Warren Buffett on 'dangerous' derivatives

Derivatives

Derivatives are dangerous. They have dramatically increased the leverage and risks in our financial system. They have made it almost impossible for investors to understand and analyze our largest commercial banks and investment banks. They allowed Fannie Mae and Freddie Mac to engage in massive misstatements of earnings for years. So indecipherable were Freddie and Fannie that their federal regulator, OFHEO, whose more than 100 employees had no job except the oversight of these two institutions, totally missed their cooking of the books.

Indeed, recent events demonstrate that certain big-name CEOs (or former CEOs) at major financial institutions were simply incapable of managing a business with a huge, complex book of derivatives. Include Charlie and me in this hapless group: When Berkshire purchased General Re in 1998, we knew we could not get our minds around its book of 23,218 derivatives contracts, made with 884 counterparties (many of which we had never heard of). So we decided to close up shop. Though we were under no pressure and were operating in benign markets as we exited, it took us five years and more than $400 million in losses to largely complete the task. Upon leaving, our feelings about the business mirrored a line in a country song: “I liked you better before I got to know you so well.”

Improved “transparency” – a favorite remedy of politicians, commentators and financial regulators for averting future train wrecks – won’t cure the problems that derivatives pose. I know of no reporting mechanism that would come close to describing and measuring the risks in a huge and complex portfolio of derivatives. Auditors can’t audit these contracts, and regulators can’t regulate them. When I read the pages of “disclosure” in 10-Ks of companies that are entangled with these instruments, all I end up knowing is that I don’t know what is going on in their portfolios (and then I reach for some aspirin).

For a case study on regulatory effectiveness, let’s look harder at the Freddie and Fannie example.These giant institutions were created by Congress, which retained control over them, dictating what they could and could not do. To aid its oversight, Congress created OFHEO in 1992, admonishing it to make sure the two behemoths were behaving themselves. With that move, Fannie and Freddie became the most intensely-regulated companies of which I am aware, as measured by manpower assigned to the task.

On June 15, 2003, OFHEO (whose annual reports are available on the Internet) sent its 2002 report to Congress – specifically to its four bosses in the Senate and House, among them none other than Messrs. Sarbanes and Oxley. The report’s 127 pages included a self-congratulatory cover-line: “Celebrating 10 Years of Excellence.” The transmittal letter and report were delivered nine days after the CEO and CFO of Freddie had resigned in disgrace and the COO had been fired. No mention of their departures was made in the letter, even while the report concluded, as it always did, that “Both Enterprises were financially sound and well managed.”

In truth, both enterprises had engaged in massive accounting shenanigans for some time. Finally, in 2006, OFHEO issued a 340-page scathing chronicle of the sins of Fannie that, more or less, blamed the fiasco on every party but – you guessed it – Congress and OFHEO.

The Bear Stearns collapse highlights the counterparty problem embedded in derivatives transactions, a time bomb I first discussed in Berkshire’s 2002 report. On April 3, 2008, Tim Geithner, then the able president of the New York Fed, explained the need for a rescue: “The sudden discovery by Bear’s derivative counterparties that important financial positions they had put in place to protect themselves from financial risk were no longer operative would have triggered substantial further dislocation in markets. This would have precipitated a rush by Bear’s counterparties to liquidate the collateral they held against those positions and to attempt to replicate those positions in already very fragile markets.” This is Fedspeak for “We stepped in to avoid a financial chain reaction of unpredictable magnitude.” In my opinion, the Fed was right to do so.

A normal stock or bond trade is completed in a few days with one party getting its cash, the other its securities. Counterparty risk therefore quickly disappears, which means credit problems can’t accumulate. This rapid settlement process is key to maintaining the integrity of markets. That, in fact, is a reason for NYSE and NASDAQ shortening the settlement period from five days to three days in 1995.

Derivatives contracts, in contrast, often go unsettled for years, or even decades, with counterparties building up huge claims against each other. “Paper” assets and liabilities – often hard to quantify – become important parts of financial statements though these items will not be validated for many years. Additionally, a frightening web of mutual dependence develops among huge financial institutions. Receivables and payables by the billions become concentrated in the hands of a few large dealers who are apt to be highly-leveraged in other ways as well. Participants seeking to dodge troubles face the same problem as someone seeking to avoid venereal disease: It’s not just whom you sleep with, but also whom they are sleeping with.

