In February 2009, economic data across the board revealed an accelerating decline of the U.S. economy, both in its financial and non-financial elements. Gross domestic product (GDP) data for the U.S. economy for the fourth quarter 2008 was revised downward, showing the U.S. economy had contracted by more than 6.2 percent.
Unemployment levels from November 2008 through February 2009 show an official rise in joblessness of nearly two million, according to official U.S. government data. When properly adjusted, however, to include the six million new underemployed since the recession began, plus discouraged and other workers not recorded in the official data, the actual U.S. unemployment has risen by at minimum three million since November. Properly calculated, there are now more than 13 million unemployed in the U.S. By December, the unemployed will very likely exceed 20 million.
Meanwhile, in January-February 2009 the balance sheets of banking and finance giants like Citigroup, Bank of America, AIG, Fannie Mae, and more than 250 regional banks now on the FDIC's official danger list continued to deteriorate badly. As the financial crisis continues to drag on unresolved, a rapidly growing number of once financially sound banks and financial institutions entered the growing ranks of zombies (i.e. banks in name only and not performing the functions of banks in fact), while previous zombies became virtual cadavers—many of the latter are the top 20 largest banks in the U.S.
In an attempt to stabilize the financial decline the Obama administration proposed a four-part recovery program. The first part was the $787 billion fiscal stimulus bill passed in February. Of equal import to the fiscal stimulus package were three proposals to try to stabilize the financial system. These include the so-called PPIF (Public-Private Investment Fund), the TALF (Term Asset Backed Securities Lending Facility), and the HASP (Homeowner Affordability and Stability Plan).
20 Million Jobless vs. $3 Trillion More for Banks
The Obama $787 billion fiscal stimulus bill designed to resurrect the non-financial economy—now in virtual freefall—provides only $180 billion in total spending in 2009. Only $26 billion of that is allocated for job spending, according to the U.S. Congressional Budget Office. New jobs created in 2009, given that level of spending, will be in the low hundred thousands at best, while simultaneously a minimum of five to seven million new unemployed will be added to the jobless rolls in 2009. That's less than a half-million new jobs compared to 13 million new unemployed.
One thing is thus quite clear about the Obama fiscal stimulus plan: it is not designed to create anything near the number of jobs that have been, and will soon be, lost. That key fact means the Obama stimulus package will not appreciably slow the collapse of consumer spending currently underway in the U.S. Job loss is at present the main driver of that collapse, along with other forces previously driving the decline of consumption—collapse of 401k and defined pension plans, freefall in stock and homeowner equity, and sharp reductions in hours and earnings for the 90 million non-supervisory and production workers in the U.S. still with jobs.
Constituting more than 70 percent of the U.S. economy's GDP, consumption has literally fallen off a cliff since October 2008. For the first time in data collecting history, consumption declined absolutely in the U.S. the past year while the index for future consumer spending hit a postwar low at 35 out of 100. Business spending has fared no better. Business plans for capital expenditures show a decline of more than one-third. At the same time, exports and world trade are contracting at the fastest rate in decades.
The $787 billion represents a stop-gap program to try to offset in part the magnitude of consumption collapse, not a spending program to turn around the economy. Fully 38 percent of the stimulus is in the form of aid measures to offset job loss income with unemployment, food stamps, medical costs assistance, and various grants to state and local government. While worthy and necessary, it will not create any jobs. Another 38 percent of the stimulus is targeted for tax cuts, which will have no net effect on consumption. In fact, as many economists now note, the multiplier effect of the tax cuts may actually be negative—that is the tax cuts will produce spending in an amount actually less than the value of the cuts themselves. That leaves only 24 percent remaining for spending on potential jobs projects. Plus, the vast majority of the jobs that might be created will be longer-term, capital-intensive, infrastructure jobs in alternative energy and public works.
