— James Saft is a Reuters columnist. The opinions expressed are his own –

Government intervention or not, banks will be cutting up America’s credit cards at an unprecedented rate, with grave implications for the economy and company profits.

The U.S. Federal Reserve last week added more nutrition to its alphabet soup of rescue programs when it unveiled the Term Asset-backed Securities Loan Facility (TALF), under which, among other things, it will lend up to $200 billion to investors in securities backed by credit-card, auto and student loans.

It did so for a very good reason: the securitization market’s freeze now extends beyond mortgages, imperiling run-of-the-mill consumer financing and making it a certainty  that many people who use credit to get them over “cash flow” situations will be, well, denied.

And even though the U.S. car industry may implode if starved of finance and many students will have to defer education, the real potential disaster is in credit card funding, which could push lots of households over the brink and in the process consumption and every business which depends on it, which would be all of them.

Put simply, even with an apparent will to try anything to bring the wheels of finance back into motion it will be very difficult for government to quickly fill the hole left by private finance. Details of the plan are still sketchy, but let’s just take it for granted that it works, even if the plan, at only one year, will give them huge fears about how they get out of their positions at the end of 2009.

Beyond that, the Fed is seeking to kick start securitization by attracting back a species of investors, leveraged ones, who don’t really exist any more.

All other things being equal, the amount the Fed is putting into the TALF should take the ABS market back to about where it was in the first half of 2008, which itself was only a third of the volume we saw in 2007.

But all other things are not equal.

The banks that provide the bulk of credit card funding  generally want to cut back, pushed by their own woes, a conservative read of the economic situation and, potentially, regulatory changes that, while intended to ward off the excesses of the last bubble, will magnify the impact of its bursting.

Meredith Whitney, the Oppenheimer and Co analyst who has so far been ahead in identifying and explaining the weaknesses in the banking system, thinks over $2 trillion of credit lines, or 45 percent of lines available, will be pulled out from under American consumers in the next 18 months, a figure that puts the Fed’s $200 billion for asset backed finance in its proper perspective.

“We are now entering a new era within the financial landscape that will be characterized by expanded forced consumer de-leveraging with a pronounced downshift in consumer spending,” she wrote in a research note.

“We view the credit card as the second key source of consumer liquidity, the first being their jobs. Pulling credit at a time when job losses are increasing by over 50 percent year-on-year in most key states is a dangerous and unprecedented combination, in our view.”

BIG BANKS ALL WANT TO CUT BACK

Whitney notes that the three largest credit card lenders, Bank of America, Citigroup and JP Morgan, who between them account for more than half of U.S. credit card outstandings, have each discussed reducing card exposure or slowing growth. Capital One and American Express, who are another 14.5 percent, have also talked about limiting lending.

That will set the tone for the rest of the industry, which will be grappling with new regulation that, if goes ahead as planned, will impair profitability of credit card lending and push more off-balance sheet securitizations back on to the banking industry’s already strained books.

Cutting back on abusive lending and forcing banks to recognize and account for the risks they take are surely good things, but will have the perverse effect of making the credit crunch worse, at least temporarily.

And looking at the balance sheets of individual Americans, there is good reason to think that the credit crunch should get worse: that they should consume and borrow less and save more. I’d argue that far from being non-functioning, financial markets are closer to pricing in the true risk of lending to consumers now with credit cards charging about 10 percentage points more than 5-year Treasuries than they were six months ago when it was only about a 7.65 percentage point gap.

But the mother of all unintended side effects is that the faster consumers cut back, the worse it will be.

The kind of consumer cut back implied by the consumer credit crunch that now looks likely would blow a hole below the waterline in the U.S. economy, and in U.S. company profits and the stocks that reflect them.

The Federal Reserve and U.S. government’s use of unconventional measures is only just beginning.

–  At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For more columns by James Saft, click here. –

For full coverage of the crisis in credit, click here.

– John Kemp is a Reuters columnist. The opinions expressed are his own –

Extreme uncertainty about the economic outlook and the depth of the recession has paralyzed normal lending activity by commercial banks in the United States and elsewhere. Even as the Federal Reserve has added liquidity and boosted bank reserves, the credit creation process has remained stalled as banks struggle to identify good borrowers willing and able to repay in a wide range of future economic conditions.

The attached chart is adapted from the Federal Reserve’s weekly H.8 release on “Assets and Liabilities of Commercial Banks in the United States” (https://customers.reuters.com/d/graphics/US_CRDT1108.gif).

It shows the ratio of loans, leases and interbank lending (risk assets) to vault cash, reserves and Treasury securities (safe assets) held by U.S. commercial banks. In essence it shows the commercial banking system’s appetite for risk and capacity for credit creation.

Credit is clearly cyclical. But the period since 1994 has witnessed a huge increase in credit extension and a massive rise in balance sheet risk overlaid with modest cyclical variations. Following a brief hiatus during the downturn of 2001-2003, explosive credit creation resumed and hit new heights in early 2008.

The ratio of loans, leases and interbank loans to vault cash, reserves and holdings of Treasury securities has increased from 2.4 in April 1994 to 3.2 in Apr 2004 and a staggering 5.3 in Apr 2008.
Since the onset of the crisis, the lending ratio has plummeted to 3.5. It is the sharpest reversal in balance sheet composition since the 1930s.

