On Friday the Dow Jones took a 280-point nosedive on fears
that that losses in the subprime market will spill over into the broader
economy and cut into GDP.
Ever since the two Bear Sterns' hedge funds folded a couple
weeks ago, the stock market has been writhing like a drug-addict in a detox
cell. Friday's sell-off added to last week�s plunge that wiped out $2.1
trillion in value from global equity markets. New York investment guru Jim
Rogers said that the real market is �one of the biggest bubbles we�ve ever had
in credit� and that the subprime rout �has a long way to go.�
We are now beginning to feel the first tremors from the
massive credit expansion which began six years ago at the Federal Reserve. The
trillions of dollars which were pumped into the global economy via low interest
rates and increased money supply have raised the nominal value of equities, but
at great cost. Now stocks will fall sharply and businesses will fail as
volatility increases and liquidity dries up. Stagnant wages and a declining
dollar have thrust the country into a deflationary cycle which has, up to this
point, been concealed by Greenspan�s �cheap money� policy. Those days are over.
Economic fundamentals are taking hold. The market swings will get deeper and
more violent as the Fed�s massive credit bubble continues to unwind. Trillions
of dollars of market value will vanish overnight. The stock market will go into
a long-term swoon.
Ludwig von Mises summed it up like this: "There is no
means of avoiding the final collapse of a boom brought about by credit
expansion. The question is only whether the crisis should come sooner as a
result of a voluntary abandonment of further credit expansion, or later as a
final and total catastrophe of the currency system involved." (Thanks to
the Daily Reckoning)
It doesn�t matter if the �underlying economy is strong,� as
Treasury Secretary Henry Paulson likes to say. That�s nonsense. Trillions of
dollars of overleveraged bets are quickly unraveling which has the same effect
as taking a wrecking ball down Wall Street.
Last week, a third Bear Stearns fund shuttered its doors and
stopped investors from withdrawing their money. Bear�s CFO Sam Molinaro
described the chaos in the credit market as the worst he'd seen in 22 years. At
the same time, American Home Mortgage Investment Corp. (AHM) -- the
10th-largest mortgage lender in the U.S. -- said that �it can't pay its
creditors, potentially becoming the first big lender outside the subprime
mortgage business to go bust.� (MarketWatch)
This is big news, mainly because AHM is the first major
lender outside the subprime mortgage business to go belly-up. The
contagion has now spread through the entire mortgage industry: Alt-A,
piggyback, interest only, ARMs, prime, 2-28, jumbo, the whole range of loans
are now vulnerable. That means we should expect far more than the estimated 2
million foreclosures by year-end. This is bound to wreak havoc in the secondary
market where $1.7 trillion in toxic CDOs (collateralized debt obligations) have
already become the scourge of Wall Street.
Some of the country�s biggest banks are going to take a
beating when AHM goes under. Bank of America is on the hook for $1.3 billion,
Bear Stearns $2 billion and Barclay�s $1 billion. All told, AHM�s mortgage
underwriting amounted to a whopping $9.7 billion. (Apparently, AHM could not
even come up with a measly $300 million to cover existing deals on mortgages!
Where�d all the money go?) This shows the downstream effects of these massive
mortgage-lending meltdowns. Everybody gets hurt.
AHM�s stock plunged 90 percent in one day. Jittery investors
are now bailing out at the first sign of a downturn. Wall Street has become a
bundle of nerves and the problems in housing have only just begun. Inventory is
still building, prices are falling and defaults are steadily rising -- all the
necessary components for a full-blown catastrophe.
AHM warned investors last Tuesday that it had stopped buying
loans from a variety of originators. Two other mortgage lenders announced they
were going out of business just hours later. The lending climate has gotten
worse by the day. Up to now, the banks have had no trouble bundling mortgages
off to Wall Street through CDOs. Now everything has changed. The banks are
buried under more than $300 billion worth of loans that no one wants. The
mortgage CDO is going the way of the Dodo. Unfortunately, it has attached
itself to many of the investment banks on its way to extinction.
And it�s not just the banks that are in for a drubbing. The
insurance companies and pension funds are loaded with trillions of dollars in
�toxic waste� CDOs. That shoe hasn�t even dropped yet. By the end of 2008, the
economy will be on life-support and Wall Street will look like the Baghdad
morgue. American biggest financials will be splayed out on a marble slab
peering blankly into the ether.
Think I�m kidding?
Already the big investment banks are taking on water.
