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Anatomy of the American Financial Crisis: How It is Turning into a Worldwide Crisis
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Prof. Rodrigue Tremblay
Global Research
October 13, 2008
"The basis for optimism is sheer terror." Oscar Wilde
[After the March 2008 Bear Stears bailout] "As more firms lost access to funding, the vicious circle of forced selling, increased volatility, and higher haircuts and margin calls that was already well advanced at the time would likely have intensified. The broader economy could hardly have remained immune from such severe financial disruptions."Ben Bernanke, Fed Chairman (March 2008)
“In accounting 101 we learn that high yields equal high risk. We know the CEOs had an incentive to disregard this because they were getting huge bonuses.” David Hartzell, dean of the University of Delaware’s business college and a former vice-president of Salomon Brothers
“Intensifying solvency concerns about a number of the largest U.S.-based and European financial institutions have pushed the global financial system to the brink of systemic meltdown.” Dominique Strauss-Kahn, Head of the IMF (October 11, 2008)
The Bush administration’s way of dealing with the ongoing financial crisis has been frantic, but probably less than adequate. In fact, tragic errors may have been made that must be remedied as quickly as possible.
The most damaging error may have been to let the global investment bank Lehman Brothers fail ($691 billion of assets at the end of 2007), on Monday September 15. This fateful date may have to be remembered in the future. This was the largest failure of an investment bank since the collapse of Drexel Burnham Lambert in 1990. In contrast, the Fed and the U.S. Treasury moved quickly in mid-March (2008) to save a similar global investment bank in distress (but half the size of Lehman), Bear Stearns, by quickly lending and guaranteeing $29 billion to the large universal J. P. Morgan Chase bank in order to absorb it. —(N.B.: Let us keep in mind that it was the collapse in June 2007 of two internal Bear Stearns hedge funds that had been heavily invested in mortgage securities that kicked off the full-fledged market panic that unfolded in August 2007, and which today has turned into a full-fledged international financial crisis).
Why was the same treatment not offered to Lehman? Possibly because of a personal lack of empathy between Treasury Secretary Henry M. Paulson Jr. (a former chief executive of rival investment bank Goldman Sacks) and Lehman’s CEO Mr. Richard S. Fuld Jr., or possibly because the Bush administration wanted to make an example that all investment banks, no matter how large, could not count on being rescued by the government. The Bush administration did not even bother to appoint a trustee to supervise Lehman’s liquidation in order to make it orderly.
Such a liquidation of a large international bank, known for its worldwide interconnections and unsound banking practices, was nearly a repeat of the mistake made in letting the large Vienna-based Creditanstalt bank fail, on May 13, 1931. This was a bank that had borrowed large amount of money in London and in New York to finance its activities. Its failure created a domino effect among other international banks that had lent to each other in the international credit chain. So much so that the failure of the Creditanstalt forced them to severely tighten their lending to absorb their sudden losses.
- A d v e r t i s e m e n t
Seventy-seven years later, in 2008, the Bush administration’s decision to let the Lehman Brothers bank fail has produced a similar ripple effect throughout the international financial system. And, perhaps more important politically, it signaled to the markets that the Bush administration was willing to let a dangerous debt deflation and an ominous credit crunch proceed. This may turn out to have been a most tragic mistake.
Indeed, Lehman’s bankruptcy forced the global investment bank to quickly write down its huge portfolio of debt, a fair amount of it in derivative products. But since banks are creditors of each other, especially Lehman which dealt with large institutions, this had the consequence of spreading the American financial disease all over the world, and especially in Europe. Why? Because Lehman’s London office was a huge center of sale and distribution for its more or less toxic derivative products all over Europe. Indeed, many European banks had invested in Lehman’s securitized paper, and when it failed, they were left with large losses. As a consequence, they had to curtail their domestic lending and that’s the reason the credit crunch is now moving to Europe.
The second mistake was to address the “liquidity problem” of American investment and mortgage banks without tackling at the same time their underlying “solvency problem”.
As we wrote right at the very beginning, on August 24, 2007, the financial crisis in the U.S. is not only a classic “liquidity problem”, when banks find themselves short of cash to pay immediate redemptions and withdrawals while their longer term loans are secure, but also and above all a “solvency problem”, because the huge losses that banks had to absorb when they wrote down the value of their toxic assets-backed securitized paper, eroded their capital base to an extent that they became de facto insolvent. Market operators saw that and they sold the banks’ shares short and the price of these shares plummeted.