In fact, commercial bank lending has increased slightly since the onset of the crisis. Increased loans and leases have offset a downturn in interbank activity. Some of this reflects the reclassification of investment banks as commercial ones.

The rest was probably “involuntary” lending as corporations unable to access other forms of credit drew down standby committed lines.

But the massive expansion of Fed lending facilities has boosted commercial bank assets by $500 billion since the end of August. All this additional money has been placed on deposit with the Fed or invested in Treasury securities (+$701 billion) more than offsetting the flight from other loans and securities (-$200 billion).

The credit crunch has manifested itself in an extreme preference for low-yielding but ultra-safe assets.
The massive cushion of cash and cash-like assets held by the commercial banks has dispelled any residual doubts about their short-term liquidity, as it was designed to do.

But by shifting their balance sheets in this way, the commercial banks have essentially blocked the monetary transmission line from the Fed to the rest of the economy, ensuring that monetary easing has not filtered through to Main Street, and forcing the Fed to turn to more unconventional measures to get credit through to the economy.

– John Kemp is a Reuters columnist.  The opinions expressed are his own –

After more than a year of denial, misdirected policies and a steadily worsening outlook, the past fortnight has witnessed a marked improvement. For the first time, there are reasons to be cautiously optimistic that the economy faces a recession rather than a prolonged slump, and recovery could get underway in H2 2009.

Markets share some of that optimism. The Dow Jones Industrial Index has risen 15.5 percent over four consecutive sessions, the most sustained rally since April 2008. It is not yet time to break out the champagne. But there are reasons to start looking through short-term weakness to focus on an eventual, albeit modest, recovery by the end of next year.

DENIAL AND MISDIRECTION

Regulators and much of the financial services industry have been in denial for more than a decade about the steady accumulation of risk within individual institutions and across the system as a whole.

Even when rising defaults on subprime loans caused the music to stop last summer, regulators and industry leaders failed to appreciate the structural nature of the crisis. There was much talk of isolated instances of poor risk-management and hope the downturn could be contained in the housing market and motor manufacturing.

Most thought the music would begin playing again after a brief pause, and the dance could resume much as before with only a few minor modifications.

As the crisis dragged on through winter and into spring and began to destabilize key financial institutions, the policy response focused on providing liquidity rather than the solvency of the banks and their borrowers.

In this view, banks were basically sound and the deterioration in asset quality was relatively minor. Toxic subprime loans were only a small part of total balance sheets.

Fire-sale prices for a growing number of assets reflected the lack of buyers amid heightened uncertainty, not their fundamental value. If sufficient liquidity could be created, and mark-to-market accounting rules eased, institutions could hold assets to maturity and realise their much higher intrinsic value.

The Fed responded by trying to organize takeovers for troubled institutions and providing a dizzying array of liquidity facilities on an unprecedented scale. The effort culminated with the creation of the U.S. Treasury’s Troubled Asset Relief Program (TARP). TARP was designed as a buyer of last resort for illiquid but supposedly valuable assets, able to stabilize the market and aid price discovery by paying more than fire-sale prices and closer to the intrinsic hold-to-maturity value.

The “Wall Street” first strategy focused on rescuing the banking system in order to keep credit flowing to consumers and businesses on “Main Street”. At no point did anyone admit the crisis of liquidity was in fact a crisis of solvency (too much debt and insufficient cashflow). Meanwhile, default rates on residential mortgages continued to climb, unemployment rose and the slowdown spread from housing and motor manufacturing to the rest of the economy.

The first hint of a reassessment came with the Treasury’s decision to re-program TARP funds from buying distressed assets to injecting capital into the banks. It was the first indication of growing concern about solvency rather than just liquidity. But the Fed and Treasury continued their focus on Wall Street first, hoping that capital injections and reserve creation would lead to a resumption of lending and forestall a deep contraction. It has not worked.

ALTERED FOCUS, NEW HOPE

In recent weeks, the dramatic failure of a series of high-profile financial institutions, mounting panic about the outlook, and clear signs businesses and households were beginning to cut spending sharply in anticipation of a depression-like drop in sales and employment next year have forced a much more dramatic reassessment.

Priority has shifted from monetary policy and financial system liquidity to fiscal policy and sustaining the real economy.

Perhaps the single most important shift is the deftness with which President-elect Barack Obama has handled the issue. By moving quickly to appoint an economic team of experienced heavyweights and announcing a stimulus package aimed at saving or creating 2.5 million jobs over two years, the incoming president has projected a calm confidence under fire and signaled an appreciation of the need to forestall a deep recession on Main Street.

Quick moves to fill the key posts, an assured performance at three press conferences in three days, and a bold but simple plan that looks big enough to make a difference but is easy to explain and communicate have given the impression fiscal policy is not ineffective and will make a difference. That in turn should blunt some of the pervasive fear and retrenchment spreading through the economy like a virus.

Confidence is an ephemeral commodity, but in a crisis it is the most important one. Repeated failures to stabilize the economy despite upbeat assurances have badly damaged the credibility of the existing Treasury and Fed teams. The presidential transition offers the possibility of a fresh start (much as Franklin Roosevelt’s transition offered one in 1933).

Some of the new appointees (Timothy Geithner for Treasury secretary and Lawrence Summers for the White House National Economic Council) are closely associated with policies of the last decade that are now coming under scrutiny. Details of the stimulus are sketchy.  But the change of cast is more important at present.

