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Bernanke's Next Big Bail Out Plan


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Bernanke's Next Big Bail Out Plan

By MIKE WHITNEY

www.counterpunch.org

Weekend Edition March 29-30, 2008

http://www.counterpunch.org/whitney03292008.html

The Federal Reserve is presently considering an emergency operation that is so risky it could send the dollar slip-sliding over the cliff. The story appeared in the Financial Times earlier this week and claimed that the Fed was examining the feasibility of buying back hundreds of billions of dollars of mortgage-backed securities (MBS) with public money to restore investor confidence and clear the struggling banks' balance sheets. The Fed, of course, denied the allegations, but the rumors abound. Currently the banking system is so clogged with exotic investments, for which there is no market, it can't perform its main task of providing credit to businesses and consumers. Bernanke's job is to clear the credit logjam so the broader economy can begin to grow again. So far, he has failed to achieve his objectives.

Since September, Bernanke has slashed interest rates by 3 per cent and opened various auction facilities (Term Securities Lending Facility, the Term Auction Facility, the Primary Dealer Credit Facility, and the new Term Securities Lending Facility) which have made $400 billion available in low-interest loans to banks and non banks. He has also accepted a "wide range" of collateral for Fed repos including mortgage-backed securities and collateralized debt obligations (CDOs) which are worth considerably less than what the Fed is offering in exchange. But the Fed's injections of liquidity have not solved the basic problem which is the fall in housing prices and the persistent downgrading of mortgage-backed assets that investors refuse to buy at any price. In fact, the troubles are gradually getting worse and spreading to areas of the financial markets that were previously thought to be risk-free. The credit slowdown has also put additional pressure on hedge funds and other financial institutions forcing them to quickly deleverage to meet margin calls by dumping illiquid assets into a saturated market at fire-sale prices. This process has been dubbed the "great unwind".

In the last six years, the mortgage-backed securities market has ballooned to a $4.5 trillion dollar industry. The investment banks are presently holding about $600 billion of these complex debt instruments. So far, the banks have written down $125 billion in losses, but there's a lot more carnage to come. Goldman Sachs estimates that banks, brokerages and hedge funds will eventually sustain $460 billion in losses, three times greater than today. Even so, those figures are bound to increase as the housing market continues to deteriorate and capital is drained from the system.

The Fed has neither the resources nor the inclination to scoop up all the junk bonds the banks have on their books. Bernanke has already exposed about half ($400 billion) of the Central Bank's balance sheet to credit risk. But what is the alternative? If the Fed doesn't intervene, then many of country's largest investment banks will wind up like Bear Stearns; DOA. After all, Bear is not an isolated case; most of the banks are similarly leveraged at 25 or 35 to 1. They are also losing more and more capital each month from downgrades, and their main streams of revenue have been cut off. In fact, many of Wall Street's financial titans are technically insolvent already. The Fed is the only force keeping them from bankruptcy.

Case in point: "Citigroup may write down $13.1 billion of assets including leveraged loans and collateralized debt obligations in the first quarter..... U.S. bank earnings overall will tumble 84 percent in the quarter....``We anticipate further downside to both estimates and stock prices'' because banks will be under pressure to mark down assets to reflect falling market indexes." (Bloomberg News)

It's generally accepted that the market for mortage-backed securities (MBS) will not improve until housing prices stabilize, but that's a long way off. Mortgages are the cornerstone upon which the multi-trillion dollar structured investment market rests. And that cornerstone is crumbling. If housing prices continue to fall, the MBS market will remain frozen and banks will fail; it is as simple as that. No one is going to purchase derivatives when the underlying asset is losing value. The Bush administration is pushing for a "rate freeze" and other clever ways to keep homeowners from defaulting on their mortgages. But it's a hopeless cause. The clerical work needed to change these complex mortgages is already proving to be a daunting task. Plus, since 60 percent of these mortgages were securitized, it is nearly impossible to change the terms of the contracts without first getting investor approval.

Also, the tentative plans to expand Fannie Mae and Freddie Mac, so they can absorb larger mortgages (up to $729,000 jumbo loans) is putting an enormous strain on the already-overextended Government Sponsored Enterprises (GSEs; financial services corporations created by the United States Congress. By attempting to reflate the housing bubble, the administration will only increase the rate of foreclosures and put the two mortgage behemoths at risk of default without any clear sign that it will revive the market.

Yesterday's release of the Case/Schiller Index of the 20 largest cities in the country, shows that housing prices have slipped 10.7 per cent in the last year while sales were down 23 per cent year over year. That means that retail equity of US homes just took a $2 trillion haircut. Still, prices have a long way to go before they catch up to the 50 percent decline in sales from the peak in 2005. From this point on, prices should fall and fall fast; following a trajectory as steep as sales. Many economists expect housing prices to drop at least 30 per cent, which means that $6 trillion will be shaved from aggregate home equity. In a slumping market, many homeowners will be better off just "walking away" from their mortgage instead of making payments on an asset of steadily decreasing value. Who wants to make monthly payments on a $500,000 mortgage when the current value of the house is $350,000? It's easier to pack the kids and vamoose then waste a lifetime as a mortgage slave. Besides, the Bush administration has no interest in helping the little guy stay out of foreclosure. It's a joke. All of the rescue plans are designed with just one purpose in mind; to save Wall Street and the banking establishment.

