30 September 2008

Why US banks are failing

The reason why the banks are going bust in simple terms is:

The banks traded in complex derivatives products between themselves, in what is termed as the over the counter market. The exposure to the Securitized debt packages was further exaggerated by the use of leverage of in many cases more than 30X the banks assets against valuations based on complex models that inflated the packages values during the boom times which allowed huge profits and bonuses to be banked (Fraud?). However the critical point is in the final link in a long chain of sliced and diced debt packages was the US housing market.

As US house prices fell, the gap between the real value and the banks inflated model values to boost profits grew, until the crunch point of August 2007, when it dawned upon market participants that in actual fact they did not have a clue as to the real value of these mortgage backed securities and hence the credit markets froze as no one wanted to buy something they could not value and nor lend to financial institutions that may default on their obligations. The impact hit all banks, whether or not they had exposure to the US housing market, as those banks whose business model relied heavily on the short-term money markets to finance long-term mortgages were in deep trouble, i.e. Northern Rock and to a lesser extent ALL of the other UK mortgage banks.

Now many banks are left with assets that are worth LESS than 50% of their "mark to market" booked value. Now that does not mean a 50% loss for the banks on investments, remember the greedy banks deployed LEVERAGE of as much as 30 times of assets, so capital of say £100 million is controlling risk of as much as £3,000 million. Therefore a 50% loss results in a loss of value of £1,500 million, that's 15 TIMES the capital. Hence the banks have been reluctant to price their debt packages at the real market price as that would mean that the bank is effectively bankrupt with losses far greater than the banks capital base. So the market remains frozen until all of the illiquid mortgage backed debt has been transferred over to the tax payers in exchange for liquid cash, hence prompting the US Mother of All bailouts plan.

So Basically there are TWO related problems at work driving the Banks Bust:

1. One of collatorised debt that is not being valued at market prices, hence frozen money markets with banks sitting on over leveraged time bombs that have started to explode in recent weeks, as the credit markets tighten further.

2. Mortgage banks reliant on short-term money markets to finance long-term mortgages that threw caution to the wind and loaned far too much money to people who could not afford to repay the mortgages are now being hit by increasing defaults as the western housing markets crash from over inflated 'bubble' levels, as their losses mushroom but now find that they are unable to borrow money to cover day to day operations due to the increased risk of default and thus hoarding of cash (if they have any left) amongst investment banks in advance of further asset price mark downs. Therefore the only avenue available for short-term cash is from either the Bank of England or individual savers, hence high savings interest rates relative to the base interest rate of 5%.

And there's more .... mortgage backed securities are the tip of the credit crunch iceberg, the next inline are credit default swaps which are basically investor insurance to protect themselves against losses on the debt packages. However as we saw with collapse of and nationalisation of the worlds biggest insurer AIG, this is another huge part of the derivatives market that is imploding, perhaps in the region of $60 trillion. Its the reason why ordinary people are going to find problems with the credit card freeze next as defaults rise and retailers start to charge a premium on card transaction due to risk of default on the transactions, or even refuse to accept credit cards, but that has yet to happen..

United States Answer To Collapsing Banks is a $700 Billion Bailout Plan

Despite all of the noise of Congress's qualms that we will witness played out during the next 24 hours or so, the bailout plan will more or less pass . Despite the fact that it represents madness, an ultimate manifestation of the subprime contaigent spreading and infecting the US Treasury with all of the consequences of loss of confidence in ALL US paper as the value of US debt devalues in the eyes of all investors.

The US Treasury and Central Bank are eager to get the US Congress to pass a blank check bill so as much of the toxic mortgage backed bonds can be bought up to prevent a further collapse of the financial system. $700 billion is not enough, not in the face of the huge deleveraging of the $500 trillion dollar market, as I warned of 6 months ago. The $700 bailout plans two un-said objectives are -

a. To delay the potential of financial collapse until AFTER the November election.

b. That the real bailout cost will run to several trillion dollars as the US government seeks to prevent a chain reaction of collapsing banks in the wake of counter party failures amongst the huge $500 trillion global derivatives market.

The latest tactics is to suggest that the US Tax payer may even make a profit on these toxic securities. The fact of the matter is that the US will probably be looking at a loss of over 50% on maturity of the anticipated price paid as there is no way that market prices will be paid, as primary reason for the freeze of the interbank money markets is that the securities are NOT being priced by the market for if they were then the market valuations would imply that the financial institutions are bankrupt, hence the free market has been suspended. Taking an estimated eventual exposure of some $2 trillions, therefore implies an eventual US tax payer loss of at least $1 trillion. Which is more than enough to send the US bond market toppling as the US is heading for a budget deficit of more than $1 trillion.

The real question that the peoples representatives should be focusing themselves on is how do we bring those who benefited from the greatest fraud in history to account for their actions and the possible repatriation of wealth stolen in recent years to the tune of more than $1 trillion due to huge bonuses paid on the back of boosted fake asset valuations. That would probably increase confidence in US paper more than signing a blank check for $700 billion .

Is your Bank Safe ?
The US Fed's and other central back actions do not mean that banks will now be saved, as last weeks example of WaMu going bust, America's biggest bank failure illustrates that literally many hundreds if not a thousand plus banks will go bust during the course of the worsening credit crisis, with all of the consequences for depositors. The following report by EWI presents a list of the 100 safest US banks.

UK Toxic State Mortgage Bank

The ground work for the bank bailouts was laid earlier in March and April 08 on the announcements that the UK Government would loan £50 billion to the Banks in exchange for toxic illiquid mortgage backed securities in an attempt to unfreeze the interbank market , at the time I warned that this is just the first step and that eventual liability would extend to several hundred billions if pounds which would still be a drop in the ocean compared to the ongoing deleveraging of a 500 trillion derivatives market which has highly deflationary implications for the credit and asset markets as we have been observing in recent weeks.

First Northern Rock and now Bradford and Bingley mark Britain's own emergency government intervention of the bailout of toxic mortgage backed securities. The estimated UK tax payer exposure in terms of anticipated losses to date is about £40 billion, £20 billion for Northern Rock and £20 billion for B&B. This is in addition to the money loaned to the UK banks as a consequence of the freeze of the interbank money markets and represents a total tax payer exposure to of at least £150 billion, or some $280 billion which compares against the US tax payer exposure of approximately $1.2 trillion that takes into account the proposed $700 billion weekend bailout.

What can Savers do ?

The only thing that savers can do is to attempt to limit real terms losses as much as possible, this implies locking in fixed savings rates ahead of now increasingly anticipated interest rate cuts. The first port of call should be fixed rate cash ISA's which currently range between 6% and 7.3%. The next port of call should be Fixed rate bonds for at least 1year and preferably 2 years, in this case savers have a window of opportunity with rates ranging from between 6.3% to as high as 7.2%. The current market leader is ICICI Bank which pays 7.2% for terms of between 1 and 3 years. Remember to adhere to the limits mentioned above of £35k per banking group.

UK Housing Market

The implications for the UK housing market both as a consequence of the HBOS takeover and Bradford and Bingley bust are going to hit the mortgage market hard with both a reduction in supply of mortgages and an eagerness of the two banks to seek to reduce their mortgage books by trying to induce their customers to remortgage to other banks via higher mortgage interest rates and therefore reduce their risks of default in the wake of the ongoing housing bear market.

The Labour government has attempted to support the housing market by suspending the 1% stamp duty taxed on house purchases on properties up to a value of £175,000 for a period of 1 year and to support new house prices through Homebuy Direct Interest Free loans.

The Halifax's latest house price data shows that the housing market crash continued to accelerate into August, plunging by 1.7% that saw another £3000 wiped off house prices following the £3,300 write off for July to stand at down 12.8% on the year to August (on a non seasonally adjusted basis). UK house prices have now fallen by more than 8% since April. If a fall of 8% in 4 months cannot be considered a crash in UK house prices than I do not know what can. No wonder Chancellor Darling virtually threw in the towel recently in his famous "I give up, please let me spend more time with my family" speech.

US military is where savings must be made

We have the money
By Chalmers Johnson

There has been much moaning, air-sucking and outrage about the US$700 billion that the US government is throwing away on rich New York bankers who have been ripping us off for the past few years and then letting greed drive their businesses into a variety of ditches. In fact, we dole out similar amounts of money every year in the form of payoffs to the armed services, the military-industrial complex, and powerful senators and representatives allied with the Pentagon.

On Wednesday, September 24, right in the middle of the fight over billions of taxpayer dollars slated to bail out Wall Street, the House of Representatives passed a $612 billion defense authorization bill for 2009 without a murmur of public protest or any meaningful press comment at all. (The New York Times gave the matter only three short paragraphs buried in a story about another appropriations measure.)

The defense bill includes $68.6 billion to pursue the wars in Iraq and Afghanistan, which is only a down payment on the full yearly cost of these wars. (The rest will be raised through future supplementary bills.) It also included a 3.9% pay raise for military personnel, and $5 billion in pork-barrel projects not even requested by the administration or Secretary of Defense Robert Gates.

It also fully funds the Pentagon's request for a radar site in the Czech republic, a hare-brained scheme sure to infuriate the Russians just as much as a Russian missile base in Cuba once infuriated us. The whole bill passed by a vote of 392-39 and will fly through the senate, where a similar bill has already been approved. And no one will even think to mention it in the same breath with the discussion of bailout funds for dying investment banks and the like.

This is pure waste. Our annual spending on "national security" - meaning the defense budget plus all military expenditures hidden in the budgets for the departments of Energy, State, Treasury, Veterans Affairs the Central Intelligence Agency (CIA) and numerous other places in the executive branch - already exceeds a trillion dollars, an amount larger than that of all other national defense budgets combined.

