Holes in the TARP: An Open Letter to Congress

An open letter to Congress:

I thank you for, and applaud, your effort to prevent the continued misuse of government "TARP" money, the current allocations of which are contrary to the original intent as proposed by the Secretary of the Treasury and approved by Congress.

This morning, again, we find, another massive government injection of taxpayer funds, largely borrowed from foreign nations, into CitiGroup, again, on the flawed premise Citi is "systemically important" and thus "too big too fail."

If we continue to allow these institutions to operate under the premise they are too big too fail, we forever will be held hostage to the consequences of poor management and risk-taking decisions, and these institutions will "fail" again and again, until at some point they are dismantled.

At minimum, Senator, the executive managements under whose tenure these institutions have failed, to the extent they require government assistance to assure their future (and this would include automakers, insurance companies and the like), should be forced to resign and forfeit any deferred compensation and golden parachute-type compensation.

Certainly in this great country of ours we can find talented individuals to take up the reins of these corporations and institutions to lead them to a more stable and profitable future. It is unconscionable employees of these companies are losing their jobs because of the bad decisions of these executives, but the executives are allowed to retain their positions without penalty or consequence.

At CitiGroup alone, more than 50,000 will lose their jobs, yet no one has called for its executive management to resign on the basis of incompetence.

If our federal, state and local governments can have regular, orderly "management" changes every two-to-four years at the direction of the voters, then certainly these rescued corporations, their employees, shareholders and their taxpayer benefactors would not inordinately suffer should the resignations of existing managements and boards of directors be required as a condition of receiving any (or any additional) taxpayer funds.

In your efforts to prevent continued abuse of EES Act of 2008 and improper allocation of TARP funds, I urge you to sponsor legislation to require any future recipients of taxpayer money to present a business plan prior to any request which includes the immediate resignation of the recipient's Chairman of the Board and its Chief Executive Officer (both, if held separately), and the resignation/replacement of all remaining executive officers and board members within one year of receiving rescue funds, with forfeiture of all deferred compensation or departure payments.

Again, thank you for your continued effort to insure the protection of taxpayer funds and to lift the veil of secrecy which has surrounded the actions of the Treasury and the Federal Reserve during the last three months.

Root of the Problem

Statement by Treasury Secretary Henry M. Paulson, Jr. on Financial Rescue Package and Economic Update, Wednesday, November 12, 2008, (Full Text Here).

While Treasury's plans to roll up the Troubled Asset Relief Plan (TARP) for troubled mortgage-related assets - its original mission - and unfurl it over a different section of the mess, namely additional capital support for banks and non-banks and to shore up faltering consumer-credit securitization markets, received the headlines of the 24-hour news cycle, almost overlooked was Secretary Paulson's identification of the root of our extant problems (hat tip CK Michaelson at Some Assembly Required):

"But let us not forget one fundamental issue which lies at the heart of our problems. Over a period of years, persistent and growing global imbalances fueled a dramatic increase in capital flows, low interest rates, excessive risk taking and a global search for return. Those excesses cannot be attributed to any single nation. There is no doubt that low U.S. savings are a significant factor, but the lack of consumption and accumulation of reserves in Asia and oil-exporting countries and structural issues in Europe have also fed the imbalances." (Emphasis Ours.)

This paragraph is toward the end, before his concluding remarks. It implies if not for the thriftiness of Asians and Middle-Easterners (mostly Asians) and the accumulation of reserves in those countries, which were lent back to the United States in the form of Treasury and Agency debt purchases to offset the complete lack of savings in America, our low interest rates and consumption binge of the last decade (two?) could not have been enabled.

Ah, so it's their fault. Their propensity to save, instead of consume, enabled our low-interest consumption blow-off. Unfortunately, if Asia and the Middle East decide to begin consuming in earnest (less likely short term), or choose not to recycle their savings into U.S. government debt (increasingly likely), an immense funding demand by the Treasury to support the unprecedented bailout and deficit spending programs of this country is destined to result in higher interest rates in the future - perhaps much higher - as the government crowds out other borrowers in its insatiable quest for fresh funds.

What a relief: It's all their fault. Oh, and those pesky structural issues in Europe. Of course our abysmal, nearly non-existent savings rate is a factor, but at least it's not OUR fault. Check please.

Revisiting the Beginning of the End

With the crystal clear clarity of hindsight, we bring you highlights (lowlights?) from the week that was in late June 2007, the week which, in our minds, officially kicked off the "sub-prime" mortgage loan crisis.

Unofficially, anecdotally, the beginning of the end most likely occurred in mid-February 2007, when Blackstone co-founder, CEO and Master of the Universe Stephen Schwarzman gave himself a "let-them-eat-cake" 60th birthday party in New York, featuring performances by Rod Stewart and Patti LaBelle for the 500 or so guests and rumored to have cost anywhere from $3million to $10+ million. (More on that, below...)

