The Insolvency of the US Financial System


(B) The US financial system does not have enough capital to cover its losses from the debt market in particular defaults of mortgages, trading of mortgages (mortgage-backed securities) and bets on mortgages (credit default swaps). Over the last year, the US financial markets have moved from a stage where too much liquidity into the system has generated highly leveraged balance sheets to a stage where balance sheets are now delivered and where capital is “insanely” needed to cover enormous and sudden losses.

This lack of capital of the current US financial system had led today the US Treasury Secretary Henry Paulson to propose a plan to buy up, in an extraordinary intervention into the capital markets, $700B in mortgage-related assets from failing US financial institutions in order for the overall financial system to work properly and as a consequence to further reduce the risk of a more severe US economic recession that has already caused a worldwide economic slow-down!

As Severe as The Great Depression of 1929

Initially started in the sub-prime lending market in the US, the present financial crisis has spread to the overall credit market and every segment of the financial markets worldwide. George Soros in his book “the credit crisis of 2008 and what it means” considered that “this is the first time since the Great Depression that the international financial system has come close to a genuine meltdown”. More specifically, in his September 2008 Investment Outlook, Bill Gross from PIMCO noted that the present average year to year decline of 10% in US housing prices, stocks and bonds of over 10% has never been really witnessed since the Great Depression.

Too Much Liquidity Led to Too Much and Too Fast Asset Appreciation

The excess in the supply of US dollars into the American economy over the last decade has contributed to the housing bubble that exploded in 2007.  Market liquidity has been expanded through debt securitization, that is funds formed from securities, with collateralized debt obligation (CDOs) instruments (CDOs are pools of obligations). By leveraging excessively their assets (Merrill Lynch the most leveraged investment banker in Wall Street, for instance, was using about $30B of equity as the foundation for $1T of assets), investment banks, private and hedge funds generated record revenues and profits from complex trading and derivative instruments in the credit market. Credit default swaps (CDS), the most utilized derivative instrument in the mortgage market exploded to more than $45T in 2007 (yes 45 trillion dollars!) according to the International Swaps and Derivatives Association. CDS are over-the-counter (OTC) derivatives (that is privately negotiated and not traded over an exchange) and so not regulated. This lack of regulation has contributed to their morphism and their growth. With a large supply of loans at low-interest rates, demand for real estate has inflated prices in particular in some areas of the country, creating a bubble. In the exuberance, loan underwriting standards fall in particular for subprime loans and accelerated the rapid rise in delinquent loans that caused the housing bubble to burst. This collapse of the subprime mortgage market and with it the CDOs in 2007 spread widely in 2008 to the overall credit and financial markets. Financial institutions and markets are interconnected in so many ways. Worldwide estimate of the losses in the credit market has ranged from $1 to $2T with roughly half of those losses in the United-States.

From Too Much Liquidity to Not Enough Liquidity

The collapse of the mortgage industry has led to large failures and write-downs for mortgage lenders such as IndyMac (which closed in July 2008), Countrywide Financial (acquired for $4B in January 2008 by Bank of America) and Washington Mutual (which put itself this week for sale). As a consequence, investment banks in particular Citigroup, Merrill Lynch, and Morgan Stanley took major write-downs from trading mortgage-backed securities and CDS in 2007. What is paradoxical is that the pendulum moved from too much liquidity from 2001 to 2006 to not enough liquidity in 2007 and 2008. Borrowing now in the financial markets is difficult. As a consequence, the Federal Reserve has flooded the credit market since January 2008 with new liquidity, lowering the Federal fund rate already three times this year down to 2.75%. Just this week, the Federal Reserve supplied $280B in the global credit markets but banks around the world are too frightened to lend to each other.

