Waiting for the other shoe to drop

SUBHEAD: Our policy makers first created a crisis of confidence, and then resolved it by legalizing a global Ponzi scheme.

By Steve Ludlum on 26 December 2010 in Economic Undertow -

Image above: Monopoly board for Banksters to play Wall Street Kleptocracy. From (http://ilene.typepad.com/).

Merry Christmas! Here is John Hussman:
4) We did not avoid a second Great Depression because we bailed out financial institutions. Rather, the collapse in the economy and the surge in unemployment were the direct result of a gaping hole in the U.S. regulatory structure that prevented the rapid restructuring of insolvent non-bank financials. Policy makers then inappropriately extended the "too big to fail" doctrine to ordinary banks. Following a striking loss of public confidence that resulted from arbitrary policy responses, coupled with fear-mongering by exactly those who stood to benefit from public handouts, the self-fulfilling crisis was contained by a change in accounting rules that effectively disabled capital requirements for all financial companies. We are now left with a Ponzi scheme.
While it's clear that the four-second tape in Ben Bernanke's head is an endless loop saying "We let the banks fail in the Great Depression, and look what happened," any disruption caused by the "failure" of a financial institution is not due to financial losses to bondholders, but is instead due to the necessity of liquidating the assets in a disorganized, piecemeal way, as was the case with Lehman Brothers.
Large, sometimes major banks fail every year without a material effect on the economy. The key is to have regulations that allow these failures to occur with the minimal amount of disruptive liquidation. It is important to recognize that nearly every financial institution has enough debt to its own bondholders on the balance sheet to absorb all of its losses without any damage to depositors or customers. These bondholders lend at a spread, and they knowingly take a risk.
Bank regulations intelligently allow the FDIC to cut away the "operating" portion of a financial institution from the obligations to its bondholders and stockholders. Consider a bank with $100 billion of assets, against which it owes $60 billion of customer deposits, $30 billion of debt to its own bondholders, and $10 billion in shareholder equity. Now suppose those assets decline in value to just $80 billion, creating an insolvent institution ($80 billion in assets, $60 billion in deposit liabilities, $30 billion in debt to bondholders, and -$10 billion in equity). The "operating portion" is the $80 billion in assets, along with the $60 billion of customer deposits, which can be sold as a "whole bank" transaction for $20 billion to another institution. The stockholders are wiped out, while the bondholders get the $20 billion residual and take a loss on the rest. Depositors and customers now get statements with a different logo at the top. The seamless "failure" of Washington Mutual is a good example of this in action (the emphasis in mine).
The problem with Bear Stearns and Lehman was that no equivalent set of regulations was in place to allow "cutting away" the operating portion of a non-bank institution. Instead, the Fed illegally expanded the definition of the word "discount" in Section 13(3) of the Federal Reserve Act and created a shell company to buy $30 billion of Bear Stearns' questionable long-term assets without recourse. The remaining entity was sold to JP Morgan, where Bear Stearns bondholders still stand to get 100 cents on the dollar plus interest.
Lehman was allowed to "fail," but because there was still no set of regulations that allowed cutting away the operating entity, it had to be liquidated piecemeal. Importantly, and even urgently, it was not this "failure" that produced the economic downturn. If you carefully observe what happened in 2008, the large-scale collapse of the financial markets and the U.S. economy started literally sixty seconds after TARP was passed by Congress on October 3, 2008. At that moment, the world was told not that the smooth operation of the global financial system would be ensured by taking receivership of failing financial institutions; not that the focus of policy would be the protection of depositors, customers, and U.S. fiscal stability; but instead that insolvent private balance sheets would now be defended, subject to the arbitrary decisions of policy makers in which nobody had confidence.
Lehman's failure simply told investors that these decisions could be completely arbitrary, since there was really no operative distinction between Bear Stearns, which was saved, and Lehman, which was not. Moreover, in order to pass TARP, the public had to be convinced that a global meltdown would result if financial institutions weren't preserved in their existing form. In this way, policy makers created a crisis of confidence.
Skip forward and carefully observe what happened in 2009, and you'll see that the crisis was suspended once the FASB threw out rules requiring financial companies to report their assets at market value, while at the same time, the Federal Reserve illegally broadened the definition of "government agency" in Section 14(b) of the Federal Reserve Act in order to purchase $1.5 trillion of Fannie Mae and Freddie Mac obligations. These actions replaced the arbitrary discretion of policy makers with confidence that no major institution would be at risk of failing because, in effect, meaningful capital standards would no longer apply. Thus, our policy makers first created a crisis of confidence, and then resolved it by legalizing a global Ponzi scheme.
Or rather, the Bernanke Money Laundry which allows finance 'friends' of the Chairman to swap their used toilet paper for cash. The friends use Fed liquidity to pump up markets allowing the same friends to sell into these rising markets on an ongoing basis. Sez Hussman:
As David Einhorn at Greenlight Capital has noted, "We learned the wrong lesson." We should have learned that existing capital standards were insufficient and that there was a large, gaping hole in our regulatory structure that failed to provide "resolution authority" for non-bank financial companies. Instead, we've learned the dangerously misguided notion that some institutions are simply too big to fail. This inevitably creates a situation where reckless misallocation of capital continues to be subsidized at increasing public cost, while bondholders go unscathed and insiders take bonuses with the same alacrity as Bernie Madoff's early investors.
In short, the downturn in the real economy occurred because regulators refused to take receivership of insolvent institutions, while pushing a story line that the entire global economy would crumble if bondholders had to take losses. This created a fear among depositors and consumers that the entire system was arbitrary and unstable, fueled periodic runs on various financial institutions, tightened the availability of credit to companies having nothing to do with real estate, and created a self-fulfilling prophecy of global economic weakness.
Had our policy makers said "depositors and customers will be protected, we will immediately exercise resolution authority over insolvent institutions, and bondholders will not be spared" we could have simply had a "writeoff recession" in paper assets, rather than an implosion of the real economy and an explosion in public debt. The facts simply do not support the idea that taking receivership of insolvent financials leads to economic distress.
Rather, it properly rests losses on the bondholders, and preserves the operation of the financial system by bolstering its solvency. One might argue that we could not possibly let bondholders take the trillions of dollars of losses that would have been required in order to restructure debt and get the bad obligations off the books. This is absurd.
A 20% stock market decline wipes out about $3 trillion in market value. Indeed, given the size and average maturity of the U.S. bond market, just the increase in interest rates that we've observed over the past 6 weeks has knocked off trillions in market value. The financial markets are perfectly capable of taking losses.
They don't do well with disorganized piecemeal liquidation - where perfectly good loans are called in and countless positions have to be unwound - but that isn't required if your regulatory structure allows receivership/conservatorship that can cut away and gradually transfer the operating portion of an institution. What the global economy is not capable of taking is the uncertainty that results when policy makers apply arbitrary rules, leaving all other decision makers in the economy frozen at the edge of their seats to discover what the results of those arbitrary decisions will be. We have learned the wrong lesson, and we continue to pay for it.
Here's part 3 of Hussman's analysis. Sue me, I'm backwards:
3) Downside risk tends to be elevated precisely when risk premiums and volatility indices reflect the most complacency
I could go on, but nobody cares
Let's look at Hussman's $100 billion bank example. It had $100b in assets (loans), $60b in deposits, $30b in bondholder (senior) debt and $10b in shareholder equity. Losses in the real estate market took assets to $80 rendering the bank insolvent: ($80 billion in assets, $60 billion in deposit liabilities, $30 billion in debt to bondholders, and -$10 billion in equity). The "operating portion" is the $80 billion in assets, along with the $60 billion of customer deposits, was sold as a "whole bank" transaction for $20 billion to another institution. The stockholders were wiped out, with the bondholders' stake converted to $20 billion in shares in the buying bank.

