US government throws oil on fire

By Henry C K Liu

Free-market fundamentalists have been operating in denial mode for more than a year, since the US financial sector imploded in a credit crisis from excessive debt in August 2007, claiming that the economic fundamentals were still basically sound, even within the debt-infested financial sector.

As denial was rendered increasingly untenable by unfolding events, champions of market fundamentalism began clamoring for increasingly larger doses of government intervention in failed free markets around the world to restore sound market fundamentals. For the market fundamentalist faithful, this amounts to asking the devil to save god.

Aside from ideological inconsistency, the real cause of the year-long credit crisis has continued to be misdiagnosed in official circles whose members had until recently tirelessly promoted the merit of small government, perhaps even purposely by those in the position to know better and in whom society has vested power to prevent avoidable disaster. The diagnosis misjudged the current credit crisis as only a temporary liquidity quandary instead of recognizing it as a systemic insolvency. (See Fed helpless in its own crisis, Asia Times Online, January 26, 2008.)

The misdiagnosis led to a flawed prognosis that the liquidity crunch could be uncorked by serial injections of more government funds into intractable credit and capital market seizure. This faulty rationale was based on the fantasy that distressed financial institutions holding assets that had become illiquid could be relieved by wholesale monetization of such illiquid asset with government loans, even if such government loans are collateralized by the very same illiquid assets that private investors have continued to shun in the open market.

It is not that government officials know more than market participants about the true value of these illiquid assets; it is only that government officials with access to taxpayers' money have decided to ignore market forces to artificially support asset overvaluation, the original root cause of the problem. Instead of being the solution, the government with flawed responses backed by the people's money has become part of the problem.

President George W Bush told the American people on October 10 that "the fundamental problem is this: As the housing market has declined, banks holding assets related to home mortgages have suffered serious losses. As a result of these losses, many banks lack the capital or the confidence in each other to make new loans. In turn, our system of credit has frozen, which is keeping American businesses from financing their daily transactions - and creating uncertainty throughout our economy."

Skipping over the basic fact that the housing market has been declining because of a burst credit bubble, the president went on to identify five problems, the first of which is that "key markets are not functioning because there's a lack of liquidity - the grease necessary to keep the gears of our financial system turning. So the Federal Reserve has injected hundreds of billions of dollars into the system. The Fed has joined with central banks around the world to coordinate a cut in interest rates. This rate cut will allow banks to borrow money more affordably - and it should help free up additional credit necessary to create jobs, and finance college education, and help American families meet their daily needs. The Fed has also announced a new program to provide support for the commercial paper market, which is freezing up. As the new program kicks in over the next week or so, it will help revive a key source of short-term financing for American businesses and financial institutions."

The market responded to the president's speech with a one-day rally before resuming its sharp downward spiral, continuing a response pattern to all previous government announcements of drastic but allegedly necessary measures in recent weeks to stop the financial hemorrhage once and for all. Stocks posted the biggest drop since the 1987 crash two days after the president and Treasury Secretary presented the government's new "comprehensive" program to arrest the financial crisis.

Four levels of the credit crisis
The current credit crunch takes form on four separate but interrelated market levels.

On the first level is the banking system which traditionally intermediates credit through deposit taking and conventional lending.

A second level is the non-bank credit market via which institutional and corporate borrowers issue commercial paper for short-term funding by borrowing directly from institutions with surplus cash to invest, bypassing banks and using banks only as standbys in case maturing commercial paper cannot be rolled over occasionally.
A third level is the structured finance market in which debt securitization provides liberal credit to large pools of high-risk borrowers, with pools of debt structured as unbundled debt instruments of varying but connected degrees of risk, financed by funds from institutional investors with varying appetite for risk commensurate with varying levels of return, thus enabling pension funds and money market funds to invest in the upper tranches of structured debt that are supposed to be safe enough to satisfy conservative fiduciary requirements, but in aggregate adds up to corresponding escalation of systemic risk should any one link in the interconnected system fails.
Finally, there is the capital market where companies go to raise new capital in times of need, where in times of sudden and severe need can turn into a market opportunity for vultures. (See The pathology of debt, a five-part series initiated on Asia Times Online, November 27, 2007.)

Central banks around the world, led by the US Federal Reserve, generally have the institutional authority, historical experience and monetary resources to keep the traditional regulated banking system from failing, by nationalization and eventual consolidation.
As currently structured, central banks are not in possession of ready authority, operational experience or financial resources to keep the now vastly larger non-bank credit and capital markets from failing. Under conditions of a liquidity trap, central banks do not even have the means to force banks to lend to credit-unworthy or unwilling borrowers. This is known as the Fed pushing on a credit string. Further, the Fed is approaching the lower end of interest rate cuts, with the Fed funds rate target already at 1.5%. It cannot go below zero.

