It's time to dump the Fed
By Mike Whitney
Online Journal Contributing Writer
Feb 26, 2008, 00:31
The credit storm, which began in July when two Bear Stearns
hedge funds were forced to liquidate, has continued to intensify.
Last week the noose tightened around auction-rate securities
(ARS), a little-known part of the market that requires short-term funding to
set rates for long-term municipal bonds. The $330 billion ARS market has dried
up overnight pushing up rates as high as 20 per cent on some bonds -- a new benchmark
for short-term debt. Auction-rate securities are now headed for extinction just
like the other previously vital parts of the structured finance paradigm.
The $2 trillion market for collateralized debt obligations
(CDOs), the multi-trillion dollar mortgage-backed securities market (MBSs) and
the $1.3 asset-backed commercial paper (ABCP) market have all shut down,
draining a small ocean of capital from the financial system and pushing many of
the banks and hedge funds closer to default.
The price of insuring corporate bonds has skyrocketed in the
last few weeks, making it more difficult for businesses to get the funding they
need to expand or continue present operations. Much of this has to do with the
growing uncertainty about the reliability of credit default swaps, a $45
trillion dollar market which remains virtually unregulated. Credit default
swaps are a type of financial instrument that are used to speculate on a
company's ability to repay debt. They pay the buyer face value in exchange for
the underlying securities or the cash equivalent if a borrower fails to adhere
to its debt agreements. When the price of CDSs increases, it means that there
is greater doubt about the quality of the bond. Prices are presently soaring
because the entire structured finance market -- and everything connected to it
-- is under withering attack from the meltdown in subprime mortgages. As
foreclosures continue to rise, the subprime loans that were transformed into
securities will continue to unwind, destroying trillions of dollars of virtual
capital in the secondary market.
It all sounds more complicated than it really is. Imagine a
200-foot conveyor belt with two burly workers and a mountain-sized pile of
money on one end and a towering bonfire on the other. Every time a home goes
into foreclosure, the two workers stack the money that was lost on the
transaction, plus all of the cash that was leveraged on the home via
"securitization" and derivatives, onto the conveyor belt where it is
fed into the fire. That is precisely what is happening right now and the amount
of capital that is being consumed by the flames far exceeds the Fed's paltry
increases in the money supply or Bush's projected $168 billion "surplus
package." Capital is being sucked out of the system faster than it can be
replaced, which is apparent by the sudden cramping in the financial system and
a more generalized slowdown in consumer spending.
According to a recent Bloomberg article: "A year ago,
$20 million would have gotten Luminent Mortgage Capital, Inc., access to $640
million in loans to buy top-rated mortgage-backed securities. Now that much
cash gets the firm no more than $80 million. . . . [Only] 6 lenders are
offering 5 times leverage, while a year ago, 20 banks extended 33 times."
The banks are not providing anywhere near as much money for
leveraged investments as they did just last year. And, when credit shrinks on a
national scale -- as it is -- so does the economy. It' a simple formula: less
money means less economic activity, less growth, fewer jobs, tighter budgets
and more pain.
Bloomberg continues: "Wall Street firms, reeling from
$146 billion in losses on their debt holdings, are fueling a credit crisis by
clamping down on lending to investors and hedge funds that use borrowed money
to buy securities. By pulling back, [the banks] are contributing to reduced
demand and lower prices throughout the fixed-income world."
The banks are in no position to be generous because they're
already saddled with $400 billion in MBSs and CDOs -- as well as another $170
billion in private equity deals -- for which there is currently no market.
They've had to dramatically cut back on their lending because they either don't
have the resources or are facing bankruptcy in the near future.
An article which appeared on the front page of the Financial
Times last week illustrates how hard-pressed the banks really are: "US
banks have been quietly borrowing massive amounts of money from the Federal
Reserve . . . $50 billion in one month."
The Fed's new Term Auction Facility "allows the banks
to borrow money against all sort of dodgy collateral," says Christopher
Wood, analyst at CLSA. "The banks are increasingly giving the Fed the
garbage collateral nobody else wants to take . . . [this] suggests a perilous
condition for America's banking system."
