Timothy Geithner’s plan to save the big banks will be a success. This success will come at a cost. The plan will hurt taxpayers, and it will lead to severe price inflation. It will not revive the faltering economy in 2009. It will not restore the housing market. Family wealth will continue to decline.
I worry a bit about my assessment. It is shared by Keynesian economists Paul Krugman and James Galbraith. Still, I am sticking to my guns.
Galbraith was unsparing in his criticisms. The Geithner plan gets toxic assets off the big banks’ books, but it does not make them any less toxic. Because the FDIC is insuring most of these assets against loss, the taxpayers will probably wind up paying the freight. You can see the two-part TV interview with him here.
Galbraith calls the banking system “massively corrupted.” I am in complete agreement.
The political issue was this, he says: “Which banks will go under?” The government does not want to face this fact: the large banks are the culprits. I agree completely. This is a big bank bailout.
Paul Krugman also gave his two cents’ worth. This appears on his blog on the New York Times (March 23).
Leave on one side the question of whether the Geithner plan is a good idea or not. One thing is clearly false in the way it’s being presented: administration officials keep saying that there’s no subsidy involved, that investors would share in the downside. That’s just wrong. Why? Because of the non-recourse loans, which reportedly will finance 85 percent of the asset purchases.
Non-recourse loans are what investors love. If the asset goes bad, the FDIC will pick up most of the tab.
Oh, say can you see, by the dawn’s early light? I hope the light is dawning for you.
Krugman in another column calls this a replay of Japan’s zombie banks of the 1990—2005 era.
The Obama administration is now completely wedded to the idea that there’s nothing fundamentally wrong with the financial system — that what we’re facing is the equivalent of a run on an essentially sound bank.
It’s not just the Administration that sees it this way. It was also mutual fund investors on Monday.
To this end the plan proposes to create funds in which private investors put in a small amount of their own money, and in return get large, non-recourse loans from the taxpayer, with which to buy bad — I mean misunderstood — assets. This is supposed to lead to fair prices because the funds will engage in competitive bidding.
But it is immediately obvious, if you think about it, that these funds will have skewed incentives. In effect, Treasury will be creating — deliberately! — the functional equivalent of Texas S&Ls in the 1980s: financial operations with very little capital but lots of government-guaranteed liabilities. For the private investors, this is an open invitation to play heads I win, tails the taxpayers lose. So sure, these investors will be ready to pay high prices for toxic waste. After all, the stuff might be worth something; and if it isn’t, that’s someone else’s problem.
That someone else, of course, is the taxpayer. The taxpayer will get nailed in this deal.
Krugman made this prediction: “I fear that when the plan fails, as it almost surely will, the administration will have shot its bolt: it won’t be able to come back to Congress for a plan that might actually work.”
This is one more move toward the nationalization of the capital markets. It is a way to postpone the day of reckoning. It is a way to let the FDIC get off the hook for bailing out a major bank. The FDIC prefers to swallow the hemlock later. The losses on the toxic assets, worst case, will be less than having to take over a large bank and administer the sale of that bank between Friday afternoon and Monday morning.
CHEERING THE DESTRUCTION OF THE DOLLAR
Unless American businesses reverse the present slide of profits, there will be no economic recovery.
Until there is economic recovery, the stock market will not be able to sustain its recent upward move, which has come only because the Federal Reserve last week promised to create $1.2 trillion in fiat money, and the Treasury has now promised to offer half a trillion dollars’ worth of leveraged grants if investors buy the banks’ toxic assets. If this isn’t enough money, it will later offer another half trillion.
How will the plan work? The banks will get off the hook 100%. This is the central fact. The FDIC will guarantee the packages of loans sold by banks. That means Congress will guarantee it. A bill introduced by Senate Banking Committee Chairman Christopher Dodd seeks a $500 billion line of credit from Congress. The FDIC will get what it asks in a crisis.
The FDIC will allow highly leveraged guarantees of up to 6 to 1. That takes most of the risk out of the deal for investors. Taxpayers will foot the bill if there are losses. Then these packages of loans will be auctioned off to investors. The investors can borrow up to 50% of their investment money from the Treasury. You think I’m exaggerating? Here is the official press release.