Not only was there no significant media coverage of this latest appropriation, there have been no signs of even the slightest urge to inquire into the relationship between our bloated military, our staggering weapons expenditures, our extravagantly expensive failed wars abroad, and the financial catastrophe on Wall Street.

The only congressional "commentary" on the size of our military outlay was the usual pompous drivel about how a failure to vote for the defense authorization bill would betray our troops. The aged Senator John Warner, former chairman of the Senate Armed Services Committee, implored his Republican colleagues to vote for the bill "out of respect for military personnel". He seems to be unaware that these troops are actually volunteers, not draftees, and that they joined the armed forces as a matter of career choice, rather than because the nation demanded such a sacrifice from them.

We would better respect our armed forces by bringing the futile and misbegotten wars in Iraq and Afghanistan to an end. A relative degree of peace and order has returned to Iraq not because of President George W Bush's belated reinforcement of our expeditionary army there (the so-called "surge"), but thanks to shifting internal dynamics within Iraq and in the Middle East region generally.

Such shifts include a growing awareness among Iraq's Sunni population of the need to restore law and order, a growing confidence among Iraqi Shi'ites of their nearly unassailable position of political influence in the country, and a growing awareness among Sunni nations that the ill-informed war of aggression the Bush administration waged against Iraq has vastly increased the influence of Shi'ism and Iran in the region.

The continued presence of American troops and their heavily reinforced bases in Iraq threaten this return to relative stability. The refusal of the Shi'ite government of Iraq to agree to an American Status of Forces Agreement - much desired by the Bush administration - that would exempt off-duty American troops from Iraqi law is actually a good sign for the future of Iraq.

In Afghanistan, our historically deaf generals and civilian strategists do not seem to understand that our defeat by the Afghan insurgents is inevitable. Since the time of Alexander the Great, no foreign intruder has ever prevailed over Afghan guerrillas defending their home turf. The first Anglo-Afghan War (1838-1842) marked a particularly humiliating defeat of British imperialism at the very height of English military power in the Victorian era. The Soviet-Afghan War (1979-1989) resulted in a Russian defeat so demoralizing that it contributed significantly to the disintegration of the former Soviet Union in 1991. We are now on track to repeat virtually all the errors committed by previous invaders of Afghanistan over the centuries.

In the past year, perhaps most disastrously, we have carried our Afghan war into Pakistan, a relatively wealthy and sophisticated nuclear power that has long cooperated with us militarily. Our recent bungling brutality along the Afghan-Pakistan border threatens to radicalize the Pashtuns in both countries and advance the interests of radical Islam throughout the region. The United States is now identified in each country mainly with Hellfire missiles, unmanned Predator drones, special operations raids, and repeated incidents of the killing of innocent bystanders.

The brutal bombing of the Marriott Hotel in Pakistan's capital, Islamabad, on September 20 was a powerful indicator of the spreading strength of virulent anti-American sentiment in the area. The hotel was a well-known watering hole for American marines, special forces troops and CIA agents. Our military activities in Pakistan have been as misguided as the Richard Nixon-Henry Kissinger invasion of Cambodia in 1970. The end result will almost surely be the same.

We should begin our disengagement from Afghanistan at once. We dislike the Taliban's fundamentalist religious values, but the Afghan public, with its desperate desire for a return of law and order and the curbing of corruption, knows that the Taliban are the only political force in the country that has ever brought the opium trade under control. The Pakistanis and their effective army can defend their country from Taliban domination so long as we abandon the activities that are causing both Afghans and Pakistanis to see the Taliban as a lesser evil.

One of America's greatest authorities on the defense budget, Winslow Wheeler, worked for 31 years for Republican members of the senate and for the General Accounting Office on military expenditures. His conclusion, when it comes to the fiscal sanity of our military spending, is devastating:
America's defense budget is now larger in inflation-adjusted dollars than at any point since the end of World War II, and yet our army has fewer combat brigades than at any point in that period; our navy has fewer combat ships; and the air force has fewer combat aircraft. Our major equipment inventories for these major forces are older on average than any point since 1946 - or in some cases, in our entire history.
This in itself is a national disgrace. Spending hundreds of billions of dollars on present and future wars that have nothing to do with our national security is simply obscene. And yet Congress has been corrupted by the military-industrial complex into believing that, by voting for more defense spending, they are supplying "jobs" for the economy.

In fact, they are only diverting scarce resources from the desperately needed rebuilding of the American infrastructure and other crucial spending necessities into utterly wasteful munitions. If we cannot cut back our longstanding, ever-increasing military spending in a major way, then the bankruptcy of the United States is inevitable. As the current Wall Street meltdown has demonstrated, that is no longer an abstract possibility but a growing likelihood. We do not have much time left.


Chalmers Johnson is the author of three linked books on the crises of American imperialism and militarism. They are Blowback (2000), The Sorrows of Empire (2004), and Nemesis: The Last Days of the American Republic (2006). All are available in paperback from Metropolitan Books.

29 September 2008

Treasury Conference Call on Bailout Bill

Mussolini-Style Corporatism in Action: Treasury Conference Call on Bailout Bill to Analysts (Updated)

Various readers wrote us, and it was confirmed by a detailed report on the call at DealBreaker, that the Treasury Department held a conference call this evening for analysts on the bailout bill. A memo was evidently sent to SIFMA members; others may have been contacted by other means. But the report I got from one person who was on the call was the the questions came from financial services industry members. In other words, this was most assuredly not intended to be a call open to the public at large. If anyone from the media or other member of the great unwashed was listening in, it was by accident.

This is simply scandalous. To have a group of interested parties get a privileged briefing by government officials on a matter of keen public interest flies in the face of what a democracy is supposed to be about. The proper method would either be a published FAQ on the Treasury website or a briefing with the media included. But why should I be surprised? Favoritism has been a staple of the Bush Administration.

There is a live blogging recap at DealBreaker. Someone who was on the call is going over his notes and other recaps on the Web and sending me his version, which I hope will add some color. Check back for that update.

Update: Here are the notes promised. Calculated Risk had put up the conference call number. so some of this is the listener's notes, some are hoisted from CR. They are admittedly skeletal at points, but track and enhance the live blogging report at DealBreaker. You can download a torrent for the call here, which I intend to do post haste and will amend the post accordingly. I've included the long form notes below, but some items jump out:

1. The tranching is a mere formality, and the Treasury boys as much as said so. They could take the $700 billion max as soon as the bill has passed,

2. However, they do not plan any action immediately, will wait a couple of weeks. They want to focus their efforts on stronger companies but also made noise about protecting the financial system. This, by the way, is the Japanese convoy system all over.

3. There seemed to be a lot of tap dancing about what price they will pay for assets and no straight answer about their policy on warrants. They did say that if the amount sold was greater than $100 million, they would take warrants. FYI, the current draft allows them to pay up to the price at which the assets were initially booked (yikes) . I wonder if this is obfuscation, if they have an idea of what the plan to do but will not admit it in any public forum.

4. As the person who listened to the call stressed, DealBreaker wasn't clear on the bifurcated process. If you come to the Treasury and you are in trouble, you get reamed. Bear/AIG style treatment, execs probably fired. But if you participate on a voluntary basis, the intent is to make it very user friendly. That is consistent with Paulson's position during the negotiations.

5. The exec comp provisions sound like a joke, They DO NOT affect existing contracts, they affect only contracts entered into during the two years of the authority of this program and then affect only golden parachutes. More detail on that point, but I don't need more detail to get the drift of the gist.

Further below are the notes, admittedly somewhat cryptic at points, but hopefully helpful. But if you have time, listen to the download. Be warned I may revise and add to the post once I have done so.

Update 12:30 AM: Have queued up recording of conference call but not yet listened to it. But reader and sometime contributor Lune provides a useful take. Hoisted from comments:
1) If even the Treasury is saying tranching is a formality, then it really is nothing. Not sure why Dems fought so hard for a fig leaf.

2) Waiting a couple of weeks because no one has any idea when or where the next bomb will blow up. In other words, all their doomsday scenarios about Black Monday were B.S. They screamed the check had to be written by Monday, but now they're saying they actually have a few weeks before they need to cash it. Plus, this will allow them to "seek guidance" from GS, JPM, and other selfless public servants about where the money should be funneled.

3. The tap dancing is because they don't want it to get out that they'll be giving a sweetheart deal. The public won't be following each individual transaction to see exactly what price is being paid. So ridiculously overpriced asset sales can be hidden in the details, and by the time some reporter (or blogger :-) combs through and analyzes the transactions, the deed will have been done. But if Paulson makes a statement that assets will be bought at par before the bailout's even begun, that will be reported and might kill the deal.

4. In other words, we need to sweeten the pot to encourage banks to come "voluntarily". Pardon my ignorance, but why the hell should we be begging banks to borrow from us? I thought a bailout should be the absolute last option for a bank. I.e., it should be so unpalatable, so unprofitable for a bank and its executives that they exhaust every private means of survival before coming for their public "reaming". I wonder if foreclosed homeowners would rate their foreclosure process as "user friendly".

5. Of course the exec comp provisions are a joke. Who do you think is going to be hiring all those banking cmte staffers and newly retired congresspeople next year during the inevitable post-election turnover? Do you really think they're going to vote to limit their salaries? Remember that for lots of people on the Hill (including elected reps), govt work is merely time you spend accumulating credentials in preparation for your real life's work in the vastly richer private world.

Taxpayer losses: "golly, let's just pray to Jesus and hope he'll make sure that in a few years our country won't be bankrupt."

Oversight: "let's appoint a committee which will file toothless reports that no one will ever read".

I'm glad to see that while much time was spent in Exec comp. and tranching kabuki theater, the real points of protection of taxpayer losses and implementation of new regulation seem to be afterthoughts.

