“A Generalized Meltdown of Financial Institutions” By Mike Whitney

Dandelion Salad

By Mike Whitney
11/24/07 “ICH

Take a Look at Professor Roubini’s Crystal Ball

Reality has finally caught up to the stock market. The American consumer is underwater, the banks are buried in dept, and the housing market is in terminal distress. The Dow is now below its 200-Day Moving Average — the first big “sell” signal. Anything below 12,500 could trigger program-trading and crash the market. The increased volatility suggests that we are watching a “real time” meltdown.

International Business editor for the UK Telegraph, Ambrose Evans Pritchard, summed up yesterday’s action in the Asian markets:

“The global credit crisis has hit Asia with a vengeance for the first time, triggering a massive flight to safety as investors across the region pull out of risky assets. Yields on three-month deposits in China and Korea have plummeted to near 1pc in a spectacular fall over recent days, caused by panic withdrawals from money market funds and credit derivatives.

“‘This’ is a severe warning sign,’ said Hans Redeker, currency chief at BNP Paribas. ‘Asia ignored the credit crunch in August but now we’re seeing the poison beginning to paralyze the whole global economy.'” (Credit ‘Heart attack’ engulfs China and Korea” Ambrose Evans Pritchard,UK Telegraph,)

The credit storm that began in the United States with subprime mortgages has spread to markets across the globe. In fact, the train has already crashed. What we’re seeing now is the boxcars piling up on top of each other.

On Tuesday Chinese government officials ordered a complete halt to bank lending to slow the speculative frenzy that has created an enormous equity bubble in the stock market. According to the Wall Street Journal:

“Chinese authorities are slamming the brakes on bank lending, in their latest attempt to curb the runaway investment threatening to overheat what is soon to be the world’s third-largest economy. In recent weeks, regulators have quietly ordered China’s commercial banks to freeze lending through the end of the year, according to bankers in several cities. The bankers say that to comply, they are canceling loans and credit lines with businesses and individuals.” (“China freezes lending to Curb Investing Frenzy” Wall Street Journal)

The move illustrates how concerned the Chinese are that a slowdown in US consumer spending will trigger a crash on the Shanghai stock market. It also shows that the Chinese are having difficulty dealing with the inflation generated by the hundreds of billions of US dollars absorbed via the trade imbalance with the US. China is awash in USDs and that surplus is causing a steady rise in food and energy costs. This could be mitigated by allowing their currency to “float” freely. But a sudden, steep increase in the Chinese yuan’s value could also send the world headlong into a global recession. For now, the lending freeze and price fixing appear to be the way out.

Another sign that the markets have reached a “tipping point” appeared in a Reuters article on Wednesday; “Interbank Covered Bond Trading Halted on Volatility”:

“Renewed credit turmoil and volatility led the European Covered Bond Council (ECBC) on Wednesday to suspend inter-bank market-making in covered bonds until Monday, Nov. 26.

The move is a sign of the stress in the covered bond market, which is dominated by German institutions that have almost a trillion euros of covered bonds outstanding.

Covered bonds — backed by pools of assets that remain on the borrower’s balance sheet — are usually highly liquid and typically rated triple-A by ratings agencies. The ECBC’s recommendation is aimed at relieving the pressure on market makers who are forced to quote prices at a fixed bid-offer spread.

“In light of the current market situation and in order to avoid undue over-acceleration in the widening of spreads, the 8-to-8 Market-Makers & Issuers Committee recommends that inter-bank market-making be suspended,” the ECBC said in a release.”

Note: This isn’t mortgage-backed junk that’s being sold, but highly liquid bonds that are usually easy to cash in. The ECBC’s action is a sign of pure desperation and indicates that credit paralysis has infected the entire euro banking system.

Reuters: “Due to general market conditions and the specific mechanics of the inter-dealer market making it even seems possible that inter-dealer market making will not be resumed this year.”

That’s bad. The mechanism for converting covered bonds into cash has broken down.

The dollar took another pasting on Wednesday, sliding to $1.49 on the euro; another new record. Gold shot up to $814 per ounce. Oil continues to flirt with the $100 per barrel mark, and the yen rose to 107 per dollar forcing a sell-off of hedge fund assets levered through the carry trade.

Jon Basile, economist at Credit Suisse, summed it up like this: “There’s a heck of a lot of bad news out there.” Indeed.

In California Governor Arnold Schwarzenegger has joined with four mortgage lenders to freeze adjustable interest rates (ARMs) for some of the state’s highest-risk borrowers; another unprecedented move. The Governor hopes to avoid a collapse of the California real estate market which has gone into a tailspin. Home sales have plummeted more than 40 per cent for the last two months. Prices have dropped sharply—roughly 12 per cent statewide. New construction has slowed to a crawl. Layoffs are steadily rising. Jumbo loans (mortgages over $417,000) have been put on the “Endangered Species” list. Even qualified borrowers can’t get mortgages. Nothing is selling. California housing is “off the cliff”.