The Fed chairman has simply responded to events as they unfold. The collapse of Bears Stearns came just weeks after the SEC had checked the bank's reserves and decided that they had sufficient capital to weather the storm ahead. But they were wrong. The bank's capital ($17 billion) vanished in a matter of days after word got out that Bear was in trouble. The sudden run on the bank created a risk to other banks and brokerages that held derivatives contracts with Bear. Something had to be done; Rome was burning and Bernanke was the only man with a hose.

According to the UK Telegraph:

"Bear Stearns had total (derivatives) positions of $13.4 trillion. This is greater than the US national income, or equal to a quarter of world GDP - at least in 'notional' terms. The contracts were described as 'swaps', 'swaptions', 'caps', 'collars' and 'floors'. This heady edifice of new-fangled instruments was built on an asset base of $80bn at best.

"On the other side of these contracts are banks, brokers, and hedge funds, linked in destiny by a nexus of interlocking claims. This is counterparty spaghetti. To make matters worse, Lehman Brothers, UBS, and Citigroup were all wobbling on the back foot as the hurricane hit.

"' Twenty years ago the Fed would have let Bear Stearns go bust,' said Willem Sels, a credit specialist at Dresdner Kleinwort. 'Now it is too interlinked to fail.'"

Bernanke felt he had no choice but to step in and try to minimize the damage, but the outcome was disappointing. Bernanke and Secretary of the Treasury Henry Paulson worked out a deal with JP Morgan that committed $30 billion of taxpayer money, without congressional authority, to buy toxic mortgage-backed securities from a privately-owned business that was failing because of its own speculative bets on dodgy investments. The only people who made out were the investors who were holding derivatives contracts that would have been worthless if Bear went toes up.

Still,the prospect of a system-wide derivatives meltdown left Bernanke with few good options, notwithstanding the moral hazard of bailing out a maxed-out, capital impaired investment bank that should have been fed to the wolves.

It is worth noting that derivatives contracts are a fairly recent addition to US financial markets. In 2000, derivatives trading accounted for less than $1 trillion. By 2006 that figure had mushroomed to over $500 trillion. And it all can be traced back to legislation that was passed during the Clinton administration.

"A milestone in the deregulation effort came in the fall of 2000, when a lame-duck session of Congress passed a little-noticed piece of legislation called the Commodity Futures Modernization Act. The bill effectively kept much of the market for derivatives and other exotic instruments off-limits to agencies that regulate more conventional assets like stocks, bonds and futures contracts.

Supported by Phil Gramm, then a Republican senator from Texas and chairman of the Senate Banking Committee, the legislation was a 262-page amendment to a far larger appropriations bill. It was signed into law by President Bill Clinton that December." ("What Created this Monster" Nelson Schwartz, New York Times)

The Fed chief is now facing a number of brushfires that will have to be put out immediately. The first of these is short term lending rates, which have stubbornly ignored Bernanke's massive liquidity injections and continued to rise. The banks are increasingly afraid to lend to each other because they don't really know how much exposure the other banks have to risky MBS. This distrust has sent interbank lending rates soaring above the Fed funds rate to more than double in the past month alone. So far, the Fed's Term Auction Facility (TAF; under the Term Auction Facility (TAF), the Federal Reserve will auction term funds to depository institutions) hasn't helped to lower rates, which means that Bernanke will have to take more extreme measures to rev up bank lending again. That's why many Fed-watchers believe that Bernanke will ultimately coordinate a $500 billion to $1 trillion taxpayer-funded bailout to buy up all the MBSs from the banks so they can resume normal operations. Of course, any Fed-generated scheme will have to be dolled up with populous rhetoric so that welfare for banking tycoons looks like a selfless act of compassion for struggling homeowners. That shouldn't be a problem for the Bush public relations team.

The probable solution to the MBS mess is the restoration of the Resolution Trust Corp., which was created in 1989 to dispose of assets of insolvent savings and loan banks. The RTC would create a government-owned management company that would buy distressed MBS from banks and liquidate them via auction. The state would pay less than full-value for the bonds (The Fed currently pays 85 per cent face-value on MBS) and then take a loss on their liquidation. "According to Joseph Stiglitz in his book, Towards a New Paradigm in Monetary Economics, the real reason behind the need of this company was to allow the US government to subsidize the banking sector in a way that wasn't very transparent and therefore avoid the possible resistance."

