Welcome to European Tribune. It's gone a bit quiet around here these days, but it's still going.

Mea Culpa: The Fed May In Fact be in a Financial Mess

by BruceMcF Thu Sep 25th, 2008 at 03:40:58 AM EST

xposted from Docudharma

In a comment [NB. in Docudharma] last week, I said,

Treasury Securities are the only assets that can ...
... be held be the people that issue the actual fiat money. So, while the US dollar could lose standing abroad and with it would go the top ranking of US Treasuries overseas, it is institutionally entrenched as the AAA ranked US dollar denominated financial asset.

And while I still believe that the gist of the argument being made is sound ... Treasury Securities are the last financial asset standing if you need financial assets denominated in US dollars, and that is intimately tied up with the way that the Fed works ...

... in the current context, the statement itself is deeply flawed ... inaccurate in a way that is probably very misleading about the "crisis" part of the current crisis.

In ordinary times, it would be a footnote. The Fed can also hold as assets loan contracts with commercial banks, and other such loan contracts as the legislature may from time to time permit.

Well, how did they keep the current crisis from blowing up? After all, it was late last year that the housing market bubble burst ... how did they string it out until September of this year?

How they strung it out was by lending to get financial institutions out of their short term liquidity bind. And as institutions ran out of Treasury Security and "high quality" mortgages to borrow against, the Fed relaxed its standards to allow borrowing against lower quality assets.

Except, the way that the Fed does short term loans with collateral is the same way that the private finance sector does ... it enters into a contract to "buy" a security at a set price, and the borrower agrees to "buy it back" at the end of the loan period for a set price. The up-front purchase price is the loan amount, and the difference between the two prices is the interest payment for the loan.

Promoted with a slight edit by afew


Now, if you are make a temporary bridging loan to a business backed by collateral, and you have to loan more than the collateral is worth, that really indicates that the business is in something more than a liquidity squeeze.

As explained by an anonymous banker friend of Jerome a Paris, that is the current crisis and the current proposal by the Bush administration, in a nutshell.

Unpacking the nutshell

The problem is that providing liquidity only fixes a problem of lack of liquidity. That is, there are sound assets sufficient to meet obligations, but because of a mismatch between cash flows, the income from those assets is not available in time to make all payments due.

That is a liquidity crisis. Folding because of an inability to meet current obligations, despite having more than enough assets to cover liabilities. In brief:


  • Total assets > total liabilities

  • Liquid assets < current obligations

That aint the problem. The problem is that these financial institutions in massively undervaluing systemic risk for more than a decade now have reaped and distributed as profits what should have been accumulated as capital reserves to cover the risk of a systemic crisis killing the value of a majority of their supposed assets.

Let me repeat that:

  • The problem is that these financial institutions in massively undervaluing systemic risk for more than a decade now
  • have reaped and distributed as profits
  • what should have been accumulated as capital reserves to cover the risk of a systemic crisis killing the value of a majority of their supposed assets.

And the symptom is right there in the main section ... as soon as the Fed started accepting low quality assets as the instrument for making short term loans, we were already in a solvency crisis (Is it Liquidity or is it Solvency?). "We" just pretended that "we" weren't.

  • (Note that the first 'we' is us, the national population collectively as a participants in an economic system, while the second and third "we" is the powers that be, the establishment, the corporate press ... everyone who should have had an eye on the till but were too busy watching the financial fireworks.)

And now the Fed has all these worthless assets it is carrying as the formal collateral for these short term loans, and if the loans are not repaid because the pirates collapse, that formal collateral is worthless.


Next Best Thing to the Fed Going Bankrupt

Now, the Fed cannot be forced into bankruptcy. In extreme cases, the Treasury issues Treasury securities, and then, rather than allowing them to be held by private owners, the Fed holds the Securities instead, crediting Federal Reserve account balances. The income from the Treasuries goes into shoring up the balance sheet instead of returning back to the Treasury as normal, and the Fed recovers its solvency.

If your obligations passed as core, high powered money, you could use them to buy Treasury Bonds and then use the income from the Treasury Bonds to repair whatever holes you had blown in your balance sheet. But you are not in that position, unless you happen to be a Reserve Bank in a reserve banking system.

However, that means issuing money to buy those securities, which is a massive injection of money into circulation, and the side effect of that is a big burst of inflation. That actually rescues debtors from their obligations ... but it will be the death knell of the US dollar as the international reserve currency, as reserve banks all over the world will flee to the Euro, and that is the end of being able to afford the massive overseas base network and reckless foreign military adventures.