. . . To start the process, banks will decide which assets — usually a pool of loans — they would like to sell. The FDIC will conduct an analysis to determine the amount of funding it is willing to guarantee. Leverage will not exceed a 6-to-1 debt-to-equity ratio. Assets eligible for purchase will be determined by the participating banks, their primary regulators, the FDIC and Treasury. Financial institutions of all sizes will be eligible to sell assets.
Pools Are Auctioned Off to the Highest Bidder: The FDIC will conduct an auction for these pools of loans. The highest bidder will have access to the Public-Private Investment Program to fund 50 percent of the equity requirement of their purchase.
Financing Is Provided Through FDIC Guarantee: If the seller accepts the purchase price, the buyer would receive financing by issuing debt guaranteed by the FDIC. The FDIC-guaranteed debt would be collateralized by the purchased assets and the FDIC would receive a fee in return for its guarantee.
Private Sector Partners Manage the Assets: Once the assets have been sold, private fund managers will control and manage the assets until final liquidation, subject to strict FDIC oversight.
Investors on Monday cheered the prospects of the destruction of the dollar and the bankruptcy of the government. They drove up the Dow by almost 500 points.
The “new economics” of the Bernanke era (since September 2008) is based on one gigantic bailout after another, either by the Federal Reserve or the Treasury. It also rests on a perpetual bailout offered by the People’s Bank of China. The PBOC is expected to create new yuans (inflationary), use these newly created yuan to buy U.S. dollars, and then use these dollars to buy U.S. Treasury debt, enabling the Treasury to fund its rapidly escalating debt at T-bill interest rates no higher than 0.25% per annum.
How realistic are these assumptions? Not very. Yet they are the foundation of the investors’ recent hope of a new bull market in stocks.
The rise in the stock market has been based on short-run factors that will inevitably undermine the profitability of U.S. businesses. Businesses need a currency unit that is predictable. For long-term profitability, interest rates must reflect the underlying conditions of supply and demand: supply and demand for capital, not supply and demand for digits called money. Digits do not make workers more productive. Capital does. Capital must come from investors who forego consumption in order to lend money to businesses, or else provide capital through the purchase of shares.
EARNINGS ARE FALLING
In the fourth quarter of 2008, earnings (profits) for the S&P 500 went negative. This has not happened before. At least 400 of the 500 firms had losses.
For six quarters, the S&P 500 had declining earnings. The sixth quarter culminated in an actual loss.
“This is the worst; after the sixth quarter of negative growth, it will be the first quarter ever of negative earnings,” said Howard Silverblatt, senior index analyst, at Standard & Poor’s.
A sixth quarter of negative growth ties the prior record set when Harry Truman was president, running from the first quarter of 1951 to the second quarter of 1952.
“Next quarter, we’re expecting a new record of seven quarters of negative growth,” Silverblatt added.
Where is there legitimate hope of turning around this economy? Investors these days trust only the U.S. government.
The government must then decide what investments to make. Investments are usually defined by politicians as government spending on government-owned projects: roads, canals, and government buildings. Sometimes, a government welfare project is described as an investment.
The government can subsidize a limited segment of the economy. Today, almost all of the government’s bailout money is going to two sectors: the government-owned mortgage market and the banks that lent money on residential real estate. Despite the bailouts, the residential real estate market continues to decline. The commercial real estate market is now beginning to decline.
COMMERCIAL REAL ESTATE
Local banks have invested heavily in this sector of the economy. Before the end of 2009, the losses on commercial real estate will begin to catch up with the losses in residential real estate.
The National Association of Realtors, usually a source of optimistic reports, said in February that the outlook is grim.
The Commercial Leading Indicator for Brokerage Activity fell 6.0 percent to an index of 109.2 in the fourth quarter from a downwardly revised reading of 116.1 in the third quarter, and is 9.1 percent lower than an index of 120 in the fourth quarter of 2007. NAR’s track of the commercial leading indicator dates back to 1990.
