[NYTr] US Banks Brace for Storm Surge as Dollar and Credit System Reel

[All the News That Doesn't Fit]

Counterpunch - Sep 18, 2007
http://www.counterpunch.org/whitney09182007.html


US Banks Brace for Storm Surge as Dollar and Credit System Reel

By MIKE WHITNEY

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 risky subprime 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 from spreading.

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 subprime crisis 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 billio unless 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 market participants.

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 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, 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.” (WSJ)

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 Bernanke is 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 Looming Crisis”:

"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 account deficit. 

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
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 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 at:
fergiewhitney at msn.com