Signs of the Economic Apocalypse, 12-3-07

From Signs of the Times (sott.net):

Gold closed at 789.10 dollars an ounce Friday, down 4.5% from $824.70 at the close of the previous week. The dollar closed at 0.6834 euros Friday, up 1.4% from 0.6740 at the close of the previous Friday. That put the euro at 1.4633 dollars compared to 1.4838 the Friday before. Gold in euros would be 539.26 euros an ounce, down 2.8% from 554.23 for the week. Oil closed at 88.71 dollars a barrel Friday, down 10.7% from $98.18 at the close of the week before. Oil in euros would be 60.62 euros a barrel, down 9.2% from 66.17 for the week. The gold/oil ratio closed at 8.90 Friday, up 6.0% from 8.40 at the end of the week before. In U.S. stocks, the Dow Jones Industrial Average closed at 13,371.72 Friday, up 3.0% from 12,980.88 for the week. The NASDAQ closed at 2,660.96 Friday, up 2.5% from 2,596.60 at the close of the week before. In U.S. interest rates, the yield on the ten-year U.S. Treasury note closed at 3.94%, down six basis points from 4.15 for the week.

Encouraging week, in some ways, even if it is only temporary pause on the death spiral. Not only did gold and oil drop sharply and stocks rise, but plans to help people avoid losing their houses in foreclosure were announced by U.S. Treasury Secretary Paulson. Last week we asked the questions, “How many people can be evicted from their homes in foreclosure? Is there a ceiling, a certain percentage above which the system collapses, above which the exploited no longer give their consent to their exploitation? Will the system pull back before it reaches that point?” It seems that the ruling groups are worried about political problems arising from the housing crisis. There has been so much neglect of the problem for so long that any acknowledgement is welcome.

Paulson, Banks in Talks to Stem Surge in Foreclosures

By Alison Vekshin and Craig Torres

Nov. 30 (Bloomberg) -- U.S. Treasury Secretary Henry Paulson is negotiating an agreement with banks to stem a surge in foreclosures by fixing interest rates on loans to subprime borrowers, according to people familiar with a meeting he led yesterday.

Paulson, who will address a housing conference on Dec. 3, presided over a one-hour gathering at the Treasury Department in Washington with federal regulators, bankers and lobbyists. Citigroup Inc., Wells Fargo & Co. and Washington Mutual Inc. executives attended, said a person present, who spoke on condition of anonymity.

The Bush administration cut its forecast for economic growth yesterday, reflecting a deepening housing recession that's roiled financial markets since August. The Commerce Department reported the same day that the median price of a new house fell 13 percent in October from a year earlier, while fewer homes were sold than economists anticipated.

“One of the roles of Treasury is to say ‘come on, let’s get together and see what we can do,’” said Wayne Abernathy, executive director of financial-institutions policy at the American Bankers Association in Washington and a former Treasury assistant secretary. “You’re likely to come up with something that will work both in the marketplace and honor the sanctity of the contracts involved.”

Stocks Advance

Stocks climbed today on speculation Paulson’s efforts may help slow credit losses. They also gained after Federal Reserve Chairman Ben S. Bernanke said “renewed turbulence” in financial markets may hurt growth, reinforcing investors’ expectations for an interest-rate cut next month. The Standard & Poor’s 500 stock index rose 0.8 percent to 1,481.14 at the close in New York.

Paulson was joined yesterday by Federal Deposit Insurance Corp. Chairman Sheila Bair, Comptroller of the Currency John Dugan and Office of Thrift Supervision Director John Reich.

Bair has proposed letting borrowers with adjustable-rate subprime mortgages, who are living in their homes and unable to afford resets, get extensions on the starter rate for at least five years. They could also be offered 30-year fixed-rate loans. Reich prefers a three-year freeze.

Also represented at the meeting was the American Securitization Forum, which lobbies for investors, traders, underwriters, accounting firms, ratings companies and other institutions involved in the creation and sale of mortgage- backed securities.

Persuade Investors

U.S. Senator Charles Schumer said the challenge will be to persuade those who buy the securities to back Paulson’s effort.

“This is the first time that the Bush administration is working toward a solution that meets the magnitude of the problem,” Schumer, a New York Democrat, said in a statement.

“But there is a $64,000 question: Will investors go along with this plan?” he said. “And if not, can they be compelled to?” …

Delinquency Rate

Delinquencies on subprime mortgages, which account for less than 15 percent of the $11.5 trillion U.S. home mortgage market, climbed after what Fed officials labeled “lax” lending standards spread the past two years. Homeowners were behind on 17 percent of adjustable-rate subprime loans in June, compared with 4.2 percent for prime mortgages of the same type, Mortgage Bankers Association data show.

Financial firms are marking down about $66 billion related to the mortgage market, and Morgan Stanley this week ousted Co- President Zoe Cruz after the firm disclosed $3.7 billion of losses on mortgage-related securities.