UNCONVENTIONAL STRATEGIES

Changed atmospherics have been buttressed by practical changes, most importantly at the Fed. The direct lending efforts announced on Tuesday (purchases of Fannie Mae and Freddie Mac bonds on the open market, and lending money to other institutions to buy securitized consumer, auto and credit card loans) offer a reasonable prospect of restoring some credit growth. They should make the Fed’s quantitative easing strategy effective and unblock the credit creation process.

More importantly, by buying GSE bonds on the open market and lending to others to buy more exotic asset-backed paper, the Fed is engaging in precisely the type of “unconventional” open market operations in a wider range of securities and maturities that could limit borrowing rates for households and corporations across the economy.

The use of unconventional operations to act on different parts of the yield curve and credit spreads has been discussed in the past as the ultimate response to a crisis. For the first time the Fed is putting it into practice.

Monetary policy is now supporting fiscal policy. Through its aggressive quantitative easing, the Fed has convinced investors short-term interest rates will remain low for an extended period. As a result it has managed to drag the yield on ten-year Treasury securities down from almost 4 percent to a little over 3 percent, achieving a key objective.

Lower yields should in turn make it much easier for the U.S. Treasury to get away the vast mountain of bills that need to be refunded and carry out the massive borrowing needed to fund the Obama administration’s massive stimulus program.

Similar reinforcing shifts in fiscal and monetary policy worldwide suggest senior policymakers share a common view of the problem and are adopting mutually reinforcing solutions.

None of this implies that the next 12-24 months will be easy. Continued adjustments will be painful (including a further shrinkage in the capacity of the financial services industry, and restructuring of U.S. motor manufacturing).

The economy will experience its deepest recession since 1979-1981. In the short term conditions look set to worsen further, and the crisis will leave a legacy of enormous public debt.

But provided the incoming administration can tailor an appropriate and credible stimulus package (that delivers front-loaded spending on labor-intensive items) and the Fed is able to support it by keeping long-term rates low and gradually compressing credit spreads, there does appear to be a way to ensure this a recession rather than a slump.

– Paul Taylor is a Reuters columnist, the views expressed are his own –

LONDON (Reuters) - Move over America! Make space Europe! The world’s top leadership table is expanding to bring in emerging powers from Asia, Africa and Latin America to help rescue the global economy.

This week’s Washington summit of 20 nations, called to discuss reforming the international financial system and avert a further worsening of the credit crisis that began in the United States, sets a precedent for a new international order.

Emerging economies such as China, India, Brazil, South Africa and Mexico are invited to share responsibility for the economic fate of the planet with the established Group of Eight industrialized nations — the United States, Japan, Germany, Britain, France, Italy, Canada and Russia.

Saudi Arabia is urged to disgorge its petrodollars and China to tap its $1.9 trillion reserves to underwrite rescue packages and buttress a Western-dominated financial system the collapse of which would wreak even worse devastation around the world.

No longer mere appendages invited for lunch at the end of the annual G8 summit, the rising powers are in demand because they have either mountains of cash, vital natural resources, fast-growing economies or regional security responsibilities.

Will they cooperate, and what do they want in exchange?

“A voice is the most important thing,” said a former senior U.S. financial policymaker, who spoke on condition of anonymity.

“As they look out at global economic prospects, they will also want to see that their money is going to be safe. They will want to see a plan that gives them confidence,” he said.

Beyond that, some of the key holders of dollars and oil may seek security guarantees and assurances that the West will not discriminate against investments by their sovereign wealth funds or their exports during the coming recession.

In a joint statement, the so-called BRIC countries — Brazil, Russia, India and China — called last week for “reform of multilateral institutions in order that they reflect the structural changes in the world economy and the increasingly central role that emerging markets now play”. They also sought assurances against protectionism in the financial crisis.

INTERESTS AT STAKE

Here are some of the interests at stake for key players:

CHINA - The world’s most populous nation, a nuclear power and member of the U.N. Security Council, still regards itself as a developing country. Its communist rulers have just announced a huge domestic stimulus package of public investment but they are deeply cautious about opening up further to the world economy.

Chinese investment has not always been welcome in the United States, where many in Congress accuse Beijing of keeping its currency artificially cheap and want to curb imports from China.
Beijing has said nothing about its terms for helping bail out the capitalist West, but it is likely to want a bigger voice in global economic governance and some guarantees against protectionist steps by Washington and Brussels.

It may also want to ease Western pressure on it to curb greenhouse gas emissions in the fight against global warming.

INDIA - The world’s second most populous country has long sought a larger role in global leadership and sees itself as a spokesman for the developing world.

Prime Minister Manmohan Singh has called for reform of the United Nations Security Council and the G8, implicitly to give India a permanent seat in both.

“Our voice on how to manage this crisis in a way that does not jeopardize our development priorities needs to be heard in international councils,” he told a summit with fellow emerging powers Brazil and South Africa last month.

India seeks both assurances against Western protectionism and the right to continue protecting its subsistence farmers. It too wants to deflect Western pressure to curb emissions which it says would deny its right to economic development.

SAUDI ARABIA - The world’s biggest oil exporter is the only Middle Eastern state in the G20, frustrating Egypt, which lacks resources but sees itself as the leader of the Arab world.
Arab specialists say Riyadh seeks above all U.S. protection against Iran’s growing regional power and nuclear ambitions and from the ascendancy of Shi’ite Muslims in Iraq, which it fears will embolden Shi’ite minorities around the Gulf.