Sleeping around, to continue our metaphor, can actually be useful for large derivatives dealers because it assures them government aid if trouble hits. In other words, only companies having problems that can infect the entire neighborhood – I won’t mention names – are certain to become a concern of the state (an outcome, I’m sad to say, that is proper). From this irritating reality comes The First Law of Corporate Survival for ambitious CEOs who pile on leverage and run large and unfathomable derivatives books: Modest incompetence simply won’t do; it’s mindboggling screw-ups that are required.

Considering the ruin I’ve pictured, you may wonder why Berkshire is a party to 251 derivatives contracts (other than those used for operational purposes at MidAmerican and the few left over at Gen Re). The answer is simple: I believe each contract we own was mispriced at inception, sometimes dramatically so. I both initiated these positions and monitor them, a set of responsibilities consistent with my belief that the CEO of any large financial organization must be the Chief Risk Officer as well. If we lose money on our derivatives, it will be my fault.

Our derivatives dealings require our counterparties to make payments to us when contracts are initiated. Berkshire therefore always holds the money, which leaves us assuming no meaningful counterparty risk. As of yearend, the payments made to us less losses we have paid – our derivatives “float,” so to speak – totaled $8.1 billion. This float is similar to insurance float: If we break even on an underlying transaction, we will have enjoyed the use of free money for a long time. Our expectation, though it is far from a sure thing, is that we will do better than break even and that the substantial investment income we earn on the funds will be frosting on
the cake.

Only a small percentage of our contracts call for any posting of collateral when the market moves against us. Even under the chaotic conditions existing in last year’s fourth quarter, we had to post less than 1% of our securities portfolio. (When we post collateral, we deposit it with third parties, meanwhile retaining the investment earnings on the deposited securities.) In our 2002 annual report, we warned of the lethal threat that posting requirements create, real-life illustrations of which we witnessed last year at a variety of financial institutions (and, for that matter, at Constellation Energy, which was within hours of bankruptcy when MidAmerican arrived to effect a rescue).

Our contracts fall into four major categories. With apologies to those who are not fascinated by financial instruments, I will explain them in excruciating detail.

• We have added modestly to the “equity put” portfolio I described in last year’s report. Some of our contracts come due in 15 years, others in 20. We must make a payment to our counterparty at maturity if the reference index to which the put is tied is then below what it was at the inception of the contract. Neither party can elect to settle early; it’s only the price on the final day that counts.

To illustrate, we might sell a $1 billion 15-year put contract on the S&P 500 when that index is at, say, 1300. If the index is at 1170 – down 10% – on the day of maturity, we would pay $100 million. If it is above 1300, we owe nothing. For us to lose $1 billion, the index would have to go to zero. In the meantime, the sale of the put would have delivered us a premium – perhaps $100 million to $150 million – that we would be free to invest as we wish.

Our put contracts total $37.1 billion (at current exchange rates) and are spread among four major indices: the S&P 500 in the U.S., the FTSE 100 in the U.K., the Euro Stoxx 50 in Europe, and the Nikkei 225 in Japan. Our first contract comes due on September 9, 2019 and our last on January 24, 2028. We have received premiums of $4.9 billion, money we have invested. We, meanwhile, have paid nothing, since all expiration dates are far in the future. Nonetheless, we have used Black-Scholes valuation methods to record a yearend liability of $10 billion, an amount that will change on every reporting date. The two financial items – this estimated loss of $10 billion minus the $4.9 billion in premiums we have received – means that we have so far reported a mark-to-market loss of $5.1 billion from these contracts.

We endorse mark-to-market accounting. I will explain later, however, why I believe the Black-Scholes formula, even though it is the standard for establishing the dollar liability for options, produces strange results when the long-term variety are being valued.

One point about our contracts that is sometimes not understood: For us to lose the full $37.1 billion we have at risk, all stocks in all four indices would have to go to zero on their various termination dates. If, however – as an example – all indices fell 25% from their value at the inception of each contract, and foreign-exchange rates remained as they are today, we would owe about $9 billion, payable between 2019 and 2028. Between the inception of the contract and those dates, we would have held the $4.9 billion premium and earned investment income on it.