The rout will get worse because defaults on home loans are likely to rise, analysts said. The FDIC estimates that 1.54 million nonprime mortgages valued at $331 billion will reset by the end of next year.

‘Down Another Level’

Rising defaults “will take the housing market down another level,” said Mark Zandi, chief economist at Moody’s Economy.com, who will attend the conference featuring Paulson next week. “In the context of an economy that is not in recession, but pretty close, we will be in a recession right in the teeth of a presidential election.”

An index of credit-default swaps tied to subprime-mortgage bonds rose today in a sign the perceived risk of owning the securities improved. The gauge, compiled by Markit, climbed about 1 point to 78, GFI Group Inc. prices showed.

President George W. Bush’s economic advisers yesterday cut their forecast for 2008 economic growth to 2.7 percent from a 3.1 percent rate projected in June. The unemployment rate will rise to 4.9 percent, compared with 4.7 percent previously estimated, according to the Council of Economic Advisers’ semi- annual forecast…

Mortgage-industry lobbyists have argued that an across-the- board solution is difficult to apply. Rewriting contracts also risks moral hazard -- encouraging borrowers to take on more debt in the expectation of being bailed out if needed later.

“It is really an indiscriminate procedure that would violate the terms of the contract that provide for loan-by-loan decision making,” George Miller, executive director of the American Securitization Forum, said in an interview this month. A broad approach would “significantly disrupt the reasonable expectation of investors” in the $7.1 trillion market for bonds backed by mortgages.

Well, we wouldn’t want to “significantly disrupt the reasonable expectation of investors,” would we? All joking aside, this kind of dilemma is becoming increasingly common for policymakers in the U.S. Bail out homeowners and stiff investors? Or vice versa? Avoid recession and stiff foreign holders of dollar assets? Or let interest rates rise to keep foreign central banks holding dollars and plunge the U.S. into severe recession?

Impending Destruction of the US Economy

Paul Craig Roberts

11/28/07

Hubris and arrogance are too ensconced in Washington for policymakers to be aware of the economic policy trap in which they have placed the US economy. If the subprime mortgage meltdown is half as bad as predicted, low US interest rates will be required in order to contain the crisis. But if the dollar’s plight is half as bad as predicted, high US interest rates will be required if foreigners are to continue to hold dollars and to finance US budget and trade deficits.

Which will Washington sacrifice, the domestic financial system and over-extended homeowners or its ability to finance deficits?

The answer seems obvious. Everything will be sacrificed in order to protect Washington’s ability to borrow abroad. Without the ability to borrow abroad, Washington cannot conduct its wars of aggression, and Americans cannot continue to consume $800 billion dollars more each year than the economy produces.

A few years ago the euro was worth 85 cents. Today it is worth $1.48. This is an enormous decline in the exchange value of the US dollar. Foreigners who finance the US budget and trade deficits have experienced a huge drop in the value of their dollar holdings. The interest rate on US Treasury bonds does not come close to compensating foreigners for the decline in the value of the dollar against other traded currencies. Investment returns from real estate and equities do not offset the losses from the decline in the dollar’s value.

China holds over one trillion dollars, and Japan almost one trillion, in dollar-denominated assets. Other countries have lesser but still substantial amounts. As the US dollar is the reserve currency, the entire world’s investment portfolio is over-weighted in dollars.

No country wants to hold a depreciating asset, and no country wants to acquire more depreciating assets. In order to reassure itself, Wall Street claims that foreign countries are locked into accumulating dollars in order to protect the value of their existing dollar holdings. But this is utter nonsense. The US dollar has lost 60% of its value during the current administration. Obviously, countries are not locked into accumulating dollars.

The reason the dollar has not completely collapsed is that there is no clear alternative as reserve currency. The euro is a currency without a country. It is the monetary unit of the European Union, but the countries of Europe have not surrendered their sovereignty to the EU. Moreover, the UK, a member of the EU, retains the British pound. The fact that a currency as politically exposed as the euro can rise in value so rapidly against the US dollar is powerful evidence of the weakness of the US dollar.

Japan and China have willingly accumulated dollars as the counterpart of their penetration and capture of US domestic markets. Japan and China have viewed the productive capacity and wealth created in their domestic economies by the success of their exports as compensation for the decline in the value of their dollar holdings. However, both countries have seen the writing on the wall, ignored by Washington and American economists: By offshoring production for US markets, the US has no prospect of closing its trade deficit. The offshored production of US firms counts as imports when it returns to the US to be marketed. The more US production moves abroad, the less there is to export and the higher imports rise.

Japan and China, indeed, the entire world, realize that they cannot continue forever to give Americans real goods and services in exchange for depreciating paper dollars. China is endeavoring to turn its development inward and to rely on its potentially huge domestic market. Japan is pinning hopes on participating in Asia’s economic development.

