Sunday, December 23, 2007

Dirty Laundry

Since the 1600s, there have been five occasions when major worldwide financial crises have occurred, and they all used securitization of credit:

The 1637 Tulip-mania bubble was based on a market in tulip futures, securitized with personal credit notes.

The 1721 South Sea Bubble was securitized by shares of the South Sea company, a company operating in South America.

The 1789-1795 bankruptcy of the French monarchy was securitized by "assignats," bills of credit based on lands confiscated from the clergy.

The Panic of 1857 was securitized by railway shares.

The 1929 Wall Street crash was securitized by stock shares, and by bonds from well over 100 foreign countries. This is described in "The bubble that broke the world."

Today of course we're securitizing credit by turning subprime mortgages and other questionable credit into credit derivatives and CDOs.

We're now overdue for the next generational crash. It could happen tomorrow, next week, next month or next year, but it's coming soon.

Will we see a stagflation, a recession or a depression?

It will be an era of severe depression, worse than the 1930s, with massive unemployment, bankruptcies, homelessness and starvation.

Can something like "circuit breakers" prevent a panic?

"Circuit breakers" are used by the stock markets to try to control a panic. If the market loses, say 15% in one day, then the market closes for a few hours, to let people catch their breath.

Unfortunately, circuit breakers are useless.

A generational crash is an elemental force of nature, like a tsunami.

There will be millions or even tens of millions of Boomers and Gen-Xers in countries around the world, never having seen anything like this before, and not having believed it was even possible, suddenly in a state of total mass panic, trying to sell all at once.

Computer systems will crash or will be clogged for hours, or perhaps even for a day or two. People who had hoped to get out just as the collapse is occurring will be totally screwed, and will lose everything. Brokers and other institutions will go bankrupt. People who went short hoping to make a fortune will find that their brokers' escrow accounts are gone, and they'll be totally screwed, and will lose everything.

Being in the market today, either short or long, is a very high risk proposition.

What's a credit crunch, and what's going on?

The easiest way to understand it is this.. The world's money is disappearing. Everday there's less money in the world than the day before. Since there is less available, it's harder to get money, unless you're willing to pay high interest rates to get it. Hence, there is a "credit crunch."

One result is that banks are hoarding money, and are increasingly reluctant to lend money to one another or to other businesses. This means that even legitimate, credit-worthy individuals and companies are having a hard time getting credit, getting mortgages, or getting loans without having to pay extremely high interest rates.

How could there possibly be less money in the world?

It's not that people are eating dollar bills for lunch.

In fact, paper money is pretty irrelevant these days. Very little money is created by means of printing presses today. Money is created by means of credit. When a central bank (like the Fed or the Bank of England) wants to create more money, it doesn't run the printing presses, but simply lowers the short-term inter-bank lending rate, so that there'll be more credit, hence more money.

Unfortunately, financial institutions found that they can use a technique called "leveraging" to create money from credit, essentially going around the powers of the central bank. They create a new security and tell you that it's worth $10, but they'll let you buy it for $1 and loan you the other $9. So $10 that didn't exist before now does, a magical 'printing press' re-invented.

These securities are called "credit derivatives", and among them are CDSs (credit default swaps) and CDOs (collateralized debt obligations).

The credit bubble has created $750 Trillion in notional value credit derivatives. Are those credit derivatives the same as money? Not exactly. You can't go into the grocery store and pay for your groceries with a credit derivative.

But you CAN use those credit derivatives in your portfolio as collateral for a loan, and then you can use THAT money to buy groceries. So in fact the credit derivatives do create money.

That's what's been happening up until July of this year. But suddenly people are discovering that the security that was supposedly worth $10 is really worth only $5 or $2 or even $1, and sometimes they're totally worthless. So the process of creating money is now going in reverse. Instead of money being created through credit, today money is being destroyed through the unwinding of the credit bubble.

How much money has been destroyed since July?

A huge amount already. Let's start with an example.

Things really started moving in mid-July, when Bear Stearns announced that its hedge funds were practically worthless. That's because the hedge funds were these CDOs that had been magically created, and were supposedly worth several billion dollars. Well, they discovered that nobody wanted to buy them, and if nobody buys them, then they have no market value when they're "marked to market."

Since then a number of financial institutions have "gone to the confessional" explaining they too have lost a great deal of money in write-downs because their portfolios contained worthless CDOs. These are major financial institutions like Citigroup, Merrill Lynch, Morgan Stanley, Goldman Sachs and JPMorgan Chase.

Citibank tried to save itself by means of a fraudulent scheme known as a "Master-Liquidity Enhancement Conduit (M-LEC)." Under the scheme, Citibank and other banks would sell worthless CDOs to each other at inflated prices in order to establish a phony "market price" for the CDOs. Citibank's fraudulent M-LEC idea didn't take off, forcing the bank to take $16.4 Billion in write-offs of worthless CDOs. Citibank might have gone bankrupt except it was saved by an investment by the Abu Dhabi Investment Authority.

These big financial institutions are announcing more every day, and mainstream estimates vary as high as $500 Billion in write-downs.

So now that $500 billion is gone. That's money that existed a few months ago, but no longer exists, and that's how money gets destroyed.

And that's only the large institutions. We've hardly heard from the small institutions, but we're beginning to. State and local governments in Florida and Montana have to freeze their investment pools because the pools were found to have invested in near-worthless CDOs. And that's the tip of the iceberg. There are tens of millions more small and medium-sized institutions around the world that are going to have similar situations, forcing them to write-down these securities.

With $750 Trillion of notional credit derivatives in the world, it would not be surprising if the total write-down amounts to $7.5 Trillion (1%) or even $75 Trillion (10%).

Is that all?

Hardly. Because next you have the De-leveraging problem.

When a bank has $1 Million in assets available, it can loan out 5 or 10 times as much as that, or $5-10 Million. That's leveraging.

But if the $1 Million in assets suddenly disappears, then there's $5-10 Million that it can't loan out any more. That's De-leveraging.

