U.S. NATIONAL DEBT CLOCK OVERWOUND?

The ridiculously large dollar amount above is an up-to-the-minute count of national debt that must be periodically refinanced by the U.S. Treasury (debt clock courtesy of Ed Hall).

U.S. 2009 gross domestic product was $14T, which means that our debt is more than the value of all of the goods and services that we produced in 2009, putting the U.S. behind only Japan of the large industrialized nations in debt as a percentage of GDP.

It will cost us, as a nation, about $500B in the 2009 fiscal year to meet the obligations of this debt.

Currently, the U.S. population is about 350M and the per capita share of our national debt is about $35,000. The per capita share of the annual interest payment on the debt is about $1,650.

However, not everyone generates tax revenue that the Treasury can use to help maintain the debt burden. Based on 2004 data, there are 131 million tax filers, of whom 43 million owed no tax. At current levels, our national debt is over $120,000 per taxpayer and the annual interest payments are $5,700 per taxpayer.

Of course, this $5,700 excludes expenses for things like social security, medicare, infrastructure, national defense, etc. (click here for a graph), which explains why the Congressional Budget Office forecasts budget deficits of over $430B in each of the next two years, or $1.4T between 2009 and 2013.

Based on the CBO predictions, the federal budget will not be in balance for any of the next ten years, and the total national debt in the year 2018 will be nearly $13T, or about $148,000 per taxpayer (again, using 2004 data), and the interest on that debt will cost each taxpayer about $7,000/year, assuming that the interest rate on Treasury debt does not exceed 4.7%.

However, the CBO is basing these deficit estimates on a projected 5.2% annual growth in nominal GDP, estimates that currently appear to be absurdly rosy. For example, the International Monetary Fund predicts nominal GDP growth for 2008 and 2009 in the U.S. of less than 0.5%. Additionally, Goldman Sachs predicts U.S. GDP to drop 5% in the fourth quarter of 2008 and be flat to slightly down in 2009.

What this means is that, with GDP growth flat to non-existent, the U.S. government engaged in vigorous rounds of Keynsian economic stimulus, and unemployment headed toward 9%, we can expect the U.S. national debt to start climbing at a new, exponential rate. How long this trend can continue before the U.S Treasury starts having problems finding buyers for its debt is anyone's guess.

Finally, it is not clear that the trillions of dollars of stimulus spending and loan guarantees are included in the current debt estimate on which I am basing these calculations, so the actual debt numbers could be up to $7T higher!

P.S.

If the amount of the U.S. debt is distressing to you and you would like to do something about it, you can send a check to the U.S. Government which will be used to reduce the national debt:

Make your check payable to the Bureau of the Public Debt, and in the memo section, notate that it is a Gift to reduce the Debt Held by the Public. Mail your check to:

Attn Dept G
Bureau Of the Public Debt
P. O. Box 2188
Parkersburg, WV 26106-2188

THROW WAGONER OFF THE TRAIN

Kirk Kerkorian (pictured above) had amassed nearly a 10% position in GM, and earned a seat on the board, but GM management blocked Mr. Kerkorian's initiatives (such as a merger with Nissan/Renault) to such an extent that Mr. Kerkorian dumped the entire position at a loss nearly two years ago.

After decades of obstructing the sort of change that Detroit really needed, the management of GM is now in Washington, hat in hand, looking for enough cash to get them through the winter. All I can think is, "I wonder what Mr. Kerkorian would have to say about it?"

I imagine that the first thing he would say is, "Throw the bums out!", referring of course to GM management. The idea that all that GM needs is more cash is absurd. The writing was on the wall as far back as 1973, and again in 1979 when Jimmy Carter was pushing for the kinds of changes that GM is going to have to embrace if they are to prosper. We are talking NEARLY 30 YEARS OF OBFUSCATION AND OBSTRUCTION.

The miracle is that GM has survived this long, which can only be attributed to America's love of American cars, especially the Chevy brand.

However, this love has been long in decline, as Japanese, and now Korean, automakers have really gotten their finger on what the median U.S. car driver in looking for (I can't tell you exactly what it is, but I can tell you that GM doesn't make it).

What did Detroit do in the face of massive market-share loss in the all-important midsize sedan segment? They put all their energies into the next generation of the large-platform SUV segment which had been generating most of their profits. However, in the face of nearly $4 gasoline, and after more than a billion dollars in R&D, GM completely pulled the plug on this project (which, allegedly, was developing an even BIGGER family of SUV's than the current crop of Suburbans and Tahoes).

So, what can or should the U.S. public do in the face of an impending Chapter 11 filing by GM? Some say nothing at all, let GM be controlled by their creditors to reemerge a different company. However, I don't think that GM would emerge on the other side. I believe that the combined weight of market-share loss, loss of public confidence, legacy costs, labor unrest, and the credit crisis would doom GM to implode in absolutely horrendous fashion, bringing down with it a large swath of the U.S. manufacturing sector.