The dollar’s decline has resulted from foreigners accumulating new dollars at a lower rate. They still accumulate dollars, but fewer. As new dollars are still being produced at high rates, their value has dropped.

If foreigners were to stop accumulating new dollars, the dollar’s value would plummet. If foreigners were to reduce their existing holdings of dollars, superpower America would instantly disappear.

Foreigners have continued to accumulate dollars in the expectation that sooner or later Washington would address its trade and budget deficits. However, now these deficits seem to have passed the point of no return.

The sharp decline in the dollar has not closed the trade deficit by increasing exports and decreasing imports. Offshoring prevents the possibility of exports reducing the trade deficit, and Americans are now dependent on imports (including offshored production) for which there are no longer any domestically produced alternatives. The US trade deficit will close when foreigners cease to finance it.

The budget deficit cannot be closed by taxation without driving up unemployment and poverty. American median family incomes have experienced no real increase during the 21st century. Moreover, if the huge bonuses paid to CEOs for offshoring their corporations’ production and to Wall Street for marketing subprime derivatives are removed from the income figures, Americans have experienced a decline in real income. Some studies, such as the Economic Mobility Project, find long-term declines in the real median incomes of some US population groups and a decline in upward mobility.

The situation may be even more dire. Recent work by Susan Houseman concludes that US statistical data systems, which were set in place prior to the development of offshoring, are counting some foreign production as part of US productivity and GDP growth, thus overstating the actual performance of the US economy.

The falling dollar has pushed oil to $100 a barrel, which in turn will drive up other prices. The falling dollar means that the imports and offshored production on which Americans are dependent will rise in price. This is not a formula to produce a rise in US real incomes.

In the 21st century, the US economy has been driven by consumers going deeper in debt. Consumption fueled by increases in indebtedness received its greatest boost from Fed chairman Alan Greenspan’s low interest rate policy. Greenspan covered up the adverse effects of offshoring on the US economy by engineering a housing boom. The boom created employment in construction and financial firms and pushed up home prices, thus creating equity for consumers to spend to keep consumer demand growing.

This source of US economic growth is exhausted and imploding. The full consequences of the housing bust remain to be realized. American consumers lack discretionary income and can pay higher taxes only by reducing their consumption. The service industries, which have provided the only source of new jobs in the 21st century, are already experiencing falling demand. A tax increase would cause widespread distress.

As John Maynard Keynes and his followers made clear, a tax increase on a recessionary economy is a recipe for falling tax revenues as well as economic hardship.

Superpower America is a ship of fools in denial of their plight. While offshoring kills American economic prospects, “free market economists” sing its praises. While war imposes enormous costs on a bankrupt country, neoconservatives call for more war, and Republicans and Democrats appropriate war funds which can only be obtained by borrowing abroad.

By focusing America on war in the Middle East, the purpose of which is to guarantee Israel’s territorial expansion, the executive and legislative branches, along with the media, have let slip the last opportunities the US had to put its financial house in order. We have arrived at the point where it is no longer bold to say that nothing now can be done. Unless the rest of the world decides to underwrite our economic rescue, the chips will fall where they may.

Dr. Roberts was Assistant Secretary of the US Treasury for Economic Policy in the Reagan administration. He is credited with curing stagflation and eliminating “Phillips curve” trade-offs between employment and inflation, an achievement now on the verge of being lost by the worst economic mismanagement in US history.

The crux of the problem is the U.S. military machine, which the U.S. can no longer afford. At this stage of imperial decline, not only is that military providing no benefit to the American people, it no longer even benefits the U.S. Empire. The way it’s being financed will doom the American Empire. As Roberts bravely pointed out, it is being used to benefit the fantasy of an Israeli Empire. According to Mike Whitney, the idea back at the beginning of the decade was that both empires could be served by illegally invading countries in the Middle East:

A Dollar the Size of a Postage Stamp
Even Larry Summers Predicts Doom

Mike Whitney

November 27, 2007

Lately it seems as though everyone wants to take a poke at the dollar. Last week, it was the Brazilian supermodel who demanded euros for her jaunts on the catwalk instead of USD. The week before that, hip-hop impresario, Jay-Z, released a video dissin’ the dollar and praising the euro as the ‘baddest Dude in the ‘hood’.

Lambasting the greenback has become trendy. It’s a favorite pastime of politicians, too. At the November OPEC meeting in Riyadh, Iran’s president Mahmoud Ahmadinejad asked the assembled finance ministers to "study the feasibility of selling oil in another currency." Ahmadinejad disparaged the dollar as "a worthless piece of paper".

The fiery Venezuelan President, Hugo Chavez, followed Ahmadinejad’s lead predicting that the demise of the dollar would mean the "end of the Empire."

