Mike Whitney – The Market Oracle September 11, 2007
”Credit booms do not end in inflation as most people believe. Credit booms ARE inflation that end in deflation. This credit boom is not any different. ”
Mike Shedlock , “Mish's Global Economic Trend Analysis”
The days of the dollar as the world's “reserve currency” may be drawing to a close. In August, foreign central banks and governments dumped a whopping 3.8% of their holdings of US debt. Rising unemployment and the ongoing housing slump have triggered fears of a recession sending wary foreign investors running for the exits. China, Japan and Taiwan have been leading the sell off which has caused the steepest decline since 1992.
To some extent, the losses have been concealed by the up-tick in Treasuries sales to US investors who've been fleeing the money markets in droves. Investors have been trying to avoid the fallout from money funds that have been contaminated by mortgage-backed assets. Naturally, they bought US government bonds which are considered a safe bet. But that doesn't change the fact that the dollar's foundation is steadily eroding and that foreign support for the dollar is vanishing. US bonds are no longer regarded as a “safe haven”.
The dollar slumped to a 15 year low against 6 of its most actively traded peers and set the stage for an early morning market rout on Wall Street.
Foreign investment and currency deregulation has been a real boon for the stock market which thrives of a steady flow of cheap capital. It's also been good for ravenous consumers who like to borrow boatloads of low interest cash for their toys, SUVs and McMansions.
Of course, when things seem too good to last – they usually don't. The economy is contracting; credit is getting tighter, and the stock market is flailing about aimlessly. Worse still, the world is quickly losing confidence in American leadership on everything from human rights to global warming. In many ways the US appears to be tragically out-of-step with its epoch. The world is looking for innovative solutions to species-threatening problems while the Bush Administration insists on following an agenda that seems more suitable to medieval warlords in the Dark Ages. The social and economic consequences of their shortsightedness are obvious. Its been a disaster.
As Capital flight accelerates; interest rates in the US will rise, unemployment will mushroom, and the dollar will fall. It can't be avoided. American markets and consumers will be compelled to curb their gluttonous appetite for cheap foreign credit. The free lunch is over.
Overseas investors own more than $4.4 trillion in US debt in the form of bonds and securities. Even if they sell only 25% of that sum, the US would feel the pinch of hyper-inflation. For the last decade foreigners have been eager to by our Treasuries and equities---gobbling up America's enormous $800 billion current account deficit and keeping demand for the dollar artificially high. But just like the subprime mortgage holder whose “teaser rate” has suddenly expired; the US now faces the painful adjustment of higher payments and less discretionary income for indulgences.
Maybe the charade could have carried on a bit longer if not for the belligerent Bush foreign policy that has alienated friends and foes alike. But, then, maybe not. After all, the Fed's loose monetary policies added to Bush's extravagant spending---$3 trillion added to the National Debt in just 6 years--- doomed the country from the beginning. Deficit spending has been the central organizing principle from day 1. Now comes the hangover.
Bernanke is expected to drop the Fed funds rate on September 18. The move will provide more “easy credit-crack” for the addicts on Wall Street but it could also trigger a run on the dollar. That's what keeps the Fed-chief up at night.
The Bush Team was warned repeatedly---by the BIS, the World Bank, the IMF and the European Central Bank ECB---that their policies were “unsustainable” and would end in an economic meltdown. But they brushed aside the warnings with the same casual indifference as they did the critics of the war in Iraq.
Why would they care if the country suffered? Their friends would still get their massive, unfunded tax cuts. Their private armies and “no bid” contractors would still get their payola. The Democrats would still cave in on the enormous “off budget” war spending. And, they'd still be able to print as much counterfeit money as they chose until every last copper-farthing was drained from the public till.
No worries. Besides the media would mop up the mess they'd made with their usual “happy talk”. As the economic calamity unfolds, we can expect to see the usual parade of lacquer-haired phonies on the Business Channel singing the praises of “free markets” and the poisonous culture of overspending and consumerism.
