The Coming Collapse of US Treasuries and the Dollar and the Role of the G7

Brad Setser nicely illustrates the increasingly artificial foundation of the US dollar. We read his site every day and find his analysis to be original and well founded, even if we do not always agree with his conclusions.

The parallels of our current situation to 1929-33 seem valid and disconcerting, although this is our view and not Brad's, which is more finely focused for now.

At some point the contrived demand for Treasuries will subside, and the bubble in US debt and the dollar will deflate, not in a monetary deflation which is the fantasy of so many, but in a shocking devaluation of the dollar and a collapse in Treasuries.

The clock is ticking.

Do not doubt that this is a real crisis: more on Fed’s balance sheet
Brad Setser
Tuesday, September 30th, 2008

My colleague at the Council on Foreign Relations, Paul Swartz, has graphed the shift in the composition of the Fed’s balance sheet. The Fed has extended a lot of credit to the financial system — and supplied even more liquidity by letting the investment banks borrow some of its Treasuries.

The amazing thing about this graph is that it doesn’t capture all the credit central banks extended to the financial system last week (Paul used the weekly average numbers, not the data for the end of the week) or the new credit that will be provided by the programs that were expanded today. Those programs should allow the Fed to increase its lending even further.

This graph also does not capture the $500 billion the Fed has lent to other central banks through various swap lines — dollars that other central banks have lent to their own troubled institutions.

Right now, the world’s central banks are truly providing the short-term financing to host of troubled banks that are having trouble raising funds in the market. Laurence H Meyers of Macroeconomic Advisers notes:

“The liquidity measures are a stopgap … You’re funding the banks’ balance sheets, but nobody wants to lend money to them because they’re all afraid of insolvency.”

That sounds right to me. Right now, the US is relying a bit too heavily on the Fed to keep this crisis from spiraling truly out of control. That avoids hard political choices –notably hard choices about how best to recapitalize the financial system — but it also creates some long-term risks for the Fed. (What we are avoiding is the downsizing of a financial sector that is still remarkably oversized, and a capital allocation system that is an unsustainable mutation of a free market. We can waste resources recapitalizing banks but without systemic reform we have accomplished nothing except to feed the instrument of our duress. - Jesse)

I fully recognize the risk that the US government eventually could flood the market with unwanted Treasuries, driving interest rates up — and thus there are limits on how much support the US government can supply the financial system. But as of now, there isn’t much evidence that there is a shortage of demand for Treasuries — indeed, recent market moves suggests a shortage of Treasury bills in the market rather than a surplus. And that certainly is not because the US government has been scaling back its bill issuance. (Demand for Treasuries is strong but not for the 'right reasons.' This is the same phenomena we saw in 1929 when excess liquidity fled the equity markets and corporate debt for Treasuries, and then the weakened dollar collapsed taking Treasuries with it. - Jesse)

By my calculations, the supply of marketable Treasury bills not held by the Fed –i.e. the bills actually in the market — increased from $738.4 to $1200.2b between August 2007 and August 2008. That is a net increase in supply of around $462b. The Treasury was issuing more bills, and the Fed was reducing its holdings to “sterilize” or offset the credit it extended to private financial institutions. The US data on foreign holdings only runs through July, but it suggests that foreign central banks only snapped up $50b or so of this increase: central bank holdings of bills rose from around $180b to $232b. There was a huge surge in private holdings of Treasury bills, with the stock in private hands nearly doubling in 12 months.

And that was before the big surge in bill issuance in September.

Yet judging from market yields, there is no shortage of demand for T-bills despite the huge increase in supply — an increase in supply that is primarily in private not central bank hands. The New York Times reports:

Yields on three-month Treasury bills shrank to just 0.29 percent on Monday, a sign that investors were fleeing from any kind of risk, even if it meant earning a return far lower than the inflation rate.

The outstanding stock of notes (coupon paying bonds with a maturity of between one and ten years) not held by the Fed rose by $280b from August 2007 to August 2008, so there wasn’t just an increase in bill supply. And again, there doesn’t seem to be a shortage of demand. Here though central banks have been big buyers.

One other interesting side note: I would estimate that foreign central banks now hold well around 70% of the outstanding $2265b stock of marketable Treasury notes not held by the Fed. To get that estimate I have to assume that central banks account for most of the $260b or so of private purchases of Treasury bonds over the past year bringing their , and that central banks hold few bonds over ten years and few TIPs — so total central bank holdings of notes are in $1650-$1700b range. Central bank holdings are actually fairly concentrated in certain market segments.

