new capitalist gods must love the poor - they are making so many
more of them."
- Bill Bonner, "The Daily Reckoning"
hope of every central bank is that the real problem can be kept
from public view. The truth is that the public - even professionals
on Wall Street - have no clue what the real problem is. They know
it has something to do with derivatives, but none of them realize
that its more than a US$20 trillion mountain of unfunded,
unregulated paper that has just been discovered to not have a
market and, therefore, no real value... When the dollar realizes
the seriousness of the situation - be that now or sometime soon
- the bottom will drop out."
- Jim Sinclair, Investment analyst
About a month
ago, I wrote an article, "Stock Market
Brushfire: Will There Be A Run On The Banks?", which
showed how the collapse in the housing market and the deterioration
in mortgage-backed bonds (CDOs) in the secondary market was creating
difficulties for the banking system. Now these problems are becoming
Wall Street Journal:
rising interbank lending rates are a proxy of sorts for the increased
risk that some banks, somewhere, may go belly up." (Editorial;
the WSJ editorial staff - which normally defends deregulation
and laissez faire economics - is now calling for regulators to
make sure they are "on top of the banks they are supposed
to be regulating, so we dont get any surprise bank failures
that spook the markets and confirm the worst fears being whispered
have tightened and banks are increasingly reluctant to loan money
to each other not knowing who may be sitting on billions of dollars
in toxic mortgage-backed debt. (Collateralized debt obligations.)
It makes no difference that the "underlying economy is sound"
as Bernanke likes to say. When banks hesitate to loan money to
each other; it shows that there is real uncertainty about the
solvency of the other banks. That slows down normal commerce and
the gears on the economic machine begin to rust in place.
woes have been exacerbated by the flight of investors from money
market funds, many of which are backed by Mortgage-backed Securities
(MBS). Wary investors are running for the safety of US Treasuries
even though yields have declined at a record pace. This is causing
problems in the Commercial Paper market as well as for the lesser-know
SIVs and "conduits". These abstruse-sounding investment
vehicles are the essential plumbing that maintains normalcy in
the markets. Commercial paper is a US$2.2 trillion market. When
it shrinks by more than US$200 billion - as it has in the last
three weeks - the effects can be felt through the entire system.
crunch has spread across the whole gamut of commercial paper and
low-grade debt. Banks are hoarding cash and refusing loans to
even credit-worthy applicants. The collapse in subprime loans
is just part of the story. More than 50 per cent of all mortgages
in the last two years have been unconventional loans - no down
payment, no verification of income "no doc", interest-only,
negative amortization, piggyback, 2-28s, teaser rates, adjustable
rate mortgages "ARMs".
All of these reflect the shoddy lending standards of the past
few years and all are contributing to the unprecedented rate of
defaults. Now the banks are holding US$300 billion of these "unmarketable"
mortgage-backed CDOs and another US$200 billion in equally-suspect
CLOs. (Collateralized loan obligations; the CDOs corporate-twin.)
banks hesitate to loan money
to each other; it shows that there
is real uncertainty about the solvency
of the other banks. That slows down
normal commerce and the gears on the
economic machine begin to rust in place.
banks woes have been exacerbated
by the flight of investors from money
market funds, many of which are backed
by Mortgage-backed Securities (MBS).
worrisome, the large investment banks have myriad "off-book"
operations which are in distress. This has forced the banks to
circle the wagons and reduce their issuance of loans which is
accelerating the downturn in housing. Typically, housing bubbles
unwind very slowly over a five- to six-year period. That wont
be the case this time. The surge in inventory, the financial distress
of many homeowners and the complete breakdown in loan-origination
(due to the growing credit crunch) ensures that the housing market
will crash-land sometime in late 2008 or early 2009. The banks
are expected to write-off a considerable portion of their CDO-debt
at the end of the 3rd Quarter rather than keep the losses on their
books. This will further hasten the decline in housing prices.
are also suffering from the sudden sluggishness in leveraged buyouts
(LBOs). Credit problems have slowed private equity deals to a
dribble. In July there were US$579 billion in LBOs. In August
that number shrunk to a paltry US$222 billion. By September those
figures will deteriorate to double-digits. The big deals arent
getting done and debt is not rolling over. More than US$1 trillion
in debt will have to be refinanced in the next five weeks. In
the present climate, that doesnt look likely. Something
has got to give. The market has frozen and the Feds US$60
billion repo-lifeline has done nothing to help.
