Capitalism Without Capital
By Mike Whitney
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.