Whence the Economy?

After months of denial to soothe a nervous market, the Federal Reserve, the US central bank, finally started to take increasingly desperate steps to try to inject more liquidity into distressed financial institutions to revive and stabilize credit markets that have been roiled by turmoil since August 2007 and to prevent the home mortgage credit crisis from infesting the whole economy.

Yet more liquidity appears to be a counterproductive response to a credit crisis that has been caused by years of excess liquidity. A liquidity crisis is merely a symptom of the current financial malaise. The real disease is mounting insolvency resulting from excessive debt for which adding liquidity can only postpone the day of reckoning
towards a bigger problem but cannot cure. Further, the market is stalled by a liquidity crunch, but the economy is plagued with excess liquidity. What the Fed appears to be doing is to try to save the market at the expense of the economy by adding more liquidity.

The Federal Reserve has at its disposal three tools of monetary policy: open market operations to keep Fed Funds rate on target, the discount rate and bank reserve requirements. The Board of Governors of the Federal Reserve System is responsible for setting the discount rate at which banks can borrow directly from the Fed and for setting bank reserve requirements. The Federal Open Market Committee (FOMC) is responsible for setting the Fed Funds rate target and for conducting open market operations to keep it within target. Interest rates affects the cost of money and the bank reserve requirements affect the size of the money supply.

The FOMC has 12 members – the seven members of the Board of Governors of the Federal Reserve System; the president of the Federal Reserve Bank of New York; and four of the remaining 11 Reserve Bank presidents, who serve one-year terms on a rotating basis. The FOMC holds eight regularly scheduled meetings per year to review economic and financial conditions, determine the appropriate stance of monetary policy, and assess the risks to its long-run goals of price stability and sustainable economic growth. Special meetings can be called by the Fed chairman as needed.

Using these three policy tools, the Federal Reserve can influence the demand for, and supply of balances that depository institutions hold at Federal Reserve Banks and in this way can alter the federal funds rate target, which is the interest rate at which depository institutions lend balances at the Federal Reserve to other depository institutions overnight. Changes in the federal funds rate trigger a chain of effects on other short-term interest rates, foreign exchange rates, long-term interest rates, the amount of money and credit, and, ultimately, a range of economic variables, including employment, output, and market prices of goods and services.

Yet the effects of changes in the Fed Funds rate on economic variables are not static nor are they well understood or predictable since the economy is always evolving into new structural relationships among key components driven by changing economic, social and political conditions. For example, the current credit crisis has evolved from the unregulated global growth of structured finance with the pricing of risk distorted by complex hedging which can fail under conditions of distress. The proliferation of new market participants such as hedge funds operating with high leverage on complex trading strategies has exacerbated volatility that changes market behavior and masked heightened risk levels in recent years. The hedging against risk for individual market participants has actually increased an accumulative effect on systemic risk.

The discount window is designed to function as a safety valve in relieving pressures in interbank reserve markets. Extensions of discount credit can help relieve liquidity strains in individual depository institutions and in the banking system as a whole. The discount window also helps to ensure the basic stability of the payment system more generally by supplying liquidity during times of systemic stress. Yet the discount window can have little effect when a liquidity drought is the symptom rather than the cause of systemic stress.

Banks in temporary distress can borrow short term funds directly from a Federal Reserve Bank discount window at the discount rate, set since January 9, 2003 at 100 basis points above the Fed Funds rate. Prior to that date, the discount rate was set below the target Fed Funds rate to provide help to distressed banks but a stigma was attached to discount window borrowing. Healthy banks would pay 50 to 75 basis points in the money market rather than going to the Fed discount window, complicating the Fed’s task in keeping the Fed Funds rate on target. Part of the reason for raising the discount rate 100 basis point above the Fed Funds rate on January 9, 2003 was to remove this stigma that had kept many banks from using the Fed discount window. (For a historical account of the change of the discount rate, see Central bank impotence and market liquidity, Asia Times Online, August 24, 2007.)

Both the discount rate and the Fed Funds rate are set by the Fed as a matter of policy. On August 17, 2007, the discount window primary credit program was temporarily changed to allow primary credit loans for terms of up to 30 days, rather than overnight or for very short terms as before. Also, the spread of the primary credit rate over the FOMC’s target federal funds rate has been reduced to 50 basis points from its customary 100 basis points. These changes will remain until the Federal Reserve determines that market liquidity has improved. The Fed keeps the Fed Funds rate within narrow range of its target through FOMC trading of government securities in the repo market.

