The Era of Global Financial Instability           

          “Scientists say they have discovered a hole in the universe. We’re not surprised. We knew something was wrong.” Bill Bonner, “The Daily Reckoning”

By Mike Whitney

09/20/07 "ICH" -- -- Wall Street loves cheap money. That’s why traders were celebrating on Tuesday when Fed chief Ben Bernanke announced that he’d drop interest rates from 5.25% to 4.75%. The stock market immediately zoomed upward adding 336 points before the bell rang. The next day the giddiness continued. By mid-morning the Dow was up another 110 points and headed for the stratosphere.  Everyone on Wall Street loves Bernanke. He brings them candy and sweets and lets the American worker pay the bill.

  We’re disappointed in the new Fed Chief.  We thought he would be different than Greenspan. We were taken in by his scholarly appearance and his modest demeanor. We thought we sensed the heart of a real patriot---a man of character and conviction. We were wrong. In his first crisis, Bernanke caved in and gave away the store. He rewarded his fat-cat friends at the hedge funds and investment banks while paving the way for more inflation for the rest of us. Presently, gold is soaring at $736 per ounce, oil is at $82 per barrel, and the euro just climbed to a new high of $1.40. Food and energy prices are bound to skyrocket. Bernanke has crushed the dollar for a “last fling” on Wall Street. It’s madness.

   Bernanke invoked the “Greenspan put”, which means that he used his power to protect his friends from the losses they should have incurred from their bad bets. Now, the big market players know that he can be counted on to bail them out whenever they make poor investment choices.  He’s also lived up to his nickname, “Helicopter Ben”; ready to deal with every new calamity by tossing trillions of freshly-minted US greenbacks into the jet-stream over the NYSE so elated traders can jack-up their PEs and fatten their bottom line . We think Bernanke should abandon the helicopter altogether and personally deliver pallet-loads of $100 bills to Wall Street’s doorstep on a Fed-owned fork-lift, just like Bush does with contractors in Iraq. That way the fund managers and blue suits can keep stoking the market with cheap cash without wasting time at the Fed’s Discount Window.

  Despite the merriment on Wall Street, there is a downside to Bernanke’s actions. The Fed chief has shown foreign investors that he WILL NOT DEFEND THE DOLLAR. That is a powerful message to anyone who hopes to profit by investing in the US. It alerts them to the fact that the “strong dollar” policy is a fraud and that they’re better off getting out of US Treasuries and dollar-backed assets. Apparently, they got the message. Last month, foreign central banks and investors dumped $9.4 billion of US Treasuries and bonds compared to net purchases in June of $24.7 billion. That means that foreigners have stopped buying our debt which is currently $800 billion per year. That’s the last leg holding up the wobbly greenback. The dollar will undoubtedly fall precipitously.

 So, why would Bernanke weaken the dollar even more by lowering rates 50 basis points?

   Is he crazy or did he panic?

   We don’t know, but we do know that this is the beginning of Capital flight---the sudden exodus of foreign investment from US debt and equities. Most likely, it will be accompanied by the hissssing sound of gas escaping from a punctured equity bubble followed quickly by a painful round of deflation, massive unemployment and the gnashing of teeth.

    Surprisingly, Bernanke’s rate cuts don’t even address the underlying problems they are supposed to cure. Millions of homeowners who took out subprime and Alt-a loans are headed for foreclosure. Only a small percentage of these will benefit from the rate cuts and avoid default because of lower “resets” on their loans. Most of them will not qualify for refinancing UNDER ANY TERMS because they don’t meet the new standards for securing a loan. Banks and mortgage companies have become much stricter in their loaning practices.

   The rate cuts don’t really help the banks or hedge funds either. Their stocks may lurch upward for a day or two, but that won’t last. Money is getting tighter and spending is down. It’s not a good time to be holding hundreds of billions in mortgage-backed liabilities (CDOs) which may have been levered many times their original-value. There’s no market for these CDOs. They’re turkeys. The debt will either have to be written off or the companies will be forced into bankruptcy.

  Rate cuts won’t stem the tide of insolvencies or fix the deeply-ingrained problems in the financial markets. All they will do is forestall the impending recession by sustaining abnormal levels of liquidity. But as consumer spending shrinks and unemployment continues to rise; the Fed’s “band-aid” approach to these systemic problems will prove to be ineffective. Bernanke is sacrificing the one thing he’ll need most in the bumpy months ahead; his credibility.

   As economist and author Henry Liu says, “A market that catches on to the impotence of central-bank intervention can go into free fall.”

  The most compelling argument for interest rate cuts was made by economist Martin Feldstein in a Wall Street Journal article “Liquidly Now”. Feldstein summarized the issue like this:

   “Three separate but related forces are now threatening economic activity: a credit market crisis, a decline in house prices and home building, and a reduction in consumer spending. These developments compound the general weakening of the economy earlier in the year, marked by slowing employment growth and declining real spendable income.”

