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Tuesday, March 31, 2009

Geithner vs. Krugman

The implosion of the private credit system--the product of inadequate regulation and easy money--has blown a huge whole in our monetary system. That damage has been done is no news; what is remarkable is the scale of the massive bailout, which includes funds issued by the Federal Reserve, which borrows on Treasuries issued it on behalf of the government.

Everyone agrees something needs to be done. In crafting a workable solution, two opposing camps have formed, one with Nobel-prize winning economist Paul Krugman, and Obama and Geithner on the other.

Geithner and New York Times columnist Paul Krugman entered into a war of words last week. Krugman is calling Geithner's plan "cash for trash." In the New York Times Monday, Krugman quoted an article by Simon Johnson in The Atlantic magazine:

...elite business interests--financiers, in the case of the U.S. --played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed..."

Krugman writes that Johnson sees "America's current difficulties as 'shockingly reminiscent' of crisis in places like Russia and Argentina--including the key role played by crony capitalism."

Krugman and Johnson could have been repeating what I've been saying on this very blog weeks before the mainstream regurgitated this "news" that the crisis and its solution have been tainted by corporate influence over the political and regulatory processes. I even brought up Michael Hudson's article, "The Oligarch's Escape Plan," which outlines similarities between the Russian oligarchs and the way the bailout was being handled.

Some would say the banking industry is, and was, still being represented by the Federal Reserve in the person of ex-Fed governor of New York, Geithner. Can we trust our gut, common sense, and what Krugman says? Or do we believe Geithner--who was and is part of the same system that directly contributed to the crisis?

On TV, the case Geithner makes for the bailout is logical, and sounds like it might work. Yes, adding more capital allows the financial entities to lend more. But will consumers spend? Our economy depends on ongoing borrowing by consumers--Americans are saving instead. Can increased government spending replace consumption that's declined?

While Geithner's plan may be credible on an intellectual level, my gut tells me he can't be trusted. Apparently most Americans agree with me. Over 50% believe the bailout should end, which indicates political momentum is against Geithner's proposition, that the Treasury needs to buy up the so-called toxic assets, or begin a public-private partnership to liquidate the securities. Obama has wrapped a lot of political capital up in the bailout.

Why are people like Geithner so worried? The answer to this question comes in the under-publicized truth that the banks are under-capitalized--having been allowed to double down on their reserves, in what would have been impossible had banking laws and regulations not been tampered with. Subsequent to lending themselves and each other too much, they then bundled financial products into derivatives, swaps, futures, and other overly complicated, hard- or impossible-to-value debt instrument which of course provided huge short-term profits.

Making these assets toxic is the fact many of these securities have Credit Default Swaps--a type of insurance against default--attached to them. Should the value of these debt securities crash, the CDSs will kick in, and incur huge payments on the issuer of the CDSs, who happen to be the same banks and financial companies whose balance sheets positions have deteriorated.

As the financial entities issuing CDSs are all interdependent, should CDS issued by one company not be payable, all CDSs could quickly become worthless.

We can't summarily write off the CDSs, as they're part of a contract. Or can we? Congress did end up taxing AIG retention bonuses, so maybe CDSs can simply be retroactively annulled. Then the markets could discount the underlying security as if the CDS weren't there. Better to take the damage upfront.

Geithner does seem to realize the need to allow the market for these securities to function with a minimum of intervention. At least Geithner is wise enough to know that the market is a far better source for evaluating the worth of the securities than any government agency. He's wise to let private sector professionals determine what constitutes fair value. So why doesn't he just leave the sector alone?

Well, as I said above, the banks are exposed to double jeopardy on paying the CDS attached to the Collateralized Debt Obligations and other debt. They owe each other vast sums and once one bank defaults, they all could. Should a ripple effect begin it's possible all the cherished big names on Wall Street might actually owe more than they can pay. Already derivatives holdings and obligations far exceed the depositor base--JPMorganChase has some $90 trillion or so.

If a collapse were to occur, would banks simply raid depositors' accounts, causing a run on the FDIC? As I said in my last post, libertarians view the FDIC bank guarantees as a moral hazard that encourages risk-taking.

CDSs have discouraged many of the debt securities from being sold. Why buy something for 80 cents on the value if the CDSs kick in at 70 cents? The only reason buyers would pay more for a CDS-insured debt security is if they think the insuring company--often the same as the one issuing the security--can cover the cost of default.

Government buying up of the CDS-insured debt, at above-market prices, shows a lack of confidence in the ability of the issuers of the CDS to pay in the event of default on the underlying security.

Now Geithner is trapped between letting free markets set prices and setting the prices itself. The worth of these securities can't be determined very well under contrived circumstances, where government guarantees and loss stopping prop up prices.

No one in the private sector wants to make a mistake or take losses when the government will subsidize the losses to some degree should they be incurred. The intent of the bailout to subsidize losses on behalf of private banks encourages gaming the system, by selling the worst debt to the government or through a market it supports.

Successful government intervention will require ongoing interventions as a self-fulfilling prophecy for as long as the government is actively participating. No government involvement in pricing can be good over the longer term: it's like setting bread prices in a communist bakery; they might be good for consumers, but no one wants to supply the wheat at such low prices so the shelves go empty.