A repurchase agreement (repo) is a loan, often for as short as overnight, typically backed by top-rated US Treasury, agency, or mortgage-backed securities. Repos are contracts for the sale and future repurchase of top-rated financial assets. It is through the repo market that the Fed injects funds into or withdraws funds from the money market, raising or lowering overnight interest rates to the level set by the Fed. (See The Wizard of Bubbleland – Part II: The repo time bomb Asia Times Online, September 29, 2005).

Until the regular FOMC meeting scheduled for January 29, 2008, the discount rate had been expected to stay at 4.75% while the Fed Funds target would stay at 4.25%, with a 50 basis points spread, half of normal, which had been set at a spread of 100 basis points since January 9, 2003. From a high of 6% set on May 18, 2000, the Fed had lowered the discount rate in 12 steps to 0.75% by November 7, 2002 and kept it there until January 8, 2003 while the Fed Funds rate target was set at 1.25%, 50 basis points above. On January 9, 2003, the discount rate was set 100 basis points above the Fed Funds rate target. Then the Fed gradually raised the discount rate back up to 6% by May 10, 2006 and again to 6.25% on June 29, 2006. On August 18, 2007, in response to the sudden outbreak of the credit market crisis, the Fed panicked and dropped the discount rate 50 basis points to 5.75%, and continued lowering it down to the current level of 4.75% set on December 12, 2007.

On Monday, January 21, a week before the scheduled FOMC meeting, global equities plunged as investor concerns over the economic outlook and financial market turbulence snowballed into a sweeping sell-off. Tumbling Asian shares – which continued to fall early on Tuesday – led European stock markets into their biggest one-day fall since the 9/11 terrorist attacks of 2001 as the prospect of a US recession and further fall-out from credit market turmoil prompted near panic among investors, forcing them to rush to the safety of government bonds.

About $490 billion was wiped off the market value of Europe’s FTSE Eurofirst 300 index and $148 billion from the FTSE 100 index in London, which suffered its biggest points slide since it was formed in 1983. Germany’s Xetra Dax slumped 7.2% to 6,790.19 and France’s CAC-40 fell 6.8% to 4,744.45, its worst one-day percentage point fall since September 11, 2001. The price collapse was driven by general negative sentiments and not, so far as was apparent at the time, by any one identifiable event.

After being closed on Monday for the Martin Luther King holiday, US stock benchmarks echoed foreign markets with big declines, extending large losses from the previous week, with bearish sentiments accelerated by heavy selling across global markets. About an hour before the NY Stock Exchange open on Tuesday, the Federal Reserve announced a cut of 75 basis points of the Fed Funds rate target to 3.50%, the first time that the Fed has changed rates between meetings since 2001, when the central bank was battling the combined impacts of a recession and the terrorist attacks.

Fed officials decided on their move at a videoconference at 6pm US time on Monday, January 21, with one policymaker – Bill Poole, the president of the St Louis Fed, dissenting. In a statement, the Fed said it acted “in view of a weakening of the economic outlook and increased downside risks to growth”. It said that while strains in short-term money markets had eased, “broader financial conditions have continued to deteriorate and credit has tightened further for some businesses and households”. And new information also indicated a “deepening of the housing contraction” and “some softening in labor markets”.

Subsequently, French bank Societe Generale SA said that bets on stock index futures by a rogue trader had caused a 4.9 billion-euro ($7.2 billion) trading loss, the largest in banking history. This led to speculation, rejected by the bank, that the market declines in Europe on Monday were in part the consequence of the Societe Generale unwinding trading positions linked to European stock index futures on January 21, when equity markets in France, Germany and the UK fell more than 5% and the day before the Fed rate cut.

“It’s not possible that our covering operations contributed to the market’s fall,” said Philippe Collas, the head of asset management at the bank, according to a Bloomberg report on January 25.

The Fed in announcing its rate cut pledged to act in a “timely manner as needed” to address the risks to growth, implying that it expects to cut the federal funds rate rates still further and will consider doing so at its scheduled policy meeting on January 30.

In overnight trade, Asian shares extended their losses. Japan’s Nikkei 225 index accumulated its worst two-day decline in nearly two decades, losing more than 5% and falling below 13,000 for the first time since September 2005.

Initially, the Fed move caused S&P stock futures to jump but within half an hour they were lower than they had been at the moment the rate cut was announced. The Dow Jones Industrial Average, down 465 points shortly after market open, fluctuated throughout the day before closing with a milder drop of 126.24, or 1.04%, at 11,973.06, the first closing below 12,000 since November 3, 2006.

