The Whiners of Wall Street - Wall Street's Great Deflation

Wall Street's Great Deflation
by William Greider
07/14/2008 12:38pm
The Nation

Phil Gramm, the senator-banker who until recently advised John McCain's campaign, did get it right about a "nation of whiners," but he misidentified the faint-hearted. It's not the people or even the politicians. It is Wall Street--the financial titans and big-money bankers, the most important investors and worldwide creditors who are scared witless by events. These folks are in full-flight panic and screaming for mercy from Washington. Their cries were answered by the massive federal bailout of Fannie Mae and Freddy Mac, the endangered mortgage companies.

When the monied interests whined, they made themselves heard by dumping the stocks of these two quasi-public private corporations, threatening to collapse the two financial firms like the investor "run" that wiped out Bear Stearns in March. The real distress of the banks and brokerages and major investors is that they cannot unload the rotten mortgage securities packaged by Fannie Mae and banks sold worldwide. Wall Street's preferred solution: dump the bad paper on the rest of us, the unwitting American taxpayers.

The Bush crowd, always so reluctant to support federal aid for mere people, stepped up to the challenge and did as it was told. Treasury Secretary Paulson (ex-Goldman Sachs) and his sidekick, Federal Reserve Chairman Ben Bernanke, announced their bailout plan on Sunday to prevent another disastrous selloff on Monday when markets opened. Like the first-stage rescue of Wall Street's largest investment firms in March, this bold stroke was said to benefit all of us. The whole kingdom of American high finance would tumble down if government failed to act or made the financial guys pay for their own reckless delusions. Instead, dump the losses on the people.

Democrats who imagine they may find some partisan advantage in these events are deeply mistaken. The Democratic party was co-author of the disaster we are experiencing and its leaders fell in line swiftly. House banking chair, Rep. Barney Frank, announced he could have the bailout bill on President Bush's desk next week. No need to confuse citizens by dwelling on the details. Save Wall Street first. Maybe lowbrow citizens won't notice it's their money.

We are witnessing a momentous event--the great deflation of Wall Street--and it is far from over. The crash of IndyMac is just the beginning. More banks will fail, so will many more debtors. The crisis has the potential to transform American politics because, first it destroys a generation of ideological bromides about free markets, and, second, because it makes visible the ugly power realities of our deformed democracy. Democrats and Republicans are bipartisan in this crisis because they have colluded all along over thirty years in creating the unregulated financial system and mammoth mega-banks that produced the phony valuations and deceitful assurances. The federal government protects the most powerful interests from the consequences of their plundering. It prescribes "market justice" for everyone else.

Of course, the federal government has to step up to the crisis, but the crucial question is how government can respond in the broad public interest. Bernanke knows the history of the last great deflation in the 1930s--better known as the Great Depression--and so he is determined to intervene swiftly, as the Federal Reserve failed to do in that earlier crisis. By pumping generous loans and liquidity into the system, the Fed chairman hopes to calm the market fears and reverse the panic. So far, he has failed. I think he will continue to fail because he has not gone far enough.

If Washington wants real results, it has to abandon the wishful posture that is simply helping the private firms get over their fright. The government must instead act decisively to take charge in more convincing ways. That means acknowledging to the general public the depth of the national crisis and the need for more dramatic interventions.

Instead of propping up Fannie Mae or others, the threatened firm should be formally nationalized as a nonprofit federal agency performing valuable services for the housing market. That is the real consequence anyway if the taxpayers have to buy up $300 billion in stock. (We would prefer an orderly liquidation. The government has no business subsidizing the housing industry - Jesse)

The private shareholders "are walking dead men, muerto," Institutional Risk Analytics, a private banking monitor, observed. Make them eat their losses, the sooner the better.

The real national concern should be focused on the major creditors who lend to Fannie Mae and other US agencies as well as private financial firms. They include China, Japan and other foreign central banks. Foreign investors hold about 21 percent of the long-term debt paper issued by US government agencies--$376 billion in China, $229 billion in Japan.