Hugo may be on to something. The dollar is America’s Achilles heel; if the dollar tanks, so does the empire. That means the taxpayer will have to foot the bill for Bush’s bloody-interventions in Iraq and Afghanistan, rather than the Chinese. That also means that the US will have to export something of greater value than Daisy Cutters and gulags. That could be a tall-order, now that Bush has boarded up the factories, hollowed out the industrial base, and outsourced 3 million manufacturing jobs. We’ll have to scrape the rust off the machinery and get back into the widget-making business like we were before the Free Trade fiasco.

Central banks across the globe are trying to figure out how to ditch their dollar reserves without triggering a stampede for the exits. No one wants to see that. But, then, nobody wants to be stuck with vaults full of Uncle Sam’s green confetti either. So, the question arises; What is the best way to divest oneself of $5.6 trillion (total USD held overseas) before the Lusitania capsizes?

Kuwait, Venezuela, Iran, Russia, and Norway have already opted to ignore the destabilizing effects of "conversion" from dollars and are in some stage of divestiture. Others will follow. The UAE, Bahrain, Qatar, Oman and Saudi Arabia are considering switching from the dollar-peg to a basket of currencies so they can hedge against the inflation that’s battering their economies. It’s only a matter of time before the Petrodollar System---which links the dollar to petroleum sales and creates a de facto "international currency"---unravels completely, precipitating the final collapse of Breton Woods.

Talk of America’s impending currency disaster is no longer relegated to the Internet blathershere. Mainstream journalists have joined the chorus and are sending up their own red flags. The UK Telegraph’s economics’s editor, Liam Halligan, made this grim observation in his recent article, "Bet Your Bottom Dollar Tensions Will Follow":

"The importance of "dollar divestment" cannot be overstated. At the very least it means the greenback has much further to fall - plunging the US into recession. But it begs a bigger, more alarming, question. How will Washington react to the end of the US hegemony?"

The dollar was savaged by the monetary policies of the Federal Reserve. The Fed’s policies were designed to coincide with Bush’s Middle East Crusade. They were supposed to work like two wheels on the same axle. The administration believed that, by 2007, the military would need only 30,000 or so troops to maintain security in Iraq. That would give Bush’s legions the chance to turn east and push on to the next target-state, Iran. If things went according to plan -- and no one thought the high-tech US war machine could be stopped -- the US would control two-thirds of the world’s oil. This would allow America to keep writing bad checks on green paper for the next century.

But then, of course, the plan hit a snag. The Iraqi resistance mushroomed, the US got bogged down in an "unwinnable" war, and the once-mighty dollar shriveled into nothingness. Now we’re at a turning point and our leaders are in a state of denial. Bush is still playing Teddy Roosevelt, while Paulson and Bernanke are just plain shell-shocked. They probably know the game is over. As the dollar continues to wither; the frustration is beginning to mount in Europe. Liam Halligan sums it up like this:

"Europe has finally had enough of America’s "benign neglect" dollar policy. As a large economic area, with a floating exchange rate, the eurozone suffers most. Over the past seven years, the single currency has risen by a shocking 82 per cent against the greenback. That’s hammered eurozone exports - provoking serious trade disputes between the EU and US, the world’s two biggest trading blocks. No wonder French President Nicolas Sarkozy describes America’s drooping dollar as "a precursor to economic war". (UK Telegraph, "Bet Your Bottom Dollar tensions Will Follow")

Sarkozy is leading the charge for "intervention"; the buzzword for shoring the greenback through exchange controls and buying up billions of dollars. But it’s a risky business; especially when net capital inflows -- which are the monthly purchases of US-backed securities and Treasuries --have gone negative for the last two months. That means the US isn’t attracting enough foreign investment to finance its trade deficit. So the dollar will have to fall to compensate.

So, how much loot is Sarkozy willing to put up to keep the dollar from slumping further -- $100 billion, $500 billion, $1,000 billion? And where’s the bottom?

The fact is, the greenback took a "header" down the stairwell and by the time it picks itself up, it could be eye to eye with the peso. Who knows? Maybe its time we all learned Spanish?

More than two-thirds of all sovereign foreign exchange holdings are denominated in dollars. When those dollars are converted into back into foreign currencies and start recycling into the US; we’re in deep trouble. Inflation will soar. Surely, the Fed must have known this day would come when they were pumping trillions of dollars into subprime mortgages and complex debt-instruments which served no earthly purpose except to fatten the bottom line for rapacious bankers and hedge-fund managers. The Fed also knew that the nation’s wealth was not being "efficiently deployed" for capital improvements on factories, technology or industry. Oh, no. That would have ensured that America would remain competitive in the global marketplace into the new century. Instead, the money was shoveled into the bottomless sinkhole of stucco homes with composition roofing and toxic credit default swaps.

