For the past few years, a central mission of this blog has been to focus on Washington’s unending efforts to protect, pamper and bail out the Wall Street megabanks at taxpayer expense. From Maiden Lane III to TARP and through countless “backdoor bailouts”, the Federal Reserve and the Treasury Department have been pumping money into businesses which should have gone bankrupt in 2008. Worse yet, President Obama and Attorney General Eric Hold-harmless have expressed no interest in bringing charges against those miscreants responsible for causing the financial crisis. The Federal Reserve’s latest update to its Survey of Consumer Finances for 2010 revealed that during the period of 2007-2010, the median family net worth declined by a whopping thirty-eight percent. Despite the massive extent of wealth destruction caused by the financial crisis, our government is doing nothing about it.
I have always been a fan of economist John Hussman of the Hussman Funds, whose Weekly Market Comment essays are frequently referenced on this website. Professor Hussman’s most recent piece, “The Heart of the Matter” serves as a manifesto of how the financial crisis was caused, why nothing was done about it and why it is happening again both in the United States and in Europe. Beyond that, Professor Hussman offers some suggestions for remedying this unaddressed and unresolved set of circumstances. It is difficult to single out a passage to quote because every word of Hussman’s latest Market Comment is precious. Be sure to read it. What I present here are some hints as to the significance of this important essay:
The ongoing debate about the economy continues along largely partisan lines, with conservatives arguing that taxes just aren’t low enough, and the economy should be freed of regulations, while liberals argue that the economy needs larger government programs and grand stimulus initiatives.
Lost in this debate is any recognition of the problem that lies at the heart of the matter: a warped financial system, both in the U.S. and globally, that directs scarce capital to speculative and unproductive uses, and refuses to restructure debt once that debt has gone bad.
Specifically, over the past 15 years, the global financial system – encouraged by misguided policy and short-sighted monetary interventions – has lost its function of directing scarce capital toward projects that enhance the world’s standard of living. Instead, the financial system has been transformed into a self-serving, grotesque casino that misallocates scarce savings, begs for and encourages speculative bubbles, refuses to restructure bad debt, and demands that the most reckless stewards of capital should be rewarded through bailouts that transfer bad debt from private balance sheets to the public balance sheet.
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By our analysis, the U.S. economy is presently entering a recession. Not next year; not later this year; but now. We expect this to become increasingly evident in the coming months, but through a constant process of denial in which every deterioration is dismissed as transitory, and every positive outlier is celebrated as a resumption of growth. To a large extent, this downturn is a “boomerang” from the credit crisis we experienced several years ago. The chain of events is as follows:
Financial deregulation and monetary negligence -> Housing bubble -> Credit crisis marked by failure to restructure bad debt -> Global recession -> Government deficits in U.S. and globally -> Conflict between single currency and disparate fiscal policies in Europe -> Austerity -> European recession and credit strains -> Global recession.
In effect, we’re going into another recession because we never effectively addressed the problems that produced the first one, leaving us unusually vulnerable to aftershocks. Our economic malaise is the result of a whole chain of bad decisions that have distorted the financial markets in ways that make recurring crisis inevitable.
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Every major bank is funded partially by depositors, but those deposits typically represent only about 60% of the funding. The rest is debt to the bank’s own bondholders, and equity of its stockholders. When a country like Spain goes in to save a failing bank like Bankia – and does so by buying stock in the bank – the government is putting its citizens in a “first loss” position that protects the bondholders at public expense. This has been called “nationalization” because Spain now owns most of the stock, but the rescue has no element of restructuring at all. All of the bank’s liabilities – even to its own bondholders – are protected at public expense. So in order to defend bank bondholders, Spain is increasing the public debt burden of its own citizens. This approach is madness, because Spain’s citizens will ultimately suffer the consequences by eventual budget austerity or risk of government debt default.
The way to restructure a bank is to take it into receivership, write down the bad assets, wipe out the stockholders and much of the subordinated debt, and then recapitalize the remaining entity by selling it back into the private market. Depositors don’t lose a dime. While the U.S. appropriately restructured General Motors – wiping out stock, renegotiating contracts, and subjecting bondholders to haircuts – the banking system was largely untouched.
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If it seems as if the global economy has learned nothing, it is because evidently the global economy has learned nothing. The right thing to do, again, is to take receivership of insolvent banks and wipe out the stock and subordinated debt, using the borrowed funds to protect depositors in the event that the losses run deep enough to eat through the intervening layers of liabilities (which is doubtful), and otherwise using the borrowed funds to stimulate the economy after the restructuring occurs. We’re going to keep having crises until global leaders recognize that short of creating hyperinflation (which also subordinates the public, in this case by destroying the value of currency), there is no substitute for debt restructuring.
