EU Fire Sale

In Live Free or Die Hard, released in mid-2007, Bruce Willis goes after the bad guys who are sabotaging the US computer systems to steal the assets of the financial markets. In the computer hackers’ term, they are creating a “fire sale” that threatens the entire system. Minus the computer hackers, this is akin to what European credit markets are suffering right now.

Alan Greenspan warned us back in 1998 about the real possibility of the world’s banking and stock markets locking up and crashing through cascading cross defaults. This problem arises when one bank doesn’t have the money to pay another bank which doesn’t have the money to pay a third bank and so on.

Originally caused by the burgeoning US sub-prime meltdown, the rot has now begun to spread around the world as bank after bank begins to falter and the international overall system of lending money between banks, the so-called LIBOR facility, has ceased to function. It may cease to exist.

Banks, both inside and outside of the United States, are now terrified of lending unsecured money to other banks – especially the giant banks like Citibank, UBS, Barclays and Deutsche Bank. They’re afraid that they won’t get repaid, that the bowering bank might default. In other words, mutual trust in the global banking system is now being replaced with fear of uncontrollable bankruptcies. Right now, there is very little “full faith and credit,” necessary when you are operating a global Ponzi scheme of fiat money creation.

This phenomena of cascading cross defaults, like falling dominos, is hard to stop once the process begins to roll. It takes massive, really massive, intervention by the central banks to flood the market with cheap dollars, euros, pounds and yen. And the dumping has begun.

On Tuesday, December 11, the day the US Federal Reserve cut interest rates by ¼ percent, the market reacted with confidence by promptly falling 210 points. The was followed the next day by a joint announcement by 5 major central banks ( FRB, ECB, Bank of England, Swiss Central Bank and the Bank of Canada) that a coordinated bailout would begin starting on Monday, December 17th.

For its part, the US Fed would pump $40 billion into the troubled US banks through December, followed by perhaps another $40 billion in early January.

The euphoria lasted for one day until the magnitude of the problem began to surface. By Friday, the DOW closed down another178 points. Then the other shoe dropped.

On Tuesday, December 18th, the Bank of England announced that it was effectively nationalizing Northern Rock, the giant failed British saving-and-loan, to the tune of – gasp – $200 billion. Nearly simultaneously, the ECB announced that it would loan its troubled banks – $500 billion – to prevent them from failing.

These numbers are truly staggering.

Never in the history of the world has such a flood of money been dumped into the world’s banking system to prop up the banks and get lending going once again. We are in uncharted waters.

The question now being asked by economists, central bankers, stock brokers, finance ministers and heads of state throughout the world is: will this be enough? Or are we in the early stages of the granddaddy of all economic nightmare scenarios publicly envisioned by Alan Greenspan a decade ago? The options look bleak indeed. Either the global money ships make it safely through these iceberg-strewn waters, or the entire convoy is in danger of sinking.

What’s this got to do with you, you might perhaps be asking?

Well, if banks can’t lend money with confidence, the credit system begins to lock up. Interbank loans — like the ones banks make to pay off the Visa and Mastercard charges made by the other bank’s customers, could be in danger. Your credit card borrowing capacity might be cut — or stopped. Getting cash from another bank’s ATM machine might not be possible. A cash-flow business with lots of receivables like, say, the airline industry, might not be able to continue to fly its planes — in fear that their bank won’t be able to continue making ongoing operating loans at rates they can afford to pay — so that their suppliers and employees can continue to be paid.

The scenarios are almost infinite and very frightening to contemplate. A global cascading cross default would push the world into a money gridlock. An instant global Depression would result.

Fortunately, calmer minds have estimated that the probability of this actually happening are quite small — perhaps no more that 10 to 20%. Here’s why.

This mess was created by the US in the first instance, and the US can bail the world out.

Over the past several decades the US has been buying lots of cheap goods and oil from China, Japan, Europe and the OPEC countries. And we’ve been paying for it by issuing mountains of US dollars and shipping them abroad. The balance of trade deficit — while not terribly large for the US super-economy, the world’s largest economy — has swamped the treasuries of our trading partners.

The foreign central banks have used a number of ways to spend these dollars.

They’ve bought lots of dollar-denominated commodities (pretty much every commodity traded in the world is traded in dollars), they’ve bought boatloads of low-paying US Treasury notes, they’ve bought US land, buildings and companies, and they’ve bought US stocks and bonds.

Now, it appears, they’ve also been buying gobs of US sub-prime packaged mortgages.

Once again, the US Wall Street brokers have been successful in selling toxic investments to otherwise smart overseas bankers — as well as to the US money center banks.

Some could argue that this is the direct result of undoing the Glass-Steagall Act which in 1933 successfully separated banking from investment banking (the stock brokers) for 7 decades. Unfortunately, the stock market abounds in creating new versions of funny money: warrants beget puts and calls and generations of exotic investment vehicles that no one can understand or properly handicap for risk ultimately result in the creation of AAA-bond rated “toxic waste”: the so-called CMO’s or collateralized mortgage obligations.

But Glass-Steagall is all but dead, killed off in the 1990’s by Bill Clinton.

Now that banks can own and operate Wall Street firms, there is no clear firewall to isolate the funny money of the stock market from the funny money of the fiat banking system. The best example of this unholy alliance is the new Citicorp. And, of course, the irony is it may suffer the fate of being broken up into tiny pieces before this debacle runs its course.

So just how does the Fed save the world? By doing two things: 1) providing an unlimited amount of credit to back up the big banks which can’t be allowed to fail: Citibank, etc., and 2) by temporarily lowering the reserve requirement that the banks must maintain to conduct business (their shareholder’s equity as a percentage of their outstanding loans) down to, say, 3% or so.

The latter could be done by whispering in the ear of the Swiss-based Bank for International Settlement (BIS) which coordinates the world’s central banks. So if this round of band aids doesn’t work, look for the BIS to announce a lowering of the global banks’ reserve requirements in early 2008.

Merry Christmas from the fiat money capital of the world- Washington, D.C. Gold anyone?