By Mike Whitney
“Despite the Dodd-Frank financial reform bill and its directive to address this issue, the problem of bank runs in the shadow system has not yet been solved.” –Mark Thoma, Professor of Economics, University of Oregon, February 13, 2012.
Wall Street is at it again.
In the last few months, the nation’s biggest banks and investment firms have resumed the same perilous activities that crashed the financial system and plunged the economy into the deepest slump since the Great Depression. According to a number of recent reports, there’s been a steady uptick in the type of risky bond deals that preceded the repo market bank run in 2008 leading to the default of 106-year old financial giant Lehman Brothers. With interest rates locked at zero percent and gradual improvements in the economic data, investors have been scouring the markets for better returns on their investments. This search for higher yield has triggered a gold rush on risky assets which has increased the probability of another major cataclysm. Here’s the story from CNN Money:
“The risky bond deals that were a hallmark of the pre-financial crisis boom are staging a comeback as investors continue to hunt for ways to find higher rates of return.
And companies are willing to meet the demand. Roughly $58 billion of high yield, or junk, bonds have been issued by 95 corporations since January. That’s the fastest start in 15 years, according to Dealogic.
Investment grade bonds, which offer a lower, albeit more stable yield, have also continued to attract investor interest. Since January, about $150 billion of corporate bonds have been issued by 315 companies, according to Dealogic. While that’s slightly faster than the past two years, it’s well behind the pace set in 2007, 2008 and 2009.” (“Bonds: Risk is back!”, CNN Money)
Trillions of dollars in bailouts, subsidies and other corporate welfare has restored many of the Too Big to Fail banks back to health, allowing them to reengage in transactions which, once again, put both the financial system and the broader economy in danger. And, although there have been modest efforts to re-regulate the system–particularly Dodd-Frank–the new laws fall well-short of what’s needed to decrease the vulnerabilities in the shadow banking system or to increase confidence in the bonds that are at the center of this latest investment binge. Congress has failed to pass legislation that would improve the underwriting standards of the loans that are pooled in these bonds to make sure that borrowers have the ability to repay their debts. Absent stricter standards, there’s certain to be a repeat of the collapse in the secondary market which followed the implosion in subprime mortgages. It’s deja vu all over again. Here’s more from International Financing Review:
“As the credit crisis recedes and underwriting standards begin to loosen, bonds backed by consumer debt such as auto loans, credit card payments, and student loans are becoming increasingly risky, Moody’s said on Thursday.
Relaxed underwriting standards, more complex structures, and new untested market participants are just three of the trends suggesting that risk is on the rise for some sectors of the asset-backed securities market, Moody’s said in a report….
With credit standards slipping in asset classes such as subprime auto loans, and risky crisis-era structural features showing up in transactions, credit rating agencies need to make sure they are keeping up with the deteriorating credit standards and rating the these bonds appropriately – which means withholding their coveted Triple A rating if it is not deserved, or making sure there are other features that mitigate the risks, said Moody’s.” (“As crisis fades, risk returns to asset-backed debt – Moody’s”, IFR)
Easy money, looser credit and poor underwriting standards: Where have we heard that before? And all this is by-design, the inevitable result of a monetary policy that feeds liquidity into an overbloated financial system that neither creates value nor provides capital for productive activity. The present arrangement merely transfers the wealth from working people to a class of investors who’ve become a danger to themselves and society. Here’s more from the IFR:
“The riskiness of securitizations is still low and has not approached the level it reached in the early to mid-2000s…ABS reached its issuance peak in 2006 at US$754bn. However, if the normal pattern of the credit cycle plays out, the easing of credit that took place in 2011 will persist into 2012 and beyond…
Originators have begun to ease underwriting standards…. in sectors such as subprime auto-loan securitizations, where underwriting is returning to its pre-recession norm, losses on loan pools backing auto ABS are bound to increase.” (“As crisis fades, risk returns to asset-backed debt – Moody’s”, IFR)
As we have noted in earlier articles, subprime auto securitization and student loans represent most of the gains in the recent credit expansion. Loans that are bundled and sold to investors are used numerous times-over as collateral (rehypothecation) so that banks and financial institutions can maximize leverage. This same “gearing” process was all the rage until 2007 when two Bear Stearns hedge funds unexpectedly defaulted precipitating a run on the shadow system that wiped out over $4 trillion in equity in less than a year.