• The second category we described in last year’s report concerns derivatives requiring us to pay when credit losses occur at companies that are included in various high-yield indices. Our standard contract covers a five-year period and involves 100 companies. We modestly expanded our position last year in this category. But, of course, the contracts on the books at the end of 2007 moved one year closer to their maturity. Overall, our contracts now have an average life of 21⁄3 years, with the first expiration due to occur on September 20, 2009 and the last on December 20, 2013.

By year end we had received premiums of $3.4 billion on these contracts and paid losses of $542
million. Using mark-to-market principles, we also set up a liability for future losses that at yearend totaled $3.0 billion. Thus we had to that point recorded a loss of about $100 million, derived from our $3.5 billion total in paid and estimated future losses minus the $3.4 billion of premiums we received. In our quarterly reports, however, the amount of gain or loss has swung wildly from a profit of $327 million in the second quarter of 2008 to a loss of $693 million in the fourth quarter of 2008.

Surprisingly, we made payments on these contracts of only $97 million last year, far below the estimate I used when I decided to enter into them. This year, however, losses have accelerated sharply with the mushrooming of large bankruptcies. In last year’s letter, I told you I expected these contracts to show a profit at expiration. Now, with the recession deepening at a rapid rate, the possibility of an eventual loss has increased. Whatever the result, I will keep you posted.

• In 2008 we began to write “credit default swaps” on individual companies. This is simply credit insurance, similar to what we write in BHAC, except that here we bear the credit risk of corporations rather than of tax-exempt issuers. If, say, the XYZ company goes bankrupt, and we have written a $100 million contract, we are obligated to pay an amount that reflects the shrinkage in value of a comparable amount of XYZ’s debt. (If, for example, the company’s bonds are selling for 30 after default, we would owe $70 million.) For the typical contract, we receive quarterly payments for five years, after which our insurance expires.

At year end we had written $4 billion of contracts covering 42 corporations, for which we receive annual premiums of $93 million. This is the only derivatives business we write that has any counterparty risk; the party that buys the contract from us must be good for the quarterly premiums it will owe us over the five years. We are unlikely to expand this business to any extent because most buyers of this protection now insist that the seller post collateral, and we will not enter into such an arrangement.

• At the request of our customers, we write a few tax-exempt bond insurance contracts that are similar to those written at BHAC, but that are structured as derivatives. The only meaningful difference between the two contracts is that mark-to-market accounting is required for derivatives whereas standard accrual accounting is required at BHAC.

But this difference can produce some strange results. The bonds covered – in effect, insured – by these derivatives are largely general obligations of states, and we feel good about them. At year end, however, mark-to-market accounting required us to record a loss of $631 million on these derivatives contracts. Had we instead insured the same bonds at the same price in BHAC, and used the accrual accounting required at insurance companies, we would have recorded a small profit for the year. The two methods by which we insure the bonds will eventually produce the same accounting result. In the short term, however, the variance in reported profits can be substantial.

We have told you before that our derivative contracts, subject as they are to mark-to-market accounting, will produce wild swings in the earnings we report. The ups and downs neither cheer nor bother Charlie and me. Indeed, the “downs” can be helpful in that they give us an opportunity to expand a position on favorable terms. I hope this explanation of our dealings will lead you to think similarly.

The Black-Scholes formula has approached the status of holy writ in finance, and we use it when valuing our equity put options for financial statement purposes. Key inputs to the calculation include a contract’s maturity and strike price, as well as the analyst’s expectations for volatility, interest rates and dividends.

If the formula is applied to extended time periods, however, it can produce absurd results. In fairness, Black and Scholes almost certainly understood this point well. But their devoted followers may be ignoring whatever caveats the two men attached when they first unveiled the formula.

It’s often useful in testing a theory to push it to extremes. So let’s postulate that we sell a 100- year $1 billion put option on the S&P 500 at a strike price of 903 (the index’s level on 12/31/08). Using the implied volatility assumption for long-dated contracts that we do, and combining that with appropriate interest and dividend assumptions, we would find the “proper” Black-Scholes premium for this contract to be $2.5 million.

