Fed's Role in the Bear Stearns Meltdown
By MIKE WHITNEY
The Bank for International Settlements
issued a warning last week that the Federal Reserve's monetary
policies have created an enormous equity bubble which could lead
to another "Great Depression". The UK Telegraph says
that, "The BIS--the ultimate bank of central bankers--pointed
to a confluence a worrying signs, citing mass issuance of new-fangled
credit instruments, soaring levels of household debt, extreme
appetite for risk shown by investors, and entrenched imbalances
in the world currency system."
The IMF and the UN have issued
similar warnings, but they've all been ignored by the Bush administration.
Neither Bush nor the Federal Reserve is interested in "course
correction". They plan to stick with the same harebrained
policies until the end.
The "easy credit"
which created the subprime crisis in mortgage lending has now
spread to the hedge fund industry. The troubles at Bear Stearns
prove that Secretary of the Treasury Henry Paulson's assurance
that the problem is "contained" is pure baloney. The
contagion is swiftly moving through the entire system taking
down home owners, mortgage lenders, banks, rating agencies,
and hedge funds. We are just at the beginning of a system-wide
The problem originated at the
Federal Reserve when Fed-chief Alan Greenspan lowered the Feds
Fund Rate to 1% in June 2003 and kept rates perilously low for
more than 2 years. Trillions of dollars flowed into the economy
through low interest loans creating a massive equity bubble in
real estate which drove up housing prices and triggered a speculative
The Feds' "easy money"
policy has disrupted the "debt-to-GDP" balance which
maintains the integrity of the currency. By expanding circulation
debt via low interest rates; Greenspan put the country on the
path to hyperinflation and, very likely, the collapse of the
The problems at Bear Stearns
are the logical upshot of Greenspan's policies. The over-leveraged
hedge funds are a good example of what happens during a "credit
boom". Liquidity flows into the markets and raises the nominal
value of all asset classes but, at the same time, GDP continues
to shrink. That's because the wages of working class people have
stagnated and not kept pace with productivity. When workers have
less discretionary income, consumer spending"which accounts
for 70% of GDP"begins to decline. That's why this quarters
earnings reports have fallen short of expectations. The American
consumer is "tapped out".
The current rise in stock prices
does not indicate a healthy economy. It simply proves that the
market is awash in cheap credit resulting from the Fed's increases
in the money supply. Consumer spending is a better indicator
of the real state of the economy than stocks. When consumer spending
drops off; it is a sign of overcapacity, which is deflationary.
That means that growth will continue to shrivel because maxed-out
workers can no longer purchase the things they are making.
The underlying problem is not
simply the Fed's reckless increases to the money supply, but
the growing "wealth gap" which is undermining solid
economic growth. If wages don't keep pace with productivity;
the middle class loses its ability to buy consumer items and
the economy slows.
The reason that hasn't happened
yet in the US is because of the extraordinary opportunities to
expand personal debt. The Fed's low interest rates have created
a culture of borrowing which has convinced many people that debt
equals wealth. It's not; and the collapse in the housing market
will prove how lethal that theory really is.
To large extent, the housing
bubble has concealed the systematic destruction of America's
industrial and manufacturing base. Low interest rates have lulled
the public to sleep while millions of high-paying jobs have been
outsourced. The rise in housing prices has created the illusion
of prosperity but, in truth, we are only selling houses to each
other and are not making anything that the rest of the world
wants. The $11 trillion dollars that was pumped into the real
estate market is probably the greatest waste of capital investment
in the nations' history. It hasn't produced a single asset that
will add to our collective wealth or industrial competitiveness.
It's been a total bust.
The Federal Reserve produces
all the facts and figures related to the housing industry. They
knew that trillions of dollars were being diverted into a speculative
bubble, but they did nothing to stop it. Instead, they kept interest
rates low and endorsed the lax lending standards which paved
the way for millions of defaults. Now the effects of their "cheap
money" policies have spread to the hedge fund industry where
hundreds of billions of dollars in pensions and savings are in
Alan Greenspan played a major
role in the housing boondoggle. On February 26, 2004, he said,
"American consumers might benefit if lenders provide greater
mortgage product alternatives to the traditional fixed rate mortgage.
To the degree that households are driven by fears of payment
shocks but willing to manage their own interest-rate risks, the
traditional fixed-rate mortgage may be an expensive method of
financing a home."
Greenspan tacitly approved
the whacky financing which produced all manner of untested loans"including
ARMs, piggyback loans, "no doc" loans, "interest
only" loans etc. These loans are a break from traditional
financing and have contributed to the increase in bankruptcies.