So, if this is true, we probably should craft a plan to inject capital into GM, but the new U.S. administration should have at least one seat on the board and the capital should come in the form of convertible preferred shares (assuming we as a nation are committed to maintaining a domestic auto industry). And, I'm sure the plan would be better received if it came with Rick Wagoner's head on a platter.

Update 12/2/2008

DRIVING FROM DETROIT TO DC? How much clearer can they make it that they just don't get it than by making the announcement that Rick Wagoner will drive a Malibu Hybrid from Detroit to D.C.? Who drives that distance for ONE DAY OF HEARINGS? What, is he going to DRIVE BACK TOO? A quick check on Expedia shows that, by booking as little as one week in advance, Rick could have flown non-stop from Detroit to Washington in coach on Northwest Airlines for $194, including taxes. Detroit to Washington, round-trip, is 1,048 miles; at $0.27/mile, driving will cost him $283.00, never mind the cost of his time. Rick Wagoner costs shareholders of GM $2,833/hour plus benefits, so his decision to spend an extra 14 hours driving is costing the company $39,662 vs. flying non-stop in coach.

TARP, PERP, OR 'WHAT, ME WORRY?'

On October 2nd I observed that the TARP program was unworkable due to the taxpayer guarantee clause, and now Hank Paulson has essentially confessed as much.

About 1/3 of the TARP program is being used to buy preferred equity in U.S. banks in an effort to provide liquidity to these institutions. However, the Treasury could not find a way to guarantee that the taxpayer would not be caught holding the bag if they went ahead and purchased the toxic assets on bank balance sheets (duh), so they are not buying the stuff. And, it is completely unclear what they plan to do with the remaining $500B.

While the legislation is still called "TARP" for "troubled assets", the implementation should be called "PERP" for "preferred equity", or, more appropriately, "WHO THE HELL IS RESPONSIBLE FOR THIS CRAP?" From the look of Hank Paulson above, it seems like he's saying "Don't Blame Me!"

What does this mean? I means that a great big heaping pile of uncertainty has been dumped on the financial markets and that the current administration is doing its best to wriggle, or slither, all the way to January 20th.

Of course the markets, which abhor uncertainty, sold off on the mere announcement that Paulson was to speak. If the banks have to continue to carry their toxic assets on their balance sheets, and if these assets continue to be marked down, what does this mean for their ability to lend? Frankly, it means that they won't lend even if Hank Paulson turns red in the face exhorting them otherwise.

A bad loan, or any other toxic asset on the books, is only a problem when you write it down or write it off. In the mean time, it can happily sit there like a rosy turd and basically do no damage (apart from the stink). If the Treasury can't buy the crap, then nobody else will and there essentially is not a market with which to put a price on these little piles of poo. Therefore, the SEC should place a moratorium on "mark-to-market" accounting practices.

While this isn't going to make the banks balance sheets smell any nicer, it will postpone the day of reckoning and will enable them to put the cash infusions to work in the form of new loans.

If this Administration waits until January 20th to take these steps, Fannie, Freddie, and a whole mess of regional banks are going to fall into receivership and the Fed, the FDIC and the Treasury will be overwhelmed.

--Christian Antalics

OBAMA 2009 or FDR 1933?

My Father astutely observed that he hears echoes of FDR in Obama's speeches. It is an interesting observation in that history may paint G.W. Bush with the same brush as was used to paint Herbert Hoover, and the Obama administration will similarly inherit a nation in the throes of a deep financial crisis.

The following is FDR's first inaugural address, in January 1933. Tell me Obama couldn't make the same address and have it sound pertinent.

President Hoover, Mr. Chief Justice, my friends:

This is a day of national consecration. And I am certain that on this day my fellow Americans expect that on my induction into the Presidency, I will address them with a candor and a decision which the present situation of our people impels.

This is preeminently the time to speak the truth, the whole truth, frankly and boldly. Nor need we shrink from honestly facing conditions in our country today. This great Nation will endure, as it has endured, will revive and will prosper.

So, first of all, let me assert my firm belief that the only thing we have to fear is fear itself -- nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance. In every dark hour of our national life, a leadership of frankness and of vigor has met with that understanding and support of the people themselves which is essential to victory. And I am convinced that you will again give that support to leadership in these critical days.

In such a spirit on my part and on yours we face our common difficulties. They concern, thank God, only material things. Values have shrunk to fantastic levels; taxes have risen; our ability to pay has fallen; government of all kinds is faced by serious curtailment of income; the means of exchange are frozen in the currents of trade; the withered leaves of industrial enterprise lie on every side; farmers find no markets for their produce; and the savings of many years in thousands of families are gone. More important, a host of unemployed citizens face the grim problem of existence, and an equally great number toil with little return. Only a foolish optimist can deny the dark realities of the moment.

And yet our distress comes from no failure of substance. We are stricken by no plague of locusts. Compared with the perils which our forefathers conquered, because they believed and were not afraid, we have still much to be thankful for. Nature still offers her bounty and human efforts have multiplied it. Plenty is at our doorstep, but a generous use of it languishes in the very sight of the supply.

