¿Existe alguna terapia de choque contra la crisis? ¿Y para prevenir las futuras? – Desconstruyendo los Informes del FMI (Parte 2) (página 5)

In sum, monitoring global systemic linkages will
undoubtedly become increasingly relevant, and thus the
development of reliable tools for this task should proceed
expeditiously. Going forward, the IMF can and should assume a
more prominent global financial surveillance role, but in
addition to strengthening its understanding of systemic linkages,
it will need to improve its gathering of relevant data. New
information sharing agreements on cross-border financial
exposures (including regulated and unregulated products and
institutions) could strengthen the capacity of IMF members to
provide it with the relevant data. In principle, such agreements
could operate on multilateral or bilateral bases and would
ideally address both the domestic and cross-border dimensions.
Information-sharing agreements will be effective to the extent
that country authorities can collect additional data in order to
monitor
systemic risk. Such a data collection exercise should be
prioritized based on a cost-benefit analysis but it should
include at the very least, off-balance-sheet exposures and
information on complex products…

Chapter 3 Detecting Systemic Risk

What Constitutes "Systemic" Risk?

"Systemic risk" is a term that is widely used, but is
difficult to define and quantify. Indeed, it is often viewed as a
phenomenon that is there "when we see it," reflecting a sense of
a broad-based breakdown in the functioning of the financial
system, which is normally realized, ex post, by a large number of
failures of FIs (usually banks). Similarly, a systemic episode
may simply be seen as an extremely acute case of financial
instability, even though the degree and severity of financial
stress has proven
difficult, if not impossible, to measure.7 Systemic risk is also
defined by the breadth of its reach across institutions, markets,
and countries.

A natural starting point to begin to investigate
systemic events is by examining individual FIs and their
interlinkages (the latter is the focus of Chapter 2). However,
during systemic events, channels over and above the normal
fundamental mechanisms that link FIs and asset markets during
noncrisis periods can be important sources of contagion.
Contagious events, which can result from asymmetric information
or uncertainty, generate changes in the normal behavior of prices
and thus in the distribution of returns used for trading and risk
management purposes, causing the distributions to be skewed and
"fat-tailed" (that is, exhibit more downside than upside risk,
the third moment or skewness; and more "risk" generally, the
fourth moment or kurtosis). Also important in identifying
systemic events are the underlying "market conditions" and the
ability for events to further alter market conditions. For
example, when the level of market uncertainty (measured by the
implicit volatility of assets) is high, then even a temporary
shock can lead to defaults and generates significant aftershocks.
Similarly when investors" risk appetite is low or global
liquidity is tight, then even relatively small shocks can have
large effects on global financial markets-and
viceversa.

In this chapter, three basic concepts that underpin the
measurement of systemic risk are used. First, several techniques
apply the notion that interlinkages across institutions are
important-including identifying groups of similarly exposed FIs
and observing the effects of potential defaults of individual
institutions on each other and the financial system as a
whole.

Second, changes in the return distributions of FIs"
assets and equity are examined during periods of stress to
determine the additional risks in the "tails" of such
distributions and how the "tails" of a multiple institution
return distribution can provide more accurate measures of
systemic risk.

Lastly, the observation that general "market conditions"
matter for the existence and propagation of risks through the
financial system, is used to examine periods of high
vulnerability to shocks that may become systemic.

Since there are several concepts of systemic risk, it is
natural to expect a collection of measures rather than a single
all-encompassing index. Moreover, by examining systemic risk with
three complementary approaches, a more comprehensive and robust
assessment can be made to guide policies, though not every method
can be expected to signal the same intensity or nature of
systemic risk…

Policy Implications

For those responsible for safeguarding financial
stability, monitoring measures of systemic stress is now
critical. This crisis has
highlighted the dangers of focusing supervisory practices and
risk management simply on ensuring that individual institutions
are adequately capitalized and individually capable of surviving
reasonable stress events.

The current crisis has demonstrated that a systemic
approach is now urgently needed, since complex financial systems
can potentially amplify the actions of single firms to a degree
that can have damaging collective effects. Indeed, a seemingly
well-capitalized and liquid institution can nevertheless become
distressed through the actions of its peers, a "run" by wholesale
creditors, or even contagious declines of equity
values.

The issue now facing authorities is not whether to
attempt to identify systemic risks, but how best to do so in an
interconnected global financial system with incomplete
information.

This chapter has reviewed and developed both balance
sheet and market-based indicators to assess the degree to which
they gave some degree of forewarning of either a particular
institution"s impending failure, or of severe knock-on effects.
Some of the advanced techniques presented here are new and
therefore more analysis is needed before a definitive judgment as
to the optimal set of measures can be made. Indeed, given the
complexity of the nature of systemic risks, it would be prudent
to use various techniques and measures in order to arrive at
robust results. A number of recommendations flow from the
results.

Financial Soundness Indicators

Mixed results were found regarding the standard FSIs"
ability to highlight those firms that proved to be vulnerable.
Basic leverage ratios were most reliable, while capital-to-asset ratios (including risk-adjusted
ratios) and nonperforming loan data proved of little predictive
power. In the current crisis, key vulnerabilities have been
unanticipated due to off-balance-sheet exposures and lenders"
dependence on wholesale funding. Indeed, many "failed"
institutions still met regulatory minimum capital requirements.
However, FSIs are still helpful in assessing individual and
systemic vulnerabilities when reliable market data may not be
available -particularly in less-developed financial markets- as
they can provide both an indication of rising vulnerabilities and
a check when other information reveals weaknesses. For countries
with more sophisticated sources of information, FSIs could be
usefully reevaluated, perhaps refocusing them on basic leverage
ratios and ROA as a proxy for
risk-taking. Of course, FSIs should be complemented by other
measures and systemic stress tests, and be broadened to better
capture off-balance-sheet exposures and liquidity
mismatches.

Market-Based Indicators

Low equity volatility and tight credit and CDS spreads
were symptoms of, and contributors to, strong risk appetite prior
to February 2007. As such, indicators derived from market data
generally provided coincident, rather than forward-looking,
indications of the break in sentiment and transition to a
systemic crisis. However, some measures are successful in
providing an indication of how vulnerable a group of FIs is to
the default of any one FI, and hence provide some signal of how
"systemic" an individual default can be. Such indicators
complement those showing the degree of interconnectedness among
FIs (Chapter 2).

Moreover, some indicators, especially those derived from
implied volatility from equity options, seem to have given more
reliable forward signals of impending banking system and
individual institution stress.

Nevertheless, the signs of increasing volatility priced
into bank equity options provided only a few months" notice that
systemic risks were rising, and further work is needed to confirm
that such forewarnings were timelier than CDS spreads.

Volatility Regime Indicators

There is also evidence that observing shifts in
volatility regimes using some measures of systemic risk can be
helpful in detecting the degree to which the financial system is
suffering a systemic event. However, in some cases this signal
proves to be relatively short-lived.

Nonetheless, regime-switching indicators can show moves
to medium- and high-volatility states and hence can be used to
assess the degree of current fragility and uncertainty. Such
indicators may also be useful in establishing whether and when a
systemic crisis is subsiding, particularly if the low-volatility
state persists, and thus when the withdrawal supportive crisis
measures can be safely considered.

Policy Messages

The findings in this chapter point to a number of broad
policy messages:

• Collect and publish more, relevant data. While
publicly available market indicators for FIs (equity and options
prices, CDS spreads) can yield useful indicators of systemic
stress, alternative signals are probably being missed because
other relevant data are not being collected or published by
supervisors in a systematic fashion. Most notably, bank FSIs
would become more useful with the inclusion of off-balance-sheet
exposures in a standardized manner; the state of market liquidity
could be assessed more easily with the publication of volumes and
bid-ask spreads in credit markets; and systemic interconnections
could be properly assessed through the collection and aggregation
of individual cross-border counterparty exposures. Overall levels
of leverage -potentially including for hedge funds- would provide
information on the potential vulnerability of a financial system
to shocks.

• Diversify information sources and have a
comprehensive plan in place for
systemic events. Some market-based indicators -using higher
moments of FIs" equity prices- did give a few months" notice of
rising systemic risks prior to July 2007. However, it would have
been difficult to know at the time whether these signals were
prescient. In general, policymakers should not depend on
receiving unambiguous signals of impending systemic crisis from
market prices, and they should be complemented with other
indicators of potential stress (including FSIs and macroeconomic
vulnerabilities). Comprehensive policies that are clearly
communicated can serve to reduce uncertainty and would be helpful
in improving overall market conditions. The relatively short
notice of systemic crisis, and high degree of noise in some
signals, mean that policymakers should rely on a number of tools
and measures to arrive at a robust assessment of when systemic
risks are bound to materialize. In particular, stress tests that
take into account systemic effects and interconnections should be
implemented. Moreover, a comprehensive and coordinated crisis
preparedness plan needs to be in place before systemic events are
detected.