Schwarzenegger’s plan to keep over-extended subprime mortgage-holders in their homes faces an uncertain future. What incentive is there for homeowners to continue paying exorbitant monthly rates when their payments are not applied to the principle? The homeowners would be better off bailing out, accepting foreclosure, and starting over with a clean slate.

It’s unrealistic to thinks that Schwarzenegger can stop the tidal wave of foreclosures that are sweeping across the state. An estimated 3 million homeowners will lose their homes nationwide.

If you want to blame someone; blame Alan Greenspan. He’s the one who created this mess. According to the economist Mike Shedlock:

“The Fed caused the credit crunch by slashing interest rates to 1 per cent to bail out its banking buddies in the wake of a dotcom bubble collapse. All the Fed did was create a bigger bubble. This bubble is so big in fact that it cannot even be bailed out. It’s the end of the line for a serially bubble blowing Fed.

“So not only was this the biggest credit bubble in history, this was also the biggest transfer of wealth from the poor and middle class to the already enormously wealthy. That is the real travesty of justice regardless of whether or not the price tag is $1 trillion, $2 trillion, or $10 trillion.” (Mike Shedlock, “Mish’s Global Economic Trend Analysis”)

The problem has gotten so serious that even Secretary of the Treasury, Henry Paulson, is putting up red flags. Last week, Paulson ignited a sell-off on Wall Street when he made this statement:

“The nature of the problem will be significantly bigger next year because 2006 [mortgages] had lower underwriting standards, no amortization, and no down payments….We’re never going to be able to process the number of workouts and modifications (to mortgages) that are going to be necessary doing it just sort of one-off. I’ve talked to enough people now to know that there’s no way that’s going to work.”

The desperation is palpable. Like Schwarzenegger, Paulson is trying to get mortgage-lenders to provide a safety net for struggling borrowers who are defaulting on their loans.

Paulson is calling for emergency legislation that will allow the Federal Housing Administration to play a greater role in the relief effort. The FHA has already expanded its traditional role by taking on hundreds of billions in extra debt just to keep a few “private” mortgage lenders and banks from going bankrupt. Of course, when Paulson’s plan goes kaput and the debts pile up; it’ll be the taxpayer that foots the bill.

“Paulson also called the Senate’s failure to pass legislation overhauling mortgage giants Fannie Mae and Freddie Mac frustrating,” saying that the two government-sponsored entities need to be playing a bigger role in the housing market.

“If we ever need them it’s during times like today, and they’re most valuable when there is distress in the mortgage market,” he said. “I’d like to see them playing an even bigger role.”(Wall Street Journal)

Fannie and Freddie, have already posted enormous quarterly losses and don’t have the capital reserves to put millions of subprime mortgage-holders under their “government-sponsored” umbrella. Paulson is just grabbing at straws.

Similar troubles are brewing in the broader market where late-payments and defaults have spread to credit card debt and new car loans. Every area of “securitized” debt has suddenly veered off the road and into the ditch. Last week the Fed injected more credit into the teetering banking system than anytime since 9-11.

No one has predicted the downward-spiral in the market more accurately than Nouriel Roubini. Roubini is a Professor at the Stern School of Business at New York University. His analysis appears regularly on his blogsite, Global EconoMonitor. Last week’s prediction was particularly dire and is worth reprinting here:

“It is increasingly clear by now that a severe U.S. recession is inevitable in next few months…I now see the risk of a severe and worsening liquidity and credit crunch leading to a generalized meltdown of the financial system of a severity and magnitude like we have never observed before. In this extreme scenario whose likelihood is increasing we could see a generalized run on some banks; and runs on a couple of weaker (non-bank) broker dealers that may go bankrupt with severe and systemic ripple effects on a mass of highly leveraged derivative instruments that will lead to a seizure of the derivatives markets… massive losses on money market funds with a run on both those sponsored by banks and those not sponsored by banks; ..ever growing defaults and losses ($500 billion plus) in subprime, near prime and prime mortgages with severe knock-on effect on the RMBS and CDOs market; massive losses in consumer credit (auto loans, credit cards); severe problems and losses in commercial real estate…; the drying up of liquidity and credit in a variety of asset backed securities putting the entire model of securitization at risk; runs on hedge funds and other financial institutions that do not have access to the Fed’s lender of last resort support; a sharp increase in corporate defaults and credit spreads; and a massive process of re-intermediation into the banking system of activities that were until now altogether securitized.” (Nouriel Roubini’s Global EconoMonitor)

“A generalized meltdown of the financial system”.

Looks like Chicken Little might have gotten it right this time; “The sky IS falling.”

