The Tumbrels Roll at Dawn

Bank of America is buying Merrill Lynch for $45 billion, AIG needs an emergency $40 billion bail-out from Uncle Sam to stay afloat, and Lehman Bros is kaput. Whew! The financial world has been turned upside-down overnight. It’ll be a rough day of trading ahead.”

The news of Wall Street’s Sunday night massacre sent foreign stock markets into a deep swoon. Shares tumbled in Asia and dropped more than four percent in Europe. The dollar is steadily losing ground to the euro and gold is on the rise. The question is not whether the Dow will fall, but “how far” and what affect that will have on increasingly fragile financial institutions.

Lehman Brothers, the 158 year old Wall Street warhorse, announced Sunday that it will file for bankruptcy after weekend rescue plans broke down without finding a buyer. Fears of credit contagion and a global recession have resurfaced and become more widespread. Lehman’s failure suggests that that the other Wall Street giants will soon be following the same path to extinction. Economist Nouriel Roubini put it like this:

All of the independent broker dealers are going to disappear. In March it was Bear Stearns. Tonight it was Lehman and Merrill Lynch. Morgan Stanley and Goldman Sachs should go find a buyer tomorrow. The business model of broker dealers is fundamentally flawed. They cannot survive.

Roubini may be right. The funny thing about capitalism is that you need capital to play. When the bank-vault is full of nothing but worthless mortgage-backed securities (MBS) and overvalued junk bonds; the whole thing goes belly-up fast. That appears to be the case with Lehman Bros, which has joined the long procession of underwater banking establishments now hurtling towards the cliff. Lehman had a great go of it during the boom times when all it took to make oodles of money was a predictable flood of low interest credit from the Fed and a compliant ratings agency that would stamp every crappy securitized pool of mortgages with a big Triple A before hawking it to some gullible investor in Shanghai or Heidelberg.

Lehman’s travails are not much different from anyone else in the banking fraternity. The problem is that the entire system is under-capitalized and over-leveraged. When Bear Stearns went down earlier this year, it was levered at a ratio of 26 to 1. When Hedgie Carlyle Capital blew up, it was levered at 32 to 1. And when Fannie and Freddie were finally taken over by the US Treasury, the two behemoths were levered at 80 to 1, which is to say that they had a one dollar capital cushion for every $80 they had loaned out. They would have continued on the same erratic path — buying up toxic mortgages and MBS from people who had no chance of ever repaying their loans — had they not been taken into federal “conservatorship”, which is a fancy way of saying they were insolvent. Treasury Secretary Henry Paulson unwisely attached a six inch-wide money hose from the bowels of the Treasury to Fannie’s front office so the two mortgage giants could continue to teeter-along at taxpayer expense regardless of the fact that the securitization business model has completely broken down and foreign investors — including China — have already started cutting back on their purchases of GSE debt. This is no laughing matter. The $700 billion US current account deficit is financed through foreign investors who are getting increasingly jittery about sinking money into a system that looks more like casino poker all the time. Here’s a clip from China Daily on Friday:

China, which holds a fifth of its currency reserves in Fannie Mae and Freddie Mac debt, may cut the portion held in US dollars, according to China International Capital Corp (CICC), one of the nation’s biggest investment banks.

The crisis has made Chinese officials realize it’s a bad idea to put all their eggs in one basket,’wrote CICC Chief Economist Ha Jiming. ‘This will likely lead to greater diversification of foreign exchange reserve investments.’ China held $447.5 billion of US agency bonds as of June 2008, according to the CICC calculations using disclosures by the US Treasury. It is likely to reduce the portion of reserves in dollar assets from the current 60 percent by purchasing more non-dollar assets with new reserves, he said.

Naturally, foreign investors and central banks will curtail their purchases of US securities and treasuries until there’s some indication that US markets have stabilized and will be able to withstand the ferocious headwinds of the biggest housing crash in history, a frozen corporate bond market, a paralyzed banking system, and steadily waning consumer demand. But Americans still seem breezily unaware of what all this means for the country’s future. They’d rather savor every new bit of gossip about the Bible-beating, Grizzly-hunting Alaska governor who wants to lead the country back to Frontierland lips rather than learn about the about the firestorm raging through the financial markets.