Primarily, this is because the rulers of the exchange of mankind's goods have failed, through their own stubbornness and their own incompetence, have admitted their failure, and have abdicated. Practices of the unscrupulous money changers stand indicted in the court of public opinion, rejected by the hearts and minds of men.

True, they have tried. But their efforts have been cast in the pattern of an outworn tradition. Faced by failure of credit, they have proposed only the lending of more money. Stripped of the lure of profit by which to induce our people to follow their false leadership, they have resorted to exhortations, pleading tearfully for restored confidence. They only know the rules of a generation of self-seekers. They have no vision, and when there is no vision the people perish.

Yes, the money changers have fled from their high seats in the temple of our civilization. We may now restore that temple to the ancient truths. The measure of that restoration lies in the extent to which we apply social values more noble than mere monetary profit.

Happiness lies not in the mere possession of money; it lies in the joy of achievement, in the thrill of creative effort. The joy, the moral stimulation of work no longer must be forgotten in the mad chase of evanescent profits. These dark days, my friends, will be worth all they cost us if they teach us that our true destiny is not to be ministered unto but to minister to ourselves, to our fellow men.

Recognition of that falsity of material wealth as the standard of success goes hand in hand with the abandonment of the false belief that public office and high political position are to be valued only by the standards of pride of place and personal profit; and there must be an end to a conduct in banking and in business which too often has given to a sacred trust the likeness of callous and selfish wrongdoing. Small wonder that confidence languishes, for it thrives only on honesty, on honor, on the sacredness of obligations, on faithful protection, and on unselfish performance; without them it cannot live.

Restoration calls, however, not for changes in ethics alone. This Nation is asking for action, and action now.

Our greatest primary task is to put people to work. This is no unsolvable problem if we face it wisely and courageously. It can be accomplished in part by direct recruiting by the Government itself, treating the task as we would treat the emergency of a war, but at the same time, through this employment, accomplishing great -- greatly needed projects to stimulate and reorganize the use of our great natural resources.

Hand in hand with that we must frankly recognize the overbalance of population in our industrial centers and, by engaging on a national scale in a redistribution, endeavor to provide a better use of the land for those best fitted for the land.

Yes, the task can be helped by definite efforts to raise the values of agricultural products, and with this the power to purchase the output of our cities. It can be helped by preventing realistically the tragedy of the growing loss through foreclosure of our small homes and our farms. It can be helped by insistence that the Federal, the State, and the local governments act forthwith on the demand that their cost be drastically reduced. It can be helped by the unifying of relief activities which today are often scattered, uneconomical, unequal. It can be helped by national planning for and supervision of all forms of transportation and of communications and other utilities that have a definitely public character. There are many ways in which it can be helped, but it can never be helped by merely talking about it.

We must act. We must act quickly.

And finally, in our progress towards a resumption of work, we require two safeguards against a return of the evils of the old order. There must be a strict supervision of all banking and credits and investments. There must be an end to speculation with other people's money. And there must be provision for an adequate but sound currency.

These, my friends, are the lines of attack. I shall presently urge upon a new Congress in special session detailed measures for their fulfillment, and I shall seek the immediate assistance of the 48 States.

Through this program of action we address ourselves to putting our own national house in order and making income balance outgo. Our international trade relations, though vastly important, are in point of time, and necessity, secondary to the establishment of a sound national economy. I favor, as a practical policy, the putting of first things first. I shall spare no effort to restore world trade by international economic readjustment; but the emergency at home cannot wait on that accomplishment.

The basic thought that guides these specific means of national recovery is not nationally -- narrowly nationalistic. It is the insistence, as a first consideration, upon the interdependence of the various elements in and parts of the United States of America -- a recognition of the old and permanently important manifestation of the American spirit of the pioneer. It is the way to recovery. It is the immediate way. It is the strongest assurance that recovery will endure.

In the field of world policy, I would dedicate this Nation to the policy of the good neighbor: the neighbor who resolutely respects himself and, because he does so, respects the rights of others; the neighbor who respects his obligations and respects the sanctity of his agreements in and with a world of neighbors.

If I read the temper of our people correctly, we now realize, as we have never realized before, our interdependence on each other; that we can not merely take, but we must give as well; that if we are to go forward, we must move as a trained and loyal army willing to sacrifice for the good of a common discipline, because without such discipline no progress can be made, no leadership becomes effective.

We are, I know, ready and willing to submit our lives and our property to such discipline, because it makes possible a leadership which aims at the larger good. This, I propose to offer, pledging that the larger purposes will bind upon us, bind upon us all as a sacred obligation with a unity of duty hitherto evoked only in times of armed strife.

With this pledge taken, I assume unhesitatingly the leadership of this great army of our people dedicated to a disciplined attack upon our common problems.

Action in this image, action to this end is feasible under the form of government which we have inherited from our ancestors. Our Constitution is so simple, so practical that it is possible always to meet extraordinary needs by changes in emphasis and arrangement without loss of essential form. That is why our constitutional system has proved itself the most superbly enduring political mechanism the modern world has ever seen.

