- The Federal Reserve is bankrupt for all intents and purposes.
The same goes for the Bank of England!
-
- This article will focus largely on the Fed, because the
Fed is the "financial land-mine".
-
- How long can someone who has stepped on a landmine, remain
standing hours, days? Eventually, when he is exhausted and his legs
give way, the mine will just explode!
-
- The shadow banking system has not only stepped on the
land-mine, it is carrying such a heavy load (trillions of toxic wastes)
that sooner or later it will tilt, give way and trigger off the land-mine![1]
-
- In a recent article, I referred to <http://www.globalresearch.ca/index.php?context=va&aid=12584>the
remarks of British Prime Minister Gordon Brown and President Obama calling
for the shadow banking system to be outlawed.
-
- Even if the call was genuine, it is too late. The land-mine
has been triggered and the explosion cannot be averted under any circumstances.
-
- The only issue is the extent of the damage to the global
economy and how long it will take for the world to recover from this fiasco
a financial madness that has no precedent. The great depression is
"Mary Poppins" in comparison!
-
- The idea of a central bank going bankrupt is not
that outlandish. I am by no means the first author who has given this stark
warning. What underlies this crisis (which I initially examined in
an article in December 2006) is the potential collapse of the global banking
system, specifically the Shadow Money-Lenders.
-
- Nouriel Roubini, the New York University professor said
[2]:
-
- "The process of socialising the private losses from
this crisis has moved many of the liabilities of the private sector onto
the books of the sovereign. At some point a sovereign bank may crack,
in which case, the ability of the government to credibly commit to act
as a backstop for the financial system including deposit guarantees
could come unglued."
-
- Please read the underlined words again. "Sovereign
bank" means central bank. When a central bank "cracks" i.e.
becomes insolvent, "all hell breaks lose", because as the professor
correctly pointed out, "any government guarantees will ring hollow
and will be useless".
-
- If a central bank goes belly up, it is as good as the
government going bankrupt. Period!
-
- In another article, Roubini admitted that the pressure
on "the financial land-mine" is totally unbearable. He wrote: "The
US Financial system is effectively insolvent". It follows that
if the financial system is bankrupt, it is a matter of time before the
"sovereign bank" goes belly up. This is a given!
-
- He stated further that:
-
- "Thus, the U.S. financial system is de facto nationalized,
as the Federal Reserve has become the lender of first and only resort rather
than the lender of last resort, and the U.S. Treasury is the spender and
guarantor of first and only resort. The only issue is whether banks and
financial institutions should also be nationalized de jure.
-
- "AIG which lost $62 billion in the fourth quarter
and $99 billion in all of 2008 is already 80% government-owned. With such
staggering losses, it should be formally 100% government-owned. And now
the Fed and Treasury commitments of public resources to the bailout of
the shareholders and creditors of AIG have gone from $80 billion to $162
billion.
-
- "Given that common shareholders of AIG are already
effectively wiped out (the stock has become a penny stock), the bailout
of AIG is a bailout of the creditors of AIG that would now be insolvent
without such a bailout. AIG sold over $500 billion of toxic credit default
swap protection, and the counter-parties of this toxic insurance are major
U.S. broker-dealers and banks.
-
- "News and banks analysts' reports suggested that
Goldman Sachs got about $25 billion of the government bailout of AIG and
that Merrill Lynch was the second largest benefactor of the government
largesse. These are educated guesses, as the government is hiding the counter-party
benefactors of the AIG bailout. (Maybe Bloomberg should sue the Fed and
Treasury again to have them disclose this information.)
-
- "But some things are known: Goldman's <http://lloyd-c-blankfein/37715>Lloyd
Blankfein was the only CEO of a Wall Street firm who was present at
the New York Fed meeting when the AIG bailout was discussed. So let us
not kid each other: The $162 billion bailout of AIG is a nontransparent,
opaque and shady bailout of the AIG counter-parties: Goldman Sachs, Merrill
Lynch and other domestic and foreign financial institutions.
-
- "So for the Treasury to hide behind the "systemic
risk" excuse to fork out another $30 billion to AIG is a polite way
to say that without such a bailout (and another half-dozen government bailout
programs such as TAF, TSLF, PDCF, TARP, TALF and a program that allowed
$170 billion of additional debt borrowing by banks and other broker-dealers,
with a full government guarantee), Goldman Sachs and every other broker-dealer
and major U.S. bank would already be fully insolvent today.
