Sunday, October 19, 2008

It’s a Banking Meltdown More Than A Stock Market Collapse!

``The argument that the government is somehow pumping new capital into the market is absurd. Government is actually borrowing the money from the capital markets that it is in turn injecting into the capital markets. There is no additional source of funding; there is only a diversion of funds from more-productive outlets to less-productive outlets, with government acting as the middleman.” -Scott A. Kjar, University of Dallas, Henry Hazlitt on the Bailout

It’s amusing how many people believe that today’s financial crisis is just a “headline” material. They carry this notion that the meltdown seen in the stock market are just confined to within the industry. They believe in media’s assertion that these are all about just banking related losses and perhaps a prospective recession. Yet, importantly governments will successfully come to the rescue. And that banking deposits will be safeguarded by sanctity of government guarantees. We hope that such smugness is correct and don’t turn out to be chimerical.

From our side, the current global stock market meltdown is like utilizing a thermometer to a gauge the body temperature of a patient. From which the mercury’s position indicates of the degree of normality or abnormality in the patient’s temperature than of its cause. Hence, the thermometer signifies as the medium and the mercury’s position the message. In the stock market we see the same message See Figure 1.

Figure 1: Mercury Indicator: Stock Market Meltdown or Banking System Meltdown?

The Performance chart from stockcharts.com shows that since the whole bubble bust cycle episode unraveled, the losses of world equity markets have been far less than the damage suffered by the housing and the entire swath of financial and banking sector.

True, everyone directly or indirectly involved in the financial sector seems to be afflicted. But some are suffering more than the others. This means that like the thermometer, the public’s attention have been on inordinately transfixed to the freefall in global equities but have glossed over the significance of the ongoing risk dynamics in the US financial sector.

From our point of view, the stock market “meltdown” has been a symptom of a deeper underlying disease: the risks of a US banking sector collapse. And this is not just about your typical banking losses, but a representation of the real risks of a total freeze of the entire global banking network system as we discussed in Has The Global Banking Stress Been a Manifestation of Declining Confidence In The Paper Money System?

As had been pointed out, the US dollar standard monetary system has been anchored upon a global banking system from which operates on a fractional reserve banking platform from where the entire global banking network revolves or interacts upon. In short, deposits, credit intermediaries, clearing and settlement, maturity transformation, asset markets etc… are all deeply interconnected.

Since the US dollar standard banking system has been at the core of our troubles, all the network of banking nodes connected to such intertwined system have likewise been bearing strains, see Figure 2 from the IMF.

Figure 2: IMF’s GFSR: The Evolution of the US Banking System From Deposits to the Shadow Banking

According to the IMF’s Global Financial Stability Report (emphasis mine), ``Banks have been shifting away from deposits to less reliable market financing. “Core deposits” dominated U.S. banks’ liabilities in the past, but have been gradually replaced by other “managed liabilities”…At the same time, near-banks—which are entirely market financed—have grown sharply. This is related to the “originate-to-distribute” financing model that relies heavily on sound short-term market liquidity management. Euro area and U.K. banks also rely more on market financing than in the past, as in the United States. Similarly, the share of deposits by households (defined roughly the same as U.S. core deposits) has been gradually declining over time, while deposits held by nonfinancial corporations, other financial intermediaries, and nonresidents have steadily increased. In addition to these “managed deposits,” financing through repurchase agreements and issuance of debt securities, both in domestic and foreign markets, have expanded, indicating that European banks are also increasingly exposed to developments in money markets. At the same time, the share of household deposits for Japanese banks has been stable and even increasing over time. This may partly reflect the prolonged low interest environment since the late-1990s.”

In other words, from a depository based banking system the US has evolved into gradual dependency on “near banks” or what is known as the “shadow banking system” (we previously featured a schematic chart from the Bank of International Settlements The Shadow Banking System) which basically relies on short term financing or maturity transformation borrow short and lend or invest long.

Thus, when the collaterals backstopping the entire short term financing channels began to deteriorate, whose chain of events included the Lehman bankruptcy, this resulted to a collapse in the commercial paper market (forbes.com) and the “breaking the buck” in the money markets (edition.cnn.com) as banks refused to deal (borrow and lend) with each other on perceived “rollover risks”.