The point of all this is that there's MUCH less money in the world today, and there's less and less everyday.

What do sub-prime mortgages have to do with all this?

For the most part, residential sub-prime mortgages were the original "seeds" for the credit explosion. Banks started requiring less and less from people wanting mortgages, and by the time it was over, anyone could get a mortgage for any amount, with no problems, even if they had no assets, no income, no job, and no hope of even making the mortgage payments.

These mortgage loans, like any other form of credit, created new money. That new money could then be leveraged into credit derivatives that were worth 5-10 times as much as the original mortgage loans. Those credit derivatives could then be leveraged further. This process would continue several times.

However, there were other "seeds" as well. Requirements for credit cards and other forms of credit were also relaxed, so that people could get credit that way as well. Delinquencies have been rising in credit cards, car loans, student loans, even business loans, just as they have in mortgage loans.

Why would banks make loans to people who couldn't pay them back?

Because the banks made money that way, lots of it. The loan officers made commissions from the loans. I'd be happy to lend you $1 Million of someone else's money if I got a $50,000 commission from it, and that's what happened. That's what happened with mortgage loans, with credit card loans, with car loans, with student loans, business loans, and so forth.

And then the financial geniuses got hold of the loan contracts and turned them magically into CDOs with phony notional prices. They sold those, and got even more in hefty commissions from selling them.

So basically along the way, Wall St bankers were loaning out other people's money, and taking fat commissions for themselves.

Isn't that illegal?

You're damn right it's illegal. And I can hardly wait to see some of these financial geniuses get put away.

I've been studying this stuff for awhile now, trying to figure out what's going on.

At first I thought that people were just being naïve or stupid.

But I've since come to the conclusion that the mess that we're in was done on purpose -- by contemptuous and nihilistic Gen-Xers taking advantage of air-head Boomers too dumb to work the numbers on their investment portfolios.

The point is that a lot of people have committed crimes, and they're going to well-deserved jail cells.

What's a "structured investment vehicle" (SIV)?

This is one of the gimmicks that the financial geniuses created. Their objectives were to collect huge commissions for themselves, while defrauding the general public with securities that they knew had to become almost worthless. The SIV is part of that.

When banks issue these CDOs, they aren't issued by the bank itself. Instead, the bank creates a new "virtual" bank called a "structured investment vehicle." All the "financial magic" is done within the SIV, so that if something goes wrong, the original bank had nothing to do with it. That's called "keeping structured securities off-balance sheet" of the original bank, a phrase you see often in the press.

However, the same people are involved in both the original bank and the SIV, and so they still PERSONALLY collect the same huge commissions, often in the millions of dollars.

To understand these, it helps to understand the structure of an SIV -

First an SIV has investors - like hedge funds, or wealthy individuals who invest say $1 Billion in the SIV. Then the SIV issues commercial paper (CP) and medium-term notes (MTN) that pay slightly higher rates than similar duration paper. The typical SIV according to Fitch, uses 14 times leverage, so in our example the SIV would sell CP and MTN for $14 Billion.

Now the SIV invests this $15 Billion ($1 Billion equity and $14 Billion borrowed) in longer term notes. The idea is simple: borrow short, lend long, hedge the interest rate and credit risks - and the profits flow to investors in the SIV.

What happens when the CP comes due and no one wants to buy any more? To cover the CP, the SIV might have to sell the longer term assets at a steep discount, and this would trigger a liquidation of the entire SIV. To prevent this "fire sale", the sponsoring banks stepped up and provided financing to cover the expiring CP.

And just so we know who we're talking about here: When it says "the SIV has investors like hedge funds or wealthy individuals" -- that's a little misleading. Because the investors also include ordinary people's pension funds and so forth. I don't think that the people of Florida would consider themselves "wealthy individuals," now that their investment pool contains SIV funds that must be written down.

The last paragraph above is the reason why banks have been forced to write-down SIV funds: no one wants to buy the commercial paper anymore, once the Bear Stearns hedge funds collapsed in July. And they've been desperately using every trick they could play to keep the fraud going by avoiding the "fire sale" as long as possible.

What part do rating agencies play?

The three ratings agencies -- Standard & Poor's, Moody's Investors Service and Fitch Ratings colluded with the banks to defraud the public, as Bloomberg news accused on June 30.

While the bankers were taking fat commissions for themselves, they were also making fat payments to the ratings agencies to provide AAA ratings on the CDOs in the SIVs. This was an essential part of the scheme.

Take, for example, the Florida investment pool we've been talking about. The people who ran that pool didn't know which securities were good and which were questionable. They just depended on the ratings from the rating agencies. And one of their internal rules is that the pool could invest ONLY in AAA securities.

So if the bank managers pay the ratings agencies to provide AAA ratings on the questionable securities in the SIVs, then Florida and anyone else could invest in them without even asking any questions. The bankers would get their fat commissions, the ratings agencies would get their fat fees, and the investors would be the only ones getting screwed.

And there is NO CHANCE WHATSOEVER that these agencies didn't know what they were doing.

Sure, maybe the first few deals really were OK. But as time went on, and the rules were bent more and more, there could have been NO DOUBT in the minds of these bankers and ratings agencies that they were defrauding the public.

After Bloomberg accused the ratings agencies of fraud on June 30, they knew they had to change. Since then, they've been re-rating many of the SIV securities, sometimes lowering their ratings as many as 10 or 20 levels lower than the original AAA rating. That's what happened to many of the securities that the Florida investment pool had invested in, and that's why they're currently facing a financial crisis.

Hey, who's minding the ship here anyway? Was everyone, all the way to the 'top' cashing in on this fraud?

The answers will come as this credit crunch unwinds, exposing all the dirty laundry on Wall Street, and possibly right up through the political administration in the US itself. Of this, I have no doubts!

Tuesday, December 18, 2007

A Collapsing Banking System

...Banks don't have the reserves to cover their downgraded assets and the Federal Reserve cannot simply monetize their bad bets. There's no way out...

