It's Time to Dump the Federal Reserve

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do not cease to exist because they are ignored."
~ Aldous Huxley

The credit
storm which began in July when two Bear Stearns hedge funds were
forced to liquidate, has continued to intensify and roil the markets.
Last week the noose tightened around auction-rate securities, a
little-known part of the market that requires short-term funding
to set rates for long-term municipal bonds. The $330 billion ARS
market has dried up overnight pushing up rates as high as 20% on
some bonds – a new benchmark for short-term debt. Auction-rate
securities are now headed for extinction just like the other previously-vital
parts of the structured finance paradigm. The $2 trillion market
for collateralized debt obligations (CDOs), the multi-trillion-dollar
mortgage-backed securities market (MBSs) and the $1.3 asset-backed
commercial paper (ABCP) market have all shut down, draining a small
ocean of capital from the financial system and pushing many of the
banks and hedge funds closer to default.

The price of
insuring corporate bonds has skyrocketed in the last few weeks making
it more difficult for businesses to get the funding they need to
expand or continue present operations. Much of this has to do with
the growing uncertainty about the reliability of credit default
swaps, a $45 trillion dollar market which remains virtually unregulated.
Credit-default swaps are a type of financial instrument that are
used to speculate on a company’s ability to repay debt. They pay
the buyer face value in exchange for the underlying securities or
the cash equivalent if a borrower fails to adhere to its debt agreements.
When the price of CDSs increases, it means that there is greater
doubt about the quality of the bond. Prices are presently soaring
because the entire structured finance market – and anything
connected to it – is under withering attack from the meltdown
in subprime mortgages. As foreclosures continue to rise, the securities
that were fashioned from subprime loans will continue to unwind,
destroying trillions of dollars of virtual-capital in the secondary

It all sounds
more complicated than it really is. Imagine a 200-ft. conveyor belt
with two burly workers and a mountain-sized pile of money on one
end, and a towering bonfire on the other. Every time a home goes
into foreclosure, the two workers stack the money that was lost
on the transaction – plus all of the cash that was leveraged
on the home via "securitization" and derivatives –
onto the conveyor-belt where it is fed into the fire. That is precisely
what is happening right now and the amount of capital that is being
consumed by the flames far exceeds the Fed’s paltry increases to
the money supply or Bush’s projected $168 billion "surplus
package." Capital is being sucked out of the system faster
than it can be replaced, which is apparent by the sudden cramping
in the financial system and a more generalized slowdown in consumer

According to
a recent Bloomberg article:

"A year
ago $20 million would have gotten Luminent Mortgage Capital Inc.
access to $640 million in loans to buy top-rated mortgage-backed
securities. Now that much cash gets the firm no more than $80
million. …(Only) 6 lenders are offering 5 times leverage, while
a year ago, 20 banks extended 33 times."

The banks are
not providing anywhere near as much money for leveraged investments
as they did just last year. And, when credit shrinks on a national
scale – as it is – so does the economy. It’s a simple
formula; less money means less economic activity, less growth, fewer
jobs, tighter budgets, more pain.

Bloomberg continues:

Street firms, reeling from $146 billion in losses on their debt
holdings, are fueling a credit crisis by clamping down on lending
to investors and hedge funds that use borrowed money to buy securities.
By pulling back, (the banks) are contributing to reduced demand
and lower prices throughout the fixed-income world."

The banks are
in no position to be extravagant because they’re already saddled
with $400 billion in MBSs and CDOs – as well as another $170
billion in private equity deals – for which there is currently
no market. They’ve had to dramatically cut back on their lending
because they either don’t have the resources or are facing bankruptcy
in the near future.

An article
which appeared on the front page of the Financial Times last week,
illustrates how hard-pressed the banks really are:

banks have been quietly borrowing massive amounts of money from
the Federal Reserve…$50 billion in one month."

The Fed’s new
Term Auction Facility "allows the banks to borrow money against
all sort of dodgy collateral," says Christopher Wood, analyst
at CLSA. "The banks are increasingly giving the Fed the garbage
collateral nobody else wants to take … [this] suggests a perilous
condition for America’s banking system."

