Although results for the quarter showed some improvement, overall performance of the industry remained uneven. Troubled assets at thrifts accounted for 3.52% of the industry's assets, up from 3.35% in the previous quarter. However, total value of troubled assets fell to $38.6 billion from $41 billion in the earlier quarter.

"Problem thrifts" on the agency's list are those which have significantly low capital reserves and other deficiencies. Their number rose to 40 from 31 sequentially and from 17 in the year-ago quarter.

According to the Office of Thrift Supervision (OTS), the uneven financial picture reflects the nation's weak job market and a generally depressed economic environment. Thrifts continued to set aside large amounts of money to protect against deteriorating loans. Though loan loss provisions declined slightly to $4.7 billion during the second quarter, it was the sixth-highest on record. We expect provisions to remain elevated until the housing and job markets stabilize.

New mortgage loans by thrifts fell sharply to $70.5 billion from $96.1 billion in the prior quarter and $128.3 billion in the prior-year period.

Thrifts are required to have at least 65% of their loans as mortgages and other consumer loans, which makes them particularly vulnerable to the housing downturn. But banks have no such compulsion. However, the banking industry is likely to face further special assessments as more institutions fail during the recession.

The OTS supervised 794 thrifts as well as 459 holding company enterprises at the end of the quarter. The agency said that three thrifts had failed during the second quarter.

A total of 81 federally insured banks have failed so far this year. This includes several large thrifts. The failure of Seattle-based Washington Mutual Inc. last year was the biggest US bank failure ever. Washington Mutual, that involved thrifts, was acquired by JPMorgan Chase & Co. (JPM).

Among the others, recently, Guaranty Bank failed and was sold to BBVA Compass, the US arm of Spain’s second-largest bank Banco Bilbao Vizcaya Argentaria (BBV). The banking operations of Colonial were sold to BB&T Corp. (BBT).

Chicago, IL – August 25, 2009 – Zacks Equity Research highlights Transcept Pharmaceuticals (TSPT) as the Bull of the Day and Nabors Industries (NBR) the Bear of the Day. In addition, Zacks Equity Research provides analysis on Guaranty Financial Group Inc. (GFG), Banco Bilbao Vizcaya Argentaria (BBVA) and BB&T Corporation (BBT).

Full analysis of all these stocks is available at http://at.zacks.com/?id=2676

Here is a synopsis of all five stocks:

Bull of the Day:

We recently initiated coverage of Transcept Pharmaceuticals (TSPT) with an Outperform rating and $12 price target. We think Intermezzo is a product that can fill a much needed void for insomnia patients with chronic nocturnal awakenings.

An FDA decision on the pending new drug application is expected in late October 2009. We think approval is a high likelihood event at that time.

With the commercialization partner signed and the financial position solid (estimated $95 million on hand), the stock is significantly under-valued, in our view.

Bear of the Day:

Nabors Industries (NBR) second-quarter earnings of 32 cents per share topped the Zacks Consensus Estimate of 28 cents, buoyed by stronger margins associated with new rig deployments in its international operations and solid performance from the Alaska sub-segment.

However, results were significantly below year-earlier levels, reflecting a sustained slowdown in North American activity levels. We remain concerned about the North American land drilling scene and its impact on Nabors, the largest onshore driller.

This, coupled with the company's relatively weak balance sheet in an environment of continued credit market turmoil, accounts for our Underperform recommendation.

Latest Posts on the Zacks Analyst Blog:

2nd Largest Bank Failure in ‘09

U.S. regulators on Friday shuttered more four banks, including Guaranty. The shutdown of Guaranty, a unit of Guaranty Financial Group Inc. (GFG), is the second-largest U.S. bank failure this year after Colonial, and the 10th-largest in U.S. history. This takes the total number of failed federally insured banks this year to 81, compared to 25 in 2008 and 3 in 2007.

Texas-based lender Guaranty had assets of about $13 billion and deposits of $12 billion. Souring losses on loans to homebuilders and mortgage-backed securities were the primary reasons which caused Guaranty to fail. GFG affirmed last Monday in a regulatory filing that the company was critically short of capital and didn't believe it could stay in business. Finally, Guaranty joined the list of the 12 biggest U.S. bank failures of all time.

Guaranty had been trying to raise fresh capital with the help of the Federal Deposit Insurance Corporation (FDIC) and the Office of Thrift Supervision, but the souring losses have muddied its plans.

The three other banks were ebank, with $143 million in assets and $130 million in deposits; First Coweta, with $167 million in assets and $155 million in deposits; and CapitalSouth Bank, with $617 million in assets and $546 million in deposits.

Failure of these banks represents another sizable hit to the FDIC’s fund for protecting customer accounts, as the FDIC has been appointed receiver of these banks. Guaranty alone is expected to cost the deposit insurance fund about $3 billion. Cost to the insurance fund is expected to be about $63 million for ebank, $48 million for First Coweta and $151 million for CapitalSouth.

