The Wreck of the U.S. Economy

As with the late great ship the Edmund Fitzgerald, the U.S. economy was a source of pride for Americans. However, the U.S. economy more resembles the plight or the Titanic than the most famous of Great Lakes shipwreck. It is similar because, like the Titanic, the U.S, economy has a severe gash in its hull. The severe gash in the hull of the U.S. economy is the banking system.


When a ship is taking water there are to ways to keep it afloat. One way is to repair the gash. The other is to turn on the pumps in an attempt to pump the water out faster than it can come in. The government has decided to try the latter to some positive affect. The government's various liquidity programs, such as the Term Auction Facility (which expanded the banks' ability to tap the Fed Discount Window) and the Term Securities Lending Faculty (which enabled investment banks and securities dealers to use investment grade securities as collateral to borrow from the Fed) encouraged interbank lending. TARP added capital to bank balance sheets. However, none of these efforts solved the real problem. All they did was act as emergency pumps. The gash in the hull are the toxic assets on bank balance sheets.


Deutsche Bank economists Peter Hooper and Torsten Slok published a report on the state of the banking system. Their belief is that government intervention has stabilized the banks, but has not repaired them. They state that credit will not flow freely until the government ease fears of bank failures. Mr. Hooper and Mr. Slok believe that can be achieved buy either removing bad assets from bank balance sheets or infusing even more capital into the banks. In other words, repair the gash or add more pumps. Although either method may keep banks afloat, only removing bad assets (hundreds of billions of dollars of which have not been marked to reflect even their "hold-to-maturity" values, if at all) will attract investors.

Only confident investors and their capital will repair the banking system. Asking investors to commit their capital to banks with assets of unknown quality and value is like asking passengers to buy tickets for passage on a ship being kept afloat by pumps and promises by the captain to add more pumps if necessary. No one will book passage on a ship which is structurally unsound, but this is what the government is asking investors to do. The market is having none if it.

There is one way to test how structurally sound the banking system is, shut down the TAF and the TSLF. This will not happen. The Fed knows full well that the banks significantly impaired and if it turns off the pumps some ships will sink. Other banks know that too. Without Fed liquidity interbank lending would dry up and we would be facing a crisis similar to last March. If you recall last March, interbank lending seized up as banks would not lend to their peers for fear of not being repaid. There is nothing to indicate that banks are any more healthy this year. In fact, all signs point to the fact that they are more fundamentally impaired. The banks will not lend to each other unless the Fed is their to ensure repayment. A similar situation exists in the credit markets where many investors will only purchase FDIC-guaranteed TLGP corporate bonds. Others will only buy non-guaranteed bonds at comparatively-high yields.

Why doesn't the government or the banks simply disclose what assets are on bank balance sheets. Although I cannot say for sure, but it appears as though they are afraid. Could it be that these assets are so toxic that some institutions would be judged to be insolvent? Could be, but there is no way to know until balance sheets are opened to review.

There is one group of investors who may have a good idea of what the banks may be holding. They are hedge funds. Many hedge funds invested in various asset-backed structures. Hedge funds obviously know the condition of their investments so it is conceivable that they have good ideas of the damage some banks may have taken. The result has been a relentless attack on share, bond and CDS values of certain financial institutions.

At some point banks and the government will probably have to come clean. It is unlikely street participants will go long shares of troubled banks. After all, they are not foolish enough to book passage on a ship with a breached hull being kept afloat by pumps.