In early 2007, we didn't know it at the time (well some of us did: Paul Volcker, Nouriel Roubini, Bill Bonner, Mike Shedlock, Eric Janzsen, Doug Nolan, Yves Smith, Peter Schiff, Calculated Risk and Tanta, and Barry Ritholtz to name but a few), but the mid-year implosion of two Bear Stearns RMBS hedge funds the the lit fuse which since has detonated a global liquidity/credit/deleveraging/solvency crisis of biblical proportion now measured in trillions of dollars.

But back to late June 2007, "the week that was" to revisit the official beginning of the end.

On Wednesday, June 20, 2007, Merrill Lynch seized about $800 million of assets from the two funds and sold a sufficient amount to cover its loan exposure, prompting Bear Stearns to buy back assets and set up a $1.6 billion loan to the two hedge funds to avoid further public sales - and pricing - of the troubled assets.

In the same week, on Friday June 22, 2007, Masters of the Universe Stephen Schwarzman, Peter Peterson, et al, of Blackstone Group took advantage of the greater fool theory and brought their private equity group public at $31/share, offering 133 million shares and raising more than $4 billion plus another $3 billion from a Chinese Sovereign Wealth Fund, and briefly valuing the firm close to $8 billion.

At Friday's (11/07/08) closing price of $7.51/share, Blackstone Group's (Symbol: BX)market capitalization hovers around a quarter of its IPO valuation at under $2 billion.

From CNNMoney.com on June 20 2007:

Merrill Lynch has seized about $800 million of assets from troubled hedge funds managed by Bear Stearns, throwing in doubt the chances that the funds will survive.

By late Wednesday, Merrill Lynch had sold enough of the assets, which were used as collateral for loans made to the two funds, to cover its exposure to the ailing funds, the news agency Reuters reported.

Efforts by Bear Stearns to rescue two hedge funds hit by bad bets on subprime loans appear to be faltering.

The assets were were mainly bonds backed by other securities. More asset sales are expected Thursday.

And from the New York Times on July 18, 2007:

The drama surrounding the two funds began in May when investors in the more leveraged hedge fund were told losses through the end of April totaled 23 percent, not 10 percent as they had been told earlier. As securities markets declined, even the more conservative fund registered losses starting in March.

Investors tried to get out of the funds, but in May, Bear Stearns halted redemptions. Shortly after that, several banks and brokerage firms that had provided loans began demanding more cash as collateral. On June 26, Bear Stearns said it would offer a $1.6 billion loan to shore up the more conservative fund and unwind its positions.

In yesterday’s letter to clients, Bear Stearns said that some $1.4 billion of the loan remains untapped.

While risky mortgages are thought to have been central to the funds’ misfortunes, Bear’s letter said that “unprecedented declines in the valuations of a number of highly rated (AA and AAA) securities” contributed to June’s woeful performance.

The more conservative of the two Bear Stearns funds was the older; established three years ago, it generated monthly gains of roughly 1 percent to 1.5 percent until March. Bear Stearns started the more leveraged fund last summer, just as the mania for mortgage securities was topping out. At their peak, the funds were valued at $16 billion, including the leverage that they used.

The announcement that the funds are now almost worthless came as a surprise to many on Wall Street. “How did you go from reporting very high returns to suddenly now saying the collateral is worth nothing?” asked Janet Tavakoli, president of Tavakoli Structured Finance, a research firm in Chicago.

And Blackstone's Mr. Schwarzman, whose declining net worth now makes him eligible only for "Master of the Solar System" status? He now "regrets" the February 2007 birthday bacchanalia (or, perhaps, regrets more the publicity surrounding his birthday largesse).

From the October 31, 2008 New York Post:

Wall Street master of the universe solar system Stephen Schwarzman might be a man with few regrets, but even he has now admitted what everyone else on Wall Street already knew: His lavish 60th birthday party in 2007 was a bit over the top.

"Obviously, I wouldn't have wanted to do that and become, you know, some kind of symbol of sorts of that period of time," Schwarzman lamented yesterday at a conference in New York. "Who would ever wish that on themselves? No one."

Though well known in financial circles, Schwarzman, CEO of buyout titan Blackstone Group, came to symbolize Wall Street's excess after he spent $3 million hosting a swanky 60th birthday party for himself at the Park Avenue Armory in February 2007.

The soirée attracted lots of bold-face names among the 500 attendees, including finance's heavy hitters and entertainers like Patti LaBelle and Rod Stewart, who provided live entertainment.

