The U.S. Economy: Playing Chicken With The Train Train… Splat!

As we watch the news, we are seeing the great financial institutions of the United States falling by the wayside on what seems like an almost daily basis right now.

Bear Stearns

In March of 2008, the first major institution Bear Stearns reached the end of the road. Over the five years leading up to the collapse of Bear Stearns, it had maintained a stock price of about $10 per share. When the company collapsed, the U.S. Government helped usher in a semi-bailout for Bear Stearns, enabling JPMorgan Chase to buy Bear Stearns for $2 per share. The Federal Reserve, who constructed the deal promised to put $30 billion dollars in cash into the deal to ensure that BSC would have some liquid capital.

The downfall of Bear Stearns was attributed to the same issue that ushered in the Stock Market crash of 1929 and the Great Depression of the 1930’s - lost confidence in the company. In the final quarter of 2007, Bear Stearns reported their first loss ever. Just weeks before the the collapse of the bank, Bear’s executives were promising that the company would show a profit for the first quarter of 2008.

But, as the month of March began, Bear’s customers began getting fidgety and uneasy about the financial soundness of Bear Stearns. Its customers started pulling their money out of Bear Stearns at a record pace. This led to a liquidity problem (cash shortfall) that eventually led to the collapse of the company and the subsequent bailout by JPMorgan.

Fannie Mae and Freddie Mac

Between the two, they guarantee or hold about half of the mortgages in the United States. (That’s somewhere near $6 trillion worth of mortgages.) When Fannie Mae and Freddie Mac got into financial trouble, the U.S. Government absolutely had to step in to prevent the complete meltdown of the U.S. mortgage market.

To exacerbate this problem, Fannie Mae and Freddie Mac have outsourced nearly $1 trillion in mortgage-backed debt guaranteed by the two, to banks in Europe and Asia. Nearly $300 billion in the mortgage based debt at Freddie and Fannie is owned by China. Foreign investors in Fannie and Freddie were so ill-at-ease with the condition of the two firms, that they had been on the phone with Treasury Secretary Henry Paulson, expressing real concern as to the viability of these two companies, backed by the U.S. Government. Foreign banks had been suggesting that they might be inclined to call their loans due immediately, which would have pushed Fannie and Freddie over the financial cliff and the U.S. Government with them.

The U.S. Dept of Treasury, along with the banker / analysts from the Federal Reserve, along with help from Morgan Stanley analysts, spent a lot of time and resources studying the position of Fannie Mae and Freddie Mac, which are privatized corporations backed by the U.S. Government. (Click this link to read the full back-story about this process.)

In the end it was determined that Fannie and Freddie would need an infusion of $50 billion to ensure their survival in the troubled real estate market and its multitude of foreclosures.

Of course, Fannie and Freddie were created to offset the risk of banks to help more Americans own homes, so it is to be expected that Fannie and Freddie would have some bad loans on their books, but the position of Fannie and Freddie were made worse by the risky behavior of banks across the country, during the real estate boom and sub-prime loan debacle, who sold their bad paper to Fannie and Freddie. (More on this later.)

In the end, Fannie and Freddie were not at the edge of the cliff just yet. But, if Fannie and Freddie were allowed to keep going forward in their present operating practices, then the cliff was racing towards the two of them quickly.

Treasury told Fannie and Freddie that they should voluntarily pass control of their corporations to the Feds, OR the Feds would go to Congress and legally TAKE control.

Fannie and Freddie voluntarily entered into an agreement to permit the U.S. Government takeover of their companies. With the takeover, the Feds had to put $50 billion in liquid capital (cash) into Fannie and Freddie. Had the government done nothing, then it is entirely possible that the government could have been out trillions when both fell under their own weight.

Lehman Brothers

Lehman Brothers, an investment banking company had been in business since 1850. On Sunday, Sept 14th 2008, Lehman Brothers was forced to declare bankruptcy. Lehman Brothers entered the history books as the LARGEST bankruptcy in U.S. history. Lehman had $639 billion in assets, just three billion dollars short of being six times larger than the previous record-holding $107 billion bankruptcy of WorldCom in 2002.

At the end of August 2008, Lehman had $600 billion of assets financed with just $30 billion of equity, which meant that a shift in the value of Lehman’s assets by a number of as little as 5% could put the bank into default.

Just like the Cowboy Troy song, “Playing Chicken With The Train Train”, Lehman Brothers and the other Wall Street banks thought they could force the U.S. Government to bail-out Lehman Brothers.