In the first quarter of 2009, the number of banks on the FDIC's list of problem institutions jumped to 305. This is the highest number since the savings and loan crisis in 1994. The FDIC anticipates U.S. bank failures to cost $70 billion through 2013.

The FDIC sold all of Guaranty’s deposits and $12 billion of the assets to BBVA Compass. BBVA Compass is the U.S. division of Spain's second-largest bank Banco Bilbao Vizcaya Argentaria (BBVA). The FDIC will share losses on Guaranty’s $11 billion assets with BBVA. The acquisition allows BBVA to expand its operation in the U.S. market. The acquisition was desirable for BBVA as it tries to extend its reach into the Spanish-speaking market of the U.S.

BBVA Compass has 600 branches from Florida to California. The takeover of Guaranty Bank, with 162 branches in Texas and California, will create the 15th-largest commercial bank in the U.S. with about $49 billion in deposits.

Earlier this month, Colonial BancGroup was seized by the FDIC. It is the biggest bank failure so far this year, and the sixth-largest in U.S. history. Colonial’s $20 billion in deposits, 346 branches and about $22 billion of assets were sold to BB&T Corporation (BBT). Guaranty was about half the size of Colonial Bank.

Get the full analysis of all these stocks by going to http://at.zacks.com/?id=5507.

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The administration has focused on five key areas for reform, which we have highlighted below along with the important actions proposed in those areas:

1) Promoting Robust Supervision and Regulation

• Raising capital and liquidity requirements
• Supervision by the Fed for all "too big to fail" firms
• Establishing a council of regulators for better coordination
• New National Supervisor to supervise all federally chartered banks
• Registration of hedge funds with the SEC
• Enhanced oversight of insurers

• Enhanced regulation of securitization markets
• Stronger regulation of credit-rating agencies
• Regulation of all OTC derivatives
• Payment & Settlement systems to be overseen by the Fed

• Establishing a new Consumer Financial Protection Agency

• Resolution mechanism for the orderly resolution of "too big to fail" financial companies
• Improving  accountability of Fed's emergency lending powers

The plan greatly extends the supervisory powers of the Federal Reserve as it would become a consolidated supervisor over all large financial institutions such as Goldman Sachs (GS), JP Morgan Chase (JPM), AIG (AIG), etc., whose problems pose potential risks to the economic system. However, the Fed would be required to receive approval from the Treasury for emergency lending under "unusual and exigent" circumstances.

The proposal will most likely be debated strongly as many critics of the Fed argue that its loose monetary policy and failure to exercise the existing powers over banks ultimately led to the current crisis.

In order to fill in regulatory gaps and coordinate with the various agencies, the plan would create a council of regulators headed by the Treasury Secretary.

The plan also requires all hedge funds and private equity funds to register with the SEC and open their books to regulators.

Some of the existing regulatory agencies' powers to oversee mortgages, credit cards and other kinds of consumer debt are proposed to be given to a new regulator, called the Consumer Financial Protection Agency.

The Office of Thrift Supervision will be merged into the Office of the Comptroller of the Currency, to create a single agency to supervise all banks with national charters.

The plan would impose tighter rules for securitization. It would also require the companies that issue mortgages to retain at least 5% of them on their books to discourage companies from marketing unsuitable loans.

The proposal also mentions that Treasury will work with other agencies to determine the future role of GSEs, Fannie Mae (FNM) and Freddie Mac (FRE) and a report will be presented at the time of 2011 budget release.

The administration has focused on five key areas for reform, which we have highlighted below along with the important actions proposed in those areas:

1) Promoting Robust Supervision and Regulation

• Raising capital and liquidity requirements
• Supervision by the Fed for all "too big to fail" firms
• Establishing a council of regulators for better coordination
• New National Supervisor to supervise all federally chartered banks
• Registration of hedge funds with the SEC
• Enhanced oversight of insurers

• Enhanced regulation of securitization markets
• Stronger regulation of credit-rating agencies
• Regulation of all OTC derivatives
• Payment & Settlement systems to be overseen by the Fed

• Establishing a new Consumer Financial Protection Agency

• Resolution mechanism for the orderly resolution of "too big to fail" financial companies
• Improving  accountability of Fed's emergency lending powers

The plan greatly extends the supervisory powers of the Federal Reserve as it would become a consolidated supervisor over all large financial institutions such as Goldman Sachs (GS), JP Morgan Chase (JPM), AIG (AIG), etc., whose problems pose potential risks to the economic system. However, the Fed would be required to receive approval from the Treasury for emergency lending under "unusual and exigent" circumstances.

The proposal will most likely be debated strongly as many critics of the Fed argue that its loose monetary policy and failure to exercise the existing powers over banks ultimately led to the current crisis.

In order to fill in regulatory gaps and coordinate with the various agencies, the plan would create a council of regulators headed by the Treasury Secretary.