It also eventually garnered Schwarzman considerable grief as many began to view the party as the beginning of the end of Wall Street's gilded age.

Indeed, the birthday celebration, followed a few months later by his $8 billion jackpot from Blackstone's initial public offering, and stories about a posh lifestyle that included costly crustaceans, transformed Schwarzman from a Wall Street king into what one magazine called a "poster child for greed." (All emphasis ours.)

What a week that was in late June 2007, the official beginning of the end, and a mid-February birthday bash which marks the unofficial beginning of the end.

All we need to know now is: If the first six months of 2007 were the beginning of the end, are we now at the "end of the beginning" of the global liquidity/credit/deleveraging/solvency crisis of biblical proportion now measured in trillions of dollars? Time will tell.

What Now?

The longest presidential election campaign ever now is history, as voters made their choices in the midst of an economic storm the brunt of which made its presence known in an almost unprecedented two months prior to election day earlier this month.

Americans voted for change, yet it will be the deteriorating economic environment here and abroad which will dictate many of the policies and much of the course of the new administration.

Democrat Barack Obama made history as the first African-American president-elect. The President-elect's choices for key cabinet positions will be telling, and, in the case of Secretaries of Treasury and Defense, the announcements will come preferably sooner rather than later.

More importantly, from an economic perspective, Democrats built a bigger majority in the House of Representatives and took a solid, though not filibuster-proof, majority in the Senate, so gone, at least for two years, will be the opportunity for legislative gridlock. A redeeming feature of our democratic republic, however, lies in our frequent ability to “correct” an imbalance of political power if it is found to have created the capacity for too much fiscal mischief.

But we mistakenly skip ahead to things unknown. We, and the new Administration and Congress, have more pressing issues requiring our collective immediate attention.

Namely, a rapidly deteriorating global economy currently connected to the life-support system of government and central bank interventions now surpassing $3 trillion and a growing number of developing countries in line for International Monetary Fund extensions of credit, including Iceland, Pakistan, Argentina, Ukraine and Hungary.

And the very likely expansion of our federal budget deficit to more than $1 trillion, possibly $1.5 trillion, in FY 2009 which ends next September. For grim perspective, the cumulative federal budget deficits under the entire eight years of the Reagan administration totalled slightly more than $2 trillion.

The president-elect inherits an economy which has shed more than a million jobs in a year, almost half of which occurred in August - October, and a 14-year high unemployment rate of 6.5% (11.8% according to a broader measure including the under-employed, those part-time employees wanting but unable to find full-time work).

America's consumer economy is beginning to shut down in self-reinforcing, circular phenomena of slowing business, job losses, credit contraction, declining tax receipts at all levels of government, pension and investment losses, real estate losses, foreclosures, repossessions and bankruptcies.

Never mind no “official” declaration of recession has been forthcoming. That will come later, perhaps early next year, when it is announced that the current downturn likely began in November 2007.

In the meantime, it certainly feels like a recession, and when consumers both voluntarily and involuntarily curb discretionary spending, it becomes - fait acompli - a recession.

Retail sales have been deteriorating, with many chains seeing October same-store sales falling by double digits ahead of what may be the leanest holiday shopping season in two decades, despite falling gasoline prices, now under $2/gallon in Texas and Oklahoma, taking some pressure off consumer spending.

Shoppers are trimming wish-lists, looking for bargains and "branding-down," to stretch dwindling holiday budgets, and retailers, for their part, are offering huge discounts well-before the traditional post-Thanksgiving start to the shopping season.

Year-to-date U.S. automobile/light truck sales have fallen more than 14 percent, but October auto sales were grim, plunging 38 percent across the board and registering annualized levels not seen in 25 years as buyers avoided showrooms in droves. Prospective buyers now sense better deals ahead and wait.

Auto dealers wait in hope of better-qualified customers as lending standards are tightened (GMAC recently cut off new loans to buyers whose credit scores fall below 700, which effectively excludes more than 25 percent of potential customers.)

GM and Ford shares trade at 50-year lows after reporting massive third quarter losses which, though alarming, are of less concern than the rapid rate at which the automakers are churning through their cash and credit facilities, the so-called cash flow "burn rate."

In 3Q Ford posted negative cash flow of $7.7 billion and General Motors burned through $6.9 billion of cash. At this pace neither company has sufficient cash and credit reserves to survive through 2Q 2009 at best, possibly earlier.

Outgoing Treasury Secretary Paulson's TARP, the $700 billion troubled asset relief plan approved after acrimonious Congressional debate in October, now may be stretched to cover the ailing auto industry as well.

