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Capitalism Without Capital                                    

By Mike Whitney 

May 12, 2010 "Information Clearing House" -- Volatility is back and stocks have started zigzagging wildly again. This time it's Greece in the hotseat, but tomorrow it could be someone else. The real problem is there's too much leverage in the system,  so crises keep popping up one after another.  For a long time,  leverage wasn't an issue, because there was enough liquidity to keep things bobbing-along smoothly.  But that changed when Lehman Bros. collapsed and non-bank funding began to shut down. When the so-called "shadow banking" system crashed, liquidity dried up and the markets went into a nosedive.  That's why Fed Chair Ben Bernanke stepped in and provided short-term loans to under-capitalized financial institutions. Bernanke's rescue operation revived the system, but it also transferred $1.7 trillion of illiquid assets and non-performing loans onto the Fed's balance sheet. So the problem really wasn't fixed at all; the debts were just moved from one balance sheet to another.

Last Thursday,  troubles in Greece triggered a major selloff on all the main indexes. At one point, shares on the Dow plunged 998 points before clawing back 600 points by the end of the day. Some of losses were due to High-Frequency Trading (HFT), which is computer-driven program-trading that executes millions of buy and sell orders in the blink of an eye. HFT now accounts for more than 60 percent of all trading activity on the NYSE. Paul Kedrosky explains what happened in greater detail in his article, "The Run on the Shadow Liquidity System". Here's an excerpt:

  "As most will know, liquidity is, like so many things in financial life, something you can choke on as long as you don't want any....Liquidity is a function of various things working fairly smoothly together, including other investors, market-makers, and, yes, technical algorithms scraping fractions of pennies as things change hands. Together, all these actors create that liquidity that everyone wants, and, for the most part, that everyone takes for granted.....

  Largely unnoticed, however, at least among non-professional investors, the provision of liquidity has changed immensely in recent years. It is more fickle, less predictable, and more prone to disappearing suddenly, like snow sublimating straight to vapor during a spring heat wave. Why? Because traditional providers of liquidity, market-makers and other participants, are not standing so ready to make the other side of the market. There are fewer traders prepared to make a market for the sake of market health.....

   For the first time we have large providers of this shadow liquidity, algorithms and high-frequency sorts, that individually account for large percentages of daily trading activity, and, at the same time, that can be turned off with a switch, or at an algorithmic w him. As a result, in market crises, when liquidity was always hardest to find, it now doesn't just become hard to find, it disappears altogether, like water rushing out sight via a trapdoor to hell. Old-style market-makers are standing aside as panicky orders pour in, and they look straight at shadow liquidity providers and say, "No thanks." (Paul Kedrosky, "The Run on the Shadow Liquidity System" Infectious Greed)

  The fact that the SEC can't figure out what happened, has been a bigger blow to investor confidence than the erratic behavior of the markets themselves. It shows that regulators really don't have a handle on the technology that's driving the markets. That just reinforces the perception that trading is a crap-shoot and the market is a casino.  

     Deregulation has also eroded confidence in the markets. Since Glass Steagall was repealed in 1999, the financial markets have been completely overhauled. Unfortunately, the new architecture is riddled with flaws.  The main levers of credit creation are now in the hands of privately-owned shadow banks instead of highly-regulated "depository" institutions. That's a problem, because the hedge funds, insurers, brokerage houses, SIVs and off-balance sheet operations are mostly unsupervised, so they can ignore capitalization requirements and traditional lending standards.
Even worse, they can  crank out as much credit as they want via the repo market or by using financial instruments (like MBS, CDS, CDO)  Here's how economist James Hamilton explains it in a recent post titled "Follow The Money". Here's an excerpt:

  "If you buy a mortgage-backed security (or collateralized debt obligation constructed from assorted MBS), you could then issue commercial paper against it to get most of your money back, essentially making the purchase self-financing. This was the idea behind the notorious off-balance sheet structured investment vehicles or conduits, which basically used money borrowed on the commercial paper market to buy various pieces of the mortgage securities created by the loan aggregators. The dollar value of outstanding asset-backed commercial paper nearly doubled between 2004 and 2007.

Yale Professor Gary Gorton has also emphasized the importance of repo operations involving mortgage-related securities. If I buy a security, I can then pledge it as collateral to obtain a repo loan, again getting most of my money back and allowing the purchase to be mostly self-financing as long as I keep rolling over repos. Although I have not been able to find numbers on the volume of such transactions, it appears to have been quite substantial.

The question of how the house price run-up was funded thus has a pretty clear answer: Other People's Money. Because of so much money pouring into house purchases, the price was driven up." ("Follow The Money", James Hamilton, Econbrowser)

This is how Wall Street pumped up leverage to ungodly levels and steered the financial system off the cliff. The debt-instruments and repo market were used to create
a ginormous debt pyramid balanced precariously atop a few crumbs of capital. The system was bound to crash.

  Naturally, the people who benefit from credit default swaps (CDS) and other derivatives, continue to sing their praises, but their numbers grow smaller and smaller all the time. Many people now understand the role that derivatives played in crashing the system and are demanding change.  But Wall Street doesn't care about public opinion. The big banks have already deployed their army of lobbyists to Capital Hill to make sure that the new reform legislation doesn't restrict their use of hybrid derivatives which have become their biggest profit-makers. Considering the amount of money they've spread around,  it would be a miracle if they didn't get their way.     

