America’s Teetering Banking System

“Where Did All Our Deposits Go?”

Somebody goofed. When Fed chairman Ben Bernanke cut interest rates to 3% on Thursday, the price of a new mortgage went up. How does that help the flagging housing industry?

About an hour after Bernanke made the announcement that the Fed Funds rate would be cut by 50 basis points the yield on the 30-year Treasury nudged up a tenth of a percent to 4.42%. The same thing happened to the 10-year Treasury which surged from a low of 3.28% to 3.73% in less than a week. That means that mortgages — which are priced off long-term government bonds — will be going up, too.

Is that what Bernanke had in mind: to stick another dagger into the already moribund real estate market?

The Fed sets short-term interest rates (The Fed Funds rate) but long-term rates are market-driven. So, when investors see slow growth and inflationary pressures building up, long-term rates start to rise. That’s bad news for the housing market.

Now, here’s the shocker: Bernanke KNEW that the price of a mortgage would increase if he slashed rates, but went ahead anyway.

How did he know?

Because nine days ago, when he cut rates by 75 basis points, the 10-year didn’t budge from its perch at 3.64%. It just shrugged it off the cuts as meaningless. But a couple days later, when Congress passed Bush’s $150 “Stimulus Giveaway,” the ten year spiked with a vengeance — up 20 basis points on the day. In other words, the bond market doesn’t like inflation-generating government handouts.

So, why did Bernanke cut rates when he knew it would just add to the housing woes?

Some critics say that he just wanted to throw a lifeline to his fat-cat investor buddies on Wall Street by providing more liquidity for the markets. But that’s not it, at all. The fact is, Bernanke had no choice. He’s facing a challenge so huge and potentially catastrophic, that cutting rates must have seemed like the only option he had. Just look at these graphs and you’ll see what Bernanke saw before he decided to cut interest rates.

Negative Bank Reserves: The Banks are Busted

The first graph (Total borrowings of Depository Institutions from the Federal Reserve) shows that the banks are “capital impaired” and borrowing at a rate unprecedented in history.

The second graph (Non borrowed reserves from of Depository Institutions) shows that the capital that the banks do have is quickly being depleted.

The third graph (Net Free or borrowed reserves of Depository Institutions) is best summed up by econo-blogger Mike Shedlock who says: “Banks in aggregate have now burnt through all of their capital and are forced to borrow reserves from the Fed in order to keep lending. Total reserves for two weeks ending January 16 are $39.98 billion. Inquiring minds are no doubt wondering where $40 billion came from. The answer is the Fed’s Term Auction Facility.” (Mish’s Global Economic Trend Analysis) So the only reserves they have is capital they borrowed from the Fed.

The forth Fed graph illustrates the steep trajectory of the ever-expanding money supply. (Monetary base)

A careful review of these graphs should convince even the most hardened skeptic that the banking system is basically underwater and insolvent. We are entering uncharted waters. The sudden and shocking depletion of bank reserves is due to the huge losses inflicted by the meltdown in subprime loans and other similar structured investments.

How Capital is Destroyed

“When US homeowners default on their mortgages en mass [sic], they destroy money faster than the Fed can replace it through normal channels. The result is a liquidity crisis which deflates asset prices and reduces monetized wealth,” says economist Henry Liu.

The debt-securitization process is in a state of collapse. The market for structured investment — MBSs, CDOs, and Commercial Paper — has evaporated leaving the banks with astronomical losses. They are incapable of rolling over their their short-term debt or finding new revenue streams to buoy them through the hard times ahead. As the foreclosure avalanche intensifies, bank collateral continues to be down-graded which is likely to trigger a wave of bank failures.

Henry Liu sums it up like this: “Proposed government plans to bail out distressed home owners can slow down the destruction of money, but it would shift the destruction of money as expressed by falling home prices to the destruction of wealth through inflation masking falling home value.” (“The Road to Hyperinflation,” Henry Liu, Asia Times) It’s a vicious cycle. The Fed is caught between the dual millstones of hyperinflation and mass defaults. There’s no way out.