With many banks’ solvency now in doubt, inter-bank lending has nearly stopped, and because of a ‘flight to safety’, the Ted spread [the difference between three-month U.S. Treasury bills yields and yields on three month eurodollar contracts, as represented by the London Inter Bank Offered Rate, called Libor] exploded, and banks cut down their lending. Credit became tight and scarce. Because banks as a whole ordinarily lend between 10 and 12 times their capital base, the most liquid money supply (M1) began to contract in real terms. Even money market funds suffered heavy losses, and a run on them was in full swing when the Treasury stepped in a month ago to offer an emergency $50 billion guarantee.
The U.S. economy may be approaching what can be called a classic “liquidity trap” situation, wherein the Fed is lowering interest rates while lending through its discount window and printing money on a high scale, however the liquid money supply figures, in real terms, are not increasing, but are rather falling. Thus, there is no immediate inflation, but the money supply is contracting as banks reduce their lending and make a rush to T-bills (their yields nearly fell to zero). The short-term result is a net deflationary effect for the overall economy and on the stock market (although the long term bond market sees inflation ahead, and long term rates are rising). —The result is stock market crashes in repetition.
In fact, this is precisely what has happened over the last few weeks, not only in the United States, but also in the U.K and in other European countries. This is a very dangerous development for the real economy, because money data in real terms are a leading indicator of the future course of the economy. Six or nine months down the road, the consequences of the credit crunch will appear in production and employment declines, because the credit crunch has the effect of placing a serious squeeze on most companies. Since the credit contraction really began in June (2008), the early part of 2009 is bound to show severe economic weakness.
On Friday, September 19 (2008), the Bush administration announced its solution to the growing banking crisis. It made public the $700 billion Paulson plan (US Emergency Economic Stabilisation Act, EESA) that primarily focused on creating a government market for some of the bad mortgage-backed securities on the banks’ books. —But this was only half of the problem. The other half of the problem was the need to stop the money supply from declining, by restoring bank credit lending and allowing companies to have access to working capital financing. The goal here is to prevent banking problems from morphing into a general contraction of consumption and capital investment plans, thus slowing down production and raising unemployement in the coming months.
For this to happen, however, banks must be allowed to find badly needed new capital. But in a time of crisis, with stock markets declining, it is doubtful that much private capital can be found. The recent association of Warren Buffett with Goldman Sachs may be more of an exception than a rule.
When private capital is not available, the government has no other choice but to inject equity (by buying the banks’ preferred shares) into the national banking system, while taking steps to safeguard the public interest by obtaining common share warrants that can be resold profitably later, when the situation stabilizes.
In conclusion, we may ask if it is possible to avoid a repetition of the U.S. Great Depression of the 1930s or the more recent Japan’s protracted recession of the 1990s, both the result of a similar severe banking crisis? The answer is yes, if the vicious cycle of asset price decline, banking credit crunch and money supply contraction can be avoided, or, at the very least, stopped and reversed. —In economics, as in medicine, it is never too late to do the right thing.
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October 13th, 2008 at 12:19 pm
Anyone who does not see this from a Biblical perspective has got to be quite confused and frightened. Jesus told us these days were coming but He is in control – we know the outcome. We also must realize that America has our own judgment coming due to the millions of murdered babies, the sodomy that is now being deemed worthy of “marriage”, drug abuse, corrupted churches that preach a false salvation and a false doctrine, etc. Fear not, unless you have not made Jesus your lord!
October 13th, 2008 at 12:34 pm
I agree, America is ripe for judgment. It’s time to do your due diligence.
http://jesusnotchristian.com/
October 13th, 2008 at 3:00 pm
BREAKING NEWS!!
Just got a call from a private source, but 99% credible.
Eight days ago (news was held up while source was in the field), the National Guard Armory in Pocatello, Idaho was seized by the U.S. regular Army and stripped of all weaponry. Everything from long range cannon to small arms.
These guys are the 148th Field Artillery Battalion They stripped it of all weaponry and ammo.
The CO asked “Why?” and was told “There’s gonna be a party this winter and you’re not invited!”
He was led to believe that this was a national happening, not just that armory.
I’ve called 5 other NG bases, but (for some odd reason) have received NO answer.
Any of you that have the ability (or strings) get on the phone and see if there’s verification from any of your sources.
[ Edited Sat Oct 11 2008, 06:02PM ]
October 13th, 2008 at 6:32 pm
I have read the bible and studied Jesus, Immanuel, or the many names he has been given. He never told us he was in control … religion did though … he told us we were in control. If we believe we could move mountains and the more that believe this we could … start taking your power back. Stop trusting any institutions.
