Postcards From the Ledge

With fears growing in the markets that six of the nation's largest banks have failed the Treasury's stress test, the pressure is on for them to bolster their capital cushions with possibly more government funding.

The list includes Bank of America and Citigroup, Wells Fargo, Regions Financial, SunTrust and Key Corp., according to analysis from Deutsche Bank analyst Matthew O'Connor, which other analysts concur with. That could mean even more government bailout money going toward the banks.

But a former top Treasury official who sat on the front lines of the government's bailouts through late January has written a detailed report, rich with disclosures and now making the rounds, about what exactly was the government thinking behind closed doors, and exactly how taxpayers and investors would get slammed with majority government ownership of banks.

It's a report that shows how the mania of the bubble led to all sorts of hysterical blindness both in Washington and on Wall Street, a blindness that could have a serious impact on the economy in ways investors and taxpayers have not foreseen.

"TARP support for unsustainable firms is akin to burning public money," says Phillip Swagel, former Assistant Secretary for Economic Policy in the Treasury Department, in a rare bit of refreshing marksmanship. "This appears to be the American approach to systemically significant 'zombie' firms--to use public resources to cushion their dissolution."

Burning taxpayer money, indeed. Banks worldwide have torched through $1 tn in losses and writedowns, with a government report noting that the 19 banks being stress-tested lost $400 bn in the six quarters through year end 2008.

Banks still hold about $2 tn in impaired assets, says McKinsey & Co. The FDIC estimates US banks had tier one capital at year end of $1.3 tn.

So that $700 bn hole is too gaping to be filled by banks praying they can earn their way out of this mess, or by the government's conversion of TARP preferred shares into common, to boost capital cushions. But not, of course, too big for the government to continue its abuse of taxpayers. 

Are the bailouts in reality a faith-based initiative?

Some analysts and economists say not so, that they really will work.

But for economists to have such faith brings to mind this quote from economist John Kenneth Gailbraith: "The only function of economic forecasting is to make astrology look respectable."

Green Shoots? Or Venus Flytrap?

The "green shoots" theory in vogue now, that we are in a nascent economic turnaround, with glimmers of hope in housing and first quarter earnings, looks more like a Venus flytrap for investors piling back in to the market on the news.

US GDP contracted for three consecutive quarters, something not seen since the first quarter of 1975--with two back to back GDP downturns of 6%, not seen since the data was first collected in 1947.

A downturn, yes, that must be taken in the context of a vertiginous bull run that rode the backs of two massive bubbles inflating coterminously, the dotcom and an even bigger, more deadly balloon of a housing bubble, a bubble-fueled bull run that gave US households a record net worth.  

The Treasury's bank stress test results are coming out next week, after weeks of delays and two months of remonstrances by the government to the banks to not discuss them publicly whatsoever, a period of "don't ask, don't tell," which the markets understood as "don't ask, do sell," given that many of the stress-tested banks are trading at the level of the cost of an ATM fee.

The markets could be hurt on the news of any surprise failures of the stress tests. Remember, American Express and MetLife are being stress tested too, though no one knows which companies failed.

Leveraged loans, corporate defaults, commercial mortgages and an embattled consumer loaded down with too much plastic will still be a drag on the banks. 

And the banking system will be lurching around in a hospital gown well into 2011, as massive amounts of option loans, including "pick a payment" loans made at the height of the bubble in 2004 to 2006, will reset after five years to higher rates.

Here's what's going on.

All Fall Down

This all started with TARP, launched off of a three-page plan that then US Treasury secretary Henry Paulson marched down to Congress with after Lehman Bros. collapsed and American International Group failed in September 2008.

Money funds that had invested in Lehman's commercial paper debt were panicked. Share prices in the Reserve Primary money fund, which held Lehman commercial paper, fell below the sacrosanct $1 mark for the first time.

The commercial paper market, which gets its liquidity from money funds, had a heart attack and collapsed.

Once the repo market fell apart, bank executives started having seizures fearing a colossal run on their coffers as companies started to draw down en masse on their bank credit lines, in lieu of short-term funding from a commercial paper market on the stretcher.

And now we have the government owning stakes in dozens of banks and companies across the country. Swagel notes that Paulson's three-page plan to launch TARP would never have passed if it meant government ownership of the banks.

Swagel says: "House Republicans would have balked at voting to allow the government to buy a large chunk of the banking system (such 'nationalization' only came into vogue among Republicans in 2009), and Democratic members of the House would not have voted for such an unpopular bill without a reasonable number of Republican votes to provide the political cover of bipartisan action."

Banks Play Politics

Once the government takes bigger stakes in the TARPed banks, don't fall for it when the TARPed banks suddenly, sheepishly, say, gosh, "we are contrite, we will buckle under and agree to any politically popular legislation to help taxpayers."

