Commercial banks profit from using low-interest-rate repo proceeds to finance high-interest-rate "subprime" lending - credit cards, home equity loans, automobile loans etc - to borrowers of high



credit risks at double-digit interest rates compounded monthly. To reduce their capital requirement, banks then remove their loans from their balance sheets by selling the CMOs (collateralized mortgage obligations) with unbundled risks to a wide range of investors seeking higher returns commensurate with higher risk. In another era, such high-risk/high-interest loan activities were known as loan-sharking. Yet Greenspan is on record as having said that systemic risk is a good tradeoff for unprecedented economic expansion.

Repos are now one of the largest and most active sectors in the US money market. More specifically, banks appear to be actively managing their inventories, to respond to changes in customer demand and the opportunity costs of holding cash, using innovative ways to bypass reserve requirements. Rising customer demand for new loans is fueled by and in turn drives further down falling credit standards and widens interest-rate spread in a vicious cycle of unrestrained credit expansion.

When asset prices rise, it reflects a change in the money supply/asset relationship, meaning more money chasing the same number of assets. Thus when asset prices rise, it is not necessarily a healthy sign for the economy. It reflects a troublesome condition in which additional money is not creating correspondingly more assets. It is a fundamental self-deception for economists to view asset-price appreciation as economic growth. A housing bubble is an example of this ...

Money now, especially virtual money, is created quite independently of Fed action, and money creation has become much less sensitive to interest-rate fluctuations. This explains why the measured pace at which the Fed has been raising the Fed funds rate target has little direct or immediate effect on the housing bubble.

In the US, where loan securitization is widespread, banks are tempted to push risky loans by passing on the long-term risk to non-bank investors through debt securitization. Credit-default swaps, a relatively novel form of derivative contract, allow investors to hedge against securitized mortgage pools. This type of contract, known as asset-back securities, has been limited to the corporate bond market, conventional home mortgages, and auto and credit-card loans. Last June [2005], a new standard contract began trading by hedge funds that bets on home-equity securities backed by adjustable-rate loans to subprime borrowers, not as a hedge strategy but as a profit center. When bearish trades are profitable, their bets can easily become self-fulfilling prophesies by kick-starting a downward vicious cycle.

Total outstanding home mortgages in the US in 1999 were $4.45 trillion, and by the end of 2004 this amount grew to $8.13 trillion, most of which was absorbed by refinancing of higher home prices at lower interest rates. When Greenspan took over at the Fed in 1987, total outstanding home mortgages in the US stood only at $1.82 trillion. On his 18-year watch, outstanding home mortgages quadrupled to $8.821 trillion by the end of third-quarter 2005. Much of this money has been printed by the Fed, exported through the trade deficit and re-imported as debt [in the capital account surplus]. Given that new housing units have been about 5% of the US housing stock per year, at the rate of about 2 million units per year, the housing stock increased by 100% over a period of 18 years while outstanding mortgages increased by more than 400%.

The Bank of Japan's zero-interest policy, combined with general asset deflation in the yen economy, has caught the Japanese insurance companies in a financial vise. Both new loan rates and asset values are insufficient to carry previous long-term yields promised to customers. Japan does not have a debtor-friendly bankruptcy law, as the US has. At any rate, insurance companies, like banks, cannot file for bankruptcy in the US. As a regulated sector, insurance companies are governed by an insurance commission in each state, which normally has a reinsurance fund to take care of unit insolvency. The funds are nowhere near sufficient to handle systemic collapse. The same happened to the US Federal Deposit Insurance Corp in the 1980s.

The insurance sector in the US will face serious problems as the Federal Reserve again lowers the Fed Funds Rate targets and keeps them near zero for extended periods. Several segments of the insurance sector, such as health insurance and casualty insurance, are already in distress for other reasons. Government-insured pension schemes are under pressure as troubled industrial giants such as General Motors default on their pension obligation, along with the airlines.

In the era of industrial capitalism, a low interest rate was a stimulant. But in this era of finance capitalism flirting fearlessly with debt, lowering rates creates complex problems, especially when most big borrowers routinely hedge their interest-rate exposures. For them, even when short-term rates drop or rise abruptly, the cost remains the same for the duration of the loan term, the only difference being that they pay a different party. While debtors remain solvent, investors in securitized loans go under. Credit derivatives have been the hot source of profit for most finance companies and will be the weapon of massive destruction for the financial system, as Warren Buffet warned.

In the United States, when house prices have generally tripled in less than a decade, it is evidence that the value of the dollar has declined by a factor of three in the same time period. Consumer prices have not risen by the same amount because of outsourcing of manufacturing to low-wage economies overseas which also acts as a depressant on domestic wages. Imbalance in the economy appears if wages and earnings have not risen proportional to prices.

A homeowner whose house has increased 300% in market price while his income has risen only 30% has not become richer. He has become a victim of uneven inflation. He may enjoy a one-time joyride with cash-out financing with a new mortgage, but his income cannot sustain the new mortgage payments if interest rates rise, and he will lose his home. And interest rates will rise if his income increases, because that is how the Fed defines inflation. Thus when his income rises, the market price of his home will fall, giving him an incentive to walk away from a big mortgage in which he has little equity tie-up. This can become a systemic problem for the mortgage-backed security sector.

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