The move was the first unscheduled Fed rate cut since September 17, 2001 and its largest increment since regular meetings began in 1994. It was a sharp departure from traditional gradualism preferred by the Fed and wild volatility in the market can be expected as a result. S&P equity volatility as measured by the Vix index surged 38%, eclipsing the high set in August when the credit crisis first surfaced.

The aggressive Fed action triggered a rebound in European stock markets, but was not enough to stop the US equity market – which had been closed when markets fell globally on Monday – from trading lower. At midday the S&P 500 index was at 1,302.24 down 1.7% on the day and 11.3% so far this year amid mounting concern over the prospect of a US recession and further credit market turmoil. While financial stocks had rebounded 1.8% in morning trading, other main sectors were sharply lower, by a 3.4% decline in technology shares.

While the Fed has the power to independently set the discount rate directly and keep the Fed Funds rate on target indirectly through open market operations, the impact of short-term rates on monetary policy implementation has been diluted by long-term rates set separately by deregulated global market forces. When long-term rates fall below short-term rates, the inverted rate curve usually suggests future economic contraction.

Both discount and Fed funds loans are required to be collateralized by top-rated securities. Since August 2007, the Fed has been faced with the problem of encouraging distressed banks to borrow from the Fed discount window without suffering the usual stigma of distress, accepting as collateral bank holdings of technically still top-rated collateralized debt obligations (CDOs) which in reality have been impaired by their tie to subprime home mortgage debt obligations that have lost both marketability and value in a credit market seizure.

As economist Hyman Minsky (1919-1996) observed insightfully, money is created whenever credit is issued. The corollary is that money is destroyed when debts are not paid back. That is why home mortgage defaults create liquidity crises. This simple insight demolishes the myth that the central bank is the sole controller of a nation’s money supply. While the Federal Reserve commands a monopoly on the issuance of the nation’s currency in the form of Federal Reserve notes, which are “legal tender for all debts public and private”, it does not command a monopoly on the creation of money in the economy.

The Fed does, however, control the supply of “high power money” in the regulated partial reserve banking system. By adjusting the required level of reserves and by injecting high power money directly into the banking system, the Fed can increase or decrease the ability of banks to create money by lending the same money to customers multiple times, less the amount of reserves each time, relaying liquidity to the market in multiple amounts because of the mathematics of partial reserve. Thus with a 10% reserve requirement, a $1,000 initial deposit can be loaned out 45 times less 10% reserve withheld each time to create $7,395 of loans and an equal amount of deposits from borrowers.

But money can be and is created by all debt issuers, public and private, in the money markets, many of which are not strictly regulated by government. While a predominant amount of global debt is denominated in dollars, on which the Fed has monopolistic authority, the notional value used in structured finance denominated in dollars, which reached a record $681 trillion in third quarter 2007, is totally outside the control of the Fed. Virtual money is largely unregulated, with the dollar acting merely as an accounting unit. When US homeowners default on their mortgages en mass, they destroy money faster than the Fed can replace it through normal channels. The result is a liquidity crisis which deflates asset prices and reduces monetized wealth.

As the debt securitization market collapses, banks cannot roll over their off-balance sheet liabilities by selling new securities and are forced to put the liabilities back on their own balance sheets. This puts stress on bank capital requirements. Since the volume of debt securitization is geometrically larger than bank deposits, a widespread inability to roll over short term debt securities will threaten banks with insolvency.

The Fed can create money, not wealth

Money is not wealth. It is only a measurement of wealth. A given amount of money, qualified by the value of money as expressed in its purchasing power, represents an account of wealth at a given point in time in an operating market. Given a fixed amount of wealth, the value of money is inversely proportional to the amount of money the asset commands: the higher the asset price in money terms, the less valuable the money. When debt pushes asset prices up, it in effect pushes the value of money down in terms of purchasing power. In an inflationary environment, when prices are kept high by excess liquidity, monetized wealth stored in the underlying asset actually shrinks. This is the reason why hyperinflation destroys monetized wealth.

When the central bank withdraws money from the market by selling government securities, it in essence reduces sovereign credit outstanding because a central bank never needs to borrow its own currency, which it can issue at will, the only constraint being the impact on inflation, which can become a destroyer of monetized wealth when inflation is tolerated not as a stimulant for growth but merely to prop up an overpriced market in a stagnant economy.

