The Federal Reserve is Bankrupt
How Did It Happen and What are the Ugly
Consequences? By Matthias Chang | |
URL of this article: www.globalresearch.ca/index.php?context=va&aid=12648 | |
Global Research, March 10, 2009 | |
The Federal Reserve is bankrupt for all intents and purposes. The same goes for the Bank of England! This article will focus largely on the Fed, because the
Fed is the "financial land-mine". In a recent article, I referred to the remarks of British Prime Minister Gordon Brown and President Obama calling for the shadow banking system to be outlawed. Even if the call was genuine, it is too late. The land-mine has been triggered and the explosion cannot be averted under any circumstances. The only issue is the extent of the damage to the global economy and how long it will take for the world to recover from this fiasco a financial madness that has no precedent. The great depression is "Mary Poppins" in comparison! The idea of a central bank going bankrupt is not that outlandish. I am by no means the first author who has given this stark warning. What underlies this crisis (which I initially examined in an article in December 2006) is the potential collapse of the global banking system, specifically the Shadow Money-Lenders. Nouriel Roubini, the New York University professor said [2]:
Please read the underlined words again. "Sovereign bank" means central bank. When a central bank "cracks" i.e. becomes insolvent, "all hell breaks lose", because as the professor correctly pointed out, "any government guarantees will ring hollow and will be useless". If a central bank goes belly up, it is as good as the government going bankrupt. Period! In another article, Roubini admitted that the pressure on "the financial land-mine" is totally unbearable. He wrote: "The US Financial system is effectively insolvent". It follows that if the financial system is bankrupt, it is a matter of time before the "sovereign bank" goes belly up. This is a given! He stated further that: Lloyd Blankfein was the only CEO of a Wall Street firm who was present at the New York Fed meeting when the AIG bailout was discussed. So let us not kid each other: The $162 billion bailout of AIG is a nontransparent, opaque and shady bailout of the AIG counter-parties: Goldman Sachs, Merrill Lynch and other domestic and foreign financial institutions. "So for the Treasury to hide behind the "systemic risk" excuse to fork out another $30 billion to AIG is a polite way to say that without such a bailout (and another half-dozen government bailout programs such as TAF, TSLF, PDCF, TARP, TALF and a program that allowed $170 billion of additional debt borrowing by banks and other broker-dealers, with a full government guarantee), Goldman Sachs and every other broker-dealer and major U.S. bank would already be fully insolvent today. "And even with the $2 trillion of government support, most of these financial institutions are insolvent, as delinquency and charge-off rates are now rising at a rate - given the macro outlook -that means expected credit losses for U.S. financial firms will peak at $3.6 trillion. So, in simple words, the U.S. financial system is effectively insolvent." McClatchy newspaper reported (03/08/2009) bad news affecting the banks:
Berkshire Hathaway Chairman, Warren Buffett is so livid by the sheer magnitude of the financial mess that he said:
The above bad news refers to the losses and potential losses that the big banks have suffered and will suffer in the near future. But what is overlooked by many financial analysts is that these very same derivative products have caused another financial organ failure. And there is no way that the said organ can be resuscitated to its former state of health. The Repo Market is gridlocked! There has been an incestuous relationship between the traditional banking system and the shadow banking system and the link that joined the two together is the Repo Market.[Repurchase Market] This is in fact the weakest link in the entire financial system. This is a very technical subject and I seek your indulgence and patience when reading the remaining part of this article. The gridlock of the repo market is the basis for my assertion that over and above the aforesaid dire financial facts, it is the major contributing factor to the bankruptcy of the Federal Reserve! I want to use a simple analogy. This will make the issue easier to understand. Picture a one-inch diameter thick rope. Such a rope is made up of a few strands of narrower ropes, say 1/10th inch which are twined together to make the thick one-inch diameter rope. Picture again that all the outer strands have been burnt away, and what remains is the middle strand, still lifting the weight. But this strand cannot on its own, lift such a weight and sooner or later, it will snap. When that happens, the weight will come crashing down! The middle strand is the repo market. Alternatively, you can use the analogy that the repo market is the heart that pumps the blood (the cash flow). The financial system is the body and it has suffered a massive heart attack! What is the repo market? The repo market is the market whereby all financial institutions (regulated and unregulated) invariably go to obtain financing to meet reserve requirements, bridging finance, to lend or purchase securities, to hedge and or to invest on short-term basis. It used to be that mainly US Treasuries (bear this in mind at all times) were used as security for