The collapse of the modern day banking system
By Mike Whitney
Online Journal Contributing Writer
Dec 18, 2007, 01:05
Stocks fell sharply
last week on news of accelerating inflation which will limit the Federal
Reserves ability to continue cutting interest rates.
Last Tuesday the Dow
Jones Industrials tumbled 294 points following the Fed's announcement of a
quarter point cut to the Fed Funds rate. On Friday, the Dow dipped another 178
points when government figures showed consumer prices had risen 0.8 percent
last month after a 0.3 percent gain in October. The stock market is now
lurching downward into a "primary bear market."
There has been a
steady deterioration in retail sales, commercial real estate, and the
transports. The financial industry is going through a major retrenchment,
losing more than 25 per cent in aggregate capitalization since July. The real
estate market is collapsing. California Gov. Arnold Schwarzenegger announced on
Friday that he will declare a "fiscal emergency" in January and ask
for more power to deal with the $14 billion budget shortfall from the meltdown
in subprime lending.
beginning to publicly acknowledge what many market analysts have suspected for
months; the nation's economy is going into a tailspin.
Asia Chairman, Stephen Roach, made this observation in a New York Times op-ed
on Sunday: "This recession will be deeper than the shallow contraction
earlier in this decade. The dot-com-led downturn was set off by a collapse in
business capital spending, which at its peak in 2000 accounted for only 13
percent of the country's gross domestic product. The current recession is all
about the coming capitulation of the American consumer -- whose spending now
accounts for a record 72 percent of G.D.P."
Most people have no
idea how grave the present situation is or the disaster the country will face
if trillions of dollars of over-leveraged bonds and equities begin to unwind.
There's a widespread belief that the stewards of the system -- Bernanke and
Paulson -- can somehow steer the economy through this "rough patch"
into calm waters. But they cannot, and the presumption shows a basic
misunderstanding of how markets work. The Fed has no magical powers and will
not allow itself to be crushed by standing in the path of a market avalanche.
As foreclosures and bankruptcies increase; stocks will crash and the Fed will
step aside to safety.
In the last few weeks, Bernanke and Paulson have tried a
number of strategies that have failed. Paulson concocted a plan to help the
major investment banks consolidate and repackage their nonperforming
mortgage-backed junk into a "Super SIV" to give them another chance
to unload their bad investments on the public. The plan was nothing more than a
public relations ploy which has already been abandoned by most of the key
participants. Paulson's involvement is a real black eye for the Dept. of the
Treasury. It makes it look as if he's willing to dupe investors as long as it
helps his d Wall Street buddies.
Paulson also put together
an "industry friendly" rate freeze that is supposed to help
struggling homeowners avoid foreclosure. But the plan falls well short of
providing any meaningful aid to the estimated 3.5 million homeowners who are
facing the prospect of defaulting on their loans if they don't get government
assistance. Recent estimates by industry experts say that Paulson's plan will
only help 140,000 mortgage holders, leaving millions of others to fend for
themselves. Paulson has proved over and over that he is just not up to the task
of confronting an economic challenge of this magnitude head-on.
Fed chief Bernanke hasn't done much better than Paulson. His
three-quarter point cut to the Fed's Funds rate hasn't lowered interest rates
on mortgages, stimulated greater home sales, stabilized the stock market or
helped banks deal with their massive debt-load. It's been a flop from start to
finish. All it's done is weaken the dollar and trigger a wave of inflation. In
fact, government figures now show energy prices are rising at 18.1 per cent
annually. Bernanke is apparently following Lenin's supposed injunction though
there's no conclusive evidence he actually said it -- that "the best way
to destroy the Capitalist System is to debauch the currency."
On Wednesday, the Federal Reserve initiated a
"coordinated effort" with the Bank of Canada, the Bank of England,
the European Central Bank, and the Swiss National Bank to address the
"elevated pressures in short-term funding of the markets." The Fed
issued a statement that "it will make up to $24 billion available to the
European Central Bank (ECB) and Swiss National Bank to increase the supply of
dollars in Europe." [Bloomberg] The Fed will also add as much as $40
billion, via auctions, to increase cash in the U.S. Bernanke is trying to loosen
the knot that has tightened Libor (London Interbank Offered Rate) rates in
England and reduced lending between banks. The slowdown is hobbling growth and
could send the world into a recessionary spiral.
Bernanke's "master plan" is little more than a cash
giveaway to sinking banks. It has scant chance of succeeding. The Fed is
offering $.85 on the dollar for mortgage-backed securities (MBSs) and
collateralized debt obligations (CDOs) that sold last week in the E*Trade
liquidation for $.27 on the dollar. At the same time, the Fed has promised to
keep the identities of the banks that are borrowing these emergency funds
secret from the public. The Fed is conducting its business like a bookie.
Unfortunately, the Fed bailout has achieved nothing. Libor
rates -- which are presently at seven-year highs -- have not come down at all.
