Tuesday, April 7, 2009

Bail Out For Dummies - Part 1

Zero Hedge believes it is a civic duty to represent the total melange of assorted concepts and alphabet soups in the ongoing debacle that is the Bail Out in a comprehensible and easily understandable context as the decisions the administration is making will have generational consequences. Therefore, I am presenting a view of the players, the mechanisms and the core of the Bail Out problem in a way that will be much easier to be comprehended by most interested parties. The conclusion is frightening.

The Players

The Core Of The Problem

As the table below tries to capture, the core of the Bail Out problem is reconciling the balance sheet of the banking and thrift system. The biggest concern is the roughly $8.1 trillion in loans currently on the asset side of the equation, however the other assets, which include $2.8 trillion in securities and $2.5 trillion in other assets should not be ignored. I point out the loans as this is where the vast majority of the "toxic assets" reside. The real question mark is what is the true value of this $8.1 trillion number as the financial system contracts massively. As has been pointed out, banks have taken only about $1.2 trillion in write downs against these assets.

Is that amount of write downs enough?

Not by a long shot if one considers the various guarantee and support programs enacted by the Federal Reserve and the Treasury. In a normal world, the Assets, by definition, should equal the Liabilities plus Shareholder Equity. As nobody knows what the true value of the assets really is, the Bail Out support programs are designed to provide the backing to make it seem like the almost $8 trillion in deposits, the core of bank and thrift liabilities, are not "supported" by toxic assets, or "hot air" to use popular jargon. As presented, the various Bail Out programs now support over 72% of the total liabilities on the balance sheet. The implications of this are staggering: Roubini anticipates the total amount of write downs (in the US) will reach $3.6 trillion, or another $2.4 trillion to go. The revised IMF estimate (which is not the final one by a long shot) estimates $3.1 trillion in total US losses, or another roughly $2 trillion to go. These provisions are optimistic. Why - because through its various implicit and explicit guarantees the administration is saying the total pain could potentially reach $8.8 trillion. The Fed and Treasury are also providing support for up to 20% of the bank system shareholder equity through TARP preferred stock. As the government has the best information about the true sad state of affairs, it is likely that as more and more information about the weakness of the financial system comes to light, more of these support guarantees will become utilized to their full extent. This also means that the asset side of the balance sheet is potentially "inflated" by almost 75% and the net result could be the most dramatic collapse in a banking system's assets in record history as over $8 trillion in "assets" are reevaluated.

The Collateral

The logical follow up is what securities are eligible for all these various support programs. As the table below demonstrates, an increasing amount (in number and absolute dollars) of "liquidity" facilities by the Fed are allowing essentially any asset to be eligible for collateralization. Whereas traditional Fed liquidity conduits had been limited to just the least risky of assets, (AAA rated ABS and CP, and Treasuries) it is becoming the norm that virtually any security, regardless of risk will be "eligible" collateral for Fed backstopped guarantees. The recent transformation in the TALF (with the PPIP) support is just such an indication. Ultimately, as additional Bail Out programs appear, it is likely that they will have no practical collateral threshold whatsoever, as more and more assets of all types are perceived to be dramatically impaired and which need systemic support.

As Zero Hedge pointed out over the past week, the U.S. deficit is increasing at a dramatic and unprecedented pace. The bulk of expenditures are currently going merely to fund the Bail Out program, in essence transferring U.S. sovereign issuance to the Fed's balance sheet which uses the newly minted cash to fund all the incremental and growing support programs. Currently only a small percentage of the guarantees are funded, and as we head to the full funding capacity on all the Bail Out programs ($8.8 trillion), Zero Hedge expects to see as much (not necessarily the full amount) as $7 trillion more of new Treasury issuance as the true "worth" of the assets is realized. All the debate over Agency, CRE, whole loan, etc. write downs are really just a drop in the bucket based on none other than the government's own estimate of just how bad things could really get eventually. In this context the Mark To Market debate is also moot, as is private participation in the PPIP, and the Stress Test: the scale of the problem is simply insurmountable using current mechanisms in place.

As more data emerges, Zero Hedge believe the real risk to the Bailout program is in fact the liability side of the balance sheet. The bottom line is that every dollar printed by the Treasury directly goes to fund (and dilute) a dollar in deposits, bypassing M1-M3. If the $8 trillion pool in total deposits realizes that it is supported by assets which even the government is saying are worth fractions on the dollar, the risk of a wholesale systemic bank run becomes unstoppable even with all the government backstops in place, as the latter will be contingent on continued willing recipients of those rapidly devaluing pieces of paper known as U.S. Treasuries and once that assumption is questioned or outright proven false, all bets are off.

big hat tip to Bank Of America for primary data. Sphere: Related Content
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James said...

Scary stuff. most people dont realize how hard it is to bail ourselves out with ourselves.

Anonymous said...

But.... what about the off balance sheet assets and liabilities, the $200 trillion of derivatives?

qadi said...

The Treasury bought a CDS on itself, and so all is well.

