It Could Be Worse - Maybe

One week ago, on January 21, I wrote the following in my blog, referring to the fact that the first bailout didn’t work to rescue the credit markets:

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 on to 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.

This week, the evidence continued to mount that the size of the bailout package was indeed too small to have any effect on the credit markets and the overall economy. 

In my quarterly market update I forecasted that the $800 billion stimulus package that the Obama administration was talking about at the beginning of the year would probably grow significantly before the predictably “free-spending” Washington politicians were finished with it.  That appears to be occurring.

In an article published on Fox News on Saturday, January 24, it was reported that the price of the next bailout package could reach $1 trillion due to the rapidly deteriorating economy and the desire of the politicians to take massive action.  The Fox News story referenced a Washington Post story,

Here’s just one of the problems – the Obama administration hasn’t yet decided where to spend the $350 billion that congress released last week prior to the Inauguration.  Now, congressional leaders and the Obama administration are considering a second bailout for almost three times that number and, based on current indications, it will undoubtedly pass.

If I were to venture a guess, I’d say that the proposed Obama stimulus package will total just under a trillion dollars after the mounting opposition to such a huge number has its say.  When combined with the $350 billion that was released last week and the $350 billion that the Bush administration released, that would bring the total cost of the combined stimulus packages to $1.7 trillion.  It’s still not enough. 

Kent Conrad, chairman of the Federal Budget Committee told the Washington Post last week, “It seems to me there are inadequate resources to deal with housing, to deal with the financial sector and to give an immediate lift (to the ailing economy).  The last thing I want is to come back here in five months and have another big package. I’d rather do it now.”

If New York University Professor Nouriel Roubini is correct, and losses experienced by US banks indeed reach $3.6 trillion, the two stimulus packages together (assuming I’m right about the numbers) solve less than 1/2 the problem.  Sorry, Mr. Conrad, this is not going away, at least anytime soon.

But, in my view and the view of many other bright people, these stimulus packages really don’t solve the problem, even though many governments around the world like to use them – the problem (debt) is just transferred from the balance sheet of a private institution to the government’s balance sheet.  Debt still has to be dealt with – either by paying the debt or by defaulting on the debt.

The only thing that’s saving the US right now, although I believe temporarily, is that the rest of the world is in as bad a shape (or even worse shape) than we are.

In Germany this week, 10 year government bonds fell more than they had in a decade on investor concerns that supply will outpace demand.  (Source:  Bloomberg, January 24, 2009)  This means simply that the German government may have more debt than investors want to buy.

Standard and Poor’s, a bond rating agency, recently put the Greek government’s credit rating on ‘negative watch’, then on January 14 lowered the country’s rating one level to A- noting the government’s rapidly growing budget deficit.  (Source:  Bloomberg, January 24, 2009) This means that S&P has growing doubts about the government’s ability to repay – more on Greece in a moment.

Standard and Poor’s has also recently cut the credit rating of Spain one level to AA+ on January 19 and Portugal’s rating was reduced to AA- from A+ on January 21.  (Source:  Bloomberg, January 24, 2009).  More growing doubts.

In France, confidence among manufacturers remained at the lowest level ever, or at least until the manufacturing confidence level began to be tracked in 1976 according to Insee; the Paris based national security office.  (Source:  Bloomberg, January 24, 2009)

The same Bloomberg article voices concerns in Italy about the Italian government’s bond auction this week during which the government hoped to sell $8.4 billion Euro’s of securities.  “Supply induced pressures” were cited as a potential problem.  That’s investor speak for “debt abounds everywhere and there aren’t enough interested investors to finance it all.”

As I’ve been preaching, you can’t use debt to fix a debt problem. 

The ‘cracks in the foundation’ are beginning to show.  Let’s look at the Eurozone, the countries who’ve adopted the Euro as their currency.  In order to be accepted into the Eurozone (the 16 countries who’ve adopted the Euro as their currency) a country has to meet certain minimum targets relating to inflation, budgets, and interest rates.

When economic times are good, a weaker economy can really benefit from being a member of the Eurozone since a ‘rising tide lifts all boats’, but when times get tougher and recession hits, membership in the Eurozone can prevent a smaller economy from doing what governments almost always do in recessions, spend like crazy.  They can still spend but not as economically as a larger, stronger economy.

Currently Germany and France, two of the stronger economies in the Eurozone, are implementing billion dollar stimulus programs and taking steps to protect their banks, leaving the smaller economies to fend for themselves.  (New York Times, January 23, 2009)

German Finance Minister Peer Steinbreck recently defended Germany’s decision not to participate in a proposed multi-billion dollar stimulus program for all Eurozone countries saying that such a move would only be ‘an ineffective populist measure’.  Steinbreck added that the Germans shouldn’t be forced to accept a €200 billion stimulus package when the economic impact can’t possibly be known.  (‘Der Spiegal’ November 2008)

The facts are that Germany implemented a €30 billion stimulus package for its own economy while their finance minister was dismissing a larger stimulus package aimed at helping all European economies as ‘populist”. (‘Der Spiegal’ November 2008)

As a result, a peripheral Eurozone country like Greece is forced to pay a much higher interest rate than a Eurozone country with a stronger economy like Germany.  That puts a country like Greece at an extreme disadvantage, they’d like to inject liquidity into their economies to deal with the economic downturn (aka borrow money), but they can do so only at high interest rates and when doing so, the country risks violating the terms of their Eurozone membership and the solvency of the country is questioned.  Currently, the government of Greece pays 3% more to borrow money than the German government.  (Source:  New York Times, January 23, 2009) – That’s significant.

And, it puts Greece in a very difficult position – paying higher interest rates when the country is already drowning in debt.  An article published in ‘The Telegraph’ a British publication, estimates that the national debt of Greece and Italy is 100 percent of GDP or Gross Domestic Product.  So, in essence the Greek government is financing 100% of the country’s total annual economic output at rising interest rates.

By contrast, the current US public debt as a percentage of GDP is about 76% of our GDP (an approximation based on the last measurement), but we’re financing that debt at lower interest rates, although this past week saw bond yields increase and bond prices contract (bond values and yields move inversely). 

According to a Bloomberg article published on January 24, US Government bonds had their worst week in 22 years with prices falling and yields decreasing.  Investors are looking ahead anticipating how large the US Government’s debt will be after a trillion dollar stimulus and are beginning to doubt the government’s ability to pay.

Here are the numbers.  Assuming a trillion dollar stimulus passes and the deficit comes in at $1.2 trillion as predicted by the CBO recently, the US would potentially add $2.2 trillion to its national debt by the end of 2009.  When added to the current debt of about $10.7 trillion, that would increase the debt to $12.9 trillion.  Assuming flat economic growth this year (although the CBO recently estimated an economic decline of 2.2% for this year), that would mean that our national debt will be about 92% of our GDP within one year – not quite the 100% of GDP that Greece and Italy are carrying, but sneaking up on them quickly – at warp speed some would argue.

When considering the CBO’s estimate of economic contraction in 2009, the debt to GDP percentage could possibly go as high as 94%.  With President Obama predicting trillion dollar deficits for the foreseeable future, it may not take much longer than another 18 months or so to find ourselves exactly where Greece and Italy find themselves today – carrying 100% of our GDP as debt.

We’re not the worst of the lot – yet.

(For a copy of Mr. Tubbergen’s complete first quarter market update visit www.usawealthmanagement.com)

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