THE REAL ECONOMY

Economics/Politics

Friday, August 24, 2007
Financial Bankruptcy, the US Dollar and the Real
Economy
par Rodrigue Tremblay
[http://www.thenewamericanempire.com/author.html]

"The U.S. government is on a 'burning platform' of
unsustainable policies and practices."
David Walker, U.S. Comptroller General

"Modern society, based as it is on the division of
labor, can be preserved only under conditions of
lasting peace."
Ludwig von Mises, Austrian economist

"People know that inflation erodes the real value of
the government's debt and, therefore, that it is in
the interest of the government to create some
inflation."
Ben S. Bernanke, Fed Chairman

"Regarding the Great Depression. You're right, we did
it. We're very sorry. But thanks to you, we won't do
it again."
Ben S. Bernanke, Nov. 8, 2002 (Fed Chairman, talking
to economist Milton Friedman)

Ordinary investors and people in general will have to
get accustomed to hearing a lot about financial terms
they never heard before, such as the subprime mortgage
market, aggressive underwriting, asset securitization,
repackaged loans, subprime loans, "no-doc" loans,
adjustable rate mortgage interest rate adjustment
(ARM) loans, collateralized debt obligations (CDOs),
asset backed securities, mortgage-backed securities,
closed-end second-lien loans, subprime second-lien
loans, alternative-A (Alt-A) mortgage loans, piggyback
loans, asset-backed commercial paper (ABCP),...etc.
—As a general definition, "subprime" or "high-risk"
loans" [http://en.wikipedia.org/wiki/Subprime_lending]
are those made to people with poor credit and at lax
conditions. Second-lien loans are loans that are
placed in second place for any potential recovery
after the primary lender on a property. —Residential
mortgage-backed security (RMBS) are created when
mortgage lenders sell their loans (and the risks
associated with such loans) to banks, which package
them together and slice them into different classes
before selling them to (gullible) investors. This
process, called "asset securitization" is the method
whereby interests in mortgage loans and other
receivables are packaged, underwritten, and sold in
the form of "asset-backed securities". This is
financial alchemy, through which subprime mortgage
loans are transformed into AAA-rated paper for
unsuspecting investors.

Some of these artificial or derivative securities are
low-grade quality, and when their prices fall because
borrowers cannot meet their interest or capital
payments, such financial instruments become quickly
"illiquid" or unsalable, since nobody wants to touch
them. They become fictitious capital.
[http://en.wikipedia.org/wiki/Fictitious_capital]
Those who hold them, investors, banks or other types
of lenders, are stuck with them: they cannot sell them
and they cannot borrow while placing such shaky assets
as collateral. These are the imprudent lenders and
investors that central banks now are trying to bail
out.

During the French Revolution (1789-1799)
[http://en.wikipedia.org/wiki/French_Revolution], the
Jacobins
[http://www.jamesrmaclean.com/archives/000168.html]
(the Neocons of the day) had the brilliant idea of
issuing securities, called "assignats",
[http://en.wikipedia.org/wiki/Assignat] based on the
properties (buildings and lands) the government had
taken away from the Church and its religious orders.
The new securities were quickly "monetized" into fiat
money [http://en.wikipedia.org/wiki/Fiat_currency] and
transformed into readily available cash. This caused a
massive hyperinflation
[http://en.wikipedia.org/wiki/Hyperinflation] and a
subsequent deflation.
[http://en.wikipedia.org/wiki/Deflation_(economics)]

Mind you, this was not the first time that
18th-century France lived an experience of
inflationary finance, since a similar incident took
place three quarters of a century before, between 1716
and 1720, when Scottish banker and businessman John
Law
[http://en.wikipedia.org/wiki/John_Law_(economist)]
(1671-1729) led France into a fiat money fiasco and
engineered a land-backed securities scheme known as
the Mississippi Bubble.
[http://www.britannica.com/eb/article-9052986/Mississippi-Bubble]
John Law's earlier experiment and the French
Revolution assignats debacle
[http://www.mises.org/story/1504"
http://www.mises.org/story/1504] should be clear
reminders of the danger and folly of "monetizing"
illiquid assets-based securities.