The notes on the call per our helpful anonymous reader (and former investment banker, it turns out):
"Draft bill is very positive for both markets and our companies"

Much explanation of Executive Comp

Residential and commercial mortgages. But very importantly, it can be any asset.

Excited about ability to guarantee assets in exchange for a guarantee fee.

Sought as much authority and as much flexibility as possible.

Eligibility: as broad participation by institutions as possible. The
more participation, the more effective it will be. Want banks of all
sizes or any financial institution that has a meaningful presence in
the US to be interested and enthusiastic.

Purpose is to help private sector clean up their balance sheets.

Highest priority: make sure it works, will attract companies to
participate. Warrants and exec comp. were very highly negotiated.

still listening ...
some1 | 09.28.08 - 9:14 pm | #


Direct purchases from failing institution e.g. Bear Stearns, AIG, F&F: will do the same thing, take maybe 79.9% equity.

Market mechanism: Congress wanted taxpayer benefit in upside. Sell
warrants for assets over $100M , but the amount of warrants is still
TBD. WE want healthy institutions to participate so it should not be
some1 | 09.28.08 - 9:17 pm | #

Exec comp.

Most difficult part of negotiation.

Direct deal: fire the management, like AIG etc.

Market mechanism: if sell over $300M into fund, some exec comp limits
come with it. For 2 years, the firm could not enter into NEW contracts
including golden parachute, for involuntary departure. And lose some

We feel really good that we have encouraged healthy institutions to participate, not just bailouts of sick institutions.
some1 | 09.28.08 - 9:22 pm | #

Clawback of taxpayer losses:
1. it's a long way out, "a lot can happen in that time"
2. it's targeted at all financial institutions, not just participants! (that means it will never happen)
3. would need more congressional and presidential action to implement this.
some1 | 09.28.08 - 9:24 pm | #

Oversight (Bob Hoyt)

1. Financial Stability Oversight Board
2. General Accountability Office and Comptroller General managing purchase auctions
3. Special Inspector General
4. Congressional Oversight Panel
5. Reporting provisions
some1 | 09.28.08 - 9:27 pm | #

Tranching of $700B (I didn't know that was a limit)

Entire 700B is appropriated entirely by the act, no further appropriation necessary.

Tranching: first $250B
Then Secretary determines that more is needed and tells Congress, another $100B
Then Secretary determines that more is needed and Congress has 15 days to refuse, the remaining $350B

No time limits. Can request all the tranches at once, no need for delays.
some1 | 09.28.08 - 9:29 pm | #

More about tranching:

To block the last $350B, Congress has to say no. Then the President can
veto that. To override that veto, Congress needs 2/3 majority.

ALL of that must happen within 15 days, otherwise the money goes out.

Can't the President wait and veto it with one minute left in the 15 days?

RTC had to go back to Congress. Kudos for making this program much EASIER!
some1 | 09.28.08 - 9:32 pm | #

Price: not a fire-sale price, not an outrageous price, a "fair" price. Firms might get a price higher than their current mark.

(Congress will be voting on this, with this aspect totally undetermined.)
some1 | 09.28.08 - 9:35 pm | #

Not trying to maximize return to the taxpayer, but to provide liquidity to the system as a whole.
some1 | 09.28.08 - 9:39 pm | #

They will prefer to help healthy banks become even healthier, as
opposed to rescuing a failing bank, because the healthy bank is more
likely to relend into the system.

They expect that the exec. comp. limits won't constrain the healthy banks, since they are so light.
artichoke | 09.28.08 - 9:43 pm | #

xIt will take several weeks, before any assets can be bought, to hire asset managers and get systems up and running.

(They're going to let the weak banks fail, then help the rest.)
artichoke | 09.28.08 - 9:45 pm | #

No provision to mandate re-lending.

Stuff that is still to be determined, will be issued as "guidelines" therefore exempt from discussion and comment period.

About 800 people on the call.
some1 (oops;) | 09.28.08 - 9:47 pm | #

A shattering moment in America's fall from power

The global financial crisis will see the US falter in the same way the Soviet Union did when the Berlin Wall came down. The era of American dominance is over

John Gray
The Observer, Sunday September 28 2008
Article history

Our gaze might be on the markets melting down, but the upheaval we are experiencing is more than a financial crisis, however large. Here is a historic geopolitical shift, in which the balance of power in the world is being altered irrevocably. The era of American global leadership, reaching back to the Second World War, is over.

You can see it in the way America's dominion has slipped away in its own backyard, with Venezuelan President Hugo Chávez taunting and ridiculing the superpower with impunity. Yet the setback of America's standing at the global level is even more striking. With the nationalisation of crucial parts of the financial system, the American free-market creed has self-destructed while countries that retained overall control of markets have been vindicated. In a change as far-reaching in its implications as the fall of the Soviet Union, an entire model of government and the economy has collapsed.

Ever since the end of the Cold War, successive American administrations have lectured other countries on the necessity of sound finance. Indonesia, Thailand, Argentina and several African states endured severe cuts in spending and deep recessions as the price of aid from the International Monetary Fund, which enforced the American orthodoxy. China in particular was hectored relentlessly on the weakness of its banking system. But China's success has been based on its consistent contempt for Western advice and it is not Chinese banks that are currently going bust. How symbolic yesterday that Chinese astronauts take a spacewalk while the US Treasury Secretary is on his knees.

Despite incessantly urging other countries to adopt its way of doing business, America has always had one economic policy for itself and another for the rest of the world. Throughout the years in which the US was punishing countries that departed from fiscal prudence, it was borrowing on a colossal scale to finance tax cuts and fund its over-stretched military commitments. Now, with federal finances critically dependent on continuing large inflows of foreign capital, it will be the countries that spurned the American model of capitalism that will shape America's economic future.

Which version of the bail out of American financial institutions cobbled up by Treasury Secretary Hank Paulson and Federal Reserve chairman Ben Bernanke is finally adopted is less important than what the bail out means for America's position in the world. The populist rant about greedy banks that is being loudly ventilated in Congress is a distraction from the true causes of the crisis. The dire condition of America's financial markets is the result of American banks operating in a free-for-all environment that these same American legislators created. It is America's political class that, by embracing the dangerously simplistic ideology of deregulation, has responsibility for the present mess.

In present circumstances, an unprecedented expansion of government is the only means of averting a market catastrophe. The consequence, however, will be that America will be even more starkly dependent on the world's new rising powers. The federal government is racking up even larger borrowings, which its creditors may rightly fear will never be repaid. It may well be tempted to inflate these debts away in a surge of inflation that would leave foreign investors with hefty losses. In these circumstances, will the governments of countries that buy large quantities of American bonds, China, the Gulf States and Russia, for example, be ready to continue supporting the dollar's role as the world's reserve currency? Or will these countries see this as an opportunity to tilt the balance of economic power further in their favour? Either way, the control of events is no longer in American hands.

The fate of empires is very often sealed by the interaction of war and debt. That was true of the British Empire, whose finances deteriorated from the First World War onwards, and of the Soviet Union. Defeat in Afghanistan and the economic burden of trying to respond to Reagan's technically flawed but politically extremely effective Star Wars programme were vital factors in triggering the Soviet collapse. Despite its insistent exceptionalism, America is no different. The Iraq War and the credit bubble have fatally undermined America's economic primacy. The US will continue to be the world's largest economy for a while longer, but it will be the new rising powers that, once the crisis is over, buy up what remains intact in the wreckage of America's financial system.

There has been a good deal of talk in recent weeks about imminent economic armageddon. In fact, this is far from being the end of capitalism. The frantic scrambling that is going on in Washington marks the passing of only one type of capitalism - the peculiar and highly unstable variety that has existed in America over the last 20 years. This experiment in financial laissez-faire has imploded.While the impact of the collapse will be felt everywhere, the market economies that resisted American-style deregulation will best weather the storm. Britain, which has turned itself into a gigantic hedge fund, but of a kind that lacks the ability to profit from a downturn, is likely to be especially badly hit.

The irony of the post-Cold War period is that the fall of communism was followed by the rise of another utopian ideology. In American and Britain, and to a lesser extent other Western countries, a type of market fundamentalism became the guiding philosophy. The collapse of American power that is underway is the predictable upshot. Like the Soviet collapse, it will have large geopolitical repercussions. An enfeebled economy cannot support America's over-extended military commitments for much longer. Retrenchment is inevitable and it is unlikely to be gradual or well planned.

Meltdowns on the scale we are seeing are not slow-motion events. They are swift and chaotic, with rapidly spreading side-effects. Consider Iraq. The success of the surge, which has been achieved by bribing the Sunnis, while acquiescing in ongoing ethnic cleansing, has produced a condition of relative peace in parts of the country. How long will this last, given that America's current level of expenditure on the war can no longer be sustained?

An American retreat from Iraq will leave Iran the regional victor. How will Saudi Arabia respond? Will military action to forestall Iran acquiring nuclear weapons be less or more likely? China's rulers have so far been silent during the unfolding crisis. Will America's weakness embolden them to assert China's power or will China continue its cautious policy of 'peaceful rise'? At present, none of these questions can be answered with any confidence. What is evident is that power is leaking from the US at an accelerating rate. Georgia showed Russia redrawing the geopolitical map, with America an impotent spectator.

Outside the US, most people have long accepted that the development of new economies that goes with globalisation will undermine America's central position in the world. They imagined that this would be a change in America's comparative standing, taking place incrementally over several decades or generations. Today, that looks an increasingly unrealistic assumption.

Having created the conditions that produced history's biggest bubble, America's political leaders appear unable to grasp the magnitude of the dangers the country now faces. Mired in their rancorous culture wars and squabbling among themselves, they seem oblivious to the fact that American global leadership is fast ebbing away. A new world is coming into being almost unnoticed, where America is only one of several great powers, facing an uncertain future it can no longer shape.