  • (That last might take time to play out, but tenacity in holding onto the base network once it becomes untenable would accelerate the collapse of the US$, and when it comes down to a crunch between buying oil and maintaining the overseas base network, recent politics suggests that the immediate need to fund payments for oil imports will win.)

For reference, consider the Weimer Republic, Brazil in the late 70's and early 80's, Argentina at the beginning of this decade, Zimbabwe at the moment. A monetary authority can lose the power to issue currency that anyone overseas cares to hold, but it cannot go bankrupt based on obligations in the currency that the reserve bank itself issues.

So there goes the American "Base Network Empire" up in flames, along with the Bush/McCain foreign policy of acting like a drunken bull in a china shop.

And of course, as part of the process wages are certain to fall behind prices, so a lot of the pain will be felt by everybody on a wage contract, as we have a bout of stagflation that makes the Oil Price Shocks feel mild by comparison.

So instead of that, the Bush administration plan is to issue Treasury securities, buy the toxic waste assets from institutions, they stay afloat long enough to repay the Fed with cash, the Fed can back out of holding the toxic waste as collateral, the Fed's balance sheet is fixed, and the public is left holding the bag for a pile of toxic waste that is funded by somewhere around 5% of GDP added to the national debt in one lump sum.

Maybe the financial sector companies still go under, at least those that are not buddy-buddy with the Bush administration, but a lot stay afloat, the Bush administration folks get cushy jobs in the firms they bailed out, and for the underlying problem, its a game of kick the can down the road to the next administration to fix.


What Can Be Done

Now that we know that the bail-out is $600b for the Fed and $100b for Bush's cronies on Wall Street, we need to find a way to keep the finance sector running while penalizing the financial pirates and sheltering ordinary Americans from experiencing the pain of a bout of hyperinflation.

If that's the target, its straightforward enough.

Set up the Resolution Trust, but make it a Public Trust. For every dollar in toxic debt sold by a financial institution, it has to also sell $1 in a first class preferred share.

Unless the dividends of the first class preferred shares are paid in full:


  • termination packages of executives are limited to two weeks of salary

  • no stock options can be included in executive compensation that mature in less than five years

  • no other preferred or common dividends may be declared

  • no new acquisitions of shares in financial institutions or mergers with financial institutions may be made without approval of the Public Trust

IOW, first claim on any profits made as a result of the bail-out goes to the Public Trust. And here is the critical part: the bigger the bail out, the bigger the share of profits that go from that institution to the Public Trust. That's why its dollar for dollar ... the worse they cheat the public on the toxic debt, the longer it will be before they escape the restrictions on firms not meeting their preferred dividends in full, and the more they mortgage their future income to the public to clean up the mess.

Now, sooner or later those profits will be forthcoming, and sooner or later the toxic assets will be liquidated, and given the first class preferred shares, sooner or later the Public Trust will repay the Treasury Securities.

And then it will be generating an income.

Issue that income as a Social Dividend, per month, to each US citizen. Full stop, whatever it is, just hand it out.

When is the Public Trust wound up? Never. The Social Dividend is Permanent.

As a permanent reminder to the would-be pirates in the finance sector that they mortgage another part of their income flow permanently if they do it again.

And also, as a permanent guarantee that those firms that have done in the past have their hands tied behind their back if they get into a position where they cannot meet their Public Trust preferred stock dividend.


Paulson wouldn't like it ...

Paulson wouldn't like it ... but would he like to admit that he and Bernanke screwed the pooch on the Federal Reserve balance sheet in a futile effort to kick the can on the capitalization crisis down the road until the next administration? The question is, what price will Paulson pay to have the possibility of avoiding a Mea Culpa, mea culpa, mea maxima culpa?

Because as far as being Treasury Secretary, collaborating in screwing up the balance sheet of the Fed is pretty far down the road of "how bad can you screw up?"


Display:
... I may even post this to dKos around 6pm.


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.
by BruceMcF (agila61 at netscape dot net) on Wed Sep 24th, 2008 at 10:04:25 AM EST
... extended to include idea of using this as a system that even Paulson and Bernanke can't screw up, because the incentive to keep bail-out requests down to what is necessary is built in, with a suggested $150b and then fix the full bail-out between Congress and the President Elect in mid-November.