Mike Whitney lives in Washington state. He can be reached at: fergiewhitney@msn.com

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Banks Gone Wild By Paul Krugman

8 thoughts on ““A Generalized Meltdown of Financial Institutions” By Mike Whitney

  1. Lo,
    What a complex mess, and we get left holding the bag, again.
    The Mortage Com.’s allowed the up pricing of standard homes, to speculate on the return on the Loan Investment, not the Home Owner’s bottom line, but rather the Co.’s.
    Some-one build an arc, we are Drowning Debt.

  2. In case you haven’t noticed, the US dollar is worth a mere 60% of its world exchange value when the stock market was hitting rock bottom in 2002. That’s a 40% loss in global purchasing power. Has anyone discussed this with frankness or clarity ? That not only has the housing market crashed, but is has crashed in concert with something akin to a banana republic currency devaluation. Not only is your house worth less, much less in dollar terms, but more, your house is worth 40% less in currency terms.


  3. First things first… the Mainstream Media have been absorbed into enormous corporate structures and do not dare publish a reality based criticism of the breakdown process. On one had we observe endless dithering and analysis… but analysis of what. ?.. Federal Reserve operations, structural minutiae of how CDO tranches are ordered… and yet, a total and complete failure to see the larger truths from a panaromic, non-abstract perspective.

    Which is ?

    Which is this: the real estate boom was the consumers last great grasp for the brass ring of financial independence. It was the last great hope of stabilizing the old “american way of life” against the tides of corporatization and globalization. It was a near-magical totem that bring back prosperity, return the midle class to its rightful place, and ward off the terrors and evils of decline into a shabby, British Empire In Decay anomie.

    Politicians understood this intuitively and dared not interfere. No individual nor any political party had anything close to the guts to stop an unreal, cripplingly addictive process. We were governed by a class of enablers who would do anything, say anything, permit anything, pretend to be blind to anything, if by so doing they could retain their grip on power. It was a conscious, deliberate policy of absolute cynicism and opportunism. It was also a great gamble. One that failed. As in, sometimes you roll snake eyes and lose the pot.

    In case you haven’t noticed, the US dollar is worth a mere 60% of its world exchange value when the stock market was hitting rock bottom in 2002. That’s a 40% loss in global purchasing power. Has anyone discussed this with frankness or clarity ? That not only has the housing market crashed, but is has crashed in concert with something akin to a banana republic currency devaluation. Not only is your house worth less, much less in dollar terms, but more, your house is worth 40% less in currency terms.

    So, let the pundits do the math. A One Million dollar house in 2002 dollars is only a $600,000 dollar house in 2007 dollars… so in world terms, the real estate boom never happened, all that was happening was that houses were barely keeping up with the dollar devaluation, as a “desperation store of value”…

    In other words, the real estate market was functioning as an adjunct to Federal Reserve Policy… hopefully allowing John and Jane Q. Public to stabilize their net worth against a globalizing, offshoring economy were their skills would compete against a newly educated third world workforce.

    But the Washington Politico-Pimps could not admit that, not woluld the Media-Pimps discuss it, except in the most convoluted, abstract, policy arcana….

    Thus, what has happened, in the bluntest terms, is that the political class acceded to the collective impoverishment of the american middle class, and make no mistake they were handsomly rewarded for so doing, and this was hidden from public view by allowing the runaway train of real estate speculation to capture the public imagination.

    Evil. Brilliant. Machiavellian. Good Business. Hope you can pay off those credit cards.

  4. I too would like to see the end of selfish capitalistic tyranny. But somehow I don’t imagine they’ll let the ‘perceived’ value of the dollar fall that far. I’m no economist, and would like to know what Paul Krugman would say– but to be sure, the massive amount of moola cornered by the fat-cats in this place since the boom began, is so unimaginably daunting, their power now so great, it seems unlikely they will allow such a vast paper devaluation. In any case, they will still be fat no matter what, and even 2k gold won’t touch their jewelry budget. Though it would be the healthiest thing to devalue this place back to growing our own veggies, I’d be very cynical about that going smoothly around here… But by all means, let the US liquidity collapse begin! I’m moving to Norway…

  5. “Last week the Fed injected more credit into the teetering banking system than anytime since 9-11.”

    This is incorrect. Practically every trading day, the Fed temporarily injects additional money into the banking system. Maturity is usually from 1 to 14 days.

    When reporting this activity, the media almost never takes into account what’s maturing and expiring the same day. Last week, the daily net add was: Mon (+5.5B), Tues (+4.5B), Wed (+2.75), Thu (none – holiday), and Fri (-8.75B). Yes, Friday was a net drain. This isn’t much different than the weeks or months before 9-11 let alone before the recent credit crisis started.

    Central banks in Europe though have had to periodically inject huge net amounts trying to keep their fed funds rates near benchmark. We haven’t experienced anywhere near the same problem in the US…yet.

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