The true cost of America's bail-outs

Over the last eight years, we have watched in horror as a two-term Republican administration furthered programmes that have effectively thrown lit sticks of dynamite into our American factories. These programmes have dismantled entire industries in the United States and encouraged their growth in China and elsewhere in Asia because of cheap labour. Also, during this time the illusion of prosperity was maintained by a Greenspan Fed as interest rates were cut to record lows, and a disastrous housing bubble was created. Americans were so seduced by home ownership that they bought houses in a frenzy that they couldn't afford, and then borrowed against them. In addition, under the administration's policies, the value of the dollar has been trashed, and commodity inflation has robbed workers lucky enough to still have jobs.

As the unprecedented credit crisis continues into its second year, it's becoming crystal clear that the American economy is slipping into the worst post-WWII recession on record. It's even beginning to dawn on third- and fourth-generation Wall Street Republicans that if the average American doesn't have a good job (much less any job), they won't be able to pay their mortgage, auto loan or credit card.

For now, Fannie Mae and Freddie Mac have been essentially nationalised and the Federal Reserve has been turned into a dumping ground for toxic-waste mortgage securities beginning with the Bear Stearns bail-out.

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What is this economic disaster going to cost the taxpayer? Let's try to add it up.

The Federal Reserve

The Fed swapped out Treasuries for tens of billions in mortgage securities it now holds on its books. It's highly likely that these securities will not hold their value. Of course, Bear Stearns was just the first major financial institution failure requiring a bail-out, but there will be more. Let's say the Fed gets stiffed for $10bn, a modest sum. That translates into $10bn less in profits for the Fed to send the US Treasury, and $10bn more for the taxpayer to pay.

Student Loans

With the capital market seizing up, if you need a loan to go to college or graduate school, the federal government has already become the lender of last resort. We estimate that several hundred billion dollars of student loans are outstanding, and the average debt per student is $20,000. Education is in the national interest and very important, but with unemployment rising and jobs for new and old graduates vanishing, many student loans simply cannot be paid back at this time. One day the old loans may get paid, but for the next few years new loans will not be funded by repaying old loans. These loans will have to be funded directly by the US government borrowing the money. Conservatively, put the cost down at $20bn.

Pension Benefit Guarantee Corporation

This government agency insures $2.5 trillion in defined benefit obligations. The PBGC covers 30,000 business plans and 44 million workers. The PBGC charges an insurance fee and has $55bn in assets. Unfortunately, the Bush administration wanted to give the stock market a boost and forced the PBGC to move from mostly safe bonds into 45% equity holdings, a move that occurred just before the stock market really headed down. The PBGC is already $14bn underfunded, and that's before the recession smashes the stock value of their portfolio. Many US businesses will continue to fail, taking down with them thousands of insured but underfunded pension plans. When Wall Street gets bailed out, don't you think Congress will bail out workers' pensions? Let's put the cost to the taxpayer at a conservative $30bn.

Federal Housing Administration

Cynics thought that the FHA was a way to give the poor a house to live in that they didn't have to pay for. Well, it looks like the cynics were right! The FHA has given insured single-family mortgages to about five million people and 17% (or one in six) are delinquent. These catastrophic losses represent the worst of 'cash for trash' lending that is crushing financial institutions in subprime. It also means that the taxpayer is paying for about one million people in the FHA programme to live rent free! Even with some of the loans swapped into Fannie & Freddie, now that those entities are backed by the taxpayer, you can't avoid the cost. Conservative cost is $20bn.

Small Business Administration

Who can vote against socialism for small business? In the last few years, private credit was so easy to obtain that anyone who could sign their name to a piece of paper could get a loan from a bank or finance company. It's actually astounding that the SBA could continue to find borrowers that had been turned down by the private sector. At the end on 2007, the balance of these SBA loans totaled $235bn, with cumulative losses of about 6%. But don't let history of only 6% losses fool you. As the economy turns down, many of the businesses with SBA loans will fail. For now, let's put this bill at a $20bn loss.

Federal Home Loan Banks

The FHLB's balance sheet is about the size of another Fannie Mae or Freddie Mac. The 12 banks of the FHL Bank system are owned by over 8,000 financial institutions and provide low-cost funding for home mortgage loans and small business. These are the loans that don't qualify for Fannie or Freddie lending programmes, which means they're really bad.

The FHLB has over $1 trillion in assets, but what are these assets really worth? Well, a lot of mortgages that went into the collateral are Alt-A loans (interest only, no income verification, principal deferred). Alt-A loans are already tracking a 12% delinquency. Some of the big name borrowers from the FHLB are Countrywide, WaMu, Downey, and other banks headed into FDIC receivership. With only 4% capital, the FHLB can be crushed by losses. The real challenge, though, will be between the FHLB and FDIC as they fight to determine who gets stuck with the losses when the banks, thrifts, and credit unions fail. Either way, we'll foot the bill. Let's put this one down for $50bn, which is only 5% of the assets of the FHLB.

Federal Deposit Insurance Corporation

The FDIC and Controller of the Currency are directly inside the US Treasury. The FDIC has already started mopping up bad banks and merging their deposit-gathering branches into the surviving banks. It's estimated that just the IndyMac failure alone will cost the FDIC at least $5bn (or 10% of its loss reserves of about $50bn). Even if a large portion of the bad single-family mortgage debt can be pushed back into the FHLB or over to Fannie & Freddie, total losses on construction, commercial properties and consumer loans will easily cost the FDIC, and therefore the US taxpayer, $100bn.

What's really scary is that the head of the FDIC has told IndyMac not to foreclose on delinquent homeowners until the loans are 300 days past due. If the government encourages people not to pay their mortgages and live rent free at our expense, we'll need to increase the expected FDIC bill to the American taxpayer to $150bn.

Fannie Mae and Freddie Mac

In 2007, there were over two million notices of foreclosure in the United States, and in 2008, foreclosures could reach three million. Fannie & Freddie account for 44% of the foreclosed loans! So, should it be any surprise that these two giants (that hold or insure over $5 trillion in mortgage loans) just announced they also will not even think of foreclosing on anyone for at least 300 days! Does the federal government really believe that by not foreclosing, the losses will be minimised?

Meanwhile, the new law pushed through by the US Treasury guarantees the debt of Fannie & Freddie. Fannie & Freddie each have about $1 trillion on their balance sheets, and they also insure about $3 trillion in GSE agency securities that pass-through mortgage interest and principal on a pool basis to owners of the securities. The new law puts an explicit government guarantee behind the GSE debt, including every pass-through security. This means all mortgage payments must be made on time to investors, even if any mortgages in the past-through security are delinquent.

With a record number of homeowners considering whether to live free for 300 days by skipping their mortgage payments, imagine the cash gap that will open up between the cash that comes into Fannie & Freddie from mortgage payments, and the cash that must go out to cover the GSE security payments. For the government, it is more important to spread the losses into the future than to minimize them. Losses on defaulted mortgage loans at the GSEs will be horrible. Put the bailout cost at $300bn.

Let's tally it up:

The financial institution bail-outs and the government taxpayer bail-outs are looking more like socialism every day. I suspect that when we look back at this time in history four years from now, and marvel at the great increase in government ownership and socialism embedded in the economy, we will have the Bush administration to thank for sending us down the road to economic serfdom.

Written by Richard Benson and published in Benson's Economic and Market Trends