For some insight as to why the American megabanks were never taken into temporary receivership, it is useful to look back to February of 2010 when Michael Shedlock (a/k/a“Mish”) provided us with a handy summary of the 224-page Quarterly Report from SIGTARP (the Special Investigator General for TARP — Neil Barofsky). My favorite comment from Mish appeared near the conclusion of his summary:
Clearly TARP was a complete failure, that is assuming the goals of TARP were as stated.
My belief is the benefits of TARP and the entire alphabet soup of lending facilities was not as stated by Bernanke and Geithner, but rather to shift as much responsibility as quickly as possible on to the backs of taxpayers while trumping up nonsensical benefits of doing so. This was done to bail out the banks at any and all cost to the taxpayers.
Was this a huge conspiracy by the Fed and Treasury to benefit the banks at taxpayer expense? Of course it was, and the conspiracy is unraveling as documented in this report and as documented in AIG Coverup Conspiracy Unravels.
On January 29 2010, David Reilly wrote an article for Bloomberg BusinessWeek concerning the previous week’s hearing before the House Committee on Oversight and Government Reform. After quoting from Reilly’s article, Mish made this observation:
Most know I am not a big believer in conspiracies. I regularly dismiss them. However, this one was clear from the beginning and like all massive conspiracies, it is now in the light of day.
David Reilly began the Bloomberg Business Week piece this way:
The idea of secret banking cabals that control the country and global economy are a given among conspiracy theorists who stockpile ammo, bottled water and peanut butter. After this week’s congressional hearing into the bailout of American International Group Inc., you have to wonder if those folks are crazy after all.
Wednesday’s hearing described a secretive group deploying billions of dollars to favored banks, operating with little oversight by the public or elected officials.
That “secretive group” is The Federal Reserve of New York, whose president at the time of the AIG bailout was “Turbo” Tim Geithner. David Reilly’s disgust at the hearing’s revelations became apparent from the tone of his article:
By pursuing this line of inquiry, the hearing revealed some of the inner workings of the New York Fed and the outsized role it plays in banking. This insight is especially valuable given that the New York Fed is a quasi-governmental institution that isn’t subject to citizen intrusions such as freedom of information requests, unlike the Federal Reserve.
At least in the Eurozone there is fear that the taxpayers will never submit to enhanced economic austerity measures, which would force the citizenry into an impoverished existence so that their increased tax burden could pay off the debts incurred by irresponsible bankers. In the United States there is no such concern. The public is much more compliant. Whether that will change is anyone’s guess.
EU-phoria Fades
The most recent “light at the end of the tunnel” for the European sovereign debt crisis was seen on Friday June 29. At a summit in Brussels, leaders of the European Union member nations agreed upon yet another “plan for a plan” to recapitalize failing banks – particularly in Spain. The Summit Statement, which briefly summarized the terms of the plan, explained that an agreement was reached to establish a supervisory entity which would oversee the European banking system and to allow recapitalization of troubled banks without adding to sovereign debt. By owning shares in the ailing banks, the European Stability Mechanism would no longer have a senior creditor status, in order to prevent investors from being scared away from buying sovereign bonds.
The bond markets were relieved to know that once again, taxpayers would be paying for the losses sustained by bondholders. The reaction was immediate. Spanish and Italian bond yields dropped faster than William Shatner’s pants when he passed through airport security. Spain’s ten-year bond yield dropped to 6.51 percent on June 29 from the previous day’s closing level of 6.87 percent. Italy’s ten-year bond yield sank to 5.79 percent from the previous closing level of 6.24 percent.
Global stock indices went parabolic after the news from Brussels on June 29. Nevertheless, many commentators expressed their skepticism about the latest plan. Economist John Hussman of the Hussman Funds discussed the shortcomings of the proposal in his Weekly Market Comment:
The criticism expressed by Charles Hugh Smith is particularly relevant because it addresses the latest move by the European Central Bank to lower its benchmark interest rate by 25 basis points (0.25%) to a record low of 0.75 percent. Smith’s essay, entitled “Sorry Bucko Europe Is Still in a Death Spiral” consisted of sixteen phases of the death spiral dynamic. Here are the final seven:
Of course, Mr. Smith is forgetting that the Martians could call upon those generous taxpayers from planet Zobion for a bailout . . .