'Tis Only My Opinion!

October 2008 - Volume 28, Number 10

Plan B - Using Common Sense to solve the Financial Problem facing the U.S. Taxpayer

The Congress of the U.S. has passed and the President has signed the Paulson II bill which was rushed through Congress in order to "save the financial system from systemic failure."

Paulson I was sent to the House of Representatives as a three-page bill seeking $700 billion and it was defeated on September 29, 2008 as members reacted to the overwhelming rejection of the plan by their constituents.  Nevertheless, the Senate then took up the challenge to pass the bailout plan and after adding over 460 pages to the bill in just two days, another $150 billion, 2,600 earmarks totaling $6.6 billion as bribes to get members of Congress to vote in favor of Paulson II, it was passed by both Houses and signed by the President.

Warren Buffet, the sage of Omaha, Paul O'Neill, the former Chairman of Alcoa and Bush's first Secretary of the Treasury are in agreement with me that the $850 billion will not solve the financial markets problem  It is not a matter of liquidity, but of solvency and until credibility and trust are restored, the problem remains.

The derivatives market was considered to be "risk management" but somewhere those in the investment business forgot where the counter-party risk was and whether the counter-party could make good on the so-called insurance scheme.  The CDS derivative market is really a form of gambling.  "Insurance" contracts without the regulations imposed upon a legitimate insurance industry to guarantee payment when a Black Swan event occurs is simply gambling ... and with housing prices deteriorating, the Black Swan has appeared.

It is simply amazing to listen to the attempts by the Bush Administration to increase oversight of Fannie Mae and Freddie Mac earlier this decade and to see those attempts to be defeated strictly on party lines by members of the Democratic party who now attempt to blame the mess on the Bush Administration.

The stock, bond and commodity markets are cyclical by nature and there are various types of cycles which interact in the grand scheme of the world economy.  Basically, most economic cycles appear as shown in the following chart.

It should be obvious that members of Congress were in panic mode when they were stampeded into passing Paulson II.  The question for most investors is where we really are in the current bear market.  In a longer term sense, investors should also be wondering if we are entering the dreaded Kondratieff winter.

Thoughts on the World Economy

It should be obvious that the world economy is slowing down.  One proxy for world economic activity is the Baltic Dry Index which is shown below.

Clearly if trade is slowing, demand for shipping will also slow and the Baltic Dry Index has plummeted since June 2008.  Everywhere you look, China, India, Europe, the Middle East and South America, economic activity is slowing.

The U.S. Economy

Although the official reports have not declared that the U.S. economy is in a recession, John Williams of Shadow Government Statistics using the methodology from the 1980's rather than the constantly changing seasonal bias' and hedonic adjustments that are reflected in the official reports would suggest that the recession began several quarters ago.  The following chart shows both series.

With non-farm payrolls falling in September for the ninth straight month, it should be obvious even to the Conference Board economists that the economy is not firing on all cylinders. 

As I have often stated, we always make decisions under uncertainty ... but making decisions using bad data often makes bad decisions.  Moreover, when less than 2 out of 10 of our members of Congress have any practical business, technical and/or scientific backgrounds, the decisions tend to be made on the basis of getting re-elected rather than anything else.  Or as one commentator said a decade ago ... "Where are the Statesman?  All we have are short-sighted politicians."

Can the U.S. retain its AAA credit rating?

The U.S. as of September 30th had a stated cash debt of about $10 billion of which the public holds about $5.8 billion.  Of course, under GAAP, the U.S. has additional liabilities somewhere north of $70 trillion for unfunded liabilities including Social Security, Medicaid, Medicare, etc.  The debt rating of the U.S. is a crucial lynch-pin of the entire world-wide credit system as it also serves as the world's reserve currency.  During the past two years, however, we have seen significant challenges to that role.  

Let us look strength of the U.S. bonds and Federal Reserve currency through the eyes of a foreign banker and/or investor. In January 2002, the U.S. dollar index was over 120 and today it stands at 80, a decline of 40 points or a loss in purchasing power of about 33%. 

With the interest currently being paid on U.S. Treasuries well below rates on other sovereign bonds, a foreign holder is getting lower interest and could be facing further reduction in the dollar's purchasing power as U.S. currency deteriorates in value following the bailout.