Merrill Lynch has fallen 22 percent since the start of the year. Citigroup is
down 16 percent and Lehman Bros Holdings has dropped 22 percent. According to
Bloomberg News: �The highest level of defaults in 10 years on subprime
mortgages and a $33 billion pileup of unsold bonds and loans for funding
acquisitions are driving investors away from debt of the New York-based
securities firms. Concerns about credit quality may get worse because banks
promised to provide $300 billion in debt for leveraged buyouts announced this year.
. . . Bear Stearns Cos., Lehman Brothers Holdings Inc., Merrill Lynch & Co.
and Goldman Sachs Group Inc., are as good as junk.�
That�s right -- �junk.�
We�ve never seen an economic tsunami like this before. The
dollar is falling, employment and manufacturing are weakening, new car sales
are off for the seventh straight month, consumer spending is down to a paltry
1.3 percent, and oil is hitting new highs every day as it marches inexorably
towards $100 per barrel.
So, where�s the silver lining?
Apart from the 2 million-plus foreclosures, and the 80 or so
mortgage lenders who have filed for bankruptcy; a growing number of investment
firms are feeling the pinch from the turmoil in real estate. Bear Stearns,
Basis Capital Funds Management, Absolute Capital, IKB Deutsche Industrial Bank
AG, Commerzbank AG, Sowood Capital Management, C-Bass, UBS-AG, Caliber Global
Investment and Nomura Holdings Inc., are all either going under or have taken a
major hit from the troubles in subprime. The list will only grow as the weeks
go by. (Check
out these graphs to understand what�s really going on in the housing
The problems in real estate are not limited to residential
housing either. The credit crunch is now affecting deals in commercial real
estate, too. Low-cost, low-documentation, �covenant lite� loans are a thing of
the past. Banks are finally stiffening their lending requirements even though
the horse has already left the barn. Commercial mortgage-backed securities are
now nearly as tainted as their evil-twin, residential mortgage-backed
securities (RMBS). There�s no market for these turkeys. The banks are returning
to traditional lending standards and simply don�t want to take the risk
Bataan Death March?
Leveraged Buy Outs (LBOs) have been a dependable source of
market liquidity. But, not any more. In the last quarter, there was $57 billion
in LBOs. In the first month of this quarter that amount dropped to less than $2
billion. That�s quite a tumble. The Wall Street Journal�s Dennis Berman summed
it up like this: �the Street is scrambling to finance some $220 billion of
leveraged buy out deals� (but) the �mood has gone from Nantucket holiday to
Bataan Death March.�
Berman nailed it. The investment banks took great pleasure
in their profligate lending; raking in the lavish fees for joining
mega-corporations together in conjugal bliss. Then someone took the punch bowl.
Now the banking giants are scratching their heads -- wondering how they can
unload $220 billion of toxic-debt onto wary investors. It won�t be easy.
�The banks and brokers are in the bull�s eye,� said Kevin
Murphy. �There�s article after article not only on subprime, but also banks
sitting on leveraged buy out loans.� (WSJ) Credit protection on bank debt is
soaring just as investor confidence is on the wane. In fact, the Chicago Board
Options Exchange (CBOE) Volatility Index (VIX) -- the �fear gauge� -- which
measures market volatility, has surged 60 percent in the last week alone. The
increased volatility means that more and more investors will probably ditch the
stock market altogether and head for the safety of US Treasuries.
But that just presents a different set of problems. After
all, what good are US Treasuries if the dollar continues to plummet? No one
will put up with 5 percent or 6 percent return on their investment if the
dollar keeps sliding 10 percent to 15 percent per year. It would be wiser to
one�s move money into foreign investments where the currency is stable.
And that is (presumably) why Treasury Secretary Paulson was
in China last week to sweet talk our Communist bankers into buying more USTs to
prop up the flaccid greenback. (Note: The Chinese are currently holding $103 billion
in toxic US-CDOs and are not at all happy about their decline in value.) If the
Chinese don�t purchase more US debt, then panicky US investors will start
moving their dollars into gold, foreign currencies and German state bonds as a
hedge against inflation. This will further accelerate the flight of foreign
capital from American markets and trigger a massive blow-off in the stock and
bond markets. In fact, this process is already underway, although it has been
largely concealed in the business media. In truth, the big money has been
fleeing the US for the last three years. What passes as �trading� on Wall
Street today is just the endless expansion of credit via newer and more opaque
debt-instruments. It�s all a sham. America�s hard assets are being sold off to
at an unprecedented pace.
Credit crunch: Whose ox gets gored?