Millions of people who were
hoodwinked into buying homes with "interest-only",
"no down" loans will now either lose their homes or
be shackled to an asset of decreasing value for the next 30 years.
They've been tricked into a life of indentured servitude.
A recent article in the Wall
Street Journal revealed the extent of Greenspan's involvement
in the housing fiasco. Here's an excerpt from the article:
"Edward Gramlich, who
was Fed governor from 1997 to 2005, said he proposed to Mr. Greenspan
in or around 2000, when predatory lending was a growing concern,
that the Fed use its discretionary authority to send examiners
into the offices of consumer-finance lenders that were units
of Fed-regulated bank holding companies.
"I would have liked the
Fed to be a leader" in cracking down on predatory lending,
Mr. Gramlich, now a scholar at the Urban Institute, said in an
interview this past week. Knowing it would be controversial with
Mr. Greenspan, whose deregulatory philosophy is well known, Mr.
Gramlich broached it to him personally rather than take it to
the full board.
"He was opposed to it,
so I didn't really pursue it," says Mr. Gramlich.
"Still, Mr. Greenspan's
views did color the regulatory environment, facilitating growing
concentration in banking and a hands-off approach to derivatives
and hedge funds. That approach, broadly shared by both the Clinton
and Bush administrations, is coming under increased scrutiny".
(Wall Street Journal)
So, Greenspan had the chance
to "crack down on predatory lending" and he refused.
Now millions of low income people are saddled with payments they
have no reasonable prospect of paying off. How much of the present
carnage could have been avoided if he had Greenspan done the
So Great" Depression
An article appeared this week
in the UK Telegraph by Ambrose Evans-Pritchard which supports
the theory that Greenspan's "loose monetary policy"
fueled a huge credit bubble, which is pushing the global economy
towards a "1930s-style slump."
The article quotes from a statement
made by The Bank for International Settlements:
"Virtually nobody foresaw the Great Depression of the 1930s,
or the crises which affected Japan and Southeast Asia in the
early and late 1990s. In fact, each downturn was preceded by
a period of non-inflationary growth exuberant enough to lead
many commentators to suggest that a 'new era' had arrived".
But today we face "worrying
signs" of another economic meltdown.
The BIS said that they were
"starting to doubt the wisdom of letting asset bubbles build
up on the assumption that they could safely be cleaned up' afterwards".
(Greenspan's method) and that, "while cutting interest rates
in such a crisis may help, it has the effect of transferring
wealth from creditors to debtors and sowing the seeds for more
serious problems further ahead.'"
"The bank said it was
far from clear whether the US would be able to ignore the consequences
of its latest imbalances, ($800 billion per year) citing a current
account deficit running at 6.5% of GDP, a rise in US external
liabilities by over $4 trillion from 2001 to 2005, and an unprecedented
drop in the savings rate. The dollar clearly remains vulnerable
to a sudden loss of private sector confidence."'
The BIS referred to the toxic
effect of the "$470 billion in collateralized debt obligations
(CDO), and a further $524 billion in "synthetic" CDOs
which have spread through hedge funds industry. These CDOs are
the loans (many sub primes) which were bundled off to Wall Street
and turned into securities which are highly leveraged in hedge
funds for maximum profitability. As Bear Stearns is discovering,
these CDOs are like roadside bombs; exploding without notice
whenever the stock market suddenly dips.
The BIS also cautioned about
the excess of "leveraged buy-outs (mergers) which touched
$753bn, with an average debt/cash flow ratio hitting a record
5.4--. Sooner or later the credit cycle will turn and default
rates will begin to rise.'"
The central banks around the
world are increasingly worried that the Bush administration's
profligate spending and irrational monetary policies will trigger
a global depression. The recent volatility in the stock market
suggests that the credit boom is just about over. Once the liquidity
dries up---stocks will fall sharply.
Yesterday's housing data, shows
that sales are still weak while inventory continues to grow.
Existing home sales dropped 3% while prices dropped another 2.1%.
Falling prices mean that cash-strapped home owners will not be
able to tap into their home's equity for other expenses. Last
year, mortgage equity withdrawals (MEWs) accounted for $600 billion
of consumer spending. This year, the amount will be negligible
The media and the Fed continue
to mislead the public about the magnitude of the housing bubble.
Fed chief Bernanke assures us that the sub prime calamity hasn't
"spread to other parts of the economy" (tell that to
Bear Stearns) and the media keeps cheerily reiterating that a
"turnaround" or "soft landing" is just ahead.