The same strategy will be used again. Now that Bernanke's liquidity operations have flopped, we can expect that some RTC-type agency will be promoted as a prudent way to fix the mortgage securities market. The banks will get their bailout and the taxpayer will foot the bill.

The problem, however, is that the dollar is already falling against every other currency. (On Wednesday, the dollar fell to $1.58 per euro, a new record) If Bernanke throws his support behind an RTC-type plan; it will be seen by foreign investors as a hyper-inflationary government bailout, which could precipitate a global sell-off of US debt and trigger a dollar crisis.

Reuter's James Saft puts it like this:

"It is also hugely risky in terms of the Fed's obligation to maintain stable prices.... it could stoke inflation to levels intolerable to foreign creditors, provoking a sharp fall in the dollar as they sought safety elsewhere." (Reuters)

Saft is right; foreign creditors will see it as an indication that the Fed has abandoned standard operating procedures so it can inflate its way out of a jam. According to Saft, the estimated price could be as high as $1 trillion dollars. Foreign investors would have no choice except to withdraw their funds from US markets and move them overseas. In fact, that appears to be happening already. According to the Wall Street Journal:

"While cash continues to pour into the U.S. from abroad, this flow has been slowing. In 2007, foreigners' net acquisition of long-term bonds and stocks in the U.S. was $596 billion, down from $722 billion in 2006, according to Treasury Department data. From July to December as jitters about securities linked to US subprime mortgages spread, net purchases were just $121 billion, a 65% decrease from the same period a year earlier. Americans, meanwhile, are investing more of their own money abroad." ("A US Debt Reckoning" Wall Street Journal)

$121 billion does not even put a dent the $700 billion the US needs to pay its current account deficit. When foreign investment drops off, the currency weakens. It's no wonder the dollar is falling like a stone.

Mike Whitney can be reached at fergiewhitney@msn.com

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Guest David Guyatt

Douglas, I thought Whitney's article highly insightful. Thanks for posting it.

This whole episode of current and forthcoming bank bankruptcies (short of being bailed out that is) -- due of the piling up of excessive risky obligations that went bad -- is reminiscent of the global Sovereign risk debts implosion that visited major world banks during the late Eighties and early Nineties.

In those days, banks built up a portfolio of ever riskier sovereign debt, in the certain knowledge that many of the indebted sovereigns couldn't redeem their obligations. The game then, as now, was the "this year" profit streams and resulting bonuses, profit shares, promotional chances etc.

The baking regulatory authorities back then looked the other way and let the chaos happen.

The same is true today. The banking regulatory authorities could have simply stepped in and placed a damn great stop sign on the past leveraging bonanza, but chose not to. Astonishingly, in the US an act was passed by Congress (the Commodity Futures Modernization Act as outlined above) that restricted/inhibited regulation of this high risky debt. This Act passed muster almost 8 years ago and suggests to me that the risks were weighed back then and seen to be absolutely suspect but extremely profitable in the short/medium term.

Now the banking sector faces rescue by the taxpayer or being extinguished. Again.

Until such time as deadly serious regulation is brought legislated that corrals the banking sector from effectively risking our money in their casino for their benefit, I dare say that a similar scenario will be visited upon us all in the next 20 years or so, and thereafter at fairly regular intervals.

Hitherto, the banks incentive to greed at out expense is perennially rewarded.

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  • 2 weeks later...
Douglas, I thought Whitney's article highly insightful. Thanks for posting it.

This whole episode of current and forthcoming bank bankruptcies (short of being bailed out that is) -- due of the piling up of excessive risky obligations that went bad -- is reminiscent of the global Sovereign risk debts implosion that visited major world banks during the late Eighties and early Nineties.

In those days, banks built up a portfolio of ever riskier sovereign debt, in the certain knowledge that many of the indebted sovereigns couldn't redeem their obligations. The game then, as now, was the "this year" profit streams and resulting bonuses, profit shares, promotional chances etc.

The baking regulatory authorities back then looked the other way and let the chaos happen.

The same is true today. The banking regulatory authorities could have simply stepped in and placed a damn great stop sign on the past leveraging bonanza, but chose not to. Astonishingly, in the US an act was passed by Congress (the Commodity Futures Modernization Act as outlined above) that restricted/inhibited regulation of this high risky debt. This Act passed muster almost 8 years ago and suggests to me that the risks were weighed back then and seen to be absolutely suspect but extremely profitable in the short/medium term.

Now the banking sector faces rescue by the taxpayer or being extinguished. Again.

Until such time as deadly serious regulation is brought legislated that corrals the banking sector from effectively risking our money in their casino for their benefit, I dare say that a similar scenario will be visited upon us all in the next 20 years or so, and thereafter at fairly regular intervals.

Hitherto, the banks incentive to greed at out expense is perennially rewarded.

Spread the Wealth and Give Workers a Raise

Want to Save the Economy?