It has met every stress of vast expansion of territory, of foreign wars, of bitter internal strife, of world relations. And it is to be hoped that the normal balance of executive and legislative authority may be wholly equal, wholly adequate to meet the unprecedented task before us. But it may be that an unprecedented demand and need for undelayed action may call for temporary departure from that normal balance of public procedure.

I am prepared under my constitutional duty to recommend the measures that a stricken nation in the midst of a stricken world may require. These measures, or such other measures as the Congress may build out of its experience and wisdom, I shall seek, within my constitutional authority, to bring to speedy adoption.

But, in the event that the Congress shall fail to take one of these two courses, in the event that the national emergency is still critical, I shall not evade the clear course of duty that will then confront me. I shall ask the Congress for the one remaining instrument to meet the crisis -- broad Executive power to wage a war against the emergency, as great as the power that would be given to me if we were in fact invaded by a foreign foe.

For the trust reposed in me, I will return the courage and the devotion that befit the time. I can do no less.

We face the arduous days that lie before us in the warm courage of national unity; with the clear consciousness of seeking old and precious moral values; with the clean satisfaction that comes from the stern performance of duty by old and young alike. We aim at the assurance of a rounded, a permanent national life.

We do not distrust the -- the future of essential democracy. The people of the United States have not failed. In their need they have registered a mandate that they want direct, vigorous action. They have asked for discipline and direction under leadership. They have made me the present instrument of their wishes. In the spirit of the gift I take it.

In this dedication -- In this dedication of a Nation, we humbly ask the blessing of God.

May He protect each and every one of us.

May He guide me in the days to come.

History Repeating Itself

Tonight, Barack Obama accepted and John McCain conceded.

This is historic because of the ethnicity of Barack Obama. This is more importantly historic because we are seeing the same sort of transition that occurred between President Hoover and President Roosevelt.

To my Father, who was alive for FDR's "Fireside Speeches", he sees the same leadership in Obama that FDR exhibited when he led our country out of the Great Depression.

I argued that Obama's oratory style is more JFK, but he disagreed with me strongly: Obama's style is FDR. He is a calming yet motivating force that unites us in the common goal of national economic recovery.

I love my Dad and I greatly respect his opinion, and in this case it is no different. While Obama possesses the youth and charisma of JFK, he also possesses the wisdom of FDR.

God Bless America, and may we unite in our efforts to work our way out of our morass.

--Christian Antalics

11 DAYS LATER

The global market events of the last eleven days remind me of the plot of the movie 28 Days Later. Only, in this case, the virus is a global solvency crisis and the zombies are bankers who are vomiting blood on us all as they fiend for additional capital.

Since the Dow Jones US Financial Index rallied 24% from the low on 10/10 to the close on 10/13, the index has given back all that gain and then some. And, the VIX index, which had posted record highs near 70 previously, is now well into uncharted territory, opening near 90 this morning before retreating.

In previous posts, I had pointed partial blame for the increase in volatility to the SEC short-sale ban that expired on October 8th. However, that was two weeks ago--- how could the volatility persist? One explanation could be that the short-sale ban had no impact on volatility and that the VIX (which measures fear, basically) is rallying because people are frantic and uncertain. However, I still believe that the SEC market manipulation that correlated to unusual options activity and a spike in the VIX is still contributing to the volatility and the fear in the market. I believe that the market came unhinged during the period of the short-sale ban, by which I mean that the normal corrective mechanisms of the markets were not behaving as expected, and those mechanisms have yet to return to normal function. This, in turn, is spooking investors who are already on edge thanks to the exceptionally poor performance in the financial sector, which is now spreading to the larger economy. They buy the dips and get bitten, looking for a snap-back rally that never materializes.

The markets, to a large extent, are disconnected from reality, unless we believe the 28 Days Later thesis that England is going to be reduced to a military compound of 10,000 inhabitants within 28 months. So, while I liked the movie a lot more than I enjoy watching the markets shred 401(k) accounts, I tend to think that what we are seeing is an opportunity in global equities the likes of which we haven't seen since the 1930's.

For example, shares of numerous companies in the water transportation sector (examples include OCNF, PRGN, ESEA, EGLE, SBLK) are trading well below book value and paying huge dividends with high profit margins. This can only be explained by the 28 Days Later thesis in which global trade shuts down and everybody heads for the basement.

So, while taking a bite at this market likely means getting bitten, sometimes the best opportunities to invest come when the zombies are roaming the streets and everyone is running in panic.

END OF SHORT SALE BAN USHERS IN BIGGEST TWO-DAY RALLY IN FINANCIAL STOCKS IN HISTORY

Those that feared that the end of the short-sale ban would trigger a sell-off in the shares of financial services companies were right: the stocks declined for for exactly one trading session, then set off on a two day rally that increased the Dow Jones U.S. Financials Index, between the lows marked near the open on Friday to the close of the markets today, by nearly 24%.

The global credit crisis is now officially a five-alarm blaze: the central banks of the U.S., England, the E.U., Japan, and China are working in a historically unprecedented and coordinated fashion to calm the markets and prop up the global financial system.

