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  • Major US banks worse than Japan's zombies?

    Major US banks worse than Japan's zombies?

    Why aren't massive expansions of banking reserves by the Fed working this time?

    Back in September 2008 we posted this chart that shows the Fed vastly expanding reserves for member banks. We show the expansion as a percentage rather than an absolute change because the numbers are so large as to be meaningless. The real story is the proportion relative to past crises -- real, as in the case of 9/11, or imagined, as in the case of Y2K:
    ...the Fed expanded its total asset holdings by $600 billion over the last 30 days, with less than a third of this going directly into reserve balances. The graph below puts the latter magnitude in perspective. When the World Trade Center towers burned down on September 11, 2001 many of the financial institutions that played a key role in trades of government securities and interbank loans were wiped out or incapacitated, posing potentially huge liquidity problems. Reserves ballooned to $67 billion, as excess reserves simply piled up in some banks while others remained in need. Last week's spike of $171 billion was 2-1/2 times as big-- the breakdown of interbank lending last week proved more profound than that caused by the physical disruptions in New York in 2001.

    Anyone who suggests that last week's ballooning reserve deposits represent inflationary pressure or the Fed monetizing the deficit simply doesn't know what they're talking about. Banks are sitting on the reserves, not withdrawing them as cash. When markets settle down, the Fed can and will absorb those reserves back in with sterilizing sales of Treasury securities, just as it did in 2001 or after the more modest spike in August 2007. Providing new reserves aggressively is absolutely and unquestionably the way the Fed needs to respond to this kind of development. - Econbrowser.com, Oct. 2008
    This explanation seemed reasonable back in October 2008 when the expansion of reserve deposits were up 150% year over year, only two and a half times larger than ever occurred before during a financial crisis, but now that the expansion has continued to 625% year over year, more than eleven times larger than during the 9/11 emergency, new questions arise.


    Pre-crisis reserve level in blue post crisis in red


    Pre-crisis reserve level in blue post crisis in red


    Pre-crisis reserve level in blue post crisis in red


    We went for a second opinion to a banking expert we know who prefers to remain anonymous of this particular opinion. For the purposes of this interview we’ll call him Dr. Banker.

    iTulip: What do you make of the extraordinary levels of bank reserves that the Federal Reserve is pumping into the Federal Reserve System, now at more than 600% higher than November 2007 levels?

    Dr. B: Think of the commercial banks that take loans from the Federal Reserve banking system as a person and the money that flows through them as the blood in a person's body. Now think of that person as injured. When he suffers a severe injury and loses blood, the Fed gives him an emergency money transfusion. You can see in your chart below the money transfusions in late 1999 just before the end of the year, due to the Y2K scare -- false, as it turns out -- and in 2001 after 9/11. Some believe that the withdrawal of reserves in mid 2000 caused the market decline that led to the recession of 2001.



    Dr. B: After the injury is operated on and healed and the patient is producing his own money again, the money that was added earlier by the Fed's transfusion is drained back out. As you can see from your chart above, the transfusions usually take two to six months and typically six months or so after the crisis is over are gradually withdrawn over a period of several months to return total money in the system to pre-crisis levels.”

    iTulip: That makes sense. But why has the Fed this time had to continue to transfuse money? Why are the transfusions so huge and why do the transfusions seem to not be working? Is he still bleeding and the money is pouring through the system? If you try to compare previous expansions with this one on the same chart on the same scale, the differences are quite stark.



    Dr. B: My theory is, and I admit not everyone will agree with it, is this: the patient is dead.

    iTulip: Interesting. That does not bode well for the efficacy of future transfusions.

    Dr. B: No it does not. They can keep the intravenous tube hooked up to a pint bottle or a 100 gallon drum of blood but it doesn’t matter if the blood is not circulating through the patient so he can take it in.

    iTulip: Controversial. I see why you are giving this to us on the sly. What evidence do you have to support this theory?

    Dr. B: Note that many smaller banks that do not operate as part of the Fed system are working just fine.

    iTulip: Go on.