Yet debt can only be issued if there are ready lenders and borrowers in the credit market. And the central bank is designed to serve as “lender of last resort” when lenders become temporarily scarce in credit markets. But when borrowers are scarce not due to short-term cash flow problems but due either to low credit rating or insufficient borrower income to service debts, the central bank has no power to be a “borrower of last resort”.

The role of “borrower of last resort” belongs to the federal government, as Keynes observed when he advocated government deficit spending to moderate business cycles. The Bush administration, through the Treasury, sells sovereign bonds to finance a hefty fiscal deficit. The only problem is that it spends both taxpayer money and proceeds from sovereign bonds mostly on wars overseas, leaving the domestic economy in a liquidity crisis.

To address an impending recession, the Bush 2008 proposal of a $150 billion stimulus package of tax relief, representing 1% of GDP, would target $100 billion to individual taxpayers and about $50 billion toward businesses. Economists said a reasonable range for tax cuts in the package might be $500 to $1,000 per tax payer, averaging $800. Bush said the income tax relief “would help Americans meet monthly bills and pay for higher gas prices”. The policy objective is to keep consumers spending to stimulate the slowing economy, as consumer spending accounts for about 70% of the US economy.

Speaking after the president, Secretary of the Treasury Henry Paulson said he was confident of long-term economic strength, but that “the short-term risks are clearly to the downside, and the potential cost of not acting has become too high.” He added that 1% of GDP would equate to $140 billion to $150 billion, which is along the lines of what private economists say should be sufficient to help give the economy a short-term boost.

“There’s no silver bullet,” Paulson said, “but, there’s plenty of evidence that if you give people money quickly, they will spend it.”

Yet the Republican proposal favors a tax rebate, meaning that only those who actually paid taxes would get a refund. That means a family of four with an annual income of $24,000 would receive nothing and only those with annual income of over $100,000 would get the full $800 rebate per taxpayer, or $1,600 for joint return households.

Further, against a total US consumer debt (which includes installment debt, but not home mortgage debt) of $2.46 trillion in June 2007, which came to $19,220 per tax payer, the Bush rebate of $800 would not be much relief even in the short term. In 2007, US households owed an average of $112,043 for mortgages, car loans, credit cards and all other debt combined. Outstanding credit default swaps is around $45 trillion, which is three times larger than US GDP of $15 trillion and 3,000 times larger than the Bush relief plan of $150 billion.

Bush did not push for a permanent extension of his 2001 and 2003 tax cuts, many of which are due to expire in 2010, eliminating a potential stumbling block to swift action by Congress, since most the controlling Democrats oppose making the tax cuts permanent. The 2008 tax relief proposal harks back to the Bush 2001 and 2003 tax cuts, which were at variance with established principles that an effective tax stimulus package needs to maximize the extent to which it directly stimulates new economic activity in the short-term and minimize the extent to which it indirectly restrains new activity by driving up interest rates.

The Bush tax cuts were implemented without first adopting an overall stimulus budget; without designing business incentives to provide reasons for new investment, rather than windfalls for old investment; nor designing household tax cuts to maximize the effects on short-term spending; without focusing on temporary (one-year) items for businesses and households, not permanent ones. Most significant of all, they failed to maintain long-term fiscal discipline.

The flawed 2001 Bush tax stimulus package included five items: 1) A permanent tax subsidy (through partial expensing) of business investment; 2) permanent elimination of the corporate alternative minimum tax; 3) permanent changes in the rules applying to net operating loss carry-backs; 4) acceleration of some of the personal income tax reductions scheduled for 2004 and 2006 and 5) a temporary household tax rebate aimed at lower- and moderate-income workers who actually paid income taxes, a condition that reduced its effectiveness.

The 2001 Bush tax stimulus package included permanent changes that were less effective at stimulating the economy in the short run than temporary changes but more expensive. And its acceleration of the recently enacted tax cuts for higher-income taxpayers was poorly targeted and potentially counter-productive. A more effective stimulus package would combine the household rebate aimed at lower- and moderate-income workers with a temporary incentive for business investment. Yet for the last two decades, even in boom time, the US middle class has not been receiving its fair share of income while increasingly bearing a larger share of public expenditure. The long-term trend of income disparity is not being addressed by the bipartisan short-term stimulus package.