Stocks fell sharply last week on news of accelerating inflation which will limit the Federal Reserves ability to continue cutting interest rates. On Tuesday the Dow Jones Industrials tumbled 294 points following the Fed's announcement of a quarter point cut to the Fed Funds rate. On Friday, the Dow dipped another 178 points when government figures showed consumer prices had risen 0.8 per cent last month after a 0.3 per cent gain in October. The stock market is now lurching downward into a "primary bear market". There has been a steady deterioration in retail sales, commercial real estate, and the transports. The financial industry is going through a major retrenchment, losing more than 25 per cent in aggregate capitalization since July. The real estate market is collapsing. California Gov Arnold Schwarzenegger announced on Friday that he will declare a "fiscal emergency" in January and ask for more power to deal with the $14 billion budget shortfall from the meltdown in sub-prime lending.

Economists are beginning to publicly acknowledge what many market analysts have suspected for months; the nation's economy is going into a tailspin.

Morgan Stanley's Asia Chairman, Stephen Roach, made this observation in a New York Times op-ed on Sunday:

This recession will be deeper than the shallow contraction earlier in this decade. The dot-com-led downturn was set off by a collapse in business capital spending, which at its peak in 2000 accounted for only 13 percent of the country's gross domestic product. The current recession is all about the coming capitulation of the American consumer - whose spending now accounts for a record 72 percent of GDP.

Most people have no idea how grave the present situation is or the disaster the country will face if trillions of dollars of over-leveraged bonds and equities begin to unwind. There's a widespread belief that the stewards of the system - Bernanke and Paulson - can somehow steer the economy through this "rough patch" into calm waters. But they cannot, and the presumption shows a basic misunderstanding of how markets work. The Fed has no magical powers and will not allow itself to be crushed by standing in the path of a market-avalanche. As foreclosures and bankruptcies increase, stocks will crash and the fed will step aside to safety.

In the last few weeks, Bernanke and Paulson have tried a number of strategies that have failed. Paulson concocted a plan to help the major investment banks consolidate and repackage their nonperforming mortgage-backed junk into a "Super SIV" to give them another chance to unload their bad investments on the public. The plan was nothing more than a public relations ploy which has already been abandoned by most of the key participants. Paulson's involvement is a real black eye for the Dept of the Treasury. It makes it look like he's willing to dupe investors as long as it helps his Wall Street fogeys.

Paulson also put together an "industry friendly" rate freeze that is supposed to help struggling homeowners avoid foreclosure. But the plan falls well short of providing any meaningful aid to the estimated 3.5 million homeowners who are facing the prospect of defaulting on their loans if they don't get government assistance. Recent estimates by industry experts say that Paulson's plan will only help 140,000 mortgage holders, leaving millions of others to fend for themselves. Paulson has proved over and over that he is just not up to the task of confronting an economic challenge of this magnitude head-on.

Fed chief Bernanke hasn't done much better than Paulson. His three-quarter point cut to the Fed's Funds rate hasn't lowered interest rates on mortgages, stimulated greater home sales, stabilized the stock market or helped banks deal with their massive debt-load. It's been a flop from start to finish. All it's done is weaken the dollar and trigger a wave of inflation. In fact, government figures now show energy prices are rising at 18.1 percent annually. Bernanke is apparently following Lenin's supposed injunction ­ though there's no conclusive evidence he actually said it -- that "the best way to destroy the Capitalist System is to debauch the currency."

On Wednesday, the Federal Reserve initiated a "coordinated effort" with the Bank of Canada, the Bank of England, the European Central Bank, and the Swiss National Bank to address the "elevated pressures in short-term funding of the markets." The Fed issued a statement that "it will make up to $24 billion available to the European Central Bank (ECB) and Swiss National Bank to increase the supply of dollars in Europe." (Bloomberg)

The Fed will also add as much as $40 billion, via auctions, to increase cash in the US. Bernanke is trying to loosen the knot that has tightened Libor (London Interbank Offered Rate) rates in England and reduced lending between banks. The slowdown is hobbling growth and could send the world into a recessionary spiral. Bernanke's "master plan" is little more than a cash give-away to sinking banks. It has scant chance of succeeding. The Fed is offering $.85 on the dollar for mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs) that sold last week in the E*Trade liquidation for $.27 on the dollar. At the same time, the Fed has promised to keep the identities of the banks that are borrowing these emergency funds secret from the public. The Fed is conducting its business like a bookie.

Unfortunately, the Fed bailout has achieved nothing. Libor rates - which are presently at seven-year highs have not come down at all. This is causing growing concern among the leaders of the Central Banks around the world, but there's really nothing they can do about it. The banks are hoarding cash to meet their capital requirements. They are trying to compensate for the loss of value to their (mortgage-backed) assets by increasing their reserves. At the same time, the system is clogged with trillions of dollars of bad paper which has brought lending to a halt. The huge injections of liquidity from the Fed have done nothing to improve lending or lower inter-bank rates. It's been a flop. The market is driving interest rates now. If the situation persists, the stock market will crash.

Staring Into the Abyss

One of Britain's leading economists, Peter Spencer, issued a warning on Saturday:

The Government must suspend a set of key banking regulations at the heart of the current financial crisis or risk seeing the economy spiral towards a future that could make 1929 look like a walk in the park.

Spencer is right. The banks don't have the money to loan to businesses or consumers because they're trying to raise more cash to meet their capital requirements on assets that continue to be downgraded. (The Fed may pay $.85 on the dollar, but investors are unwilling to pay anything at all.) Spencer correctly assumes that the reason the banks have stopped lending is not because they "distrust" other banks, but because they are capital-strapped from all their "off balance" sheets shenanigans. If the Basel regulations aren't modified, money markets will remain frozen, GDP will shrink, and there'll be a wave of bank closings.