• John Gray is the author of Black Mass: Apocalyptic Religion and the Death of Utopia (Allen Lane)

Falling Into Fall

So many shoes are poised to drop this week that the American scene might be confused for the world's greatest-ever clog dancing festival, but a closer look will reveal a circle of cavorting skeletons.
Last week's ripe moment turned out to be the Thursday night Washington photo op when Treasury Secretary Paulson and Fed Chief Bernanke emerged from a huddle with House Speaker Nancy Pelosi and just about every other legislative eminentissimo in an attempt to reassure the nation that its financial system had not turned into something like unto a truckload of stinking dead carp. I don't know about you, but I got two distinct vibes from the faces in that particular tableau: 1.) abject fear, and 2.) a total lack of conviction that they knew what they were doing.
The product of that huddle was a cockamamie scheme for the US treasury to absorb all the losses from a twenty-year binge in which Wall Street created and retailed the most complex set of swindles ever seen on this planet Earth. The background music to the tableau was the whoosh of a several trillion dollars exiting the US financial system never to be seen again.
The next day (Friday) many particulars of that scheme began to emerge -- such as the complete lack of oversight and review mechanisms for Treasury's new power to monetize private business failures and frauds -- and the stock market soared in response. Other new features of the reformed capital landscape also resolved later that day, like a new experiment aimed at eliminating the short sale as a way of guaranteeing that henceforth market bets could only be placed on the upside of the table. It will be interesting to see how that reform works out in the days ahead.
Over the weekend, all these various playerz retreated into their gilded bunkers to negotiate the details, and by Sunday night, among other things, Goldman Sachs and Morgan Stanley -- the two remaining investment giants left standing -- announced that they would metamorphose into regular banks in order to qualify for additional truckloads of government loans in exchange for any leftover fraudulant securities still lurking in their vaults. Another new provision had the Treasury rescuing swindled foreign companies, too -- in effect, saving the world, which seemed at least, how you say, pretty ambitious.
By this morning, many new arguments had been raised by a suddenly de-zombified congress as to whether the proposed grand bail-out might reward recent Wall Street turpitudes and incentivize future mis-deeds and it looks like enough objections may be lodged to gum-up the process before it even goes into effect -- which, of course, would tend to revert the whole reeking cargo of trouble to its original train-wreck trajectory. I guess we'll see what happens now.
Any way you paint this grotesque panorama, it looks like a very new chapter of history for life in the USA. Basically, we are a much poorer nation than we were even a couple of years ago, and we have a much-reduced ability to project our will around the world, or even among our own floundering sectors and regions. Most troubling to me is the question of legitimacy that now hangs over the proscenium like a guillotine blade. Factoring in the old saw that history doesn't repeat but it rhymes, I think the situation emerging is rather like the crisis of legitimacy that preceded the Civil War. Then, in the 1850s, the nation's two symbiotic political parties, Whig and Democrat, entered a zone of fatal discredit. The White House had been occupied by a sequence of empty cravats named Fillmore, Pierce, and Buchanan, and so much pent-up mistrust roiled the centers of power that the nation entered a convulsion.
At issue then was the great festering unresolved polity of slavery. The Whig party, in its oafish, craven fecklessness, disappeared so quickly from the scene that an embarrassed God Almighty seemed to have hooked it off-stage in a nanosecond. Into the vacuum stepped an awkward lawyer from Illinois -- widely mocked by the coarser elements of what was then called the press as a figure resembling an ape in a stovepipe hat. He accomplished one crucial thing in the process of his emergence: he deployed a potent rhetoric that captured the essence of the crisis and clarified it for all to understand what was at stake -- and then the convulsion commenced in earnest.
The Republican Party amounts to today's Whigs. Their candidate for president, John McCain, is trying to run away from his own party -- as one might shrink away from a colony of importuning lepers. I am actually not kidding when I label the Republicans "the party that wrecked America," because I believe that is truly how the popular strain of history will regard them when (maybe if) the wreckage of their ministrations ever clears. But history doesn't repeat exactly. The current figure from Illinois, Barrack Obama, has yet to offer a truly crisis-clarfying rhetoric, though he labors under the expectation of being able to do so. Like his long-ago predecessor, he is mocked by the coarser elements of what we call "the media" these days -- Fox News and the moron-rousers of talk radio.
Some of the issues yet-to-be-clarified concern the behavior of the American public in the broad sense. We have obdurately resisted the reality of the energy crisis that hangs over everything we do (as slavery hung over the 1850s), from the way we inhabit the landscape to the way we do daily business in our 240-million-plus fleet of cars and trucks that ply the ribbons of asphalt and the lagoons of parking that now run from sea to shining sea where the fruited plain was replaced by the Wal Marts.
Mr. Obama isn't kidding either when he alludes to the change America faces, though history has not yet rhymed enough for his rhetoric to really set forth the terms of this change in its stark particulars. And even if he is able to articulate these things, he won't forestall the convulsion anymore than Lincoln held back a war between the states. That prior crisis was when America learned good and hard how tragic life could be, and it colored our national character for a century -- until we chucked it all to become a society of overfed clowns, with God Almighty replaced by Ronald McDonald. That pageant of happy idiocy is now ending. Like everyone else in this fraught and nervous land, I'm standing by to see what transpires in the days just ahead.

Gold and silver dealer reports an ‘unprecedented’ shortage of metals

Sunday, September 28, 2008 By David Clerkin, Markets Correspondent
A surge for demand in gold and silver has resulted in an unprecedented shortage of the metals for retail investors in recent days, according to Gold and Silver Investments, a Dublin-based firm that allows retail investors to speculate on movements in the value of precious metals.

Gold and Silver Investments director Mark O’Byrne said the supply of gold and silver available for small retail investors suffered a dramatic deterioration within hours on Friday, as wholesalers reported that government mints and refiners, the primary suppliers of the metals, had stopped offering new supplies.

‘‘It’s absolutely unprecedented,” said O’Byrne, who said the shortages were likely to drive up the costs of gold and silver in the secondary market.

‘‘This did not happen even in the 1930s and the 1970s, and will result in markedly higher prices in the coming months.”

According to O’Byrne, gold and silver were now only easily accessible in the primary market, which consisted of central banks and other major traders of the precious metals.

However, he said that minimum transaction sizes in this market were out of reach for most retail investors - at approximately $350,000 for gold and $135,000 for silver.

Things Look Bad - Do Something

by Randolph Buss | September 24, 2008

Unfortunately, the amount of work on my desk is piling up incessantly and the amount of research ongoing for „best buys" in the resource sectors I follow (precious, base metals, energy, agro and water) is also bursting ... I remind readers that when opportunities present themselves, we must be ready to act. Needless to say, I have not been getting a lot of sleep these last weeks...

Almost, as if I had written the below article myself, it points out the exact issues I talked about in the last entry "Minding the Shop ". As credit markets contract and junior companies struggle with financing issues, this will crimp / inhibit the ability for new resources to be found and exploited - thus driving supply down as demand either is maintained, or, as I suppose, increases. This due to the lag times associated with surveying, exploration drilling, , environmental issues, in-country legislation, mine setup, etc. A myriad of hindrances to increasing supply.

Commodity Supply May Be Curbed by Crisis, Goldman JBWere Says

By Jae Hur | Sept. 24 (Bloomberg) -- Commodity prices will stay ``stronger for longer'' as financing becomes a real constraint on supply growth because of the global credit turmoil, Goldman Sachs JBWere Pty said.

``Credit restrictions and volatile equity markets have implications for the supply side,'' the Melbourne-based firm said in a report. ``Junior companies wishing to finance greenfield projects that would have had little difficulty in raising either debt or equity 18 months ago, would likely struggle today.''

Raw material prices, as measured by the Standard & Poor's GSCI index, have climbed 12 percent since Sept. 16 as the dollar dropped on concern the U.S. government's $700 billion plan to buy bad mortgage debts would erode confidence in the currency. Gold, a traditional haven in times of financial crisis, has gained 13 percent.

``Longer term, we believe the structural bull market endures, based on supply and demand fundamentals,'' Goldman Sachs JBWere said. ``The theme of industrialization and urbanization in emerging markets has not disappeared. Neither have the supply constraints for certain commodities been sustainably alleviated.''

In China, ``growth rates have been slowing for some time, but fears of a collapse in demand for raw materials post- Olympics are unfounded,'' it said.

``We expect sentiment to improve as a cleaner read on the Chinese economy becomes available during the fourth quarter of 2008, and that the outcome in China will be considerably stronger than the market currently seems to fear,'' it said.

Credit Curbs

For the medium-term, credit restrictions will put pressure on demand for raw materials.
``The housing market collapse in the U.S. has already taken a large and obvious toll on demand for raw materials,'' as well as the weaker outlook for automotive sales in many parts of the world, the firm said.

In the short-term, tighter credit availability and higher financing costs have restricted the activities of commodities traders in the physical and derivatives markets with de-risking and switching of counterparties, it said.

``The dollar has become the key short-term price driver, not just for gold, but for all exchange-traded commodities,'' it said. Short-term speculative money has moved neutral for oil or net-short for base metals, it said.

A few interesting remarks : Last week, as I sent out the entry "Minding the Shop " I had to run and catch a flight to Zürich. Now, this is the interesting part : On Tuesday, it was announced that AIG would be saved by Paulson & Bernanke - a "classic" flip-flop if ever there was one, having just said on the Sunday prior, that saving Lehman Brothers was "not on" and that of moral hazard was mentioned.

On Wednesday morning, the streets of Zürich were very sombre and seemingly many more smokers stood out on the pavement in huddled groups, especially in front of the main UBS building. The AIG office just down the street was empty. They had been told.

