- By now, you've probably seen the photos of the angry
customers queued up outside of Northern Rock Bank waiting to withdraw their
money. This is the first big run on a British bank in over a century. It's
lost an eighth of its deposits in three days. The pictures are headline
news in the U.K. but have been stuck on the back pages of U.S.newspapers.
The reason for this is obvious. The same Force 5 economic-hurricane that
just touched ground in Great Britain is headed for America and gaining
strength on the way.
- On Monday night, desperately trying to stave off a wider
panic, the British government issued an emergency pledge to Northern Rock
savers that their money was safe. The government is trying to find a buyer
for Northern Rock.
- This is what a good old fashioned bank run looks like.
And, as in 1929, the bank owners and the government are frantically trying
to calm down their customers by reassuring them that their money is safe.
But human nature being what it is, people are not so easily pacified when
they think their savings are at risk. The bottom line is this: The people
want their money, not excuses.
- But Northern Rock doesn't have their money and, surprisingly,
it is not because the bank was dabbling in riskysubprime loans. Rather,
NR had unwisely adopted the model of "borrowing short to go long"
in financing their mortgages just like many of the major banks in the U.S.
In other words, they depended on wholesale financing of their mortgages
from eager investors in the market, instead of the traditional method of
maintaining sufficient capital to back up the loans on their books.
- It seemed like a nifty idea at the time and most of the
big banks in the US were doing the same thing. It was a great way to avoid
bothersome reserve requirements and the loan origination fees were profitable
as well. Northern Rock's business soared. Now they carry a mortgage book
totaling $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's business model is hopelessly flawed and no longer viable. Their
assets are illiquid and (presumably) "marked to model", which
means they have no discernible market value. They might as well have been
"marked to fantasy",it amounts to the same thing. Investors don't
want them. So Northern Rock is stuck with a $200 billion albatross that's
dragging them under.
- A more powerful tsunami is about to descend on the United
States where many of the banks have been engaged in the same practices
and are using the same business model as Northern Rock. Investors are no
longer buying CDOs,MBSs, or anything else related to real estate. No one
wants them, whether they're subprime or not. That means that US banks will
soon undergo the same type of economic gale that is battering the U.K right
now. The only difference is that the U.S. economy is already listing from
the downturn in housing and an increasingly jittery stock market.
- That's why Treasury Secretary Henry Paulson rushed off
to England yesterday to see if he could figure out a way to keep the contagion
- Good luck, Hank.
- It would interesting to know if Paulson still believes
that "This is far and away the strongest global economy I've seen
in my business lifetime", or if he has adjusted his thinking as troubles
in subprime, commercial paper, private equity, and credit continue to mount?
- For weeks we've been saying that the banks are in trouble
and do not have the reserves to cover their losses. This notion was originally
pooh-poohed by nearly everyone. But it's becoming more and more apparent
that it is true. We expect to see many bank failures in the months to come.
Prepare yourself. The banking system is mired in fraud and chicanery. Now
the schemes and swindles are unwinding and the bodies will soon be floating
to the surface.
- "Structured finance" is touted as the "new
architecture of financial markets". It is designed to distribute capital
more efficiently by allowing other market participants to fill a role which
used to be left exclusively to the banks. In practice, however, structured
finance is a hoax; and undoubtedly the most expensive hoax of all time.
The transformation of liabilities (dodgy mortgage loans) into assets (securities)
through the magic of securitization is the biggest boondoggle of all time.
It is the moral equivalent of mortgage laundering. The system relies on
the variable support of investors to provide the funding for pools of mortgage
loans that are chopped-up into tranches and duct-taped together as CDOs
(collateralized debt obligations). It's madness; but no one seemed to realize
how crazy it was until Bear Stearns blew up and they couldn't find bidders
for their remaining CDOs. It's been downhill ever since.
- The problems with structured finance are not simply the
result of shabby lending and low interest rates. The model itself is defective.
- John R. Ing provides a great synopsis of structured finance
in his article, "Gold: The Collapse of the Vanities":
- "The origin of the debt crisis lies with the evolution
of America's financial markets using financial engineering and leverage
to finance the credit expansion. Financial institutions created a Frankenstein
with the change from simply lending money and taking fees to securitizing
and selling trillions of loans in every market from Iowa to Germany. Credit
risk was replaced by the "slicing and dicing" of risk, enabling
the banks to act as principals, spreading that risk among various financial
institutions.. Securitization allowed a vast array of long term liabilities
once parked away with collateral to be resold along side more traditional
forms of short term assets. Wall Street created an illusion that risk was
somehow disseminated among the masses. Private equity too used piles of
this debt to launch ever bigger buyouts. And, awash in liquidity and very
sophisticated algorithms, investment bankers found willing hedge funds
around the world seeking higher yielding assets. Risk was piled upon risk.