Constant meddling hinders free market activity, reducing prices as the result of a massive injection of risk, which accompanies any market subject to political control.

Whatever excess profits might have been lost to regulatory burdens that could have been imposed but weren't far exceed the tens of trillions in home and stock equity losses. Hard-core market fundamentalists like Larry Kudlow have to eat their own words as the bailout costs incur huge deficits that must be remedies by higher taxes, or inflation, sooner or later. Worse, Kudlow and others who view regulatory burdens as an impediment now have to depend on the political consensus in Washington to keep the bailout, and prospects for a recovery alive.

In my opinion, the financial system is simply too unstable right now to support a recovery. Until we can stabilize our dollar and our federal spending, we can't expect a sustained recovery. And as I've said, until we tackle the inherent instabilities in our monetary system--like the creation of private credit and derivatives--we can't restore our financial system which is the backbone of our economy in the post-industrial age.

I'd reiterate that the bailout intends to re-inflate the debt bubble. The banks and Federal Reserve are clearly the main players in this effort. Not only did they issue the most toxic debt, they also are on the hook for Credit Default Swaps if borrowers default on the underlying securities.

Last fall's hurried rush to flow so much money to the banks and companies like AIG demonstrates how fearful top officials were by the prospect of system-wide defaults. It bears mentioning that subprime mortgages only compromise 2% of Mortgage Backed Securities. Larger by many multiples are risk obligations on the Collateralized Debt Obligations and other forms of derivatives unrelated to subprime.

So the bailout isn't really about bad mortgages, it's about preventing the banking system from collapsing as a consequence of its greed. The CDOs and CDSs brought in huge profits for people like former Treasury Secretary Paulson, who made over $300 million while heading Goldman Sachs, a major recipient of bailout funds.

Managing perception

Hitler said that the big lie was more easily sold to the public than the little lie. The big lie is clearly the idea that it will be worse for us all if we don't submit to the administration and its call for bailout funds.

There's an entire perception management effort afoot. By controlling what Americans hear about regulatory breakdowns, the easier it is to convince the American people about necessity of the bailout, how it's administered, and its size.

Over-selling the plan diminishes its credibility, so I hope Geithner has been working on smoother delivery of his message. Geithner's delicate treatment of perception shows how the credit crisis is also a crisis of confidence. However, the more effort is expended to create confidence in the system, the more circumspect it becomes.

It's important not to let the American people see what really happened. It's possible that the spigots of federal money creation expended to re-inflate the bubble could still be turned off, which would mean that Federal Reserve would have to go it alone. Already, they've issued billions in debt based on unprecedented backstopping of toxic debt.

By instigating the crisis through easy money policies and a lack of regulatory oversight, the federal government is now compelled to mask its role in failing to reign in the banks. So complicit our government has been that it was actually sued by former Governor of New York Elliott Spitzer for failing to control shady behavior by mortgage lenders.

Who knows how effective the government will be in covering up the regulatory failure and easy money policies that precipitated the crisis. One key factor in holding people responsible is Americans' willingness to stay informed and participate politically. Many are apathetic, believing neither party represents their interests.

Skepticism doesn't justify disengagement from the political process, it should precipitate greater involvement. Thomas Jefferson said eternal vigilance is the price of liberty.

The disconnect between the cause of the regulatory failure and the clean-up also exploits American's very limited understanding of finance. If Americans knew that the dismantling of Glass Steagall directly led to the crisis we're experiencing today, they'd be outraged at their representatives, and reject the two-party political status quo entirely. It was Democrats that helped pass the Financial Modernization Act in 1999 that gutted Glass Steagall. These key changes in regulations and the law came as the direct result of the banking industry's lobbying efforts.

The elite are surely gambling on Americans never learning enough about the origins of the crisis to do anything about it. As long as Americans are fundamentally ignorant as to the causes of the economic crisis, they're easy prey to any insider actions that attempt to compensate private sector investors for their losses in risky derivatives. Unless Americans catch on to the need to rebuild a regulatory framework, abuses of the monetary system by the Federal Reserve and its member banks will continue.

According to plan?

Some conspiracists have gone so far as to suggest that the dumbing down of America is attributable to an pre-planned agenda by the uberclass Bilderberger/Trilateral Commission elite bent on making the "sheople" easier to manage, less able to understand the failures that led to the problems of their making. Once conditioned not to think or question authority, we're susceptible to a repeat, another abuse of the public trust and draining of public coffers.

Whether or not an evil organization is bent on world domination, we Americans are dumbed down in economic matters and thereby allow those in charge to design a solution that benefits the elite at the expense of the general public. We trust blindly, out of ignorance.

A theory that accompanies the dumbing down one is often that of financial exploitation: turn the people into peasants, then bilk them for all they have. Yet in the most recent financial crisis, we see the beggar-thy-neighbior policies typical of capitalism-on-steroids have really been used in competition between rich people for each other' money, as the Madoff case demonstrates.

Yet the investor class can't tolerate so much exploitation of the system, even if that system invariably leaves them better off. Short of a steady regulatory climate, no structure is stable enough to allow the systematic looting of the new peasantry, although I guess emptying the Treasury is the next best thing. Plundering public resources for the benefit of the wealthy class could continue until the dumbed down can somehow summon up the wits to wake up from their slumber and confront the investor class, pitchforks in hand, ready to storm the castle gates, or the mansions on the Upper East Side as in Gangs of New York.

