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	Forecasting America's Destiny ... and the World's

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Generational Dynamics Web Log for 12-Jul-2008
Economic turmoil increases as California's IndyMac Bank collapses

Web Log - July, 2008

Economic turmoil increases as California's IndyMac Bank collapses

Fannie Mae and Freddie Mac are "insolvent"

Economic turmoil

Economic turmoil

Government officials, including President George Bush, Treasury Secretary Henry Paulson and Senator Christopher Dodd, were expressing confidence in the soundness of the American economy on Friday, as the bad news poured in. The problem is that, since the August 2007 beginning of the global credit crisis, there have been so many lies about the soundness of the economy coming from government officials and media sources like CNBC and the Wall Street Journal, that fewer people are finding such reassurance credible.

The Federal Deposit Insurance Corp. seized IndyMac Bancorp Inc. on Friday, after panicky customers withdrew $1.3 billion in deposits in the past 11 days. This may be the largest bank failure in US history, and the FDIC will pay an estimated $4-8 billion to insured depositors. About another $1 billion in deposits are uninsured, and depositors may still be able to recover half of those. The bank will reopen on Monday morning under a new name, the IndyMac Federal Bank.

IndyMac has been a troubled bank for a while, but the current panic is being blamed on Senator Charles Schumer, who said on June 26 that IndyMac's lax lending standards left it on the brink of failure. Senator Schumer was telling the truth, but he won't be saying anything like that again any time soon. This little drama shows why politicians, journalists and analysts simply cannot be trusted: If they tell the truth, then they're blamed for the results. So they lie about the soundness of the economy, so they won't be blamed for anything. (I've actually had a couple of people write to me suggesting that this web site might be causing people to panic and that I might be to blame for economic problems, a concept to which I can only react with ironic laughter.)

There was a lot more bad news on Friday as well. Stock prices for Lehman Brothers investment bank fell 16% on Friday, despite reassurances from the Standard & Poor's ratings agency that Lehman Brothers is financially sound. Lehman was once the largest U.S. underwriter of mortgage bonds, and has lost nearly 78% of its market value this year after reporting its first quarterly loss in its history.

We can really see the "chickens coming home to roost" here. S&P ratings has no credibility at all these days, after years of taking fat fees in return for AAA ratings for CDOs and other mortgage-backed securities that turned out to be worthless. Lehman Bros is now the smallest Wall Street investment bank, ever since Bear Stearns collapsed in March, and investors aren't taking any chances for fear that it might collapse as well.

Insolvency of Fannie Mae and Freddie Mac

The biggest news on Friday was the 20%+ plunge in stock share prices for Fannie Mae and Freddie Mac. Fannie and Freddie shares have both dropped more than 80 percent in the last year, because of the housing crisis. The two are called GSEs (Government Sponsored Enterprises), and they're responsible for guaranteeing most home mortgages. They've guaranteed $6 trillion in home mortgages, but the high foreclosure rate in the last year has put both agencies into technical insolvency, according to former St. Louis Federal Reserve president William Poole.

Should Fannie and Freddie be bailed out by the Federal government? It depends on whom you believe -- and keep in mind that there are no barriers to lying these days, among politicians, analysts and journalists:

Everyone seems to be saying that Fannie and Freddie cannot be allowed to default. With $6 trillion in mortgage guarantees in their portfolio, a default would create a massive chain reaction that would affect numerous financial institutions around the world.
There is talk of nationalizing Fannie and Freddie, just as IndyMac bank has been nationalized. This would means that shareholders would lose their entire remaining investments. However, Treasury Secretary Henry Paulson said, "Today our primary focus is supporting Fannie Mae and Freddie Mac in their current form as they carry out their important mission," signaling the administration's intent to keep them as shareholder-owned companies.
There is talk of making the Fed's discount window available to Fannie and Freddie. What this means is as follows: The Fed has always allowed highly regulated commercial banks to borrow money from the Fed's discount window at the current "discount rate," which is normally about ½% above the overnight Fed funds rate. However, after Bear Stearns debacle in March, the Fed has opened the discount window to unregulated investment banks, such as Lehman. The new proposal is to open the discount window to borrowing from Fannie and Freddie as well. Unfortunately, the Fed only has about $1 trillion in assets on its books, and it's already loaned out half of that, so this proposal could bankrupt the Fed.
There's talk of Congress passing a bailout law to fund Fannie and Freddie. (This is what's known as "printing money.") This gets into ideological issues. Thus, liberal NY Times economist Paul Krugman writes:

"[B]ig financial crises always end with an expensive bailout of the banking system. It happened in Sweden, it happened in Japan. Why should we be different? Except that in this case banks proper took on very little of the risk; Fannie and Freddie, on the other hand, took on a lot of it."

