U.S. banks brace for storm surge as dollar and credit system reel
By Mike Whitney
Online Journal Contributing Writer
Sep 20, 2007, 00:56
By now, you�ve probably seen the photos of the angry
customers queued up outside of Northern Rock Bank waiting to withdraw their
money. This is the first big run on a British bank in over a century. It�s lost
an eighth of its deposits in three days.
The pictures are headline news in the U.K. but have been
stuck on the back pages of U.S. newspapers. The reason for this is obvious. The
same Force 5 economic-hurricane that just touched ground in Great Britain is
headed for America and gaining strength on the way.
On Monday night, desperately trying to stave off a wider
panic, the British government issued an emergency pledge to Northern Rock
savers that their money was safe. The government is trying to find a buyer for
This is what a good old-fashioned bank run looks like. And,
as in 1929, the bank owners and the government are frantically trying to calm
down their customers by reassuring them that their money is safe. But human
nature being what it is, people are not so easily pacified when they think
their savings are at risk. The bottom line is this: The people want their
money, not excuses.
But Northern Rock doesn�t have their money and,
surprisingly, it is not because the bank was dabbling in risky subprime loans.
Rather, NR had unwisely adopted the model of �borrowing short to go long� in
financing their mortgages, just like many of the major banks in the U.S. In other
words, they depended on wholesale financing of their mortgages from eager
investors in the market, instead of the traditional method of maintaining
sufficient capital to back up the loans on their books.
It seemed like a nifty idea at the time and most of the big
banks in the US were doing the same thing. It was a great way to avoid
bothersome reserve requirements and the loan origination fees were profitable
as well. Northern Rock�s business soared. Now they carry a mortgage book
totaling $200 billion dollars.
$200 billion! So why can�t they pay out a paltry $4 or $5
billion to their customers without a government bailout?
It�s because they don�t have the reserves and because the
bank�s business model is hopelessly flawed and no longer viable. Their assets
are illiquid and (presumably) �marked to model,� which means they have no
discernible market value. They might as well have been �marked to fantasy,� it
amounts to the same thing. Investors don�t want them. So Northern Rock is stuck
with a $200 billion albatross that�s dragging them under.
A more powerful tsunami is about to descend on the United
States where many of the banks have been engaged in the same practices and are
using the same business model as Northern Rock. Investors are no longer buying
CDOs, MBSs, or anything else related to real estate. No one wants them, whether
they�re subprime or not. That means that US banks will soon undergo the same
type of economic gale that is battering the U.K right now. The only difference
is that the U.S. economy is already listing from the downturn in
housing and an increasingly jittery stock market.
That�s why Treasury Secretary Henry Paulson rushed off to
England Monday to see if he could figure out a way to keep the contagion from
Good luck, Hank.
It would interesting to know if Paulson still believes that
�This is far and away the strongest global economy I�ve seen in my business
lifetime,� or if he has adjusted his thinking as troubles in subprime,
commercial paper, private equity, and credit continue to mount?
For weeks we�ve been saying that the banks are in trouble
and do not have the reserves to cover their losses. This notion was originally
pooh-poohed by nearly everyone. But it�s becoming more and more apparent that
it is true. We expect to see many bank failures in the months to come. Prepare
yourself. The banking system is mired in fraud and chicanery. Now the schemes
and swindles are unwinding and the bodies will soon be floating to the surface.
�Structured finance� is
touted as the �new architecture of financial markets.� It is designed to
distribute capital more efficiently by allowing other market participants to
fill a role which used to be left exclusively to the banks. In practice,
however, structured finance is a hoax; and undoubtedly the most expensive hoax
of all time. The transformation of liabilities (dodgy mortgage loans) into
assets (securities) through the magic of securitization is the biggest
boondoggle of all time. It is the moral equivalent of mortgage laundering. The
system relies on the variable support of investors to provide the funding for
pools of mortgage loans that are chopped up into tranches and duct-taped
together as CDOs (collateralized debt obligations). It�s madness; but no one
seemed to realize how crazy it was until Bear Stearns blew up and they couldn�t
find bidders for their remaining CDOs. It�s been downhill ever since.
The problems with structured finance are not simply the
result of shabby lending and low interest rates. The model itself is defective.
John R. Ing provides a great synopsis of structured finance
in his article, �Gold: The Collapse of the Vanities�: "The origin of the
debt crisis lies with the evolution of America's financial markets using
financial engineering and leverage to finance the credit expansion. . . . Financial
institutions created a Frankenstein with the change from simply lending money
and taking fees to securitizing and selling trillions of loans in every market
from Iowa to Germany. Credit risk was replaced by the "slicing and
dicing" of risk, enabling the banks to act as principals, spreading that
risk among various financial institutions. . . . . Securitization allowed a
vast array of long term liabilities once parked away with collateral to be
resold along side more traditional forms of short term assets. Wall Street
created an illusion that risk was somehow disseminated among the masses.