It is not in our national interest to burn these nations with heavy losses. On the contrary, we need to sustain their good regard because they can help us recover by bailing out the US economy with more lending. If these foreign creditors turn away and stop their lending now, the US economy is toast and won't soon recover. (We would let them take their losses too. They purchased that Agency debt as part of a cycle of pegging their currencies at artificially low rates to the dollar for their own industrial export policy - Jesse)

Americans should forget about whining; it's too late for that. People need to get angry--really, really angry--and take it out on both parties. What the country needs right now is a few more politicians in Washington with the guts to stand up and tell us the hard truth about out situation. It will be painful to hear. They will be denounced as "whiners." But truth might be our only way out.

Stand up for the Constitution and send Washington a message. Vote out all Republicans and the Democratic leadership this fall.

US Banks with the Greatest Exposure to Home Equity

This chart is from Reggie Middleton's Boom Bust Blog

We've taken the liberty of turning it on its side to make it easier to read.

Reggie's site is worth reading. He tends to specialize in analyzing banks.

CitiFed's Results Boost Stocks into Option Expiration

And it only took a half trillion dollars of the taxpayer's money and an emergency SEC ruling that restricted trading in the big banks to create another important option expiration rally for the Wall Street trading houses.

Citi Posts Smaller-Than-Estimated Loss on Writedown
By Josh Fineman and Bradley Keoun

July 18 (Bloomberg) -- Citigroup Inc. reported a smaller- than-estimated loss by reducing mortgage-bond writedowns, eliminating jobs and borrowing money at lower rates. (Two of those three positives are courtesy of the Fed's balance sheet coverage for Citi - Jesse)

Citigroup, the biggest U.S. bank by assets, rose in New York trading after the company said its second-quarter net loss was $2.5 billion, or 54 cents a share, because of $12 billion in writedowns and increased bad-loan reserves. Analysts estimated the New York-based bank's loss at $3.67 billion.

Led by Chief Executive Officer Vikram Pandit, Citigroup is the third major U.S. bank to beat analysts' predictions this week, after JPMorgan Chase & Co. and Wells Fargo & Co. Merrill Lynch & Co.'s results yesterday fell short of Wall Street's estimates. Pandit, who took over in December, reduced assets by about $67 billion during the quarter, making progress on the $400 billion he has targeted.

``Conditions have eased a little bit and at the same time they have been able to grow their top line,'' William Fitzpatrick, an equity analyst at Optique Capital Management in Milwaukee, which manages $1.4 billion, said in a Bloomberg Television interview. ``They haven't had a lot of clients run out the door. They have been able to maintain relationships. Now it's just a matter of being more profitable.'' (Details, details - Jesse)

Writedowns for subprime-related assets and debt linked to bond insurers totaled $7.2 billion. The bank's credit costs increased $4.5 billion from the second quarter of 2007, mainly because of bad consumer loans in North America and the company's credit-card business.

Writedown Estimate

Credit Suisse Group analyst Susan Roth Katzke predicted in a June 24 note that the company would have as much as $10 billion of writedowns.

Shares of the company rose to $19.29 in New York trading, from $17.97 at the close on the New York Stock Exchange yesterday.

Second-quarter revenue dropped 29 percent to $18.7 billion, compared with the average estimate of $17.3 billion among analysts surveyed by Bloomberg. Earnings in the same quarter last year were $6.23 billion, or $1.24 a share.

The U.S. consumer unit, which includes retail banking and loans to individuals and small businesses, had revenue of $7.89 billion, virtually unchanged from a year earlier. The global cards business rose 3 percent to $5.47 billion.

Tier 1 Ratio

Citigroup's Tier 1 capital ratio, a measure regulators use to monitor a bank's ability to withstand loan losses, rose to 8.7 percent at the end of the quarter from 7.7 percent in the first quarter and 7.1 percent at the end of 2007. The minimum for a ``well-capitalized'' rating from U.S. regulators is 6 percent. Citigroup sets its own target at 7.5 percent, partly to assure its AA- rating from Standard & Poor's. (One way to increase that ratio is to take the 'bad stuff' off the balance sheet and let Benny carry it for you - Jesse)

Seven interest-rate cuts by the Federal Reserve in the past year have reduced the bank's borrowing costs and allowed it to trim the rates it pays depositors.