According to free-market principles, a healthy banking system is supposed to be able to save itself from systemic collapse by allowing individual wayward banks to fail. The fact that increased number of mismanaged banks is threatened with failure does not normally add up to any threat of systemic failure in the banking system. It in fact testifies to the systemic resilience of a healthy banking system.

The current problem arises from intricate and close interconnection among financial institutions and markets, which has made too many financial institutions "too big to fail" because their individual failure can cause systemic collapse through widespread interconnected contagion throughout the market.

For example, the trigger point behind Bear Stearns's near failure came from the repo market, where banks and securities firms routinely extend and receive short-term loans, typically made overnight and backed by top grade securities. Hours before 7:30am on March 14, 2008, Bear Stearns was faced with the problem of not being able to roll over its huge repo debt because its high-rated collaterals had fallen in market value. If the firm did not repay the maturing debt on time with new funds from new repo contracts, its creditors could start selling at fire-sale prices the collateral Bear had pledged to them, to cause substantial loss to Bear Stearns.

The implications would go far beyond losses for Bear Stearns. The sale receipts might not repay all investors and cause losses to conservative institutional investors such as pension funds and money market funds. If investors begin to question the safety of loans collateralized by triple-A securities they make in the repo market that are now worth less than their face value, they could start to withhold funds from the credit market when other investment banks and companies need to roll over their maturing short-term debts.

Hundred of firms would default and fail from a seizure of the $4.5 trillion repo market, bringing down banks that have issued standby credit to them in a financial chain reaction.

The distressing part is that the $4.5 trillion repo market is not an untested novel financial innovation such as subprime-mortgage-backed collateralized debt obligations. It is a decades-old, plain-vanilla debt market where market risk is considered minimal. A major counterparty default in the repo market would have been unprecedented because the collateral accepted in a repo contract is generally considered as triple-A rated, and such a default could have systemic consequences for the entire credit market and even impair the ability of the central bank to maintain the Fed funds rate target, which it normally does by participating in the repo market.

As I wrote three years ago (see The repo time bomb, Asia Times Online, September 29, 2005):
As with other financial markets, repo markets are subject to credit risk, operational risk and liquidity risk. However, what distinguishes the credit risk on repos from that associated with uncollateralized instruments is that repo credit exposures arise from volatility (or market risk) in the value of collateral. For example, a decline in the price of securities serving as collateral can result in an under-collateralization of the repo. Liquidity risk arises from the possibility that a loss of liquidity in collateral markets will force liquidation of collateral at a discount in the event of a counterparty default, or even a fire sale in the event of systemic panic. Leverage that is built up using repos can exponentially increase these risks when the market turns. While leverage facilitates the efficient operation of financial markets, rigorous risk management by market participants using leverage is important to maintain these risks at prudent levels.

In general, the art of risk management has been trailing the decline of risk aversion. Up to a point, repo markets have offsetting effects on systemic risk. They can be more resilient than uncollateralized markets to shocks that increase uncertainty about the credit standing of counterparties, limiting the transmission of shocks. However, this benefit can be neutralized by the fact that the use of collateral in repos withdraws securities from the pool of assets that would otherwise be available to unsecured creditors in the event of a bankruptcy. Another concern is that the close linkage of repo markets to securities markets means they can transmit shocks originating from this source. Finally, repos allow institutions to use leverage to take larger positions in financial markets, which adds to systemic risk.
A crisis emerges
In the structured finance market, a separate crisis was emerging, exacerbated by problems in the repo market. In March 2008, the Federal Reserve created a new facility to swap up to $200 billion of its Treasury securities for hard-to-trade mortgage-backed securities held by investment banks. A week later, the Fed took over $29 billion of investment bank Bear Stearns' obligations to prevent a chaotic failure of the firm and to enable its takeover by JPMorgan Chase with loans from the Fed discount window and by limiting potential loss to JPMorgan Chase to $2 billion. The Fed also opened its discount window to investment banks, making it the first time since the Great Depression that non-banks had been allowed to borrow from that window.

And in July, the Fed agreed to lend to Fannie Mae and Freddie Mac from its discount window should it "prove necessary". In the same month, another government arranged "shotgun marriage" induced Bank of America to acquire Merrill Lynch at a fire sale price of $50 billion. On September 18, the Federal Reserve pumped another $105 billion into the banking system.

Credit rating agencies may play a key role in structured finance transactions. Unlike a "typical" loan or bond issuance, where a borrower offers to pay a certain return on a loan, structured financial transactions may be viewed as either a series of loans with different characteristics, or else a number of small loans of a similar type packaged together into different loans called "tranches". Credit ratings often determine the interest rate or price ascribed to a particular tranche, based on the quality of loans or quality of assets contained within that grouping.

