Chris Tomaras / Straight Talk / February 7, 2009

We continuously hear about how bad things are in the economy, but how do you even begin to comprehend the meaning of bad? What we know is that housing prices have been in a free fall, foreclosures are becoming commonplace, food banks are running out of food, homeless shelters are overflowing and it’s almost impossible for the average person to borrow money from a bank or find a job. We’re now getting ready  to throw another trillion dollars down the toilet with this utterly ridiculous stimulus boondoggle and that’s just the second phase of our financial stupidity. I promise you it will not be long until phase three will be upon us under some other panic scenario that the world is going to come to an end.

This morning I would like to delve deeper into the financial crisis and help you to better understand what is meant by many banks and financial institutions being on the brink of collapse and why and what is being done by our government to correct the problem.

Let’s begin by discussing the state of our financial system as it relates to the banking system and the Federal Reserve, our country’s central bank.

In the past 12 months, about a trillion dollars has been injected by the government and taxpayers into failing US and British financial institutions while at the same time the central banks of both countries have slashed their cost of funds to nothing and reduced significantly the amount of cash reserves required to be held by these same banks. When I refer to cost of funds I’m referring to the interest rate that the Fed charges its member banks to borrow money. Wouldn’t you like to borrow money for free?

And now the government and congress is talking about another trillion dollars under the guise of stimulus for the economy.

So why with all of this so-called stimulus, are the banks and financial institutions not lending and continuing to flounder and collapse? Especially after the first 700B that we were coerced into supporting has been a debacle?
In a recent news article it was described like this:

Bank losses from the write-offs of bad loans and busted derivatives, the fancy name for leveraged financial products that very few people can understand, add up to about $1.5 trillion so far. In addition there is another $5 trillion to $10 trillion worth of off-balance-sheet bank investments. These were investments which are highly leveraged, used by big banks to fatten their profits in boom times, but because they’re off balance sheet, they were hidden from regulators. When they were making tons of money, everything was fine but obviously not anymore. So now the regulators are forcing these shockingly discovered hidden investments back on to the banks' balance sheets. In doing so, the rules require banks to reserve a base of real shareholder capital amounting to 10% of the total amount of those investments. That means if the number is 10 trillion, banks need to come up with 10% or $1 trillion to meet the required reserve requirement.
 
In layman’s terms it’s like someone buying shares of stock on margin. As an example let’s assume the size of a purchase is $100,000 but you only have to put up $10,000. If the investment increases in value - great. If the value of the stock goes down you have to deposit more money. That sounds logical, right? But imagine buying that same stock with no required reserve and the stock drops in price significantly. This is what these financial geniuses are now facing. They leveraged themselves, supposedly unbeknownst to the regulators, and now don’t have the money to cover their required reserves. So the Government and Congress is giving these culprits disguised in suits and ties our tax money to pay off their gambling debts.

When you add the $1trillion in losses we discussed earlier to the $1.5 trillion in required new reserves, you can see that they are in need of as much as $2.5 trillion in new capital to remain solvent under current rules. I know that we throw around words like "trillion" like they're nothing, but that is a lot of money, especially when you consider this. The entire world banking system had only $2 trillion in shareholder capital in 2007, before everything blew up.

OK, so the ugly reality is:

In aggregate, the entire financial system is insolvent, broke, busted as liabilities far exceed assets. Governments aren't forcing banks to admit this because they didn’t monitor them closely enough, but the investors are, and that is why big banks' shares have lost a large percentage of their value this year. Governments, meanwhile, are trying desperately to help banks plug the gap, but still after injecting $1 trillion they're coming up short leaving a gap of about $1.5 trillion.
 
Because the calculation is so easy -- and so devastating -- it kind of makes you wonder why the Bush administration created the TARP stimulus package in the first place. But the administration couldn't just do nothing, as that would have been politically unpalatable, so what they did by spending 100’s of billions was buy more time for someone to come up with a better answer. Quite a few days have passed since October's TARP passage, and though bank shares enjoyed a brief end-of-year respite, investors' patience has worn thin.

The banking system simply has no capital and all of the money that's been allocated so far has been like pouring water into a bucket with a hole in the bottom.
You can't very well have a bankrupt banking system however…… so the market has spent the first several weeks of the new year pricing in the inevitable next step: the nationalization of most large banks. The reason is simple: If your owner can print money, you don't need to keep any reserves, so you can forget about the $1.5 trillion and the problem is solved.

Wouldn’t it be cool to walk into your study, turn on your printer and print out as much money as your heart desires. Wow!

So then guess who’s going to own and run the banks? The guy with the printing press. I believe the term is nationalization. What has and is happening is this. The banks issue preferred stock to the government and the existing shareholders become past history as the value of their common stock goes to zero. This means no more quarterly reports to shareholders and no more high salaries to bank executives. The concept is being sold as a temporary solution until things get back to normal and then the banks would once again be privatized, but in reality that will take many decades at the very least.

To be sure, the landscape of world business is going to change dramatically. I agree that private owners have made a mess of things, but you can bet government bureaucrats will be worse. They probably will take fewer smart risks, such as lending money to the next Michael Dell or Bill Gates, and more dumb ones, like giving mortgages to low-income families with meager means of repayment.
They would almost certainly not support lending to hedge funds or providing money for leveraged buyouts, or do much merger-and-acquisition financing at all. You can pretty much count on the government, in a huge over-reaction, knocking the financial system back to the Stone Age, or at least the 1950s -- a situation in which banks accepted passbook savings accounts from Mr. and Mrs. Smith and then made plain-vanilla loans to Mr. and Mrs. Jones.

If this is to be the case, then perhaps the new Treasury secretary and Congress should stop the charade with the second tranche of TARP money and this ridiculous stimulus package they are about to pass. It’s nothing but a facade for all their special interest spending programs.  Just nationalize the banks and get on with the next phase rather than pour more money down a bottomless hole.
We already have mortgage lenders Fannie Mae and Freddie Mac under federal control. And like the banking industry, the housing industry is being nationalized. If you check out the requirements for getting a conventional home mortgage you will see that it is virtually impossible for the average homebuyer to qualify unless you go through FHA.

I believe the term nationalism is closely tied to that dreaded word -  socialism if I am not mistaken.

The best course of action, which would have been the most painful in the short term but beneficial in the long term, would have been to force banks to open all their books to regulators and investors, allowing them to see which were solvent and which were not instead of just handing them a blank check. Then the FDIC. could have closed the bad banks and merged their assets into strong banks, and we would be halfway through the crisis by now.

Instead, the previous Treasury Secretary, Henry Paulson, decided on this disastrous course of putting insolvent banks on life support at our expense, which has only led to a massive waste of taxpayer money and time.

History shows that defaults will probably hit 10% or higher over the next year or two as commercial real estate and business loans will follow the trend of the residential housing market while our brilliant Washington politicos spend us down the tubes.

And it is so unfortunate that terms such as capitalism and entrepreneurial spirit will no longer be part of the dreams of our children and grandchildren because of people’s greed, overindulgence and misguided values which has resulted in our country now being dominated by a liberal, self-serving bunch of socialist politicians and reporters all in the name of change.

Eventually, when we see that trillions of dollars of American taxpayer money was spent without a morsel of stimulus, in the next election we can all run out into the street and scream that we need change. The problem is that it will be too late because trillions of dollars will already have been wasted and our children and grandchildren will have to foot the bill. So much for change!

And that’s this week’s straight talk.