A System that even a Bush Administration cannot Screw Up. (... too badly)

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Wed Sep 24th, 2008 at 06:19:06 PM EST
[ Parent ]
I obviously agree with your analysis.  I would add one item to your solution:

Enact what Sen. Chris Dodd referred to as "clawbacks." I.e. require disgorgement of everything these bastards have accumulated up to the total extent of the damage they have caused, including their real estate, cars, boats, stocks, bonds, safety deposit box contents--everything!  For those who have expatriated their profits or themselves, make arrangements with foreign countries for them to expropriate those assets, using that portion they recover as required to cover losses to their citizens and returning the remainder to the USA.  Do the same for them.

As a final sop, qualify them for SSI as being emotionally disabled and allow them to receive food stamps.  Call it tough love.  It would give them the basis in personal experience to develop compassion for those less fortunate than they are.  There would still be many of those.

"It is not necessary to have hope in order to persevere."

by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Sep 24th, 2008 at 12:51:50 PM EST
Well, yeah, but I wouldn't want that to depend on whether or not the firm generates a profit. And indeed, there's no need for that to be in the temporary measure before the election ... I have seen back of the envelope figures of around $150b, and that sounds reasonable if the full bailout is supposed to be $700b.

That can indeed be the first thing brought to Congress to start pounding away at the vestiges of the Republican Senate Fillibuster ... make them vote against making the executives who created the mess personally liable, or else turn class traitor in defense of their own necks, especially the large Republican class up for re-election in 2010.

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Wed Sep 24th, 2008 at 12:58:33 PM EST
[ Parent ]
In this climate such a bill could pass unanimously.  The problem would be in the details.  This will remain the case unless and until they reform campaign finance.  A start could be to revoke the right of corporations and individuals to make campaign contributions for, say, 10 years after receiving a government bail out.  Then Congress would have to enact public financing just to cover the hole in their campaign budgets. (I read hints that loss of contributions from bankrupt firms was one of the dire consequences with which congress was presented on Thursday night by Paulson and Bernanke.)

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Sep 24th, 2008 at 03:24:24 PM EST
[ Parent ]
I don't see how this impacts the US military threat. 50% of all US govt elective spend is on the military. So they increase that total a lot more, I don't see anything stopping them cos the US is so completely militarised. I don't believe any american can imagine the US as anything other than an overwhelming military power because they have enemies everywhere and must be prepared and maintain vigilance or they'll fight them here instead of over there. Anything and everything will be sacrificed to maintain it (except the wealth of the top 1%).

So the bases will stay, the fleets will be maintained, because anything else is unthinkable.

keep to the Fen Causeway

by Helen (lareinagal at yahoo dot co dot uk) on Wed Sep 24th, 2008 at 01:06:42 PM EST
... Empire will collapse, I wrote it threatens the American Base Empire.

What often happens with Imperial Overstretch is that lots of essential stuff are sacrificed in the medium term to preserve the Empire, but in the longer term it is for naught, because that sacrifice includes the economic basis for actually being able to maintain the base empire.

If the US$ collapses, there goes the overseas base network. It may require throwing a lot of essential government spending overboard first, and could take a decade with cycles of dollar dives before it becomes completely untenable, but its a system that is a drain on the external accounts, and a country cannot simply will the rest of the world into wanting to acquire financial assets denominated in its currency.


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Wed Sep 24th, 2008 at 01:24:38 PM EST
[ Parent ]
If US creditors are savvy they will say to the military industrial complex - or rather,to their banks - that they are quite happy to provide funding beyond the dreams of avarice to "re-skill" in more constructive technologies......

....but funding allowing continued weaponry etc development is no longer available....

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Wed Sep 24th, 2008 at 01:35:50 PM EST
[ Parent ]
US creditors that are creditors due to standing at the Military Industrial Complex trough filling their bellies?

Those creditors are less than likely to make that argument. That's why there is a serious risk of the US pursuing the maintenance of the Base Network Empire well after it becomes clear to all and sundry that it is not sustainable over the longer term.


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Wed Sep 24th, 2008 at 01:40:27 PM EST
[ Parent ]
When I say US creditors I mean everyone to whom US Inc owes money.....

Maybe led by China, of course, but they would never dream of acting alone.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Wed Sep 24th, 2008 at 01:52:28 PM EST
[ Parent ]
That gets back to the window of opportunity that I referred to previously ... as long as China is rushing headlong through this stage of its demographic transition, its focus will remain fairly short term.

Once the bulge created by the pro-population-explosion policies of Mao begins to pass out of child bearing age, the need to grow employment at this massive pace will begin to ebb with it. And unless the US gets its economic house in order, there's a good chance that that will be the end of the Chinese propping up the US$.