The fact remains that the uber-capitalists who gamed the system are now reaping huge rewards for investing in a class of debt securities that the for-profit banking industry created, or their losses are being limited by government intervention.

Getting my bailout

If we've dumbed down, I guess it's time to capitalize on the ignorance of the masses.

Hey well if the banking industry can get away with it, why not me? Well, unfortunately for the Detroit auto industry, controlling the flow of government bailout expenditures is no easy task, even if you are a vital-for-national-security industry like automobiles, one that hardly as expendable as banking, which appears to be little more than shoving piles of money around. Now making steel and making cars, that was real work back in the day America was a real man's country.

In keeping with this exploitation theme (isn't this what unrestricted free-market capitalism ends up being about, how to get yours?) I came across a good post in businessinsider.com, "Five ways to scam the bailout". One commentator, Mark Meyers, had this to say about the bailout plan:

It's an elegant stock manipulation engine. First my hedge fund buys ten million shares of Citigroup at $2.50. Then I go in with the government on a hundred million in toxic assets, risking 3 million of my own money and paying whatever I have to pay. I assume other hedge funds are thinking along the lines I am and so are also buying this stuff. As the toxic assets are removed from Citi's balance sheet, the stock price inevitably goes up. I sell my ten million shares at $3, covering 100% of my potential loss on the toxic assets and pocketing 2 million in additional profit. If the toxic assets appreciate, I split the profit with the government. If they don't, it's not my problem. And Geithner is happy, because he and I have started to re-inflate the bubble. Through market manipulation, we've once again created value where there isn't any. On Monday, when Geithner announced the plan, Citi gained 41%, so it's already working. Of course, it won't be long before we're bailing out the FDIC.

Not so sure how good the bet on Citigroup stock will be long-term, but maybe the kind of people who benefit from bailout activities are only in it for the quick money.

Lower down the post, a comment by brian also offers a more technical explanation of how CDOs (Collateralized Debt Obligations) are bundled and sold which you may want to see.

I admit to my own perplexity at the complexity of the derivatives market and how much I learn from posts like brian's, coming well after the point I thought I knew how they worked. Despite my lack of knowledge about derivatives, I do know enough about how they work to recognize their dangers. If anything, all the surprises that I get in my protracted derivatives learning experience should send red flags up.

Credit Default Swaps and other Structured Investment Vehicles compromise a large portion of the systemic risk remaining. Mortgage foreclosures are a serious problem indeed, with ripple effects, but their problem is largely in how to value them once they're bundled and resold.

When an issuer of Mortgage-Backed Security bundles mortgages which are then sold, the connection between the debt security and its collateral are greatly distanced. By bundling and re-selling mortgage-backed securities, the banks have managed to disconnect assets from their debt security. A single MBS tranch could contain a thousand houses.

By piling on tranches of debt, at different levels of risk, the value of the underlying mortgage is obscured. Yes, the tranch system does allow for classification of risk, as brian explains in his post. But the process of securitizing the debt, and mixing mortgages into a single security is inherently unstable.

The market for that kind of debt was created under the false presumption that Credit Default Swaps, a type of insurance--or insurance fraud depending on your view of how collectable they truly are--, could cover the consequences of a default or, worse, systemic collapse throughout the credit markets.

* * *

As much as we'd like to vilify Geithner, or even Obama, I've argued that it's not so much the individuals responsible but more the political system, which supports corporate patronage. At its core is a re-election scheme that repeats the injustice of cash exchanged for influence. Winning politicians bestow regulatory and legal changes that reward corporate benefactors that contributed to their campaigns.

There is however a price to pay. The more that the political system intrudes into the economy, the more subjected to the ebb and flow of political control our economy becomes.

The more the Federal Government spends, the more vulnerable our overall economy becomes. Government spending always creates inefficiency in the private sector, as the Federal trough makes for far easier slurping than making money the old fashioned way. If more and more Americans get their incomes from the government, it's inevitable that there will be more taxes, or that the currency will simply be over-produced, causing monetary inflation. Tax burdens are already at record levels, surely they can't go up any more.

Government spending has an Achilles Heel: it fosters dependency on federal spending among the recipients, which include corporations receiving contract revenue, citizens employed by government, and direct beneficiaries. The increased spending and aura of entitlement it spawns reflect political pressure on incumbents to keep the money train flowing.

Military spending exemplifies governmental inefficiency. Now if the US were to suddenly cut off war spending, an amount of over $400 million PER DAY, JUST FOR IRAQ, we'd see the recipients of that military spending experience an overdue contraction. Now if you're think that money we spend on our military is spent efficiently, consider that over 40% of the Pentagon's budget flows to private contractors.

In economics, eventually the consequence of an imbalance will have an effect somewhere else, disrupting or redirecting supply and demand. Ultimately the war spending sends cash to companies that are less efficient than those that must compete in the private sector. Government contracts become a crutch--crucial in keeping employment from dropping even more.

