G
Gandalf Grey
Guest
Are The Banks In Trouble?
By Mike Whitney
Created Sep 8 2007 - 6:49pm
"The new capitalist gods must love the poor - they are making so many more
of them." Bill Bonner, "The Daily Reckoning"
"The hope of every central bank is that the real problem can be kept from
public view. The truth is that the public---even professionals on Wall
Street---have no clue what the real problem is. They know it has something
to do with derivatives, but none of them realize that it's more than a $20
trillion mountain of unfunded, unregulated paper that has just been
discovered to not have a market and, therefore, no real value. When the
dollar realizes the seriousness of the situation---be that now or sometime
soon---the bottom will drop out." Jim Sinclair, Investment analyst
About a month ago, I wrote an article "Stock Market Brushfire: Will there be
a run on the banks?" which showed how the collapse in the housing market and
the deterioration in mortgage-backed bonds (CDOs) in the secondary market
was creating difficulties for the banking system. Now these problems are
becoming more apparent.
From the Wall Street Journal:
"The rising interbank lending rates are a proxy of sorts for the increased
risk that some banks, somewhere, may go belly up." (Editorial; WSJ, 9-6-07)
Ironically, the WSJ editorial staff--which normally defends deregulation and
laissez faire economics "tooth-n-nail"---is now calling for regulators to
make sure they are "on top of the banks they are supposed to be regulating,
so we don't get any surprise bank failures that spook the markets and
confirm the worst fears being whispered about."
"Surprise bank failures?"
Henry Liu sums it up like this in his article, "The Rise of the non-bank
system"---required reading for anyone who wants to understand why a stock
market crash is imminent:
"Banks worldwide now reportedly face risk exposure of US$891 billion in
asset-backed commercial paper facilities (ABCP) due to callable bank credit
agreements with borrowers designed to ensure ABCP investors are paid back
when the short-term debt matures, even if banks cannot sell new ABCP on
behalf of the issuing companies to roll over the matured debt because the
market views the assets behind the paper as of uncertain market value.
This signifies that the crisis is no longer one of liquidity, but of
deteriorating creditworthiness systemwide that restoring liquidity alone
cannot cure. The liquidity crunch is a symptom, not the disease. The disease
is a decade of permissive tolerance for credit abuse in which the banks,
regulators and rating agencies were willing accomplices." (Henry Liu,"The
Rise of the Non-bank System", Asia Times)
That's right; nearly $1 trillion in worthless asset-backed paper is clogging
the system putting the kybosh on the big private equity deals and spreading
panic through the money markets. It's a slow-motion train wreck and there's
not a thing the Fed can do about it.
This isn't a liquidity problem that can be fixed by lowering the Fed's fund
rate and creating more easy credit. This is a solvency crisis; the
underlying assets upon which this world of "structured finance" is built
have no established market value, therefore---as Jim Sinclair
suggests---they're worthless. That means that the trillions of dollars which
have been leveraged against these shaky assets---in the form of credit
default swaps (CDSs) and numerous other bizarre-sounding derivatives---will
begin to cascade down wiping out trillions in market value.
How serious is it? Economist Liu puts it like this:
"Even if the Fed bails out the banks by easing bank reserve and capital
requirements to absorb that massive amount, the raging forest fire in the
non-bank financial system will still present finance capitalism with its
greatest test in eight decades."
OVERVIEW
Credit standards are tightening and banks are increasingly reluctant to loan
money to each other not knowing who may be sitting on billions of dollars in
toxic mortgage-backed debt. (Collateralized debt obligations) It makes no
difference that the "underlying economy is sound" as Bernanke likes to say.
When banks hesitate to loan money to each other; it shows that there is real
uncertainty about the solvency of the other banks. It slows down commerce
and the gears on the economic machine begin to rust in place.
The banks woes have been exacerbated by the flight of investors from money
market funds, many of which are backed by Mortgage-backed Securities (MBS).
Wary investors are running for the safety of US Treasuries even though
yields that have declined at a record pace. This is causing problems in the
Commercial Paper market as well as for the lesser-know SIVs and "conduits".
These abstruse-sounding investment vehicles are the essential plumbing that
maintains normalcy in the markets. Commercial paper is a $2.2 trillion
market. When it shrinks by more than $200 billion ---as it has in the last 3
weeks--the effects can be felt through the entire system.
The credit crunch has spread across the whole gamut of commercial paper and
low-grade debt. Banks are hoarding cash and refusing loans to even
credit-worthy applicants. The collapse in subprime loans is just part of the
story. More than 50% of all mortgages in the last two years have been
unconventional loans-no down payment, no verification of income "no doc",
interest-only, negative amortization, piggyback, 2-28s, teaser rates,
adjustable rate mortgages "ARMs". All of these reflect the shoddy lending
standards of the past few years and all are contributing to the
unprecedented rate of defaults. Now the banks are holding $300 billion of
these "unmarketable" mortgage-backed CDOs and another $200 billion in
equally-suspect CLOs. (Collateralized loan obligations; the CDOs
corporate-twin).
