Boom2Bust.com

U.S. Deficit, Debt Grows As Financial Crisis Heats Up

The financial crisis is burning one big fat hole in Uncle Sam’s wallet. From Bloomberg’s Matthew Benjamin today:

The global financial crisis is turning into a bigger drain on the U.S. federal budget than experts estimated two weeks ago, ballooning the deficit toward $2 trillion.

Bailouts of American International Group, Fannie Mae and Freddie Mac likely will be more expensive than expected. States are turning to Washington for fiscal help. The Federal Reserve said this week it will begin buying commercial paper, the short- term loans companies used to conduct day-to-day business, further increasing costs. And analysts now say the $700 billion bank- rescue plan passed by Congress last week may have to be significantly larger…

The 2009 budget deficit could be close to $2 trillion, or 12.5 percent of gross domestic product, more than twice the record of 6 percent set in 1983, according to David Greenlaw, Morgan Stanley’s chief economist. Two weeks ago, budget analysts said the measures might push deficit to as much as $1.5 trillion.

The Bloomberg reporter also brought up the issue of our national debt. Benjamin wrote:

Gross U.S. debt, which includes debt held by the public and by government agencies, this year reached about $9.6 trillion, or about 68 percent of gross domestic product. The rescue legislation increased the government’s debt limit to more than $11.3 trillion from $10.6 trillion.

Well, at least you can’t fault Congress for not planning ahead. Further exacerbating the problem with our nation’s finances, the Associated Press is reporting tonight:

Treasury Secretary Henry Paulson said Friday that the Bush administration will move ahead with a plan to buy stock in financial institutions.

Mr. Paulson said the program to purchase stock in financial institutions will be open to a broad array of institutions.

Ahead of the curve, Benjamin noted even before tonight’s announcement:

Meanwhile, Treasury Secretary Henry Paulson indicated two days ago that he is considering buying stakes in a wide range of banks in coming weeks to help recapitalize them.

Such a move is allowed under the $700 billion bailout package Congress passed last week. Edmund Phelps, winner of the 2006 Nobel Prize for economics and a professor at Columbia University, said such action is necessary — and will likely turn out to increase the measure’s cost…

The additional borrowing could push the national debt well past 70 percent of GDP, the highest since the immediate aftermath of World War II, when the U.S. was still paying off war debt.

In an attempt to illustrate just how out of control the debt is becoming, the Wall Street Journal’s Phil Izzo wrote in the “Real Time Economics Blog” yesterday:

The national debt clock, the unofficial tracker of the federal deficit maintained by the Durst Organization in New York, has reached its limits. Last month, as the national debt exceeded $10 trillion for the first time, the clock ran out of digits to record the number.

The dollar sign in the clock had to be deleted and replaced with a one to record the massive number. The clock’s owners say a new model — with space for two extra digits — will be in place early next year.

Now the debt clock will be able to reach the quadrillions. Hopefully, that’s not a level that will be breached any time soon.

Wow. I didn’t even know there was such a word as “quadrillions.”

I’ve given you a decision to make
Things to lose, things to take
Just as she’s about ready to cut it up
She says
Wait a minute honey I’m gonna add it up

-Violent Femmes, “Add It Up” (1982)

Sources:

“Cost of U.S. Crisis Action Grows, Along With Debt (Update1)”
Matthew Benjamin
Bloomberg, October 10, 2008

”U.S. Plans Bank Stakes”
Associated Press, October 10, 2008

“Sign of the Times: National Debt Clock Runs Out of Digits”
Phil Izzo
Wall Street Journal (Real Time Economics Blog), October 9, 2008

Second Stimulus Package May Include More Tax Rebates

As the economic boost from the first stimulus package wanes, Democrats are hoping to inject new life into the U.S. economy through a second stimulus package. The Washington Post’s Lori Montgomery wrote earlier today:

House Speaker Nancy Pelosi said yesterday that she may call lawmakers back to Washington after the Nov. 4 elections to put together a new federal spending package worth as much as $150 billion in hopes of stimulating the nation’s flagging economy.