Like all "Ponzi schemes",
[http://en.wikipedia.org/wiki/Ponzi_scheme] such
pyramidings of debts with no liquid assets behind them
are bound to implode sooner or later. And that is what
we are witnessing today, i.e. the implosion of
unfunded credit derivatives-based
[http://en.wikipedia.org/wiki/Credit_derivatives]
"Ponzi schemes". In 1998-2000, we got an idea of what
could happen when portfolios are highly leveraged
[http://en.wikipedia.org/wiki/Leverage_(finance)] and
laden with derivative financial products with the
collapse of one large hedge fund, the Long-Term
Capital Management.
[http://en.wikipedia.org/wiki/Long-Term_Capital_Management]


This should have been a warning sign to regulators of
financial markets. But hedge funds
[http://en.wikipedia.org/wiki/Hedge_fund] and other
financial operators' greed—and political
corruption—were too strong, and no one stopped the
march to disaster. Now, things are getting worse,
because central banks, led by the Fed, are following
the assignats route and have been aggressively
"monetizing" the unfunded derivative debts, lending
new cash not for a day or two, and not against
T-bills, but for months on end against illiquid and
partly unsolvable and artificial derivative debts. Who
knows where this could lead?

One possibility is the complete collapse of the U.S.
dollar and an uncontrollable burst of inflation
[http://en.wikipedia.org/wiki/Inflation] in the years
ahead if the salvaging operation were to increase
money supply
[http://en.wikipedia.org/wiki/Money_supply] on a
permanent basis. Indeed, if central banks continue to
shore up the artificial financial houses of cards to
prevent them from going bankrupt, they may end up
monetizing mountains of unsolvable debts with the
potential of creating a monstrous inflation. A dollar
panic may be just around the corner —Thus, the cure
for fighting a credit crisis could be a tremendous
push of inflation in a few years, if the Fed cannot
withdraw the new cash fast enough from the system.
This surely can be the case, since it has announced
that it is discounting non-government home mortgages
and mortgage-backed securities, jumbo mortgages, and
asset-backed commercial paper, and a broad range of
collateral for discount-window loans, besides the
typical Treasury and government agency paper. The
problem is that some of these so-called "securities"
may be worthless in a few months, thus making it
difficult for the Fed to sell them back and retrieve
its cash.

Over the past few weeks, central banks worldwide have
supplied hundreds of billions of fresh loans to banks
and other financial dealers, to make cash available
for lending and they have lowered interest rates amid
signs that credit was drying up. The partly
privately-owned Fed,
[http://en.wikipedia.org/wiki/Federal_Reserve] for
example, has accepted billions in "repos", by which it
bought billions in illiquid securities from dealers,
who then deposited the money into commercial banks,
thus "liquifying" the entire financial system. This is
a short-term measure designed to alleviate the
"liquidity crisis",[
http://academic.uofs.edu/faculty/gramborw/tucrisis.html]
even if it is pursued for a few months.

It alleviates the "liquidity crisis", for sure, but
this does nothing to cure the underlying "solvency
crisis"
[http://www.ramconsultancy.com/solvency_crisis.htm] of
institutions holding large chunks of non-performing
mortgage-based assets. Sooner or later, such low
valued derivatives will have to be written off, and
this will necessarily lead to an erosion of these
institutions' capital base. Bankruptcies of the most
leveraged and imprudent institutions are to be
expected. For a few weeks, the Fed's interventions and
buying by the Treasury's special division, the
"Working Group on Financial Markets", also commonly
known as the "Plunge Protection Team" (PPT)
[http://www.financialsense.com/fsu/editorials/dorsch/2007/0809.html]
will sustain the financial markets. But come
mid-September and early October, the law of gravity is
likely to regain its importance.

As I explained in my blog of last October 16 (2006),
(Headwinds for the US Economy),
[http://www.TheNewAmericanEmpire.com/tremblay=1041]
macroeconomic conditions made it a "matter of months,
not years", before the U.S. economy and the U.S.
dollar begin to experience some downward pressures.
And, as I repeated on May 5 (2007), (A Slowdown or a
Recession in the U.S. in 2008?),
[http://www.TheNewAmericanEmpire.com/tremblay=1064] we
are "approaching [the] point of reckoning."

As I said in May, we could expect "the collapse of one
and possibly several major financial institutions
under the pressures of bad loans and record
foreclosures. Particularly at risk is the some $2.5
trillion mountain of debt concentrated in subprimes
and Alt-A loans. Already, one major sub-prime lender
(New Century Financial) has filed for Chapter 11
bankruptcy protection.
[http://news.bbc.co.uk/2/hi/business/6519051.stm]
Others are likely to follow, because 2007 is the year
when a large number of sub prime real estate loans
have to be renegotiated at higher interest rates. The
rate of foreclosure is bound to spike in the coming
months, possibly culminating in the next two years
into a financial hurricane."

