- 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.
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- 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:
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- 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.
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- 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.
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- 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.
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- 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."
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- 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.
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- Staring Into the Abyss
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- One of Britain's leading economists, Peter Spencer, issued
a warning on Saturday:
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- 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.
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- 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.
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- Spencer said:
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- 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)
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- 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:
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- 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.
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- 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.
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- Greenspan's apologia is a masterpiece of circuitous logic,
deliberate evasion and utter denial of reality. He says:
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- 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.
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- "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.
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- Greenspan also adds this revealing bit of information
in his article:
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- 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)
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- 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.
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- 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.
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- 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".
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- 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:
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- 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.
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- 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."
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- 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)
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- 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.
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- 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.
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- Now everyone will pay the price.
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- 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.
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- 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)
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- 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.
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- Mike Whitney lives in Washington state. He can be reached
at: <mailto:fergiewhitney@msn.com>fergiewhitney@msn.com
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