The plan also requires all hedge funds and private equity funds to register with the SEC and open their books to regulators.

Some of the existing regulatory agencies' powers to oversee mortgages, credit cards and other kinds of consumer debt are proposed to be given to a new regulator, called the Consumer Financial Protection Agency.

The Office of Thrift Supervision will be merged into the Office of the Comptroller of the Currency, to create a single agency to supervise all banks with national charters.

The plan would impose tighter rules for securitization. It would also require the companies that issue mortgages to retain at least 5% of them on their books to discourage companies from marketing unsuitable loans.

The proposal also mentions that Treasury will work with other agencies to determine the future role of GSEs, Fannie Mae (FNM) and Freddie Mac (FRE) and a report will be presented at the time of 2011 budget release.

"Looking forward, I believe a more macroprudential approach to supervision--one that supplements the supervision of individual institutions to address risks to the financial system as a whole--could help to enhance overall financial stability. Our regulatory system must include the capacity to monitor, assess, and, if necessary, address potential systemic risks within the financial system. Elements of a macroprudential agenda include:   

• "monitoring large or rapidly increasing exposures--such as to subprime mortgages--across firms and markets, rather than only at the level of individual firms or sectors;"

• "assessing the potential systemic risks implied by evolving risk-management practices, broad-based increases in financial leverage, or changes in financial markets or products;"

• "assessing the potential systemic risks implied by evolving risk-management practices, broad-based increases in financial leverage, or changes in financial markets or products;"

• "ensuring that each systemically important firm receives oversight commensurate with the risks that its failure would pose to the financial system;"

The solution to that is to make sure that no bank gets big enough to pose such a risk. It is time to break them up, both by function (i.e. reimpose a modern equivalent of Glass-Steagall) and perhaps by region. Ten mini Citigroups (C) would each would not pose an overall risk to the system if one of them were to fail.

Of course you would want to keep an eye on them, just as the military keeps an eye on its 1,000 lb conventional bombs. However, the consequences of one of those going missing is much less profound than a missing nuke warhead.

Unfortunately, in the largely ad-hoc response to the crisis, we have been moving in exactly the wrong direction. JP Morgan (JPM) swallows up Bear Stearns and Washington Mutual, Wells Fargo (WFC) takes over Wachovia, and Bank of America (BAC) now owns Countrywide and Merrill Lynch. All of them were too big to fail before this started, and now they are way too big to fail. Either we regulate them extremely closely -- to the point where they will be complaining that every credit card being issued has to be first cleared with the Federal Reserve Board of N.Y. (OK, I'm exaggerating for effect here) -- or we break them up.   

• "providing a resolution mechanism to safely wind down failing, systemically important institutions;"

Without being in bankruptcy, we had to honor the CDS contracts at 100 cents on the dollar. The result was a huge backdoor handout to the banks (a much bigger scandal than the bonuses, IMHO). This would have provided an intermediate step where the new 80% owners of AIG (aka the taxpayers) could have just returned the premiums on the CDS's and rewritten the bonus contracts when we came in.

We can do this with smaller banks, but not with big bank holding companies or huge non-bank financial firms. We need this, and we need it right away.   

• "ensuring that the critical financial infrastructure, including the institutions that support trading, payments, clearing, and settlement, is robust;"

• "working to mitigate procyclical features of capital regulation and other rules and standards;"

However, somehow I suspect that as soon as good times come back, the banks will flex all their political influence (they have a lot, as Sen. Durbin (D-Il) said of the bankers and the Senate, "they own this place") so the cushion is never built up in the good times. After all requiring more equity will result in a lower ROE, and that might result in bonuses that are only in the seven figures rather than in the eight figures. The horror, the horror!   

• "and identifying possible regulatory gaps, including gaps in the protection of consumers and investors, that pose risks for the system as a whole."

The OTS actively went looking for more institutions to fall under its supervision, and its key marketing policy was that it would be the most toothless and ineffective of regulators. It was the most gung-ho on deregulation, and many of the biggest failures were firms that it was the primary regulator for, including Washington Mutual, Indymac and of course AIG.

We have to find ways to stop shopping around for your regulator and regulatory capture. The Fed would be a very good place to start. It is not comforting that the head of the New York Fed comes from Goldman, and still holds over ten figures worth of Goldman stock when he is now the primary regulator of the firm. That is more than just an appearance of a conflict of interest.

The board of directors of each of the regional Federal Reserve Banks are all made up of bankers. That is because the Federal Reserve is not owned by the government, rather it is owned (literally, not just figuratively) by the banks. Perhaps it is time we reconsider that arrangement. 

The speech is a good start, but it does not go far enough. We need to return to the principals that were behind the financial regulatory reforms of the 1930's. The three-legged stool of good solid accurate information, including of potential conflicts of interest (the SEC), making it safe to keep your money in the bank (the FDIC) and making sure the bank does not take your money and use it to play the tables in Vegas (Glass-Steagall). The precise form will be different than the old regulations, but the new order should embody the same spirit.