Other signs that Fed chairman Bernanke’s loosy-goosy monetary policy is inflating another asset bubble include the fact that banks have doubled the volume of their credit card solititations since 2010 “with an increased emphasis on offerings to individuals with less than pristine credit histories.” In other words, the banks don’t care whether they get their money back provided they can offload the unpaid debt onto gullible investors in the form of bundled loans. The former head of the FDIC, William Seidman, figured this scam out long before the dot.com bubble burst and issued this warning to regulators:
“Instruct regulators to look for the newest fad in the industry and examine it with great care. The next mistake will be a new way to make a loan that will not be repaid.”
If only someone had been listening.
IFR also reports that private equity high-rollers are joining in the fray by loading up on junk paper that promises slightly better returns than low yielding CDs or US Treasuries. Here’s the clip:
“The entrance of players … with higher risk profiles is a sign that competition for asset origination will increase”….Additionally, small originators and issuers with low credit quality have been getting back into the game, and their ability to honor representations and warranties may be limited.”
“Too Big To Fail” ensures that any investment in high-yield garbage bonds is a reasonably safe bet due to the fact that US taxpayers now guarantee Wall Street against any substantial loss. That implicit backstop includes all manner of financial institutions including insurers, PE, hedge funds etc. The Fed has wrapped its arms around the entire system while transferring trillions of dollars in red ink from the balance sheets of these foundering Wall Street casinos onto its own.
This below-the-radar surge in financial offal has spread to the same complex assets that were at the heart of the crisis, collateralized debt obligations or CDOs. The big boys–Goldman and Barclays–have been inquiring about the $47 billion in AIG assets held by the New York Fed. Some of these assets have already been sold off in, what appeared to many to be, secret auctions. Even so, there’s more dreck where that came from which has piqued the interest of other banks and brokerages. Here’s more from the Wall Street Journal:
“The $47 billion face value in assets, held by the Federal Reserve Bank of New York, are the same kinds of financial instruments that … caused record losses across the financial industry. Plunging values of the securities, called collateralized debt obligations, or CDOs, caused AIG’s near collapse and a government rescue in 2008. The $182 billion bailout was widely criticized because a chunk of taxpayer aid was funneled through AIG to large banks.
Now, amid rising investor demand for riskier, higher-yielding assets, attempts by Wall Street firms to buy those same assets may spark further controversy. Some large banks were on the winning end of bets with AIG over the instruments during the crisis, and benefited from the insurer’s bailout….
Banks that bought credit-default swaps from AIG on the CDOs had inundated AIG with demands for collateral when the housing downturn caused market prices of the CDOs to nose dive. The New York Fed’s move made more than a dozen U.S. and foreign banks whole on their bets with the weakened insurer. Some of those banks, including Goldman and Barclays, are now the same ones interested in buying the securities, people familiar with the matter said.” (“Banks Want Fed to Iron Out ‘Maiden’”, Wall Street Journal)
Wow. So all 12 banks were paid 100 cents on the dollar for bogus insurance policies (CDS) that were essentially worthless since AIG did not have the resources to repay the claims. And now these same banks want to buy the remaining AIG assets at firesale prices? That’s what you call the double whammy.
The reason that most people can’t grasp how serious these new developments are, is because their understanding of the financial crisis remains sketchy. The Crash of ’08 had less to do with subprime mortgages and Lehman Brothers than it did with the flawed architecture of a shadow system that performs the same tasks as traditional banking, but is unregulated, undercapitalized and hopelessly crisis-prone. ”What happened in September 2008 was a kind of bank run,” said Robert E. Lucas, of the Minneapolis Fed. “Creditors lost confidence in the ability of investment banks to redeem short-term loans, leading to a precipitous decline in lending in the repurchase agreements (repo) market.” Yes, but there’s more to it than that. The reason that “creditors lost confidence” was because they knew the banks were using bonds that were comprised of dodgy loans to people who had no ability to repay the debt. In other words, there was a moment of enlightenment (when two Bear Stearns hedge funds stopped redemptions) when the main players suddenly realised that the entire $10 trillion shadow banking system and repo market was propped up on a foundation of pure quicksand. (ie–”bad loans”) That’s when the race for the exits began.
And now, not even 4 years later, the banks are at it again, buying up toxic bonds by the boatload. We’re back to Square One. Barring a dramatic reversal in the present policy, (which is extremely unlikely) it’s hard to see how another disaster can be averted.