Revenue at Citigroup's corporate and investment bank plunged 71 percent to $2.94 billion. The wealth management division, which includes the Smith Barney brokerage, gained 4 percent to $3.32 billion.

Pandit, 51, put former Morgan Stanley colleague John Havens in charge of trading and investment banking, moved U.S. consumer head Steve Freiberg to oversee a new credit-card division and recruited former Wells Fargo executive Terri Dial to oversee consumer banking in the U.S....

How Bad Will It Get?

How bad is it? How bad will it become?

The straight answer is: worse than it is now, and it will last longer than you think. There is no easy way out. Bill Poole does not think it will be as bad as the Great Depression. But then again, we are in uncharted waters, and even he does not know.

There are some folks in Washington who think you cannot handle the truth, or at least handle it gracefully, without creating a fuss, maybe getting hysterical, and perhaps demanding a chunk of their hides. After all, your ignorance is their power.

Is it worth it? Ignorance? Is it worth making bad decision after bad decision, blissfully happy all the while, until you have doomed yourself and your family to a very painful and protracted period of near hopelessness and desperation?

Sometimes it gets so bad that an entire nation will surrender itself, willingly, to der Fuhrer or il Duce or the State, then to the madness, and finally, to the abyss.

The truth is not hidden. But it will not come to you unless you seek it, allow it in despite discomfort, and accept it, act on it.

"The secret of happiness is freedom. The secret of freedom is courage." Thucydides (c. 460 BC – c. 395 BC)

And the secret of courage is to care for something, someone, more than you care for yourself.

Seven Questions: How Bad Will It Get?
An Interview With William Poole
Foreign Policy

When William Poole warned in 2003 that Fannie Mae and Freddie Mac lacked the capital to weather a financial storm, his advice went unheeded. Five years later, the outspoken former president of the Federal Reserve Bank of St. Louis is far too polite to say “I told you so,” but he does have a message for the Fed: Wait too long to tackle inflation, and you’ll face an even worse recession in the years to come.

Foreign Policy: What’s your diagnosis of what happened to Fannie Mae and Freddie Mac?

William Poole: First of all, they had too little capital to withstand adverse circumstances. And the adverse circumstances were the severe downturn in housing, the decline in house prices, and the rising default rate on mortgages. I don’t know of anyone who early enough was saying that there would be a major national decline in house prices, so I can’t hold them to that standard, but I can hold them to a standard of holding adequate capital to be able to withstand unforeseen circumstances. That’s what capital is for.

FP: In 2003, you called for the government to eliminate its implied guarantee for Freddie Mac and Fannie Mae. Do you feel that Alan Greenspan, the Federal Reserve chairman at the time, didn’t listen to you?

WP: No. I never had any inkling that he disagreed with what I was saying. Greenspan was pretty much out in front also, saying we should try to scale back these companies and the implied guarantee—make them fully private companies so they’d be subject to market discipline. If Greenspan thought that I was way off base, he would have talked to me about it or had a staff member talk to me about it. That, I can attest, did not happen.

FP: Now, there has obviously been some turmoil in the banking sector. IndyMac, a regional California bank, collapsed last week. Analysts are wondering where the line is in terms of what banks are considered “too big to fail.” Where would you draw that line?

WP: I like the way that Greenspan used to put it and probably still does put it, that no firm should be too big to fail. Some might be too big to liquidate quickly and may require some support until they can be wound down, but there should be no firm too big to fail. We don’t know yet what the nature of the bailout of Fannie and Freddie is going to be, but I believe the plan would be to pay off at par all of the regular obligations. They are being turned into full faith and credit obligations of the United States government.

