September 24th, 2008 7:52 AM by Lehel Szucs
Uncle Sam's $700+ Billion Toxic Securities Fundby Gary D. HalbertSeptember 23, 2008
IN THIS ISSUE:
Details Of The Massive $700 Billion BailoutGovernment Guarantees Money Market FundsWill Congress Pass The Bailout Plan?Should The Government Bail Out Homeowners?Will Uncle Sam Overpay For The Assets?Credit Crisis May Tip The Election To ObamaTime To Prepare For A Recession Just AheadIntroduction By now, everyone reading this is well aware that the Bush Administration, the Treasury Department and the Federal Reserve Bank are pushing Congress to quickly approve a gargantuan $700+ billion bailout plan, with the hope of saving large banks, investment firms and other financial institutions that are overloaded with troubled mortgage-related securities.
This is by far the largest financial rescue plan ever envisioned on the part of the government, and I would argue, by far the most risky – both in terms of the potential losses for American taxpayers, and in terms of the sweeping, unchallengeable powers it would grant to the government. I will have more to say about the latter in the pages that follow.
Three questions emerge:
1) Is this massive bailout necessary?;
2) Is it the best way to solve the credit crisis?; and
3) Will it work? Unfortunately, the answer to all three is, we just don't know.
I believe that Treasury Secretary Paulson and Fed Chairman Bernanke were correct last week to fear that we were headed for a potentially serious run on banks and money market funds, starting possibly as early as this week, had the carnage in the markets continued. Whether you agree or disagree with the bailout, I think Paulson and Bernanke believed they had no other choice.
Of course, it remains to be seen if Congress will pass the colossal $700+ billion bailout this week as Bush, Paulson and Bernanke are urging. The stock markets that plunged lower early last week reversed their losses late in the week as rumors of the huge bailout package surfaced, culminating with the official announcement on Friday.
Yet on Monday of this week, the stock markets plunged again amid fears that Congress may not go along with the government's massive bailout plan. As this is written, it is impossible to know what will happen. But what is clear is that the US financial markets have frozen up, and if something significant isn't done soon, I believe we will be headed for a stock market crash and a serious recession or worse.
Finally, there will be millions of Americans who do not understand the dire implications of this financial meltdown, and will assume that this is just another massive bailout of the Wall Street rich by the Bush Administration and the Republicans (McCain included). Therefore, I expect this latest crisis and enormous bailout will likely hand the election to Barack Obama.
There are so many ramifications of this massive bailout that I don't even know where to start. But start we must, so here we go.
Details Of The Massive $700 Billion Bailout
We are told that the government's proposed $700 billion bailout may be structured along the lines of the Resolution Trust Corporation ("RTC") established in 1989 to liquidate the assets of failed Savings & Loans. But there is one distinct difference this time around. In 1989, the RTC was formed to take over assets of S&Ls that had already gone into bankruptcy. This time, should the massive Treasury bailout (or something like it) be passed, the government will be taking over toxic assets of financial institutions that still survive, but are at risk of failure due to the mortgage related securities they hold. Here are the details of the massive government bailout plan, at least as we know at this point.
Under the proposal (the "Act") submitted to Congress on Saturday, the Treasury Secretary would be authorized to purchase mortgage-related assets from any financial institution having its headquarters in the United States, totaling up to $700 billion at any given time. On Monday, the government expanded the bailout to include foreign corporations with "significant operations" in the US that bought mortgage related securities.
The term "mortgage-related assets" is defined in the Act as: "residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before September 17, 2008."
If the bailout passes in its proposed form, the Treasury Secretary would be authorized to take wide-sweeping actions at his sole discretion.
Such actions include: 1) designating financial institutions as "financial agents" of the government, and requiring them to perform duties related to the Act as the government may require of them; 2) creating agencies to carry out the bailout and appointing such employees as may be required to carry out the authorities in the Act and defining their duties; and 3) issuing such regulations and other guidance that may be necessary to carry out the authorities of the Act.