And, despite the rise in stocks and the dollar last week, the housing collapse is still gathering steam, with headlines like New-Home Prices Take Biggest Dive Since 1970:Median Cost Tumbles 13 Percent, and, Foreclosures Piling Up. According to Martin Hutchinson, U.S. markets are in the early stages of a death spiral:

The Bear’s Lair: Spirals of death

Martin Hutchinson

November 26, 2007

Close observers of the US housing finance disaster in recent months will have noted a curious phenomenon. Companies such as Countrywide that were in late August regarded as rock solid have recently passed clearly into the danger zone while those like Fannie Mae and Freddie Mac that were regarded as potential market saviors have come under a cloud. In Britain Northern Rock, whose September bailout was said to be modest, involving little risk to the taxpayer has now turned into an immense 25 billion pound ($51 billion) potential black hole – real money even in the US economy let alone in the much smaller British one. This illustrates a deeply troubling quality of the largest downturns: the tendency for the free market to turn into a death spiral, in which even sound well-run institutions are engulfed.

Death spirals are fairly rare in financial history. The Wall Street Crash of 1929 was perhaps the most virulent example. After the first downturn, the market recovered for several months. Then the collapse of the Bank of the United States in December 1930, together with the further economic damage from the Smoot-Hawley Tariff caused a further collapse in confidence and activity that was concentrated in the banking sector, as relatively solid institutions followed the Bank of the United States into bankruptcy. The Federal Reserve failed to correct for the money supply contraction caused by the bank bankruptcies, leading the US economy further into the pit. The additional shove given by President Herbert Hoover’s 1932 tax increase was almost unnecessary; only the confidence brought by a new president (albeit with equally counterproductive economic policies) brought recovery from 1933. By the time the spiral was over, more than one fourth of the banks in the United States had gone bankrupt and the stock market had bottomed out at one tenth of its peak.

A second death spiral, with somewhat less dire economic consequences, occurred in Britain in 1973-74. Edward Heath’s government had removed the quantitative controls on bank lending in 1971, which resulted in an orgy of high risk lending against real estate, very similar to the recent episode in the US except that most of the loans were made against commercial real estate rather than housing. When the first major real estate lender, London and County Bank, collapsed in November 1973 another more conservative house, First National Finance (FNFC), was used as the epicenter of the “lifeboat” rescue organized by the Bank of England. However, the decline in confidence and real estate values quickly sucked FNFC into the maelstrom.

The lifeboat rescue fund grew larger and larger for more than a year as the stock market declined to record low levels, 70% below its 1972 high. Homebuilders such as Northern Developments, in no way involved in the original crash but dependent on bank lending, were dragged down. So were the two most important entrepreneurial finance houses, both internationally diversified and neither significantly involved in commercial real estate lending – Jessel Securities, founded by Oliver Jessel and Slater Walker, founded by Jim Slater.

Neither Jessel nor Slater had been aggressively run – indeed Jim Slater had begun de-leveraging a year before the crash, as he saw trouble coming – and no wrongdoing was proved against the head of either organization, yet by the end of 1975 both very substantial companies had gone bankrupt and neither founder played a significant further role in the British financial sector. This was a great pity: in losing Jessel and Slater Britain had lost not only their very able founders but the most aggressive entrepreneurial teams in the City of London, who might have been best able to compete against the foreign invasion when Britain deregulated the financial services sector in 1986.

The British experience of 1973-74 seems more like the current position in the United States. National policy is currently reasonably neutral, so far avoiding the twin dangers of protectionism and tax increases which caused the medium sized downturn of 1929-30 to turn into the Great Depression. The problem is concentrated in the property sector. However there are already worrying signs that the magic alchemy of modern finance, though such mechanisms as securitization vehicles whose funding falls apart and complex derivative securities that prove to be unsalable in a crisis, is causing the problem to metastasize. In the consumer sector, GMAC has reported problems with its automobile loan portfolio, while it appears that credit card debt quality is rapidly deteriorating. In the corporate loan sector, loans to aggressive leveraged buyouts have got in trouble, and loans to hedge funds and private equity funds have been sharply cut back. (The latter effect can be seen in the movement of the yen/dollar exchange rate from 120 to 108, as the hedge funds’ ”carry trade” positions have been de-leveraged.)

The “death spiral” characteristics of the current market are pretty clear. If Fed Chairman Ben Bernanke’s original estimate of subprime loan losses of $50-100 billion had been anywhere close to accurate, there would have been no problem. The market deals with difficulties of that size all the time, without significant effect on surrounding sectors. A few fringe operators go bankrupt, a few large houses show unexpected losses, and the overall market continues without a tremor. The collapse of the Amaranth hedge fund in September 2006 or that of Refco a year earlier were substantial events, causing losses to a number of those institutions’ business partners, but there was no question of any general market disturbance.

When the subprime problem first emerged in February, it appeared that it would also be limited. A number of subprime lenders, relatively insignificant institutions, were forced to shut down. However the general market appeared unaffected; its view appeared to be that the problem was localized and should have no effect on the real economy, nor even any great effect on the broader housing finance market.

