US Financial Earthquake; bailout rejected, what’s next?

Stocks suffered their worst decline ever on a point basis Monday afternoon, as the failure of the House of Representative to pass Wall Street bailout legislation led to widespread selling of stocks.

If you haven’t noticed already the US politicians are now claiming their decisions are not considered a “bailout” rather an “insurance program” aimed at protecting the consumer from taking on close to a trillion dollars of new debt. The reason for the change in terminology is the politicians don’t want to be associated with a “bailout” rather the term “insurance” appears to be more dignified and safe. Plus it creates great spin for the media and the average consumer will simply equate this legislation to “safety in the markets” which the politicians will take credit for and stand proud for protecting American consumers and the global financial markets in general.

I think we are watching economic history unfold.

No, not the kind that most analysts are whining about: the excess debt that will make the prophecy of US meltdown. a reality sooner, rather than later.

Everyone takes some risk. Some take more risk than others. Gambling in Las Vegas has risk. Starting a business has risk. Those that take risk hope to receive the reward of their risk. Calculating and providing protection from risk is the business of insurance companies.

As Ajit Dayal puts it - Hank Paulson may go down in history as the man who took the world from its path of greed and destruction to a more “socialist” path. And he may help reduce the US debt by selling the companies he is buying at a huge profit.

Hundreds of billions of dollars of profit.

Enough money to stay another 436 days in Iraq and Afghanistan.

Enough profit to cover - for 269 days – the oil required to fill all those 50 million cars driving across USA.

Hank’s deals may not save the USA but it will postpone the inevitable.

The Secretary of the Treasury, Hank Paulson, is not a typical government bureaucrat and a “do-gooder”. Nor is he an academic that made it to the top job because of some theoretical paper on “inflation targeting” or “interest rates and cost of money” or “public ownership of private goods”.

Oh, no.
No, no.

Remember: Mr. Paulson has worked with Goldman, Sachs. He was a key member responsible for the firm’s global success. This man is a walking power-point on building businesses – successfully. He is a turn-around artist.

I think he knows what he is doing: there is method in this madness. Or is there?

AIG, one of the world’s largest insurers, took risk and did not calculate the potential impact of the risk they took. Subsequently the US Government decided to bail AIG out at the tune of $85 Billion in addition to the roughly $600 billion of other financial risk gone bad by banks and Wall Street firms.

The current U.S. Government Bailout program represents a significant shift for financial markets, and for individuals and businesses alike, in that US government has now become the largest insurer in the world. However the government insurance program is unlike any other insurance offered by the private sector. The U.S. Government Insurance Program basically says to business markets, don’t worry if you fail we’ll back you up. What a deal for big business but what about small business and individuals? If a small business or a family fails financially will the government come to our rescue as well?

The problem with the proposed plan and the attitude from US politicians, indeed any politician for that matter, is that both are fundamentally flawed in their assumptions. The basis of risk management is founded on a set of choices about risk. Individually and institutionally there are five choices one makes relative to managing risk.

- Avoid the risk: Don’t participate in activities or endeavors that increase risk
- Spread (share) the risk: In the insurance world this is known as reinsurance
- Transfer the risk: Move the consequences of related risk for others to assume
- Mitigate the risk: The Wall Street firms, banks and AIG first choose to assume the risk they took which then fueled failure. By declaring bankruptcy they in essence transferred the risk for someone else to assume. The U.S. Government, and our beloved politicians, looked at the situation that their own previous legislation had created and decided the risk of a global economic meltdown needed to be mitigated by the US government assuming the risk of those that had failed to manage the risk to begin with.

The problem with this thinking and the related decisions is that by assuming the risk the US government is actually increasing rather than mitigating the risk. How many other banks, insurance companies and Wall Street firms will fail and expect the government to bail them out. How many “big businesses”, the auto industry has already begun, will ask the government to help them mitigate the risk of their own decisions.