Candidate Explanations

In particular, when one examines the mixture of policies and events that have led us to the brink of possibly the deepest and most persistent downturn since the Great Depression, one can see several suspects listed.

• Fannie and Freddie
• Community Reinvestment Act
• CDO's and CDS's
• Global saving glut
• Monetary policy
• Deregulation
• Criminal activity and regulatory disarmament
• Tax cuts and fiscal profligacy
• Tax policy

Red Herrings

I've already dealt with the first two "betes noire" -- favorite villains in the fevered commentary of certain noneconomists -- in this post, so we can dispense with these as key drivers (Jim attributes some blame, here, although I don't think he attributes central blame here either). I don't think CDO's and CDS's in and of themselves caused the crisis, although they certainly obscured the primary problem of overleveraging (CDO's) and lack of transparency (CDS's). And the saving glut -- well, the saving glut was a worldwide phenomenon, but I think it safe to say the countries that did and didn't borrow from the Chinese have suffered in the current crisis (here is my critique from 2005; CFR report [pdf]).

Synergy

So what I want to think about is the toxic mixture of the last five items, which interacted in a synergistic manner to place us in the situation we are now in.

First, monetary policy. While there seems to be a widespread consensus that it was too lax in 2002-04, this is a viewpoint made with the benefit of hindsight. As Orphanides and Wieland (2007) [pdf] have pointed out, according to the Greenbook forecasts, monetary policy was not -- according to a Taylor rule framework -- overly lax.

Second, deregulation. On this front, I think it's important to not indict all deregulation (eliminating the Glass-Steagall barriers makes sense to me, while the Phil Gramm-sponsored Commodity Futures Modernization Act exemption of regulation of CDS's does not). I outline some empirical research on what factors were important in this crisis in this post.

Third, regulatory disarmament/nonenforcement and "criminal activity". I would have discounted this item in the absence of clear evidence, but now that we know about how the OTS "helped out" IndyMac [2] [3], I think we can be reasonably confident that we'll hear a lot more about how deregulatory zeal [4] [5] metastatized over into criminal activities on the part of regulators and the regulated.

Fourth, fiscal profligacy via tax cuts. I think it's important to focus on profligacy (because it pushed the economy more into a boom exactly at a time when not needed) and on tax cuts (because it made people feel like they had more discretionary income than reasonable), thereby pushing the asset boom.

Fifth, tax policy. In particular, I have been thinking about the tax deductibility on second homes, a provision dating back to 1997 [6] [7] [8]. (I've been thinking about this in part because mortgage deductibility on a second home never made sense to me, let alone on a first home). Capital Games and Gains has pointed out this provision, citing a NYT article. But even this last article doesn't locate primary blame here; rather it's cited as a contributing factor. I suspect that on its own, this provision wouldn't had a big impact, but in combination, it might have. My caveat here is that I haven't found much empirical work backing a big role for this factor.

Typically, in my academic work, I would think of these factors adding up in a linear fashion, so that each of the impulses would sum to the total effect. But (departing from a model, and with no econometric work to back up the hypothesis interactive effects), I think it's worthwhile to think about lax monetary policy, deregulatory zeal and criminal activity/regulatory disarmament, and tax cuts and tax policy changes, all combining to lead to the "bubble" (in a nontechnical sense) we've witnessed, the deflation of which has been associated with the ongoing financial crisis.

Consider one example of a pernicious synergy: the 2001 and 2003 tax cuts were aimed at higher income households, while the second home mortgage deductibility benefited mostly higher income households [7]; with regulatory oversight absent, and low interest rates, well the stage was set.

Prescient, or Not

To sum up, I won't claim to have foreseen the full enormity of the crisis we're now undergoing. As I indicated when I posted my first blogpost some three years ago, I thought the sheer irresponsibility of the fiscal policy being pursued, against a backdrop of overconfidence in largely nontraded derivatives, would lead to grief in the form of a "sudden stop" of net capital flows to the US. In this respect, I was wrong -- what we've achieved instead is a sort of "global sudden stop" where the process of deleveraging proceeded in a discrete (and "disorderly") fashion. So, unlike some, I was only partially -- not completely -- blindsided. (And, I'm sure Akerlof and Romer were completely aware of what was coming...)

I believe history will look critically on the Bush Administration's economic stewardship, in particular how the policies propelled an unsustainable bubble, and tied our hands in the use of fiscal policy tools. In sum, I think Kevin (Dow 36,000) Hassett's view "Bush's Legacy May End Up Better Than You Think" will not prove true.

Technorati Tags: financial crisis, recession, subprime, regulation, Bush Administration, Office of Thrift Supervision, Fannie Mae, and Freddie Mac.

First, what is the source of the crisis? Is it as is asserted here in this statement from John McCain today?

....

