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Where are we now in the credit
crisis, and why isn’t the massive Fed and ECB weekly lending working to
loosen interbank lending? Why is the credit crisis not really improving?
Where is this going next? We describe what may happen next as Credit Crisis
II in this article.
Now that the credit crisis that
started in 2007 is a year old, there has been a debate about whether the
financial system will recover, or will the Western/world financial system end
up like the Japanese financial system after the stock and real estate crashes
in the 1990’s. In that case, the Japanese banks more or less carried
their tremendous losses for ten years, and Japan entered a mild but painful
decade of deflation. To this day, Japan is battling some of the deflationary
forces from that time.
The question now becomes, will
the Western financial system recover some normalcy, or are things merely
going to get worse and the world end up with a financial malaise lasting ten
years like Japan’s?
If the second alternative is the
case, then the central banks which are merely propping up the financial
institutions with their ‘temporary’ lending will find they are
taking the losses off the banks hands, taking them on to their balance
sheets, and effectively monetizing the losses.
The ECB and the Fed are both
hoping to find a way out of having to keep the bad assets they took as
collateral. They have lent hugely to financial institutions, taking their bad
mortgage bonds, securities, derivatives as collateral. And at the same time,
the financial institutions in question are carrying a sum total of $500
billion of losses on their books, the losses they admit so far, while estimates
of ongoing losses from these bad assets runs well over $1 trillion. In
effect, the Western credit industry is still crippled. Why is it so crippled
still?
Either the financial industry
earns its way out (will take ten or more years) and drastically pull back
credit, or they find enough new investors to pony up new capital infusions,
perhaps through stock sales. And new such investors are becoming increasingly
hard to find. Hence, the central banks are the only alternative.
A theme now arises where it is
becoming apparent that it is impossible to actually purge the escalating
losses from the financial system, and that even big public bailouts
don’t purge the losses because of interlinkages between stocks, bonds
and derivatives. If one class or institution is bailed out, the losses of
capital merely move to the other class. And the losses are clearly so huge as
of now, that they weigh on the currencies themselves and cause a fall in
their exchange rates.
It is estimated that the
USTreasury/Fed/FHLB has infused a total of $2 trillion and counting since Aug
07 to the various credit infusions to the US financial system, and that the
ECB is in at similar levels. And even after $ 4 trillion worth of infusions
over the last year has been thrown out by the Fed and ECB, the world
credit/financial system is actually getting worse. What will be the outcomes
into 09?
Bankrupt en masse
In effect, this means the
Western banks, etc are bankrupt en masse. The only thing propping up the
entire Western financial system, and its respective stock markets has been
massive ‘temporary’ lending, on an ongoing basis, by the Fed and
ECB. Both central banks are beginning to balk at this situation. Even as they
are starting to have second thoughts, the Western financial institutions continue
to borrow more money than ever on a weekly basis. Why aren’t things
loosening up?
Can’t stop or else
And, if the ECB or the Fed stops
the emergency infusions, or even admit who the borrowers are, another round
of collapsing banks/bank runs ensues as investors flee and pull their money
out. In other words, the central banks have no choice but to continue the
weekly $30-50 billion or so of infusions each for the Fed and the ECB, or
else face a cascade of bank runs around the world.
…And each week the Fed and
the ECB are effectively taking on another $30 or $50 billion of the bad
assets from the various and sundry financial institutions scattered across
the EU and the US. So, week after grueling week, the Fed and the ECB keep
adding another $50 to $100 billion of bad assets to their balance sheets, as
‘collateral’ and making ‘temporary’ loans they keep
having to roll over and extend the repayment on. Ie, the junk stuff is
becoming a permanent resident on the central bank’s balance sheets. If
either the Fed or the ECB stop the weekly infusions, quite possibly the
entire Western financial system stops dead. And we get a massive world stock
crash.
The question now becomes, what
happens when these two central banks finally decide they have to let go? You
are not going to tell me they are going to keep infusing a combined $50 to
$100 billion worth of financial bailouts each week forever? This massive
temporary lending certainly has to end at some point.
And even with all this new money
every week, the credit system is barely functional anyway right now. And this
half dead world credit system is dragging economies downward, as there is
less and less and less credit. This is a paltry return for all the bailouts
and massive temporary lending.