The following table shows the U.S. debt from a foreign investors point of view.  It was sent to me on 9/14/2008 from a European banker.

The U.S. GDP for 2008 is about $13.4 trillion while the stated cash debt is $9.6 trillion representing 72% of GDP.  Foreign held debt is about 48% of public held debt.  However, with the U.S. Treasury and/or the Federal Reserve's takeover and guarantee of Freddie Mac, Fannie Mae, AIG, and the FED held paper, all of a sudden, the public held debt balloons from $5.4 trillion to $12.8 trillion and in the foreign mind, that is not worthy of a AAA rating.

The Shadow Banking System

For at least twenty years, the Federal Reserve has been trying to reduce the impact of the shadow banking system and within the last 90 days they have largely achieved their goal.  The old investment banks (Bear, Stearns, Merrill, and Lehman) are either gone or have become assimilated (Morgan, Stanley and Goldman Sachs) into the commercial banking system. 

The securitization of various mortgage paper tranches was the downfall of the shadow banking system as counter-party risk defaulted.  The growth of U.S. bank credit derivative exposures went well beyond reason as shown in the following two charts.  The hockey stick growth rate was clearly unsustainable.  In fact, the amount held by Wachovia and HSBC were relatively minor compared to that held by Citi, Bank America and JP Morgan Chase.  Could one expect that JPM Chase would not have a problem?

The takeover of Bear Stearns as orchestrated by the FED was probably more a desperate move to save JP Morgan Chase than anything else.  For Bear Stearns and JP Morgan Chase were intertwined in derivatives.  Take a good look at how much JP Morgan Chase got for "rescuing poor old Bear Stearns."  It was the risk of deleveraging at JP Morgan Chase that was the problem, not the squeeze on Bear Stearns.  The tremendous profits made on the Bear Stearns options should tell you that it was a transaction that had been well-thought out before it happened.

Beginning in March 2008, the repo pool began to increase greatly.  At the start of the month, the pool was roughly $170 billion but by month end, it had almost doubled as the problems in the banking system began to surface.  In September, it peaked near $500 billion.  But if the problem was really a liquidity problem and the FED can increase liquidity almost at will, why was $100 billion drained from the repo pool during the past two weeks while loans at the discount window soared?

Might it have been the FED's move to push the banking system further into financial crisis? Or to guarantee the bailout passage to hopefully enable the survival of the upcoming credit default swaps auctions in October?  Was the FED's takeover of AIG and the infusion of $85 billion necessary to prevent a loss of $20 billion at Goldman Sachs from its holdings of AIG paper?  Obviously, the decision of both Goldman Sachs and Morgan Stanley to become bank holding companies was credit driven because suddenly, they could feed at the discount window and were no longer limited by the TSF and TSLF facility.

The Balance Sheet of the Federal Reserve is Impaired

With all the moves of the FED since March 2008, the holdings of U.S. Treasuries has fallen significantly.  Through 9-11-2008, the differences are shown in the following chart.  During this period, the FED has swapped U.S. Treasury bonds for toxic waste at par materially affecting the quality of the collateral undermining their Federal Reserve Notes. 

As the supply of U.S. Treasury bonds fell and as the financial crisis deepened, the FED provided access to its discount window to not only commercial banks but investment banks.  Discount window lending has soared in recent weeks as shown in the following chart.

Since May 2008, bank reserves at the FED have gone negative.  The last time, bank reserves were negative was just before the bank holiday in 1933. 

To stay solvent, the U.S. Banking system had to borrow $250 billion since June.

The following chart shows how the FED's reserves have become increasingly toxic as they have swapped U.S. Treasuries for sub-prime debt beginning in December 2007.

As toxic waste replaced U.S. Securities on the FED's balance sheet, the FED increased the amount of FED credit outstanding as shown in the following chart.

As a result, the holdings of U.S. Treasuries as a percent of total FED credit has fallen dramatically since August 2007 as shown below.