Even more worrisome, the large investment banks have myriad "off-book"
operations which are in distress. This has forced the banks to circle the
wagons and reduce their issuance of loans which is accelerating the downturn
in housing. Typically, housing bubbles unwind very slowly over a 5 to 10
year period. That won't be the case this time. The surge in inventory, the
financial distress of many homeowners and the complete breakdown in
loan-origination (due to the growing credit crunch) ensures that the housing
market will crash-land sometime in late 2008 or early 2009. The banks are
expected to write-off a considerable portion of their CDO-debt at the end of
the 3rd Quarter rather than keep the losses on their books. This will
further hasten the decline in housing prices.
The banks are also suffering from the sudden sluggishness in leveraged
buyouts (LBOs). Credit problems have slowed private equity deals to a
dribble. In July there were $579 billion in LBOs. In August that number
shrunk to a paltry $222 billion. By September those figures will deteriorate
to double-digits. The big deals aren't getting done and debt is not rolling
over. More than $1 trillion in debt will have to be refinanced in the next 5
weeks. In the present climate, that doesn't look likely. Something's has got
to give. The market has frozen and the Fed's $60 billion repo-lifeline has
done nothing to help.
In the first 7 months of 2007, LBOs accounted for "$37 of every $100 spent
on deals in the US".
37%! How will the financial giants make up for the windfall profits that
these deals generated?
Answer: They won't. Just as they won't make up for the enormous origination
fees they made from "securitizing" mortgages and selling them off to
credulous pension funds, insurance companies and foreign banks.
As Steven Rattner of DLJ Merchant Banking said, "It's become nearly
impossible to finance a private equity transaction of over $1 billion."
(WSJ) The Golden Era of Acquisitions and Mega-mergers is coming to an end.
We can expect that the financial giants will probably follow the same
trajectory as the Dot.coms following the 2001 NASDAQ-rout.
The investment banks are also facing enormous potential losses from
liabilities that "operate off their balance sheets" In David Reilly's
article "Conduit Risks are hovering over Citigroup" (WSJ 9-5-07) Reilly
points out that "banks such as Citigroup Inc. could find themselves burdened
by affiliated investment vehicles that issue tens of billions of dollars in
short-term debt known as commercial paper". Citigroup, for example, owns
about 25% of the market for SIVs, representing nearly $100 billion of assets
under management. The largest Citigroup SIV is Centauri Corp., which had $21
billion in outstanding debt as of February 2007, according to a Citigroup
research report. There is NO MENTION OF CENTAURI IN ITS 2006 ANNUAL FILING
with the Securities and Exchange Commission.
Yet some investors worry that if vehicles such as Centauri stumble, either
failing to sell commercial paper or suffering severe losses in the assets it
holds, Citibank could wind up having to help by lending funds to keep the
vehicle operating or even taking on some losses".
So, many investors don't know that Citigroup could be holding the bag for
"$21 billion in outstanding debt"? Or, perhaps, the entire $100 billion is
red ink; who knows? (Citigroup's stock dropped by more than 2% after this
report appeared in the WSJ.)
Another report which appeared in CNN Money further adds to the suspicion
that the banks' "brokerage affiliates" may be in trouble:
"The Aug. 20 letters from the Fed to Citigroup and Bank of America state
that the Fed, which regulates large parts of the U.S. financial system, has
agreed to exempt both banks from rules that effectively limit the amount of
lending that their federally-insured banks can do with their brokerage
affiliates. The exemption, which is temporary, means, for example, that
Citigroup's Citibank entity can substantially increase funding to Citigroup
Global Markets, its brokerage subsidiary. Citigroup and Bank of America
requested the exemptions, according to the letters, to provide liquidity to
those holding mortgage loans, mortgage-backed securities, and other
securities.This unusual move by the Fed shows that the largest Wall Street
firms are continuing to have problems funding operations during the current
market difficulties." (CNN Money)
Does this mean that the other large banks are involved in the same type of
"hide-n-seek" strategies? Sounds a lot like Enron's "off-the-books"
shenanigans, doesn't it?
Wall Street Journal:
"Any off-balance-sheet issues are traditionally POORLY DISCLOSED, so to some
extent, you're dependent on the insight that management is willing to
provide you and that, frankly, is very limited," says Mark Fitzgibbon,
director of research at Sandler O'Neill & Partners."...Accounting rules
DON'T
REQUIRE BANKS TO SEPARATELY RECORD ANYTHING RELATED TO THE RISK that they
will have to loan the entities money to keep them functioning during a
markets crisis.".." The vehicles (SIVs and conduits) ARE OFTEN ESTABLISHED
IN A TAX HAVEN AND ARE RUN SOLEY FOR INVESTMENT PURPOSES AS OPPOSED TO
TYPICAL CORPORATE ACTIVITIES."