When money gets tight; anyone who is �overextended� is apt
to get hurt. That means that the maxed-out hedge fund industry will continue to
get clobbered. At current debt-to-investment ratios, the stock market only has
to fall about 10 percent for the average hedge fund to take a 50 percent
scalping. That�s more than enough to put most funds underwater for good. The
carnage in Hedgistan will likely persist into the foreseeable future.
That might not bother the robber baron fund managers who�ve
already extracted their 2 percent �pound of flesh� on the front end. But it�s a
rotten deal for the working stiff who could lose his entire retirement in a
matter of hours. He didn�t realize that his investment portfolio was a
crapshoot. He probably thought there were laws to protect him from Wall Street
scam artists and flim-flam men.
It�ll be even worse for the banks than the hedge funds. In
fact, the banks are more exposed than anytime in history. Consider this: the
banks are presently holding a half trillion dollars in debt (LBOs and CDOs) for
which there is no market. Most of this debt will be dramatically downgraded
since the CDOs have no true �mark to market� value. It�s clear now that the rating
agencies were in bed with the investment banks. In fact, Joshua Rosner admitted
as much in a recent New York Times op-ed: �The original models used to rate
collateralized debt obligations were created in close cooperation with the
investment banks that designed the securities.� . . . [The agencies] actively
advise issuers of these securities on how to achieve their desired ratings.�
(Joshua Rosner, �Stopping the Subprime Crisis,� NY Times)
Pretty cozy deal, eh? Just tell the agency the rating you want
and they tell you how to get it.
Now we know why $1.7 trillion in CDOs are headed for the
The downgrading of CDOs has just begun and Wall Street is
already in a frenzy over what the effects will be. Once the ratings fall, the
banks will be required to increase their reserves to cover the additional risk.
For example, �As a recent issue of Grant�s explains, global commercial banks
are only required to set aside 56 cents ($0.56) for every $100 worth of
triple-A rated securities they hold. That�s roughly 178 to 1 ratio. Drop that
down to double-B minus, and the requirement skyrockets to $52 per $100 worth of
securities held -- a margin increase of more than 9,000 percent.�
�56 cents ($0.56) for every $100 worth of triple-A rated
securities?� Are you kidding me?
As Mugambo Guru says, "That is 1/18th of the 10 percent
stock margin equity required in 1929!" (Mugambo Guru; kitco.com)
The high-risk game the banks have been playing of
�securitizing� the loans of applicants with shaky credit is falling apart fast.
There�s no market for chopped up loans from overextended homeowners with bad
credit. The banks don�t have the reserves to cover the loans they have on the
books and the CDOs have no fixed market value. End of story. The music has
stopped and the banks can�t find a chair.
The public doesn�t know anything about this looming disaster
yet. How will people react when they drive up to their local bank and see
plywood sheeting covering the windows?
This will happen. There will be bank failures.
The derivatives market is another area of concern. The
notional value of these relatively untested instruments has risen to $286
trillion in 2006 -- up from a meager $63 trillion in 2000. No one has any idea
of how these new �swaps and options� will hold up in a slumping market or under
the stress of increased volatility. Could they bring down the whole market?
That depends on whether they�re backed up by sufficient
collateral to meet their obligations. But that seems unlikely. We�ve seen over
and over again that nothing in this new deregulated market is �as it seems.�
It�s all stardust mixed with snake oil. What the Wall Street hucksters call the
�new financial architecture of investment� is really nothing more than one
overleveraged debt-bomb stacked atop another. Ironically, many of these same
swindles were used in the run-up to the Great Depression. Now they�ve
resurfaced to do even more damage. When the crooks and con men write the laws
(deregulation) and run the system; the results are usually the same. The little
guy always gets screwed. That much is certain.
At present, the stock market is running on fumes. Another
four to six months of wild gyrations and it�ll be over. The NASDAQ plunged 75
percent after the dot.com bust. How low will it go this time?
Keep an eye on the yen. The ongoing troubles in subprime and
hedge funds are pushing the yen upwards which will unwind trillions of dollars
of low interest, short term loans which are fueling the rise in stock prices.
If the yen strengthens, traders will be forced to sell their positions and the
market will tank. It�s just that simple. The Dow Jones will be a dead duck.