Such actions also include: The Secretary shall have authority to manage mortgage-related assets purchased under the Act, including revenues and portfolio risks. The Secretary may, at any time at his discretion, sell or enter into securities loans, repurchase transactions or other financial transactions in regard to any mortgage-related asset purchased under the Act.
In short, the Treasury Secretary would have complete control of how the massive bailout effort is undertaken. The Act states: "The Secretary may, at any time, exercise any rights received in connection with mortgage-related assets purchased under this Act."
The only requirement under the proposal sent to lawmakers on Saturday is that the Treasury Secretary must report to Congress within three months of the first exercise of the authority granted in the Act and only semi-annually thereafter. Wow! $700 billion, and you only have to report to Congress twice a year!! But that is not likely to stand.
Over the weekend, Democratic leaders discussed enhancing oversight by carving out a special monitoring role for the Government Accountability Office (GAO), the investigative arm of Congress. The Republican leadership echoed similar wishes for tougher scrutiny, suggesting the creation of a congressional oversight panel, headed by top leaders in both parties.
Oversight, or lack thereof not withstanding, there was another bombshell in the rescue package. The bailout proposal sent to Congress on Saturday states the following: "Decisions by the [Treasury] Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency."
This provision, if it stands, would mean that the Treasury bailout would be beyond the rule of law, both as it relates to the current Treasury Secretary and the next one appointed by McCain or Obama. Obviously, this provision was included to protect against potentially unlimited challenges in the courts which could stall or prohibit the rescue efforts. This is very troubling.
While the brief summary above is not comprehensive, it should give you an idea of the enormity of the latest massive plan to rescue financial institutions to the tune of at least $700 billion – actually much more as I will discuss later on.
We will continue our discussion of the bailout plan below, but first here's the latest on the money market fund developments.
I trust that virtually everyone reading this E-Letter has some assets in money market funds. As you probably know, the turmoil in the financial markets spilled over into the supposedly safe money market mutual funds last week. Last Tuesday, one of the oldest and largest institutional money market funds, the Reserve Primary Fund, announced that its share price had fallen below the $1.00 level to 97 cents. In financial terms, it "broke the buck."
The Reserve Primary Fund dipped below $1.00 as a result of the bankruptcy of Lehman Brothers. The Reserve Primary Fund, with over $62 billion in assets, announced last week that it owned $785 million in Lehman bonds, and that it was writing those bonds down to zero, which effectively caused its share price to break the buck. Redemptions were halted.
Also, last week Putnam Investments closed an institutional money market fund and said it will return money to clients, after investors pulled out cash despite the fund's lack of exposure to troubled financial firms such as Lehman.
To shore up investor confidence, the Treasury Department announced plans Friday to insure and guarantee US money market funds.
President Bush authorized the Treasury to tap up to $50 billion from a Depression-era fund to insure the holdings of eligible money market mutual funds. And the Federal Reserve announced it will expand its emergency lending program to help support the apprx. $3.5 trillion in assets in US money market funds.
The government guarantee will be in place for at least one year. Money market funds will pay a fee to be in the insurance program. So for now, at least, your money in money market funds is as safe as if it were in a FDIC insured bank. Note, however, that the Treasury pronouncement on the money market funds guarantee stated that the insurance only applies to money that was on deposit with such funds on or before September 19. Money deposited after September 19 is apparently not covered by the guarantee.
Now back to the $700 billion mortgage bailout.
As noted in the Introduction, the stock markets surged higher late last week as news of the massive bailout plan surfaced, reversing all or most of the huge losses incurred early last week. But then the nation had the weekend to think about the enormous bailout plan, and whether or not the Congress would go along with the gigantic intervention.
The House of Representatives and the Senate are both controlled by the Democrats. While I believe there is a sufficient sense of urgency regarding the passage of some kind of large bailout plan, I will not be surprised if the Democrats, along with some Republicans as well, will not approve the rescue package. I believe that is precisely why the stock markets tanked again on Monday.