October 13th, 2008 at 7:52 pm
It’s bad enough that the government is getting involved in any of this financial crisis. Usually, where they are involved INCOMPETENCE reigns. be that as it may, this whole idea of a government bailout would go over a lot smoother with the American people except it looks like bad behaviour by the bankers & Wall Street is not only being ignored………but rewarded by this bailout. The idea would be alot easier to sell to the American People if we actually saw some of these criminals in suits get charged with something and go to jail. the fact thay they appear to be getting off scot free pisses me off to no end. Am I alone in this regard?
October 13th, 2008 at 8:17 pm
Oct. 13 (Bloomberg) — Dubai may need help from Abu Dhabi and the United Arab Emirates government to finance a surge in borrowing that paid for the world’s tallest tower, palm tree- shaped man-made islands and stakes in banks worldwide.
Dubai’s “potential reliance” will be “most significant” in coming years, Moody’s Investors Service said in a report today. Government-controlled companies owe at least $47 billion, more than Dubai’s gross domestic product, and they will continue to accumulate debt at a faster pace than the economy grows, the New York-based rating firm said.
“These companies that are based in Dubai have become larger than Dubai itself,” said Giyas Gokkent, chief economist at National Bank of Abu Dhabi, the U.A.E.’s second-largest commercial bank by assets. “If anything were to go wrong with any of these companies, Dubai does not have the wherewithal to deal with it.”
State-owned Dubai World paid about $5.1 billion for almost 10 percent of Kirk Kerkorian’s MGM Mirage last year; the price has tumbled since to $16.80 from $84. DP World, the government- run company that bought Peninsula and Oriental Steam Navigation Co. for $6.8 billion in 2006, has slumped 55 percent this year on the Dubai International Financial Exchange.
Ruler Sheikh Mohammed bin Rashid al-Maktoum has borrowed to replace Dubai’s dwindling revenue from oil, investing to boost earnings from tourism and finance. State-owned carrier Emirates has increased its fleet to the largest in the Middle East, in a bid to double tourists per year to 15 million by 2015. Dubai Holding LLC, which groups assets belonging to Sheikh Mohammed, owns hotel chain Jumeirah Group.
Abu Dhabi Oil
Abu Dhabi, by contrast, owns more than 90 percent of the U.A.E.’s oil reserves, almost 8 percent of the world’s total. The Abu Dhabi Investment Authority, its sovereign wealth fund, is the world’s largest with assets of between $250 billion and $875 billion, according to the International Monetary Fund.
ADIA’s Head of Media Relations Erik Portanger declined to comment on Moody’s report.
Dubai’s approach is backfiring as investors avoid the most indebted companies on concern the global credit crunch will increase defaults, while real-estate and company assets slump.
Deutsche Bank has fallen nearly 70 percent since Dubai government-owned DIFC Investments bought a 2.2 percent stake for about $1.8 billion in May 2007. Standard Chartered has declined 15 percent since state-owned Istithmar PJSC acquired a 2.7 percent stake for about $1 billion in October 2006.
The cost of insuring Dubai Holding’s bonds has increased nearly four-fold since May, according to traders of credit default swaps. Credit-default swaps on Dubai Holding Commercial Operations traded at 679.3 basis points on Oct. 10, up from 172.99 at the beginning of May, CMA Datavision prices show.
The company’s $500 million of 10-year notes due 2017 fell 2.2 percent today, raising the yield to a record 13.1 percent, Bloomberg data shows.
Dubai Model
While Dubai’s economic model “has proved successful to date, cumulative liabilities are currently rising faster than investments are able to generate returns,” Moody’s senior vice president in Dubai, Philipp Lotter, said in the report. This “necessitates a clear understanding of wider implicit federal support when rating key government-backed corporation.”
October 14th, 2008 at 1:02 am
does anyone know how this will affect australia? our ecconomy is linked to china.
October 14th, 2008 at 2:02 am
So how do you rectify this problem? Quite simple, by implementing global taxation based on net worth of individuals (billionaire tax) which would include the offshore accounts and Swiss accounts. If you don’t declare the wealth, you loose it or you will never be able to spend the secret accounts. Forbes 500 has a list of these net worths. Tax the over $4.5 trillion at 10%-30%. With the current movement of money today, this amount could far exceed this prior net worth of $4.5 trillion listed in Forbes 500.
November 10th, 2008 at 1:45 pm
You are absolutely right “Line in the sand”…..Bush is quiet for a reason…that being, getting ready for the police state to take over when he declares martial law…when the markets are 00, which is a plan/agenda, that has been forth coming for years…sometime between now and January 20,Bush will give the order to “push the button” that activate chaos & martial law, bringing out the police state, plus our own US army (that was assigned to this job, Sept 08)…plus the UN, that has been stationed in our mountains (for years), training for “this time”. This will activate the “New Constitution” and The New World Order…….we can all figure it out from there…right?