In the first
seven months of 2007, LBOs accounted for "$37 of every $100
spent on deals in the US". 37
per cent! How will the financial giants make up for the windfall
profits that these deals generated?
They wont. Just as they wont make up for the enormous
origination fees they made from "securitizing" mortgages
and selling them off to credulous pension funds, insurance companies
and foreign banks.
Rattner of DLJ Merchant Banking said, "Its become nearly
impossible to finance a private equity transaction of over US$1
billion." (WSJ) The Golden Era of Acquisitions and Mega-mergers
is coming to an end. We can expect that the financial giants will
probably follow the same trajectory as the Dot.coms following
the 2001 NASDAQ-rout.
banks are also facing enormous potential losses from liabilities
that "operate off their balance sheets." In David Reillys
article, "Conduit Risks are hovering over Citigroup"
(WSJ 9-5-07), Reilly points out that "banks such as Citigroup
Inc. could find themselves burdened by affiliated investment vehicles
that issue tens of billions of dollars in short-term debt known
as commercial paper." Citigroup, for example, owns about
25 per cent of the market for SIVs, representing nearly US$100
billion of assets under management. The largest Citigroup SIV
is Centauri Corp., which had US$21 billion in outstanding debt
as of February 2007, according to a Citigroup research report.
There is NO MENTION OF CENTAURI IN ITS 2006 ANNUAL FILING with
the Securities and Exchange Commission.
investors worry that if vehicles such as Centauri stumble, either
failing to sell commercial paper or suffering severe losses in
the assets it holds, Citibank could wind up having to help by
lending funds to keep the vehicle operating or even taking on
investors dont know that Citigroup could be holding the
bag for "$21 billion in outstanding debt"? Or, perhaps,
the entire US$100 billion is red ink; who knows? (Citigroups
stock dropped by more than 2 per cent after this report appeared
in the WSJ.)
surge in inventory, the financial
distress of many homeowners and
the complete breakdown in loan-origination
(due to the growing credit crunch)
ensures that the housing market
will crash-land sometime in late 2008
or early 2009. The banks are expected
to write-off a considerable portion
of their CDO-debt at the end of
the 3rd Quarter rather than keep
the losses on their books. This will further
hasten the decline in housing prices.
which appeared in CNN Money further adds to the suspicion that
the banks "brokerage affiliates" may be in trouble:
Aug. 20 letters from the Fed to Citigroup and Bank of America
state that the Fed, which regulates large parts of the U.S. financial
system, has agreed to exempt both banks from rules that effectively
limit the amount of lending that their federally-insured banks
can do with their brokerage affiliates. The exemption, which is
temporary, means, for example, that Citigroup's Citibank entity
can substantially increase funding to Citigroup Global Markets,
its brokerage subsidiary. Citigroup and Bank of America requested
the exemptions, according to the letters, to provide liquidity
to those holding mortgage loans, mortgage-backed securities, and
This unusual move by the Fed shows that
the largest Wall Street firms are continuing to have problems
funding operations during the current market difficulties."
mean that the other large banks are involved in the same type
of "hide-n-seek" strategies? Sounds a lot like Enrons
"off-the-books" shenanigans, doesnt it?
off-balance-sheet issues are traditionally POORLY DISCLOSED, so
to some extent, you're dependent on the insight that management
is willing to provide you and that, frankly, is very limited,"
says Mark Fitzgibbon, director of research at Sandler O'Neill
& Partners." ...Accounting rules DONT REQUIRE BANKS
TO SEPARATELY RECORD ANYTHING RELATED TO THE RISK that they will
have to loan the entities money to keep them functioning during
a markets crisis."... " The vehicles (SIVs and conduits)
ARE OFTEN ESTABLISHED IN A TAX HAVEN AND ARE RUN SOLEY FOR INVESTMENT
PURPOSES AS OPPOSED TO TYPICAL CORPORATE ACTIVITIES."
the banks are on solid ground?
the nation's largest bank as measured by market value and assets.
Its latest financial results showed that it administers off-balance-sheet,
conduit vehicles used to issue commercial paper that have assets
of about US$77 BILLION.
is also affiliated with structured investment vehicles, or SIVs
that have "nearly US$100 billion" in assets, according to a letter
Citigroup wrote to some investors in these vehicles last month."
how many of these "assets" are in fact cooperate debt,
auto loans, credit card debt, and student loans that have been
securitized and are now under extreme pressure in a slumping market?
In an "up
market," loans can provide a valuable income-stream that
transforms someone elses debt into a valuable asset. In
a down market, however, defaults can wipe out trillions in market
the nation's largest bank
as measured by market value and assets.
