[NYTr] The Collapse of the Modern Day Banking System

[All the News That Doesn't Fit]

Counterpunch - Dec 17, 2007
http://www.counterpunch.org/whitney12172007.html

Staring Into the Abyss

The Collapse of the Modern Day Banking System

By MIKE WHITNEY

Stocks fell 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 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.

Economists are beginning to publicly acknowledge what many market
analysts have suspected for months; the nation's economy is going into
a tailspin. Morgan Stanley's 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 like 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, the
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 park.

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 is 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 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 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 as 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
world-wide, 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 3 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."

    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 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. (Wall Street Journal)

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
for nothing.

Now, unfortunately, 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.

    Non-bank 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.


[Mike Whitney lives in Washington state. He can be reached at:
fergiewhitney at msn.com ]