• Take care when interpreting market signals during
the crisis. If supervisors and central bankers are planning to
use market-based data to assess systemic risk, it is important
that they recognize that policy interventions themselves may
affect their informational content.

For instance, prohibitions on short selling or other
impediments to the free flow of information into prices are
likely to distort signals given by market prices. Similarly, the
introduction of government guarantees for bank debt can alter the
informational content of FIs" CDS spreads and equity
prices.

As such, market-based indicators may only contain
relatively unbiased information about systemic risk in the early
phases of a crisis, prior to policy actions. Further work on the
indicators, to control for
policy responses so that their informational content remains
intact, is needed.

• Charge for contributions to systemic risk through
higher capital requirements. Some of the analysis presented here
allows for the calibration of the contribution of individual
institutions to systemic risk, providing a starting point for
additional regulatory capital to be required to penalize
practices that add to systemic risk giving due attention to
potential procyclicality.

In addition, indicators of distress could also be used
to adduce the appropriate perimeter of regulation, or intensity
of supervision, thereby allowing institutions whose failure is
unlikely to cause distress to others to be less intensively
supervised.

Conclusions

Although every measure of systemic risk has limitations
to some degree, and indeed all models are by nature
simplifications of the complexity of the real world, this chapter
discusses various tools that can be used to shed light on
potential systemic events. Thus far, financial sector regulation
and supervision have focused on the risk of failure of each
financial institution in isolation. The analysis presented here
suggests that regulators should take into account the risk of
both individual and systemic failures. Indeed, some proposals
have begun to surface on how to account for systemic risks in
prudential regulation (e.g., Acharya, 2009; and Pedersen and
Roubini, 2009). Some of these proposals rely on the assumption
that correlation among FIs is a good proxy for detecting systemic
risks. As discussed in this chapter, measures based solely on
asset return correlations are constrained in their ability to
detect (and address) systemic risks, since they fail to capture
the "fat-tailed" nature and constant changes in the probability
distribution of asset returns of key FIs, which are
characteristic of systemic crises. This suggests that prudential
norms based on simple return correlations will be insufficient to
capture systemic risk, and supervisors will need to broaden their
approaches. The results presented in this chapter suggest that
authorities need to diversify their sources of information and
the tools used to detect systemic risk…

DANGEROUS UNINTENDED CONSEQUENCES:

HOW BANKING BAILOUTS, BUYOUTS AND
NATIONALIZATION

CAN ONLY PROLONG AMERICA"S SECOND GREAT DEPRESSION
AND WEAKEN ANY SUBSECUENT RECOVERY

PRESENTED BY MARTIN D. WEISS, PH.
D.

WEISS RESEARCH, INC. – NATIONAL PRESS CLUB –
WASHINGTON DC, MARCH 19, 2009

Executive Summary

The Fed Chairman, the Treasury Secretary, and Congress
have now done more to bail out financial institutions and pump up
financial markets than any of their counterparts in
history.

But it"s not nearly enough; and, at the same time, it"s
already far too much.

Two years ago, when major banks announced multibillion
losses in subprime mortgages, the world"s central banks injected
unprecedented amounts of cash into the financial markets. But
that was not enough.

Six months later, when Lehman Brothers and American
Insurance Group (AIG) fell, the U.S. Congress rushed to pass the
Troubled Asset Relief Program, the greatest bank bailout
legislation of all time. But as it turned out, that wasn"t
sufficient either.

Subsequently, in addition to the original goal of TARP,
the U.S. government has loaned, invested, or committed $ 400
billion to nationalize the world"s two largest mortgage
companies, $ 42 billion for the Big Three auto manufacturers; $
29 billion for Bear Stearns, $ 185 billion for AIG; $ 350 billion
for Citigroup; $ 300 billion for the Federal Housing
Administration Rescue Bill; $ 87 billion to pay back JPMorgan
Chase for bad Lehman Brothers trades; $ 200 billion in loans to
banks under the Federal Reserve"s Term Auction Facility (TAF); $
50 billion to support short-term corporate IOUs held by money
market mutual funds; $ 500 billion to rescue various credit
markets; $ 620 billion in currency swaps for industrial nations,
$ 120 billion in swaps for emerging markets; trillions to cover
the FDIC"s new, expanded bank deposit insurance plus trillions
more for other sweeping guarantees; and it still wasn"t
enough.

If it had been enough, the Fed would not have felt
compelled yesterday to announce its plan to buy $ 300 billion in
long-term Treasury bonds, an additional $ 750 billion in agency
mortgage backed securities, plus $ 100 billion more in GSE
debt.

Total tally of government funds committed to date:
Closing in on $ 13 trillion, or $ 1.15 trillion more than the
tally just 24 hours ago, when the body of this white paper was
printed. And yet, even that astronomical sum is still not enough
for a number of reasons:

First, most of the money is being poured into a
virtually bottomless pit. Even while Uncle Sam spends or lends
hundreds of billions, the wealth destruction taking place at the
household level in America is occurring in the trillions – $ 12.9
trillion vaporized in real estate, stocks, and other assets since
the onset of the crisis, according to the Fed"s latest Flow of
Funds.

Second, most of the money from the government is still a
promise, and even much of the disbursed funds have yet to reach
their destination. Meanwhile, all of the wealth lost has already
hit home – in the household.

Third, the government has been, and is, greatly
underestimating the magnitude of this debt crisis.
Specifically,

?? The FDIC"s "Problem List" of troubled banks includes
only 252 institutions with assets of $ 159 billion.

However, based on our analysis, a total of 1,568 banks
and thrifts are at risk of failure with assets of $ 2.32 trillion
due to weak capital, asset quality, earnings and other
factors.

?? When Treasury officials first planned to provide TARP
funds to Citigroup, they assumed it was among the strong
institutions; that the funds would go primarily toward
stabilizing the markets or the economy. But even before the check
could be cut, they learned that the money would have to be for a
very different purpose: an emergency injection of capital to
prevent Citigroup"s collapse. Based on our analysis,
however,

Citigroup is not alone. We could witness a similar
outcome for JPMorgan Chase and other major banks.

?? AIG is big, but it, too, is not alone. Yes, in a
February 26 memorandum, AIG
made the case that its $ 2 trillion in credit default swaps (CDS)
would have been the big event that could have caused a global
collapse. And indeed, its counterparties alone have $ 36 trillion
in assets. But AIG"s CDS portfolio is just one of many:
Citibank"s portfolio has $ 2.9 trillion, almost a trillion more
than AIG"s at its peak. JPMorgan Chase has $ 9.2 trillion, or
almost five times more than AIG. And globally, the Bank of
International Settlements (BIS) reports a total of $ 57.3
trillion in credit default swaps, more than 28 times larger than
AIG"s CDS portfolio.

Clearly, the money available to the U.S. government is
too small for a crisis of these dimensions. But at the same time,
the massive sums being committed by the U.S. government are also
too much: In the U.S. banking industry, shotgun mergers, buyouts
and bailouts are accomplishing little more than shifting their
toxic assets like DDT up the food chain. And the government"s
promises to buy up the toxic paper have done little more than
encourage banks to hold on, piling up even bigger
losses.

The money spent or committed by the government so far is
also too much for another, less-known reason: Hidden in an
obscure corner of the derivatives market is a unique credit
default swap that virtually no one is talking about -contracts on
the default of the United States Treasury bonds. Quietly and
without fanfare, a small but growing number of investors are not
only thinking the unthinkable, they"re actually spending money on
it, bidding up the premiums on Treasury bond credit default swaps
to 14 times their 2007 level. This is an early warning of the
next big shoe to drop in the debt crisis- serious potential
damage to the credit, credibility and borrowing power of the
United States Treasury.

We have no doubt that, when pressed, the U.S. government
will take whatever future steps are necessary to sufficiently
control its finances and avoid a fatal default on its debts.
However, neither the administration nor any other government can
control the perceptions of its creditors in the marketplace. And
currently, the market"s perception of the U.S. government"s
credit is falling, as anticipation of a possible future default
by the U.S. government, no matter how unlikely, is
rising.

This trend packs a powerful message – that there"s no
free lunch; that it"s unreasonable to believe the U.S. government
can bail out every failing giant with no consequences; and that,
contrary to popular belief, even Uncle Sam must face his day of
reckoning with creditors.

