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     Jan 26, 2008
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Fed helpless in its own crisis

By Henry C K Liu

debt. The swaps are structured to cancel each other out, but only if every counterparty meets its obligations. Any number of counterparty defaults could start a chain reaction of credit crisis. The Financial Times reported that Jamie Dimon, chief executive of JPMorgan, said when asked about bond insurers: "What [worries me] is if one of these entities doesn't make it ...? The secondary effect ...? I think could be pretty terrible."

The danger of high leverage
The factor that has catapulted the subprime mortgage market into

content  crisis proportion is the high leverage used on transactions involving the securitized underlying assets. This leverage multiplies profits during expansive good times and losses in during times of contraction. By extension, leverage can also magnify insipid inflation tolerated by the Fed into hyperinflation.

As big as the residential subprime mortgage market is, the corporate bond market is vastly larger. There are a lot of shaky outstanding corporate loans made during the liquidity boom that probably could not be refinanced even in a normal credit market, let alone a distressed crisis. A large number of these walking-dead companies held up by easy credit of previous years are expected to default soon to cause the CLO valuations to plummet and CDS to fail.

Commercial real estate is another sector with disaster looming in highly leveraged debts. Speculative deals fueled by easy cheap money have overpaid massive acquisitions with the false expectation that the liquidity boom would continue forever. As the economy slows, empty office and retail spaces would lead to commercial mortgage defaults.

Emerging markets will also run into big problems because many borrowers in those markets have taken out loans denominated in foreign currencies collateralized by inflated values of local assets that could be toxic if local markets are hit with correction or if local currencies lose exchange value.

The last decade has been the most profligate global credit expansion in history, made possible by a new financial architecture that moved much of the activities out of regulated institutions and into financial instruments traded in unregulated markets by hedge funds that emphasized leverage over safety. By now there are undeniable signs that the subprime mortgage crisis is not an isolated problem, but the early signal of a systemic credit crisis that will engulf the entire financial world.

Myth of poor folk over-saving
Both former Fed chairman Greenspan and his successor Ben Bernanke have tried to explain the latest US debt bubble as having been created by global over-saving, particularly in Asia, rather than by Fed policy of easy credit in recent years.

Yet the so-called global savings glut is merely a nebulous euphemism for overseas workers in exporting economies being forced to save to cope with stagnant low wages and meager worker benefits that fuel high profits for US transnational corporations. This forced saving comes from the workersí rational response to insecurity rising from the lack of an adequate social safety net. Anyone making around $1,000 a year and faced with meager pension and inadequate health insurance would be suicidal to save less than half of his/her income. And thatís for urban workers in China. Chinese rural workers make about $300 in annual income. For China to be an economic superpower, Chinese wages would have to increase by a hundredfold in current dollars.

Yet these underpaid and under-protected workers in the developing economies are forced to lend excessive portions of their meager income to US consumers addicted to debt. This is because of dollar hegemony under which Chinese exports earn dollars that cannot be spent domestically without unmanageable monetary penalties.

Not only do Chinese and other emerging market workers lose by being denied living wages and the financial means to consume even the very products they themselves produce for export, they also lose by receiving low returns on the hard-earned money they lend to US consumers at effectively negative interest rates when measured against the price inflation of commodities that their economies must import to fuel the export sector. And thatís for the trade surplus economies in the developing world, such as China. For the trade deficit economies, which are the majority in the emerging economies, neoliberal global trade makes old-fashion 19th-century imperialism look benign.

Central banks support fleecing
The role central banking plays in support of this systematic fleecing of the helpless poor everywhere around the world to support the indigent rich in both advanced and emerging economies has been to flood the financial market with easy money, euphemistically referred to as maintaining liquidity, and to continually enlarge the money supply by financial deregulation to lubricate and sustain a persistently expanding debt bubble.

Concurringly, deregulated financial markets have provided a free-for-all arena for sophisticated financial institutions to profit obscenely from financial manipulation. The average small investor is effectively excluded from reaping the profits generated in this esoteric arena set up by big financial institutions. Yet the investing public is the real victim of systemic risk. The exploitation of mortgage securitization through the commercial paper market by special investment entities (SIVs) is an obvious example.

When the Fed repeatedly pulls magical white rabbits from its black opaque monetary policy hat, the purpose is always to rescue overextended sophisticated institutions in the name of preserving systemic stability, while the righteous issue of moral hazard is reserved only for unwitting individual borrowers who are left to bear the painful consequences of falling into financial traps they did not fully understand, notwithstanding that the root source of moral hazard always springs from the central bank itself.

Local governments versus financial giants
The city of Baltimore is filing suit against Wells Fargo, alleging the bank intentionally sold high-interest mortgages more to blacks than to whites - a violation of federal law. Cleveland is filing suit against investment banks such as Deutsche Bank, Goldman Sachs, Merrill Lynch and Wells Fargo for creating a public nuisance by irresponsibly buying and selling high-interest home loans, resulting in widespread defaults that have depleted the citiesí tax base and left entire neighborhoods in ruins. The cities hope to recover hundreds of millions of dollars in damages, including lost taxes from devalued property and money spent demolishing and boarding up thousands of abandoned houses.

"To me, this is no different than organized crime or drugs," Cleveland Mayor Frank Jackson said in an interview with local media. "It has the same effect as drug activity in neighborhoods. It's a form of organized crime that happens to be legal in many respects."

