My last economy posting was about the monoliners. Credit insurance companies who actually have two lines of business, municipal bond insurance and CDS/CDO/junk insurance. As the second business line is in the doldrums, there were attempts to split the sound business from the risky one. Two arguments have come up against this.

The first, by Roubini, says that the municipal credit insurance will likely turn out to be a bad business too. The housing crisis will hit municipals hard and some might well default. For examples look at the problems of Vallejo, CA or Lavon, TX.

The second reason is that astonishingly no one is volunteering to be on the losing side of such business split and people are threatening to litigate:

It appears they have discovered that they lack a legal basis for preferring the muni policyholders over the others, and even if they try not to prefer one group over another, it is going to be well nigh impossible to come up with a formula that won’t be contested.

When the bond insurers will be downgraded, the debt they insured will be downgraded too. 

Then the Banks who hold such debt will need $20-30 billion in additional reserves, i.e. real fresh capital, or go into bankruptcy. That can not be allowed because the systemic effects of large bank defaults would threaten to tear down the whole Jenga tower of the finacial system. We will therefore likely see some big U.S. banks getting nationalized and their losses socialized. (The system might come down anyway.)

In the UK the government has taken over
Northern Rock and now the taxpayer will have to carry the risk
of a likely default of at least $200 billion in bad Northern Rock debt. The housing crisis in Britain
has started a bit later than in the U.S., but it might well become
worse. Until Monday banks in the UK financed up to 125%
of home equities that are now in decline. The concentration of financial
business in London and its shrinking due to the downturn will reinforce the house price slump there.

There are other forms of socializing losses. The Pension Benefit Guaranty Corp, the federal backup for company pension plans, announced to move 45% instead of the current 28% of its $55 billion holding from bonds into stocks. That is quite an injection for Wall Street and will pump up stock prices. But it will bring a huge loss for the government backed pension fund when equity markets will finally acknowledge the coming economic slump.

Yesterday Roubini argued that there will be 10-15 million repossessions in the U.S. housing market generating losses between $1 and 2 trillion.
People will send in the keys to the banks and just walk away. Companies get advised to do so. Citizens will do so too. (Are there enough sound bridges for these people to live under?)

The whole debt based financial and credit scam that has driven the expansion of the last years is threatening to come and there is nothing that can be done about it.

The Financial Times’ Martin Wolf, widely read, now agrees with Roubini’s dark general outlook and explains how all these losses will be socialized:

The risks are indeed high and the ability of the authorities to deal with them more limited than most people hope. This is not to suggest that there are no ways out. Unfortunately, they are poisonous ones. In the last resort, governments resolve financial crises. This is an iron law.

Rescues can occur via overt government assumption of bad debt, inflation, or both.

Japan chose the first, much to the distaste of its ministry of finance. But Japan is a creditor country whose savers have complete confidence in the solvency of their government.

The US, however, is a debtor. It must keep the trust of foreigners. Should it fail to do so, the inflationary solution becomes probable. This is quite enough to explain why gold costs $920 an ounce.

The U.S. government can not carry much more debt without bad consequences. It can not nationalize all big banks. The solution has therefore to be inflation. If the Dollar loses half its value, the bad debt will have been halved too.

The process of igniting inflation to ‘clean up’ the bad debt has, I believe, already started. The Fed currently pumps out unprecedented amounts of fresh money towards the banking system and this money finds its way into commodity markets. Oil closed over $100/barrel yesterday and, inflation adjusted, is near its historic 1979 high.

By paying higher prices for essential products, gas, food, toilet paper etc., and by higher taxes consumers will, in the end, pay for the big bailout.