    Dr. B: The reason: Credit Default Swaps. It is now well understood that CDS are at the root of today’s financial crisis. Your readers have known that risk since 1999 when you first posted Someone Please Turn on the Lights. Some have suggested the simple expedient of canceling them all, declaring all of the CDS contracts null and void.

    iTulip: That will bring the dead patient back to life, assuming as you assert that he is dead?

    Dr. B: CDS certainly killed him but removing them is no cure.

    iTulip: Why not?

    Dr. B: Federal Reserve Bank of New York Staff Report no. 276 "Credit Derivatives and Bank Credit Supply" by Beverly Hirtle, February 2007 concluded that all of the nation’s largest banks used credit default swaps not to protect existing assets but to expand their balance sheets between 1997 and 2006.
    Summary and Conclusions

    This goal of this paper is to examine the relationship between banks’ use of credit derivatives and the supply of bank credit. Credit derivatives represent an important credit market innovation that, in theory, allows banks to originate and fund loans without holding the associated credit risk. More broadly, credit derivatives are the latest in a series of innovations that have facilitated credit risk management and made it easier for banks to diversify their credit risk exposures.

    The key question is whether banks have used these instruments primarily to diversify and thus reduce their risk exposures, or whether banks have undone the diversification by expanding their lending. Research on earlier credit market innovations has found that activities such as loans sales and securitizations have not resulted in overall reductions in bank risk, but rather an expansion of lending (Cebenoyan and Strahan 2004 and Franke and Krahnen 2005). Such an increase is credit supply would be an important consequence of the recent rapid growth of the market for credit derivatives.


    Source: Federal Reserve


    Dr. B: That was in 2006. As we all know, CDS have doubled again since then.

    iTulip: So all of the largest banks relied on CDS to make new loans since 1997.

    Dr. B: Correct, and that means that central banks cannot wave a magic wand and declare all CDS contracts null and void because if they do loans that were made in the US by the largest banks only because they were insured by CDS will have to be declared null and void, too. No one knows exactly the total loan value is of these CDS-dependent loans but it must be high enough to call their solvency into question because these banks refuse to lend to each other no matter how much the Fed increases reserves.

    iTulip: Have you tried to estimate total CDS dependent loan value?

    Dr. B: I have. Back in 2006 when the Fed did the research there were eight banks with assets over $100 billion. As of May 2008 there are 20, as you can see in the chart below.

    Bank Assets in $1,000s


    Source: Federal Reserve


    Dr. B: How much of the combined $10 trillion in assets of these banks was taken on since 1997 and what portion of that expansion was enabled solely by use of credit derivatives? Conservatively, let us estimate the total is 20% of loans. That represents $2 trillion in loans that have to be cancelled in order for the CDS to be cancelled. That is why canceling them is a non-starter.

    iTulip: But why does the total value need to be that high to make the decision to cancel all CDS a non-starter for central banks? Doesn’t the act of canceling the CDS mean that these loans are technically ‘bad" loans? No bank can survive a write-down of 10% of assets never mind 20%. Doesn’t this mean these largest banks are technically insolvent?

    Dr. B: Now you understand the problem! You nailed it. That is why I say they are dead and all the cash infusions in the world from the Fed won’t bring them back to life. They are dead with the CDS and dead without them. The Fed may as well stop the intra-venous injections of reserves.

    iTulip: That implies a loss of, if not all of the banks' assets, a portion of the aggregate value at distressed sale prices. Best case, what, 50% or $10 trillion?

    Dr. B: For a $10 trillion loss.

    iTulip: Thank you for the opinion. I'm sure it will generate a lively response.

    Dr. B: You are very welcome.

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    Last edited by FRED; 12-02-08, 12:02 AM.
    Ed.

  • #2
    Re: Major US banks worse than Japan's zombies?

    Originally posted by FRED View Post

    Dr. B: My theory is, and I admit not everyone will agree with it, is this: the patient is dead.
    Excellent insight. Bottom line, the patient is dead and CDS killed him is consistent with what Sinclair has been saying for a long time.

    Although others here disagree, I cannot see how gold [& commodities] will not rise significantly over the next few years, as the governments of the world attempt to reflate.

    Comment


    • #3
      Re: Major US banks worse than Japan's zombies?

      enlightening facts!

      I too was reminded of J.Sinclair.