-
- "And even with the $2 trillion of government support,
most of these financial institutions are insolvent, as delinquency and
charge-off rates are now rising at a rate - given the macro outlook -that
means <http://media.rgemonitor.com/papers/0/RGECreditLossesEPCNRJan09.pdf>expected
credit losses for U.S. financial firms will peak at $3.6 trillion. So,
in simple words, the U.S. financial system is effectively insolvent."
-
- McClatchy newspaper reported (03/08/2009) bad news affecting
the banks:
-
- "America's five largest banks, which already have
received $145 billion in taxpayer bailout dollars, still face potentially
catastrophic losses from exotic investments if economic conditions substantially
worsen, their latest financial reports show.
-
- "Citibank, Bank of America, HSBC Bank
USA, Wells Fargo Bank and J.P. Morgan Chase reported
that their "current" net loss risks from derivatives - insurance-like
bets tied to a loan or other underlying asset - surged to $587 billion
as of Dec. 31. Buried in end-of-the-year regulatory reports that McClatchy
has reviewed, the figures reflect a jump of 49 percent in just 90 days.
-
- "The disclosures underscore the challenges that
the banks face as they struggle to navigate through a deepening recession
in which all types of loan defaults are soaring.
-
- "The government has since committed $182 billion
to rescue AIG and, indirectly, investors on the other end of the firm's
swap contracts. AIG posted a fourth quarter 2008 loss last week of more
than $61 billion, the worst quarterly performance in U.S. corporate history.
-
- "The five major banks, which account for more than
95 percent of U.S. banks' trading in this array of complex derivatives,
declined to say how much of the AIG bailout money flowed to them to make
good on these contracts.
-
- "The banks' quarterly financial reports show that
as of Dec. 31:
-
- - J.P. Morgan had potential current derivatives losses
of $241.2 billion, outstripping its $144 billion in reserves, and future
exposure of $299 billion.
-
- - Citibank had potential current losses of $140.3 billion,
exceeding its $108 billion in reserves, and future losses of $161.2 billion.
-
- - Bank of America reported $80.4 billion in current exposure,
below its $122.4 billion reserve, but $218 billion in total exposure.
-
- - HSBC Bank USA had current potential losses
of $62 billion, more than triple its reserves, and potential total exposure
of $95 billion.
-
- - San Francisco-based Wells Fargo, which agreed
to take over Charlotte-based Wachovia in October, reported current potential
losses totaling nearly $64 billion, below the banks' combined reserves
of $104 billion, but total future risks of about $109 billion.
-
- "Kopff, the bank shareholders' expert, said that
several of the big banks' risks are so large that they are "dead men
walking."
-
- Berkshire Hathaway Chairman, Warren Buffett is so livid
by the sheer magnitude of the financial mess that he said:
-
- "These instruments [derivatives] have made it almost
impossible for investors to understand and analyze our largest commercial
banks and investment banks . . . When I read the pages of 'disclosure'
in (annual reports) of companies that are entangled with these instruments,
all I end up knowing is that I don't know what is going on in their portfolios.
And then I reach for some aspirin."
-
- The above bad news refers to the losses and potential
losses that the big banks have suffered and will suffer in the near future.
-
- But what is overlooked by many financial analysts is
that these very same derivative products have caused another financial
organ failure. And there is no way that the said organ can be resuscitated
to its former state of health.
-
- The Repo Market is gridlocked!
-
- There has been an incestuous relationship between the
traditional banking system and the shadow banking system and the link
that joined the two together is the Repo Market.[Repurchase Market]
-
- This is in fact the weakest link in the entire
financial system.
-
- This is a very technical subject and I seek your indulgence
and patience when reading the remaining part of this article. The gridlock
of the repo market is the basis for my assertion that over and above the
aforesaid dire financial facts, it is the major contributing factor
to the bankruptcy of the Federal Reserve!
-
- I want to use a simple analogy. This will make the issue
easier to understand.
-
- Picture a one-inch diameter thick rope. Such a rope is
made up of a few strands of narrower ropes, say 1/10th inch which
are twined together to make the thick one-inch diameter rope.
-
- Picture again that all the outer strands have been burnt
away, and what remains is the middle strand, still lifting the weight.
But this strand cannot on its own, lift such a weight and sooner or later,
it will snap. When that happens, the weight will come crashing down!
-
- The middle strand is the repo market.
-
- Alternatively, you can use the analogy that the repo
market is the heart that pumps the blood (the cash flow). The
financial system is the body and it has suffered a massive heart attack!