That evening we had dinner and were constantly checking the Blackberry - gold was up $90 - its highest one-day advance in near history and the red wine flowed... silver was up about $1.30. That night the steak simply tasted better.

The point is : as I have already hammered home to readers, VOLATILITY is here to stay and the US authorities are obviously VERY cared. As a former executive in industry, I once paid for classes myself to learn nuances in body language and human behaviour to prepare myself for business negotiation - anything to give me an advantage.

In yesterdays Capitol Hill testimony to Congress, Paulson and Bernanke were exhibiting body language of dire frustration, urgency, and fear. Obviously THEY know more than they are willing to say - obviously. Dick Cheney, absent, was noted to have said "Things are bad - do something".

Another tidbit - I went to a local coin dealer to exchange some gold coins - I was given MORE than the spot price - the spread has been totally whacked out of alignment. Nobody currently knows where this massive bailout is going and if the government puts a $700 billion price tag on it, we can likely assume the REAL price is either unknown or shall exceed to the upside - I consider that a safe assumption. The markets will likely take years to recover and the financial institutions are, as I have previously said, the key to growth going forward.

To get a perspective on what the low-end cost of $700 billion means : according to the website http://www.nationalpriorities.org/costofwar_home the ongoing cost of the Iraq War - now going for 5 years is $555 billion. The economist Joseph Stiglitz' book said with all collateral costs, it is likely to be $3 trillion. The US' endless War on Drugs http://www.drugsense.org/wodclock.htm is costing $37 billion. Total is $592 billion. In total, the bailout is so massive by itself, that for all intents and purposes, such a bailout plus war, plus drug wars, plus a 50yr. old infrastructure, plus Medicare ... is the de-facto bankruptcy of the US when including ongoing expenditures and future obligations.

In further thought, and I have thought about this long and hard - very critical indeed, the bailout dynamics. In either case, should the massive bailout be approved, then the USD and confidence in the US economy will likely plummet as massive debt and deficits will be piled on. If no bailout is approved (this seems unlikely) then likely the US economy would tailspin into a massive recession / depression. That is what Paulson and Bernanke were alluding to in their body language and often rather straightforward testimony - the US taxpayer is already "on the hook", Paulson kept saying.

Now, we have seen that they - the authorities - in US, UK and Europe - have started to bully and ban short selling. The US has short-term rescued the horrendous US auto industry with a $50 billion injection - it must be obvious to all : they will do ANYTHING to save the system. This is not necessarily wrong , but it is being done in dictatorial fashion. The government can OUTLAW anything, including non-fungible gold instruments. They could even ban going LONG on gold stocks - but I doubt it.

My market thoughts are : accumulate more gold ; my downside DOW target is currently 8000. A swiss banker (now retired) which I met, now has put in standing orders to his bank to buy gold coins every week - price is of no interest - just buy & accumulate.

Reminder : we are currently in a real no-mans land as Paulson and Bernanke stated. Nobody knows where the markets are headed nor what the REAL underlying debt of these derivatives is and what instruments the government can or plan to use in "cleansing" these, e.g. reverse auctions, etc.

We are in unprecedented times : I have talked about a massive hyperinflationary bust in past newsletters and blog entries and also of a Kondratieff Winter. We may be witnessing this soon in more gore and detail. If the last 300 years of European history is any guide, we can assume that any US bailout will be bloated, taxpayer and consumer negative, intransparent and bad for your personal wealth and well being. I know of no historical guideline whereby holding some gold has been detrimental to ones well-being in times of crisis.

Copyright © 2008 Randolph Buss

Rasputin on the bailout

(a) AUTHORITY.—The authority of the Secretary topurchase troubled assets under this Act shall be limited
as follows:

(1) Effective upon the date of enactment of this Act, such authority shall be limited to $250,000,000,000 outstanding at any one time.

(2) If at any time, the President submits to the Congress a written certification that the Secretary is exercising the authority under this paragraph, effective upon such submission, such authority shall be limited to $350,000,000,000 outstanding at any one time.

(3) If at any time after obligations of amounts described in paragraphs (1) and (2) have been made,the President transmits to the Congress a written report detailing the plan of the Secretary to exercise the authority under this paragraph, unless there is enacted, within 15 calendar days of such submission, a joint resolution described in subsection (c), effective upon the expiration of such 15-day period, such authority shall be limited to $700,000,000,000 outstanding at any one time.

(b) AGGREGATION OF PURCHASE PRICES.—The amount of troubled assets purchased by the Secretary outstanding at any one time shall be determined for purposes of the dollar amount limitations under subsection (a) by aggregating the purchase prices of all troubled assets held.

(1) IN GENERAL.—Notwithstanding any other provision of this section, the Secretary may not exercise any authority to make purchases under this Act with regard to any amount in excess of $300,000,000,000 previously obligated, as described in this section if, within 10 calendar days after the date on which Congress receives a report of the Secretary described in subsection (a)(3), Congress enacts a joint resolution disapproving the plan of the Secretary with respect to such additional amount."

(Ras Summary): We're saved...I think. for a few weeks to months anyway, if this bill is passed in anywhere near its current form.

That is if my little Rasputin brain is interpreting this section correctly--and believe me, these guys did their very best to disguise what they are REALLY authorizing here--then it appears that the "Rolling Pool" to launder dead assets which Hank was demanding in his original proposal last week was in fact granted by Congress.

However, it seems that the "Rolling Pool" to launder the dead assets from the failed financial institutions will start out at a measly:

$250 billion

...then increments up to:

$350 billion

...if the President asks Congress nicely.

AND THEN, if the President asks nicely, but this time says "Pretty please?", Congress will allow the "Rolling Pool" to grow to:

$700 billion

...outstanding at any one time.

This, my friends, if I am interpreting the language correctly and Congress passes it as written in the draft, IS the "Infinite Fiat" blank check that Hank demanded--albeit initially doled out in smaller increments.

However, it apparently can quickly grow to the $700 billion OUTSTANDING AT ANY ONE TIME which truly allows it to launder literally the TRILLIONS of fiatscos of dead "assets" from failed financial institutions over time, jsut as I have been telling everyone needs to be done in order to even attempt to stave off "Great Depression II".

And you can bet that the FIRST entity who will be lined up with its hand out will be the Federal Reserve, which DESPERATELY wants to unload the $500 billion or so in (undisclosed) toxic trash accepted from failed (And also undisclosed) Wall Street gamblers.

(Ras Conclusion): This bill, if passed in anywhere near its present form tells me that Congress realizes that the financial system has collapsed.

Furthermore, it clearly shows that the Federal Reserve will now be "made whole".

However, what it DOESN'T tell me is: Who is gonna step up and buy the trillions of fiatscos worth of Treasuries that are gonna have to be issued in order to fund this little laundering scheme over time?:

1. Will the FCBs swallow another trillion or so of U.S. Treasuries? At low interest rates? To keep the export scam running and their workers employed?

2. Will the Fed, now having been "made whole" and gotten rid of all dead, toxic trash, turn around and buy another trillion or so of U.S. Treasuries because now the U.S. taxpayer will be on the hook to pay the Fed back?

3. OR, will taxes be raised to pay outright for the bailout?

4. Or, some combination of all three above?

It's simply too early to tell how this plays out, but one thing is perfectly clear:

Congress blinked.

Because obviously the message was communicated to them that had they NOT authorized "Infinite Fiat", then we would proceed directly to "Great Depression II".


See, we really ARE scroomed.

And Congress just admitted it.

Now, if this bill passes, we might even have a few more months before "Great Depression II" begins.

Enjoy the precious remaining time, my fellow bears.
(P.S. If any more legal/scholarly types than the stupid, ill-educated Rasputin would be so kind as to offer their interpretation of this provision of the bill, I personally would be very appreciative--even if they completely refuted my own assesment of what this language actually says. Ras.)

28 September 2008

500 Trades Away from Armageddon

The People vs. the Banksters


The financial system is blowing up. Don't listen to the experts; just look at the numbers. Last week, according to Reuters, "U.S. banks borrowed a record amount from the Federal Reserve nearly $188 billion a day on average, showing the central bank went to extremes to keep the banking system afloat amid the biggest financial crisis since the Great Depression." The Fed opened the various "auction facilities" to create the appearance that insolvent banks were thriving businesses, but they are not. They're dead; their liabilities exceed their assets. Now the Fed is desperate because the hundreds of billions of dollars of mortgage-backed securities (MBS) in the banks vaults have bankrupted the entire system and the Fed's balance sheet is ballooning by the day. The market for MBS will not bounce back in the foreseeable future and the banks are unable to roll-over their short term debt.

The Federal Reserve itself is in danger. So, it's on to Plan B; which is to dump all the toxic sludge on the taxpayers before they realize that the whole system is cratering. It's called the Paulson Plan, a $700 billion outrage which has already been disparaged by every economist of merit in the country.

From Reuters: "Borrowings by primary dealers via the Primary Dealer Credit Facility, and through another facility created on Sunday for Goldman Sachs, Morgan Stanley, and Merrill Lynch, and their London-based subsidiaries, totaled $105.66 billion as of Wednesday, the Fed said."

See what I mean; they're all broke. The Fed's rotating loans are just a way to perpetuate the myth that the banks aren't flat-lining already. Bernanke has tied strings to the various body parts and jerks them every so often to make it look like they're alive. But the Wall Street model is broken and the bailout is pointless.

