The FDIC's list has only 117 institutions with $78 billion in assets. But given the current proposal for a $700 billion bailout, it is clear that Administration officials tacitly recognize that the FDIC list understates the problem. (Ibid)
The most pessimistic among us believe that we are headed to a financial and economic meltdown and even the venerable Washington Post has joined the chorus of doom predictors.
This is what a Category 4 financial crisis looks like. Giant blue-chip financial institutions swept away in a matter of days. Banks refusing to lend to other banks. Russia closing its stock market to stop the panicked selling. Gold soaring $70 in a single trading session. Developing countries' currencies in a free fall. Money-market funds warning they might not be able to return every dollar invested. Daily swings of three, four, five hundred points in the Dow Jones industrial average. (Washington Post, 9-18-08)
In essence, the Post believes that this “correction”, which includes the greatest loss of financial wealth in known history, did not result in the customary rise in interest rates and curtailment of borrowing. Something else, even more insidious happened.
Instead, the Wall Street banks that originally made these loans before selling them off in pieces decided to try to keep the good times rolling -- and, significantly, keep the lucrative underwriting fees pouring in. Some used their own "AAA" credit ratings to borrow more money and keep the loans on their own balance sheets or those of "structured investment vehicles" they created to hide these new liabilities from regulators and investors. Others went back to the foreigners and offered to insure those now-unwanted takeover loans and asset-backed securities against credit losses, through the miracle of a new kind of derivative contract known as the credit-default swap. (Ibid)
The banks created a shell game, hiding unrecoverable loans in subsidiaries, and using Wall Street’s version of “aggressive accounting” to pretend that liabilities were sellable assets. In the process, they packaged risky or uncollectible loans and bundled and sold those toxic loans as “mortgage backed securities.”
Banks and financial institutions around the world bought these venomous “investments”, resulting in a poisoning of the world’s financial markets, aided and abetted by a coven of asleep at the wheel federal banking regulators, under whose eyes the whole poison pill was gracefully injected into the nation’s financial markets.
Bank and financial institution failures are frightening, because the financial institutions are the life’s blood of the economy.
Whether under attack by hedge funds or fleeing retail depositors, no depository, solvent or not, can survive a sustained bank run, whether by retail depositors or institutional clients. This contraction in credit by commercial banks is affecting the entire global economy and threatens to turn the US recession into a prolonged period of no growth or outright reduction of economic activity. (Christopher Whalen, The Institutional Risk Analyst, 9-16-08)
The economy runs on liquidity, access to capital, and investment. An economist writing in the Cato Journal in 1995, George S. Kaufman, noted:
…the bulk of the evidence suggests that the greatest danger of systemic risk comes not from the damage that may be imposed on the economy from a series of bank failures, but from the damage that is imposed on the economy from the adverse effects of poor public policies adopted to prevent systemic risk. As a result it can be argued that the last two decades reflects primarily regulatory or government failures, rather than market failures. (Kaufman, “Bank Failures, systemic risk, and Bank Regulation”)
Kaufman believes that bank failures are not costless, and that shareholders, creditors, and the deposit insurers lose when banks fail. However, he argues that while small loan customers may be inconvenienced by changes in the failed banks loan personnel, loan standards and other post-failure/takeover changes in policy and procedure,
“it is no different from the losses and disruptions in firm-customer relationships that accompany failure of almost any business entity of comparable (sic) in firm-customer relationships that accompany failure of almost any business entity of comparable size in the community.” (Ibid)
The problem with this line of thought is that banks are not “just another business entity.” Banks, both symbolically and literally are the life’s blood of the nation’s economy. Bank failures generate a lack of confidence in the viability of the economy, even when the failure is “only one bank.”
The problem is, banks fail these days in a climate of rapid information transfer, cross continental, bank-to-bank loans and investment vehicle purchase. If no man is an island, that most certainly is true of banks and financial institutions. Banks do not operate in an isolated atmosphere and even the most egregious failures of individual banks and financial institutions have cross-market, national and even international consequences because banks these days are more than “single entities”.
Today’s massive tidal wave of systemic failure reaches not only across the country, but around the world. Massive failures in the strength and viability of its economic conduits and exchange medium generate a loss of confidence in the system, which generates another source of poison. An economy is only as strong as the faith in its exchange medium.
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