Spencer said:

Banks are staring into the abyss. The Financial Services Authority must go round and check that all banks are solvent, and then it should cut the Basel capital requirement level from 8pc to about 6pc. ("Call to Relax Basel Banking Rules, UK Telegraph)

Spencer confirms what we already knew; the banks are seriously under-capitalized and will come under growing pressure as hundreds of billions of dollars of mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs) continue to lose value and have to be propped up with additional capital. The banks simply don't have the resources and there's going to be a day of reckoning.

Pimco's Bill Gross put it like this: "What we are witnessing is essentially the breakdown of our modern day banking system." Gross is right, but he only covers a small portion of the problem.

The economist Ludwig Von Mises is more succinct in his analysis:

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.

The basic problem originated with the Federal Reserve when former Fed chief Alan Greenspan lowered interest rates below the rate of inflation for 31 months straight which pumped trillions of dollars of low interest credit into the financial system and ignited a speculative frenzy in real estate. Greenspan has spent a great deal of time lately trying to avoid any blame for the catastrophe he created. He is a first-rate "buck passer". In Wednesday's Wall Street Journal, Greenspan scribbled out a 1,500-word defense of his actions as head of the Federal Reserve, pointing the finger at everything from China's "low cost workforce" to "the fall of the Berlin Wall". The essay was typical Greenspan gibberish. In his trademark opaque language, Greenspan tip-toes through the well-documented facts of his tenure as Fed chief to absolve himself of any personal responsibility for the ensuing disaster.

Greenspan's apologia is a masterpiece of circuitous logic, deliberate evasion and utter denial of reality. He says:

I do not doubt that a low US federal-funds rate in response to the dot-com crash, and especially the 1 per cent rate set in mid-2003 to counter potential deflation, lowered interest rates on adjustable-rate mortgages (ARMs) and may have contributed to the rise in US home prices. In my judgment, however, the impact on demand for homes financed with ARMs was not major.

"Not major"? 3.5 million potential foreclosures, 11-month inventory backlog, plummeting home prices, an entire industry in terminal distress pulling down the global economy is not major?

But Greenspan is partially correct. The troubles in housing cannot be entirely attributed to the Fed's "cheap credit" monetary policies. They were also nursed along by a Doctrine of De-regulation which has permeated US capital markets since the Reagan era. Greenspan's views on how markets should function were -- to a great extent, shaped by this non-interventionist and non-supervisory ideology which has created enormous equity bubbles and imbalances. The former Fed chief's support for adjustable-rate mortgages (ARMs) and sub-prime lending shows that Greenspan thought of himself more as a cheerleader for the big market-players than an impartial referee whose job was to monitor reckless and unethical behavior.

Greenspan also adds this revealing bit of information in his article:

"The value of equities traded on the world's major stock exchanges has risen to more than $50 trillion, double what it was in 2002. Sharply rising home prices erupted into major housing bubbles world-wide, Japan and Germany (for differing reasons) being the only principal exceptions." ('The Roots of the Mortgage Crisis', Alan Greenspan, Wall Street Journal)

This admission proves Greenspan's culpability. If he knew that stock prices had doubled their value in just 3 years, then he also knew that equities had not risen due to increases in productivity or demand, (market forces). The only reasonable explanation for the asset inflation therefore, was monetary policy. As his own mentor, Milton Friedman famously stated, "Inflation is always and everywhere a monetary phenomenon". Any capable economist would have known that the explosion in housing and equity prices was a sign of uneven inflation. Now that the bubble has popped, inflation is spreading like mad through the entire economy.

Greenspan is a very sharp man. It is crazy to think he didn't know what was going on. This is basic economic theory. Of course he knew why stocks and housing prices were skyrocketing. He was the one who put the dominoes in motion with the help of his printing press.

But Greenspan's low interest credit is only part of the equation. The other part has to do with the way that markets have been transformed by "structured finance".

What's so destructive about structured finance is that it allows banks to create credit "out of thin air", stripping the Fed of its role as controller of the money supply. David Roach explains how this works in an excerpt from his book "New Monetarism" which appeared in the Wall Street Journal:

The reason for the exponential growth in credit, but not in broad money, was simply that banks didn't keep the loans on their books any more-and only loans on bank balance sheets get counted as money. Now, as soon as banks made a loan, they "securitized" it and moved it off their balance sheet.

There were two ways of doing this. One was to sell the securitized loan as a bond. The other was "synthetic" securitization: for example, using derivatives to get rid of the default risk (with credit default swaps) and lock in the interest rate due on the loan (with interest-rate swaps). Both forms of securitization meant that the lending bank was free to make new loans without using up any of its lending capacity once its existing loans had been "securitized."

So, to re-define liquidity under what I call New Monetarism, one must add, to the traditional definition of broad money, all the credit being created and moved off bank balance sheets and onto the balance sheets of non-bank financial intermediaries. This new form of liquidity changed the very nature of the credit beast. What now determined credit growth was risk appetite: the readiness of companies and individuals to run their businesses with higher levels of debt. (Wall Street Journal)

The banks have been creating trillions of dollars of credit (by originating mortgage-backed securities, collateralized debt obligations and asset-backed commercial paper) without maintaining the proportional capital reserves to back them up. That explains why the banks were so eager to provide mortgages to millions of loan applicants who had no documentation, no income, no collateral and a bad credit history. They believed there was no risk, because they were making enormous profits without tying up any of their capital. It was, quite literally, money for nothing.

But now the mechanism for generating new loans (and fees) has broken down. The main sources of bank revenue have either been seriously curtailed or dried up entirely. Mortgage-backed Commercial Paper (MBCP) one such source of revenue, has decreased by a full-third (or $400 billion) in just 17 weeks. Also, the securitization of mortgage-backed securities is DOA. The market for MBSs and CDOs and other complex bonds has followed the Pterodactyl into the history books. The same is true of structured investment vehicles (SIVs) and other "off balance-sheet" swindles which have either gone under entirely or are presently withering with every savage downgrade in mortgage-backed bonds. The mighty juggernaut that was grinding out the hefty profits (structured investments) has suddenly reversed, and is crushing everything in its path.

