The Great Credit Unwind of ’08

The current crisis is not only the bust that follows the housing boom, it’s basically the end of a 60-year period of continuing credit expansion based on the dollar as the reserve currency. Now the rest of the world is increasingly unwilling to accumulate dollars.

— George Soros, World Economic Forum in Davos, Switzerland.

Global market turmoil continued into a second week as stock markets in Asia and Europe took another tumble on Monday on growing fears of a recession in the United States. China’s benchmark index plummeted 7.2% to its lowest point in six months, while Japan’s Nikkei index slipped another 4.3%. Equities markets across Asia recorded similar results and, by midmorning in Europe, all three major indexes — the UK FTSE “Footsie”, France’s CAC 40, and the German DAX — were all recording heavy losses. It’s now clear that Fed Chairman Bernanke’s ‘surprise’ announcement of a 75 basis points cut to the Fed Funds rate last Tuesday has neither stabilized the markets nor restored confidence among jittery investors.

At the time of this writing, the storm clouds are swiftly moving towards Wall Street where markets are likely to be roiled on the very day that President Bush will give his farewell State of the Union speech.

In Monday’s Financial Times, Harvard economics professor, Lawrence Summers, made an impassioned plea for further government action in addition to the Fed’s rate cuts and Bush’s $150 billion “stimulus plan.” Summers believes that steps must be taken immediately to mitigate the damage from the sharp downturn in housing and persistent troubles in the credit markets. He suggests a “global coordination of policy,” which is another way of admitting that the Fed has lost control of the system and cannot solve the problem by itself.

Summers is right, although it’s easy to wonder why he remained silent while the markets were soaring and the investment banks were reaping trillions of dollars in profits on a “structured investment” swindle which has left the global financial system teetering on the brink of catastrophe. Now that the US economy is sliding towards recession, Summers is calling for “transparency”. How convenient.

“Financial institutions are holding all sorts of credit instruments that are impaired but are difficult to value, creating uncertainty and freezing new lending. Without more visibility, the economy and financial system risk freezing up as Japan’s did in the 1990s.”

Right again. The banks are “capital impaired” because they are holding nearly $600 billion in mortgage-backed assets which are declining in value every month. This is forcing many banks to conceal their real condition from investors while they scour the planet for the extra capital they need to continue operations. As long as the banks are in distress, consumer and business lending will dwindle and the economy will continue to shrink. The main gear in the credit-generating mechanism is now broken. The rate cuts can provide liquidity, but they cannot bring insolvent banks back from the dead. Summers is expecting too much.

The United States has led the world into the greatest credit bust in history, and yet, few people even know what has transpired. The US massive current account deficit (nearly $800 billion) has been recycling into US Treasuries and securities from foreign investors. Up to this point, American markets were an attractive place to put one’s savings. The dollar was strong, and the stock market had a proven record of profitability and transparency. But since President Bill Clinton repealed Glass-Steagall in 1999, the markets have been reconfigured according to an entirely new model, “structured finance.” Glass-Steagall was the last of the Depression-era bulwarks against the merging of commercial and investment banks. As a result banking has changed from a culture of “protection” (of deposits) to “risk taking”, which is the securities business. Through “financial innovation” the investment banks created myriad structured debt instruments which they sold through their Enron-like “off balance” sheets operations (SIVs and Conduits) Now, trillions of dollars of these subprime and mortgage-backed bonds — many of which were rated triple A — are held by foreign banks, retirement funds, insurance companies, and hedge funds. They are steadily losing value with every rating’s downgrade. Here is a graph which illustrates how the scam works.

Summers, of course, understands the enormity of the swindle that has taken place beneath the noses of US regulators, but chooses not to hold any of the main actors accountable. Instead, he draws our attention to a little known part of the market which will probably lead the way to a stock market crash and a system-wide meltdown.

Here’s Summers:

“It is critical that sufficient capital is infused into the bond insurance industry as soon as possible. Their failure or loss of a AAA rating is a potential source of systemic risk. Probably it will be necessary to turn in part to those companies that have a stake in guarantees remaining credible because they have large holdings of guaranteed paper. It appears unlikely that repair will take place without some encouragement and involvement by financial authorities. Though there are many differences and the current problem is more complex, the Long-Term Capital Management work-out is an example of successful public sector involvement.”

Some of the largest bond insurers are currently unable to cover the losses that are piling up from the meltdown in mortgage-backed securities (MBS) and collateralized debt obligations (CDO). Their business model is hopelessly broken and they will require an immediate $143 billion bailout to maintain operations. The largest of the bond insurers is MBIA.

“MBIA’s total exposure to bonds backed by mortgages and CDOs was disclosed to be $30.6 billion, including $8.14 billion of holdings of CDO-squareds (editor’s note: pure garbage). MBIA was being priced as a weak CCC-rated credit when it issued its bonds last week; it is now being priced for a bankruptcy. MBIA’s stock, which traded just under $68 per share last October, dropped another $3.50 this morning to under $10.00 per share.” (Stock analyst Michael Lewitt, quoted in Bloomberg)

Barclay’s estimates that the investment banks alone are holding as much as $615 billion of structured securities guaranteed by bond insurers. If the insurers default, hundreds of billions will be lost via downgrades.