Now in Keynesian terms, the government should be spending more in down times. But Keynes also stated that government should be saving, or lowering debt, in good times. Well, unless the period from about 1999 on can be considered bad times, we have a Republican-led Congress and Presidency responsible for the largest expansion of Federal Spending ever. Their constant prattling about lower taxes flies in the face of their track record on government expansion.

Not only did we not retire debt during the good times, Clinton plundered from Social Security, though he did manage to avoid creating the warfare state that our present economy seems dependent upon.

Government deficit financing requires constant search for more and more investment capital. Foreigners have long filled this need, but the appetite for cash is simply too large to fill. The Fed's reckless lending of Treasuries for trash has hardly made this problem easier.

People tend to flock to the safest debt during times of great uncertainty. These are US Treasuries, which the Fed has in abundance. Unfortunately, the more unstable the overall market for debt, the more attractive Treasuries become, and the more are bought, creating what economists call "crowding out," where lending to the government drives out lending to private sector companies, driving up their costs of borrowing.

Building a bigger trough will mean weakening our fiscal situation, and lead to less borrowing and slower growth in the private sector. And as market conditions contract with higher borrowing costs--as the recession can't be stopped through the power of Federal spending alone--tax revenues dip and even more borrowing is required.

Eventually the Federal Reserve will start spending trillions to buy up the Treasury debt simply because no other investor will. Now while this might inflate the price of Treasuries, the supply of money will actually go up...way up. This is monetary inflation, where increasing prices come not as the result of too much wages being paid to wage-earners or money being spent by consumers, but rather from too many dollars being spent by government, which enter the credit system via the Fed (see last week's article by Chang for more on the Repurchase Market which finances the Fed's activities.)

Now there has been a shadow banking system created which has expanded the de facto money supply. I heard that the amount of this money being lent and traded based on swaps, repurchase agreements, and other forms of derivatives exceeds the supply of public money. The creation of a vast private credit bubble based on debt securities has changed fundamentally the variables which economists must study when evaluating the supply of money.

It's no coincidence that financial companies constitute some 40% of our GNP. In actuality these people make nothing. Yes they do provide loans in the retail banking market, but essentially they are moving piles of money around. Through a lack of regulation, they were able to create a shadow banking system which generated vast profits for insiders.

Of course the economic consequences of this free-market capitalism have "come home to roost," to borrow the words of former Obama pastor, Rev. Jeremiah White. Private credit money evaporated, and with it our entire monetary system has been shaken to its core. Unless we gut the shadow banking system, and reinstitute Glass Steagall, we're likely to see the effects of more uber-class control over our monetary and financial system.

Judging by how far the Obama administration and Congress appear willing to go to protect the banking system from its own malfeasance, the financial companies lobbying has paid handsome dividends. The scale of the public borrowing which we've undertaken shows just how far our government is willing to go to save the banks.

Our Treasury drained, and our ability to borrow in the future greatly diminished, the long-term interest of the people are being sacrificed. Increased self-reliance could emerge as a result or we could simply see more government, acting as a surrogate employer, displacing investment and jobs typically generated within the private sector.

Ironically, in trying to save the banking system, we could be destroying the value of our money. So much excess borrowing to prop up the failed shadow banking system could make dollars too plentiful and thus cheapen their worth. While exports could rise, we have little left of our manufacturing base to exploit the comparative advantage of a weak dollar. Besides, other nations appear to be suffering from weakening currencies so American exports might not be any cheaper in those countries.

Obama may be able to straighten out the bankers, but in the end it'll be the private market--the one for investment capital--that'll shake out the bad debt and punish those who own it. Should the Federal Government intervene, or allow its fiscal authority to be undermined to support a broader intervention, the reordering of the banking system will be much slower in coming. And no, just because regulations cut some profits doesn't mean they should be discarded. This crisis proves that the costs to everyone--rich and poor alike--will likely be far higher if insiders aren't held accountable.


The lower video--Geithner's Meet the Press appearance--contains a lot more hard information than the thin soup offered by the ABC panel in the video above.

Follow-up by Arianna herself. She brings up Obama's comment on Jay Leno that Geithner had been doing a great job, just like Bush said of FEMA director "heckuva job Brownie" during Katrina. Arianna was also on CNN's Larry King Friday night.


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Wednesday, March 18, 2009

Obama Hamstrung

Today in testimony before Congress, AIG CEO Liddy was asked about the bonuses. AIG intends to spend over $160 million on retention bonuses to which they were "legally obligated," according to CEO Liddy.

There's a scandal brewing within the White House over the AIG bonuses, one involving Geithner's role in perhaps keeping Obama in the dark. HuffingtonPost at 10PM EST was headlining "Whodunnit solved" in reference to determining who weakened a bonus provision in TARP. Geithner was apparently fingered by Senator Dodd.

I'd been thinking Dodd. Mid-afternoon, HuffPo was questioning (the whodunnit) who in Congress had blocked a clause in the TARP funding that would have stopped AIG from paying the bonuses. At the time, I'd guessed that the Congresscritter has been responsible, one who'd received large campaign donations from companies receiving bailout funds or perhaps even AIG, like our President.

The damage of one Democrat ratting out another can hardly be good for the Democratic Party. In short the whole AIG bonus deal is an unfolding liability. Earlier today, President Obama, trying to damage control get ahead of today's Congressional testimony by Liddy, offered some comments about the egregious bonuses on the lawn of the White House. (See the video.) Obama's explains the origins of the financial crisis in concise, easy-to-understand language which I recommend.