We view that as a positive force. We are optimistic
that, thanks to the power of investors, creditors, and the people
of the United States, we will ultimately guide, nudge and push
ourselves to make prudent and courageous choices:

1. We will back off from the tactical debates about how
to bail out institutions or markets, and rethink our overarching
goals. Until now, the oft-stated goal has been to prevent a
national banking crisis and avoid an economic depression.
However, we will soon realize that the true costs of that
enterprise -the 13-digit dollar figures and damage to our
nation"s credit- are far too high.

2. We will replace the irrational, unachievable goal of
jury-rigging the economic cycle, with the reasoned, achievable
goal of rebuilding the economy"s foundation in preparation for an
eventual recovery.

?? Right now, the public knows intuitively that a key
factor that got us into trouble was too much debt. Yet, the
solution being offered is to encourage banks to lend more and
people to borrow more.

?? Economists almost universally agree that one of the
grave weaknesses of our economy is the lack of savings needed for
healthy capital formation, investment in better technology,
infrastructure, and education. Yet, the solution being offered is
to spend more and, by extension, to save less.

These disconnects will not persist. Policymakers will
soon realize they have to change course.

3. When we change our goals, it naturally follows that
we will also change our priorities – from the battles we can"t
win to the war we can"t afford to lose: Right now, for example,
despite obviously choppy seas, the prevailing theory seems to be
that the ship is unsinkable, or that the government can keep it
afloat no matter how bad the storm may be.

With that theory, they might ask: "Why have lifeboats
for every passenger? Why do much more for hospitals that are
lying off ER staff, for countless charities that are going broke,
or for one in 50 American children who are homeless? Why prepare
for the financial Katrinas that could strike nearly every
city?"

The answer will be: Because we have no other choice;
because that"s a war we can and will win. It will not be very
expensive. We have the infrastructure. And we"ll have plenty of
volunteers.

4. Right now, our long-term strategies and short-term
tactics are in conflict. We try to squelch each crisis and kick
it down the road. Then we do it again with each new crisis.
Meanwhile, fiscal reforms
are talked up in debates but pushed out in time. Regulatory
changes are mapped out in detail, but undermined in
practice.

Soon, however, with more reasonable, achievable goals,
theory and practice will fall into synch.

5. Instead of trying to plug our fingers in the dike,
we"re going to guide and manage the natural flow of a deflation
cycle to reap its silver-lining benefits – a reduction in
burdensome debts, a stronger dollar, a lower cost of living, a
healthier work ethic, an enhanced ability to compete
globally.

6. We"re going to buffer the population from the most
harmful social side-effects of a worst-case scenario.

Then we"re going to step up, bite the bullet, pay the
penalty for our past mistakes, and make hard sacrifices today
that build a firm foundation for an eventual economic recovery.
We will not demand instant gratification. We will assume
responsibility for the future of our children.

7. We will cease the doubletalk and return to some basic
axioms, namely that:

?? The price is the price. Once it is established that
our overarching goal is to manage – not block- natural economic
cycles, it will naturally follow that regulators can guide,
rather than hinder, a market-driven cleansing of bad debts. The
market price will not frighten us. We can use it more universally
to value assets.

?? A loss is a loss. Whether institutions hold asset or
sell assets, whether they decide to sell now or sell later, if
the asset is worth less than what it was purchased for, it"s a
loss.

?? Capital is capital. It is not goodwill, or other
intangible assets that are unlikely to ever be sold. It is not
tax advantages that may never be reaped.

?? A failure is a failure. If market prices mean that
institutions have big losses, and if the big losses mean all
capital is gone, then the institution has failed.

8. We will pro-actively shut down the weakest
institutions no matter how large they may be; provide
opportunities for borderline institutions to rehabilitate
themselves under a slim diet of low-risk lending; and give the
surviving, well-capitalized institutions better opportunities to
gain market share.

Kansas City Federal Reserve President Thomas Hoenig
recommends that "public authorities would be directed to declare
any financial institution insolvent whenever its capital level
falls too low to support its ongoing operations and the claims
against it, or whenever the market loses confidence in the firm
and refuses to provide funding and capital. This directive should
be clearly stated and consistently adhered to for all financial
institutions that are part of the intermediation process or
payments system." We agree.

9. We will build confidence in the banking system, but
in a very different way: Right now, banking authorities are their
own worst enemy. They paint the entire
banking industry with a single broad brush -"safe." But when
consumers see big banks on the brink of bankruptcy, their
response is to paint the entire industry with an alternate broad
brush- that the entire banking industry is "unsafe." To prevent
that outcome, we will challenge the authorities to release their
confidential CAMELS ratings on each bank in the country. And to
restore some risk for depositors, we will ask them to reverse the
expansion of FDIC coverage limits, bringing back the $ 100,000
cap for individuals and businesses.

Although these steps may hurt individual banks in the
short run, it will not harm the banking system in the long run.
Quite the contrary, when consumers have a reason to discriminate
rationally between safe and unsafe institutions, and when they
have a motive to shift their funds freely to stronger hands, they
will strengthen the banking system.

I am making these recommendations because I am
optimistic we can get through this crisis. Our social and
physical infrastructure, our knowledge base, and our Democratic
form of government are strong enough to make it possible. As a
nation, we"ve been through worse before, and we survived then.
With all our wealth and knowledge, we can certainly do it again
today.

But my optimism comes with no guarantees. Ultimately,
we"re going to have to make a choice: The right choice is to make
shared sacrifices, let deflation do its work, and start
regenerating the economic forces that have made the United States
such a great country. The wrong choice is to take the easy way
out, try to save most big corporations, print money without
bounds, debase our dollar, and ultimately allow inflation to
destroy our society.

This white paper is my small way of encouraging you,
with data and reason, to make the right choice starting right
now…

Part I

The FDIC Greatly Understates the Number and Assets of
U.S. Banks Currently at Risk of Failure

Financial failure can appear in many forms. Sometimes
the company files for bankruptcy voluntarily; sometimes it"s
bought out, bailed out or simply liquidated. No matter what the
final outcome, for the purposes of this paper, we consider it a
failure.

To flag potential failures in the banking system, the
Federal Depositors Insurance Corporation (FDIC) maintains a
"Problem List" of banks, often used by the public and
policymakers to gage the severity of the banking
crisis.

And in its most recent release, the FDIC reported
that

?? Its Problem List grew during the fourth quarter from
171 to 252 institutions, the largest number since the middle of
1995.

?? The total assets of institutions on the Problem List
increased from $ 115.6 billion to $ 159 billion.

?? Compared to a year earlier, the number of
institutions on the list rose 232 percent, while their total
assets surged by a surprisingly sharp 623 percent.

The FDIC does not disclose the names of the institutions
on its Problem List. However, there is abundant evidence that it
understates the risk of bank failures in the U.S. by a wide
margin, as follows:

First, it was widely reported that one of the largest
banks to fail in 2008, IndyMac Bank of Pasadena, California, with
assets of $ 32 billion, was not on the FDIC"s Problem List,
evidence that the list is not capturing the broader threats to
the U.S. banking system.

Second, several large institutions, each of which has
assets many times larger than the $ 159 billion tally of the
FDIC"s Problem List, were troubled enough to receive large
emergency injections of TARP funds. Therefore, it"s obvious that
they are also not on the FDIC"s list.

Third, a statistical ratings model conceptually similar
to those used by federal regulators for identifying high risk
banks generates a list of institutions at risk of failure which
we believe is more comprehensive and accurate than the Problem
List maintained by the FDIC.

A Brief History of Some Statistical Ratings Models
for Banks and Thrifts

The banking regulators have developed a methodology for
flagging troubled banks, currently called CAMELS ratings, which
evaluate capital adequacy, asset quality, management, earnings,
liquidity, and sensitivity to market risk.

The results of this model are not published. However, in
the 1980s, when the official Call Report data became more readily
available to the public, independent research firms, such as
Veribanc of Massachusetts and T. J.

Holt and Co. of Connecticut, developed ratings
methodologies that were based conceptually (albeit not
mathematically) on the Fed"s CAMELS ratings. Subsequently,
actuarial studies performed on both the T. J. Holt and Veribanc
ratings demonstrated a consistent pattern whereby

?? virtually all institutions that subsequently failed
had received low rating months earlier;

?? few, if any, institutions with a high rating failed
within a year after the ratings were published.

Although not all low-rated institutions subsequently
failed, the failure rate of low-rated institutions was very high,
validating our view that they are at risk of failure, especially
in a deep recession or depression.

In 1987, Weiss Research purchased the Holt bank ratings
database and quantitative models, incorporating elements of its
own qualitative bank ratings methodology and publishing these
under the banner of Weiss Safety Ratings.