The move has sparked unease among some analysts about the
stress developing in opaque corners of the US banking system and the banks'
growing reliance on indirect forms of government support." ["US Banks
borrow $50 billion via New Fed Facility", Financial Times] (The story
appeared nowhere in the US media.)
At the same time the banks are getting backdoor injections
of liquidity from the Fed. Banking giant Citigroup has been trying to offload
some of its branches so it can cover its structured investment losses. It all
looks rather desperate, but scouring the planet for capital to shore up
flagging balance sheets is turning out to be a full-time job for many of
America's largest investment banks. It is the only way they can stay one step
ahead of the hangman.
In the last few days, gold has spiked to $950, a new high,
while oil futures passed the $100 per barrel mark. The battered greenback has
already taken a beating, and yet, Fed Chairman Bernanke is signaling that there
are more rate cuts to come. The prospect of a global run on the dollar has
never been greater. Still, Bernanke will do whatever he can to resuscitate the
faltering banking system, even if he destroys the currency in the process.
Unfortunately, interest rates alone won't cut it. The banks need capital; and
fast. Meanwhile, the waning dollar has sent food and energy prices soaring
which is leaving consumers without the discretionary income they need for
anything beyond the basic necessities. As a result, retail sales are down and
employers are forced to lay off workers to reduce their spending. This is all
part of the self-reinforcing negative-feedback loop that begins with falling
home prices and then rumbles through the broader economy. There is no chance
that the economy will rebound until housing prices stabilize and the rate of
foreclosures returns to normal. But that could be a long way off. With housing
inventory at historic highs and mortgage applications at new lows, the economy
could keep somersaulting down the stairwell for a good two years or more. Only
then, will we hit rock-bottom.
The country is now headed into a deep and protracted
recession. Low interest credit and financial innovation have paralyzed the
credit markets while inflating a monstrous equity bubble that is wreaking havoc
with the world's financial system. The new market architecture,
"structured finance," has collapsed under the stress of falling asset
values and rising defaults. Many of the banks are technically insolvent already,
drowning in their own red ink. Public confidence in the nations' financial
institutions has never been lower. Monetary policy and deregulation have
failed. The system is self-destructing.
Now that the credit crunch has rendered the markets
dysfunctional, spokesmen for the investor class are speaking out and confirming
what many have suspected from the very beginning; that the present troubles
originated at the Federal Reserve and, ultimately, that's where the
responsibility lies. In an article in the Wall Street Journal last week,
Harvard economics professor and former member of the Council of Economic
Advisers under President Reagan, Martin Feldstein, made this candid admission:
"There is plenty of blame to go around for the current situation. The
Federal Reserve bears much of the responsibility, because of its failure to
provide the appropriate supervisory oversight for the major money center banks.
The Fed's banking examiners have complete access to all of the financial
transactions of the banks that they supervise, and should have the technical
expertise to evaluate the risks that those banks are taking. Because these
banks provide credit to the nonbank financial institutions, the Fed can also
indirectly examine what those other institutions are doing.
"The Fed's bank examinations are supposed to assess the
adequacy of each bank's capital and the quality of its assets. The Fed declared
that the banks had adequate capital because it gave far too little weight to
their massive off balance-sheet positions -- the structured investment vehicles
(SIVs), conduits and credit line obligations---that the banks have now been
forced to bring onto their balance sheets. Examiners also overstated the
quality of the banks' assets, failing to allow for the potential bursting of
the house price bubble. The implication of this for Fed supervision policy is
clear. The way out of the current crisis is not."
How odd. So, when all else fails, tell the truth?
But Feldstein is right, the Fed refused to perform its
oversight duties because its friends in the banking industry were raking in
vast profits selling sketchy, subprime junk to gullible investors around the
world. They knew about the "massive off balance-sheet positions"
which allowed the banks to create mortgage-backed securities and CDOs without
sufficient capital reserves. They knew it all -- every last bit of it -- which
simply proves that the Federal Reserve is an organization which serves the
exclusive interests of the banking establishment and their corporate brethren in
the financial industry.
The upcoming global recession/depression will give us plenty
of time to mull over the ruinous effects of Fed policy and to devise a plan for
abolishing the Federal Reserve once and for all. That is, if it doesn't destroy
Whitney lives in Washington state. He can be reached at firstname.lastname@example.org.
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