Central bankers are finally coming to the realization that the global financial crisis is NOT a liquidity crisis, but rather a crisis of confidence based on the rapidly deteriorating credit worthiness of financial institutions small and large. This crisis is the culmination of years of banks chasing after each other to sell debt against ever-weakening standards, fueled by artificially low input costs in the form of a Fed Funds rate that stayed too low too long, and exacerbated by investment banks that sought in 2001, and were given, a regulatory increase in reserve requirements from 7x to 40x.

Since Alan Greenspan cut the Fed Funds rate to 1% in the wake of 9-11, and the Wall St. banks sought regulatory relief in the same period and used similar arguments (increasing the M2 money supply will help ward off a post 9-11 recession), you could say that Osama bin Laden may have finally succeeded in what he set out to do: end the longest period of free and unfettered economic growth in the history of the planet.

While I do not believe that this crisis will result in the end of social democracies and the fundamental tenets of free market economics, nor result in the kind of suffering that marked the dark years of the Great Depression, the period that started with Ronald Reagan in which the financial markets facilitated individuals and businesses to take wild risk, to pursue a crazy dream, or to rapidly turn a small business with a great idea into a multinational powerhouse is over.

In the upcoming decades, for better or for worse, we will be back to a time when cash is king, when credit will be meted out conservatively, in which businesses will grow gradually over time, and in which Americans will be forced to make hard choices in which they must figure out how to do more with less. It will be a simpler time, to be sure. And, it will be a time of dramatically lower earnings per share growth.

This fear has been at the heart of the recent stock market sell-off, and is why a two-day, 24% gain in financial stocks only takes them back to where they were three days before. The fear is that, in a period of single-digit earnings growth, the years of +20x P/E ratios is over, that this recovery will NOT be like the others.

While I was long skeptical of the extremes in valuations that led to boom and bust cycles, I somehow prefer that to the future that I now see taking shape. The old future was one that was marked by optimism, by self-confidence, by Greenspan's "irrational exuberance", in which you could take a business plan written on the back of a napkin and find investors willing to front you a cool million to get it off the ground. Somehow, that feels more American to me, even if it proved wildly irresponsible in many cases, than the future that now seems to be in store for us.

Christian Antalics

FINANCIAL SHORT SALE BAN SET TO EXPIRE

The SEC's ban on short sales of a market basket of financial firms is set to expire at 11:59 p.m. Wednesday evening.

You can say that, if the intent of the ban was to support the price of the targeted stocks, the effort has failed: from the close of 9/17 (the last full day of trading before the ban was imposed) through the close today, financial stocks were down nearly 40% more than the Dow.

Additionally, volatility is now at record levels; the VIX index, which basically measures levels of fear in the financial markets, is nearly twice as high as it was in the early stages of this crisis (and at the highest point since the index was created over 18 years ago):

Why would volatility have continued to rise in the face of a ban on short selling, which we might think would calm the markets? Short selling, rather than the parasitic behavior that the SEC and the CEO's of financial firms perceive it to be, is just one more tool that investors can use to hedge, or limit risk. By restricting short selling, the SEC sent a signal to investors to stay out of the market until the short sale ban is over. Since the vast majority of investors take long positions in stocks, this translated into a generalized buyer's strike. Why would this be? On one hand the ban on short selling increased the risk of taking long positions in financial companies as hedging those positions had become more difficult; and on the other hand the ban gave investors the perception that the ban would result in pent-up selling pressure that could precipitate a new leg down in financial stocks once the ban was lifted.

Since financial stocks lead the stock market as a whole (no stock market rally can be sustained in the face of a decline in financial stocks), why would any investor take ANY position in the stock market during the period of the short sale ban? During the period of the ban, the U.S. stock market lost over $6T in value, losses that would have been realized by anyone who was scared out of the market or was forced to sell by virtue of a margin call. Therefore, we can reasonably argue that Christopher Cox and the SEC helped the pension funds of the United States lose $6T by their wrong-headed decision.

So, now that the ban is set to expire, what can we expect to happen? While it is very hard to say, I believe that the end of the ban will usher in a rally in financial stocks, for the same reasons that I attribute the steep market declines to the ban. Able to hedge positions, investors will feel safer taking those positions. And, any good news could easily trigger short covering rallies, which were out of the picture when short selling was banned.

Moral of the story: don't mess with the free market.

Christian Antalics

CENTRAL BANKS CUTS RATES IN TANDEM

Prior to the start of trading in New York, central bankers around the world cut rates by equivalent amounts in an effort to avert a deflationary spiral and to prevent a run on any one currency. This decision was especially difficult for the Europeans, who have been reluctant to accept the thesis as presented by Paulson and Bernanke. However, healthy declines in global indices pushed their hand. Above, France's Prime Minister Francois Fillon delivers a speech during a special debate on the global financial crisis at the National Assembly in Paris October 8, 2008.

Time will tell if the concerted rate cuts have the desired effect. In the short-term, a cut in the Fed Funds rate will reduce the cost of commercial bank's primary input by 25%, which should flow through to their bottom line. However, the Fed has been shoveling low-cost short-term money into the financial system to the tune of nearly $1T since September in an unprecedented effort to keep U.S. banks solvent and liquid. Therefore, it is somewhat doubtful that the rate cut will have as big an impact as it would otherwise.