So far, Japan �s monetary manipulations have been a real
boon for Wall Street, enriching the investment bankers, the big-time traders and
the hedge fund managers. They�re the one�s who can take advantage of the
interest rate spread and then maximize their leverage in the stock market. It
works like a charm in an up-market, but things can unravel quickly when the
market retreats or starts to zigzag erratically. The recent rumblings suggest
that the volatility will continue which will push the yen upwards and cut off
the flow of cheap credit to the stock market. When that happens, the end is
The American people: �We�re not a dumb as you
It�s always refreshing to find out that the majority of
Americans seem to have a grasp of what is really going on behind the fake
headlines. For example, the Wall Street Journal/NBC conducted a poll last week
which shows that two-thirds of Americans believe that �the economy is either in
a recession now or will be in the next year.� That matches up pretty well with
the 71 percent of Americans who now feel the Iraq War �was a mistake.�
Americans are clearly downbeat in their outlook on the economy and haven�t been
taken in by the daily infusions of happy talk about �low inflation� and
�sustained growth� from toothy TV pundits. In fact, the mood of the country
regarding the economy is downright gloomy. �Only 19 percent of Americans say
things in the nation are headed in the right direction, while 67 percent say
the country is off on the wrong track.� Iraq, of course, is the number one
reason for the pessimism, but the dissatisfaction runs much deeper than just
�Only 16 percent expressed substantial confidence in the
financial industry; 18 percent in the energy or pharmaceutical industries;� 17
percent in large corporations and 11 percent in health-insurance companies.�
Only 18 percent of the people have confidence in the corporate media and only
16 percent in the federal government.
These are encouraging numbers. They show that the vast
majority of people have lost confidence in the system and its institutions.
They also illustrate the limits of propaganda. People are not as easily
indoctrinated as many believe. Eventually the �bewildered herd� catches on and
sees through the lies and deception.
The American people know intuitively that something is
fundamentally wrong with the economy. They just don�t know the details or the
extent of the damage. Decades of neoliberal policies have inflated the
currency, broadened the wealth gap, and destroyed manufacturing. Workers can no
longer buy the things they produce because wages have stagnated through a
stealth campaign of inflation which originated at the Federal Reserve. When
wages shrink, prices eventually fall from overcapacity and the economy slips
into a deflationary cycle. This downward spiral ultimately ends in depression.
So far, that's been avoided because of the Fed�s massive expansion of cheap
credit. But that won�t last.
Economic policy is not �accidental.� The Fed�s policies were
designed to create a crisis, and that crisis was intended to coincide with the
activation of a nationwide police state. It is foolish to think that Alan
Greenspan or his fellows did not grasp the implications of the system they put
in place. These are very smart men and very shrewd economists. They knew
exactly what they were doing. They all understand the effects of low interest
rates and expanded money supply. And they�re also all familiar with Ludwig von
Mises, who said, "There is no means of avoiding the final collapse of a
boom brought about by credit expansion.�
A crash is unavoidable because the policies were designed to
create a crash. It�s that simple.
The Federal Reserve is a central player in a carefully
considered plan to shift the nation�s wealth from one class to another. And
they have succeeded. Nearly 4 million American jobs have been sent overseas,
the country has increased the national debt by $3 trillion dollars, and foreign
investors own $4.5 trillion in US dollar-backed assets. While the Fed has been
carrying out its economic strategy; the Bush administration has deployed the
military around the world to conduct a global resource war. These are two
wheels on the same axel. The goal is to maintain control of the global economic
system by seizing the remaining energy resources in Eurasia and the Middle East
and by integrating potential rivals into the American-led economic model under
the direction of the Fed. All of the leading candidates -- Democrat and
Republican -- belong to secretive organizations which ascribe to the same basic
principles of global rule (new world order) and permanent US hegemony. There�s
no quantifiable difference between any of them.
The impending economic crisis is part of a much broader
scheme to remake the political system from the ground up, so it better meets
the needs of ruling elite. After the crash, public assets will be sold at fire
sale prices to the highest bidder. Public lands will be auctioned off. Basic
services will be privatized. Democracy will be shelved.
The unsupervised expansion of credit through interest rate
manipulation is the fast-track to tyranny. Thomas Jefferson fully understood
this. He said, �If the American people ever allow private banks to control the
issue of our currency, first by inflation, then by deflation, the banks and the
corporations that will grow up will deprive the people of all property until
their children wake up homeless on the continent their fathers conquered.�
We are now in the first phase of Greenspan�s Depression. The
stock market is headed for the doldrums and the economy will quickly follow.
Many more mortgage lenders, hedge funds and investment banks will be carried
out feet first.
As the disaster unfolds, we should try to focus on where the
troubles began and keep in mind Jefferson�s injunction: �The issuing of power
should be taken from the banks and restored to the people to whom it properly
Rep. Ron Paul is the only presidential candidate who
supports abolishing the Federal Reserve.
Whitney lives in Washington state. He can be reached at email@example.com.