Companies involved in structured financing arrangements often consult with credit rating agencies to determine how to structure individual tranches of debt so that each receives a desired credit rating to certify its risk exposure. For example, a firm may wish to borrow a large sum of money by issuing debt securities. However, the amount is so large that the return investors may demand on a single issuance would be prohibitive. Instead, it decides to issue three separate bonds, with three separate credit ratings: A (medium low risk), BBB (medium risk), and BB (speculative), using the rating system of Standard & Poor's. The firm expects that the effective interest rate it pays on the BB-rated bonds will be more than the rate it must pay on the A-rated bonds, but that, overall, the amount it must pay for the total capital it raises will be less than it would pay if the entire amount were raised from a single bond offering. This is the basic principle of structured finance: the squeezing of financial value out of unbundling of debt.

As the transaction is devised, the firm may consult with a credit rating agency to see how it must structure each tranche - in other words, what types of assets must be used to secure the debt in each tranche - in order for that tranche to receive the desired rating. The structure is such that the credit rate of any one tranche will change if the credit ratings of other tranches at the riskier end change. This could cause triple-A rated tranches to be down rated in a down market.

Criticism surfaced in the wake of large losses in the collateralized debt obligation (CDO) market that occurred despite being assigned top ratings by the credit rating agencies. For instance, losses on $340.7 million worth of CDOs issued by Credit Suisse Group added up to about $125 million, despite being rated AAA or Aaa by Standard & Poor's, Moody's Investors Service and Fitch Group.

The rating agencies respond that their advice constitutes only a "point in time" analysis, that they make clear that they never promise or guarantee a certain rating to a particular tranche, and that they also make clear that any change in circumstance regarding the risk factors of any particular tranche will invalidate their analysis and result in a different credit rating. In order words, the risk structure is dynamic and systemic. In addition, most credit rating agencies do not rate bond issuances upon which they have offered rating structure advice, unless a firewall exists to avoid potential conflict.

Complicating matters for structured finance transactions, the rating agencies state that their ratings are opinions regarding the likelihood that a given debt security will fail to be serviced over a given period of time, and not an opinion on the volatility of that security and certainly not the wisdom of investing in that security.
In the past, most highly rated (AAA or Aaa) debt securities had characteristics of low volatility and high liquidity - in other words, the price of a highly rated bond did not fluctuate greatly day-to-day, and sellers of such securities could easily find buyers. However, structured transactions that involve the bundling of hundreds or thousands, or even millions, of similar (and similarly rated) securities tend to concentrate similar risk in such a way that even a slight change on a chance of default can have an enormous effect on the price of the bundled security.

This means that even though a rating agency could be correct in its opinion that the chance of default of a structured product is very low under normal market conditions, even a slight change in the market's perception of, and aversion to the risk of that product can have a disproportionate effect on the product's market price, with the result that an ostensibly AAA or Aaa-rated security can collapse in price even without there being any actual default or changes in significant chance of default. This possibility raises significant regulatory issues because the use of ratings in securities and banking regulation assumes incorrectly that high ratings correspond with low volatility and high liquidity.

Fed supports money market mutual Funds
The US Federal Reserve on October 21 announced it would create a Money Market Investor Funding Facility (MMIFF) to support a private-sector initiative designed to provide liquidity to US money market investors. MMIFF will finance up to $540 billion in purchases of short-term debt from money market mutual funds to shore up a key pillar of the US financial system.

MMIFF will provide senior secured funding to a series of special purpose vehicles to facilitate an industry-supported private-sector initiative to finance the purchase of eligible assets from eligible investors. Eligible assets will include US dollar-denominated certificates of deposit and commercial paper issued by highly rated financial institutions and having remaining maturities of 90 days or less. Eligible investors will include US money market mutual funds and over time may include other US money market investors.

The implosion of Enron eight years ago was caused by "special purpose vehicles" which were early incarnations of present-day "conduits" backed by phantom collaterals. Enron's collapse was a high-profile event that briefly brought credit risk to the forefront of concern in the financial services industry. Collateral management rose briefly from the Enron ashes as a critical mechanism to mitigate credit risk and to protect against counter-party default. Yet in the recent liquidity boom, collateral management has again been thrown out the window and rendered dysfunctional by faulty ratings based on values "marked to theoretical models" that fall apart in disorderly markets. (See The rise of the non-bank financial system, Asia Times Online, September 6, 2007).

Money market funds are facing severe redemption pressures since the financial crisis deepened last month, forcing them to raise cash by scaling back their short-term lending to banks and selling their holdings of commercial paper. This retreat has contributed both to a freeze in the interbank market and a steep decline in activity in the commercial paper market, which has made it difficult for banks and companies to raise short-term funds.