The banks don't have the reserves to cover their downgraded assets and the Federal Reserve cannot simply "monetize" their bad bets. There's no way out. There are bound to be bankruptcies and bank runs. "Structured finance" has usurped the Fed's authority to create new credit and handed it over to the banks.

Now everyone will pay the price.

Investors have lost their appetite for risk and are steering clear of anything connected with real estate or mortgage-backed bonds. That means an estimated $3 trillion of securitized debt (CDOs, MBSs and MBCP) will come crashing to earth delivering a violent blow to the economy.

It's not just the banks that will take a beating. As Professor Nouriel Roubini points out, the broker dealers, investment banks, money market funds, hedge funds and mortgage lenders are in the cross-hairs as well.

Non-bank institutions do not have direct access to the Fed and other central banks for liquidity support, and so are now at risk of a liquidity run as their liabilities are short term while many of their assets are longer term and illiquid; so the risk of something equivalent to a bank run for non-bank financial institutions is now rising. And there is no chance that depository institutions will re-lend to these non-banks the funds borrowed by central banks as these banks have severe liquidity problems themselves and do not trust their non-bank counter-parties. So now monetary policy is totally impotent in dealing with liquidity problems and the risks of runs on liquid liabilities of a large fraction of the financial system. (Nouriel Roubini's Global EconoMonitor)

As the downgrades on CDOs and MBSs continue to accelerate, there'll likely be a frantic "flight to cash" by investors, just like the recent surge into US Treasuries. This could well be followed by a series of spectacular bank and non-bank defaults. The trillions of dollars of "virtual capital" that were miraculously created through securitzation when the market was buoyed-along by optimism will vanish in a flash when the market is driven by fear. In fact, the equity bubble has already been punctured, so the process is well underway.

Friday, November 16, 2007

Global Economic Meltdown

Present contraction of credit

The West (US, EU, Canada) is in the midst of a gigantic and spreading credit crisis that may well to lead it into a depression, if it is not fixed soon. So far, Central bank infusions (Over $1trillion worth in a few months since July!) have been the only thing that has stopped a massive bank liquidity crisis from shutting down commerce. But the damage to credit markets thus far is so huge, and worsening rapidly, that a very bad outcome seems assured. Gregory Peters of Morgan Stanley said there is a better than 50% chance of a systemic banking crisis that will hammer credit markets at this time.

So far, equity markets have barely reflected this turmoil to the degree it should. That is going to rapidly change. Central banks have been doing back-flips to stem the crisis, and I think, things are rapidly spinning out of control. They have barely been able to stem a collapse in interbank lending, which would halt credit markets. The damage a paralyzed credit system will do to our credit dependent economies is going to be staggering. It would appear that much of the crisis is hidden from view, but the way it will inevitably reveal itself will be in falling corporate earnings, and collapsing consumer and business spending. In a few short months, we will see if I am right. So far, stock markets have not priced in falling earnings that we expect to appear in coming months, as contracting credit markets constrain all manner of spending and investment.

Genesis of collapsing credit

As late as July of this year, a crashing housing market appeared to be something that could be weathered by other growing sectors of the US/Western economies. Then, the inevitable credit dominoes started to fall, after the first one fell, the mortgage delinquencies. Next we entered a scary August and September world credit crisis, as huge forms of liquidity, formerly seeming of endless supply, rapidly dropped to nothing. That would be the securitized credit markets.

Rapidly, the emerging losses in securitized credit, from CDOs, MBS and such (packages of loans such as mortgages sold off as securities and derivatives) caused a cascade of falling confidence in our banking sectors. All of a sudden, the credit crisis spread from the mortgage derivatives markets to the commercial paper markets in an almost instantaneous fashion, after BNP Paribas, France's largest bank, had to freeze redemptions on two hedge funds that had losses in mortgage derivatives . In about a week from that announcement, the entire European commercial paper market froze, as banks were afraid to roll over each other's commercial paper, not knowing who else had $billions worth of exposure to the huge mortgage derivatives market. This was in August.

The credit market damage is so severe that the largest banks in the US are at risk of losing much of their capital. Citibank alone said it needs to raise $30 billion in capital. If the 5 largest banks in the US are already in crisis mode, and other major banks in the EU too, and don't forget Canada, England and so on, things look incredibly negative. And the losses have only just begun to pile up. There are many more to come, as we will partly discuss. Bernanke stated that 450,000 mortgages reset each quarter in the US in the coming year. But this is not all about just mortgage resets and the housing market. This is about the spreading damage to other key sectors of the credit markets.

Since July, the West's commercial paper markets (CP) have contracted by hundreds of $billions worth, as banks and investors refused to roll over CP of 270 days or less maturity. The ECB (European Central Bank), and US Fed, and other western central banks had to step in and offer short term money to cover the shortfalls, or else a massive world banking liquidity crisis would have emerged.

As it is, interbank lending is quite bad, and Central banks have not been able to stop either the continued shrinking of the CP markets, nor the ever increasing losses stemming from a collapse of the securitized debt markets. Central banks have had to step in as lenders of last resort to keep the banking and financial system from imploding, and there is little progress on this front to date. The $75 billion SIV bailouts arranged by the US Treasury department is on and off again. The key banks involved may not be able or wish to complete it. Citi, for example has to raise $30 billion in capital to cover the mess that has emerged since July.

Next big credit domino

Now, other huge credit markets are about to fall in turn. The next one is the credit insurance market. Credit insurance is an essential part of any credit market. Lenders can buy credit insurance to help cover the risk of loss when they lend. Credit insurance is a key component rating agencies use to asses credit risk of bonds and such, and assume that if any of the bonds that have credit insurance default, the credit insurers will pay off.

But, the amount of securitized credit loss is so huge at this time, losses on CDOs, MBS, and other securitized credit vehicles, that the viability of credit insurers is now in question. Credit insurers will have to start paying off in the next several months. They will be reporting big losses. That will affect the credit ratings of every security they insure.

This means that all the securities these credit insurers insure will be downgraded by rating agencies – if the credit insurer becomes insolvent.

