What a Difference a Year Makes

“The troubles in the subprime sector seem unlikely to spill over to the broader economy.” Ben Bernanke, September 2007.

“I believe if the credit markets are not functioning, that jobs will be lost; the unemployment rate will rise; more houses will be foreclosed upon; GDP will contract; that the economy will just not be able to recover in a normal, healthy way, no matter what other policies are taken.” Ben Bernanke, September 2008.

Wow. The Fed Chairman is supposed to be the calm voice of reason. It’s his job to avoid using the “R” word until, of course, the National Bureau of Economic Research tells us after the fact that, yes indeed, we have been in recession.

But now, Dr. Bernanke has donned the Chicken Little costume for Halloween. Meanwhile, his counterpart at the Treasury Department, Hank Paulson, has been doing his best Hollywood impersonations.

A year ago, Hank was playing the Kevin Bacon role from the closing parade scene in Animal House, running through the streets amid the chaos, screaming, “All is well! All is well!”

Now, he’s playing Jerry McGuire: “Show me the money!!”

Paulson's bailout request should scare you. It scares me. Here's the Secretary of the Treasury asking for an amount greater than the combined budgets of the Departments of Defense, Education, and Health and Human Services, with broad executive powers as to how to deploy it. And, he's insisting on immunity - in other words, a provision that he can't be sued if anyone is harmed.

Why does someone ask for that provision in advance, unless they know what they're going to do is going to be very harmful?

Here’s what you, the average American, need to understand about the proposed bailout plan. First, we’ll look at what the plan – called the TARP, or Troubled Asset Repurchase Program, actually means. Then, we’ll look at what happens to the US economy with or without the TARP.

Everyone has seen the $700 billion figure bandied about. But what is the actual cost of the plan?

The $700 billion figure is what the government – read, the US taxpayer – can actually hold in “troubled assets” at any given point in time between now and the end of 2010, when the sun sets on Treasury’s TARP authority.

Bernanke testified before Congress that it’s important that the government not pay “fire sale” prices for this toxic crap on the balance sheets of banks, investment banks, and other financial firms. He said the government should be prepared to pay “as close to the ‘hold-to-maturity’ values as possible.”

These are accounting terms, related to Statement of Financial Accounting Standards (SFAS) 115. Under SFAS 115, if an institution classifies its securities as “held to maturity” (HTM), they can carry them on their books at historical cost, without marking them to market. (Marking to market means writing down – or up – the value of the securities to their current market value.) If the institution classifies the bonds as “available for sale” (AFS), they have to mark them to market, and take the difference between cost and current market value as an adjustment to their capital, or net worth. And if they classify them as “trading,” the mark-to-market adjustment flows through the income statement as well as capital.

A significant problem in the whole credit debacle has been that institutions have been valuing their securities above their true market value, because they don’t want the full mark-to-market adjustment to be reflected on their financial statements. Some of them have even shifted securities from AFS to HTM in order to not even have to show “unrealized” losses on their books. (An unrealized loss is a paper loss; it becomes realized when they sell their bonds, at which time the loss hits both income and capital.)

These institutions try to argue that the market values are nebulous, because these securities aren’t actually trading, so no one really knows what the market value is.

Folks, let me present two truths to you. First, these bonds are trading. I know; I see them trade every day. They may not trade in significant volumes, but they do trade. And the prices are well below where most institutions are carrying their investments. Simply put, they are overstating the value of their bonds. The market value of any investment is not historical cost, or what you say current book is, or even the discounted value of the cash flows.

It is, quite simply, what the next buyer will pay you for it.

And the fact that the next buyer is only willing to pay 20 to 30 cents on the dollar has nothing to do with panic, as the Administration and Congress would have you believe. The only people panicked are Paulson, Bernanke, Bush, the Congressional Democrats, and a few CEOs on Wall Street who may - and should - lose their jobs.

Second, they argue that the bonds have been performing; that is, they have been paying as scheduled.

The problem is, that’s not how these bonds trade. They trade on expectations of how the underlying collateral – subprime and Alt-A mortgages, in this case – will pay in the future. Subprime delinquencies are more than 25% at latest count, and Alt-A delinquencies are not far behind that. Even prime mortgages – those made to the most credit-worthy borrowers – are going delinquent at a rapidly accelerating rate.