By MIKE WHITNEY

Weekend edition

Counterpunch.org

April 12-13, 2008

http://www.counterpunch.org/whitney04122008.html

Insolvency's dark shadow hangs over Wall Street. One major player, Bear Stearns, has already gone under, and from the looks of it, another investment giant may be on the way down. It's getting ugly out there. The so-called TED spread*, which measures the reluctance of banks to lend to each other, has begun to widen ominously suggesting that the money markets think another dead body will be floating to the surface any day now.

The ongoing deleveraging of financial institutions and the persistent downgrading of assets has the Fed in a tizzy. Bernanke has backed himself into a corner by stretching the Fed's mandate to include everyone on Wall Street with a mailing address and a begging bowl. Now he's taken on the even larger task of fixing the plumbing that keeps credit flowing between the various investment banks. Good luck. There's plenty of more pain ahead. The IMF expects the final tally will be $945 billion, that means $3 trillion in lost loans for the banks. Bernanke better pace himself; this mess could last for years.

The US subprime fiasco has spiraled into what the IMF is calling "the largest financial shock since the Great Depression." America's capital markets are on the fritz. The corporate bond market is frozen, the banks are buckling from their losses, and the housing market is in a shambles. No one is buying and no one is lending. Private equity deals are off 75 per cent from last year and no one will touch a mortgage-backed security (MBS) with a ten foot pole. The mighty wheel of modern finance is grinding to a standstill and no one's quite sure how to rev it up again.

The US consumers are feeling the pinch, too. Credit cards are maxed out, student loans overdue, car payments in arrears, and mortgages entering foreclosure. Also, wages haven't kept pace with production and and the home-equity ATM has been shut down. Now that the credit tap has been turned off; the American worker is hurting, but no one is offering a bailout or a even helping hand; just a few table-scraps from Bush's "surplus package". 500 bucks will just about fill the tank of a normal-sized SUV. A new survey from the Pew research Center "Inside the Middle Class-Bad Times Hit the Good Life", shows that working families are in debt up to their ears and that fewer Americans "believe they are moving forward" than anytime in the last half century. The study also shows that most people believe "it's harder to maintain a middle class life style" and that "since 1999, they have not made economic gains." Average families are struggling just to make ends meet.

That's why so many people bought homes when they should have opened savings accounts. They were duped into speculating on housing so they could get a chunk of money. It looked like a good way to overcome stagnant wages and crappy hours. The cheer-leading TV pundits offered assurances that "housing prices never go down". It was all baloney. Now 15 million homeowners are upside-down on their mortgages and the very same experts are scolding workers for fudging the facts on their income disclosure forms. It's all backwards.

No wonder consumer confidence has dropped to record lows. Working people don't need lectures on saving money; they need a raise. The big-wigs at Bear Stearns are still dining on crab-cakes at the Four Seasons while the working folk are just trying to make their way through Greenspan's nuclear winter living on beef jerky and Big Gulps. Where's the justice?

Volumes have been written about the current crisis; subprime-this, subprime that. Everything that can be said about collateralized debt obligations (CDOs) credit default swaps(CDS) and mortgage-backed securities (MBS) has already been said. Yes, they are exotic "financial innovations" and, no, they are not regulated. But what difference does that make? There's always been snake oil and there have always been snake oil salesmen. Greenspan simply raised the bar a notch, but he's not the first huckster and he won't be the last. What really matters is underlying ideology; that's the root from which this economy-busting hydra sprung. 30 years of trickle down, supply-side gibberish; 30 years of idol worship for the waxy-haired reactionary, Ronald Reagun; 30 years of unrelenting anti-labor, free market, deregulated orthodoxy which inflated the biggest equity-Zeppelin in history.

Now the bubble is hissing out of the blimp and the escaping gas is wreaking havoc across the planet. There are food riots in Haiti, Egypt, and Kuwait. Wherever the local currency is pegged to the falling dollar, inflation is soaring and trouble is brewing. Also, European banks are listing from the mortgage-backed garbage they bought from brokerages in the US and need central bank bailouts to stay afloat. It's just more fallout from the subprime swindle. Finance ministers in every capital in every country are getting ready for a 1930's-type typhoon that could send equities crashing and food and energy prices rocketing into the stratosphere. And it can all be traced back to the wacko doctrines of neoliberalism. These are the theories that guide America's "screw-thy-neighbor" monetary policies and spread financial turmoil to every city and hamlet around the world.

The present stewards of the system are incapable of fixing the problem because they represent the interests of the people who benefit most from the disruptions. Paulson's latest "blueprint" for the financial markets is a good example; a more pro-business, self-serving scheme has never been put to paper. Gary North sums it up in his article "Really Stupid Loans":

"With the Federal Reserve System's latest proposal, presented to the public by Secretary of the Treasury Henry "Goldman Sachs" Paulson, the Fed is asking the United States government to make it the Great Protector of Capital....The new proposals will centralize power over finance in the hands of an agency that is officially run by the government but in fact is run by agents of the largest fractional reserve banks. ...Regulation by tenured staff economists will not make the system less fragile. It will make it more top-heavy and less flexible..