To judge the rationality of that premium, we need to assess whether the S&P will be valued a century from now at less than today. Certainly the dollar will then be worth a small fraction of its present value (at only 2% inflation it will be worth roughly 14¢). So that will be a factor pushing the stated value of the index higher. Far more important, however, is that one hundred years of retained earnings will hugely increase the value of most of the companies in the index. In the 20th Century, the Dow-Jones Industrial Average increased by about 175-fold, mainly because of this retained-earnings factor.

Considering everything, I believe the probability of a decline in the index over a one-hundred-year period to be far less than 1%. But let’s use that figure and also assume that the most likely decline – should one occur – is 50%. Under these assumptions, the mathematical expectation of loss on our contract would be $5 million ($1 billion X 1% X 50%).

But if we had received our theoretical premium of $2.5 million up front, we would have only had to invest it at 0.7% compounded annually to cover this loss expectancy. Everything earned above that would have been profit. Would you like to borrow money for 100 years at a 0.7% rate?

Let’s look at my example from a worst-case standpoint. Remember that 99% of the time we would pay nothing if my assumptions are correct. But even in the worst case among the remaining 1% of possibilities – that is, one assuming a total loss of $1 billion – our borrowing cost would come to only 6.2%. Clearly, either my assumptions are crazy or the formula is inappropriate.

The ridiculous premium that Black-Scholes dictates in my extreme example is caused by the inclusion of volatility in the formula and by the fact that volatility is determined by how much stocks have moved around in some past period of days, months or years. This metric is simply irrelevant in estimating the probabilityweighted range of values of American business 100 years from now. (Imagine, if you will, getting a quote every day on a farm from a manic-depressive neighbor and then using the volatility calculated from these changing quotes as an important ingredient in an equation that predicts a probability-weighted range of values for the farm
a century from now.)

Though historical volatility is a useful – but far from foolproof – concept in valuing short-term options, its utility diminishes rapidly as the duration of the option lengthens. In my opinion, the valuations that the Black- Scholes formula now place on our long-term put options overstate our liability, though the overstatement will diminish as the contracts approach maturity.

Even so, we will continue to use Black-Scholes when we are estimating our financial-statement liability for long-term equity puts. The formula represents conventional wisdom and any substitute that I might offer would engender extreme skepticism. That would be perfectly understandable: CEOs who have concocted their own valuations for esoteric financial instruments have seldom erred on the side of conservatism. That club of optimists is one that Charlie and I have no desire to join.

Extracted from http://www.berkshirehathaway.com/letters/2008ltr.pdf

Credit crunch explained?

Barack Obama's Economic Recovery Plan.
Interview with Prof. Jack Rasmus

By Shamus Cooke

URL of this article: www.globalresearch.ca/index.php?context=va&aid=12601

Global Research, March 8, 2009

The following is an interview with Prof. Jack Rasmus by the Workers Emergency Relief Campaign (WERC). Rasmus is a professor of economics at St. Mary's College and Santa Clara University in Northern California. Below he outlines the details of Obama's economic recovery plan, showing the plan's inadequacies and the resulting implications.

WERC: What is your assessment of Obama's economic recovery plan? Can you describe it for our readers and tell us if you think it will deliver the jobs and benefits that people are anxiously awaiting?

Jack Rasmus: The Obama Plan has five major components, The first is the $787 billion stimulus plan that was adopted recently by the U.S. Congress. The second, third and fourth parts aim to resuscitate the financial markets: Part 2 is the PPIF, or Public-Private Investment Fund; Part 3 is the TALF, or Term Asset-Backed Securities Loan Facility; and Part 4 is the Homeowner Affordability and Stability Plan. The fifth component is Obama's proposed 2009 budget -- which is likely to be modified substantially by the Republicans before it is finally adopted.

As for the stimulus package: As I have stated repeatedly, it's too little too late. First, it's not a jobs bill. By the end of 2009, there could be a total of 20 million people unemployed. We are now at 14 million jobs lost, and the job losses are accelerating. Over the past three months, we lost one million jobs each month, when job losses are calculated correctly. This package is not going to regenerate the jobs that we are talking about -- and jobs are the most important thing, because job loss is what's driving the collapse of consumption and bringing down the economy.Thirty-eight percent of the stimulus package goes to providing aid; that is, unemployment, food stamps, vets' benefits, medical aid, COBRA -- as well as aid to state and local governments. This is all necessary, but what it shows is that this plan is aimed at softening the collapse, not at creating jobs. This aid will have little effect in terms of job creation. As for the aid to state and local governments, it is nowhere near the amount needed to halt the massive job cuts in state after state.