Probably what is happening is
that this is a classic case of a parabolic world credit peak, as more and
more money is needed each week merely to keep the bubble from collapsing. And
the only ones left to infuse this money are the central banks. No one else is
willing to step in. Financial institutions won’t lend to each other,
and investors won’t recapitalize the crippled banks. As financial
institution’s stocks fall, issuing new stock becomes prohibitively
expensive.
Parabolic peak
One could say all that is happening
is that all financial institutions in the world don’t really trust each
other, and won’t lend to each other. And that an astounding $50 to $100
billion of weekly infusions from the Fed and the ECB is not fixing the
situation, and that we are witnessing the final parabolic peak of the world
credit bubble that has built up for the 63 years after WW2 ended. That, and
the end of the USD and Yen driven credit/asset/finance bubble which ensued
from the early 1970’s.
So, before we continue, it might
be said that the present development of the credit crisis, from August 07 to
now, is Credit Crisis I. And the present state of affairs is that the Fed and
the ECB have to infuse a weekly $50-100 billion plus into their respective
financial regions merely to prevent a world finance implosion.
I also have noticed that the
Credit Crisis I has had a one year periodicity of major new developments, ie
that if one major sector had a problem on a given month, that the next year
the same sector seems to reinvent a new worse manifestation.
I made a graphic to describe the
general situation:
So, when the central banks stop
this massive weekly lending, what happens? Massive forced deleveraging and
probably world financial Armageddon. This would be Credit Crisis II, or Phase
II. We will look into Credit Crisis II in a moment.
This is the conclusion we came
to here at PrudentSquirrel, trying to ascertain where we are in the big
picture on the Credit Crisis now. It is that the Central Banks are
desperately trying to stave off Credit Crisis II, and they are losing, and
probably knowing this, they will at some point confer together and pick a
time to let the credit system implode, and try to weather the stock/financial
crashes that will occur at that time. Likely, some currencies can collapse as
well, and a great deal of FX (foreign exchange) chaos and restrictions will
ensue for several years after the fatal date.
If it is true, as we suspect,
that we are at the peak of a credit/financial bubble that started right after
WW2 ended, and it is at a parabolic peak and cannot be sustained, then the
world’s central banks already know this too. They probably are trying
to decide when to let go…They all don’t have to agree, it only
will take one major Central Bank to let go, then the others will be forced to
follow.
The central banks in question
would be the BOJ, the US Fed and the ECB, and likely the BOC. The Russian
central bank is an odd man out and is a wild card, but not as central to the
equation. Either all the major central banks listed keep up the same rate of
infusions, or the end of the world credit system comes in a week or two after
one ‘lets go’.
Now as to the USD strengthening
now, and gold’s vexing $100 plus volatility, it just seems best to make
any protective moves well ahead of the fatal day. Once the situation gets out
of control, Credit Crisis II begins, in a week from that point you will find
it hard to make any changes. I view gold’s present volatility as a
total side issue, compared to what would happen if all one’s money was
tied to the financial system, the USD and so on, and then one’s
financial situation was frozen if the central banks decide to let go, and
world foreign exchange restrictions are instituted. Gold is still one of the
best ways to ride out what may come to pass.
Our present state of affairs in
Credit Crisis I
Let’s look at a few
examples of why I am saying the world is at a parabolic credit bubble peak,
and why the Central banks are finding they have no choice but to keep pumping
out $50 plus billion a week of new ‘temporary’ lending, or else
face a real financial Armageddon…
The ECB, Spanish banks, and
North-South EU dissention
How Spanish banks are creating mortgage
securities to get ECB funding is a perfect example of our present financial
crisis…and how the ECB seems to have no choice but to continue the
short term funding of the entire EU financial system, and it is causing big
dissention between the North EU and South.
By Ambrose Evans-Pritchard
Last Updated: 3:06pm
BST 21/08/2008
The European Central Bank has
issued the clearest warning to date that it cannot serve as a perpetual
crutch for lenders caught off-guard by the severity of the credit crunch.
Not Wellink, the Dutch central
bank chief and a major figure on the ECB council, said that banks were
becoming addicted to the liquidity window in Frankfurt and were putting the
authorities in an invidious position.