The pace at which money is currently being destroyed will greatly accelerate as trillions of dollars in derivatives are consumed in the flames of a falling market. As GDP shrinks from diminishing liquidity, the Fed will have to create more credit and the government will have to provide more fiscal stimulus. But in a deflationary environment; public attitudes towards spending quickly change and the pool of worthy loan applicants dries up. Even at 0% interest rates, Bernanke will be stymied by the unwillingness of under-capitalized banks to lend or over-extended consumers to borrow. He’ll be frustrated in his effort to restart the sluggish consumer economy or stop the downward spiral. In fact, the slowdown has already begun and the trend is probably irreversible.

The financial markets are deteriorating at a faster pace than anyone could have imagined. Mega-billion dollar private equity deals have either been shelved or are unable to refinance. Asset-backed Commercial Paper (short-term notes backed by sketchy mortgage-backed collateral) has shrunk by $400 billion (one-third) since August. Also, the market for corporate bonds has fallen off a cliff in a matter of months. According to the Wall Street Journal, a paltry $850 million in high-yield debt has been issued for January, while in January 2007 that figure was $8.5 billion — ten times bigger. That’s a hefty loss of revenue for the banks. How will they make it up?

Judging by the Fed’s graphs, they won’t!

Bernanke’s rate cuts sent stocks climbing on Wall Street, yesterday, but by early afternoon the rally fizzled on news that Financial Guaranty, one of the nation’s biggest bond insurers, would be downgraded. The Dow lost 37 points by the closing bell.

The plight of other major bond insurers, MBIA and Ambac, could be known as early as today, but it is reasonable to expect that they will lose their Triple A rating. According to Bloomberg:

“MBIA Inc, the world’s largest bond insurer, posted its biggest-ever quarterly loss and said it is considering new ways to raise capital after a slump in the value of subprime-mortgage securities the company guarantee.” The insurer lost $2.3 billion in the fourth-quarter. Its downgrading from AAA will “cripple its business and throw ratings on $652 billion of debt into doubt.” Many of the investment banks have assets that will get a haircut.

The New York State Insurance Department tried to work out a bailout plan but the banks could not agree on the terms (Editor’s note: “They don’t have the money”)

“Bond insurers guarantee $2.4 trillion of debt combined and are sitting on losses of as much as $41 billion, according to JPMorgan Chase & Co. analysts. Their downgrades could force banks to write down $70 billion, Oppenheimer & Co. analyst Meredith Whitney said yesterday in a report.” (Bloomberg)

The bond insurers were working the same scam as the investment banks. They found a loophole in the law that allowed them to deal in the risky world of derivatives, and they dove in headfirst. They set up shell companies called “transformers” (the same way the investment banks established SIVs; structured Investment Vehicles), which they used as “off balance” sheets operations where they sold “credit default swaps, which are derivative instruments where one party, for a fee, assumes the risk that a bond or loan will go bad.” (“The Bond Transformers,” Wall Street Journal) The bond insurers have written about $100 billion of these swaps in the last few years. Now they’re all blowing up at once.

Credit default swaps (CDS) have turned out to be a gold mine for the bond insurers and they’ve given a boost to the banks too, by freeing up capital to use in other ventures. “The banks profited on the interest rate difference between the CDOs (collateralized debt obligations) they bought and the payments they made to transformers … The banks sometimes booked profits UPFRONT on the streams of income they expected to receive.” (WSJ)

Neat trick, eh? Who wouldn’t want to enjoy the profit from a job before they’ve done a lick of work?

Even now that the whole swindle is beginning to unravel — and tens of billions of dollars are headed for the shredder — industry spokesmen still praise credit default swaps as “financial innovation.” Go figure?

Politicians Still Getting Their Marching Orders From Wall Street

The leaders of Europe’s four largest economies (England, France, Germany, Italy) held a meeting this week where they discussed better ways to monitor the world’s markets and banks. They did not, however, push to create a new regime of oversight, regulation and punitive action that would be directed at financial fraudsters and their structured Ponzi-scams. Politicians love to talk about “greater transparency” and “watchdog agencies.” but they have no stomach for establishing the hard-fast rules and independent policing organizations that are required to keep the carpetbaggers and financial hucksters from duping gullible investors out of their life savings. That is simply beyond their “pay-grade”. And that is why even now — when the world is facing the most serious financial crisis since the Great Depression, corporate toadies like British Prime Minister Gordon Brown merely reiterate the script prepared for them by their boardroom paymasters:

“If these agencies don’t reform themselves, the Europeans would turn to regulatory response to enforce change.”

