Friday, August 24, 2007
Financial Bankruptcy, the US Dollar and the Real Economy
"The U.S. government is on a 'burning platform' of
unsustainable policies and practices."
David Walker, U.S. Comptroller General
"Modern society, based as it is
on the division of labor, can be preserved only under conditions of lasting
peace."
Ludwig
von Mises, Austrian economist
"People
know that inflation erodes the real value of the government's debt and,
therefore, that it is in the interest of the government to create some
inflation."
Ben S. Bernanke, Fed Chairman
"Regarding the Great Depression. You're right, we did it.
We're very sorry. But thanks to you, we won't do it again."
Ben S. Bernanke, Nov. 8, 2002 (Fed Chairman, talking to economist
Milton Friedman)
Ordinary
investors and people in general will have to get accustomed to hearing a lot
about financial terms they never heard before, such as the subprime mortgage market, aggressive underwriting, asset securitization, repackaged loans, subprime
loans, "no-doc" loans, adjustable rate mortgage interest rate adjustment (ARM)
loans, collateralized debt obligations (CDOs),
asset backed securities, mortgage-backed securities, closed-end
second-lien loans, subprime second-lien loans, alternative-A
(Alt-A) mortgage loans, piggyback loans, asset-backed
commercial paper (ABCP),...etc. —As a general definition, "subprime" or
"high-risk" loans" are those made to
people with poor credit and at lax conditions. Second-lien loans are loans that
are placed in second place for any potential recovery after the primary lender
on a property. —Residential mortgage-backed security (RMBS) are created
when mortgage lenders sell their loans (and the risks associated with such
loans) to banks, which package them together and slice them into different classes
before selling them to (gullible) investors. This process, called "asset securitization" is the method whereby
interests in mortgage loans and other receivables are packaged, underwritten,
and sold in the form of "asset-backed securities". This is financial
alchemy, through which subprime mortgage loans are transformed into AAA-rated
paper for unsuspecting investors.
Some
of these artificial or derivative securities are low-grade quality, and when
their prices fall because borrowers cannot meet their interest or capital
payments, such financial instruments become quickly "illiquid" or
unsalable, since nobody wants to touch them. They become fictitious capital.
Those who hold them, investors, banks or other types of lenders, are stuck with
them: they cannot sell them and they cannot borrow while placing such shaky
assets as collateral. These are the imprudent lenders and investors that
central banks now are trying to bail out.
During
the French Revolution (1789-1799),
the Jacobins
(the Neocons of the day) had the brilliant idea of issuing securities, called "assignats", based on the properties (buildings and
lands) the government had taken away from the Church and its religious orders.
The new securities were quickly "monetized" into fiat money and
transformed into readily available cash. This caused
a massive hyperinflation and a subsequent deflation.
Mind
you, this was not the first time that 18th-century
France lived an experience of inflationary finance, since a similar incident
took place three quarters of a century before, between 1716 and 1720, when
Scottish banker and businessman John Law (1671-1729) led
France into a fiat money fiasco and engineered a land-backed securities scheme
known as the Mississippi Bubble. John Law's
earlier experiment and the French Revolution assignats debacle should be clear
reminders of the danger and folly of "monetizing" illiquid
assets-based securities.
Like
all "Ponzi schemes", such pyramidings
of debts with no liquid assets behind them are bound to implode sooner or
later. And that is what we are witnessing today, i.e. the implosion of unfunded
credit derivatives-based "Ponzi schemes". In 1998-2000, we got an
idea of what could happen when portfolios are highly leveraged and laden with derivative financial products with the
collapse of one large hedge fund, the Long-Term Capital Management.
This should have been a warning sign to regulators of financial markets. But hedge funds and
other financial operators' greed—and political corruption—were too
strong, and no one stopped the march to disaster. Now, things are getting
worse, because central banks, led by the Fed, are following the assignats route
and have been aggressively "monetizing" the unfunded derivative
debts, lending new cash not for a day or two, and not against T-bills, but for
months on end against illiquid and partly unsolvable and artificial derivative
debts. Who knows where this could lead?
One possibility is the complete collapse of the U.S. dollar and an
uncontrollable burst of inflation in
the years ahead if the salvaging operation were to increase money supply on a
permanent basis. Indeed, if central banks continue to shore up the artificial
financial houses of cards to prevent them from going bankrupt, they may end up
monetizing mountains of unsolvable debts with the potential of creating a
monstrous inflation. A dollar panic may be just around the corner —Thus, the cure
for fighting a credit crisis could be a tremendous push of inflation in a few
years, if the Fed cannot withdraw the new cash fast enough from the system.
This surely can be the case, since it has announced that it is discounting
non-government home mortgages and
mortgage-backed securities, jumbo mortgages, and asset-backed commercial paper,
and a broad range of collateral for discount-window
loans, besides the typical Treasury and government agency paper. The
problem is that some of these so-called "securities" may be worthless
in a few months, thus making it difficult for the Fed to sell them back and
retrieve its cash.
Over the past few weeks, central banks worldwide have supplied
hundreds of billions of fresh loans to banks and other financial dealers, to
make cash available for lending and they have lowered interest rates amid signs
that credit was drying up. The partly privately-owned Fed,
for example, has accepted billions in "repos", by which it bought
billions in illiquid securities from dealers, who then deposited the money into
commercial banks, thus "liquifying" the entire financial system. This
is a short-term measure designed to alleviate the "liquidity crisis",
even if it is pursued for a few months.
