FRFI 202 April / May 2008
In mid-March, by the narrowest of squeaks, the US Federal Reserve Bank managed to stop the financial system from toppling over the edge and into the abyss. Around the world, stock exchanges, which had been in decline, suddenly bounced back up. Many financial commentators claimed that a floor had been hit from which they could only move back up. First appearances are deceptive, however, and it is clear that the credit crisis is far from over. The measures taken by the US, British and European central banks, are just buying time. The deeper underlying problems with capitalism particularly in the US and Britain, remain; the write downs are far from over and the cancer has spread well beyond its origins in the mortgage market. Newly proposed regulation is just empty political posturing.
Fed changes muck into brass
What has the Federal Reserve done and why? Already last year, the credit crisis brought with it a crisis of liquidity: risky sub-prime mortgage-backed securities were no longer acceptable collateral against loans. Banks, uncertain of getting their money back, began to stop lending to each other. If banks do not lend to each other, capital ceases to circulate and if capital stops circulating, it stops making profits. Since profit-making is the whole point of capitalist economies, liquidity crises risk triggering much deeper economic crises, dragging production to a halt. Instead of lending to other banks and customers, funds were increasingly diverted into purchase of ‘Treasuries’ (US government-backed Treasury securities), the safest type of security. This is what is meant by a ‘flight to quality’.
The Fed has tried to address this by a series of increasingly desperate measures. In concert with other central banks, the Fed introduced what is known in the US as the Term Auction Facility (TAF). The TAF allowed the Fed to make short-term loans against much riskier assets than usual, including the mortgage-backed securities which triggered the credit crisis. The risky mortgage-backed muck would be recycled into liquid funds to free up lending.
However, the various rate cuts failed to prevent continued uncertainty over credit risks and liquidity problems increased. The ‘flight to quality’ continued and can be measured by the extent of the unsatisfied demand for Treasuries. By the week of 5 March, ‘Fails’ – the number of Treasuries purchasers had requested but failed to receive and how many dealers were asked to deliver but didn’t – had grown to $1,795bn, way up from just $87bn on 20 February, and far above the $374bn average for 2007 (Federal Reserve Bank of New York, Primary Dealer Statistics). More had to be done if the system was not to grind to a halt.
On 7 March, the Fed announced that it would be making a further $100bn available through the TAF. In addition, it would undertake $100bn of ‘Repurchase Agreements’ – ‘repos’. With a repo, money is exchanged for securities with an agreement to repurchase it later – the Fed would purchase securities from banks and the banks would repurchase them up to a month later. This apparently pointless exercise increases liquidity by providing money in exchange for less liquid securities. Further, the Fed increased the amount of Treasuries it would auction to $40bn.
On 11 March, the Fed announced the Term Securities Lending Facility (TSLF). The TSLF, a temporary measure for six months, allows the Fed to lend up to a total of $200bn of Treasuries to ‘Primary Dealers’ – the big investment banks like Goldman Sachs and Morgan Stanley – in exchange for far riskier assets. The TSLF would then allow the primary dealers to supply Treasuries to meet this demand in exchange for money which they could lend.
Finally, the US Treasury directed Fannie Mae and Freddie Mac, the government-chartered companies which purchase mortgages, and which guarantee some 40% of US home loans, to increase their portfolio, putting more liquidity into the system and taking more muck off the hands of the private banks.
Although the Fed had now opened the taps to allow $400bn to flow into the system – putting half of its entire assets of some $800bn on the line – this was not enough. On 14 March, within 24 hours, investment bank Bear Stearns lost nearly half its market value. JP Morgan, a rival investment bank, backed by the Fed, announced it was making a loan of unspecified size to Bear. By Monday, this had turned into outright purchase, backed by the Fed up to $30bn of losses, for $2 per share – a total of $240m, when even its office building is valued at $1.1bn! Howls from stockholders and threats of lawsuits forced JP Morgan to increase the ‘offer’ to $10 per share. This extraordinary and unprecedented shotgun marriage, combined with a further cut in Fed rates by a total of 1%, finally encouraged the stock market to
move up.
But the credit problems remain: all that has happened is that the Fed and the other central banks have taken on the risk – temporarily. The securities they have taken on are still of dubious worth and will be returned to the banks in the next few months. The very worst of the sub-prime backed securities remain. Although there have been almost $200bn in write downs since this crisis began, the subprime crisis which triggered it has not run its course. The Fed has bought time – but has spent a lot of its ammunition fighting the crisis: half its reserves are committed and interest rates are now down to 2½%.