War costs

The Congressional Research Service (CRS) report, updated November 9, 2007, shows that with enactment of the FY2007 supplemental on May 25, 2007, Congress has approved a total of about $609 billion for military operations, base security, reconstruction, foreign aid, embassy costs, and veterans’ health care for the three operations initiated since the 9/11 attacks: Operation Enduring Freedom (OEF) Afghanistan and other counter terror operations; Operation Noble Eagle (ONE), providing enhanced security at military bases; and Operation Iraqi Freedom (OIF). A 2006 study by Columbia University economist Joseph E Stiglitz, the 2001 Nobel laureate in economic, and Harvard professor Linda Bilmes, leading expert in US budgeting and public finance and former Assistant Secretary and Chief Financial Officer of the US Department of Commerce, concluded that the total costs of the Iraq war could top $2 trillion.

Greenspan sees no Fed cure

Alan Greenspan, the former Fed chairman, wrote in a defensive article in the December 12, 2007 edition of the Wall Street Journal: “In theory, central banks can expand their balance sheets without limit. In practice, they are constrained by the potential inflationary impact of their actions. The ability of central banks and their governments to join with the International Monetary Fund in broad-based currency stabilization is arguably long since gone. More generally, global forces, combined with lower international trade barriers, have diminished the scope of national governments to affect the paths of their economies.”

In exoteric language, Greenspan is saying that short of moving towards hyperinflation, central banks have no cure for a collapsed debt bubble.

Greenspan then gives his prognosis: “The current credit crisis will come to an end when the overhang of inventories of newly built homes is largely liquidated and home price deflation comes to an end … Very large losses will, no doubt, be taken as a consequence of the crisis. But after a period of protracted adjustment, the US economy, and the global economy more generally, will be able to get back to business.”

Greenspan did not specify whether “getting back to business” as usual means onto another bigger debt bubble as he had repeatedly engineered during his 18-year-long tenure at the Fed. Greenspan is advocating first a manageable amount of pain to moderate moral hazard, then massive liquidity injection to start a bigger bubble to get back to business as usual. What Greenspan fails to understand, or at least to acknowledge openly, is that the current housing crisis is not caused by an oversupply of homes in relation to demographic trends. The cause lies in the astronomical rise in home prices fueled by the debt bubble created by an excess of cheap money.

Mortgage crisis to corporate debt crisis

Many homeowners with zero or even negative home equity cannot afford the reset high payments of their mortgages with current income which has been rising at a much slower rate than their house payments. And as housing mortgage defaults mount, the liquidity crisis deepens from money being destroyed at a rapid rate, which in turn leads to counterparty defaults in the $45 trillion of outstanding credit swaps (CDS) and collateralized loan obligations (CLO) backed by corporate loans that destroy even more money, which will in turn lead to corporate loan defaults.

Proposed government plans to bail out distressed home owners can slow down the destruction of money, but it would shift the destruction of money as expressed by falling home prices to the destruction of wealth through inflation masking falling home value.

Credit insurers such as MBIA, the world’s largest financial guarantor, whose shares have dropped 81% in 2007 to $13 from a high of $73, are on the brink of bankruptcy from their deteriorating capital position in light of rating agencies reviews of residential mortgage-backed securities and collateralized debt obligations that have been insured by MBIA, or similar insurers, reviews that are expected to stress claims-paying ability.

On December 10, 2007, MBIA received a $1 billion boost to its cash reserves from private equity firm Warburg Pincus in an effort to protect its credit rating. By January 10, 2008, MBIA announced it would try to raise another $1 billion in “surplus notes” at 12% yield. The next day, traders reported that the deal was facing problems in attracting investors and might have to raise the yield to 15%. But Bill Ackman of Pershing Square Capital Management told Bloomberg that regulators can be expected to block payment to surplus note holders. Further, raising enough new capital to retain credit ratings would so dilute existing shareholder value as to remove all incentive to save the enterprise.

Maintaining an AAA credit rating is of utmost important to bond insurers like MBIA because they need a strong credit rating in order to guarantee debt. Moody’s, Standard & Poor’s and Fitch are all reviewing the financial strength ratings of bond insurers, which write insurance policies and other contracts protecting lenders from defaults.

For the insurers to maintain the necessary triple-A rating, their capital reserve would have to be repeatedly increased along with the premium they charge. There will soon come a time when insurance premium will be so high as to deter bond investors. Already, the annual cost of insuring $10 million of debt against Bear Stern defaulting has risen from $40,000 in January 2007 to $234,000 by January of 2008. To buy credit default insurance on $10 million of debt issued by Countrywide, the big subprime mortgage lender, an investor must as of January 11, 2008 pay $3 million up front and $500,000 annually. A month ago, the same protection could be bought at $776,000 annually with no upfront payment.