Others are philosophically opposed to the bailout on ideological grounds, and some make a further point: $1.3 trillion in these GSE bonds are held by foreign governments. The top five are: China, Japan, the Cayman Islands, Luxembourg, and Belgium. Thus, bailing out the GSEs would effectively subsidize these foreign governments (who have been subsidizing our government for years).

Bank failures and the FDIC

You can take a look at the FDIC's failed bank list, and notice that bank failures are relatively rare:

There were 27 bank failures in 2000-2004, following the dot-com bubble crash.
There were no bank failures whatsoever in 2005-2006, during the height of the real estate and credit bubbles.
There were 3 bank failures in 2007.
There have been 5 bank failures so far in 2008.

These figures aren't so high, when compared to the almost 9,000 financial institutions whose deposits the FDIC insures.

However, that's about to change. In February, the Wall Street Journal reported that the FDIC was staffing up to handle the dozens of additional bank failures expected later this year and next.

This was confirmed on Friday, when FDIC Chairman Sheila Bair said that IndyMac could be the biggest bank failure in US history, and that there would be many more bank failures. (Other news sources say that the FDIC has 90 banks on its confidential watch list.) However, Bair adds, "There will be increased failures, but it will be within range of what we can handle. People should not worry." She added, "Nobody's ever lost a penny of insured deposits."

The last statement is true, but somewhat disingenuous. The FDIC was formed in 1933, after the last stock market crash, it's never been severely tested since then.

Besides, what would Bair be saying if she were worried that the FDIC was going to fail? The answer is that she would be saying exactly what she did say.

The collapse of Depression-era institutions

I recently wrote: "Basically, if a major banking crisis occurred, then the FDIC would run out of money." I referred to an article I wrote last year, "Is your bank deposit protected by the FDIC?"

I received the following criticism from a web site reader:

"Why do you keep posting stuff like this? FDIC is backed by the credit of the US government. For FDIC to run out of money would be for the US Government to run out of money. You know darn well that the US government can NEVER run out of money, because they are the ones that make it! Our money is not backed by anything. In case you haven't noticed we currently have a 9+ TRILLION dollar debt. Why haven't we "run out" yet? And at what point do you believe we will "run out"?

First off, I don't believe anything that government officials say these days. In particular, the soothing words of FDIC Chairman Sheila Bair would have been uttered no matter what the true situation was.

Second, the arithmetic doesn't add up. The FDIC has under $50 billion in its insurance fund, and it's losing $4-8 billion for just IndyMac. There are 90 more banks on the watch list, and that could eat through the entire fund very quickly.

Third, even that doesn't account for the chain reaction effect. Those 90 banks on the watch list are those that are ALREADY in trouble. If dozens of those banks are expected to fail, then many other assets (bank bonds, credit default swaps) will also lose value, leading to many more bank failures.

In fact, what we're seeing is the failure of one Depression-era institution after another.

Let's start with the dot-com bubble of the late 1990s. The Securities and Exchange Commission (SEC) was formed in the 1930s specifically for the purpose of preventing any such bubble from occurring. They had learned that the 1929 crash was the result of the 1920s bubble, so they wanted to make absolutely certain that no such bubble ever occurred again. The occurrence of the dot-com bubble, and subsequently the housing and credit bubbles, are testaments to the complete failure of the SEC.

The Federal National Mortgage Association, nicknamed Fannie Mae, was created in 1938 in reaction to the massive homelessness of the Great Depression, after so many people lost their homes through foreclosure. Its purpose was to make sure that every American family could live the American dream with his own home. In 1968, Fannie Mae was made into a private, shareholder-owned agency, since it was felt that it could make money on its own. However, it still had special privileges as a GSE (government sponsored entity) that made it a virtual monopoly. As a result, Congress created a competitor in 1970 -- the Federal Home Mortgage Corporation, nicknamed Freddie Mac.

Now Fannie Mae and Freddie Mac are insolvent.

In 2004, Fed Chairman Alan Greenspan gave a speech warning the Baby Boomer generation not to count on Social Security and Medicare. He advocated that policy changes be made immediately to protect the Social Security and Medicare programs, since the Boomer generation would begin retiring very soon. Well, Congress did nothing, of course, and the Boomers are now retiring, pushing those programs in the direction of insolvency.