WERC: This is clear. In California Republican Governor Arnold Schwarzenegger is demanding that public-sector workers across the state take two days off per month with no pay. His plan also calls for tens of thousands of layoffs statewide.The Progressive States Network (PSN) reported that the Obama stimulus plan would cover less than half of projected state deficits. The authors of the PSN report note, "A new study by the Center on Budget and Policy Priorities details that state deficits are projected to be $350 billion over the next 30 months. But the stimulus recovery plan includes only about $150 billion that can be used to address those shortfalls, meaning that 55% to 60% of projected state deficits will remain."

Rasmus: Indeed. These "shortfalls" will mean millions of destroyed jobs, lives, families, and entire communities.To continue with the stimulus plan: Another 38% of the package, or $300 billion, is tax cuts: (1) business tax cuts, (2) reversing the alternative minimum tax; and (3) payroll tax cuts. The business tax cuts will not have any effect in stimulating the economy. Some economists in fact are arguing they will have a negative effect that the spending from the tax cuts will be less than the amount of the tax cuts; they call this "negative multipliers."When you're in a deep downturn like this, businesses sit on their tax cuts, waiting for better days ahead; they use the money to pay off their debts and that sort of thing. Even the payroll taxes will have virtually no effect in terms of consumption and stimulating the economy.

Only 24% of the stimulus plan, or $200 billion, will go to federal spending, with just $27 billion allocated this year to job-creating expenditures. The rest is long-term alternative energy technology and other similar projects, all of which are capital intensive.The point is this: It's not a jobs bill. Obama says the plan will create 3 million to 4 million jobs. But over what time period? It's over multiple years, with the hope that the biggest impact will come in the second year.This year the total spending impact of this bill, dollar-wise, is only $180 billion, which is roughly what 2008 stimulus package was last year. It had virtually no effect last year, and the conditions are even worse this year. We will continue to be gushing jobs this year at the continued rate of half a million to 1 million jobs per month.

We're going to be in very bad shape at the end of the year. The number one cause driving foreclosures is job loss. I was just reading a statistic today that 72% of all the sub-prime loans issued between 2005 and 2007 are going to default. In other words, we haven't seen the total impact of the housing price collapse. Housing prices will fall at least another 20%. There is no light at the end of this downturn tunnel.With 20 million unemployed at the end of the year, with an additional 5 million to 7 million people losing their homes to foreclosure, the stimulus plan fails miserably when it comes to creating jobs -- so bad that I predict they will have to come up with a Stimulus Plan II at some point.So if there not a program this year to deal with this situation, the odds go up significantly that what I call an epic recession will become a classic global depression in 2010. We are on the cusp of this now. The momentum is moving in that direction.

WERC: Let's look at the other components of Obama's program. You mentioned that the administration is putting most of its hopes into reviving the banking system as a means to jump-start the economy. What about the Public-Private Investment Fund, for example?In mid-February Treasury Secretary Tim Geithner announced that up to $1 trillion would be provided by the Treasury to "provide financing for private investors to buy 'distressed securities.'" Geithner said the the goal is to clean up the banks' "toxic assets so that the credit crunch that is hobbling the economy can be ended." What is your take on the PPIF?

Rasmus: This is really Part Two of the big banks' rescue plan -- and the $1 trillion figure that Geithner presents is just for starters; the figure is going to increase significantly.As you say, they plan to use taxpayer money to help the banks and investors buy bad assets that exist in these banks and financial institutions. It's the existence of these bad assets that prevent the banks from making loans to businesses and homeowners. It's what's been clogging up the system.But the Treasury has refused to deal with these bad assets. If you go back to then-Treasury Secretary Henry Paulson and the Troubled Assets Relief Plan (TARP), you can see that we gave the banks $700 billion in bailout funding. But Paulson didn't buy up the bad assets, which was the whole idea behind the rescue plan. Why is that?It's because the banks are on strike. The banks don't want to lend, or if they do, it's at ridiculously high rates. They don't want to sell all the bad assets on their books because they are essentially worthless now, and they don't want to sell at their worthless market price.