So, in practical terms, what does it mean if the bond insurers go under?

It means that the system will freeze and the stock market will crash. Here’s how TV stock guru Jim Cramer summed it up last week in an interview with MSNBC’s Chris Matthews:

“But, Chris, there is something I would urge all the candidates to think about and our Treasury Secretary, which is that there are a group of insurance companies which insure all these bad mortgages and, Chris, I think they are all about to go belly-up, and that will cause the Dow Jones to decline 2,000 points. They’ve got to be shut down and the insurance given to a New Resolution Trust. This is going to happen in maybe two or three weeks, Chris, it going to on the front of every newspaper and no one in Washington is even willing to admit it.

Chris Matthews: “So who are you including in these mortgage companies that are going to go belly-up; give me a description?

These are MBIA and Ambac, remember, the companies that Merrill Lynch and Citigroup wrote down a lot of stuff the other day? All these companies are relying on insurance to save them. The insurers don’t have the money. There’s also personal mortgage insurance, that’s PMI, is one company; MGIC is another. Chris, I am telling you that these companies do not have the capital to “make good.” And when they do fall, and I believe it is when — if the government does not have a plan in action; you will not be able to open the stock market when they collapse.” No one is even talking about the fact that these major insurers, who insure $450 billion of mortgages are all about to go under.” (See the whole video)

Cramer is correct in assuming that the market won’t open. And yet, so far, nothing has been done to avert the disaster which lies just ahead. Maybe nothing can be done?

So, how did things get so bad, so fast? How could the world’s most resilient and profitable markets be transformed into a carnival sideshow peddling poisonous “mortgage-backed” snake oil to every gullible investor?

Author and stock market soothsayer Pam Martens puts it like this:

“How could a layered concoction of questionable debt pools, many of dubious origin, achieve the equivalent AAA rating as U.S. Treasury securities, backed by the full faith and credit of the U.S. government, and time-tested over a century of panics, crashes and the Great Depression?

How did a 200-year old ‘efficient’ market model that priced its securities based on regular price discovery through transparent trading morph into an opaque manufacturing and warehousing complex of products that didn’t trade or rarely traded, necessitating pricing based on statistical models?” (“The Free Market Myth Dissolves into Chaos,” Pam Martens, CounterPunch)

How, indeed?

The answer to all these questions is “deregulation”. The financial system has been handed over to scam artists and fraudsters who’ve created a multi-trillion dollar inverted pyramid of shaky, hyper-inflated, subprime slop that they’ve sold around the world with the tacit support of the ratings agencies and the US political establishment (wink, wink). Now that system is about to collapse and there’s nothing that the Federal Reserve can do to stop the Great Credit Unwind of ’08.

As economist Ludwig von Mises said:

“There is no means of avoiding the final collapse of a boom brought on by credit expansion. The question is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

Mike Whitney lives in Washington state. He can be reached at: Read other articles by Mike.

9 comments on this article so far ...

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  1. Don Hawkins said on January 30th, 2008 at 11:21am #

    Not everything that counts can be counted, and not everything that can be counted counts.

  2. rhodomontade said on January 31st, 2008 at 4:15am #

    Cramer is right about the fiscal obligation of these worthless, comical, inept piece of crap rating agencies to lower the rating on these garbage “bond insurers.” The fact these clown colleges continue to fail to do their duty is, like any display of clowns, sad and scary, not funny at all.

    The problem with Cramer though he was screaming, yelling — he leads the pack of hedge fund troglodytes — howling for lower interest rates, when that is not what this country needs.

    This country needs Volcker-style discipline, face in the mud discipline. We need force the speculators and the greedy fools to die type discipline, and we need it now.

    But it is impossible, because the political machine is so venal that the only response to crippling deficits is voting for more deficits. More money for homeowners. More money for defense industries. More money even for illegals, if you take that piece of crap mayor in Chicago seriously. Traitors all. All of you. Anyone voting for ANYTHING when you’ve already doomed us all to bankruptcy is a traitor and a liar.

    And yet we have an entire, vast class of so-called educated people swooning under the spell of Barack Obama and his utter lack of positions, his utter failure to address a single problem raised by real outsider candidates — Kucinich and Paul.

    But the whole pack of you Hollywood-brainwashed, trash-eating eroding middle class, cultural illiterates will vote for this establishment puppet because he offers “Hope.” Because you’re all so badly-educated and horribly ignorant, you know more about Britney Spears and Tom Cruise than you do about the damn money and the damn laws that rules you.

    Take your hope and shove it up your windpipe, you godforsaken innumerate bloated ignorant thieves. Your stupidity, your fat, blind ignorance, will doom us to a horrible depression and probably at the end of it, fascism. Democracy failed.

    Good work, baby boomers! God-forsaken fatted swine.

  3. David A. Smith said on January 31st, 2008 at 9:53am #

    I love all the hand wringing about economic collapse. And Mr. Whitney’s weekly installment of hysteria is most welcome. I await it’s publication as one of the most amusing five minutes I will spend at work all week.