As this is written, several prominent Democrats are insisting that such a bailout must be accompanied by increased regulation and oversight. Certainly everyone would agree that the regulation of our financial markets is sorely overdue for an overhaul. But as Treasury Secretary Paulson made clear over the weekend, he believes the funding of the huge bailout package needs to happen NOW, whereas the regulatory changes will take time to implement.
Over the weekend, Democrats and some Republicans also complained that the proposed $700 billion bailout does little to help homeowners that are struggling to make their mortgage payments. It is very possible that lawmakers will tack on additional hundreds of billions of dollars to the already enormous rescue package that would go directly to homeowners who may be facing foreclosure.
Some Democrats, including Barack Obama, are arguing that the rescue package must include restrictions on the compensation of corporate executives of companies that make use of the rescue program to unload toxic mortgage securities on the government. On Monday, even John McCain suggested that the top executives of companies seeking to participate in the bailout should not make more than $400,000 a year (no more than President Bush's salary).
Some Democrats, including Senators Chris Dodd (D-CN) and Chuck Schumer (D-NY), are pushing for more egregious changes in US bankruptcy laws regarding home foreclosures. The proposal that Dodd has sent to Treasury Secretary Paulson would let bankruptcy judges modify the mortgages of homeowners facing foreclosure to allow them to keep their homes. Judges rewriting existing mortgages so people can stay in their homes? This is scary!
Some Democrats, including Barack Obama, are arguing that the rescue package must include a second economic stimulus package of up to $100 billion, following the $160 billion sent out earlier this year.
Then there is always the risk that Congress will load the already huge bailout legislation with billions more in "earmarks." It would not surprise me if the final bill easily surpasses $1 trillion if it is actually passed, which is looking increasingly uncertain. In that case, one can only wonder if President Bush will sign it.
So, it remains to be seen if the massive bailout Act, or something like it, is passed or not. Based on the stock market plunge on Monday, and the rhetoric coming out of the Senate banking hearings this morning, I would say the odds are no better than 50/50 for passage. If that is the case, look for the stock markets to continue to tank. Something serious needs to happen soon.
As discussed above, many Democrats and some Republicans are arguing that, as a part of the government bailout, something should be done to help homeowners who are struggling to make their mortgage payments. In particular, many in Congress want to minimize the effect on homeowners who financed their homes with subprime and other non-traditional mortgages.
Never mind that many of these families should never have been given a mortgage due to their credit history or employment (or unemployment) situation in the first place. Most of us have heard the term NINJA loans: No Income, No Job or Assets. We also heard about the so-called LIAR loans where mortgage applicants purposely lied about their financial condition to buy a house.
Of course, in the spirit of political correctness, the government has now identified families who lied on their applications to get a mortgage as "victims." Thus, while many moan and groan about the lack of moral hazard in relation to the Wall Street bigwigs who wanted to make money, no one seems to want to hold individuals responsible for lying on their applications.
Instead, as John McCain ridiculously claimed last week, they were "forced" to take these mortgages. Give me a break! While many mortgage lenders were clearly too aggressive in offering home loans, no one forced borrowers to take out these loans. Let's get real.
It is clear now that the Democrats who run Congress are going to insist that additional billions be added to the bailout plan that will help out homeowners who are having a hard time making their mortgage payments, with little regard to whether they lied about their financial condition when they applied. If so, the bailout plan could be substantially higher than the $700 billion the Treasury asked for – if it is passed at all.
In fact, if we consider what has already been spent on the mortgage crisis, the total may be well above $1 trillion already, assuming that Congress passes the $700 billion rescue package this week, plus whatever amounts they add to it.
Treasury Secretary Paulson made the rounds on the Sunday talk shows, pushing the $700 billion bailout plan, and urging lawmakers to pass it this week before they adjourn. One thing Secretary Paulson did not make clear was how the government would value the mortgage-related assets that it would purchase from those wishing to participate in the program.