Right-o, Gordon. Right-o.

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. Mark Wilson said on February 2nd, 2008 at 1:01pm #

    I think these doom and gloom scenario’s are fraught with emotional reflexes. Everything you say Mr. Whitney is true no doubt. You unfortunatly exclude the exuberance of capitalism, which has undoubedly led to this mess. This exuberance will ultimately lead us out of it. No doubt, many will suffer in the interim but to shallowly say we are doomed is certainly no better than the Bushies saying everything is fine.
    Your reads are great but personally I would expect better from someone that is as well read as yourself. You have been dooming and glooming us for nearly a decade. Eventually, all systems fail; you have not predicted anything outside of the obvious and your to be frank your timing is time and time again off imprecise.
    So stop with the negativity, and look fwd to the day when answers are found. If the powers that be scrap the dollar open the borders and go with the “Amero” so be it. You will wake up, I will wake up and the sun will shine.
    My only advice to the masses/readers is use any reserve’s you may have to pay off your house in case the worse case conspiracies are correct!

  2. John Wilkinson said on February 2nd, 2008 at 3:39pm #

    I would effing hang all these immoral bastards, and their enablers, too. There would be massive hangings, all over the world. Thousands of gallows would be set up in every major city. And their stinking bodies would be left to twist in the wind, for months, to be picked over by vultures like themselves.

  3. Mulga Mumblebrain said on February 2nd, 2008 at 3:54pm #

    The most telling lines are in the last couple of paragraphs. As is made plain whenever these ‘crises’ hit, although there is about this particular conflagration, coming on top of Peak Oil, Climate Change and the rise of China and decline of Amerikkka, a real sulphurous stench of ‘end times’, our real rulers are not the politicians. Those glib, plausible (at least at the beginning)hucksters, are, as observed, simply employees of the real rulers. Of course in these circumstances John Jay’s infamous aphorism ‘ Those people who own the country, are going to run the country’, whether apocryphal or not, comes straight to mind. ‘Democracy without choices’ is the system, as choices concerning economic policy would call into question the rule of our shadow masters. Here in Australia we are witnessing a particularly instructive episode in our increasingly unidimensional political life.
    The voters here finally ejected the Howard government, by far the worst regime in our history. We have plumbed depths of mendacity, hypocrisy, racism and hatemongering as Government policy over these eleven years that would have been unimaginable in any other era. No matter how useless, all our previous Federal Governments have been led by men with some moral scruples. Howard, in my opinion, an obvious victim of intense self-loathing projected on various hate-figures (pardon the amateur psychology), was urged on all the while by a powerful propaganda apparatus, centred on Murdoch’s News Ltd, and its national broadsheet The Fundament, or The Australian in their nomenclature. One knows this type of rag, because it is ubiquitous throughout the world these days. Extreme Rightwing, censorious of opposing opinions, its commentary and editorials fevered in their language, the diatribes replete with ad hominem attacks, open racism, mendacity and hypocrisy of particular audacity, and endless smug self-satisfaction at their self-proclaimed intellectual superiority.
    With Howard gone, there was much anticipation of a ‘New Dawn’. Alas, and it’s only a couple of months, these illusions are being dashed by the day. The ‘Labor’ Government has changed almost nothing. There have been some purely symbolic gestures, like signing Kyoto and promising to say ‘sorry’ to the indigenous for 200 years of murder and dispossession. However, in the world of real activity, the action is all in the other direction, precisely the same policies as under Howard. Labor’s appointed climate change ‘guru’, Garnaut, a long-time, hard-core neo-liberal Market Fundamentalist, has delighted the Right and the Climate Change Denialists, and surprised only those who were asleep during his public career, by announcing that action to reduce emissions must be put off until ‘The Market’ is ready to weave its ‘magic’. As this is precisely the most dangerous course imaginable, and the one rejected by climatologists, but pushed by the Right, its a very big straw in the wind. Moreover Labor has refused to countenance the payment of compensation to Aborigines stolen from their families, a real cause celebre for the racist Right, who delight in inflicting more suffering on people whose lives and families were destroyed, by speaking of them as ‘rescued’ from their supposedly vile and abusive parents.
    The delightful irony is that this Blairite regime of the far Right, clearly the most Rightwing ‘Labor’ regime in our history, continuing the inexorable march to the Right of our polity, pushed by media agit-prop, will be destroyed by the economic processes outlined by Mr Whitney. I believe Australians were considered very easy patsies for selling off the toxic sludge of Wall Street bankers. We continue to enjoy economic growth amongst rising debt levels completely unparalleled in our history. Labor is already speaking of spending cuts, aimed at the poor, of course, demanding wage restraint, but none from business or the parasite class, and mouthing the familiar Market Fundamentalist nostrums as if they were divine revelation. Howard sowed the wind, and our very own Blairite regime is to reap the whirlwind. As for we plebs, well we will be required, as ever, to shut up, consume and die, and never, ever disturb the quiet self-satisfaction of our Masters.