Government officials told the major banking institutions to support Lehman’s, by buying off some of its assets, or else be prepared for more major investment banks to lose investor confidence and fail.

But, according to those close to the negotiations, prospective bidders refused to buy Lehman without government support and assurances. Banks were looking for the U.S. Government to secure the bad debt on Lehman’s books, but the Feds refused.

Wall Street and Lehman’s felt that the Feds would back down when faced with the largest bankruptcy in U.S. history. The Feds did not blink, so Lehman went down in flames.

Now, Lehman is in the process of selling off its assets. Many of their wholly-owned subsidiaries are smaller investment companies. With the bankruptcy of Lehman, many of these subsidiaries need a quick sale, otherwise investors will start pulling their assets from the smaller firms as well. This is why it is important for Lehman to sell its subsidiaries quickly, because every day that goes buy without action, the subsidiaries are losing customers and therefore losing market value.

For the banking industry as a whole, Lehman is good news for smaller and stronger banks to pick up assets at a bargain basement prices.

The Lehman Brothers bankruptcy, plunged the global financial system into turmoil. The massive Lehman bankruptcy filing in US federal court in New York listed 639 billion dollars in assets and 613 billion in debt.

On Saturday, Sept 20th, the U.S. Bankruptcy Court charged with handling the Lehman bankruptcy has approved selling several Lehman units to Barclays for $1.75 billion. Barclays will acquire Lehman Brothers’ investment banking and trading units that employ about 9,000 people in the U.S., units that have branches Canada, Argentina and Uruguay, and a skyscraper that Lehman occupied in Manhattan.

Ironically, before Lehman declared bankruptcy, they had been in talks with Barclay about a merger between the two banks. Lehman executives rejected Barclays’ initial merger offer because they said it would not have been in the best interests of Lehman’s stock holders! (So, was it truly better for Lehman’s stockholders to lose all of their investment as opposed to some of their investment ?)

Chicken With The Train Train… Splat!

Within 24 hours of the bankruptcy of Lehman Brothers, the Bank of America Corp agreed to buy what was seen as the next weakest U.S. investment bank, Merrill Lynch & Co Inc.

Other banks are now seriously considering the purchase of troubled banks. Wachovia is in talks to buy the troubled Washington Mutual.

Of course, the $32 billion California-based IndyMac went down in July of 2008. It was taken over by FDIC (Federal Deposit Insurance Corporation) in July and stabilized.

In an August 2008 report, the FDIC reported that the list of troubled banks rose from 90 in the first quarter of 2008 to 117 by the end of the second quarter of 2008. This list of troubled banks has assets of $78 billion, according to the FDIC.

In comparison to the Wall Street banks, the price tag of the 117 troubled banks is really small, although in comparison to the kind of money that most of us manage, the price tag for these additional banks will be huge.

This kind of puts into perspective the reasons why the Federal Reserve and the U.S. Government is walking the ice flow and picking which banks to bail-out.

With our local banks, the FDIC has insured most of our savings. The basic insurance amount is $100,000 per depositor, per insured bank. Deposits in separate branches of an insured bank are not separately insured. Deposits in one insured bank are insured separately from deposits in another insured bank.

Joint Accounts can be insured up to $200,000, but there are a number of caveats to that insurance. So if you need to know the terms on a joint account, you need to review the FDIC documentation for Joint Accounts at the FDIC website.

AIG Insurance

AIG Insurance was the largest insurance company in the world. According to a story in the Wall Street Journal, CitiGroup analysts suggested that the troubles at AIG bode well for AIG’s competitors, which may be good for the insurance industry overall. They said that AIG got to be the largest insurance company by being one of the lower-cost insurance underwriters.

In the AIG bailout, the U.S. Government invested $85 billion into AIG to help their cash flow. In return, the Feds took a 79% stake in the future of AIG and was able to replace its leadership. The government put Edward Liddy, former Allstate Corp chief executive, as AIG’s new chief executive.

Top state and federal officials said the AIG deal was made in hopes of staving off further turmoil in the financial markets and the economy.

The Root Cause Of All This Economic Turmoil

The United States experienced rising home prices for several years, leading most economists to talk about a real estate bubble. It was said that housing prices were rising faster than what they should have been increasing, leading to people buying homes at inflated prices.