“We have some very harsh decisions to make and some of them can’t wait until January,” Pelosi (D-Calif.) told reporters at a health clinic in Denver. “We may have to go back into session before the next Congress.”

Montgomery pointed out that the new stimulus plan may include more tax rebates. She wrote:

Last month, the House approved $60 billion in new federal spending on infrastructure, food stamps, extended unemployment benefits and aid to state governments struggling to avoid cuts in Medicaid coverage. The new package could include a second round of tax rebates in addition to those provisions, according to a senior Democratic aide.

The House bill was blocked in the Senate, which could take it up when it returns to Washington on Nov. 17.

Stay tuned, folks…

Source:

“Pelosi Talks Stimulus”
Lori Montgomery
Washington Post, October 9, 2008

Mystery Solved? Why Washington And Wall Street Are So Incompetent

Narcissism: Self-admiration or self-love; a tendency to over-estimate one’s abilities and importance

On October 3, award-winning Washington Post columnist Steven Pearlstein claimed that Wall Street’s incompetence, rather than greed, was behind the U.S. financial crisis. Unfortunately for Main Street, a new study shows that such incompetence may be a common trait not only among Wall-Street types, but government policymakers as well. From the MSNBC website yesterday:

Narcissists like to be in charge, so it stands to reason that a new study shows individuals who are overconfident about their abilities are most likely to step in as leaders, be they politicians or power brokers.

However, their initiative doesn’t mean they are the best leaders. The study also found narcissists don’t outperform others in leadership roles.

Narcissists tend to be egotistical types who exaggerate their talents and abilities, and lack empathy for others. The researchers stress that narcissism is not the same as high self-esteem.

“A person with high self-esteem is confident and charming, but they also have a caring component and they want to develop intimacy with others,” said lead researcher Amy Brunell, a psychologist at Ohio State University at Newark. “Narcissists have an inflated view of their talents and abilities and are all about themselves. They don’t care as much about others.”

She added, “It’s not surprising that narcissists become leaders. They like power, they are egotistical, and they are usually charming and extroverted. But the problem is, they don’t necessarily make better leaders.”

The results, which will be detailed in an upcoming issue of the journal Personality and Social Psychology Bulletin, come from three studies, two with students and the other with business managers.

According to MSNBC, narcissists are drawn to this country’s political and financial power centers. From yesterday’s peice:

“Many people have observed that it takes a narcissistic person to run for president of the United States,” Brunell said. “I would be surprised if any of the candidates who have run weren’t higher than average in narcissism.”

Wall Street traders could also have a high dose of narcissism, she suggested. “There have been a lot of studies that have found narcissistic leaders tend to have volatile and risky decision-making performance and can be ineffective and potentially destructive leaders.”

Brunell does hedge though, saying that not all troubles in Washington and Wall Street can be blamed on narcissists, and of course, you can’t boil everything down to personalities.

Maybe so, but I have a feeling some Americans would like to see a number of “personalities” boiled right about now…

Source:

“Narcissists more likely to be leaders”
MSNBC, October 8, 2008

Did Secretary Paulson Mislead President Bush On The Bailout?

Along with Fed Chairman Ben Bernanke, U.S. Treasury Secretary Henry Paulson has quickly become a household name in recent days. As one of President Bush’s top economic advisers, Paulson has helped spearhead the movement to rescue Wall Street and the financial system on behalf of Main Street and the U.S. economy. His efforts to date have resulted in the $700 billion bailout legislation that was signed into law by President Bush over the weekend. The bailout authorizes the Treasury Department to buy bad mortgages and other troubled securities associated with them from banks and other financial institutions. It is hoped that these purchases will allow credit to flow more freely throughout the financial system.

