The Warning: A Financial Cauldron of Very High Leverage and Interwoven Risks

"The current bubbles in junk bonds and foreign debt are not in any way driving the economy. Presumably we are seeing somewhat more investment as a result of the fact that uncreditworthy companies were able to borrow at a low cost, but there is no notable boom in such investment.

Similarly, if foreign borrowers have a harder time getting access to credit, it may be bad news for them, but the impact on the U.S. economy will be limited.

If some banks or other financial institutions have over committed themselves in these areas, the plunge in prices may threaten their survival. This could lead to some late nights for folks at the Fed and other regulators, but it will not pose a major risk to the economy."

Dean Baker, Bubbles that We Have to Worry About and Bubbles We Don't, 18 December 2015

And how large was Long Term Capital Management? And the Knickerbocker Trust?

Could they have been said to be 'driving the economy?

And most importantly, is the failure of any major financial institution likely to be an 'isolated incident' in this current financial structure?

I like Dean Baker quite a bit, and read his column every day, often linking to it.

But he may be greatly underestimating the size and interconnectedness and the leverage in the derivatives markets, which while it is a bit harder to see than the housing or tech bubbles is nonetheless there and even more deadly.

It is not the bubble itself that causes the problem alone, but the context in which a risk like that develops, the 'transmission' of the failure throughout the system.  Often in a system that has become sufficiently vulnerable the actual event that causes a collapse can seem relatively minor, until it is examined with an open systems mind after the fact.

The system is at the heart of the problem, not the source of the particular failure that sets its tumbling.

Should one ignore the estimated notional size of the $1.2 quadrillion global derivatives market. And the estimates that put it at more than 10 times the total world GDP.

Oh yes, I know, the insurance and cross-party netting surely mitigates these risks.  And this is the same bad estimate and theory that feeds and precedes almost every major financial panic and crisis.

What happens when a large failure of a 'single institution' takes down a major counterparty affecting multiple financial firms in a cascading of mispriced risks?

Suddenly these theoretically controlled derivatives turn into a tsunami of cross party financial contagion.   This is the real risk, not the derivatives themselves, but their size and their relative fragility to the unexpected, and the concentration of their holdings in a few systemically important places.

Does Dean really believe that it may be too bad for some 'foreign borrowers' but the exceptional American financial system will be able to withstand the winds that blow through the world markets?

What is the estimate of the damage that can be done when confidence fails and there is a widespread and sudden withdrawal of liquidity and a freezing of the short term global credit markets from an enormously interconnected and grossly leveraged financial system that resembles a pyramid scheme?

Are we going to go through all of this again, with the hopes that only the Fed and few Bank regulators will have some sleepless nights but otherwise all is well?   The last time they quickly panicked and went to the Congress with a blank check and a threat of civil chaos.

And what is so different now?   Now they are like the 300 Spartans, willing to risk all and lay down their careers for the sake of the American public, saving them from the consequences a financial system that has been gorging itself on the rich rewards of massive speculation?

Are you kidding me?

Genuine financial reform and hard systemic firewalls like Glass-Steagall are the only remedy.  And we most certainly do not have them now.

Why are there so many plans that now include the 'bail-ins' of public savings and pensions?

I am not fear-mongering.  I am raising all of the hard questions that politicians like Elizabeth Warren and Bernie Sanders have been asking, and which have largely gone unanswered behind a wall of opaque secrecy inside a crony club of the revolving door,  with deriding dismissals and vague assurances of hope for change.

And we had all of that before the financial crisis of 2008 as well.

Remember Brooksley Born?

"We didn't truly know the dangers of the market, because it was a dark market," says Brooksley Born, the head of an obscure federal regulatory agency -- the Commodity Futures Trading Commission [CFTC] -- who not only warned of the potential for economic meltdown in the late 1990s, but also tried to convince the country's key economic powerbrokers to take actions that could have helped avert the crisis. "They were totally opposed to it," Born says. "That puzzled me. What was it that was in this market that had to be hidden?"