A Treasury pronouncement released on Saturday made the following statements about pricing: "Treasury will have authority to issue up to $700 billion of Treasury securities to finance the purchase of troubled assets… The timing and scale of any purchases will be at the discretion of Treasury and its agents, subject to this total cap. The price of assets purchases will be established through market mechanisms where possible, such as reverse auctions."
The problem is, there's no liquid market for subprime mortgages and other mortgage-backed securities that have dragged down banks and investment firms. With no trading in the assets, no one knows what they are worth now or might be worth in the future. They are being carried on institutions' books with values based on various indexes that are in some cases little more than guesses. And as those indexes have gone down, the institutions have recorded huge losses.
Furthermore, some of the instruments are complex, opaque derivatives tied to slices of other derivatives and financed by the sale of credit-default swaps to hedge funds and a variety of buyers. How do you price something like that? 80 cents on the dollar, 20 cents on the dollar, or somewhere in between? Who knows?
The government is, in some respects, constrained in driving a hard bargain because the whole point of the rescue program is to help banks get back on solid footing - not to force them into much deeper write-downs, potentially exacerbating their problems staying afloat. At the same time, the market turmoil has complicated efforts to determine the "real" value of the assets.
Obviously, it is too early for the Treasury to have all these details worked out. Suffice it to say that it will be a complicated process that will have serious implications, not only for the government and the holders of toxic debt, but also for the financial markets themselves.
Americans have grown increasingly nervous as the mortgage/credit crisis has unfolded this year. The failure of Wall Street financial giants like Bear Stearns, Lehman Brothers, Merrill Lynch, AIG and others has only heightened concerns among the public.
Add to that the significant stock market downturn over the last year, which has affected tens of millions of Americans' investment and retirement accounts. Until now, most people thought this credit problem was at least reasonably under control.
Yet, last Friday's announcement of a $700+ billion government bailout of the banks and financial institutions sent a shockwave not only to Americans but investors around the world. Few, if any, had an inkling that the number would be remotely that large, and now we know that the ultimate number could be much higher, well over $1 trillion. It was a startling revelation!
But here's the reason I now believe the massive bailout may gift the election to Obama. Millions of American voters will see the bailout as nothing more than another George Bush giveaway to his rich friends and cronies on Wall Street – at the taxpayers' expense. Many may believe that John McCain would do the same thing if he were president.
Many Americans will not understand the gravity of the current financial crisis which has the potential to trigger a global recession or worse. Many will not understand Secretary Paulson's plea to enact the bailout now and reform the system and pursue and prosecute the bad guys later.
John McCain and Barack Obama have been in a statistical dead-heat for the last several months, although Obama has been marginally ahead most of the time. McCain got a bump up following his selection of Sarah Palin and the GOP convention, but over the last week or so, Obama pulled back into the lead, marginally, in the national polls.
Because of the latest escalation in the credit crisis, and the gigantic $700+ billion bailout request, I expect that potentially millions of undecided voters will now opt to go for Barack Obama. Even some who had never before considered voting for Obama may be rethinking that decision in light of the latest developments.
A lot can change in the next 43 days to the election. Who knows what other financial surprises may await us between now and November 4? But if I were to have to bet today, I would sadly put my money on Obama to win by a comfortable margin.
I have made no secret that John McCain was not my first choice for the GOP presidential nominee. But I have also made it known that I would certainly prefer Senator McCain over Senator Obama by a long-shot. So, it is not easy for me to predict now that Obama will likely be our next president.
One last political point: the current financial crisis and the enormous $700+ billion government bailout virtually assure that, if elected: 1) Obama will not be able to push through his aggressive spending plans; and 2) McCain will not be able to push through any tax cuts. Realistically, the money for either of these proposals is no longer there.
