It's Time to Dump the Federal Reserve
by Mike Whitney <mailto:fergiewhitney@…>
"Facts do not cease to exist because they are ignored."
~ Aldous Huxley
The credit storm which began in July when two Bear Stearns hedge funds
were forced to liquidate, has continued to intensify and roil the
markets. Last week the noose tightened around auction-rate securities, a
little-known part of the market that requires short-term funding to set
rates for long-term municipal bonds. The $330 billion ARS market has
dried up overnight pushing up rates as high as 20% on some bonds - a new
benchmark for short-term debt. Auction-rate securities are now headed
for extinction just like the other previously-vital parts of the
structured finance paradigm. The $2 trillion market for collateralized
debt obligations (CDOs), the multi-trillion-dollar mortgage-backed
securities market (MBSs) and the $1.3 asset-backed commercial paper
(ABCP) market have all shut down, draining a small ocean of capital from
the financial system and pushing many of the banks and hedge funds
closer to default.
The price of insuring corporate bonds has skyrocketed in the last few
weeks making it more difficult for businesses to get the funding they
need to expand or continue present operations. Much of this has to do
with the growing uncertainty about the reliability of credit default
swaps, a $45 trillion dollar market which remains virtually unregulated.
Credit-default swaps are a type of financial instrument that are used to
speculate on a company's ability to repay debt. They pay the buyer face
value in exchange for the underlying securities or the cash equivalent
if a borrower fails to adhere to its debt agreements. When the price of
CDSs increases, it means that there is greater doubt about the quality
of the bond. Prices are presently soaring because the entire structured
finance market - and anything connected to it - is under withering
attack from the meltdown in subprime mortgages. As foreclosures continue
to rise, the securities that were fashioned from subprime loans will
continue to unwind, destroying trillions of dollars of virtual-capital
in the secondary market.
It all sounds more complicated than it really is. Imagine a 200-ft.
conveyor belt with two burly workers and a mountain-sized pile of money
on one end, and a towering bonfire on the other. Every time a home goes
into foreclosure, the two workers stack the money that was lost on the
transaction - plus all of the cash that was leveraged on the home via
"securitization" and derivatives - onto the conveyor-belt where it is
fed into the fire. That is precisely what is happening right now and the
amount of capital that is being consumed by the flames far exceeds the
Fed's paltry increases to the money supply or Bush's projected $168
billion "surplus package." Capital is being sucked out of the system
faster than it can be replaced, which is apparent by the sudden cramping
in the financial system and a more generalized slowdown in consumer
spending.
According to a recent Bloomberg article:
"A year ago $20 million would have gotten Luminent Mortgage Capital Inc.
access to $640 million in loans to buy top-rated mortgage-backed
securities. Now that much cash gets the firm no more than $80 million.
...(Only) 6 lenders are offering 5 times leverage, while a year ago, 20
banks extended 33 times."
The banks are not providing anywhere near as much money for leveraged
investments as they did just last year. And, when credit shrinks on a
national scale - as it is - so does the economy. It's a simple formula;
less money means less economic activity, less growth, fewer jobs,
tighter budgets, more pain.
Bloomberg continues:
"Wall Street firms, reeling from $146 billion in losses on their debt
holdings, are fueling a credit crisis by clamping down on lending to
investors and hedge funds that use borrowed money to buy securities. By
pulling back, (the banks) are contributing to reduced demand and lower
prices throughout the fixed-income world."
The banks are in no position to be extravagant because they're already
saddled with $400 billion in MBSs and CDOs - as well as another $170
billion in private equity deals - for which there is currently no
market. They've had to dramatically cut back on their lending because
they either don't have the resources or are facing bankruptcy in the
near future.
An article which appeared on the front page of the Financial Times last
week, illustrates how hard-pressed the banks really are:
"US banks have been quietly borrowing massive amounts of money from the
Federal Reserve...$50 billion in one month."
The Fed's new Term Auction Facility "allows the banks to borrow money
against all sort of dodgy collateral," says Christopher Wood, analyst at
CLSA. "The banks are increasingly giving the Fed the garbage collateral
nobody else wants to take ... [this] suggests a perilous condition for
America's banking system."
The move has sparked unease among some analysts about the stress
developing in opaque corners of the US banking system and the banks'
growing reliance on indirect forms of government support." ("US Banks
borrow $50 billion via New Fed Facility," Financial Times.) (The story
appeared nowhere in the US media.)