Last week, there was a digital run on the banks that most people never even heard about; a "real time" crash. An article in the New York Post by Michael Gray gave a blow by blow description of how events unfolded. Here's a clip from Gray's "Almost Armageddon":

"The market was 500 trades away from Armageddon on Thursday...Had the Treasury and Fed not quickly stepped into the fray that morning with a quick $105 billion injection of liquidity, the Dow could have collapsed to the 8,300-level - a 22 percent decline! - while the clang of the opening bell was still echoing around the cavernous exchange floor. According to traders, who spoke on the condition of anonymity, money market funds were inundated with $500 billion in sell orders prior to the opening. The total money-market capitalization was roughly $4 trillion that morning.

“The panicked selling was directly linked to the seizing up of the credit markets - including a $52 billion constriction in commercial paper - and the rumors of additional money market funds ‘breaking the buck,’ or dropping below $1 net asset value.

“The Fed's dramatic $105 billion liquidity injection on Thursday (pre-market) was just enough to keep key institutional accounts from following through on the sell orders and starting a stampede of cash that could have brought large tracts of the US economy to a halt."

Commercial paper is the lubricant that keeps the financial markets functioning. When confidence vanishes, investors withdraw their money, normal business operations become impossible, and the markets collapse. End of story. So, rather than restore the public's confidence by strong leadership and behavior designed to reassure investors; President Bush decided to give a major prime-time speech stating that if Paulson's emergency bailout package was not passed immediately, the nation's economy would vaporize into the ether.

Last week, the commercial paper market, (much of which is backed by mortgage-backed securities) shrunk by $61 billion to $1.702 trillion, the lowest level since early 2006. So, Paulson's bailout will effectively underwrite CP as well as the whole alphabet soup of mortgage-backed derivatives for which there is currently no market. The US taxpayer is not only getting into the plummeting real estate market, he is also backstopping the entire financial system including defaulting car loan securities, waning student loan securities, flailing home equity loan securities and faltering credit card securities. The whole mountainous pile of horsecrap-debt is about to be stacked on the back of the maxed-out taxpayer and the ever-shriveling greenback.

How did Treasury Secretary Paulson figure out that recapitalizing the banking system would cost $700 billion? Or did he just estimate the amount of money that could be loaded on the back of the Treasury's flatbed truck when it sputters off to shower his buddies at Goldman Sachs with freshly minted greenbacks? The point is, that Paulson's calculations were not assisted by any economists at all, and they cannot be trusted. It is a purely arbitrary, "back of the envelope" type figuring. According to Bloomberg: Swiss investor Marc Faber, known for a long track record of good calls, believes the damage may come to $5 trillion:

"Marc Faber, managing director of Marc Faber Ltd. in Hong Kong, said the U.S. government's rescue package for the financial system may require as much as $5 trillion, seven times the amount Treasury Secretary Henry Paulson has requested....

``The $700 billion is really nothing,'' Faber said in a television interview. ``The Treasury is just giving out this figure when the end figure may be $5 trillion.''

Most people who follow these matters would trust Faber's assessment way over Paulson's. In his latest blog entry, economist Nouriel Roubini said that "no professional economist was consulted by Congress or invited to present his/her views at the Congressional hearings on the Treasury rescue plan." Roubini added:

"The Treasury plan is a disgrace: a bailout of reckless bankers, lenders and investors that provides little direct debt relief to borrowers and financially stressed households and that will come at a very high cost to the US taxpayer. And the plan does nothing to resolve the severe stress in money markets and interbank markets that are now close to a systemic meltdown."

Roubini is right on all counts. So far, more than a 190 prominent economists have urged Congress not to pass the $700 bailout bill. There is growing consensus that the so-called "rescue package" does not address the central economic issues and has the potential to make a bad situation even worse.
The Bankers’ Coup

Financial industry rep. Paulson is the ringleader in a bankers’ coup the results of which will decide America's economic and political future for years to come. The coup leaders have drained tens of billions of dollars of liquidity from the already-strained banking system to trigger a freeze in interbank lending and hasten a stock market crash. This, they believe, will force Congress to pass Paulson's $770 billion bailout package without further congressional resistance. It's blackmail.

As yet, no one knows whether the coup-backers will succeed and further consolidate their political power via a massive economic shock to the system, but their plan continues to move jauntily forward while the economy follows its slide to disaster.

The bailout has galvanized grassroots movements which have flooded congressional FAXs and phone lines. Callers are overwhelmingly opposed to any bailout for banks that are buckling under their own toxic mortgage-backed assets. One analyst said that the calls to Congress are 50 per cent "No" and 50 percent "Hell, No". There is virtually no popular support for the bill.

From Bloomberg News: "Erik Brynjolfsson, of the Massachusetts Institute of Technology's Sloan School, said his main objection ‘is the breathtaking amount of unchecked discretion it gives to the Secretary of the Treasury. It is unprecedented in a modern democracy.’

“‘I suspect that part of what we're seeing in the freezing up of lending markets is strategic behavior on the part of big financial players who stand to benefit from the bailout,’ said David K. Levine, an economist at Washington University in St. Louis, who studies liquidity constraints and game theory.’” (Mish's Global Economic Trend Analysis)

Brynjolfsson's suspicions are well-founded. "Market Ticker's" Karl Denninger confirms that the Fed has been draining the banking system of liquidity in order to blackmail Congress into passing the new legislation. Here's Denninger:

"The Effective Fed Funds rate has been trading 50 basis points or more below the 2% target for five straight days now, and for the last two days, it has traded 75 basis points under. The IRX is demanding an immediate rate cut. The Slosh has been intentionally drained by over $125 billion in the last week and lowering the water in the swamp exposed one dead body - Washington Mutual - which was immediately raided on a no-notice basis by JP Morgan. Not even WaMu's CEO knew about the raid until it was done....The Fed claims to be an ‘independent central bank.’ They are nothing of the kind; they are now acting as an arsonist. The Fed and Treasury have claimed this is a ‘liquidity crisis’; it is not. It is an insolvency crisis that The Fed, Treasury and the other regulatory organs of our government have intentionally allowed to occur."

Grassroots resistance, spearheaded by Internet bloggers (like Mish, Roubini and Denninger) are demonstrating that they can mobilize tens of thousands of "peasants with pitchforks" and be a factor in political decision making. It also helps to have elected officials, like Senator Richard Shelby, who stand firm on principle and don't faint at the first whiff of grapeshot (like his weak-kneed Democratic counterparts) Shelby has shouldered the full-weight of executive pressure which has descended on him like a Appalachian rockslide. As a result, there's still a slight chance that the bill will have to be shelved and the industry reps will have to go back to Square One.

The country's economic predicament is steadily deteriorating. Orders for manufactured durable goods were off 4.5 percent last month while inventories continued to rise. Unemployment is soaring and the housing crash continues to accelerate. Credit Suisse now expects 10.3 million foreclosures (total) in the next few years. Numbers like that are not accidental, but part of a larger scheme to use monetary policy as a way to shift wealth from one class to another while degrading the nation's overall economic well-being. More alarming, the country's primary creditors are now staging a rebellion that is likely to cut off the flow of capital to US markets sending the dollar plummeting and triggering a deflationary credit collapse. This is from Reuters:

"Chinese regulators have asked domestic banks to stop lending to U.S. financial institutions in the interbank money markets to prevent possible losses during the financial crisis, the South China Morning Post reported Thursday. The China Banking Regulatory Commission's ban on interbank lending of all currencies applied to U.S. banks, but not to lenders from other countries, the report added."

Bloomberg News reports that Dallas Federal Reserve Bank President Richard Fisher has broken with tradition and lambasted the proposed bailout saying that it "would plunge the U.S. government deeper into a fiscal abyss."

From Bloomberg: "The plan by Treasury Secretary Henry Paulson to buy troubled assets from financial institutions would put 'one more straw on the back of the frightfully encumbered camel that is the federal government ledger,' Fisher said today in the text of a speech in New York. 'We are deeply submerged in a vast fiscal chasm.'...The seizures and convulsions we have experienced in the debt and equity markets have been the consequences of a sustained orgy of excess and reckless behavior, not a too-tight monetary policy," Fisher said to the New York University Money Marketeers Club." (Bloomberg)

Surely, the cure for hyperbolic "credit excesses and reckless behavior" cannot be "more of the same." In fact, Paulson's bailout does not even address the core issues which have been obscured by demagoguery and threats. The worthless assets must be written-down, insolvent banks must be allowed to go bust, and the crooks and criminals who engineered this financial blitz on the nation's coffers must be held to account.

The carnage from Greenspan's low interest rate, "easy money" binge is now visible everywhere. Inflated home and stock values are crashing as the gas continues to escape from the massive equity bubble. The FDIC will have to be recapitalized--perhaps, $500 billion--to account for the anticipated loss of deposits from failing banks caught in the cross-hairs of asset-deflation and steadily contracting credit. Recession is coming, but economic collapse can still be avoided if Paulson's misguided plan is abandoned and corrective action is taken to put the country on solid financial footing. Market Ticker lays out framework for a workable solution to the crisis, but they must be acted on swiftly to rebuild confidence that major systemic changes are underway:

1--Force all off-balance sheet "assets" back onto the balance sheet, and force the valuation models and identification of individual assets out of Level 3 and into 10Qs and 10Ks. Do it now. : (In other words, no more Enron-type accounting mumbo-jumbo and no more allowing the banks assign their own "values" to dodgy assets)

2--Force all OTC derivatives onto a regulated exchange similar to that used by listed options in the equity markets. This permanently defuses the derivatives time bomb. Give market participants 90 days; any that are not listed in 90 days are declared void; let the participants sue each other if they can't prove capital adequacy. (If trading derivatives contracts can damage the "regulated" system, than that trading must take place under strict government regulations)

3--Force leverage by all institutions to no more than 12:1. The SEC intentionally dropped broker/dealer leverage limits in 2004; prior to that date 12:1 was the limit. Every firm that has failed had double or more the leverage of that former 12:1 limit. Enact this with a six month time limit and require 1/6th of the excess taken down monthly. (Ed: The collapse in the "structured finance" model is mainly due to too much leverage. For example, Fannie Mae and Freddie Mac had $80 of debt for every $1 dollar of capital reserves when they were taken into government conservatorship.)

