By Mike Whitney -
28/03/08 "ICH' -- - The Federal Reserve is presently considering an
emergency operation that is so risky it could send the dollar slip-
sliding over the cliff. The story appeared in the Financial Times
earlier this week and claimed that the Fed was examining the
feasibility of buying back hundreds of billions of dollars of mortgage-
backed securities (MBS) with public money to restore investor
confidence and clear the struggling banks' balance sheets. The Fed, of
course, denied the allegations, but the rumors abound. Currently the
banking system is so clogged with exotic investments, for which there
is no market, they can't perform their main task of providing credit
to businesses and consumers. Bernanke's job is to clear the credit
logjam so the broader economy can begin to grow again. So far, he has
failed to achieve his objectives.
Since September, Bernanke has slashed interest rates by 3 percent and
opened various auction facilities (Term Securities Lending Facility,
the Term Auction Facility, the Primary Dealer Credit Facility, and the
new Term Securities Lending Facility) which have made $400 billion
available in low-interest loans to banks and non banks. He has also
accepted a "wide range" of collateral for Fed repos including mortgage-
backed securities and collateralized debt obligations (CDOs) which are
worth considerably less than what the Fed is offering in exchange. But
the Fed's injections of liquidity have not solved the basic problem
which is the fall in housing prices and the persistent downgrading of
mortgage-backed assets that investors refuse to buy at any price. In
fact, the troubles are gradually getting worse and spreading to areas
of the financial markets that were previously thought to be risk-free.
The credit slowdown has also put additional pressure on hedge funds
and other financial institutions forcing them to quickly deleverage to
meet margin calls by dumping illiquid assets into a saturated market
at fire-sale prices. This process has been dubbed the "great unwind".
In the last six years, the mortgage-backed securities market has
ballooned to a $4.5 trillion dollar industry. The investment banks are
presently holding about $600 billion of these complex debt
instruments. So far, the banks have written-down $125 billion in
losses, but there's a lot more carnage to come. Goldman Sachs
estimates that banks, brokerages and hedge funds will eventually
sustain $460 billion in losses, three times greater than today. Even
so, those figures are bound to increase as the housing market
continues to deteriorate and capital is drained from the system.
The Fed has neither the resources nor the inclination to scoop up all
the junk bonds the banks have on their books. Bernanke has already
exposed about half of the Central Bank's balance sheet to credit risk.
($400 billion) But what is the alternative? If the Fed doesn't
intervene, then many of country's largest investment banks will wind
up like Bear Stearns; DOA. After all, Bear is not an isolated case;
most of the banks are similarly leveraged at 25 or 35 to 1. They are
also losing more and more capital each month from downgrades, and
their main streams of revenue have been cut off. In fact, many of Wall
Street's financial titans are technically insolvent already. The
generosity of the Fed is the only thing that keeps them from
bankruptcy.
It's generally accepted that the market for MBS will not improve until
housing prices stabilize, but that's a long way off. Mortgages are the
cornerstone upon which the multi-trillion dollar structured investment
market rests, and that cornerstone is crumbling. If housing prices
continue to fall, the MBS market will remain frozen and banks will
fail; it is as simple as that. No one is going to purchase derivatives
when the underlying asset is losing value. The Bush administration is
pu****ng for a "rate freeze" and other clever ways to keep homeowners
from defaulting on their mortgages, but its a hopeless cause. The
clerical work needed to change these complex mortgages is already
proving to be a daunting task. Plus, since 60 percent of these
mortgages were securitized, it is nearly impossible to change the
terms of the contracts without first getting investor approval;
another fly in the ointment.
Also, the tentative plans to expand Fannie Mae and Freddie Mac, so
they can absorb larger mortgages (up to $729,000 jumbo loans) is
putting an enormous strain on the already-overextended GSE's. By
attempting to reflate the housing bubble, the administration will only
increase the rate of foreclosures and put the two mortgage behemoths
at risk of default without any clear sign that it will help.