What happens next? Real estate continues to lose value keelhauling the new institution's assets the same way falling real estate undermined Hussman's original bank. Bank insolvency becomes self-sustaining as no new good loans (assets) are made to offset the rapidly devaluing existing loans. Net credit declines leaving values unsupported which effects assets system-wide. The only business that keeps the 'institutions' afloat is arbitraging the difference between short and long term lending rates and by trading credit derivatives: indirect forms of debt subsidy, courtesy of central bank manipulation of bond markets.

As the process gains internal momentum, asset devaluation outstrips the amounts bondholders have at risk, ruining all of them and the banks as well. Bondholders - turned stockholders are fed into the liquidation furnace. This is the mechanism behind Nicole Foss' suggestion that the likely final price level for (debt-free) real estate: that is, the cash value with all credit stripped out will be 90% below cycle highs. Absent a significant restructuring plan and resolution of property values relative to worker incomes there will simply be no credit available to anyone to buy anything. Prices will be set by whatever cash currency folks have in their pockets.

Asset values will be meaningless as there will be no 'assets' per se. This is no new invention but the sequence that destroyed banking and credit in the US and elsewhere in the early 1930's. What John Hussman illuminates is a process dependent upon a return to bubble values: finance markets can sustain SOME losses not a total, self-amplified collapse of value. Losses cannot be confined to real estate. Price stability is insufficient to pay returns to the banks' assets, only liquidity- driven (bubble) growth. This is not any criticism of Hussman's analysis which is a classic model of restructuring. The problem is the need for exogenous support for values ... so that constantly declining assets do not continue to bleed balance sheets.

Where do these supporting funds come from, an invasion of Bankers from Outer Space with spaceships full of money? Right now the only support is more sovereign debt and the continuation of extend-pretend. Both of these are illusory as sovereigns can only recycle not create value nor can E/P conjure value when it has evaporated. The constant debt/subsidy requires the pristine appearance of 'integrity of debt'. This must be maintained at all cost which requires still more subsidy. This is the circular Ponzi Scheme Hussman paints. Outside of the Ponzi lurks Irving Fisher's debt deflation. Anchored to fuel prices set in dollars and the self- estructive propensity of finance to serve itself at the expense of the rest, deflation cannot be outmaneuvered.