  “The subprime mortgage defaults have triggered a widespread flight from risky assets, with a substantial widening of all credit spreads, and a general freezing of credit markets. Official credit ratings came under suspicion. Investors and lenders became concerned that they did not know how to value complex risky assets.

 

  In some recent weeks credit became unavailable. Loans to support private equity deals could not be syndicated, forcing the banks to hold those loans on their own books. Banks are also being forced to honor credit guarantees to previously off-balance-sheet conduits and other back-up credit lines, further reducing the banks' capital available to support credit of all types.

 

 The inability of credit markets to function properly will weaken the overall economy in the coming months. And even when the credit market crisis has passed, the wider credit spreads and increased risk aversion will be a damper on economic activity.

 

 In addition to these general credit market problems, the decline of house prices and home building will be a growing drag on the economy….Falling house prices would not only cause further declines in home building but would also shrink household wealth and thus consumer spending.”

  

 Feldstein demonstrates a keen understanding of the problem, but backpedals on the remedy:

 

 “Fed action to lower interest rates cannot solve the credit market problems, but it would help the economy: by stimulating the demand for housing, autos and other consumer durables; by encouraging a more competitive dollar to stimulate increased net exports; by raising share prices to increase both business investment and consumer spending; and by freeing up spendable cash for homeowners with adjustable-rate mortgages”.

 

 What? So Feldstein wants rate cuts even though he admits that “lower interest rates cannot solve the credit market problems” but will just stimulate more wasteful “consumer spending”?!?

 

 That’s not a cure, Martin. That’s just more Greenspan snake oil.

 

 “Too much liquidity” is the problem not the solution. The reason the markets are so volatile and likely to implode at any minute is because every asset-class has been foolishly inflated by a monetary policy that followed Feldstein’s prescription. Now he wants to avoid the consequences of these misguided policies by reflating the bubble and destroying the dollar in the process. It’s a bad idea.   

  The Fed’s cuts coincide with the dismal earnings reports from Wall Street’s investment giants; Lehman Brothers, Morgan Stanley, Bear Stearns and Goldman Sachs. The four banks have taken a combined 22% haircut in the last quarter and are expected to sustain heavy losses from the billions of dollars of subprime CDOs they’ll have to either downgrade or write-off. So far, Bernanke’s rate cuts have diverted attention from the grim news and falling profits from America’s investment core.

  The big financials aren’t the only one’s feeling the pinch from the housing meltdown either. There are many others including Bank of America that announced “unprecedented dislocations” in credit markets will have a “meaningful impact” on third-quarter results at its corporate investment bank. “Chief Financial Officer Joe Price told investors at a conference in San Francisco, ‘These are quite challenging financial times, and I cannot remember when credit markets in particular have been as volatile and unpredictable as they have been for the last few months.”’ (Bloomberg News)

   Bernanke’s rate cuts are “thin gruel” for the banks bottom line, but they do offer a welcome distraction from the relentless drumbeat of bad economic news. The subprime sarcoma has spread to every part of the financial markets. It’s not just the steady up tick of foreclosures and mushrooming real estate inventory. The banks are also hoarding capital to cover their losses on unmarketable CDOs and leveraged buyouts (LBOs) which means that new mortgages will slow to a crawl even to credit-worthy applicants. An article in Bloomberg News gives us some idea of how quickly the market for housing-related bonds has deteriorated:

  “Sales of US asset-backed securities, such as bonds that repackage subprime loans or credit card debts as well as collateralized debt obligations., FELL73% FROM A YEAR EARLIER to $30 billion last month, according to estimates from analysts at Deutsche Bank AG”. (Bloomberg News) 

   Bernanke is just prolonging the pain by not allowing the market to complete its cycle so that bad debts to be written off and industry can retool for the future.  He’s buying time for his banker-friends, but doing considerable damage to the dollar in the process. Jim Rogers, the chairman of Beeland Interests Inc. summed up the rate cuts like this:

   ``Every time the Fed turns around to save its friends on Wall Street, it makes the situation worse. The dollar's going to collapse, the bond market's going to collapse. There's going to be a lot of problems in the U.S.''

Rogers is not alone in his conclusions.

  Even foreign leaders, like Venezuelan President Hugo Chavez, have commented recently on the worrisome state of US markets. Three days ago Chavez said on public television that we may be facing a "global financial earthquake" as the result of "irresponsible" US economic policies. Chavez quoted Nobel Laureate Joseph Stiglitz’s warning that we may be facing a major economic disaster which could lead to “widespread misery, hunger and severe unrest. And the United State is to blame.”