-
- What is the repo market?
-
- The repo market is the market whereby
all financial institutions (regulated and unregulated) invariably go to
obtain financing to meet reserve requirements, bridging finance, to lend
or purchase securities, to hedge and or to invest on short-term basis.
-
- It used to be that mainly US Treasuries (bear this
in mind at all times) were used as security for Repo transactions,
as it is considered as most secure i.e. as good as cash since it is backed
by the credit of the US government!
-
- This requirement is no longer the case. More of this
issue later.
-
- The Nature of Repo Transactions
-
- In repo transactions, securities are exchanged for
cash with an agreement to repurchase the securities at a future date.
The securities serve as collateral for what is effectively a cash loan.
A distinguishing feature of repos is that they can be used either to obtain
funds or to obtain securities. As repos are short-maturity collateralized
instruments, repo markets have strong linkages with securities markets,
derivative markets and other short term markets such as inter-bank and
money markets. [3]
-
- Like other financial markets, repo markets are subject
to credit risks, operational risks and liquidity risks. However, what distinguishes
the credit risks on repos from that associated with uncollateralized instruments
is that repos credit exposures arise from volatility (or market risk) in
the value of collateral. Bear this in mind at all times.
-
- Repos allow institutions to use leverage to take larger
positions in financial markets which could add to systemic risks. Bear
this in mind at all times.
-
- And because of the close linkages between repo markets
and securities markets, any shocks will be transmitted quickly, resulting
in a gridlock. Bear this in mind at all times.
-
- Transactions covered by definition of repos are as follows:
-
- (A) Repurchase Agreement
-
- A repurchase agreement involves the sale of an asset
under an agreement to repurchase the asset from the same counter-party.
Interest is paid on the repurchase agreement by adjusting the sale and
purchase price. A reverse repo is the purchase of an asset with
an agreement to re-sell the same or a similar asset.
-
- A hold-in-custody repurchase agreement is a trade
whereby the repoer (the borrower of cash) continues to hold the collateralizing
securities in custody for the lender of cash. The risks are obvious!
-
- A deliver-out repurchase agreement is where securities
are delivered to the cash lender for custody in exchange for cash.
-
- A tri-party repurchase agreement is similar to a
deliver-out repurchase agreement, except that the security is placed in
the custody of a third-party entity. The third-party ensures that the security
meets the cash lender's requirements and provides valuation and margining
services. This is the primary form of repurchase agreement for securities
dealers in the United States. Bank of New York and JP Morgan Chase
are the two main custodians or clearing banks in the US and supervise the
vast majority of the tri-party repos. Bear this in mind at all times.
-
- (B) Sell/Buy-Back Agreement
-
- A sell buy-back is two distinct outright cash market
trades, one for forward settlement. The forward price is set relative to
the spot price to yield a market rate of return.
-
- (C) Securities Lending
-
- This is where the owner of the security lends them to
another person in return for a fee. The borrower of the security is contractually
obliged to redeliver a like quantityof the same securities, or return
precisely the same securities.
-
- Repos can be of any duration but are most commonly
over-night loans. Repos longer than over-night are called Term
Repos. There are also Open Repos which are transactions
which can be terminated by both parties on a day's notice.
-
- The largest players of repos and reverses are the dealers in
government securities. There are about 20 primary dealers recognised by
the Fed which are authorised to bid for new-issued treasury securities
for resale in the market. The dealers are highly leveraged, 50 to 100 times
their own capital. To finance the purchase of treasury securities, the
dealers need to have repo monies in large amounts on a continuing basis.
The institutions that supply such huge funds in the repo market are money
funds, large corporations, state and local governments and foreign central
banks.
-
- The Repo Market and the Financial Crisis
-
- As stated earlier when the repo market first started,
US treasuries were the preferred security. But when financial engineering
exploded and many financial products (i.e. CDOs) were rated AAA by rating
agencies, these securities were also traded as described above in
the repo market. This was when problems started.
-
- According to Gary Gorton [4], the repo market before
the crisis was estimated to be worth a whopping $12 trillion as compared
to the total assets in the entire US banking system of $10 trillion.
-
- The former CEO of Federal Reserve Bank of New York (NYFRB)
and now the US Treasury Secretary, Tim Geithner observed in 2008:
-
- "The structure of the financial system changed fundamentally
during the boom, with dramatic growth in the share of assets outside the
traditional banking system. This non-bank financial system grew to be very
large, particularly in money and funding markets.
