Capitalism Without Capital--Why Rescue Bankers?

Volatility is Back With a Vengeance 
By MIKE WHITNEY

Volatility is back and stocks have started zigzagging wildly again. This time the catalyst is Greece, but tomorrow it could be something else. The problem is there's too much leverage in the system, and that's generating uncertainty about the true condition of the economy. 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. filed for bankruptcy 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 hasn't been fixed after all; the debts have just been moved from one balance sheet to another.

Last Thursday, troubles in Greece triggered a selloff on all the main indexes. At one point, shares on the Dow plunged 998 points before regaining 600 points by the end of the session. 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. 

Low interest rates didn’t cause the crisis

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 per cent 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 per cent 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 were. 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 simply staggering. 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 glorify 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 lifted 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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"Thumbs Down" on EU Bailout 

By MIKE WHITNEY

Barack Obama must have been very frightened, indeed. Otherwise he never would have inserted himself so forcefully into Greece's debt crisis. The truth is, there's much more at stake then people seem to realize. A Greek default would be a major blow to the banking system and the damage would not be limited just to Europe. It could easily spread to the United States and trigger another meltdown. That's why Obama spent most of his weekend on the phone, exhorting EU finance ministers to take swift action to put out the brushfire. Not surprisingly, the details were omitted in the US media. Here's an excerpt from the UK Independent explaining what happened behind the scenes last weekend: 

"As the dust settles and the markets cool, details are beginning to emerge of the frantic background negotiations which generated the €750bn plan to save the euro in the early hours of Monday.....the most startling – and most pivotal role – may have been played by Barack Obama, according to both American and French officials. He convinced the Europeans that it was time not just to Do Something, but to Do Something Very Big, to rescue the euro and prevent the world from plunging into another financial crisis and recession..... 

“It was after these calls that the headline figure for the EU rescue plan inflated rapidly to €500bn, plus another €250bn from the IMF." ("Was the euro saved by a call from Barack Obama?", John Lichfield, Independent)

The Telegraph's Ambrose Evans-Pritchard tells a similar tale, but with a twist. In this incident, Obama spoke directly to Spanish Premier Jose Luis Zapatero. Here's an excerpt from the Telegraph:

"Premier Jose Luis Zapatero told a stunned nation that public sector pay will be reduced by 5 percent this year and frozen in 2011...Pension rises will be shelved. The country’s €2,500 baby bonus will be canceled. Aid to the regions will be slashed and infrastructure projects will be put on ice....

“US President Barack Obama played a key role behind the scenes, pleading with Mr Zapatero for ‘resolute action’. The telephone call from the White House is a clear indication that contagion from Greece and Portugal to the much larger debt markets of Spain had become a global systemic threat by late last week. 

"The markets were going in for the kill: the eurozone itself was on the brink of collapse," said Jose Garcia Zarate from 4Cast." ("EU imposes wage cuts on Spanish 'Protectorate", Ambrose Evans-Pritchard, Telegraph)

Is that why Obama was twisting arms all Saturday and Sunday, because he thought the EU might collapse? Does that explain why the Federal Reserve reopened its controversial swap lines with European central banks, providing unlimited short-term loans in dollars for collateral to prop up the euro and exposing the US to tens of billions in potential losses without congressional approval? And is that why ECB chief Jean Claude Trichet reversed his position on monetization and agreed to initiate an EU quantitative easing (QE) program to would buy up government and corporate bonds?

What's clear, is that very little of last weekend's behind-the-scenes maneuvering had anything to do with the problems facing ordinary Greeks, who are merely the victims in this latest bank bailout fiasco.

Greece will not escape default, so it's not in its long-term interests to stick with the euro. That just ensures years of high unemployment, severe cuts to public spending, and neverending recession. A return to the drachma would provide an opportunity to restructure debt and regain fiscal equilibrium via devaluation. It would give Greek exports and tourism a boost by making them instantly cheaper.  The fact that the Greek “rescue” and kindred efforts in Spain, Portugal and other tottering economies is designed to bail out bankers and the rich and sock it to ordinary people was well explained on this site last week by Michael Hudson, and also by T.P. Wilkinson on this site this weekend.