Now, under much of the conventional wisdom, the economic threat to the US of the Base Network Empire does not appear to be a short-term problem, though it clearly undermines the strength of the US Economy long term.

Now, certainly, if the US$ appears to be not worth holding in the short term, then obviously the Chinese will abandon it. But if the US government has bungled economic management that badly, it would also be a poor risk in terms of making a "we'll keep financing you if you deliberately adopt a peace-time economy" deal. The pragmatic focus would be on Europe and Japan among high income nations, probably also including Australasia for its resources.


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Wed Sep 24th, 2008 at 02:14:43 PM EST
[ Parent ]
Interesting perspective re demographics, Bruce.

But China would have a big incentive to invest in a US "Green New Deal" or maybe a redeployment from a War on Terror to a War on Climate Change:

(a) substitution - because every barrel the US saves and does not consume is one more available to China;

(b) technology transfer - any breakthrough technologies or advances would be simpler and cheaper for them to get at if they invested heavily in them, or even owned them.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Wed Sep 24th, 2008 at 03:00:47 PM EST
[ Parent ]
... start spirally down the toilet. If it does, we'll be going through demand destruction because of the collapsing dollar, and Europe, Japan and Australasia are better bets for technology transfer.


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.
by BruceMcF (agila61 at netscape dot net) on Wed Sep 24th, 2008 at 04:04:03 PM EST
[ Parent ]
I doubt that economic necessity will ever suffice to dial down fantasies of Imperial Domination.  That will require political leadership and re-education of the US population as to what their defense dollars really have been buying.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Sep 24th, 2008 at 03:29:04 PM EST
[ Parent ]
... people overseas to want to hold US dollars.

A polity rebelling against the fact that it cannot afford the external account spending that it wishes to engage in gets to see its exchange rates plunge as long as it keeps up the fight.

And a country that has its exchange rates plunge rapidly enough is heading for hyperinflation, if it is structurally dependent on imports, as the US has become over the last three decades.

When people are faced with the hard choice between handing over hard currency (by hypothesis, not US$) to get oil, or to fund an overseas base network, I'm expecting the Military Industrial Complex to go up against the Highway Suburban Complex and come out second.


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Wed Sep 24th, 2008 at 04:09:00 PM EST
[ Parent ]
As the external account deficit is the problem, that creates a national security argument for switching transportation energy over to renewables.  Add that to an  easily salable "neo-mercantilist" popular argument and you have even more ammunition for rebuilding the energy and transportation sectors around renewables.  It is not like we don't have any oil.  But we may have trouble financing reconstruction of energy and transportation while simultaneously playing global hegemon.  Perhaps we can engineer a "twofer" here.  End of Empire and Dawn of Self Sufficiency on Energy.

Without a vibrant economy that can generate money and goods we cannot long maintain effective military power.  Played intelligently, we can maintain enough power to matter.  Played stupidly we could become irrelevant. That should be the outline of the national security discussion.

"It is not necessary to have hope in order to persevere."

by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Sep 24th, 2008 at 08:36:40 PM EST
[ Parent ]
... process ... pursuit of Energy Independence leading the rise of a hot growth industry without a stake in the Military-Industrial-Complex and acting a core part of the opposing coalition that is necessary to wind back from Imperial Overstretch.

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.
by BruceMcF (agila61 at netscape dot net) on Wed Sep 24th, 2008 at 09:13:57 PM EST
[ Parent ]
China doesn't want USD. The government already has quite enough junk T-bills.

South China Morning Post
China banks told to halt lending to US banks
by Alan Wheatley and Langi Chiang
Sep 24, 2008 9:52pm EDT

BEIJING, Sept 25 (Reuters) - Chinese regulators have told domestic banks to stop interbank lending to U.S. financial institutions to prevent possible losses during the financial crisis, the South China Morning Post reported on Thursday.

The Hong Kong newspaper cited unidentified industry sources as saying the instruction from the China Banking Regulatory Commission (CBRC) applied to interbank lending of all currencies to U.S. banks but not to banks from other countries.

"The decree appears to be Beijing's first attempt to erect defences against the deepening U.S. financial meltdown after the mainland's major lenders reported billions of U.S. dollars in exposure to the credit crisis," the SCMP said.

A spokesman for the CBRC had no immediate comment.

The only resolution to this political quandry is of course to seize all assets of Chineses nationals and banks held by US bank branches. That'll show 'em, the terrists.