The Baltimore and Cleveland efforts are believed to be the first attempts by major cities to recover social costs and public financial losses from the foreclosure epidemic, which has particularly plagued cities with significant low-income neighborhoods. Clevelandís suit is more unique because the city is basing its complaints on a state law that relates to public nuisances. The suit also is far more wide-reaching than Baltimoreís in that instead of targeting the mortgage brokers, it targets the investment banking side of the industry, which feeds off the securitization of mortgages.

Greenspan blames Third World - not the Fed
Greenspan in his own defense describes the latest credit crisis as a result of a sudden "re-pricing of risk - an accident waiting to happen as the risk was under-priced over the past five years as market euphoria, fostered by unprecedented global growth, gained traction." Greenspan spoke as if the Fed had been merely a neutral bystander, rather than the "when in doubt, ease" instigator that had earned its chairman wizard status all through the years of easy money euphoria.

The historical facts are that while the Fed kept short-term rates too low for too long, starting a downward trend from January 2001 and bottoming at 0.75% for the discount rate on November 6, 2002, and 1% for the Fed Funds rate target on June 25, 2003, long-term rates were kept low by structured finance, a.k.a. debt securitization and credit derivatives, with an expectation that inflation would be perpetually postponed by global slave labor. The inflation rate in January 2001 was 3.73%. By November 2002, the inflation rate was 2.2%, while the discount rate was at 0.75%. In June 2003, the inflation rate was 2.11% while the Fed Funds rate target was at 1%. For some 30 months, the Fed provided the economy with negative real interest rates to fuel a debt bubble.

Greenspan blames "the Third World, especially China" for the so-called global savings glut, with an obscene attitude of the free-spending rich who borrowed from the helpless poor scolding the poor for being too conservative with money.

Yet Bank for International Settlements (BIS) data show exchange-traded derivatives growing 27% to a record $681 trillion in third quarter 2007, the biggest increase in three years. Compared this astronomical expansion of virtual money with Chinaís foreign exchange reserve of $1.4 trillion, it gives a new meaning to the term "blaming the tail for wagging the dog". The notional value of outstanding over-the-counter (OTC) derivative between counterparties not traded on exchanges was $516 trillion in June, 2007, with a gross market value of over $11 trillion, which half of the total was in interest rate swaps. China was hardly a factor in the global credit market, where massive amount of virtual money has been created by computerized trades.

Belated warning on stagflation
I warned in May 9, 2007 (Liquidity boom and looming crisis, Asia Times Online):
The Fed's stated goal is to cool an overheated economy sufficiently to keep inflation in check by raising short-term interest rates, but not so much as to provoke a recession. Yet in this age of finance and credit derivatives, the Fed's interest-rate policy no longer holds dictatorial command over the supply of liquidity in the economy. Virtual money created by structured finance has reduced all central banks to the status of mere players rather than key conductors of financial markets. The Fed now finds itself in a difficult position of being between a rock and a hard place, facing a liquidity boom that decouples rising equity markets from a slowing underlying economy that can easily turn toward stagflation, with slow growth accompanied by high inflation.
Seven months after my article, on December 16, Greenspan warned publicly on television against early signs of stagflation as growth threatens to stall while food and energy prices soar.

Crisis of capital for finance capitalism
The credit crisis that was detonated in August 2007 by the collapse of collateralized debt obligations (CDOs) waged a frontal attack on finance institution capital adequacy by December. Separately, commercial and investment banks and brokerage houses frantically sought immediate injection of capital from sovereign funds in Asia and the oil states because no domestic investors could be found quickly. But these sovereign funds investments have reached the US regulatory ceiling of 10% equity ownership for foreign governmental investors before being subject to reviews by the inter-agency Committee on Foreign Investment in the US (CFIUS), which investigates foreign takeover of US assets.

Still, much more capital will be needed in coming months by these financial institutions to prevent the vicious circle of expanding liabilities, tightening liquidity conditions, lowering asset values, impaired capital resources, reduced credit supply, and slowing aggregate demand feeding back on each other in a downward spiral. New York Federal Reserve President Tim Geithner warned of an "adverse self-reinforcing dynamic".

Ambrose Evans-Pritchard of The Telegraph, who as a Washington correspondent gave the Clinton White House ulcers, reports that Anna Schwartz, surviving co-author with the late Milton Friedman of the definitive study of the monetary causes of the Great Depression, is of the view that in the current credit crisis, liquidity cannot deal with the underlying fear that lots of firms are going bankrupt. Schwartz thinks the critical issue is that banks and the hedge funds have not fully acknowledged who is in trouble and by how much behind the opaque fog that obscures the true liabilities of structured finance.

While the equity markets are hanging on for dear life with the Fedís help through stealth inflation, the bond markets have collapsed worldwide, with dollar bond issuance falling to a stand still, euro bonds by 66% and emerging market bonds by 75% in Q3 2007. Lenders are simply afraid to lend and borrowers are afraid to take on more liabilities in an imminent economic slowdown. The Fed has a choice of accepting an economic depression to cut off stagflation, or ushering hyperinflation by flooding the market with unproductive liquidity. Insolvency cannot be solved by injecting liquidity without the penalty of hyperinflation.

Next:Central banks always fail to stabilize markets

Henry C K Liu is chairman of a New York-based private investment group. His website is at http://www.henryckliu.com.

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