The White House, the Fed, the Debt, the Inequality and Larry

It’s going to be an explosive fall, financially speaking, regardless of what transpires in the Middle East. The culmination of faux regulation, debt ceiling debates, derivatives growth and the ever-expanding Federal Reserve books will provide lots of volatility- for which the White House will be caught unprepared.

In the wake of the Great Crash of 1929, FDR and Congress passed an act to isolate people’s deposits from the speculative pursuits of financiers. The Glass-Steagall or Banking Act of 1933, was even promoted by some of the biggest bankers of the time, as I will explain in greater detail in All the Presidents’ Bankers.

Their reasons were self-serving, yet they also helped the population. They wanted a safer banking structure, they wanted citizens to feel more confident in the financial system that they dominated, and they were willing to forego their trading and securities creation operations to achieve this goal. They were willing to become smaller and substantively less risky in accordance with the Act that FDR signed on June 16, 1933.

We got nothing like that legislation this time around, just a lot of talk about ‘sweeping reform.’ President Obama signed the Dodd-Frank Act in July, 2010 to supposedly protect consumers from Wall Street. But it did not make big banks smaller. It did not separate their speculative / securities creation ability from their FDIC backed deposit and lending business. It did not require banks to dramatically reduce their derivatives positions, the leverage imbedded in complicated assets, or the dangerous chains of inter-dependent exposures to other firms.

Despite billion of dollars of fines, which mean little in the scheme of their bottom lines, the biggest banks are bigger and more complex than ever, and thus, their leaders more sheltered by Washington. Unnecessary global risk remains in the system. We need banking reform ala Glass-Steagall. Anything less is an exercise in political posturing and regulatory futility, no matter how many back-pats accompany the procedure.

Derivatives Take over the World

Last quarter, the total notional value of US banks’ derivatives positions increased by $8.5 trillion to $232 trillion, still mostly concentrated in interest rate products. Credit derivatives, 6% of the total, increased 5.4% to $13.9 trillion. The four largest banks account for 93% of that amount, and 81% of industry credit exposure, 36% of it below investment grade.

The total assets of JPM are $1.95 trillion and total derivatives notional $70.3 trillion, or more than 35 times its asset amount. Citigroup has $1.3 trillion in assets and  $58 trillion in derivatives notional. Bank of America has $1.4 trillion in assets and $44 trillion in derivatives, and Goldman has $133 billion in assets and $42 trillion in derivatives. Banks will say they are hedged, notional volume does not equate to the total potential loss, but that just doesn’t matter. In the event that one area of the market or one firm goes belly up, the rest follow. No mega-bank is isolated from the others, though some are more politically connected, have more lobbyists, or are better subsidized than others.

Before the fall of 2008, US banks’ notional derivatives exposure was $180 trillion.  Then, five banks held 97% of that notional, and 85% of the industry’s net credit exposure. The concentration of risk and amount of derivatives has increased, since before the government orchestrated bank bailout and subsidization, and Dodd-Frank.

There are $564 trillion worth of notional over-the-counter derivatives that the Bank of International Settlements (BIS) knows about, as of June 2013. America’s global derivatives presence, has now eclipsed its comparative military expenditures; the US is responsible for 39% of the world total of $1.7 trillion of such expenditures, but US banks account for a whopping 41%, and JPM for 12.4%, of the world’s derivatives.

Debt Ceiling Drama

In the backdrop of ongoing discourse conducted by minions of lobbyists over the minutia of Dodd-Frank that can be still be deliberated to keep them employed, comes the major déjà vu non-debate of the season, resurfacing from two years ago – that of the infamous Debt Ceiling. Tune it out. For, Congress will do a lot of partisan grumbling and then vote to raise the debt ceiling anyway.

In the highly unlikely event that it doesn’t, the US is in no danger of defaulting on its debt. At its current credit rating, it’s many notches away from that, plus, it just won’t happen. S&P pre-empted even the potential of a downgrade in June, when it raised its outlook from ‘negative’ to ‘stable’ and left the rating at AA+, citing the Fed’s “timely and conservative actions” to mitigate the effects of the “great recession” of 2008 and 2009 and noted it expects the US economy to match or top other highly rated countries in the next few years.

