September 18, 2007
U.S. Banks Brace for Storm Surge as Dollar and Credit System Reel
By MIKE WHITNEY
Bynow, you’ve probably seen the photos of the angry customers queued upoutside of Northern Rock Bank waiting to withdraw their money. This isthe first big run on a British bank in over a century. It’s lost aneighth of its deposits in three days. The pictures are headline news inthe U.K. but have been stuck on the back pages of U.S. newspapers. Thereason for this is obvious. The same Force 5 economic-hurricane thatjust touched ground in Great Britain is headed for America and gainingstrength on the way.
OnMonday night, desperately trying to stave off a wider panic, theBritish government issued an emergency pledge to Northern Rock saversthat their money was safe. The government is trying to find a buyer forNorthern Rock.
Thisis what a good old fashioned bank run looks like. And, as in 1929, thebank owners and the government are frantically trying to calm downtheir customers by reassuring them that their money is safe. But humannature being what it is, people are not so easily pacified when theythink their savings are at risk. The bottom line is this: The peoplewant their money, not excuses.
ButNorthern Rock doesn’t have their money and, surprisingly, it is notbecause the bank was dabbling in risky subprime loans. Rather, NR hadunwisely adopted the model of “borrowing short to go long” in financingtheir mortgages just like many of the major banks in the U.S. In otherwords, they depended on wholesale financing of their mortgages fromeager investors in the market, instead of the traditional method ofmaintaining sufficient capital to back up the loans on their books.
Itseemed like a nifty idea at the time and most of the big banks in theUS were doing the same thing. It was a great way to avoid bothersomereserve requirements and the loan origination fees were profitable aswell. Northern Rock’s business soared. Now they carry a mortgage booktotaling $200 billion dollars.
$200 billion! So why can’t they pay out a paltry $4 or $5 billion to their customers without a government bailout?
It’s because they don’t have the reserves and because the bank’sbusiness model is hopelessly flawed and no longer viable. Their assetsare illiquid and (presumably) “marked to model”, which means they haveno discernible market value. They might as well have been “marked tofantasy”,it amounts to the same thing. Investors don’t want them. SoNorthern Rock is stuck with a $200 billion albatross that’s draggingthem under.
Amore powerful tsunami is about to descend on the United States wheremany of the banks have been engaged in the same practices and are usingthe same business model as Northern Rock. Investors are no longerbuying CDOs, MBSs, or anything else related to real estate. No onewants them, whether they’re subprime or not. That means that US bankswill soon undergo the same type of economic gale that is battering theU.K right now. The only difference is that the U.S. economy is alreadylisting from the downturn in housing and an increasingly jittery stockmarket.
That’s why Treasury Secretary Henry Paulson rushed off toEngland yesterday to see if he could figure out a way to keep thecontagion from spreading.
Good luck, Hank.
Itwould interesting to know if Paulson still believes that “This is farand away the strongest global economy I’ve seen in my businesslifetime”, or if he has adjusted his thinking as troubles in subprime,commercial paper, private equity, and credit continue to mount?
Forweeks we’ve been saying that the banks are in trouble and do not havethe reserves to cover their losses. This notion was originallypooh-poohed by nearly everyone. But it’s becoming more and moreapparent that it is true. We expect to see many bank failures in themonths to come. Prepare yourself. The banking system is mired in fraudand chicanery. Now the schemes and swindles are unwinding and thebodies will soon be floating to the surface.
“Structuredfinance” is touted as the “new architecture of financial markets”. Itis designed to distribute capital more efficiently by allowing othermarket participants to fill a role which used to be left exclusively tothe banks. In practice, however, structured finance is a hoax; andundoubtedly the most expensive hoax of all time. The transformation ofliabilities (dodgy mortgage loans) into assets (securities) through themagic of securitization is the biggest boondoggle of all time. It isthe moral equivalent of mortgage laundering. The system relies on thevariable support of investors to provide the funding for pools ofmortgage loans that are chopped-up into tranches and duct-tapedtogether as CDOs (collateralized debt obligations). It’s madness; butno one seemed to realize how crazy it was until Bear Stearns blew upand they couldn’t find bidders for their remaining CDOs. It’s beendownhill ever since.
The problems with structured finance are notsimply the result of shabby lending and low interest rates. The modelitself is defective.
John R. Ing provides a great synopsis of structured finance in his article, “Gold: The Collapse of the Vanities”:
"Theorigin of the debt crisis lies with the evolution of America'sfinancial markets using financial engineering and leverage to financethe credit expansion…. Financial institutions created a Frankensteinwith the change from simply lending money and taking fees tosecuritizing and selling trillions of loans in every market from Iowato Germany. Credit risk was replaced by the "slicing and dicing" ofrisk, enabling the banks to act as principals, spreading that riskamong various financial institutions….. Securitization allowed a vastarray of long term liabilities once parked away with collateral to beresold along side more traditional forms of short term assets. WallStreet created an illusion that risk was somehow disseminated among themasses. Private equity too used piles of this debt to launch everbigger buyouts. And, awash in liquidity and very sophisticatedalgorithms, investment bankers found willing hedge funds around theworld seeking higher yielding assets. Risk was piled upon risk. Webelieve that the subprime crisis is not a one off event but thebeginning of a significant sea change in the modern-day financialmarkets.”