Earlier today, Dean Baker, an economist and co-director of the Washington, D.C.- based Center for Economic and Policy Research, questioned whether or not Secretary Paulson presented all the available options to the White House. He wrote in the Huffington Post:

According to the Washington Post, after the initial defeat of the bailout package in the House last Monday, Treasury Secretary Henry Paulson went to see President Bush in the White House. The Post reports that President Bush asked Paulson about “Plan B.” According to the Washington Post, Paulson told Bush “there is no Plan B.”

Of course this was not true. Paulson could have easily designed a bailout plan that was centered on the direct infusion of capital in the banking system, as was suggested by George Soros in a Financial Time column later in the week. Virtually every economist who has written on the bailout argued that a direct infusion of capital is a far more effective approach to dealing with the financial crisis than the approach outlined by Paulson.

Clearly Paulson had not invested a great deal of time in crafting the initial proposal he submitted to Congress since it was just three pages and few of the details of the plan had yet been decided. This means that Paulson easily could have switched gears and developed a plan along the lines advocated by economists.

Baker, who has been warning of an economic crisis for years now, added:

If the Post accurately described the meeting between Paulson and Bush (there is no source given for this account), then Secretary Paulson badly misled President Bush on the most important economic decision of his presidency.

Do you think it’s possible Hank Paulson may have had an ulterior motive when he allegedly told President Bush there was no other option available?

“If there is anything that a public servant hates to do it’s something for the public”

-Kin Hubbard (American humorist/writer. 1868-1930)

Source:

“Post Claims Paulson Misled Bush on Bailout”
Dean Baker
Huffington Post, October 6, 2008

The Week Of Financial Crisis

Now that it’s Monday morning, when I look back at the financial chaos that took place last week, one term in particular comes to mind…

“Hell in a handbasket”

And Dr. Prieur du Plessis, the chairman and principal holder of South African-based Plexus Asset Management, best summed up the week of financial crisis in Market Oracle (UK) yesterday when he wrote:

Whew – what a wild week! Global stock markets and commodities tumbled, whereas government bonds and the US dollar surged amid mounting fears that the ongoing turmoil in financial markets was foreshadowing a hard landing for the US and Europe.

The first-ever trillion-dollar loss (as measured by the Dow Jones Willshire 5000 Index) on Wall Street came on Monday in the wake of the US House of Representatives failing to gather enough votes to pass the $700 billion bank rescue package. Globally, more than $1.7 trillion got wiped off the MSCI World Index.

Considering the entire history of the Dow Jones Industrial Average since 1896, Monday’s decline of 777 points ranked as the largest points decline in history (see post “Fear Grips Global Markets”). However, and let’s be thankful for small mercies, the percentage decrease of 6.98% was still significantly less than 1987’s 22.61% decline.

Although the Senate’s passing of the bailout plan on Wednesday brought temporary relief, the reversal on Friday of the House’s earlier decision brought more volatility. In classic “buy on the rumor, sell on the news” fashion, the Dow Jones Industrial Index rallied by 3.0% leading up to the vote, but then sold off by a massive 486 points (4.5%) to end 1.5% down on the day and 7.3% lower on the week.

Already, this week is off to a bang-up start. As I type this, the Dow is off over 400 points this morning, while in Europe, the pan-European Dow Jones Stoxx 600 index posted its biggest one-day percentage loss ever on Monday (according to preliminary data). The index fell 7.6% to 241.57, surpassing the 6.21% fall recorded back on September 11, 2001.

Source:

“Fear Grips Stock Markets as Economies Tip Into Recession”
Prieur du Plessis
Market Oracle (UK), October 5, 2008

Gold Stars, Or The Gallows, For Congress?

So what do you think, Boom2Bust readers?

Did Congress do the right thing in passing the bailout legislation the second time around?

Let’s hear your opinions on this matter!

Ron Paul: Welcome To The Next Great Depression

Congressman Ron Paul warned his colleagues in the U.S. House of Representatives before they approved the bailout legislation:

By doing more mischief, by not allowing markets to adjust, debt to be liquidated, you’re going to guarantee a Depression…

YouTube Video Link

Even With Bailout, Talk Of Additional Intervention

Well, it’s official. The U.S. government bailout of Wall Street and the financial system is now law. From the Wall Street Journal’s Greg Hitt and Deborah Solomon today:

President George W. Bush signed into law an unprecedented $700 billion plan to rescue the U.S. financial system, one of the largest-ever government interventions in the nation’s economy — and almost certainly not the last.