Still think the banks are on solid ground?
"Citigroup, the nation's largest bank as measured by market value and
assets. Its latest financial results showed that it administers
off-balance-sheet, conduit vehicles used to issue commercial paper that have
assets of about $77 BILLION.
Citigroup is also affiliated with structured investment vehicles, or SIVs
that have "nearly $100 billion" in assets, according to a letter Citigroup
wrote to some investors in these vehicles last month." (IBID)
Yes; and how many of these "assets" are in fact cooperate debt, auto loans,
credit card debt, and student loans that have been securitized and are now
under extreme pressure in a slumping market?
In an "up market" loans can provide a valuable income-stream that that
transforms someone else's debt into a valuable asset. In a down-market,
however, defaults can wipe out trillions in market capitalization overnight.
HOW DID WE GET INTO THIS MESS?
More than 20 years of dogged lobbying from the financial industry paid off
with the repeal of the Glass-Steagall Act which was passed by Congress
following the 1929 stock market crash. The bill was written to limit the
conflicts of interest when commercial banks are permitted to underwrite
stocks or bonds.
The financial industry whittled away at Glass-Steagall for years before
finally breaking down its regulatory restrictions in August 1987, Alan
Greenspan -- formerly a director of J.P. Morgan and a proponent of banking
deregulation -- became chairman of the Federal Reserve Board.
"In 1990, J.P. Morgan became the first bank to receive permission from the
Federal Reserve to underwrite securities, so long as its underwriting
business does not exceed the 10 percent limit. In December 1996, with the
support of Chairman Alan Greenspan, the Federal Reserve Board issues a
precedent-shattering decision permitting bank holding companies to own
investment bank affiliates with up to 25 percent of their business in
securities underwriting (up from 10 percent).
This expansion of the loophole created by the Fed's 1987 reinterpretation of
Section 20 of Glass-Steagall effectively rendered Glass-Steagall obsolete."
("The Long Demise of Glass Steagall, Frontline, PBS)
In 1999, after 25 years and $300 million of lobbying efforts, Congress aided
by President Bill Clinton, finally repealed Glass-Steagall. This paved the
way for the problems we are now facing.
Another contributing factor to the current banking-muddle is the Basel
rules. According to the BIS (Bank of International Settlements) website:
"The Basel Committee on Banking Supervision provides a forum for regular
cooperation on banking supervisory matters. Its objective is to enhance
understanding of key supervisory issues and improve the quality of banking
supervision worldwide. It seeks to do so by exchanging information on
national supervisory issues, approaches and techniques, with a view to
promoting common understanding. At times, the Committee uses this common
understanding to develop guidelines and supervisory standards in areas where
they are considered desirable. In this regard, the Committee is best known
for its international standards on capital adequacy; the Core Principles for
Effective Banking Supervision; and the Concordat on cross-border banking
supervision."
The Basel Committee on Banking (Basel 2) requires "banks to boost the
capital they hold in reserve against the loans on their books."
Sounds like a good thing, doesn't it? This protects the overall financial
system as well as the individual depositor. Unfortunately, the banks found a
way to circumvent the rules for minimum reserves by "securitizing" pools of
mortgages (MBS) rather than holding individual mortgages. (which called for
more reserves) This provided lavish origination and distribution fees for
banks, but shifted much of the risk of default to Wall Street investors.
Now, the banks are saddled with roughly $300 billion in mortgage-backed debt
(CDOs) that no one wants and it is uncertain whether they have sufficient
reserves to cover their losses.
By October, we should know how this will all play out. As David Wessel
points out in "New Bank Capital requirements helped to Spread Credit Woes":
"Banks now behave more like securities firms, more likely to mark down the
value of assets when market prices fall---even to distressed levels---rather
than sitting on bad loans for a decade and pretending they'll be paid back."
The downside of this is that once that banks write off these toxic MBSs and
CDOs; the hedge funds, insurance companies and pension funds will be forced
to do the same----dumping boatloads of this bond-sludge on the market
driving down prices and triggering a panic-sell-off. This is what the Fed is
trying to prevent through its $60 billion repo-bailout.
Regrettably, the Fed cannot hope to remove half-trillion of bad debt from
the balance sheets of the banks or forestall the collapse of related
financial institutions and funds which are loaded with these "unmarketable"
time-bombs. Besides, most of the mortgage derivatives (CDOs) have been
massively enhanced with low interest leverage from the "carry trade". When
the value of these CDOs is finally determined---which we expect will happen
sometime before the end of the 3rd Quarter-we can expect the stock market to
fall sharply and the housing recession to turn into a full-blown economic
crisis.
ALAN GREENSPAN: THE FIFTH HORSEMAN?