Yesterday's release of the Case/Schiller Index of the 20 largest
cities in the country, shows that housing prices have slipped 10.7
percent in the last year while sales were down 23 percent year over
year. That means that retail equity of US homes just took a $2
trillion haircut. Still, prices have a long way to go before they
catch up to the 50 percent decline in sales from the peak in 2005.
From this point on, prices should fall and fall fast; following a
trajectory as steep as sales. Many economist expect housing prices to
drop at least 30% (Paul Krugman and G-Sax) which means that $6
trillion will be shaved from aggregate home equity. In a slumping
market, many homeowners will be better off just "walking away" from
their mortgage instead of making payments on an asset of steadily
decreasing value. Who wants to make monthly payments on a $500,000
mortgage when the current value of the house is $350,000? It's easier
to pack the kids and vamoose then waste a lifetime as a mortgage
slave. Besides, the Bush administration has no interest in helping the
little guy stay out of foreclosure. Its a joke. All of the rescue
plans are designed with just one purpose in mind; to save Wall Street
and the banking establishment. Period.
There is a widespread belief that Bernanke has been proactive in
addressing the turmoil in the credit markets. But it's not true. The
Fed chairman has simply responded to events as they unfold. The
collapse of Bears Stearns came just weeks after the SEC had checked
the bank's reserves and decided that they had sufficient capital to
weather the storm ahead. But they were wrong. The bank's capital ($17
billion) vanished in a matter of days after word got out that Bear was
in trouble. The sudden run on the bank created a risk to other banks
and brokerages that held derivatives contracts with Bear. Something
had to be done; Rome was burning and Bernanke was the only man with a
hose.
According to the UK Telegraph: "Bear Stearns had total (derivatives)
positions of $13.4 trillion. This is greater than the US national
income, or equal to a quarter of world GDP - at least in "notional"
terms. The contracts were described as "swaps", "swaptions", "caps",
"collars" and "floors". This heady edifice of new-fangled instruments
was built on an asset base of $80bn at best.
On the other side of these contracts are banks, brokers, and hedge
funds, linked in destiny by a nexus of interlocking claims. This is
counterparty spaghetti. To make matters worse, Lehman Brothers, UBS,
and Citigroup were all wobbling on the back foot as the hurricane hit.
"Twenty years ago the Fed would have let Bear Stearns go bust," said
Willem Sels, a credit specialist at Dresdner Kleinwort. "Now it is too
interlinked to fail." (Ambrose Evans-Pritchard, UK Telegraph)
Bernanke felt he had no choice but to step in and try to minimize the
damage, but the outcome was disappointing. Bernanke and Secretary of
the Treasury Henry Paulson worked out a deal with JP Morgan that
committed $30 billion of taxpayer money, without congressional
authority, to buy toxic mortgage-backed securities from a privately-
owned business that was failing because of its own speculative bets on
dodgy investments. Wow. The transaction turned out to be bad for
shareholders, bad for employees and bad for taxpayers. It made the
Federal Reserve look like the unelected and unaccountable oligarchy of
bankster sharpies they really are. The only people who made out were
the investors who were holding derivatives contracts that would have
been worthless if Bear went toes up.
Still,the prospect of a system-wide derivatives meltdown left Bernanke
with few good options, notwithstanding the moral hazard of bailing out
a maxed-out, capital impaired investment bank that should have been
fed to the wolves.
It is worth noting that derivatives contracts are a fairly recent
addition to US financial markets. In 2000, derivatives trading
accounted for less than $1 trillion. By 2006 that figure had
mushroomed to over $500 trillion. And it all can be traced back to
legislation that was passed during the Clinton administration.
"A milestone in the deregulation effort came in the fall of 2000, when
a lame-duck session of Congress passed a little-noticed piece of
legislation called the Commodity Futures Modernization Act. The bill
effectively kept much of the market for derivatives and other exotic
instruments off-limits to agencies that regulate more conventional
assets like stocks, bonds and futures contracts.