PBS Frontline, The Warning

And the risks are still hidden, and growing rather than diminishing, such is the tide of the influence of Big Banking and Big Money.

In this current financial system, no TBTF Bank is an island of secular failure anywhere in the world.

GolemXIV: Trouble In Bankland

In the US:

• Home Equity Loans (HELOCs) are up 20% this year. 15% of all home loans originated are home equity extraction loans.
• People are taking equity out of their homes in the reigniting housing bubble, but adding to their bank debt.
• Student loans now total $1.2 Trillion.
• Nearly 35% of student loans [I believe David inadvertently says HELOC at one point] given to people under 30 are now 90 days delinquent.
• There are $924 Billion in auto loans, with nearly one third being subprime.
• It will not take much of a downturn for the HELOCs to go underwater.
• Jobs for those servicing new student loans are often low paid and hard to find and could become scarcer prompting more defaults.

In Europe:

• Royal Bank of Scotland (RBS) has now lost ALL of the £46 Billion bailout from taxpayers
• Espirito Santo recently went bankrupt AFTER recently passing the ECB stress test.
• Not only the bank, but the entire Espirito Santo group went bankrupt, after the bank sold their associated debt to unsuspecting clients.
• This certainly does not inspire confidence in any of the ECB testing of the Banks. We would have no confidence in an agency that tested cars with these kinds of results.
• There were fifteen other EU banks that passed in the weak manner of Espirito Santo.
• The Spanish/Italian/Greek Banks were allowed to count tax credits from the government as assets.
• What if China decides to support its domestic coal production by assessing a 3 to 6 percent surcharge on imported Australian coal? It would dampen exports and GDP.
• Australia's huge housing bubble is counting on 8 to 12 percent house increase NEXT year.

If things go south, the ECB,  Fed, and other Central Banks will have to engage in another enormous bailout.





Source: GolemXIV

The New York Fed's Primary Dealers, Liquidity, Monetary Policy, Excess Reserves and Financial Dreadnoughts in Times of Currency War

Someone asked me about Primary Dealers today.   I think it was in regard to liquidity concerns.

Cutting to the punchline, however one wishes to characterize and attribute it, the financial system is once again over-leveraged, over-concentrated, fraught with interconnected with counterparty risk, and fragile.

This is because of the policy failure of the Treasury and the Fed which could be characterized as extend and pretend without engaging in significant reforms and law enforcement in the aftermath of what might be best described as a control fraud. 

I also postulated years ago that when push came to shove, the Fed would gather around itself a few 'friendly banks' which would act on its behalf in private to enforce certain policy decisions in markets in which the Fed and Treasury do not wish to openly operate.  

It is hard to think of any other somewhat moral reason for the government to babysit and subsidize these very expensive and dangerous TBTF monstrosities, except as instruments of policy to provide some degree of freedom to shape events and responses. 

If you want to wage a currency war, you need to have some dreadnoughts packing serious financial throw-weight, and economic muscle.  Think of economic hitmen on steroids.   It may be Machiavellian,  counter-democratic, and expensive, but that is the dictate of strategy if you want to control things and wield power to do what you will, both at home and abroad. 

Is a corollary to the currency war a financial arms race and the construction of institutional behemoths?  I think it might be.  Or it could just be widespread ignorance and corruption amongst the ruling class which certainly is conceivable.  Or some of both.  Why do governments sometimes engage in corporatism?  Take your pick.

So putting that bit of editorial fuss and postulating out of the way, let's talk about some loosely related details of what Primary Dealers are all about.

The Fed uses Primary Dealers to manage monetary policy and its market in Treasury transactions,  first and foremost.   

These operations are both 'temporary' and 'permanent' transactions involving Treasuries, involving repos/reverse repos and purchases/sales respectively. 