If there's going to be a bailout, let's get it right. Paulson's $700 billion bill does nothing to fix the deep structural problems in the financial markets; it merely pushes the day of reckoning a little further into the future while shifting the burden of payment for toxic assets onto the taxpayer.

Mike Whitney lives in Washington state. He can be reached at fergiewhitney@msn.com

Anatomy of meltdown of Wall Street & beyond

The question is if the whole financial system collapses and the real economy is pulled into a deep recession, what will be the cost. Therefore, our concern is on the consequence of this plan, not its superficial costs to taxpayers.”

The recent fall of Lehman Brothers, the sale of Merrill Lynch and the defacto nationalization of the insurance giant AIG touched off a run of $3 trillion dollars from money market mutual funds. Funds holding the paper of Lehman Brothers have sustained substantial losses.

We will not argue here whether US Treasury should have bailed out Lehman Brothers just like Bear Stearns but will only point out that, apparently, this firestorm caught the US Treasury by surprise and sent it into panic to the degree they proposed the hastily assembled 700 billion dollar Wall Street bailout plan.

What this huge government spending will do to the financial market, where the money will come from and what impact this plan will have on the overall economy needs to be evaluated carefully. This comment is dedicated to this purpose.

To understand the full scope and the impact of this R.T.C.II on the financial market, we need to examine the process of the meltdown of Wall Street and extract common characters of failures

To begin with we post our favorite updated graph to show the onset of financial panics.

The heights of the red and the green curves measure the level of panic of the financial market; the definitions of those curves are given in the graph so will not be repeated here.

Section (1) of the graph covers the period of the first firestorm that shut down the market of commercial paper backed by ill fated mortgages and the implosion of SIV.

Section (2) of the graph covers the 2007 year-end panic that has forced The Federal Reserve Board to lower the target rate of federal funds by an unprecedented amount in a very short period.

Section (3) covers the period of the fall of Bear Stearns, and

Section (4) deals with the current panic of our concern.

The period of the fall of Fannie Mae and Freddie Mac is not included since everyone knows that US Government will not walk away from debt obligations and mortgage backed securities guaranteed by those two mortgage giants, and so the financial market did not panic very much.

We can see that in the ongoing panic the heights of the red and the green curves far exceed the previous peaks in Sections (1) to (3). This helps us to understand why US Treasury is panicked into proposing the 700 billion dollar bailout plan.

We estimate that there are 3 trillion dollar toxic debts in face value.

When various entities purchased those toxic debts, most used short-term borrowings to finance the purchases. The reason for this financial scheme is as follows: The entities that bought the toxic debt profit from the difference between the interest received from the toxic debt and the interests paid out to borrow the money to finance the purchases.

The lowest cost borrowing is the short-term borrowing.

Since the efficiency of profit in this model is rather poor due to the small difference between two kinds of interest rates, the participating entities need to borrow huge amount of money to purchase large amount of toxic debt in order to have enough profits to make the effort worthwhile.

The ratio of borrowed amount to the capital of an entity is called the “leverage” ratio. Those entities loaded up with large amount of toxic debts usually have a very high leverage ratio, often as high as 30 times or more.

During bubble times those entities had no trouble rolling over their short-term borrowings and enjoyed enormous amount of easy profit. However, when the bubble burst and the liquidity squeeze set in, those highly leveraged entities encounter increasing difficulty of rolling over their short-term debts and start to fall apart, naturally with the financially weak ones going first.

Consider an example to illustrate how the leverage backfires

Suppose an investment bank with $30 billion dollars of capital decides to use $3 billion dollars of its capital to engage in the game of toxic debts.

It borrows 30 times $3 billion dollars, that is $90 billion dollars, in the short-end of the market to purchase $90 billion dollars of toxic debt. Such purchases naturally boost the price of toxic debt. During the bubble years, the rollover of $90 billion dollars of short-term borrowings is not a problem and the game brings in handsome profits quarter after quarter.

However, when the bubble bursts and the liquidity squeeze sets in, purchasers of the toxic debt dry up and the price of those toxic debts naturally fall. Suppose the price of toxic debts falls by one-third so the market value of the $90 billion dollar of toxic debt held by the investment bank is now only worth $60 billion dollars. This loss of $30 billion dollars wipes out all the capitals of the firm so that it is insolvent by definition.

When the market notices the trouble of the firm, lenders refuse to rollover the $90 billion dollar short-term borrowings, and the clients of the firm will withdraw money from their accounts managed by the firm.

Thus the investment bank collapses, literally within a very short time. That's what happened to Bear Stearns and Lehman Brothers. That is also why Merrill Lynch merged with Bank of America so its short-term borrowings can be supported by Bank of America's huge deposit base.

The demise of the insurance giant AIG took somewhat of a different path. In Comment 54 we estimated the exposure to toxic debts for various industries by examining the pattern of sale of corporate bonds in the last half of 2007, using data from the z1-report of The Federal Reserve Board.

In that comment we found no evidence that insurance companies were exposed significantly to toxic debts directly. However, we warned that it does not mean insurance companies are free from indirect exposure to toxic debts through financial derivatives.

Considering large amount of financial derivatives (to insure the default on those toxic debts outstanding) the insurance industry is one of the natural suspects that has provided such “protection”. Unfortunately that suspicion has become the reality with AIG. AIG had sold more than $100 billion dollar worth of such insurances. As the price of toxic debts fell, AIG sustained increased call for collateral to cover its losses on those insurances, and thus was driven to the brink of bankruptcy.

Those financial derivatives, called Credit Default Swap or CDS, are unregulated private contracts between two parties. The default of AIG will nullify the protection bestowed on the holders of actual toxic debts through the insurance, so many of them will be pulled into destruction, too.

It is estimated that there are over $60 trillion dollar worth of CDS outstanding. Considering that there are only less than 10 trillion dollars of US corporate bonds in total, the players in the game of CDS are multiple players. This means that many players pulled into destruction by the default of AIG must have sold some form of CDS to others, so the buyers of their CDS will also fail, and so on.

This kind of domino effect will bring down the whole house cards of $60 plus trillion dollars of CDS . The collapse of the house of CDS will certainly bring down the whole global financial system and will usher in a global depression.

That is the reason why US Government has no choice but to infuse $85 billion dollars into AIG to prevent its outright default.

The bane of heavy leverage is not only limited to the entities that lose big in toxic debts.

Even the firms showing reasonable earnings cannot escape the fate of demise as it becomes increasingly difficult to roll over their short-term borrowings, even though those borrowings are not related to losing positions, at the time of steadily advancing liquidity squeeze.

That is why the remaining two prominent investment bankers, Morgan Stanley and Goldman Sachs have abruptly transformed themselves into commercial bank holding companies. Investment bankers are loosely regulated by SEC but commercial bank holding companies are regulated tightly by The Federal Reserve Board.

Readers interested in the detailed implications of the transition are referred to an excellent article by John Hilsenrath, Damian Paletta and Aaron Lucchetti on the website of The Wall Street Journal.

In essence, commercial banks are not allowed to have as high leverage as investment banks and are forbidden to conduct risky dealings, but are allowed to take deposits from depositors to secure a more stable funding.

This transition is tantamount to an announcement that, going forward, leverage will be reduced and the firms will be managed much more conservatively from now on. This transition allows Goldman and Morgan to attract urgently needed capital infusion to reduce their leverage. After the announcement Morgan Stanley has already received capital infusion from a giant Japanese bank, and Goldman Sachs has received capital infusion from Warren Buffett's Berkshire Hathaway.

The rapid-fire disappearance of five major investment banks and the demise of AIG can be properly described as the meltdown of Wall Street. Some claim that after the meltdown, Wall Street will be dominated by hedge funds and private equity firms, playing the role of the five disappeared investment bankers. But no matter who play the dominant roles on Wall Street from now on, the days of high leverages are over.

Swash-buckling wheeler dealers will be replaced by stogy commercial bankers with regulators looking over their shoulders every step on the way. Total size of deals on Wall Street will be much smaller since high leverage ratios are not allowed. Overall profits from the deals will be reduced substantially as the result. Far fewer people will be working for Wall Street, too. Though this meltdown will not send Wall Street into oblivion yet, as depicted in the sarcastic drama of article 7 on this website, its former glory days have definitely gone with the wind.

The common undertone in our discussion of the meltdown of Wall Street is the ongoing liquidity squeeze.

Readers not familiar with previous writings in this series titled “Tracing the liquidity squeeze” may wonder where this liquidity squeeze come from

Let us summarize our finding here quickly. Since articles 1, 2, and 2A, we have found that the US economic cycle is synchronized with the flows and ebbs of trade deficits and the trade deficit is in turn pushed around by the exchange rate of US Dollar with the currencies of its trade partners. In Comment 46, the starting comment of this series, we have pointed out that the formation of the current debt bubble and its burst are due to the third phase of the runaway trade deficit and the wane of that trade deficit since 2006. In article 10 a more thorough study of the relation between bubbles and trade deficits is presented.

The reason that the flows and ebbs of trade deficit will cause the formation of bubble and its burst can be summarized quickly as follows:

A modern financial system requires seed money to operate. In the era before globalization the seed money must come from personal savings. In the globalization era, the runaway trade deficit can replace personal savings to serve as the seed money to the financial system. As the US runs its trade deficit, dollars are handed over to foreign manufacturers and those dollars eventually flow into the hands of foreign governments through the process of currency market intervention to keep their currency suppressed and their exports humming.