Repo transactions, as it is considered as most secure i.e. as good as cash since it is backed by the credit of the US government! This requirement is no longer the case. More of this issue later. The Nature of Repo Transactions In repo transactions, securities are exchanged for cash with an agreement to repurchase the securities at a future date. The securities serve as collateral for what is effectively a cash loan. A distinguishing feature of repos is that they can be used either to obtain funds or to obtain securities. As repos are short-maturity collateralized instruments, repo markets have strong linkages with securities markets, derivative markets and other short term markets such as inter-bank and money markets. [3] Like other financial markets, repo markets are subject to credit risks, operational risks and liquidity risks. However, what distinguishes the credit risks on repos from that associated with uncollateralized instruments is that repos credit exposures arise from volatility (or market risk) in the value of collateral. Bear this in mind at all times. Repos allow institutions to use leverage to take larger positions in financial markets which could add to systemic risks. Bear this in mind at all times. And because of the close linkages between repo markets and securities markets, any shocks will be transmitted quickly, resulting in a gridlock. Bear this in mind at all times. Transactions covered by definition of repos are as follows: (A) Repurchase Agreement A repurchase agreement involves the sale of an asset under an agreement to repurchase the asset from the same counter-party. Interest is paid on the repurchase agreement by adjusting the sale and purchase price. A reverse repo is the purchase of an asset with an agreement to re-sell the same or a similar asset. A hold-in-custody repurchase agreement is a trade whereby the repoer (the borrower of cash) continues to hold the collateralizing securities in custody for the lender of cash. The risks are obvious! A deliver-out repurchase agreement is where securities are delivered to the cash lender for custody in exchange for cash. A tri-party repurchase agreement is similar to a deliver-out repurchase agreement, except that the security is placed in the custody of a third-party entity. The third-party ensures that the security meets the cash lender's requirements and provides valuation and margining services. This is the primary form of repurchase agreement for securities dealers in the United States. Bank of New York and JP Morgan Chase are the two main custodians or clearing banks in the US and supervise the vast majority of the tri-party repos. Bear this in mind at all times. (B) Sell/Buy-Back Agreement A sell buy-back is two distinct outright cash market trades, one for forward settlement. The forward price is set relative to the spot price to yield a market rate of return. (C) Securities Lending This is where the owner of the security lends them to another person in return for a fee. The borrower of the security is contractually obliged to redeliver a like quantity of the same securities, or return precisely the same securities. Repos can be of any duration but are most commonly over-night loans. Repos longer than over-night are called Term Repos. There are also Open Repos which are transactions which can be terminated by both parties on a day's notice. The largest players of repos and reverses are the dealers in government securities. There are about 20 primary dealers recognised by the Fed which are authorised to bid for new-issued treasury securities for resale in the market. The dealers are highly leveraged, 50 to 100 times their own capital. To finance the purchase of treasury securities, the dealers need to have repo monies in large amounts on a continuing basis. The institutions that supply such huge funds in the repo market are money funds, large corporations, state and local governments and foreign central banks. The Repo Market and the Financial Crisis As stated earlier when the repo market first started, US treasuries were the preferred security. But when financial engineering exploded and many financial products (i.e. CDOs) were rated AAA by rating agencies, these securities were also traded as described above in the repo market. This was when problems started. According to Gary Gorton [4], the repo market before the crisis was estimated to be worth a whopping $12 trillion as compared to the total assets in the entire US banking system of $10 trillion. The former CEO of Federal Reserve Bank of New York (NYFRB) and now the US Treasury Secretary, Tim Geithner observed in 2008:
Economic historians will argue for another century as to the cause for the run on the repo market. The collapse of Bear Stearns is as good a starting point as any. When the market discovered that its securities were duds, pure junk, shock waves ripped through the system. Recall that I had mentioned earlier that Federal Bank of New York and JP Morgan Chase were the primary clearing banks for repos. The Fed's rescue of Bear Stearns through JP Morgan was not so much to save the former but rather to shore up the "clearing system" of the repos for which JP Morgan Chase and the Bank of New York were the main pillars. One of the functions of a "clearing bank" for repos is to value and match securities tendered for cash borrowings. If Bear Stearns securities are now valued as junks, the integrity of JP Morgan and Federal Bank of New York as clearing banks in this market is as good as zero! And bearing in mind that the five major investment banks in the US rely heavily on the repo market for their funding, any gridlock in this part of the shadow banking system would tear wide open the entire banking system, including the traditional counter-part. Hence, the FED intervention by the creation of the Primary Dealer Credit Facility (PDCF) which was in effect the backstop for all investment banking using tri-party repos! This was what Bernanke said:
Louis Crandall, economist at Wrightson ICAP observed:
The inherent weakness of tri-party repos is that the counter-party risks of billions worth of funding agreements are shouldered by essentially two players Federal Bank of New York and JP Morgan Chase. Yet, way back then, they were held up as rock solid. It is almost hilarious to read the then advert of the Federal Bank of New York as to their expertise and service:
Panic swept across the entire repo market. No securities were considered safe enough for repos except US treasuries. Fundings in the repo market grind to a halt. Market players withdrew funds and began hoarding treasuries. The rest who own structured products were slaughtered. I would like to quote Gary Gorton again:
This change led to a sharp increase in the demand for government securities for repo transactions, which was compounded by significantly higher safe-haven demand for US Treasuries and the increased unwillingness to lend such securities in repo transactions. As the crisis unfolded, this combination resulted in US government collateral becoming extremely scarce. [6] I will now turn to the issue of the FED's solvency. As has been observed, the Fed intervened aggressively to check the run on the repo market. Various measures were taken, but in my view the most dangerous was the widening of the collaterals which the Fed was willing to accept to secure funding of the players in the repo market. The Fed also intervened by lending a huge chunk of its US treasuries in exchange for junks to facilitate credit expansion. In the result, what happened was that the Fed's present balance sheet of approximately $2 trillion is made up mostly of junk securities. The Fed is no different from banks in that confidence in the quality of its assets is critical and that if and when the market recovers, there is in fact a market for the junk assets that it took on to unravel the gridlock in the financial markets. By way of analogy, if your high street bank's balance sheet is made up of junk, what would you do? There are just not enough assets to meet its liabilities. But of course, one can argue that the Fed is not your high street bank. It is the central bank of the mighty USA. It will always be able to "print money" or "digitalise" money and keep the markets going. But beware that the Federal Reserve Note is mere paper, fiat money which cannot be redeemed for anything tangible such as gold. And although it is stated boldly in the notes issued - "In God we trust" - you and I are not actually placing our trust in God when accepting the Federal Reserve Notes as "money". When Joe Six-Packs realises that the Federal Reserve Note is not even secured by US treasuries and or the FED has real tangible assets, but its balance sheet is littered with junks and toxic waste, there will be a run on the Fed i.e. when Americans and foreigners no longer have faith in the Federal Reserve Notes as "money". If confidence could vaporise in a second and cause a stampede in what was once considered solid security, the triple A rated bonds in the repo and money markets, the same confidence that is now reposed in the Federal Reserve Notes can likewise disappear into the memory hole. All these years, the con was maintained by the Fed that it was solid because it has on its balance sheet over $800 billion of US treasuries i.e. its notes "were so-called backed by these treasuries". It could sell its treasuries in the repo market for cash and thereby control the money flows in the economy and vice versa. In their subconscious mind, Americans and stupid foreign central banks and their executives (brain-washed by the Chicago School of Economics) somehow believe in the infallibility of the Fed. Now it has been exposed that the Fed's "assets" comprise of junk bonds and toxic wastes. The Emperor has no clothes! Paul Volcker, former Chairman of the Federal Reserve may have given the ultimate epitaph: "The bright new financial system for all its talented participants, for all its rich rewards has failed the test of the market place." And it is any wonder that Professor Nouriel Roubini declared:
In my opinion, the Fed has already become "unglued". Whatever guarantees given to secure the indebtedness of CitiGroup and others to prevent a run on these banks are useless. It is bankrupt! End Notes [1] There are two banking systems in
existence today. The Traditional Banking System i.e. High Street banks
and the Shadow Banking System. But the players in both the systems overlap
because, the major banks of the traditional system helped spawn the shadow
banking system. In fact they are the key players in the use of the
so-called "new financial products, the CDOs, CLOs, MBS" etc and which have
now turned toxic worthless, junk to be exact.
| |
Please support Global Research Global Research relies on the financial support of its readers. Your endorsement is greatly appreciated | |
Subscribe to the Global Research e-newsletter | |
| |
|
|