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 last 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'
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, it can't perform its main task of
providing credit to businesses and consumers. Federal Reserve
chairman Ben 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.
Bernanke has slashed interest rates by 3 per cent 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 US$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 ($400 billion) of the Central Bank's balance
sheet to credit risk. But what is the alternative?
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.
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 Fed is the only force keeping
them from bankruptcy.
"Citigroup may write down $13.1 billion of assets including
leveraged loans and collateralized debt obligations in the first
quarter... U.S. bank earnings overall will tumble 84 per cent
in the quarter... 'We anticipate further downside to both estimates
and stock prices'' because banks will be under pressure to mark
down assets to reflect falling market indexes." (Bloomberg
accepted that the market for mortage-backed securities (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 pushing for a "rate freeze" and other
clever ways to keep homeowners from defaulting on their mortgages.
But it's a hopeless cause. The clerical work needed to change
these complex mortgages is already proving to be a daunting task.
Plus, since 60 per cent of these mortgages were securitized, it
is nearly impossible to change the terms of the contracts without
first getting investor approval.
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 Government Sponsored
Enterprises (GSEs; financial services corporations created by
the United States Congress). 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 revive the market.
release of the Case/Schiller Index of the 20 largest cities in
the country, shows that housing prices have slipped 10.7 per cent
in the last year while sales were down 23 per cent 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 per cent 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 economists expect housing
prices to drop at least 30 per cent, 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
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 than waste a lifetime as a mortgage slave.
Besides, the Bush administration has no interest in helping the
little guy stay out of foreclosure. It's a joke. All of the rescue
plans are designed with just one purpose in mind; to save Wall
Street and the banking establishment.
fact, many of Wall Street's financial titans are technically
insolvent already. The Fed is the only force keeping them
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.
to the UK Telegraph:
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.
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.
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.'"
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. The only people who made out were the investors
who were holding derivatives contracts that would have been worthless
if Bear went toes up.
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.
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.
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.
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)
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 Term Auction Facility (TAF; under the Term Auction
Facility (TAF), the Federal Reserve will auction term funds to
depository institutions) 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
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 per cent 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."
probable solution to the MBS mess is the restoration of
the Resolution Trust Corp... The RTC would create a government-owned
management company that would buy distressed MBS from banks
and liquidate them via auction.
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.
however, is that the dollar is already falling against every other
currency. (On March 26, the dollar fell to $1.58 per euro, a new
record.) If Bernanke throws his support 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.
James Saft puts it like this:
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 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:
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 per
cent 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)
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. It's no wonder the dollar is falling like
Mike Whitney is a well respected freelance writer living in Washington
state, interested in politics and economics from a libertarian
perspective. He can be reached at firstname.lastname@example.org.
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