The Fed move on October 21 highlights the extent to which policymakers are concerned about US money markets, even as inter-bank lending rates dropping slightly. Policymakers are also worried that moves to prop up US banks may have undermined money funds, which compete with bank savings accounts.

"The short-term debt markets have been under considerable stress in recent weeks as money market mutual funds and other investors have had difficulty selling assets to satisfy redemption requests and meet portfolio rebalancing needs," the Fed said.

Under the Fed scheme, the US central bank will lend money to five special purpose vehicles, to be managed by JPMorgan Chase, tasked with purchasing assets from money market funds. These assets are low-risk paper, including certificates of deposit, bank notes and commercial paper with three-month maturities or less.

The creation of an extra liquidity facility on October 21 was seen as complementing a move the Fed announced two weeks earlier to create a vehicle aimed at purchasing potentially unlimited amounts of three-month debt from banks and non-financial companies. The size of the Fed's balance sheet has nearly doubled.

Each of the five vehicles may purchase paper from 10 financial institutions. The overall size of the program is capped at $600 billion - with the Fed funding 90% and the funds, which sell assets, taking the first 10% of losses. The Fed announced its plan even as money markets showed signs of easing. Overnight dollar Libor (London Interbank Offered Rate) declined 23 basis points to 1.28%, below the Fed's target rate of 1.5%. Three-month dollar Libor eased to 3.83%, its lowest fix in nearly a month. Three-month Libor was fixing about 2.80% prior to upheavals and has yet to reflect the Fed's rate cut on October 8 of 50 basis points.

Strategy ignores asset overvaluation
Although each step by the government in reaction to the credit crisis was a logical, targeted response to new systemic financial upheavals, the result was to prop up select distressed firms deemed too big to fail and support failing markets as they occurred, hoping in vain that it would be the last move needed to resolve the systemic crisis to put the economy on a path of recovery. The Fed and the Treasury appeared to be rushing from emergency to emergency without a strategic plan to deal with the fundamental problem of a debt bubble collapse.

The disjointed interventions appeared designed to keep a collapsing debt bubble from collapsing, a hopeless task that even former Fed chairman Alan Greenspan, the bubble wizard par excellence, was not naive enough to try. Greenspan merely replaced a burst bubble with a new bigger bubble, never trying to stop a collapsing bubble in mid course. Greenspan's approach was that of a post-disaster cleanup crew, not rushing into a collapsing structure as the current bailout team appears to be trying to do. Throwing good money after bad merely makes good money into bad. Spending good money after the collapse would infinitely buy more in the cleanup task.

Added to the mix was the political problem of government credit allocation. In April, Chris Dodd, chairman of the Senate Banking Committee, demanded that the Fed permit top-rated securities backed by student loans that now had uncertain market value and anemic liquidity to qualify for its $200 billion swap program. "If the Fed and the Treasury can commit $30 billion of taxpayer money to enable the takeover of Bear Stearns by JPMorgan Chase, then surely they can step in to enable working families to achieve the dream of a higher education for their children," the senator declared.

Two weeks later, the Fed said it would accept any AAA-rated securities as collateral, including those backed by student loans. The Fed has forced to move from its traditional role of neutral macro policy of stabilization to direct specific credit allocation, albeit in this particular case for a worthy cause, for where is the logic of saving the banking system to save tax payers' homes and not save the education of the nation's youths. As a matter of national policy, all education should be financed by public funds since education is the most rewarding social investment a society can make. Another is universal health care.

The economies of New York and New Jersey are also now severely impacted by the financial crisis on Wall Street. These states normally derive up to 30% of their revenue from the financial sector. The governors of the two states are calling for further stimulative aid from Washington. California is also saying it needs low-interest loans from the federal government to help with its budgetary shortfalls. The problem will spread to all states as the problems in financial sector spread to the economy.

The Fed floods Europe with dollars
On Monday, October 13, the Federal Reserve opened up the dollar spigot to European central banks to support the European dollar credit markets by agreeing to provide unlimited dollars, up from its previous $620 billion in currency swaps, to the three major central banks: the European Central Bank, the Bank of England and the Swiss National Bank, to allow them to relieve liquidity pressure on commercial banks across their respective regions.

Dollars had become elusive in recent weeks in the European banking system as short-term money markets around the world deteriorated. Domestic and foreign banks in Europe had been frozen out of loans beyond a day as institutions hoarded dollar resources amid concerns about counterparty default. Around the world, central banks were forced to move from the traditional role of monetary rule-makers to that of money and currency market players.

Meanwhile, to offer vastly more operational space to expand its liquidity facilities during the credit crisis, the Fed received authority from the Treasury in early October to start paying interest on reserves that commercial banks are required to deposit at the Fed.