And, if the U.S. and world economies should finally gain traction, the amount of cash sloshing around in the system could trigger runaway inflation.

At the moment, however, the central bankers seem to fear a deflationary spiral more than an inflationary one. This is an interesting hypothesis, considering that there is ample anecdotal evidence that core inflation, excluding volatile food and energy, is running north of 5%. If inflation rates are running this high (even higher if we count the grocery store and the gas station), interest rates will trend higher regardless of the Fed's efforts to peg rates at a low level. In fact, LIBOR (an index that tracks the rates that banks charge for short-term loans to one another) peaked at 5.39% today, but should ease slightly in light of the concerted rate cuts.

What does this mean? It means that the world economy is locked in a crisis of confidence and that the largest banks are no longer confident that the counter-party to their short-term loan will be around long enough to pay the loan back; they are therefore demanding an insurance premium which is shown by the wide spread between the Fed funds rate and LIBOR. This insurance premium, however, virtually insures that the bank accepting those terms will be at increased risk of failure, so the lending bank basically refuses to lend, regardless of how cheap their access to cash may be.

At the moment, however, the Federal Reserve is actively shooting the U.S. dollar full of holes. It is only by virtue of the global nature of this crisis that the dollar has not collapsed completely. The Japanese yen is now on parity with the U.S. cent, something that happened only once before, in the period between July 1994 and August 1995. This dramatic decline in the value of the U.S. dollar, especially if it continues to worsen as can be reasonably expected, is inflationary and reduces the buying power of those on fixed incomes.

Rather than flooding the financial system with liquidity (which isn't getting down to the inner workings of the credit markets due to the fear of bank failure), why doesn't the Fed start a program of loan guarantees for a rate equal to half of the historical spread between Fed Funds and LIBOR? In other words, banks that subscribe to the program can make interbank loans at a rate close to the historical average and have the assurance of the U.S. Treasury that the loan will be repaid. This program, in my opinion, would be cash-flow positive for the Treasury, and, since it will get to the heart of the credit crisis, will increase bank liquidity and reduce the risk of bank failure.

The Federal Reserve announced a program earlier this week that is similar in some regards to my proposal. Essentially, the Federal Reserve began buying commercial paper on the open market with the hope that they could help the market become "unstuck". However, participants in this market know perfectly well that the Fed is a buyer of last resort who is participating in the auctions out of a sense of necessity, rather than because the Fed believes that commercial paper is a good investment. Therefore, this is yet another liquidity move that fails to get at the heart of the problem, which is the fundamental solvency risk of U.S. institutions.

Christian Antalics

WELLS FARGO BID FOR WACHOVIA SHOWS THAT THE FREE MARKET IS NOT DEAD

Today, Wells Fargo announced a nearly $16B bid for Wachovia, prompting the latter's stock to pop nearly 60%. Days earlier, the Federal Reserve and FDIC had engineered the sale of Wachovia to Citigroup for $2B and had agreed to provide over $300B in loan guarantees. Wells Fargo's bid is 8x larger and does not involve implicit or explicit government guarantees!

If this level of interest exists in Wachovia, why did the U.S. Government short-circuit the free market and put over $300B of taxpayer money at risk? Are we to assume now that similar government deals involving Bear Stearns, Washington Mutual, and Merrill Lynch were similarly flawed? What does it say, in general, about government interventions into the free market?

Clearly, the sweetheart deal that the Feds gave Citigroup needs to be cancelled and the terms of government-sponsored deals involving Bear Stearns, Washington Mutual, and Merrill Lynch need to be reviewed to see if any institutions were unfairly enriched and if any taxpayer money was improperly put at risk.

Christian Antalics

PORKY PAULSON PLAN PASSES SENATE

The U.S. Senate passed this evening, by a wide margin, legislation that has at the heart of it the Paulson Plan:

AUTHORITY.— The Secretary is authorized to establish the Troubled Asset Relief Program (or ‘‘TARP’’) to purchase, and to make and fund commitments to purchase, troubled assets from any financial institution, on such terms and conditions as are determined by the Secretary, and in accordance with this Act and the policies and procedures developed and published by the Secretary.

So, the U.S. Senate blinked and granted Hank Paulson authority to spend an amount greater than the gross domestic product of Australia with virtually no strings attached.

Not only is this unprecedented, but it is of questionable economic and constitutional merit.

This legislation will do the following:

• Will cause the shares of financial stocks to rally as investors will perceive that the risk of outright failure due to "troubled assets" has diminished significantly.
• Will guarantee that the Treasury, and by extension the U.S. taxpayer, will be saddled with the absolutely worst bonds and securities that banks and other institutions, both U.S. and foreign, have clanking around in their basements.
• Will potentially provide the banks with an incredible windfall as they unload toxic assets at above market prices, and buy them back later at "fire-sale" prices.
  