So, who's to blame? The finger-pointing has already begun and more and more
people are beginning to see how this massive economy-busting equity bubble
originated at the Federal Reserve--- it is the logical corollary of former
Fed-chief Alan Greenspan's "easy money" policies.
Henry C K Liu sums up Greenspan's tenure at the Fed in his article "Why the
Subprime Bust will Spread":
"Greenspan presided over the greatest expansion of speculative finance in
history, including a trillion-dollar hedge-fund industry, bloated Wall
Street-firm balance sheets approaching $2 trillion, a $3.3 trillion repo
(repurchase agreement) market, and a global derivatives market with notional
values surpassing an unfathomable $220 trillion.
On Greenspan's 18-year watch, assets of US government-sponsored enterprises
(GSEs) ballooned 830%, from $346 billion to $2.872 trillion. GSEs are
financing entities created by the US Congress to fund subsidized loans to
certain groups of borrowers such as middle- and low-income homeowners,
farmers and students. Agency mortgage-backed securities (MBSs) surged 670%
to $3.55 trillion. Outstanding asset-backed securities (ABSs) exploded from
$75 billion to more than $2.7 trillion."( Henry Liu, "Why the Subprime Bust
will Spread", Asia Times)
"The greatest expansion of speculative finance in history". That says it
all.
But no one makes the case against Greenspan better than Greenspan himself.
Here are some of his comments at the Federal Reserve System's Fourth Annual
Community Affairs Research Conference, Washington, D.C. April 8, 2005. They
show that Greenspan "rubber stamped" every one of the policies which have
since metastasized and spread through the entire US economy.
Greenspan: Champion of Subprime loans:
"Innovation has brought about a multitude of new products, such as subprime
loans and niche credit programs for immigrants. Such developments are
representative of the market responses that have driven the financial
services industry throughout the history of our country. With these advance
in technology, lenders have taken advantage of credit-scoring models and
other techniques for efficiently extending credit to a broader spectrum of
consumers."
Greenspan: Main Proponent of Toxic CDOs
"The development of a broad-based secondary market for mortgage loans also
greatly expanded consumer access to credit. By reducing the risk of making
long-term, fixed-rate loans and ensuring liquidity for mortgage lenders, the
secondary market helped stimulate widespread competition in the mortgage
business. The mortgage-backed security helped create a national and even an
international market for mortgages, and market support for a wider variety
of home mortgage loan products became commonplace. This led to
securitization of a variety of other consumer loan products, such as auto
and credit card loans."
Greenspan: Supporter of Loans to People with Bad Credit
"Where once more-marginal applicants would simply have been denied credit,
lenders are now able to quite efficiently judge the risk posed by individual
applicants and to price that risk appropriately.
These improvements have led to the rapid growth in SUBPRIME mortgage
lending.fostering constructive innovation that is both responsive to market
demand and beneficial to consumers."
"Improved access to credit for consumers, and especially these more-recent
developments, has had significant benefits.
Unquestionably, innovation and deregulation have vastly expanded credit
availability to virtually all income classes. Access to credit has enabled
families to purchase homes, deal with emergencies, and obtain goods and
services. Home ownership is at a record high, and the number of home
mortgage loans to low- and moderate-income and minority families has risen
rapidly over the past five years. Credit cards and installment loans are
also available to the vast majority of households"
Greenspan: Big Fan of "Structural Changes" which increase Consumer Debt
As we reflect on the evolution of consumer credit in the United States, we
must conclude that innovation and structural change in the financial
services industry have been critical in providing expanded access to credit
for the vast majority of consumers, including those of limited means.
Without these forces, it would have been impossible for lower-income
consumers to have the degree of access to credit markets that they now have.
This fact underscores the importance of our roles as policymakers,
researchers, bankers, and consumer advocates in fostering constructive
innovation that is both responsive to market demand and beneficial to
consumers." (Federal Reserve Chairman, Alan Greenspan; Federal Reserve
System's Fourth Annual Community Affairs Research Conference, Washington,
D.C. April 8, 2005)
Greenspan's own words are the most powerful indictment against him. They
show that he played a central role in our impending disaster. The effort on
the part of media pundits, talking heads, and so-called experts to foist the
blame on the rating agencies, predatory lenders or gullible mortgage
applicants misses the point entirely. The problems began at the Federal
Reserve and that's where the responsibility lies.
_______
Mike Whitney
--
NOTICE: This post contains copyrighted material the use of which has not
always been authorized by the copyright owner. I am making such material
available to advance understanding of
political, human rights, democracy, scientific, and social justice issues. I
believe this constitutes a 'fair use' of such copyrighted material as
provided for in section 107 of the US Copyright
Law. In accordance with Title 17 U.S.C. Section 107
"A little patience and we shall see the reign of witches pass over, their
spells dissolve, and the people recovering their true sight, restore their
government to its true principles. It is true that in the meantime we are
suffering deeply in spirit,
and incurring the horrors of a war and long oppressions of enormous public
debt. But if the game runs sometimes against us at home we must have
patience till luck turns, and then we shall have an opportunity of winning
back the principles we have lost, for this is a game where principles are at
stake."