      Regarding CDS:
      If there is no cure for the patient - turn of that machine and let them die !

      The rest of the economy can't wait for the banks to be saved, because there is no cure.

      This also implies the big banks will never lend out to main street again.
      A sudden stop of lending to main-street has already occurred. And not only consumer credit. Anybody tried to get an Letter of credit (L/C) these days - The Dry-Ship says no?

      So let them fail and start programs to direct lend to sound main-street projects & companies. Maybe via remaining sound banks or via a public bank. (like in Germany with the KfW Bank after WWII). (Sound projects exclude the carmakers )

      Hole of the discussion about the crisis in the mainstream media and all of the rescue programs seem to be dominated by the big banks.
      But they can not be part of the solution. They are already dead. All that money is wasted.
      The same goes for Europe.

      The world needs credit - but the world does not need these zombie banks.

      However the current spin seems to be: the world needs credit - so you need us (wall-street) - save us!!
      Last edited by makkie; 12-01-08, 08:37 PM.

      Comment


      • #4
        Re: Major US banks worse than Japan's zombies?

        I'm glad CDS was brought up because it is does seem to be the one piece that few analyze in terms of what will happen and it is downright scary that Sinclair seems to understand it - having been in the clearinghouse / derivatives business.

        What's interesting is where iTuilip and Sinclair converge and diverge. Both see gold rising above $1500 and a reconstitution of gold into the monetary system - perhaps halting the devaluation of the dollar. However, Sinclair seems more and more certain of hyperinflation - and it is precisely these OTC derivatives that he blames as the eventual culprit.

        I had a conversation with him the other day if you can call it that via email and he remains steadfast that hyperinflation is a real possibility based on this derivative problem despite the debt being denominated in USD.

        What I have not been able to understand is:

        1) By what mechanism does banking circulation become unclogged?

        2) What level of investment margin is in the system and has yet to be deleveraged? Everyone throws in the towel on this, yet there must be some way to measure leverage, no?

        3) What does the Fed have to do if the $8 trillion pledged already has not already compelled trading partners to begin exchanging dollars for non-dollar denominated assets?
        --ST (aka steveaustin2006)

        Comment


        • #5
          Re: not just dead but about to be declared dead?

          What was that movie "Weekend at Bernie's." Now starring Hank and Ben

          There's a very valuable discussion of the significance of CDS in the Institutional Risk Analytics report from today:

          http://us1.institutionalriskanalytic...ry.asp?tag=326

          A few details are sort of mind blowing:

          - no collateral is posted for CDS contracts (infinite levearge?)
          - they have been used as a tool to trade equity volatility (ie, if I understand it correctly, in the way they are actually used there is no serious attempt to assess the actual default risk of the underlying entity)....

          Best to just read it; its beyond me to paraphrase. But the takeaway is exactly as described by EJ above:

          "... we have taken the view that the only way to deal with situations such as AIG (NYSE:AIG) is bankruptcy. Funding the AIG CDS portfolio is an open-ended proposition. But of course Paulson, Geithner et al would rather use tax dollars to subsidize this example of global casino gambling rather than tell the American people the truth about AIG and the other large CDS dealer banks such as C and JPM. And the truth, in our view, is that these large, CDS dealers are basically insolvent, with or without the distorting effects of fair value accounting. And the solvency problems arise not only because of their own CDS positions, but because their dealer counterparties have problems of their own."

          But most importantly, the piece of perhaps prescient news is this:

          "We hear from a very well placed Buy Side investor with extensive business interests in the US and EU that three primary banking institutions in Europe, two French and one German, have such significant CDS exposure and other problems that they cannot even begin to fund the payouts anticipated over the next quarter.
          The funding squeeze reportedly is exacerbated by a near-collapse among weaker players in the hedge fund market, who were accustomed to receiving loans from one large French institution, which then stupidly converted the loans into equity. That's right. This past summer, when the bank put out a call for redemptions of $4 billion in hedge fund investments, says the source, only $400 million was returned. And the French bank also used these same hedge funds and others to reinsure some of its own CDS exposure. Sound familiar? Yup, just like AIG.
          Unlike the approach taken by Paulson and Geithner to bailout AIG and JPM (via the Bear Stearns rescue), however, the investor claims that EU officials are considering a moratorium on CDS payments by the three Euroland banks in question. The banks would be given ten years to write down their CDS and hedge fund exposures and would receive additional infusions of capital by their respective governments. The source claims that French banks have such huge exposure to both hedge funds and CDS, sometimes linked together, that the positions are beyond the ability of the EU governments to bail them out without a cessation of CDS payments.
          The IRA was not able to obtain a comment from EU officials over the weekend about these allegations. We'll be making some calls Sunday night and Monday. But if this unconfirmed report turns out the be true, then the beginning of the end of the CDS market as we have known it will be at hand. And ironically, the catalyst for the final solution will come not from the failure of a US dealer, but instead by a moratorium on CDS payments by an EU bank"

          There's a lot of colour here that somehow fleshes out the issue... well worth a read.

          Comment


          • #6
            Re: Major US banks worse than Japan's zombies?

            Originally posted by FRED View Post
            Dr. B: My theory is, and I admit not everyone will agree with it, is this: the patient is dead.
            Tonight I was reviewing the ECRI Weekly Leading Index, (WLI), and this position helps me understand what I'm seeing there. The economy is dying. It's still breathing shallowly but business activity has fallen off a cliff.

            I keep thinking of the scene in The Day After Tomorrow where the RAF helicopter pilots realize their fuel lines are freezing and never understand that the temperature has fallen to -100C.

            The chart below is a 40 year business cycle chart representing year-over-year percent of change.
            40YearECRI_WRI.jpg

            The chart below is a 20 year business cycle chart representing business activity level.
            19YearECRI_Level.jpg

            Comments welcome.

            Comment


            • #7
              Re: Major US banks worse than Japan's zombies?

              So CDS liabilities are behind the liquidity trap currently facing the CBs. Thoughts?

              Comment


              • #8
                Re: not just dead but about to be declared dead?

                Originally posted by oddlots View Post

                "... But of course Paulson, Geithner et al would rather use tax dollars to subsidize this example of global casino gambling rather than tell the American people the truth about AIG and the other large CDS dealer banks such as C and JPM.
                I just read Traders, Guns & Money by Satyajit Das, and the only word to describe the CDS and other OTC derivatives is as a casino. It's an absolute joke/outrage/crime what has taken place.

                A good interview by Das my be found here although is was recorded in September, 2007 and the focus was subprime mortgage meltdown.

                Comment


                • #9
                  Re: Major US banks worse than Japan's zombies?

                  Originally posted by FRED View Post



                  Dr. B: After the injury is operated on and healed and the patient is producing his own money again, the money that was added earlier by the Fed's transfusion is drained back out. As you can see from your chart above, the transfusions usually take two to six months and typically six months or so after the crisis is over are gradually withdrawn over a period of several months to return total money in the system to pre-crisis levels.”
                  I must point out that the "drain start" and "drain end" points on the chart are being misinterpreted. Since the chart uses year-over-year change, the apparent "drains" are actually mirror image artifacts created one year after the crisis when comparing relatively normal reserve levels to the crisis levels.

                  However this does not affect the core thesis of the article. Great stuff.

                  Jimmy

                  Comment


                  • #10
                    Re: Major US banks worse than Japan's zombies?

                    So what insulates small banks from falling real estate prices? Is the assumption their mortgages were sold off to Wall St. and thereby their exposure is manageable? What if the "walking dead" flood the market with foreclosed homes and cut prices for quick sale purposes? At the least the volume of loan writing should drop off, and with that, a small bank's staff. Perhaps the small bank survives, albeit, with one employee working the teller window and lots of empty desks.

                    By the way, what ever happened to Brian Wesbury's solution of changing the accounting rules? Then again, whatever happened to Brian Wesbury? Haven't seen him in a while. Perhaps he's been reassigned to the Icelandic banking sector???

                    Comment


                    • #11
                      Re: Major US banks worse than Japan's zombies?

                      Originally posted by Chief Tomahawk View Post
                      So what insulates small banks from falling real estate prices? Is the assumption their mortgages were sold off to Wall St. and thereby their exposure is manageable? What if the "walking dead" flood the market with foreclosed homes and cut prices for quick sale purposes? At the least the volume of loan writing should drop off, and with that, a small bank's staff. Perhaps the small bank survives, albeit, with one employee working the teller window and lots of empty desks.

