Financial Pandemonium

Metastasis

What began as a housing bust and credit crunch has metastasized into a full-scale financial meltdown. Banks have found that the securities they bought with depositors’ money are now worth far less than they could imagine. Bank write-downs have reached $792 billion offset by $826 billion in capital raised. ^ $380 billion of the capital raised represents public monies. ^

Lender of Last Resort

Several first-round investors, including sovereign wealth funds, billionaire financiers, private equity and hedge funds have lost their investments. It now appears no one will give financial companies any more money. As a result, the taxpayers, through their proxies – the Treasury and the Fed – are the ‘lender of last resort’.

Shouldn’t We Just Let Them Fail

The alternative to the lender of last resort is to allow the financial system to implode and see what rises from the wreckage. This solution may not be particularly palatable as the adjustment could be harsh (riots, populism, massive layoffs, deflation, hyperinflation) and what could emerge on the other side is a much smaller economy, lower incomes, higher unemployment, and potentially a much different political landscape.

Seizure and Liquidation

When a bank’s reserves fall below a certain level we have instructed the FDIC to seize those banks and liquidate the assets. When this happens to our biggest banks, we have to decide if this liquidation process would heighten the level of anxiety, induce further financial pandemonium and potentially compound the problems in the economy.

Capital Injections and Nationalization

The alternative to seizure and liquidation is for the taxpayer to inject capital into these institutions. Nationalization is the process where the taxpayer takes ownership stakes in systemically important financial firms. The dilution of the existing shareholders is good because it essentially makes them pay dearly for their foolishness.

Eatin’ Boiled Crow

Hopefully, we are getting closer to the beginning of the end of this mess. A healthy and efficient financial system enables our economy to be far more productive than otherwise. To return to health will likely mean that the so-called toxic assets are quarantined. The quicker we ‘eat crow’ – i.e. the banks clean up their balance sheets -- the sooner the economy can begin a recovery.

Written by Jason McMillen, Chief Investment Strategist, PPWM

^ International Monetary Fund, Global Financial Stability Report, Update, January 2009, Updated as of January 26^th, 2009.

Toxic Assets

“In the past ten years, the field of money, banking, and financial markets has become one of the most exciting in all of economics. Financial markets are changing rapidly, with new financial instruments appearing almost every day; the once staid banking industry is now highly dynamic, with the distinction between commercial banks and other financial institutions becoming increasingly blurred.”

Frederic Mishkin, Professor of Economics, Columbia University, The Economics of Money, Banking & Financial Markets, 2^nd Edition, 1989

MIshkin was a former Member of the Federal Reserve Board of Governors from 2006 to 2008.

In 1990, I was a sophomore at a small liberal arts college in Salem, Oregon. Money and Banking was a second level course for students majoring in economics. The topic that dominated economic lectures during my time in college was the Savings & Loan Bailout. Thousands of small banks were seized and subsequently liquidated by the federal government. At the same time, one of the largest bank in the United States, was teetering near insolvency due to soured loans in emerging markets and commercial real estate. (Financial crises are like movie sequels -- the same characters and a slightly modified plot line.)

Roughly two pages of Professor Mishkin’s 500-page textbook published in 1989 are devoted to the subject of securitization. Securitization is the very much the root of the troubles facing today’s financial system. Professor Mishkin described securitization as the process of transforming otherwise illiquid financial assets into marketable capital market instruments.

Securitization was born in the 1970s, but in the 1980’s it gained momentum. Little did Professor Mishkin know that securitization would eventually bring the global financial system to a standstill. Ironically, 20 years later, these illiquid assets have been transformed, but into instruments that are still illiquid. These assets are more commonly know as toxic assets that sit on balance sheets of our biggest banks.

The problem facing Timothy Geitner, our new Treasury Secretary, and it is the same problem that faced former Treasury Secretary, Hank Paulson, is that banks believe these securitized instruments are worth far more than the market is currently willing to pay. Since no one will pay the banks what they are asking, these instruments cannot be converted to cash to loan out to borrowers, or pay out depositors if there was a run on these banks.

If we are to get the financial system working again, this problem must be resolved and it seems likely that the Federal Government will have to put taxpayer money at risk to create liquidity. If the government does nothing, the economy may spiral into a deflationary depression. And if government does something, we still have a very nasty recession and the taxpayers may be stuck with a substantial loss. But addressing the problem in a timely manner may pave the way to a stronger and more stable financial system in the future.

Written by Jason McMillen, Chief Investment Strategist, PPWM

C + I + G + (X – M)

The amount of the fiscal stimulus plan is not some random number. It is not calculus, quantum mechanics or rocket science. It is arithmetic. In Economics 101, every first year student is taught the equation for aggregate demand (a term used to describe total spending in any economy generally referred to as gross domestic product (GDP).

Consumption (C) is all consumer expenditures for goods and services. Investment (I) is private sector spending on capital goods (i.e. a factory or equipment). Government (G) is expenditures for publicly provided goods and services (i.e. military expenditures and social security payments). Exports (X) are revenues for goods and services shipped internationally. Imports (M) are payments for foreign goods and services from places like China, Canada and Mexico.

According to the Bureau of Economic Analysis (BEA), GDP ended the fourth quarter of 2008 at $14.2 trillion.* GDP decreased 4.1% from the end of the third quarter of 2008. If we assume the economy will decline 4% for next year, roughly $568 billion in economic activity will disappear relative to the prior year. In other words, C (Consumption) and I (Investment) will decrease by $568 billion if economy contracts by 4% in 2009. If this is the case, the fiscal policy prescription is to increase G (Government) by some amount to offset that decline. In fact, the government intends to increase G by nearly $787 billion of which 74% will be spent by September 30, 2010.

A poll of economists on February 12, 2009, estimate that the U.S. economy will shrink by 1.9% in 2009.^ I assume their assumptions include some level of fiscal stimulus by the U.S. government. However, the majority of economists are in agreement that the fiscal stimulus plan will not be enough to stop economy from contracting. The Congressional Budget Office (CBO), a non-partisan government agency, reported that the fiscal stimulus plan will increase GDP somewhere between 1.8% and 3.8% in 2009, 1.3% and 3.3% in 2010, and .4% and 1.3% in 2011.^^ The CBO also estimates that the stimulus plan will increase employment between .8 million and 2.3 million in 2009, 1.2 million to 3.6 million in 2010, and .6 million and 1.9 million in 2011. But despite the fiscal stimulus plan we are still facing negative GDP growth and a nasty recession.

In March of 1933, Franklin Delano Roosevelt launched a series of fiscal stimulus measures to stabilize the U.S. banking system and promote economic growth. Past performance is no guarantee future performance, but 1 year later the S&P 500 was 72% higher and 5 years later the S&P 500 was 190% higher than the day FDR become President. Perhaps better times are not too far ahead.

* Bureau of Economic Analysis, Press Release, January 30, 2009.

** New York Times, A Smaller, Faster Stimulus Plan, but Still With a Lot of Money, February 13, 2008.

^ The Economist, February 12, 2009.

^^ Congressional Budget Office, February 11, 2009.

^^^ Robert Shiller, Irrational Exuberance.

Written by Jason McMillen, Chief Investment Strategist, PPWM