We believe that the subprimecrisis is not a one off event but the beginning
of a significant sea change in the modern-day financial markets."
- The investment sharks who conjured up "structured
finance" knew exactly what they were doing. They were in bed with
the ratings agencies----off-loading trillions of dollars of garbage-bonds
to pension funds, hedge funds, insurance companies and foreign financial
giants. It's a swindle of epic proportions and it never would have taken
place in a sufficiently regulated market.
- When crowds of angry people are huddled outside the banks
to get their money, the system is in real peril. Credibility must be restored
quickly. This is no time for Bush's "free market" nostrums or
Paulson's soothing bromides (he thinks the problem is "contained")
or Bernanke's feeble rate cuts. This requires real leadership.
- The first thing to do is take charge, alert the public
to what is going on and get Congress to work on substantive changes to
the system. Concrete steps must be taken to build public confidence in
the markets. And there must be a presidential announcement that
all bank deposits will be fully covered by government insurance.
- The lights should be blinking red at all the related
government agencies including the Fed, the SEC, and the Treasury Dept.
They need to get ahead of the curve and stop thinking they can minimize
a potential catastrophe with their usual public relations mumbo jumbo.
- Last week, an article appeared in the Wall Street Journal,
"Banks Flock to Discount Window". (9-14-07) The article chronicled
the sudden up-tick in borrowing by the struggling banks via the Fed's emergency
bailout program, the "Discount Window":
- "Discount borrowing under the Fed's primary credit
program for banks surged to more than $7.1 billion outstanding as of Wednesday,
up from $1 billion a week before."
- Again we see the same pattern developing; the banks borrowing
money from the Fed because they cannot meet their minimum reserve 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 the Fed is trying to convince people
that it's really not a sign of distress at all. It's "a sign of strength".
Baloney. Banks don't borrow $3 billiounless they need it. They don't have
the reserves. Period.
- The real condition of the banks will be revealed sometime
in the next few weeks 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
- "Before they (the financial industry) take down
the entire market this fall by shocking Wall Street with unexpected losses,
I suggest that they brush aside their attorneys and media handlers and
come clean. They need to tell the world about the reality of their home
lending and loan securitization teams' failures of the past four years
-- and the truth about the toxic paper that they've flushed into the world
economic system, or stuffed into Enron-like off-balance sheet entities
-- before the markets make them walk the plank."." Since government
regulators and Congress have flinched from their responsibility to administer
"tough love" with rules forcing financial institutions to detail
the creation, securitization and disposition of every ill-conceived subprime
loan, off-balance sheet "structured investment vehicle," secretive
money-market "conduit" and commercial-paper-financing vehicle,
the market will do it with a vengeance."
- Good advice. We'll have to wait and see if anyone is
listening. The investment banks may be waiting until Tuesday hoping that
Fed-chief Ken Bernanke announces a cut to the Fed's fund rate that could
send the stock market roaring back into positive territory.
- But interest rate cuts do not address the underlying
problems of insolvency among homeowners, mortgage lenders, hedge funds
and (potentially) banks. As market-analyst John R. Ing said, "A cut
in rates will not solve the problem. This crisis was caused by excess liquidity
and a deterioration of credit standards.A cut in the Fed Fund rate is simply
heroin for credit junkies."
- The cuts merely add more cheap credit to a market that
that is already over-inflated from the ocean of liquidity produced by former-Fed
chief Alan Greenspan. The housing bubble and the credit bubble are largely
the result of Greenspan's misguided monetary policies. (For which he now
blames Bush!) The Fed's job is to ensure price stability and the smooth
operation of the markets, not to reflate equity bubbles and reward over-exposed
- It's better to let cash-strapped borrowers default than
slash interest rates and trigger a global run on the dollar. Financial
analyst Richard Bove says that lower interest rates will do nothing to
bring money back into the markets. Instead, lower interest rates will send
the dollar into a tailspin 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 for higher rates to compensate for risk, the solution is not
to create more liquidity and lower the rates that are available to compensate
for risk. ... (The Fed) cannot reduce fear by stimulating inflation
- "It is illogical to assume that holders of cash
will have a strong desire to lend money at low rates in a currency that
is declining in value when they can take these same funds and lend them
at high rates in a currency that is gaining in value. By lowering interest
rates the Federal Reserve will not stimulate economic growth or create
jobs. It will crash the currency, stimulate inflation, and weaken the economy
and the job markets".