When this artificial demand from the Central Banks subsides the dollar and the US sovereign debt will utterly collapse unless the world is ready to accept the dollar as the fiat currency above all others. And do not think for one minute that the US does not see this outcome. One ring to rule them all...

This is what our bankers do; keep borrowing until you become their problem, and they finally own you by 'default.' This is the blackmail under which the US public is being held today. - Jesse

G7 was 'Staring Into the Abyss'

Interesting interview, and a peek into the bureaucratic mind.

Denial runs deep, although it should be noted this is a career politician speaking, and compared to many of our politicians he is a savant. Unfortunately he is no match for the current schemes emanating from the world's banks.

The German government seems to be in a state of self-delusion, if one can judge from this interview.

To friends and colleagues in Europe: protect yourselves, otherwise your fate will be solely in the hands of well-intentioned but misguided, old-fashioned officials who are operating well behind the financial learning curve.

Der Spiegel
'We Were All Staring into the Abyss'
09/29/2008

SPIEGEL spoke with German Finance Minister Peer Steinbrück about the roots of the US credit disaster, whether Germany is in grave danger and what the future has in store for world banking.

SPIEGEL: Mr. Steinbrück, Wall Street is imploding. The government of the United States wants to establish a $700 billion (€480 billion) bailout program for its banks and their bad loans. How serious is the situation for the rest of the world?

Steinbrück: We are experiencing the most severe financial crisis in decades, although one should be careful about historic comparisons with 1929. One thing is clear: After this crisis, the world will no longer be the same. The financial architecture will change globally.

SPIEGEL: Could you be more specific, please.

Steinbrück: There will be shifts in terms of the importance and status of New York and London as the two main financial centers. State-owned banks and funds, as well as commercial banks from Europe, China, Russia and the Arab world will close the gaps, creating new centers of power in the financial world.

SPIEGEL: In other words, we are experiencing the beginning of a tectonic shift…

Steinbrück:... but not one that is abrupt and jarring. It will be an evolutionary process that will take several years.

SPIEGEL: The current thunder is certainly deafening. We have just seen all US investment banks disappear in one fell swoop.

Steinbrück: Three of them were either taken over or went bankrupt. The two others, because they abandoned their business model to save themselves. No one would have thought this possible until recently. Meanwhile, 25 financial service providers have disappeared from the market in the United States. All of this is illustrative of an earthquake. In addition, many institutions are still fundamentally lacking liquidity.

SPIEGEL: And is the United States completely to blame?

Steinbrück: The source and focus of the problems are clearly in the United States. There are many causes. After 9/11, a great deal of cheap money was tossed into the market. Apparently some of that money went to people with poor creditworthiness. This led to the growth of the real estate bubble. The banks embarked on a race over profit margins. Then speculation spun completely out of control.

SPIEGEL: …which also benefited German banks for a while.

Steinbrück: But they didn't invent these transactions. The stokers on the financial markets were responsible for that. (There are benefits to being well behind the innovation curve apparently - Jesse)

SPIEGEL: And how is the US patient doing now?

Steinbrück: It's in the ICU with pneumonia. This means that here in Europe, we can at least expect to get a bad cold. The US patient lacked legislation, a regulatory framework that could have helped avoid this development. That's the key issue for me. The financial products became more and more complex, but the rules and safeguards didn't change. I don't know anyone in New York or London who would have asked for a stronger regulatory framework 18 months ago. They were always saying: The market regulates everything. What a historic mistake!

SPIEGEL: Your US counterpart, Treasury Secretary Henry Paulson, began by essentially nationalizing the two US mortgage giants, Fannie Mae and Freddie Mac. But then he allowed investment bank Lehman Brothers to plunge in bankruptcy before saving the insurance giant AIG with an $85 billion (€58 billion) bailout. This doesn't exactly look like a clear course of action.

Steinbrück: In the case of Lehman, the US government wanted to send a signal to the market that they are not prepared to offer a bailout under any circumstances. In the case of AIG, we had direct talks at the G7 level and implored them to stabilize the situation. An AIG bankruptcy would have triggered shock waves around the world. We were all staring into the abyss at that point.

SPIEGEL: What role does the US election campaign play in resolving the crisis?

Steinbrück: I hope that my US counterpart will be capable of taking action for as long as possible. We cannot have a six-month vacuum until the next president takes office and his administration is ready to get to work.

SPIEGEL: Paulson headed the investment bank Goldman Sachs for a long time. Does this make him part of the problem?

Steinbrück: He is undoubtedly doing a good job. And at least Goldman Sachs still had the option of making its own decision to transform itself into a bank holding company.