This crisis has spread to Money Market funds for various reasons. First, many money market funds have a large part of their capital invested in short term commercial paper that provides a slight yield bonus. Since much CP is not rolling over, MMFs are having trouble rolling forward those maturities. Also, MMFs have invested heavily in the securitized debt (mortgage derivatives like MBS and SIVs and CDOs) all of which are in deep trouble.

I have had readers email me stories of being put off from redemptions from many money market funds since August. These are from major name institutions. I have been told of games like telling people to fill out forms and not executing what people wanted to do in their fund. Those stories still come in as I write this. It is very important that you read the disclosures about your MMFs, and know that these are generally not FDIC insured. The same goes for other nations MMFs and their deposit insurance.

How this crisis develops

First, US mortgages default, Jan to June 07. Then, the credit securities back of them collapse in value July 07 to present. Then the banks and others holding these have to take huge losses/write-downs. Then those institutions have to raise capital. Then credit insurers have to pay off (coming in the next several months). Then as they go bankrupt, all the rated securities they insure will be downgraded, as the supposed insurance that was purchased is now worthless, as the insurer is insolvent. Then a new cycle of losses as the newly downgraded credit securities have to be marked down.

Then…here is the rub – banks and such have to stop lending, and you get a system wide freeze of new credit. We are right in the middle of this part. HSBC, for example, has stated they are going to pull back lending in the US, as they have been badly hit in the mortgage markets. Consider this, and see credit contraction in the US increasing across lenders. As I said, Citi stated they need to raise $30 billion of capital.

Main source of credit now totally dead

What's more, the source of most of the credit in the last 5 years, securitized credit, is literally disappearing. As that entire sector becomes discredited, the source of most of the money coming into the world's bubble economies, securitized debt, is drying up.

As banks are forced to raise capital and stop lending, consumers find new credit hard to get or not available at all. The same goes for businesses. You then get system wide credit collapse, and the resultant collapse in economic growth. And if no recovery is made quickly, you get a depression. Not a recession, a depression, due to collapsing economic demand.

Sunday, October 28, 2007

The Fed's Conundrum

In the US we have a slowing economy, however prices are rising for commodities like food and energy, and this just doesn’t make any sense. It doesn’t make sense having low interest rates while mortgage debt defaults are hitting all-time highs. Rising equity prices don’t make sense with all of this going on, as well as the US Dollar hitting new all-time lows. And contrary to what the financial media proclaims, the liquidity the world is awash in, is not the result of high productivity and wealth accumulation. So are the answers to these economic conundrums a result of the new global economy?

Back when the US Dollar was much higher, the US was able to import goods cheaply since we paid fewer dollars than today, so part of the reason we’re paying higher prices is a direct result of a dollar that’s lower in value. But the main reason for rising prices is global competition for commodities. Developing countries like China are growing as much as 15% a year, and demand raises prices. However in answer to these demands we’re not seeing a corresponding increase in business investment to create the additional supply needed to meet rising demand. And the reason is because both asset prices and debt levels are too high to justify the low return on investment relative to risk. This ‘stagflation’ is the direct result of interest rates which have been set at too low levels to bring down asset prices and increase returns that business and investors demand for taking on risk. So we see US energy companies preferring to buy back stock in their companies rather than increase business investment since it appears their return for gambling in the stock market has returned a higher reward than building their business to meet the increasing global demand for energy.

Across the economy, we see a simple and consistent theme. Capacity is full, costs are rising, asset prices are high, government, corporate and consumer debt is at staggering heights, and perceived returns on new projects is low. Is it possible the US Fed is the cause of this global mess? After-all, they were the jackals who kept rates suppressed at 1% back in 2003 and 2004. And that's what caused the housing ‘boom’ turned bust that resulted in debt defaults, which ignited the current global credit crisis responsible for massive foreclosures on a global basis. So why have they returned to their old tricks of lowering rates again below the real rate of inflation?

The truth is the US Fed is backed into a corner, they need to continue lowering interest rates in order to cover-up the real estate and financial Ponzi scheme they created to remedy the 2k Nasdaq crash they created. Sure, free markets would cause real estate prices to collapse and a recession to bring down consumer spending. That would cause supply and demand to fall into line. But, that would also reveal the incompetence of the Fed and the major banks, which would simply be unacceptable, so free markets must be subverted. Look for liquidity and some fancy academic justifications in the face of oil over $100. The Fed and market watchers may wonder at the theoretical cause of stagflation, but it’s real obvious who the culprits are here.

So the next time you hear a US Fed official wondering about economic conundrums, the only ones to blame are the master manipulators themselves. There would be no irrational booms and busts were it not for the direct actions of this entity. We are in a crisis so deep now with over $300 trillion in derivatives at risk, the downside of this story may finally reveal the destructive capacity of the Federal Reserve system, but not without the dearest consequences in the history of our society. And I suppose that’s what it will take to finally rid ourselves of these economic Demons of Disaster.

Below is a fantastic video explaining how our monetary system works and the US Fed's part in what amounts to the most hideous financial scam ever perpetrated.

Money, Banking and the Federal Reserve..

Thursday, October 25, 2007

Global Warming - Science vs Crap

The following is adapted from a lecture delivered on the Hillsdale College campus on June 30, 2007, during a seminar entitled “Economics and the Environment,” sponsored by the Charles R and Kathleen K Hoogland Center for Teacher Excellence.

IN THE PAST few years there has been increasing concern about global climate change on the part of the media, politicians, and the public. It has been stimulated by the idea that human activities may influence global climate adversely and that therefore corrective action is required on the part of governments. Recent evidence suggests that this concern is misplaced. Human activities are not influencing the global climate in a perceptible way. Climate will continue to change, as it always has in the past, warming and cooling on different time scales and for different reasons, regardless of human action. I would also argue that should it occur, a modest warming would be on the whole beneficial.