It also wants the next U.S. administration to take up an Arab League plan for peace with Israel and pressure the Jewish state to reach accommodations with Syria and the Palestinians and to stop discrimination against Arab investments, such as the blocking of Dubai Ports World’s purchase of six U.S. ports.

The Saudi monarchy also wants an end to what it regards as destabilizing U.S. pressure for democracy in the Middle East.

INCUMBENT POWERS UNEASY

The first-ever G20 leaders summit, for which the European Union has made all the running, comes in the lame-duck period when President George W. Bush is preparing to hand over to President- elect Barack Obama, putting Washington on the defensive.

“It is outrageous that the Europeans would take advantage of the moment of maximum U.S. weakness to call such a meeting,” the former U.S. financial policymaker said.

The G20 was created in 1999 but until now has been limited to broad-brush discussions among finance and monetary officials.

The world’s only superpower prefers bilateral financial diplomacy, in which it has the upper hand, and tried-and-tested smaller formats such as the G7 grouping of finance ministers and central bankers, which does not include Russia.

Washington is trying to deflect a battery of ideas from hyper-active French President Nicolas Sarkozy for supranational regulation or supervision of financial markets, hedge funds, private equity, mortgage lenders and sovereign wealth funds.

The EU has led pressure to expand the G8 to incorporate the emerging nations, whose cooperation the Europeans see as vital not only to help restore financial stability but also on issues such as trade liberalization and fighting climate change.

Despite anomalies in its make-up, such as the inclusion of Argentina, the G20 summit is well placed to become a key forum on financial reform because it already exists, and there are plans to hold a series of such meetings.

This might prove more practical than British Prime Minister Gordon Brown’s proposal for a sweeping review of the post-World War Two financial order, known as Bretton Woods.

But the G20 may be too unwieldy to be effective, and smaller leadership forums seem bound to emerge. One favorite is a G13 or G14 — a forum that would expand the G8 to include China, India, Brazil, Mexico and South Africa. Some see an Arab or Muslim member, either Egypt or Saudi Arabia, as essential.

Spain, Europe’s fifth largest economy and the world’s ninth but not a G20 member, announced at the weekend that it had won a last-minute invitation to the summit.

However many policymakers, both in the United States and in the developing world, see the over-representation of Europe at the world’s top tables as part of the problem.

The Europeans only reluctantly yielded a little of their voting powers to China in the International Monetary Fund this year. The big EU member states remain unwilling to pool their seats into a single EU delegation in global institutions, with the notable exception of the World Trade Organization.

But a further redistribution of European and U.S. votes at the IMF and some consolidation of Europe’s seats at the world’s top tables may be the price to pay for the emerging world’s help in resolving this financial crisis.

(Pictured above: Brazil’s Finance Minister Guido Mantega, South Africa’s Finance Minister Trevor Manuel (R) and British Treasury Financial Secretary Stephen Timms (L) attend a news conference in Sao Paulo November 9, 2008.)

Juan Enriquez is managing director of Excel Medical Ventures and the author of “As The Future Catches You.” Any opinions expressed are his own.

There are two ways of viewing this debt crisis. One is that it is simply a temporary dislocation in the credit markets and a liquidity problem. The second is that it is a crisis triggered by subprime lending, accentuated because most people still can’t afford their houses, and compounded because almost every bad loan was highly leveraged. If it is the second type of crisis, one should remember: if trapped in a ditch full of debt, quit digging.

We are piling debt on debt. U.S. consumers are tapped out. Net household savings have gone negative. Corporate debt, particularly derivatives exposure, has reached truly dangerous levels. (Outstanding derivatives exceed $655 trillion. The U.S. economy is around $13 trillion). Government indebtedness is also approaching levels that exceed even those reached in the Depression and World War II. Add these three sources of debt together and the U.S. already owes almost four times its GDP. Now we are adding trillions in bailouts and face rocket-fueled mandatory spending programs. These trends may end up being fatal if we do not act. Right now.

For years, many have been warning, pleading, threatening. Now the crisis really is upon us. And because the numbers are so large, the Obama administration has a very narrow window, say thirty to sixty days, to send ten very clear signals and buy itself some financial breathing room.

First and foremost, Obama has to focus on the dollar. There is ever more pressure on rating agencies to question whether the U.S. remains a triple AAA credit risk given the current debt overhang. If U.S. debt is downgraded then a whole series of institutions could not hold T Bills and short sellers would begin to hunt. Maybe some of the same ones that brought down the British pound.

We have to send a very clear signal that we are going to begin to live within our means, spend what we earn, eventually begin to save. This requires a bipartisan program that makes both Democrats and Republicans most unhappy as we begin to restructure our debt.

We cannot save every dying whale. Everyone wants a handout. Some are essential. But we simply cannot afford most bailouts. We cannot spend a few hundred billion more, every week, without major consequences. Some banks, some major companies, cannot be saved.

All entitlements must be fair game. They were going to exceed all government revenues by 2030. The current bailout, guarantees, and supports accelerate this reckoning by five to ten years. We are out of time. So if you are 60 to 65 you probably just lost a good chunk of your nest egg. You get a free pass. 55 to 60? We need a year’s more work out of you before retirement and benefits. Under 55? We will need at least three more years. This is fair given that benefits like Social Security were provided when being 65 was considered old and life expectancy was 68.