SPIEGEL: That same Paulson snubbed you a year and a half ago. You arrived late for a meeting with him in Washington and he gave you all of 11 minutes of his time -- standing up.

Steinbrück: You don't seriously believe that such trivia plays any role whatsoever in my assessment of a counterpart and of the situation!

SPIEGEL: We are alluding to arrogance and a way of thinking that Paulson may have shared with many major players on Wall Street.

Steinbrück: The way of thinking on Wall Street was quite clear: "Money makes the world go round!" The logic went like this: The government should stay out of our business! And when we Germans began -- and perhaps it was even too late by then -- to ask for controls, for more transparency and equity guidelines, they laughed at us at first.

SPIEGEL: When did those initiatives begin?

Steinbrück: Back in the days of Gerhard Schröder's chancellorship. It was reinforced when Germany assumed the G-7 presidency in early 2007. The first real debate on the subject happened in February 2007, during a meeting of the G-7 finance ministers at Villa Hügel in Essen. Then British Chancellor of the Exchequer Gordon Brown was not very amused by our call for more transparency for hedge funds. The talks have been significantly more constructive since last fall.

SPIEGEL: What, specifically, will you call for?

Steinbrück: A few agreements were already reached with the British and Americans within the G-7 in April. They include imposing new rules on the conduct of the rating agencies, tightening equity regulations and gaining a better handle on cross-border bank supervision. But as far I am concerned, it isn't enough for the industry to develop its own code of conduct. I also want to see the banks no longer allowed to sell all of their risks as they see fit. I think it as a dangerous systemic design flaw that not only loans, but also credit risk is 100-percent marketable. This can lead to uncontrollable wildfires, as we are now seeing.

SPIEGEL: How much government does capitalism need? How much can it tolerate?

Steinbrück: Overall, we have to conclude that certain elements of Marxist theory are not all that incorrect.

SPIEGEL: And you, of all people, are saying this?

Steinbrück: Every exaggeration creates, in a dialectic sense, its counterpart -- an antithesis. In the end, unbridled capitalism with all of its greed, as we have seen happening here, consumes itself…

SPIEGEL: …because it creates an unbridled state?

Steinbrück: That would the wrong development. And I don't believe in it, either. Fortunately, we in Germany have done quite well for ourselves with a happy medium, the social market economy.

SPIEGEL: The German government is unwilling to participate in America's $700 billion bailout package. Is this your final word?

Steinbrück: I see neither the need for nor the possibility of taking on the responsibility for American banks. Besides, our situation is more robust.

SPIEGEL: But the United States will certainly bail out US banks first -- a distortion of competition that could put European institutions under more pressure than ever.

Steinbrück: That's an issue, of course. But I can't give you a shoot-from-the-hip solution. First we have to see what exactly the Americans intend to do.

SPIEGEL: And if things became serious in Europe, you would also have to butt heads with Brussels over intervention options.

Steinbrück: You couldn't be more right! And I have already pointed this out. The Americans are clearly faster when it comes to crisis management, because they aren't hampered by these aid procedures.

SPIEGEL: Nevertheless, you do have worst-case scenarios on the back burner.

Steinbrück: It doesn't make any sense to speculate publicly over something like this. A crisis can easily become a self-fulfilling prophecy that way.

SPIEGEL: You recently met with the top executives from the German banking and insurance industries. What was the mood like?

Steinbrück: Very serious and open. But discretion is needed to achieve any progress on this front.

SPIEGEL: The German state-owned banks, at any rate, are a prime example of a case in which government influence does not automatically guarantee more security. On the contrary. The amount of gambling that took place at institutions like SachsenLB was unbelievable. And taxpayers are the ones who end up footing the bill.

Steinbrück: The responsibility lies with the respective shareholders. Some of them, however, are showing signs of wanting to pass this responsibility on to the government. That's when I stop playing Mr. Nice Guy. They should kindly solve their own problems.

SPIEGEL: Some, it would seem, have failed to apply the rules that already exist in the German system.

Steinbrück: I cannot confirm that. The auditors can only examine what is in the financial statements and what is presented to them. IKB and SachsenLB simply outsourced tremendous risks. I also caution against taking a stop-the-thief approach. In one case, for example, a former department head from the finance ministry who was on the supervisory board of one of these banks has been severely criticized. In an effort to pass some blame on to me, it has been conveniently forgotten that half of the who's who in the German economy was on this same board.

SPIEGEL: Perhaps you should have simply allowed something like IKB to go bankrupt, instead of bailing it out with billions from the state-owned bank KfW and then essentially giving it away to an American financial investor.