In its 1994 study, Insurance Ratings: Comparison of
Private Agency Ratings for Life/Health Insurers, the U.S. General
Accountability Office (GAO)
reviewed the Weiss ratings scale (from A to F) and determined
that a Weiss Safety Rating of D+ or lower denotes institutions
that are "vulnerable" to future financial failures.

Further, the high percentage of companies rated D+ or
lower that subsequently failed again validated the general
accuracy of that designation. Although the GAO was referring to a
different industry (life and health insurers), the Weiss ratings
scale was designed to convey the same significance across various
financial industries, including commercial banks, savings banks,
and savings and loan associations.

In 2006, the New York media firm TheStreet.com purchased
the Weiss Ratings, now called Financial Strength Ratings.
However, TheStreet.com ratings scale (A through F) is the same as
the earlier Weiss ratings scale, while the ratings methodology
has remained virtually the same as well.

Now, for the purposes of this paper, TheStreet.com has
provided a list of all rated depository institutions with a
Financial Strength Rating of D+ (weak) or lower.4 And based on
the background cited above, we believe the list is both more
comprehensive and more accurate than the FDIC"s.5 From the list,
Weiss Research finds that:

?? 1,372 commercial and savings banks are at risk of
failure with total assets of $ 1.79 trillion.

?? 196 savings and loan associations are at risk with $
528 billion in assets.

?? In sum, a total of 1,568 banks and thrifts are at
risk with assets of $ 2.32 trillion. That"s 6 times the number or
institutions and 15 times the assets of banks and thrifts on the
FDIC"s fourth quarter 2008 Problem List.

?? Given the deterioration in banks and in the economy
reported by the FDIC and the Commerce Department, it is likely
that more banks and thrifts will be added to the list once fourth
quarter ratings become available.

Supervision"s Thrift Financial Reports for the third
quarter of 2008, as provided by Highline Financial, Inc., with
reference to the fourth quarter Call Reports strictly to
determine which banks were still in business at
yearend.

The precise differences between the FDIC"s method for
flagging problem banks and the method used here are not known.
However, the aggregate results should make it clear that the
magnitude of the banking troubles in the U.S. today could be far
greater than what the FDIC is publicly recognizing.

Part II

U.S. Commercial Banks Have Taken Massive,

Often Unquantifiable, Risks in Their Derivatives
Holdings

The collapse of major financial institutions since 2008
has come as a shock to both Wall Street and Washington. But
nearly 15 years ago, the U.S. Government Accountability Office
(GAO) explicitly warned of this possibility. On May 18, 1994, in
a landmark study, Financial Derivatives, Actions Needed to
Protect the Financial System, it stated that:

1. Derivatives trading involves exposure to five
different risks:

(a) credit risk, defined as "the possibility of loss
resulting from counterparty"s failure to meet its financial
obligations";

(b) market risk, "adverse movements in the price of a
financial asset or commodity";

(c) legal risk, "an action by a court or by a regulatory
or legislative body that could invalidate a financial
contract";

(d) operations risk, "inadequate controls, deficient
procedures, human error, system failure, or fraud";
and

(e) system risk, a chain reaction of financial failures
that could threaten the national or global banking
system.

2. Over-the-counter (OTC) derivatives trading at
affiliates of securities and insurance companies are unregulated
and growing too rapidly.

3. Just five major securities firms, three insurance
companies and seven commercial banks account for the overwhelming
bulk of the derivatives trading.

4. "If one of these large OTC dealers failed, the
failure could pose risks to other firms -including federally
insured depository institutions- and the financial system as a
whole".

5. "Financial linkages among firms and markets could
heighten this risk. Derivatives clearly have expanded the
financial linkages among the institutions that use them and the
markets in which they trade. Various studies of the October 1987
market crash showed linkages between markets for equities and
their derivatives. According to those studies, prices in the
stock, options, and futures markets were related, so that
disruptions in one were associated with disruptions in the
others".

6. "The concentration of OTC derivatives activities
among a relatively few dealers could also heighten the risk of
liquidity problems in the OTC derivatives markets, which in turn
could pose risks to the financial system. Because the same
relatively few major OTC derivatives dealers now account for a
large portion of trading in a number of markets, the abrupt
failure or withdrawal from trading of one of these dealers could
undermine stability in several markets simultaneously, which
could lead to a chain of market withdrawals, possible firm
failures, and a systemic crisis".

7. "The federal government would not necessarily
intervene just to keep a major OTC derivatives dealer from
failing, but to avert a crisis, the Federal Reserve may be
required to serve as lender of last resort to any major U.S. OTC
derivatives dealer, whether regulated or unregulated".

In response to the GAO"s 1994 warnings above, the
financial industry"s response was both audible and caustic. Major
Wall Street firms pushed back with concerted lobbying efforts to
block any regulatory changes at the pass, while "Chicken Little"
accusations were leveled at the authors, Congressional requesters
of the study, and any independent firm, such as Weiss Research,
that made forecasts based on its conclusions.

The industry"s primary argument in defense of
derivatives was that they helped to reduce risk through hedging,
and that each derivatives position was generally balanced against
offsetting positions. However, many large financial institutions
-such as Bear Stearns, Lehman Brothers, Merrill Lynch and the
American Insurance Group (AIG)- went far beyond hedging,
transforming their derivatives divisions into major profit
centers based on speculative trading. Moreover, they did not
adequately protect themselves against defaults by their trading
partners or anticipate the severity of the system risk stressed
by the GAO.

Subsequently, as detailed in the GAO"s follow-up report,
Financial Derivatives: Actions Taken or Proposed Since May 1994,
some, mostly cosmetic, changes were made. But they did nothing to
slow the meteoric growth of the very instruments and practices
that the GAO identified as posing the greatest threats to
financial institutions and the financial system.
Specifically,

?? In its 1994 study, the GAO reported, "The best
available data indicate that the total volume of worldwide
derivatives outstanding as of year-end 1992 was at least $12.1
trillion in terms of the notional, or principal, amount of
derivatives contracts." Although the GAO recognized that the $
12.1 trillion overstated the actual risk, it also stated that
"firms that use derivatives can sustain significant losses,"
implying that $ 12.1 trillion was already considered a
dangerously large number.

However, that number pales in comparison to the latest
tally of notional OTC derivatives by the Bank of International
Settlements (BIS). At mid-year 2008, the BIS reported $ 683.7
trillion, or 56.5 times the level reported by the GAO for
1992.

Worse, among these were $ 57.3 trillion in credit
default swaps, or bets on the failure of named corporations.
These contracts are widely recognized as the highest risk
category of derivatives and are directly responsible for the
demise of AIG, one of the largest threats to the global financial
system today.

At the time of the 1994 GAO study, credit default swaps
barely existed; now they are nearly five times larger than the
total tally of global derivatives in all categories reported by
the GAO for 1992.

?? In its 1994 study, the GAO warned of extreme
concentration in the derivatives market, with the top seven
domestic bank derivatives dealers accounting for more than 90
percent of all U.S. bank derivatives activity as of December
1992.

Today, the data reported by the Comptroller of the
Currency (OCC) demonstrates that not only has there been a
failure to better diversify derivatives trading across a broader
range of players, the concentration has actually increased. As of
September 30, 2008, instead of seven major players among U.S.
commercial banks, there were only five. And instead of
controlling 90 percent, these five banks controlled 97 percent of
the total industry notional amount.

Moreover, the OCC also reports that, of the $ 175.8
trillion in notional derivatives held by U.S. commercial banks at
September 30, 2008, one single player, JPMorgan Chase Bank NA,
controls $ 87.7 trillion, or 49.9%, raising serious questions
regarding its virtual monopoly in the U.S. derivatives market and
the systemic risk implied by any failure…

?? In its 1994 study, the GAO also reported "a similar
concentration of activity among U.S. securities derivatives
dealers. The top five by notional/contract amounts accounted for
about 87 percent of total derivatives activity for all U.S.
securities firms as of their fiscal year-end 1992".

Today, most of the major U.S. securities derivatives
dealers have failed, been bought out, or bailed out by the
federal government.

?? In its 1994 study, the GAO stressed that "credit risk
is a key consideration in managing OTC derivatives," but pointed
out that "managing credit risk can be difficult for OTC
derivatives because credit exposure can change
rapidly."

Today, the OCC data demonstrate that the credit risk is
beyond excessive: Four out of five of the major U.S. commercial
bank derivatives players have total credit exposure that exceeds
their risk-based capital. (More on this subject below)

Thus, despite the modest reforms discussed in the GAO"s
1996 follow-up report, the dangers associated with derivatives
-their accelerated pace of growth and multiple levels of risk-
only changed for the worse.