Because underneath sits a real wallop for taxpayers.

Because at the same time the banks are agreeing to legislation, behind the scenes, Citi and BofA can quietly dump all of their rotten assets created by such legislation right back onto the US taxpayer, thanks to the government's insurance wrap on their balance sheets that protect them from further big writedowns.

Citigroup, which has had three government bailouts, suddenly agreed to back mortgage cram downs in bankruptcy, the lone, enfeebled backer when every other bank shrieked bloody murder.

In a cram down, politically appointed judges would get to reset loan amounts lower, delivering a punch to the banking industry's weakened solar plexus, as the legislation slams the banks' mortgage loans and their mortgage-backed securities. The Senate recently defeated this legislation.

But TARPed banks have already buckled under political pressure to do a moratorium on foreclosures.

And so far they are not fighting legislation to prevent banks from hiking credit card rates on delinquent borrowers, or to have the government entirely control student lending, which will hurt their loan assets via a price war. And the banks, including Citigroup and JPMorgan Chase, are losing their fight against a drastic reduction in the debt they are owed from the automakers.

The Treasury, the Federal Reserve, and the FDIC have already waded deep into the mono-line bond insurance business and have given Citigroup a $306 bn insurance backstop to its balance sheet, and the government is guaranteeing $118 bn in bad assets at Bank of America. That means Citi and BofA can unload those assets onto the US taxpayer.

"Many within Treasury viewed this [Citi's agreement to the mortgage cramdown bill] as an artifact of the transfer of risk to the public balance sheet inherent in the non-recourse financing behind the ring fence insurance," former Treasury official Swagel says. "Citi could make this politically popular offer [the mortgage cramdown advocacy] because taxpayers ultimately were on the hook for the losses."

The government bailouts have clearly derailed. For instance, FDIC chairman Sheila Bair has hailed the success of its Debt Guarantee Program, in which the FDIC guarantees the payment of newly-issued senior unsecured debt, as helping to "free up funding for banks to make loans to credit worthy businesses and consumers."

However, Goldman Sachs and Morgan Stanley do very little lending and instead can use the cheap, taxpayer guarantee to pay back their $20 bn in combined TARP borrowings (plus show earnings).

World's Biggest Bond Insurer and Junk Investor: You

Just as the US government is now one of the world's biggest mono-line bond insurers, the Federal Reserve is now the world's biggest junk investor.

Taking a cue from companies like Enron, Citigroup, General Electric, Wells Fargo, you name it, the central bank has housed in off-balance sheet vehicles (called "Maiden Lane," after the street in downtown Manhattan's financial district), warehoused away from its own balance sheet, $74 bn in radioactive assets it picked up when the government rescued Bear Stearns and AIG.

What is this stuff? The Fed won't say exactly.

We know that 80% of its portfolio represent Fannie Mae and Freddie Mac securitizations.

But since just 9.6% of this portfolio is rated Triple-A, already the central bank has lost $9.6 bn on these investments as of year-end 2008.

Along with ownership of Citi and Bofa assets, taxpayers will be staring morosely at a mountain of rotting paper for some time to come. That's because exotic dderivatives concocted by the habitually self-deceiving Wall Street, derivatives that funded trillions of dollars in mortgages to reckless borrowers and enriched Wall Street, but now have the same rights to the public purse as plain vanilla Treasurys.

Don't Ask, Don't Tell

But you won't ever see the government's increasing ownership of the banks on its budget, just like you don't see now the government's ownership of AIG, Freddie Mac and Fannie Mae.

That's because the US government purposely keeps its ownership stake in these bombed-out companies under an 80% ceiling, at 79.9 %, "in light of [government] accounting rules that would have brought GSE (Fannie and Freddie) assets and liabilities onto the government balance sheet at 80 % ownership," says Swagel.

So the government plays fast and loose with accounting rules, too.

Faster Than a Goose in Winter

How will the US government unload its shares in the TARPed banks without roiling their stock prices, driving their stock prices south faster than a goose in winter?

Doesn't a $700 bn TARP investment in the banks represent one massive sell order that would swamp the trading floor in red ink?
And how can the Federal Reserve cork back up its fire hydrant gusher of liquidity without roiling the credit markets?

How can the government's $11 tn bailout gusher stop inflation from going up, just when taxes will likely have to rise to pay for the president's $3.5 tn budget? A bailout gusher fast approaching the size of the country's entire GDP of $14 tn.

All of that government borrowing will vacuum up any spare private capital out of the markets.