No country large or small has managed to close a fiscal gap as large as 10.9 per cent  of GDP (which is what Greece is being asked to do.) It's cruel, especially in an environment where deflation is gradually tightening its grip. Greece needs counter-cyclical fiscal stimulus to get out of the hole its in and to grow its way out of recession. The EU plan implements an anti-Keynesian regimen that is the exact opposite of Obama's American Recovery and Reinvestment Act (ARRA) the $787 billion fiscal stimulus package to build aggregate demand and lower unemployment. The EU has no funding mechanism to implement such a plan, so it is prescribing extreme austerity measures instead. It's stupid, cruel  and won't work, except as a short-term shot for the banks.

Greece didn't create this crisis by itself anyway. It had help from Germany. Germany dictates monetary policy in the EU, which means that it bears much of the responsibility for the deficit-mess in the south. Of course, now that the countries that enriched Berlin (by gobbling up their exports) are flailing about in red ink, German politicians have started lecturing them about the evils of profligate spending. Here's how Michael Pettis sums it up: 

"The strong euro and burgeoning liquidity it brought on meant that much of Germany’s trade surplus had to be absorbed within the eurozone, forcing especially southern Europe into high trade deficits.  These deficits were dismissed, very foolishly it turns out, and against all historical precedents, as being easily managed as long as the sanctity of the euro was maintained.....

“As I see it,  domestic German policies, perhaps aimed at absorbing East German unemployment, forced a structural trade surplus.  The strong euro, along with the automatic recycling of Germany’s large trade surplus within Europe, ensured the corresponding trade deficits in the rest of Europe – unless Europeans were willing to enact policies that raised unemployment in order to counter the deficits.  As long as the ECB refused to raise interest rates, southern Europe had to accept asset bubbles and rapidly rising debt-fueled consumption.

“This couldn’t go on forever, or even for very long.  Now southern Europe is paying the inevitable price, and of course the moralists are accusing the south of being shiftless and lazy, confusing the automatic balancing mechanisms in the balance of payments with moral weakness." ("Are you ready for the united States of Germany?", Michael Pettis, China Financial Markets)

Only a small portion of the nearly-$1 trillion bailout will go to Greece. And, even that pittance comes with strict "belt-tightening" conditions. The bulk of the funds will be held in an structured investment vehicle (SIV) as a way to ward off speculators who smell blood in the water and think they can make a killing by toppling sovereign bond markets in Portugal, Spain and Italy.

Obama's concern is that a Greek default will put pressure on French and German banks (which have 110 billion-euro exposure) that will start the dominoes tumbling again. According to Dow Jones, "JP Morgan's holdings of non-U.S. government bonds increased by $36.5 billion in 2009, while Citigroup's increased by almost $40 B." ("The European Bailout", James Hamilton, Econbrowser)

So, despite the  news this week that all four of the nation's biggest banks (Bank of America, Goldman Sachs, JP Morgan, and Citigroup) racked up perfect quarters off their trading desks, (showing that the Fed's liquidity and zero-rates has restored profitability) the banking system is still so weak that the President of the United States has to spend his whole weekend hectoring heads-of-state throughout Euroland to beef up their bailout or the whole financial system will come crashing down.

What does that tell us? It tells us that the whole "recovery" meme is a fraud.  It tells us that the banks (where lending is down 20 per cent, and foreclosures are running at 300,000 per month) are once again engaged in the riskiest type of speculation; that they're using complex financial assets and repo to maximize leverage to goose profits in the middle of a slump. And, it tells us that Obama is Wall Street's  biggest champion, a real "enabler" in chief.

Greece should walk away from this farce and start fresh. "Thumbs down" on the EU bailout.