Diversity is the key to economic and political evolution.

by Cat on Thu Sep 25th, 2008 at 06:12:31 AM EST
[ Parent ]
... "freezing assets" tool an awful lot it seems ... another reason why a lot of countries would be happier with the Euro as the international reserve currency. If their central banks have reserve accounts in Euros, they get to choose which Eurozone country to hold it in, and if one gets stroppy, they can move it to another.

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.
by BruceMcF (agila61 at netscape dot net) on Thu Sep 25th, 2008 at 06:58:16 AM EST
[ Parent ]
MT, any sense of what kind of tsunami would be unleashed should China decide to sell even 0.1% of its supply of US paper?  How about 1?

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Thu Sep 25th, 2008 at 10:02:07 AM EST
[ Parent ]
LOL. No. I'm more interested in how Congress can support the US labor force with greenbacks no matter their banana value.

Diversity is the key to economic and political evolution.
by Cat on Thu Sep 25th, 2008 at 11:46:35 AM EST
[ Parent ]
Ah sorry. Timescale is all and in this you are correct.

keep to the Fen Causeway
by Helen (lareinagal at yahoo dot co dot uk) on Wed Sep 24th, 2008 at 01:38:26 PM EST
[ Parent ]


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.
by BruceMcF (agila61 at netscape dot net) on Wed Sep 24th, 2008 at 01:48:14 PM EST
[ Parent ]
I wonder why not a direct nationalziation.. if this option was palatable a direct takeover and elimination of wall-Street to provide directly the liquidity and the solvency to the new ameican companies makes the same sense as the Dodd's program.

With a nationalization you can also cover any hole the fedeal reserve may have.

From a purely technical analysis I am not sure yet that dodd proposal is better than direct nationalziation (nor worse), so if it could be implemented (which can not), what is your take?

regarding the military network, I am with Helen here, I do not see the US rejecting it, even with the US$ dollar losing its status..the idea of a crazy presdent of the US with all those nukes can force other countries to bail out...so the military stays even if the US economy collapses.. unless there is a political decition..which I admit will be easier with a dollar meltdown.

A pleasure

I therefore claim to show, not how men think in myths, but how myths operate in men's minds without their being aware of the fact. Levi-Strauss, Claude

by kcurie on Thu Sep 25th, 2008 at 06:54:36 AM EST
... the national banking system even less than I trust the private sector under a system of regulations. It took from the 1930's to the 1990's to completely demolish the New Deal banking regulation reforms ... Nixon and Reagan and Bush I could have done the job much more quickly with a nationalized system of banks to privatize.


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.
by BruceMcF (agila61 at netscape dot net) on Thu Sep 25th, 2008 at 07:01:07 AM EST
[ Parent ]
I see,
Would you trust democrats selling them back in 8 years?
If Obama wins, of coruse.

A pleasure.

I therefore claim to show, not how men think in myths, but how myths operate in men's minds without their being aware of the fact. Levi-Strauss, Claude

by kcurie on Thu Sep 25th, 2008 at 07:03:11 AM EST
[ Parent ]
I don't understand the question.

Selling what back, to whom?


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Thu Sep 25th, 2008 at 06:12:20 PM EST
[ Parent ]
Privatizing without deregulating.

A vivid image of what should exist acts as a surrogate for reality. Pursuit of the image then prevents pursuit of the reality -- John K. Galbraith
by Migeru (migeru at eurotrib dot com) on Thu Sep 25th, 2008 at 06:22:05 PM EST
[ Parent ]
... would certainly make it harder for progressives to win Democratic primaries.


I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.
by BruceMcF (agila61 at netscape dot net) on Fri Sep 26th, 2008 at 01:03:28 PM EST
[ Parent ]
Why?

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Sat Sep 27th, 2008 at 04:26:40 PM EST
[ Parent ]
... in Democratic primaries for the House is bad enough as it stands ... if they think a friendly Congressman can get them an inside track on bank lending, it'll only make a bad situation worse.

NB. Because of gerrymandering, the larger number of Democratic held House seats are in effect decided by the primary.

I've been accused of being a Marxist, yet while Harpo's my favourite, it's Groucho I'm always quoting. Odd, that.

by BruceMcF (agila61 at netscape dot net) on Sat Sep 27th, 2008 at 05:26:18 PM EST
[ Parent ]
A couple of days ago, I saw a suggestion on another blog that people mail their congresscritters a torch and a pitchfork... That idea sounds better and better with each passing day.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Sat Sep 27th, 2008 at 10:29:44 PM EST
[ Parent ]


Display:
Go to: [ European Tribune Homepage : Top of page : Top of comments ]