This base problem was underscored by sub-prime lending practices, where banks were making loans that they would never have considered making in previous decades. One analyst described the sub-prime market as NINJA Lending, which in essence means that loans were given to people with No Income, No Job and No Assets - Approved. At the very root of the problem, people were given loans for homes that they could not afford to pay back.

At a certain point, people could not afford to pay their house note, and their payments started to come later and later. Eventually, home owners were in default of their loans and the banks had to foreclose homes that they had loaned money to purchase.

In a normal market, foreclosures are not that uncommon. What is uncommon is the high rate of foreclosures that have pummeled the economy. Those sub-prime NINJA Loans are coming back to bite the banking industry on the butt.

Now in a normal market, banks will make loans and then package those loans for resell to an investor group at a discount. (Read here to get a more in depth understanding of this practice. If you only have time to read the information from one link in this story, this is the link that you need to follow.)

Fannie Mae, Freddie Mac and the investment banks Bear Stearns, Lehman Brothers, and Merrill Lynch were unfortunate enough to buy loan packages that had far too many bad loans mixed in with the good loans. This is where the fissures in the economy started undermining the foundations of these once large and once proud companies.

A Stone Hits The Pond and Sends Ripples Across the Surface

Banking institutions started to worry about the high foreclosures in the marketplace. They were further troubled by the fact that the values of other homes were diminished by the rut of empty homes in neighborhoods across America. When a neighborhood has several homes sitting empty and unsold in the neighborhood, this drives down the market value of other homes in the neighborhood.

Not only were homeowners troubled by falling real estate prices, but the banks that loaned for their homes were troubled too, in that people were now upside-down, owing more money for their homes than their homes were worth.

This situation opened the door on banks cutting back on what they were willing to loan to consumers. Fearing the real estate market, banks began rejecting and avoiding additional home loans on their books.

The consumer lending market began to dry up in 2007, as a result.

Consumers needing home loans, car loans and other types of loans began to see banks turning them away at every corner. Consumers have been feeling the pinch of a dried up consumer lending market for more than one year.

As the Summer of 2008 wound down, a new threat to the marketplace opened up.

Banks typically loan money to one another to help each other stay on the positive side of government regulations concerning how much liquid cash the banks are required to have on hand at any one time. These loans have a seperate interest rate, which is governed by the Federal Reserve.

These bank-to-bank loans are generally made for only a few days to cover cash flow at the banking institution. These bank-to-bank loans have operated unfettered for years. But with the financial situation in 2008, banks began to question the liquidity of their fellow banking institutions.

When Bank A is asked to supplement Bank B with a $50,000 one week loan, Bank A began to question the soundness of Bank B. One year ago, Bank A would have immediately moved the money from their vaults to Bank B’s vaults, without question or concern. But now Bank A is worried. Is Bank B financially sound? Will Bank B be able to pay that loan back by next week, as agreed? If Bank A lends to Bank B and Bank B fails to pay that loan back on time, then Bank A may be facing liquidity problems of its own.

Wham! Bank A said “no” to the loan, and now Bank B is facing financial crisis.

Bank A is concerned, because they do not know how many bad loans Bank B has on its books. As a result, the trust factor between banking institutions has been damaged, thereby putting more banks at risk of failure.

This is how the September 2008 banking crisis came to fruition.

Lehman Brothers was in such bad shape that banks stopped loaning short-term money to Lehman Brothers. When money began to tighten at Lehman Brothers, its’ customers got wind of the problem and made a run on the bank to withdraw their funds before Lehman hit the brick wall. As more customers rushed to Lehman Brothers to get their money out, Lehman Brothers was doomed to fail as their liquid cash assets were drained to nothing.

Post Lehman Brothers

Banks need to be able to sell their loan packages to investors in order to be able to free themselves from the government regulations that limit their asset-to-loans value, so that they can finance new loans.

When the bank is able to sell a chunk of its loans to an investor, then the bank will have replaced its liabilities with assets. The government requires that banks must have a specific amount of assets in their bank, against a specific amount of liabilities. If the banks’ debt-to-asset ratio nears a certain percentage, then they must stop loaning money, period. Selling their loan packages to investors gives the banks the ability to move their assets up and their liabilities down, to ensure that they can stay on the right side of the banking industry regulators.

In the current market, investors have no idea how many of the loans in a package are bad loans.

Surviving banking institutions are keen to avoid the mistakes of Fannie Mae, Freddie Mac, Bear Stearns, Lehman Brothers and Merrill Lynch, who bought loan packages without knowing the true value of those loan packages (as a true measure of good loans vs. bad loans).