When the net foreign purchases of US financial assets begin to slow, the game is over. The Fed will be forced to raise interest rates to attract foreign capital, which will put downward pressure on the economy and accelerate the housing crash. Paulson’s decision to provide unlimited capital to Fannie and Freddie will stack more and more debt atop the faltering dollar and US Treasuries. It is the equivalent of latching the greenback to an anvil and tossing it overboard. Paulson’s attempts to stave off a systemic banking crisis ensure that the federal government will undergo an unprecedented funding crisis sometime in the near future. There will be higher taxes for the battered middle class and higher interest rates for businesses and consumers. This will trigger a protracted economic slowdown and weaker growth. Credit will get tighter, banks will default, unemployment will soar and GDP will shrivel. A negative feedback loop will develop from the faltering financial system to the real economy: a vicious circle ending in massive layoffs, weakening demand, falling stock prices, and withering consumer confidence.

Welcome to Soup kitchen USA.

Presently, Paulson and New York Fed chief Timothy Geithner are pressing Wall Street banking elites to pony-up enough money to buy up Lehman’s devalued real estate assets. The Fed’s proposal is similar to Greenspan’s rescue of Long-Term Management LP (LTCM) which roiled financial markets in the late 1990s. Paulson has signaled that there be NO government bailout like Bear Stearns when the Fed bought up $29 billion in mortgage-related assets. The Fed is tapped out, having already committed half of its balance sheet — nearly $500 billion — in repos through its “auction facilities” which have recently skyrocketed to record highs of $19 billion per week for the last three weeks. The crisis is deepening by the day. Similarly, the Treasury has hitched its wagon to Fannie and Freddie which expands the National Debt by another $5.2 trillion and seriously undermines the “full faith and credit” of the US in the process. Keep in mind, the biggest source of American power is its access to cheap capital via the US taxpayer. Paulson has now put that source of revenue at risk by nationalizing the housing industry and burdening the taxpayer with (potentially) astronomical future obligations, even though he knows full-well that the market could drop another 15 to 20 per cent before the end of 2010. Paulson’s recklessness has doomed the country to years of struggle.

As of Sunday afternoon, no deal had been struck to buy Lehman Bros. and it looked like the bank was headed for bankruptcy. Wall Street prepared for the worst. Nouriel Roubini gave a particularly grim assessment of a Lehman default in his latest post on his blogsite Global EconoMonitor:

It is now clear that we are again — as we were in mid- March at the time of the Bear Stearns collapse — an epsilon away from a generalized run on most of the shadow banking system, especially the other major independent broker dealers (Lehman, Merrill Lynch, Morgan Stanley, Goldman Sachs). If Lehman does not find a buyer over the weekend and the counterparties of Lehman withdraw their credit lines on Monday, you will have not only a collapse of Lehman but also the beginning of a run on the other independent broker dealers…Then this run would lead to a massive systemic meltdown of the financial system. That is the reason why the Fed has convened in emergency meetings the heads of all major Wall Street firms on Friday and again today to convince them not to pull the plug on Lehman and maintain their exposure to this distressed broker dealer.

The giant investment banks are inescapably trapped in a net of complex, unregulated, over-the-counter derivatives contracts which — given the right conditions — could threaten every financial skyscraper in lower Manhattan.

A sizable portion of Lehman’s $128 billion in long-term debt will probably be ring-fenced in a “bad bank” which will hold its toxic mortgage-backed assets and be financed by either the Treasury or the other Wall Street banks. The good assets can then be separated and sold off to either Bank of America or Barclays, the two prospective buyers. That way, according to Forbes, “the bad bank would be kept afloat while its assets could be unwound over a period of time in a way that wouldn’t disrupt the financial system more than it already has been.”