The Treasury Department is expected to move quickly to start buying distressed assets from struggling financial institutions, although any impact might not be felt for some weeks. Many details — such as who will administer the program and how — are still to be worked out.

Even with the massive bailout, there is already talk of additional government intervention. Hitt and Solomon wrote:

It will likely be followed by other moves. The Federal Reserve could cut interest rates and take further steps to ensure there are enough funds coursing through the financial system. Congress has already beefed up jobless benefits and is expected next year to push for new stimulus efforts, such as spending on infrastructure.

Looking to next year, Democratic lawmakers are planning to revamp financial-system regulations, with hedge funds, private-equity funds and investment banks all likely to come in for tighter scrutiny. House Speaker Nancy Pelosi (D, Calif.) portrayed the legislation as “only the beginning” of the legislative response to the faltering economy…

“We will be back next year to do some serious surgery,” said House Financial Services Chairman Barney Frank (D., Mass.). Mr. Frank wants legislation to rewrite housing finance — including the roles of mortgage giants Fannie Mae and Freddie Mac – and overhaul regulation of financial services.

More intervention? Can’t wait…

Call me skeptical, but Congress has a habit of rendering things F.U.B.A.R. Speaker Pelosi may
want to pay heed to something one of her predecessors said many years ago:

One of the greatest delusions in the world is the hope that the evils in this world are to be cured by legislation.

-Thomas Reed, Speaker of the House of Representatives (1886)

Sources:

“Historic Bailout Passes As Economy Slips Further”
Greg Hitt, Deborah Solomon
Wall Street Journal, October 3, 2008

Second Bailout Proposal More Criminal Than First

If you thought the first bailout plan was a piece of garbage, the second one is one hell of a stinker.

Besides using American taxpayer money to pay for the handiwork of those greedy bastards that live among us, this new bill also takes care of executives’ golden parachutes, increases the deficit, and aids and abets Wall Street in cooking the books. Way to go Congress. The Founding Fathers are rolling in their graves. Even faster now.

From MarketWatch’s Greg Robb and Robert Schroeder last night:

The Senate approved a revised $700 billion U.S. plan to stabilize the financial industry and kick-start credit on Wednesday night, just two days after the House defied President Bush and leaders of both political parties to reject the original package.

By a vote of 74-25, senators authorized the Treasury secretary to buy bad assets from companies’ books, allowed the Federal Deposit Insurance Corp. to raise its deposit-insurance cap to $250,000 from $100,000, extended several tax breaks and required government agencies to modify troubled mortgages…

House Majority Leader Steny Hoyer said the House leadership will likely bring the bill to the floor on Friday.

I wouldn’t expect anything less. As most of us know, money talks on Capitol Hill. And Wall Street banks are anxious to receive their share of the plunder.

A lot of anger has been directed at executive compensation packages. Predictably, that issue won’t be addressed in the new bill. Robb and Schroeder noted:

Executive pay would also be limited in some cases under the bill, as would “golden parachutes” for some corporate chiefs.

Note the multiple use of “some.” The looting goes on.

Greg Hitt Sarah Lueck of the Wall Street Journal pointed out other problems with the “new and improved” bailout plan, such as deficit growth and accounting rule modifications. They wrote last night:

The 10-year, $150.5 billion package of tax proposals includes a measure to ease the bite of the alternative minimum tax, as well as research-and-development tax credits coveted by high-tech companies and drug makers. Its addition is designed to secure the support of Republicans, who were overwhelmingly opposed in the House. But it could irk conservative House Democrats because the measure will add to the deficit.

Add to the deficit? Bring it on, I’m sure the discredited followers of John Maynard Keynes are saying at this very moment.

