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CREDIT BUST BYPASSES BANKS
PART 2: Bank deregulation fuels abuse
By Henry C K Liu

(See also Part 1: The rise of the non-bank financial system)

US Federal Reserve data show that the outstanding stock of US commercial paper has fallen by US$255 billion or 11% over the past three weeks, a sign that many borrowers have been unable to roll over huge amounts of short-term debt at maturity. Asset-backed commercial paper (ABCP), which accounted for half the commercial-paper (CP) market, tumbled $59.4 billion to $998



billion in the last week of August, the lowest since December. Total short-term debt maturing in 270 days or less fell $62.8 billion to a seasonally adjusted $1.98 trillion. The yield on the highest-rated asset-backed paper due by August 30 rose 0.11 percentage point to a six-year high of 6.15%.

Some analysts are comparing the current collapse of the CP market to the sudden drain on liquidity that occurred at the onset of the 2001 dotcom bust. Others are comparing the current crisis to the 1907 crash, when large trusts did not have access to a lender of last resort, as the Fed had not yet been established. Still others are comparing the current crisis to the 1929 crash, when the Fed delayed needed intervention.

Today, key market participants who dominate the credit market with unprecedented high levels of securitized debt operate beyond the purview of the Fed in the non-bank financial system, and these market participants do not have direct access to a lender of last resort when a liquidity crisis develops except through the narrow window of the banking system.

Banks get no respect
US banks are now unhappy about capital and debt markets, where they are no longer getting respect. Market analysts have been crediting capital and debt markets for the long liquidity boom, rather than bank lending. Banks' share of net credit markets, according to Fed data on flow of funds, dropped from a peak of more than 62% in 1975 to 26% in 1995 and was still falling rapidly, while securitization's share rose from negligible in 1975 to more than 20% in 1995 and more than 30% in 2006 and was still rising rapidly, with insurers and pension funds taking the rest.

Debt securitization in the first half of 2007 stood at more than $3 trillion, up from $2.15 trillion in 2006, $375 billion in 1985 and 156 billion in 1972. About $1.2 trillion is asset-backed securities. The biggest issuers are: Countrywide, $55 billion; Washington Mutual, $43 billion; and General Motors Acceptance Corp (GMAC), $40 billion. Big bank issuers are: JPMorgan Chase, $38 billion; Citibank, $29 billion; Barclays Bank, $29 billion. Big brokerage issuers are: Lehman Brothers, $37 billion; Merrill Lynch, $31 billion, Bear Sterns, $31 billion; and Morgan Stanley, $26 billion.

Asia, including Japan, which still funds its economies mostly through banks, could not recover quickly from the 1997 Asian financial crisis primarily because of an underdeveloped debt-securitization market.

The Dow and interest rates
In February 2000, the Dow Jones Industrial Average (DJIA) closed below 10,000 - a psychological benchmark from a peak of 11,723 just four weeks earlier, and 10,000 was only a transitional barrier. Some bears predicted lack of support until 8,000. It was the first retreat from the 10,000 mark in 10 months, off 14.22% for the year, while the broader S&P 500 lost 9.25%.

On September 17, 2000, the DJIA fell 684.81 points to close at 8,920.70, largest dollar loss in history, down 7.13%. On October 9, the DJIA fell 215.22 points to close at 7,286.27. The market had declined 4,436.71 points, or 38%, from January 14, 2000, when it rose 140.55 to close at all time high of 11,722.98, the first close above both 11,600.00 and 11,700.00.

On May 16, 2000, the Fed Funds rate was raised to 6.5%. After that, the Fed began lowering it on January 3, 2001, and did so again 12 more times to 1% on June 25, 2003, and held it there - below inflation rate - for a full year, unleashing the debt bubble.

On July 19, 2007, the DJIA closed at 14,000.41, reaching a new all-time high. The DJIA had risen 6,714 points, or 92%, since the low point of 7,286.27 on October 9, 2002, in four years and 10 months. The US gross domestic product rose from $10.5 trillion in 2002 to $13.2 trillion in 2006, an increase of 30%. Asset prices outpaced economic growth by a multiple of three during that period.

