by Mike Whitney
April 11, 2009
It's been 21 months since two Bear Stearns hedge
funds defaulted setting off a series of events which have led to the gravest
economic crisis since the Great Depression.
No one expected the financial
meltdown to hit this hard or spread this fast. The failure at Bear triggered
a freeze in the secondary market where mortgage loans are repackaged into
securities and sold to investors. That market is now completely paralyzed
cutting off 40 percent of funding for consumer and business loans and
thrusting the broader economy into a deep recession.
Banks and financial
institutions have been forced to curtail their off-balance sheet operations
and build their reserves which have ballooned from $45 billion to nearly
$700 billion in the last 6 months alone. Like millions of homeowners who
have seen their home equity vanish and their retirement savings slashed in
half, the banks are hunkering down hoping they can outlast the deflationary
The deteriorating economic conditions have taken their toll on consumer
confidence and forced businesses to lay off employees that won't be needed
during the slowdown. The system is bursting with overcapacity.
falling faster than any time since the 1930s. Inventories will have to be
trimmed and budgets cut to muddle through the down-times. Foreign trade has
slowed to a crawl, auto sales are down by 40 percent or more, and
unemployment is rising at 650,000 per month. Policymakers have pushed
through a $800 billion stimulus plan, but it won't be nearly enough to stop
the steady rise in unemployment or take up the slack in an economy where
industrial output has been cut in half, new home construction has dropped to
record lows, and manufacturing has fallen off a cliff.
Economists warn that
when governments don't step in and provide stimulus to increase aggregate
demand, consumers cut back sharply on spending and push the economy deeper
Treasury Secretary Geithner and Fed chief Bernanke have lent or committed
$13 trillion trying to keep the financial system functioning, but they've
only managed to plug a few holes and avoid a system-wide collapse.
financial system is hobbled and unable to provide sufficient credit to
generate growth. Every sector has suffered cutbacks, layoffs and slimmer
profits. The problems go beyond toxic assets or complex derivatives.
system is plagued with stagnation, overcapacity and redundancy.
professor Robert Brenner sums it up like this in an interview in the Asia
"The current crisis is more serious than the
worst previous recession of the postwar period, between 1979 and 1982,
and could conceivably come to rival the Great Depression, though there
is no way of really knowing. Economic forecasters have underestimated
how bad it is because they have over-estimated the strength of the real
economy and failed to take into account the extent of its dependence
upon a buildup of debt that relied on asset price bubbles.
In the U.S., during the recent business
cycle of the years 2001-2007, GDP growth was by far the slowest of the
postwar epoch. There was no increase in private sector employment. The
increase in plants and equipment was about a third of the previous, a
postwar low. Real wages were basically flat. There was no increase in
median family income for the first time since World War II. Economic
growth was driven entirely by personal consumption and residential
investment, made possible by easy credit and rising house prices.
Economic performance was weak, even despite
the enormous stimulus from the housing bubble and the Bush
administration's huge federal deficits. Housing by itself accounted for
almost one-third of the growth of GDP and close to half of the increase
in employment in the years 2001-2005.
It was, therefore, to be expected that when
the housing bubble burst, consumption and residential investment would
fall, and the economy would plunge. "
("Overproduction not Financial Collapse
is the Heart of the Crisis", Robert P. Brenner speaks with Jeong
Seong-jin, Asia Pacific Journal)
The economy is now in a downward spiral.
Tightening in the credit markets has made it harder for consumers to borrow
or businesses to expand. Overextended financial institutions are forced to
shed assets at firesale prices to meet margin calls from the banks. Asset
deflation is ongoing with no end in sight. Price declines in housing have
reached 30 percent already and are now accelerating on the downside.
the nightmare scenario that Bernanke hoped to avoid; a capitulation in real
estate that drags the rest of economy into a black hole. Economist Nouriel
Roubini and market analyst Meredith Whitney predict that housing prices will
drop another 20 percent before they hit bottom.
Nearly half of all
homeowners will be underwater and owe more on their mortgages than the
current value of their homes. That will increase the foreclosures and push
scores of banks into default.
According to Merrill Lynch's economist David
"It would take over three years to achieve
price stability (in housing). The problem is that prices do not begin to
stabilize until we break below eight months' supply and they tend to
deflate 3% per quarter until that happens. So as impressive as it is
that the builders have taken single-family starts below underlying
sales, their efforts are just not sufficient to prevent real estate
prices from falling further.