"Some version of this plan will probably pass in the next Congress. No matter whether it does or does not, the direction is the same: toward an economy controlled by the federal government in conjunction with titular private ownership of the means of production, that is, toward fascism."

(Gary North, "Really Stupid loans" lewrockwell.com)

The whole point is to put the markets in the Fed's control so that when the next financial crisis arises (from the next swindle) the Fed can bailout the bankers and hedge fund managers without consulting Congress.

Paulson's plan is a power-play; nothing more. The investment Mafia wants to take over the whole financial system lock, stock and barrel. They want to liquidate the SEC and any other government watchdog and put the investment banks, hedge funds and brokerages on the honor system. It's the end of transparency and accountability which, of course, are already in short supply.

Currently, Paulson and Bernanke are expanding the balance sheets of the Government Sponsored Enterprises (GSEs) so that Fannie Mae and Freddie Mac will underwrite 85 per cent of all mortgages while FHA will cover 10 per cent more. The mortgage industry is being nationalized to save banking fellowship while the taxpayer is on the hook for another $4.4 trillion of dodgy loans. Paulson doesn't care if the taxpayer gets stuck with the bill. What bothers him is the prospect that, somewhere along the line, workers will demand higher wages to keep pace with inflation. Then all hell will break loose. Paulson and Co. would rather see the economy perish in a deflationary holocaust than add another farthing to a working person's salary. He and his ilk take class warfare seriously; that's why they are winning. But their strategy also creates problems. When wages don't keep pace with production, demand decreases and the economy falters. That's what's happening now and Paulson knows it. Workers are over-extended and can't buy the things they make. They barely have enough to feed the kids and fill the tank for work. Consumer spending (which is 72 per cent of GDP) is nose-diving at the very same time the Fed's equity bubble is exploding.

Neoliberalism has a twenty-year record of producing the very same economic calamities. Why is this crisis different? Why should the US be spared the same predatory treatment as the many other victims of the global corporate oligarchy? After the Fed's equity bubble bursts, the corporate vultures will swoop down and buy up vital resources and industries for pennies on the dollar.

Economist Michael Hudson anticipated many of the present-day developments in the financial markets in an amazingly prescient interview in

CounterPunch in 2003 called "The Coming Financial Reality":

Michael Hudson: "Free enterprise under today's financial conditions threatens to bring about an unprecedented centralization of planning, not in the hands of government but by the financial conglomerates and money managers. Whatever government planning power is destroyed becomes available for them to appropriate, with plenty of vigorish left for the politicians whose campaigns they back and who will "descend from heaven" into high-paying private-sector jobs, Japanese style, after having performed their service for the new regime.

Question: The financial regime is nothing but parasites?

Michael Hudson: "The problem with parasites is not merely that they siphon off the food and nourishment of their host, crippling its reproductive power, but that they take over the host's brain as well. The parasite tricks the host into thinking that it is feeding itself.

"Something like this is happening today as the financial sector is devouring the industrial sector. Finance capital pretends that its growth is that of industrial capital formation. That is why the financial bubble is called 'wealth creation,' as if it were what progressive economic reformers envisioned a century ago. They condemned rent and monopoly profit, but never dreamed that the financiers would end up devouring landlord and industrialist alike. Emperors of Finance have trumped Barons of Property and Captains of Industry." (Michael Hudson, "The Coming Financial Reality", counterpunch, interviewed by Standard Schaefer.)

Bingo. Hudson not only explains how finance capitalism is inserting itself into the governmental power structure but, also predicts that "industrial capital formation" -- which is the production of things that people can really use to improve their lives -- will be replaced with complex debt-instruments and derivatives that add no tangible value to people's lives and merely serve to expand the wealth of an entrenched and increasingly powerful investor class.

Finance capitalism has "devoured landlord and industrialist alike" and created a galaxy of seductive liabilities which masquerade as assets. Derivatives contracts, for example, represent over $500 trillion of unregulated counterparty transactions; a "shadow banking system" completely disconnected from the underlying "real" economy, but large enough to send the world into a agonizing depression for years to come.

The goal should be to dismantle this corrupt Ponzi-system, which merely wraps debt in a ribbon, and rebuild the economy on a solid foundation of productive labor, worker solidarity and and above all the redistribution of income and hence purchasing power away from the system which now flow to the top two or three per cent.

Political power has to be taken from the financial mandarins or the disparity of wealth will continue to grow and democracy will wither. We've already seen our main institutions -- the courts, the congress, the media, and the presidency -- polluted by the steady flow of corporate contributions which only serve the narrow interests of elites.