Theinvestment sharks who conjured up “structured finance” knew exactlywhat they were doing. They were in bed with the ratingsagencies----off-loading trillions of dollars of garbage-bonds topension funds, hedge funds, insurance companies and foreign financialgiants. It’s a swindle of epic proportions and it never would havetaken place in a sufficiently regulated market.
Whencrowds of angry people are huddled outside the banks to get theirmoney, the system is in real peril. Credibility must be restoredquickly. This is no time for Bush’s “free market” nostrums or Paulson’ssoothing bromides (he thinks the problem is “contained”) or Bernanke’sfeeble rate cuts. This requires real leadership.
Thefirst thing to do is take charge, alert the public to what is going onand get Congress to work on substantive changes to the system. Concretesteps must be taken to build public confidence in the markets. Andthere must be a presidential announcement that all bank deposits willbe fully covered by government insurance.
Thelights should be blinking red at all the related government agenciesincluding the Fed, the SEC, and the Treasury Dept. They need to getahead of the curve and stop thinking they can minimize a potentialcatastrophe with their usual public relations mumbo jumbo.
Lastweek, an article appeared in the Wall Street Journal, “Banks Flock toDiscount Window”. (9-14-07) The article chronicled the sudden up-tickin borrowing by the struggling banks via the Fed’s emergency bailoutprogram, the “Discount Window”:
“Discountborrowing under the Fed’s primary credit program for banks surged tomore than $7.1 billion outstanding as of Wednesday, up from $1 billiona week before.”
Again we see the same pattern developing; the banksborrowing money from the Fed because they cannot meet their minimumreserve requirements.
WSJ: “The Fed in its weekly release said average daily borrowing through Wednesday rose to $2.93 billion.”
$3 billion.
Traditionally,the “Discount Window” has only been used by banks in distress, but theFed is trying to convince people that it’s really not a sign ofdistress at all. It’s “a sign of strength”. Baloney. Banks don’t borrow$3 billio unless they need it. They don’t have the reserves. Period.
Thereal condition of the banks will be revealed sometime in the next fewweeks when they report earnings and account for their massive losses in“down-graded” CDOs and MBSs.
Market analyst Jon Markman offered these words of advice to the financial giants
"Beforethey (the financial industry) take down the entire market this fall byshocking Wall Street with unexpected losses, I suggest that they brushaside their attorneys and media handlers and come clean. They need totell the world about the reality of their home lending and loansecuritization teams' failures of the past four years -- and the truthabout the toxic paper that they've flushed into the world economicsystem, or stuffed into Enron-like off-balance sheet entities -- beforethe markets make them walk the plank.”….” Since government regulatorsand Congress have flinched from their responsibility to administer"tough love" with rules forcing financial institutions to detail thecreation, securitization and disposition of every ill-conceivedsubprime loan, off-balance sheet "structured investment vehicle,"secretive money-market "conduit" and commercial-paper-financingvehicle, the market will do it with a vengeance."
Goodadvice. We’ll have to wait and see if anyone is listening. Theinvestment banks may be waiting until Tuesday hoping that Fed-chief KenBernanke announces a cut to the Fed’s fund rate that could send thestock market roaring back into positive territory.
But interestrate cuts do not address the underlying problems of insolvency amonghomeowners, mortgage lenders, hedge funds and (potentially) banks. Asmarket-analyst John R. Ing said, “A cut in rates will not solve theproblem. This crisis was caused by excess liquidity and a deteriorationof credit standards….A cut in the Fed Fund rate is simply heroin forcredit junkies.”
Thecuts merely add more cheap credit to a market that that is alreadyover-inflated from the ocean of liquidity produced by former-Fed chiefAlan Greenspan. The housing bubble and the credit bubble are largelythe result of Greenspan’s misguided monetary policies. (For which henow blames Bush!) The Fed’s job is to ensure price stability and thesmooth operation of the markets, not to reflate equity bubbles andreward over-exposed market participants.
It’sbetter to let cash-strapped borrowers default than slash interest ratesand trigger a global run on the dollar. Financial analyst Richard Bovesays that lower interest rates will do nothing to bring money back intothe markets. Instead, lower interest rates will send the dollar into atailspin and wreak havoc on the job market.
“There is no liquidity problem, but a serious crisis of confidence," Bove said:
"In a financial system where there is ample liquidity and a desire forhigher rates to compensate for risk, the solution is not to create moreliquidity and lower the rates that are available to compensate forrisk. ... (The Fed) cannot reduce fear by stimulating inflation…
"Itis illogical to assume that holders of cash will have a strong desireto lend money at low rates in a currency that is declining in valuewhen they can take these same funds and lend them at high rates in acurrency that is gaining in value. By lowering interest rates theFederal Reserve will not stimulate economic growth or create jobs. Itwill crash the currency, stimulate inflation, and weaken the economyand the job markets".