At least Professor Obama scores some points for his professorial abilities, making a complex issue easier to understand. (For people who want more, lower down I have some more technical explanations for the crisis based on a summary of the collapse of the repo market, which is how the Federal Reserve raises cash.)

Obama has clarified what the government's role is to be, although Geithner may be trying to limit the impact of the mistakes the Fed made when he was a major player during the Bush years, CEO of the New York Fed.

As I've said in the past, I don't know how any solution can be engineered involving anyone who participated in the decision-making process that contributed to the crisis. They're damaged goods as far as I'm concerned.

The risks are high as Obama has invested a large amount of political capital in the bailout. Of course the more politicized government interventions have been, the more political risk associated with any extension of government credit grow.
As Congressman Gary Ackerman (D-NY) told AIG CEO Liddy during testimony, further help for AIG could be jeopardized by public reaction to the bonuses. The uproar over the AIG bonuses has unmasked inter-class tensions. The bonuses in particular show how little Wall Street cares about its public face, which could put into jeopardy any future bailouts, assuming the American people remain involved and incensed and politicians remain sensitive to these sentiments.

The scope of corporate influence--in this case from the financial sector--seems to limit Wall Street's accountability at the expense of the broader economy. Many of the people responsible for the mess still occupy lucrative positions on Wall Street, unlike millions of lower level jobs that have been unemployed.

The AIG bonuses reveal a huge gap between the compensation atmosphere on Wall Street and any accountability brought as a consequence of government intervention, i.e. for saving their ass. Essentially the management seems to be treating its top executives as if the house had never burned down. The crisis is showing itself to be a method, a la Naomi Klein's disaster capitalism, to funnel more public resources to private industries. Citigroup, the recipient of loan guarantees in excess of $200 billion, reported recently they'd made a profit. Is this a surprise to their management, who were whining Stuart Little-like as if the sky were falling as they begged for help in Washington.

The AIG spending on bonuses echoes the bonuses paid by Merrill Lynch (some $3.5 billion) to its top executives, after its merger with Bank of America. Now in defense of free-spending compensation on Wall Street, to retain the best talent requires large retention bonuses--less perhaps in bad times but amounts that stun the average person nonetheless. During the roaring days of deregulation, the way Wall Street does business was in the best interests of its shareholders--the rich and successful become even more so. As reality has set in, the losers in the post-crash are the taxpayers, assuming they've been granted ownership stakes in companies which have over-leveraged themselves and destroyed their share prices, perhaps never to recover. In typical disaster capitalism style, the public is left holding the expenses of running dying companies, wile those who profitted during the run-up are pampered by preferential treatment in Washington, and given lucrative bonuses to sustain their profligate lifestyles.

Without any bonus pool, the over-pampered lot which makes up the Wall Street investment banking corps will simply go elsewhere or retire on the billions they made during the run-up whose end was inevitable, billions now sitting in overseas banking centers no doubt. Now, leaving the wreckage of their greed behind, they'll only work for ridiculous amounts of money, cashing in a second time on the fruits of their handiwork, whatever the cost to the public or long-term economy.

The role of our media in not covering Wall Street compensation has also strengthened outrage over the bonuses. The culture of greed is only a problem when transparency exposes the Wall Street culture, or when profits dry up as they have. Historically, the size of these bonuses go uncovered in the mass media.

I've written a great deal about how the increasingly corporate media become consolidated under Bush and lost any investigative edge while dumbing down content. The fruits of this media neglect is a shock wave of public outrage which could ignite politicians fury, or at least encourage meddling for political reasons, which is no way to engineer a private sector recovery, although allowing millions in bonuses is hardly constructive use of funds either.

Now Liddy has explained that AIG notified Geithner about the bonuses on March 14th, a day before their distribution. This struck me as odd, because AIG must have known the political controversy they would stir. And the presumption is that because Geithner knew the bonuses were coming, the White House knew late last week as well. Here is HuffPo:

"The White House for the first time on Tuesday night said Geithner learned of the impending bonus payments a week ago Tuesday; he told the White House about them last Thursday, and senior aides informed President Barack Obama later that day."

A small point but a crucial one if Obama now claims that the bonuses need to be stopped. Why wait until this week to stop them? It's as if the bailout has been conceived independently of the political ramifications of its implementation. Obama appears to be reacting to the news instead of working to prevent the bonuses behind the scenes. Apparently Obama can't exert that level of control over what AIG can do with the bailout money and it will take Congress to pass a law taxing the bonuses

The fruit doesn't fall far from the tree. Geithner is a product of the Wall Street environment he's now trying to save, perhaps by re-inflating the derivatives bubble and real estate markets by flowing cash in massive quantities to anyone, anywhere.

Above all, remember that the Fed is an extension of the New York banks. Geithner was the CEO of the New York Fed and actually oversaw the distributions in TARP while Bush was in charge. He's still intimately connected to the financiers whose misconduct precipitated the collapse and Bush-era people who failed their regulatory responsible or those in the Fed who fed it so much cheap money.

