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Bernanke Deep-Sixes the Dollar to Save Wall Street

Bernanke Deep-Sixes the Dollar to Save Wall Street
Contre Info

Sunday 16 March 2008

In the absence of the authority and political courage required to cut to the quick, the Fed has been reduced to using expedients that - while allowing the extent of losses to remain concealed - postpone the moment of truth and compromise the dollar. To save Wall Street, Bernanke exports the crisis and stokes a global inflationary fever, risking a devastating boomerang: rejection of the dollar as the global reserve currency.

Basic Math

Mortgage-backed securities in circulation total $11,000 billion. US real estate is overvalued by 20 to 30 percent. If a quarter of the wealth of US households vaporizes, that represents $2,750 billion worth of debt that will probably not be repaid and will become losses for the financial system.

According to the study by Greenlaw, Hatzius, Kashyap and Shin (pdf), the total capitalization of United States' banks, government agencies and savings banks amounts to $1,681 billion.

Their direct exposure to mortgage securities totals $5,591 billion, or half of the outstanding amount. They are, consequently, potentially faced with write-downs of up to $1,375 billion - close to their total capital.

These figures do not take into account possible losses in other credit sectors: consumption, auto loans and commercial real estate.

Credit-related risks are covered by insurance contracts signed by mutual agreement between companies - CDS or Credit Default Swaps - bearing a total value of $45,000 billion, over three times the United States' gross domestic product.

If this risk coverage mechanism is set in motion, it could propagate a cascade of refund demands from "counterparties" - that is, those that sold the insurance - counterparties which for the most part have no provisions available to meet those calls.

Speculative funds - hedge funds - are also involved. These enterprises are based on the principle of massive credit use - called leveraging - to increase their earnings. Here's how:

Mr. Smith has $100 to invest and buys a mortgage-backed security that earns $8 a year. By borrowing $1,500 at 6 percent to invest 15 times more, he earns a total of $128, pays $90 in interest and is left with a net return of $38 for an initial outlay of $100.

An excellent return until the day the securities lose 20 percent of their value. The lending bank demands reimbursement. Mr. Smith sells his securities: $1,600 less (20 percent) $320 = $1,280. He has lost his $100 and owes the bank $220.

It is, in fact, this mechanism of inverse leveraging that is asphyxiating "the auxiliary banking system," i.e. the investment funds.

Illiquidity and Insolvency

The central banks, lenders of last resort, can help healthy establishments meet a strained liquidity situation by supplying an interim loan. But the situation in which the financial system finds itself does not result from a lack of liquidity. It's an insolvency - that is, bankruptcy - crisis.

The market will only recover stability and confidence on three conditions: That the insolvent enterprises disappear and the bad paper they are holding along with them; that the companies that can survive receive a capital infusion to offset their losses; and that falling real estate assessments reach true prices, at the same time restoring a reliable value to the securities backed by those assets.

That's a great deal of ground to cover. Especially when the tool for intervention - the central bank - is absolutely not adapted to the mission of the day: saving Wall Street.

Bernanke's Tool Box

Bernanke has two levers he may use: loans and rates.

He uses these two tools on either end of the financial institution balance sheet: the reserves in the banks' portfolio and real estate values. Loans reinforce banks' capital funds; the reduction in rates, which would normally re-launch economic activity, should also shore up real estate prices by bringing the recession to an end.

But these two axes of intervention have their limits - and their perverse consequences.

As the crisis has intensified, the loans have lost their character as a very temporary interim measure against illiquidity to take on the aspect of concealed infusions of capital. The requirement for impeccable collateral, securities held at the central bank as a guarantee for the liquidities accorded, has been relaxed in the extreme. Instead of Treasury bills, the Fed is now accepting dubious real estate debt for which there is no longer any market. The term of these loans, normally overnight, has now been extended to three months. The volume of these operations has become significant: $400 billion or half the Fed's available reserves are committed to the end of March.

This massive and very unconventional intervention presents two major disadvantages.

While it authorizes banks to maintain presentable balance sheets, by deferring the moment when the accounts will be sold off in pain, it does allow time to be gained, but does not reestablish confidence - which will be restored only when the losses have been recognized. On the other hand, by virtue of its very scope, the intervention indicates that the Fed is losing ground. At the rate things are going, the Fed's $400 billion war chest in the form of Treasury Bonds on its books is no longer an indication of its strength, but of its weakness.* To what expedients will it be reduced when it comes to the end of its reserves? The printing press? We can see on the horizon that the very credibility of the dollar is at stake.

The Dollar, Collateral Victim

The massive and repeated rate reductions Bernanke has chosen - we expect another one tomorrow - directly challenge the status of the American currency.

As his predecessor did at every slowdown of activity, the new Fed chairman tries to relaunch the credit machine, hence monetary creation, to prop up the economy and prices and to break the deflationary spiral.

Without much success. The gears in the transmission have jammed and the confidence of already-overextended households and companies is faltering.

But as he acts this way, he reinforces the already well-anchored sentiment that the dollar - weighted down by the United States' $9,000 billion debt that cannot be reimbursed - is overvalued, which amplifies the American currency's slide.

The inflows of foreign capital that have allowed deficits to grow and the currency to maintain its value for twenty years (the Clinton episode aside) are in the process of drying up. During the last three months of 2007, the influx of foreign investments went from $113 billion to $56 billion.

Just recently, US Treasury bonds have been evaluated as less reliable than Germany's.

This drop in the dollar Bernanke has accepted and precipitated to save Wall Street looks like a runaway train that will export the American crisis to the rest of the world, and do so at an exorbitant cost.

Since most raw materials markets, including most obviously oil, are denominated in dollars, the slide in the US currency mechanically entails a revaluation of raw materials' prices and provokes significant global inflation.

This phenomenon is further reinforced by the flight of capital abandoning dollar-denominated securities, the value of which is melting like snow in the sun, and seeking refuge in raw materials markets.

Indecision 2008

Because it cannot "think the unthinkable," that is, accept the extent of the losses and take the drastic measures that are required: true prices, nationalizations and bankruptcies, the United States, by deferring the purge, allows the toxic contagion imprudently concocted on Wall Street to propagate.

The United States' trompe l'oeil economic success, built on the engine of debt, asset inflation and the influx of capital its currency's status allowed, threatens to collapse.

The man occupying the Oval Office is obviously not equal to the situation, and the next team will not be in command before next January.

From now until then, Bernanke does what he can, with the tools that he's got. Thus, the United States takes the road Japan took in 1991, but without the same advantages. It has no savings and its industrial base has been massively eliminated.

There remains the dollar, the symbol of the preeminence of empire. But by exporting its crisis, the US plays double or nothing. Either the pain provoked by the greenback's fall forces the global powers to take concrete action or we run the risk of witnessing the overthrow of the global economic and financial system with the disorderly desertion of this fallen idol.

*The announcement of support for the purchase of Bear Sterns has just mobilized an additional $30 billion, reducing this sum by an equal amount.

Translation: Truthout French language editor Leslie Thatcher.