There are certainly plenty of places to point fingers, and it may be hard to pinpoint the original event that set it all in motion. But let me give you an educated guess. The financial crisis we're living through today started with the corruption and manipulation of our home mortgage system. At the center of the problem were the lobbyists, politicians, and bureaucrats who succeeded in persuading Congress and the administration to ignore the festering problems at Fannie Mae and Freddie Mac.

These quasi-public corporations lead our housing system down a path where quick profit was placed before sound finance. They institutionalized a system that rewarded forcing mortgages on people who couldn't afford them, while turning around and selling those bad mortgages to the banks that are now going bankrupt. Using money and influence, they prevented reforms that would have curbed their power and limited their ability to damage our economy. And now, as ever, the American taxpayers are left to pay the price for Washington's failure.

...

I certainly concur with the first sentence. But I do wonder about the assertion that the problem started with and is fundamentally driven by Fannie Mae and Freddie Mac. After all, neither of these two institutions were at the heart of the massive surge in subprime mortgages that are the most toxic component of these asset backed securities. Smarter people than me (Justin Fox, Tanta at CR h/t Mark Thoma) have been similarly dubious.

Moreover, the originating entities for these subprime mortgages were not Fannie Mae and Freddie Mac, by large, but rather the banks that the Federal government refused to let state agencies regulate. Or the ones the Treasury's OTS itself failed to regulate. To refresh memories, consider this article from December 18, 2007 NYT:

WASHINGTON-- Until the boom in subprime mortgages turned into a national nightmare this summer, the few people who tried to warn federal banking officials might as well have been talking to themselves.

Edward M. Gramlich, a Federal Reserve governor who died in September, warned nearly seven years ago that a fast-growing new breed of lenders was luring many people into risky mortgages they could not afford.

But when Mr. Gramlich privately urged Fed examiners to investigate mortgage lenders affiliated with national banks, he was rebuffed by Alan Greenspan, the Fed chairman.

In 2001, a senior Treasury official, Sheila C. Bair, tried to persuade subprime lenders to adopt a code of "best practices" and to let outside monitors verify their compliance. None of the lenders would agree to the monitors, and many rejected the code itself. Even those who did adopt those practices, Ms. Bair recalled recently, soon let them slip.

And leaders of a housing advocacy group in California, meeting with Mr. Greenspan in 2004, warned that deception was increasing and unscrupulous practices were spreading.

John C. Gamboa and Robert L. Gnaizda of the Greenlining Institute implored Mr. Greenspan to use his bully pulpit and press for a voluntary code of conduct.

"He never gave us a good reason, but he didn't want to do it," Mr. Gnaizda said last week. "He just wasn't interested."

Today, as the mortgage crisis of 2007 worsens and threatens to tip the economy into a recession, many are asking: where was Washington?

An examination of regulatory decisions shows that the Federal Reserve and other agencies waited until it was too late before trying to tame the industry's excesses. Both the Fed and the Bush administration placed a higher priority on promoting "financial innovation" and what President Bush has called the "ownership society."

...

On Tuesday, under a new chairman, the Federal Reserve will try to make up for lost ground by proposing new restrictions on subprime mortgages, invoking its authority under the 13-year-old Home Ownership Equity and Protection Act. Fed officials are expected to demand that lenders document a person’s income and ability to repay the loan, and they may well restrict practices that make it hard for borrowers to see hidden fees or refinance with cheaper mortgages.

It is an action that people like Mr. Gramlich and Ms. Bair advocated for years with little success. But it will have little impact on many existing subprime lenders, because most have either gone out of business or stopped making subprime loans months ago.

...

The Fed was hardly alone in not pressing to clean up the mortgage industry. When states like Georgia and North Carolina started to pass tougher laws against abusive lending practices, the Office of the Comptroller of the Currency successfully prohibited them from investigating local subsidiaries of nationally chartered banks.

Virtually every federal bank regulator was loathe to impose speed limits on a booming industry. But the regulators were also fragmented among an alphabet soup of agencies with splintered and confusing jurisdictions. Perhaps the biggest complication was that many mortgage lenders did not fall under any agency's authority at all.

...

And for some more concrete examples of how deregulatory zeal had an effect, consider this account from the WSJ (March 22, 2007):

Regulators appointed by President Bush often have been more sympathetic to industry concerns about red tape than their Clinton administration predecessors. When James Gilleran, a former California banker and bank supervisor, took over the OTS in December 2001, he became known for his deregulatory zeal. At one press event in 2003, several bank regulators held gardening shears to represent their commitment to cut red tape for the industry. Mr. Gilleran brought a chain saw.

He also early on announced plans to slash expenses to resolve the agency's deficit; 20% of its work force eventually left. When he left in 2005, Mr. Gilleran declared that the OTS had "exercised increased diligence in its review of abusive consumer practices" while reducing thrifts' regulatory burden. But his successor, Mr. Reich, a former community banker, has reversed many of Mr. Gilleran's cuts. Citing "understaffing," he hired 80 examiners last year and plans to add 40 more this year. A spokeswoman for Mr. Gilleran, now chief executive of the Federal Home Loan Bank of Seattle, said he wasn't available to comment.