Meanwhile the GAO"s warnings about the possible
disasters resulting from a derivatives-related failure were
prescient:

1. As the GAO clearly implied in its report, the rapid
growth of unregulated OTC derivatives now poses a serious threat
to the global financial system.

2. As the GAO warned, the concentration of trading among
a small number of large players has pinned the future of the
financial system on a handful of high-rollers.

3. As the GAO warned, each of the five risks it cited
-credit risk, market risk, legal risk, operations risk and system
risk- have come together in a single explosive mix now
threatening stability.

4. As the GAO warned, the failure of one large OTC
derivatives dealer has posed risks to other major firms,
including federally insured depository institutions and the
financial system as a whole. Its name: Lehman Brothers. Moreover,
as explained below, the near failure of a larger firm, American
Insurance Group (AIG), poses even greater threats.

5. As the GAO warned, the financial linkages among firms
have heightened this risk. Moreover, as it explained with its
reference to the 1987 stock market crash, these linkages have
become especially critical in the wake of recent market crashes –
in both the U.S. housing market and global stock
markets.

6. As the GAO warned, the abrupt failure or withdrawal
from trading of one of the large dealers has undermined the
stability of several markets simultaneously, leading to a chain
of market withdrawals, firm failures and systemic crisis: We"ve
seen simultaneous and extreme instability in the markets for
mortgages, interbank loans, asset backed securities (ABS),
commercial paper, corporate bonds and even money market
funds.

7. Finally, as the GAO also warned, the Federal Reserve
has been required to serve as a lender of last resort to major
U.S. OTC derivatives dealers, whether regulated or unregulated:
The Fed has jumped in to extend massive loans not only to
commercial banks under its jurisdiction but also to
broker-dealers, insurers and others.

Major Financial Institutions at Risk of
Failure

Due to the continuing scarcity of detailed data on the
multiple risk factors associated with derivatives, it is
difficult to pinpoint precisely which large institutions are at
greatest risk. However, the OCC has developed a measure of the
total credit exposure of major derivatives players, as
follows:

Major U.S. Banks Overexposed to Default Risk

(Credit Exposure with Derivatives as a % of Risk-Based
Capital)

HSBC Bank USA 664.2

JPMorgan Chase 400.2

Citibank 295.5

Bank of America 177.6

Wachovia 85.2

Data: OCC

This chart answers the question: For each dollar of
capital, how much exposure does each bank have to the possible
defaults of its derivatives trading partners? And it shows that
among commercial banks, all but one of the five largest players
are exposed to the tune of over 100 percent of their capital, an
alarming level even in the absence of a financial crisis or
depression…

In sum, in addition to the list of institutions with
TheStreet.com Financial Strength Ratings of D+ or lower, Weiss
Research has added four banks to its list of institutions at risk
of failure, as follows:

Banks Added by Weiss Research to List of Banks at Risk
of Failure

Bank name Total assets ($ billions)

Citibank 1,207.0

HSBC Bank USA 181.6

JPMorgan Chase 1,768.7

SunTrust Bank 174.7

Total 3,157.3

In conclusion, beyond the $ 2.32 trillion in assets of
banks at risk based on their Financial Strength Ratings cited in
Part I, Weiss Research estimates there are additional assets of $
3.16 trillion in large institutions at risk, for a total of $
5.48 trillion in at-risk institutions…

Part III

Silencing the Potential Triggers of Global Collapse Does
Not Address Its Causes

Anyone still skeptical of the nature and magnitude of
the systemic dangers need only review the February 26, 2009 draft
memorandum issued by AIG, titled "AIG: Is the Risk Systemic?"
Although marked "strictly confidential," it found its way into
the public domain in early March.19 In it, AIG states:

?? "Systemic risk is the risk imposed by inter-linkages
and interdependencies in a system or market, which could
potentially bankrupt or bring down the entire system or market if
one player is eliminated, or a cluster of failures
occurs.

?? "Systemic financial risks occur when contingency
plans that are developed individually to address selected risks
are collectively incompatible. It is the quintessential "knee
bone is connected to the thigh bone …" where every element that
once appeared independent is connected to every other
element.

?? "AIG"s business model -a sprawl of $ 1 trillion of
insurance and financial services businesses, whose AAA credit was
used to backstop a $ 2 trillion dollar financial products trading
business- has many inherent risks that are correlated with one
another. As the global economy has experienced multi-sector
failures, AIG"s vast business has been weakened by these
multi-sector failures. …

?? "If AIG were to fail notwithstanding the previous
substantial government support, it is likely to have a cascading
impact on a number of U.S. life insurers already weakened by
credit losses. State insurance guarantee funds would be quickly
dissipated, leading to even greater runs on the insurance
industry. …

?? "In addition, the government"s unwillingness to
support AIG could lead to a crisis of confidence here and abroad
over other large financial institutions, particularly those that
have thus far remained viable because of government support
programs.

?? "The loss of confidence is likely to be particularly
acute in countries that have large investments in U.S. companies
and securities and whose citizens may suffer significant losses
as a result of the failure of AIG"s foreign insurance
subsidiaries.

?? "This could lead directly to a decrease in the
attractiveness of U.S. government securities and a consequent
increase in borrowing costs for the U.S. government and related
issuing entities …

?? "The extent and interconnectedness of AIG"s business
is far-reaching and encompasses customers across the globe
ranging from governmental agencies, corporations and consumers to
counterparties. A failure of AIG could create a chain reaction of
enormous proportion…

?? "Just as the government was unable to predict that
the failure of Lehman would lead to the collapse of the Reserve
Fund, followed by much of the money market industry, the
government would be even less capable of predicting the fallout
from the collapse of a much larger, more global and more
consumer-oriented institution such as AIG".

The agenda behind AIG"s confidential memorandum is
precisely the opposite of a company"s typical agenda in public
communications: Rather than sugar-coat the facts, they sought to
make the gloomiest possible argument to persuade regulators to
provide more bailout funds. AIG"s thesis: The company is so large
and has linkages to so many other major players in the
derivatives market, its demise would cause a chain reaction of
financial collapses.

It is true that AIG is very large. And based on its
recent disclosures, it"s also true that it is linked to major
derivatives players around the globe. As depicted in the
accompanying chart,

?? AIG does business with at least 30 financial
institutions, primarily in the U.S. and Western
Europe.

?? Some of those companies have significant financial
weaknesses of their own, as indicated by the borderline ratings
issued by TheStreet.com and less-than-stellar ratings by
Moody"s.

?? Those companies have total assets of at least $ 36
trillion, far more than the total committed by the U.S. and
European governments for corporate bailouts.

However, if this global structure is shaky, neither a
future failure of AIG nor the 2008 bankruptcy of Lehman Brothers
can be properly construed as the underlying cause. Rather, they
are merely potential triggers of a global collapse.

The underlying causes of global instability are many
years of overborrowing and undersaving, plus the cumulative
weight of the U.S. housing bust, mortgage meltdown, widespread
deleveraging in the financial system, and the deepest economic
downturn since the Great Depression.

Meanwhile, the potential triggers of a global collapse
are ubiquitous – not limited to just one or two firms such as AIG
or Lehman Brothers. As we demonstrate in this paper, in the
banking industry alone, there are at least four megabanks and
thousands of smaller institutions at risk. Thus, although
abundant taxpayer funds may lock down some of the potential
triggers some of the time, it is unreasonable to expect the
government to silence all the guns all the
time…

Part IV

U.S. Commercial Banks Are Vulnerable to Contagion
Despite Expanded Deposit Insurance

One justification often cited privately -and sometimes
publicly- for government actions to avert large bank failures is
the concern that

?? the failures might lead to hasty withdrawals by
depositors,

?? the panic could spread to other institutions,
and

?? in a worst-case scenario, the contagion could shut
down the entire banking system.

This fear is not totally unjustified. Banking and
related panics have occurred before — not only in prior
eras but also in more recent times.

In January 1991, for example, due to a flood of
withdrawals by panicked depositors, Rhode Island Governor Bruce
Sundlun declared a banking emergency and shut down all 45
state-chartered savings banks and credit unions in his state.
Shortly thereafter, we witnessed a similar situation in Maryland.
The lesson was that panic and contagion was not strictly a
phenomenon that ended in the 1930s…

Why FDIC Insurance Coverage Does Not Protect the Banking
System

There are several reasons banks and thrifts remain
vulnerable to a run on their assets, despite expanded FDIC
insurance coverage.