Automaker troubles are not limited to North America. In Europe, heavy truck maker Volvo saw new orders fall by 55% in the 3rd Quarter, but combined with existing order cancellations, the continent's second-largest manufacturer registered net sales of only 115 vehicles, a 99.4 percent decline from the 42,000 units sold a year ago.

State and local governments also are coming to grips with declining income, sales and real estate tax revenues. California governor Arnold Schwarzenegger is proposing a sales tax increase and employee layoffs to patch a $12 billion deficit and Los Angeles is facing a $400 million shortfall.

New York City must now “borrow” a billion dollars from its health-care trust to shore up its battered pension fund as its Wall-Street dominated tax base evaporates in the wake of tens of billions of dollars of losses the last year posted by the city's financial sector, and New York state now projects a 2009-2010 deficit of more than $10 billion largely for the same reason.

Financial losses in stocks and real estate now are estimated to exceed $10 trillion from a year ago, and one of the principal engines of consumer spending, mortgage equity withdrawals, have nearly ground to a halt after ramping up significantly beginning in 1998.

From 2004 -2006, homeowners tapped $700 billion a year of unrealized home price appreciation via home equity loans, refinances and lines of credit, and not quite $500 billion last year. Through 2Q 2008, mortgage equity withdrawals hardly register at $50 billion and could end the year closer to zero.

In 2004 alone, mortgage equity withdrawals of $720 billion equalled six percent of GDP and since 1998, on average, equity extractions easily added four percentage points or more per year to overall GDP, a staggering amount of purchasing power which now has all but disappeared.

Consumer spending likely has peaked at nearly 71 percent of GDP, and a return to its long-term average of two-thirds of GDP, prior to the last decade, signals shrinking economic activity in the absence of more government spending, business investment and an increase in exports. That's the economic model which now makes us all Keynesians - that declining consumption and business investment can be offset by increased, deficit government spending.

The difference, however, in 2008 compared with the Great Depression, is our dependence on investors both foreign and domestic to finance the twin deficits - budget and merchandise trade - of the world's largest debtor nation.

One disturbing similarity between then and now: U.S. non-financial debt as a percentage of GDP now exceeds 350 percent and the only other time in our history when that percentage has been so high was on the eve of the market crash of 1929 when debt/GPD exceeded 260 percent.

Then, as perhaps now, a tipping point was reached. After 1929 the unwinding of debt, the deleveraging, lasted a decade as non-financial debt/GDP retreated to about 130% until the beginning of our participation in World War II.

Once again, what appears now to be emerging is a “balance sheet recession,” in which people and businesses are quickly trying to liquefy themselves by selling assets and paying down debt. This is pattern of the protracted, "L-shaped" recessionary environment which has dominated Japan's economic landscape for nearly two decades.

In Japan, its government reduced interest rates to zero to little avail for years as business and individual borrowers not only eschewed additional credit but strived to repay existing debt. America could follow suit as Baby Boomers, already concerned with declining retirement account values, get some of that old-time savings religion in light of their realization time no longer is on their side and early retirement may be a fading dream.

Ultimately that would be a good thing - a national savings rate more than one percent - but not in the short run as the nation attempts to transform itself away from a consumer-dominated economy. Which is where government spending becomes key.

The 2008 tax rebate, $150 billion fiscal stimulus, had a negligible impact as many recipients paid down debt or saved the rebate. In 2009 we will see government spending directed toward an infrastructure improvement program designed to create jobs and a $500 billion, or more, fiscal stimulus plan may begin to take shape before the end of this year.

There is some good news, some encouraging developments now materializing after a tumultuous September and October. The Federal Reserve's newest lending programs appear to be calming credit markets, unlocking vital short-term credit for companies otherwise shut out of commercial paper markets.

The Fed's $540 billion Commercial Paper Funding Facility, introduced in late October, already has extended more than $260 billion in short-term financing to General Electric and other S&P 500 companies. It's $120 billion of loans to insurer AIG International, one of the largest derivatives players, have eased fears of a domino-effect systemic meltdown of cascading defaults.

And the Fed's Money Market Fund Investing Facility, which quickly peaked in October at $152 billion as funds delivered troubled commercial paper to the Fed to avoid "breaking the buck," now has receded to about $85 billion.

The Federal Reserve's balance sheet has more than doubled in six weeks, ballooning to $2.1 trillion in it's role as lender of "only" resort, and Dallas Fed President Richard Fischer foresees $3 trillion - roughly 20 percent of GDP - by early 2009 as the Fed takes unprecedented efforts to counter the collapse of credit markets.

Yet the deleveraging process will continue until it has run its course, handmaiden of a great, global reassessment of asset valuations across every investment class. As Federal Reserve Board Governor Kevin Warsh recently observed: "We are witnessing a fundamental reassessment of the value of virtually every asset everywhere in the world."