Behind the scenes, the largest partner and co-conspirator with the Wall Street banks is the Federal Reserve, especially the branch in New York once headed by Geithner. The Federal Reserve Banks are represented by the Fed, and two main banks--JP Morgan Chase and the Bank of New York essentially interoperate with the Fed to raise cash. What's good for the banks is basically good for the Fed. Now the Chairman of the Fed is a political appointee, but the entity is largely commercial, and aims to maximize profitability for bankers who compose its membership.

The Fed has poured in trillions in purchase agreements, debt windows, and other forms of guarantees and assurances to minimize pain for the bankers. Unfortunately their easy credit may be coming in an end, due to 1) the Chinese/Japanese dis-propensity to continue to fund US trade and budget deficits, and 2) the deconstruction of the Repurchase Agreement market through which the Fed typically raises cash.

On Wednesday, they announced they'd buy $300 billion in Treasuries, which sent inflation fears rising. The fear is that the Fed has added too much money--liquidity--and put at risk the dollar by making it too plentiful and therefore too cheap. The dollar set an all-time low versus the Euro.

Apparently the scope of losses is sufficiently great as to make all these additional funds more or less replaced the huge deficits created in the private credit markets--called also the shadow banking system--which came as the result of debt securitization, the bundling of debts as financial instruments known as derivatives.

I've said in the past that I don't know how any solution can be designed that doesn't make the banking constituency the ultimate beneficiary, even at the expense of sound money policy or the economy at large. If you use insiders to fix a problem, don't expect a solution that's constructed outside the corrupt influence of the system, one that benefits insiders at the expense of taxpayers.

With the initial stipulations of TARP so hurried, it's possible that AIG had to pay the bonuses, so I guess no one thought to include restrictions on them. Or maybe the concession to AIG and other TARP recipients was a well-planted sweetheart clause meant to help Geithner's friends.

So now the Treasury is thrusting ever more cash into the AIG ovens, where it goes out to financial institutions to whom AIG is obligated. Those companies in turn reduce the size of their derivatives, but at a very slow pace, leading possibly to a Japanese-style recession, where banks there were unable to clear bad loans off their balance sheets. Yes, it's great that AIG can pay its creditors, and that could prevent a collapse, but then again how many years can the government bail out AIG? How long before Congress has enough and reneges on AIG's obligations, opting instead for bankruptcy.

Ostensibly taxpayers own 80% of AIG--in itself a questionable number because no sane investor would pour so much into a company that can't possibly meet its obligations. I guessed we owned 80% when we put the first $60 billion in. After the second installment, I guess we now own 160% of what AIG is worth, which is according to the markets a lot less than we've out into the failing company. The government is either acting solely out of concern for the contagion effect or simply a really bad investor since letting AIG go bankrupt would likely save billions more that needs to be continually poured out in the years to come in order to pay its creditors, as well as manage whatever losses it produces (the company's losses in 2008 were the largest of any company ever.)

We saw billions in the AIG bailout go to foreign banks for precisely this reason. In order to calm fears of a system-wide collapse, the Treasury saw the need to fully capitalize AIG so it could handle any potential claims against it. Now as potential investors see that the system won't collapse, they are more likely to invest in the derivatives products which are at the center of post-Glass Steagall banking in the US and abroad.

What's done at one bank is duplicated in another--so much so that when Credit Default Swaps were the hottest game in town all the investment banks loaded up on them. The Your-On-Your-Own period which saw so many gains in wealth for the rich has evolved into a corporate nanny state.

The way previous borrowings were spent reflects a culture of corruption in D.C. that revolves around systemic problems based on lobbying influence and corporate over-representation. Like the environment surrounding AIG CEO Liddy, this overly cozy relationship dictates the options available to Obama, who's now part of the establishment. The new President can't offend the companies who've contributed so much to his campaign. AIG gave the President over $100,000 while he was a Senator.


Nowhere in recent memory has Washington's culture of corruption been made more evident than in the bailouts. The way funds have been spent so far by the recipients shows an elitist culture of self-entitlement prevailing on Wall Street.
The Federal government's mismanagement of bailout funds has contaminated the solution, turning it not into a savior for the broader economy but an ever-broadening morass, an Afghanistan of sorts, where more and more must be poured in, to save AIG, to save us all.

Our corrupt system obstructs any real recovery. Instead cash is thrown on the problem in the hopes it will go away. The more capital gets interjected, the less real accountability the recipients have. The more Washington gets involved with the bailout the more moral hazard emerges--namely the risk that executives feel they can get away with anything, or are too big and precious to the overall economy to be in any real danger.

The more politics dominate the recovery, the less impact it can have, as our nation's economy can't be directed out of Washington, even if the federal government is by far the nation's largest employer.

The amount of dollars needed to stave off a collapse cause by the concussion of the shadow banking collapse will continue to grow. Until the private credit money system is demolished, the dollar will be at the mercy of unscrupulous fraudsters who buy and sell debt-based securities, creating private credit out of thin air.

One day our government's capacity to borrow will eventually run dry. With a thousand stabs, the government albatross is bled, and feeds all the corruption and inefficiency that the invisible hand of the market should have cleansed. Yet the social safety net has hardly been repaired, the public's financial interests go underrepresented as evidenced in the bailout. Wouldn't it make more sense to just get out, and invest in something other than a bottomless pit?