Both the magnitude of the direct spending on jobs creation ($26 billion in 2009 and less than $200 billion over the life of the package), as well as the composition of the jobs creation, are grossly deficient. Measured in terms of jobs, consumption, and general economic recovery, the stimulus package represents "too little too late." The likelihood is therefore high that a second stimulus package will be necessary within the next 12 months.
In sharp contrast to the paltry spending for jobs is the virtually unlimited, rapidly disbursed, and open-ended flow of funds now underway from U.S. government coffers to banks and other financial and quasi-financial institutions. This uninhibited flow includes a second $200 billion injection for Fannie Mae/Freddie Mac now that they ran out of the first $200 billion given them last August; another $60 billion for AIG, American Insurance Group, bringing its total to more than $200 billion to date; tens of billions more for Citigroup and Bank of America; hundreds of billions more for brokers of commercial paper and money market funds, for foreign banks holding U.S. securities, for credit card company giants like American Express, for auto companies, plus a long list of others waiting in the wings. The grand total is at least $3 trillion thus far—and rising—disseminated to the banks, the broader financial sector, and beyond. That includes $1 trillion designated to the PPIF for buying banks' bad assets; another $1 trillion to TALF for resurrecting the shadow banking system of hedge funds, private equity firms, and the like (the people who gave us runaway speculation in securitized assets, excess leveraging, and debt run-up, which underlies the continuing collapse of the financial system); and another $275 billion to HASP, which will be used primarily to subsidize mortgage lenders, servicers, and investors.
What follows is an assessment and critique of these three elements of Obama's bank-finance bailout, showing why the bank bailout won't succeed in stabilizing the financial system and why a totally new kind of restructured banking system is required before the real economy halts its accelerating decline.
Public-Private Investment Fund (PPIF)
The PPIF is the inheritor of the failed TARP program launched in September 2008. Then Secretary of the Treasury Paulson panicked Congress into granting him a check worth $700 billion in order to buy the bad assets on the balance sheets of banks. Cleaning up the bad assets was necessary, he argued, in order to get the banks to begin lending again—to homeowners, the mortgage markets, and to general business.
Paulson was given the money and then did nothing about buying bad assets. He instead threw $125 billion at the 9 biggest banks, followed by another roughly $125 billion to scores of regional and smaller banks. Another $80 billion or so went to AIG in several installments. Tens of billions more to Citigroup. Nearly $20 billion to auto companies. Further billions were disbursed here and there, so that by February 2009 less than $190 billion of the $700 billion remained, none of it expended to purchase bad assets.
The reason why it was never used to sop up the bad assets is because Paulson faced the dilemma of buying the assets at their market price, which was virtually worthless. Since the banks were keeping the assets on their books at inflated, above market prices, they had no incentive to sell them at market prices and register even greater losses in doing so. They wanted Paulson to buy them at above market prices. If he did, however, he would be charged with providing a windfall profit to the banks. So he used TARP to purchase preferred stock in the banks, in the hope that it would at least partially close up the black hole on bank balance sheets that was ever-widening as the value of housing prices, mortgage bonds, and other securities continued to collapse. The fall in housing prices was in turn due to the flood of houses coming onto the market as a result of foreclosures.
In other words, pumping money into the banks via TARP addressed the symptom of collapsing balance sheets and not the cause. All the measures of the Treasury and Federal Reserve since the crisis began in 2007 share the common strategic error of throwing liquidity (read: taxpayer money) at the balance sheet hole while ignoring solutions to stop the cause of the hole's constant expansion.
PPIF and Geithner face the same dilemma, namely how to get the banks that are refusing to lend to begin doing so. Geithner's plan is TARP with a twist. The idea is to subsidize the price of the bad assets at government expense, and, by doing so, provide an incentive to both the banks to sell and investors to buy at well above their market price.