The problems we're now facing should have been easy to spot for anyone willing to look beyond the empty rhetoric of the TV Pollyannas or their cheerleading co-conspirators at the White House. Instead, we were anesthetized by Greenspan's low-interest snake oil and Bush's “tax-slashing” mumbo-jumbo thinking that they‘d found a new path to prosperity.
It was a hoax. And the seven years of sleepwalking has cost us dearly. Unemployment is up, consumer spending is down, the housing market has slipped into recession, and the stock market is lurching back and forth like an overloaded washing machine. All of this could have been foreseen by anyone with minimal critical thinking skills and a healthy dose of skepticism of government.
Consider this: US GDP is 70% consumer spending. That means that wages have to increase beyond the rate of inflation OR THE ECONOMY CAN'T GROW. It's just that simple. So how is it that 50% of the American people still believe Bush's supply side baloney that cutting taxes for the uber-rich strengthens the economy? How does that increase wages or build a healthy middle class. If we want a strong economy wages have to keep pace with productivity so that workers can buy the goods they produce.
Greenspan knows that. So does Bush. But they chose to hide it behind an “easy credit” smokescreen so they could weaken the dollar, off-shore thousands of industries, out-source 3 million manufacturing jobs, fund an illegal war, and maintain the lethal flow of the $800 billion current account deficit into American equities and Treasuries. In truth, there hasn't been any growth in the economy since Bush took office in 2000. What we've seen is an ever-expanding bubble of personal and corporate debt amplified by a “structured finance” system that magically transforms liabilities (subprime loans) into securities and increases their value through leveraging.
That's it. No growth---just a galaxy of debt-instruments with odd-sounding names (CDOs, MBSs, CDSs, etc) stacked precariously on top of each other. That's what we call "wealth" in America.
It's all smoke and mirrors. The financial system has decoupled from the productive elements of the economy and is now beginning to show disturbing signs of instability. That's why the big blow-off in the bond market. The halcyon days of supplying our armies, funding our markets and building our subprime “ownership society” empire on the backs of foreign creditors is over. The stock market is headed for the landfill and housing is leading the way. Economic fundamentals can only be ignored for so long.
GREENSPAN'S BLOODY FINGERPRINTS
The problems began when Greenspan dropped interest rates to 1% in 2003 for more than a year pumping trillions of low interest credit into the economy. This created the appearance of prosperity but it also inflated a massive equity bubble in housing which is now in its death throes. The Fed “rubber stamped” many of the “creative financing” scams which lowered lending standards and turned the subprime fiasco into a $1.5 trillion doomsday machine.
The devastation in real estate is almost too vast to comprehend. The mortgage bubble is roughly $5.5 trillion, and yet, prices have just begun to fall. It's a long way to the bottom and there's bound to be plenty of bloodshed ahead. Two million homeowners will lose their homes. 151 mortgage lenders have already gone belly up. Many of the hedge funds—which are loaded with billions of dollars in “mortgage-backed” securities are struggling to stay alive. Perhaps the most shocking projection was made by Yale University Professor, Robert Schiller, who believes that home prices could decline as much as 50% in some of the “hotter markets”. (Schiller's book “Irrational Exuberance” predicted the dot.com bust before it took place) The effects on the US economy would be considerable. If other factors come into play---like a stock market crash and a subsequent period of deflation---we could see housing prices descend 90% as they did between 1928 and 1933.