The proposed “bailout” is nothing more than a band aid on a damn of rising expectations actually created and enhanced by those who think their past and current decisions can be covered up or protected from risk. The truth is their decisions are fueling the risk and related cost which will eventually fall onto the back of every consumer.

The government, any government, is funded by the people and any assumption of risk falls onto “we the people”. Ultimately we the people have to provide the economics of any bailout or insurance program created by those “we the people” elect to make these decisions for us?

Our Fragile Global Economy…

“Greed is good,” insisted Gordon Gekko in the 1987 film Wall Street. Most of us disagree. Recent events in the mortgage lending industry prove us right.

The “subprime loan crisis” has been making headlines since it began in August. It refers to the fact that a relatively high percentage of mortgages offered to people with significant probability of default have gone sour.

The moniker is a bit misleading, though. The crisis we are witnessing starts from risky loan deals but will extend to all varieties of credit and risk: consumer loans, credit cards, businesses, and so on. It is just about to heat up but the roots of this crisis were laid years ago.

It’s a credit crisis, but credit per se is not the problem. The problem lies in how credit was traded from one hand to another on an unprecedented scale. This was done through financial innovations called derivatives.

In recent memory – translated as in the last few weeks of media glare – we have noticed and witnessed a US and to some extent global financial meltdown of historic proportions. Most of media and the people quoted (as experts by media) are calling it the greatest threat to “world” economy since the Great Depression of 1930s.

Addison Wiggin and Bill Bonner wrote the classic, must-read, “The Empire of Debt”. The US Empire, the book surmised, had grown economically weak and unsustainable. It has burdened itself with too much debt. Its collapse is imminent. From the roots of this book has emerged one of the most talked about documentaries: “I. O. U.S.A.” (the “O” as in “owe”) which highlights the extraordinary debt levels of the US government. A debt that is estimated at USD 410,000 per full-time worker in America – about 9x the average annual per capita income in USA.

So here we are yet again in the midst of another "global economic crisis." From the hilltops of Davos, Switzerland, Morgan Stanley's permabear Stephen Roach has shouted warnings of potential economic "Armageddon." Superinvestor George Soros designated the current state of the global economy "the worst market crisis in 60 years." Bill Clinton labeled it "the biggest financial crisis since the Great Depression" -- even as global stocks responded by slumping 7.7% in January -- the worst start to an investing year since Morgan Stanley began publishing data in the 1970s.

It seems that certain quarters had been warning of this for a long time. In it’s public pronouncement – “Global systemic crisis / September 2008 - Phase of collapse of US real economy” - LEAP/E2020 – had predicted – “the end of the third quarter of 2008 will be marked by a new tipping point in the unfolding of the global systemic crisis. At that time indeed, the cumulated impact of the various sequences of the crisis (see table below) will reach its maximum strength and affect decisively the very heart of the systems concerned, on the frontline of which the United States, epicentre of the current crisis. In the United States, this new tipping point will translate into a collapse of the real economy, final socio-economic stage of the serial bursting of the housing and financial bubbles and of the pursuance of the US dollar fall. The collapse of US real economy means the virtual freeze of the American economic machinery: private and public bankruptcies in large numbers, companies and public services closing down massively,...”

It has a dire warning – “On the occasion of the second anniversary of the publication of our famous “Global systemic crisis Alert” which toured the world in February 2006 (4), LEAP/E2020 wishes to remind that we are now resolutely stepping into an era with no historical precedent. Our researchers insisted on that many times in the last two years: any comparison with the previous crises of our modern economy would be fallacious. It is neither a “remake” of the 1929 crisis nor a repetition of the 1970s oil crises or 1987 stock market crisis. It is truly a global systemic crisis, that is to say a crisis affecting the entire planet and questioning the very foundations of the international system upon which the world was organised in the last decades”

So wasn’t anybody paying attention?

