Is The Worst Yet to Come?

By Reuters Staff
September 22, 2008

Below is a reprint of the Op-Ed I published in today’s Baltimore Sun.

“Is the Worst Yet to Come?”

Will it ever end? For more than a year, the financial system has struggled to function, stricken as it is with economic Ebola. Cash is the only cure, and banks have raised almost $400 billion. That’s not nearly enough, however, so the federal government has committed to various bailouts that will cost hundreds of billions over time. The most expensive yet – a new super-agency to buy bad debt – may eventually cost north of $1 trillion.

As bad as the situation is, we’re in deeper trouble than most realize. The virus infecting banks – too much debt – is spreading to the federal government. If Washington falls victim, we could be headed for another Great Depression.

Trillions of dollars in bad loans infected bank balance sheets during the housing bubble. As house prices started to decline nationwide, those loans turned virulent, dropping in value and robbing banks of the capital they need to stay in business. The disease spread so quickly because banks have little uncommitted capital to defend against losses.

During the housing bubble days, bankers lent as much as possible, confident that housing prices would never go down. Consequently, they were left vulnerable to even a small decline.

Understanding why too much “leverage” can kill a bank is crucial to understanding why the credit crisis is dropping major financials like flies, and why the federal government is vulnerable.

Like all businesses, banking involves risk. If, for instance, borrowers default on their mortgages, the bank may struggle to pay back its lenders. So it keeps cash in reserve. But reserves earn no profits for the bank, so it minimizes them.

Assets make money, and reserves provide protection. Putting the first in the numerator and the second in the denominator, a bank’s “leverage ratio” measures how much risk a bank is taking to make money. A higher ratio means more potential for profit but also less protection against loss. A sound bank should have a leverage ratio around 10-1. The major Wall Street banks operated with leverage ratios north of 30-1.  And when you consider that much of their capital was bogus “deferred tax assets,” Fannie and Freddie has leverage ratios near 250:1.

If leverage gets high enough, even small losses will cause a bank’s creditors to panic. Worried that cash in reserve won’t be sufficient to pay them back, they cancel credit. When a bank loses access to credit, it is put out of business.

Fannie Mae, Freddie Mac, AIG, Lehman Brothers, Bear Stearns and even Baltimore’s Constellation Energy Group all relied on credit in order to do business. When their credit disappeared, they ceased to function independently.

At this point, much of the U.S. financial system would be out of business without taxpayer support. Banks need credit to operate, and Uncle Sam has stepped in as creditor of last resort. In addition to the trillion dollars of bailout money on the way, taxpayers have pumped another trillion-plus into the banking system via the Federal Home Loan Banks and the Federal Reserve.

Before the credit crisis, the Fed only accepted the highest quality paper as collateral for its loans. Now it accepts risky mortgage-backed securities and even equities, exposing taxpayers to significant risk. The FHLBs – off-balance-sheet entities of the federal government such as Fannie and Freddie – have advanced more than $900 billion to banks, up nearly $300 billion since the credit crisis hit.

If the U.S. financial system relies on government funding to borrow, what will happen if the federal government’s creditors take a walk? Consider Argentina, which in 2002 devalued its currency to pay off a crushing debt burden. Foreign capital fled the country, the banking system collapsed, inflation hit 80 percent and unemployment reached 25 percent as the economy sank into a depression.

That could never happen here, argue some. The $10 trillion national debt is “only” 70 percent of GDP, leaving the government plenty of borrowing capacity. But that ignores $60 trillion of projected liabilities for Medicare and Social Security, according to economist John Williams.

What’s true of companies is true of countries: The more they borrow, the more they operate at the mercy of creditors. The more they borrow, the more violent their inevitable failure.

Under no scenario can Uncle Sam raise the trillions it needs to meet all these obligations. No tax rate is high enough, no discretionary spending cuts draconian enough. And there is no creditor of last resort for the U.S. Treasury. If default implies an Argentina-like scenario, that would leave us with only two options. The first is to print money; Mr. Williams says this would lead to “hyperinflation on the order of 1920s Germany.”

The other option is to eliminate Medicare and Social Security.


Rolfe Winkler, chartered financial analyst, is publisher of OptionARMageddon.com.

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