Page 3 of
3 THE ROAD TO
HYPERINFLATION 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
workers’ 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 that’s 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 that’s 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 cities’ 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. Cleveland’s
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 Baltimore’s 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 China’s 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.
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 Fed’s 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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