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Saturday, October 01, 2011

Money Power bailout fuels growing rage

"We are the 99 percent!" the chanters chantabout halfway through this video, taken in the streets of downtown Chicago. Soon the chant turns to "we got sold out...banks got bailed out." Michael Moore's reference to how the banks urged bailouts and "we bought it" during the "We Ain't Broke" speech in Madison in March echoes the same meme.

As the occupywallstreet movement rages, its momentum grows, as many have turned on the Wall Street establishment. The amount of money poured from public coffers into those of the mismanaged banks could reach over $13 trillion, when the Federal Reserve's activities are exposed.

Among the long list of recipients of Federal Reserve largesse were foreign banks, including the central bank of Libya. Why, one might ask, if the purpose of the largest bailout in history was to protect Americans, why so much help for foreign banks? Last time I check, not too many Americans--at least middle class ones--held deposits in Libya. The fruits of intervention go the investment class instead, socializing private losses with borrowed public funds.

It's important to understand how the American people got snookered. Some of their taxes (or to be more accurate, their children's taxes since this is mostly borrowed money) went to TARP, which was the direct subsidy to the banks and conglomerates hurt by the collapse in mortgage securities.

TARP was sold as a stimulus package. A good portion of TARP consisted of tax cuts which were meant to stimulate economic activity. Tax cuts aren't direct expenditures, but they do represent a loss of revenue and thus a need for more future taxation (including of course all the interest that accrues until the debt is repaid.)

Taxes and interest payments on borrowings will be used to finance the current deficit--debt spent on wars and bailouts, although the immediate impact of the latter may not be felt for some time, assuming toxic debt doesn't infiltrate the financial markets once again. Interest payments on government debt have been minimal but are set to rise, time bomb-like, consuming much more than the 7% of the budget that it currently does, with the average interest rate on outstanding government debt at about 3% currently.

TARP itself is just a tiny fraction of the total amount lent to banks and financial entities. The Federal Reserve's activities opened the spigot, allowing everyone connected to the financial establishment to borrow. The idea was to allow those in established financial circles access to as much capital as they want. Providing money virtually free of any interest meant that any borrowers in trouble could repay creditors, who were the banks at the top of the economic pyramid the Fed intended to protected. This wild feeding of debt--to reflate the debt whose value had crashed--extended even to the wives of bankers. See the Rolling Stone articel by Matt Taibbi here.

The implications of so much borrowing aren't readily grasped by average Americans. The sheer size of the entire derivatives debt bubble is over $250 trillion, a number so large none of us could scarcely fathom. We got take every bit of wealth owned by every person on the planet and not be able to come up with that much. See the post by Tyler Durden on this topic at Zero Hedge.

The cause of so much debt is the ability to leverage. Much of this borrowing is "off balance sheet," generated by trading and lending among TBTF financial entities. No direct financing is necessary with this form of shadow banking--a promise to pay is enough to keep the derivatives shell game rolling.

Under normal circumstances, the promise to pay is backed by access to nearly unlimited quantities of capital. However, should one of the players lose access to new money--Lehman--then the whole system can crash because the derivatives are based on trust. The tiny bits of over-leveraged assets which serve as an anemic tidbit of collateral offer nothing more than a token connection to the vast pile of leveraged debt tied to it.

It's important to lift up the rock and see how this insidious derivates trade, coupled with access to vast amounts of almost free capital--goes on. Leverage is essentially the piling up of debt based on other debt. One purchase of debt becomes the collateral for a second loan. The second loan can be several multiples higher than the initial amount of securities bought. In this way profits can be synthesized--generated without actually owning anything but rather through pushing piles of purely speculative, highly leveraged money around to create more synthetic, paper profits to further leverage more speculative capital, so on and so forth until the underlying collateral may be leveraged 35-45 times.