The bonds backed by these loans are structured with credit enhancements designed to make the highest-rated classes of bonds less risky. But they only remain less risky as long as the supporting classes remain intact to protect them. Those support bonds, as they’re called, take the hit from defaults first, protecting the senior bonds. But the support is eroding at an alarming rate as defaults mount. Once the support bonds have been completely wiped out – which is happening even as we speak – the senior bonds are at risk of taking actual losses.

So while the bonds have been paying as scheduled thus far, the day is soon coming when they won’t. Hence the widespread ratings downgrades on those bonds, and the decimation of their values. The bottom line is that the market values you hear about – 20 to 30 cents on the dollar – are the truly reflective values of the bonds, based on their anticipated, not historical, cash flows. And that’s verified by the fact that they are trading in the market, and those are the prices at which they’re trading.

So, Bernanke is proposing that the Treasury pay something close to the HTM value – in other words, the historical cost, which is around 100 cents on the dollar, or par value – for these bonds. But they’re actually worth 20 to 30 cents on the dollar.

Let’s do the math. If the TARP provides that Treasury can only own $700 billion at any one time, this is how the plan will work. Treasury will buy $700 billion worth of bonds, paying – under Bernanke’s vision for the plan, and he’s basically dancing to Paulson’s tune – something near par. Then, they’ll sell them to private investors willing to buy them, at whatever price those investors are willing to pay.

Private investors aren’t stupid. They won’t pay more than the market value. In fact, when they know securities are going to be dumped on the market, they’ll pay less than market value. More sellers than buyers mean it’s a buyer’s market, and the prices get driven down. So in round one, let’s say Treasury is able to sell the $700 billion worth of bonds at 30 cents on the dollar. So they clear that initial inventory, incurring a loss of 70 cents on the dollar. On $700 billion worth of bonds, that’s a $490 billion loss.

Let us not forget that when we say “the Treasury,” we’re talking about the American taxpayer – you and me.

So, now the Treasury has freed up the $700 billion limit, and can buy the next round. Guess what? Given the fire-sale mentality that has at this point ensued, the selling price this time will be maybe 20 cents on the dollar. So Treasury clears the second round of inventory at an 80-cents-on-the-dollar loss. That’s a $560 billion loss.

Round three might bring a price of 15 cents on the dollar, producing a loss of 85 cents on the dollar, or $595 billion. Round four, maybe 10 cents on the dollar, for a loss of 90 cents on the dollar, or $630 billion.

So after four rounds, the Treasury has cleared $2.8 trillion worth of bad bonds from the books of banks and investment firms – including foreign banks, let’s not forget, because Paulson wants to bail them out too – at a net loss to the US taxpayer of $2.275 trillion.

And Paulson wants Treasury’s authority to foist this debacle on the US taxpayer for two years. And he wants Treasury indemnified from any possible lawsuits brought by anyone who might be “harmed” by these actions.

The bottom line is that this fiasco could wind up costing the US taxpayer trillions of dollars, without recourse through the normal legal process.

Now, let’s look at the impact on the economy, with or without the TARP.

I actually find myself agreeing with Ben Bernanke, for the first time ever, perhaps: if the TARP is not passed, jobs will be lost, GDP will contract, financial institutions will fail, and more homes will be in foreclosure.

But what Ben’s not telling you – and here, you should take note of the fact that while Ben was pooh-poohing the notion that the subprime malaise would spill over to the broader economy, both here and abroad, yours truly was warning of the worst economic environment since the Great Depression – is that all that will come to pass anyway.

The US economy has shed about a million jobs since the end of last year. And it will shed more. A number of financial institutions have failed this year – upwards of 12 at last count, including the most recent, Washington Mutual, which was the biggest bank failure in US history, plus IndyMac, Bear Stearns, Lehman Brothers, and Fannie Mae and Freddie Mac. And more are going to fail. After third quarter earnings are announced, we’re going to see a rash of failures. And the TARP won’t prevent that.

Part of the reason is that a number of the most troubled institutions won’t take part in the plan. Why? Because the last thing they want is price discovery, which Paulson promises the TARP will bring. They’ve moved their bonds into their HTM account, where they can mask the market losses. If the true market values are discovered, they’ll have to acknowledge their losses, and take the write-downs.

And the truth will then be revealed: they are insolvent.