Consequently, major financial institutions dumped the banking channels and stampeded into US treasuries. This exodus or flight to safety set a record yield of .0203% for 3 months bills last September 17th (Bloomberg), which we described last week as an “institutional run”. And these strains reverberated throughout the network of banks all over the world which raised credit spreads and resulted to a dearth of US dollars and lack of liquidity in the system as banks and companies hoarded cash. Thus as a result to the credit gridlock the liquidity crunch inspired the sharp selloffs.

So while the defensive mechanism for the global banking system has been designed against isolated instances of retail depositors run via a depositors insurance (e.g. FDIC, PDIC etc…), an institutional run has not been part of such contingencies.

Hence what you have been witnessing is an unprecedented monumental development which has a potential risk of a downside spiral.

To consider, the assets of Shadow Banking system was estimated at some $10 trillion dollars which is almost comparable to the assets of traditional banking system. According to a report from CBS Marketwatch (all highlights mine),

``By early 2007, conduits, structured investment vehicles and similar entities that borrowed in the commercial paper market and bought longer-term asset-backed securities, held roughly $2.2 trillion in assets, according to the Fed's Geithner.

``Another $2.5 trillion in assets were financed overnight in the so-called repo market, Geithner said.

``Geithner also highlighted big brokerage firms, saying that their combined balance sheets held $4 trillion in assets in early 2007.

``Hedge funds held another $1.8 trillion, bringing the total value of asset in the "non-bank" financial system to $10.5 trillion, he added.

``That dwarfed the total assets of the five largest banks in the U.S., which held just over $6 trillion at the time, Geithner noted. The traditional banking system as a whole held about $10 trillion, he said.”

So as hedge funds continue to shrink from redemptions, TrimTrabs estimates a record $43 billion in September-liquidity requirements, margin call positions, maintaining balance sheet leverage ratio or plain consternation could risks triggering more negative feedback loop of more forced liquidation.

Besides, risk of a deep and extended recession could imply larger corporate bankruptcies and larger defaults from corporate leveraged loans that could trigger credit events in the CDS market that could give rise to new bouts of forcible liquidations. All these could similarly shrink the capital base of existing banks, even under those buttressed by capital from the US treasury.

In addition, the risks of heavy damages in the asset markets could spread to the insurance and pension funds which risks reinforcing the downside spiral. In short, the shadow banking system poses enough risk to destabilize the entire US banking system.

Global Governments Throws The Kitchen Sink And the House

Governments have virtually thrown not just the proverbial kitchen sink but the entire house to deal with such outsized dilemma. The US government pledged to “deploy all of our tools” as the G7 counterparts have “committed to a global strategy”.

Specifically the US government will earmark some $250 billion for its “capital purchase program” to be infused as capital to the banking system in return for preferred shares of which 9 of the major banks have “agreed” or “coerced” to participate, a temporary guarantee by the FDIC on the “senior debt of all FDIC-insured institutions and their holding companies, as well as deposits in non-interest bearing deposit transaction accounts”, the broadening scope Commercial Paper Funding Facility (CPFF) program which will “fund purchases of commercial paper of 3 month maturity from high-quality issuers” (Federal Reserve) and unlimited swap lines or “Counterparties in these operations will be able to borrow any amount they wish against the appropriate collateral in each jurisdiction” with major central banks as the Bank of England (BoE), the European Central Bank (ECB), the Federal Reserve, the Bank of Japan, and the Swiss National Bank (SNB) as “necessary to provide sufficient liquidity in short-term funding markets”. (Federal Reserve)

Figure 3: Wall Street Journal: Europe’s Bailout Package

Of course, it’s no different with the European counterparts which have committed aggressively some €1.8 trillion (US $2.4 trillion)-AFP.

So overall, including the US Congress’ contribution of $850 billion plus the Federal Reserves liquidity infusion via US dollar swaps these should amount to over $3 trillion or over 5% of global GDP (2007) of $54.62 trillion based on official exchange rate-CIA.

