A Garden Hose on a Forest Fire

While some may consider it inappropriate to post a blog like this the day after Inauguration Day while the ‘warm fuzzies’ still abound – the headlines relating to the world economy continue to tell a story of a system overloaded with debt and politicians trying to solve the problem by getting banks to lend more money.  Although to be fair, it’s not just US politicians – its politicians from almost every industrialized country around the globe.  It’s a universal political instinct.  Got a problem?  Throw money at it, even if you don’t have it.

By now, the data has shown that the initial bailout offered by the government didn’t work.  In my view, it failed for the following three reasons: 

First, there was no accountability as to how the money was spent.  Former Treasury Secretary Paulson initially told congress that the money was needed to buy back ‘toxic assets’ (aka bad debt) from banks in order to free up the banks to make loans again.  Then after the emergency bailout bill known as TARP, an acronym for Troubled Asset Relief Program, was passed he did an about face and decided instead to make loans to these financial institutions in exchange for a stake in the company.  As I’ve discussed in prior blog entries, the taxpayers have a 79.9% stake in AIG.  However this isn’t the major reason that bailout wasn’t effective.

The main reasons follow.

Reason Number Two: the size of the bailout was too small.  Thinking that injecting $350 billion into the banking system immediately would make an impact on the credit crunch is akin to wondering why there is no noticeable difference in the size of the forest fire after unleashing a garden hose on it to douse it.

Any reasonable person looking at the numbers would agree.

According to an article published on ‘Bloomberg’ yesterday, banks have already written off or experienced market losses in excess of $1 trillion, a number that exceeds the size of the entire bailout package significantly. 

According to New York University Professor Nouriel Roubini, who predicted last year’s economic crisis, losses experienced by US banks could reach $3.6 trillion, which, according to Roubini, makes the banking system effectively insolvent.

Even with the additional bailout of over $800 billion proposed by President Obama, we’ve still not even solved 1/3 of the problem.  And that doesn’t consider the cost of assuming the bad assets of Fannie Mae and Freddie Mac; when considering those commitments, we’ve solved an even smaller percentage of the problem.

The goal of all this government action is to get banks lending again, but it’s not happening.  Even though the Federal Reserve has been actively, aggressively cutting interest rates, that savings isn’t being passed onto consumers.  According to numbers complied by Bloomberg and Freddie Mac, the current spread between the interest rate on a 30-year mortgage and a 10-year Treasury is about 2.6%, up from 1.6% in 2003 and 1.5% in 1993.  In other words, put into context, the real cost of borrowing money is now higher than at any point in the last 15 years meaning that banks aren’t passing the interest rate savings on to their customers.

And, the lending standards are getting tighter.  According to a Credit Suisse study just completed only 50% of loan applications were approved last month as compared to an average of 70% over the past 18 months.

As focused as the politicians are on getting credit flowing again, in my view it’s simply not that simple.

Bankers are going to be hesitant to loan money on assets that are depreciating in value.  I believe that one of the largest contributing factors to the current ‘credit freeze’ is the back end securities market.  While bankers may have some extra money to loan as a result of the government bailout, bankers are just building reserves in light of the fact that it’s currently virtually impossible to sell mortgage backed securities.  Prior to the credit crunch, bankers would make loans and then package up those loans as securities and then sell those securities to investors.  Those markets are frozen today – there are no buyers for these securities.

Why are there no buyers for mortgage backs securities?

The continued deterioration of the housing market is one reason.  According to the S&P/ Case-Schiller Index housing prices have dropped an eye-popping 18% in the 12 months ending in October of 2007 and have fallen every month on a year-to-year basis since January 2007.  According to Realty Track of Irvine, California foreclosure filings last year reached a record 3.2 million, another record.

Until the housing market bottoms (which I believe won’t happen for awhile – in my 1^st Quarter Market Update, I forecasted that the housing market would decline another 20% or so before a bottom is reached), there will be few, if any investors for mortgage backed securities.

Reason Number Three:  The government has no real money to use to bailout these financial institutions.  In effect, the government’s printing presses have been in high gear printing money to fund the bailouts and then selling the debt to investors who are flocking to US Government Bonds because of their liquidity.

The US Government has a debt problem that’s bigger than the debt problem that they’re trying to solve.  Trying to solve a debt problem by adding more debt is like trying to sober up a drunk by giving him another drink.  It may make him feel better short term, but long term the hangover is worse.

Should the next bailout package pass, and I’m assuming that it will, mark my words, there will be another and maybe another after that – politicians will continue to try to create money to throw at the problem as long they can continue to sell the debt that they’re creating.  But, when this massive amount of debt can no longer be managed – and I believe we’ll be there soon – the economic problems will be magnified and will intensify.

Then, even the garden hose will burn.

Note:  To receive Mr. Tubbergen’s First Quarter Market Update visit:  www.usawealthmanagement.com

Securities offered through USA Advanced Planners (Member FINRA/SIPC).  Advisory services offered through USA Wealth Management. USA Advanced Planners and USA Wealth Management are affiliated companies.  The opinion expressed herein is that of the writer and not necessarily that of the above noted affiliated companies. Forward looking statements involve known and unknown risks, uncertainties and other factors which may cause actual events or results to differ materially from those that were forecasted.

·          Investing in market related securities involves a risk of principal loss.  Prior to making any investment decision, the services of an appropriate professional should be sought as investment related recommendations are dependent upon the personal financial situation of each individual investor.