Follow-Up on Loan Delinquency

The FDIC is reporting delinquent bank loans are 7.75% of all loans. While this is not yet as bad as mortgage delinquency which we discussed in yesterday's post, it is still capital-annihilating (since most of these deadbeat loans will have to be written off).

With their capital evaporating, banks must shrink lending. It is no wonder that so many businesses and individuals are seeing their credit lines cut or cancelled. As those who have the means to pay off said lines of credit race to do so, they will not be investing or spending money. This will have a dampening effect on economic activity, to say the least.

If the nationalised, yet insolvent Freddie Mac and Fannie Mae being ordered to expand their books to keep mortgage loans flowing were a precedent, we would anticipate an imminent, very large bank nationalisation instigated in order to have banks under political control and follow the directive to grow loans, no matter the ultimate cost. (The hurried, and ill-conceived TARP investments do little to give the Federal Government adequate policy leverage over the banks).

We think it wiser to let banks gradually expire. In the post peak-oil, resource-constricted world, there will likely be no further economic growth. In the aggregate, borrowing and lending will become much riskier propositions since loans will tend to impoverish, rather than enrich borrowers. There will always be room for lending to promising enterprises, but this will be a small niche.

It will be very shocking to witness much of the 20% or so of the US economy that is the banking and financial sector just go away. But there is no way around it. Like house building and automobile manufacturing, it is a sector whose preeminence has come and gone.

Synthetic CDO's are Beginning to Bloom

One of our many interests in the unfolding calamity in the financial world are the hell-spawn known as Synthetic Collateralised Debt Obligation, or SCDO. For an indepth refresher on exactly what these monsters are, please read our first post on the nature of SCDOs. We'll include a brief definition here, but we recommend brushing up on your SCDOs... we needed to do so, as well, since they're impressively complicated.

Put simply, SCDOs are issued by American super-huge banks, and are composed of credit default swaps taken out against a list of about 100 or so major companies, called the reference entities. The investors who buy these SCDOs (under the impression that the instruments are 'bonds') become, in effect, a pool of 'names' - the people who pony up the money when insurance needs to be paid out. In this case, the credit default swap is the insurance for the issuing bank against the reference entities going bankrupt. When a small number of the reference entities - about seven or so - go bankrupt, the SCDO is triggered and the investors' money is immediately and irreversibly transferred to the issuing bank.

As an aside, reference entities typically include such fine companies as: AIG, Fannie Mae, Freddie Mac, Bear Stearns, Merrill Lynch, Chrysler, General Motors, et cetera. All are, as we are sure you noticed, not in the best of shape.

When that slew of reference entities bit the dust, we wondered when the SCDOs' 'trigger' would be tripped; which company or companies were going to start the flood of wealth? Ever heard of Syncora Guarantee Inc? According to Asia One, the Pinnacle Series 1 notes out of Morgan Stanley have wiped out every last cent of those who invested in the notes. Pinnacle Series 1 is a SCDOs, and it has been triggered by a Syncora default. The article also reports that Pinnacle Series 2, 3, 4, 5, 6, and 7 are careening toward being triggered.

As the 2007 Depression puts the screws to the world's economy, Morgan Stanley has tasted some of the first blood in the SCDO arena. When General Motors enters bankruptcy, we strongly suspect that many more SCDOs will be triggered, and thus what will likely be the single greatest transfer of wealth in world history will continue. As the action on the SCDO front is heating up, we will be reporting much more regularly on the topic. You can likely expect another update soon after GM enters bankruptcy.

Pakistan, War, and Obama's 100 Days

A short post today, as we're a bit pressed for time. We got word of an apartment which needed cleaning out, and boy does it ever. Apparently the former tenant possessed several cats and dogs... and a goat. No, we do not jest, a goat. Still, free stuff is free stuff; we don't call ourself a frugal Scotsman for no reason.

Within the first one hundred days of U.S. President Barack Obama's term, he's behaved more or less as we expected. He's been busy, busy, busy: cutting deals with the super-huge banks, handing blank cheques over to American International Group, nationalising automobile manufacturers... and otherwise cementing our opinion that he is the Herbert Hoover of the 2007 Depression. A quick read even of President Hoover's wikipedia page shows eerie similarities between policies of these two Administrations.

But the one thing that President Obama hasn't done, which we were (and are) expecting him to do is to start a new war. Quite the contrary, he seems to be actually ending the occupation of Iraq! However, he has ordered a 'surge' in Afghanistan, which will probably end badly. Afghanistan is the meat-grinder of the world, where over-confident militaries are broken, defeated, and taught some humility in the process.