Because banks and investors have no idea how many of the loans in a loan package are going to be bad loans, no investor truly knows how much they can actually pay for those loan packages and still make a profit on the purchase.

For example, if the gross estimated value of the loans in a loan package are valued at one billion dollars, then the buyer should get a good idea of how many bad loans are in that package. If 30% of the loans ($300 million) in a package are bad, and the investor pays 60 cents on the dollar ($600 million) for the loan package, then the investor has a 10% margin in which they can secure a profit for their investment. If the investor paid $600 million for a loan package and they can get back $700 million, then the investor will profit $100 million.

But, if that investor pays 80 cents on the dollar ($800 million) for the loan package and it turns out that 30% of the loans are bad ($300 million), then the investor risks losing 15% of its investment or $100 million, when those bad loans start going bad.

Because investors do not know how much of a loan package is based on bad loans, the investor does not know if it should offer $600 million or $800 million for a loan package valued at $1 billion. But then the package may be at greater risk and the $1 billion in mortgages may only be worth $400 million.

Because no one truly knows the real value of these loan packages, investors are unwilling to agree to a purchase price for these loan packages.

Suddenly, banks are not able to sell their loan packages. Because banks are not able to sell their loan packages to investors, most banks have hit the top end of their lending capabilities, according to the cash-to-loans ratio that the Feds require banks to maintain.

The banks are not able to sell their loans, enabling them to make new loans. This has forced the consumer lending market to dry up. Further, banks are forced to eat their own loans, if they made bad loans to begin with.

The One Trillion Dollar Bail-Out

The Bush Administration is trying to work with Congress as I write this. The Bush Administration is proposing a government bailout package that will move all of the bad loans out of the marketplace and into government conservatorship.

From the standpoint of our current credit crunch, this is on the surface a good idea.

A lot of those loans out there that people are sweating will be paid in full and on-time. Not all of those NINJA Loans will go into default. (As the writer of this article, I must admit that our home loan could be lumped into the sub-prime loans. We bought when we really could not afford to buy, but we have done well with our home loan. We are five years in and $2000 ahead on our house payments.) So, as exhibited by my own experience, not all of those NINJA Loans will go bad. In fact, many of those loans that will be absorbed by the Bush bailout will be paid on time and be worth their full-estimated value.

The important thing is that the Bush bailout will take those worrisome loans out of the public marketplace, and bring them under government ownership. It may turn out that Bushs’ one trillion dollar bailout will earn back most, if not all, of the $1 trillion invested to balance this shaky marketplace.

Some of those homes going into foreclosure that will be harnessed under the Bush bailout may actually sell on the open market, permitting the government to recover most if not all of the lost money.

Many of the homeowners whose home loans are covered under this plan will be able to pay their notes in full.

So, Bushs’ trillion dollar debacle may earn back most of the initial trillion dollar outlay. Maybe… Maybe not…

The benefit of pulling the bad loans out of the open market is that it will strengthen the entirety of the banking industry. It will return trust to the banks currently operating in the marketplace. It will permit bank-to-bank lending to resume unfettered. And it will permit banks to sell their loans, so that they can open up the consumer lending industry to the public once again.

Bushs’ plan is a good one in that it will free our market to do what it does best, to strengthen our continued economic growth into the future.

The downside on the Bush plan is that it could potentially make the U.S. taxpayer bail out people who have made bad decisions, from the person who took a loan that they knew they could not afford, to the banks that should have known better than to make sub-prime loans to people who would not be able to afford the home considered. The Bush plan could cost the U.S. taxpayer as much as one trillion dollars, and as little as next to nothing.

In Conclusion…

Hopefully Congress will get on board with Bushs’ one trillion dollar bailout package. Doing so, they will resurrect our failing banking industry and replace a bad market with a good market.

Once the Congress gets through the bailout, we can then hope that the Congress finds wisdom enough to introduce the kinds of regulations that will enable our global economy to move forward with strength and resolve, while prohibiting the piranhas that got us into this situation from repeating the chaos they created in the global economy.

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Continue reading about the economic collapse and the subsequent $700 billion economic bailout here.

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Your Financial Observer at: http://cash-advance-payday-loans.org/blog/

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Tags: aig, aig insurance, Banking Industry, banks, bear stearns, chicken with the train, financial bail-outs, financial bailouts, indymac, lehman brothers, merrill lynch, troubled banks, US Economy, wall street, washington mutual