Steinbrück: And what would have happened then? We had less then five weeks to conduct a thorough audit. We had 36 hours to decide what would be more costly -- stabilization or insolvency. That was the situation on July 28 and 29 of last year. What happens to the €25 billion ($36 billion) worth of deposits at the IKB? Are they supposed to vanish into thin air? What would have been the consequences for the overall German financial economy? The damage would have disproportionately higher. It's easy to be critical now.

SPIEGEL: And what about the fact that KfW just happened to transfer €319 million ($463 million) to Lehman Brothers, the US investment bank that declared bankruptcy that very same day? This sort of thing doesn't exactly create confidence in state-owned banks.

Steinbrück: That was an awful mistake, of course. A grotesque error. But it was a mistake made by bank executives, not the administrative board, which includes politicians among its members.
SPIEGEL: It proves that normal risk management procedures failed completely -- directly under the nose of the finance minister.

Steinbrück: No, it proves that an inexcusably wrong decision was made. Do you think I wasn't livid about this? The entire crisis we are talking about here is incomprehensible for the normal citizen. But such an idiotic transfer -- even my 89-year-old mother is outraged about it. All 80 million German citizens understand this…

SPIEGEL: …and suddenly you had the tabloid Bild calling the KfW "Germany's stupidest bank."

Steinbrück: Okay, okay. But it's also worth noting that KfW passed all tests and checks regarding its risk management procedures that were performed by the federal audit court and auditors last year. (LOL - Jesse) Of course, I know that the bottom line is that what happened was completely ridiculous. But even that has to be carefully examined. We cannot simply start shooting at random, just to flush out a few executives and keep the public happy.

SPIEGEL: At any rate, the failures and breakdowns among many state-owned German banks show that the government isn't exactly an effective banker.

Steinbrück: I never claimed that it was. The government is neither better nor worse as a banker. Financial transactions are not its core field of operations. The fact that many bankers working for state-owned banks clearly miscalculated is partly the result of their having lost sight of the relationships between risks and profitability. But let me say this once again: Lehman was no state-owned bank, nor was Bear Stearns, Northern Rock or IKB.

SPIEGEL: How dramatic will the effects of the financial crisis be on the German economy?

Steinbrück: So far, the only obvious outcome is that numbers are getting worse. At this point, no one can provide a credible estimate of how bad they will become. Of course, this crisis will also affect growth. However, some developments are currently moving in the opposite direction. The employment market is still strong. And we are still pleased with our tax revenues.

SPIEGEL: You were optimistic only two weeks ago. You said that there was no reason to expect cataclysmic scenarios, and that growth for the year would remain at 1.7 percent.

Steinbrück: I object to your criticism. I have always been on the cautious side, and at the beginning of the year I stated that 2009 will be worse than 2008. I have no reason to revise my predictions for 2008. But 2009 will be significantly worse than the previous estimate of 1.2 percent growth.

SPIEGEL: Should German depositors be concerned about their savings?

Steinbrück: No. No one should be worried about savings accounts. We will see a tectonic shift in the global financial system. Entire types of banks and their business models will disappear, but that doesn't mean that anyone in Germany should be worried about their savings.

SPIEGEL: Is capitalism currently undergoing a general crisis?

Steinbrück: I don't think so. But the behavior of some elites is worth criticizing. We have to be careful not to allow enlightened capitalism to become tainted with questions of legitimacy, acceptance or credibility. This isn't merely an issue of excessive salary developments in some areas. I'm talking about tax evasion and corruption. I'm talking about scandals and affairs of the sort we have recently experienced, although one shouldn't generalize these occurrences. But they are the sort of thing the general public understands all too well. And when they are allowed to continue for too long, the public gets the impression that "those people at the top" no longer have to play by the rules. There have been times in Germany when these elites were closer to the general population. Some things have gotten out of control in this respect.

SPIEGEL: One cannot regulate morality. (The point is not to regulate morality, the point is to circumscribe the effects of those who make free choices, and in some cases to limit those choices. - Jesse)

Steinbrück: No, but that too is dialectics. The elites must understand that it is a matter of self-protection, of developing a sense of the right balance or allowing judgment to prevail.

SPIEGEL: Mr. Steinbrück, thank you very much for taking the time to speak with us.

Interview conducted by Wolfgang Reuter and Thomas Tuma

Translated from the German by Christopher Sultan

Peer Steinbrück, born January 10, 1947, has dedicated his entire professional life to politics.

Steinbrück studied macroeconomics and social sciences in Kiel. Beginning in 1974, he works in various functions for the federal government, among others as a consultant within the Federal Ministry of Research and in the Office of the Chancellor.