The U.S. cannot simply pull out of all military commitments overnight; we already saw the consequences of this in Afghanistan in the 1990s. And even if we did pull out, there are enormous cost overhangs in veteran care and benefits that have to be respected. But at the same time, we cannot afford to maintain the military we have. So there has to be a commitment to cut military spending by 2-3% per year for a decade. If we can do this in the context of mutual disarmament treaties with China and Russia, so much the better.

The greatest single threat to the budget is medical spending and benefits. We currently spend about 17% of GDP but the trends are horrific. And we only spend one out of seven dollars directly on doctors and nurses. There is much to be cut, much to be rationalized. So let’s commit to capping medical costs at 20% of GDP (it is 17% today). Begin by covering essential services first so we do not end up in budget games like: “if you wish, I’ll just shut the emergency room.”

Which brings up the matter of budget transparency… CEOs who exceeded a budget by as much, or hid as much debt, as most governments routinely do would, at best, be fired. More likely they would be jailed. We need to apply a simplified Sarbanes Oxley to business and to state and federal government. We also need to apply some transparency to unregulated markets, like derivatives.
While cutting in some places, the U.S does have to keep fast-growing start ups alive. Venture backed companies invested about 0.2% of U.S. GDP to create close to 18% of the economy. This is where you generate most of the jobs, not in the Fortune 500.

As a last, and perhaps the most important commandment and priority, the financial crisis will pass. But the long term survival of the country depends on treating education like a varsity sport. If you want to play varsity you have to put in the twice daily practices, summer training, hire the best coaches, move the incompetent aside, and build large organizations of committed parents and boosters. Not everyone can, or even wants to, play varsity, but those who choose to compete should get extraordinary resources.

If the U.S. lets people know it is serious about getting its financial house in order, we will survive and thrive. The alternative that was followed by so many others is just to keep spending, which is why the last thing most great empires do is drive themselves into bankruptcy.

This essay is adapted from a talk that Enriquez gave at the Pop!Tech conference in October. View the video below.

Juan Enriquez (2008) Pop!Tech Pop!Cast from Pop!Tech on Vimeo

–John Kemp is a Reuters columnist. The views expressed are his own–

By John Kemp

LONDON (Reuters) - The bitter political divisions between middle America and Wall Street on display when the House of Representatives first rejected the Emergency Economic Stabilization Act last month look set to be re-opened in even more dramatic form in the remaining months of the year.

Rep Henry Waxman, chairman of the powerful House Committee on Oversight and Government Reform, on Tuesday sent identical letters to the chief executives of nine major banks receiving $125 billion of capital injections under the Troubled Assets Relief Program (TARP) demanding details of total bonus payments for 2006, 2007 and 2008 (see http://oversight.house.gov/documents/20081028142314.pdf).

The issue of bonuses and dividend payouts from banks that accepted the TARP injection looks set to become highly charged.

It is going to be hard for the banks and Treasury to explain why so much taxpayer funding needs to go in through the front door, only for it to flow out again as staff bonuses and dividend payments to ordinary shareholders. Bonus and dividend payments could quickly absorb all the TARP capital funding.

The issue of responsibility for the credit crisis will intensify during the quarterly dividend and annual bonus payout period in Dec-Feb, just when a new administration will be taking office and Democrats are likely to extend their control over both houses of Congress.

The equation between bonus and dividend payments on the one hand and capitalization and TARP funding is a false one. But it will stoke fury in middle America about the cost of bailing out banks while homeowners continue to be foreclosed.

By heightening the political temperature at a key time, it will make a more radical solution to the crisis more likely. For example, buying off political hostility to the continued bonus and dividend payments will almost certainly force Congress and the incoming administration to consider widespread restructuring, loan guarantees and other financial support to homeowners and troubled companies (eg GM) which in turn will intensify the upward pressure on the budget deficit.

The toxic cocktail of TARP, compensation and dividends will complicate budget planning and makes it almost certain there will be significant slippage on the federal government’s budget deficit. Even before the crisis struck, the Congressional Budget Office (CBO) and White House Office of Management and Budget (OMB) were projecting deficits of around $450 billion in 2009.

TARP will add at least another $250 billion to the deficit — because CBO has already reportedly decided capital injections into banks will be counted as 100 pct spending (and 100% revenue when they are finally cashed in) rather than just counting the subsidy element of the credits and estimates of likely losses (which is what would have happened if the TARP had been utilized only to buy troubled assets, as the Treasury originally proposed).

OMB is likely to take a similar view. There is already speculation the Treasury could use TARP funds to help smooth a merger between General Motors and Chrysler. The more of TARP is used for equity injections rather than troubled asset purchases, the higher the deficit will be.

In addition, the worsening downturn may well cut income tax and corporation tax revenues, while boosting expenditure on unemployment insurance and aid to families with dependent children in the form of food stamps.

This is before Congress considers tax cuts, homeowner bailouts or extra spending to stem the tide of foreclosures and stimulate the economy. Using conservative estimates, the budget deficit for fiscal 2009 could easily hit a record $900 billion — $450 billion originally projected plus $250 billion of TARP equity capitalization plus $100 billion in underlying deterioration from the automatic stabilizers of lower tax receipts and higher welfare spending plus $100 billion of stimulus from extra tax cuts and spending.

