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Msg  6 of 6  at  3/23/2009 6:26:33 PM  by


Dangerous Unintended Consequences

Executive Summary

The Fed Chairman, the Treasury Secretary, and Congress have now done more to bail out financial institutions

and pump up financial markets than any of their counterparts in history.

But it’s not nearly enough; and, at the same time, it’s already far too much.

Two years ago, when major banks announced multibillion losses in subprime mortgages, the world’s central

banks injected unprecedented amounts of cash into the financial markets. But that was not enough.

Six months later, when Lehman Brothers and American Insurance Group (AIG) fell, the U.S. Congress rushed to

pass the Troubled Asset Relief Program, the greatest bank bailout legislation of all time. But as it turned out,

that wasn’t sufficient either.

Subsequently, in addition to the original goal of TARP, the U.S. government has loaned, invested, or

committed $400 billion to nationalize the world’s two largest mortgage companies, $42 billion for the Big

Three auto manufacturers; $29 billion for Bear Stearns, $185 billion for AIG; $350 billion for Citigroup; $300

billion for the Federal Housing Administration Rescue Bill; $87 billion to pay back JPMorgan Chase for bad

Lehman Brothers trades; $200 billion in loans to banks under the Federal Reserve’s Term Auction Facility

(TAF); $50 billion to support shortterm corporate IOUs held by money market mutual funds; $500 billion to

rescue various credit markets; $620 billion in currency swaps for industrial nations, $120 billion in swaps for

emerging markets; trillions to cover the FDIC’s new, expanded bank deposit insurance plus trillions more for

other sweeping guarantees; and it still wasn’t enough.

If it had been enough, the Fed would not have felt compelled yesterday to announce its plan to buy $300

billion in longterm Treasury bonds, an additional $750 billion in agency mortgage backed securities, plus $100

billion more in GSE debt.

Total tally of government funds committed to date: Closing in on $13 trillion, or $1.15 trillion more than the

tally just 24 hours ago, when the body of this white paper was printed. And yet, even that astronomical sum is

still not enough for a number of reasons:

First, most of the money is being poured into a virtually bottomless pit. Even while Uncle Sam spends or lends

hundreds of billions, the wealth destruction taking place at the household level in America is occurring in the

trillions — $12.9 trillion vaporized in real estate, stocks, and other assets since the onset of the crisis,

according to the Fed’s latest Flow of Funds.

Second, most of the money from the government is still a promise, and even much of the disbursed funds

have yet to reach their destination. Meanwhile, all of the wealth lost has already hit home — in the household.


Third, the government has been, and is, greatly underestimating the magnitude of this debt crisis. Specifically,

�� The FDIC’s “Problem List” of troubled banks includes only 252 institutions with assets of $159 billion.

However, based on our analysis, a total of 1,568 banks and thrifts are at risk of failure with assets of $2.32

trillion due to weak capital, asset quality, earnings and other factors. (The details are in Part I of our paper,

and the institutions are named in Appendix A.)

�� When Treasury officials first planned to provide TARP funds to Citigroup, they assumed it was among the

strong institutions; that the funds would go primarily toward stabilizing the markets or the economy. But

even before the check could be cut, they learned that the money would have to be for a very different

purpose: an emergency injection of capital to prevent Citigroup’s collapse. Based on our analysis, however,

Citigroup is not alone. We could witness a similar outcome for JPMorgan Chase and other major banks.

(See Part II.)

�� AIG is big, but it, too, is not alone. Yes, in a February 26 memorandum, AIG made the case that its $2

trillion in credit default swaps (CDS) would have been the big event that could have caused a global

collapse. And indeed, its counterparties alone have $36 trillion in assets. But AIG’s CDS portfolio is just one

of many: Citibank’s portfolio has $2.9 trillion, almost a trillion more than AIG’s at its peak. JPMorgan Chase

has $9.2 trillion, or almost five times more than AIG. And globally, the Bank of International Settlements

(BIS) reports a total of $57.3 trillion in credit default swaps, more than 28 times larger than AIG’s CDS


Clearly, the money available to the U.S. government is too small for a crisis of these dimensions. But at the

same time, the massive sums being committed by the U.S. government are also too much: In the U.S. banking

industry, shotgun mergers, buyouts and bailouts are accomplishing little more than shifting their toxic assets

like DDT up the food chain. And the government’s promises to buy up the toxic paper have done little more

than encourage banks to hold on, piling up even bigger losses.

The money spent or committed by the government so far is also too much for another, lessknown reason:

Hidden in an obscure corner of the derivatives market is a unique credit default swap that virtually no one is

talking about — contracts on the default of the United States Treasury bonds. Quietly and without fanfare, a

small but growing number of investors are not only thinking the unthinkable, they’re actually spending money

on it, bidding up the premiums on Treasury bond credit default swaps to 14 times their 2007 level. This is an

early warning of the next big shoe to drop in the debt crisis — serious potential damage to the credit,

credibility and borrowing power of the United States Treasury.

We have no doubt that, when pressed, the U.S. government will take whatever future steps are necessary to

sufficiently control its finances and avoid a fatal default on its debts. However, neither the administration nor

any other government can control the perceptions of its creditors in the marketplace. And currently, the

market’s perception of the U.S. government’s credit is falling, as anticipation of a possible future default by

the U.S. government, no matter how unlikely, is rising.

This trend packs a powerful message — that there’s no free lunch; that it’s unreasonable to believe the U.S.

government can bail out every failing giant with no consequences; and that, contrary to popular belief, even

Uncle Sam must face his day of reckoning with creditors.