The Journal reporters added:

The compromise bill represented a marriage of the rescue proposal with a host of measures designed to win the support of reluctant lawmakers. Additions include an increase in bank deposit insurance limits, a suggested change to accounting rules, and a $150.5 billion package of unrelated personal and corporate tax cuts.

And just what is this “suggested change” to accounting rules? Hitt and Lueck explained:

The bill also reaffirms the Securities and Exchange Commission’s authority to suspend so-called mark-to-market accounting, an issue that gained surprising traction among lawmakers looking for less costly alternatives to the Bush plan. The practice, adopted in the aftermath of the savings-and-loan collapse in the 1980s, pegs the value of assets to their current market price, rather than the price paid for them.

Banks have complained the strict application of mark-to-market rules have forced them to write down billions worth of mortgage-related securities for which there are no buyers, intensifying the squeeze in the credit markets.

Um, yeah, there’s a good reason why mark-to-market accounting was implemented after that other famous episode of financial greed in America. Joanna Ossinger of FOX Business wrote yesterday:

Mark-to-market, which is part of fair-value accounting, simply means that companies assigning values to assets they hold must value them at current market levels. If something is trading right around $10, it’s given a value of $10, regardless of whether it was bought for $2 or $20.

That sounds logical, right? The problem, though, and the reason M2M is getting so many opponents, is that the credit markets are in such a bind now that a lot of securities aren’t selling at all. So, technically, you might have a “market” of $0 for a security.

In effect, change the rules, assign fictitious values to securities, announce less write-downs… and pencil in some dates to look at property in The Hamptons and the latest Maserati to roll of the line in Italy.

I don’t know about you, but the suspension of mark-to-market accounting sure sounds like cooking the books to me. With the help of the U.S. government, no less.

We hang the petty thieves and appoint the great ones to public office.

-Aesop

Sources:

“Senate approves $700 billion financial rescue plan”
Greg Robb, Robert Schroeder
MarketWatch, October 2, 2008

“Senate Vote Gives Bailout Plan New Life”
Greg Hitt, Sarah Lueck
Wall Street Journal, October 2, 2008

“In Defense of Mark-to-Market Accounting”
Joanna Ossinger
FOX Business, October 1, 2008

U.S. Bailout Plan For Dummies

Obviously, there’s a lot of info on the proposed U.S. government bailout of the financial system circulating around cyberspace this Monday morning. Filtering out the noise, I tried to get at the nuts-and-bolts of what is being proposed in this post.

For those of you who prefer a short, multimedia-based breakdown of the bailout proposal, John Bussey of the Wall Street Journal talks about what’s at stake in a 3-minute MarketWatch video:

MarketWatch Video Link

For an in-depth, print-based explanation of the $700 billion scheme, this morning the Journal’s Deborah Solomon picked apart the proposed legislation and talked about its components:

The Troubled Asset Relief Fund:

The bill authorizes $700 billion for the fund in installments. Treasury will first get $250 billion, with an additional $100 billion immediately accessible. Congress would have the option of blocking the final installment of $350 billion by issuing a joint resolution within 15 days of any requests.

How it works:

Treasury plans to hire asset managers to determine how to buy bad loans and other ailing assets from financial institutions. Many of the details, including pricing and purchase procedures, will be worked out between those managers and Treasury. The legislation requires Treasury to set guidelines within 45 days for pricing methods and setting the value of troubled assets, as well as mechanisms for purchasing assets, procedures for selecting asset managers and criteria for identifying troubled assets to buy.

The legislation requires Treasury to purchase assets at the lowest price, and allows the government to buy through auction or direct from institutions.

Treasury expects to start buying the simplest assets first — mortgage-backed securities, for example — followed by more complex securities. Treasury likely will publish a list of the assets it is seeking to purchase. Banks and other institutions are expected to submit bids in a competition to sell bad loans and securities.