The US government will therefore need to borrow about $900 billion to finance new deficits as well as around $2.3 trillion to roll over existing debt maturing within the next twelve months.

The cocktail of TARP, compensation, dividends and record debt issuance promises to be very bitter indeed.

(john.kemp@thomsonreuters.com)

— James Saft is a Reuters columnist. The opinions expressed are his own –

By James Saft
NEW YORK (Reuters) - Some time before the end of the year it is a good bet that stock markets will throw off their gloom and begin a powerful rally of as much as 15 or 20 percent.

Some time one to three months after that it is a good bet that the prospect of a deep global recession and shockingly bad earnings will send them right back down again to make new lows. Rallies in the midst of bear markets can be sustained, powerful and feel very much like the ones that often mark the beginning of a real recovery.

So, why should we believe that we could get an early, if transient, Christmas present from the stock market?

Global markets are more scared, tired and depressed than at any time in my reasonably long memory, excellent breeding conditions for a rally. Given that most people are now on the same side of the debate, it would not take terribly much by way of money being committed to developed market stocks to send them higher. There may even be some momentum investors left who will pile on if a rally can get just a little traction.

The Vix index of stock market volatility hit a record high of 89.53 last week while the ratio of bulls to bears is at a several year low. And stocks have absolutely cratered — the S&P 500 index is down more than 40 percent this year and was heading lower at the time of writing.

Secondly, in historical terms valuations are as good as they have been in quite a while and increasing numbers of stocks are appealing to even the most hard-bitten value managers.

Perhaps most compelling, bear market rallies are simply what often happens in these circumstances. Nothing, not the housing market, nor the Roman Empire nor Alan Greenspan’s reputation keeps going in a straight line in one direction.

“Whether they are bull or bear, markets move in waves,” said Albert Edwards, the famously bearish global strategist at Societe Generale in London.

“You typically get three or four rallies by 25 percent within a bear market. And even though I think the S&P is going to 500 we should get a fairly healthy bounce at some stage.”

Edwards, who has been not just bearish but structurally bearish and who in September predicted a crash, has started to put a toe back into the water, raising his weighting of equities within a diversified portfolio.

He is still underweight equities, but has moved away from more extreme levels.

ARGUMENTS OF AUTHORITY

And it’s not just him. Both Warren Buffett and famed value investor and long time bear and bubble detector Jeremy Grantham have recently become more positive on equities, to varying degrees and in Grantham’s case with a proviso that we will ultimately go lower.

I hate arguments of authority; a long string of them have got us where we are today. The deal must be safe, the ratings agency called it AAA. It must be sensible to borrow five times my earnings to buy a house that just tripled in value, after all the bank is willing to lend me the money. The Fed must know what it is doing.

But that said, the arguments that we may have a rally soon, even an evanescent one, are pretty good.

Grantham looked at 28 bubbles which met his criteria since 1920, all of which, including now the recent bubble in the stock market, reverted to the trend line of growth. Earlier in October, he called S&P at 900 good value and said he would be a steady buyer, though he says he is reconciled to buying too soon. He acknowledges that in the largest bubbles, 1929, 1965 and Japan’s in 1989, the market overcorrected by substantial amounts. He thinks the index, which was trading on Monday at around 880, will bottom at between 600 and 800.

Given that reverses are always part of market trends, and especially given that few awful things in life are as terrible as they seem when first the shock sets in, I do think it is reasonable to expect a rally. It could be quite powerful and will immediately get strategists and talking heads reminding us that large portions of bull market gains usually come in the first few weeks of a recovery.

But though I wouldn’t bet against such a rally, I also wouldn’t buy it a season ticket. Let’s all hope that the financial system doesn’t fall over, but let’s not confuse it remaining standing with a recovery.
Analyst expectations for earnings in the developed world are still at laughable levels. And though everyone laughs at them, stocks still get sold off when they disappoint.

The ongoing deleveraging of the Western economies has further to go and anyone with any sense will admit they don’t really know what this crisis may throw up.

So, prepare yourself for a bit of holiday season cheer, but remember that a long lean period usually come after.

– At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund –

John Kemp is a Reuters columnist. The opinions expressed are his own.

LONDON (Reuters) - The Federal Reserve has unveiled a dizzying array of new lending and liquidity support facilities over the last six weeks, but the diminishing law of marginal returns already looks to have set in. Each new lending and liquidity facility announced by the Fed is providing a smaller boost to confidence than the last.

The market is increasingly focused on how the Treasury and the Fed will fund the ever-expanding array of facilities, and the huge overhang of very short-term paper that needs to be rolled over into longer-term securities in a market that already looks queasy about the forthcoming flood of notes.
Rather than multiplying the number of acronymned facilities further, restoring confidence now rests on solving two issues.

First, the market needs to see buyers for all this new Treasury paper that will have to be issued in the coming year.

The government is under pressure to line up support from overseas central banks and other institutional investors to continue supporting the market by absorbing a large share of the new issuance that will be required.

A much higher share may need to be in the form of Treasury Inflation Protected Securities (TIPS) to reassure buyers the government will not seek to inflate its way out of the problem.

Additional commitments on exchange-rate stability may also need to be given, at least implicity, to solicit strong foreign participation.