This is causing growing concern among the leaders of the central banks around
the world, but there's really nothing they can do about it. The banks are
hoarding cash to meet their capital requirements. They are trying to compensate
for the loss of value to their (mortgage-backed) assets by increasing their
reserves. At the same time, the system is clogged with trillions of dollars of
bad paper which has brought lending to a halt. The huge injections of liquidity
from the Fed have done nothing to improve lending or lower interbank rates.
It's been a flop. The market is driving interest rates now. If the situation
persists, the stock market will crash.
Staring into the abyss
One of Britain's leading economists, Peter Spencer, issued a
warning on Saturday: "The Government must suspend a set of key banking
regulations at the heart of the current financial crisis or risk seeing the
economy spiral towards a future that could make 1929 look like a walk in the
Spencer is right. The banks don't have the money to loan to
businesses or consumers because they're trying to raise more cash to meet their
capital requirements on assets that continue to be downgraded. (The Fed may pay
$.85 on the dollar, but investors are unwilling to pay anything at all.)
Spencer correctly assumes that the reason the banks have stopped lending is not
because they "distrust" other banks, but because they are
capital-strapped from all their "off balance" sheets shenanigans. If
the Basel regulations aren't modified, money markets will remain frozen, GDP
will shrink, and there'll be a wave of bank closings.
Spencer said: "The Bank is staring into the abyss. The
Financial Services Authority must go round and check that all banks are
solvent, and then it should cut the Basel capital requirement level from 8pc to
about 6pc." [Call to Relax Basel Banking Rules, UK Telegraph]
Spencer confirms what we already knew; the banks are
seriously under-capitalized and will come under growing pressure as hundreds of
billions of dollars of mortgage-backed securities (MBSs) and collateralized
debt obligations (CDOs) continue to lose value and have to be propped up with
additional capital. The banks simply don't have the resources and there's going
to be a day of reckoning.
Pimco's Bill Gross put it like this: "What we are
witnessing is essentially the breakdown of our modern day banking system."
Gross is right, but he only covers a small portion of the problem.
The economist Ludwig von
Mises was more succinct in his analysis: "There is no means of avoiding
the final collapse of a boom brought on 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."
The basic problem originated with the Federal Reserve when
former Fed chief Alan Greenspan lowered interest rates below the rate of
inflation for 31 months straight, which pumped trillions of dollars of low
interest credit into the financial system and ignited a speculative frenzy in
real estate. Greenspan has spent a great deal of time lately trying to avoid
any blame for the catastrophe he created. He is a first-rate "buck
passer." In last Wednesday's Wall Street Journal, Greenspan scribbled out
a 1,500-word defense of his actions as head of the Federal Reserve, pointing
the finger at everything from China's "low cost workforce" to
"the fall of the Berlin Wall." The essay was typical Greenspan
gibberish. In his trademark opaque language; Greenspan tiptoes through the
well-documented facts of his tenure as Fed chief to absolve himself of any
personal responsibility for the ensuing disaster.
Greenspan's apologia is a masterpiece of circuitous logic,
deliberate evasion and utter denial of reality. He says, "I do not doubt
that a low U.S. federal-funds rate in response to the dot-com crash, and
especially the 1 per cent rate set in mid-2003 to counter potential deflation,
lowered interest rates on adjustable-rate mortgages (ARMs) and may have
contributed to the rise in U.S. home prices. In my judgment, however, the
impact on demand for homes financed with ARMs was not major."
"Not major"? -- 3.5 million potential foreclosures,
11-month inventory backlog, plummeting home prices, an entire industry in
terminal distress pulling down the global economy is not major?
But Greenspan is partially correct. The troubles in housing
cannot be entirely attributed to the Fed's "cheap credit" monetary
policies. They were also nursed along by a Doctrine of Deregulation which has
permeated US capital markets since the Reagan era. Greenspan's views on how
markets should function were -- to a great extent -- shaped by this
non-interventionist/non-supervisory ideology which has created enormous equity
bubbles and imbalances. The former Fed chief's support for adjustable rate
mortgages (ARMs) and subprime lending shows that Greenspan thought of himself
as more of a cheerleader for the big market players than an impartial referee
whose job was to monitor reckless or unethical behavior.
Greenspan also adds this revealing bit of information in his
article, "The value of equities traded on the world's major stock
exchanges has risen to more than $50 trillion, double what it was in 2002.
Sharply rising home prices erupted into major housing bubbles worldwide, Japan
and Germany (for differing reasons) being the only principal exceptions."
["The Roots of the Mortgage Crisis," Alan Greenspan, Wall Street Journal]
This admission proves Greenspan's culpability. If he knew
that stock prices had doubled their value in just three years, then he also
knew that equities had not risen due to increases in productivity or
demand.(market forces) The only reasonable explanation for the asset inflation,
therefore, was monetary policy. As his own mentor, Milton Friedman, famously
stated, "Inflation is always and everywhere a monetary phenomenon."