"There is a limit how long
you can do this. There is a point where you take over the market," he
told Het Finacieele Dagblad, the Dutch financial daily.
"If we see banks becoming
very dependent on central banks, then we must push them to tap other sources
of funding," he said.
While he did not name the chief
culprits, there are growing concerns about the scale of ECB borrowing by
small Spanish lenders and 'cajas' with heavy exposed to the country's
property crash. Dutch banks have also been hungry clients at the ECB window.
One ECB source told The Daily
Telegraph that over-reliance on the ECB funds has become an increasingly
bitter issue at the bank because the policy amounts to a covert bail-out of
lenders in southern Europe.
"Nobody dares pinpoint the
country involved because as soon as we do it will cause a market reaction and
lead to a meltdown for the banks," said the source.
This "soft bail-out"
is largely underwritten by German and North European taxpayers, though it is
occurring in a surreptitious way. It has become a neuralgic issue for the increasingly
tense politics of EMU.
The latest data from the Bank of
Spain shows that the country's banks have increased their ECB borrowing to a
record €49.6bn (£39bn). A number have been issuing mortgage
securities for the sole purpose of drawing funds from Frankfurt.
These banks are heavily reliant
on short-term and medium funding from the capital markets. This spigot of
credit is now almost entirely closed, making it very hard to roll over loans
as they expire.
The ECB has accepted a very wide
range of mortgage collateral from the start of the credit crunch. This is a
key reason why the eurozone has so far avoided a major crisis along the lines
of Bear Stearns or Northern Rock.
While this policy buys time, it
leaves the ECB holding large amounts of questionable debt and may be storing
up problems for later.
The practice is also skirts
legality and risks setting off a political storm. The Maastricht treaty
prohibits long-term taxpayer support of this kind for the EMU banking system.
Few officials thought this
problem would arise. It was widely presumed that the capital markets would
recover quickly, allowing distressed lenders to return to normal sources of
funding. Instead, the credit crunch has worsened in Europe…” Bold emphasis is mine
Fannie and Freddie rescue
dilemma- their stocks and debt are held by other banks
Another perfect example of the
impossible state of affairs in the world credit crisis is Fannie/Freddie. And
that means that if the Fed/Treasury does a bailout, their stocks collapse in
value, and all the other financial institutions take losses on that because
they hold lots of Fannie and Freddie stock. Of course the stock is already in
the tank, but the issue is still there and shows the interlinkages.
Then there is the question of
the Fannie and Freddie bonds out. That is another can of worms, and the
Chinese just stated this week that a collapse of Fannie-Freddie could lead to
an economic catastrophe – their Central Bank advisor Yu Yongding
stated. The Chinese hold hundreds of billions ($376 billion mostly in US
agency bonds) of Fannie and Freddie debt and stock.
In many respects, because of all
these cross holdings of the Fannie Freddie bonds and stocks by banks
everywhere, and by Central Banks, it would seem that the losses cannot really
be removed from the financial system – ie purged. If Fannie and Freddie
are bailed out, their stocks collapse and those losses now translate to all
these other banks and central banks that hold them. It’s virtually a no
win situation.
These cross linkages reveal that
it is virtually impossible, even with bailouts, to purge the ever growing
$500 billion and counting losses of capital from the banking/financial
system. The latest numbers being speculated on are the losses will be over $1
trillion (IMF) and $2 trillion or more (Roubini).
Now, maybe $2 trillion
doesn’t sound like a lot compared to the entire world economy. The
trouble is, that capital is leveraged anywhere from 10 to 50 times by the
financial system. Fannie and Freddie have 60 to 1 leverage.
Losing $2 trillion of capital
will totally wipe out the entire world financial system for a decade because
of the leverage at 60 to 1. Basically, unless those losses can be purged in
some way, it has to be earned back over a period of years/decades. That
essentially cripples the entire world financial system.
I remember a very well put quote
from a banker last Fall 07 about the credit crisis then. (I’m sorry, I
don’t remember his name.) He stated “The credit deleveraging will
not be denied.” I think that sums things up very well.