___ said...

The LBO of America

Anonymous said...


Advice from Argentina

Sid said...

"Scary stuff. most people dont realize how hard it is to bail ourselves out with ourselves."

Why not? The Japanese did it. Took a lot of debt, a moribund economy and ten years... but they did it.

Combine this excellent post with this Nomura presentation and you have it all, me thinks.

www.csis.org /media/csis/events/090326_koo_presentation.pdf

ts said...

I doubt if the Treasury would allow a bank run of any kind. At the first whiff of trouble they'd monetize the whole thing, just as the Fed is monetizing much of the new Treasury issuance.

QE is another thing entirely. I think all Bernanke is hopeful for is purchasing all the additional issuance that our Asian benefactors can no longer take off our hands. Bernanke managed QE earlier without lifting a finger when the credit implosion had everyone fleeing into treasuries. It didn't even matter that Japan had a $600 billion trade deficit or the Chinese had stopped buying everything but bills.

You are right that this will impair the banking system until the proper value of the assets is realized. Much of Japan's residential real estate is in 100 year mortgages (I'm assuming at very low interest rates) that will be on bank books until our grandchildren are dead.

I expect our glorious leaders to kick that can down the line as long as they can.

Anonymous said...

great post as always. Best financial blog in the world.

qadi said...

You can QE or a bull market: choose one.

Mijadedios said...

Zero. I follow you on Twitter. please review this and tell me what you think http://cdt.org/security/CYBERSEC4.pdf

Could this be the means for the Bigger Storm coming?


GS751 said...

Yay Geitner is handing out free call options to anybody who has 10 Bil lol.

S said...

hyperinflation = they win
deflation = J6P "wins"

place your betsa accordingly

ts said...

The economics conceit behind this plan has always been that all we need to do is make banks "whole" again (unlike the Depression), and everything will be just super.

There are enough problems with that idea to write a book about, but the three largest ones are:

1) If you lie to yourself and everyone else about what these assets are worth, how the hell can one be made whole? The first step should be complete transparency whereby every asset gets a fair value and we put our limited capital exactly where it is needed. The current strategy is like trucking US dollars into Iraq on pallets and handing it out willy-nilly to whomever will be our friend. We all know how well that worked out.

2) The most important facet of making the banks whole is to replace bad loans with good. A nonperforming $500K mortgage on a $350K house is a $150K loss with $350K of zombie capital. The sooner you foreclose, the quicker you get your capital back. Our response seems to be whenever we get any money back, we compel lenders to make lower interest loans to worse credits. Absent any good places to put the money (except t-bonds), we should take this opportunity to forcibly de-leverage the financial system along with households and businesses. Their leverage is built on our leverage and it shares the same income stream. For one to cut back while the other doubles-down is only a recipe for a more fragile financial structure.

3) Finally, no matter what you do the mechanism that worked so well during the bubble is gone. It's wasted. Game over man. Half the firms that participated are on tombstones. The prime motivation for homeowners to participate in the housing credit bubble was they won too. No way you get housing prices rising by indirect methods that don't support homebuying. And the money supply for this is gone too. We have lots of "money" sloshing around, but the kind we need to buy houses is home equity, cash in hand, and the ability to get the balance with a loan. The former and latter are contracting, and we never had much of the middle one in the first place. At the current savings rate, the average American will have enough to put 20% down on a house sometime around 2030.

We cannot get the bubble back because it was self-financing based on rising home prices and complete confidence that home prices never ever fall. If you are delusional enough to believe that we can somehow get to that point from here, well, there are a lot of job openings at the FDIC. Sheila's gonna need more sock-puppets.

dashingdwl said...

What we need is some loose credit.

No seriously. The plan is this: transfer all the problematic, legacy debt from the banks to the public. End of problem.

buchlajoe said...

The best economics blog on earth. Thank you thank you thank you ....

Unknown said...

The fact that there hasn't been a systemic shattering bank run by this point tells me there won't be one - this time.

If there was going to be a major bank run, why isn't gold over $2K?

The fact is that this system is our societies creation. As long as we agree to play the game the game will exist. There are much more dire and compelling issues in the world that threaten our existence than the credit crisis.

Anonymous said...

you say "The real question mark is what is the true value of this $8.1 trillion number as the financial system contracts massively. As has been pointed out, banks have taken only about $1.2 trillion in write downs against these assets."

looking at the fdic q4 data it looks like the industry took $99.5 billion in loans charge-offs in 2008 and $44.1 billion in 2007. this is only about one-tenth of the $1.2 trillion you mention. where did the banking industry take the other 90% of the $1.2 trillion in losses? it appears that the hole is even bigger than what you state.

less than zero said...

mija, looks like the US is looking more like china every day.

Economic Darwinism said...

Hi ZeroHedge,

Thanks for your blog. It rocks.

One thing I find frustrating is that bloggers like yourself have fantastic ideas that really should be translated into policy, but the chance of that happening is nil.