The NAR report indicates declining real estate activity for at least six to nine more months. The NAR is not alone.
The Society of Industrial and Office Realtors®, in its SIOR Commercial Real Estate Index, a separate attitudinal survey of 644 local market experts, also expects a lower level of business activity in upcoming quarters. Ninety percent of respondents indicate leasing activity in their market is down, and vacancy rates are generally higher.
The SIOR index has declined for eight consecutive quarters and is 58.5 percentage points below the 100 point criteria that represents a balanced marketplace.
Losses in the job market are depressing commercial real estate. These losses show no sign of abating.
Vacancy rates in the office market are expected to approach 17%, up from a little over 13% in late 2008. Industrial vacancy rates are expected to exceed 12% in the third quarter, up from 10.7% in the third quarter of 2008. The retail market is also falling. Rents are expected to fall by 9% this year. They fell by 2% in 2008. This indicates contraction across the board.
The standard estimate for unemployment by the end of the year is 9%. Some forecasters, myself included, think it will exceed 10% in 2010. Unemployment creates fear in the minds of the still employed. They will move toward reduced spending on non-essential consumer goods. This will force retailers to cut back. The pressure on commercial real estate will accelerate in 2009. This will put additional pressure on commercial real estate.
DIGITS ARE NOT WEALTH
The bailouts are restoring the balance sheets of the big banks by taking bad debt off these balance sheets. These debts are being transferred to taxpayers. These are trillion-dollar subsidies to the largest banks.
Investors in stocks assume that these subsidies to the narrow financial sector will solve the problems facing the banks. This assumes that all of the bad loans have been registered. This is not the case. The fact that the worst of the subprime crisis is behind us is irrelevant. The re-sets of Alt-A mortgages and option adjustable rate mortgages will continue to escalate through 2011.
There will have to be additional purchases of toxic assets by the Treasury. The FED will have to exchange additional Treasury debt assets for bad mortgages if there is not going to be a replay of the last six months. One of the reasons why the FED is trying to push down 30-year mortgage rates by buying Freddie and Fannie debt ($500 billion) is to make possible the rollovers of the Alt-A mortgages and option adjustable mortgages. The problem will be the credit worthiness of the signers of these loans. Rates are low, but only for solvent home buyers.
If the bailouts continue, as they will, at some point these large banks will stop holding money as excess reserves at the Federal Reserve at 0%. The stock market is anticipating this. What it is not anticipating is a return of fractional reserve money multiplication. What seems good to stock investors — banks returning to lending — is in fact the engine of inflation.
The size of the FED’s asset base has more than doubled over the 12 months, from about $950 billion to over $2.2 trillion.
This does not count the additional $1.2 trillion dollars that Bernanke announced on March 18. This 3.6-to-one expansion of the monetary base will spread to M1 when banks finally start lending into the capital markets.
Just because the public has 3.6 times more money to spend does not mean that people will be 3.6 times richer. Bernanke has vowed that when the economy recovers, this $1.2 trillion increase of funds will be reversed. That would take the FED’s balance sheet back to $2.2 trillion: more than doubling the monetary base as of March 2008.
I think Galbraith is wrong about banks’ refusing to lend. I think they will lend as soon as the toxic assets are off their books. They will move assets from excess reserve category (0%) to a loan category, such as Treasury debt. When they do, the fractional reserve process will take over. The monetary base will be put to profitable use — profitable for the banks, disastrous for holders of dollars.
Americans have been set up for massive price inflation, all for the sake of bailing out Fannie and Freddie, two grossly mismanaged corporations, and bailing out the large banks that lent to companies that leveraged themselves 30-to-1 to profit from the real estate bubble created by the FED by way of Fannie and Freddie.
Digits are not wealth. More money in your bank account will not make you richer unless no one else has a comparable increase.
Wealth comes from deferred consumption. It does not come from increased consumption. The FED and the Treasury have subsidized consumption, not thrift. Theirs is an ersatz productivity, an illusion of wealth as reported by digits.