How We Got Here

As the Street recklessly built all sorts of paper trades on the back of all sorts of rotten banana loans-securities that far exceed the actual number of the underlying loans--Wall Street's risk modelers took into account 9/11, the '87 crash, the Asian debt crisis, the Latin American debt crisis, the Russian debt crisis, wars, terrorism, famine in assessing whether mortgages would default. 

But no one on Wall Street took into account that, hey, there might be a massive collapse in the housing market from the tonnage of rotten subprime loans.

And the same hysterical blindness held true for the government. The US Treasury didn't model for defaults on subprime loans, including the no-documentation, no-money-down loans given to borrowers from Spongebob Squarepants to the Beverly Hills Chihuahua.

Federal Reserve and Treasury staffers considered "sudden crises such as terror attacks, natural disasters," former Treasury official Swagel says, "or massive power blackouts; ..market-driven events such as the failure of a major financial institution; ..a large sovereign government default; ..huge losses at hedge funds; energy price shocks; ..corporate bankruptcies; ..or a large and disorderly movement in the exchange value of the dollar," Swagel notes.

They also considered all sorts housing data, too, he notes.

"What we missed was that the regressions did not use information on the quality of the underwriting of subprime mortgages in 2005, 2006, and 2007," Swagel says.

"This was something pointed out by staff from the Federal Deposit Insurance Corporation (FDIC), who had already (correctly) pointed out that the situation in housing was bad and getting worse and would have important implications for the banking system and the broader economy," he adds.

Market Cops Amnesia: We've Been Here Before

The derivatives that have caused the markets' collapse--mortgage-backed and other asset-backed securities and credit defaults swaps (insurance on these bets)--far outnumber the underlying loans that support these paper trades.

But stock market regulators forget that we've been here before.

Eric Dinallo, chief insurance regulator for New York State, has noted that the current financial crisis eerily resembles that of 1907, which produced the so-called Bucket Shop laws.

The bucket shops emerged after the Civil War and were storefronts where people came to bet on stocks without owning them. The shop owners actually owned blocks of stock, but they'd let customers place speculative trades literally in buckets in their shops.

The storeowners were then able to place bets on movements in financial markets or indexes without any ownership of the underlying securities (naked credit default swaps?)

If customers bet a stock would rise, the bucket shops would unload. If they bet shares would plunge, the shops would buy. In this way, they moved the markets and cleaned the clocks of their customers. The bucket-shops grew so large they helped cause the Panic of 1907-which eventually led to market reforms.

Like the newly minted Federal Reserve in 1913.

A decade or so later, Wall Streeters again sold worthless paper in the form of bonds to clueless investors, triggering a high-level investigation called the Pecora Commission which unearthed massive Wall Street bonuses and political donations. Sound familiar?

The Pecora Commission led to the Glass-Steagall Banking Act of 1933 to separate commercial and investment banking.

Which was abolished after then President Bill Clinton signed legislation wiping out Glass Steagall, at the urging of his then top economic officials, banker Robert Rubin and Lawrence Summers.

And only now, way after the fact, Mary Schapiro, the new head of the Securities and Exchange Commission, has finally got the SEC to launch new fraud units focusing on specific types of wrongdoing, market cops on the corner of Wall and Broad, after the government has stationed market kiosk stuffed with taxpayer bailout money.

Teabag Protesters

Vilified because extremists with placards calling the president Hitler were in their midst, or that right wing conservative groups backed them, called 'an abomination' by ivory tower pundits, the teabag protesters are regular taxpayers who live by this credo "I think, therefore I am debt free."

A movement that quietly got started by followers of former presidential candidate and Congressman Ron Paul under the Bush administration, to protest reckless deficit spending under a conservative President.

The teabag protestors are parents, teachers, nurses, doctors, firemen, policemen, small business owners, people in the service industry, middle managers, homeowners who would be ashamed to march away from their mortgages or any debt.

They never ask for any help. Ever. They struggle day to day raising children, paying health care costs, tuition costs, paying their bills on time.

They are Americans who in their hearts and minds simply want to do things right - and they are the very same Americans now being abused by elected politicians.

When will members of Congress grow a backbone now to stop this ocean liner of deficit spending to help regular Americans who will have to pay for their profligate spending? 

Deficit hawks on both sides of the political aisle have flown the coop a long time ago.

Instead, we get representatives who, blinded by klieg lights on election day, contract sudden post dramatic press disorder, wandering around looking for cameras, a condition which then quickly mutates into Stockholm's syndrome as they become annexed by the Supersize me government spenders.  

In March 2009, the Pew Research Center asked people about this government intervention in the US economy. They were asked if we are better off "in a free market economy even though there may be severe ups and downs from time to time."

Fully 70% agreed, versus 20% who disagreed.