Its latest financial results showed
that it administers off-balance-sheet,
conduit vehicles used to issue
commercial paper that have assets
of about US$77 BILLION..."
Yes; and how many of these "assets"
are in fact cooperate debt, auto loans,
credit card debt, and student loans that
have been securitized and are now under
extreme pressure in a slumping market?
did we get into this mess?
20 years of dogged lobbying from the financial industry paid off
with the repeal of the Glass-Steagall Act which was passed by
Congress following the 1929 stock market crash. The bill was written
to limit the conflicts of interest when commercial banks are permitted
to underwrite stocks or bonds.
industry whittled away at Glass-Steagall for years before finally
breaking down its regulatory restrictions in August 1987, Alan
Greenspan - formerly a director of J.P. Morgan and a proponent
of banking deregulation - became chairman of the Federal Reserve
1990, J.P. Morgan became the first bank to receive permission
from the Federal Reserve to underwrite securities, so long as
its underwriting business does not exceed the 10 per cent limit.
In December 1996, with the support of Chairman Alan Greenspan,
the Federal Reserve Board issues a precedent-shattering decision
permitting bank holding companies to own investment bank affiliates
with up to 25 per cent of their business in securities underwriting
(up from 10 per cent).
of the loophole created by the Fed's 1987 reinterpretation of
Section 20 of Glass-Steagall effectively rendered Glass-Steagall
obsolete." ("The Long Demise of Glass Steagall, Frontline,
after 25 years and US$300 million of lobbying efforts, Congress
aided by President Bill Clinton, finally repealed Glass-Steagall.
This paved the way for the problems we are now facing.
contributing factor to the current banking-muddle is the Basel
rules. According to the BIS (Bank of International Settlements)
Basel Committee on Banking Supervision provides a forum for regular
cooperation on banking supervisory matters. Its objective is to
enhance understanding of key supervisory issues and improve the
quality of banking supervision worldwide. It seeks to do so by
exchanging information on national supervisory issues, approaches
and techniques, with a view to promoting common understanding.
"At times, the Committee uses this common understanding to
develop guidelines and supervisory standards in areas where they
are considered desirable. In this regard, the Committee is best
known for its international standards on capital adequacy; the
Core Principles for Effective Banking Supervision; and the Concordat
on cross-border banking supervision."
Committee on Banking (Basel 2) requires "banks to boost the
capital they hold in reserve against the loans on their books."
a good thing, doesnt it? This protects the overall financial
system as well as the individual depositor. Unfortunately, the
banks found a way to circumvent the rules for minimum reserves
by "securitizing" pools of mortgages (MBS) rather than
holding individual mortgages (which called for more reserves).
This provided lavish origination and distribution fees for banks,
but shifted much of the risk of default to Wall Street investors.
Now, the banks are saddled with roughly US$300 billion in mortgage-backed
debt (CDOs) that no one wants and it is uncertain whether they
have sufficient reserves to cover their losses.
downside of this is that once
banks write off these toxic MBSs
and CDOs; the hedge funds, insurance
companies and pension funds will be
forced to do the same - dumping boatloads
of this bond-sludge on the market,
driving down prices and triggering a
panic-sell-off. This is what the Fed
is trying to prevent through
its US$60 billion repo-bailout.
we should know how this will all play out. As David Wessel points
out in "New Bank Capital requirements helped to Spread Credit
now behave more like securities firms, more likely to mark down
the value of assets when market prices fall - even to distressed
levels - rather than sitting on bad loans for a decade and pretending
theyll be paid back."
of this is that once banks write off these toxic MBSs and CDOs;
the hedge funds, insurance companies and pension funds will be
forced to do the same - dumping boatloads of this bond-sludge
on the market, driving down prices and triggering a panic-sell-off.
This is what the Fed is trying to prevent through its US$60 billion
the Fed cannot hope to remove half-trillion of bad debt from the
balance sheets of the banks or forestall the collapse of related
financial institutions and funds which are loaded with these "unmarketable"
time-bombs. Besides, most of the mortgage derivatives (CDOs) have
been massively enhanced with low interest leverage from the "carry
trade". When the value of these CDOs is finally determined
- which we expect will happen sometime before the end of the 3rd
Quarterwe can expect the stock market to fall sharply and
the housing recession to turn into a full-blown economic crisis.