It appears that a relentless
unwinding of the world credit/finance bubble with many dimensions and twists
and turns cannot be avoided, even if the central banks were willing to try. The
issue is the cross linkages and the fact that the capital losses in every
corner of the world will not and maybe cannot be purged from the financial
system, even with big public bailouts. There is possibly no way to do it
other than to allow things to just unwind and try to re earn it all back the
hard way.
Even if it appeared the central
banks could figure out a way to purge the losses from the financial system,
and take them on their books, then their currencies are in danger. The
capital losses are there – period. The deleveraging of 60 to 1 credit
is happening – period. The financial institutions don’t trust
each other – period.
The Fannie – Freddie
bailout proposals are being discussed in the light that the US
government/Treasury can just about double the so called national debt from $9
trillion by possibly adding another $5 plus trillion, as they effectively
have to guarantee those GSE bonds. That is now playing into a debate on the US fiscal situation….as if the USD needed another problem.
In short, once again, we see
that it appears impossible to purge the effects of so much lost capital to
the world financial system. The deleveraging will not be denied. We see this
a year after the Credit Crisis I exploded worldwide Aug 07.
End of a huge world bubble
If that is true, then the theory
I laid out above, that we are witnessing a peak in a parabolic
finance/asset/stock bubble of world proportions, is going to pan out. I think
the entire credit crisis can be looked at from that perspective. We are
merely witnessing the relentless unwinding of the biggest financial bubble in
history. And, ominously, this particular bubble has grown from the end of WW2
to the present. That is one HUGE economic bubble, and this one envelops the
entire world. This is not just a bubble in one country’s economy.
The point of emphasizing
it’s from the end of WW2 is that we are not talking merely about a
banking crisis, or whatever. We are talking about the deleveraging of the
greatest economic/finance bubble in history. Once the level of leverage
reached 60 to 1, it becomes impossible to stay ahead of the deleveraging,
even for central banks. The implications are staggering. Every major economy
in the world is involved. The outcomes of deleveraging this monster bubble,
represented by the green oval, will be what I term Credit Crisis II. At 60 to
1 leverage, a loss of 1 to 2% wipes out the capital.
Whether it’s the Chinese
Central Bank (BOC), the Fed, the ECB, and then all the other world financial
institutions of every type, insurance companies, gigantic retirement funds,
other banks, you name it, the present losses of capital to the world
financial system is pervasive worldwide.
Nobody will escape the wrath of
this deleveraging, and that is why I call it Credit Crisis II. Credit Crisis
I was only the preliminary round…Credit Crisis II is characterized by
the realization that the gigantic losses of capital cannot be purged from the
financial system, even with big public bailouts. And that this deleveraging
cannot be stopped. There are too many interlinkages. And, without writing a
book on this, the next victim when Credit Crisis II unfolds, will be massive
world currency instability. This will make any of the banking and currency
crises we have seen since WW2 look like child’s play. It is not clear
when Credit Crisis II begins but it is threatening already.
The Prudent Squirrel newsletter
is our financial and gold commentary. Subscribers get 44 newsletters a year
on Sundays, and also mid week email alerts as needed. We alerted our
subscribers April 20 that the USD was bottoming. The USD has strengthened
significantly since. The alerts include quick notification of important
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alone are worth subscribing for.
I had one potential subscriber
ask me if the newsletter has much more content than these public articles,
ie, if it was worth subscribing. The answer is that the public articles have
less than 10% of our research and conclusions that subscribers see, not to
mention the subscriber email alerts of important breaking financial news. We
have anticipated many significant market moves in the last year, such as
imminent drops in world stock markets within days of them happening, and big
swings in the gold markets within days of them occurring. We have also made a
number of good calls on big currency swings, such as with the USD, the Euro
and the Yen.
Chris
Laird
Prudent
Squirrel
Chris Laird has been an Oracle
systems engineer, database administrator, and math teacher. He has a BS in
mathematics from UCLA and is a certified Oracle database administrator. He
has been an avid follower of financial news since childhood. His father is
Jere Laird, former business editor of KNX news AM 1070, Los Angeles (ret). He
has grown up immersed in financial news. His Grandmother was Alice Widener,
publisher of USA magazine in the 60?s to 80?s, a newsletter that covered many
of the topics you find today at the preeminent gold sites. Chris is the
publisher of the Prudent
Squirrel
newsletter, an economic and
gold commentary.
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