This extraordinary divergence shows more than the different economic fundamentals of the old and new economies. It shows the financial effect of a shift of importance from banks as funding intermediaries to the exploding capital and debt markets in which, with the advent of structured finance, the line between equity and debt has in effect been blurred.

Greenspan's forked-tongue pronouncements
Nasdaq companies rely less on banks for funds and were thus less affected by then Fed chairman Alan Greenspan's threats of interest-rate hikes. Greenspan had been vocal in explaining that his monetary-policy moves of rising Fed Funds rate targets were not specifically targeted toward "irrational exuberance" in the stock markets, but toward the unsustainable expansion of the US economy as a whole. But data show that the economy did not expand at the same rate as the rise of equity prices. Economic growth would be more sustainable with irrational exuberance in the stock market.

In the same breath, Greenspan decried the dangers of the wealth effect if it ever ended up heavier on the consumption side than on the investment side. It was a curious position, as most Greenspan's positions seem to be. The Greenspan gospel says asset inflation is good unless it is spent rather than used to fuel more asset inflation. He continued to restrain demand in favor of supply in an already overcapacity economy.

The need for demand management was argued by post-Keynesian economists who had been pushed out of the mainstream in recent decades by supply-siders. In housing, Greenspan was trapped in a classic dilemma of not knowing whether housing is consumption or investment. Homeowners have been living in an asset (thus consuming it) that rises in market value faster than the rise of their earned income. Home-equity loans enabled homeowners to monetize their housing investment gains to support their non-housing consumption.

It is hard to see how home prices rising higher than homebuyers can afford to pay can be good for any economy. Yet the Fed celebrates asset-price appreciation for shares and real estate, but treats wage rises like a dreaded plague.

Bifurcated markets
The so-called "bifurcated" market indices of the tech boom of the early 2000s indicated clearly that the Fed, whose sole monetary weapon was the Fed Funds rate, lost control of the new economy, which appears impervious to short-term interest-rate moves.

Under such conditions, the only way the Fed could restrain unsustainable economic expansion in one sector was to overshoot the interest-rate target to rein in an impervious Nasdaq at the peril of the whole economy. Interest-sensitive stocks were battered badly in 2000, including banks and non-bank lenders, such as GE, GMAC and Amex. This forced the Fed to keep Fed Funds rate at 1% for a whole year, from June 2003 to June 2004, to create the housing bubble. With the inflation rate at 2%, the Fed was in effect giving borrowers a net payment of $1,000 for every $100,000 borrowed between 2002 and 2003.

The peril of uneven profit sharing
Financial-services companies, including commercial banks, brokerage firms and mortgage lenders, investment-bank and non-bank financial companies such as GE and GMAC, had since produced some of the biggest profits in the recent bull market fueled by a liquidity boom.

The trouble with the financial sector making the bulk of the profit in the debt economy is that when newly created wealth is unevenly distributed to favor return on capital rather than through rising wages, it exacerbates the supply-demand imbalance, which can only be sustained by a consumer debt bubble. The public have insufficient income to consume all that the debt economy can produce from over-investment except by taking on consumer debt and home-equity debt.

Liquidity crunch only an early symptom
In recent weeks, the combination of sudden rise in interest rates due to a liquidity crunch and the hefty leverage employed by businesses in the financial sector has proved to be fatally hazardous to company cash flow and stock prices. Money-center banks and broker dealers, along with their hedge-fund customers, are most vulnerable because they are most exposed to interest-rate-related risks through products such as interest-rate swaps, default swaps and securitized mortgages. But this was just an early symptom, like an initial wave of high fever.

Lipper TASS reports that institutional and wealth private investors poured $41.1 billion into hedge funds in the second quarter of 2007, which through performance gains swelled industry assets to an estimated $1.67 trillion by the end of June. The aggregate 

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