"I just saw a picture of Bernanke
stripped to the waist in the boiler-room shoveling greenbacks into the
furnace.� Rob Dawg, Calculated Risk blog-site
On January 14, the FDIC web site began posting the rules for
reimbursing depositors in the event of a bank failure.
Deposit Insurance Corporation (FDIC) is required to �determine the total
insured amount for each depositor. . . . as of the day of the failure� and
return their money as quickly as possible. The agency is �modernizing its
current business processes and procedures for determining deposit insurance
coverage in the event of a failure of one of the largest insured depository
The implication is clear, the FDIC has begun a �death
vigil" for the many banks which are currently drowning in their own red
ink. The problem for the FDIC is that it has never supervised a bank failure
which exceeded 175,000 accounts. So the impending financial tsunami is likely
to be a crash-course in crisis management. Today some of the larger banks have
more than 50 million depositors, which will make the FDIC's job nearly
It's worth noting that, due to a rule change by Congress in
1991, the FDIC is now required to use �the least costly transaction when
dealing with a troubled bank. The FDIC won't reimburse uninsured depositors if
it means increasing the loss to the deposit insurance fund. . . . As a result,
uninsured depositors are protected only if a bank acquiring the failed bank
will pay more for all of the deposits than it would for insured deposits only.�
Great. That's reassuring. And there's more, too. FDIC
Chairman Shiela Bair warned that �as of Sept. 30, there were 65 institutions
with assets of $18.5 billion on its list of 'problem' institutions;� although
she wouldn't give names.
So, what does it all mean?
It means there's going to be an unprecedented wave of bank
closures in the US and that people who want to hold on to their life savings
are going have to be extra vigilant as the situation continues to deteriorate.
And it is deteriorating very quickly.
Right now, many of the country's largest investment banks
are holding $500 billion in mortgage-backed securities and other structured
investments that are steadily depreciating in value. As these assets wear-away
the banks' capital, the likelihood of default becomes greater. Last week, Fitch
Ratings announced that it will (probably) cut ratings on the five main bond
insurers (Ambac, MBIA, FGIC, CIFG,SCA) �regardless of their capital levels.�
This seemingly innocuous statement has roiled markets and put Wall Street in a
panic. If the bond insurers lose their AAA rating (on an estimated $2.4
trillion of bonds) then the banks could lose another $70 billion in downgraded
assets. That would increase their losses from the credit crunch -- which began
in August 2007 -- to $200 billion with no end in sight. It would also impair
their ability to issue loans to even credit worthy customers, which will
further dampen growth in the larger economy. Structured investments have been
the banks' �cash cow� for nearly a decade, but, suddenly, the trend has shifted
into reverse. Revenue streams have dried up and capital is being destroyed at
an accelerating pace. The $2 trillion market for collateralized debt
obligations (CDOs) is virtually frozen leaving horrendous debts that will have
to be written-down leaving the banks' either deeply scarred or insolvent. It's
There were some interesting developments in a case involving
Merrill Lynch which sheds a bit of light on the true �market value� of these
complex debt-pools called CDOs. The Massachusetts Secretary of State on Feb. 1
charged Merrill with �fraud and misrepresentation� for selling them a CDO that
was "highly risky and esoteric" and "unsuitable for the City of
Springfield.� (Most cities are required by law to only purchase Triple A rated
bonds) The city of Springfield bought the CDO less than a year ago for $13.9
million. It is presently valued at $1.2 million -- more than a 90 percent loss
in less than a year.
Merrill has quietly settled out of court for the full amount
and seems genuinely confused by the Massachusetts Secretary of State's apparent
anger. A Merrill spokesman said blandly, �We are puzzled by this suit. We have
been cooperating with the Secretary of State Galvin's office throughout this
Is it really that hard to understand why people don't like
getting ripped of?