These claims are ridiculous.
Apart from the 80 or more sub-prime lenders that have gone "belly-up"
in the last few months, the rickety collateralized debt obligations
(CDOs) and mortgage backed securities (MBSs) are steamrolling
their way through the stock market bowling down everything their
path. Bear Stearns is just the first on the casualties list.
There'll be many more before the storm is over.
Fed-chairman Bernanke knows
what's going on. He was given a full rundown by "John Burns
Real Estate Consulting that the national sales information for
both new and existing homes, is "misleading and covering
up a deep plunge of the housing sector." The housing market
is freefalling. Existing-home sales are down 22% in May and mortgage
applications have fallen a whopping 18%....In Florida home sales
are down 34%, not 28% as NAR reported; Arizona sales are down
38%, not 28%; and California's down 37%, not 24% as NAR reports."
Down 37% in California!?! It's
As the defaults continue to
pile up; the hedge funds will take a bigger and bigger pounding.
It can't be avoided. That's what happens when bankers abandon
traditional lending standards and lend trillions of thousands
of dollars to people who have bad credit and lie on their loan
Thousands of these same shaky
sub primes loans have been wrapped up like the Crown Jewels and
sold off to Wall Street as CDOs. Now they are ripping through
the hedge fund industry like a tornado in a trailer park. The
media has tried to downplay the damage, but its not hard to see
what is really going on. According to Reuters:
"Banks doubled the amount
of CDOs outstanding in the past two years to $2.6 trillion, including
a record $769 billion sold last year, according to J.P. Morgan.
These figures include funded and unfunded issuance. Pimco's Bill
Gross said there are hundreds of billions of dollars of subprime
residential mortgage-backed securities (RMBS), derivatives on
subprime RMBS and collateralized debt obligations (CDOs) that
buy subprime RMBS and/or the derivatives on the RMBS -- all of
which he considers "toxic waste."'
That's enough to bring down the whole economy. And, as Bear Stearns
proves, the whole mess is beginning to unwind pretty quickly.
"Foreign investors have
been the dominant buyers of these exotic debt instruments in
recent years, owing to their insatiable demand for yield. If
investors start dumping them, oh boy, watch out for some massive
credit widening," said Dan Fuss, Vice Chairman at Loomis
If the hedge fund industry
follows the downward slide of the housing bubble, foreign investors
will run for the exits. In fact, this may already being happening.
China sold $5.8 billion in
US Treasuries in May; the first time they have dumped USTs on
the market. This may be the first sign of "capital flight"---foreign
investment fleeing the US for more promising markets in Asia
and Europe. The greenback's survival now depends on the generosity
of foreign bankers. If they refuse to recycle our $800 billion
current account deficit by purchasing US bonds and securities,
then the dollar will sink like a stone and lose its place as
the world's reserve currency.
Last Friday, the stock market
took a 185-point nosedive on the news that Bear Stearns was trying
to raise $3.2 billion to rescue its battered hedge fund. According
to the New York Times, however, Bear was only able to came up
with "$1.6 billion in secured loans to bail out one of the
2 hedge funds".
The funds are the latest victim
of the sub-prime meltdown which Bernanke and Paulson assured
us was "largely contained". In fact, Paulson even said,
"We have had a major housing correction in this country,"
and "I do believe we are at or near the bottom."
Anyone who believes Paulson
should take a
look this chart It illustrates that how loan "resets"
will continue to pound the housing market for at least another
year and a half getting steadily worse as inventory grows.
The disaster is so bad that
even the realtors are beginning to tell the truth. As one agent
noted, "It's a bloodbath."
But the debacle in housing
is only the first part of a much larger problem"a global
liquidity crisis. Banks and mortgage lenders have already begun
to tighten up their lending practices and many have abandoned
sub prime loans altogether. (20% of the housing market in 2006
was sub prime) Now the focus has shifted to the stock market,
where banks are beginning to see that "risk" has not
been properly calculated. That means that if more hedge funds
collapse, the banks may not be able to cover the losses.
The Bear Stearns fiasco has
had a chilling affect on lending. In fact, the New York Times
reported on 6-26-07 that "After years of supersize private
equity deals--the buyout boom may be about to hit a bump--Rising
interest rates and tougher terms from investors may signal that
private equity players will soon be struggling to continue reaping
the outsize returns that have made the buyout business so lucrative."