  Last week,  economists Edward L. Glaeser, Joshua Gottlieb and Joseph Gyourko published a research paper and presented their findings to the Federal Reserve Bank of Boston. Here's what they said:

"It isn't that low interest rates don't boost housing prices. They do. It isn't that higher mortgage approval rates aren't associated with rising home values. They are. But the impact of these variables, as predicted by economic theory and as estimated empirically over many years, is too small to explain much of the housing market event that we have just experienced."

Glaeser, Gottlieb and Gyourko say those factors can explain only about a 10 percent increase in home prices between 2000 and 2006. That's only one-third of the 30 percent increase in prices (adjusted for inflation) during that period, as measured by the Federal Housing Finance Agency, or the 74 percent increase measured by the Case-Shiller/Standard and Poor's index of prices in 20 large metro areas.

So what is to blame for the bubble? Well, they're not sure. "Using the standard toolkit of the empirical economist, we are unable to offer much of an explanation for what happened," they write." ("Low interest rates didn't cause the bubble economists say", Elizabeth Razzi, Washington Post)

The crisis was not sparked by interest rates or lax lending standards, but by leverage. In fact, the repo market, securitization and the vast array of debt-instruments are all designed with one purpose in mind; to conceal the amount of leverage in the system. It's capitalism without capital.

The $1.5 trillion in subprime mortgages wasn't nearly enough to bring down the entire financial system. But the losses on trillions of dollars of derivatives that were balanced on top of these mortgages, certainly was. So, what really happened? Here's a summary of the meltdown by economist Henry Liu:

"...the current financial crisis that began in mid-2007 was caused not by bank runs from depositors, but by a melt down of the wholesale credit market when risk-averse sophisticated institutional investors of short-term debt instruments shied away en mass.

The wholesale credit market failure left banks in a precarious state of being unable to roll over their short-term debt to support their long-term loans. Even though the market meltdown had a liquidity dimension, the real cause of system-wide counterparty default was imminent insolvency resulting from banks holding collateral whose values fell below liability levels in a matter of days. For many large, public-listed banks, proprietary trading losses also reduced their capital to insolvency levels, causing sharp falls in their share prices." ("Two Different Banking Crisis--1929 and 2007" Henry Liu)

  The banks don't fund themselves by taking deposits and then using them to lend out money at higher rates.  What they do is buy long-term illiquid assets (mortgage-backed securities, asset-backed securities) and  exchange them in the repo market for short-term loans.  It's like going to a pawn shop and borrowing money by posting collateral, except --in this case--a financial institution (counterparty) takes the other side of the deal.

   When the subprimes started blowing up, the institutions that had been taking the other side of the deals, (the counterparties) got nervous, because they thought the subprime-backed collateral might be worth less than the money they were providing in loans.  So they demanded more collateral from the banks which forced the banks to sell more assets to raise money to cover their losses. This pushed prices down, sparked a flurry of firesales, and drove the weaker institutions into bankruptcy.

The amount of leverage built up in these derivatives was mind-boggling. Take a look at this article from the Wall Street Journal:

"Documents released by Senate investigators last week provide clues as to why the losses were so severe. The documents show how Wall Street banks packaged and repackaged the same risky bonds into securities that ultimately helped magnify the impact of defaulting subprime mortgages on the financial system.

In one case, a $38 million subprime-mortgage bond created in June 2006 ended up in more than 30 debt pools and ultimately caused roughly $280 million in losses to investors by the time the bond's principal was wiped out in 2008, according to data reviewed by The Wall Street Journal.....("Senate's Goldman Probe Shows Toxic Magnification", Carrick Mollenkamp and Serena Ng, Wall Street Journal)

So it wasn't the subprime mortgages that caused most of the damage, but the amount of leverage bundled into the  derivatives and the repo market. Congress needs to focus their attention on the particular instruments and processes (derivatives, repo and securitization) that are used to maximize leverage and inflate bubbles.  That's where the problem lies.

Nomi Prins explains it a bit differently in this month's The American Prospect.  Here's an excerpt from her article "Shadow Banking":

 "Between 2002 and early 2008, roughly $1.4 trillion worth of sub-prime loans were originated by now-fallen lenders like New Century Financial. If such loans were our only problem, the theoretical solution would have involved the government subsidizing these mortgages for the maximum cost of $1.4 trillion. However, according to Thomson Reuters, nearly $14 trillion worth of complex-securitized products were created, predominantly on top of them, precisely because leveraged funds abetted every step of their production and dispersion. Thus, at the height of federal payouts in July 2009, the government had put up $17.5 trillion to support Wall Street's pyramid Ponzi system, not $1.4 trillion. The destruction in the commercial lending market could spur the next implosion." ("Shadow Banking", Nomi Prins, The American Prospect)

  This is a point that bears repeating:  "...nearly $14 trillion worth of complex-securitized products were created" on top of just "$1.4 trillion" of subprime loans." No doubt, the investment bankers and hedge fund managers who inflated  these monster balloons, knew that they were doomed from the get-go, but then, they must have also known that  "I.B.G.-Y.B.G.", which in Wall Street parlance means, "I'll Be Gone and You'll Be Gone."

For a long time, Wall Street concealed its bubblemaking and racketeering behind theories that glorified the wisdom and flexibility of unregulated markets. Government intervention was disparaged as an unnecessary intrusion into a divinely-harmonized system. Now the curtain has been drawn and the sham exposed. The state has a clear interest in making sure that credit-generating institutions are adequately capitalized, that lending standards are strictly upheld, and that reasonable limits are put on the amount of leverage that financial institutions are allowed to use. That's the only way the public can be protected.



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