At the root of the credit crisis is the underlying crisis of profitability. This is becoming evident even to the most reluctant observer. Total domestic profits fell by $46.9bn in the third quarter of 2007 and by $108.7bn in the fourth quarter. It was only increased profits from abroad that prevented the decline being any worse; net profits from abroad rose by $26.4bn and $55.8bn during the same period. Non-farm employment fell by 63,000 in February.
Consequences
As we have explained in previous articles in FRFI, the credit crisis is spreading wider. In the flight to quality, the demand for Treasuries has driven their yields lower. Last year both 2-year and 10-year Notes yielded over 5%; currently the yields have declined to about 1.68% and 3.5% respectively. The Financial Times quotes a manager at South Korea’s National Pension Service: ‘The Fed continues to cut interest rates. We are still making profits from the Treasuries that we bought in the past but we think we’d better dispose of them and had better buy higher-yielding European government debt, for example.’ This is very bad news for the US economy, because foreign purchases of Treasuries have been key to funding the US government – in June 2007, foreigners held some $6,007bn of US long term debt, about 66% of the entire Federal debt. As foreign buying of Treasuries declines, it will be more difficult to finance government spending and will worsen the US balance of payments.
The drop in interest rates in the US compared to the rest of the world has driven the dollar down against other currencies. This has made US exports cheaper, but it has made imports more expensive – petrol at the pump is about 20% more expensive than a year ago; government figures show inflation running around 4%, but more realistic alternative calculations show 10%. This pushes workers’ living standards down. At the same time it reduces earnings of foreign companies operating in the US. Toyota’s revenue is estimated to have fallen by some $8.75bn since June. The Japanese Nikkei stock exchange index has fallen 30%, from about 18,000 to under 13,000, forcing the unwinding of so-called ‘carry trades’ – the cheap money many hedge funds used to finance the bubble in the US. These unwinds will lead to massive de-leveraging.
The various write-downs and lack of liquidity have forced hedge funds and others to sell what would normally be their safest assets, municipal bonds, driving their price down. Many of these bonds have been issued as ‘auction-rate’ bonds, so-called because the rates are reset at auctions every 7 to 35 days. The attraction was the lower rates that normally had to be paid compared to fixed-rate bonds – perhaps 1-11?2% lower. Normally ‘munis’ are snapped up but now purchases have dwindled. The uncertainty surrounding the creditworthiness of bond insurers, and the general reluctance to lend have driven many potential investors away. In the absence of sufficient bids, the rate reverts to a punitive rate set by the bank which is managing the issue. The New York Port Authority found itself paying 20% interest on its bonds in February, up from 4.3%. Some schools in New York are paying as much as 12%. The Louisiana Superdome, home of the New Orleans Saints, is now paying $1.2m per month instead of $500,000 – money which is lining the pockets of wealthy capitalists instead of helping the reconstruction of the wrecked city. Several student loan companies, which used to rely on the auction rate market, have withdrawn from lending. This may affect thousands of students who have been accepted at colleges this autumn.
The massive wave of mergers and acquisitions has almost completely subsided. The most spectacular exception, which goes to prove the point is the leveraged buy-out of Clear Channel, a huge US radio network, which is the object of a $19bn private equity deal from Bain Capital. Citigroup, Morgan Stanley, Credit Suisse, Royal Bank of Scotland and Wachovia agreed to lend some $22bn in 2006, but have got cold feet as they watched the share price fall to $26.92, way short of the original offer price of $39.20. As we go to press, their attempts to renegotiate the deal or withdraw have apparently been prevented by a Texas court.
The consequences are felt in capital markets outside the US and western Europe. In Australia, the Centro Properties Group is facing margin calls from lenders and has to repay their loans. So is Rubicon Japan Trust. It is expected that capital inflows into Russia will fall to some $25bn this year, down from $82.3bn in 2007, because most Russian companies will be unable to issue bonds on foreign exchanges.
So far the ruling class has been able to arrange its financial affairs to its own liking, throwing the responsibility for paying for the credit crisis largely upon the shoulders of US workers and the middle class. But these cosy arrangements are so blatant that they invite protest and on 26 March dozens of protesters paraded around inside Bear Stearns, contrasting the bail-out of Bear Stearns with the pain and suffering created by the increased mortgage rates and foreclosures.
The capitalists say that Bear Stearns investment bank was ‘too big’ to be ‘allowed to fail’. This is another way of saying that the rest of us are too small and unimportant to be bothered about. Ruling class tinkering with regulation won’t help us. The fightback against this wretched, selfish, unjust, crisis-ridden system has begun and will grow stronger!
Steve Palmer
US correspondent