This is not to say that we don’t face a serious problem. But the problem is political. Because of the mistaken idea that governments can and must do something about climate, pressures are building that have the potential of distorting energy policies in a way that will severely damage national economies, decrease standards of living, and increase poverty. This misdirection of resources will adversely affect human health and welfare in industrialized nations, and even more in developing nations. Thus it could well lead to increased social tensions within nations and conflict between them.

If not for this economic and political damage, one might consider the present concern about climate change nothing more than just another environmentalist fad, like the Alar apple scare or the global cooling fears of the 1970s. Given that so much is at stake, however, it is essential that people better understand the issue.

Man-Made Warming?

The most fundamental question is scientific: Is the observed warming of the past 30 years due to natural causes or are human activities a main or even a contributing factor?

At first glance, it is quite plausible that humans could be responsible for warming the climate. After all, the burning of fossil fuels to generate energy releases large quantities of carbon dioxide into the atmosphere. The CO2 level has been increasing steadily since the beginning of the industrial revolution and is now 35 percent higher than it was 200 years ago. Also, we know from direct measurements that CO2 is a “greenhouse gas” which strongly absorbs infrared (heat) radiation. So the idea that burning fossil fuels causes an enhanced “greenhouse effect” needs to be taken seriously.

But in seeking to understand recent warming, we also have to consider the natural factors that have regularly warmed the climate prior to the industrial revolution and, indeed, prior to any human presence on the earth. After all, the geological record shows a persistent 1,500-year cycle of warming and cooling extending back at least one million years.

In identifying the burning of fossil fuels as the chief cause of warming today, many politicians and environmental activists simply appeal to a so called “scientific consensus.” There are two things wrong with this. First, there is no such consensus: An increasing number of climate scientists are raising serious questions about the political rush to judgment on this issue. For example, the widely touted “consensus” of 2,500 scientists on the United Nations Intergovernmental Panel on Climate Change (IPCC) is an illusion: Most of the panelists have no scientific qualifications, and many of the others object to some part of the IPCC’s report. The Associated Press reported recently that only 52 climate scientists contributed to the report’s “Summary for Policymakers.”

Likewise, only about a dozen members of the governing board voted on the “consensus statement” on climate change by the American Meteorological Society (AMS). Rank and file AMS scientists never had a say, which is why so many of them are now openly rebelling. Estimates of skepticism within the AMS regarding man-made global warming are well over 50 percent.

The second reason not to rely on a “scientific consensus” in these matters is that this is not how science works. After all, scientific advances customarily come from a minority of scientists who challenge the majority view or even just a single person (think of Galileo or Einstein). Science proceeds by the scientific method and draws conclusions based on evidence, not on a show of hands.

But aren’t glaciers melting? Isn’t sea ice shrinking? Yes, but that’s not proof for human caused warming. Any kind of warming, whether natural or human caused, will melt ice. To assert that melting glaciers prove human causation is just bad logic.

What about the fact that carbon dioxide levels are increasing at the same time temperatures are rising? That’s an interesting correlation; but as every scientist knows, correlation is not causation. During much of the last century the climate was cooling while CO2 levels were rising. And we should note that the climate has not warmed in the past eight years, even though greenhouse gas levels have increased rapidly.

What about the fact—as cited by, among others, those who produced the IPCC report—that every major greenhouse computer model (there are two dozen or so) shows a large temperature increase due to human burning of fossil fuels? Fortunately, there is a scientific way of testing these models to see whether current warming is due to a man-made greenhouse effect. It involves comparing the actual or observed pattern of warming with the warming pattern predicted by or calculated from the models. Essentially, we try to see if the “finger-prints” match, “fingerprints” meaning the rates of warming at different latitudes and altitudes.

For instance, theoretically, greenhouse warming in the tropics should register at increasingly high rates as one moves from the surface of the earth up into the atmosphere, peaking at about six miles above the earth’s surface. At that point, the level should be greater than at the surface by about a factor of three and quite pronounced, according to all the computer models. In reality, however, there is no increase at all. In fact, the data from balloon borne radiosondes show the very opposite: a slight decrease in warming over the equator.

The fact that the observed and predicted patterns of warming don’t match indicates that the man-made greenhouse contribution to current temperature change is insignificant. This fact emerges from data and graphs collected in the Climate Change Science Program Report 1.1, published by the federal government in April 2006. It is remarkable and puzzling that few have noticed this disparity between observed and predicted patterns of warming and drawn the obvious scientific conclusion.

What explains why greenhouse computer models predict temperature trends that are so much larger than those observed? The answer lies in the proper evaluation of feedback within the models. Remember that in addition to carbon dioxide, the real atmosphere contains water vapor, the most powerful greenhouse gas. Every one of the climate models calculates a significant positive feedback from water vapor - ie: a feedback that amplifies the warming effect of the CO2 increase by an average factor of two or three. But it is quite possible that the water vapor feedback is negative rather than positive and thereby reduces the effect of increased CO2.

There are several ways this might occur. For example, when increased CO2 produces a warming of the ocean, a higher rate of evaporation might lead to more humidity and cloudiness (provided the atmosphere contains a sufficient number of cloud condensation nuclei). These low clouds reflect incoming solar radiation back into space and thereby cool the earth. Climate researchers have discovered other possible feedbacks and are busy evaluating which ones enhance and which diminish the effect of increasing CO2.

Natural Causes of Warming

A quite different question, but scientifically interesting, has to do with the natural factors influencing climate. This is a big topic about which much has been written. Natural factors include continental drift and mountain-building, changes in the Earth’s orbit, volcanic eruptions, and solar variability. Different factors operate on different time scales. But on a time scale important for human experience, a scale of decades let’s say, solar variability may be the most important.

Solar influence can manifest itself in different ways: fluctuations of solar irradiance (total energy), which has been measured in satellites and related to the sunspot cycle; variability of the ultraviolet portion of the solar spectrum, which in turn affects the amount of ozone in the stratosphere; and variations in the solar wind that modulate the intensity of cosmic rays (which, upon impact into the earth’s atmosphere, produce cloud condensation nuclei, affecting cloudiness and thus climate).

