankers. By using AIG as a conduit, the Federal Reserve
System could protect the counter-parties to the CDS swaps and hide the true
loss picture caused by the securitization of the mortgage and credit card
markets.
By switching the toxic assets from the banks to the Federal Reserve System, the
problem is made to disappear in the public's mind. Coupled with increasing
pressure by Congress on the Financial Accounting Standards Board (FASB) to
revise FASB 157, the mark-to-market accounting rules, it was hoped that the
bankruptcy of the banking system would not create a banking panic. The
revised FASB 157 took effect on April 2, 2009. Several bank analysts speculated
that the revision of FASB 157 would increase bank profits by at least 20% and at
Citibank by more than 20%. The profitability of many banks were favorably
changed with the FASB 157 revision in the 2nd quarter of 2009. Once again,
illusions of price enabled the extent of the toxic assets to evaporate from
investor's minds.
The Federal Deposit Insurance Corporation also enters the
arena.
The FDIC as of the beginning of 2008 had reserves of approximately $55 billion
dollars to cover the losses which depositors might suffer if banks failed. As the
credit crisis at banks escalated in 2008, the FDIC requested Congress to
authorize on September 30, 2008 a temporary increase in its insured deposit
guarantee from $100,000 to $250,000. Little noticed by the press was the
announcement that it would also fully guarantee all non-interest bearing
accounts without limit. Supposedly, the FDIC insurance fund is replenished by
an assessment on the banking industry, not taxpayers.
By portraying the increase as temporary, the FDIC did not have to consider the
increase in the increased guarantee program or the TLGP as a liability of the
FDIC. Of course, the total exposure for the FDIC was only about $5 trillion and
the FDIC's capital base was by then less than $40 billion.
The FDIC also created the Temporary Liquidity Guarantee Program (TLGP) on
November 21, 2008. This program allowed the banking system to issued new
senior unsecured debt of banks, thrifts, and certain holding companies, and
provided full insurance coverage of non-interest bearing deposit transaction
accounts, regardless of dollar amount. Immediately, many major banks rushed
to market to take advantage of the program by selling bonds.
As we stand today, the FDIC insurance fund is less than $10 billion and the FDIC
has gone to Congress to receive authorization for a $500 billion line of credit
from the U.S. taxpayer. It would seem that there just might be some problems
still in the financial system. The FDIC is facing problems with the Colonial Bank
group of Florida which might cost it about $800 million and the possible seizure
of Guaranty Bank of Texas which could cost the fund $5.4 billion wiping out the
insurance fund.
The banking system crisis yet has to face substantial possible losses from falling
commercial real estate loans, increasing delinquencies in credit card loans and
educational loans. Perhaps, the FDIC is concerned that more problems exist in
the banking system as shown in the following two charts. Since December 2007,
the FDIC has reported that its "problem institutions" has increased from 76 to
305, or about four times during the fifteen months. However, the amount of
assets held by those "problem institutions" has increased more than 10 times.
The FDIC insurance fund has heretofore been financed by fees accessed on the
banking industry. In July 2009, the FDIC changed course and got Congress to
authorize $500 billion in taxpayer funds from the U.S. Treasury. At the moment,
Congress still has to appropriate the funds.
Directors of the NY Federal Reserve Bank
The bailouts of the banking system by the U.S. Treasury and the Federal Reserve
System reek of conflicts of interest. The largest recipients of bailout money sat
as directors of the New York Federal Reserve Bank. They were:
Stephen Freidman, Goldman Sachs Chairman
Jeffrey Immelt, General Electric Chairman
Jaime Dimon, JP Morgan Chase Chairman
Although the federal funds rate is supposedly set by the Federal Open Market
Committee (FOMC), remember that the entire Federal Reserve System is a
private organization run for the primary benefit of the banks. To suggest
otherwise is simply false. As the following chart shows, when the Bear Stearns
hedge funds blew up, the fed funds rate was at 5.25%. As the crisis worsened,
the FOMC began lowering the fed funds rate to the lowest level in history in an
effect to help banks make money.
As the FED pumped reserves into the banking system, it also initiated a new
policy of paying 2% interest on the excess reserves beginning October 1, 2008.
Banks were suddenly parking TARP funds. Banks had already begun increasing
the amount of their money on deposit with the Fed at the beginning of
September, up from about $10 billion total at the end of August, 2008, to $880
billion by the end of the second week of January, 2009. Little by little, the FED
was trying to rebuild the banking systems balance sheet. As the monetary base
was increased by the FED, the banks were not loaning money but putting the
funds back on deposit at the FED as excess reserves. The cost of the funds was
basically 0 and the spread was 2% ... not bad.
The 2008 Election
Barack Obama was elected as President of the U.S. as the economy faltered
replacing a Republican President Bush who had involved the country in two wars
and also presided over an economy that was in a financial crisis and with
increasing unemployment. The Obama campaign was based upon "transparency
in government", health care reform and no increase in taxes on those making
less than $250,000 per year. Obama was portrayed as a "change agent" and a
person who could unite the country which had become polarized further after the
Bush election over Al Gore in 2004.
