By Mike Whitney
-- - On Friday morning, Senator Christopher Dodd, the head
of the Senate Banking Committee, was interviewed on ABC's “Good
Morning America.” Dodd revealed that just hours earlier at an
emergency meeting convened by Secretary of the Treasury Henry
Paulson and Federal Reserve chairman Ben Bernanke, lawmakers
were told that "We’re literally maybe days away from a complete
meltdown of our financial system.” Dodd added somberly, that in
his three decades of serving in public office, he had "never
heard language like this.”
The system is at the breaking point, and despite Wall Street's
elation from the proposed $1 trillion dollar bailout to remove
toxic mortgage-backed debt from banks balance sheets, the market
is still correcting in what has become a vicious downward cycle.
This cycle will persist until the bad debts are accounted for
and written off for or until the exhausted dollar-system
collapses altogether. Either way, the volatility and violent
dislocations will continue for the foreseeable future.
Most people don't understand what happened on Thursday, but the
build-up of bad news on the Lehman default and the $85 billion
government takeover of AIG, triggered a run on the money markets
and a freeze in interbank lending. The overnight LIBOR rate
(London Interbank Offered Rate) more than doubled to 6.44%! Bank
of America reported overnight borrowing rates in excess of 6%.
Longer-term LIBOR rates also rose sharply. On Wednesday, jittery
investors removed their money from money markets and flooded
short-term US Treasurys for the assurance of a government
guarantee on their savings even though interest rates had turned
negative which means that their balance would actually shrink at
the date of maturity. This is unprecedented, but it does help to
illustrate how raw fear can drive the market.
The TED spread (the TED Spread measures market stress by
revealing the reluctance of banks to lend to each other) widened
and the credit markets froze in place. Borrowing three-month
dollars on the interbank market and the U.S. Treasury's
three-month borrowing costs widened five full percentage points.
That's huge. The banking system shut down.
What does it mean? It means the Federal Reserve has lost
control of the system. The market is driving interest rates now,
and the market is terrified. End of story.
When the Fed announced its emergency program to dump $180
billion into the global banking system, short term Libor
retreated slightly but long-term rates have remained stubbornly
high. The noose continues to tighten. These rates are pinned to
6 million US mortgages which will be resetting in the next few
years. That's more bad news for the housing industry.
The entire system is deleveraging with the ferocity of a Force-5
gale touching down in the Gulf, and yet, Henry Paulson has
decided that the prudent thing to do is build levies around the
system with paper dollars. Naturally, many people who understand
the power of market-corrections are skeptical. It won't work.
Libor is pushing rates upwards--that's the "true" cost of money.
The Fed Funds rate (2 percent) is supported by infusions of
paper dollars into the banking system to keep interest rates
artificially low. Now the extreme pace of deleveraging has the
Fed on the ropes. Trillions of dollars of credit is being sucked
into a black hole which is raising the price of money. It's out
of Bernanke's control. He needs to step out of the way and let
prices fall or the dollar system will vanish in a deflationary
The problems cannot be resolved by shifting the debts of the
banks onto the taxpayer. That's an illusion. By adding another
$1 or $2 trillion dollars to the National Debt, Paulson is just
ensuring that interest rates will go up, real estate will crash,
unemployment will soar, and foreign central banks will abandon
the dollar. In truth, there is no fix for a deleveraging market
anymore than there is a fix for gravity. The belief that massive
debts and insolvency can be erased by increasing liquidity just
shows a fundamental misunderstanding of economics. That's why
Henry Paulson is the worst possible person to be orchestrating
the so called rescue project. Paulson comes from a business
culture which rewards deception, personal acquisitiveness, and
extreme risk-taking. Paulson is to finance capitalism what
Rumsfeld is to military strategy. His leadership, and the
congress' pathetic abdication of responsibility, assures
disaster. Besides, why should the taxpayers be happy that the
stocks of Morgan Stanley, Washington Mutual and Goldman Sachs
surged on the news that there would be a government bailout
yesterday? These banks are essentially bankrupt and their
business models are broken. Keeping insolvent banks on life
support is not a rescue plan; it's insanity.
No one has any idea of the magnitude of the deleveraging ahead
or the size of the debts that will have to be written down.
That's because 30 years of deregulation has allowed a parallel
financial system to arise in which over $500 trillion dollars in
derivatives are traded without any government supervision or
accounting. These counterparty transactions are interwoven
throughout the entire "regulated" system in a way that poses a
clear and present danger to the broader economy. It's a
mess. For example, there are an estimated $62 trillion of Credit
Default Swaps (CDS) alone, which are basically insurance
policies for defaulting bonds. AIG was as heavily involved in
CDS as they were in regulated insurance products. So why would
AIG sell CDS rather than conventional insurance?
Because, just like the banks, AIG could maximize its profits by
minimizing its capital cushion. In other words, it didn't really
have the capital to pay off claims when its CDS contracts began
to blow up. If it had been properly regulated, then government
regulators would have made sure that it was sufficiently
capitalized with adequate reserves to pay off claims in a
down-market. Now taxpayers will pay for the lawless system which
men like "industry rep" Henry Paulson put in place. That's
deregulation in a nutshell; a system that allows Wall Street
banksters to create credit out of thin air and then run
weeping to Congress when their swindles backfire.
Inflating the currency, printing more money, and increasing
the deficits won't help. The bad debts have to be accounted for
and liquidated. The Paulson strategy is to create another ocean
of red ink while refusing to face the underlying problem
head-on. This just further exacerbates the consumer-led
recession which economists know is already setting in everywhere
across the country. Demand is down and consumer spending is off
due to falling home equity, job losses, and tighter lending
standards at the banks. The broader economy does not need the
added downward pressure from higher taxes, bigger deficits, or
inflation. Paulson's plan is a band-aid approach to a sucking
chest wound. The debts are enormous and the pain will be
substantial, but the problem cannot be resolved by crushing the
middle class or destroying the currency.
The malfunctioning of the markets and the freeze-over in the
banking system are the outcome of a massive credit
unwind instigated by trillions of dollars of low interest credit
from the Federal Reserve which was magnified many times over via
complex derivatives contracts and extreme leveraging by
speculative investment bankers. This has generated the biggest
equity bubble in history. That bubble is now set for
a "hard-landing" which is the predictable result of an
unsupervised marketplace where individual players are allowed to
create as much credit as they choose.
If Paulson is not removed and his rescue plan scrapped
altogether; the dollar will lose its position as the world's
reserve currency and the US government will face a historic
funding crisis as foreign sources of capital dry up. That will
thrust the country into a hyper-inflationary depression.
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