FP: So, what happens now?

WP: Here’s an analogy I like to use. In a formal bankruptcy, the court appoints a receiver. The receiver’s job is to, in some cases, reorganize a firm’s capital structure. Sometimes, the shareholders get wiped out and the bondholders become shareholders. Sometimes a company is liquidated and the creditors are paid according to certain legal rules. Depending on how particular credits are set up, a receiver’s job is to keep the company going long enough to obtain the maximum possible benefit for the creditors as a whole. In some cases, the company might be shut down quickly.

So that’s the analogy, and now the secretary of the Treasury is de facto in that position. But he’s operating under no established law. For the most part, everything that is now done to deal with Fannie Mae and Freddie Mac, to reorganize them financially or scale them back, is done now by negotiation between the secretary of the Treasury, Congress, and the companies. The companies have what you might call a “well-oiled political machine.” They have many members of Congress they talk to regularly who will represent their interests in this negotiation.

FP: NYU economist Nouriel Roubini, who has been sounding the alarm for quite a while, told Bloomberg News that we’re seeing the worst U.S. financial crisis since the Great Depression.

WP: I think that’s right, but let’s go back and revisit the Great Depression for a moment. In 1932, the economy was spiraling down and there were large numbers of bank failures. Eventually, in early 1933, various states started to declare banking holidays. They closed the banks and allowed them to continue to exist, but the depositors were not permitted to take any money out. They shut the doors.

When Franklin Roosevelt took office, he declared a national banking holiday. All the banks were closed, including the Federal Reserve banks. There was a total and complete collapse of the banking system, and the economy that had functioned on credit and deposits was suddenly left to function on hand-to-hand currency. We aren’t anywhere close to that and we won’t get close to that because of ample Federal Reserve resources and also intellectual understanding that would not permit that to happen. (What if the currency itself became nearly worthless? - Jesse)

FP: How bad will it get, then?

WP: We are going to have failures of large numbers of firms, financial firms in particular. A traditional important piece of business for community banks and regional banks are loans to real estate developers and builders. And now that some of those are going into default, it’s leading to failures of smaller commercial banks, and the ones that were the most heavily involved in real estate are the ones at the greatest risk. The longer these things go, the greater the depletion of capital. In time, the losses accumulate and exhaust capital and the firm fails, so the [Federal Deposit Insurance Corporation] shuts it down. It looks like there’s more of that to come, because there is no sign of a revival in home-building.

FP: Meanwhile, consumer prices are rising at their fastest rate in 17 years. Does that mean the Fed is running out of tools to keep growth going?

WP: All the financial turmoil that we’ve just been talking about—the tightening of credit, the fact that so many banks have impaired capital—that’s putting downward pressure on the economy, and the big increase in fuel prices is also putting downward pressure on real activity. You see that in transportation, the airlines, the auto industry—anything that has a big fuel cost. There is a growing amount of unemployment in those sectors, and the Federal Reserve is trying to support economic activity by holding the federal funds rate—the interest rate—at its current level. If the downturn in employment becomes much more severe, the Fed might even cut rates.
Now, to me, the inflation problem is actually part of what is depressing economic activity, because the generalized inflation that I think we have underway—although it’s not showing up in core inflation and wages just yet—is showing up in the depreciating dollar, and the depreciating dollar directly feeds through to increased energy prices and food prices. So, the depreciation itself is leading to depressed economic activity.

Moreover, if the inflation really starts to go into wages and into the core—the non-energy, non-food part—of the price indices, it will probably develop a fair amount of momentum and the Federal Reserve is not going to be able to reverse it even with a tighter monetary policy for probably a year or two, maybe even three. If the policy is too expansionary too long and we end up with a real inflation problem, all we’re doing is trading a bigger recession later for a smaller recession now. (Hell, we've been taking the easy way out of that trade off for twenty years or more. There must be a whopper of a recession just a waiting to get uncorked. - Jesse)

William Poole is the recently retired president of the Federal Reserve Bank of St. Louis.