Private equity too used piles of this debt to launch ever bigger buyouts. And,
awash in liquidity and very sophisticated algorithms, investment bankers found
willing hedge funds around the world seeking higher yielding assets. Risk was
piled upon risk. We believe that the subprime crisis is not a one off event but
the beginning of a significant sea change in the modern-day financial markets.�
The investment sharks who conjured up �structured finance�
knew exactly what they were doing. They were in bed with the ratings agencies
-- off-loading trillions of dollars of garbage-bonds to pension funds, hedge
funds, insurance companies and foreign financial giants. It�s a swindle of epic
proportions and it never would have taken place in a sufficiently regulated
When crowds of angry people are huddled outside the banks to
get their money, the system is in real peril. Credibility must be restored
quickly. This is no time for Bush�s �free market� nostrums or Paulson�s
soothing bromides (he thinks the problem is �contained�) or Fed Chairman
Bernanke�s feeble rate cuts. This requires real leadership.
The first thing to do is take charge, alert the public to
what is going on and get Congress to work on substantive changes to the system.
Concrete steps must be taken to build public confidence in the markets. And
there must be a presidential announcement that all bank deposits will
be fully covered by government insurance.
The lights should be blinking red at all the related
government agencies including the Fed, the SEC, and the Treasury Dept. They
need to get ahead of the curve and stop thinking they can minimize a potential
catastrophe with their usual public relations mumbo jumbo.
Last week, an article appeared in the Wall Street Journal,
�Banks Flock to Discount Window.� (9-14-07) The article chronicled the sudden
up-tick in borrowing by the struggling banks via the Fed�s emergency bailout
program, the �Discount Window�:
�Discount borrowing under the Fed�s primary credit program
for banks surged to more than $7.1 billion outstanding as of Wednesday, up from
$1 billion a week before.�
Again we see the same pattern developing; the banks
borrowing money from the Fed because they cannot meet their minimum reserve
WSJ: �The Fed in its weekly release said average daily
borrowing through Wednesday rose to $2.93 billion.�
Traditionally, the �Discount Window� has only been used by
banks in distress, but the Fed is trying to convince people that it�s really
not a sign of distress at all. It�s �a sign of strength.� Baloney. Banks don�t
borrow $3 billion unless they need it. They don�t have the reserves. Period.
The real condition of the banks will be revealed sometime in
the next few weeks when they report earnings and account for their massive
losses in �down-graded� CDOs and MBSs.
Market analyst Jon Markman offered these words of advice to
the financial giants: "Before they [the financial industry] take down the
entire market this fall by shocking Wall Street with unexpected losses, I
suggest that they brush aside their attorneys and media handlers and come
clean. They need to tell the world about the reality of their home lending and
loan securitization teams' failures of the past four years -- and the truth
about the toxic paper that they've flushed into the world economic system, or
stuffed into Enron-like off-balance sheet entities -- before the markets make them
walk the plank..� . . ." Since government regulators and Congress have
flinched from their responsibility to administer 'tough love' with rules
forcing financial institutions to detail the creation, securitization and
disposition of every ill-conceived subprime loan, off-balance sheet 'structured
investment vehicle,' secretive money-market 'conduit' and
commercial-paper-financing vehicle, the market will do it with a
Good advice. But, so far, the banks aren't listening and
Tuesday's cut to the Fed�s fund rate has sent the stock market roaring back
into positive territory.
But interest rate cuts do not address the underlying
problems of insolvency among homeowners, mortgage lenders, hedge funds and
(potentially) banks. As market analyst John R. Ing said, �A cut in rates will
not solve the problem. This crisis was caused by excess liquidity and a
deterioration of credit standards. . . . A cut in the Fed Fund rate is simply
heroin for credit junkies.�
The cuts merely add more cheap credit to a market that that
is already overinflated from the ocean of liquidity produced by former Fed
chief Alan Greenspan. The housing bubble and the credit bubble are largely the
result of Greenspan�s misguided monetary policies (for which he now blames
Bush!). The Fed�s job is to ensure price stability and the smooth operation of
the markets, not to reinflate equity bubbles and reward overexposed market
It�s better to let cash-strapped borrowers default than
slash interest rates and trigger a global run on the dollar. Financial analyst
Richard Bove says that lower interest rates will do nothing to bring money back
into the markets. Instead, lower interest rates will send the dollar into a
tailspin and wreak havoc on the job market.
�There is no liquidity problem, but a serious crisis of
confidence," Bove said.
"In a financial system where there is ample liquidity
and a desire for higher rates to compensate for risk, the solution is not to
create more liquidity and lower the rates that are available to compensate for
risk. . . . [The Fed] cannot reduce fear by stimulating inflation . . .
"It is illogical to assume that holders of cash will
have a strong desire to lend money at low rates in a currency that is declining
in value when they can take these same funds and lend them at high rates in a
currency that is gaining in value. By lowering interest rates the Federal
Reserve will not stimulate economic growth or create jobs. It will crash the
currency, stimulate inflation, and weaken the economy and the job
Bove is right. The people and businesses that cannot repay
their debts should be allowed to fail. Further weakening the dollar only adds
to our collective risk by feeding inflation and increasing the likelihood of
capital flight from American markets. If that happens, we�re toast.
