Debtor Nation

Despite his pledges to curb federal spending, President Bush will leave office next year with an eye-popping federal deficit that tops $400 billion. And that's just one of the shocking revelations in the president's $3.1 trillion budget request to Congress for fiscal year 2009, which the White House unveiled Monday.

The president has proposed to freeze or cut 151 discretionary programs, as well as make drastic reforms to entitlement programs--including a $178 billion cut for Medicare over the next five years.

"Good intentions alone do not justify a program that is not working," Bush said in his budget message.

Most of Bush's proposals are non-starters. A Democratic Congress is going to delay acting on his final budget request for as long as possible. For that reason, the deficit increase is immediately grabbing headlines. For 2008, the federal deficit is expected to soar to $410 billion, up from $162 billion in 2007. The reasons: A projected $146 billion stimulus plan to invigorate the economy, a one-year plan to keep the Alternative Minimum Tax from drastically expanding and reduced corporate tax receipts.

Still, Bush says his proposal will balance the federal budget by 2012. The White House wants to cap non-security discretionary spending at less than 1% growth for 2009, then hold it at that level through 2013. And it plans to drastically reform and cut spending on many discretionary programs, including elimination of Social Services Block Grants and the Perkins loan program. The proposal would also reform the disability insurance program. The White House estimates that these measures would save $18 billion in 2009.

The budget proposes that the 2001 and 2003 tax cuts Bush championed be made permanent. It also includes a $515.4 billion non-war defense budget, a modest increase over last year. From 2001 to 2007, "security spending" (which includes funding for the Pentagon and the Department of Homeland Security) increased 48%, the White House says. The fiscal-year 2009 budget would increase this spending by another 8.2%

Reform of entitlement programs is expected to save $16 billion in 2009 and $208 billion over the next five years, the White House says. As much as $178 billion of this savings would come from Medicare reductions. The president also wants to implement a standard health insurance tax deduction of $7,500 per person, a deviation from the current tax exclusion for employer-sponsored insurance.

In an echo of a past policy failure, Bush proposed that Social Security be reformed to allow workers to use up to 4% of their Social Security earnings to fund personal retirement accounts. The contributions, which would begin in 2013, would be capped at $1,400 during their first year and would be allowed to gradually increase until 2018.

The president's request Monday is the first step in what is likely to be a protracted battle over spending in an election year, when politicians like to ruffle as few voter feathers as possible and demonize opponents as much as they can. If Democrats in Congress don't pass appropriations bills by the Sept. 30 deadline, they can always pass a "continuing resolution" to fund the government at current levels until a new president takes office, and they're betting that person is going to be a Democrat. That gives lawmakers leverage in putting their own budget proposals into place.

In other words, Congress' reaction to this budget will be a gauge of Bush's status as a lame-duck president.

Credit Crisis: Where Was The SEC?

02.06.08, 6:00 AM ET

Six years after the lessons of Enron and a decade after Long-Term Capital collapsed, regulators still can't seem to blunt the damage complex securities can have on financial markets. Why?

It's a fair question. Investment banks, mortgage brokers and ratings agencies are all being blamed for the subprime mortgage bubble and its sudden and stunning demise. But little has been said about the watchdogs at the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority, the regulators who oversee the activities of the banks. They have the power to stop fraud in the business of selling the complex credit derivatives, and they have jurisdiction over whether the complex securities sold by the banks met suitability requirements for the investors who bought them. Yet time and again, they've failed to do so.

Most notably, the SEC has the power to monitor whether the investment banks had adequate capital relative to their trading positions and balance sheets and the proper risk management systems to prevent catastrophic losses. More than $100 billion in write-downs later, several banks are scrounging for capital, and it's clear those risk management procedures weren't functioning very well, if at all.

One of the problems is the lack of clear information, outside the banks and trading floors, about the credit derivatives market. Collateralized debt obligations (CDO) and other structured finance products trade over-the-counter rather than on an exchange, at least in the United States. Many of them trade infrequently, meaning price information is limited.

Washington and Wall Street have been hesitant to clamp down on the over-the-counter market, the source of much profit-making. Last year, as the subprime market began its collapse, the President's Working Group, which includes the Treasury Department, the Federal Reserve, the SEC and the Commodities Futures Trading Commission, recommended against tighter oversight of the over-the-counter market, in the context of vetoing tighter regulation of hedge funds, saying the industry can self-police.

A counterparty risk group led by former New York Fed President Gerald Corrigan has also recommended industry "best practices" in lieu of tighter regulation of the derivatives trading market.