THE FIFTH HORSEMAN?
to blame? The finger-pointing has already begun and more and more
people are beginning to see how this massive economy-busting equity
bubble originated at the Federal Reserve - it is the logical corollary
of former Fed-chief Alan Greenspan's "easy money" policies.
and author Henry C K Liu sums up Greenspans tenure at the
Fed in his article, "Why the Subprime Bust will Spread":
presided over the greatest expansion of speculative finance in
history, including a trillion-dollar hedge-fund industry, bloated
Wall Street-firm balance sheets approaching US$2 trillion, a US$3.3
trillion repo (repurchase agreement) market, and a global derivatives
market with notional values surpassing an unfathomable US$220
18-year watch, assets of US government-sponsored enterprises (GSEs)
ballooned 830 per cent, from US$346 billion to US$2.872 trillion.
GSEs are financing entities created by the US Congress to fund
subsidized loans to certain groups of borrowers such as middle-
and low-income homeowners, farmers and students. Agency mortgage-backed
securities (MBSs) surged 670 per cent to US$3.55 trillion. Outstanding
asset-backed securities (ABSs) exploded from US$75 billion to
more than US$2.7 trillion." ( Henry Liu, "Why the Subprime
Bust will Spread", Asia Times.)
expansion of speculative finance in history". That says it all.
But no one
makes the case against Greenspan better than Greenspan himself.
Here are some of his comments at the Federal Reserve Systems
Fourth Annual Community Affairs Research Conference, Washington,
D.C. April 8, 2005. They show that Greenspan "rubber stamped"
every one of the policies which have since metastasized and spread
through the entire US economy.
Champion of Subprime Loans
has brought about a multitude of new products, such as subprime
loans and niche credit programs for immigrants. Such developments
are representative of the market responses that have driven the
financial services industry throughout the history of our country.
With these advance in technology, lenders have taken advantage
of credit-scoring models and other techniques for efficiently
extending credit to a broader spectrum of consumers."
whos to blame? The finger-pointing
has already begun and more and more
people are beginning to see how
this massive economy-busting equity bubble
originated at the Federal Reserve - it is
the logical corollary of former Fed-chief
Alan Greenspan's "easy money" policies.
Main Proponent of Toxic CDOs
development of a broad-based secondary market for mortgage loans
also greatly expanded consumer access to credit. By reducing the
risk of making long-term, fixed-rate loans and ensuring liquidity
for mortgage lenders, the secondary market helped stimulate widespread
competition in the mortgage business. The mortgage-backed security
helped create a national and even an international market for
mortgages, and market support for a wider variety of home mortgage
loan products became commonplace. This led to securitization of
a variety of other consumer loan products, such as auto and credit
Supporter of Loans to People with Bad Credit
once more-marginal applicants would simply have been denied credit,
lenders are now able to quite efficiently judge the risk posed
by individual applicants and to price that risk appropriately.
improvements have led to the rapid growth in subprime mortgage
lending... fostering constructive innovation that is both responsive
to market demand and beneficial to consumers.
access to credit for consumers, and especially these more-recent
developments, has had significant benefits.
innovation and deregulation have vastly expanded credit availability
to virtually all income classes. Access to credit has enabled
families to purchase homes, deal with emergencies, and obtain
goods and services. Home ownership is at a record high, and the
number of home mortgage loans to low- and moderate-income and
minority families has risen rapidly over the past five years.
Credit cards and installment loans are also available to the vast
majority of households."
Big Fan of "Structural Changes" which increase Consumer
we reflect on the evolution of consumer credit in the United States,
we must conclude that innovation and structural change in the
financial services industry have been critical in providing expanded
access to credit for the vast majority of consumers, including
those of limited means. Without these forces, it would have been
impossible for lower-income consumers to have the degree of access
to credit markets that they now have.
fact underscores the importance of our roles as policymakers,
researchers, bankers, and consumer advocates in fostering constructive
innovation that is both responsive to market demand and beneficial
to consumers." (Federal Reserve Chairman, Alan Greenspan;
Federal Reserve Systems Fourth Annual Community Affairs
Research Conference, Washington, D.C. April 8, 2005.)
own words are the most powerful indictment against him. They show
that he played a central role in our impending disaster. The effort
on the part of media pundits, talking heads, and so-called experts
to foist the blame on the rating agencies, predatory lenders or
gullible mortgage applicants (who may have lied on their loans)
misses the point entirely. The problems began at the Federal Reserve
and thats where the responsibility lies.
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].
Stock Market Brushfire: Will There Be A Run On The Banks?
Judgment Week On Wall Street