Credit-default swaps tied to MBIA’s bonds soared 10 percentage points to 26% upfront and 5% a year, according to CMA Datavision in New York. The price implies that traders are pricing in a 71% chance that MBIA will default in the next five years, according to a JPMorgan Chase & Co valuation model. Contracts on Ambac Financial, the second-biggest insurer, rose 12 percentage points to 27% upfront and 5% a year. Ambac’s implied chance of default is 73%.

MBIA and competitors such as Ambac and ACA Capital insure mortgage-backed securitized debt and bonds, which came under pressure as the subprime fallout all but wiped out mortgage credit. The credit ratings agencies have since tried to determine whether the bond insurers’ ability to pay claims against a sudden rise in defaulted debt has been impacted by the deterioration of the home mortgage market. A ratings downgrade has broad fallout, causing billions of bonds insured by the firms to also lose value. Banks have been major buyers of debt insurance on the bonds they hold.

MBIA is also facing a series of class action suits for misrepresenting and/or failing to disclose the true extent of MBIA exposure to losses stemming from its insurance of residential mortgage-backed securities (RMBS), including in particular its exposure to so-called “CDO-squared” securities that are backed by residential mortgage-backed securities. Other class action suits involve alleged violation of the Employee Retirement Income Security Act of 1974 (ERISA) relating to MBIA 401(k) plan.

Synthetic CDO-squared are double-layer collateralized debt obligations that offer investors higher spreads than single-layer CDOs but also may present additional risks. Their two-layer structures somewhat increase their exposure to certain risks by creating performance “cliffs” that cause seemingly small changes in the performance of underlying reference credits to produce larger changes in the performance of a CDO-squared.

If the actual performance of the reference credits deviates substantially from the original modeling assumptions, the CDO-squared can suffer unexpected losses. On January 11, MBIA announced in a public filing it has $9 billion of exposure to the riskiest structures known as CDO of CDO, or CDO-squared, $900 million more than the company disclosed only three weeks earlier. MBIA also said it now had $45.2 billion of exposure to overall residential mortgage-backed securities, which comprises 7% of MBIA’s insured portfolio, as of September 30, 2007.

The triple-A credit rating of the bigger bond insurers is crucial because any demotion could lead to downgrades of the $2.4 trillion of municipal and structured bonds they guarantee. This could force banks to increase the amount of capital held against bonds and hedges with bond insurers – a worrying prospect at a time when lenders such as Citigroup and Merrill are scrambling to raise capital. Significant changes in counterparty strengths of bond insurers could lead to systemic issues. Warren Buffett’s Berkshire Hathaway set up a new bond insurer in December 2007 after the New York State insurance regulator pressed him to do so.

If credit insurers turn out to have inadequate reserves, the credit default swap (CDS) market may well seize up the same way the commercial paper market did in August 2007. The $45 trillion of outstanding CDS is about five times the $9 trillion US national debt. The swaps are structured to cancel each other out, but only if every counterparty meets its obligations. Any number of counterparty defaults could start a chain reaction of credit crisis. The Financial Times reported that Jamie Dimon, chief executive of JPMorgan, said when asked about bond insurers: “What [worries me] is if one of these entities doesn’t make it …? The secondary effect …? I think could be pretty terrible.”

The danger of high leverage

The factor that has catapulted the subprime mortgage market into content crisis proportion is the high leverage used on transactions involving the securitized underlying assets. This leverage multiplies profits during expansive good times and losses in during times of contraction. By extension, leverage can also magnify insipid inflation tolerated by the Fed into hyperinflation.

As big as the residential subprime mortgage market is, the corporate bond market is vastly larger. There are a lot of shaky outstanding corporate loans made during the liquidity boom that probably could not be refinanced even in a normal credit market, let alone a distressed crisis. A large number of these walking-dead companies held up by easy credit of previous years are expected to default soon to cause the CLO valuations to plummet and CDS to fail.

Commercial real estate is another sector with disaster looming in highly leveraged debts. Speculative deals fueled by easy cheap money have overpaid massive acquisitions with the false expectation that the liquidity boom would continue forever. As the economy slows, empty office and retail spaces would lead to commercial mortgage defaults.

Emerging markets will also run into big problems because many borrowers in those markets have taken out loans denominated in foreign currencies collateralized by inflated values of local assets that could be toxic if local markets are hit with correction or if local currencies lose exchange value.