This anecdote shows that these exotic mortgage-backed
securities are real stinkers. They're worthless. The market for structured
debt-instruments has evaporated overnight leaving a massive hole in the banks'
balance sheets. The likely outcome will be a rash of defaults followed by
greater consolidation of the major players (re: banking monopolies). The Fed's
multi-billion bailout plan; the �Temporary Auction Facility� (TAF) is a quick
fix, but not a permanent solution. The real problem is insolvency, not
The smaller banks are in dire straights, too. They're bogged
down with commercial and residential loans that are defaulting faster than at
any time since the Great Depression. Comptroller of the Currency John Dugan --
who is presently investigating commercial real estate loans -- discovered that
commercial banks �wrote off $524 million in construction and development loans
in the third quarter of 2007, almost nine times the amount of 2006.� The
commercial real estate market is following residential real estate off a cliff
and will undoubtedly be the next shoe to drop.
Dugan found out that, �More than 60 percent of Florida banks
have commercial real estate loans worth more than 300 percent of their capital,
a level that automatically attracts more attention from examiners.� [Wall
Street Journal] He said that his office was prepared to intervene if banks with
large real estate exposure maintained unreasonably low reserves for bad loans.
Dugan is forecasting a steep �increase in bank failures.�
According to Reuters: �Dozens of U.S. banks will fail in the
next two years as losses from soured loans mount and regulators crack down on
lenders that take too much risk, especially in real estate and
construction," predicts Gerard Cassidy, RBC Capital Markets analyst. Apart
from the growing losses in commercial and residential real estate, the banks
are carrying over $150 billion of �unsyndicated� debt connected to leveraged buyout
deals (LBOs) which are presently stuck in the mud. Like CDOs, there's no market
for these sketchy transactions which require billions in cheap, easily
available credit. They've just become another anvil dragging the banks under.
On January 31, Bloomberg News reported: �Losses from
securities linked to subprime mortgages may exceed $265 billion as regional
U.S. banks, credit unions and overseas financial institutions write down the
value of their holdings.� Standard & Poor's added that �it may cut or reduce
ratings of $534 billion of subprime-mortgage securities and CDOs as default
rates rise.� Another blow to the banks withering balance sheets. Is it any
wonder why the "new loans" spigot has been turned off?
Surprisingly, there's an even bigger threat to the financial
system than these staggering losses at the banks. A default by one of the big
bond insurers could trigger a meltdown in the credit-default swaps market,
which could lead to the implosion of trillions of dollars in derivatives bets.
The inability of the under-capitalized monolines (bond insurers) to �make good�
on their coverage is likely to set the first domino in motion by increasing the
number of downgrades on bond issues and intensifying the credit-paralysis which
already is spreading throughout the system.
MSN Money's financial analyst Jim Jubak summed it up like
this: "Actually, I'm worried not so much about the junk-bond market itself
as the huge market for a derivative called a credit-default swap, or CDS, built
on top of that junk-bond market. Credit-default swaps are a kind of insurance
against default, arranged between two parties. One party, the seller, agrees to
pay the face value of the policy in case of a default by a specific company.
The buyer pays a premium, a fee, to the seller for that protection.
"This has grown to be a huge market: The total value of
all CDS contracts is something like $450 trillion . . . Some studies have put
the real credit risk at just 6 percent of the total, or about $27 trillion.
That puts the CDS market at somewhere between two and six times the size of the
"All it will take in the CDS market is enough buyers
and sellers deciding they can't rely on this insurance anymore for junk-bond
prices to tumble and for companies to find it very expensive or impossible to
raise money in this market." [Jim Jubak's Journal; "The Next Banking
Crisis is on the Way", MSN Money]
Jubak really nails it here. In fact, this is what Wall
Street is really worried about: $450 trillion in cyber-credit has been created
through various off balance sheet operations which neither the Fed nor any
other regulatory body can control. No one even knows how these abstruse,
credit-inventions will perform in a falling market. But, so far, it doesn't
The enormity of the derivatives market ($450 trillion) is
the direct result of Greenspan's easy-credit monetary policies as well as the
reconfiguring of the markets according to the �structured finance� model. The
new model allows banks to run off-balance sheet operations that, in effect,
create money out of thin air. Similarly, �synthetic� securitization, in the
form of credit default swaps (CDS), has turned out to be another scam to avoid
maintaining sufficient capital to cover a sudden rash of defaults. The bottom
line is that the banks and non-bank institutions wanted to maximize their
profits by keeping all their capital in play rather than maintaining the
reserves they'd need in the event of a market downturn.