And, even in a pinch, the Fed is holding about $2 trillion worth of Treasury securities in excess reserves. Technically, these could be returned or sold– which won’t occur because that would mean the end of Zero-Interest-Rate-Policy, an even tighter credit market and plummeting stock and bond market. Congress and Bernanke won’t let that happen.

For the record, I’d retire that $2 trillion in debt, since it’s doing nothing productive anyway, which would alleviate the need to discuss raising the debt ceiling, or put it to some productive job-creating purpose, so we wouldn’t have to hear Bernanke talk about the need for more jobs to be created, while presenting no concrete ideas as to how to do that. Oh gee, I have an extra $2 trillion lying around here, what to do?

But none of that matters. Since Obama came to office, the debt limit has been increased from $10.6 trillion in 2008 to $16.394 trillion now. Under Bush, the debt limit rose from $5.95 trillion to $10.6 trillion.  Republican and Democrat controlled bodies of Congress approved the steps along the way.  They will again.

Epic Inequality and Excess Capital of the Wealthy

While hundred of trillions of dollars of derivatives and trillions of dollars of debt swirl around the bankosphere, the top 10 percent of earners nabbed more than half of the country’s total income in 2012, the highest level recorded since the government began collecting income data in 1917, according to the latest study by noted Economists, Emmanuel Saez and Thomas Piketty.

These are sad, but unfortunately not shocking results. Income and wealth inequality will continue to grow because of the wealth-accumulation effect of excess capital investment in a political system whose restrictions on damaging financial speculation are so lax. In this construct, it still “takes money to make money.” During the pre-Depression years of the 1920s, investors with more ‘cash to burn’, could – and did - take more investment risks like speculating in the stock market or the various trusts, than those living from paycheck to paycheck. Those with less excess capital to begin with, that did chose to invest it more speculatively, or that were otherwise impacted by losses related to the speculation of others and the general economic crisis (losing jobs because their employers had borrowed or invested recklessly and were cut off from bank loans to run payrolls as banks shut or entered hoarding-survival mode), had no financial cushion for necessary expenses, let alone investments later.

Still during and after the Great Depression, for several decades, inequality shrank because even the wealthier investors chose to behave more prudently, and the financial institutions were forced to by legislation.

Today, more complex investing and speculating avenues abound - from stock market options to credit derivatives to commodities indices - through advanced technology and the sheer scope and opaqueness of the practices of major players.

What is particularly scary about the timing of this study, is that it did not take place during the build-up to this financial crisis, which would have been a more even parallel to the 1920s build-up before the 1929 Crash and 1930s Great Depression. Instead, these results were tabulated after the height of this recent crisis - the plummeting of the stock market in 2009, the escalating foreclosures, and the restriction of credit to individuals and small businesses. The resurgence of the stock market - on the back of the Fed’s Zero-Interest-Rate and QE programs and other forms of cheap capital made available to the banks, and the hedge funds, and other wealthy individual clients to which they cater -  has increased capital returns for these participants, but not helped those with less excess capital to begin with that continue struggling for jobs, more livable wages, more affordable health-care and education, and are under mounting other daily expenses.

This time around, there has been a marked divergence in the thing that the White House and Main Stream press calls a “recovery” that renders our overall economy in a more precarious position for more people. The Saez-Piketty study is another indicator that this “recovery” was for the banks and that were disproportionally subsidized by the Fed, Treasury and government policies, and for their wealthy clients and customers that could afford to pick up and churn cheap assets. It was not for the general population.

The Fed and the Fat 

Meanwhile, the US bank subsidization exercise isn’t over. It’s in its fifth year. Despite all the will-he-or-won’t-he speech analysis games, the Fed remains an active buyer of securities from banks and holder of treasuries in excess reserve. Since the Fed instituted its plan to buy $85 billion per month (up from an original $40 billion, why be incremental when you can double-down?) – or more than $1 trillion per year – of mortgage securities from banks, its actions have artificially boosted the prices of those securities and related ones. This provides the illusion of a healthier banking system.

