The Great Credit Unwind of '08

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current crisis is not only the bust that follows the housing boom,
it’s basically the end of a 60-year period of continuing credit
expansion based on the dollar as the reserve currency. Now the
rest of the world is increasingly unwilling to accumulate dollars.”

George Soros, World Economic Forum, Davos, Switzerland

Global market
turmoil continued into a second week as stock markets in Asia and
Europe took another tumble on Monday on growing fears of a recession
in the United States. China’s benchmark index plummeted 7.2% to
its lowest point in six months, while Japan’s Nikkei index slipped
another 4.3%. Equities markets across Asia recorded similar results
and, by midmorning in Europe, all three major indexes — the UK FTSE
"Footsie," France’s CAC 40, and the German DAX — were
recording heavy losses. It’s now clear that Fed Chairman Bernanke’s
"surprise" announcement of a 75 basis points cut to the
Fed Funds rate last Tuesday has neither stabilized the markets nor
restored confidence among jittery investors.

At the time
of this writing, the storm clouds are swiftly moving towards Wall
Street where markets are likely to be roiled on the very day that
President Bush will give his farewell State of the Union speech.

In Monday’s
Financial Times, Harvard economics professor, Lawrence Summers,
made an impassioned plea for further government action in addition
to the Fed’s rate cuts and Bush’s $150 billion "stimulus plan."
Summers believes that steps must be taken immediately to mitigate
the damage from the sharp downturn in housing and persistent troubles
in the credit markets. He suggests a "global coordination of
policy" with the other foreign central banks. It is a tacit
admission that the Fed has lost control of the system and cannot
solve the problem by itself.

Summers is
right; although it’s easy to wonder why he remained silent for so
long while the markets were soaring and the investment banks were
reaping trillions of dollars in profits on a "structured investment"
swindle which has left the global financial system teetering on
the brink of catastrophe. Now that the US economy is sliding towards
recession; Summers has suddenly found his voice and is calling for
"transparency." How convenient.

institutions are holding all sorts of credit instruments that are
impaired but are difficult to value, creating uncertainty and freezing
new lending. Without more visibility, the economy and financial
system risk freezing up as Japan's did in the 1990s."

Right again.
The banks are "capital impaired" because they are holding
nearly $600 billion in mortgage-backed assets which are declining
in value every month. This is forcing many banks to conceal their
real condition from investors while they scour the planet for the
extra capital they need to continue operations. As long as the banks
are in distress, consumer and business lending will dwindle and
the economy will continue to shrink. The main gear in the credit-generating
mechanism is now broken. The rate cuts can provide liquidity, but
they cannot bring insolvent banks back from the dead. Summers is
expecting too much.

The United
States has led the world into the greatest credit bust in history,
and yet, few people have any idea of what has transpired. The US
current account deficit — nearly $800 billion — has been recycling
into US Treasuries and securities from foreign investors. Up to
this point, American markets were an attractive place to put one’s
savings. The dollar was strong, and the stock market had a proven
record of profitability and transparency. But since President Bill
Clinton repealed Glass-Steagall in 1999, the markets have been reconfigured
according to an entirely new model, "structured finance."
Glass-Steagall was the last of the Depression-era bulwarks against
the merging of commercial and investment banks. As a result banking
has changed from a culture of "protection" (of deposits)
to "risk taking," which is the securities business. Through
"financial innovation" the investment banks created myriad
structured debt instruments which they sold through their Enron-like
"off balance" sheets operations (SIVs and Conduits) to
credulous investors. Now, trillions of dollars of these subprime
and mortgage-backed bonds — many of which were rated triple A —
are held by foreign banks, retirement funds, insurance companies,
and hedge funds. They are steadily losing value with every rating’s
downgrade. Here
is a graph which illustrates how the scam works.

Summers, of
course, understands the enormity of the swindle that has taken place
beneath the noses of US regulators, but chooses not to hold any
of the main actors accountable. Instead, he draws our attention
to a little-known part of the market which will probably lead the
way to a stock market crash and a system-wide meltdown.

Here’s Summers:

is critical that sufficient capital is infused into the bond insurance
industry as soon as possible. Their failure or loss of a AAA rating
is a potential source of systemic risk. Probably it will be necessary
to turn in part to those companies that have a stake in guarantees
remaining credible because they have large holdings of guaranteed
paper. It appears unlikely that repair will take place without
some encouragement and involvement by financial authorities. Though
there are many differences and the current problem is more complex,
the Long-Term Capital Management work-out is an example of successful
public sector involvement."