The last decade has been the most profligate global credit expansion in history, made possible by a new financial architecture that moved much of the activities out of regulated institutions and into financial instruments traded in unregulated markets by hedge funds that emphasized leverage over safety. By now there are undeniable signs that the subprime mortgage crisis is not an isolated problem, but the early signal of a systemic credit crisis that will engulf the entire financial world.

Myth of poor folk over-saving

Both former Fed chairman Greenspan and his successor Ben Bernanke have tried to explain the latest US debt bubble as having been created by global over-saving, particularly in Asia, rather than by Fed policy of easy credit in recent years.

Yet the so-called global savings glut is merely a nebulous euphemism for overseas workers in exporting economies being forced to save to cope with stagnant low wages and meager worker benefits that fuel high profits for US transnational corporations. This forced saving comes from the workers’ rational response to insecurity rising from the lack of an adequate social safety net. Anyone making around $1,000 a year and faced with meager pension and inadequate health insurance would be suicidal to save less than half of his/her income. And that’s for urban workers in China. Chinese rural workers make about $300 in annual income. For China to be an economic superpower, Chinese wages would have to increase by a hundredfold in current dollars.

Yet these underpaid and under-protected workers in the developing economies are forced to lend excessive portions of their meager income to US consumers addicted to debt. This is because of dollar hegemony under which Chinese exports earn dollars that cannot be spent domestically without unmanageable monetary penalties.

Not only do Chinese and other emerging market workers lose by being denied living wages and the financial means to consume even the very products they themselves produce for export, they also lose by receiving low returns on the hard-earned money they lend to US consumers at effectively negative interest rates when measured against the price inflation of commodities that their economies must import to fuel the export sector. And that’s for the trade surplus economies in the developing world, such as China. For the trade deficit economies, which are the majority in the emerging economies, neoliberal global trade makes old-fashion 19th-century imperialism look benign.

Central banks support fleecing

The role central banking plays in support of this systematic fleecing of the helpless poor everywhere around the world to support the indigent rich in both advanced and emerging economies has been to flood the financial market with easy money, euphemistically referred to as maintaining liquidity, and to continually enlarge the money supply by financial deregulation to lubricate and sustain a persistently expanding debt bubble.

Concurringly, deregulated financial markets have provided a free-for-all arena for sophisticated financial institutions to profit obscenely from financial manipulation. The average small investor is effectively excluded from reaping the profits generated in this esoteric arena set up by big financial institutions. Yet the investing public is the real victim of systemic risk. The exploitation of mortgage securitization through the commercial paper market by special investment entities (SIVs) is an obvious example.

When the Fed repeatedly pulls magical white rabbits from its black opaque monetary policy hat, the purpose is always to rescue overextended sophisticated institutions in the name of preserving systemic stability, while the righteous issue of moral hazard is reserved only for unwitting individual borrowers who are left to bear the painful consequences of falling into financial traps they did not fully understand, notwithstanding that the root source of moral hazard always springs from the central bank itself.

Local governments versus financial giants

The city of Baltimore is filing suit against Wells Fargo, alleging the bank intentionally sold high-interest mortgages more to blacks than to whites – a violation of federal law. Cleveland is filing suit against investment banks such as Deutsche Bank, Goldman Sachs, Merrill Lynch and Wells Fargo for creating a public nuisance by irresponsibly buying and selling high-interest home loans, resulting in widespread defaults that have depleted the cities’ tax base and left entire neighborhoods in ruins. The cities hope to recover hundreds of millions of dollars in damages, including lost taxes from devalued property and money spent demolishing and boarding up thousands of abandoned houses.

“To me, this is no different than organized crime or drugs,” Cleveland Mayor Frank Jackson said in an interview with local media. “It has the same effect as drug activity in neighborhoods. It’s a form of organized crime that happens to be legal in many respects.”

The Baltimore and Cleveland efforts are believed to be the first attempts by major cities to recover social costs and public financial losses from the foreclosure epidemic, which has particularly plagued cities with significant low-income neighborhoods. Cleveland’s suit is more unique because the city is basing its complaints on a state law that relates to public nuisances. The suit also is far more
wide-reaching than Baltimore’s in that instead of targeting the mortgage brokers, it targets the investment banking side of the industry, which feeds off the securitization of mortgages.

Greenspan blames Third World – not the Fed

Greenspan in his own defense describes the latest credit crisis as a result of a sudden “re-pricing of risk – an accident waiting to happen as the risk was under-priced over the past five years as market euphoria, fostered by unprecedented global growth, gained traction.” Greenspan spoke as if the Fed had been merely a neutral bystander, rather than the “when in doubt, ease” instigator that had earned its chairman wizard status all through the years of easy money euphoria.