    But clearly, I’m not as worried about it all. Why not?

    Let me start with the assumption that most reading DV are not believers in the growth model of economics, that we share the understanding that modern global capitalism is not sustainable. Let me also assume that most of us reading DV also understand that those who steer that system aren’t going to let the rest of us wrench control from their wealthy little fingers. (In other words, no realistic alternative will be allowed to enter into public discussion.)

    If these two assumptions are correct, than I believe we must conclude that no graceful climb down from growth based global capitalism to a people centered sustainable economy is possible. Therefore, the only way we get to sustainability is for the global capitalist economy to collapse. Is that what Mr. Whitney is chronicling? If so, then I must ask, why are we all so fired up and concerned about economic collapse when it is necessary to reach a more sustainable way of life?

    Yes, I understand that there will be suffering and that the poor are the most defenseless during the collapse. But that’s going to happen anyway. So why don’t we stop bemoaning the credit collapse and start trying to find ways where we can turn it into a positive and sustainable future. The last thing we should be doing is looking for ways to prop up the global economy so that we can get a few more years of planet and people destroying “growth” out of it.

  4. Gary Lapon said on January 31st, 2008 at 3:00pm #

    rhodomontade: Even if Obama wins, he’ll get about 25% of the vote, since half of eligible voters don’t even bother anymore (I can’t blame them). You seem to be buying into the very nonsense you blame others for buying into. Regular people are not to blame for the situation this country (and world) is in. Democracy didn’t fail…true democracy (not the “formal” democracy we have now, where both Bill Gates and I have the same “right” to donate big money to campaigns and PACs) is impossible under capitalism. Instead of dismissing the mass of people, perhaps you should try talking to them. Or you could go live in the mountains and not bother anybody, to quote Don Rickles.

  5. Gary Lapon said on January 31st, 2008 at 3:05pm #

    P.S. David, I think it’s important to understand what’s going on with the economy and be able to explain things to people. A lot of people are going to be pissed off by the coming crisis, and it’s necessary to organize, both to help people out in the short term and to ultimately change this irrational system. That said, pointing out the tragic absurdity of this unnecessary crisis, and showing how crises such as this are built into the system, are key tools for rebuilding the Left in the coming period. Mike Whitney does a good job of providing analysis that’s useful to that project.

  6. Jim Klingbeil said on February 1st, 2008 at 2:43pm #

    It is very important to know what’s going on. I show these articles to true believers of the capitalist religion and mostly they get nervous and deny reality and say everything will work out. Like Mr. Smith i believe a economic collapse could help bring about real change. For 30+ years since i’ve understood the true nature of the beast i’ve wished for global economic collapse. But the capitalist system always seems to pull through and today the criminal ruling elite has such a lock on the media and thought control that i doubt even a depression as deep as the 30’s will be able to bring about as great of progressive change. Most Americans would be happy with a Hitler, they are incapable of electing another Roosevelt, let alone someone even better. I and other working people have been watching our well being decline for 25 years, if there is an economic collapse we will suffer more than the truly wealthy, but nothing else is even going to come close to making progressive change possible.

  7. J McBeal said on February 1st, 2008 at 3:51pm #

    I predict a Clinton/Obama ticket. The dems will win after ’08 crisis unwinds before election day, after Bush goes half-cocked and out of control over the middle east, after food and water shortages become apparent, and before the riots begin.

  8. B Alfant said on February 1st, 2008 at 10:52pm #

    “This country needs Volcker-style discipline, face in the mud discipline. We need force the speculators and the greedy fools to die type discipline, and we need it now….And yet we have an entire, vast class of so-called educated people swooning under the spell of Barack Obama and his utter lack of positions, his utter failure to address a single problem raised by real outsider candidates”

    Volcker just endorsed Obama.
    Do you really believe the first African American President of Harvard Law Review could not also be the most brilliant politician this country has ever seen. Possibly even? If the problems raised by ‘outside candidates’ need to be effectively addressed…..he needs to win the nomination first.

    From The Cure at Troy–

    “Human beings suffer,
    they torture one another,
    they get hurt and get hard.
    No poem or play or song
    can fully right a wrong
    inflicted or endured.

    The innocent in gaols
    beat on their bars together.
    A hunger-striker’s father
    stands in the graveyard dumb.
    The police widow in veils
    faints at the funeral home.

    History says, Don’t hope
    on this side of the grave.
    But then, once in a lifetime
    the longed for tidal wave
    of justice can rise up,
    and hope and history rhyme.

    So hope for a great sea-change
    on the far side of revenge.
    Believe that a further shore
    is reachable from here.
    Believe in miracles
    and cures and healing wells.

    Call the miracle self-healing:
    The utter self-revealing
    double-take of feeling.
    If there’s fire on the mountain
    Or lightning and storm
    And a god speaks from the sky

    That means someone is hearing
    the outcry and the birth-cry
    of new life at its term.”

  9. B Alfant said on February 1st, 2008 at 10:58pm #

    ….sorry about the double post, thought it wouldn’t accept due to length.