I cannot stress enough that in a period of ZIRP, some things are not quite the same and do not carry the same significance as they might imply in 'normal times.'   I think the last chart show the Fed's Adjusted Monetary Base and Excess Reserves helps to illustrate this.

Although the analogy is a bit strained and far from perfect, I think what Bernanke has been doing with the Fed's monetary base and the excess reserves is roughly comparable to what had been done in 1933 with the removal from gold from private hands, and it revaluation afterwards in order to re-capitalize the banks with what was essentially seignorage.

They used gold instead of a platinum coin.  There is no need to confiscate gold when you are not on an external standard, the only constraint being the Fed's willingness to expand its balance sheet, and of course, the value at market of the bond and the dollar, which some conveniently forget when it suits them.

And the 'platinum coin' was a political rather than a monetary play. It is important to keep the two separate, although both are dysfunctional these days. Corruption ranges far and wide.

Certainly Bernanke and Paulsen/Geithner have been much less selective in spreading the wealth to banks, and never engaged in the sort of reforms and bank holiday that the FDR Administration had done.

The management of liquidity in the banking system with particular member banks, non-banks, and foreign entities is not relevant to the Primary Dealers list per se.

I am not sure why they wanted to know this, but since it has been some time I have written about them,  here is a current list of the Primary Dealers from the NY Fed.

"Primary dealers serve as trading counterparties of the New York Fed in its implementation of monetary policy.

This role includes the obligations to:

(i) participate consistently in open market operations to carry out U.S. monetary policy pursuant to the direction of the Federal Open Market Committee (FOMC); and

(ii) provide the New York Fed's trading desk with market information and analysis helpful in the formulation and implementation of monetary policy.

Primary dealers are also required to participate in all auctions of U.S. government debt and to make reasonable markets for the New York Fed when it transacts on behalf of its foreign official account holders."

Here is some additional information about the nature of the Primary Dealer relationship with the NY Fed.

As one can easily see not all banks, including member banks of the Federal Reserve, and not only banks, are primary dealers.  For example, MF Global was removed from this list in October, 2011.

An institution is not required to be a Primary Dealer to borrow funds from the Fed's various lending facilities including the Discount Window. 

And being a Primary Dealer, or a member bank of the Federal Reserve for that matter, does not oblige a Bank to engage in money laundering or rigging LIBOR, or any other markets. That sort of activity is largely engaged at the discretion of the Bank.

There is a distinction therefore, between the management of monetary policy and the Treasury sales, and the Fed's other operations with banks including reserves, excess reserves, and discount lending among other things.  So one has to have some care about drawing broader conclusion from their activities.

With the advent of ZIRP, the role of excess reserves held at the Fed, and the payment of interest by the Fed to the banks on those reserves, has taken on an added importance in the management of monetary policy and system liquidity. 

In regard to foreign dollar transactions, the Fed typically arranges swap lines with foreign central banks,  as they did in the case of the dollar short squeeze we had seen in Europe for example.

At one time I kept detailed spreadsheets of most of the Fed's weekly operations.  I gave that up around the time of the financial crisis, when the Fed's activities became much more convoluted and even less transparent than they already had been.


Current List of Primary Dealers

Bank of Nova Scotia, New York Agency
BMO Capital Markets Corp.
BNP Paribas Securities Corp.
Barclays Capital Inc.
Cantor Fitzgerald & Co.
Citigroup Global Markets Inc.
Credit Suisse Securities (USA) LLC
Daiwa Capital Markets America Inc.
Deutsche Bank Securities Inc.
Goldman, Sachs & Co.
HSBC Securities (USA) Inc.
Jefferies & Company, Inc.
J.P. Morgan Securities LLC
Merrill Lynch, Pierce, Fenner & Smith Incorporated
Mizuho Securities USA Inc.
Morgan Stanley & Co. LLC
Nomura Securities International, Inc.
RBC Capital Markets, LLC
RBS Securities Inc.
SG Americas Securities, LLC
UBS Securities LLC.