 Chavez added that the Bush administration "has had to inject $300 US billion into the private banks this month to avoid a collapse of the dollar and the world economy ….The dollar is going down, they don't see that it isn't supported by reality” and because it is "because its fiscal deficit is the largest in history."

  Chavez’s predictions appear to be accurate as we can see that gold has suddenly skyrocketed while the dollar continues to fall.

    The firestorm that began with the Fed’s low interest rates in 2002-2003 and evolved into the subprime-lending crisis of 2006-2007 is now threatening the stability of the entire financial system and the broader global economy. The reason for this is that mortgage debt is the foundation upon which all manner of bizarre-sounding debt-instruments are now resting. These debt-instruments (derivatives) greatly magnify the leverage on the underlying asset which is often is nothing more than a dodgy subprime loan.

According to Satyajit Das, a respected authority on derivatives trading, “A single dollar of "real" capital supports $20 to $30 of loans. This spiral of borrowing on an increasingly thin base of real assets, writ large and in nearly infinite variety, ultimately created a world in which derivatives outstanding earlier this year stood at $485 trillion -- or eight times total global gross domestic product of $60 trillion.” (Are We Headed for an Epic Bear Market” Jon Markman) 

  We are now seeing the first signs that this enormous debt-bubble is beginning to unwind. There’s very little the Fed can do to affect the inevitable crash. As defaults in housing continue to rise; the swaps and derivatives in the secondary market will implode. Trillions in market capitalization will vanish in a flash.

   US GDP for the last 6 years has largely depended on transactions involving the exchange of massively over-levered assets. Production in the real economy has remained flat. The investment banks are at the epicenter of this controversial new system called “structured finance”. We continue to believe that the banks that depended on mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs) (as well as asset-backed commercial paper) for the bulk of their income; are in deep trouble. Robert E. Lucas alluded to potential bank-woes in an article in the Wall Street Journal, “Mortgages and Monetary Policy”:

   “There is an immediate risk of a payments crisis, a modern analogue to an old-fashioned bank run. Many institutions -- not just banks – HAVE PAYMENT OBLIGATIONS THAT ARE FAR IN EXCESS OF THE RESERVES TO WHICH THEY HAVE IMMEDIATE ACCESS. Against these obligations they hold short-term securities that they believed could be liquidated on short notice at little cost. If some of these securities turn out not to be liquid in this sense (and especially if no one is sure who holds them) then everyone wants to get into Treasury bonds.”

   It‘s rare when we are in agreement with the far-right viewpoints of the WSJ’s Editorial page, but in this case, Lucas nailed it. The banks have “obligations that are far in excess of the reserves to which they have immediate access.” This is a direct result of the new market architecture of “structured finance” which stacks debt on debt until the whole system is pushed to the breaking point. 

  Low interest rates can’t fix this “systemic” problem. Only fiscal policy can soften the blow of a deflating credit bubble. Economist Henry Liu offers this constructive “New Deal-type” proposal which is a sensible (and ethical) way to address the prospect of growing unemployment and increasing economic hardship for the middle and lower classes:  

   “A case can be made that what is needed under current conditions is not more cheap money from the Fed, but full employment with rising wages by government fiscal stimulants to boost consumer demand. The US government should make use of the money that the banks cannot find worthy borrowers to lend to, with money-cautious investors seeking to lend to the government, creating jobs for infrastructure rehabilitation and upgrading education to get the economy moving again off the destructive track of privatized systemic financial manipulation.” (“Either Way, It could be an Unkind Cut” Henry C K Liu, Asia Times)

   Americans will be forced to wean themselves off debt-spending but---at the same time---the current market system must be completely transformed and re-regulated. The financial innovations of the last decade have created an opaque system that rewards clever debt-schemes and ignores productivity. Structured finance promised to use capital with greater efficiency  while distributing risk more evenly throughout the system. Instead, it has polluted world financial markets and pushed the global economy to the brink of disaster. 

   Author Gabriel Kolko summed it up better than anyone in his article “The Predicted Financial Storm Has Arrived”:

 

  “We are at an end of an era…Now begins global financial instability. It is impossible to speculate how long today's turmoil will last-but there now exists an uncertainty and lack of confidence that has been unparalleled since the 1930s-and this ignorance and fear is itself a crucial factor. The moment of reckoning for bankers and bosses has arrived. What is very clear is that losses are massive and the entire developed world is now experiencing the worst economic crisis since 1945, one in which troubles in one nation compound those in others.

Internationalization of finance has meant less regulation than ever, and regulation was scarcely very effective even at the national level….. Greed's only bounds are what makes money. Existing international institutions-of which the IMF is the most important--or well-intentioned advice will not change this reality.”