Henry Liu expands on this idea in his excellent article "A Panic-stricken Federal Reserve":

"In the 1920s, the wide disparity of wealth between the rich and the average wage earner increased the vulnerability of the economy. For an economy to function with stability on a macro scale, total demand needs to equal total supply. Disparity of income eventually will result in demand deficiency, causing over-supply. The extension of credit to consumers can extend the supply/demand imbalance but if credit is extended beyond the ability of income to sustain, a debt bubble will result that will inevitably burst with economic pain that can only be relieved by inflation.....More investment normally increases productivity. However, if the rewards of the increased productivity are not distributed fairly to workers, production will soon outpace demand. The search for high returns in a low demand market will lead to consumer debt bubbles with wide-spread speculation .... Today, outstanding consumer credit besides home mortgages adds up to about $14 trillion, about the same as the annual GDP. "

Voila. A strong economy requires a strong workforce and an equitable distribution of wealth. When money is concentrated in too few hands, the political system atrophies and becomes unresponsive to the needs of its people. That's when the nation's laws and institutions are reshaped to reflect the ambitions of rich and powerful.

The financial system is doing exactly what it was designed to do, it is crumbling from the decades-long trickle-down experiment. Social programs have been gutted, civil infrastructure is in tatters, legal protections have been savaged, and workers rights have been trounced. Is it any wonder why we're embroiled in an unwinnable war and the financial system is on its last legs?

The only way to break the stranglehold of Wall Street's financial Politburo is to level the playing field through greater wealth distribution. That's the best way to rekindle democracy and make America the land of opportunity again. And it all starts with giving America's workers a raise.

*Initially, the TED spread was the difference between the interest rate for the three month U.S. Treasuries contract and three month Eurodollars contract as represented by the London Inter Bank Offered Rate (LIBOR). However, since the Chicago Mercantile Exchange dropped the T-bill futures, the TED spread is now calculated as the difference between the T-bill interest rate and LIBOR. The TED spread is a measure of liquidity and shows the flow of dollars into and out of the United States (Wikipedia).

Mike Whitney lives in Washington state. He can be reached at: fergiewhitney@msn.com

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Douglas, I thought Whitney's article highly insightful. Thanks for posting it.

This whole episode of current and forthcoming bank bankruptcies (short of being bailed out that is) -- due of the piling up of excessive risky obligations that went bad -- is reminiscent of the global Sovereign risk debts implosion that visited major world banks during the late Eighties and early Nineties.

In those days, banks built up a portfolio of ever riskier sovereign debt, in the certain knowledge that many of the indebted sovereigns couldn't redeem their obligations. The game then, as now, was the "this year" profit streams and resulting bonuses, profit shares, promotional chances etc.

The baking regulatory authorities back then looked the other way and let the chaos happen.

The same is true today. The banking regulatory authorities could have simply stepped in and placed a damn great stop sign on the past leveraging bonanza, but chose not to. Astonishingly, in the US an act was passed by Congress (the Commodity Futures Modernization Act as outlined above) that restricted/inhibited regulation of this high risky debt. This Act passed muster almost 8 years ago and suggests to me that the risks were weighed back then and seen to be absolutely suspect but extremely profitable in the short/medium term.

Now the banking sector faces rescue by the taxpayer or being extinguished. Again.

Until such time as deadly serious regulation is brought legislated that corrals the banking sector from effectively risking our money in their casino for their benefit, I dare say that a similar scenario will be visited upon us all in the next 20 years or so, and thereafter at fairly regular intervals.

Hitherto, the banks incentive to greed at out expense is perennially rewarded.

An Economy Built On Lies

by Gary North

www.lewrockwell.com

April 13, 2008

http://www.lewrockwell.com/north/north619.html

In this report, I am going to present an astounding document. You have not heard of it. It is at the heart of the current residential real estate crisis. It has to do with xxxx loans.

By now, the term "xxxx loans" is common. Prospective house buyers provided false information to representatives of loan-initiating firms.

The loan-initiating firms knew that there were people who did this, but they winked at the practice. Their well-compensated job was to pass on the paperwork to a government-created agency, either Fannie Mae or Freddie Mac, who then sold scientifically diversified packages of statistically safe mortgages to investors.

Some of these investors were hedge funds. They in turn borrowed money from investment banks at up to 32-to-1 leverage (Carlyle Capital) to buy even more packages of statistically safe mortgages.

Everyone was happy until reality caught up with the lying borrowers, whose meager incomes did not allow them to keep paying their monthly mortgages.

The dominoes started to topple in August, 2007. The experts were caught flat-footed.

The mortgage interest rate re-sets will continue through 2009. This process is barely half over. Meanwhile, a recession has appeared.

From start to finish, from top to bottom, the entire structure was based on lies. It began with this one: "I'm from the government, and I'm here to help you." This is the third most widely believed lie in history, right after this:

And the serpent said unto the woman, Ye shall not surely die: For God doth know that in the day ye eat thereof, then your eyes shall be opened, and ye shall be as gods, knowing good and evil.

And this:

Of course I will still respect you as a person in the morning.