The response of the FED and the Treasury has been to increase the national debt, increase the issuing of fiat money, and swapping toxic assets for AAA-rated T-bills at face value. All of this has put at risk the solvency of the government, the stability of the dollar, and the economic futures of most Americans.
The people in charge of policy-making have some vague understanding of cause and effect in monetary theory. They are money-managers. Paulson was an ex-CEO of Goldman Sachs. Geithner got his start with Kissinger & Associates. He went to the Treasury late in Reagan’s second term. Then he went to the Council on Foreign Relations as a senior fellow. Then he went to the International Momentary Fund (IMF). Then he became President of the New York FED. It is not possible that he does not understand the implications of Federal Reserve monetary policy. He helped set this policy and execute it.
We can expect a continuing series of monetary and fiscal interventions as the mortgage market continues to deteriorate, as housing prices continue to fall, as the credit card debt market continues to become burdened with unpaid debt, as Asian central banks reduce their purchase of Treasury debt, and as corporate bonds begin to fall because of rising prices and therefore rising long-term interest rates.
The promise of $300 billion in FED purchases of 2-year to 10-year Treasury bonds did push down rates. The rate on 2-year bonds on March 17 was 1.05%. On March 20, it was .89%. The rate for 10-year bonds was at 3.02%. On March 20, it was 2.65. The reduction was less for 20-year and 30-year bonds. The FED’s promise to buy an extra $300 billion is marginal in a market that must roll over $11 trillion every three to four years.
The FED has one policy: inflation. The Treasury has one policy: deficits. The FED can dance with the Treasury by buying a portion of its deficit. I think the FED will buy an ever-increasing portion of this debt as it rolls over. The FED will try to keep down Treasury rates that would otherwise rise as a result of the departure of private investors from this market at today’s rates. This will not help corporate bonds, which will fall as a result of the FED’s selective subsidizing of the Treasury and the largest banks.
The bailouts serve as temporary subsidies for the stock market at every announcement. But then investors think through the implications of more fiat money and larger deficits. The stock market then falls back. The underlying pressure is downward because of falling earnings. The inflationary implications of the interlocked bailouts threaten the present structure of long-term interest rates.
Bailouts always come at the expense of the majority of taxpaying citizens. The FED and the Treasury can and do subsidize big banks. The biggest banks will be protected from bankruptcy by the existing political structure. But these narrow subsidies must be paid for. They will be paid for by four groups: those who buy and hold Treasury debt; those who buy and hold dollar-denominated assets; those who are dependent on fixed dollar income; and taxpayers in the higher brackets.
If you are a member of one or more of these groups, your future is at risk. Your dreams are being sacrificed by the money managers who enjoy operating in a nice cartel. They have gained the support of the senior decision-makers in the U.S. Treasury, which is staffed by representatives of the cartel.
Subsidies benefit those who are subsidized. The subsidies eventually result in repercussions in the broad economy that put at risk the economic recovery. Until the prices of capital assets in all stages of production are allowed to rise or fall in terms of stable money and the demand for capital, corporate earnings will remain low. They will fall. Falling earnings will undermine the bull market that investors hope for.
It is sad to see fund investors pour money short-term into the equity markets, despite the fact that corporate earnings have fallen and are expected to fall. The mutual fund market remains committed to the idea that investors can become rich by playing the greater-fool game. Expected future earnings are the basis of rational pricing of assets. If earnings fall, asset prices should also fall. Only a rising price/earnings ratio can keep this decline from happening. A rising price/earnings ratio was the essence of Greenspan’s stock market bubble, which ended in March 2000.
Are retirement fund investors willing to trust the FED to bring back the post-1991 stock market? Will they remain fully invested in stocks because they think that fiat money and the largest deficits in American history will bring back the NASDAQ’s P/E ratio in early 2000: 200 to 1?
Incredibly, if we use the TMT figure for earnings — twelve-month trailing earnings — the S&P 500 in today’s range will be 183 in the second quarter and 235 in the third.
I don’t think this is likely, which means either that reported earnings will rise dramatically or prices will fall dramatically.
March 25, 2009
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