In fact, even if the builders were to
declare a moratorium immediately, that is, taking starts to zero, demand
is so weak and the unsold inventory so intractable that it would now
take over three years to achieve the holy grail of price stability in
the residential real estate market."
The main economic indicators all point to a long
period of retrenchment ahead.
The slowdown in global trade has hit Germany,
Japan, and most of Asia particularly hard. The export-driven model of growth
has suffered a major setback and won't rebound for some time to come.
the US consumer unable to continue his debt-fueled spending spree, surplus
countries will have to develop domestic markets for growth, but it won't be
easy. Chinese workers save 50 percent of what they earn and German workers
already have a comfortable life without increasing personal consumption.
Higher wages and lower interest rates can help stimulate demand, but
cultural influences make it difficult to change spending habits.
the economy will continue to languish operating well below its optimum
Capital flows have also suddenly reversed causing turmoil in the currency
markets. January's TIC data indicates that net capital outflows for the US
were negative $148 billion in January. Capital is now fleeing the country.
Financial protectionism has triggered the repatriation of foreign investment
causing a sharp drop in the purchase of US sovereign debt.
This is from Brad Setser, economist for
"The obvious implication of the recent
downturn in total reserve holdings - and the $180 billion fall in q4
wasn't driven by currency moves - is that the pace of growth in the
world's dollar reserves has slowed dramatically...
The obvious implication: most of the 2009 US fiscal deficit WILL NEED TO
BE FINANCED DOMESTICALLY. The Fed's custodial data indicates central
banks are still buying Treasuries, though at a somewhat slower pace than
in late 2008. But their demand hasn't kept up with issuance. Foreign
Central banks aren't going to finance much of the 2009 US fiscal
deficit; Their reserves aren't growing anymore"
(Brad Setser, Council on Foreign
The United States does not have the reserves to
finance it own massive deficits which will soar to $1.9 trillion by the end
The Fed will have to increase its purchases of US Treasuries and
monetize the debt. Foreign holders of Treasuries and dollar-backed assets
($5 trillion overseas) will be watching carefully as Bernanke revs up the
printing presses to fight the recession and meet government obligations.
China, Russia, Venezuela and Iran have already called for a change in the
world's reserve currency. It won't happen overnight, but the momentum is
The S&P 500 has soared 23 percent in the last four weeks, but the current
bear market rally is misleading.
The prospects for a quick recovery are
remote at best. The fundamentals are all weak. Corporate profits are down,
GDP is negative 6 percent, housing is in a shambles, and the banking system
broken. The Fed has increased the money supply by 22 percent, but economic
activity is at a standstill.
The velocity at which money is spent is the
slowest since 1987. Nothing is moving.
The banks are hoarding, credit has
dried up, and consumers are saving for the first time in 2 decades. The
banks' credit-conduit cannot function properly until bad assets are removed
from their balance sheets. But the magnitude of the losses make it
impossible for the government to purchase them outright without bankrupting
According to the Times Online,
the IMF has
increased its estimates of how much toxic mortgage-backed paper the banks
"Toxic debts racked up by banks and insurers
could spiral to $4 trillion, new forecasts from the International
Monetary Fund (IMF) are set to suggest.
The IMF said in January that it expected the deterioration in
US-originated assets to reach $2.2 trillion by the end of next year, but
it is understood to be looking at raising that to $3.1 trillion in its
next assessment of the global economy, due to be published on April 21.
In addition, it is likely to boost that total by $900 billion for toxic
assets originated in Europe and Asia.
Banks and insurers, which so far have owned up to $1.29 trillion in
toxic assets, are facing increasing losses as the deepening recession
takes a toll, adding to the debts racked up from sub-prime mortgages.
The IMF's new forecast, which could be revised again before the end of
the month, will come as a blow to governments that have already pumped
billions into the banking system."
Since banks lend at a ratio of 10 to 1; the
amount of credit cut off to the broader economy will ensure that sluggish
growth well into the future.
If there is a recovery, it will be weak.
The Obama administration will have to increase its capital injections even
though they will add to mushrooming deficits. So far, financial institutions
have only written down $1 trillion or 25 percent of their losses. This means
the banking system is insolvent. Eventually, Obama will have to resolve the
bad banks and auction off troubled assets, even though political support is
According to political analyst F. William Engdahl, most of the garbage assets are concentrated in the nation's five
"Today five US banks according to data in
the just-released Federal Office of Comptroller of the Currency's
Quarterly Report on Bank Trading and Derivatives Activity, hold 96% of
all US bank derivatives positions in terms of nominal values, and an
eye-popping 81% of the total net credit risk exposure in event of
The five US banks are, in declining order of importance:
JPMorgan Chase which
holds a staggering $88 trillion in derivatives ($66 trillion!)