-Thomas Jefferson
By Mike Whitney
Created Sep 8 2007 - 6:49pm
"The new capitalist gods must love the poor - they are making so many more
of them." Bill Bonner, "The Daily Reckoning"
"The hope of every central bank is that the real problem can be kept from
public view. The truth is that the public---even professionals on Wall
Street---have no clue what the real problem is. They know it has something
to do with derivatives, but none of them realize that it's more than a $20
trillion mountain of unfunded, unregulated paper that has just been
discovered to not have a market and, therefore, no real value. When the
dollar realizes the seriousness of the situation---be that now or sometime
soon---the bottom will drop out." Jim Sinclair, Investment analyst
About a month ago, I wrote an article "Stock Market Brushfire: Will there be
a run on the banks?" which showed how the collapse in the housing market and
the deterioration in mortgage-backed bonds (CDOs) in the secondary market
was creating difficulties for the banking system. Now these problems are
becoming more apparent.
From the Wall Street Journal:
"The rising interbank lending rates are a proxy of sorts for the increased
risk that some banks, somewhere, may go belly up." (Editorial; WSJ, 9-6-07)
Ironically, the WSJ editorial staff--which normally defends deregulation and
laissez faire economics "tooth-n-nail"---is now calling for regulators to
make sure they are "on top of the banks they are supposed to be regulating,
so we don't get any surprise bank failures that spook the markets and
confirm the worst fears being whispered about."
"Surprise bank failures?"
Henry Liu sums it up like this in his article, "The Rise of the non-bank
system"---required reading for anyone who wants to understand why a stock
market crash is imminent:
"Banks worldwide now reportedly face risk exposure of US$891 billion in
asset-backed commercial paper facilities (ABCP) due to callable bank credit
agreements with borrowers designed to ensure ABCP investors are paid back
when the short-term debt matures, even if banks cannot sell new ABCP on
behalf of the issuing companies to roll over the matured debt because the
market views the assets behind the paper as of uncertain market value.
This signifies that the crisis is no longer one of liquidity, but of
deteriorating creditworthiness systemwide that restoring liquidity alone
cannot cure. The liquidity crunch is a symptom, not the disease. The disease
is a decade of permissive tolerance for credit abuse in which the banks,
regulators and rating agencies were willing accomplices." (Henry Liu,"The
Rise of the Non-bank System", Asia Times)
That's right; nearly $1 trillion in worthless asset-backed paper is clogging
the system putting the kybosh on the big private equity deals and spreading
panic through the money markets. It's a slow-motion train wreck and there's
not a thing the Fed can do about it.
This isn't a liquidity problem that can be fixed by lowering the Fed's fund
rate and creating more easy credit. This is a solvency crisis; the
underlying assets upon which this world of "structured finance" is built
have no established market value, therefore---as Jim Sinclair
suggests---they're worthless. That means that the trillions of dollars which
have been leveraged against these shaky assets---in the form of credit
default swaps (CDSs) and numerous other bizarre-sounding derivatives---will
begin to cascade down wiping out trillions in market value.
How serious is it? Economist Liu puts it like this:
"Even if the Fed bails out the banks by easing bank reserve and capital
requirements to absorb that massive amount, the raging forest fire in the
non-bank financial system will still present finance capitalism with its
greatest test in eight decades."
OVERVIEW
Credit standards are tightening and banks are increasingly reluctant to loan
money to each other not knowing who may be sitting on billions of dollars in
toxic mortgage-backed debt. (Collateralized debt obligations) It makes no
difference that the "underlying economy is sound" as Bernanke likes to say.
When banks hesitate to loan money to each other; it shows that there is real
uncertainty about the solvency of the other banks. It slows down commerce
and the gears on the economic machine begin to rust in place.
The banks woes have been exacerbated by the flight of investors from money
market funds, many of which are backed by Mortgage-backed Securities (MBS).
Wary investors are running for the safety of US Treasuries even though
yields that have declined at a record pace. This is causing problems in the
Commercial Paper market as well as for the lesser-know SIVs and "conduits".
These abstruse-sounding investment vehicles are the essential plumbing that
maintains normalcy in the markets. Commercial paper is a $2.2 trillion
market. When it shrinks by more than $200 billion ---as it has in the last 3
weeks--the effects can be felt through the entire system.
The credit crunch has spread across the whole gamut of commercial paper and
low-grade debt. Banks are hoarding cash and refusing loans to even
credit-worthy applicants. The collapse in subprime loans is just part of the
story. More than 50% of all mortgages in the last two years have been
unconventional loans-no down payment, no verification of income "no doc",
interest-only, negative amortization, piggyback, 2-28s, teaser rates,
adjustable rate mortgages "ARMs". All of these reflect the shoddy lending
standards of the past few years and all are contributing to the
unprecedented rate of defaults. Now the banks are holding $300 billion of
these "unmarketable" mortgage-backed CDOs and another $200 billion in
equally-suspect CLOs. (Collateralized loan obligations; the CDOs
corporate-twin).