The historical facts are that while the Fed kept short-term rates too low for too long, starting a downward trend from January 2001 and bottoming at 0.75% for the discount rate on November 6, 2002, and 1% for the Fed Funds rate target on June 25, 2003, long-term rates were kept low by structured finance, a.k.a. debt securitization and credit derivatives, with an expectation that inflation would be perpetually postponed by global slave labor. The inflation rate in January 2001 was 3.73%. By November 2002, the inflation rate was 2.2%, while the discount rate was at 0.75%. In June 2003, the inflation rate was 2.11% while the Fed Funds rate target was at 1%. For some 30 months, the Fed provided the economy with negative real interest rates to fuel a debt bubble.

Greenspan blames “the Third World, especially China” for the so-called global savings glut, with an obscene attitude of the free-spending rich who borrowed from the helpless poor scolding the poor for being too conservative with money.

Yet Bank for International Settlements (BIS) data show exchange-traded derivatives growing 27% to a record $681 trillion in third quarter 2007, the biggest increase in three years. Compared this astronomical expansion of virtual money with China’s foreign exchange reserve of $1.4 trillion, it gives a new meaning to the term “blaming the tail for wagging the dog”. The notional value of outstanding over-the-counter (OTC) derivative between counterparties not traded on exchanges was $516 trillion in June, 2007, with a gross market value of over $11 trillion, which half of the total was in interest rate swaps. China was hardly a factor in the global credit market, where massive amount of virtual money has been created by computerized
trades.

Belated warning on stagflation

I warned in May 9, 2007 (Liquidity boom and looming crisis, Asia Times Online): The Fed’s stated goal is to cool an overheated economy sufficiently to keep inflation in check by raising short-term interest rates, but not so much as to provoke a recession. Yet in this age of finance and credit derivatives, the Fed’s interest-rate policy no longer holds dictatorial command over the supply of liquidity in the economy. Virtual money created by structured finance has reduced all central banks to the status of mere players rather than key conductors of financial markets. The Fed now finds itself in a difficult position of being between a rock and a hard place, facing a liquidity boom that decouples rising equity markets from a slowing underlying economy that can easily turn toward stagflation, with slow growth accompanied by high inflation.

Seven months after my article, on December 16, Greenspan warned publicly on television against early signs of stagflation as growth threatens to stall while food and energy prices soar.

Crisis of capital for finance capitalism

The credit crisis that was detonated in August 2007 by the collapse of collateralized debt obligations (CDOs) waged a frontal attack on finance institution capital adequacy by December. Separately, commercial and investment banks and brokerage houses frantically sought immediate injection of capital from sovereign funds in Asia and the oil states because no domestic investors could be found quickly. But these sovereign funds investments have reached the US regulatory ceiling of 10% equity ownership for foreign governmental investors before being subject to reviews by the inter-agency Committee on Foreign Investment in the US (CFIUS), which investigates foreign takeover of US assets.

Still, much more capital will be needed in coming months by these financial institutions to prevent the vicious circle of expanding liabilities, tightening liquidity conditions, lowering asset values, impaired capital resources, reduced credit supply, and slowing aggregate demand feeding back on each other in a downward spiral. New York Federal Reserve President Tim Geithner warned of an “adverse self-reinforcing dynamic”.

Ambrose Evans-Pritchard of The Telegraph, who as a Washington correspondent gave the Clinton White House ulcers, reports that Anna Schwartz, surviving co-author with the late Milton Friedman of the definitive study of the monetary causes of the Great Depression, is of the view that in the current credit crisis, liquidity cannot deal with the underlying fear that lots of firms are going bankrupt. Schwartz thinks the critical issue is that banks and the hedge funds have not fully acknowledged who is in trouble and by how much behind the opaque fog that obscures the true liabilities of structured finance.

While the equity markets are hanging on for dear life with the Fed’s help through stealth inflation, the bond markets have collapsed worldwide, with dollar bond issuance falling to a stand still, euro bonds by 66% and emerging market bonds by 75% in Q3 2007. Lenders are simply afraid to lend and borrowers are afraid to take on more liabilities in an imminent economic slowdown. The Fed has a choice of accepting an economic depression to cut off stagflation, or ushering hyperinflation by flooding the market with unproductive liquidity. Insolvency cannot be solved by injecting liquidity without the penalty of hyperinflation.

Henry C K Liu is chairman of a New York-based private investment group. His website is at www.henryckliu.com.