A few years ago, the securitization of debt made great profits, now it's become a survival tool for anyone still standing in the banking industry, as the sheer amount of derivates owed is too great for any bank or even the government to reproduce through the traditional credit system, at least not without completely altering the ground rules.

Because all the players in the shadow banking system are interconnected, as long as there are AIGs out there teetering on the edge of collapse, buyers won't pay top price or worse, not even be able to calculate the value of a financial instrument, making them illiquid and of indeterminate value.

The swing away from real capitalism to a semi-socialist (as the word is defined in our mass media), bailout state signals the creation of a whole new level of big government, a political economy which dispenses federal funds--all borrowed to support its own reelection. Change is simply not possible.

The expanded budget has greater opportunities for those in the private sector who are tied to the federal spending machine. The private sector outcome is clear: executives who would have been fired are retained, a culture of corruption continues, and moral hazard inflates.

With corporations directing government policies, huge sums of government monies are claimed to be required in order to prevent a wider collapse. The FDIC, now headed by Forbes Magazine's second most powerful woman in the world, Sheila Bair, stepped in during the S&L crisis and is increasingly active in combatting a lack of confidence in the stability of the credit markets, which I consider a healthy disposition.

Confidence does play a huge role in reassuring investors and depositors, but just how good can it be for the banking industry to require such large-scale intervention. If the maangement of the banks is so bad as to lose trillions in stockholder equity, just how much confidence can they inspire?

Recently the FDIC jacked up the bank's deposit insurance limits to $250,000 per account holders in FDIC-insured banks. Again, not a gesture that indicates the FDIC has much confidence in the ability of banks to keep depositor money safe.
Libertarians have blamed the creation of FDIC insurance as encouraging banks to take on too much risk. If banks knew they needed to meet depositor redemptions without government aid, they'd be less likely to indulge in risky behaviors. Still, top banking executives appear a lot more concerned with bonuses and their own personal financial positions than those of their shareholders. It's unlikely that government guarantees alone would lead to mismanagement, but the confidence double-speak doesn't hold up, especially as bank stock languish at record lows.

Solution path

Obama talked about creating new federal government entity to solve the crisis, one that I see largely as the consequence of gutting regulations that would limit the growth of the shadow banking system and the Fed making too much credit available.

Creating a new governmental department is always sought as the ideal remedy for any problem. Bureaucracy always creates more bureaucracy and typically lower efficiency. Look no farther than Homeland Security for a new bureaucracy created after 9/11.

There was a precedent for a Resolution Trust-type arrangement. Still, the present bailout lacks additional safeguards and restrictions placed on the corporate recipients, perhaps like those issued in the S & L Debacle in the Eighties, a crisis which has some parallels with the current situation. The banks, or S&Ls, really had lost billions on risky speculation. The so-called Keating Five senators were associated with influence-peddling with Charles Keating, a figure at the center of the S&L crisis. Like banks with their powerful army of lobbyists in DC today, Keating had no qualms about reducing the regulations he saw as an impediment to (his) speculative profits.

The scale of the current bailout dwarfs that incurred by the Resolution Trust Company, a for-profit entity owned by taxpayers which sold off the real estate holdings of the bankrupt S&Ls. At least the RTC has land to sell. Land has a measurable value, unlike the trillions in derivatives held by the investment companies.

The instruments of financial mass destruction called Credit Default Swaps weren't as prevalent in Keating's day. Instead we have a credit crisis created by derivatives which banks lent to one another, carrying the CDSs as insurance. Now no one knows the value of derivatives because of the CDS which insure their failure may or may not have to be called. If the value of the underlying derivatives fall below a set point, the CDSs kick in, and insure the holder. But if a bank or entity like AIG falls, the CDSs, held by third parties, issued by AIG will become worthless. So there's a ripple effect.

Few buyers want to complex derivatives like CDOs (Credit Default Swaps) that aren't insured because of the concerns with the creditworthiness of the issuer of the financial product.

Should the CDSs get called, the insurers will simply be unable to cover the size of the liabilities involved. If the government were to stop bailing out AIG, for example, all those trillions in derivatives they own would get called, and AIG not be able to cover their obligations, leading to a ripple effect in all the companies who own securities insured by AIG. Here is a post by Matthias Chang from marketoracle.co.uk:

"Dealer banks would not accept collateral because they rightly believed that if they had to seize the collateral should the counter-party fail, then there would be no market in which to sell it. This was due to the absence of buyers because of the deleveraging. This led to an absence of prices for these securities. If the value cannot be determined because there is no market – no liquidity or there is the concern that if the asset is seized by the lender, it will not be saleable at all, then the dealer will not engage in repo."

Chang explains the repo markets--Repurchase Market--in great detail, where "securities are exchanged for cash with an agreement to repurchase the securities at a future date." Chang lays down how the unraveling credit markets as the heavily leveraged players in the repo market either exited the market, or stayed in and lost big.

Anyone who wants to understand the origins of risk in our monetary system should look at Chang's description of the root causes. He breaks down the types of repurchase agreements and the problems with each financial instrument, or inadequacies in cash-raising methodologies used by the big banks, which contribute to the possibility of systematic failure.