The Obama Stimulus Bill #1
Signed into law shortly after Obama's inauguration, the Obama $787 billion
Stimulus package was expected to create or save 3.65 million jobs by the 4th
quarter of 2010. It was also said to mean that GDP would be 3-4% higher by
then. Also, it would lower the unemployment rate by 2% by mid-2010.
Now, of course, these expectations are very difficult to prove or refute since
there is no way that any rational person can project with certainty the events
that one course of action may or may not have in a random-event driven world
where Black Swans occasionally show up. Nevertheless, politicians of both
parties and economists routinely use forecasts to sway the opinion of a public
which continues to only make decisions upon sound bites.
The $787 billion stimulus package was passed by Congress without being read
by a single member and signed by Obama. It was over 1,000 pages long and
contained three major components as shown in the following charts from
recovery.gov.
Only a third of the stimulus will find its way into the economy in 2009. In 2010
which is an election year, the first stimulus package will generate the largest
amount of spending and about 25% of the $787 billion will not be spent until
2011 and beyond.
Stimulus costs and revenue shortfalls increase deficits.
But beside the stimulus plan costs, revenue from corporation and individual
income taxes were falling as we showed earlier and with overall federal spending
rising, the federal deficit on a 12 month moving average basis had exceeded $1
trillion for the first time in history by the end of the first quarter of 2009. By the
end of June, the deficit was over $1.427 trillion and headed higher.
However, the real problem is not the cash-based deficit but the GAAP deficit
which a study by the Dallas Federal Reserve Bank now believes put the total
GAAP deficit of the U.S. federal government in excess of $107 trillion.
Stimulus costs continue to increase
The first Bush stimulus was only $168 billion. The TARP program was initially
projected at $700 billion but saw $150 billion of pork barrel spending added.
When the FDIC increased the guaranteed deposit insurance levels along with the
FED's infusion of cash into various financial institutions and currency swaps with
other central banks, the total taxpayer exposure to the financial mess created by
the housing bubble and the monetization of mortgages had grown to over $17
trillion by June 2009. In mid July, TARP Inspector General Neil Barofsky
announced:
"total Federal exposure for all TARP "spending" had been leveraged
to $23.7 trillion, equal to approximately one and one half time U.S.
GDP."
Despite all the cash infusions into the market, the economy continues to lose
jobs and GDP remains negative despite major benchmark additions at the end of
the second quarter of 2009. Lending remains difficult to obtain for the small and
medium-sized businesses.
The Politicians and the FED are in a real bind.
The Obama administration is facing not only an increasingly hostile electorate
over health-care reform but burgeoning costs associated with it. The
Congressional Budget Office (CBO) has concluded that the initial cost estimates
are understated. The possible rationing of health care to seniors and the
eventual difficulty in obtaining any private health insurance if you are laid off or
change jobs has also helped anger the public.
The "cap and trade bill" will also increase the operating costs for not only every
U.S. business but also every individual.
Previous members of Congress purchased votes by making promises that can not
possibly be paid without bankrupting the country, i.e., Social Security, Medicare
and Medicaid. By focusing on cash-based accounting, politicians have been able
to hide the full extent of their vote-buying promises from the public.
The Obama programs on health care reform, cap & trade, and a possible second
stimulus package can only add to the $107 trillion of federal liabilities. It is
simply impossible for the nation to pay for the current unfunded liabilities
without destroying the U.S. dollar through hyper-inflation. Adding a second
Obama stimulus package will only reduce the time line for the destruction.
The 55% of the electorate that gets more back from the U.S. government than
they pay in taxes will not allow the necessary tax increases and benefit
reductions which must be made to begin to shrink the $107 trillion deficit in a
$13 trillion GDP economy. The math simply does not work and it becomes even
worse if interest rates return to historical median levels.
The Mid-Term Stimulus Report Card
To conclude, the Stimulus package has not materially benefited the economy.
The assertion by Bernanke and Paulson that failure to act would have caused a
financial system meltdown is a statement which can not be proven or disproven
by history. However, Rahm Emanuel's comments that "no crisis should go to
waste" clearly outlines the Democrat Party's decision to legislate for more federal
control over the economy for this country.
The mid-term report card is now ready as follows:
Group
Wall Street
Money Center
Banks
General Electric
Foreign Banks
Small/Medium
Banks
General
Motors/Chrysler
Taxpayer
Grade
A+ with
Distinction
A+
A
AD
D
F____D
There is one fundamental law that the politicians have not learned. You
can not borrow your way out of debt!
But then - 'Tis Only My Opinion!
Fred Richards
August 5, 2009
Corruptisima republica plurimae leges. [The more corrupt a republic, the more laws.] -Tacitus, Annals III 27
This issue of 'Tis Only My Opinion was copyrighted by Strategic Investing in 2009.
All rights reserved. Quotation with attribution is encouraged.
'Tis Only My Opinion is intended to provoke thinking, then dialogue among our readers.
'Tis Only My Opinion! Archive Menu
Last updated - December 13, 2008