Baseball91's Weblog

November 30, 2008

Government Revival of Lending Uses Taxpayers’ Money to Recreate “The Shadow Banking System”


In the world of the Establishment, the greatest transgression was not failure but betrayal.

How could valuations be false?  If they were create by a certain percentage of false appraials, false financing,  had values dropped enough?  Have the fundamentals really changed much over the last 3 months.    

Warren Buffett said many years ago: “You don’t know who’s swimming naked until the tide goes out.”  There are a lot of people in the water wearing something who were trained in the day of program traders, as Bill Gross said, to buy on dips. 

William McChesney Martin was the Fed’s chairman from 1951 through 1970. Martin said his job as central-bank chief was “to take away the punchbowl just as the party gets going” to keep the economy from overheating.   Paul McCulley said that the government’s efforts to aid financial firms in effect are reversing this well-known quip.  “Now they are actually creating ‘punchbowl banks’ where you have the equity coming in from the Treasury,” McCulley said. “They are de facto banks owned by the Treasury and funded by the Fed.  If the U.S. is putting its ‘full faith and credit’ behind the liabilities of the various financial institutions, then I want to be a co-investor with Uncle Sam, which is another way of saying I want to invest with the American taxpayer.  It sounds a little like socialism only because it is.” The government’s attempts to revive lending have led policy makers to use taxpayer money to recreate “the shadow banking system,” he said.

Bill Gross writes, “The past era can best be described as a more than half-century build up in credit extension and levered finance.  Uranium-238 has something like 92 electrons circling its nucleus, sort of like the diagram you see in Figure 1. And, importantly, uranium-238 is metaphorically quite similar to the global financial system of the past half century. At its nucleus was the overnight Fed Funds rate which, when priced low enough, led to an ever-increasing circle of productive financial electrons. The overnight policy rate led to cheap commercial paper borrowing and then leapfrogged outward and across the oceans to become LIBOR. In turn, government notes and bonds as well as markets for corporate obligations were created, leading to their use as collateral (repos), which fostered additional credit and additional growth. Levering has turned into deleveraging; uranium-238 has morphed into uranium-239 and we’ve had a nuclear implosion – destructive fusion not controllable fission.”

Daniel Altman writes, “Just how much money is $7 trillion? Well, it’s enough to buy half of what the United States produces in a year, or two years’ worth of China’s output. It is also, as Edmund Andrews writes, the amount of money the United States is committing to various injections of capital, loan guarantees and mortgage subsidies. Is it enough… or too much?  It’s not really a fair question, since the probability is close to zero that the Treasury and the Federal Reserve have guessed exactly the right figure their ever-changing financial bailout. (Think of it as cooking exactly the right amount of food for a dinner party – an almost impossible task!) “

From the International Herald Tribune: “Germany, with the largest economy in Europe, appears unconvinced so far, or is at least reluctant to follow the rest of the pack into a spending splurge after years devoted to bringing its public finances back into balance.  The fact that the European Central Bank is expected to cut interest rates heavily again Thursday, as is the Bank of England, demonstrates the seriousness of the deterioration in the economic climate. Chancellor Angela Merkel of Germany has said she does not want to get into a ‘race for billions,’ a stance that is worrying some other governments in Europe, according to officials in other capitals. And it is troubling economists, too.”

On November 26, 2008, Pimm Fox and Daniel Kruger at quoted Pacific Investment Management Co.’s Paul McCulley, that U.S. policy makers “have finally recognized the enormity of the problem” afflicting the financial system and are sparing no effort to address it. 

According to Pimm Fox and Daniel Kruger, “So far, that has included expanding the Fed’s assets to $2.2 trillion, promising to buy $600 billion in mortgage securities related to government-sponsored enterprises and injecting $270 billion of capital into what Paul McCulley called ‘punchbowl banks.’”  The government’s attempts to revive lending have led policy makers to use taxpayer money to recreate “the shadow banking system,” he said. Before the start of the financial crisis in August 2007, that comprised institutions which lacked access to the Fed’s discount window and whose customer accounts were not insured by the Federal Deposit Insurance Corp.  

According to its Website where Bill Gross and Paul McCulley work, Pimco’s Total Return Fund, the world’s largest bond fund with $129.6 billion in assets, had 79 percent of its holdings in mortgage securities. 

Todd Harrison wrote on October 1, 2008, “Pretending socioeconomic situation doesn’t exist won’t make an already fragile socioeconomic situation go away or avoid a downside spiral that sucks the global capital market structure into an abyss.  The U.S government did change the rules of engagement, but it ain’t over yet.  The credit crisis has already infected the economy, starting with the home builders, spreading to the financials, engulfing financials in drag such as General Electric, GM, Ford, and will eventually phase through retail, technology, credit card companies and commodities.  This is a stair-step process through industries until debt is destroyed and a more sustainable economic foundation takes root. It’s akin to credit cancer and once it spreads through our entire financial body, we’ll be in a position to enjoy the globalization-themed “outside-in” recovery which awaits.” 


Timothy Geithner believes the U.S. government allowed the creation of a massive shadow banking system run by investment banks, hedge funds and brokerage firms over the last 30 years that rivaled the traditional system in size but lacked every one of the stabilizing pillars that had been erected beneath it after the Great Depression: deposit insurance, access to a lender of last resort, a system for orderly failure, and reasonable constraints on risk and leverage.   -Time


Past performance continues to be no guarantee of future results.  The fat lady has not sung yet. 


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