If they sold them at their market prices, they would have even greater losses than they have now. They don't want to loan when their balance sheets are so negative, because if they loan that reduces their reserves on hand. And this is freezing up the system.Paulson and TARP could not buy them at above-market prices because Congress was looking over their shoulders and saying, "Hey! What are you doing, subsidizing these banks, giving them more than the market value of these assets?"So, Paulson looked around, saw that he couldn't do anything, and did nothing in relation to these bad assets.Today, with the PPIF, we have essentially the same situation, but with a little twist.

What they're trying to do with PPIF is to create a market price to sell these bad assets, thereby subsidizing not only the banks but the investors who would buy them. In other words, this $1 trillion is designed to give money incentives to the banks to make up the difference between what the price would be and what the market value would be. So, they are giving the banks a windfall to encourage them to sell at above-market price.At the same time, they're giving an incentive to the investors; in other words, they are subsidizing the investors as well, with taxpayer money, to come in and buy. They hope this will create a new market price that will take off on its own and unblock the lending. It's going to cost well over $1 trillion to get that going, and it's really questionable whether investors will want to buy those bad assets at any price.

WERC: All the business media report that investors are not willing to buy these assets, even at higher rates. ...

Rasmus: That's right. And if the $1 trillion doesn't work, the government is prepared to throw more money at them. The investors know this, so they are going to sit and wait, saying that the price is not high enough and that you have to subsidize us even more. With the government already so committed to this effort, they will throw more money at the banks. Geithner and Obama are already saying that this is just a start, and that we may have to throw more money into this bad assets plan some time soon.

WERC: Some economists, and even some top-level financial gurus such as Former Federal Reserve chief Alan Greenspan, are saying that the government should simply take over and nationalize these bad assets. They say the Obama plan is doomed to fail.

Rasmus: The banks would love this. Keep in mind that Obama and Geithner are not talking about confiscating these bad assets. They are talking about is buying them. But they would have to buy at above-market price because the banks won't sell them. The bankers are holding out for even-higher prices. That's the crux of the problem.And when Greenspan and the others talk about nationalization, we must be clear, that's a misnomer. They don't really mean nationalization. Buying preferred stock or even common stock does not amount to nationalization. It's just partial receivership, or subsidization, at taxpayer expense.Seizure of private companies on behalf of investors is not nationalization. Their goal is to buy the bad assets and then sell them back to private investors at below-market prices -- all at taxpayers' expense.

WERC: What is the total amount of bad assets, assuming there's agreement on the amount?

Rasmus: Professor Rubini at New York University estimates that there's at least $3.6 trillion in bad assets. Fortune magazine says $4 trillion. Geithner, last June, indicated he thought there was about $6 trillion.So to buy these bad assets, the taxpayers; would have to fork over $6 trillion.

WERC: The figure is staggering. Clearly, this situation calls out for true nationalization.

Rasmus: Yes, it does. But what is true nationalization? It means totally taking over these banks and financial institutions -- with bondholders and shareholders not just taking a haircut, but taking a scalping. It means getting rid of management. It means consolidating and running these banks on behalf of the interests of the working-class majority in the country. You don't pay dividends. You don't pay stock shares. you take full day-to-day operational control of all strategic decision-making. You run it and turn over the profits for public investment, not to line the pockets of private investors.Without a doubt, what we need is a fully nationalized banking system.

WERC: Many of the initiators of the Workers Emergency Recovery Campaign are calling for the nationalization of the banks without compensation. They also say that the $700 billion in the Paulson plan -- funds that are simply sitting in the banks waiting to ride out the recession -- should be confiscated by the government and placed at the service of job creation.Today, the government could nationalize the banks and use that $1 trillion in the PPIF fund -- just to give one example -- to put people back to work. If we assume a living wage of $50,000 per worker for one year, and we multiply this number by the 20 million projected unemployed workers, this gives us exactly $1 trillion. Shouldn't the Obama administration earmark that $1 trillion to provide unionized, living-wage jobs for one year to the 20 million unemployed? Isn't this a better way to jump-start the economy?