First, an analysis of third quarter Call Reports shows
that banks still rely heavily on what"s often termed "hot money"
deposits – those that have historically been more prone to rapid,
mass withdrawals. Specifically,

1. Among 7,400 reporting banks, total domestic deposits
were $ 6.48 trillion. Of these, $ 1.18 trillion, or 18.21%, were
time deposits in accounts exceeding $100,000, considered hot
money.

2. Data is not available regarding the proportion of hot
money deposits that are in accounts affected by the new expanded
FDIC limits – those exceeding $ 100,000 but less than $ 250,000.
However, we know that many banks routinely provide yield
incentives for jumbo deposits and that these can attract
investors with accounts exceeding $ 250,000. Although the number
of these jumbo accounts is not likely to be large, the total
dollars invested could be.

3. The 7,400 reporting banks also had $ 353 billion, or
5.45% of the total, in FDIC-insured brokered deposits.

Despite the insurance coverage, these can also be
volatile. Unlike deposits gathered in each bank"s local
community, they are acquired through intermediaries from
depositors around the country that have historically tended to be
less loyal and more likely to shift institutions. Moreover, the
movement of funds can be motivated by various factors that
transcend FDIC insurance coverage:

a. the search for higher yields in other depository
institutions;

b. the desire to shift to higher-yielding instruments
available outside of the banking system, including annuities,
corporate bonds, or foreign currency deposits, plus,

c. the fear that, in the event of an FDIC takeover,
yields on Certificates of Deposit and other bank deposits will be
summarily reduced;

d. the fear of disruption and inconvenience that can
accompany a failure, despite FDIC intervention.

4. Summing the jumbo deposits and brokered deposits, we
find that banks were dependent on $ 1.53 trillion in hot money,
representing a substantial 23.66% of their total domestic
deposits, with many individual institutions significantly more
reliant on hot money than the overall industry.

Second, an analysis of third quarter Thrift Financial
Reports reveals that the reliance on hot money in the S&L
industry is even greater than among banks, as follows:

1. Among 819 reporting thrifts, deposits totaled $ 734
billion. Of these, $ 107.1 billion, or 14.59%, were in time
deposit accounts exceeding $ 100,000.

2. Another $ 85.2 billion, or 11.60%, were in fully
insured brokered deposits.

3. In total, the thrifts were dependent on $ 192.3
billion in hot money deposits, representing 26.19% of the total,
with many individual institutions more reliant on hot money than
the industry as a whole.

Third, government officials have historically recognized
that, in the long term, expanded FDIC coverage limits can be
counterproductive, raising -rather than diminishing- systemic
risk.

It was for this reason, for example, that National
Economic Council chief Lawrence Summers spoke out in opposition
to higher FDIC coverage limits when he was Treasury Secretary in
the last year of the Clinton Administration, stating "such an
increase would be ill-advised and would represent a serious
policy error that could increase systemic risk by eroding market
discipline".

It was also for this reason that Former Fed Chairman
Alan Greenspan stated that most economists considered prior
coverage increases to be "a bad mistake," and that any new
proposal to do so would also be "a major policy
mistake".

Similarly, we believe the most recent increase in FDIC
coverage limit was yet another rush to judgment by policymakers
lacking the critical data needed to support prudent decisions for
the benefit of the economy as a whole.

Fourth, most recent bank runs have not been caused by
insured depositors. They have been caused by the exodus of large,
uninsured institutional depositors who are typically the first to
rush for cover at the earliest hint of trouble. That"s the main
reason Washington Mutual, America"s largest savings and loan,
lost over $ 16 billion in deposits in its final eight days in
2008. That"s also a major reason Wachovia Bank suffered a similar
run soon thereafter. During the many financial failures of the
1980s and 1990s, the story was similar: we rarely saw a run on
the bank by individuals. Rather, it was uninsured institutional
investors that jumped ship long before most consumers realized
the ship was sinking.

Fifth, even if the government can calm nervous
depositors, it has no control over shareholders, who, in recent
months, have demonstrated that they can swiftly drive a company"s
stock into the gutter. The investor panic, in turn, sends the
signal to depositors that trouble is brewing, greatly diminishes
each bank"s market capitalization, and makes it more difficult
for the institution to raise additional capital.

Sixth, banks and banking regulators have so far made it
difficult for consumers to discriminate between weak and strong
institutions, as follows:

1. Despite known, endemic vulnerabilities, officials
paint the entire banking industry with the broad brush of safety
and trustworthiness. The FDIC expands its coverage to
deliberately create an aura of blanket protection for consumers
and businesses. The Treasury promises that it will backstop
Citigroup and Bank of America. The Fed Chairman promises Congress
that no large institutions will be allowed to fail.

2. But if the aura of safety is not matched by an
underlying reality of security, the public will sooner or later
perceive that the official broad brush is false or misleading.
Worse, they may replace it with an equally false broad brush of
their own that paints the entire industry as unsafe and
untrustworthy. Given the large number of stronger banks and
thrifts in the country, this perception would be a great loss for
the banking system as a whole.

3. Newly expanded FDIC insurance further blurs the
distinction between safe and unsafe institutions. As long as the
coverage was limited, consumers continued to have an incentive to
make that distinction. However, with coverage increased to $
250,000 and with unlimited coverage provided for business
checking, the FDIC is sending the message to individuals and
businesses that virtually all their deposits are covered, leaving
little remaining incentive for them to distinguish between weak
and strong institutions or take rational safety
precautions.

4. As explained in Part I, the FDIC both understates the
number of problem banks and fails to provide a mechanism for
consumers to discriminate between weak and strong institutions.
As it becomes more widely known that the FDIC"s Problem List is
both inadequate and unavailable to the public, the danger of
panicky responses could be heightened.

5. Other than some commentary about uninsured deposits,
the FDIC provides little or no education regarding bank safety.
As a result, the overwhelming majority of consumers

?? do not understand why or how banks are
failing,

?? cannot fathom the labyrinthine world of
derivatives,

?? have little understanding of government rescue
efforts,

?? do not know how to evaluate a bank"s relative
safety,

?? are unaware of private sector bank ratings,
and

?? are at a loss regarding where to go for further
information.

In sum, we have a dangerous combination of (a) official
statements the public cannot trust and (b) critical information
the public cannot find, leaving the field wide open to rumor and
contagion.

Rather than making it possible for consumers to
rationally shift their funds from weaker to stronger
institutions, banking regulators have created an environment
that, in a deepening depression, may drive consumers to withdraw
their funds from the banking system as a whole. In its efforts to
protect all banks and depositors, the government is ultimately
protecting none. In its zeal to avert panic at all costs, it may
actually be rendering the system more vulnerable to a far more
costly panic.

Part V

Government Rescues Have Both, Failed to Resolve the Debt
Crisis And Weakened the Banking System

With the exception of Lehman Brothers, the federal
government"s response to the debt crisis has been to avoid large
financial failures at all costs. Moreover, the consensus view is
that the Lehman failure was responsible for the implosion of
global credit markets in the fall of 2008, reinforcing the "too
big to fail" doctrine.

In line with this doctrine, multiple novel strategies
have been implemented and many more proposed.

However, most tend to fall under one of the three
following general approaches: (1) government-backed mergers or
buyouts, (2) government purchases of toxic paper, and (3)
nationalization. Below are their general goals, along with our
comments on their likely consequences.

Approach #1. Government-Backed Mergers and
Buyouts

Traditionally, when a financial institution fails, the
applicable regulatory authorities step in, take over the
operation, and fire the senior management. They then seek to find
a buyer for the company, rehabilitate the institution under
receivership, or sell the assets. However, under the
too-big-to-fail doctrine, the authorities bypass standard
bankruptcy procedures: They broker a shotgun merger or buy-out,
typically assuming some responsibility for future losses if the
assets sink further or the deal turns sour. All parties involved
in the transaction -the seller, the buyer and the regulators-
recognize that the institution has failed. But they tacitly agree
to maintain the fiction it has not.

Accordingly, in recent months, federal authorities have
arm-twisted large financial conglomerates to acquire failing
companies in the midst of the debt crisis, turning a blind eye to
the enormous risks, while offering the carrot of much larger
market shares…

Dangerous Unintended Consequences

Each of these government-inspired mergers may have
helped quell the immediate crisis, while relieving regulators of
the immediate burden of a takeover. However, they also came with
dangerous unintended consequences, as follows:

1. Concentration of risk. Most toxic assets that would
be liquidated in a bankruptcy or regulatory takeover were,
instead, shuffled from weaker to stronger institutions. Like DDT
moving up the food chain, the toxic paper becomes more
concentrated on the balance sheets of financial
institutions.

2. Worst of both worlds for taxpayers: To the degree
that the government backstopped the mergers, taxpayers got
responsibility for future losses but little or no authority over
management decisions.