  4. Don Hawkins said on February 2nd, 2008 at 4:28pm #

    The Shadow on American Democracy
    I just did an interview with CNN (Miles O’Brien) re “censoring science”. The point I
    emphasized is that overreaching by the Executive Branch, trying to make government science
    submit to political command and control, is a threat to our democracy, and, as a result, a threat to
    the planet. The scary part about this story is that seeds have been sown, and a playbook has been
    codified (although not written!), that will make the situation much worse unless the American
    public recognizes the problem and makes an issue of it. This is a bi-partisan problem – and
    neither party is trying to fix it. It is remarkable how wimpish Congress has become in accepting
    subjugation to the Executive Branch, contrary to designs and intents of our Founding Fathers.
    Congressional testimony. Do you know that before a government scientist testifies to Congress
    his/her testimony is typically reviewed and edited by the White House Office of Management
    and Budget? When I asked for a justification, I was told that a government scientist’s testimony
    “needs to be consistent with the President’s budget”.
    Huh? There have never been any budget numbers in my testimony or in the testimony of
    most scientists. And OMB’s editing of the scientific content is invariably designed to make the
    testimony fit better with the position of the political party in power (yes, it is a bi-partisan
    problem). Where is it stated or implied in the Constitution that the Executive Branch should
    have such authority? (Actually, does the Constitution not vest control of the purse strings to
    Congress?) Why does not Congress get incensed about this and fight back?
    Offices of Propaganda. The Public Affairs Offices (PAOs) of science agencies have become
    mouthpieces for the Administration in power. This, too, is a bi-partisan problem. Top people in
    the Headquarters Offices of Public Affairs can and often are thrown out in a heart-beat when an
    election changes the party in control of the Executive Branch.
    The Executive Branch has learned that the PAOs can be effective political instruments
    and, with some success, they are attempting to turn them into Offices of Propaganda, masters of
    double-speak (“clean coal”, “clear skies”, “healthy forests”…) that would make Orwell envious.
    Again it is a bi-partisan problem, the control of PAOs being exercised by top political appointees
    who are replaced rapidly with a change of administration. It is these political appointees that are
    the problem – the career civil servants at the NASA Centers, e.g., are professionals of high
    integrity, as are most people at Headquarters.
    One may wonder: why doesn’t the media object to this situation? I believe that I learned
    the reason: it is encapsulated in the phrase “that’s hearsay!”. I heard that phrase over and over
    again in 2004 after I stated publicly that NASA press releases were being spirited from NASA
    HQ to the White House for either editing or deep-sixing, when they concerned “sensitive” topics
    such as global warming. Even NPR did not seem to want to touch that story unless there were
    multiple pieces of proof on paper.
    The phrase “that’s hearsay” seems to make the media folks quake in their boots,
    doubtless because of the threat of a lawsuit. That probably explains why the New York Times
    stories about censorship of scientists at NASA that came out in early 2006 became a story about
    a low-level 24-year-old, who then “resigned”. Reporters, New York Times included, knew that
    the problem went much higher, but instead of focusing on the threat to democracy, it became
    too-much an amusing story about a renegade trying to reverse scientific understanding of the
    “big bang”, etc.
    The actual story is made crystal clear in the new book “Censoring Science” by Mark
    Bowen (author of “On Thin Ice”, a gripping, albeit long, story about Lonnie Thompson’s quest
    for ice cores from alpine glaciers). Bowen gets insiders at HQ and elsewhere to provide
    extensive information, most of it “on the record”, about how PAO works to cover its tracks
    (“Gretchen, don’t e-mail me on this!” There are some heroines in this story, middle level people
    who refused to comply with orders from political appointees that they recognized as being
    inappropriate.) By the way, I gave Bowen some long interviews and documentation (and my
    mug is on the book jacket), but I have no financial interest in the book.
    The scary part of this story is that PAO political appointees are learning how to cover
    their tracks. The picture that Bowen presents is one in which PAO political appointees can
    communicate directly with the White House. One has to wonder, if the Administrator objected
    to the PAO political appointee activities, how long would it be before he was on the soup line?
    As the tracks are covered better and better, it is as if we have a shadow government organization
    controlling information that the public receives. James Hansen