August’s widening in Libor spreads, at which banks lend money to each other, should have told us that this problem would be different, and altogether more important. If leading banks were unable to assess each other’s credit quality for short term transactions then something much more serious was wrong than the collapse of a modest fringe sector of the housing finance market. The Fed’s chosen solution, dropping interest rates and pumping more money into the system, did not address the real problem and was thus useless, as it has since proved. It has only postponed the denouement for a few months and stored up further trouble with inflation.

Two factors are at play here. The first is sheer size. If as now appears likely the eventual losses in the home mortgage market do not total only $100 billion, but a figure much closer to $1 trillion, then the subprime debacle becomes something much more than a localized meltdown. $1 trillion of losses is 7% of US Gross Domestic Product. The market cannot absorb losses of that size without some major institutional bankruptcies or a lengthy recession. The closest equivalent problem is the savings and loan collapse of 1989-92; that caused a major housing downturn but only a minor recession. However its cost (mostly borne by the US taxpayer) of $176 billion was about 3% of 1990 US GDP, only half the size of the likely current losses on mortgage loans.

The second is lack of transparency, and the blow to confidence that comes from the dawning suspicion that a large portion of the derivatives and securitization mechanisms designed in the last quarter century are faulty. The unluckily timed implementation for years beginning after November 15 of FAS Rule 157, requiring banks to divide their assets into three levels according to their degree of marketability, has thrown an unwelcome spotlight on the problem. If Level 3 assets can be valued only by reference to an internal valuation model, and have been allowed to accrue value in banks’ financial statements for a decade or more (enabling hefty bonuses to their progenitors) then how do we know they are really worth anything close to what the model says, and how do we go about realizing them, in a market where confidence has vanished?

To ask those questions is to answer them. Since every incentive led bank mathematicians to devise models that maximized the reported value of the bank’s holdings, and since little or no market existed by which those values could be checked, it is likely that today those assets’ book values are highly overstated. Moreover, even in banks where the mathematicians and their bosses were scrupulously, even impossibly disinterested and intelligent, there still remains the problem that those assets are worth far less in a downturn, because their illiquidity makes them intrinsically unattractive in a market where liquidity has become once more important. Anyone who has attempted to sell venture capital positions in a bear market can attest to how rapidly and completely the value of such assets can disappear. It is thus perfectly possible that the true realizable value of “Level 3” holdings in a bear market is no more than 10% of their book value.

This immediately demonstrates the problem. Goldman Sachs, generally regarded as insulated from the subprime mortgage problem, has $72 billion of Level 3 assets; its capital is only $36 billion. If anything like 90% of the Level 3 assets’ value has to be written off, Goldman Sachs is insolvent. They do not have the option of acting like Nomura Securities did recently, selling everything possible and writing the remainder down to zero, because they would be without capital. Instead they are likely to be dragged kicking and screaming, quarter by quarter, to a gradual writedown and sale of their Level 3 assets, with their true position remaining undisclosed and obfuscated by meaninglessly optimistic statements by top management. Only the bonuses will survive, paid in cash and draining liquidity from the struggling company.

That’s what a death spiral looks like. The US survived the Great Depression, eventually, and Britain survived the 1973-74 debacle. However the market recovered only after it had plumbed depths previously thought impossible, at which even the soundest investments were trading far below their true value. After normality returned, the financial services landscape was very different, with many large and apparently solid houses having disappeared, a generation of participants reduced to driving taxis or selling apples and a generation of investors scarred by their losses and unwilling to return to the market. Emergency infusions of money, from the Fed or the taxpayers, generally do no good, only postponing the denouement and delaying the arrival of truly bargain price levels.

Such spirals of death represent the final definitive triumph of the Bears.

Hutchinson’s descriptions of valuation shenanigans by large investment banks is probably too generous to the banks. Hutchinson believes in “free market” neoliberal principals. Commentators on the left are better able to see the criminality involved:

Credit crisis reveals widespread accounting manipulation by top US banks

Joe Kay

27 November 2007

The developing credit crisis in the United States, linked to the bursting of the housing market bubble, is beginning to reveal the accounting manipulations employed by major US banks to engage in speculative activities and hide risks. Several major banks have already announced billions of dollars in losses associated with subprime mortgages, and in the next months are expected to announce tens of billions of dollars in further write-downs.

Among those most severely affected is Citigroup—an American financial conglomerate that is the world’s largest company measured by asset value. CNBC reported on Monday that Citigroup is planning major cost-cutting in response to its difficulties, with layoffs of up to 45,000 of the company’s approximately 320,000 employees.


In a statement, the bank insisted that reports involving specific numbers of layoffs were “not factual,” but acknowledged that the company is “planning ways in which we can be more efficient and cost effective to position our businesses in line with economic realities.” New cuts would come on top of 17,000 layoffs announced in April.