Prompted by the US, governments across Europe took action to bail out their respective banks and protect their separate banking systems after the meeting of the Group of Seven leading industrialized countries in Washington during the weekend of October 11.

France extended state guarantees to $435 billion of senior bank debt to help jumpstart that country's credit markets. It created a state company with up to $54 billion in capital to recapitalize distressed French banks. The UK guaranteed $434 billion of bank debts and injected $64 billion into Royal Bank of Scotland Group, HBOS, a banking/insurance group in the UK, and Lloyds TSB Group, as part of its already announced ฃ400 billion (US$651 billion) bail-out plan.

Germany guaranteed up to $544 billion inter-bank debts, setting aside $27 billion for potential losses and injected up to $109 billion equity in German banks. Italy announced it will recapitalize Italian banks and guarantee bonds on a case-by-case basis. Spain will guarantee $136 billion in Spanish bank debts, set up a preventive facility to inject new capital into distressed Spanish banks until 2009 and establish up to $68 billion to buy Spanish bank assets.

The Netherlands is injecting 10 billion euros (US$13.4 billion) into ING Group, the banking and insurance giant which just weeks earlier was the white knight to bail out troubled Fortis. Austria, Portugal and Norway joined the effort, committing a total of 501 billion euros in guarantees and capital for banks in their respective jurisdiction.

Iceland banking crisis and geopolitics
Iceland's banking system meanwhile collapsed in September causing losses to non-Icelandic European depositors who were attracted by higher interest rates paid by Icelandic banks. The tiny country over the past decade had embraced neoliberal free-market capitalism and built a financial sector that brought unprecedented but unsustainable prosperity to its 300,000 people and won temporary favor with foreign savers and investors.

Iceland's financial crisis cannot be solved by bank nationalization, currency de-pegging and stock market suspension because its central bank, unlike the US Federal Reserve, which can produce dollars at will, must either earn or borrow euros and dollars. Failing to access International Monetary Fund loans because it is not yet part of the EU, Iceland turned to Russia for help. Commenting on the possibility of a 4 billion euro loan from Russia, Icelandic journalist Omar Valdimarsson ridiculed the value of 50 years of "special relationship" with the US by quoting Deng Xiaoping's famous saying: "It does not matter if the cat is black or white as long as it catches mice." The fat cat is Russia, although at the time of writing agreement with Moscow had yet to be reached.

Various reports, including in Business Week, on October 21 indicated Iceland "was likely" to receive a $6 billion rescue package "tailored by the International Monetary Fund (IMF), Nordic countries and Japan".

Crisis in East European banks
Banks in emerging economies in post-communist Eastern Europe, such as Hungary and Ukraine, were also hard hit. Ukraine, whose economy has been badly hurt from falling steel prices, may be unable to quickly accept a loan offered by the International Monetary Fund because the fund is seeking assurances on next year's budget from the cabinet, and the cabinet was recently dissolved by the president in a political shakeup.

While, with Iceland and Hungary, one of three European nations seeking aid from the IMF, Ukraine has complex political problems, being a country of 46 million culturally and politically divided between historical affinity towards Russia and new orientation towards the West.

Members of the Ukrainian parliament have filed an appeal to the country's top court, contesting an order by President Viktor Yushchenko to disband parliament and the cabinet and hold new elections on December 7, subsequently postponed to December 14. Until that case is decided, it is unclear whether the current cabinet holds power. Prime Minister Yulia Tymoshenko says it does, while the president's office is contesting that assessment. The IMF delegation has been meeting with both sides. The fund is offering a loan of as much as $15 billion to shore up Ukraine's finances as foreign investors flee for safe havens. As a condition for the loan, the IMF is asking that Ukraine run a balanced budget



in 2009, a condition that the Federal Reserve did not impose on the US government.

The Fitch rating agency downgraded Ukraine's sovereign debt rating on October 17 and issued a negative outlook for the country. A Ukrainian shipping company, Industrial Carriers, has collapsed. The government has frozen rail tariffs for steel companies, and as foreign investment dries up, speculators are betting on a decline in the national currency. In response, Ukraine plans to nationalize some commercial banks, which are suffering liquidity problems.

In Hungary, the authorities agreed to a loan of 5 billion euros ($6.7 billion) from the European Central Bank to allow banks to continue to loan to one another and businesses. In Iceland, officials said they would decide within a week whether to take out an IMF loan.

Crisis in Asian banks
In Asia, South Korea announced a $100 billion government guarantee on foreign currency loans and a $30 billion infusion into the Korean banking system. Malaysia and Singapore announced government guarantees of all deposits in their nations' banks through the end of 2010, mirroring a move made earlier by Hong Kong, Australia and others in the region.

