10.13.2011 0

The next depression

By Robert Romano — The next depression is already here.  It is a realization this author does not come to lightly, but unless and until the capital regime formalized internationally in Basel, Switzerland in 1988 is brought to a swift conclusion as the greatest colossal mistake ever made in financial history, the global economy will be in a constant state of ever-worsening crisis.

Warning signs have been flashing for years now, but through a coordinated campaign of misinformation, as well as marginalization of anyone who dares to question the established order, the public at large has been kept in the dark as to the dangers posed by the financial system in its current state.

The trouble boils down to capital requirements and leverage that has been built into the system as a matter of government policy.  It used to be banks operated under a system of reserve requirements — deposits plus cash reserves — with which it could make loans and borrow.  For simplicity’s sake, a 10 percent reserve requirement under the old system would have meant for every $100 deposited, $90 of it could be lent out.  No new money was created.

Basel changed all of that.  In reality, it changed before then, but this is when it went global and was homogenized.  In switching to a regime of capital requirements, credit expansion by banks became the primary mechanism through which new money is created.  Again, for the sake of keeping it simple, under a 10 percent capital requirement, for every $100 held in capital, $1,000 could be created to lend out.

Consider it a rendition on Archimedes, who thought with enough leverage, he could move the world.  So it is with bankers.

This is how U.S. banks, according to the American Bankers Association (ABA), have $13 trillion of assets but only $1.5 trillion of capital.  But, even that is slightly misleading.  According to the Federal Reserve’s L.1. release, there is over $52.5 trillion of total outstanding debt in the U.S.  So clearly, deposits and cash reserves are not the source for lending, and have not been for some time.

Need more proof? There’s only $5.8 trillion of savings deposits, according to the St. Louis Fed, clearly an insufficient sum to complete ten times as much loans.

Still, the ABA likes to pretend, writing, “In addition to being a safe place to store money, banks put the savings of their communities to work by using deposits to provide loans directly back into those communities.” Uh-huh.  Tell us another one.

Really, to call these banks lending institutions is a misnomer, since to lend something, one would have to have it in the first place.

Still, the $52.5 trillion of outstanding credit does not even show the entire picture, because it does not include so-called derivatives.  Those total globally about $601 trillion according to the Bank of International Settlements, of which $249 trillion are held in the U.S., as reported by the U.S. Comptroller of Currency.

According to the data, most of those are interest rate contracts, commodities futures, and the like.  But they also include insurance contracts banks take out in the event of loan defaults to cover themselves from losses, which is where in part counterparty risk comes into play.

Overall, such a system is inherently unstable and prone to massive failure, because just like buying stocks on margin, if 10 percent of the loans fail and default, 100 percent of the bank’s capital is wiped out.

Which, is what happened in 2008, more or less, leading the taxpayer-funded $700 billion bank recapitalization fund (TARP) and the Federal Reserve’s massive $1.25 trillion purchase of mortgage-backed securities, $442.7 billion of which was bought from foreign financial institutions.

The systemic collapse also led to insurer AIG being bailed out, with the Fed stepping in to honor its derivatives contracts, as well as mortgage giants Fannie Mae and Freddie Mac being nationalized and whose losses are now added directly to the U.S. $14.7 trillion national debt.

In Europe it has led to a sovereign debt crisis, wherein even governments — whose debt is supposed to be risk-free under Basel — can no longer make good on their obligations.

Now, in China, it has led to a bank rescue.  Why? According to Zerohedge.com, Credit Suisse’s Sanjay Jain  “has revised his base case Non Performing Loan ratio forecast from 4.5%-5.0% to 8.0%-12.0%: a unprecedented doubling in cumulative losses. Why unprecedented? Because as he explains, this ‘would work out to 65–100% of banks’ equity.’” In other words, massive losses in China’s banks would have wiped out their capital, so China had to step in and buy shares of the companies to recapitalize them.

So, everywhere one looks all over the entire planet, this leveraged system established at Basel is leading to catastrophic failure.  That’s ironic, because Basel’s original stated justification was to “strengthen the soundness and stability of the international banking system”.

It has done quite the opposite — utilizing credit expansion to fuel asset bubbles, which, when they pop, lead to massive losses on loans that then necessitate gargantuan bailouts by government.  It has left the global economy in a perpetual state of crisis — a depression — to which the only way out is a complete overhaul of the entire system.

Tinkering around the edges — whether on taxes, spending, and regulatory policies — will not fix what is fundamentally flawed in the global economy.  Mere half-measures and muddling through will not restore robust economic growth and lead to job creation at the pace that is sorely needed to prevent an entire generation of lost opportunity.

At its core, unless and until the considerable debt overhang brought about by excessive leverage in the financial system is dealt with systematically, and the banks’ powers to create new money via credit expansion is completely removed, things will sadly only get worse.

Basel was wrong; its premise, fundamentally flawed.  And until we can get our heads around that truth, a real, sustainable recovery will remain nothing more than a fantasy.

Robert Romano is the Senior Editor of Americans for Limited Government.

Copyright © 2008-2022 Americans for Limited Government