Even more worrisome, the large investment banks have myriad "off-book"
operations which are in distress. This has forced the banks to circle the
wagons and reduce their issuance of loans which is accelerating the downturn
in housing. Typically, housing bubbles unwind very slowly over a 5 to 10
year period. That won't be the case this time. The surge in inventory, the
financial distress of many homeowners and the complete breakdown in
loan-origination (due to the growing credit crunch) ensures that the housing
market will crash-land sometime in late 2008 or early 2009. The banks are
expected to write-off a considerable portion of their CDO-debt at the end of
the 3rd Quarter rather than keep the losses on their books. This will
further hasten the decline in housing prices.
The banks are also suffering from the sudden sluggishness in leveraged
buyouts (LBOs). Credit problems have slowed private equity deals to a
dribble. In July there were $579 billion in LBOs. In August that number
shrunk to a paltry $222 billion. By September those figures will deteriorate
to double-digits. The big deals aren't getting done and debt is not rolling
over. More than $1 trillion in debt will have to be refinanced in the next 5
weeks. In the present climate, that doesn't look likely. Something's has got
to give. The market has frozen and the Fed's $60 billion repo-lifeline has
done nothing to help.
In the first 7 months of 2007, LBOs accounted for "$37 of every $100 spent
on deals in the US".
37%! How will the financial giants make up for the windfall profits that
these deals generated?
Answer: They won't. Just as they won't make up for the enormous origination
fees they made from "securitizing" mortgages and selling them off to
credulous pension funds, insurance companies and foreign banks.
As Steven Rattner of DLJ Merchant Banking said, "It's become nearly
impossible to finance a private equity transaction of over $1 billion."
(WSJ) The Golden Era of Acquisitions and Mega-mergers is coming to an end.
We can expect that the financial giants will probably follow the same
trajectory as the Dot.coms following the 2001 NASDAQ-rout.
The investment banks are also facing enormous potential losses from
liabilities that "operate off their balance sheets" In David Reilly's
article "Conduit Risks are hovering over Citigroup" (WSJ 9-5-07) Reilly
points out that "banks such as Citigroup Inc. could find themselves burdened
by affiliated investment vehicles that issue tens of billions of dollars in
short-term debt known as commercial paper". Citigroup, for example, owns
about 25% of the market for SIVs, representing nearly $100 billion of assets
under management. The largest Citigroup SIV is Centauri Corp., which had $21
billion in outstanding debt as of February 2007, according to a Citigroup
research report. There is NO MENTION OF CENTAURI IN ITS 2006 ANNUAL FILING
with the Securities and Exchange Commission.
Yet some investors worry that if vehicles such as Centauri stumble, either
failing to sell commercial paper or suffering severe losses in the assets it
holds, Citibank could wind up having to help by lending funds to keep the
vehicle operating or even taking on some losses".
So, many investors don't know that Citigroup could be holding the bag for
"$21 billion in outstanding debt"? Or, perhaps, the entire $100 billion is
red ink; who knows? (Citigroup's stock dropped by more than 2% after this
report appeared in the WSJ.)
Another report which appeared in CNN Money further adds to the suspicion
that the banks' "brokerage affiliates" may be in trouble:
"The Aug. 20 letters from the Fed to Citigroup and Bank of America state
that the Fed, which regulates large parts of the U.S. financial system, has
agreed to exempt both banks from rules that effectively limit the amount of
lending that their federally-insured banks can do with their brokerage
affiliates. The exemption, which is temporary, means, for example, that
Citigroup's Citibank entity can substantially increase funding to Citigroup
Global Markets, its brokerage subsidiary. Citigroup and Bank of America
requested the exemptions, according to the letters, to provide liquidity to
those holding mortgage loans, mortgage-backed securities, and other
securities.This unusual move by the Fed shows that the largest Wall Street
firms are continuing to have problems funding operations during the current
market difficulties." (CNN Money)
Does this mean that the other large banks are involved in the same type of
"hide-n-seek" strategies? Sounds a lot like Enron's "off-the-books"
shenanigans, doesn't it?
Wall Street Journal:
"Any off-balance-sheet issues are traditionally POORLY DISCLOSED, so to some
extent, you're dependent on the insight that management is willing to
provide you and that, frankly, is very limited," says Mark Fitzgibbon,
director of research at Sandler O'Neill & Partners."...Accounting rules
DON'T
REQUIRE BANKS TO SEPARATELY RECORD ANYTHING RELATED TO THE RISK that they
will have to loan the entities money to keep them functioning during a
markets crisis.".." The vehicles (SIVs and conduits) ARE OFTEN ESTABLISHED
IN A TAX HAVEN AND ARE RUN SOLEY FOR INVESTMENT PURPOSES AS OPPOSED TO
TYPICAL CORPORATE ACTIVITIES."