Some variation of the “Forbes solution” will probably be enacted, but, let’s be clear — this is really no solution at all. It’s just a way of buying time by rolling-over debt to avoid the ugly consequences of accounting for the massive losses. In other words, it is cheaper to keep burning up capital to prop up moribund assets than take the loss and make a genuine effort to restructure the dysfunctional system. Here’s how former Fed chief Paul Volcker summed it up just two weeks ago:

This bright new system, this practice in the United States, this practice in the United Kingdom and elsewhere, has broken down. Growth in the economy in this decade will be the slowest of any decade since the Great Depression, right in the middle of all this financial innovation. The current financial system is dysfunctional. That is a polite way of saying it failed.

Securitization has failed. The cuts to the Fed’s Funds rate have failed. The auction facilities — TAF, PDCF, and TSLF — have all failed. The off-balance sheets operations, the debt-pyramiding asset-inflation, the Enron-style accounting, the SIVs, the CP, MBS, CDOs, have failed. The subprimes, the piggybacks, the option-ARMs, the Alt-As have all failed. Structured finance has failed. The system doesn’t work, won’t work, can’t work. It’s built on the misguided assumption that capitalism can thrive without capital; that one dollar can be infinitely magnified by complex debt-instruments and mega-leveraging to generate real wealth and keep the wheels of finance and industry humming along. It can’t be done. The system is under-water. Economist and author Henry Liu put it like this:

Yet this approach is preferred by those in authority, trapped in self deception about unregulated market capitalism being still fundamentally sound. They try to calm markets by asserting that the current turmoil is merely a minor liquidity bottleneck that can be handled by the central bank releasing more liquidity against the full face value of collateral of declining worth. [There are] no signs of any coherent grand strategy or plan to save the cancerous system from structural self-destruction.

Instead, the marauding of a handful of Wall Street “innovators” — drunk with hubris and blinded by their own bizarre sense of entitlement — have thrust the financial markets to the brink of catastrophe and pushed the broader “real” economy towards a painful retrenchment. Now everyone will pay for the greed of the few.

So, what’s next?

An article in the Financial Times spells it out, but government officials will undoubtedly deny it until after the November presidential election.

The debate over whether an RTC-style (Resolution Trust Corporation) vehicle is needed — perhaps just to ring-fence troubled mortgage assets — also gained traction among central bankers at the Jackson Hole symposium hosted by the Federal Reserve Bank of Kansas City in August. . . .

The problem that an RTC vehicle could help to solve is that there are very few buyers for troubled mortgage assets, and few investors now willing to inject fresh capital into the tattered balance sheets of the banks left holding them. As a result, banks such as Lehman and Washington Mutual have struggled to sell their soured mortgage portfolios, and to broker deals for fresh capital. The takeover of Fannie and Freddie, which virtually wiped out preferred equity holders, has also made banks’ access to the preferred capital market increasingly difficult. Through a new RTC, the government could provide financial support if needed in return for a share in potential profits once the assets were liquidated.

What the Feds are refusing to admit, is that there is already a plan in place to make the government an active, “shareholding” partner in failing commercial banks. (There’s no way the FDIC could pay for all the projected losses anyway) That will give the US Treasury the authority to provide insolvent banks with enough capital to muddle through while their impaired assets are liquidated via the RTC: a morgue for distressed mortgage-backed garbage.

How this will affect the already-anemic dollar is anyone’s guess. But it won’t be pretty.

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

5 comments on this article so far ...

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  1. Jim Cronin said on September 18th, 2008 at 9:09am #

    My money market account was just frozen, due to losses incurred through the Lehman Brothers bankruptcy. The account rep phoned and told me the loss would be about two percent. In the meantime, the money is unavailable while they liquidate the assets in the money market, which will take about a week while they search (desperately?) for another money market in which to put the funds. Between June of 2007 and today, I’ve lost about a year’s income. I am luckier than some. So far.

