Global No Confidence Vote: New Boss, Same Problem

While the euphoria of Obama's inauguration is still in the air, the cold, hard reality is our financial system is a walking corpse. Even worse, Obama's plan to fix the economy is more of the same bungled policies that failed to get Bush's economy out of the black hole it's trapped in.

President Barack Obama's economic team is pushing to complete a bank-rescue plan that can be twinned with the $825 billion stimulus package being negotiated with Congress to alleviate the rapidly deepening financial crisis.

While full details of the rescue haven't been settled yet, people familiar with the deliberations said the package is likely to include a $50 billion-plus program to stem foreclosures, fresh injections of capital into the banks and steps to deal with toxic assets clogging lenders' balance sheets.

While that's certainly a step in the right direction, the plan itself is much, much too small to effectively deal with the tens of trillions in toxic derivative debt on their books. Roubini explains the crux of the problem in the article:

American banks are reluctant or unable to lend after suffering more than $700 billion in writedowns and credit losses since the collapse of the market for subprime U.S. mortgages 18 months ago. The slump in lending, even after the government has pumped billions into the nation's banks, is exacerbating the worst recession since the 1980s.

U.S. financial losses may reach $3.6 trillion, suggesting the banking system is "effectively insolvent," New York University Professor Nouriel Roubini, told a conference in Dubai on Jan. 20. Obama will have to use as much as $1 trillion of public funds to bolster the capitalization of the industry, he estimates.

In other words, there's a very good chance we have a good $3 trillion in losses in just the financial sector to deal with. Where are the rest of these losses coming from?
Just like the subprime mortgage market, commercial mortgages, credit card debt, auto loans, and other residential and commercial loans were securitized and packaged into toxic waste derivatives. These particular securitized products have yet to fully collapse into losses. Collectively they dwarf the mortgage losses banks have already suffered. $700 billion in writedowns have ravaged the sector. What will more than four times those losses do?
Yesterday the Dow sank under 8,000 again. Banks took a massive hit across the board. Citigroup and Bank of America are not solvent companies. As Paul Krugman explains, they are "zombie banks".

To explain the issue, let me describe the position of a hypothetical bank that I'll call Gothamgroup, or Gotham for short.
On paper, Gotham has $2 trillion in assets and $1.9 trillion in liabilities, so that it has a net worth of $100 billion. But a substantial fraction of its assets -- say, $400 billion worth -- are mortgage-backed securities and other toxic waste. If the bank tried to sell these assets, it would get no more than $200 billion.
So Gotham is a zombie bank: it's still operating, but the reality is that it has already gone bust. Its stock isn't totally worthless -- it still has a market capitalization of $20 billion -- but that value is entirely based on the hope that shareholders will be rescued by a government bailout.

The reality is that an overwhelming majority of the banks in this country, right now, at this moment, are zombie banks. They are insolvent because not only are the toxic derivative assets they have are virtually worthless, but the coming tsunami of losses from the rest of the massive collapse of securitized loan products will assure they are wiped out.
We'll need a trillion dollars more just to begin to fix the problem in the financial sector alone. And that's if they survive at all.
And that brings us to Obama. His plan to fix the problem? The same thing the Bush crew rejected as unworkable, the so called "bad bank" strategy.

Ben Bernanke, Federal Reserve chairman, argues that dealing with toxic assets through purchases of these assets, insurance-style guarantees or one or more bad banks would help banks to lend and raise new capital. Policymakers used the insurance model for Citi and BofA. It directly addresses the so-called "tail risk" of extreme loss, but lacks the finality of taking the assets off balance sheet.

It is not easy for either the Fed or Treasury to provide the insurance - the Fed has problems with credit risk and its balance sheet, Treasury has accounting issues.

There is more enthusiasm for an "aggregator bank" through which, for instance, $100bn of Tarp equity could be geared up five times to provide $600bn of purchasing power. The aggregator bank would issue its own long term debt - probably with a guarantee from the FDIC or Treasury.

The big challenge would be how to value illiquid assets. Officials in the Paulson Treasury say they made real progress on this, but outsiders are sceptical.

In other words, Obama's boys are leaning towards a plan that would dump trillions of dollars of long-term debt on a government bank...a government bank whose debt would then weigh down the country like a stone and transfer the burden of insolvency from the banks to the taxpayers. If they pay too much for these toxic assets, the taxpayer will foot a bill for trillions. If pay too little, the banks will collapse. And even if they pay the right amount, the US taxpayer just bought enough worthless derivative crap to sink the entire country. Who will buy it from America? Do you think China will magically step in and give us trillions for worthless IOUs?

Even better, Team Obama plans to use the "full faith and credit" of our country to back a time bomb of trillions upon trillions of additional debt. Instead of the financial system being insolvent...the United States will be insolvent. Not only will we be dealing with the massive financial sector losses, but the losses in every other sector of the economy as well. A $700 billion loss in banks put us on life support. Another $3 trillion will not only kill us, it'll disintegrate the corpse.

There's a cheery thought. While the country parties hard and is glad to see Bush gone, the reality is we've only faced a small fraction of the economic nuclear blast so far. When the rest of the shock waves reach us, the reality of America as a third-world economic pariah will crush us.

Time is almost up. Yesterday's bank sector hit put many of the remaining banks in our country on knife's edge. Another round of massive financial bailouts will be on the way and much sooner than you think. All the progressive legislation that many of us dream of will not happen. It will get smashed by the tsunami of financial reality.

The reality is America is already insolvent. Bush bankrupted us. The bill is past due already. 2009 is going to be a hideous year, and despite all of Obama's abilities, not even he will be able to fix things. We're too far gone at this point.

Be prepared, for what it's worth.