3. Weaker banking system: With three of the nation"s
largest banks bogged down by massive portfolios of nonperforming
loans, the nation"s entire banking system is weakened. The
mergers increase the system"s vulnerability to a depression and
hamper credit creation in any subsequent recovery.

Approach #2. Government Purchases or Subsidies of Toxic
Assets

This concept has various permutations:

?? In the original proposal under TARP, the Treasury
would use taxpayer funds to buy up toxic assets from banks,
helping to remove them from their books.

?? Subsequently, during the transition period following
the 2008 election, there was much discussion of a "bad bank"
which would serve a similar purpose, but with a more permanent
structure reminiscent of the Resolution Trust Corporation,
created to house the toxic paper during the S&L crisis of the
1980s.

?? Most recently, in a proposal reminiscent of the
Treasury"s failed "Super-SIV" program of late 2007, Treasury
Secretary Geithner has proposed a plan whereby taxpayers would
subsidize the purchase of the banks" toxic assets by investors.
Banks selling their bad assets would get a higher price than they
could achieve otherwise, and investors buying the assets would
get financing plus guarantees against losses.

Although the idea is to avoid the astronomical expenses
of a program fully funded by the government, early estimates of
the cost run as high as $ 1 trillion.

Dangerous Unintended Consequences

These plans come on the heels of earlier failed plans,
including the TAF, the TSLF, the PDCF, and the "Super SIV", all
of which have done little more than keep "zombie" financial
institutions alive, even as deterioration in the marketplace
continues. Despite massive and multiple government interventions,
we have witnessed an 80 percent year-over-year decline in
commercial mortgage originations in the fourth quarter of 2008, a
58 percent delinquency rate on mortgages that had been modified
just eight months earlier, and further sharp declines in the
value of toxic assets still clogging the books of the nation"s
largest banks.

Regardless of the plan"s acronym, the benefits are
uncertain, but the damage is not. In anticipation of a possibly
better deal from the government, banks, which otherwise might
bite the bullet and sell, instead turn down bona fide investor
bids. Similarly, in anticipation of possible government
guarantees against losses, private investors, who might be
willing buyers, withdraw their bids and bide their
time.

Banks, which might have long ago dumped their toxic
assets, wind up holding them on their books. Trading volume,
already thin, dries up. The market, already limping along,
freezes. In the interim, as the economy slides and delinquency
rates rise, bank losses continue to pile higher.

Approach #3. Nationalization

Nationalization is the hot word of the
moment, but the term itself is frequently misused.

Correct usage would restrict it exclusively to a
permanent or semi-permanent shift of corporate assets from the
private to the public sector, e.g., the nationalization of
Mexico"s oil industry with the creation of Petróleos
Mexicanos (PEMEX), the Brazilian government"s control over
Banco do
Brasil,
America"s control over its postal services, or, in the more
extreme historical examples, the wholesale nationalization of
private enterprises in Nazi Germany, Bolshevik USSR and
post-revolutionary Cuba.
Nationalization is the opposite of privatization. It is not a
synonym for temporary government takeovers.

Incorrect usage applies the term to virtually any
government actions to rehabilitate or liquidate failed companies.
If this definition were to be accepted, it would have to also
apply to every receivership under the auspices of a federal
judge, every insurance company takeover by state insurance
commissioners, and every shutdown of failed banks by the
FDIC.

Intentionally or unintentionally, the politically-loaded
"N" word casts a shroud of doubt over the much-feared "B" word:
bankruptcy.

The dangerous unintended consequences of
nationalization, correctly defined, are clear: They would
undermine and stifle the nation"s future growth, creating even
larger, less efficient institutions.

Part VI

The Most Dangerous Unintended Consequence of All: A
Continuing Expansion of Federal Rescues Can Severely Damage the
Government"s Borrowing Power

The government"s most precious asset is not federal
lands, military hardware or even its gold in
Fort Knox. It"s the power to borrow money readily in the open
market, without which it would be unable to run the country"s
basic operations, finance the deficit, or refund maturing debt.
Unfortunately, however, that borrowing power could be jeopardized
by a perfect storm of forces, beginning with a ballooning budget
deficit.

The budget proposal submitted to Congress by the
administration on February 26, 2009, assumes a 1.2% decline in
real GDP in 2009 and forecasts a $ 1.75 trillion deficit for the
year. However, in our view, this deficit forecast is greatly
understated due to a series of flawed assumptions underlying the
current budget planning process, as follows:

Flawed assumption #1. It assumes that the banking crisis
will not act as a serious continuing drag on the
economy.

Why it"s flawed: As demonstrated in this paper, the
number of institutions at risk of failure is larger than
generally believed; the risks to credit markets are deeper; and
the government"s response, less likely to succeed.

Flawed assumption #2. Econometric GDP forecasting models
are reliable tools to establish a basis for budgetary planning
even in the midst of a debt crisis.

Why it"s flawed: GDP models are primarily designed to
forecast gradual, continuous, linear changes in the economy. They
are poorly equipped to handle sudden, discontinuous, structural
changes, such as those we have experienced in recent months,
including the housing market collapse, the mortgage meltdown,
major financial failures, credit market shutdowns, and a deep
decline in equities.

Flawed assumption #3. In GDP forecasting models, the
sharp declines in the U.S. economy recorded in the most recent
six months are less important than the growth patterns
established over a period of many years since the end of World
War II.

Why it"s flawed: There is abundant empirical evidence
that, in September 2008, the bankruptcy of Lehman Brothers and
the subsequent disruptions in global credit markets marked a
break with historical patterns, ending the six-decade era of
growth since World War II. Therefore, any viable GDP forecasting
model must reduce its weighting for prior growth pattern and
increase its weighting for the contraction in the economy since
September 2008. In addition, GDP forecasting models must also
consider the patterns associated with the prior depression cycle
of the 1930s.

Flawed assumption #4. The Great Depression was an
anomaly that will not repeat itself and therefore is irrelevant
to GDP forecasting in the modern era.

Why it"s flawed: Other than the 1930s Great Depression,
there are no modern precedents for the current crisis.

In the first three years of that cycle, GDP contracted
as follows:

1930: -8.6 percent

1931: -6.4 percent

1932: -13.0 percent

These data points, no matter how extreme they may
appear, must be considered in any objective model that seeks to
forecast GDP for the period 2009-2011.

Flawed assumption #5. Thanks to a more assertive role by
government, the current crisis cannot be -and will not be- as
severe as the Great Depression.

Why it"s flawed: To our knowledge, administration
economists and budget planners have not undertaken the in-depth
comparison between the most recent events and the 1930s that
would be needed to make such an assumption.

Moreover, a cursory comparison reveals the assumption
may be incorrect:

?? The 1930s depression was precipitated by a severe
stock market decline and loss of wealth in 1929. The loss of
wealth in this cycle so far -$ 12.9 trillion- is
similar.

?? In the 1930s, the U.S. was a creditor nation. Today,
it is the world"s largest debtor nation.

?? The 1930s depression was deepened and prolonged by
financial collapses. This time, despite government intervention,
the collapses experienced to date in this cycle may have an
equal, or even greater, impact.

Flawed assumption #6. With the help of the stimulus
package, the typical GDP growth pattern of prior years will
reassert itself, containing the recession to a meager 1.2 percent
GDP contraction in 2009, and ending the recession with a 3.2
percent GDP expansion in 2010.

Why it"s flawed:

?? For the fourth quarter of 2008, the government
estimates that GDP contracted 6.2 percent, and due to a
sharper-than-expected drop in construction spending, it may have
to revise that figure to a 7 percent decline.

?? In the first quarter of 2009, the recently-released
unemployment data (651,000 jobs lost in February plus 161,000
additional job losses beyond those previously reported in prior
months) indicates that the economy is contracting at a similar
pace.

?? Therefore, to contain the economy"s contraction to a
meager 1.2 percent in 2009 would require a dramatic second-half
turnaround that is highly unlikely; and attempts made in
mid-March 2009 by large banks and the administration to talk up
hope for an early recovery seem premature.

The fact that the financial crisis so far could be
similar to the equivalent period in the 1930s depression does not
necessarily mean that the subsequent GDP declines will also be
similar. But it does clearly imply that the government"s GDP
forecasts -the meager 1.2 percent decline in 2009 and the
relatively robust 3.2 percent growth in 2010- are
unrealistic.

Flawed assumption #7. With a 1.2 percent GDP decline in
2009 and 3.2 percent growth in 2010, the budget deficit will be
$1.75 trillion in the current fiscal year and will decline
substantially in future years.