I've proposed (unsuccessfully so far) to get bloggers to get together and prepare a formal proposal. If all major finance bloggers signed off on a plan, that would carry the weight of most, if not all, their readers.

Would that be something you'd be interested in? A kind of consortium of bloggers?

I've started holding small gathering at local pubs (as well as blogging) trying to explain what's going on to anyone who will listen, but I think more needs to be done. The situation is quite ominous.

Of anyone, I think you've done the most trying to educate people and I applaud that. Is there more we can do? Can we step it up and try to make a real impact somehow?

Best regards

PS: If you haven't seen it, check out


Antoine said...

Zero Hedge - thx for the big picture view but your numbers are wrong : IMF projections are for global losses not US- same for Roubini...

Also, to my view, US banks are the best long opportunity as 1. can borrow freely to the FED 2. will raise capital with TARP etc.. to plug holes 3. huge competitive advantage against EU banks 4. as credit risk is more properly priced, they will make fortune making loans...

OSR said...

I disagree. Worse case: All $8.1T in loans go sour. The gov't replaces the assets out of the $8.8T. The depositors are still whole, so why would there be a systemic bank run.

There is an impending catastrophe in all of this, but I'll leave it to the professional economists to figure it out.

Anonymous said...

We need am open revolution. We need to physically put the DCers out on the curb with the rest of the garbage. Lets make a date and clean up the place! Yes we can!

Andrew P said...

The mega-bank run was stemmed back in september, but they barely averted it. The main risks now are (1) massive inflation, and (2) political risk. If inflation starts, the economy will crash soon afterward. Inflation could surge suddenly and uncontrollably, especially if China starts booming again amd bids up the prices of commodities. The extreme leftists currently controlling Congress and the WH could kill any recovery in its crib when (not if) they pass Card Check and cap 'n trade. The next Senate will be much more Democratic no matter what happens in the 2010 House elections, so in some ways the biggest political risks are in Obama's 3rd and 4th year.

Remember - It is possible to have Depression and Inflation at the same time.

Anonymous said...

Tyler, this is moronic beyond belief. You ought to know better really.

What you are missing is the the US government is backstopped by the wealth of the Nation. Wealth of US households as of December 2008 is Gross $65tn- Debt $15tn = $50tn. A rather conservative balancesheet.

So, yes, the Government, representing the US People, can backstop a $8tn loan book. The USA is rich enough to do it, afford it. But don't forget that the vast majority of this loan book is itself directly backed by the $50tn of private net worth, and so there no way the loss ratio will go anywhere near 100%. Just cut it out, Tyler.

The only condition for the rescue to work is to accept the collectivization of loan losses. The Fed obviously has no qualms about it. The Prudent will be forced to bail out the reckless. Yes, makes me puke too.

So Tyler, do your country and all of us a favor, as a patriot: get you head into a bucket of iced water and stop the scaremongering.

killben said...

While the amount is scary, my assumption had all along been that it has got to be HUGE .. else why are these triad of jokers (gethner, bernanke, bair) running scared..

FRom this it is clear it all amounts to how much U.S. can take before it becomes the case of last straw on the Camel's back.

Just like Hercules holding up Atlas!

ernesto said...

Can you please give the data source for the $1.2 trillion in write downs by the banks.

Tyler Durden said...

anecdotal. do a news search for cumulative bank write downs. 1.2 is a higher estimate based on conversations

BG said...

If the government is essentially providing a guarauntee for all of the loans on the banks' books, then isn't this bullish for the banks? And why would there be a risk that there is a run on the banks (if people act rationally) if the government is backstopping everything with its programs.

Your analysis that the government has programs for all of the loans on these companies' books means therefore the losses are going to be way higher than people think is idiotic. You don't think there's a good chance that the government, like all people, has overreacted?

Most loans have some recovery rate and it is also likely that a large portion of loans are going to get repaid. The math that "75% of loans are inflated" is nonsensical. This post is total garbage.

Tong said...

I would be interested to know where you find the break-down of common stock vs. preferred stock in the balance sheet chart. Also, did you have to reconcile equity figures with assets/liabilities from the Flow of Funds data? Thanks.

Anonymous said...

Agree with commenter above. Physical revolution needed. Make a date, put them on the curb.

Yes we can!

Harry said...

What a good post! I have been shouting for long that all these so called efforts by the govt and fed are mere "Crisis Postponement Plan" and the real trouble is way too bigger!

However, I find the roots of the problem not in the govt action, but in the AMERICAN PEOPLE'S PSYCHE. Americans voted Obama to make a change but the only change he seems to be capable to do is change the recent trend of "TWO CONSECUTIVE TERMS" of presidency. Obama had a "GOD SENT" opportunity of cleaning up this mess, and it would be the easiest - let the free markets punish the wrongdoers and REALLOCATE resources based on merit; BUT, He chose the popular line of action - bailouts and interference. The result will be catastrophic for economy and him. Please do read this post on my blog:


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Kaito said...

thank you for your explanation, I was a beginner in this matter, and I will continue to learn in order to become like you, one of my blog also discussed this issue


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