Take away the willingness of creditors to lend and galloping insolvency freezes the credit system. This is indeed what is taking place right now in the Eurozone. Borrowing is becoming more difficult, lending more risky and the loans less effective. Bondholders hold the euro hostage. At the same time, the hostage is already a corpse. Talk of 'haircuts' once started cannot be contained. Greece's suggestion a few days ago that it will quietly default sometime in the future triggered a mad panic in Credit Default Swaps written against Greek bonds. Ambrose Evans- Pritchard:
The Greek newspaper Ta Nea said Athens was examining plans to impose a cut in interest rates on its debt and to extend maturities once the €110bn (£94bn) rescue deal from the EU and the International Monetary Fund expires in mid 2013.
The proposals stop short of "haircuts" on the principle of the debt and would be done in a co-operative fashion with bondholders. While this would qualify as an orderly restructuring of debt, it is tantamount to default. Ta Nea said Brussels had given a "green light" to the idea, provided that Greece complies with the terms of its fiscal austerity package and carries out deep structural reforms. The European Commission denied that it had given its blessing for "any restructuring of government bonds by Greece or anywhere else".
The claims caused a wild spike in credit default swaps for Greek debt, with ripple effects across the EMU periphery. Markit's iTraxx SovX Western Europe index measuring risk on sovereign debt in the region surged to a record 208 basis points in intra-day trading, though the moves may have been distorted by a lack of liquidity in the run-up to Christmas.
If Greece becomes the first country in developed Europe to restructure sovereign debt since the Second World War, it breaks a powerful taboo and risks opening the floodgates to serial defaults in southern Europe and Ireland. "This is going to worry the markets a lot: if it is true, it changes the whole politics of the eurozone debt crisis," said Elizabeth Afseth, a bond expert at Evolution Securities.
The fantasy is that the hundreds of trillions of dollars/euros/yen/renmimbi in claims will all be repaid one way or another while keeping depositors whole and doing so on the backs of retirees and schoolchildren with growth constrained by $100 crude oil. The absurdity is self- vident and yet this is where the world places itself as a first prescription for 'recovery'.

Adults cannot even discuss the idea of an orderly restructuring because the creditors hold the world's finance structures by the heels from the ledge of very high window. Absent is the acknowledgement that any regime that can be held by the heels at all has nothing left to contribute to society. Complacency belongs to those whistling past the graveyard. Where are the risks lurking?

The Bernanke Money Laundry can be brought to an end by actions in Congress by way of Bernanke nemesis Ron Paul. Reining in the laundry would cause the stock market to decline, perhaps sharply. Congress can fail to extend the national debt ceiling for political (posturing) reasons triggering a government shutdown. A US state can default or an important city declare bankruptcy leading to a run out of municipal issues. Chinese hyperinflation can reach Hungarian or Weimar proportions: 100% or more per week. A run could be made against the banks of a large European country such as France or Italy.

This would mean the end of the euro as the whole lacks the resources and -- more importantly -- the will to support the unpayable debt such a run would reveal. The risk begins when Ireland's government-to-come tells the EU what it can do with its bailout of German and French banks on the backs of Irish working people. Adults cannot speak about debt restructuring until it is forced on them, the same adults refuse to discuss energy conservation. Instead of creating an artificial fuel shortage with large 'incentives' to cut fuel use/waste we subsidize more waste! Instead of allocating fuel in a way that sets humane priorities and allows nature to recover from our all-out assault on it with our machines, the chosen path is to allow 'the market' to create real shortages.

When these appear they will be distressing because there will be no way short of physical rationing to allocate what remains. Our fuel supply's affordability is determined by economic profitability. Profitability declines because the credit system is insolvent. This reduces the funds available to extract harder to reach fuels. It also constrains the ability of customers to bid for it. Peak oil effects are amplified by the inability of society to afford the fuel as well as afford new means to 'use' it. Here is Chris Skrebowski's observation from October's ASPO Convention:  

What are our options? What policies might work?
  • Leave it to the market and hope high prices will improve supply and reduce demand. This popular policy led to the 2008 crash.
  • Hope Opec sees our welfare as their priority. Hmmn ...
  • Keep activity at low levels and accept little growth and high unemployment Or we could:
  • Maximise efficiency in use
  • Maximise use of economic alternatives (The economic bit is the rub)
  • Maximise the use of alternative fuels (Shale gas is exciting but realistic?)
  • Start taking the oil out of transport (Not easy but probably the best policy)
  • Reduce the energy needed in our economies (Note -moving production overseas only moves the location of demand)
  • All these can and to some extent are being done but will it be fast enough to avoid the next price spike and its economic consequences?
ASPO-USA Washington 7-9 October 2010 I agree with Skrebowski to a point: our culture- wide energy bank is insolvent alongside our credit/money versions and for the same reason. Our assets -- workers output translated into aggregate demand -- is declining relative to liabilities which includes our massive fuel- wasting infrastructure. One cannot support the other. Absent conservation the only alternative is for an invasion of fuel tankers from Mars. .

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