The Fed continues to shatter its own records monthly, now holding a total of $3.6 trillion of debt securities on its books, about ten times the figure of 5 years earlier (in July 2008), including $2 trillion of US Treasuries in excess reserve balances maintained by banks at the Fed, receiving .25% interest. The Fed’s mortgage backed securities component is $1.3 trillion, up from zero 5 years ago.  None of this helps the general economy, all of it helps interest rates remain low, securities prices high, and money cheap for the big banks.

And, not only are banks coddled by the Fed, they are sitting on record amounts of cash. JPM Chase, for instance, is holding a record $345 billion in cash, just to protect itself, while its earnings statements say things are fine. Hoarding is never a sign of stability.

Then, there’s Larry

As the Fed’s books bulge at the seams, chatter about who the next Fed Chairman will be, persists.  Given his proven tendency to populate his inner economic circle with Clintonite-Rubinites, it makes perfect sense for Obama to go with his former economic advisor, and Clinton’s former Treasury Secretary, Larry Summers – if Summers wants the job. Obama has verbally applauded Bernanke many times for saving the country from a Depression (while ignoring the risk, that his policies are infusing into the economy that will manifest after he leaves office). Summers was there through the ‘tough times’ too. 

Wall Street will be as happy with Summers in Bernanke’s chair, as they were when Summer’s replaced Robert Rubin as Treasury Secretary under Clinton, days after Congress passed the Financial Modernization Act that repealed the last remnants of the Glass-Steagall Act, and present for Clinton's signing ceremony. Plus, when Hillary Clinton runs for president, she will need all of Rubin’s circle of campaign contributors. What better way to secure them, than to also have an old friend that understands their need to remain ‘globally competitive’ at the Fed? Summers, fresh from a Citigroup-arranged, Kuwait Investment Authority sponsored May talk in Kuwait, would also keep relations with the Middle East sweet for his banker friends.  

Obama’s argument for Summers, after he retrieves his foot from his mouth regarding Syria, will be continuity, just as it was for Bernanke’s reappointment, and as it was Bush’s argument for Bernanke after Alan Greenspan. Continuity is a big theme with Congress and with bankers, too. Ergo. 

The Real Libor Scandal by Paul Craig Robert & Nomi Prins

(Note: I was deeply honored to have been asked to be a co-author on this piece by Paul Craig Roberts)

According to news reports, UK banks fixed the London interbank borrowing rate (Libor) with the complicity of the Bank of England (UK central bank) at a low rate in order to obtain a cheap borrowing cost. The way this scandal is playing out is that the banks benefitted from borrowing at these low rates. Whereas this is true, it also strikes us as simplistic and as a diversion from the deeper, darker scandal.

Banks are not the only beneficiaries of lower Libor rates. Debtors (and investors) whose floating or variable rate loans are pegged in some way to Libor also benefit. One could argue that by fixing the rate low, the banks were cheating themselves out of interest income, because the effect of the low Libor rate is to lower the interest rate on customer loans, such as variable rate mortgages that banks possess in their portfolios. But the banks did not fix the Libor rate with their customers in mind. Instead, the fixed Libor rate enabled them to improve their balance sheets, as well as help to perpetuate the regime of low interest rates. The last thing the banks want is a rise in interest rates that would drive down the values of their holdings and reveal large losses masked by rigged interest rates.

Indicative of greater deceit and a larger scandal than simply borrowing from one another at lower rates, banks gained far more from the rise in the prices, or higher evaluations of floating rate financial instruments (such as CDOs), that resulted from lower Libor rates. As prices of debt instruments all tend to move in the same direction, and in the opposite direction from interest rates (low interest rates mean high bond prices, and vice versa), the effect of lower Libor rates is to prop up the prices of bonds, asset-backed financial instruments, and other "securities." The end result is that the banks' balance sheets look healthier than they really are.

On the losing side of the scandal are purchasers of interest rate swaps, savers who receive less interest on their accounts, and ultimately all bond holders when the bond bubble pops and prices collapse.

We think we can conclude that Libor rates were manipulated lower as a means to bolster the prices of bonds and asset-backed securities. In the UK, as in the US, the interest rate on government bonds is less than the rate of inflation. The UK inflation rate is about 2.8%, and the interest rate on 20-year government bonds is 2.5%. Also, in the UK, as in the US, the government debt to GDP ratio is rising. Currently the ratio in the UK is about double its average during the 1980-2011 period.