Executive compensation:

The legislation places restrictions on executive compensation for certain companies that sell assets to Treasury. If Treasury buys assets from a company directly — something it would do if a firm were failing — then no “golden parachute” exit payments could be made during the period when Treasury has an ownership stake in the firm. Companies that sell assets to Treasury through an auction process will be subject to some limits. Firms that sell more than $300 million of assets to Treasury won’t be allowed to make any new golden-parachute payments to top executives. A tax-deduction limit on compensation above $500,000 also will apply.

Equity stakes:

The legislation requires Treasury to receive warrants in companies that participate in the program. If a company sells its assets through an auction, Treasury will get a nominal amount of nonvoting warrants. If Treasury buys assets directly, it could get a majority equity stake.

Oversight:

The Troubled Asset Relief Fund will be overseen by a bipartisan congressional commission that will receive reports from Treasury every 30 days. The program will also be overseen by a board comprising the heads of Treasury, the Federal Reserve, the Securities and Exchange Commission, the Housing and Urban Development Department and the Federal Housing Finance Agency.

The office of accountability will have an inspector-general office within Treasury.

Treasury will have to submit a written report to Congress no later than April 30 on the overall financial regulatory system and “its effectiveness at overseeing the participants in the financial markets, including the over-the-counter swaps market and government-sponsored enterprises” and recommend improvements.

Protecting taxpayers:

If after five years the government has a net loss, the president will be required to submit a legislative proposal to seek reimbursement from the financial institutions that participated.

Help for homeowners:

Treasury will buy mortgage-backed securities, mortgages and other assets secured by residential real estate. The legislation requires Treasury to use its position as the investor in those loans and securities to “encourage the servicers of the underlying mortgages” to help minimize foreclosures.

It also calls for Treasury to “identify opportunities” to acquire “classes of troubled assets” that will improve the ability of Treasury to help modify and restructure loans. The idea is that Treasury would be more patient with homeowners who have fallen behind on their payments than commercial lenders.

Insurance:

The bill would require Treasury to establish, alongside the asset-purchase plan, a program to insure mortgage-backed securities. Financial institutions that want to participate would essentially pay the government a fee and, in return, the government would insure their assets against any future losses.

Accounting:

The legislation would require the Securities and Exchange Commission to study so-called mark-to-market accounting standards, which require that firms reflect the market value of assets on their books. Such accounting has culminated in many financial institutions writing down big losses as the value of certain assets has fallen in price. The SEC would have to study the accounting rule’s effect on balance sheets and report to Congress within 90 days of its findings.

The bailout legislation (in .pdf format) can be accessed here.

Sources:

MarketWatch Video
MarketWatch, September 28, 2008

“Shape of Massive Bailout Bill Starts to Develop Definition”
Deborah Solomon
Wall Street Journal, September 29, 2008

Quotes For The Week

This week, the QFTW (plural!) have to do with the looming government bailout of Wall Street and the financial system:

It’s astonishing, devastating, and very harmful for America and American citizens. It means we’re in for the worst recession since World War II, as well as higher long-term interest rates, higher inflation, higher taxes, a weaker dollar and substantially lower stock prices.

-Jim Rogers, legendary investor and CEO of Rogers Holdings, in the September 22, 2008, issue of the New York Sun

CBS News found 21 former staffers from the Senate Banking, Housing and Urban Affairs and House Financial Services Committees are now lobbyists for financial firms. Their job? To lobby those in Congress who will shape the financial bailout. The former staffers now represent hedge funds, private equity firms, investment banks and the failed mortgage giants Fannie Mae and Freddie Mac.

-CBS News, September 26 2008

The bottom line is the Democrats want to give this money to the banks because most of it’s going to go to the large New York city banks, and those folks are generous supporters of the National Democratic Party, senators and congressmen running for re-election, and Barack Obama.

-Peter Morici, University of Maryland business professor and multiple-time winner of MarketWatch’s “Forecaster of the Month” award, September 28, 2008

You have the former Chairman of Goldman Sachs asking for 700 billion dollars, and in his initial request, asking for it in such an un-American way that I think he should have resigned. I think Paulson has terminally misunderstood the nature of the American system. Not just no review, no judicial review, no congressional accountability. Give me 700 billion dollars, 700 BILLION dollars! I’ll be glad to spend it for you. That’s a centralization of power that is totally un-American.

