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December 11th, 2008

THE RESTLESS MISCREANT: VERTIGO.

by Delbert Grady

Vertigo n. A disorder in which a person or his surroundings seem to whirl about in such a way as to make the person dizzy and usually sick.

Investment banks blowing up. Banks failing. Stock markets melting down. Millions (M) become billions (B) become trillions (T). Almost makes me feel like I was a cockeyed optimist in my previous economic articles (GUNS, BUTTER AND PIZZA – Spring 2006 issue, reprinted Fall 2008 and THE GREAT BOOMER BUST – Spring 2008 issue).

Trying to get a better handle on the diverse components of this Byzantine disaster, I’ve culled a pile of interesting facts from a wide variety of sources over the last few years, herewith submitted for your approval as Rod Serling used to say. (All figures approximate).

There is about $4.5T deposited in 8500 U.S. banks. The number of “troubled” banks jumped from 90 to 117 in the second quarter of 2008 and Bloomberg Markets estimates that 100 regional banks may fall next year costing the Federal Deposit Insurance Corp. (FDIC) $150B more than it actually has, and that doesn’t include potential losses on an additional $1.9T of deposits now covered due to the recent increase in coverage to $250K per account, up from $100K. The FDIC had only $45.2B on hand as of June after shelling out almost $9B for the IndyMac collapse.

Now to the subprime bailout: The International Monetary Fund (IMF) estimates that losses on subprime mortgages and mortgage derivatives known as collateralized debt obligations (CDO’s) could amount to $1.4T of which, to date, banks have written off less than half. Concerning the gigantic $700B Troubled Assets Relief Program (TARP) approved by Congress to purchase these problem mortgage assets from banks in order to stimulate new lending, the government will undoubtedly take on this “toxic waste” at much higher prices than true market value because otherwise it won’t do the banks any good. And in addition to the mortgage debt it is supposed to relieve, Treasury Secretary Hank Paulson, that attack dog of a man, seems to have successfully bullied Congress into providing himself authority to potentially cover credit card, auto and home equity loan losses as well should he see “systemic risk” in them (as a good ol’ boy from Goldman Sachs, he’s the proverbial fox guarding the hen house). All of this means, of course, that the prudent taxpayer picks up the tab for the profligate in virtually every financial area. And whether TARP works or not, it’s only a band-aid for all the other underlying problems out there. Let’s tote this up along with the other bailout costs so far:

BEAR STERNS (to J.P. Morgan Chase)………………………$29B
FANNIE MAE & FREDDIE MAC…………………………$200B
AIG(as of 11-10-2008)………………………………………$150B
TARP…………………………………………………………$700B
Additional Funding To The 9 Largest Banks…………………$125B
Additional Funding To Regional Banks………………………$125B
Conservative Projected FDIC 2009 Losses……………………$150B
TOTAL…(One Trillion 479 Billion)…………$1,479,000,000,000.00

Yes, folks, that’s almost a trillion and a half and certainly far from where it’s going before all is said and done. Of course, some of this money will eventually come back to the Treasury but, in the meantime, the government has to borrow it since we’re in serious deficit mode. And what happens if China et al., who have been supporting our spending sprees, decide they’ll just use all the dollars they have to support their own economies’ problems rather than loan them to us anymore?

Other mortgage monsters under the bed are Option ARM’s, Alt-A’s, Jumbos and 2nds, many of which will be resetting higher in the near future on homes already underwater (i.e. the principal left on the mortgage is greater than the current property value), further adding to the problem. Prof. Robert Shiller (of the Case-Shiller Housing Index) stated recently that currently there are approximately 10,000 foreclosures in the U.S. per day. At a current average house valuation of around $190,000, that works out to about another $700B/year for which a doubling of the existing TARP, at a minimum, will have to be provided down the road as an additional fix. Credit Suisse estimates that 13% of homeowners with mortgages could lose their homes. As of Spring 2008, 9% of all mortgages were past due or in foreclosure and 17% of all mortgage holders, or 8.8M, were underwater. The Economist estimates that the latter figure will rise to 14M if house prices fall another 10% (which seems like a gimme) and, if a lot of those people walk away it could, in turn, give the banks another $1T-2T in losses. And since nobody’s going to be getting funny-money mortgages any more, house prices won’t be able to stabilize until borrowers can afford 20% down with the loan principal limited to about 3 times household income. You can do the math on that one.

So much for the housing mess. What other punji traps lie ahead? Well, there’s the hedge fund and fund-of-hedge-funds problems raising their ugly heads as we speak. As of last year it was estimated by The Wall Street Journal that there were 6000-8000 U.S. hedges managing $1.5T in assets. There were redemptions of $43B in September (which figured prominently in the October market panic) and may be dwarfed by further large withdrawals in December – J.P. Morgan Chase has estimated $100B and I think that figure could be exceeded by a wide margin. (Hedge funds generally do not permit redemptions earlier than quarterly except funds-of-hedge-funds which offer monthly liquidity, thereby putting even more pressure on the others). And the hedgies have other serious problems going forward – severe reductions in leverage due to the unwinding of the “carry trade” (borrowing currencies at low interest rates to invest in higher-yielding instruments) at the same time banks and prime brokers have shut off the easy-loan spigot and, most disturbing, the looming credit default swaps (CDS’s) disaster which will be discussed shortly.