    That was James Hansen talking about the insanity he and many more have had to contend with from this administration. It is as if we have a shadow government organization controlling information that the public receives, yes you could certainly say that. What Mike just wrote about how the banks are “capital impaired” because of many different reasons the main one being greed. Well what Hansen just said about the government the same thing is true about the financial system. It’s a shadow organization controlling information that the public receives. Also remember one more thing the reason this administration wants to keep the public in the dark about climate change is it will cost the financial system a lot of money so as we all know much better to just do nothing and destroy the Planet we live on. It is to the point where we need to slow down the economy’s worldwide until we can make the big change over. Bill Clinton the other day said that very thing and a few people on Wall Street called him crazy. Now let’s be nice here the shakers and movers Worldwide. Fat Cats on Wall Street and policy makers and Bankers and the titans of industry need to just go sit in a nice quiet coffee shop and do some thinking. A little figuring using reason instead of instinct. The choices are getting fewer so courage people change is on the way for better or worst our choice.

  5. Gary Welz said on February 2nd, 2008 at 9:15pm #

    The Fed changed the definition of Net Free or Borrowed Reserves yesterday, February 1, 2008. Why? Probably because seeing it fall off a cliff the way it does on the third graph among the ones that Whitney refers to on The Financial Ninja, was just too disturbing.

    Notice the change in the definition of the data on

    The bottom now says:
    “Observation Range: 1959-01-01 to 2007-12-01
    Last Updated: 2008-02-01
    Notes: Prior to 2003-01-01, the data are calculated as excess reserves minus total borrowings plus extended borrowings. From 2003-01-01 till 2007-11-01, the observations reflect excess reserves minus total borrowings plus secondary borrowings. From 2007-12-01, the definition changes to excess reserves minus discount window borrowings plus secondary borrowings. ”

    It looks like they took the Term Auction Facility borrowing out of the data calculation. Makes a big difference to the picture, but not the reality.

  6. siamdave said on February 3rd, 2008 at 5:59am #

    This really is the worst sort of voodoo economics, and it’s all run by witch doctors trying to keep the peasants in line. You need to get to some real basic basics before trying to find your way through the great gordion knot of spell upon spell upon spell, of which the above is part. You could start here, and get your feet on some solid ground to begin with – They’re Building a Box – and You’re In It –

  7. Tom Joad said on February 3rd, 2008 at 3:02pm #

    And those of us who are REAL conservatives are getting scewed. My nestegg is in fixed intrest paying FDIC insured accounts, and therefore my return is shinking with each of these cuts.

  8. Ben Bittrolff said on February 4th, 2008 at 7:04am #

    I’ve updated my post and charts: Fed CHANGES Really Scary Fed Charts

    Removing TAF makes a significant difference.

    $50 billion to be exact.

    TAF operations are ongoing. So this discrepancy would just continue to grow.

    LIBOR is also starting to misbehave, again. Nothing too serious yet (not like before Christmas) but you get my drift. Stress is creepying back into the system.

    The (counter trend) rally in risky assets should just about be over, if I’ve interpreted this correctly.


  9. John said on February 5th, 2008 at 11:37am #

    The Federal Reserve system is a reverse money pyramid scam designed to transfer wealth to the top. This system is designed to fail but not before the top 1% cash out.

    It’s been done over and over again in history there is no big mystery or conspiracy.