People who say that there's no serious problem are only looking at one problem at a time.

If the FDIC were the ONLY problem, then we'd be OK.

If Fannie and Freddie were the ONLY problems, then we'd be OK.

If Social Security and Medicare were the ONLY problems, then we'd be OK.

UK housing price index from mortgage lender Halifax <font face=Arial size=-2>(Source: Telegraph)</font>

UK housing price index from mortgage lender Halifax (Source: Telegraph)

For that matter, if the US economy were the only one in trouble, then perhaps things wouldn't be so bad.

But in the UK, the slide in housing prices is the worst since the Great Depression.

In Spain, government officials have been shocked by the intensity of the downturn now engulfing the country. Car sales fell 31% in June, industrial production has fallen 5.5% over the past year and the collapsing property sector is shedding almost 100,000 jobs a month.

In France, industrial output fell 2.6% in May, and in Germany it was down 2.4%.

China's stock markets are crashing big time, and there are plenty of good reasons to believe that China will have some sort of financial crisis once the Olympics games end. In addition, the economies of many emerging markets are collapsing, including Iceland, Vietnam, Russia and China. Soaring food and oil prices are making thing worse everywhere.

Each one of these problems, when looked at in isolation, might be solvable. But when you put everything together, you see a massive slide into financial chaos in progress. The entire financial structure built by the generations that survived the Great Depression and World War II has been sabotaged by ignorant and destructive Boomers and Generation-Xers.

The climax of my "bloated mansion" analogy appears to be getting closer and closer each day. Here's how I described it in November of last year:

"Think of the world economy as a huge, enormous bloated mansion made of wood, with all kinds of additions tacked on all over the place. Think of the CDOs as millions of termites that are eating away at the insides, so that another piece of the mansion falls off into the ravine almost every day.

The Fed and other central banks have been running around the mansion with hammers and glue and nails, patching things up as fast as they can, trying to keep ahead of termites. They've been pretty successful with their hammers and glue and nails in postponing the inevitable, even bloating the mansion up a little more, but they can't keep up with the termites.

[What's happening] is that the hammers and glue and nails aren't working, and it won't be long now before the entire mansion collapses into the ravine."

And so, the final answer to my web site reader's question is that the printing presses can't possibly print fast enough to keep up with all this.

Government institutions around the world made many promises after World War II. They promised a world where everyone could eat, everyone could survive, and everyone could have a decent life. All of those promises are now coming into question. It will not be possible for any but a small portion of those promises to be kept.

Which promises will be kept and which will be discarded? What kind of triage process will be used?

It's impossible to predict with certainty, but some clues are provided by Neil Howe and the late William A. Strauss, founding fathers of generational theory, on whose theory Generational Dynamics was originally based. On page 258 of their book, The Fourth Turning, they describe historically what happens when a major disaster (like the 1929 crash or the bombing of Pearl Harbor) propels a society from a generational Unraveling era into a generational Crisis era:

"Private life also transforms beyond prior recognition. Now less important than the team, individuals are expected to comply with the new Fourth Turning standards of virtue. Family order strengthens, and personal violence and behavior now face implacable public stigma, even punishment. Winner-take-all arrangements give way to enforceable new mechanisms of social sharing. Questions about who does what are settled on grounds of survival, not fairness. This leads to a renewed social division of labor by age and sex. In the realm of public activity, elders are expected to step aside for the young, women for men. When danger looms, children are expected to be protected before parents, mothers before fathers. All social arrangements are evaluated anew; pre-Crisis promises and expectations count for little. Where the Unraveling had been an era of fast-paced personal lives against a background of public gridlock, in the Crisis the pace of daily life will seem to slow down just as political and social change accelerates."

I've estimated that the probability of a major financial crisis (generational stock market panic and crash) in any given week from now on is about 3%. The probability of a crisis some time in the next 52 weeks is 75%, according to this estimate. (12-Jul-2008) Permanent Link
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Generational Dynamics Web Log for 12-Jul-2008 Economic turmoil increases as California's IndyMac Bank collapses

Insolvency of Fannie Mae and Freddie Mac

Bank failures and the FDIC

The collapse of Depression-era institutions

Web Log Pages

Generational Dynamics Web Log for 12-Jul-2008
Economic turmoil increases as California's IndyMac Bank collapses