Unregulated speculation on oil is a good example of shadow banking at work. Some of my readers may have remembered the testimony of Commodities Futures Trading Association director Michael Greenberger before a Senate subcommittee a few years back bemoaning dismantling of regulatory constraints on speculation by the banks in oil futures...[ Here is a recording of an Greenberger interview. I blogged on Greenberger in two posts from 2008 and 2009. A C-SPAN interview can be found under Greenberger's C-Span bio. ]

Now with real assets, take silver for instance, there's the silver sitting there being used as collateral. So if the borrower puts up the silver as collateral, the lender can grab hold of it should the balance on the borrower's account shrink below margin requirements. (As a sidenote, Comex did increase margin requirements for the third time recently, in a move which has driven silver below $30/oz.. Some theorize the tightening margin requirements aid JP Morgan, which has a huge losing short position on the metal.)

Back to our leverage example. Banks and other financial entities with access to virtually interest-free loans found themselves able to leverage up, once freed of the regulatory shackles imposed on the industry by Glass Steagall, a post-Depression regulatory framework meant to avoid the kind of over-speculation by commercial banks we saw prior to the '08-9 collapse.

A glimpse back at the '08-09 crisis might serve to reveal the genesis of the next crisis. After all, the bad debt is still out there. Sure the Fed's outgoing spigot has refilled the depleted coffers of the banks. But the velocity of money--a key indicator of economic growth--is slow. The velocity of money is a measure of how fast it circulates: too few hands touch it, then the economy doesn't benefit.

For instance, if a millionaire gets a refund check from the government, rather than spend it by putting it into circulation, they might let it languish in a deep, dark pool of capital where it won't see the light of day. This is like the sheikhs receiving huge petrodollar deposits: the agreement was that those dollars would stay out of the U.S. and therefore not contribute to inflation.

The Fed doesn't want the money to get out there. If for instance social security benefits were raised more people would get more, spend more. Wages would be more likely to go up as a result of more economic activity, demand.

Some inflation is a good thing. The Fed has said as much. Yet recently Bernanke did acknowledge that the persistent unemployment did constitute a failure. And of course much of the reason unemployment is high is because money isn't circulating in the economy--low velocity. Then there's the $2 trillion corporations have left in cash management accounts earning next to nothing.

The Fed is tasked with reducing inflation and maximizing employment, but in the current dilemma, it's uncertain if it can achieve one policy objective without hurting the other. If enough money--and there's a lot of money out there--circulates fast enough, inflation will grow rapidly. Increasing economic activity does stimulate inflation, but the opposite--too little growth--becomes a deflationary monster--as described by George Ure--eating up the increase in the money growth, which Ure cites to be over 30% per annum. Even with so much new money emerging--in digital form--if velocity is stagnant, the economy can't be stimulated through monetary growth.

One wonders if the Fed hasn't been tasked with a third objective: maintaining a rapidly growing pile of Federal debt. If the carrying cost of so much debt increases--by having to pay more interest--then the government's fiscal situation would deteriorate rapidly, consuming ever greater portion of the budget for interest payments.

Operation Twist may be mostly about buying Treasuries to keep the deficit-running fiscal operations going forward. By keeping money from (re-)circulation, at a low velocity, the Money Power does allow inflation and prices to grow less quickly despite what would be the typically result from wild government spending we see today.

For the Fed to act as buyer of first resort makes our monetary system a Ponzi, a means of sustaining government spending through the Fed's purchase of government debt. Theoretically, new money can be added to the system by buying Treasuries forever. But the Fed's actions don't incur in isolation; the more that the Fed buys, the more evident the scope of monetization (of the debt.) Eventually interest rates will rise, either because no one other than the Fed buys our Treasuries, or because of expectations of rising interest rates due to inflation. By reducing the interest rate to zero, savers get savaged, reducing further what they might earn, especially retirees dependent on income-producing investments, as this Marketoracle article by Dan Amerman explains.