So, from my perspective, locating the source of the current crisis in corruption/influence peddling surrounding Fannie and Freddie exhibits a misreading of recent history. (More important might have been lax monetary policy and the saving glut, and exemptions from capital requirements for certain investment banks... [see Ritholtz])

Second, how hard will the rescue be given the reckless decisions of the past? It seems that whatever entity is established to purchase these bad assets will require some fiscal outlay. Estimates are all over the place, given that there is so much uncertainty over how much the assets will be bought for and eventually sold; here is one account:

U.S. Debt May Grow $1 Trillion on Rescue, Barclays' Pond Says

By Sandra Hernandez

Sept. 19 (Bloomberg) -- The U.S. may have to borrow an extra $700 billion to $1 trillion to fund the biggest rescue of the financial system since the Great Depression, according to Barclays Capital Inc.'s Michael Pond.

Federal takeovers of Fannie Mae, Freddie Mac, and American International Group Inc.; the central bank's expansion of lending to financial firms; and a slowing economy will add $455 billion to the Treasury's borrowing needs, the New York-based interest-rate strategist estimated. Pond said Treasury Secretary Henry Paulson's plan to rid banks of "hundreds of billions" of troubled assets would bring the amount to $700 billion assuming the plan costs $200 billion.

"We could easily add up to an additional trillion to the outstanding Treasury debt just from the initiatives announced over the past couple of weeks," said Pond, ranked the best Treasury Inflation-Protected Securities analyst in 2008 by Institutional Investor magazine.

The government's liabilities swelled in past weeks as policy makers sought to arrest a growing financial crisis by taking over financial institutions threatened by a shortage of capital.

The Treasury on Sept. 7 took over mortgage-finance companies Fannie Mae and Freddie Mac and said it would buy mortgage-backed debt in the open market. The Fed this week boosted its Treasury auctions to bond dealers by $25 billion, loaned $85 billion to the insurer AIG, and quadrupled the amount of dollars foreign central banks can auction to $247 billion. Paulson today said the government will buy illiquid assets from banks' balance sheets and insure money-market mutual fund holdings.

Deficit Widens

"The odds of the deficit becoming enormous are certainly there," said Nils Overdahl, a bond fund manager in Bethesda, Maryland, at New Century Advisors, which oversees $500 million. "I suspect you will see issuance at a variety of maturities."

The deficit will likely widen to $650 billion in fiscal 2009 because of the U.S. rescue of Fannie and Freddie, analysts at JPMorgan Chase & Co. wrote in a Sept. 12 report.

Over the next decade, the gap between spending and receipts will swell to $5.3 trillion, Goldman Sachs Group Inc. analysts wrote Sept. 10, revising a previous forecast of $3.6 trillion. The non-partisan Congressional Budget Office forecast a record $438 billion deficit for 2009 on Sept. 9.

"The deficit will soar to enormous proportions,'' said Lou Crandall, the chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. ``Even before this week's events, estimates based on visible factors were pointing to a deficit above $500 billion next year, with the prospect of billions of mortgage- backed securities on top of that."

See also this Bloomberg article.

Here, I want to return the issue I've brought up countless times before. We cut taxes, and we embarked upon a war of choice, and in addition to the opportunity and fiscal costs, this constrained our range of actions for the future. Even if you thought the Bush tax cuts of 2001 and 2003 "benefitted" the US economy on net, we know that the war in Iraq has cost on the order of $653 billion nominal dollars from FY03-FY0-09 [2] -- in current dollars that's even more given inflation. Those dollars could have been spent fixing the financial system. Now, we'll have to either borrow or tax to to finance the operation.

So, if you wanted the McCain extension of the Bush tax cuts, and the additional $1.3 trillion tax cuts, then you might wonder about the impact on US borrowing rates. If you were hoping for more domestic initiatives, perhaps to give tax relief to the lower and middle income households, or to invest in infrastructure, the borrowing constraints will be more binding than they otherwise would have been.

Perhaps that's obvious, but sometimes in the midst of crisis, the obvious bears repeating. Here's a picture to illustrate the budget balance outlook pre-intervention....

The purple square is just for illustrative purposes. If you think the Treasury will only have to borrow $350 billion in FY2009, then the orange square is relevant. Further, if we're lucky (and Brad Delong is right), in future years we will recoup all and more of these outlays, so the deficit will be smaller than otherwise. But, in the short run, we'll have to take a hit (of unknown magnitude) now and hope for the best.

Technorati Tags: , subprime, Fannie Mae, Freddie+Mac, and deregulation, Office of Thrift Supervision, and tax cuts.

First, what is the source of the crisis? Is it as is asserted here in this statement from John McCain today?