THE GREAT AMERICAN DREAM

We all remember the 1946 movie, It's a Wonderful Life. It centers around one family's funding of the great American dream: home ownership. We love the movie because it's about a man who is shown by an angel that his life really mattered. So, our lives really matter, too. We all like to believe that we also have a guardian angel, though perhaps not so incompetent as Clarence.

Jimmy Stewart's nemesis was the town's banker, Mr. Potter. He was a xxxx and a thief, preying on sin-loving local citizens (as we see in the sequence about Pottersville) and the likes of the kindly but imbecilic Uncle Billy.

Potter used the fractional reserve banking system to borrow short and lend medium. The Bedford Falls Building and Loan borrowed short and lent long.

Potter was able to survive the bank run because his bank had liquid reserves and assets it could sell. The Building and Loan survived because George Bailey had liquid reserves – his honeymoon money – and a script writer who ended the bank run at 6 p.m. and did not let it extend to the next day, which it obviously would have done when word got out that Jimmy's honeymoon money was gone.

Potter was a xxxx: he was lent medium. George Bailey was a much bigger xxxx: he was lent long.

The Federal Deposit Insurance Corporation was created in 1933 by the Roosevelt Administration as part of the Glass-Steagall Act. This bailed out the mini-liars: bankers. The Savings and Loan oligopoly then pressured Congress to provide something similar, which Congress delivered: the Federal Savings & Loan Corporation was created by the National Housing Act of 1934. This bailed out the bigger liars.

The American dream was extended to the masses by means of government insurance against runs by investors – who mistakenly thought they were depositors – in Savings & Loans. This did more to establish the economics of the carry trade – borrowing short to lend long – than anything in history. The investment world saw the profit potential. The carry trade has increased ever since.

But who will insure the middlemen who profit from the carry trade? Who has sufficient resources to bail out the profit-seeking, loss-avoiding hedge fund entrepreneurs who decided that the interest rate spread between short-term money paid to investment banks and long-term money paid by borrowers was just too tempting. In short, who will come to the rescue of our generation of George Baileys? Congress? It did in 1986 during the S&L collapse. But the on-budget Federal deficit is running at an estimated $410 billion this year. This deficit is accelerating.

Then how about the Federal Reserve System? It can swap Treasury debt for not-statistically-safe-after-all mortgages, but only until it runs out of Treasury debt, about $800 billion to go. Then it will have to create money. Lots and lots of money.

xxxx, xxxx, PANTS ON FIRE

We live in the FIRE economy: finance, insurance, and real estate.

The crucial insurance today is Federal insurance – explicit, implicit, and widely assumed even when legally absent. Big institutions are considered too big to fail, meaning too big for the government to allow to fail. Think Bear Stearns. So, promises made by the government serve as the ultimate back-up for the promises made by the largest carry traders.

The extent of the participation of the Federal government in the residential real estate markets can be seen in the law governing xxxx loans.

You need to read the following law. I realize that no one except lawyers reads a document like this one. It has two sentences. One of them is 291 words long. Only lawyers write sentences that are 291 words long. Nevertheless, I am asking you to read it.

Here is what you should understand after you have read it. There is hardly a nook or cranny left in the residential real estate market that is not covered by this law. The extent of government control, which derives from government insurance of real estate lending, is enormous. How enormous? Read for yourself.

Whoever knowingly makes any false statement or report, or willfully overvalues any land, property or security, for the purpose of influencing in any way the action of the Farm Credit Administration, Federal Crop Insurance Corporation or a company the Corporation reinsures, the Secretary of Agriculture acting through the Farmers Home Administration or successor agency, the Rural Development Administration or successor agency, any Farm Credit Bank, production credit association, agricultural credit association, bank for cooperatives, or any division, officer, or employee thereof, or of any regional agricultural credit corporation established pursuant to law, or a Federal land bank, a Federal land bank association, a Federal Reserve bank, a small business investment company, as defined in section 103 of the Small Business Investment Act of 1958 (15 U.S.C. 662), or the Small Business Administration in connection with any provision of that Act, a Federal credit union, an insured State-chartered credit union, any institution the accounts of which are insured by the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, any Federal home loan bank, the Federal Housing Finance Board, the Federal Deposit Insurance Corporation, the Resolution Trust Corporation, the Farm Credit System Insurance Corporation, or the National Credit Union Administration Board, a branch or agency of a foreign bank (as such terms are defined in paragraphs (1) and (3) of section 1(:rolleyes: of the International Banking Act of 1978), or an organization operating under section 25 or section 25(a) [1] of the Federal Reserve Act, upon any application, advance, discount, purchase, purchase agreement, repurchase agreement, commitment, or loan, or any change or extension of any of the same, by renewal, deferment of action or otherwise, or the acceptance, release, or substitution of security therefor, shall be fined not more than $1,000,000 or imprisoned not more than 30 years, or both. The term State-chartered credit union includes a credit union chartered under the laws of a State of the United States, the District of Columbia, or any commonwealth, territory, or possession of the United States.