Why it"s flawed: For the reasons cited above, it is
unreasonable to assume that economists can use their traditional
tools to forecast GDP and the budget deficit in this environment.
Much as with the stress-testing currently proposed for banks, a
common-sense approach to budgeting must assume a wider range of
possible

GDP scenarios, including a worst-case scenario similar
to the 1930s. Even in a GDP scenario that"s only half as severe
as the 1930s, the federal budget deficit for 2009 and 2010 would
dramatically exceed the $1.75 trillion now forecast by the
administration.

In conclusion, the combination of (a) multi-trillion
federal commitments to financial bailouts plus (b) multitrillion
federal deficits would place a financing burden on the government
that is both unprecedented and overwhelming.

Why Additional Trillions Needed to Finance Further
Bailouts, Rescues and Deficits Could Fatally Cripple the Credit
and Borrowing Power of the U.S. Government

In an environment of already-bulging federal deficits,
continuing attempts by the U.S. government to provide all or most
of that capital needed to bail out failing institutions can only
force it to

?? borrow even larger amounts in the open
market,

?? drive up market interest rates,

?? damage its credit rating,

?? jeopardize its borrowing power in the financial
markets,

?? make it increasingly difficult or expensive to
finance its bulging deficits, and

?? in a worst-case scenario, make it next to impossible
to refund maturing debts.

In response to these growing concerns, America"s largest
creditor, the People"s Republic of China, has
explicitly stated doubts regarding the security of U.S. Treasury
debt, to which the administration has quickly responded with
assurances.

We have no doubt that, when pressed, the U.S. government
will take whatever future steps are necessary to sufficiently
control its finances and avoid a fatal default on its
debts.

However, neither the administration nor any other
government can control the perceptions of its creditors in the
marketplace.

And currently, the market"s perception of the U.S.
governments credit is falling, as anticipation of a possible
future default by the U.S. government, no matter how unlikely, is
rising.

Already, as an indication of this rising perception of
risk, owners of U.S. government securities and other investors
are flocking to purchase insurance against a possible future
default by the U.S. Treasury, driving the premiums on U.S.
Treasury credit default swaps to new highs.

Thus, it recently cost investors 98 basis points to buy
protection against a Treasury default, up 14-fold from just 7
basis points in late 2007, or a premium cost of $ 9,800 per $ 1
million of U.S. debt, compared to only $ 700 previously. If this
premium cost becomes prohibitive, lenders will demand higher
yields on U.S. Treasuries or may begin to reduce their current
Treasury bond holdings, making it increasingly expensive for the
U.S. Treasury to refund its maturing debts – let alone raise new
funds to finance its bulging deficits.

This is evidence that, even in the absence of a
depression, the credit of the U.S. government is being damaged by
its assumption of trillions of dollars in direct or indirect
liabilities for companies like Fannie Mae, Freddie Mac, AIG,
Citigroup, and many others. In a depression, unless the U.S.
government ceases to assume responsibility for these liabilities,
the credit and credibility of the U.S. government can be damaged
far more…

Part VII

The "Too-Big-Too-Fail" Doctrine Has Failed

Over the past two years, the too-big-to-fail doctrine
has had a track record that is both big and bad.

Mid-year 2007. Major banks in the U.S. and Europe
announced multibillion losses in subprime mortgages, investors
recoiled in horror, and many feared the world"s financial markets
would collapse. They didn"t – but only because the U.S. Federal
Reserve and European central banks intervened. The authorities
injected unprecedented amounts of cash into the world"s largest
banks; the credit crunch subsided, and market participants
breathed a great sigh of relief. But it was a pyrrhic
victory.

Early 2008. The crunch struck anew, this time in a more
virulent and violent form, impacting a much wider range of
players. The nation"s largest mortgage insurers, responsible for
protecting lenders and investors from mortgage defaults on
millions of homes, were ravaged by losses. Municipal governments
and public hospitals were shocked by the failure of nearly 1,000
auctions for their bonds, causing their borrowing costs to triple
and quadruple. Many low-rated corporate bonds were abandoned by
investors, their prices plunging to the lowest levels in history.
Hedge funds were hurt badly, with one fund, CSO Partners, losing
so much money and suffering such a massive run on its assets that
its manager, Citigroup, was forced to shut it down. And above
all, major financial firms, at the epicenter of the crisis, were
hit with losses that would soon exceed $ 500 billion.

March 2008: The question asked on Wall Street was no
longer "Which big firm will post the worst losses?" It was "Which
big firm will be the first to go bankrupt?" The answer: Bear
Stearns, one of the largest investment banks in the world. Again,
the Federal Reserve intervened. Not only did they finance a giant
buyout for Bear Stearns, but, for the first time in history, they
also began lending hundreds of billions to any other primary
broker-dealer that needed the money. Again, the crisis subsided
temporarily. Again, Wall Street cheered, and the authorities won
their battle. But the war continued.

Fall 2008. Despite the Fed"s special lending operations,
another Wall Street firm — almost three times larger than
Bear Stearns – was going down: Lehman Brothers. For the Fed
chairman and Treasury secretary, it was the long-dreaded day of
reckoning, the fateful moment in history that demanded a
life-or-death decision regarding one of the biggest financial
institutions in the world – bigger than General Motors, Ford, and
Chrysler put together. Should they save it? Or should they let it
fail? They let Lehman fail, and the response of global markets
was immediate. Bank lending froze. Interbank borrowing costs
surged. Global stock markets collapsed. Corporate bonds tanked.
The entire global banking system seemed like it was coming
unglued.

"I guess we made a mistake!" were, in essence, the words
of admission heard at the Fed and Treasury. "Now, instead of just
a bailout for Lehman, what we"re really going to need is the
Mother of All Bailouts -for the entire financial system". The
U.S. government promptly complied, delivering precisely what was
asked- the $ 700-billion Troubled Asset Relief Program (TARP),
rushed through Congress and signed into law by the president in
record time.

Early 2009. To counter "continuing substantial strains
in many financial markets," the Fed announced the extension
through October 30, 2009, of its existing liquidity programs that
were scheduled to expire on April 30, 2009. The Board of
Governors approved the extension through October 30 of the
Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity
Facility (AMLF), the Commercial Paper Funding Facility (CPFF),
the Money Market Investor Funding Facility (MMIFF), the Primary
Dealer Credit Facility (PDCF), and the Term Securities Lending
Facility (TSLF).

Latest "too-big-to-fail" tally. In addition to TARP, the
U.S. government has loaned, invested, or committed $ 400 billion
to nationalize the world"s two largest mortgage companies, Fannie
Mae and Freddie Mac; over $ 42 billion for the Big Three auto
manufacturers; $ 29 billion for Bear Stearns, $ 185 billion for
AIG, and $ 350 billion for Citigroup; $300 billion for the
Federal Housing Administration Rescue Bill to refinance bad
mortgages; $ 87 billion to pay back JPMorgan Chase for bad Lehman
Brothers trades; $ 200 billion in loans to banks under the
Federal Reserve"s Term Auction Facility (TAF); $ 50 billion to
support short-term corporate IOUs held by money market mutual
funds; $500 billion to rescue various credit markets; $ 620
billion for industrial nations, including the Bank of Canada, Bank of
England, Bank of Japan, National Bank of Denmark, European
Central Bank, Bank of Norway, Reserve Bank of Australia, Bank of
Sweden, and Swiss National Bank; $ 120 billion in aid for
emerging markets, including the central banks of Brazil, Mexico,
South Korea, and Singapore; trillions to guarantee the FDIC"s
new, expanded bank deposit insurance coverage from $ 100,000 to $
250,000; plus trillions more for other sweeping
guarantees.

The grand total of U.S. public funds spent, lent,
committed or guaranteed to date: An astronomical $ 11.6 trillion,
and counting…

By any measure, under any academic discipline, or any
political philosophy, clearly, the too-big-to-fail doctrine has
surpassed the threshold of the absurd. Former Treasury Secretary
and Secretary of State Baker James Baker recently put it this
way:

"Our ad hoc approach to the banking crisis has helped
financial institutions conceal losses, favored shareholders over
taxpayers, and protected senior bank managers from the
consequences of their mistakes. Worst of all, it has crippled our
credit system just at a time when the US and the world need to
see it healthy.

"Many are to blame for the current situation. But we
have no time for finger-pointing or partisan posturing. This
crisis demands a pragmatic, comprehensive plan. We simply cannot
continue to muddle through it with a Band-Aid
approach.

"During the 1990s, American officials routinely urged
their Japanese counterparts to kill their zombie banks before
they could do more damage to Japan"s economy. Today, it would be
irresponsible if we did not heed our own advice".