When the oldest money market fund (Reserve Primary Fund) broke the buck by writing off $785 million of debt issued by bankrupt Lehman Brothers Holdings Inc., it started an exodus from those instruments as investors suddenly woke up to the fact that increased returns sometimes were driven by increased risks. Reserve Primary Fund shareholders pulled more than 60 percent of the fund's $64.8 billion in assets in the two days since Lehman folded. With the auction bond market still a problem from February, investors were now spooked by the inability to obtain funds from money market funds.

Assets in money market funds had risen in September to $3.59 trillion as investors sought to exit stock and commodity markets and place assets out of harm's way.  Withdrawals of money market funds rose to $120.5 billion in the week ending September 23.  Clearly, fear was increasing and to stem the tide of withdrawals, the U.S. Treasury announced that it would use $50 billion from the Exchange Stabilization Fund to guarantee losses in money market funds.

The Financial Crisis is deemed critical finally by Bernanke and Paulson.

Despite all their previous assurances of the past 18 months that the sub-prime situation was in hand, clearly their grasp of the situation was slow.  Nevertheless, in less than a few hours, Paulson crafted a document that would cost the taxpayer $700 billion and virtually make him the most powerful person in the U.S. with no oversight. Section 8 of Paulson I, in effect, allowed the U.S. Treasury to do anything it wants ... and without any supervision, recourse, or review by any agency, legislative body or court of law. Section 8 in Paulson I states:

Decisions by the 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.

The money market withdrawals and the upcoming Collateral Default Swap auctions in October were clearly putting pressure on Bernanke and Paulson to act.

Despite all of the toxic waste the FED has already eaten, the bailout bill proposes another $700 (excuse me, $850) billion to alleviate the financial mess.  The real problem is again not one of liquidity but solvency.

The commercial credit market remains in lock-down and until that is fixed, there is little hope of a major long-term change.  Asset-based financial paper has fallen from over $1.2 trillion in August 2007 to under $750 billion.  As a result, AT&T, GE and other Dow Jones stocks, let alone most others, are facing significant financing challenges.

To meet the pressures in the financial system since 9/11/2008, the FED has taken extraordinary and perhaps, unconstitutional steps in an effort to prevent systemic financial problems from overwhelming the fiat currency system.  A partial list of those actions follows:

•$185B to JPM for LEH clearings ($58B repaid)
•$621B for FNM & FRE
•FNM + FRE could reach $2.5T
•$274B for FHLB
•$90B for FHA
•$45B for FDIC
•$25B for TSF
•$50B for MM (ESF)
•$85B for AIG
•$380B for CB Swaps
•$500B-$3T for Bad Bank
•$145B + for FED

And now we have the $850 billion bailout to add to the list.  Paulson II also added many earmarks including these ...

•         $223M for Alaskan Fisherman

•         $192M for Rum Producers in Puerto Rico and the Virgin Islands

•         $128M for Auto Racing

•         $33M for companies operating in American Samoa

•         $10M for film & TV production

•         $6M for producers of Wooden Arrows

•         $2 million study of “hibernation genomics at the University of Alaska

•         $800,000 for the study of razor bumps to a St. Louis pharmaceutical company

•         $1.6 million for research on low-temperature vehicle performance at Wayne State University

•         $5 million for a sustainable-energy project for the Vermont National Guard

•         $1.75 million for a Presidio Heritage Center

•         $1 million for a Military Intelligence Service Historic Learning Center

•         $1.75 million for Expanding Access to Proven Lifestyle Modification Treatments Focused on Preventing and Reversing Chronic Diseases

The total bribery bill to get Paulson II passed was $6.6 billion and 2,200 earmarks to entice 13 members of the House of Representatives to change their votes against the overwhelming voices of their constituents.

In 1933, the nation was in a major banking crisis and depression. In an attempt to solve it, Roosevelt confiscated all the gold held by U.S. citizens at $20/ounce and then soon after revalued gold at $35/ounce.  The move effectively stole $15/ounce from those American citizens who held gold.  Today, the FED is using massive infusions of liquidity to accomplish the same fleecing of its citizens.

When, not if, the current bailout fails to restore confidence, what steps should we take to start the recovery.

A Common Sense Solution to Restoring Confidence

The following are steps that would begin to instill confidence in not only the financial system but also the democratic republic of the U.S. 