The only place which might be worse to invade than Afghanistan is probably Pakistan... and we have the sneaking suspicion that the U.S. may be 'invited' in by the Pakistani government to help 'secure' the nation against 'the Terrorists.' The rumblings for such a thing are already evident, at least to us, in articles like this one from the Associated Press. We suggest keeping an eye on the situation, as it could become very exciting very quickly if the U.S. decides that Pakistan needs 'assistance.'

Problems of Comparing the U.S. with the U.S.S.R.

We have made several arguments in the past that the United States is following the Soviet Union's path to oblivion. Although we do feel that the basic trajectory is a reasonable one for analysing the U.S.'s descent, we have been giving the matter some thought recently. Some results from this pondering have been critiques of the U.S.S.R./U.S.A. collapse comparison.

First, though, is a proposal we have to offer the Obama Administration, although we expect it would be very unpopular. The first step would be to have President Obama admit the banking system is completely fracked up. He would then nationalise the entire banking system, thus wiping out the stockholders, the bondholders, and all uninsured depositors. From there, two new sectors would be formed: a national system of "good" banks, which would hold all insured deposits; and a trust to hold all the toxic 'assets' in an attempt to wind down the contracts and garner a profit therefrom.

After this schism is complete, the Federal Government would then issue vouchers to every American citizen. These vouchers would be good for stock or bonds in either the 'good' banking system, or in the trust of bad 'assets.' Through this system, the profit from both the renewed banking system, as well as the winding-down of toxic assets, will accrue to the Citizenry, and not to some banking elite or corrupt political toadies.

This voucher concept is not original; it was something that arose from the Soviet Union, in an attempt by the post-Soviet Government to unwind failed economic models and structures. The effort failed, because the Soviet system failed so utterly, but the concept behind the vouchers is brilliant: it distributes the potential benefit amongst the largest number of people, something that the United States desperately needs in dealing with its failed banking system (and automobile manufacturers).

However, we honestly would be shocked if a system of vouchers was ever implemented in the United States. The 'why' is simple: to do so would be a proactive admission of failure, which is anathema to the American ethic. Very few citizens in the U.S. would be able to admit that the entire U.S. banking system is in failure-mode, and needs to be liquidated as rapidly and efficiently as possible. The post-Soviet voucher system would be better a 'cure' than simply tossing vast sums of money indirectly into the over-seas retirement funds of the CEOs.

Americans are not able to understand that something so pervasive as banking could collapse utterly... and they really would not understand that, if the Federal Government were to lose its effectiveness in keeping the zombie super-huge banks limping along, the banking industry would utterly implode overnight. Failure of Government is totally alien to the American Citizenry, whereas it was very familiar to the Soviet populace. Soviets could clearly see that their economic system was non-functional, and cavorting with utter failure. Americans cannot understand that the "American Way" is just as hopelessly flawed as the Soviet's system, and just as doomed to failure.

It is in this great difference between the collapse of the Soviet Union and the decay of the United States that comparisons break down. The Citizenry of those two systems are so incredibly different in skills and outlook it boggles the mind; Soviets were lean, mean, frugal machines... while Americans go ape when they can't park their SUV right at the entrance to the strip mall. Comparative analysis between the U.S.S.R. and the U.S. are still valid, we feel, but it must be done with a caveat: the average American is likely going to suffer far worse than an average Soviet.

Is the FDIC Inept, Panicked, or Corrupt?

We looked over the latest bank closures by the Federal Deposit Insurance Corporation (FDIC), and we noted with some alarm how costly these closures were. Putting the cost to the FDIC in terms of losses/assets, the four closures (as of 25/04/09) were insolvent to the tune of 26% to 39% of assets! This level of insolvency is horrible, and marks an incredible deterioration of the health of the United States' banking system. Below is a chart of the losses/assets of all bank closures since December 2007 to April 25, 2009(the beginning of the Depression). We used the data from the FDIC's failed bank list to construct the graph.
Needless to say, the closures by the FDIC are not getting better; we suppose the bright side it that they're not getting worse, either.

Let's look at the hard data: Total assets of all FDIC-failed banks, December 2007 to April 25 2009, and including Washington Mutual (WaMu), in millions, is $388,388.03 - that's $388,388,030,000. The cost to the FDIC for these failures was $18,783.20, in millions. That's a losses/assets percentage of 4.84%; not bad, we suppose...

But WaMu didn't cost the FDIC anything, so let's throw out their assets ($307,000 in millions) from the equations. Revised total assets becomes a modest $81,388.08 in millions, while the cost to the FDIC stays $18,783.20. Sitting down, dear Reader? The losses/assets percentage on these numbers is a whopping 23.08%! On average, approximately a full quarter of every failed bank's assets are trash, and if the latest percentages continue to get higher, that number will be getting much, much worse.

The horrifying insolvency of these FDIC-failed banks begs the question in our post's title: is the FDIC inept, panicked, or corrupt? Bear with us as we ponder each in turn.