Scientists have been able to trace the impact of the sun on past climate using proxy data (since thermometers are relatively modern). A conventional proxy for temperature is the ratio of the heavy isotope of oxygen, Oxygen-18, to the most common form, Oxygen-16.

A paper published in Nature in 2001 describes the Oxygen-18 data (reflecting temperature) from a stalagmite in a cave in Oman, covering a period of over 3,000 years. It also shows corresponding Carbon-14 data, which are directly related to the intensity of cosmic rays striking the earth’s atmosphere. One sees there a remarkably detailed correlation, almost on a year by year basis. While such research cannot establish the detailed mechanism of climate change, the causal connection is quite clear: Since the stalagmite temperature cannot affect the sun, it is the sun that affects climate.

Policy Consequences

If this line of reasoning is correct, human-caused increases in the CO2 level are quite insignificant to climate change. Natural causes of climate change, for their part, cannot be controlled by man. They are unstoppable. Several policy consequences would follow from this simple fact:

1. Regulation of CO2 emissions is pointless and even counterproductive, in that no matter what kind of mitigation scheme is used, such regulation is hugely expensive.

2. The development of non-fossil fuel energy sources, like ethanol and hydrogen, might be counterproductive, given that they have to be manufactured, often with the investment of great amounts of ordinary energy. Nor do they offer much reduction in oil imports.

3. Wind power and solar power become less attractive, being uneconomic and requiring huge subsidies.

4. Substituting natural gas for coal in electricity generation makes less sense for the same reasons.

None of this is intended to argue against energy conservation. On the contrary, conserving energy reduces waste, saves money, and lowers energy prices irrespective of what one may believe about global warming.

Science vs Hysteria

You will note that this has been a rational discussion. We asked the important question of whether there is appreciable man-made warming today. We presented evidence that indicates there is not, thereby suggesting that attempts by governments to control greenhouse gas emissions are pointless and unwise. Nevertheless, we have state governors calling for CO2 emissions limits on cars; we have city mayors calling for mandatory CO2 controls; we have the Supreme Court declaring CO2 a pollutant that may have to be regulated; we have every industrialized nation (with the exception of the US and Australia) signed on to the Kyoto Protocol; and we have ongoing international demands for even more stringent controls when Kyoto expires in 2012. What’s going on here?

To begin, perhaps even some of the advocates of these anti-warming policies are not so serious about them, as seen in a feature of the Kyoto Protocol called the Clean Development Mechanism, which allows a CO2 emitter—ie, an energy user to support a fanciful CO2 reduction scheme in developing nations in exchange for the right to keep on emitting CO2 unabated. “Emission trading” among those countries that have ratified Kyoto allows for the sale of certificates of unused emission quotas. In many cases, the initial quota was simply given away by governments to power companies and other entities, which in turn collect a windfall fee from consumers. All of this has become a huge financial racket that could someday make the UN’s “Oil for Food” scandal in Iraq seem minor by comparison. Even more fraudulent, these schemes do not reduce total CO2 emissions, not even in theory.

It is also worth noting that tens of thousands of interested persons benefit directly from the global warming scare at the expense of the ordinary consumer. Environmental organizations globally, such as Greenpeace, the Sierra Club, and the Environmental Defense Fund, have raked in billions of dollars. Multi-billion dollar government subsidies for useless mitigation schemes are large and growing. Emission trading programs will soon reach the $100 billion a year level, with large fees paid to brokers and those who operate the scams. In other words, many people have discovered they can benefit from climate scares and have formed an entrenched interest. Of course, there are also many sincere believers in an impending global warming catastrophe, spurred on in their fears by the growing number of one-sided books, movies, and media coverage.

The irony is that a slightly warmer climate with more carbon dioxide is in many ways beneficial rather than damaging. Economic studies have demonstrated that a modest warming and higher CO2 levels will increase GNP and raise standards of living, primarily by improving agriculture and forestry. It’s a well known fact that CO2 is plant food and essential to the growth of crops and trees, and ultimately to the well being of animals and humans.

You wouldn’t know it from Al Gore’s An Inconvenient Truth, but there are many upsides to global warming. Northern homes could save on heating fuel. Canadian farmers could harvest bumper crops. Greenland may become awash in cod and oil riches. Shippers could count on an Arctic shortcut between the Atlantic and Pacific. Forests may expand. Mongolia could become an economic superpower. This is all speculative, even a little facetious. But still, might there be a silver lining for the frigid regions of Canada and Russia? “It’s not that there won’t be bad things happening in those countries,” economics professor Robert O Mendelsohn of the Yale School of Forestry & Environmental Studies says. “But the idea is that they will get such large gains, especially in agriculture, that they will be bigger than the losses.” Mendelsohn has looked at how gross domestic product around the world would be affected under different warming scenarios through 2100. Canada and Russia tend to come out as clear gainers, as does much of northern Europe and Mongolia, largely because of projected increases in agricultural production.

To repeat a point made at the beginning: Climate has been changing cyclically for at least a million years and has shown huge variations over geological time. Humans have adapted well, and will continue to do so.


The nations of the world face many difficult problems. Many have societal problems like poverty, disease, lack of sanitation, and shortage of clean water. There are grave security problems arising from global terrorism and the proliferation of nuclear weapons. Any of these problems are vastly more important than the imaginary problem of man-made global warming. It is a great shame that so many of our resources are being diverted from real problems to this non-problem. Perhaps in ten or 20 years this will become apparent to everyone, particularly if the climate should stop warming (as it has for eight years now) or even begin to cool.

We can only trust that reason will prevail in the face of an onslaught of propaganda like Al Gore’s movie and despite the incessant misinformation generated by the media. Today, the imposed costs are still modest, and mostly hidden in taxes and in charges for electricity and motor fuels. If the scaremongers have their way, these costs will become enormous. When will sound science and good sense finally prevail in the face of all this irrational and scientifically baseless climate fears?