Financial Sense

Meltdown of the Banking System?

by Dr. Chris Martenson | March 31, 2008

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Continuing the tradition of "telling it like it is" in stark contrast to US news where everything is soft pedaled and downplayed, Spiegel (one of my favorite foreign news sources) comes out with this astonishing article.

Here they do an incredible job summing up the situation.

�For some time, there has been a tacit agreement among central bankers and the financial ministers of key economies not to allow any bank large enough to jeopardize the system to go under -- no matter what the cost. But, on Sunday, the question arose whether this agreement should be formalized and made public. The central bankers decided against the idea, reasoning that it would practically be an invitation to speculators and large hedge funds to take advantage of this government guarantee.�

�Everyone involved knows how explosive the agreement is. It essentially means that while the profits of banks are privatized, society bears the cost of their losses. In a world in which the rich are getting richer and the poor poorer, that is political dynamite.�

�Nevertheless, central bankers are running out of options. They are anxious to avert the nightmare scenario of a financial crisis like the one that rocked Germany in 1931, when the failure of a major Berlin bank prompted a massive run on other banks by a nervous public, which plunged those banks into insolvency. For decades, a repetition of that disaster had seemed unthinkable. But ever since former Fed Chairman Alan Greenspan dubbed the current financial crisis the worst since the end of World War II, old certainties have no longer applied.�

For those who are paying attention, this open admission that our choices are seemingly reduced to either a systemic market crash or shoveling untold amounts of money into the coffers of the wealthiest banks (and individuals) on the planet reveals just how ridiculous, and potentially explosive, this situation really is.

Let's continue. This is a telling passage and quote:

In this situation, even the most zealous disciples of the free market are calling for more government intervention.�I no longer have faith in the ability of the markets to heal themselves," Deutsche Bank CEO Josef Ackermann confessed in a speech delivered last Monday in Frankfurt.�

�Ackermann said that the American example shows that governments and central banks must now play a stronger role. Even his counterpart at Commerzbank, Klaus-Peter M�ller, agreed, saying that the current situation has the potential to develop into "the biggest financial crisis in postwar history" as long as "the markets are allowed to continue operating unchecked."�

�According to M�ller, "It would make sense to permit the banks -- retroactively to Jan. 1 -- to account for securities differently by eliminating the daily revaluation requirement." He argues that this would stop the downward spiral on the banks' financial statements.�

As someone who has been observing this "sudden crisis" develop over the past 4 years, I am amused by this sentiment that banks be permitted some additional leeway in how they treat record their losses so as to continue to hide their poor decisions. I am amused because I have a small child who tries the same tactic during scary movies and I find it to be a developmentally quaint �strategy�.

The somewhat aggravating part of all this is that the central banks have known about this problem for a long time yet chose to do absolutely nothing about it until now. Let me illustrate this in two parts, first with a quote from a Federal Reserve Governor made in 2006 which reveals that they were precisely focused on the exact cause of this crisis, and then with a graph showing what happened next.

Exhibit A:

�There are aspects of the latest changes in financial innovation that could increase systemic risk" -- the danger that the losses of a few investors could set off a chain reaction of events that disrupts the broader financial system, as did the near-collapse of a heavily leveraged hedge fund in 1998.� ~Federal Reserve governor Timothy Geithner March 1st, 2006

The "aspects of financial innovation" is banker code-speak for derivatives which are the very innovations that have now blown up and which Klaus-Peter M�ller, above, is arguing should be more-or-less swept off the bank balance sheets and out of view. The "systemic risk" referred to is precisely the situation in which we now find ourselves and refers to the possibility that bank after bank will topple into each other like so many unstable dominoes until the entire banking system lies in a ruined heap.

Given the seriousness of this possibility, and given the fact that the US central bank is on record as being very concerned about this back in 2006 (and most certainly before), let's see what happened to the growth of derivatives after Mr. Geithner�s warning. Did the central banks crack down on derivatives limiting their growth? Even better, did derivatives decline?

Exhibit B:

http://www.chrismartenson.com/system/files/u4/Derivatives.jpg

What we see here is that at the moment of Geithner's warning (which I took very seriously at the time) total world derivatives had a value of around $380 trillion (with a "t") and 18 months later that number had exploded to $684 trillion. So, however concerned the central banks were at the time, they were not concerned enough to prevent a near doubling of derivatives over the next year and a half. More than $300 trillion of new bets were recklessly balanced on a monetary system whose very design requires continuous compounding, or exponential, growth in the aggregate levels of debt (credit). Did nobody at the central bank notice that the US consumers at bottom of this massive inverted pyramid were running a negative savings rate during this period of explosive growth? Did they not have access to the fact that US manufacturing (that is, the actually productive portion of the economy) has been in a recession for over 10 years?

And so it is that now, in a stroke of irony, we find that it is the NY Fed itself, the very branch that Mr. Geithner heads up, which is saddled with taking on the almost $30 billion of Bear Stearn �assets� during this past rescue. I bet that sticks in his craw. However, it should also be obvious that there's a vast gulf between $30 billion and $300 trillion - that's 4 orders of magnitude for you math geeks and Richter scale fans - so we might reasonably assess that some risk remains that the problem has not been entirely solved.

But now all of us are going to be expected to pay for these mistakes while the already fabulously wealthy are going to be bailed out and probably made even richer in the process. Even worse, it turns out that Germany is openly discussing the risks and responses in an open manner while the US media and political leadership have opted a stance of consistently reassuring us all that is fine and under control.

As if we could simply close our eyes during the scary parts and wish it all away.

Copyright © 2008 Dr. Chris Martenson
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