Any capable economist would have known that the explosion in housing and equities
prices was a sign of uneven inflation. Now that the bubble has popped,
inflation is spreading like mad through the entire economy.
Greenspan is a very sharp man. It is crazy to think he
didn't know what was going on. This is basic economic theory. Of course he knew
why stocks and housing prices were skyrocketing. He was the one who put the
dominoes in motion with the help of his printing press.
But Greenspan's low interest credit is only part of the
equation. The other part has to do with way that the markets have been
transformed by "structured finance."
What's so destructive about structured finance is that it
allows the banks to create credit "out of thin air," stripping the
Fed of its role as controller of the money supply. David Roache explains how
this works in an excerpt from his book, "New Monetarism," which
appeared in the Wall Street Journal: "The
reason for the exponential growth in credit, but not in broad money, was simply
that banks didn't keep their loans on their books any more -- and only loans on
bank balance sheets get counted as money. Now, as soon as banks made a loan,
they 'securitized' it and moved it off their balance sheet.
"There were two
ways of doing this. One was to sell the securitized loan as a bond. The other
was 'synthetic' securitization: for example, using derivatives to get rid of
the default risk (with credit default swaps) and lock in the interest rate due
on the loan (with interest-rate swaps). Both forms of securitization meant that
the lending bank was free to make new loans without using up any of its lending
capacity once its existing loans had been 'securitized.'
redefine liquidity under what I call New Monetarism, one must add, to the
traditional definition of broad money, all the credit being created and moved
off banks' balance sheets and onto the balance sheets of nonbank financial
intermediaries. This new form of liquidity changed the very nature of the
credit beast. What now determined credit growth was risk appetite: the
readiness of companies and individuals to run their businesses with higher
levels of debt."
The banks have been
creating trillions of dollars of credit (by originating mortgage-backed
securities, collateralized debt obligations and asset-backed commercial paper)
without maintaining the proportional capital reserves to back them up. That
explains why the banks were so eager to provide mortgages to millions of loan
applicants who had no documentation, no income, no collateral and a bad credit
history. They believed there was no risk, because they were making enormous
profits without tying up any of their capital. It was, quite literally, money
the mechanism for generating new loans (and fees) has broken down. The main
sources of bank revenue have either been seriously curtailed or dried up
entirely. (Mortgage-backed) commercial paper (ABCP), one such source of
revenue, has decreased by a full third (or $400 billion) in just 17 weeks.
Also, the securitization of mortgage-backed securities is DOA. The market for
MBSs and CDOs and other complex bonds has followed the Pterodactyl into the
history books. The same is true of structured investment vehicles (SIVs) and
other "off balance-sheet" swindles, which have either gone under
entirely or are presently withering with every savage downgrade in
mortgage-backed bonds. The mighty juggernaut that was grinding out the hefty
profits ("structured investments") has suddenly reversed and is
crushing everything in its path.
The banks don't have
the reserves to cover their downgraded assets and the Federal Reserve cannot
simply "monetize" their bad bets. There's no way out. There are bound
to be bankruptcies and bank runs. "Structured finance" has usurped
the Fed's authority to create new credit and handed it over to the banks.
Now everyone will
pay the price.
Investors have lost
their appetite for risk and are steering clear of anything connected to real
estate or mortgage-backed bonds. That means that an estimated $3 trillion of
securitized debt (CDOs, MBSs and ASCP) will come crashing to earth, delivering
a violent blow to the economy.
It's not just the
banks that will take a beating. As Professor Nouriel Roubini points out, the
broker dealers, the investment banks, money market funds, hedge funds and
mortgage lenders are in the crosshairs as well.
institutions do not have direct access to the Fed and other central banks
liquidity support and they are now at risk of a liquidity run as their
liabilities are short term while many of their assets are longer term and
illiquid; so the risk of something equivalent to a bank run for non-bank
financial institutions is now rising. And there is no chance that depository
institutions will re-lend to these to these non-banks the funds borrowed by
central banks as these banks have severe liquidity problems themselves and they
do not trust their non-bank counterparties. So now monetary policy is totally
impotent in dealing with the liquidity problems and the risks of runs on liquid
liabilities of a large fraction of the financial system." [Nouriel
Roubini's Global EconoMonitor]
As the downgrades on CDOs and MBSs continue to accelerate,
there'll likely be a frantic "flight to cash" by investors, just like
the recent surge into US Treasuries. This could well be followed by a series of
spectacular bank and non-bank defaults. The trillions of dollars of
"virtual capital" that were miraculously created through
securitzation when the market was buoyed-along by optimism will vanish in a
flash when the market is driven by fear. In fact, the equity bubble has already
been punctured and the process is well underway.
Whitney lives in Washington state. He can be reached at email@example.com.
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