The question is, why do investors purchase long term bonds, which pay less than the rate of inflation, from governments whose debt is rising as a share of GDP? One might think that investors would understand that they are losing money and sell the bonds, thus lowering their price and raising the interest rate.

Why isn’t this happening?

PCR’s June 5 column, “Collapse at Hand,” explained that despite the negative interest rate, investors were making capital gains from their Treasury bond holdings, because the prices were rising as interest rates were pushed lower. 

What was pushing the interest rates lower?

The answer is even clearer now. First, as PCR noted, Wall Street has been selling huge amounts of interest rate swaps, essentially a way of shorting interest rates and driving them down. Thus, causing bond prices to rise.

Secondly, fixing Libor at lower rates has the same effect. Lower UK interest rates on government bonds drive up their prices.

In other words, we would argue that the bailed-out banks in the US and UK are returning the favor that they received from the bailouts and from the Fed and Bank of England’s low rate policy by rigging government bond prices, thus propping up a government bond market that would otherwise, one would think, be driven down by the abundance of new debt and monetization of this debt, or some part of it.

How long can the government bond bubble be sustained? How negative can interest rates be driven?

Can a declining economy offset the impact on inflation of debt creation and its monetization, with the result that inflation falls to zero, thus making the low interest rates on government bonds positive?

According to his public statements, zero inflation is not the goal of the Federal Reserve chairman. He believes that some inflation is a spur to economic growth, and he has said that his target is 2% inflation. At current bond prices, that means a continuation of negative interest rates.

The latest news completes the picture of banks and central banks manipulating interest rates in order to prop up the prices of bonds and other debt instruments. We have learned that the Fed has been aware of Libor manipulation (and thus apparently supportive of it) since 2008. Thus, the circle of complicity is closed. The motives of the Fed, Bank of England, US and UK banks are aligned, their policies mutually reinforcing and beneficial. The Libor fixing is another indication of this collusion.

Unless bond prices can continue to rise as new debt is issued, the era of rigged bond prices might be drawing to an end. It would seem to be only a matter of time before the bond bubble bursts.

The Fed’s European “Rescue”: Another back-door US Bank / Goldman bailout?

In the wake of chopping its Central Bank swap rates today, the Fed has been called a bunch of names: a hero for slugging the big bailout bat in the ninth inning, and a villain for printing money to help Europe at the expense of the US. Neither depiction is right.

The Fed is merely continuing its unfettered brand of bailout-economics, promoted with heightened intensity recently by President Obama and Treasury Secretary, Tim Geithner in the wake of Germany not playing bailout-ball.  Recall, a couple years ago, it was a uniquely American brand of BIG bailouts that the Fed adopted in creating $7.7 trillion of bank subsidies that ran the gamut from back-door AIG bailouts (some of which went to US / some to European banks that deal with those same US banks), to the purchasing of mortgage-backed–securities, to near zero-rate loans (for banks).

Similarly, today’s move was also about protecting US banks from losses – self inflicted by dangerous derivatives-chain trades, again with each other, and with European banks.

Before getting into the timing of the Fed’s god-father actions, let’s discuss its two kinds of swaps (jargon alert - a swap is a trade between two parties for some time period – you swap me a sweater for a hat because I’m cold, when I’m warmer, we’ll swap back). The Fed had both of these kinds of swaps set up and ready-to-go in the form of : dollar liquidity swap lines and foreign currency liquidity swap lines. Both are administered through Wall Street's staunchest ally, and Tim Geithner's old stomping ground, the New York Fed.

The dollar swap lines give foreign central banks the ability to borrow dollars against their currency, use them for whatever they want - like to shore up bets made by European banks that went wrong, and at a later date, return them. A ‘temporary dollar liquidity swap arrangement” with 14 foreign central banks was available between December 12, 2007 (several months before Bear Stearn’s collapse and 9 months before the Lehman Brothers’ bankruptcy that scared Goldman Sachs and Morgan Stanley into getting the Fed’s instant permission to become bank holding companies, and thus gain access to any Feds subsidies.)