Rasmus: That's the point I have been making all along. People are referring to the Great Depression. But what got us out of the Depression? It was not the New Deal.The New Deal did not really come on the scene till 1935, with some success. It stopped the decline, but it did not generate the recovery, and after two years, Roosevelt and others started dismantling the New Deal. Once they started doing this and trying to balance the budget, in mid-1937, we went right back into the Depression. We did not come out of the Depression till 1942. Why was this? It was because government spending, i.e., public investment, rose from 20 percent to 40 percent of annual Gross Domestic Product (GDP), the total annual spending in the economy.

WERC: How are they planning to finance the PPIF: Would it be through the Treasury?

Rasmus: Yes. They've got about $190 billion left over from that $700 billion TARP fund, and they will put in initially another $810 million, again, to subsidize the investors and the banks with the hope that they will come into the market to start buying and selling the bad assets at above the market price. They want to induce a market and a price, and they hope that once they do this, all the investors will step in and follow suit. But that's a big if. I don't see it coming.Now the second part of the financial plan is designed to work in conjunction with the PPIF, and that's the TALF, or Term-Backed Securities Loan Facility. This will be run by the Federal Reserve.The Fed had $200 billion assigned for this last November 2008, but it just held onto it. Now in about a week they are going to issue another $800 billion. So they'll have an addition $1 trillion for TALF.

WERC: Will this mean that the Federal Reserve will issue bonds for the TALF?

Rasmus: Not exactly. The idea is for Fed to lend money to investors, particularly investors in the hedge funds, money-marked mutual funds, and private equity funds -- that is, to the shadow banks that are responsible for so much of the speculation that got us into the mess we're in today -- so that they can buy the bad assets. As you see, they are coming at it from two directions.But bad assets of what? The plan is to buy up the securitized bonds and loans associated with consumer credit. We are on the verge of another sub-prime-like bust in the consumer credit markets -- meaning auto loans, student loans, credit card loans, and commercial property loans.

The whole idea here is that the Fed will loan money to hedge funds and private equity funds to buy these bad assets that are about to collapse. Estimates are that defaults on credit cards alone are going to rise from their current 2% to 3% today to 8% to 10%.It's ironic, when you think about it, that the government is going to try to resurrect this thing through the shadow banking system and securitized markets, which collapsed from more than a trillion dollars in credit a few years ago and which have lost close to $4 trillion total. The hedge funds have lost $1 trillion of their total value, and yet we are going to give them money to buy out all these bad assets ... all of this to try to stimulate and increase the lending to industry, to commerce, and the like.This doesn't make any sense. It just shows that the government has absolutely no confidence that the commercial banks can lead a recovery.

The question is, Is anyone going to re-enter into these securitized markets that have collapsed and buy up these bad assets, even with these government loans? Does anyone want to touch the toxic securitized markets? I don't think so. Even with loans ... unless the government gives them interest-free loans -- and if that happens, the government should just enter and take over these consumer credit markets and provide credit directly through the Fed the auto, student, commercial property and other markets. Let the Fed provide the funds directly to, for instance, credit unions as the local loaning institutions. Why have middle-men come in and skim off the profits?We must also keep in mind that the $2 trillion they are throwing at the banks with this plan is just the beginning. Everyone is lining up at the trough for a taxpayer payout.

WERC: Let's talk now about Homeowner Affordability and Stability Plan, which is both the third financial package and the fourth component of the Obama recovery plan.

Rasmus: There are two parts to it. The first is $200 billion to go to Fannie Mae and Freddie Mac, because they already ran through the $200 billion we gave them back in August 2008. They have bought up the bad housing loans, or mortgage loans -- and as their values continue to fall as housing prices fall, the values of the loans they bought up have collapsed. So they have run through their $200 billion, and they need $200 billion more.

It's not really going to improve anything when you just keep buying up these bad loans. That's the first part.Regarding the second part, we have to keep in mind that Fannie Mae, Freddie Mac, and AIG, which is now supposedly "government owned," only constitute about 20% to 30% of the housing market. That leaves 70% to 80% of the bad housing mortgage market, which the government had not been addressing. It's this other portion that the Homeowner Affordability and Stability Plan now addresses -- but with only $75 billion, a paltry sum!And even this $75 billion is targeting subsidies to mortgage lenders; in other words, it's trickle-down once again -- that is, give money to the mortgage lenders to have the government and taxpayers pay to lower the interest rates on new home loans -- up to $75 billion, which is not all the many home loans.