Some of the
largest bond insurers are currently unable to cover the losses that
are piling up from the meltdown in mortgage-backed securities (MBSs)
and collateralized debt obligations (CDOs). Their business model
is hopelessly broken and they will require an immediate $143 billion
bailout to maintain operations. The largest of the bond insurers
is MBIA.

“MBIA’s total
exposure to bonds backed by mortgages and CDOs was disclosed to
be $30.6 billion, including $8.14 billion of holdings of CDO-squareds
(eds. note; pure garbage). MBIA was being priced as a weak CCC-rated
credit when it issued its bonds last week; it is now being priced
for a bankruptcy. MBIA’s stock, which traded just under $68 per
share last October, dropped another $3.50 this morning to under
$10.00 per share." (Stock analyst Michael Lewitt, quoted
in Bloomberg)

Barclay’s estimates
that the investment banks alone are holding as much as $615 billion
of structured securities guaranteed by bond insurers. If the insurers
default, hundreds of billions will be lost via downgrades.

So, in practical
terms, what does it mean if the bond insurers go under?

It means that
the system will freeze and the stock market will crash. Here’s how
TV stock guru Jim Cramer summed it up last week in an interview
with MSNBC’s Chris Matthews:

But, Chris,
there is something I would urge all the candidates to think about
and our Treasury Secretary, which is that there are a group of
insurance companies which insure all these bad mortgages and,
Cris, I think they are all about to go belly-up, and that will
cause the Dow Jones to decline 2,000 points. They’ve got to be
shut down and the insurance given to a New Resolution Trust. This
is going to happen in maybe two or three weeks, Chris, it going
to on the front of every newspaper and no one in Washington is
even willing to admit it.

Chris Matthews:
"So who are you including in these mortgage companies that
are going to go belly-up; give me a description?"

These are
MBIA and Ambac remember the companies that Merrill Lynch and Citigroup
wrote down a lot of stuff the other day? All these companies are
relying on insurance to save them. The insurers don’t have the
money. There’s also personal mortgage insurance; that’s PMI, is
one company; MGIC is another. Chris, I am telling you that these
companies do not have the capital to "make good." And
when they do fall, and I believe it is when — if the government
does not have a plan in action; you will not be able to open the
stock market when they collapse. No one is even talking about
the fact that these major insurers, who insure $450 billion of
mortgages are all about to go under. (See
the whole video.

Cramer is correct
in assuming that the market won’t open. And yet, so far, nothing
has been done to avert the disaster which lies just ahead. Maybe
nothing can be done?

So, how did
things get so bad, so fast? How could the world’s most resilient
and profitable markets be transformed into a carnival sideshow peddling
poisonous "mortgage-backed" snake-oil to every gullible

Author and
stock market soothsayer Pam Martens puts it like this:

How could
a layered concoction of questionable debt pools, many of dubious
origin, achieve the equivalent AAA rating as U.S. Treasury securities,
backed by the full faith and credit of the U.S. government, and
time-tested over a century of panics, crashes and the Great Depression?

How did a
200-year-old “efficient” market model that priced its securities
based on regular price discovery through transparent trading morph
into an opaque manufacturing and warehousing complex of products
that didn’t trade or rarely traded, necessitating pricing based
on statistical models? (The
Free Market Myth Dissolves into Chaos
, Pam Martens, CounterPunch.)

How, indeed?

The answer
to all these questions is "deregulation." The financial
system has been handed over to scam-artists and fraudsters who’ve
created a multi-trillion dollar inverted pyramid of shaky, hyper-inflated,
subprime slop that they’ve sold around the world with the tacit
support of the ratings agencies and the US political establishment.
(wink, wink) Now that system is about to collapse and there’s nothing
that the Federal Reserve can do to stop the Great Credit Unwind
of ’08. As economist Ludwig von Mises said:

“There is
no means of avoiding the final collapse of a boom brought on by
credit expansion. The question is only whether the crisis should
come sooner as a result of a voluntary abandonment of further
credit expansion, or later as a final and total catastrophe of
the currency system involved.”

29, 2008

Mike Whitney
[send him mail] lives
in Washington state.

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