Looks like it. Although some institutions/ people did see…

As far back as April, 2008 – IMF warned – “Credit Crisis Is Broadening”. The widening and deepening fallout from the U.S. subprime mortgage crisis could have profound financial system and macroeconomic implications, according to the IMF's latest Global Financial Stability Report (GFSR).

"Financial markets remain under considerable stress because of a combination of three factors," said Jaime Caruana, head of the IMF's Monetary and Capital Markets Department. "First, the balance sheets of financial institutions are weakening; second, the deleveraging process continues and also that asset prices continue to fall; and, finally, the macroeconomic environment is more challenging because of the weakening global growth," he added.

The most profound aspect of this meltdown is that the crisis has weakened the capital and funding of large systemically important financial institutions, raising systemic risks.

So how did it begin?

According to an article on Wikipedia - The subprime mortgage crisis is an ongoing economic problem which became more apparent during 2007 and 2008, and is characterized by contracted liquidity in the global credit markets and banking system. The downturn in the U.S. housing market, risky lending and borrowing practices, and excessive individual and corporate debt levels have caused multiple adverse effects on the world economy. The crisis has passed through various stages, exposing pervasive weaknesses in the global financial system and regulatory framework

The crisis began with the bursting of the United States housing bubble and high default rates on "subprime" and adjustable rate mortgages (ARM), beginning in approximately 2005-2006. For several years prior to that, an increase in loan incentives such as easy initial terms and a long-term trend of rising housing prices had encouraged borrowers to assume difficult mortgages in the belief they would be able to quickly refinance at more favorable terms. However, once housing prices started to drop moderately in 2006–2007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically, as easy initial terms expired, home prices failed to go up as anticipated, and ARM interest rates reset higher. Foreclosures accelerated in the United States in late 2006 and triggered a global financial crisis through 2007 and 2008. During 2007, nearly 1.3 million U.S. housing properties were subject to foreclosure activity, up 79% from 2006.

Major banks and other financial institutions around the world have reported losses of approximately US$435 billion as of 17 July 2008. In addition, the ability of corporations to obtain funds through the issuance of commercial paper was affected. This aspect of the crisis is consistent with a credit crunch. The liquidity concerns drove central banks around the world to take action to provide funds to member banks to encourage lending to worthy borrowers and to restore faith in the commercial paper markets.

Who is to blame?

According to LEAP/E2020 - It is always a repeated astonishment for our team to see the degree of incapacity of these same experts and managers in understanding the specific nature of the phenomenon currently unfolding. According to them, this crisis would only be a usual crisis but bigger. As a matter of fact that's how the financial media reflect the dominant interpretations of the ongoing crisis. According to our team, this approach is not only intellectually lazy; it is also morally guilty, because it has for a main consequence to prevent their readers (whether they are simple citizens, private investors or public or private organization managers) from preparing for the upcoming shocks.

They continue their forecast of doom - For this reason, in opposition to all what can be read in the mainstream media always eager to conceal the truth and serve the interests of those who rule them, LEAP/E2020 wishes to remind that it is first and foremost in the United States that the systemic crisis is taking an unprecedented shape (the « Very Great US Depression » as our team decided to call it in January 2007) because it is around this country, and this country alone, that the world got progressively organized after the second World War. The various issues of the GEAB extensively described this situation. In short, it appears to be useful to make clear that neither Europe nor Asia have a negative saving rate, a full-scale housing crisis throwing millions of citizens out of their homes, a free-falling currency, abysmal public and trade deficits, an economic recession and, on top of all this, a number of costly wars to finance.

So is there a silver lining for Asia and Europe?

Time will tell… for now, we, as individuals, can do little except watch this unprecedented systemic crisis unfold and reshape the financial landscape of this planet. The tectonic shifts in balance of financial power due to collapse of pillars of US economy (such as Lehman) is definitely reshaping the world order – but not with war this time, but with economics… Asia’s rise was anyway foretold… :-)