Boveis right. The people and businesses that cannot repay their debtsshould be allowed to fail. Further weakening the dollar only adds toour collective risk by feeding inflation and increasing the likelihoodof capital flight from American markets. If that happens; we’re toast.
Considerthis: In 2000, when Bush took office, gold was $273 per ounce, oil was$22 per barrel and the euro was worth $.87 per dollar. Currently, goldis over $700 per ounce, oil is over $80 per barrel, and the euro isnearly $1.40 per dollar. If Bernanke cuts rates, we’re likely to seeoil at $125 per barrel by next spring.
Inflationis soaring. The government statistics are thoroughly bogus. Gold, oiland the euro don’t lie. According to economist Martin Feldstein, “Thefalling dollar and rising food prices caused market-based consumerprices to rise by 4.6 per cent in the most recent quarter.” (WSJ)
That’s 18.4 per cent a year, and yet Bernanke is still considering cutting interest rates and further fueling inflation.
Whatabout the American worker whose wages have stagnated for the last sixyears? Inflation is the same as a pay-cut for him. And how about thepensioner on a fixed income? Same thing. Inflation is just a hidden taxprogressively eroding his standard of living. .
Bernanke’s rate cutmay be boon to the “cheap credit” addicts on Wall Street, but it’s thedeath-knell for the average worker who is already struggling just tomake ends meet.
Nobailouts. No rate cuts. Let the banks and hedge funds sink or swim likeeveryone else. The message to Bernanke is simple: “It’s time to takeaway the punch bowl”.
The inflation in the stock market is just asevident as it is in the price of gold, oil or real estate. Economistand author Henry Liu demonstrates this in his article “Liquidity Boomand the Looming Crisis”:
"The conventional value paradigm is unable to explain why the marketcapitalization of all US stocks grew from $5.3 trillion at the end of1994 to $17.7 trillion at the end of 1999 to $35 trillion at the end of2006, generating a geometric increase in price earnings ratios and thelike. Liquidity analysis provides a ready answer".(Asia Times)
Marketcapitalization zoomed from $5.3 trillion to $35 trillion in 12 years?Why?Was it due to growth in market-share, business expansion orproductivity?
No. It was because there were more dollars chasing the same number of securities; hence, inflation.
Ifthat is the case, then we can expect the stock market to fall sharplybefore it reaches a sustainable level. As Liu says, “It is notpossible to preserve the abnormal market prices of assets driven up bya liquidity boom if normal liquidity is to be restored.” Eventually,stock prices will return to a normal range.
Bernankeshould not even be contemplating a rate cut. The market needs morediscipline not less. And workers need a stable dollar. Besides, anotherrate cut would further jeopardize the greenback’s increasingly shakyposition as the world’s “reserve currency”. That could destabilize theglobal economy by rapidly unwinding the U.S. massive current accountdeficit.
The International Herald Tribune summed up the dollar’s problems in a recent article, "Dollar's Retreat Raises Fear of Collapse."
"Financeministers and central bankers have long fretted that at some point, therest of the world would lose its willingness to finance the UnitedStates' proclivity to consume far more than it produces - and that apotentially disastrous free-fall in the dollar's value would result.
"The latest turmoil in mortgage markets has, in a single stroke, shakenfaith in the resilience of American finance to a greater degree thaneven the bursting of the technology bubble in 2000 or the terrorattacks of Sept. 11, 2001, analysts said. It has also raised prospectof a recession in the wider economy.
"This is all pointing to a greatly increased risk of a fast unwindingof the U.S. current account deficit and a serious decline of thedollar".
Otherexperts and currency traders have expressed similar sentiments. Thedollar is at historic lows in relation to the basket of currenciesagainst which it is weighted. Bernanke can’t take a chance that hiseffort to rescue the markets will cause a sudden sell-off of the dollar.
The Fed chief’s hands are tied. Bernanke simply doesn’t have the toolsto fix the problems before him. Insolvency cannot be fixed withliquidity injections nor can the deeply-rooted “systemic” problems in“structured finance” be corrected by slashing interest rates. Theserequire fiscal solutions, congressional involvement, and fundamentaleconomic policy changes.
Rate cuts won’t help to rekindle the spending spree in the housingmarket either. That charade is over. The banks have already tightenedlending standards and inventory is larger than anytime since they begankeeping records. The slowdown in housing is irreversible as is thesteady decline in real estate prices. Trillions in marketcapitalization will be wiped out. Home equity is already shrinking asis consumer spending connected to home-equity withdrawals.
The bubble has popped regardless of what Bernanke does. The same istrue in the clogged Commercial Paper market where hundreds of billionsof dollars in short-term debt is due to expire in the next few weeks.The banks and corporate borrowers are expected to struggle to refinancetheir debts but, of course, much of the debt will not roll over. Therewill be substantial losses and, very likely, more defaults.
Bernanke can either be a statesman---and tell the country the truthabout our dysfunctional financial system which is breaking down fromyears of corruption, deregulation and manipulation---or he can take thecowards-route and buy some time by flooding the system with liquidity,stimulating more destructive consumerism, and condemning the nation toan avoidable cycle of double-digit inflation.
We’ll know his decision soon enough.