-Newt Gingrich, former Speaker of the House on ABC’s “This Week with George Stephanopoulos” roundtable, September 28, 2008

Quote For The Week

From the office of U.S. Senator Jim Bunning (R-K.Y.) last week:

Bunning Declares The Free Market Dead

Washington, DC
Friday, September 19, 2008

U.S. Senator Jim Bunning today issued the following statement regarding the Treasury Department’s bailout of Wall Street.

“Instead of celebrating the Fourth of July next year Americans will be celebrating Bastille Day; the free market for all intents and purposes is dead in America,” said Bunning. “The action proposed today by the Treasury Department will take away the free market and institute socialism in America. The American taxpayer has been misled throughout this economic crisis. The government on all fronts has failed the American people miserably.

“My great grandchildren will be saddled with the estimated $1 trillion debt left in the wake of this proposal. We have gotten to this point because nobody has been minding the store. Both Secretary Paulson and Chairman Bernanke should be held accountable for their inaction – and now because of that inaction – the American taxpayer is left with bill.”

“We must take care of Main Street. Small businesses in Ashland, Bowling Green, and Paducah are hurting because of high taxes, and energy costs. Those small businesses are the economic engines that fuel our economy. I hope in the closing days of this Congress we can pass legislation to help those good people on Main Street rather than helping the power brokers on Wall Street.”

U.S. Economy Headed Towards Doom And Gloom?

This morning I came across two pieces which were notable in that they painted a gloomy picture for the U.S. economy going forward. Jonathan Burton of MarketWatch talked about TCW Group’s Jeffrey Gundlach’s economic outlook, and wrote:

An influential investment strategist has a dire forecast for U.S. stocks, credit markets and the continued independence of some of the nation’s top financial institutions.

Jeffrey Gundlach, chief investment officer at Los Angeles-based mutual-fund company TCW Group Inc., told clients on a conference call late Wednesday that the crisis in credit and housing may not abate for several years and is actually getting worse.

In the deteriorating climate he sees unfolding, Gundlach said, the Standard & Poor’s 500 Index could fall another 30%, giant Citigroup could become an “AIG-sized debacle,” Morgan Stanley would merge with a banking company, Wachovia won’t be able to stand alone, default rates on even prime mortgages could soar, and European banks’ woes are just beginning.

“This is no market for old men,” said Gundlach, who also manages TCW’s flagship Total Return Bond Fund . “This is no market for old-school thinking.”

Gundlach based his assessment on a belief that housing prices still face several more years of decline, a protracted slump, he said, not seen since the Great Depression. Moreover, Gundlach said it’s possible that home prices could be sluggish until 2022.

“If it’s like the Depression experience — and it sure is shaping up that way — it could take several years. Maybe we won’t see a bottom in home prices until 2014,” he said.

Burton talked about Gundlach’s credentials for making such statements. He wrote:

As a forecaster, Gundlach didn’t just climb aboard the gloom-and-doom wagon. He was early to spot the cracks that subprime loans were making in the financial system, and among the first to warn that an era of easy money would come to a bad end.

The MarketWatch reporter noted:

Expect loan default rates to rise, Gundlach said, not just in the subprime market, but among the top-drawer prime borrowers as well. The prime default rate could approach 10% from a current 2% before the carnage is over, he said…

Accordingly, financial institutions may suffer write-offs that could surpass $1 trillion before conditions improve, he said…

The breakdown will take a further toll on U.S. stocks, Gundlach added. The S&P 500 will tumble below 800, he said, about 35% below its 1156 close on Wednesday.

Said Gundlach: “None of us have ever seen this, and it’s no market for old men, but risk aversion is the order of the day.”