So they’ll keep holding the crap, but no one in the market will lend to them, thus depriving them of desperately needed liquidity, because the other market participants know that the market values are far below the HTM value. So they’ll dry up and fail, as was the case with Bear and Lehman.

GDP is going to contract no matter what. It was barely positive in the fourth quarter of last year, and was only positive because the fourth quarter includes the all-important holiday shopping season. Last year’s holiday season started earlier than most years because Thanksgiving came early. So we got a nice bump in consumption in November. But spending then fell out of bed in December. If we measured GDP growth monthly, instead of quarterly, we’d find that GDP growth was positive in October and November, but negative in December.

In the first quarter of this year, GDP also barely grew. And the only thing that kept it in positive territory was inventory growth. That inventory growth resulted from the fact that businesses built up inventories in anticipation that domestic consumption would remain fairly healthy. It wasn’t, so the inventories they built up couldn’t be worked off. Had they accurately forecasted the sharp drop in domestic consumption, GDP would have contracted, which is the definition of recession.

In the second quarter, GDP grew by 3.3%. It was aided in part by a temporary boost to consumption resulting from the mailing of the stimulus checks. About half of the stimulus was saved, not spent. What was spent, was largely spent on gas and groceries, because inflation was through the roof. There was very little discretionary spending – you know, i-phones and the like.

The other boost to second quarter growth came from exports. We had an improvement in our bulging trade deficit, because the dollar was so weak that US goods were cheap, and foreign economies were still sufficiently strong that there was demand for our stuff.

Those temporary boosts to output growth won’t be repeated. The stimulus package was a one-time deal. (Unless Nancy Pelosi gets her wish; she announced Wednesday that she wants another round of stimulus checks. When I heard that, I told my wife that the government should just send a letter to all of those who make more than $120,000 a year, with the name and address of a taxpayer who makes less than that amount, so the former can just send the latter a check. My wife made the sage observation that at least those benefactors could send their beneficiaries a nice card along with their check.)

And the boost from trade is unlikely to be repeated as well. The economies of Britain, Japan, southern Europe and Australia are either contracting or near contraction. So foreign demand is down, and we’ll be selling less stuff to them. The dollar has rebounded of late – at least, it was until Paulson unveiled the TARP – relative to those countries’ currencies. So our stuff doesn’t look as cheap anymore. Combine that with reduced foreign demand, and exports shrink.

So third quarter GDP growth is likely to be negative. Fourth quarter GDP will almost surely be negative, as will growth in 2009.

More homes will also be foreclosed upon. They’re not talking about this much, but the TARP won’t bring relief to homeowners who are late on their mortgage payments. It is designed to only benefit banks that already hold mortgages and mortgage-backed bonds that are in default. Plus, delinquencies on Alt-A mortgages, prime mortgages, option ARMs, and credit cards, home equity lines, and auto loans held by those whose mortgage payments are delinquent and/or have lost their jobs, are rising fast.

The bottom line is that, even with the TARP, jobs will be lost, homes will be foreclosed on, and GDP will contract.

So what happens if the TARP gets killed? Credit will dry up. Banks won’t lend to each other, much less to you and me. So consumption and business investment will stall, driving us into a recession that is inevitable anyway. And many banks and other financial institutions will fail. Other businesses will, too, and thus jobs will be lost, exacerbating the recession. In that scenario, we’re in for a long and painful recession.

On the back side of that recession – as with all recessions – we will recover. People will have curtailed their huge appetite for credit. Household debt will decline from today’s record levels. The ratio of debt payments to disposable income will decline from today’s record levels. And savings will grow.

Savings are the true engine of growth, not consumption, contrary to the kool-aid we’ve all been served since the consumption craze began in the late ‘80s. At the beginning of every long-term, sustainable economic growth period our country has experienced since the 1920s, the savings rate has been around 8-10% of disposable income.

It’s been near zero for several years now.

Now, what about the scenario if the TARP gets passed?

We’re in recession anyway. Financial institutions will fail anyway. Jobs will be lost anyway. Consumption and GDP will contract anyway.

But, we’ll have provided short-term relief to the banking sector. Credit might not freeze entirely. However, that will come at the cost of adding trillions of dollars to the US debt. Our national debt is currently 82% of GDP. Within two years, if the TARP is passed, it could reach 95% or more.