-
- "This parallel system financed some of these very
assets on a very short term basis in the bilateral or tri-party repo markets.
As the volume of activity in repo markets grew, the variety of assets financed
in this manner expanded beyond the most highly liquid securities to include
less liquid securities, as well. Nonetheless, these assets were assumed
to be readily sellable at fair values, in part because assets with similar
credit ratings had generally been tradable during past periods of financial
stress. And the liquidity supporting them was assumed to be continuous
and essentially frictionless, because it had been so for a long time.
-
- "The scale of long term risky and relatively illiquid
assets financed by very short-term liabilities made many of the vehicles
and institutions in this parallel financial system vulnerable to a classic
type run, but without the protection such as deposit insurance that the
banking system has in place to reduce such risks."
-
- Economic historians will argue for another century as
to the cause for the run on the repo market. The collapse of
Bear Stearns is as good a starting point as any. When the market discovered
that its securities were duds, pure junk, shock waves ripped through the
system.
-
- Recall that I had mentioned earlier that Federal Bank
of New York and JP Morgan Chase were the primary clearing banks for repos.
-
- The Fed's rescue of Bear Stearns through JP Morgan was
not so much to save the former but rather to shore up the "clearing
system" of the repos for which JP Morgan Chase and the Bank of New
York were the main pillars. One of the functions of a "clearing bank"
for repos is to value and match securities tendered for cash borrowings.If
Bear Stearns securities are now valued as junks, the integrity of JP Morgan
and Federal Bank of New York as clearing banks in this market is as good
as zero! And bearing in mind that the five major investment banks
in the US rely heavily on the repo market for their funding, any gridlock
in this part of the shadow banking system would tear wide open the entire
banking system, including the traditional counter-part.
-
- Hence, the FED intervention by the creation of the Primary
Dealer Credit Facility (PDCF) which was in effect the backstop
for all investment banking using tri-party repos!
-
- This was what Bernanke said:
-
- "We have been working with market participants to
develop a contingency plan should there ever occur a loss of confidence
in either of the two clearing banks that facilitate the settlement of tri-party
repos."
-
- Louis Crandall, economist at Wrightson ICAP observed:
-
- "The vulnerability of the tri-party repo system
has been a recurring theme among Federal Reserve and Treasury officials
in recent weeks."
-
- The inherent weakness of tri-party repos is that the
counter-party risks of billions worth of funding agreements are shouldered
by essentially two players Federal Bank of New York and JP Morgan
Chase.
-
- Yet, way back then, they were held up as rock solid.
It is almost hilarious to read the then advert of the Federal Bank of New
York as to their expertise and service:
-
- "Sophisticated collateral selection: enforce diversification
and credit quality; control adequacy, volatility & liquidity.
-
- "Cutting edge infrastructure: economies of scale
facilitate extensive data warehousing, access to more asset classes and
markets, auto-substitution, auto-allocation & optimisation technology,
same day reporting.
-
- "Introduction to new counterparts: A Global Collateral
Clearing House."
-
- Panic swept across the entire repo market.
-
- No securities were considered safe enough for repos except
US treasuries.
-
- Fundings in the repo market grind to a halt.
-
- Market players withdrew funds and began hoarding treasuries.
-
- The rest who own structured products were slaughtered.
-
- I would like to quote Gary Gorton again:
-
- "Imagine a firm that is levered 30:1, by borrowing
in the repo market. If the haircut [5] doubles, or goes from zero to a
positive amount, the required deleveraging is massive! Most investment
banks were levered 30:1, equivalent to about a 3 per cent haircut. If the
haircut rises to 6 per cent, at least half the assets will have to be sold.
-
- "Another sign of trouble is a 'repo fail'. A 'repo
fail' occurs when one side of the agreement fails to abide by the contract.
[Fail to deliver the security under the repurchase agreement.]
-
- "Dealer banks would not accept collateral because
they rightly believed that if they had to seize the collateral should the
counter-party fail, then there would be no market in which to sell it.
This was due to the absence of buyers because of the deleveraging. This
led to an absence of prices for these securities. If the value cannot be
determined because there is no market no liquidity or there is the
concern that if the asset is seized by the lender, it will not be saleable
at all, then the dealer will not engage in repo. Repo dealers report that
there was uncertainty about whether to believe the ratings on these structured
products, and in a very fast moving environment, the response was to pull
back from accepting anything structured. If no one would accept structured
products for repo, then these bonds could not be traded and then
no one would want to accept them in repo transactions."