• Will put extreme pressure on the dollar and will prove to be highly inflationary.
• Will dramatically limit the discretionary spending authority of the U.S. Legislature.
• Will increase the risk of a credit downgrade on U.S. Sovereign debt.
• Will cause U.S. interest rates to rise as inflationary pressures increase.
• Will be viewed in hindsight as a boondoggle the magnitude of which can never be repeated.

That being said, if the legislation helps unglue the stuck wheels of lending, that will be a good thing. However, as I mentioned in previous posts, the credit-worthiness of U.S. businesses and individuals is at a historic low, and any extended period of economic weakness will worsen this condition. In other words, the credit markets cannot come completely "unstuck" until the balance sheets of businesses and individuals regain their strength.

So, we'll see what the House has to say about it, but it looks like a done deal.

UPDATE 10/2/08

Continued study of the Senate TARP bill revealed a clause that could render the entire bill unworkable:

PREMIUMS.—

IN GENERAL. — The Secretary shall collect premiums from any financial institution participating in the program established under subsection 9 (a). Such premiums shall be in an amount that the Secretary determines necessary to meet the purposes of this Act and to provide sufficient reserves pursuant to paragraph (3).

AUTHORITY TO BASE PREMIUMS ON PRODUCT RISK. — In establishing any premium under paragraph (1), the Secretary may provide for variations in such rates according to the credit risk associated with the particular troubled asset that is being guaranteed. The Secretary shall publish the methodology for setting the premium for a class of troubled assets together with an explanation of the appropriateness of the class of assets for participation in the program established under this section. The methodology shall ensure that the premium is consistent with paragraph (3).

MINIMUM LEVEL. — The premiums referred to in paragraph (1) shall be set by the Secretary at a level necessary to create reserves sufficient to meet anticipated claims, based on an actuarial analysis, and to ensure that taxpayers are fully protected.

The key language here is in the final paragraph, "The premiums referred to in paragraph (1) shall be set by the Secretary at a level necessary to create reserves sufficient to meet anticipated claims, based on an actuarial analysis, and to ensure that taxpayers are fully protected." What the legislation is calling for is bond insurance, or credit default swaps, both of which are at the heart of the financial crisis, as they have become prohibitively expensive.

The point of the TARP legislation, as I understand it, is to pay banks and other holders of distressed assets a price above the current market, or "fire-sale" price that they could currently earn if the assets were liquidated through public auction. How the Secretary of the Treasury is going to structure the purchase of toxic assets such that the taxpayer is "fully protected" without charging a premium that puts the net price of the assets below the fire-sale price, I have NO idea, but it will be very interesting to watch him try!

Christian Antalics

HOUSE DEFEATS PAULSON BAILOUT

In what media pundits called a "great surprise", the U.S. House of Representatives defeated, by a substantial margin, proposed legislation that would have granted the Treasury Secretary of the United States unprecedented authority to buy securities and debt in the open market in an effort to prevent continued deterioration in the value of these assets.

Although he didn't participate in the vote, presidential candidate and U.S. Senator John McCain stated in a brief post-vote news conference that legislators from both houses would have to go "back to the drawing board" to fashion a new plan, which seems to imply that the Paulson Plan is dead. In the mean time, the stock market reacted violently; financial stocks lost 13% but ended the day 10% above the lows posted in July, which implies that they could have much further to fall.

Also in the news today the FDIC put down another massive bank, North Carolina-based Wachovia (formed by the merger of First Union and Philly-based Corestates banks), and fed it to Citigroup, only days after they had euthanized Washington Mutual and fed it to JP Morgan, and folded Merrill Lynch into Bank of America (for some reason, Lehman Brothers was left to the bankruptcy courts to sort out). At the moment there appears to a consortium of five banks that the Federal Reserve is utilizing as the repository for the deposits of competitor banks that become functionally insolvent: Goldman Sachs, JP Morgan, Citigroup, Bank of America, and Morgan Stanley. It appears that the Federal Reserve has decided that these banks must not fail, and is prepared to print as much money as it has to in order to keep them solvent. That could be expensive, especially if JP Morgan fails to sell enough stock to fund their capital base. In fact, the capital positions of all of these banks if far from certain, as a deep recession and increased defaults could push them into insolvency, in particular JP Morgan which is more highly leveraged. However, if you feel the need to buy the common stock of a U.S. bank, these five would be a good place to start looking.

So, what can the Congress do at this point to prevent another Hoover-era financial meltdown? Right now, without Congressional approval, the SEC can alter a rule that says that banks must price their mortage-backed paper and derivatives to market, rather than face value, increasing the book value of the banks that hold the paper; however, since the paper is highly illiquid (nobody wants to buy it off them), it does not really guarantee the solvency of the institution, and other institutions will still view these banks as vulnerable. In any event, a move such as this will buy the banks additional time and could forestall an FDIC take-over, which may be enough to allow the free market to find a solution without government intervention. Additionally, the FDIC can help assuage the fears of depositors over the security of their deposits, especially small businesses who have more than $100K of deposits in U.S. banks, by increasing the federal insurance amount to $250K.