The practice of sub-prime loans and the creation of
even more creative and artificial "derivative
financial products" is much more widespread in the USA
than in other countries. For example, such risky loans
represent as much as 20 percent of mortgage loans in
the U.S., while the incidence is only 5 percent in
neighboring Canada. [Indeed, out of the U.S. $10
trillion mortgage market, about $2 trillion constitute
the sub-prime mortgage market.] —But where were the
American central bank, the Fed under Alan Greenspan
and B. S. Bernanke, the Security and Exchange
Commission (SEC) under former congressman and venture
capitalist Christopher Cox, and the Bush-Cheney
Treasury Department when this mountain of shaky real
estate debt was being built by unscrupulous and
ruthless financial operators?

Why did they not intervene -first, to protect mortgage
borrowers by putting a stop to mortgage loans that
require no or not much documentation about a
borrower's income (so-called "no doc" or "low doc"
loans), -second, to prevent a solvency dilution of the
capital base of American financial institutions and,
-third, to prevent an unsustainable real estate bubble
that sooner or later was going to burst and drag down
the rest of the economy? —It is indeed the duty of a
lifeguard to prevent people from jumping into a
swimming pool that is without water. —But when you
have a Treasury Secretary who is a former president of
deal-making and hedge-funds-famous Goldman Sacks, a
SEC chairman who is a former venture capitalist and a
chairman of the Fed who is on record as saying he
favors inflationary policies, you may have part of the
answer. When the fox is put in charge of the chicken
coop, you cannot expect the chickens to be safe. One
has to remember that President Herbert Hoover’s
Secretary of the Treasury, in 1929, was financier
Andrew W. Mellon,
[http://en.wikipedia.org/wiki/Andrew_Mellon] with his
far right economic policies of lowering taxes for the
rich. We have the uneasy feeling that history repeats
itself.

Since the Bush-Cheney White House
[http://www.democraticunderground.com/discuss/duboard.php?az=view_oet&address=358x4797]
wanted the economy to keep bubbling before the 2004
and 2006 elections, there was nobody to whistle the
end of the recreation. As the French King Louis XIV
said, "Après moi, le déluge!" ("When I am gone, I
don't care what happens!). In fact, U.S. regulators
not only did not intervene to stop the madness of
no-interest, no questions asked, no down payment
loans, but they encourage unbridled speculation by
abolishing the Roosevelt era crash-preventing "uptick
rule"
[http://64.233.167.104/search?q=cache:zofyRgjbh5AJ:www.sec.gov/rules/final/2007/34-55970.pdf+The+SEC+ruling+about+the+uptick+rule&hl=en&ct=clnk&cd=2&gl=ca&ie=UTF-8]
designed to force short sellers to wait for an uptick
in the price of a stock before they could complete
their short trade. Indeed, it will be an historic
irony that on July 6 (2007), the Security and Exchange
Commission
[http://www.investopedia.com/terms/s/sec.asp] (SEC)
removed the protection in order to allow hedge fund
operators
[http://www.amazon.com/Inside-House-Money-Traders-Profiting/dp/0471794473/ref=pd_bxgy_b_text_b/103-7927243-4175016]
to short stocks on down ticks, thus making sure that
market volatility would increase tremendously.

It is said that London financiers, greedy speculators
and incompetent central bankers were responsible for
the 1929-1939 worldwide financial crisis
[http://www.cambridge.org/catalogue/catalogue.asp?isbn=0521365376]
and economic depression. This came after a domino
effect of financial collapses, starting with the
failure in September 1931, of the big Austrian
CreditAnstalt bank,
[http://en.wikipedia.org/wiki/Creditanstalt] owned by
the Rothschild
[http://en.wikipedia.org/wiki/Rothschild -
Rothschild_family_banks] family. The crisis spread
throughout the German, the British and the global
financial system. This time, the financial infection
has started in the United States. If the current
financial collapse in the U.S. were to stall the real
economy, as it has already begun to do in many
sectors, the Bush-Cheney administration would have to
carry a lot of blame because of its lax regulatory
policies.

_______________________________________

Rodrigue Tremblay is a Canadian economist who lives in
Montreal; he can be reached at
rodrigue.tremblay@yahoo.com
Visit his blog site at:
http://www.thenewamericanempire.com/blog.
Author's Website: www.thenewamericanempire.com/
Check Dr. Tremblay's coming book "The Code for Global
Ethics" at: http://www.TheCodeForGlobalEthics.com/
Posted, Friday August 24, 2007, at 5:30 am

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© 2007. All rights reserved.–This article is published
by permission of Big Picture World Syndicate, Inc.


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