financial crises... the Fed has been able to wave its magic wand
and make market turmoil disappear. But this time the magic isn't
working. Why not? Because the problem with the markets isn't just
a lack of liquidity - there's also a fundamental problem of solvency."
Krugman's essay here http://www.informationclearinghouse.info/article18894.htm
sharply last week on news of accelerating inflation which will
limit the Federal Reserves' ability to continue cutting interest
rates. On 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 per cent
last month after a 0.3 per cent 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
California Governor Arnold Schwarzenegger announced on Friday
that he will declare a "fiscal emergency" in January and ask for
more power to deal with the US$14 billion budget shortfall from
the meltdown in subprime lending. Economists are beginning to
publicly acknowledge what many market analysts have suspected
for months; the nation's economy is going into a tailspin which
will inevitably end in a hard landing.
Asia Chairman, Stephen Roach, made this observation in a New York
Times op-ed on Sunday:
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 per cent 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 per cent of G.D.P."
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 - [Fed chairman Ben] Bernanke
and [Treasury Secretary Henry] 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 it 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. That much is certain.
In the last
few weeks, Bernanke and Paulson have tried a number of strategies
that have failed miserably. Paulson concocted a plan to help the
major investment banks consolidate and repackage their non-performing
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 Department of the Treasury. It makes it look
like he's willing to dupe investors as long as it helps his well-heeled
Wall Street buddies.
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 a meager 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.
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 - [Fed
chairman Ben] Bernanke and [Treasury Secretary Henry] Paulson
- can somehow steer the economy through this "rough patch"
into calm waters. But they cannot...
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 has done is weaken the
dollar and trigger a wave of inflation. In fact, government figures
now show energy prices are rising at a whopping 18.1 per cent
annually. Bernanke is apparently following Lenin's injunction
that "The best way to destroy the Capitalist System is to debauch
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 rates in England and reduced lending between banks. The
slowdown is hobbling growth and could send the world into a recessionary
Bernanke's "master plan" is little more than a cash giveaway to
sinking banks. It has no 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. Thus, accountability and transparency
have both been shattered by one shortsighted action. The Fed is
conducting its business like a bookie.
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 grinding halt. The
massive injections of liquidity from the Fed have done nothing
to improve lending or lower interbank rates. It's been a complete
flop. Bernanke has lost control of the system. The market is driving
interest rates now. If the situation persists, the stock market
INTO THE ABYSS
of Britain's leading economists, Peter Spencer, issued a warning
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 park".
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 park".
- Economist Peter Spencer
is right. The banks don't have the money to loan to businesses
or consumers because they're desperately 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.
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)
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.
Bill Gross put it like this:
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.
Ludwig von Mises is more succinct in his analysis:
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."
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 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
polemic 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."
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?
banks simply don't have the resources and there's going
to be a day of reckoning.
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 horrendous imbalances.
The former-Fed chief's support for adjustable-rate mortgages (ARMs)
and subprime lending shows that Greenspan thought of himself as
more a cheerleader for the big market-players than an impartial
referee whose job was to monitor reckless or unethical behavior.
also adds this revealing bit of information in his article:
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 world-wide,
Japan and Germany (for differing reasons) being the only principal
exceptions." ("The Roots of the Mortgage Crisis", Alan Greenspan,
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.
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 well-oiled
low interest credit is only part of the equation. The other part
has to do with the way that the markets have been transformed
by "structured finance".
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. Author David Roache explains
how this works in an excerpt from his book "New Monetarism" which
appeared in the Wall Street Journal:
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.
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'.
"So, to 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 non-bank 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."
(Wall Street Journal)
This is truly
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.
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 their was no risk, because they were making
enormous profits without tying up any of their capital. It was,
quite literally, money for nothing.
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 gear that was grinding out
the hefty profits ("structured investments") has suddenly reversed
and - like a millstone that breaks free from its support-axle
- is crushing everything in its path.
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
finance" has usurped the Fed's authority to create new credit
and handed it over to the banks. Now everyone will pay the price.
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 withering blow
to the economy.
not just the banks that will take a beating either. 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 non-banks the funds borrowed by central banks as these
banks have severe liquidity problems themselves and they do not
trust their non-bank counterparts.
"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
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 will be followed by a series of spectacular
bank and non-bank defaults. The trillions of dollars of "virtual
capital" that was 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.
Mike Whitney is a well respected freelance writer living in Washington
state, interested in politics and economics from a libertarian
perspective. He can be reached at [email protected].
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