Hong Kong's bank deposit guarantee channeled capital flows into its banks and away from the rest of the region, as depositors shifted funds to seek out safety. Similar moves by Australia, Indonesia and others have increased pressure for hold-outs to make guarantees of their own. A joint statement by Singaporean fiscal and monetary authorities acknowledged the need to respond to other countries' deposit guarantees: "The announcement by a few jurisdictions in the region of government guarantees for bank deposits has set off a dynamic that puts pressure on other jurisdictions to respond or else risk disadvantaging and potentially weakening their own financial institutions and financial sectors," adding it would guarantee a total of 150 billion Singapore dollars (US$102 billion).

Financial nationalism
While this wave of government intervention was billed as a positive sign of international coordination, the fact remains that such government measures were really driven by financial nationalism to prevent funds from leaving one national banking system for safer havens in another national banking system that offers better government guarantee.

Even the US Treasury dropped its earlier opposition to sovereign guarantees for funding, as such guarantees spreading across Europe to put US banks at a competitive disadvantage with their European rivals. Under the US plan, deposit guarantees will be provided by the Federal Deposit Insurance Corporation at higher limits. The US shift on sovereign guarantees makes it very likely that Canada, and possibly Japan, will follow suit out of self interest.

Once sovereign bank loan guarantees spread across Europe, the US had no choice but to follow suit, despite concerns among senior US policymakers that this could put added stress on the larger non-bank financial sector that competes with bank lenders. This development will prolong the seizure of the much larger non-bank credit market and possibly hasten its final collapse.

Non-bank financial system out in the cold
By yielding to the need to save the banking system as a first priority, the US has in fact abandoned its more advanced but complex and diverse non-bank financial system and reverted back to one based on a relatively small number of large universal banks on the traditional European model. By nationalizing the banking system with sovereign capital at a stage earlier than in past financial crises around the world, US policymakers hope to halt a credit market meltdown in mid-stream and engineer a quick turnaround of the the faltering economy before it reaches full momentum.

Unfortunately, it is a strategy similar to amputating the limbs of a patient to relieved circulatory pressure on the heart. The fact of the matter is that the US financial system has transformed into one in which banks get no respect from the non-bank sector. Banks have been relegated to a supportive role rather than their traditional prime role of intermediating of credit for the economy. The terms of the US sovereign recapitalization plan are much more favorable to the banks and bank shareholders than the UK proposal. The US terms favor weak banks by establishing the same terms for all, regardless of varying capital strength. It is directing needed medicine to the wrong organ.

To offer favorable terms to get the core group of nine top US banks to sign up immediately for half the $250 billion nationalization program was an essential part of US strategy. It removed uncertainty over uneven share prices of these banks that presented "co-ordination" problems, destabilizing swings in relative capital strength, and the "stigma" problem as a sign of weakness for participating banks. Most importantly, it eased the risk that the $125 billion would be too thinly spread across the vast US banking sector to make a real difference to the core group of financial institutions.

Questions remain in the market as to whether $250 billion will be enough for the gargantuan task. Measured against the size of capital injections in Europe and the larger scale of the US banking system, the fund appears visibly undersize. Also, diverting up to $250 billion to recapitalize banks, away from the $700 billion fund created to finance the purchase of illiquid toxic assets raises doubts of curative efficiency. The US Treasury has better ways to transfer assets from bank balance sheets to the government balance sheet with less cost.

The focus of the US rescue effort is now on the recapitalization and loan guarantee in the banking system. In effect, the US has decided to build a defensive wall around a core group of nine banks. These banks will not be allowed to fail, and the US government will rely on them to provide the bedrock of ongoing lending in the economy while trying to avoid any of them gaining dominant market share, as JP Morgan did in the 1907 crash. (See THE ROAD TO HYPERINFLATION, Part 2: A failure of central banking, Asia Times Online, June 30, 2008).

But in taking extreme measures to ensure the core banks will survive, the government appears to be abandoning the vast non-bank financial sector to its fate. The Fed will try to offset the enormous competitive advantage gained by banks by buying commercial paper from non-bank financial firms such as GE Capital and GMAC. However, this will not come close to balancing the full benefits of the guarantees for the banks provided by the Federal Deposit Insurance Corporation.

Still, these radical measures to guarantee inter-bank loans and to provide backstops for the commercial paper market do not address the structured finance problem, which few market participants fully understand, and no one alive knows its full extent in terms of who owns what and owes to whom and how much. Bank of International Settlement (BIS) data show that in June 2007, two months before the current credit crisis broke out, total over-the-counter (OTC) derivative contracts notional value outstanding was $516 trillion, with gross market value of $11 trillion; $347 trillion in interest rate derivative contracts with gross market value of $6 trillion; $43 trillion in credit default swaps (CDS) with $741 billion in gross market value. Notional value is not the amount at risk - only market value is at risk. Still, on a notional value of $516 trillion, a fluctuation of 1% in interest can cause market movements of $5.16 trillion, making the government's $700 billion rescue package look like a garden hose in a forest fire. It is true that many of the contracts are mutually canceling in a normal market. But in a market dominated by one sided sell off, the mutual canceling can turn into a receding tide that lowers all boats.