Bank of America with $38 trillion in derivatives
Citibank with $32 trillion
Number four in the derivatives
sweepstakes is Goldman Sachs with a 'mere' $30 trillion in derivatives
Number five, the merged Wells Fargo-Wachovia Bank, drops dramatically in
size to $5 trillion
"Geithner's 'Dirty Little Secret': The
Entire Global Financial System is at Risk", F. William Engdahl, Global
These five banking Goliaths are at the center of
political power in America today.
Their White House emissary, Timothy Geithner, has concocted a rescue plan
- the Public-Private Investment
Program - which will provide 94 percent funding from the FDIC for the
purchase bad assets. The program is designed to keep asset prices
artificially high while transferring the bulk of the losses to the taxpayer.
The plan has been widely criticized and has even
raised a few eyebrows even among usually-supportive members of the
establishment like the Financial Times:
"US banks that have received government aid,
including Citigroup, Goldman Sachs, Morgan Stanley and JP Morgan Chase,
are considering buying toxic assets to be sold by rivals under the
Treasury's $1,000bn (£680bn) plan to revive the financial system.
The plans proved controversial, with critics charging that the
government's public-private partnership - which provide generous loans
to investors - are intended to help banks sell, rather than acquire,
troubled securities and loans.
Banks have three options if they want to buy toxic assets: apply to
become one of four or five fund managers that will purchase troubled
securities; bid for packages of bad loans; or buy into funds set up by
others. The government plan does not allow banks to buy their own
assets, but there is no ban on the purchase of securities and loans sold
(The Financial Times)
It's a multi-billion dollar shell game with
myriad opportunities for fraud.
In theory, the banks could create their own
off-balance sheet operations (SIVs or SPEs) and use them to purchase their
own bad assets taking advantage of the government's 94 percent low interest
non recourse loans. It's a blatant swindle and another windfall for Wall
Geithner's plan does not fix the problems with the banks, it only delays the
final outcome. The next leg-down in the recession will push many of the
undercapitalized banks into receivership. Geithner's PPIP won't change that.
As housing prices fall and foreclosures rise, the capital position of many
of the banks will become untenable leading to a rash of bank failures.
An article in Monday's Wall Street Journal puts
adds some historical perspective to today's financial crisis:
"The events of the past 10 years have an
eerie similarity to the period leading up to the Great Depression. Total
mortgage debt outstanding increased from $9.35 billion in 1920 to $29.44
billion in 1929. In 1920, residential mortgage debt was 10.2% of
household wealth; by 1929, it was 27.2% of household wealth....
The causes of the Great Depression need more study, but the claims that
losses on stock-market speculation and a monetary contraction caused the
decline of the banking system both seem inadequate. It appears that both
the Great Depression and the current crisis had their origins in
excessive consumer debt -- especially mortgage debt -- that was
transmitted into the financial sector during a sharp downturn.
Why does one crash cause minimal damage to the financial system, so that
the economy can pick itself up quickly, while another crash leaves a
devastated financial sector in the wreckage? The hypothesis we propose
is that a financial crisis that originates in consumer debt, especially
consumer debt concentrated at the low end of the wealth and income
distribution, can be transmitted quickly and forcefully into the
It appears that we're witnessing the second great
consumer debt crash, the end of a massive consumption binge."
(From Bubble to Depression? Steven Gjerstad and Vernon L. Smith, Wall Street Journal)
PARTY LIKE ITS 1929
Two leading economic historians, Barry Eichengreen and Kevin H. Rourke, have
written an article "A Tale of Two Depressions" which has been widely
circulated on the Internet.
It illustrates (with graphs) how the global
economy is plummeting faster now than during the 1930s.
By nearly every objective standard, the present downturn is worse than the
Great Depression. Manufacturing, industrial production, foreign trade,
capital flows, consumer confidence, housing, and even stocks are falling
faster today than after the crash of 1929.
So far, Bernanke's monetary
bandaids have prevented the wholesale collapse of the financial system, but
that could change.
The economy continues its downhill slide and it looks
like there's nothing to stop it from falling further still.