-
- This change led to a sharp increase in the demand for
government securities for repo transactions, which was compounded by significantly
higher safe-haven demand for US Treasuries and the increased unwillingness
to lend such securities in repo transactions. As the crisis unfolded, this
combination resulted in US government collateral becoming extremely scarce.
[6]
-
- I will now turn to the issue of the FED's solvency.
-
- As has been observed, the Fed intervened aggressively
to check the run on the repo market. Various measures were taken, but in
my view the most dangerous was the widening of the collaterals which the
Fed was willing to accept to secure funding of the players in the repo
market. The Fed also intervened by lending a huge chunk of its US treasuries
in exchange for junks to facilitate credit expansion.
-
- In the result, what happened was that the Fed's present
balance sheet of approximately $2 trillion is made up mostly of junk securities.
-
- The Fed is no different from banks in that confidence
in the quality of its assets is critical and that if and when the market
recovers, there is in fact a market for the junk assets that it took
on to unravel the gridlock in the financial markets.
-
- By way of analogy, if your high street bank's balance
sheet is made up of junk, what would you do? There are just not enough
assets to meet its liabilities.
-
- But of course, one can argue that the Fed is not your
high street bank. It is the central bank of the mighty USA. It will always
be able to "print money" or "digitalise" money and
keep the markets going.
-
- But beware that the Federal Reserve Note is mere paper, fiat
money which cannot be redeemed for anything tangible such as gold. And
although it is stated boldly in the notes issued - "In God we trust"
- you and I are not actually placing our trust in God when accepting the
Federal Reserve Notes as "money".
-
- When Joe Six-Packs realises that the Federal Reserve
Note is not even secured by US treasuries and or the FED has real tangible
assets, but its balance sheet is littered with junks and toxic waste, there
will be a run on the Fed i.e. when Americans and foreigners no longer have
faith in the Federal Reserve Notes as "money".
-
- If confidence could vaporise in a second and cause a
stampede in what was once considered solid security, the triple A rated
bonds in the repo and money markets, the same confidence that is now reposed
in the Federal Reserve Notes can likewise disappear into the memory hole.
-
- All these years, the con was maintained by the Fed that
it was solid because it has on its balance sheet over $800 billion of US
treasuries i.e. its notes "were so-called backed by these treasuries".
It could sell its treasuries in the repo market for cash and thereby control
the money flows in the economy and vice versa.
-
- In their subconscious mind, Americans and stupid foreign
central banks and their executives (brain-washed by the Chicago School
of Economics) somehow believe in the infallibility of the Fed.
-
- Now it has been exposed that the Fed's "assets"
comprise of junk bonds and toxic wastes.
-
- The Emperor has no clothes!
-
- Paul Volcker, former Chairman of the Federal Reserve
may have given the ultimate epitaph: "The bright new financial
system for all its talented participants, for all its rich rewards
has failed the test of the market place."
-
- And it is any wonder that Professor Nouriel Roubini declared:
-
- "The process of socialising the private losses from
this crisis has already moved many liabilities of the private sector onto
the books of the sovereign. At some point a sovereign bank may crack, in
which case the ability of the government to credibly commit to act as a
backstop for the financial system including deposit guarantees
could come unglued."
-
- In my opinion, the Fed has already become "unglued".
Whatever guarantees given to secure the indebtedness of CitiGroup and others
to prevent a run on these banks are useless.
-
- It is bankrupt!
-
- End Notes
-
- [1] There are two banking systems in existence today.
The Traditional Banking System i.e. High Street banks and the Shadow
Banking System. But the players in both the systems overlap because, the
major banks of the traditional system helped spawn the shadow banking system.
In fact they are the key players in the use of the so-called "new
financial products, the CDOs, CLOs, MBS" etc and which have now turned
toxic worthless, junk to be exact.
- [2] See my website archives: Roubini Warns of Sovereign
Bank Failure February 20, 2009 www.theage.com.au
- [3] See: Implications of repo markets for central
banks, CGFS Publications No 10, March 1999.
- [4] Gary Gorton, Information, Liquidity, and the
(Ongoing) Panic of 2007 prepared for the Jackson Hole Conference 2008
- [5] "haircut" here refers to the rate payable
for the cash loan or the margin.
- [6] Peter Hordahl and Martin R King, Developments
in repo markets during the financial turmoil BIS Quarterly Review,
December 2008
-
-
- Matthias Chang is a prominent barrister, author and
analyst of the New World Order based in Malaysia.
|