At the same time the banks are getting backdoor injections of liquidity
from the Fed, banking giant Citigroup has been trying to off-load some
of its branches so it can cover its structured investment losses. It all
looks rather desperate, but scouring the planet for capital to shore up
flagging balance sheets is turning out to be a full-time job for many of
America's largest investment banks. It is the only way they can stay one
step ahead of the hangman.
In the last few days, gold has spiked to $950, a new high, while oil
futures passed the $100 per barrel mark. The battered greenback has
already taken a beating, and yet, Fed chairman Bernanke is signaling
that there are more rate cuts to come. The prospect of a global run on
the dollar has never been greater. Still, Bernanke will do whatever he
can to resuscitate the faltering banking system, even if he destroys the
currency in the process. Unfortunately, interest rates alone won't cut
it. The banks need capital; and fast. Meanwhile, the waning dollar has
sent food and energy prices soaring which is leaving consumers without
the discretionary income they need for anything beyond the basic
necessities. As a result, retail sales are down and employers are forced
to lay off workers to reduce their spending. This is all part of the
self-reinforcing negative-feedback loop that begins with falling home
prices and then rumbles through the broader economy. There is no chance
that the economy will rebound until housing prices stabilize and the
rate of foreclosures returns to normal. But that could be a long way
off. With housing inventory at historic highs and mortgage applications
at new lows, the economy could keep somersaulting down the stairwell for
a full two years or more. Only then, will we hit rock-bottom.
The country is now headed into a deep and protracted recession. Low
interest credit and financial innovation have paralyzed the credit
markets while inflating a monstrous equity bubble that is wreaking havoc
with the world's financial system. The new market architecture,
"structured finance" has collapsed from the stress of falling
asset-values and rising defaults. Many of the banks are technically
insolvent already, hopelessly mired in their own red ink. Public
confidence in the nations' financial institutions has never been lower.
Monetary policy and deregulation have failed. The system is
self-destructing.
Now that the credit crunch has rendered the markets dysfunctional,
spokesmen for the investor class are speaking out and confirming what
many have suspected from the very beginning; that the present troubles
originated at the Federal Reserve and, ultimately, they are the ones who
are responsible for the meltdown. In an article in the Wall Street
Journal this week, Harvard economics professor and former Council of
Economic Advisers under President Reagan, Martin Feldstein, made this
revealing admission:
"There is plenty of blame to go around for the current situation. The
Federal Reserve bears much of the responsibility, because of its failure
to provide the appropriate supervisory oversight for the major money
center banks. The Fed's banking examiners have complete access to all of
the financial transactions of the banks that they supervise, and should
have the technical expertise to evaluate the risks that those banks are
taking. Because these banks provide credit to the nonbank financial
institutions, the Fed can also indirectly examine what those other
institutions are doing.
The Fed's bank examinations are supposed to assess the adequacy of each
bank's capital and the quality of its assets. The Fed declared that the
banks had adequate capital because it gave far too little weight to
their massive off balance-sheet positions - the structured investment
vehicles (SIVs), conduits and credit line obligations - that the banks
have now been forced to bring onto their balance sheets. Examiners also
overstated the quality of the banks' assets, failing to allow for the
potential bursting of the house price bubble. The implication of this
for Fed supervision policy is clear. The way out of the current crisis
is not."
How odd? So, when all else fails, tell the truth?
But Feldstein is right; the Fed refused to perform its oversight duties
because its friends in the banking industry were raking in obscene
profits selling sketchy, subprime junk to gullible investors around the
world. They knew about the "massive off balance-sheet positions" which
allowed the banks' to create mortgage-backed securities and CDOs without
sufficient capital reserves. They knew it all; every last bit of it,
which simply proves that the Federal Reserve is an organization which
serves the exclusive interests of the banking establishment and their
corporate brethren in the financial industry.
Surprised?
The upcoming global recession/depression will give us plenty of time to
mull over the ruinous effects of Fed policy and to devise a plan for
abolishing the Federal Reserve once and for all. That is, if they don't
destroy us first.
February 22, 2008
Mike Whitney [send him mail <mailto:fergiewhitney@…> ] lives in
Washington state.
Copyright (c) 2008 LewRockwell.com