Chairman Ben Bernanke of the Federal Reserve and Secretary Hank Paulson of the U.S. Treasury should resign. 


Every Senator and Congress member that voted for Paulson II should resign because of incompetency.


The Federal Reserve System should be taken over by the U.S. Treasury.


The Treasury Secretary should have a business background other than Wall Street and have an extensive knowledge of both domestic and foreign politics.


Utilize the O'Neill plan to recapitalize the banks, i.e., issue Treasury bonds at 2% over prime which can be held as core capital.


Allow banks to hold assets to be held to maturity. These assets would be separate from trading assets subject to FASB 157 ... the mark to market regulation.


Rather than purchase distressed assets, set up a government fund to insure them against default at a fee to be paid by the holder of the distressed asset. Distressed assets held by foreign interests could purchase the insurance if they desire.


Reset all existing Adjustable Rate Mortgages (ARM's) to fixed 30-year mortgages at a 6% rate for all current ARM mortgages not currently in default.  The term would take into account the number of years already paid.


Revise the Community Reinvestment Act rules to reinstate good lending standards and eliminate sub-prime, Alt-A and no-doc loans.


The U.S. Treasury should issue greenbacks in lieu of Federal Reserve Notes and the exchange of greenback for FED notes be restricted to a narrow time window.  With a large portion of our currency held outside the U.S. territories, a large amount would not be redeemable for a variety of reasons.


Fannie Mae, Freddie Mac and Farmer Mac should be liquidated within two years.


AIG should be liquidated in the same time period.


Merge the Federal Home Loan Banks into the U.S. Treasury.


Reinstate the Glass-Steagall Act and require commercial banks to divest all investment and advisory activities.  Also restrict investment banks from borrowing from the U.S. Treasury.


Reduce concentration of total banking assets of the top 5 institutions to less than 12% of total banking assets. Currently, top 3 have over 22%.


Establish transparency in the derivative markets through public trading on an exchange.


Prohibit dark pools of capital trading outside of public view.  Trading of all publicly held securities must be on exchanges.


Reinstate the up-tick rule on short sales and require that failure to deliver share is subject to both civil and criminal penalties after the T-3 date. Naked shorting is prohibited on all stocks and not just on a selected few.


Audit the U.S. Gold reserve and value it at market including accounting for the seizures of gold reserves held by Japan and Germany at the end of WWII.


Adjust the FDIC limit on banking accounts for inflation since 1933 and index it for inflation every year.


Insist on GAAP accounting for all government agencies and unfunded liabilities including statements of U.S. government debt.  No of-balance sheet accounting to be allowed.


While I am sure that the steps enumerated above will generate considerable opposition, they will create a environment from which meaningful progress can be made towards improving confidence in the U.S.

Let's be honest, the market is unstable as market volatility is increasing.  The Paulson II bailout increases liquidity but fails to solve the solvency problem.  Until the Ministry of Truth starts reporting real data for CPI, PPI, and GDP, politicians will continue to make decisions on bad data which even in the best of situations, they will have little understanding of how the data is compiled and more importantly, what it really portends.

For several quarters, we are likely to see housing prices under pressure and a housing bottom fail to materialize.  As the Credit Default Swap auctions of distressed assets from Lehman, Fannie Mae, Freddie Mac and AIG takes center stage in October, the unwinding of the leveraged markets will continue. The CDS problem is the $65 trillion problem that Paulson II fails to address with anything other than a small band-aid.

In a world with between $50 - $55 trillion in GDP and over $1.3 quadtrillion in derivatives, the deleveraging of the credit markets is not going to look pretty under the best of circumstances. Warren Buffet called the CDS derivatives "weapons of financial mass destruction."  It will become evident in October 2008 that Mr. Buffet was not overstating the case.

What is absolutely needed are leaders that will make hard decisions ... until then, prudent investors should be cautious.

But then - 'Tis Only My Opinion!

Fred Richards
October 4, 2008

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 Adrich Corporation in 2008.
All rights reserved. Quotation with attribution is encouraged.
'Tis Only My Opinion is intended to provoke thinking, then dialogue among our readers.

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Last updated - September 18, 2008