Such astounding financial theater of operations reminds us of the D-Day 1944 Normandy Landings. Bernanke’s helicopters have not only been operating on round the clock sorties, but they are also flying all over the globe as the Fed has essentially outsourced its printing press functions to international Central banks!

The Illusions of Government Guarantees

If only those unlimited injections of liquidity can translate to REAL capital.

The unfortunate part is that government guarantees depend on the hard currency that backs the system.

For instance, in the case of Iceland which basically guaranteed deposits of its financial system and nationalized its major banks, the lack of hard currency has precipitated a crisis (See our Iceland, the Next Zimbabwe? A “Riches To Rags” Tale?).

As the Icelandic government operated on a huge current account deficit in the face of a paucity of global liquidity, rising risk aversion, global bear markets, global deleveraging and the monumental debt incurred by its banking system, investors withdrew funding and sold the currency aground. Last October 9th the Iceland Prime Minister even pleaded to the public to restrain from withdrawals (Reuters).

Now goods shortages have emerged and consumer price inflation has soared. If Iceland can’t obtain the sufficient funding from overseas lenders (IMF or Russia or etc.) soon enough, then it would have to resort to the printing press or our developed country equivalent of Zimbabwe.

In a varied strain, Pakistan’s economy and banking system has allegedly been suffering from “some” depositor’s run (thaindian.news) on rumors that the government might impose withdrawal restrictions. Global volatility has exposed Pakistan’s vulnerability to its heavy dependence on short term debt financing and huge current account deficits (see our Increasing Signs of Pakistan's Depression?). Pakistan is now seeking a bailout package from China.

In both examples, government guarantees won’t serve any good if governments can’t support such claims.

Think of it, government revenues basically derive from three channels: taxpayers, borrowing through debt issuance or the printing press.

Even if your government guarantees deposits or other loans, assets etc…, if taxpayer’s can’t pay up, or if the government can’t raise enough borrowings to fund its present expenditure or settle its liabilities seen via fiscal or current account, your government ends up using the printing press to meet its needs.

This means that in the assumption that your government remains functional under a banking system collapse, whatever money guaranteed by the government will surely have its purchasing power evaporated!

If for instance the Philippine government allows deposit guarantees to increase at P 500,000 per depositor (from the present Php 250,000-PDIC) and our doomsday scenario occurs, such an amount which can momentarily buy a second car will eventually (perhaps in just months) buy up only a bottle a beer! That is if government even allows you to withdraw your money. In Argentina’s case during its 1999-2001 crisis, particularly in December of 2001, the Argentine government restricted depositors from withdrawing money to only a specified amount (BBC).

To Austrian economics, such restriction is equivalent to “Confiscatory Deflation”, which according to Joseph Salerno in his Austrian Taxonomy of Deflation, ``There does exist an emphatically malign form of deflation that is coercively imposed by governments and their central banks and that violates property rights, distorts monetary calculation and undermines monetary exchange. It may even catapult an economy back to a primitive state of barter, if applied long and relentlessly enough. This form of deflation involves an outright confiscation of people’s cash balances by the political and bureaucratic elites…

``Confiscatory deflation is generally inflicted on the economy by the political authorities as a means of obstructing an ongoing bank credit deflation that threatens to liquidate an unsound financial system built on fractional-reserve banking. Its essence is an abrogation of bank depositors’ property titles to their cash stored in immediately redeemable checking and savings deposits.” (highlight mine).

Yet when government mandated money loses trust among its constituents people tend to find a substitute, as example see our previous, The Origin of Money and Today's Mackarel and Animal Farm Currencies.

So as shown above, government guarantees do not constitute as an outright safety net. These will all depend on government’s access of available financing at future costs.

Under the same line of thought, the idea that the US dollar as the international foreign currency reserve with unlimited lending capacity is another mirage.

The US economy has been supported by the financing of its current account deficits by foreign exchange surpluses of current account surplus countries mostly found in Asia and Gulf Cooperation Council (GCC). This vendor financing scheme effectively recycles money earned from exports of EM economies by buying into US financial papers to keep their currencies from appreciating.