(Private Equity Investors Hint at Cool Down" NY Times)
Liquidity is drying up in the
private equity business. The troubles at Bear Stearns has changed
the credit-landscape overnight. Bankers are nervous, money is
getting tighter, and liquidity is vanishing.
"We know that these holdings
are not unique to Bear Stearns," said Professor Joseph R.
Mason, co-author of a recent study warning of dangers in securities
backed by home loans to high-risk borrowers. "It would be
hard to find a Wall Street firm that hasn't created similar funds."
That's right; the industry
is waist-deep in these sub-prime time-bombs. Shaky loans and
rising foreclosures threaten to knock the foundation blocks out
from under the stock market and set off a wave of panic selling.
Could it have been avoided?
Perhaps, if there were better
regulations on rating bonds and restricting leverage.
Consider this: one of Bear
Stearns hedge funds took a $600 million investment and leveraged
it 10 times its value to $7 billion. Their portfolio was chock-full
of dicey CDOs and "illiquid assets" such as timber
holdings in foreign countries and toll roads. These assets are
difficult to price and nearly impossible to quickly auction off
if the market suddenly takes a downturn.
It looked like Merrill Lynch
& Co., was going to auction off $850 million of Bear Stearns
CDOs this week, but backed off at the last minute. (They were
reportedly only offered 30 cents on the dollar!) Once the hedge
funds start selling these CDOs, then everyone will know how little
they're worth. That could trigger a wave of selling that could
bring down the stock market. Even if that scenario doesn't play
out, the Bear Stearns incident ensures that CDOs in other hedge
funds will be face a substantial downgrading that could take
a big chunk out of their bottom line.
And, there's a bigger fear
on Wall Street than the fact that 2 hedge funds are headed into
bankruptcy, that is, that a sudden tightening of credit will
send the over-leveraged stock market into a downward spiral.
The market is particularly
sensitive to any rise in interest rates or tougher lending standards.
It's become addicted to cheap credit and any break in the chain
will cause equities to plummet.
Economist Henry C K Liu sums
it up like this:
"The liquidity boom has
been delivering strong growth through asset inflation without
adding commensurate substantive expansion of the real economy.
--. Unlike real physical assets, virtual financial mirages that
arise out of thin air can evaporate again into thin air without
warning. As inflation picks up, the liquidity boom and asset
inflation will draw to a close, leaving a hollowed economy devoid
of substance. --A global financial crisis is inevitable".
(Henry C K Liu "Liquidity boom and looming crisis"
In other words, the "virtual"
wealth of Wall Street is a chimera which was created by the Fed's
inexorable expansion of debt. It can vanish in a flash if the
sources of liquidity are cut off.
Puru Saxena draws the same
conclusion in his article "A Gradual Transition":
"Thanks to the Federal
Reserve's expansionary monetary policies over the past 5 years,
US asset-prices have risen considerably; also known as the "wealth
effect". At the end of last year, the market capitalization
of the US stock market rose to a record-high of US$20.6 trillion,
matching the value of household real-estate, which also rose
to a record-high at the same time. On the surface, this may seem
like brilliant news, however you must realize that this "wealth
illusion" achieved by an ocean of money and record-high
indebtedness is only a consequence of inflation."
We expect that the mounting
losses in CDOs and the continuing defaults in the housing industry
will precipitate a "severe credit crunch" which will
end in a stock market crash. A report which appeared yesterday
in the UK Telegraph appears to agree with this analysis. Lombard
Street Research predicted that:
"Excess liquidity in the
global system will be slashed. Banks Capital is about to be decimated,
which will require calling in a swathe of loans. This is going
to aggravate the US hard landing"' ("Banks set to call
in swathe of loans" UK Telegraph 6-26-07)
Three of the main hoses which
provide liquidity for the market, have either been cut off or
severely damaged. These are "securatized" subprime
CDOs, corporate mega-mergers and hedge fund leveraging. Without
these instruments for expanding debt; liquidity will dry up and
stocks will fall. The period of "easy credit" will
end in disaster.
We should now be able to see
the straight line that connects the Fed's low interest rates
to the impending stock market meltdown. The problems began at
the central bank.
Presidential candidate Rep.
Ron Paul (R-Texas) summed it up best when he said:
"From the Great Depression,
to the stagflation of the seventies, to the burst of the dot.com
bubble; every economic downturn suffered by the country over
the last 80 years can be traced to Federal Reserve policy. The
Fed has followed a consistent policy of flooding the economy
with easy money, leading to a misallocation of resources and
artificial "boom" followed by recession or depression
when the Fed-created bubble bursts".