Here's how PPIF will work: Geithner will put in what remains of TARP ($190 billion) plus additional money up to $1 trillion (which will likely be expanded eventually well beyond $1 trillion). This trillion will be used to pay the banks the difference between the low market price and whatever the new price might be. In addition, the government will pay the investors another amount at taxpayer expense to entice them to purchase at a price above the market value. An auction-like event will be held. Whatever the seller (banks) and buyer (investors) end up with as a price, the government will subsidize the difference for both. That will, theoretically, establish a new market price at which subsequent assets might be sold.
But how much bad assets are out there that must be sold in order to clean up bank balance sheets? The estimates range from $3.6 trillion according to New York University professor Nouriel Roubini (who has been accurately predicting the crisis for more than a year now) to $4 trillion by Fortune magazine to $6 trillion by Treasury secretary Geithner in a talk he gave in June 2008 before becoming Secretary. So there's at least $2.5 to $5 trillion more that taxpayers may have to fork over to the PPIF before it's over.
The flawed premise of PPIF is that enough investors will enter the market if subsidized to buy such a huge amount of bad assets or that the banks will agree to sell at the auction-determined price or that the U.S. government will be able to throw in $2.5 to $5 trillion more.
Another problem is that the root cause of the bad asset price decline—i.e. the collapsing housing and other asset prices—will still continue despite PPIF. The $2.5 to $5 trillion is what the bad assets are worth at the moment. Those values can potentially fall further, as in fact they have for the past 18 months. Housing prices have fallen by 25 percent to date and may fall at least another 20 percent. Foreclosures are rising, as are delinquencies and defaults. Moreover, they are spreading from subprime to Alt-A to prime mortgage loans and bleeding into the commercial property mortgage markets as well. Homeowners with negative equity will also walk away from properties, throwing more supply on the market and further depressing prices. Then there are the millions more now experiencing unprecedented job loss. They too will add appreciably to the delinquency, default, and foreclosure downward pressures on home prices. Bank assets will continue to erode in value and bad asset totals will rise. The fundamental problem is thus still not addressed, let alone resolved.
This scenario is not unique or unprecedented. The same happened in the 1930s. Housing prices did not stop falling for more than five years into the Depression, until the Roosevelt administration created the Reconstruction Finance Corp (RFC) and revitalized the Home Owners Loan Corp (HOLC) and went into the mortgage market directly. The RFC arbitrarily determined a price and enforced it. It dissolved bad banks and wrote off their worthless assets. It forced mergers with those banks that could be saved. The HOLC then directly renegotiated with homeowners, resetting their interest and principal. That finally stabilized the housing market. It quickly produced an equity/stock market resurgence in 1935-36.
The day after Geithner's PPIF announcement, the press panned the plan and the market fell significantly. The spin in the business press was that the plan was not explained clearly. But the opposite likely occurred. The markets knew full well what the plan represented. They didn't believe investors would sufficiently enter the market to buy enough of the bad assets. This would mean the government would eventually have no alternative except to reluctantly engage in rolling nationalizations of the banking sector. That's why a debate on the meaning of bank nationalization emerged in the general business and political press, which still continues.
TALF As Plan B
Another problem with PPIF is what was the alternative if PPIF did not succeed in cleaning up the bad assets? How much longer and further would Congress and the public support throwing more money down the black hole of bank balance sheets? Enter TALF (Term Asset Backed Securities Lending Facility) as Plan B. TALF is another $1 trillion plan for financial bailouts at taxpayer expense. The idea originated at the Federal Reserve in the closing months of 2008 but was put on hold. Originally funded at $200 billion, Federal Reserve Chair Ben Bernanke held the program back until the Obama administration assumed office.
Unlike PPIF, TALF is envisioned as a plan to resurrect the shadow banking system and the securitized asset markets that collapsed after 2007. Approximately one half of total lending in 2007 ($5.65 trillion) occurred in the securitized markets. This declined to $160 billion in 2008 and to a mere several billion by early 2009.
The shadow banking system, a network of non-bank financial institutions, was responsible for much of the speculation driving the subprime and other asset markets until they busted in the summer of 2007. It is thus ironic that the Fed and Treasury now pursue via TALF the resurrection of those same markets and that same system.