Did you read it? If so, I hope you noticed this passage: ". . . shall be fined not more than $1,000,000 or imprisoned not more than 30 years, or both."

Here is the inescapable reality: the Federal government let the subprime disaster build up for many years. This law was never enforced. No one in the entire government-insured scam worried about it. The bureaucrats were in on the deal from day one.

All of the posturing by politicians about the exploited borrowers who lost their homes – liars – and the need for new laws to be passed by Congress to prevent unscrupulous mortgage brokers – liars – from ever exploiting the poor again, and also preventing them from endangering the solvency of the nation's financial institutions – liars – is nothing but election-year politicking by the biggest liars of all: politicians.

Do we need more laws? Hardly. A law that imposes a million-dollar fine and 30 years in jail is more than sufficient. This law's stiff penalties were supposed to make people take it seriously. But it was not taken seriously. No one ever intended to enforce the law. No one ever did. It was all posturing by the politicians.

The biggest housing bubble in American history, 1995–2005, took place under the watchful eyes of the entire Federal real estate bureaucracy, the bureaucracy listed by name in the law. No one in government issued a warning. No one in government saw the bubble coming. No one in government identified it as a bubble.

The appraisals were made, the loans were made, the mortgages were bought and re-packaged and sold again. The carry trade did its work. And now there is a line in front of the banks.

No, scratch that. There are no lines. There are instead collapsing prices in the scientifically packaged mortgage sector because investors now see that those mortgages, rated AAA by independent firms (it says here), are in fact packages of promises to pay made by liars.

Everyone knew. This is the famous bottom line. Everyone knew. Nobody cared.

We live in an economy built on lies. Everyone knows. Almost nobody cares.

Do you care? If so, what have you done to protect yourself?

WHO INSURES THE INSURERS?

The Federal Deposit Insurance Corporation insures bank accounts up to $100,000. It holds about a penny in reserve (in T-bills) for every dollar worth of insured deposits.

Who insures the T-bills? The Federal Reserve System. Who insures the Federal Reserve System? No one. It doesn't need insurance. It can create money.

Then who insures the purchasing power of the dollar? The central banks of the world, which hold dollars as legal reserves for their own currencies.

What happens if they decide not to add to their holdings of dollars?

That is the ultimate default today. If the liars known as central bankers decide that our central bank's liars are no longer to be trusted, there will be a great dumping of Treasury debt.

There will be no lines in front of American banks. There will instead be rising prices for imported goods. There will be rising domestic interest rates because foreign central banks are not buying Treasury debt any longer. There will be unemployment. There will be bankruptcies.

There will be defaults. Above all, there will be defaults. The lies will be exposed as lies. The promises will not be kept.

When the checks from Washington no longer buy much of anything, the great political transformation will begin.

The promises will not be fulfilled. I assume that you know this. The economy built on lies will fall. So will the political order.

When will this take place? I don't know. But we have seen it happen in our lifetime. The Soviet Union fell in three days: August 19–21, 1991. No one predicted this. The best and the brightest in the West did not see it coming. One man suspected it and did what he could to accelerate it: John Paul II. But the politicians were universally caught flat-footed.

The USSR was $140 billion in debt to the West in 1991. The West is now in debt to Russia by $500 billion. No one predicted that, either.

CHOOSE YOUR LIARS CAREFULLY

The modern economy is built on debt. It is therefore built on promises to pay. It is therefore built on lies.

As investors, we must look at the dominoes and try to get out from under the next one to topple.

If all of them topple, the division of labor will collapse. Then most of us will die. Think of a world without digital money. The trains would stop rolling. The trucks would stop rolling. The government would intervene and force some deliveries, such as coal to power plants in large cities. But the government would also have a problem: how to pay the bureaucrats and troops.

So, most of us cannot plan for a complete collapse of banking. That would bring down Western civilization. We have to assume that some lies will still be accepted, that some promises will be kept.

But which ones?

I think it is wise to have reserves that are not digital. You can't eat digits. But if your neighbors are starving, reserves won't help much. This is why you should not try to prepare for complete collapse today. You can't afford it.

I hope you have the familiar six months' of expenses in reserve. You could lose your job. If you don't, what about your spouse?

Today, most American families have about 19 days' worth of expenses. The chart on this decline since the year 2000 is shocking.

You must not follow the herd on this one.

CONCLUSION

The tissue of lies that held together the subprime market was believed by the best and the brightest. They were blind to what was coming. It has wiped out over $200 billion in assets.

We are assured that the worst is over. But who assures us of this? Salaried reporters in a dying field: newspapers and network TV.

The ill-informed tout the liars. We are assured that the liars know what went wrong and will not let it happen again.

Re-read the liars' law. That will give you some indication of how serious the liars were. They are no more serious today.

When they tell you the worst is over, batten down the hatches.

April 12, 2008

Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com.He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

Find this article at:

http://www.lewrockwell.com/north/north619.html

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