Back to the lessons not learned from the the last crisis. There's the issue of accountability. Not only did not one CEO of the major banks lose their job, there's not been a single prosecution (although the SEC did make some rumblings about suing the TBTF banks recently.)

A lack of accountability will surely encourage more bad behavior, a psychological condition called moral hazard. Why would any of the banks change their ways? If the addition of more debt brought federal relief, why would the banks shy away from taking on too much debt. So the leverage monster is back on.

So despite all the prognostications of doom, the collapse didn't come to the world economic order, or at least hasn't yet. Markets bounced back, until recently where they've become especially volatile. If one were to examine charts of the Dow and Fortune 500 earnings, things might not seem too bad at all. So why hex it, you might ask?

Well, I need look no further than the huge--and mounting pile of debt derivatives--to say that the system is at dire risk. Not all banks have participated in the crazy derivatives shadow banking system, but all banks are clearly at risk of being damaged by another inevitable collapse of their loan portfolios. The reasoning simple: by piling one debt on another, and that atop even more, it only takes one little miscalculation at the bottom of the house of cards to bring the whole banking system (and monetary system on which it depends) down.

We can see how the collapse in residential mortgage securities valuations decimated the ability of the banks to lend. Without new mortgages, there's the secondary impact of declining home prices. If homes decline in value, the banks' greatest source of collateral--mortgages--declines and so too does the credit quality of the bank. Now if the banks hadn't been encouraged to lend as eagerly during the Bush years, they might not have such a vast inventory of unsold homes nowadays, but that's history. Likewise, if banks hadn't sold mortgages to other financial entities, and kept them, they might have taken more precautions with the creditworthiness of their borrowers. Instead the originating firms quickly sold the new mortgages away, which of course encouraged risk-taking with the quality of mortgage applicants, since the originating firm need not worry about whether the loans would eventually be repaid.

Enough of the history lesson...or not? Can we ignore what happened in the past? The shelf life of history lessons for most Americans can probably be counted in months, not years. So we're clearly primed for another crisis. And the careless way we approach the accumulation of debt means we're always deeper in debt than we care to acknowledge, meaning that we will face austerity measures like the Greeks, yet steadfastly refuse to acknowledge--perhaps due to our belief in American exceptionalism-- that we could be in trouble.

From personal experience I know it, that silent creeping of debt until it metastasizes. Once we "burn through our credit" we only two choices: to repay it or declare bankruptcy. With government however, there is a third option: print it away. If the government can continue to get the Federal Reserve to buy all its bonds, it will have an inextinguishable source of financing.

The Fed meanwhile will accumulate more and more our our nation's debt. For now, the American people don't have to deal with the immediate effects of so much borrowing. Because of the ridiculously low rates, the amount of our current budget devoted to interest payments is only around 7 %. And even if the amount we're higher, it'd simply be borrowed.

I'd make the case that until the average Americans is impacted by the scale of government borrowing they will remain blissfully ignorant about it. This is like a marriage where one partner is hiding the scope of their credit card borrowings from the other. Uncle Sam keeps getting new credit cards as he maxes them out. The US public--meanwhile--doesn't get the bill so they don't know just how bad it really is--until they--like the spouse-in-the-dark--discovers theircredit score has been violated and the debt load is not Uncle Sam's problem alone, but theirs as well.

The Federal Reserve is the enabler for the debt addict, which is our government. Fedgov has grown so bloated that it must have the Federal Reserve around to feed it, like some chronically obese fat man confined to a bed. Its weight keeps growing, and it demands more. Unfortunately, the only way to keep the status quo going is to disguise the scale of the addiction and thus perpetuate the state of denial until the enabler succeeds in letting the addict die from overeating.

Obviously government can't gorge themselves to death. So which form such a collapse might take is a topic for another day, but I'd highly recommend taking steps to prepare and mitigate the consequences of a collapse of purchasing power of our money, coupled with Depression-like economic circumstances unable to be remedied through quantitative easing in any quantity.

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