Leaving it up to Wall Street hasn't proven very effective, however. "The decision by the President's Working Group to recommend no detailed regulation of the over-the-counter market was wrong," says David Ruder, a former SEC chairman and now law professor at Northwestern University.

Regulators are taking a hard look at how banks structured, priced and sold mortgage-laden securities, but by the estimate of some it's too little and too late. "I don't think all the king's horses and all the king's men will put this together again," says Gary Aguirre, a former SEC lawyer.

There were warning signs.

In the summer of 2006, Jeff Kronthal, a senior executive in Merrill Lynch's (nyse: MER - news - people ) structured products group, was fired after reportedly balking at then-Chief Executive Stanley O'Neal's demands that the firm get more aggressive in its risk-taking with mortgage securities. Kronthal was hired back by new Chief Executive John Thain in December to advise on the firm's risk management.

He wasn't the only one to sound alarms about the housing bubble and the explosion of the credit derivatives market. "Many credible people were public about their dissatisfaction with the mortgage loan market," says Janet Tavakoli, a structured finance expert with her own Chicago consulting firm.

She blames the ratings agencies for flawed ratings methodologies. The Fed and the SEC, among other regulators, are just packs of economists and lawyers. "I do not expect lawyers to be rigorous in their analysis."

Regulators saw warning signs as early as 2005, but failed to pursue them. Bear Stearns (nyse: BSC - news - people ), in its first quarter 2005 financial disclosure, said it faced the threat of a civil enforcement action in connection with its pricing, valuation and analysis of $63 billion worth of CDOs. In the same filing, Bear Stearns said it was contacted by the New York State attorney general, then Eliot Spitzer, about $16 billion worth of CDOs it sold to an unnamed client.
The inquiries were brought up again in the August quarterly regulatory report and in the year-end 2005 filing, when Bear Stearns said it was "continuing to respond to subpoenas and other requests for information from regulatory and law enforcement officials."
But that's the last time Bear Stearns brought it up, suggesting the matter had been sidelined or dropped. Aguirre says it sounds fishy. "I find it troubling," he says.

Aguirre has his own beef with the SEC. He was fired in 2005 after aggressively pursuing an insider trading case against Pequot Capital, the powerful New York hedge fund. Aguirre, who says he was fired after trying to interview current Morgan Stanley (nyse: MS - news - people ) Chief Executive John Mack in the matter, says the agency is too close to the industry it covers to be effective as a watch dog. A spokesman for the SEC wouldn't comment for this story.

Others say it's just a matter of things spiraling out of control more quickly than anyone could imagine. "It's very late in the game to be pointing fingers," said Howard Pitkin, Commissioner of Banking in Connecticut. "We all need to sharpen our pencils as far as spotting these problems."
On Friday, Massachusetts securities regulators filed a civil fraud suit against Merrill Lynch over $14 million worth of collateralized debt obligations it sold to the town of Springfield. The state claims the CDOs were unsuitable and sold without the town's consent. (Merrill has acknowledged the latter and paid the town back in full for the investment, which is now practically worthless.)
Earlier last week, the Federal Bureau of Investigation disclosed it had opened criminal fraud probes into 14 companies over their mortgage securitization activities, which includes everything from originating loans to buying them, packaging them and selling them to investors. The FBI didn't identify the companies.

Connecticut and New York attorneys general have also opened investigations into how Wall Street structured and sold mortgage-laden securities.

Goldman Sachs (nyse: GS - news - people ), Morgan Stanley and Bear Stearns have disclosed in their recent regulatory filings that they have been questioned by multiple regulators about their activities involving subprime mortgage securities. In November, Merrill Lynch said the SEC had initiated an inquiry into its subprime mortgage portfolio. All the banks have said they are cooperating. Maybe they should shore up their risk management while they're at it.

Wachovia sells $3.5 billion in preferred shares

NEW YORK, Feb 6 - Wachovia Corp (WB.N: Quote, Profile, Research) said on Wednesday that it sold $3.5 billion of preferred shares as the bank looks to rebuild its capital position.
The preferred shares pay a dividend of 7.98 percent for 10 years, and then change to floating interest rates. The shares may be redeemed after 10 years.
Wachovia's Tier 1 capital ratio, a measure of capital strength, was 7.2 percent at Dec. 31. This issue would essentially raise that ratio to 7.9 percent. (Reporting by Dan Wilchins, editing by Gerald E. McCormick)