We view that as a positive force. We are optimistic that, thanks to the power of investors, creditors, and the

people of the United States, we will ultimately guide, nudge and push ourselves to make prudent and

courageous choices:

1. We will back off from the tactical debates about how to bail out institutions or markets, and rethink our

overarching goals. Until now, the oftstated goal has been to prevent a national banking crisis and avoid an

economic depression. However, we will soon realize that the true costs of that enterprise — the 13digit dollar

figures and damage to our nation’s credit — are far too high.

2. We will replace the irrational, unachievable goal of juryrigging the economic cycle, with the reasoned,

achievable goal of rebuilding the economy’s foundation in preparation for an eventual recovery.

�� Right now, the public knows intuitively that a key factor that got us into trouble was too much debt. Yet,

the solution being offered is to encourage banks to lend more and people to borrow more.

�� Economists almost universally agree that one of the grave weaknesses of our economy is the lack of

savings needed for healthy capital formation, investment in better technology, infrastructure, and

education. Yet, the solution being offered is to spend more and, by extension, to save less.

These disconnects will not persist. Policymakers will soon realize they have to change course.

3. When we change our goals, it naturally follows that we will also change our priorities — from the battles we

can’t win to the war we can’t afford to lose: Right now, for example, despite obviously choppy seas, the

prevailing theory seems to be that the ship is unsinkable, or that the government can keep it afloat no matter

how bad the storm may be.

With that theory, they might ask: “Why have lifeboats for every passenger? Why do much more for hospitals

that are laying off ER staff, for countless charities that are going broke, or for one in 50 American children who

are homeless? Why prepare for the financial Katrinas that could strike nearly every city?”

The answer will be: Because we have no other choice; because that’s a war we can and will win. It will not be

very expensive. We have the infrastructure. And we’ll have plenty of volunteers.

4. Right now, our longterm strategies and shortterm tactics are in conflict. We try to squelch each crisis and

kick it down the road. Then we do it again with each new crisis. Meanwhile, fiscal reforms are talked up in

debates but pushed out in time. Regulatory changes are mapped out in detail, but undermined in practice.

Soon, however, with more reasonable, achievable goals, theory and practice will fall into synch.

5. Instead of trying to plug our fingers in the dike, we’re going to guide and manage the natural flow of a

deflation cycle to reap its silverlining benefits — a reduction in burdensome debts, a stronger dollar, a lower

cost of living, a healthier work ethic, an enhanced ability to compete globally.

6. We’re going to buffer the population from the most harmful social sideeffects of a worstcase scenario.

Then we’re going to step up, bite the bullet, pay the penalty for our past mistakes, and make hard sacrifices

today that build a firm foundation for an eventual economic recovery. We will not demand instant

gratification. We will assume responsibility for the future of our children.


7. We will cease the doubletalk and return to some basic axioms, namely that:

�� The price is the price. Once it is established that our overarching goal is to manage — not block — natural

economic cycles, it will naturally follow that regulators can guide, rather than hinder, a marketdriven

cleansing of bad debts. The market price will not frighten us. We can use it more universally to value assets.

�� A loss is a loss. Whether institutions hold asset or sell assets, whether they decide to sell now or sell later,

if the asset is worth less than what it was purchased for, it’s a loss.

�� Capital is capital. It is not goodwill, or other intangible assets that are unlikely to ever be sold. It is not tax

advantages that may never be reaped.

�� A failure is a failure. If market prices mean that institutions have big losses, and if the big losses mean all

capital is gone, then the institution has failed.

8. We will proactively shut down the weakest institutions no matter how large they may be; provide

opportunities for borderline institutions to rehabilitate themselves under a slim diet of lowrisk lending; and

give the surviving, wellcapitalized institutions better opportunities to gain market share.

Kansas City Federal Reserve President Thomas Hoenig recommends that “public authorities would be directed

to declare any financial institution insolvent whenever its capital level falls too low to support its ongoing

operations and the claims against it, or whenever the market loses confidence in the firm and refuses to

provide funding and capital. This directive should be clearly stated and consistently adhered to for all financial

institutions that are part of the intermediation process or payments system.” We agree.

9. We will build confidence in the banking system, but in a very different way: Right now, banking authorities

are their own worst enemy. They paint the entire banking industry with a single broad brush — “safe.” But

when consumers see big banks on the brink of bankruptcy, their response is to paint the entire industry with

an alternate broad brush — that the entire banking industry is “unsafe.” To prevent that outcome, we will

challenge the authorities to release their confidential CAMELS ratings on each bank in the country. And to

restore some risk for depositors, we will ask them to reverse the expansion of FDIC coverage limits, bringing

back the $100,000 cap for individuals and businesses.

Although these steps may hurt individual banks in the short run, it will not harm the banking system in the

long run. Quite the contrary, when consumers have a reason to discriminate rationally between safe and

unsafe institutions, and when they have a motive to shift their funds freely to stronger hands, they will

strengthen the banking system.

I am making these recommendations because I am optimistic we can get through this crisis. Our social and

physical infrastructure, our knowledge base, and our Democratic form of government are strong enough to

make it possible. As a nation, we’ve been through worse before, and we survived then. With all our wealth

and knowledge, we can certainly do it again today.

But my optimism comes with no guarantees. Ultimately, we’re going to have to make a choice: The right

choice is to make shared sacrifices, let deflation do its work, and start regenerating the economic forces that

have made the United States such a great country. The wrong choice is to take the easy way out, try to save

most big corporations, print money without bounds, debase our dollar, and ultimately allow inflation to

destroy our society.

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