Then there’s the budget deficit which will continue to be hammered via more bailouts, serious entitlement program shortages and major reductions in tax revenue due to the collapsing economy. In 2007, 40% of American business profits came from the financial sector, now in serious trouble; taxes it pays will decline substantially. Job losses are now hitting 250,000/month with new jobless claims crowding 500,000/week, and numerous states are starting to run out of funds to pay those claims guaranteeing further strains on the Treasury in the near future. Just for the record, the gap between U.S. future expenses vs. tax receipts has been calculated to be negative $63.3T (that’s right, 4+ times current GNP) and will undoubtedly grow much worse as time goes on.

Let’s not, of course, forget the beleaguered and bewildered American consumer who is now virtually tapped out, and therefore credit unworthy, just at the time when the banks are broke, too, and getting broker. So, like previously indulgent parents who finally realized that their children spent a little too much at the fair, banks are cutting back “allowances” (credit lines) while continuing to collect exorbitant interest and fees on existing credit card debt which, due to the recent bankruptcy law changes, virtually guarantees that the consumer will be harnessed to the wheel for the foreseeable future. (Julie Williams, Chief Counsel of the Comptroller of the Currency, remarked in a 2005 speech that the banks don’t even want full repayment any more, just a “perpetually earning asset”). In 1980, household debt was 50%of GDP; in 2006 it was 100%. Household debt to disposable income was 100% in 2002, now it’s 140%.

And what of pensions? It seems that public employee pension funds across the land are about $700B in the red. As well as happening to be the same incredible amount being given to banks via TARP, it also happens to be, believe it or not, the total of all combined property, sales and corporate taxes collected by every state and local government in the U.S. in 2004. And just to make the cheese more binding, the Pension BenefitGuaranty Corp. (PBGC), the government agency charged with making up for non-government pensions lost when companies go broke, is $23.5B short now and projected to be in far worse shape as more businesses declare bankruptcy.

Not to be ignored either is the international banking situation. In the U.S., the Federal Reserve and Treasury seem big enough to corral the various damages, at least for now. But what about, for instance, UBS, a Swiss Corporation? It’s the world’s biggest wealth manager, and certainly “too big to fail”, at $2.7T. Since the Swiss Treasury would be too small to save it if there were a run, what then? (They’ve already given shore-up funds to UBS and the Swiss franc keeps working lower, possibly more than just a coincidence). A smaller but significant situation occurred in Iceland recently when its 3 major banks were nationalized after being unable to cover their debts of $61B, more than 4 times Iceland’s GDP. Iceland, in turn, became insolvent and has been being bailed out by loans from the IMF and other nearby countries.

And so we come to the piece de resistance, an abomination of such magnitude it could virtually destroy the world financially. It’s the dreaded, previously-mentioned CDS, a form of financial “insurance” that has grown from an outrageous $26T 2 years ago to an unbelievable $62T recently and nobody knows too much about who has what, in what quantities, and whether they’ll ever be honored if triggered (that occurs when the underlying asset, usually a corporate bond, goes belly up and somebody, known as the “counterparty”, has to pay off if they can). Hedge funds, many already with about as much trouble as they can handle, account for about 58% of CDS trading. If that’s not scary enough, these derivatives can lever the underlying debt they cover by 30 times or more, and the International Swaps and Derivatives Assn. says that about 1/3 of them lack collateral backing. So far these time bombs have remained relatively under control because of the various bailouts and because there have been lower than normal corporate defaults in the last few years, less than 1% at the end of 2007. But a Standard & Poor’s forecast for a year hence estimates a rise in those defaults to 4.9%, possibly as high as 8.5% – a disastrous trend considering that even if such defaults reach only the historical average of 4.4%, CDS contracts of about $500B would be triggered in short order. Heaven help us then.

I’m expecting this bear market we are embroiled in to be ultimately similar in character to that of 1929-1932: a series of “waterfalls”, crescendos and huge short-term and intermediate snap-back rallies. It’s taken mighty armies of quants many years to get us to this godforsaken place and, as David Crosby said, “It’s been a long time comin’, it’s goin’ to be a long time gone”. The 1930’s were long and hard and, though it’s possible the soup lines won’t be as lengthy this time, don’t bet on it – I think it could be 2020 or beyond before things get back to any semblance of the prosperity trends of the last 60 years. In the meantime, it’s probably safe to say that we’ve seen the last of bottled water from some eternal Tibetan spring.

I’ll be back in the next issue attempting to deal with the effects of all these things on the New York City and Hamptons economies. Ta-ta.

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