Those dollar-swap lines ended on February 1, 2010. BUT – three months later, they were back on, but this time the FOMC re-authorized dollar liquidity swap lines with only 5 central banks through January 2011. BUT – on December 21, 2010 – the FOMC extended the lines through August 1, 2011. THEN– on June 29^th, 2011, these lines were extended through August 1, 2012.  AND NOW – though already available, they were announced with save-the-day fanfare as if they were just considered.

Then, there are the sneakily-dubbed “foreign currency liquidity swap” lines, which, as per the Fed's own words, provide "foreign currency-denominated liquidity to US banks.” (Italics mine.) In other words, let US banks play with foreign bonds.

These were originally used with 4 foreign banks on April, 2009  and expired on February 1, 2010. Until they were resurrected today, November 30, 2011, with foreign currency swap arrangements between the Fed, Bank of Canada, Bank of England, Bank of Japan. Swiss National Bank and the European Central Bank.

They are to remain in place until February 1, 2013, longer than the original time period for which they were available during phase one of the global bank-led meltdown, the US phase. (For those following my work, we are in phase two of four, the European phase.)

That’s a lot  of jargon, but keep these two things in mind: 1) these lines, by the Fed’s own words, are to provide help to US banks. and 2) they are open ended.

There are other reasons that have been thrown up as to why the Fed acted now – like, a European bank was about to fail. But, that rumor was around in the summer and nothing happened. Also, dozens of European banks have been downgraded, and several failed stress tests. Nothing. The Fed didn’t step in when it was just Greece –or Ireland  - or when there were rampant ‘contagion’ fears, and Italian bonds started trading above 7%, rising unabated despite the trick of former Goldman Sachs International advisor Mario Monti replacing former Prime Minister, Silvio Berlusconi’s with his promises of fiscally conservative actions (read: austerity measures) to come.

Perhaps at that point, Goldman thought they had it all under control, but Germany's bailout-resistence was still a thorn, which is why its bonds got hammered in the last auction, proving that big Finance will get what it wants, no matter how dirty it needs to play.  Nothing from the Fed, except a small increase in funding to the IMF.

Rating agency, Moody’s  announced it was looking at possibly downgrading 87 European banks. Still the Fed waited with open lines. And then, S&P downgraded the US banks again, including Goldman ,making their own financing costs more expensive and the funding of their seismic derivatives positions more tenuous. The Fed found the right moment. Bingo.

Now, consider this: the top four US banks (JPM Chase, Citibank, Bank of America and Goldman Sachs) control nearly 95% of the US derivatives market, which has grown by 20% since last year to  $235 trillion. That figure is a third of all global derivatives of $707 trillion (up from $601 trillion in December, 2010 and $583 trillion mid-year 2010. )

Breaking that down:  JPM Chase holds 11% of the world’s derivative exposure, Citibank, Bank of America, and Goldman comprise about 7% each. But, Goldman has something the others don’t – a lot fewer assets beneath its derivatives stockpile. It has 537 times as many (from 440 times last year) derivatives as assets. Think of a 537 story skyscraper on a one story see-saw. Goldman has $88 billon in assets, and $48 trillion in notional derivatives exposure. This is by FAR the highest ratio of derivatives to assets of any so-called bank backed by a government. The next highest ratio belongs to Citibank with $1.2 trillion in assets and $56 trillion in derivative exposure, or 46 to 1. JPM Chase's ratio is 44 to 1. Bank of America’s ratio is 36 to 1.  

Separately Goldman happened to have lost a lot of money in Foreign Exchange derivative positions last quarter. (See Table 7.) Goldman’s loss was about equal to the total gains of the other banks, indicative of some very contrarian trade going on. In addition, Goldman has the most credit risk with respect to the capital  it holds, by a factor of 3 or 4 to 1 relative to the other big banks. So did the Fed's timing have something to do with its star bank? We don't really know for sure. 

Sadly, until there’s another FED audit, or FOIA request, we’re not going to know which banks are the beneficiaries of the Fed’s most recent international largesse either, nor will we know what their specific exposures are to each other, or to various European banks, or which trades are going super-badly.

But we do know from the US bailouts in phase one of the global meltdown, that providing ‘liquidity' or ‘greasing the wheels of ‘ banks in times of ‘emergency’ does absolute nothing for the Main Street Economy. Not in the US. And not in Europe. It also doesn’t fix anything, it just funds bad trades with impunity.