  2. Donald Hawkins said on September 18th, 2008 at 12:55pm #

    The Arctic sea ice cover appears to have reached its minimum extent for the year, the second-lowest extent recorded since the dawn of the satellite era. While above the record minimum set on September 16, 2007, this year further reinforces the strong negative trend in summertime ice extent observed over the past thirty years. With the minimum behind us, we will continue to analyze ice conditions as we head into the crucial period of the ice growth season during the months to come. NSIDC

    Has anybody noticed all these records not just with the Earth but humans and what they do. The markets is a big one and how about the speed rate that these records seem to come up and then with record speed the way humans try and fix these records. The speed at which we are moving to our own destruction is moving forward faster, faster. The answer of course is to slowdown that seems to be an idea that is so out of the question it is never talked about. It’s like you hear maybe this company will be bailed out then ten minutes later it is. Fast, faster, fastest and these fixes do they do any good yes for about ten minutes. Hard choices to try and fix the problems no fast now the short term. Strange isn’t it.

  3. Gliscameria said on September 18th, 2008 at 4:09pm #

    These people act like the money vanished. A few very greedy people have it. Granted they lent out 100x what they actually have… but there are tens of trillions of dollars in the hands of these greedy swine. If anyone was interested in getting anything done they would get some laws together to get this money back into the system.

    The president can declare martial law and strip us of everything we have if it’s deemed to be for the greater good… why can’t they hold .005% of the country accoutable for their greed and deceit?

  4. Edwin Pell said on September 18th, 2008 at 4:38pm #

    From an email from Bernie Sanders Senator from Vermont. He says we peasants do not have to bailout the rich! What a concept. I hope he is wearing Kevlar.

    “An Economy in Crisis

    Amid one of the worst financial crises in American history, Senator Bernie Sanders laid out a four-part plan to cope with the collapse of financial institutions and avoid future failures of businesses “too big to fail.” First, Sanders proposed a surtax on the very wealthy to pay for bailouts of Fannie Mae, Freddie Mac and American International Group. “The wealthiest 400 families in America saw an increase in their wealth of $670 billion since President Bush has been in office. They have seen extraordinary benefits under Bush’s reckless economic policies. The middle class, whose standard of living has declined, should not be paying for these bailouts. Rather, we need an emergency surtax on those at the very top in order to pay for any losses the federal government suffers as a result of necessary efforts to shore up the economy,” Sanders said. Second, he called for stronger oversight of financial institutions and an end to President Bush’s deregulation policies. Third, huge businesses like Bank of America, which is swallowing up other large corporations, should be broken up so no company in the future could bring the American economy down with it. Said Sanders, “This country can no longer afford companies that are ‘too big to fail.’ Fourth, he called for an immediate economic stimulus package which would put people back to work rebuilding our crumbling infrastructure, and moving us to energy efficiency and sustainable energy.”

  5. Donald Hawkins said on September 18th, 2008 at 5:40pm #

    I listened to the Presidents speech and I don’t know about you but I feel much better. The man’s imagination is nothing short of incredible. Here is the speech many would like to hear.

    My fellow Americans I had a dream last night and the song Blowin’ in the wind just kept playing over and over again. This morning as I awoke I knew what to do. I have directed Congress the fed and the Treasure that we are going to nationalize the oil industry in the United States. We are also going to nationalize the auto makers as they are on there last legs anyway. The power companies in the United States will also be nationalized. People we are going to repower America and do it in less than ten years. These changes will be under one agency and some of the smartest minds we have will run this project the largest project ever done. I have asked James Hansen to help find the people we need and fast. The money at first from the companies that have been nationalized of course will go to funding these projects and any money needed for research will be there. That’s team A in the United States and there will be team B that will help China and India do the same thing. As of today there will be no more tress cut down in the United States and another team team C will begin to change the way we farm in the United States. The makers of big machinery used in farming and bigger projects have been given the chance to change over to natural gas. If you live in a city you will drive an electric car. Some trucks will be natural gas. If you live in the country some trucks and cars will be converted to natural gas. The way electricity is produced will be from solar using the Southwest and low loss power lines. Wind will be a big part of this project and geothermal. Research into new power sources will be given what they need. It’s the people’s money so after completion of most of this any profits will be returned to the people all the people and incentives for conservation will be build in. I know that’s a lot to take in and will not be easy at first and can we do this? Yes we can and let me finish as I have much work to do let’s all “put a little love in are heart” Thank you thank you very much.