The announcement, coming amidst Wall Street nervousness over the ongoing credit crisis, sent Citigroup’s stock down more than 6 percent. Over the past six months, the price of the company’s stock has fallen nearly 50 percent. Citi led a steep market decline on Monday, with the Dow Jones Industrial Average falling nearly 240 points, more than wiping out its increase on Friday.

Chief among the “economic realities” behind Citigroup’s announcement is the credit crisis brought on by record defaults on home mortgages in the United States. Citigroup has already announced a $5 billion write-down related to home mortgages, which provoked the resignation of its CEO Charles Prince. It is expected to announce further losses of up to $11 billion in the fourth quarter.

The bank’s exposure could be much greater, however, as it may be forced to acknowledge losses that it had previously kept off its books. An article by Wall Street Journal reporter David Reilly on Monday (“Citi’s $41 Billion Issue: Should it put CDOs On the Balance Sheet?”) noted that the bank faces an “immediate threat” from troubles involving off-balance-sheet entities called collateralized debt obligations (CDOs)

The Journal notes that Citigroup “was one of the biggest arrangers of CDOs—products that pools debt, often mortgage securities, and then sell slices with varying degrees of risk.” The bank may be forced to bring these CDOs onto its balance sheet. “If Citigroup had to include an additional $41 billion in CDO assets on its books,” the Journal noted, “that could potentially spur a further $8 billion in write-downs, above and beyond those already signaled, according to a report earlier this month by Howard Mason, an analyst at Sanford C. Bernstein.”

Throughout the housing boom of the past several years, the CDOs, and related entities known as structured investment vehicles (SIVs), made substantial returns. SIVs are also off-balance-sheet entities, but are more open-ended, investing in other risky securities, including CDOs. Even those entities closely associated with banks have been nominally independent. The “independence” of these entities has been entirely fraudulent, however. They have been critical for the banks’ bottom line as sources of lucrative fees, buying up mortgages and other assets from their parent banks.

As the CDOs and SIVs have faltered with the collapse of the housing bubble, the banks have looked for ways to bail them out. The Journal notes, “Over the summer, [Citigroup] was forced to buy $25 billion in commercial paper issued by its CDO vehicles because investors were no longer interested in the paper. Citigroup already had an $18 billion exposure to these vehicles through other funding it had provided.”

The determination with which Citigroup and other banks have scrambled to bail out these investment entities is itself testament to the fact that they were never really independent to begin with.

Commenting on the way that major banks were able to shift their risks off their balance sheets, New York Times economic writer Floyd Norris noted in an article published November 16 (“As Bank Profits Grew, Warning Signs Went Unheeded,”), “Instead of being suspicious, many analysts believed that banks had found a new way to prosper. Making a loan and keeping it on the balance sheet until it was repaid was so old-fashioned. It was far better to collect fees for arranging transactions and passing on the risks to others.”

In fact, many of these risks were not really transferred. Norris notes that the banks often made arrangements (called “liquidity puts”) with the purchasers of their CDO securities that would allow the purchasers to sell the CDO securities back to the bank if there was no other market. “That risk may have seemed slight when the securitization market was booming. But now the banks are being forced to buy back securities for more than they are worth.”

In essence, the puts allowed the banks to sell CDOs and other assets without really selling them. Use of the puts actually increased as the housing market began to unravel, as it was necessary to provide the guarantees in order for the banks to get investors to buy mortgage-backed securities whose value was increasingly in question.

The legality of these operations is highly dubious, since part of the intention appears to have been to mislead investors regarding the financial health of the company. Even if the operations by banks were legal, the fact that they were not reported to investors was likely a violation of accounting rules.

According to Norris, Citigroup and Bank of America were among those banks that used “liquidity puts” heavily.

All of these arrangements amount to attempts by banks to gamble on risky investments without acknowledging the risks they were taking on. As the market for these investments has begun to collapse, the real extent of the losses is only beginning to reveal itself—and no one knows how severe the crisis really is.

Most banks were involved in such activities. Earlier this month, the Securities and Exchange Commission opened an investigation into investment bank Merrill Lynch that, according to the Wall Street Journal, is intended to examine how the bank “has been valuing, or ‘marking,’ its mortgage securities and how it has disclosed its positions to investors.”

In a November 2 article, the Journal reported that Merrill arranged one deal with a hedge fund to sell $1 billion in commercial paper related to mortgages, while giving the hedge fund the right to sell it back after one year at a set price. The newspaper later corrected its article to note that this deal, similar in many ways to the arrangements at Citigroup, was rejected because the bank determined that it was a violation of accounting rules.