Undercapitalization Leads to Insolvency

Global financial institutions have to brutally deliver their balance sheets by writing downs credit default swaps from their balance sheets that they cannot sell. But without any new capital inflow, financial institutions have no choice than to proceed to asset sales that even lower market asset prices. And, since those assets are highly leveraged, the more they decline, the more margin calls they generate, leading to further declining asset pricing. And, this dangerous cycle goes on. The outcome of this painful process is that financial institutions are in “extreme” need of new capital. At the beginning of the crisis this year, investment banks were able to raise capital (Citigroup $12.5B, UBS $11.5B and Merrill Lynch $11.8B) from sovereign funds from Singapore, Kuwait, Saudi Arabi, Abu Dhabi, and Korea. But as the equity value of investment banks is shrinking more (see The New York Times: A Year of Heavy Losses), investments made by those sovereign funds in the US financial sector have lost money and have stopped. So, investment banks have to sell more assets through weird deals. Merrill Lynch sold $30.6B in CDOs for $6.7B to Lone Star, a private equity fund, while providing 75% of the financing for the purchase to Lone Star! Without being able to sell their distressed debt assets and without new capital inflows, financial institutions have to quickly shut their operations if they cannot sell their equity even at a low price. And, that’s how earlier this year, the US Federal Reserve and the Treasury Department orchestrated the rescue of Bear Stearns (too interconnected with other financial institutions to fail), from bankruptcy by JP Morgan Chase. And, why this week again, the US Federal Reserve and the Treasury Department provided an $85B bridge loan to AIG, that ensures $441B in CDOs including $58B in subprimes, until it can sell some of its profitable insurance assets. A worldwide insurer of $1B of assets could not go to chapter 11. While at the same time, Merrill Lynch sold itself for $50B to Bank of America and Lehman Brothers without support from the US Federal Reserve and US Treasury collapsed until Barclays purchased some of its US assets.

The Unthinkable Interventions of the US Government

According to Professor Robert Shiller from Yale University, the US housing market has already declined by more than 20% since its peak in 2006 and will likely decline more (See for more detailed information the Case-Shiller indices). Unfortunately, more foreclosures are expected in 2009 leading to more bank failures. With a rise in the number of troubled banks, the $45B Federal Deposit Insurance Fund (FDIC) set up to repay insured deposits at failed banks has been significantly drained. And in order to replenish her fund, Chairwoman Sheila Bair announced last August that she will likely borrow funds from the Treasury.

According to former Federal Reserve Chairman Alain Greenspan, many times interviewed by Maria Bartiromo on CNBC, “Fannie Mae and Freddy Mac was an economic fraud which socializes the losses and privatizes the gains and an accident waiting to happen”. Well, the accident occurred on September 7th when Treasury Secretary Henry Paulson nationalized both institutions responsible together for half of the country’s $12T in mortgages at a cost between $200 and $300B.

Earlier this year, Treasury Secretary Henry Paulson has many times announced that the US Government will ensure that the US capital markets run properly. With a lack of critical needed capital for the US financial system, the strong leadership of Paulson has led today to a more unthinkable intervention of the US Government: a plan to purchase $700B in mortgage-related assets from financial institutions based in the United-States that is likely to be significantly discussed politically and socially in the country for many weeks. If the plan is approved by the US Congress, the US Treasury can acquire illiquid mortgage-related assets from failing financial institutions, hold them and sell them knowing that those assets cannot be sold right away.

However, no one knows if this intervention of the US Treasury will suffice and if additional funds will not be required to restore the US financial system.

The Structural Weakening of the US Economy

The US is on an unsustainable long-term deficit course.

The present war in Iraq has already cost roughly a $1T (or $100B every 6 months) to the country. However, Professor Joseph Stiglitz from Columbia University estimates that the “total budgetary and economic cost” of the war will turn out to be around $3T. With the present US Treasury goal for a $700B intervention plan, the funding required for the nationalization of Fannie Mae and Freddy Mac and additional FDIC funding, the cost to the Treasury Department to provide the required capital to stop the collapse of the US financial system will likely be around $1T. The Federal budget deficit will rise to $3.1T in 2009. As a consequence, this will further weaken the US economy and the dollar which is not anymore the international reserve currency (sovereign funds are moving in particular to Asian currencies).

The US is the world’s biggest debtor nation with a national debt of $11.3T (including the new Treasury plan).

The present 2008 insolvency of the US financial system has been really unprecedented since the Great Depression.

The Great Depression was caused by the collapse of the banking system. So it is an urgency that worldwide financial markets operate with appropriate stability to support world economies. Although moving forward, the landscape of the financial system will be quite different with new regulations likely to come.

Note 1: Sources of an estimate of the losses of the credit market (that includes residential and commercial real estate debt, corporate debt and consumer credit debt): IMF:  $945B, , PIMCO: $1B, Goldman Sach: $1.2T, Professor Nouriel Roubini from NYU: $2T.

Note 2: Sources of an estimate of the nationalization of Fannie Mae and Freddy Mac. NYT: $200B, William Pole, former head of the St Louis Fed: $300B.

Note 3: Sources of an estimate of today’s increase of the Federal budget deficit: NYT: $3.1T.

Note 4: The picture above is New York Manhattan taken from Conny Island.

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Categories: Financial Markets