- Bove is right. The people and businesses that cannot
repay their debts should be allowed to fail. Further weakening the dollar
only adds to our collective risk by feeding inflation and increasing the
likelihood of capital flight from American markets. If that happens; we're
- Consider this: 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, gold is over $700 per ounce, oil is over $80 per barrel,
and the euro is nearly $1.40 per dollar. If Bernanke cuts rates, we're
likely to see oil at $125 per barrel by next spring.
- Inflation is soaring. The government statistics are thoroughly
bogus. Gold, oil and the euro don't lie. According to economist Martin
Feldstein, "The falling dollar and rising food prices caused market-based
consumer prices to rise by 4.6 per cent in the most recent quarter."
- That's 18.4 per cent a year, and yet Bernanke is still
considering cutting interest rates and further fueling inflation.
- What about the American worker whose wages have stagnated
for the last six years? Inflation is the same as a pay-cut for him. And
how about the pensioner on a fixed income? Same thing. Inflation is just
a hidden tax progressively eroding his standard of living. .
- Bernanke's rate cut may be boon to the "cheap credit"
addicts on Wall Street, but it's the death-knell for the average worker
who is already struggling just to make ends meet.
- No bailouts. No rate cuts. Let the banks and hedge funds
sink or swim like everyone else. The message to Bernankeis simple: "It's
time to take away the punch bowl".
- The inflation in the stock market is just as evident
as it is in the price of gold, oil or real estate. Economist and author
Henry Liu demonstrates this in his article "Liquidity Boom and the
- "The conventional value paradigm is unable to explain
why the market capitalization of all US stocks grew from $5.3 trillion
at the end of 1994 to $17.7 trillion at the end of 1999 to $35 trillion
at the end of 2006, generating a geometric increase in price earnings ratios
and the like. Liquidity analysis provides a ready answer".(Asia Times)
- Market capitalization zoomed from $5.3 trillion to $35
trillion in 12 years? Why?Was it due to growth in market-share, business
expansion or productivity?
- No. It was because there were more dollars chasing the
same number of securities; hence, inflation.
- If that is the case, then we can expect the stock market
to fall sharply before it reaches a sustainable level. As Liu says, "It
is not possible to preserve the abnormal market prices of assets driven
up by a liquidity boom if normal liquidity is to be restored." Eventually,
stock prices will return to a normal range.
- Bernanke should not even be contemplating a rate cut.
The market needs more discipline not less. And workers need a stable dollar.
Besides, another rate cut would further jeopardize the greenback's increasingly
shaky position as the world's "reserve currency". That could
destabilize the global economy by rapidly unwinding the U.S. massive current
- The International Herald Tribune summed up the dollar's
problems in a recent article, "Dollar's Retreat Raises Fear of Collapse."
- "Finance ministers and central bankers have long
fretted that at some point, the rest of the world would lose its willingness
to finance the United States' proclivity to consume far more than it produces
- and that a potentially disastrous free-fall in the dollar's value would
- "The latest turmoil in mortgage markets has, in
a single stroke, shaken faith in the resilience of American finance to
a greater degree than even the bursting of the technology bubble in 2000
or the terror attacks of Sept. 11, 2001, analysts said. It has also raised
prospect of a recession in the wider economy.
- "This is all pointing to a greatly increased risk
of a fast unwinding of the U.S. current account deficit and a serious decline
of the dollar".
- Other experts and currency traders have expressed similar
sentiments. The dollar is at historic lows in relation to the basket of
currencies against which it is weighted. Bernanke can't take a chance that
his effort 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 tools to fix the problems before him. Insolvency cannot be fixed
with liquidity injections nor can the deeply-rooted "systemic"
problems in "structured finance" be corrected by slashing interest
rates. These require fiscal solutions, congressional involvement, and fundamental
economic policy changes.
- Rate cuts won't help to rekindle the spending spree in
the housing market either. That charade is over. The banks have already
tightened lending standards and inventory is larger than anytime since
they began keeping records. The slowdown in housing is irreversible as
is the steady decline in real estate prices. Trillions in market capitalization
will be wiped out. Home equity is already shrinking as is consumer spending
connected to home-equity withdrawals.
- The bubble has popped regardless of what Bernanke does.
The same is true in the clogged Commercial Paper market where hundreds
of billions of dollars in short-term debt is due to expire in the next
few weeks. The banks and corporate borrowers are expected to struggle to
refinance their debts but, of course, much of the debt will not roll over.
There will be substantial losses and, very likely, more defaults.
- Bernanke can either be a statesman---and tell the country
the truth about our dysfunctional financial system which is breaking down
from years of corruption, deregulation and manipulation---or he can
take the cowards-route and buy some time by flooding the system with liquidity,
stimulating more destructive consumerism, and condemning the nation to
an avoidable cycle of double-digit inflation.
- We'll know his decision soon enough.
- Mike Whitney lives in Washington state. He can be reached