All jokes about the Government aside, it is quite possible that the FDIC's leadership is indeed inept. Many other policy-makers in the U.S. Government are showing themselves to be very inept, so we can't rule out the FDIC. However, we don't feel the FDIC is necessarily inept in the classic sense; we posit the FDIC is instead following in the footsteps of the Federal Savings and Loan Insurance Corporation. Simply put, the FSLIC sat on its hands at the beginning of the Savings and Loan Crisis, hoping that the situation with the thrifts would solve itself. Instead, the situation deteriorated and the FSLIC itself went insolvent, and its mission was absorbed by the FDIC. We would be hardly surprised of the FDIC is likewise hoping that the banks will heal themselves. Perhaps by sitting on its hands, the FDIC is rendering itself insolvent, and therefore dooming its mission to be absorbed by a bigger Government agency... oh, perhaps the Federal Reserve.

Instead of inept, let us assume that the FDIC is, instead in a panic. The leadership knows that the greater part of the U.S. banking system is horrifyingly insolvent. They also know that the FDIC insurance fund is completely unable to absorb the losses incurred from fast and hard failures of all the insolvent banks in the U.S. (i.e. most of them). So, instead of having a proactive plan for dealing with the major problems within the banking system, the FDIC instead is reactively lurching from one super-insolvent bank to another with no cohesive plan of attack - or, indeed, of how to pay for all the damage. This panic is only allowing the problems in the banking system to fester, thereby creating even bigger problems down the road. Those could come sooner than anyone might imagine...

Finally, let's assume that the FDIC is corrupt. In this situation, the FDIC's actions are planned and carefully implemented. They are starting with the smallest banks in the nation, and slowly forcing mergers into larger ones, selling off the good assets to the bigger banks and holding the bad assets on its books. As the banking crisis continues, the FDIC will work its way up the food chain, successively cleaning out the banks, until the only remaining banks are the nineteen (or so) super-huge money-centre banks. At this point, the best assets in the U.S. will be in the hands of quasi-private banks, while the worst will be on the books of the Federal Government. Simply put, all losses will be paid for by the American Citizenry, while all potential profits will accrue to the super-huge banks.

Frankly, we can see aspects of all three possibilities at work; any and all combinations thereof would not surprise us. The big question in our mind is, which one is dominant?

The United States Needs Canada to Survive

We have been pointing at the problems of the concentration of decision-making quite a bit recently, but we feel it bears repeating. Much blame for the 2007 Depression can be placed on, for example, the U.S. Federal Government allowing the super-huge American banks to become... well, super-huge. It gave those banks, and therefore their respective managements, so much power that the bad decisions made by the banks had global implications. The rest, as they say, is history.

Now the United States is hurtling down the first dip of the 2007 Depression, and the programmes for a quick "recovery" back to the consumer economy are only opium-induced hallucinations. In our opinion, the only real way to bring the Depression to a close is the old-fashioned way: liquidation, down-sizing, and reformation. If we were the optimistic type, we would suggest that the Government is running out of time to allow this. Realistically, though, we fear that the point-of-no-return is several economic pot-holes in the past.

So... where does that leave the average American citizen? Nowhere comfortable is our reply; the Citizenry is faced with a mind-numbingly-large (and exponentially growing) national debt, the fallout from the imploded consumer economy, and a world in a Depression. Whether or not the Citizenry is aware of this is another matter; the important point is that the United States probably will not be able to bring itself out of the 2007 Depression by its lonesome anymore.

Hence, the U.S. will need friends. Specifically, friends with usable industrial capacity, a less-unsound currency, a less-irresponsible Federal Government, and a Citizenry with a healthy work ethic. Bonus points for having a border with the U.S., as well as being a major trading partner.

We would suggest Canada: it is the only functional country which borders the U.S., and it offers the qualities we listed above, more-or-less. Canadian Citizens have their problems, to be sure, but Canada has not done many important things: the Federal Government hasn't been usurped by the super-huge banks; it isn't running massive wars of occupation; it hasn't annihilated its cities and industrial capacity in favour of strip malls and hair salons, it is the U.S.'s largest trading partner.

It seems, however, that the U.S. Federal Government is intent on de-friending Canada. We'll write more on this topic tomorrow.

Read part two here.

Government and the Concentration of Decision Making

There is a trend we have noticed in the past: in the course of Depressions, a Federal or Republican Government will attempt to usurp various regulatory and legislative powers from its constituent nations (be they States, Provinces, Territories, et cetera). This can be seen in the efforts of the Hoover and Roosevelt Administrations during the 1929 Depression; many of Roosevelt's social programmes were so heavy-handed in their scope, they were struck down as unconstitutional.