Still think the banks are on solid ground?
"Citigroup, the nation's largest bank as measured by market value and
assets. Its latest financial results showed that it administers
off-balance-sheet, conduit vehicles used to issue commercial paper that have
assets of about $77 BILLION.
Citigroup is also affiliated with structured investment vehicles, or SIVs
that have "nearly $100 billion" in assets, according to a letter Citigroup
wrote to some investors in these vehicles last month." (IBID)
Yes; and how many of these "assets" are in fact cooperate debt, auto loans,
credit card debt, and student loans that have been securitized and are now
under extreme pressure in a slumping market?
In an "up market" loans can provide a valuable income-stream that that
transforms someone else's debt into a valuable asset. In a down-market,
however, defaults can wipe out trillions in market capitalization overnight.
HOW DID WE GET INTO THIS MESS?
More than 20 years of dogged lobbying from the financial industry paid off
with the repeal of the Glass-Steagall Act which was passed by Congress
following the 1929 stock market crash. The bill was written to limit the
conflicts of interest when commercial banks are permitted to underwrite
stocks or bonds.
The financial industry whittled away at Glass-Steagall for years before
finally breaking down its regulatory restrictions in August 1987, Alan
Greenspan -- formerly a director of J.P. Morgan and a proponent of banking
deregulation -- became chairman of the Federal Reserve Board.
"In 1990, J.P. Morgan became the first bank to receive permission from the
Federal Reserve to underwrite securities, so long as its underwriting
business does not exceed the 10 percent limit. In December 1996, with the
support of Chairman Alan Greenspan, the Federal Reserve Board issues a
precedent-shattering decision permitting bank holding companies to own
investment bank affiliates with up to 25 percent of their business in
securities underwriting (up from 10 percent).
This expansion of the loophole created by the Fed's 1987 reinterpretation of
Section 20 of Glass-Steagall effectively rendered Glass-Steagall obsolete."
("The Long Demise of Glass Steagall, Frontline, PBS)
In 1999, after 25 years and $300 million of lobbying efforts, Congress aided
by President Bill Clinton, finally repealed Glass-Steagall. This paved the
way for the problems we are now facing.
Another contributing factor to the current banking-muddle is the Basel
rules. According to the BIS (Bank of International Settlements) website:
"The Basel Committee on Banking Supervision provides a forum for regular
cooperation on banking supervisory matters. Its objective is to enhance
understanding of key supervisory issues and improve the quality of banking
supervision worldwide. It seeks to do so by exchanging information on
national supervisory issues, approaches and techniques, with a view to
promoting common understanding. At times, the Committee uses this common
understanding to develop guidelines and supervisory standards in areas where
they are considered desirable. In this regard, the Committee is best known
for its international standards on capital adequacy; the Core Principles for
Effective Banking Supervision; and the Concordat on cross-border banking
supervision."
The Basel Committee on Banking (Basel 2) requires "banks to boost the
capital they hold in reserve against the loans on their books."
Sounds like a good thing, doesn't it? This protects the overall financial
system as well as the individual depositor. Unfortunately, the banks found a
way to circumvent the rules for minimum reserves by "securitizing" pools of
mortgages (MBS) rather than holding individual mortgages. (which called for
more reserves) This provided lavish origination and distribution fees for
banks, but shifted much of the risk of default to Wall Street investors.
Now, the banks are saddled with roughly $300 billion in mortgage-backed debt
(CDOs) that no one wants and it is uncertain whether they have sufficient
reserves to cover their losses.
By October, we should know how this will all play out. As David Wessel
points out in "New Bank Capital requirements helped to Spread Credit Woes":
"Banks now behave more like securities firms, more likely to mark down the
value of assets when market prices fall---even to distressed levels---rather
than sitting on bad loans for a decade and pretending they'll be paid back."
The downside of this is that once that banks write off these toxic MBSs and
CDOs; the hedge funds, insurance companies and pension funds will be forced
to do the same----dumping boatloads of this bond-sludge on the market
driving down prices and triggering a panic-sell-off. This is what the Fed is
trying to prevent through its $60 billion repo-bailout.
Regrettably, the Fed cannot hope to remove half-trillion of bad debt from
the balance sheets of the banks or forestall the collapse of related
financial institutions and funds which are loaded with these "unmarketable"
time-bombs. Besides, most of the mortgage derivatives (CDOs) have been
massively enhanced with low interest leverage from the "carry trade". When
the value of these CDOs is finally determined---which we expect will happen
sometime before the end of the 3rd Quarter-we can expect the stock market to
fall sharply and the housing recession to turn into a full-blown economic
crisis.