How do we finance our debt? We sell Treasury securities – that is, we literally print money to sell to others to finance our spending.

Those others are increasingly outside our borders. Japan is the largest holder of US Treasury debt, followed by China. But Japan’s economy is now in contraction, and China has made increasing amounts of noise suggesting that it will stop buying our bonds and invest elsewhere – the Middle East, sub-Saharan Africa, etc.

Do you honestly believe that foreign countries will want to continue buying Treasury debt as we approach insolvency (defined as the point at which our national debt exceeds our output)?

No, they won’t. Not unless we pay them a higher return. That means Treasury rates go up. Treasury rates are the basis for all other interest rates, from the rates our corporations pay on the debt they issue to fund their operations, to the rates you and I pay for a mortgage.

So interest rates on everything will go up – into double-digits. We’ve enjoyed relatively low mortgage rates for a long time now. My first mortgage, which I took out in 1989, had a rate of 10.5%. My last refinance was at about half that. But we’ll go back to those pre-1990 levels. What will that do to homeownership?

Also, when we’re printing money to fund our operations – for individuals, companies and state, local and federal government – we create inflation. So inflation will also hit double digits, as the dollar tanks. And I don’t mean it tanks like it has over the last few years. I mean it seriously tanks, as in 1930s Germany, when people took wheelbarrows full of marks to the grocery store.

What happened in the wake of that crisis? Hitler came into power on the promise of restoring sovereignty to Germany. And we had World War II.

Here’s the truth, in a nutshell. Without the TARP, we face a long and difficult recession. That recession will be the piper we pay for the leveraged excesses of the past two decades. It will hurt. People will suffer. But we’ll emerge stronger, and poised for long-term, sustainable growth.

With the TARP, we’ll still face a long and difficult recession. But it will be exacerbated by a decimated dollar, creating an erosion of our purchasing power. Interest rates, inflation and tax rates – to fund the gargantuan deficits we’ll be running, deficits in the trillions of dollars – will soar. So will joblessness. The Depression will be a fond memory, a walk in the park.

Until some savior waltzes in and promises to fix it all, if we’ll just follow his or her lead. And we’ll be desperate for a savior, so we’ll fall in line. That savior will have to be strong enough economically to bail us out. The only truly strong economy right now is China’s.

Look, I love kung pao chicken as much as the next guy. But I love my freedoms more.

So write your Congressperson and your Senators today, before it’s too late. Tell them you’ll vote them right out of office if they vote for this thing. Our very sovereignty may depend on it.

As an aside, if the TARP passes, US Treasury debt may be downgraded.

Do you get that? The world’s traditional safe haven, the Treasury bill, note or bond, may lose its triple-A rating.

This is unprecedented in my lifetime. But it’s already been threatened by the agencies. They’ve become more trigger-happy of late, quickly downgrading bonds, after too many years of slapping triple-A ratings on subprime toxic waste. They’re even being criticized for acting too fast now, which is incredible, seeing how they screwed the pooch for so long.

Early this week, a client called my firm and asked to buy some T-bills. We went to execute the trade using one of our online trading systems. When we entered the order, the screen went blank. Then it read, “Expired.” We couldn’t execute the trade.

We called the dealers behind the systems. They wouldn’t sell the bills. They were hoarding them for themselves. We finally executed the trades with one dealer, but at a considerable discount to the rates shown on the screens. And these were rates that were already less than half of one percent.

These are uncharted waters. These are scary times. I’ve never seen conditions like this in my 20-plus years in the capital markets. I’ve never heard of them in the 80 years of market history that I’ve studied in-depth.

But in the course of those studies and that experience, I’ve been right more often than I’ve been wrong. I called the dot-com collapse, and I predicted then that stocks would trade sideways for a decade or more.

The S&P 500 today, almost nine years later, is below where it was then.

I called this recession 18 months ago, and I said it would be severe. Ben Bernanke missed it, Hank Paulson missed it, but I didn’t.

I don’t say this to toot my own horn. I say it hoping beyond hope that I’m wrong. I’m not prone to sensationalization. I’m not a Chicken Little type.

But I’m worried. I can live with a recession. I’ve survived several, and if you’re an adult reading this, so have you.

I just don’t know if we can survive the sacrifice of our sovereignty, both economic and political.