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Financial bankruptcy, the US dollar and the real economy

Online Journal | August 24, 2007
Rodrigue Tremblay

"The U.S. government is on a 'burning platform' of unsustainable policies and practices." --David Walker, U.S. Comptroller General

"Modern society, based as it is on the division of labor, can be preserved only under conditions of lasting peace." --Ludwig von Mises, Austrian economist

"People know that inflation erodes the real value of the government's debt and, therefore, that it is in the interest of the government to create some inflation." --Ben S. Bernanke, Fed Chairman

"Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again." --Ben S. Bernanke, Nov. 8, 2002 (Fed Chairman, talking to economist Milton Friedman)

Ordinary investors and people in general will have to get accustomed to hearing a lot about financial terms they never heard before, such as the subprime mortgage market, aggressive underwriting, asset securitization, repackaged loans, subprime loans, "no-doc" loans, adjustable rate mortgage interest rate adjustment (ARM) loans, collateralized debt obligations (CDOs), asset backed securities, mortgage-backed securities, closed-end second-lien loans, subprime second-lien loans, alternative-A (Alt-A) mortgage loans, piggyback loans, asset-backed commercial paper (ABCP), . . . etc.

As a general definition, "subprime" or "high-risk" loans" are those made to people with poor credit and at lax conditions. Second-lien loans are loans that are placed in second place for any potential recovery after the primary lender on a property. Residential mortgage-backed security (RMBS) are created when mortgage lenders sell their loans (and the risks associated with such loans) to banks, which package them together and slice them into different classes before selling them to (gullible) investors. This process, called "asset securitization" is the method whereby interests in mortgage loans and other receivables are packaged, underwritten, and sold in the form of "asset-backed securities". This is financial alchemy, through which subprime mortgage loans are transformed into AAA-rated paper for unsuspecting investors.

Some of these artificial or derivative securities are low-grade quality, and when their prices fall because borrowers cannot meet their interest or capital payments, such financial instruments become quickly "illiquid" or unsalable, since nobody wants to touch them. They become fictitious capital . Those who hold them, investors, banks or other types of lenders, are stuck with them: they cannot sell them and they cannot borrow while placing such shaky assets as collateral. These are the imprudent lenders and investors that central banks now are trying to bail out.

During the French Revolution (1789-1799) , the Jacobins (the neocons of the day) had the brilliant idea of issuing securities, called " assignats ," based on the properties (buildings and lands) the government had taken away from the Church and its religious orders. The new securities were quickly "monetized" into fiat money  and transformed into readily available cash. This caused a massive hyperinflation and a subsequent deflation .

Mind you, this was not the first time that 18th-century France lived an experience of inflationary finance, since a similar incident took place three quarters of a century before, between 1716 and 1720, when Scottish banker and businessman John Law (1671-1729) led France into a fiat money fiasco and engineered a land-backed securities scheme known as the Mississippi Bubble . John Law's earlier experiment and the French Revolution assignats debacle should be clear reminders of the danger and folly of "monetizing" illiquid assets-based securities.

Like all Ponzi schemes , such pyramidings of debts with no liquid assets behind them are bound to implode sooner or later. And that is what we are witnessing today, i.e. the implosion of unfunded credit derivatives -based Ponzi schemes. In 1998-2000, we got an idea of what could happen when portfolios are highly leveraged and laden with derivative financial products with the collapse of one large hedge fund, Long-Term Capital Management .

This should have been a warning sign to regulators of financial markets. But hedge funds and other financial operators' greed -- and political corruption -- were too strong, and no one stopped the march to disaster. Now, things are getting worse, because central banks, led by the Fed, are following the assignats route and have been aggressively "monetizing" the unfunded derivative debts, lending new cash not for a day or two, and not against T-bills, but for months on end against illiquid and partly unsolvable and artificial derivative debts. Who knows where this could lead?

One possibility is the complete collapse of the U.S. dollar and an uncontrollable burst of inflation in the years ahead if the salvage operation were to increase money supply on a permanent basis. Indeed, if central banks continue to shore up the artificial financial houses of cards to prevent them from going bankrupt, they may end up monetizing mountains of worthless debts with the potential of creating monstrous inflation. A dollar panic may be just around the corner.

Thus, the cure for fighting a credit crisis could be a tremendous push of inflation in a few years, if the Fed cannot withdraw the new cash fast enough from the system. This surely can be the case, since it has announced that it is discounting non-government home mortgages and mortgage-backed securities, jumbo mortgages, and asset-backed commercial paper, and a broad range of collateral for discount-window loans, besides the typical Treasury and government agency paper. The problem is that some of these so-called "securities" may be worthless in a few months, thus making it difficult for the Fed to sell them back and retrieve its cash.