ALAN GREENSPAN: THE FIFTH HORSEMAN?
So, who's to blame? The finger-pointing has already begun and more and more
people are beginning to see how this massive economy-busting equity bubble
originated at the Federal Reserve--- it is the logical corollary of former
Fed-chief Alan Greenspan's "easy money" policies.
Henry C K Liu sums up Greenspan's tenure at the Fed in his article "Why the
Subprime Bust will Spread":
"Greenspan presided over the greatest expansion of speculative finance in
history, including a trillion-dollar hedge-fund industry, bloated Wall
Street-firm balance sheets approaching $2 trillion, a $3.3 trillion repo
(repurchase agreement) market, and a global derivatives market with notional
values surpassing an unfathomable $220 trillion.
On Greenspan's 18-year watch, assets of US government-sponsored enterprises
(GSEs) ballooned 830%, from $346 billion to $2.872 trillion. GSEs are
financing entities created by the US Congress to fund subsidized loans to
certain groups of borrowers such as middle- and low-income homeowners,
farmers and students. Agency mortgage-backed securities (MBSs) surged 670%
to $3.55 trillion. Outstanding asset-backed securities (ABSs) exploded from
$75 billion to more than $2.7 trillion."( Henry Liu, "Why the Subprime Bust
will Spread", Asia Times)
"The greatest expansion of speculative finance in history". That says it
all.
But no one makes the case against Greenspan better than Greenspan himself.
Here are some of his comments at the Federal Reserve System's Fourth Annual
Community Affairs Research Conference, Washington, D.C. April 8, 2005. They
show that Greenspan "rubber stamped" every one of the policies which have
since metastasized and spread through the entire US economy.
Greenspan: Champion of Subprime loans:
"Innovation has brought about a multitude of new products, such as subprime
loans and niche credit programs for immigrants. Such developments are
representative of the market responses that have driven the financial
services industry throughout the history of our country. With these advance
in technology, lenders have taken advantage of credit-scoring models and
other techniques for efficiently extending credit to a broader spectrum of
consumers."
Greenspan: Main Proponent of Toxic CDOs
"The development of a broad-based secondary market for mortgage loans also
greatly expanded consumer access to credit. By reducing the risk of making
long-term, fixed-rate loans and ensuring liquidity for mortgage lenders, the
secondary market helped stimulate widespread competition in the mortgage
business. The mortgage-backed security helped create a national and even an
international market for mortgages, and market support for a wider variety
of home mortgage loan products became commonplace. This led to
securitization of a variety of other consumer loan products, such as auto
and credit card loans."
Greenspan: Supporter of Loans to People with Bad Credit
"Where once more-marginal applicants would simply have been denied credit,
lenders are now able to quite efficiently judge the risk posed by individual
applicants and to price that risk appropriately.
These improvements have led to the rapid growth in SUBPRIME mortgage
lending.fostering constructive innovation that is both responsive to market
demand and beneficial to consumers."
"Improved access to credit for consumers, and especially these more-recent
developments, has had significant benefits.
Unquestionably, innovation and deregulation have vastly expanded credit
availability to virtually all income classes. Access to credit has enabled
families to purchase homes, deal with emergencies, and obtain goods and
services. Home ownership is at a record high, and the number of home
mortgage loans to low- and moderate-income and minority families has risen
rapidly over the past five years. Credit cards and installment loans are
also available to the vast majority of households"
Greenspan: Big Fan of "Structural Changes" which increase Consumer Debt
As we reflect on the evolution of consumer credit in the United States, we
must conclude that innovation and structural change in the financial
services industry have been critical in providing expanded access to credit
for the vast majority of consumers, including those of limited means.
Without these forces, it would have been impossible for lower-income
consumers to have the degree of access to credit markets that they now have.
This fact underscores the importance of our roles as policymakers,
researchers, bankers, and consumer advocates in fostering constructive
innovation that is both responsive to market demand and beneficial to
consumers." (Federal Reserve Chairman, Alan Greenspan; Federal Reserve
System's Fourth Annual Community Affairs Research Conference, Washington,
D.C. April 8, 2005)
Greenspan's own words are the most powerful indictment against him. They
show that he played a central role in our impending disaster. The effort on
the part of media pundits, talking heads, and so-called experts to foist the
blame on the rating agencies, predatory lenders or gullible mortgage
applicants misses the point entirely. The problems began at the Federal
Reserve and that's where the responsibility lies.
_______
Mike Whitney
--
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"A little patience and we shall see the reign of witches pass over, their
spells dissolve, and the people recovering their true sight, restore their
government to its true principles. It is true that in the meantime we are
suffering deeply in spirit,
and incurring the horrors of a war and long oppressions of enormous public
debt. But if the game runs sometimes against us at home we must have
patience till luck turns, and then we shall have an opportunity of winning
back the principles we have lost, for this is a game where principles are at
stake."
-Thomas Jefferson