Typically, housing bubbles deflate very slowly, over a period of 5 to 10 years. Not this time. Credit problems in the broader market are speeding up the pace of the decline. The subprime sarcoma has spread to all loan categories and filtered into the banking system. This is forcing the banks to hoard reserves to cover their potential losses (from CDOs and mortgage-backed bonds “gone bad”). Now, even credit worthy applicants are being turned away on new mortgages. At the same time, “nearly half of borrowers with adjustable rate mortgages were not able to refinance their loans. That's a major concern for policymakers as an estimated 2.5 million mortgages given to borrowers with weak credit will reset at higher rates by the end of next year.” (Associated Press)
Think about that. It's no longer just a matter of 40% of loan-types disappearing overnight (Subprime, Alt-A, piggyback, negative amortization, interest only etc). Even people with good credit are being rejected because the banks are hoarding capital. That suggests the banks are in dire straights and hiding losses that are kept off their balance sheets. (more on this later)
So, it's harder to get a mortgage. And, if you already have one you may not be able to roll it over. This will greatly accelerate the rate of the housing crash. (In fact, the LA Business Journal reported on Sunday that home sales plunged 50% in one month. We can expect to see similar numbers in all the hot spots.)
The troubles facing the dollar are as grave as those in housing. The stock market and the teetering hedge funds are counting on an interest rate cut, but they've ignored the effects it will have on the greenback. If Bernanke lowers rates---as everyone expects--- the bottom could drop out of the dollar. We're already seeing gold soar to new highs (above $700 per Ounce) That's an indication of dollar-weakness and a potential sell-off of US Treasuries. If Bernanke lowers rates, the greenback will nosedive.
Author Gary Dorsch explains the potential hazards in his recent article, “ Hopes for an Easier Fed Policy Boost the Euro and Copper”:
“Interest rate differentials have played a key role in determining exchange rates. Since the ECB (European Central Bank) began its rate hike campaign in December 2005, the US dollar's interest rate advantage over the Euro has narrowed from 240 basis points to as low as 70 basis points today. Thus, the Fed can only afford a small rate cut to bail out Wall Street bankers who hold toxic sub-prime debt and avoid tipping the dollar into a free-fall. But that might not be enough to prevent a housing led recession in the months ahead.”
After years of abuse under Greenspan--an $800 billion current account deficit, a $9 billion per month war, and a 13% yearly increase in the money supply---the poor dollar has run out of wiggle-room. If the Fed slashes rates, the mighty greenback will be a dead duck.
COMMERCIAL PAPER: WHAT YOU DON'T KNOW CAN HURT YOU
Commercial paper is something that is rarely understood outside of the investor class. It is, however, a critical factor in keeping the markets operating smoothly. “Commercial paper is highly-rated short-term notes that offer investors a safe haven investment with a yield slightly above certificates of deposit or government debt. Banks use the money to purchase longer-term investments such as corporate receivables, auto loans credit card debt, or mortgagees.” (Wall Street Journal 9-5-07)
Commercial paper has been vanishing at an alarming rate in the last month. $240 billion has been drained in just the last 3 weeks. (There is $2.2 trillion of commercial paper in circulation in the US) Because CP is “short term”, hundreds of billions of dollars need to roll over (be refinanced) regularly.
CP is at the very heart of the credit crisis which has spread through the financial markets and it could result in a massive catastrophe. The large investment banks are in a panic---and that is probably an understatement. Consider this article in the UK Telegraph which provides an eye-popping summary of what is going on behind the scenes.
“Britain's biggest banks could be forced to cough up as much as £70bn over the next 10 days, as the credit crisis that has seized the global financial system sparks a fresh wave of chaos.
“ Almost 20 per cent of the short-term money market loans issued by European banks are due to mature between September 11 and September 19. Senior bankers fear that they will have to refinance almost all of these debts with funds from their own coffers, putting a further strain on bank balance sheets.
Tens of billions of pounds of these commercial paper loans have already built up in the financial system, because fear-ridden investors no longer want to buy them. Roughly £23bn of these loans expire on September 17 alone.
Fears of this impending call on bank credit lines are the true reason that lending between banks has ground to a halt, according to senior money market sources.
Banks have been stockpiling cash in preparation for this "double rollover" week, which sees quarterly loans expire alongside shorter term debts - exacerbating a problem that lies at the heart of the credit crisis.” (UK Telegraph)
Fortunately, the British still have a few newspapers—like the Telegraph-- that still report the news.