Finally, Congress can focus on the segment of the economy that suffers the most from a dysfunctional credit market: small business. Small businesses, which are generally more lightly capitalized and usually cannot tap the equity markets for funding, are highly dependent upon short-term lines of credit to buy raw materials and make payroll. Congress can act quickly to allocate additional authorizations to the Small Business Administration so that it can secure loans to small businesses that cannot get the necessary capital from the commercial banks. With the SBA guarantee, the commercial banks will gladly extend the loans at reasonable terms, and small businesses can continue to operate.

So, the failure of the Paulson Plan, which would have allowed companies like his former employer, Goldman Sachs, to sell their toxic paper to the U.S. Treasury, and then buy it back at a later date at a discount, is a good thing, and kudos to the American public for having their voices heard.

Christian Antalics

Ron Paul on Government Price Fixing

During his questioning of Ben Bernanke on 9/24/08, Ron Paul's diatribe was all over the place (as is his style), but by the end he had hit on the key points in one of the most lucid and candid assessments of the predicament:

1) The so-called "toxic assets" that the investment banks are trying to dispose of are only "illiquid" because the holders of this paper do not want to mark them to their market value. Instead of auctioning some of this this paper to the market in order to seek true price discovery, the banks want to place reverse bids to the Treasury Dept., essentially telling Treasury what price they will accept for the paper, which the Treasury Dept. is obligated to pay, until the $700B is gone, or until more money is authorized. When the buyer must accept the seller's price and must execute the transaction, it becomes a form of price fixing which elevates the price above the intrinsic value. Not to mention that this is a government transfer payment (read: welfare payment) equal to the difference between the "market price" and the price paid. Only if the assets appreciate over a reasonable period of time will the government be made whole, but if this expectation were rational, there would be a liquid market for mortgage-backed paper. The government tried price fixing in the 1930's, as Ron Paul astutely pointed out, which deepened and prolonged the Great Depression.

2) The heart of the problem is that home prices went up too far too fast, and now they have to come down, which is depressing the value of mortgage-backed paper and derivatives thereof. If problem is one of home price inflation the government, by essentially putting a floor under mortgage-backed paper, is fighting inflation with more inflation, which is a lot like pouring gasoline on a fire (to be fair, they are fighting the deflation in the debt instruments linked to property values). The point that I think Ron Paul was getting at is that the issue is less one of illiquid assets and more so one of fundamental solvency: a number of the investment banks cannot remain solvent if their assets are priced correctly. By inflating the value of mortgage-backed paper, you are simply allowing the taxpayer to stop a bullet that was meant for the investment banks. It does nothing to solve the underlying problem, which is that the asset backing the debt is deflating, and must continue to deflate, to reach equilibrium with rents and personal income.

3) The credit markets have "seized" because, as occurred in 1920's, credit was grossly (some might say insanely) over-extended for many years with poor underwriting standards and little oversight. Less-so than the credit markets having "seized" is that borrowers are fundamentally over-extended, and cannot handle any more credit. When the economy was growing robustly, and home prices were marking double-digit annual price gains, it may have seemed like a reasonable bet to issue mortgages to individuals of limited means, at least if you were willing to extrapolate those home price gains off into eternity, or if you have the opportunity to bundle all these loans together (making it difficult to judge their risk) and let the Wall Street banks sell them to pension funds. However, trees don't grow to the sky, and home prices had to fall to come back into line with rents and personal income (neither of which were growing nearly as fast as home prices). The home loans that were issued near the peak, especially variable-rate mortgages that kept the early payments affordable, are at the center of this storm, and are the loans that the investment banks want the government to take off their hands.

So, kudos to Ron Paul for shining a bright light on the faults of the government bail-out plan.

Christian Antalics

P.S.

For a comic yet surprisingly erudite interpretation of the Paulson Plan, check with the fictional character, Paul Bernankson.

VOTE NO ON THE PAULSON/BERNANKE WALL STREET BAILOUT PLAN

The way to properly resolve this crisis is to put banks that fall below minimal capital ratios into Treasury receivership, canceling the common and preferred equity and allowing the Treasury to retain the assets of the institutions as collateral against the current obligations of these companies, shielding holders of cash equivalent deposits against default (i.e. money market funds).

Treasury can then unwind those assets in orderly auctions, thereby permitting other institutions to price similar assets on their own books.

We as a Nation cannot stand idly by as private investment banks attempt to socialize their losses, however large and frightening as they may be, when they took risks as private and largely unregulated institutions and retained in their private coffers billions of dollars in profits since the last banking crisis.

OUR SYSTEM OF FREE MARKET ECONOMICS IS NOT BROKEN -- IT WILL ABSORB THE IMPLOSION OF YET MORE INSTITUTIONS AND WILL BE STRONGER ON THE OTHER SIDE.

Allowing these banks to foist the worst of their paper off on the U.S. taxpayers in unconscionable.

Any bank that needs the U.S. Treasury to bail it out should be fully prepared to be seized by the government, restructured, and sold back onto the open market at a profit to the U.S. Treasury and taxpayer, either in pieces or as a newly formed financial institution.

Christian Antalics