Someone else who sees massive problems ahead for the American economy is Harvard economic professor and former chief economist of the International Monetary Fund Kenneth Rogoff. He wrote on the Financial Times (UK) website last night:

Were the financial crisis to end today, the costs would be painful but manageable, roughly equivalent to the cost of another year in Iraq. Unfortunately, however, the financial crisis is far from over, and it is hard to imagine how the US government is going to succeed in creating a firewall against further contagion without spending five to 10 times more than it has already, that is, an amount closer to $1,000bn to $2,000bn.

In other words, $1 to $2 trillion. Rogoff continued:

True, the US Treasury and the Federal Reserve have done an admirable job over the past week in forcing the private sector to bear a share of the burden. By forcing the fourth largest investment bank, Lehman Brothers, into bankruptcy and Merrill Lynch into a distressed sale to Bank of America, they helped to facilitate a badly needed consolidation in the financial services sector. However, at this juncture, there is every possibility that the credit crisis will radiate out into corporate, consumer and municipal debt. Regardless of the Fed and Treasury’s most determined efforts, the political pressures for a much larger bail-out, and pressures from the continued volatility in financial markets, are going to be irresistible…

The Ivy League professor talked about the potential fallout from allocating so much money to deal with the escalating financial crisis. He wrote:

It may prove to be possible to fix the system for far less than $1,000bn- $2,000bn. The tough stance taken by regulators this past weekend with the investment banks Lehman and Merrill Lynch certainly helps.

Yet I fear that the American political system will ultimately drive the cost of saving the financial system well up into that higher territory.

A large expansion in debt will impose enormous fiscal costs on the US, ultimately hitting growth through a combination of higher taxes and lower spending. It will certainly make it harder for the US to maintain its military dominance, which has been one of the linchpins of the dollar.

The shrinking financial system will also undermine another central foundation of the strength of the US economy. And it is hard to see how the central bank will be able to resist a period of allowing elevated levels of inflation, as this offers a convenient way for the US to deflate the mounting cost of its private and public debts.

It is a very good thing that the rest of the world retains such confidence in America’s ability to manage its problems, otherwise the financial crisis would be far worse.

Let us hope the US political and regulatory response continues to inspire this optimism. Otherwise, sharply rising interest rates and a rapidly declining dollar could put the US in a bind that many emerging markets are all too familiar with.

A new banana republic?

Sources:

“The worst is yet to come”
Jonathan Burton
MarketWatch, September 18, 2008

“America will need a $1,000bn bail-out”
Kenneth Rogoff
Financial Times (UK), September 17, 2008

Bank Deposit Insurance Fund May Require Taxpayer Dollars

Marcy Gordon of the Associated Press reported yesterday that the insurance fund for protecting bank deposits has run into a bit of a problem. She wrote:

Banks are not the only ones struggling in the growing financial crisis. The fund established to insure their deposits is also feeling the pinch, and the taxpayer may be the lender of last resort.

The Federal Deposit Insurance Corp., whose insurance fund has slipped below the minimum target level set by Congress, could be forced to tap tax dollars through a Treasury Department loan if Washington Mutual Inc., the nation’s largest thrift, or another struggling rival fails, economists and industry analysts said Tuesday…

Eleven federally insured banks and thrifts have failed this year, including Pasadena, Calif.-based IndyMac Bank, by far the largest shut down by regulators. Additional failures of large banks or savings and loans companies seem likely, and that could overwhelm the FDIC’s insurance fund, said Brian Bethune, U.S. economist at consulting firm Global Insight.

“We’ve got a … retail bank run forming in this country,” said Christopher Whalen, senior vice president and managing director of Institutional Risk Analytics…

Gordon noted the FDIC has turned to the Treasury Department before. She wrote:

If the FDIC doesn’t have enough cash to cover the initial costs of a bank or thrift failure, one option would be short-term loans from the Treasury. That last happened in 1991-92, during the last part of the savings and loan crisis, when the FDIC borrowed $15.1 billion from the Treasury and repaid it with interest about a year later.

Source:

“Federal bank insurance fund dwindling”
Marcy Gordon
Associated Press, September 16, 2008