On Friday morning, Senator Christopher Dodd, the head of the
Senate Banking Committee, was interviewed on ABC�s �Good Morning America.� Dodd
revealed that just hours earlier at an emergency meeting convened by Secretary
of the Treasury Henry Paulson and Federal Reserve chairman Ben Bernanke,
lawmakers were told that �We�re literally maybe days away from a complete
meltdown of our financial system.� Dodd added somberly, that in his three
decades of serving in public office, he had �never heard language like this.�
The system is at the breaking point, and despite Wall Street�s
elation over the proposed $1 trillion dollar bailout to remove toxic
mortgage-backed debt from banks� balance sheets, the market is still correcting
in what has become a vicious downward cycle. This cycle will persist until the
bad debts are accounted for and written off for or until the exhausted
dollar-system collapses altogether. Either way, the volatility and violent
dislocations will continue for the foreseeable future.
Most people don�t understand what happened on Thursday, but
the build-up of bad news on the Lehman default and the $85 billion government
takeover of AIG triggered a run on the money markets and a freeze in interbank
lending. The overnight LIBOR rate (London Interbank Offered Rate) more than
doubled to 6.44 percent! Bank of America reported overnight borrowing rates in
excess of 6 percent. Longer-term LIBOR rates also rose sharply. On Wednesday,
jittery investors removed their money from money markets and flooded short-term
US Treasuries for the assurance of a government guarantee on their savings even
though interest rates had turned negative, which means that their worth would
actually shrink at the date of maturity. This is unprecedented, but it
does help to illustrate how raw fear can drive the market.
The TED spread (the TED spread measures market stress by
revealing the reluctance of banks to lend to each other) widened and the credit
markets froze in place. Borrowing three-month dollars on the interbank market
and the U.S. Treasury�s three-month borrowing costs widened five full
percentage points. That�s huge. The banking system shut down.
What does it mean? It means the Federal Reserve has lost
control of the system. The market is driving interest rates now, and the market
is terrified. End of story.
When the Fed announced its emergency program to dump $180
billion into the global banking system, short term LIBOR retreated slightly but
long-term rates have remained stubbornly high. The noose continues to tighten.
These rates are pinned to 6 million US mortgages which will be resetting in the
next few years. That�s more bad news for the housing industry.
The entire system is deleveraging with the ferocity of a
Force-5 gale touching down in the Gulf, and yet, Henry Paulson has decided that
the prudent thing to do is build levies around the system with paper dollars.
Naturally, many people who understand the power of market-corrections are
skeptical. It won�t work. LIBOR is pushing rates upwards -- that�s the �true�
cost of money. The Fed Funds rate (2 percent) is supported by infusions of
paper dollars into the banking system to keep interest rates artificially low.
Now the extreme pace of deleveraging has the Fed on the ropes. Trillions of
dollars of credit are being sucked into a black hole which is raising the price
of money. It�s out of Bernanke�s control. He needs to step out of the way and
let prices fall or the dollar system will vanish in a deflationary vacuum.
The problems cannot be resolved by shifting the debts of the
banks onto the taxpayer. That�s an illusion. By adding another $1 or $2
trillion dollars to the national debt, Paulson is just ensuring that interest
rates will go up, real estate will crash, unemployment will soar, and foreign
central banks will abandon the dollar. In truth, there is no fix for a
deleveraging market anymore than there is a fix for gravity. The belief that
massive debts and insolvency can be erased by increasing liquidity just shows a
fundamental misunderstanding of economics. That�s why Henry Paulson is the
worst possible person to be orchestrating the so-called rescue project. Paulson
comes from a business culture which rewards deception, personal
acquisitiveness, and extreme risk-taking. Paulson is to finance capitalism what
Rumsfeld is to military strategy. His leadership, and the Congress� pathetic
abdication of responsibility, assures disaster. Besides, why should the
taxpayers be happy that the stocks of Morgan Stanley, Washington Mutual and
Goldman Sachs surged Friday on the news that there would be a government bailout?
These banks are essentially bankrupt and their business models are broken.
Keeping insolvent banks on life support is not a rescue plan; it�s insanity.
No one has any idea of the magnitude of the deleveraging
ahead or the size of the debts that will have to be written down. That�s
because 30 years of deregulation have allowed a parallel financial system to
arise in which over $500 trillion dollars in derivatives are traded without any
government supervision or accounting. These counterparty transactions are
interwoven throughout the entire �regulated� system in a way that poses a clear
and present danger to the broader economy. It�s a mess. For example, there
are an estimated $62 trillion of Credit Default Swaps (CDS) alone, which are
basically insurance policies for defaulting bonds. AIG was as heavily involved
in CDS as they were in regulated insurance products. So why would AIG sell CDS
rather than conventional insurance?
Because, just like the banks, AIG could maximize its profits
by minimizing its capital cushion. In other words, it didn�t really have the
capital to pay off claims when its CDS contracts began to blow up. If it had
been properly regulated, then government regulators would have made sure that
it was sufficiently capitalized with adequate reserves to pay off claims in a
down-market. Now taxpayers will pay for the lawless system which men like �industry
rep� Henry Paulson put in place. That�s deregulation in a nutshell; a system
that allows Wall Street banksters to create credit out of thin air and then run
weeping to Congress when their swindles backfire.
Inflating the currency, printing more money, and increasing
the deficits won�t help. The bad debts have to be accounted for and liquidated.
The Paulson strategy is to create another ocean of red ink while refusing
to face the underlying problem head-on. This just further exacerbates the
consumer-led recession which economists know is already setting in
everywhere across the country. Demand is down and consumer spending is off
due to falling home equity, job losses, and tighter lending standards at the
banks. The broader economy does not need the added downward pressure from
higher taxes, bigger deficits, or inflation. Paulson�s plan is a Band-Aid
approach to a sucking chest wound. The debts are enormous and the pain will be
substantial, but the problem cannot be resolved by crushing the middle class or
destroying the currency.
The malfunctioning of the markets and the freeze-over in the
banking system are the outcome of a massive credit unwind instigated by
trillions of dollars of low interest credit from the Federal Reserve, which was
magnified many times over via complex derivatives contracts and extreme
leveraging by speculative investment bankers. This has generated the
biggest equity bubble in history. That bubble is now set for a �hard-landing�
which is the predictable result of an unsupervised marketplace where
individual players are allowed to create as much credit as they choose.
If Paulson is not removed and his rescue plan scrapped
altogether; the dollar will lose its position as the world�s reserve currency
and the US government will face a historic funding crisis as foreign sources of
capital dry up. That will thrust the country into a hyper-inflationary
Whitney lives in Washington state. He can be reached at firstname.lastname@example.org.