....

There are certainly plenty of places to point fingers, and it may be hard to pinpoint the original event that set it all in motion. But let me give you an educated guess. The financial crisis we're living through today started with the corruption and manipulation of our home mortgage system. At the center of the problem were the lobbyists, politicians, and bureaucrats who succeeded in persuading Congress and the administration to ignore the festering problems at Fannie Mae and Freddie Mac.

These quasi-public corporations lead our housing system down a path where quick profit was placed before sound finance. They institutionalized a system that rewarded forcing mortgages on people who couldn't afford them, while turning around and selling those bad mortgages to the banks that are now going bankrupt. Using money and influence, they prevented reforms that would have curbed their power and limited their ability to damage our economy. And now, as ever, the American taxpayers are left to pay the price for Washington's failure.

...

I certainly concur with the first sentence. But I do wonder about the assertion that the problem started with and is fundamentally driven by Fannie Mae and Freddie Mac. After all, neither of these two institutions were at the heart of the massive surge in subprime mortgages that are the most toxic component of these asset backed securities. Smarter people than me (Justin Fox, Tanta at CR h/t Mark Thoma) have been similarly dubious.

Moreover, the originating entities for these subprime mortgages were not Fannie Mae and Freddie Mac, by large, but rather the banks that the Federal government refused to let state agencies regulate. Or the ones the Treasury's OTS itself failed to regulate. To refresh memories, consider this article from December 18, 2007 NYT:

WASHINGTON-- Until the boom in subprime mortgages turned into a national nightmare this summer, the few people who tried to warn federal banking officials might as well have been talking to themselves.

Edward M. Gramlich, a Federal Reserve governor who died in September, warned nearly seven years ago that a fast-growing new breed of lenders was luring many people into risky mortgages they could not afford.

But when Mr. Gramlich privately urged Fed examiners to investigate mortgage lenders affiliated with national banks, he was rebuffed by Alan Greenspan, the Fed chairman.

In 2001, a senior Treasury official, Sheila C. Bair, tried to persuade subprime lenders to adopt a code of "best practices" and to let outside monitors verify their compliance. None of the lenders would agree to the monitors, and many rejected the code itself. Even those who did adopt those practices, Ms. Bair recalled recently, soon let them slip.

And leaders of a housing advocacy group in California, meeting with Mr. Greenspan in 2004, warned that deception was increasing and unscrupulous practices were spreading.

John C. Gamboa and Robert L. Gnaizda of the Greenlining Institute implored Mr. Greenspan to use his bully pulpit and press for a voluntary code of conduct.

"He never gave us a good reason, but he didn't want to do it," Mr. Gnaizda said last week. "He just wasn't interested."

Today, as the mortgage crisis of 2007 worsens and threatens to tip the economy into a recession, many are asking: where was Washington?

An examination of regulatory decisions shows that the Federal Reserve and other agencies waited until it was too late before trying to tame the industry's excesses. Both the Fed and the Bush administration placed a higher priority on promoting "financial innovation" and what President Bush has called the "ownership society."

...

On Tuesday, under a new chairman, the Federal Reserve will try to make up for lost ground by proposing new restrictions on subprime mortgages, invoking its authority under the 13-year-old Home Ownership Equity and Protection Act. Fed officials are expected to demand that lenders document a person’s income and ability to repay the loan, and they may well restrict practices that make it hard for borrowers to see hidden fees or refinance with cheaper mortgages.

It is an action that people like Mr. Gramlich and Ms. Bair advocated for years with little success. But it will have little impact on many existing subprime lenders, because most have either gone out of business or stopped making subprime loans months ago.

...

The Fed was hardly alone in not pressing to clean up the mortgage industry. When states like Georgia and North Carolina started to pass tougher laws against abusive lending practices, the Office of the Comptroller of the Currency successfully prohibited them from investigating local subsidiaries of nationally chartered banks.

Virtually every federal bank regulator was loathe to impose speed limits on a booming industry. But the regulators were also fragmented among an alphabet soup of agencies with splintered and confusing jurisdictions. Perhaps the biggest complication was that many mortgage lenders did not fall under any agency's authority at all.

...

And for some more concrete examples of how deregulatory zeal had an effect, consider this account from the WSJ (March 22, 2007):

Regulators appointed by President Bush often have been more sympathetic to industry concerns about red tape than their Clinton administration predecessors. When James Gilleran, a former California banker and bank supervisor, took over the OTS in December 2001, he became known for his deregulatory zeal. At one press event in 2003, several bank regulators held gardening shears to represent their commitment to cut red tape for the industry. Mr. Gilleran brought a chain saw.