The move has
sparked unease among some analysts about the stress developing in
opaque corners of the US banking system and the banks’ growing reliance
on indirect forms of government support." ("US Banks borrow
$50 billion via New Fed Facility," Financial Times.)
story appeared nowhere in the US media.)

At the same
time the banks are getting backdoor injections of liquidity from
the Fed, banking giant Citigroup has been trying to off-load some
of its branches so it can cover its structured investment losses.
It all looks rather desperate, but scouring the planet for capital
to shore up flagging balance sheets is turning out to be a full-time
job for many of America’s largest investment banks. It is the only
way they can stay one step ahead of the hangman.

In the last
few days, gold has spiked to $950, a new high, while oil futures
passed the $100 per barrel mark. The battered greenback has already
taken a beating, and yet, Fed chairman Bernanke is signaling that
there are more rate cuts to come. The prospect of a global run on
the dollar has never been greater. Still, Bernanke will do whatever
he can to resuscitate the faltering banking system, even if he destroys
the currency in the process. Unfortunately, interest rates alone
won’t cut it. The banks need capital; and fast. Meanwhile, the waning
dollar has sent food and energy prices soaring which is leaving
consumers without the discretionary income they need for anything
beyond the basic necessities. As a result, retail sales are down
and employers are forced to lay off workers to reduce their spending.
This is all part of the self-reinforcing negative-feedback loop
that begins with falling home prices and then rumbles through the
broader economy. There is no chance that the economy will rebound
until housing prices stabilize and the rate of foreclosures returns
to normal. But that could be a long way off. With housing inventory
at historic highs and mortgage applications at new lows, the economy
could keep somersaulting down the stairwell for a full two years
or more. Only then, will we hit rock-bottom.

The country
is now headed into a deep and protracted recession. Low interest
credit and financial innovation have paralyzed the credit markets
while inflating a monstrous equity bubble that is wreaking havoc
with the world’s financial system. The new market architecture,
"structured finance" has collapsed from the stress of
falling asset-values and rising defaults. Many of the banks are
technically insolvent already, hopelessly mired in their own red
ink. Public confidence in the nations’ financial institutions has
never been lower. Monetary policy and deregulation have failed.
The system is self-destructing.

Now that the
credit crunch has rendered the markets dysfunctional, spokesmen
for the investor class are speaking out and confirming what many
have suspected from the very beginning; that the present troubles
originated at the Federal Reserve and, ultimately, they are the
ones who are responsible for the meltdown. In an article in the
Wall Street Journal this week, Harvard economics professor
and former Council of Economic Advisers under President Reagan,
Martin Feldstein, made this revealing admission:

is plenty of blame to go around for the current situation. The
Federal Reserve bears much of the responsibility, because of its
failure to provide the appropriate supervisory oversight for the
major money center banks. The Fed’s banking examiners have complete
access to all of the financial transactions of the banks that
they supervise, and should have the technical expertise to evaluate
the risks that those banks are taking. Because these banks provide
credit to the nonbank financial institutions, the Fed can also
indirectly examine what those other institutions are doing.

The Fed’s
bank examinations are supposed to assess the adequacy of each
bank’s capital and the quality of its assets. The Fed declared
that the banks had adequate capital because it gave far too little
weight to their massive off balance-sheet positions – the
structured investment vehicles (SIVs), conduits and credit line
obligations – that the banks have now been forced to bring
onto their balance sheets. Examiners also overstated the quality
of the banks’ assets, failing to allow for the potential bursting
of the house price bubble. The implication of this for Fed supervision
policy is clear. The way out of the current crisis is not."

How odd? So,
when all else fails, tell the truth?

But Feldstein
is right; the Fed refused to perform its oversight duties because
its friends in the banking industry were raking in obscene profits
selling sketchy, subprime junk to gullible investors around the
world. They knew about the "massive off balance-sheet positions"
which allowed the banks’ to create mortgage-backed securities and
CDOs without sufficient capital reserves. They knew it all; every
last bit of it, which simply proves that the Federal Reserve is
an organization which serves the exclusive interests of the banking
establishment and their corporate brethren in the financial industry.


The upcoming
global recession/depression will give us plenty of time to mull
over the ruinous effects of Fed policy and to devise a plan for
abolishing the Federal Reserve once and for all. That is, if they
don’t destroy us first.

22, 2008

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

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