Sup****ted by Phil Gramm, then a Republican senator from Texas and
chairman of the Senate Banking Committee, the legislation was a 262-
page amendment to a far larger appropriations bill. It was signed into
law by President Bill Clinton that December." ("What Created this
Monster" Nelson Schwartz, New York Times)
Now the investment giants are lashed together by trillions of dollars
of unregulated counterparty swaps. If one bank fails, it could domino
through the whole system. Bernanke now finds himself in the unenviable
position of having to make sure that all the equity bubbles are
properly inflated so the banking system doesn't suddenly come cra****ng
to earth. Meanwhile, the tumbling housing market has paralyzed the
cor****ate bond and structured investment markets which means that
Bernanke's job will get much harder, if not impossible.
The Fed chief is now facing a number of brushfires that will have to
be put out immediately. The first of these is short term lending
rates, which have stubbornly ignored Bernanke's massive liquidity
injections and continued to rise. The banks are increasingly afraid to
lend to each other because they don't really know how much exposure
the other banks have to risky MBS. This distrust has sent interbank
lending rates soaring above the Fed funds rate to more than double in
the past month alone. So far, the Fed's TAF hasn't helped to lower
rates, which means that Bernanke will have to take more extreme
measures to rev up bank lending again. That's why many Fed-watchers
believe that Bernanke will ultimately coordinate a $500 billion to $1
trillion taxpayer-funded bailout to buy up all the MBSs from the banks
so they can resume normal operations. Of course, any Fed-generated
scheme will have to be dolled up with populous rhetoric so that
welfare for banking tycoons looks like a selfless act of compassion
for struggling homeowners. That shouldn't be a problem for the Bush
public relations team.
The probable solution to the MBS mess is the restoration of the
Resolution Trust Corp., which was created in 1989 to dispose of assets
of insolvent savings and loan banks. The RTC would create a government-
owned management company that would buy distressed MBS from banks and
liquidate them via auction. The state would pay less than full-value
for the bonds (The Fed currently pays 85% face-value on MBS) and then
take a loss on their liquidation. "According to Joseph Stiglitz in his
book, Towards a New Paradigm in Monetary Economics, the real reason
behind the need of this company was to allow the US government to
subsidize the banking sector in a way that wasn't very transparent and
therefore avoid the possible resistance."
The same strategy will be used again. Now that Bernanke's liquidity
operations have flopped, we can expect that some RTC-type agency will
be promoted as a prudent way to fix the mortgage securities market.
The banks will get their bailout and the taxpayer will foot the bill.
The problem, however, is that the dollar is already falling against
every other currency. (On Wednesday, the dollar plunged to $1.58 per
euro, a new record) If Bernanke throws his sup****t behind an RTC-type
plan; it will be seen by foreign investors as a hyper-inflationary
government bailout, which could precipitate a global sell-off of US
debt and trigger a dollar crisis.
Reuters James Saft puts it like this:
"It is also hugely risky in terms of the Fed's obligation to maintain
stable prices.... it could stoke inflation to levels intolerable to
foreign creditors, provoking a sharp fall in the dollar as they sought
safety elsewhere." (Reuters)
Saft is right; foreign creditors will see it as an indication that the
Fed has abandoned standard operating procedures so it can inflate its
way out of a jam. According to Saft, the estimated price for this
folly could be as high as $1 trillion dollars. Foreign investors would
have no choice except to withdraw their funds from US markets and move
them overseas. In fact, that appears to be happening already.
According to the Wall Street Journal:
"While cash continues to pour into the U.S. from abroad, this flow has
been slowing. In 2007, foreigners' net acquisition of long-term bonds
and stocks in the U.S. was $596 billion, down from $722 billion in
2006, according to Treasury Department data. From July to December as
jitters about securities linked to US subprime mortgages spread, net
purchases were just $121 billion, a 65% decrease from the same period
a year earlier. Americans, meanwhile, are investing more of their own
money abroad." ("A US Debt Reckoning" Wall Street Journal)
$121 billion does not even put a dent the $700 billion the US needs to
pay its current account deficit. When foreign investment drops off,
the currency weakens. Its no wonder the dollar is falling like a
stone.
Bernanke should seriously consider the consequences of his next move
before he acts. Once the dollar starts to free-fall, there's no
telling where it will land.
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