Chang concludes the Federal Reserve is insolvent, because of the massive liquidity hole created by demands from failing institutions whose shadow banking activities precipitated the collapse. To keep the collapsing entities alive, the Fed has committed to pouring in billions, but their source of collateral is US Treasuries, but Chang ascertains that the Fed can't sell those assets through the Repo Markets any more.

The Fed does plan on issuing its own securities in order to re-inflate the bubble. As long as billions can flow into the banks, the loss of so many billions in shadow transactions, where private credit money was created without any asset backing it, making the value unascertainable.

By creating enough liquidity, the theory goes, the disappearance of so many billions can be overcome. Simply re-inflate the deflated holdings of the banks, which weren't real anyway, but rather repurchase agreements for which buyers now can't be found, except of course the Fed, operating on behalf of our government in trying to mend the damage from the shadow banking collapse.

All the Fed response does is delay the inevitable unwinding. The problem is not so much the loss of so many billions, in assets that weren't real anyway, but rather the systemic inadequacies of our monetary system. To grow--itself a biased term considering financial companies produce up to 40% of our GNP--we need more borrowing. And to finance the borrower, we need a lender. No amount of repurchase agreements can redefine the classic relationship between money and its demand. The more money is needed, the more expensive it gets. As risks of systemic problems like inflation rise, so too does the risk premium associated with holding dollars. Foreign lenders simply avoid buying dollars.

Many people have been surprised by the dollar's gains against most foreign currencies. As it turns out many foreign nations might be even more exposed to the impact of a collapsing private credit money system than we are. As such a big net importer, we've had to hand our money to foreign creditors and sovereign funds, which have seen fit to keep their dollar holding here in the US.

Every dollar spent on an imported product represents a increase in the exporter's dollar hoard. Likewise every dollar spent, or borrowed by our government, needs to come from somewhere. So at no time can we separate the dollar's value from how much it is in demand. Too many dollars out there will mean the dollar will be worth less. As the dollar loses value, all those dollars accumulated by foreigners will be sold, and converted into another currency rather than used to finance our debt by buying real estate, government, or corporate debt. When that happens the dollar will drop in value.

So far the Asian nations remain interested in holding dollars, which are still the world's reserve currency. As long as the Euro remains comparatively weak, the dollar might be safe. Still, dollars can't be created out of thin air without some real world consequence. Dollars can only be brought into existence through some transaction involving a lender--probably foreign--and a US borrower, whether the government itself, the Fed, or any private entity. We can ship dollars abroad but not without eventually reducing what they can buy, and requiring us to pay more interest to overseas lenders.

Oil exporters in the Mideast have been holding dollars abroad, without spending them, so at least the inflation effects are reduced. This does make us vulnerable to political risk, as per the Oil Shocks during the 70s, particularly considering we're dependent on foreign energy. The first shock came as a result of the 1973 Yom Kippur war where the Israelis dominated, os if Iran were attacked, the US could suffer a similar shock. (Worse in fact as we import now more of our petroleum needs from the Mideast than we did then.)

See Robert Reich's post at HuffPo.

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Friday, March 06, 2009

Article posted on OpEdNews.com

My article, "More spending brings little change" was published on OpEdNews on Saturday.

I've been researching the private credit money fiasco. Since writing my article, I've come across high-value opinion pieces throughout the Web, including this excellent piece by Mike Whitney, When securitization blew up so did the economy.

My comment is there at dissidentvoice.org, complementing Whitney. Now if you're fairly new to the blogosphere, Whitney may be a new name to you, but he's been writing for a while now about complex economic issues, most notably the motives and actions behind the scenes and out of the eye of the mass media.

The dysfunction we're now experiencing is the financial equivalent of Naomi Klein's disaster capitalism: we didn't arrive here by chance. And there's a real benefit to getting the truth: if you're following people like Whitney and me, you're definitely not as surprised by the crisis or its severity.

For a hilarious poke at the comments by CNBC report Rick Santelli, see Jon Stewart's Comedy Central review.

My article does include a reference to Senator Bernie Sanders (S.-Vt.) , as part of a critique of our failed two-party system. I cite an article by John Nichols in the article, but since writing I found this squib about Sanders. On a personal note, I saw Sanders speak, with Nichols, at a media reform conference at the University of Illinois in May, 2005. {If you're wondering about the S. after Sanders' name, it stands for socialist, which Sanders is by his own admission, a reference you will not see in the mass media.}

As I say in my dv post, Sanders apparently got in a tangle with Federal Reserve Chairman Bernanke during recent Senate subcommittee testimony. Bernanke said "no" when asked to reveal where TARP funds had been allocated; Sanders is sponsoring legislation to force the Fed to post on their website this information. See the squib in truthdig.

Hope to have the recently submitted article back and posted or linked here. In the meantime, I recommend my 2007 video of an antiwar protest, its accompanying still photos, and the link to sites where I've posted comments like OpEdNews and commondreams.org.

If you should have technical problems seeing the video, try to run the video several times, even if it breaks up first few times. Hopefully it will play without interruption after a few runs. I'm looking for a host that will cast streaming video. I would have done youtube, if I thought the picture quality was better. The video recorder I used at that rally was somewhat aged.

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