The bailout needs a bailout

The bailout needs a bailout... You can't handle the truth... The snake eats its tail... A $220 billion gift for Citi... Get two months of cash, now... Dan Ferris warned us... Subscribers with terrible math skills...

As you well know, the House surprised the markets by voting against the $700 billion bailout to the banks. And the FDIC and Citigroup are bailing out Wachovia. We'll examine both of these actions below, but first we pose a deeper question: Will these bailouts – assuming they can eventually be passed – work?

Can this crisis of too much debt and too much economic power concentrated in a handful of bankers and brokers be cured by creating still more debt and larger, more powerful banks?

By the end of the week, Citigroup, JPMorgan, and Bank of America will control more than 30% of the deposits in the United States. This is "The Club." The government cannot allow these institutions to fail. There is no bailout for their massive deposits. But rather than the strong buying the weak, it seems as though the weak are buying the weakest, courtesy of massive amounts of government money. Citigroup has written off $46 billion – the most of any financial institution in the world! Should it be buying Wachovia? Does that make any sense, fundamentally?

What we see happening is a collapse in credit, fueled by a lack of confidence. Two things backed the liquidity of the world's financial markets: residential real estate and government bonds. These assets served as the collateral for banks, insurance companies, mortgage lenders, credit default swaps (unregulated insurance contracts), hedge funds, and, of course, additional mortgage lending. Liquidity has disappeared because confidence in the value of residential real estate has collapsed. Nobody wants to buy real estate. Knowledgeable buyers know how much supply is coming on to the market. Everyone knows prices for houses are going to fall even farther. The feds can bail out as many institutions as they want, but it won't cause investors to buy real estate.

Meanwhile, flooding the world with dollars will undermine confidence in U.S. government bonds, which is the world's other major form of collateral. You can imagine this confidence/collateral problem like a snake eating its own tail. The more money the government creates to solve the problem, the faster the head will eat the tail. Fears will grow. And less credit will be available.

For example, let's look at the deal for Wachovia. Citigroup will pay $2 billion in stock (no cash) and assume $50 billion in debt, in exchange for Wachovia's retail banking business and a $312 billion loan portfolio. The deal wouldn't have happened without the government. The FDIC has agreed to assume all losses from the loan portfolio in excess of $42 billion.

To break this down in terms that are easier to understand, Citi will take the first 13.4% of the loan losses. Assuming the losses consume this reserve (which is highly likely), the FDIC will "eat" the rest and pay Citi back for any further losses. Thus in exchange for a few pieces of paper (Citi shares), Citigroup will get $270 billion in loans in exchange for $50 billion in debt. The government just gave Citigroup about $220 billion in value, risk free, plus one of the largest retail banking networks in the world.

Keep in mind, this gift from the government is worth twice as much as Citi's entire market capitalization. Nice work, if you can get it. That's how the government will make sure "The Club" survives, whether the House votes for a bailout or not.

The downside to this deal is the FDIC's entire reserve is only $45 billion. That's about 16% of the $270 billion it just guaranteed. So while confidence in Citi might have just been increased, faith in the FDIC surely has been eroded. Where will the money come from when it's needed?

The head of the FDIC, Sheila Bair, says of the situation: "On the whole, the commercial banking system in the U.S. remains well capitalized..." She sounds just like the finance minister of a banana republic on the eve of a devaluation.

Without a bailout paid for by the taxpayers, what will save the financial system? Inflation, of course. The Federal Reserve pumped an additional $630 billion into the global financial system last night, via currency swaps with foreign central banks. It has also tripled the size of its emergency lending to banks and brokers, which will now grow from $100 billion to $450 billion. Said one senior executive at the Bank of Tokyo-Mitsubishi, "The Fed's balance sheet is about to explode."

What should you do? What we've been telling you for months and months and months. Buy gold and silver bullion. Buy high-quality equities. Buy bonds with good assets, trading at a wide discount. And now, one more thing: Take at least two months worth of cash out of your bank, right away. There's at least a chance now of a real run on the banks. If that happens, the Feds will lock up the cash overnight. I've been in Argentina during a banking crisis. It's horrible. Make sure you've got the cash you need for basic necessities.

Kudos to Dan Ferris, who spelled out exactly what was going to happen to Wachovia and National City.

Take a look at the share prices of financial holding company National City Corp. (NCC) and Wachovia (WB). These two are the next big risks for failure. Remember: Wachovia bought Golden West at the top of the bubble in 2005. It's just like Lehman buying Archstone-Smith at the peak. These deals are the failure flags. They tell you which managements really drank the Kool-Aid on perpetually rising real estate values (or which didn't care... or which ones were criminals). Wachovia is holding something like $122 billion of option-ARMs... National City has $101 billion of deposits. Wachovia has $449 billion of deposits. That's $550 billion... more than seven times the FDIC's capacity ($45 billion reserve + $30 billion Treasury line of credit = $75 billion).

– Dan Ferris, September 26 Digest

New highs: Are you kidding?

In the mailbag, a demonstration of basic math by dozens of our subscribers. If you'd like us to critique your analytical skills, send your work here: feedback@stansberryresearch.com.

"I have my own bail-out proposal. Instead of giving $700 billion to Wall Street, let's split that money up and give it to all taxpayers that are over 18 years old. I figure that there are 301 million men, women, and children in the United States. I roughly figure that 200,000,000 are over 18 years old. Divide that $700 billion by the 200 million people, and that would give us about $3.5 million apiece. With that money, Uncle Sam gets his 30%, ($1,050,000.00), which leaves us with a measly $2,450,000.00. We take part of that money and pay off our mortgages, (well, maybe not yours Porter), POOF – mortgage crisis solved! Take another part of it and pay off our credit cards, and lines of credit, POOF – credit crisis solved! Take another part of it and put it in a SAFE bank, POOF – banking crisis solved! Take some more and buy a 'bitchin' new American made car that doesn't use gasoline, and my 'bitchin' new neighbor has got a job again, POOF – unemployment crisis solved. And just think, if we had even more money, we'd be talking about some serious change! I forgot to include that your wives would get that same amount too! So each man and wife would get $4.9 million after 30% taxes. It would be brisket and brunello for all!" – Paid-up subscriber Tim Spiewak

Porter comment: While I'll assume Tim meant his e-mail in jest, we've received dozens of similar treatments from people who were serious. These e-mails all claim the amount of the AIG bailout or the Treasury bailout plan is enough money for every American to be rich, etc. All of these e-mails have fantastically bad math. If you assume every bailout plan is funded, you're looking at about $1.5 trillion in total expenditure. Divided by the 100 million American households, that comes to about $15,000 per family. Too bad we all can't just tax the rich and live happily ever after.

Regards,

Porter Stansberry

Baltimore, Maryland

September 29, 2008

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