It alleviates the "liquidity crisis", for sure, but this
does nothing to cure the underlying "solvency crisis" of
institutions holding large chunks of non-performing mortgage-based assets.
Sooner or later, such low valued derivatives will have to be written off, and
this will necessarily lead to an erosion of these institutions' capital base.
Bankruptcies of the most leveraged and imprudent institutions are to be
expected. For a few weeks, the Fed's interventions and buying by the Treasury's
special division, the "Working Group on Financial Markets", also
commonly known as the "Plunge Protection
Team" (PPT) will sustain the financial markets.
But come mid-September and early October, the law of gravity is likely to
regain its importance.
As
I explained in my blog of last October 16 (2006), (Headwinds for the US Economy), macroeconomic
conditions made it a "matter of months, not years", before
the U.S. economy and the U.S. dollar begin to experience some downward
pressures. And, as I repeated on May 5 (2007), (A Slowdown or a Recession in
the U.S. in 2008?), we are "approaching [the] point
of reckoning."
As I said in May, we
could expect "the collapse of one and possibly several major financial
institutions under the pressures of bad loans and record foreclosures.
Particularly at risk is the some $2.5 trillion
mountain of debt concentrated in subprimes and Alt-A loans. Already, one
major sub-prime lender (New Century Financial) has
filed for Chapter 11 bankruptcy protection. Others are likely to follow, because 2007
is the year when a large number of sub prime real estate loans have to be
renegotiated at higher interest rates. The rate of foreclosure is bound to
spike in the coming months, possibly culminating in the next two years into a
financial hurricane."
The
practice of sub-prime loans and the creation of even more creative and
artificial "derivative financial products" is much more widespread in
the USA than in other countries. For example, such risky loans represent as
much as 20 percent of mortgage loans in the U.S., while the incidence is only 5
percent in neighboring Canada. [Indeed, out of the U.S. $10 trillion mortgage market, about $2 trillion constitute the sub-prime
mortgage market.] —But where were the American central bank, the
Fed under Alan Greenspan and B. S. Bernanke, the Security and Exchange
Commission (SEC) under former congressman and venture capitalist Christopher Cox, and the Bush-Cheney Treasury Department
when this mountain of shaky real estate debt was being built by unscrupulous
and ruthless financial operators?
Why
did they not intervene -first, to protect mortgage borrowers by putting a stop to mortgage loans that require no or not much
documentation about a borrower's income (so-called "no doc" or
"low doc" loans), -second, to prevent a solvency dilution of
the capital base of American financial institutions and, -third, to prevent an
unsustainable real estate bubble that sooner or later was going to burst and
drag down the rest of the economy? —It is indeed the duty of a lifeguard
to prevent people from jumping into a swimming pool that is without water.
—But when you have a Treasury Secretary who is a former president of
deal-making and hedge-funds-famous Goldman
Sacks, a SEC chairman who is a former venture capitalist and a chairman of the
Fed who is on record as saying he favors inflationary policies, you may have
part of the answer. When the fox is put in charge of the chicken coop, you
cannot expect the chickens to be safe. One has to remember that President
Herbert Hoover’s Secretary of the Treasury, in 1929, was financier Andrew W. Mellon,
with
his far right economic policies of lowering taxes for
the rich. We have the uneasy feeling that history repeats itself.
Since
the Bush-Cheney White House
wanted the economy to keep bubbling before the 2004 and 2006 elections, there
was nobody to whistle the end of the recreation. As the French King Louis XV
said, "Après moi, le déluge!" ("When I am
gone, I don't care what happens!")[1].
In fact, U.S. regulators not only did not intervene to stop the madness of
no-interest, no questions asked, no down payment loans, but they encourage
unbridled speculation by abolishing the Roosevelt era crash-preventing "uptick rule" designed to
force short sellers to wait for an uptick in the price of a stock before they
could complete their short trade. Indeed, it will be an historic irony that on
July 6 (2007), the Security and Exchange Commission (SEC) removed
the protection in order to allow hedge fund operators to short stocks on down ticks, thus making sure
that market volatility would increase tremendously.
It is said that
London financiers, greedy speculators and incompetent central bankers were
responsible for the 1929-1939 worldwide financial crisis
and economic depression. This came after a domino effect of financial
collapses, starting with the failure in September 1931, of the big Austrian CreditAnstalt bank,
owned by the Rothschild family. The
crisis spread throughout the German, the British and the global financial
system. This time, the financial infection has started in the United States. If
the current financial collapse in the U.S. were to stall the real economy, as
it has already begun to do in many sectors, the Bush-Cheney administration
would have to carry a lot of blame because of its lax regulatory policies.
[1] "Après moi le déluge" is a proverb
meaning indifference and egoism regarding the consequences of one's acts.
"Après
nous, le déluge" is more appropriately attributed to Louis XV's
favorite, Mme de Pompadour.
__________________________________________________
Rodrigue
Tremblay is a Canadian economist who lives in Montreal; he can be reached at rodrigue.tremblay@yahoo.com
Visit his blog site at: www.thenewamericanempire.com/blog.
Author's Website: www.thenewamericanempire.com/
Check
Dr. Tremblay's coming book "The Code for Global Ethics"
at: www.TheCodeForGlobalEthics.com/
Posted,
Friday August 24, 2007, at 5:30 am
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