Hence, the US economy’s ability to provide unlimited finance is moored upon the willingness of foreigners as China, Japan and GCCs to sustain the present system. Said differently, for as long as these financers continue to buy US financial claims, they automatically provide the wherewithal or the “quiet bailout” to the US government.

So China, Japan and others essentially determines the guarantee provisions the US extends to its financial institutions aside from the world’s faith on its printing presses.

Besides, guarantees in the banking system as we previously discussed represent as “beggar-thy-neighbor” policy which keeps at a disadvantage countries offering less amount of guarantees, like the Philippines, since the former tend to attract more capital or savings because of the higher amount of safety.

Hence, guarantees signify as subsidies to those who apply more and a tax to nations who apply less. Thus, the policy regime of surging guarantees on deposits by Europe and the US tend to put into the downside pressures to the Philippine Peso.

Yet, our discussions above are some examples of isolated banking crisis and not of a systemic banking collapse, a domino effect from a prolonged cardiac arrest of the US banking system, the ultimate recipe for a global depression, where guarantees will just be that- a political rhetoric.

US Banking Collapse: You Can Run, But You Can’t Hide; Revival of Bretton Woods?

We proposed last week that this could mark the beginning of the end of the current form of paper money system or even signify as a harbinger to a new paradigm shift from our present monetary system.

Perhaps European Central Bank’s Jean Trichet heard our whispers and began to talk about the revival of a modern version of a “Bretton Woods” (see Did ECB’s Trichet Fire The First Salvo For A Possible Overhaul Of The Global Monetary Standard? and Bretton Woods II: Bringing Back Gold To Our Financial Architecture?)

So aside from the rapid aggressive policy response (bailouts, liquidity injections, nationalization, blanket guarantees), some European leaders have also raised the idea for a shift in the global financial architecture.

As the Reuters report indicates ``Italy's economy minister said a reform of the Bretton Woods institutions should also review trade, foreign exchange and capital markets and questioned whether the dollar should remain the reference currency under a new system.” (highlight mine) So it won’t be a far fetched idea for a movement among nations to address the need to reform the present monetary system.

Yet as the crisis continues to unfold, everything now seems to depend on how the global markets will respond to the massive stimulus applied and how it will measure up to remedy the apparent weakening of the foundations of the US banking system.

Nonetheless the threat remains real.

This means that should the US banking system collapse, there will probably be no escape for almost everyone dependent directly or indirectly on the global banking system, not even for those who aren’t invested in the stock market. While it is true that alternative sources for financing such as microfinancing and trade finance may be picking up on some of the slack, it won’t be enough for it to replace the rapidly mounting losses in the financial system that risks becoming a financial black hole.

We can only guess what implications of a global depression as an offshoot to the US banking collapse could be: pension, insurance, and other money market funds will perhaps evaporate, stock markets will close, a collapse in the international division of labor means each country will have to fend for themselves or dominant “protectionist” policies will prevail (hence some countries will experience hyperinflation and others will suffer from deflation), a run of the US dollar or the present paper money system, rising crime and security risks, civil wars, return of authoritarianism etc…

On the other hand, some sectors would be quite happy- the extreme left will glee with the resultant equality from a depression, as well as bureaucrats and political leadership who will benefit from more government spending. Outside these sectors, everyone will probably be equally poor!

Sorry for the gloom.

Conclusion

Thus, it is an arrant misguided fairy tale to suggest that today’s stock market meltdown is just seen for its “media feed”.

Today’s stock market meltdown is representative of the real risks of a US banking collapse. While I am not betting that this devastation is gonna happen, a US banking collapse would have deep adverse repercussions to our domestic and global banking system, aside from the global economy which practically means the ushering in of the great depression (version 2008) . Why would global central banks have earmarked over $3trillion of bailout money? Why would Bernanke’s Federal Reserve Helicopters be doing simultaneous missions globally to drop “helicopter money”?

So it is equally myopic to suggest that our banking system will be “immune” to such extreme risk scenario. If the issue is only about banking losses and some disruptions in the system then yes the Philippine banking system will escape with some bruises.

Nonetheless if the US banking industry does collapse, not even those out of the stock market will be spared unless their money is stashed under their pillowcase or buried underground.

That is if street muggers don’t figure them out.


1 comment:

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