The idea of TALF is to loan $1 trillion or more to the shadow banking system to have its various institutions (hedge funds and private equity in particular) buy up securitized assets that bundle auto loans, credit card loans, student loans, and even commercial property loans. These latter consumer credit markets are about to collapse and in doing so provide a subprime-like magnitude of losses for financial institutions, including banks. Credit card companies, for example, estimate that defaults on payments will rise from around 4 percent in early 2009 to 8-10 percent or more. TALF is designed to prevent the collapse of these securitized asset backed consumer credit markets.
But TALF represents something more significant. It represents the lack of confidence on the part of the Obama administration that the regular banking system can lead a lending recovery and restore financial market stability. The logic of TALF, moreover, is that if the shadow banking system does not rise to the incentive and finance the consumer credit markets, then the Federal Reserve will have to do so itself directly. Should that happen, the Fed will not only evolve from lender of last resort and lender of first resort (since 2007), to lender of primary resort—at least in the consumer credit markets. There is no other alternative. The consumer credit markets cannot be allowed to collapse. To do so would precipitate a bona fide depression given the current weakness of the economy and financial system.
The question is whether the hedge and private equity funds can sufficiently participate. Hedge funds in particular have lost half their value in the past 18 months due to losses and withdrawals. Once a $2 trillion industry it is now barely $1 trillion. Similar declines have characterized the state of the private equity funds. Furthermore, it is hard to see how the securitized asset markets can be revived, given their toxic reputation and the virtual total collapse of these markets.
Should the Fed have to go it alone, that would represent a major shift in banking structure. There is also the possibility that TALF and the Fed would serve as a holding action to buy time for the implementation of a Swedish Model of bank nationalization, such as occurred in that country in the early 1990s when the government took over the banks directly, and then spun them off to private interests again in a kind of capitalist form of nationalization.
HASP—Obama's Housing Recovery Proposal
Obama's housing plan has two parts. The first is another $200 billion funding set aside for Fannie Mae and Freddie Mac. This is a continuation of prior arrangements under the Bush-Paulson period. The two companies were partially nationalized in August 2008 and provided with $200-$300 billion to buy home mortgages. By February 2009 they had run out of those funds, and now another $200 billion is allocated as part of the Obama plan. The problem with Fannie/Freddie, however, is that they own only roughly 26 percent of the $12 trillion residential mortgage market. The major problem with subprime mortgages and foreclosures is occurring totally outside Fannie/Freddie's reach—in the securitized residential mortgage market segment.
Another major problem with this first part of the Obama Housing Plan is that any homeowner that is delinquent, in default, or in foreclosure proceedings is not eligible. Those who need it the most are thus excluded. And if the market value of your home has fallen more than 5 percent below the mortgage owed, forget it. You don't qualify. In other words, Part 1 is a subsidy to the industry, a gimmick to help lenders refinance safe mortgages and thus generate refinancing income for lenders; it is not a program to help homeowners in distress or to stop housing supply continuing to flood the market and depress housing prices.
As of late February, data show that the U.S. home price index has fallen 27 percent from its peak in 2006, for the 30th consecutive month. The last three months show an accelerating rate of decline. Should prices continue to fall at the rate registered between last November and January 2009, it will mean another 33 percent fall in median home prices this coming year, according to data from the National Association of Realtors.
A second part of the Obama housing program would provide a further $75 billion. These funds are committed to subsidizing mortgage lenders to lower their interest rates on new mortgages to 4-4.5 percent on average from current higher market rates at around 5.5 percent. Under Plan 2 loan principal may also be lowered to 31 percent of the homeowners' gross income, but only as a very last resort and for a temporary period of up to five years. And the government will pay (i.e., subsidize) the lenders the difference between the 31 and 38 percent, or 7 percent of the loan for that period. Part 2 may apply to homeowners who are delinquent, but it is still largely a voluntary program dependent on the agreement of lenders. If they are unwilling to modify rates and principals when requested by the homeowner, too bad for the homeowner. While progressive Democrats in Congress are attempting to give bankruptcy judges the power to force lenders to modify loans if they refuse after requested, that legislation has been vigorously blocked so far by industry groups like the American Bankers Association.