Foreign governments have no choice but to bring large blocks of those dollars back to the US financial market to generate some returns. Those returned dollars flow through the hands of Wall Street and become the seed money to the US financial market to be lent out repeatedly. By this way Wall Street can brew bubbles by repeatedly lending out this huge sum of flowing back dollars without the constraints imposed by The Federal Reserve Board.

At the present stage US personal savings have dwindled to near zero and almost all the seed money comes from the runaway trade deficit. However, the runaway trade deficit causes the US Dollar to depreciate in spite of tremendous efforts of foreign governments to prevent its fall. As Dollar falls, US trade deficit wanes.

The US trade deficit peaked in early 2006 at 6% of GDP, but dwindled to 5% of GDP by early 2008. This means less seed money for the financial market and an ongoing liquidity squeeze. There is no prospect that US Dollar will strengthen in near future to the degree that US trade deficit will expand anew, and there is also no prospect that US personal savings can grow rapidly in foreseeable future. Thus we should expect the liquidity squeezed to continue for quite a while.

As Wall Street melts away under its own weight, the burden to carry toxic debts shifts mainly to the shoulder of commercial banks, posing serious danger for the whole financial system.

The US Treasury's proposed $700 billion dollar bailout plan is designed to prevent the collapse of the financial system

The plan is to buy toxic debts held by various financial entities. The first question is at what price to buy those toxic debts. The current ongoing market price is like 50% to 60% discount from their face value. Some financial entities have written down their toxic debts to a certain degree, some already to the level of the market price. There are also substantial number of holders of toxic debts that have not written down their holdings.

The buying of the toxic debts will be performed through reverse auctions that works as follows: the US Government will announce a reverse auction, say of buying $50 billion dollars of toxic debts. The entities that want to participate will submit a price for their toxic debts. The US Government buys those debts from the lowest priced ones first until it fills all $50 billion dollars.

How about to view the auction from the holders of the toxic debts? If a holder sells his toxic debt below the price that has been written down, he will receive a financial hit. Therefore, the holders will be reluctant to sell their holdings below the already written down prices.

For example, if a holder has already written down his holdings by 30%, he will not sell the holdings to US Government beyond this 30% discount, otherwise he will receive a financial hit.

We can expect that the most written down toxic debts will be sold first. As the reverse auctions are repeated, the prices that US Government pays will steadily rise. As a whole the prices sold to US Government will be substantially higher than the ongoing market price.

To deflect the unavoidable criticism that US taxpayers are ripped off by paying such high prices, an idea of “maturity price” is floated

The maturity price is the money that can be recovered if the toxic debts backed by subprime mortgages are allowed to be kept to maturity.

- Let us estimate what this maturity price is:

It is said that totally $5 million mortgages will be foreclosed in the aftermath of the mortgage bubble burst. Let us assume that only $3.5 million foreclosures are due to subprime mortgages. There are $1 trillion dollar worth of subprime mortgages. With an average housing price of about $200,000, there are totally 5 million subprime mortgages outstanding. The 3.5 million foreclosures mean an eventual 70% foreclosure rate. Suppose 60% of the amount of the mortgage can be recovered at the time of foreclosure. That means at the end $1 trillion dollar worth of subprime mortgages will become $580 billion dollars, that is a discount of 48%. If this whole process takes 10 years to complete and annual inflation rate is 3%, after adjusted for this inflation, the current value of maturity price of this 1 trillion dollar subprime mortgages becomes about $400 billion dollars, or 60% discount.

This number is not so different from the current market price for such toxic debts. The expected substantially higher buying price of those debts under the plan, thus, cannot be the maturity price. It is an arbitrary higher price necessary to save the troubled financial system.

If we concentrate only on this plan, US taxpayers are almost certain to lose a substantial sum when the dust finally settles. However, what amount US taxpayers will lose should not be the concern here. The question is if the whole financial system collapses and the real economy is pulled into a deep recession, what will be the cost. Therefore, our concern is on the consequence of this plan, not its superficial costs to taxpayers.

Even with this $700 billion dollar rescue plan, there is still a serious uncertainty hanging on the head of the whole financial system. We estimate that there are about $3 trillion dollars of toxic debt outstanding. With a market price of 50% discount the loss is something like 1.5 trillion dollars. So far various financial entities have written down about $500 billion dollars.

Counting the $85 billion dollar infusion by US Government to AIG and the likely under write-down by those financial entities, there are still about $800 billion dollars of loss not accounted for

Some of those hidden toxic debts are probably held by deep pocket investors who purchased those toxic debts from their own capital, so they do not need to roll over short-term borrowings, and are willing to hold them to maturity. We do not need to worry about those lucky (may be unlucky) investors. However, we suspect there are a few hundred billion dollars of loss, or about $600 billion dollars of toxic debts not accounted for.

Most likely the holders of those toxic debts are protected by derivatives like CDS so that those holders do not consider that they have lost any money and thus no need to report their holdings. As explained in the discussion about the demise of AIG those private unregulated derivatives are zero sum games.

If someone is protected by insurance, someone must have sold those insurances and is now carrying enormous potential losses

We do not know who those insurance sellers are, but the market participants speculate that they may be large multinational banks.

The sales of those insurances are not tangible securities and certainly are not covered by the rescue plan

What if the mystery holders of those toxic debts decide to tender their securities to US Government through the reverse auctions and then request insurance sellers to make good of the difference between the price they bought those securities and the price that US Government buys those toxic debts. At that time another firestorm is certain to erupt.

Liquidity & Turnover: Tracing the Squeeze

The amount of liquidity, or some call it credit, is determined not totally by the amount of the seed money for the financial market, but also influenced by the speed of turning over the seed money.

- In a simplistic way we may consider as follows:

Suppose there are $600 billion dollars of trade deficit to serve as the seed money for the financial market. If it is turned over 5 times a year, $3 trillion dollars of liquidity or credit are created. If it turns over 10 times a year, $6 trillion dollars of liquidity or credit are created, and so on. At the height of the bubble, both the seed money from the trade deficit and the turn over speed reached the maximum and thus allowed the entities leveraged to the maximum.

When the trade deficit wanes, the seed money starts to shrink, buyers of the already highly inflated debt instruments dwindle, the prices of those toxic debts start to fall, and the turnover speed also slumps. The resulting squeeze on liquidity is thus much worse than the rate of the shrinkage of the seed money.

The $700 billion dollar rescue plan replaces some toxic debts with cash for the financial system. The financing of this rescue plan is to get the money by selling Treasuries into the open market. This means that the source of the financing of this rescue plan also come from the seed money provided by the trade deficit, so the plan will not increase the total amount of seed money.

What this rescue plan will do is to push up the turnover rate of the seed money somewhat by unclogging the artery of the financial system that are clogged by toxic debts, and thus helps to ease the liquidity squeeze to certain degree.

However, if the trade deficit continues to wane as we expect, the dwindling seed money will eventually overwhelm the stimulus on the turnover rate provided by the plan, and the condition of the liquidity squeeze will return to the level before the rescue plan, probably within 6 months. We regard this rescue plan as a temporary relief, but not as the panacea.

What will US Government do if our projection becomes the reality and the grand liquidity squeeze returns?

The last resort of the US Government is for The Federal Reserve Board to print money in large scale to replenish the dwindling seed money for the financial market. Such large scale monetization,of course, is highly inflationary. Any time when economy rises its head, inflation is going to zoom up. If The Federal Reserve Board acts prudently by raising interest rate at that time, then another economic slow down will set in, creating a prolonged stop-and-go scenario with the economy standing still when averaged out.

If The Federal Reserve Board lags behind the inflation surge, then high inflation will turn into hyper inflation and the scene of 1970's will be repeated.

The (much quieter) bank panic

Need for action on the banking panic

Published: September 25 2008 18:10 | Last updated: September 25 2008 18:10

Banks are not to be trusted. This is not just the view of the public and policymakers, but that of the banks themselves. Spreads on unsecured inter-bank lending have reached unprecedented levels, particularly in dollars and, to a lesser degree, sterling. Such stresses cannot continue for long, without serious damage to both the financial system and the economy. Something has to be done. The question is: what?

Thursday’s spread over one month between the London interbank offered rate and future expected policy rates was close to 200 basis points for dollar loans and 120 basis points for sterling ones. In the case of dollar loans, the spread was nearly twice as high as at any point since the crisis began in August 2007. Market stress has evidently reached frightening levels.

If lenders demand huge spreads for such short periods, they are either tightly constrained in their ability to lend, deeply concerned about the solvency of counterparties, or engaged in predatory behaviour. Whichever of these possibilities is true, credit to the economy will dry up. If banks do not trust banks, what do they trust? The answer is: only the government.

This dire situation makes decisive action essential. Beyond doubt, failure by the US Congress to pass a rescue package would court catastrophe. But the plan proposed by Hank Paulson, US treasury secretary, is inadequate. This, too, is the banks’ view. They know his plan is likely to pass, in some form, yet seem increasingly nervous.

So what is to be done? The response must have three elements.

First, in the absence of private funding, central banks must do the intermediation among banks. Moreover, banks cannot fund ongoing operations overnight. So all central banks must shift liquidity provision away from overnight lending, towards much longer maturities.

Second, the US Congress must pass a version of the Paulson plan. This must promise to make the distressed securitised mortgage assets now on the books of the banks more liquid. While the initial plan needed improvement, a better version must be enacted extremely soon.

Finally, not only the US, but also other countries, and particularly the UK, need to put in place a credible plan for the forced recapitalisation, or closure, of weakened banks. Banks unable to borrow are zombies. They must be restored to health or allowed to perish quietly.

Some of these actions are going to be highly unpopular with powerful interests, including the banks themselves. So be it. With the banking system in dire distress, effective action is needed right now.