The Guardian 26 September, 2007

Are the banks in trouble?

Mike Whitney

"The new capitalist gods must love the poor — they are making so many more of them." Bill Bonner, The Daily Reckoning

"The truth is that the public — even professionals on Wall Street — have no clue what the real problem is. They know it has something to do with derivatives, but none of them realise that it’s more than a $20 trillion mountain of unfunded, unregulated paper that has just been discovered to not have a market and, therefore, no real value. When the dollar realises the seriousness of the situation — now or sometime soon — the bottom will drop out", said Jim Sinclair, Investment analyst in July.

The Wall Street Journal (WSJ) says: "The rising inter-bank lending rates are a proxy of sorts for the increased risk that some banks may go belly up." (Editorial; WSJ 9/6/07)

Ironically, the WSJ editorial staff which normally defends deregulation and laissez faire economics — is now calling for regulators to make sure they are "on top of the banks they are supposed to be regulating, so we don’t get any surprise bank failures that spook the markets and confirm the worst fears being whispered about."

Bank uncertainty

Credit standards have tightened and banks are increasingly reluctant to loan money to each other not knowing who may be sitting on billions of dollars in toxic mortgage-backed debt. It makes no difference that the "underlying economy is sound" as Bernanke likes to say. When banks hesitate to loan money to each other; it shows that there is real uncertainty about the solvency of the other banks. That slows down normal commerce and the gears on the economic machine begin to rust in place.

The woes of the banks have been exacerbated by the flight of investors from money market funds, many of which are backed by Mortgage-backed Securities. Wary investors are running for the safety of US Treasury [bonds] even though yields have declined at a record pace. This is causing problems in the Commercial Paper market as well as for the lesser-known State Investment Volumes and "conduits". These abstruse-sounding investment vehicles are the essential plumbing that maintains normalcy in the markets. Commercial paper is a $2.2 trillion market. When it shrinks by more than $200 billion — as it has in the last 3 weeks — the effects can be felt through the entire system.

The credit crunch has spread across the whole gamut of commercial paper and low-grade debt. Banks are hoarding cash and refusing loans to even credit-worthy applicants. The collapse in sub-prime loans (that is loans to customers who have little to pay back the interest, let alone the original loan) is just part of the story.

Unconventional loans

More than 50% of all mortgages in the last two years have been unconventional loans — no down payment, no verification of income, interest-only repayments.

Even more worrisome, the large investment banks have myriad "off-book" operations which are in distress. This has forced the banks to circle the wagons and reduce their issuance of loans which is accelerating the downturn in housing.

The financial distress of many homeowners and the complete breakdown in loan-origination (due to the growing credit crunch) ensures that the housing market will crash-land sometime in late 2008 or early 2009. The banks are expected to write-off a considerable portion of their debt at the end of the 3rd quarter rather than keep the losses on their books. This will further hasten the decline in housing prices.

The investment banks are also facing enormous potential losses from liabilities that "operate off their balance sheets".

Citigroup could be holding the bag for $21 billion in outstanding debt? Or, perhaps, their entire $100 billion is red ink; who knows?

Does this mean that the other large banks are involved in the same type of "hide-n-seek" strategies? Sounds a lot like Enron’s "off-the-books" shenanigans, doesn’t it?

How did we get into this mess?

More than 20 years of dogged lobbying from the financial industry paid off with the repeal of the Glass-Steagall Act which was passed by Congress following the 1929 stock market crash. The bill was written to limit the conflicts of interest when commercial banks are permitted to underwrite stocks or bonds.

In August 1987, Alan Greenspan — formerly a director of JP Morgan and a proponent of banking deregulation — became chairman of the Federal Reserve Board.

"In 1990, JP Morgan became the first bank to receive permission from the Federal Reserve to underwrite securities, so long as its underwriting business does not exceed the 10 percent limit. In December 1996, with the support of Chairman Alan Greenspan, the Federal Reserve Board issued a precedent-shattering decision permitting bank holding companies to own investment bank affiliates with up to 25 percent of their business in underwritten securities (up from 10 percent).

Sounds like a good thing, doesn’t it? This protects the overall financial system as well as the individual depositor. Unfortunately, the banks found a way to circumvent the rules for minimum reserves by "securitising" pools of mortgages rather than holding individual mortgages. (which called for more reserves) This provided lavish origination and distribution fees for banks, but shifted much of the risk of default to Wall Street investors. Now, the banks are saddled with roughly $300 billion in mortgage-backed debt that no one wants and it is uncertain whether they have sufficient reserves to cover their losses.

Banks now behave more like securities firms, more likely to mark down the value of assets when market prices fall — even to distressed levels — rather than sitting on bad loans for a decade and pretending they’ll be paid back.

The downside of this is that once the banks write off these toxic loans; the hedge funds, insurance companies and pension funds will be forced to do the same — dumping boatloads of this bond-sludge on the market driving down prices and triggering a panic.

Regrettably, the Fed Reserve cannot hope to remove a half-trillion of bad debt from the balance sheets of the banks or forestall the collapse of related financial institutions and funds which are loaded with these "unmarketable" time-bombs. We can then expect the stock market to fall sharply and the housing recession to turn into a full-blown economic crisis.

Who is to blame?

So, who’s to blame? The finger-pointing has already begun and more and more people are beginning to see how this massive economy-busting equity bubble originated at the Federal Reserve — it is the logical corollary of former Fed-chief Alan Greenspan’s "easy money" policies.

Greenspan presided over the greatest expansion of speculative finance in history with the notional value of derivatives surpassing an unfathomable $220 trillion.

On Greenspan’s 18-year watch, the assets of US government-sponsored enterprises ballooned by 830%, from $346 billion to $2.872 trillion.

"The greatest expansion of speculative finance in history". That says it all.

But no one makes the case against Greenspan better than Greenspan himself. Here are some of his comments at the Federal Reserve System’s Fourth Annual Community Affairs Research Conference on April 8, 2005.

They show that Greenspan "rubber stamped" every one of the policies which have since spread through the entire US economy.

Greenspan championed sub-prime loans

"Innovation has brought about a multitude of new products, such as sub-prime loans and niche credit programs for immigrants. Such developments are representative of the market responses that have driven the financial services industry throughout the history of our country. With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers", said Greenspan.

"Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately.

"These improvements have led to the rapid growth in sub-prime mortgage lending, fostering constructive innovation that is both responsive to market demand and beneficial to consumers."

"Improved access to credit for consumers, and especially these more-recent developments, has had significant benefits.

"Unquestionably, credit availability to virtually all income classes has vastly increased. Access to credit has enabled families to purchase homes, deal with emergencies, and obtain goods and services. Home ownership is at a record high, and the number of home mortgage loans to low- and moderate-income and minority families has risen rapidly over the past five years. Credit cards and instalment loans are also available to the vast majority, including those of limited means. Without these policies, it would have been impossible for lower-income consumers to have the degree of access to credit markets that they now have.

Greenspan’s own words show that he played a central role in our impending disaster. The problems began at the Federal Reserve and that’s where the responsibility lies.

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