Consider this: In 2000, when Bush took office, gold was $273
per ounce, oil was $22 per barrel and the euro was worth $.87 per dollar.
Currently, gold is over $700 per ounce, oil is over $80 per barrel, and the
euro is nearly $1.40 per dollar. With Bernanke's rate cuts, we�re likely to see
oil at $125 per barrel by next spring.
Inflation is soaring. The government statistics are
thoroughly bogus. Gold, oil and the euro don�t lie. According to economist
Martin Feldstein, �The falling dollar and rising food prices caused
market-based consumer prices to rise by 4.6 per cent in the most recent
That�s 18.4 percent a year, and yet Bernanke is cutting
interest rates and further fueling inflation.
What about the American worker whose wages have stagnated
for the last six years? Inflation is the same as a pay cut for him. And how
about the pensioner on a fixed income? Same thing. Inflation is just a hidden
tax progressively eroding his standard of living.
Bernanke�s rate cut may be boon to the �cheap credit�
addicts on Wall Street, but it�s the death-knell for the average worker who is
already struggling just to make ends meet.
Let the banks and hedge funds sink or swim like everyone
else. The message to Bernanke is simple: �It�s time to take away the punch
The inflation in the stock market is just as evident as it
is in the price of gold, oil or real estate. Economist and author Henry Liu
demonstrates this in his article �Liquidity Boom and the Looming Crisis�:
"The conventional value paradigm is unable to explain why the market
capitalization of all US stocks grew from $5.3 trillion at the end of 1994 to
$17.7 trillion at the end of 1999 to $35 trillion at the end of 2006,
generating a geometric increase in price earnings ratios and the like.
Liquidity analysis provides a ready answer." (Asia Times)
Market capitalization zoomed from $5.3 trillion to $35
trillion in 12 years? Why? Was it due to growth in market share, business
expansion or productivity?
No. It was because there were more dollars chasing the same
number of securities; hence, inflation.
If that is the case, then we can expect the stock market to
fall sharply before it reaches a sustainable level. As Liu says, �It is not
possible to preserve the abnormal market prices of assets driven up by a
liquidity boom if normal liquidity is to be restored.� Eventually, stock prices
will return to a normal range.
Bernanke should not have even be contemplated a rate cut.
The market needs more discipline not less. And workers need a stable dollar.
Besides, another rate cut further jeopardizes the greenback�s increasingly
shaky position as the world�s �reserve currency.� That could destabilize the
global economy by rapidly unwinding the U.S. massive current account deficit.
The International Herald Tribune summed up the dollar�s
problems in a recent article, "Dollar's Retreat Raises Fear of
Collapse": "Finance ministers and central bankers have long fretted
that at some point, the rest of the world would lose its willingness to finance
the United States' proclivity to consume far more than it produces -- and that
a potentially disastrous free-fall in the dollar's value would result.
"The latest turmoil in mortgage markets has, in a
single stroke, shaken faith in the resilience of American finance to a greater
degree than even the bursting of the technology bubble in 2000 or the terror
attacks of Sept. 11, 2001, analysts said. It has also raised prospect of a
recession in the wider economy.
"This is all pointing to a greatly increased risk of a
fast unwinding of the U.S. current account deficit and a serious decline of the
Other experts and currency traders have expressed similar
sentiments. The dollar is at historic lows in relation to the basket of
currencies against which it is weighted. Bernanke is taking a chance that his
effort to rescue the markets won't cause a sudden sell-off of the dollar.
The Fed chief�s hands are tied. Bernanke simply doesn�t have
the tools to fix the problems before him. Insolvency cannot be fixed with
liquidity injections, nor can the deeply-rooted �systemic� problems in
�structured finance� be corrected by slashing interest rates. These require
fiscal solutions, congressional involvement, and fundamental economic policy
Rate cuts won�t help to rekindle the spending spree in the
housing market, either. That charade is over. The banks have already tightened
lending standards and inventory is larger than anytime since they began keeping
records. The slowdown in housing is irreversible as is the steady decline in
real estate prices. Trillions in market capitalization will be wiped out. Home
equity is already shrinking as is consumer spending connected to home equity
The bubble has popped regardless of what Bernanke does. The
same is true in the clogged Commercial Paper market where hundreds of billions
of dollars in short-term debt is due to expire in the next few weeks. The banks
and corporate borrowers are expected to struggle to refinance their debts but,
of course, much of the debt will not roll over. There will be substantial
losses and, very likely, more defaults.
Bernanke can either be a statesman and tell the country the
truth about our dysfunctional financial system which is breaking down from
years of corruption, deregulation and manipulation or he can take the
coward's route and buy some time by flooding the system with liquidity,
stimulating more destructive consumerism, and condemning the nation to an
avoidable cycle of double-digit inflation.
Whitney lives in Washington state. He can be reached at email@example.com.
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