By December 2007, the total notional amount of outstanding derivatives in all categories rose to $596 trillion. Two-thirds of contracts by volume or $393 trillion were interest rate derivatives. Credit default swaps had a notional volume of $58 trillion, up from $43 trillion a year earlier. Currency derivatives reached a volume of $56 trillion. Unallocated derivatives had a notional amount of $71 trillion.

The non-bank financial sector in the US is already under even more severe stress than its banking system. US sovereign aid for banks could intensify the non-bank collapse, unless more steps are taken to aid non-bank institutions in coming days. Contraction of the non-bank sector and failure of non-bank institutions could lead to more distressed sales of assets and firms, frenzied scrambles by non-banks for bank licenses and an accelerated shift of both assets and liabilities into the banking sector. The recent movement of investment banks, such as Morgan Stanley and Goldman Sachs, to transform themselves as regulated banks, is a direct response to new government policy.

The problem is that if the core banks have not only to fill the "capital hole" left by their trading losses and to fund de-leverage moves but also must absorb a wave of illiquid toxic assets liabilities coming into the banking system from the wider non-bank financial sector, banks will need a lot more than their half-share of the $250 billion in government capital, perhaps in multiples of trillions of dollars. No one knows exactly how much.


For example, bankruptcy hearings revealed that Lehman needs to unravel more than 1.5 million contracts, mostly derivative swaps, before it can even to begin dealing with creditor requests for information on the bank's financial situation. Lehman's restructuring advisor is hiring 300 financial specialists for the challenging task, which will take between 45 and 60 days for Lehman merely to get its records in order. It is not clear if the final value of these contracts can be determined before they work themselves out at maturity.

Bank nationalization and private capital
The US plan to nationalize the banking system to save market capitalism will only work if it succeeds in attracting much larger amounts of private capital to the banking system. If not, geometric



multiples of the $250 billion of new government capital may be needed. And market response in days following the government announcement of drastic action suggests that private capital is not likely to be attracted because the value of the toxic assets have been kept at unrealistic levels by government intervention.

Two of the nine core banks being rescued, Citigroup and Merrill Lynch, reported fresh multibillion dollar losses on October 16 that essentially wiped out all profit of recent years. Since mid-2007, when the credit crisis first broke out, the nine core banks have written down the value of the troubled assets by $323 billion, more than double the government's bank rescue package of $125 billion. It is highly unlikely that the core banks can resist the temptation to hoard the new government capital to protect their individual solvency rather taking on new risk of unlocking the flow of credit through the economy, particularly when the credit crunch contagion is spreading to auto finance, credit cards, commercial real estate and corporate finance.

The trading pattern in the stock markets in recent weeks is ominous, with massive selling pressure concentrated in the final hour of trading. This means that traders are unwilling to hold securities overnight for fear of new bad news while they are sleeping. Technically, such trading patterns are a clear signs of a protracted bear market.

Ten days after Congress passed and President Bush signed into law the Emergency Economic Stabilization Act of 2008, the US Treasury announced on October 13 a comprehensive update on progress in implementing the $700 billion Troubled Asset Relief Program (TARP) as authorized by the new law. The law gives the Treasury Secretary broad and flexible authority to purchase and insure mortgage assets, and to purchase any other financial instrument that the secretary, in consultation with the Federal Reserve chairman, deems necessary to stabilize financial markets - including equity securities.

The Treasury worked hard with Congress to build in this flexibility because, it said, "the one constant throughout the credit crisis has been its unpredictability". In other words, the Treasury is not certain what the real problem is, or where it lies, or what the total dimension is and how to go about defusing it. It reserves the legislative fexibility of adopting new approaches as the new situation develops overnight, with announcements of new measures before the market opens the next morning.

The new law empowers the Treasury to design and deploy numerous tools to attack the root cause of the current turmoil: which the Treasury characterizes as "the capital hole created by illiquid troubled assets". The term "capital hole" signifies that the credit crisis is more than a passing problem of liquidity. A capital hole is a physical description of systemic insolvency.

The Treasury statement asserts that "addressing this problem should enable our banks to begin lending again." Yet bank lending is only part of the problem. The banking system as currently constituted covers only a fraction of the total credit market, with the non-bank financial sector covering the lion share. (See Credit bust bypasses banks, Asia Times Online, September 6, 2007.)

