August 21, 2007

Cracks in the Global Economy

Want to know why investors throughout the world are spooked? Read the piece by numerian (of the Agonist) which lays out the reason the global economy looks about to go bust. Comments in italics are mine.

Loans held at banks [Ed: aka real money] have interest income, which is the difference between what the customer pays in interest and what the bank pays on its liability funding the loan. This interest income dribbles in over the life of the loan, is relatively unexciting, but does pay the bills over time for a well-run bank.

The securitization process accounts for transactions very differently. The securities, composed of thousands of loans, [Ed: aka fairy dust] are marked-to-market, which means that at day one all the projected income over the life of the security is present valued and taken completely into income. This has the great advantage for the traders of creating a big pool of revenue for their bonuses, but unfortunately no further income can be assured in the future to cover the bills. So the traders have to book more and more securities to keep covering their costs, including the sizeable bonuses to which (no surprise here) they quickly become accustomed.

As he writes: liquidity is not cash. Oh no, it's not. But the guys running the ponzi scheme thought they could keep the illusion going.

The Fed earlier in the week had said it would intervene in the markets only if a “calamity” occurred, and a few days later the discount rate cut suggested that something calamitous had happened. Based on the fact that the discount window can now be accessed for 30 day loans rather than just overnight money, and that the Fed also will now accept mortgage securities as collateral, we can assume one of the calamities involved Countrywide Bank. This commercial bank is a member of the Federal Reserve System and has access to the discount window. It is owned by Countrywide Financial, the country’s largest mortgage lender, and a company which a Merrill Lynch analyst said earlier in the week was possibly heading for bankruptcy. This led to an old-fashioned run on the bank, in which depositors were beginning to line up to get their money out. Nothing instills primal fear in a central banker like a run on a bank, which brings back all sorts of images from the 1930s Depression. This discount rate cut is first and foremost designed to stop the bank run in its tracks by giving Countrywide Bank whatever cash it needs.

The second likely calamity involved the ABCP market. Many conduits are simply unable to roll over their commercial paper, and they are turning to their commercial bank sponsors for emergency liquidity. This is very serious stuff because of the potential that hundreds of billions of dollars of loans now may need to be booked by the banks themselves, in effect bringing all this off-balance-sheet business right back on to their balance sheet. This could dramatically weaken their capital ratios, and certainly will put strain on their own financing activity. Hence not only did the Fed open the discount window to these banks, it specifically said that to borrow from the Fed was no longer to be considered an embarrassment and sign of failure, but a sign of “strength.” Discount window borrowing has always be shunned by the banks, and as of last week the amount borrowed was a paltry $11 million. Now it is the Fed itself that is trafficking in illusions, trying to convince the market that nothing is wrong if discount window borrowings balloon by billions of dollars.

They took the wealth of the world and spun this inverted pyramid and now everyone is going to get to see how much real money was poured into the foundation of this scheme.

Read it and weep.

Posted by Mary at August 21, 2007 12:58 AM | Economy | Technorati links |