That is not the case in the US.
There's roughly $1.3 trillion in “asset-backed” commercial paper filtering through American markets. These are the notes that are connected to mortgage-backed securities (MBSs) that no one wants and which have NO MARKET VALUE. They are referred to as “toxic waste”. (No one is buying anything remotely connected to real estate CDOs)
Hundreds of billions of dollars of CP has been issued through SIVs (structured investment vehicles) and “conduits” which are affiliates (subsidiaries) of the large banks. The banks have kept these operations hidden from the public, but now they are in the spotlight because they cannot meet their obligations and are stuck with billions of CP that they cannot refinance. (The reader may recall that Enron kept similar “off balance sheets” operations secret from the public before they declared bankruptcy)
The banks are now forced to assume responsibility for the commercial paper held by their affiliates, which means that they need sufficient capitalization to cover the losses.
Sound confusing? Don't give up, yet!
The bottom line is this: The banks are responsible for hundreds of billions of dollars in commercial paper that probably won't be refinanced. IT IS BEGINNING TO LOOK LIKE THEY DON'T HAVE THE RESERVES TO COVER THEIR LOSSES.
That's why we continue to believe that the banks are in trouble.
According to the Wall Street Journal: “So do the banks and their shareholders have nothing to worry about? Not quite….Negligible losses in August were enough to force the banks to run to the authorities for help. Regulators may decide that the best way to prevent a recurrence is to require banks to hold more capital. They might even limit some types of transactions. Such moves might be good for the economy, but would reduce the bank's returns on equity.” (“Banks Seem Fine—For Now”, WSJ, 9-8-07)
Read carefully and I think you will agree with me that the WSJ is “tipping its hand” and suggesting that the banks needed “more capital” even after “negligible losses.” The predicament is much more serious now.
Bank troubles are never minor. That's why there has been so much effort put into covering up the real source of the problem. When people lose their confidence in the banks, they lose their confidence in the system. That ends up inciting social turmoil.
Don't think they're not aware of that at the White House.
THE LIKELIHOOD OF A HARD LANDING
Notwithstanding the imminent shakeup at the major investment banks, the path ahead is poorly lit and full of potholes. The reckless “spendthrift” policies of the last 7 years have edged us ever-closer to the inevitable day of reckoning. Professor Nouriel Roubini summed it up best in a recent blog-entry, “The Coming US Hard Landing”:
“ The forthcoming easing of monetary policy by the Fed will not rescue the economy and financial markets from a hard landing as it will be too little too late. The Fed underestimated the severity of the housing recession, its spillovers to other sectors, and the contagion of the sub-prime carnage to other mortgage markets and to the overall financial markets. Fed easing will not work for several reasons: the Fed will cut rate too slowly as it is still worried about inflation and about the moral hazard of perceptions of rescuing reckless investors and lenders; we have a glut of housing, autos and consumer durables and the demand for these goods becomes relatively interest rate insensitive once you have a glut that requires years to work out;
SERIOUS CREDIT PROBLEMS AND INSOLVENCIES CANNOT BE RESOLVED BY MONETARY POLICY ALONE; and the liquidity injections by the Fed are being stashed in excess reserves by the banks, not relent to the parts of the financial markets where the liquidity crunch is most severe and worsening. The Fed provided liquidity to banking institutions but it cannot provide direct liquidity to hedge funds, investment banks, other highly leveraged institutions and parts of the credit markets – such as asset backed commercial paper – where the crunch is severe. Thus, the liquidity crunch in most credit markets remains severe, even in the usually most liquid interbank markets.” (Nouriel Roubini's Blog)
SOUP KITCHEN USA
There are no quick-fixes or “silver bullets” as Bush likes to say. It'll take years to dig our way out of this mess. In the meantime, there's little to look forward to except the steady weakening of the dollar, the persistent decline in housing and the looming police-state apparatus that's supposed to keep us in line while the soup kitchens open.
Last updated 13/12/2007