Comment 58: Can R.T.C. style solution save Wall Street? Tracing the liquidity squeeze (8) (Sept. 19, 2008)

Since the onset of the liquidity squeeze many financial firestorms have been generated, just like a major hurricane spurring many violent tornadoes. Wishful thinkers always thought that the worst is over and bid up stock prices sky high after a financial firestorm subsidized with FED action. Unfortunately those wishful thinkings were always dashed as the next financial firestorm arrived. Recent financial firestorms appeared in a rapid fire pace. First was the Government takeover of mortgage giants, Fannie Mae and Freddie Mac, followed by the bankruptcy of investment bank Lehman Brothers and the sale of Merrill Lynch to The Bank of America. Then the nationalization of the insurance giant AIG followed. Now the market is focusing its attention on Morgan Stanley and Goldman Sachs to see whether they can survive as independent investment bankers. With this background in mined, the report that the US Government is contemplating the establishment of a R.T.C. style institute to resolve the current financial crises has sent Dow Jones Industrial Average surging more than 400 points in one day. Let us analyze this idea and see whether it can really resolve the problem of the liquidity squeeze.

What is R.T.C.? In the aftermath of the burst of Reagan's junk-bond bubble in late 1980's, many savings and loans had failed, leaving a large amount of bad loan related assets in the hands of US Government after the government paid off depositors of those failed financial entities through the federal deposit insurance program. US Government established an entity to manage those troubling assets with the mandate to sell them back to the private sector later. That entity is called “The Resolution Trust”, abbreviated as R.T.C. . Thanks to the succeeding bubbles of Clinton era and then the current bubble under the watch of Bush administration, R.T.C. was able to unload all the bad assets in its hand without significant losses. The current idea is to establish a similar entity with the mandate to buy up all the poisonous securities ranging from structured papers backed by ill fated mortgages to very complicated instruments like CDO that is beyond description here, and sell them back to Wall Street later during the next even bigger bubble, if it ever comes. What is the implication of such a clearly socialistic approach undertaking by the unquestionably conservative current administration so hastily assembled and scarcely examined in order to prevent the total meltdown of the US financial system, symbolized by the run on the money market mutual funds? The first order of business to examine this proposal is to estimate what amount of money is involved in this proposal. The financial poison is already spread beyond subprime and alternate-A mortgages into some prime rated mortgages, commercial mortgages, auto and credit card loans, junk bonds issued to buy up public companies and to turn them into privately held ones, and CDOs. Also the derivative markets related to those poisonous stuff are in the roil after the collapse of Lehman Brothers and AIG. The face value of total amount of poisonous stuff needed to be bought up probably already exceed three trillion dollars. Assuming that US Government will buy them with 50% discount, the government needs to spend 1.5 trillion dollars to purchase all the poisonous stuffs. This also means that the private sector needs to realize a loss of 1.5 trillion dollars. Up to this time the private sector has written down about 600 billion dollars related to the poisonous stuff gradually. Can the private sector absorb another 900 billion dollars of losses if this grand scheme is enacted? Apparently the scheme needs to be operational in a very short order in order to prevent the total meltdown of the financial system, so the 900 billion dollar loss of the private sector also needs to be realized very quickly. A whole sale collapses will occur throughout Wall Street and beyond, and the plan itself will destroy the financial system instead of saving it. What will be done is obvious. US Government will nationalize those collapsing entities and convert the US into a socialistic country at least as socialistic as France. This scenario means that US Government needs to spend the whole 3 trillion dollars to carry out this plan, not just 1.5 trillion dollars to buy the poisonous stuff at 50% discount. Next we need to analyze where this 3 trillion dollars will come from.

For a modern financial system to function there needs some seed money for the system. Under the condition that the central bank does not print a large sum of money arbitrary, the seed money usually comes from two sources, the personal savings and the trade deficit. At the time of the original R.T.C. of late 1980's, the US personal saving was about 5 to 6 percent of the nominal GDP. The US trade deficit during that era peaked at about 3.2% of GDP in 1987 and had started to decline steadily toward zero by 1991. As has been pointed out in article 10 and other places throughout this website, it is the rapid increase of the trade deficit that induces bubbles and it is the shrinkage of the trade deficit that burst the bubbles and ushers in liquidity squeezes. As the Reagan bubble burst, the requirement of loans from the private sector declined, and the still healthy level of personal savings were enough to fund the original Resolution Trust Corporation without the need for FED to print money to cover the expense. Currently US personal saving is less than 0.5% of nominal GDP. The US trade deficit has peaked around 6% of GDP at eraly 2006 and has declined to about 5% of GDP by early 2008. If FED does not create money to fund this 3 trillion dollar plan, the funding needs to come out of the already dwindling trade deficit, meaning that the private sector lending will be squeezed further and the US economy will not be able to hold at current level. What if FED monetizes the funding by just printing this 3 trillion dollars? Monetizing government debt is always inflationary. As long as the economy is in the poor house, inflation will not be noticeable, but once the economy picks up inflation will explode. This means that if FED monetize this 3 trillion dollar funding, then we can expect the US economy to be in the poor house for many years to come.