The justification for this centralisation (in the U.S., as well as elsewhere) is simple: a single, cohesive approach to 'solving' a Depression has a higher chance for success than numerous, uncoordinated approaches. Logically this can make sense, as it would seem that, if a recovery programme (or programmes) are based on a Federal/Republic level, it would be less mired in regional politics.

In practise, we feel such a top-down approach simply does not work. One only needs to look at the American super-huge banks to see how a top-heavy administrative technique will inevitably pan out. Simply put, it concentrates the decision-making powers into too few hands... and those hands will make many mistakes. One person given the decision-making powers of ten thousand will eventually make one bad choice with the power of ten thousand bad choices.

It is a serious fallacy to assume that Government, somehow, is bereft of this concern, when it is just as mired by the problems of the concentration of decision-making. As a Federal/Republican Government works to gather-up the power of decision-making in various sectors - ostensibly to alleviate an economic problem - it increases the destructiveness of its bad decisions. Such concentration seems more efficient, but in actuality it is a very large problem.

That is why it is important for members (States and Provinces, cities and municipalities, et cetera) of a Federal or Republican Government to defend their decision-making powers. At the very least, this is to avoid the concentration of decision-making and the damaging actions which come from this concentration. Beyond that, though, the only feasible way to craft a regional recovery programme at the regional level; the best place of the Federal/Republican Government is to coordinate these various lower-level programmes, rather than usurp them.

If the sub-Federal/Republic level is gutted to such a degree that they are effectively rendered non-functional, this creates an even bigger problem: lack of resiliency. That is a serious concern in the 2007 Depression, as it is placing an unbelievable amount of stress upon the Federal/Republican Governments of the world. If such a Government were to collapse (or suffer 'interruptions'), having gutted the powers of its constituent entities, there would be no effective system of law-enforcement beneath it to ensure some degree of social order. Without State or municipal governments, it is not outside of the realm of possibility to see the rise of another Somalia, and the many problems which that non-nation experiences.

Let's Play Pretend: Letting Banks 'Mark to Make-Believe'

Many of the problems presently facing the world financial system (and consequently the world economy as a whole) can be blamed squarely on the deregulation of American super-banks. Although it would be a somewhat hollow gesture, one of the primary pursuits of policy-makers probably should be to un-deregulate the U.S. banking system, and bring these super-destructive super-banks to heel.

Unfortunately, it seems that quite the opposite is going to happen. The Financial Accounting Standards Board has just untied one of the few remaining mooring lines holding these super-banks to reality. The change in policy means that banks will no longer need to mark their mortgage-backed securities to market values, but rather "value the securities instead at their value in a normal market."

The problem centres around this concept of a "normal market." Who defines what "normal" is, and how it is defined? We sincerely doubt the FASB will be defining "normal." The most likely definer is the super-banks themselves. These banks are not known for their, shall we say, sobriety. Simply put, the FASB has effectively allowed banks holding mortgage-backed securities to value them in their favourite manner: marked to make-believe.

If this isn't an invitation to cook the books, we don't know what is. Given the track record of these super-banks, we would be very surprised indeed if this new policy isn't thouroughly abused to the hilt. Now that the super-banks can call the value of their mortgage-backed securites whatever they wish, they can use them to effectively wipe out most (if not all) of their gambling debts. They will then appear much stronger (i.e. solvent) then they actually are, and thereby dig an even deeper grave for themselves, their customers, and their investors.

Bring Back Bank Branch Laws

In the present popular discourse, a great deal is said about how to clean up the financial mess, but not much about how to prevent a future financial catastrophe. Vague calls of "more regulation" fill the air, but not many concrete proposals can be found.

Our very concrete proposal is to return banking to a fragmented industry where the preponderance of financial assets are held by tens of thousands of institutions instead of a few global behemoths.

In the past, fragmentation was enforced not by heavy-handed regulation, but by a simple principle of law: a bank could have only a few branches, or even in the most restrictive jurisdictions, just one.

For example, from 1870 to 1967 in the State of Illinois, banks were not allowed to have even one branch in addition to its home office. In 1967, banks were allowed to open a separate drive-through building, so long as it was withing 1500 feet of the main office! Gradually the law was liberalised, and by 1993 Illinois banks could open an unlimited number of in-state branches.

In 1994, the US allowed interstate branch banking for the first time, and since then banks have expanded and consolidated across state lines. As a result of this 'reform', there has been an enormous concentration of banking assets in the hands of the nations largest institutions.

Interestingly most of the problem assets currently involved in 'rescue' schemes are held by these largest institutions. In other words, these super-huge banks that have grown up over the past few decades have made terrible investment decisions, blown their capital, and are now giant purse-sucks on the US taxpayer.

The whole housing bubble fiasco and consequent Depression might have been avoided if the Branch Banking Laws had not been 'liberalised'. It is true that a fragmented banking industry is more expensive in theory, but in practice the de-fragmented industry has turned out to be vastly more expensive.