In 1985, he switches to the Düsseldorf State Government, where he is, among other things, Chief of Staff for then-Prime Minister Johannes Rau.

Steinbrück went to Schleswig-Holstein in 1990, where he first served as Secretary of State, later as Minister for Economics and Transportation.

In 1998, he returns to North Rhine-Westphalia, becomes Economics Minister, then in early 2000 Finance Minister.

At the end of 2002, the sitting Prime Minister Clement left for Berlin to serve as the Economics and Labor Minister in the federal government. On November 6, 2002, Steinbrück is elected Prime Minister of North Rhine-Westphalia.

Ireland Guarantees Banks for More than Twice GDP

Hard to believe, but the US is still looking like the bastion of capitalism and free markets. We suppose everything is relative.

WSJ Europe
Irish Government Moves to Safeguard Banking System
By QUENTIN FOTTRELL
SEPTEMBER 30, 2008, 6:04 A.M. ET

DUBLIN -- The Irish government Tuesday announced a surprise decision to safeguard the Irish banking system for two years, guaranteeing all deposits, covered bonds, senior debt and dated subordinated debt of the four main banks.

The government said it aims "to safeguard the Irish financial system and to remedy a serious disturbance in the economy caused by the recent turmoil in the international financial markets."
Finance Minister Brian Lenihan said the guarantee will cover €400 billion ($577.64 billion) of the €500 billion of bank assets involved. That is more than Ireland's gross domestic product of €190 billion and national ...

Raymond James Applies to Become a Bank Holding Company

This has the look of a trend. First Goldman and Morgan Stanley and Now RJ. When the going gets tough, the Masters of the Universe slither over to their safe haven at the Fed.

Bring back Glass-Steagall.

The Bond Buyer
Raymond James Financial Will Apply for Bank Holding Company Status
By Patrick Temple-West
September 29, 2008

Raymond James Financial Inc. confirmed Thursday that it will apply for bank holding company status, following the course taken last week by the larger investment banks, Goldman Sachs Group Inc. and Morgan Stanley.

The firm's management stressed that the move comes as part of a long-term strategy and does not indicate any immediate capital needs. The conversion "will have little impact" on the firm's operations and management structure, officials said in a financial statement filed with the Securities and Exchange Commission.

"It's an unfortunate misperception that Goldman Sachs, Morgan Stanley, and now Raymond James are fundamentally changing their business models," Thomas A. James, the firm's CEO and chairman, said in the filing. "In fact, these changes are more form than substance in that regard."

Raymond James ranked 24th among municipal underwriters and was senior manager on 54 issues this year through Sept. 25, according to Thomson Reuters. The firm ranked 34th among financial advisors, serving as FA on 12 issues for the same period. With $40.8 billion in assets under management as of June 30, Raymond James would rank 32nd among bank holding companies, according to the Federal Reserve.

The conversion to a bank holding company is the first step toward eventually becoming a financial holding company, the firm said. If approved by the Fed, the St. Petersburg, Fla.-based Raymond James will convert its thrift, Raymond James Bank, into a state-chartered commercial bank.

The conversion of the bank, which had $7.7 billion in deposits as of June 30, would allow it to engage in more corporate lending, which historically has been more profitable and bears less interest rate risk, the firm said. A financial holding company is a subset of a bank holding company that allows a firm to engage in investing, insurance, and other activities when its commercial bank meets the regulatory standards set by the Fed.

The conversion would lead to greater regulation by the Federal Reserve. Under Regulation Y, the Fed may regulate non-banking activities of the parent company, including mergers and acquisitions. The parent is also expected to maintain the capital and leverage requirements the Fed places on the commercial banks. Subsidiary commercial banks are limited by how much they can lend to the parent company.

Once the conversion for Raymond James takes place, oversight of the Raymond James Bank will be transferred from the Office of Thrift Supervision to the Office of the Comptroller of the Currency.

Goldman Sachs and Morgan Stanley received Fed approval on Sept. 22 to convert to bank holding companies on an expedited basis. The five-day waiting period the Fed requires to examine antitrust concerns before beginning the conversion status was waived for both firms because "emergency conditions exist that justify expeditious action," the Fed said.

Raymond James said it is not looking for emergency funding and that it expects the conversion to a banking holding company to be completed by summer 2009.

The shift to bank holding companies signifies a change in the financial sector. Investment banks like Raymond James rely on short-term borrowing to fund its businesses. Large bank holding companies like Citigroup Global Markets Inc. and JPMorgan Chase & Co. have weathered the liquidity crisis better than the investment banks because they are perceived as being safer under Fed regulations.