Second, the market needs to see that the financial crisis can be contained by a stabilisation of home values, corporate cash flows and default rates.

Until collateral values and default rates stabilise, the steady flow of losses will continue to eat into even the banking system’s supplemented capital base.

The Federal Reserve System’s balance sheet has almost doubled since the start of Sep 2008, as the central bank has created or expanded a dizzying array of new lending facilities providing around $750 billion more support to the commercial banking system.

The chart here (https://customers.reuters.com/d/graphics/US_FEDCND1008.gif) shows the balance sheet expansion — with Fed lending (assets) above the line and sources of funding (liabilities) below.

The Fed is now providing extra credits through the Term Auction Facility ($263 billion); increased primary credits from the discount window ($106 billion); equivalent credits to other primary dealers and broker-dealers ($111 billion); liquidity support to money market mutual funds ($114 billion); and a variety of other uncategorised credit extensions including swap lines ($87 billion); as well as support for JPMorgan’s acquisition of Bear Stearns ($29 billion); and enhanced repo activity ($41 billion).

The Fed has run down its portfolio of Treasury securities as a result of lending operations, swapping them for other less liquid mortgage-backed securities, and has lent out about half of those which remain to securities dealers to provide temporary liquidity (https://customers.reuters.com/d/graphics/US_FDCND1.gif).

The attached graphic is an annotated version of the Fed’s weekly “Statement of Condition” showing the full array of new and enhanced lending and swap facilities (see chart https://customers.reuters.com/d/graphics/FEDBSH1008.mht).

Some of these extra credits have simply remained on deposit or flowed back into the Fed as member banks increased their reserve balances with the central bank.

Excess reserves held with the central bank above the minimum required for operational purposes have risen by around $289 billion in the past twelve months.

But the rest of the Fed’s balance sheet expansion has been funded from the proceeds of a massive US Treasury borrowing programme deposited into a special new account at the central bank.
The Treasury has borrowed $876 billion since the end of Aug (net of refunding).

In the first instance, most of the funding has been raised through the sale of an unprecedented volume of short-term cash management bills in Sep ($320 billion) and Oct ($520 billion).

Only a small proportion has so far been funded through the issue of bills, notes and bonds in the regular series to the public, leaving a massive overhang of debt that will need to be funded at longer maturities in the coming months.

As a result of this huge borrowing programme, the US Treasury now has a staggering $715 billion of cold hard cash and near-equivalents on deposit in various accounts:

(1)  Some $559 billion is on deposit in the Treasury’s new “special supplementary financing programs” account at the Fed to back increased Fed lending and credit facilities to the banking system.

(2)  Another $137 billion is being held in the Treasury’s regular account at the Fed. Presumably this money will eventually be allocated to another account. In the meantime it is a general deposit against which the Fed can lend.

(3)  The Treasury also has $20 billion in its Treasury Tax and Loan (TTL) accounts with commercial banks and had as much as $80 billion in recent days.

The TTL accounts are a holding facility used for surplus Treasury funds which are left with commercial banks for short but fixed maturities to earn commercial rates of interest.

Normally, the Treasury tries to keep balances on both its regular account and the TTL loans to a minimum.
Surpluses are withdrawn to finance spending and reduce borrowing. But in the current climate, the Treasury has no difficulty borrowing overnight.

In fact, it is the only borrower able to do so effectively. So the Treasury is maximising its short term borrowing and depositing the money with the Fed and the commercial banks, in effect doing the borrowing they cannot do for themselves.

The higher than usual balance in the Treasury’s regular Fed account is a form of quiet supplementary support for the central bank.

The higher than usual balances in the TTL facility are a quiet form of support for the banking system.

The problem with all this borrowing is that it is now taking the Treasury perilously close to the statutory debt limit, which was only raised by Congress in July and then again in Oct, as part of the Emergency Economic Stabilisation Act. The statutory debt ceiling currently stands at $11.315 trillion.

The Treasury has already borrowed $876 billion since the end of Aug. Total debt outstanding is now $10.457 trillion, just $858 billion below the revised ceiling.

But the Troubled Assets Recovery Programme (TARP) will require as much as $700 billion worth of borrowing.

It is not clear from the Treasury and Fed accounts whether some of the borrowing already done and the money already deposited into the various accounts is to support the TARP in future. But it looks like those funds are already fully committed backing existing facilities — meaning the Treasury still has to borrow most or all of the TARP funding.

With just $858 billion of unused borrowing authority, and as much as $700 billion of that committed to TARP, the Treasury has just $158 billion of uncommitted borrowing authority left.

A substantial rise in the debt limit is now both inevitable and urgent.

The administration looks set to recall Congress for a special lame-duck session after the Nov elections to approve a further rise in the limit as part of a broader package of financial reform measures and help for homeowners and corporate borrowers designed to stem the rising tide of bankruptcies.

At the time of publication John Kemp did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.

(James L. Melcher is the president of Balestra Capital, a New York-based hedge fund. He co-authored this article with Joan McCullough, macro-economic strategist at East Shore Partners. They are writing in a personal capacity and the opinions expressed are their own.)

Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke have been behind the curve in dealing with the breakdown in the banking system and financial markets. All of their initiatives have had only limited impact as they persist in treating the symptoms and not the cause. We are in the early stages of a severe global recession. It is critically important to take more aggressive steps.