In light of the credit crisis and the massive bailout plan, McCain is now hedging on his promise of tax cuts, realistically so. Obama on the other hand says his social spending programs, including nationalized health care, are "already paid for." How is that? By allowing the Bush tax cuts to expire (a tax increase) and raising taxes on those making over $250,000 a year. Yet Obama claims shamelessly that he will cut taxes for 95% of Americans. Never mind it's a lie.
On Friday, the Commerce Department will release its final report on 2Q Gross Domestic Product. In its previous estimate, 2Q GDP was 3.3%, well above most expectations. The pre-report estimate is that the government will raise that number to 3.4-3.5% on Friday. But in light of the deepening financial crisis, this week's final 2Q GDP report will be ignored.
While I have tended to be on the more optimistic side for the last several years as it pertains to the US economy, I am now turning bearish. I believe the events we have seen over the last two weeks will crush consumer confidence in the weeks and months ahead.
It seems clear that most consumers are angered and alarmed by the proposed massive $700+ billion bailout of financial institutions. They certainly are not comforted by it. Many are scared by the magnitude of the crisis. Virtually everyone knows who Merrill Lynch is - or was. Now it is gone as an independent American financial icon. People are realizing that we are in dangerous territory.
I predict we will see a significant slowdown in consumer spending for the balance of this year unless the financial markets stabilize quickly. Consumer spending accounts for over 70% of GDP. If I am correct, then we are headed for a recession.
The Index of Leading Economic Indicators fell 0.7% in July and 0.5% in August (latest data available). The Index has been down in three of the last four months. This suggests that economic growth slowed significantly in the 3Q. I will be surprised if economic growth doesn't fall into negative territory in the 4Q.
Much will depend on whether or not the mortgage bailout works.
Given the scope and magnitude of the recent mortgage-backed securities bailout proposed by the government, I think there are a number of conclusions that we can draw:
1. The massive mortgage bailout is unprecedented and extremely risky, but some kind of government intervention is most likely necessary in order to avert a global financial meltdown;
2. While the government is asking for $700 billion, we already know that the Fannie Mae, Freddie Mac and AIG bailouts transactions will push the combined cost to well over $1 trillion, plus whatever the Congress adds on, and you can bet there will be a major addition that will directed, rightly or wrongly, to struggling homeowners;
3. We are now past the issue of "moral hazard," in my opinion. We are now truly in a financial crisis that could easily spiral out of control very quickly. Something major needs to be done quickly, and there is no time for political games. People are on the verge of panic, and the stock markets may continue to plunge. Expect volatility to remain sky-high for a while longer.
4. I now believe this financial crisis will send us into a recession just ahead. While I have correctly been more optimistic than most of my peers in newsletter-land for the last several years, I am now turning bearish on the US economy. It now appears just a question of how deep it will be and how long it will last;
5. It remains to be seen just how deeply this financial crisis will affect the campaign rhetoric coming out of the two presidential contenders. Any thinking person can see that a $700 billion to $1 trillion bailout will severely restrict any politician's ability to cut taxes or increase social spending, but let's see if we hear any scaling back of such campaign promises; and
6. Finally, I now believe that the housing/financial crisis and the massive government bailout may hand the presidential election to Barack Obama in November. The general public does not fully understand the seriousness of the credit crisis, and will deem the massive bailout as just one more example of President Bush bailing out his rich cronies on Wall Street
The race between McCain and Obama has been neck-and-neck for several months, but Obama has pulled back into the lead following McCain's convention bounce. Barring something unusual, I expect the credit crisis and the bailout to send Obama increasingly ahead in the polls, with a win likely in November.
In fact, the latest polling data out this morning show Obama pulling decisively ahead in Colorado, ahead in Virginia and up to even in Ohio and North Carolina. McCain has to carry every one of these battleground states to win, yet they are now trending to Obama.
If this trend continues, it will be Obama, a Senator for less than three years, who will be in charge of solving the worst financial crisis in most of our lifetimes.
Sorry for a depressing E-Letter, but things are what they are.