Nevertheless, Merrill is highly exposed to the housing markets. Earlier reports suggested that Merrill hid its own exposure to the subprime mortgage crisis by shifting its assets to different parts of the company subject to less strict accounting regulations. (See “Wall Street hides impact of subprime mortgage meltdown”)

As late as July 2007 executives at the bank, including former CEO Stan O’Neal, were assuring employees that its mortgage risks were under control. At the end of October, Merrill announced a $7.9 billion write-down, which was followed by O’Neal’s departure.

The crisis facing banks is an international phenomenon. The stock market sell off on Monday was provoked in part by an announcement from British-based HSBC—Europe’s largest bank and the world’s fourth largest corporation in terms of assets—that it would bail out two of its SIVs and transfer their assets onto its balance sheet.

Since the credit crisis began in full force this summer, banks have scrambled to stave off a reckoning with the enormity of the losses involved. The hope has been that the economic crisis will be short-lived and that the housing market will eventually recover, restoring the value of the assets in question.

It is unlikely that this will happen, however, and there is an increasing likelihood of a recession. In an article published in the Financial Times on Sunday (“Wake up to the dangers of a deepening crisis”), Lawrence Summers, former Treasury Secretary in the Clinton Administration, warned, “[T]he odds now favor a US recession that slows growth significantly on a global basis.” Summers noted, “Forward-looking indicators suggest that the housing sector may be in free-fall from what felt like the basement levels of a few months ago.”

The initial revelations of accounting manipulations and indications of fraudulent activities are only a small indication of the extent to which the American economy is pervaded by financial speculation and out-and-out criminality.

It was the collapse of the dot-com boom in 2001 that ultimately unwound the elaborate structure of corruption at companies such as Enron, WorldCom, and Tyco. These companies were no longer able to perpetuate their fraudulent activities once the stock market ceased its continual upward march.

The major banks were heavily involved in the activities exposed at that time. In 2003, Citigroup and JP Morgan Chase were forced to pay out fines for aiding Enron in disguising loans as cash to reduce reported risk and liabilities, thereby defrauding investors. Essentially, the banks gave Enron loans, but cloaked these loans in an apparent purchase of assets. This manipulation improved Enron’s financial reports, which was beneficial for banks that were heavily invested in Enron stock. (See “Citigroup, Morgan Chase fined for Enron deals: corruption at the heights of American finance”)

The operations involving CDOs and SIVs bear a certain resemblance in that they too were evidently intended to disguise risk. Much of the risk was ultimately held by the bank itself, but this was not readily apparent to investors.

Though the banks were involved in the manipulations at Enron and other companies, the fraud was generally explained by the media and the political establishment as the product of a few “bad apples.” Several executives were put on trial and imprisoned, but the underlying conditions remained and the banks remained largely untouched. The dot-com bubble was quickly replaced by the housing bubble, which had the effect of extending the speculative mania of Wall Street to a much broader section of the economy.

The pervasiveness of accounting manipulation is closely linked to the increasingly dominant role that speculation has come to play in the American economy. Vast sums of wealth—including tens and hundreds of millions of dollars to top executives and hedge fund managers—have been made through mechanisms that are largely divorced from any relationship to actual production. The importance of these forms of speculative wealth accumulation has increased as the underlying health of the American economy has decreased.

The housing market has been a case in point, as a small layer of the population has made billions through high-risk loans to working class Americans who are now bearing the burden of a crushing level of debt. The loans have been used to transfer wealth into the hands of the ruling elite, and at the same time became a means of speculation.

Entities such as CDOs and SIVs were set up as a means for Wall Street to extract enormous profits, while at the same time cloaking the extremely fragile foundation for this supposed economic growth. As the housing market deflates, this whole structure is beginning to unravel.

Joe Kay and Paul Craig Roberts point out something important that is often overlooked. The U.S. economy has been producing less and less and the financial shenanigans are designed to conceal that fact while extracting wealth from the decline. The major area of creativity has been financial creativity which easily becomes financial criminality. Ran Prieur sees the good news in this. There is a lot of creativity waiting to be unleashed:

November 25. In the same way that we can get sexually frustrated, I think industrial civilization is full of people who are technically frustrated. The other day I made a few offhand comments about hauling shipping containers and cutting up girders and finding uses for abandoned steel-framed towers, and I got a small flood of technical advice about biodiesel trucks and DIY oxy-acetylene and pulley systems to raise dirt up buildings. I have no doubt that I could assemble a team of 100 people, from readers of this site, with the knowledge and inventiveness to turn the Sears Tower into a greenhouse with mobile ballistas to fight off invaders, constructed from rails left over from converting railroads into bike paths... or more likely you could all think of even better uses for old railroads and buildings. And yet here we are sitting at computers we didn't make, on chairs and in buildings we didn't make, doing jobs nobody likes to buy food we didn't grow. This is actually good news! As the dominant system breaks down, all this creative energy will be breaking out all over, and it will get harder for the jealous haters of life to crush it.