The US Treasury describes its strategy as "to achieve one simple goal - to restore capital flows to the consumers and businesses that form the core of the US economy by employing multiple tools to help financial institutions remove illiquid assets from their balance sheets, and attract both private and public capital."

Left unsaid is that fact that public capital of course leads to nationalization, and nationalization crowds out private capital unless public capital sells at a loss to private capital. In other words, the government's plan appears to be relying on an ultimate massive transfer of wealth from US taxpayers to holders of surplus private capital, some of whom may be foreigners.

Treasury said that in building the foundation for a strong, decisive and effective TARP, it is working very closely with both domestic and international regulators to "understand" how best to design tools that will be most effective in dealing with the challenges in the US and presumably the global financial system. For example, regulators are helping the Treasury to identify the quickest and most efficient method to purchase equity in financial institutions so they can resume lending. Throughout this process, the Treasury said it has kept in mind one clear priority: "to protect taxpayers by making the best use of their money."

Left unsaid is the certainty that taxpayers will have to take a haircut, and that by bailing out wayward banks, taxpayers may get by with a crew cut instead of a shaved bald head. Unsavory bankers appear to raking the taxpayers over hot coals by first wiping out their savings and then laying an inescapable claim on taxpayer future tax liabilities. On top of a trickling down of prosperity during the boom phase of the bubble in which wealth stayed mostly at the top, there will be a pouring down of the hot oil of loss on taxpayers with the bursting of the bubble.

Investigations of criminal fraud
Prosecutors in three New York area jurisdictions are trying to determine whether top managers at the now-bankrupt Lehman Brothers misled the public about its financial condition and some of the securities it sold during the past nine months. Dick Fuld, Lehman Brothers chief executive, is among 12 executives who have received subpoenas related to federal investigations into the events leading up to the company's bankruptcy filing last month. Other former Lehman executives known to have received subpoenas include Joe Gregory, chief operating officer, Erin Callan, chief financial officer, and Ian Lowitt, chief accounting officer, who replaced Callan as CFO. Grand jury investigations have been launched by federal prosecutors in Manhattan, Brooklyn and New Jersey.

The federal probes had been widely anticipated since Lehman entered bankruptcy protection in September in what became the biggest such filing in US history. Lawsuits filed against the firm allege that its top executives misled investors about Lehman's financial health in 2008. The US attorney in Manhattan, Andrew Cuomo, is reportedly looking at whether Lehman executives marked the firm's commercial real estate properties accurately on its balance sheet, and the US attorney in Brooklyn is investigating Lehman's sale of auction-rate securities, as well as what the company presented at an analysts conference call held by management on September 10, five days before the bankruptcy filing. The US attorney in New Jersey is believed to be investigating disclosures surrounding the sale of securities by Lehman in June.

In addition to the Lehman probes, federal investigators have opened investigations into at least 25 other companies, including AIG, the insurer, and mortgage financiers Fannie Mae and Freddie Mac. The US attorney in Seattle has announced an investigation into the collapse of Washington Mutual, the biggest bank failure in US history.

In September, prosecutors indicted two former Credit Suisse brokers for allegedly lying to clients about what kind of auction-rate securities they were being sold. They also indicted two former Bear Stearns hedge fund managers in June on charges that they intentionally misled investors about the financial conditions of the funds that collapsed in 2007. The Federal Bureau of Investigation has been working closely with the Securities and Exchange Commission and the Department of Justice on many of these cases.

In China's Special Administrative Region of Hong Kong, banks have agreed to buy back complex investment products guaranteed by Lehman Brothers, known as mini-bonds, after public complaints by investors, many elderly, prompted government investigation into bank sales practices for the financial products, which entered into default due to the Lehman bankruptcy in New York. Most investors said that they were led to believe they were buying high-yield bonds, while in reality the mini-bonds were a form of credit default swap with Lehman acting as counterparty.

The Hong Kong Monetary Authority, the bank regulator, referred 24 complaints of alleged misconduct by two unnamed local banks in the sale of Lehman-linked financial products to the watchdog Securities and Futures Commission. The HKMA has received 12,901 complaints concerning mini-bonds days after the Lehman bankruptcy filling. More than 33,000 Hong Kong investors purchased a total HK$11.2 billion (US$1.44 billion) of the mini-bonds from about 20 banks.

Singapore, meanwhile, said it would examine possible inadequate internal controls by financial institutions and suggested some banks would have to take responsibility for compensating investors for allegedly providing misleading information. The Monetary Authority of Singapore estimates that nearly 10,000 people in Singapore invested S$501 million in the products.

Next: Treasury's Assets Relief Program in trouble

Henry C K Liu is chairman of a New York-based private investment group. His website is at http://www.henryckliu.com.