The most vexing variable in this entire crisis has been the value of underlying collateral. Any remedy, therefore, is ineffective unless we acknowledge first that the fate of the collateral lies in the hands of the borrowers. Thus, it is imperative that triage measures be taken without delay to ensure the survival of the mortgagors.

Recent government decisions assume that the banking system and financial markets are the center of the universe. Thus all efforts are focused squarely on these areas to the gross disadvantage of our citizenry. Paulson and Bernanke have clearly opted to address the current crisis by pouring ever-increasing amounts of money into the banks with a view towards boosting lending activity. With other financial entities, such as AIG, they have enacted similar liquidity enhancements in a gambit to forestall the forced dumping of illiquid securities, which they believe would threaten the entire global financial system. A functioning banking system is required; but so far official efforts have failed to seize an opportunity to shore up both the mortgagees and the mortgagors.

Personal income tax relief offers a solution that would benefit both targets. The tax-deductible allowance on all home mortgage interest on principal residences should be meaningfully expanded beyond the amount of the interest for a period of at least three years, with the greatest multiple awarded to households in the lowest tax brackets. For a family in the 20 percent bracket, a deduction of four times its mortgage interest would effectively cut their mortgage interest cost by 80 percent. This tax incentive would serve to keep families in their homes from a pure financial-relief viewpoint. It would also entice prospective buyers to buy a home without further delay.

Housing prices would start to stabilize and “bad” mortgages could ostensibly be nursed back to health, having an immediate, positive impact on lenders’ balance sheets. This Mortgage Interest Relief Plan would eliminate the need to transfer risk unnecessarily and unjustly to the back of the U.S. taxpayer. By implementing this plan instead of yet another Washington-originated, one-by-one refinance initiative, any fear-mongering suggestion of an expropriating action by the US government would be silenced permanently. Washington would also be able to recoup some of the credibility it has lost, as both homeowners and Wall Street will be in a position to offer kudos instead of scorn.

There are, of course, significant details to be worked out. But key here is that the plan be executed with a blanket approach. This broad scope removes from the equation the complaint that only bad behavior is rewarded along with other perverse conditions as set forth in earlier government programs. It has the forward benefit, too, of acting as a deterrent to the spread of foreclosure fever further up the socio-economic ladder; in a protracted global recession prime loans also fall under pressure.

Non-mortgagor taxpayers can be compensated with enhanced stimulus checks from Treasury, further facilitating the equitable nature of the proposal with a view towards jump starting consumption across the board. And by using the IRS to effectuate and monitor the process, it can be implemented expeditiously and relatively simply.

There would be substantial benefits to the financial system also. Rather than having Treasury or the Fed buy or lend against distressed mortgage-backed securities (much of which will turn out to be worthless), keeping people in their homes and current on their mortgages will raise the value of those securities and bolster cash-flow to their holders. The effect would be enormously positive, directly and indirectly, to the entire financial system and would substantially raise confidence levels. Instead of trying to control the smoke, we could start to put out the fire.

The cost of this program in lost tax revenues would be enormous. However, the amount of money that the Fed and Treasury are pouring into the financial system is already huge. While these recent initiatives are producing a tremendous amount of resentment as the costs to the taxpayer mount, they are producing very little bang for the buck. This Mortgage Interest Relief Plan may turn out to be both less costly and more productive than the current economic “rescue” program.

Financial systems run on confidence, and confidence has vanished abruptly. People are afraid to buy a home and they are panicking out of the markets. Speed is critical. We cannot wait for the current program to produce results, if it ever will.

A radical expansion of the mortgage-tax deduction is a blunt tool, but so is a sledge hammer. This forceful, proactive initiative puts the money where it is most needed – in the hands of individuals. It could be the shock treatment that both the economy and the financial system desperately need right now.

When we first began talking about a new section that would encourage Reuters.com readers to debate the issues of the day, the credit crisis had yet to explode into the global threat that it is today. Less than four months later, the public appetite for debate and new ideas has never been greater. Barack Obama was speaking for many across the political spectrum when he said the crisis “calls for the best ideas, the brightest minds, the most innovative solutions from every corner of this country,” although few would expect the search for ideas to stop at the U.S. border.

The debate around those ideas would have once been limited largely to the corridors of power, the newspaper editorial writers and the occasional letter to the editor. But this crisis is taking place at a time when every idea is challenged in the public forum of the Internet. The economic proposals discussed at the Nov. 15 meeting of world leaders in Washington will be instantly dissected, debated and reworked, and the consensus of that global conversation will feed back in some form to the policy makers.

With our global reach and expertise in finance and politics, Reuters is uniquely placed to host that debate. On this page, you will find Reuters columnists and other interesting voices from outside our newsroom discussing the credit crisis and other issues that concern our readers, such as politics, corporate ethics, technology and religion. You’ll also find selected entries from our blogs and pointers to the news stories of the day. We invite you to advance the debate by posting insightful comments, adhering to the house rules listed below. The pithiest and most insightful will be highlighted on the Great Debate home page.

While the topics won’t always be as far-reaching as the original Great Debate of 1920, when two astronomers tried to define our place in the universe, we hope the discussion will be just as passionate.

Richard Baum
Global editor, Reuters consumer media

Picture: Stagehands erect a piece of the set at the site of the third and final US presidential debate REUTERS/Jim Bourg