And what's even more outrageous, these loans are to go to new buyers -- not to those 5 million to 7 million homeowners who face foreclosure, delinquency, or default. The government is not attempting to do anything about people who are losing their homes. What they plan to do is subsidize the markets, so that the lenders can create new, affordable buyers to buy up some of the foreclosed homes.This is a sop, a freebie, thrown to the mortgage lenders who are asked to come in buy some of the foreclosures and some of the huge stock of homes, to help them sell all the new homes. So really, it's a plan to benefit the mortgage lenders and construction firms holding all these new, unsold homes.

WERC: Now, let's get to the last item: the 2009 budget. This is the part that many are touting as New Deal and even "socialist," if we are to believe Rush Limbaugh.

Rasmus: This is a $3.6 trillion budget with a lot of spending. There is going to be a firestorm over it. Watch the Republicans, the corporations and the banking interests come out of the woodwork. The gloves are going to come off. This is where the big split in the capitalist class is going to reveal itself, because there are some proposals in this plan that would shift income. It's a shift that is insufficient, -- too little too late, once again -- but it is certainly moving in a better direction.

This is what we know so far about the budget:It will increase taxes on the wealthiest 2% of households -- but it will only increase taxes from 35% to 39.5%. This will effect people making more than $250,000 per year. This amounts to a rollback to the Clinton period. But that tax increase on the top-margin rate does not take effect until 2011, when the Bush tax cuts expire. This is absurd. It should take effect in 2009. They shouldn't be putting it off, when funding is needed so desperately to stop teacher layoffs, prevent home foreclosures, or to stop autoworker layoffs.

What's more, they will not come close to obtaining the funding they need for a real economic recovery by only rolling back the capital gains' and capital incomes' tax cuts only to the 1990s levels. They have to roll them back to the pre-Reagan, pre-1980s, rates. They have to raise these rates back to 50%, minimum.So there is some increase in the tax rate, but it is delayed and it is far less than what is needed. Again, 2009 is a critical juncture year. If the declining situation is not reversed, the odds are increasing that we will be moving in 2010 to a global recession. There really is no way out without a real re-distribution of income, reversing the redistribution of income from workers to investors and corporations that has been going on since 1980.Second, on healthcare. The budget calls for $634 billion in healthcare funding, but this is only half of what is needed for single-payer. Also, if this funding goes to the private insurance companies, as appears to be the case, there will be no real solution to the healthcare crisis in our country. Only single-payer offers a solution.

Third, the budget calls for deprivatizing student loans. This is one point that is commendable in the plan.The details of the plan are only emerging. We will have to monitor it closely. But one thing is certain: What has been proposed by the Obama administration is likely to be modified substantially by the Republicans and centrist Democrats. There is going to be a big fight, with major changes expected.

WERC: The government is talking about incurring a $1.75 trillion deficit with this budget. What does this mean? How will the deficit be financed?

Rasmus: First, it should be noted that the real deficit by 2010 will be $2.25 trillion.One way they are talking about financing this deficit is with carbon credits. These are carbon pollution permits. The government is expecting a $526 billion revenue from this source, though it's questionable whether they will be able to raise this amount. Governments and corporations in Europe want to give corporations credits for free. They'll try that here too.They will issue more Treasury bonds, and they will simply have go to the printing presses and print more money. Clearly, they are in a bind -- especially if the economy continues to tank.

WERC: You have made many predictions that have actually come true -- unlike just about every mainstream economist and forecaster. What are your predictions today?

Rasmus: We're on the knife's edge of a transition between this epic recession and a depression. The bank bailout will require trillions more dollars. And even then, the impact is likely to be marginal.The depression could be triggered by one or more of the following factors: sovereign debt crises in Eastern Europe, deepening job losses in the United States, the collapse of the treasuries' markets; the collapse of the global bond markets. These are among the many possible scenarios.

WERC: What is to be done?

Rasmus: I have outlined some policy recommendations here. Readers who would like to delve into this question in greater depth can get my full set of proposals on my website, which is www.kyklosproductions.com. You can also see my latest article in the March 2009 of "Z" magazine, where I describe my full set of proposals for recovery as an alternative to the Obama program.