In a deregulated market, the Federal Reserve cannot control
the creation of credit by non-bank institutions. As the massive derivatives
bubble unwinds, it is likely to have real and disastrous effects on the
underlying productive economy. That's why Jubak and many other market analysts
are so concerned. The persistent rise in home foreclosures, means that the
derivatives which were levered on the original assets (sometimes exceeding 25
times their value) will vanish down a black hole. As trillions of dollars in
virtual-capital are extinguished by a click of the mouse; the prospects of a
downward deflationary spiral become more likely.
As economist Nouriel Roubini said, �One has to realize that
there is now a rising probability of a 'catastrophic' financial and economic
outcome, i.e., a vicious circle where a deep recession makes the financial
losses more severe and where, in turn, large and growing financial losses and a
financial meltdown make the recession even more severe. That is why the Fed has
thrown caution to the wind and taken a very aggressive approach to risk
management.� [Nouriel Roubini EconoMonitor]
"In the fourth quarter of 2007, new foreclosures
averaged 2,939 a day, double the pace of a year earlier." [RealtyTrac
Inc.] The banks are presently cutting back on home equity loans which provided
an additional $600 billion to homeowners last year for personal consumption.
Bush's $150 billion �stimulus package� will barely cover a quarter of the
amount that is lost. As consumer spending slows and the banks become more
constrained in their lending, businesses will face overproduction problems and
will have to limit their expansion and lay off workers. This is the downside of
�low interest� bubble-making, a painful descent into deflation.
Capital is now being destroyed at a faster pace than it is
being created. That's why the Fed is looking for solutions beyond mere rate
cuts. Bernanke wants direct government action that will provide immediate
stimulus. But that takes political consensus and there's still debate about the
gravity of the upcoming recession. The pace of the economic contraction is
breathtaking. Last week's release of the Institute for Supply Management's
Non-Manufacturing Index (ISM) was a shocker. It showed steep declines in all
areas of the nation's service sector -- including banks, travel companies,
contractors, retail stores, etc. -- The Business Activity Index, the New Orders
Index, the Employment Index, and the Supplier Delivery Index have all
contracted at a �historic� pace. Everyone took a hit.
�The numbers are so terrible, it's beyond belief,� said
Scott Anderson, senior economist at Wells Fargo & Co.
The $2 trillion that has been wiped out from falling home
prices, the slowdown in lending activity at the banks, the loss of $600 billion
in home equity loans, and the faltering stock market have all contributed to a
noticeable change in the public's attitudes towards spending. Traffic to the
shopping malls has slowed to a crawl. Retail shops had their worst January on
record. Homeowners are hoarding their earnings to cover basic expenses and to
make up for their lack of personal savings. The spending spigot has been turned
off. America's consumer culture is in full retreat. The slowdown is here. It is
now. We are likely to see the sharpest decline in consumer spending in US history.
Bush's $150 billion will be too little too late.
America's place in the world has been guaranteed not by what
it produces but by what it consumes. The American consumer has been the
locomotive that drives the global economy. Now that engine has been derailed by
the reckless monetary policies of the Fed and by shortsighted financial
innovation. When equity bubbles collapse; everybody pays. Demand for goods and
services diminishes, unemployment soars, banks fold, and the economy stalls.
That's when governments have to step in and provide programs and resources that
keep people working and sustain business activity. Otherwise there will be
anarchy. Middle class people are ill-suited for life under a freeway overpass.
They need a helping hand from government. Big government. Good-bye, Reagan.
The Bush stimulus plan is just a drop in the bucket. It'll
take more; much more. And, we're not holding our breath expecting a New Deal
from George Walker Bush.
Whitney lives in Washington state. He can be reached at email@example.com.