Who are the financial institutions that will benefit most from Plan 2? The banks. Two thirds of all the home loans in the U.S. are serviced by Citi, JP Morgan Chase, Bank of America, and Wells Fargo. Once again, we have a subsidy to the same institutions set to benefit from the PPIF. It is another version of trickle down, in which government-taxpayer money is given to companies to entice them to lower rates, which they should be doing on their own in the first place.
Like prior Bush initiatives, the HASP approach is to try to stimulate housing demand and in that way to slow the collapse of housing prices. But the supply of houses coming on to the market is massive, swamping any tepid attempts to put a floor under housing prices via a demand-side approach. Housing supply has been and will continue to overwhelm housing demand, with the consequent decline of housing prices continuing. Thus far no credible approach has been offered to check housing supply and stem price declines. In the end housing price decline can only be contained by a nationalization of residential mortgage markets and a fundamental reset of both interest and principle [sic, principal] for homeowners in stress, much as was done in the 1930s.
Summary and Predictions
The fiscal stimulus side of the Obama program fails to address the central need of massive job creation. It lacks in both magnitude and composition of its focus. A second stimulus package within a year is inevitable.
The bank and finance stability measures of the Obama program are no more likely to succeed. They do not focus on housing asset price collapse directly. PPIF attempts to create a market for bad assets by subsidizing banks and investors at taxpayer expense. That expense will eventually have to exceed the initial $1 trillion by several more trillions using the PPIF approach. Other less costly approaches exist and pursuing the PPIF virtually prevents any real stimulus spending. TALF represents a wild gamble that a revived shadow banking system and a resurrection of the securitized asset markets will somehow be able to prevent the collapse of the consumer credit (auto, student loan, credit cards) and the commercial property markets which will have to refinance more than $170 billion in 2009. This is unlikely to happen, given the declining condition of hedge funds, private equity, and the rest of the shadow banking community.
The cost of all this excess bank rescue spending to the U.S. taxpayer is a minimum of $4 to $5 trillion over the next few years. A recent study by two University of California economists, Alan J. Auerbach and William G. Gale, projects annual deficits of $1 trillion or more for each of the next 10 years. It is highly doubtful the U.S. economy can sustain that kind of deficit spending for that period of time without seriously threatening the U.S. Treasury markets and causing an eventual collapse of the U.S. dollar in world markets.
The U.S. and world economy are on the knife-edge of a transition from an epic recession to a bona fide depression. Any number of several severe events could precipitate this. A series of sovereign debt crises in Europe are a real possibility. A likely scenario is the collapse of one or more east European countries that might pull down, for example, Austrian and then Italian banks and spread thereafter to other banking institutions. Another scenario might be the continued escalation of job loss beyond 20 million in the U.S., TALF failure to rescue consumer credit markets, a collapse of the Treasuries markets, and the like. Another precipitating scenario might be the global collapse of bond markets, in particular investment grade bonds, or a severe crisis in the credit default swaps market globally as well. There are, of course, other potentially serious scenarios that might serve as precipitating events.
A new, alternative plan will have to be proposed and implemented before the end of 2009. That effort now moves to the battle lines being drawn over the Obama budget. The Obama administration will have to get much bolder and aggressive, as its enemies on the right, in corporate boardrooms, and among evangelical interests are now gathering forces. It will be interesting to see whether the Obama team can make the transition from a vision that is much like 1993 to one that is more like 1933.
Jack Rasmus's forthcoming book is Epic Recession And Global Financial Crisis (Pluto Press). His articles, speeches, and interviews are available at www.kyklosproductions.com