U.S. Banks Brace for Storm Surge as Dollar and Credit System Reel

2007-09-29

Richard Moore

Original source URL:
http://www.counterpunch.org/whitney09182007.html

September 18, 2007
U.S. Banks Brace for Storm Surge as Dollar and Credit System Reel
By MIKE WHITNEY

By now, you¹ve 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. It¹s 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 doesn¹t have their money and, surprisingly, it is not because 
the bank was dabbling in risky subprime loans. Rather, NR had unwisely adopted 
the model of ³borrowing short to go long² 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 
Rock¹s business soared. Now they carry a mortgage book totaling $200 billion 
dollars.

$200 billion! So why can¹t they pay out a paltry $4 or $5 billion to their 
customers without a government bailout?

It¹s because they don¹t have the reserves and because the bank¹s business model 
is hopelessly flawed and no longer viable. Their assets are illiquid and 
(presumably) ³marked to model², which means they have no discernible market 
value. They might as well have been ³marked to fantasy²,it amounts to the same 
thing. Investors don¹t want them. So Northern Rock is stuck with a $200 billion 
albatross that¹s 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 they¹re 
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.

That¹s why Treasury Secretary Henry Paulson rushed off to England yesterday to 
see if he could figure out a way to keep the contagion from spreading.

Good luck, Hank.

It would interesting to know if Paulson still believes that ³This is far and 
away the strongest global economy I¹ve seen in my business lifetime², or if he 
has adjusted his thinking as troubles in subprime, commercial paper, private 
equity, and credit continue to mount?

For weeks we¹ve 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 it¹s 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.

³Structured finance² is touted as the ³new architecture of financial markets². 
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). It¹s madness; but
no one seemed to realize how crazy it was until Bear Stearns blew up and they 
couldn¹t find bidders for their remaining CDOs. It¹s 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, 
³Gold: The Collapse of the Vanities²:

"The origin of the debt crisis lies with the evolution of America's financial 
markets using financial engineering and leverage to finance the credit 
expansionŠ. 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 institutionsŠ.. 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 subprime crisis is not a one off event but the beginning of a 
significant sea change in the modern-day financial markets.²

The investment sharks who conjured up ³structured finance² 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. It¹s 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 Bush¹s ³free market² nostrums or Paulson¹s soothing bromides (he thinks
the problem is ³contained²) or Bernanke¹s 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, ³Banks Flock to 
Discount Window². (9-14-07) The article chronicled the sudden up-tick in 
borrowing by the struggling banks via the Fed¹s emergency bailout program, the 
³Discount Window²:

³Discount borrowing under the Fed¹s primary credit program for banks surged to 
more than $7.1 billion outstanding as of Wednesday, up from $1 billion a week 
before.²

Again we see the same pattern developing; the banks borrowing money from the Fed
because they cannot meet their minimum reserve requirements.

WSJ: ³The Fed in its weekly release said average daily borrowing through 
Wednesday rose to $2.93 billion.²

$3 billion.

Traditionally, the ³Discount Window² has only been used by banks in distress, 
but the Fed is trying to convince people that it¹s really not a sign of distress
at all. It¹s ³a sign of strength². Baloney. Banks don¹t borrow $3 billio unless 
they need it. They don¹t 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 ³down-graded² 
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.²Š.² 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. We¹ll 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 Fed¹s 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, ³A cut in rates will not solve the problem. 
This crisis was caused by excess liquidity and a deterioration of credit 
standardsŠ.A cut in the Fed Fund rate is simply heroin for credit junkies.²

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 
Greenspan¹s misguided monetary policies. (For which he now blames Bush!) The 
Fed¹s job is to ensure price stability and the smooth operation of the markets, 
not to reflate equity bubbles and reward over-exposed market participants.

It¹s 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.

³There 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 inflationŠ

"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; we¹re toast.

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, we¹re 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 don¹t lie. According to economist Martin Feldstein, ³The falling 
dollar and rising food prices caused market-based consumer prices to rise by 4.6
per cent in the most recent quarter.² (WSJ)

That¹s 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. .

Bernanke¹s rate cut may be boon to the ³cheap credit² addicts on Wall Street, 
but it¹s 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 Bernanke is simple: ³It¹s time to take away the 
punch bowl².

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 ³Liquidity Boom and the Looming Crisis²:

"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, ³It is not possible to preserve 
the abnormal market prices of assets driven up by a liquidity boom if normal 
liquidity is to be restored.² 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 greenback¹s increasingly shaky position as the 
world¹s ³reserve currency². That could destabilize the global economy by rapidly
unwinding the U.S. massive current account deficit.

The International Herald Tribune summed up the dollar¹s 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 result.

"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 can¹t take a chance that his effort to rescue the markets 
will cause a sudden sell-off of the dollar.

The Fed chief¹s hands are tied. Bernanke simply doesn¹t have the tools to fix 
the problems before him. Insolvency cannot be fixed with liquidity injections 
nor can the deeply-rooted ³systemic² problems in ³structured finance² be 
corrected by slashing interest rates. These require fiscal solutions, 
congressional involvement, and fundamental economic policy changes.

Rate cuts won¹t 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.

We¹ll know his decision soon enough.

Mike Whitney lives in Washington state. He can be reached at: 
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