Over the past few weeks, central banks worldwide have supplied hundreds of billions of fresh loans to banks and other financial dealers, to make cash available for lending and they have lowered interest rates amid signs that credit was drying up. The privately-owned Fed , for example, has accepted billions in "repos", by which it bought billions in illiquid securities from dealers, who then deposited the money into commercial banks, thus "liquifying" the entire financial system. This is a short-term measure designed to alleviate the liquidity crisis , even if it is pursued for a few months.

It alleviates the liquidity crisis, for sure, but this does nothing to cure the underlying "solvency crisis" of institutions holding large chunks of non-performing mortgage-based assets. Sooner or later, such low valued derivatives will have to be written off, and this will necessarily lead to an erosion of these institutions' capital base. Bankruptcies of the most leveraged and imprudent institutions are to be expected. For a few weeks, the Fed's interventions and buying by the Treasury's special division, the Working Group on Financial Markets, also commonly known as the "Plunge Protection Team" (PPT) will sustain the financial markets. But come mid-September and early October, the law of gravity is likely to regain its importance.

As I explained in my blog of last October 16 (2006), Headwinds for the US Economy , macroeconomic conditions made it a " matter of months, not years, " before the U.S. economy and the U.S. dollar begin to experience some downward pressures. And, as I repeated on May 5 (2007), A Slowdown or a Recession in the U.S. in 2008? , we are " approaching [the] point of reckoning . "

As I said in May, we could expect "the collapse of one and possibly several major financial institutions under the pressures of bad loans and record foreclosures. Particularly at risk is the some $2.5 trillion mountain of debt concentrated in subprimes and Alt-A loans. Already, one major subprime lender (New Century Financial) has filed for Chapter 11 bankruptcy protection . Others are likely to follow, because 2007 is the year when a large number of subprime real estate loans have to be renegotiated at higher interest rates. The rate of foreclosure is bound to spike in the coming months, possibly culminating in the next two years into a financial hurricane."

The practice of subprime loans and the creation of even more creative and artificial "derivative financial products" is much more widespread in the USA than in other countries. For example, such risky loans represent as much as 20 percent of mortgage loans in the U.S., while the incidence is only 5 percent in neighboring Canada. (Indeed, out of the U.S. $10 trillion mortgage market, about $2 trillion constitute the subprime mortgage market.) But where was the Fed under Alan Greenspan and Ben S. Bernanke, the Security and Exchange Commission (SEC) under former congressman and venture capitalist Christopher Cox, and the Bush-Cheney Treasury Department when this mountain of shaky real estate debt was being built by unscrupulous and ruthless financial operators?

Why did they not intervene, first, to protect mortgage borrowers by putting a stop to mortgage loans that require no or not much documentation about a borrower's income (so-called "no doc" or "low doc" loans), second, to prevent a solvency dilution of the capital base of American financial institutions and, third, to prevent an unsustainable real estate bubble that sooner or later was going to burst and drag down the rest of the economy? It is indeed the duty of a lifeguard to prevent people from jumping into a swimming pool that is without water. But when you have a Treasury secretary who is a former president of deal-making and hedge-funds-famous Goldman Sacks, a SEC chairman who is a former venture capitalist and a chairman of the Fed who is on record as saying he favors inflationary policies, you may have part of the answer. When the fox is put in charge of the chicken coop, you cannot expect the chickens to be safe. One has to remember that President Herbert Hoover's secretary of the Treasury, in 1929, was financier Andrew W. Mellon , with his far right economic policies of lowering taxes for the rich. We have the uneasy feeling that history repeats itself.

Since the Bush-Cheney White House wanted the economy to keep bubbling before the 2004 and 2006 elections, there was nobody to whistle the end of the recreation. As the French King Louis XIV said, " Après moi, le déluge ! " ("When I am gone, I don't care what happens!). In fact, U.S. regulators not only did not intervene to stop the madness of no-interest, no questions asked, no down payment loans, but they encouraged unbridled speculation by abolishing the Roosevelt era crash-preventing "uptick rule" designed to force short sellers to wait for an uptick in the price of a stock before they could complete their short trade. Indeed, it will be an historic irony that on July 6 (2007), the Security and Exchange Commission (SEC) removed the protection in order to allow hedge fund operators to short stocks on down ticks, thus making sure that market volatility would increase tremendously.

It is said that London financiers, greedy speculators and incompetent central bankers were responsible for the 1929-1939 worldwide financial crisis and economic depression. This came after a domino effect of financial collapses, starting with the failure in September 1931, of the big Austrian CreditAnstalt bank , owned by the Rothschild family. The crisis spread throughout the German, the British and the global financial system. This time, the financial infection has started in the United States. If the current financial collapse in the U.S. were to stall the real economy, as it has already begun to do in many sectors, the Bush-Cheney administration would have to carry a lot of blame because of its lax regulatory policies.

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