                      By the way, what ever happened to Brian Wesbury's solution of changing the accounting rules? Then again, whatever happened to Brian Wesbury? Haven't seen him in a while. Perhaps he's been reassigned to the Icelandic banking sector???
                      the way i read it... the big banks are dead. that's wrecking the economy. then comes the little banks.

                      Comment


                      • #12
                        y-to-y artifact

                        Originally posted by jimmygu3 View Post
                        I must point out that the "drain start" and "drain end" points on the chart are being misinterpreted. Since the chart uses year-over-year change, the apparent "drains" are actually mirror image artifacts created one year after the crisis when comparing relatively normal reserve levels to the crisis levels.

                        However this does not affect the core thesis of the article. Great stuff.

                        Jimmy
                        I think that the misperception caused is important though.

                        It makes us think that "normally", as in the past two occasions, reserves are not withdrawn untll almost a year later. But that is not the case.

                        The "infusion spike" from zero and back ot zero is really an infusion AND withdrawal all in one. And the past two cases the reserves were in and back out again in just a couple of months (ok, the y2k ramp up took longer, but that was a planned event and it started out gradually).

                        So, if we see a drop in that y-to-y growth in the next couple of months or so, then that would be a very important sign and we might all cry Hallelujah. (I mean, we don't have to wait to see the line go negative to see draining of reserves - that's an artifact of charting y-on-y change, as you point out.)

                        But, if it is CDS that is the problem, we won't all be betting on a rapid slide down to zero!

                        But if the chart levels off and flat lines, that's an important sign too since it would seem to imply that those reserves are there to stay a while, it perhaps suggests that maybe a stable situation has been reached. (Those reserves might then better be likened to formaldehyde rather than blood?)

                        But while the thing keeps goes up and up .... Oy!

                        How far can it go before the Fed goes completely Weimar?

                        Comment


                        • #13
                          Re: Major US banks worse than Japan's zombies?

                          Originally posted by Chief Tomahawk View Post
                          So what insulates small banks from falling real estate prices?
                          The big guys bought the crap real estate mortgage paper, and used CDS's to spread the risk amongst themselves. The little guys sold the crap paper to the big guys as soon as the mortgage closed. The big guys ended up with massive counter-party risk on each other; the little guys don't have that.

                          Metaphorically, it is as if the big banks are swimming at sea, and each roped themselves to the others, thinking that this reduced their individual risk of drowning. Having thought that, they each took on a much greater load of risky debt, because they were calculating the risk of bankruptcy (drowning) too low, by not adequately accounting for the systemic risk of mutual counter party collapse in a major downturn.

                          The smaller banks avoided direct involvement in this Jonestown suicide pact, by not using CDS's to rope themselves in too tightly, and by not then using the resulting "collective (in)security" to justify carrying massively more risky debt than they could safely manage individually.

                          A massive economic downturn will take out some smaller banks, just as it takes out some other businesses, individuals and governments. But some small banks will survive as well. The collective suicide pact of the worlds largest banks is however awe inspiring. The mutually assured destruction that we risked with nuclear weapons of war has been revisited with CDS weapons of finance.
                          Most folks are good; a few aren't.

                          Comment


                          • #14
                            Re: Major US banks worse than Japan's zombies?

                            I've been hearing this from a lot of people, the question is where it will lead or what can be done

                            Larouche said it and he thinks its back to the 13th centry

                            The patient is dying; we're at a bedside death-watch. The patient is the US economy. We don't know exactly when it will die, but it will be very soon. In principle, the patient is dead already.

                            Mandelbrot & Taleb mentioned the revolution which is 18th century or so

                            http://www.youtube.com/watch?v=H3zZ6qNWeGw

                            And than we have a lot of people comparing it to 1931

                            Comment


                            • #15
                              Re: Major US banks worse than Japan's zombies?

                              Yes, I don't see how the little guys avoid getting sucked down the liquidity whirlpool short of having a massive stash of gold in the vault to support themselves.

                              Comment

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