He also early on announced plans to slash expenses to resolve the agency's deficit; 20% of its work force eventually left. When he left in 2005, Mr. Gilleran declared that the OTS had "exercised increased diligence in its review of abusive consumer practices" while reducing thrifts' regulatory burden. But his successor, Mr. Reich, a former community banker, has reversed many of Mr. Gilleran's cuts. Citing "understaffing," he hired 80 examiners last year and plans to add 40 more this year. A spokeswoman for Mr. Gilleran, now chief executive of the Federal Home Loan Bank of Seattle, said he wasn't available to comment.

So, from my perspective, locating the source of the current crisis in corruption/influence peddling surrounding Fannie and Freddie exhibits a misreading of recent history. (More important might have been lax monetary policy and the saving glut, and exemptions from capital requirements for certain investment banks... [see Ritholtz])

Second, how hard will the rescue be given the reckless decisions of the past? It seems that whatever entity is established to purchase these bad assets will require some fiscal outlay. Estimates are all over the place, given that there is so much uncertainty over how much the assets will be bought for and eventually sold; here is one account:

U.S. Debt May Grow $1 Trillion on Rescue, Barclays' Pond Says

By Sandra Hernandez

Sept. 19 (Bloomberg) -- The U.S. may have to borrow an extra $700 billion to $1 trillion to fund the biggest rescue of the financial system since the Great Depression, according to Barclays Capital Inc.'s Michael Pond.

Federal takeovers of Fannie Mae, Freddie Mac, and American International Group Inc.; the central bank's expansion of lending to financial firms; and a slowing economy will add $455 billion to the Treasury's borrowing needs, the New York-based interest-rate strategist estimated. Pond said Treasury Secretary Henry Paulson's plan to rid banks of "hundreds of billions" of troubled assets would bring the amount to $700 billion assuming the plan costs $200 billion.

"We could easily add up to an additional trillion to the outstanding Treasury debt just from the initiatives announced over the past couple of weeks," said Pond, ranked the best Treasury Inflation-Protected Securities analyst in 2008 by Institutional Investor magazine.

The government's liabilities swelled in past weeks as policy makers sought to arrest a growing financial crisis by taking over financial institutions threatened by a shortage of capital.

The Treasury on Sept. 7 took over mortgage-finance companies Fannie Mae and Freddie Mac and said it would buy mortgage-backed debt in the open market. The Fed this week boosted its Treasury auctions to bond dealers by $25 billion, loaned $85 billion to the insurer AIG, and quadrupled the amount of dollars foreign central banks can auction to $247 billion. Paulson today said the government will buy illiquid assets from banks' balance sheets and insure money-market mutual fund holdings.

Deficit Widens

"The odds of the deficit becoming enormous are certainly there," said Nils Overdahl, a bond fund manager in Bethesda, Maryland, at New Century Advisors, which oversees $500 million. "I suspect you will see issuance at a variety of maturities."

The deficit will likely widen to $650 billion in fiscal 2009 because of the U.S. rescue of Fannie and Freddie, analysts at JPMorgan Chase & Co. wrote in a Sept. 12 report.

Over the next decade, the gap between spending and receipts will swell to $5.3 trillion, Goldman Sachs Group Inc. analysts wrote Sept. 10, revising a previous forecast of $3.6 trillion. The non-partisan Congressional Budget Office forecast a record $438 billion deficit for 2009 on Sept. 9.

"The deficit will soar to enormous proportions,'' said Lou Crandall, the chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. ``Even before this week's events, estimates based on visible factors were pointing to a deficit above $500 billion next year, with the prospect of billions of mortgage- backed securities on top of that."

See also this Bloomberg article.

Here, I want to return the issue I've brought up countless times before. We cut taxes, and we embarked upon a war of choice, and in addition to the opportunity and fiscal costs, this constrained our range of actions for the future. Even if you thought the Bush tax cuts of 2001 and 2003 "benefitted" the US economy on net, we know that the war in Iraq has cost on the order of $653 billion nominal dollars from FY03-FY0-09 [2] -- in current dollars that's even more given inflation. Those dollars could have been spent fixing the financial system. Now, we'll have to either borrow or tax to to finance the operation.

So, if you wanted the McCain extension of the Bush tax cuts, and the additional $1.3 trillion tax cuts, then you might wonder about the impact on US borrowing rates. If you were hoping for more domestic initiatives, perhaps to give tax relief to the lower and middle income households, or to invest in infrastructure, the borrowing constraints will be more binding than they otherwise would have been.

Perhaps that's obvious, but sometimes in the midst of crisis, the obvious bears repeating. Here's a picture to illustrate the budget balance outlook pre-intervention....

The purple square is just for illustrative purposes. If you think the Treasury will only have to borrow $350 billion in FY2009, then the orange square is relevant. Further, if we're lucky (and Brad Delong is right), in future years we will recoup all and more of these outlays, so the deficit will be smaller than otherwise. But, in the short run, we'll have to take a hit (of unknown magnitude) now and hope for the best.

Technorati Tags: , subprime, Fannie Mae, Freddie+Mac, and deregulation, Office of Thrift Supervision, and tax cuts.

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