Why Another Financial Crash is Certain

ilene's picture

Why Another Financial Crash is Certain

Courtesy of MIKE WHITNEY, originally published at CounterPunch 

On August 9, 2007, an incident took place at a bank in France that touched-off a financial crisis that that would eventually wipe out more than $30 trillion in capital and thrust the world into the deepest slump since the Great Depression. The event was recounted in a speech by Pimco's managing director Paul McCulley, at the 19th Annual Hyman Minsky Conference on the State of the U.S. and World Economies. Here's an excerpt from McCulley's speech:

"If you have to pick a day for the Minsky Moment, it was August 9. And, actually, it didn’t happen here in the United States. It happened in France, when Paribas Bank (BNP) said that it could not value the toxic mortgage assets in three of its off-balance sheet vehicles, and that, therefore, the liability holders, who thought they could get out at any time, were frozen. I remember the day like my son’s birthday. And that happens every year. Because the unraveling started on that day. In fact, it was later that month that I actually coined the term “Shadow Banking System” at the Fed’s annual symposium in Jackson Hole.

“It was only my second year there. And I was in awe, and mainly listened for most of the three days. At the end....I stood up and (paraphrasing) said, ‘What’s going on is really simple. We’re having a run on the Shadow Banking System and the only question is how intensely it will self-feed as its assets and liabilities are put back onto the balance sheet of the conventional banking system.’”

BNP had been involved in credit intermediation, that is, it was exchanging bonds made up of mortgage-backed securities (MBS) for short-term loans in the repo market. It all sounds very complex, but it's no different than what banks do when they take deposits from customers and then invest the money in long-term assets. (aka--"maturity transformation") The only difference here was that these activities were not regulated, so no government agency was involved in determining the quality of the loans or making sure that the various financial institutions were sufficiently capitalized to cover potential losses. This lack of regulation turned out to have dire consequences for the global economy.

It took nearly a year from the time that subprime mortgages began to default en masse, until the secondary market (where these "toxic" bonds were traded) went into a nosedive. The problem was simple: No one knew whether the underlying mortgages were any good or not, so it became impossible to price the assets (MBS). This created, what Yale Professor Gary Gorton calls, the e coli problem. In other words,  if even a small amount of meat is contaminated, millions of pounds of hamburger has to be recalled. That same rule applies to mortgage-backed securities. No one knew which MBS contained the bad loans, so the entire market froze and trillions of dollars in collateral began to fall in value.

Subprime was the spark that lit the fuse, but subprime wasn't big enough to bring down the whole financial system. That would take bigger ructions in the shadow banking system.  Here's an excerpt from an article by Nomi Prins which explains how much money was involved:

"Between 2002 and early 2008, roughly $1.4 trillion worth of sub-prime loans were originated by now-fallen lenders like New Century Financial. If such loans were our only problem, the theoretical solution would have involved the government subsidizing these mortgages for the maximum cost of $1.4 trillion. However, according to Thomson Reuters, nearly $14 trillion worth of complex-securitized products were created, predominantly on top of them, precisely because leveraged funds abetted every step of their production and dispersion. Thus, at the height of federal payouts in July 2009, the government had put up $17.5 trillion to support Wall Street's pyramid Ponzi system, not $1.4 trillion." ("Shadow Banking", Nomi Prins, The American Prospect)

Shadow banking emerged so that large cash-heavy financial institutions would have a place to park their money short-term and get the best possible return.  For example, let's say Intel is sitting on $25 billion in cash. It can deposit the money with a financial intermediary, such as Morgan Stanley, in exchange for collateral (aka MBS or ABS), and earn a decent return on its money. But if a problem arises and the quality of the collateral is called into question, then the banks (Morgan Stanley, in this case) are forced to take bigger and bigger haircuts which can send the system into a nosedive. That's what happened in the summer of 2007. Investors discovered that many of the subprimes were based on fraud, so billions of dollars were quickly withdrawn from money markets and commercial paper, and the Fed had to step in to keep the system from collapsing.

Regulations are put in place to see that the system runs smoothly and to protect the public from fraud. But banking without rules is more profitable, so industry leaders and lobbyists have tried to block the efforts at reform.  And, they have largely succeeded.  Dodd-Frank – the financial reform act -- is riddled with loopholes and doesn't really resolve the central issues of loan quality, additional capital, or risk retention. Banks are still free to issue bogus mortgages to unemployed applicants with bad credit, just as they were before the meltdown. And, they can still produce securitized debt instruments without retaining even a meager 5 per cent of the loan's value. (This issue is still being contested) Also, government agencies cannot force financial institutions to increase their capital even though a slight downturn in the market could wipe them out and cause severe damage to the rest of the system. Wall Street has prevailed on all counts and now the window for re-regulating the system has passed.

President Barack Obama understands the basic problem, but he also knows that he won't be reelected without Wall Street's help.  That's why he promised to further reduce "burdensome" regulations in the Wall Street Journal just two weeks ago. His op-ed was intended to preempt the release of the Financial Crisis Inquiry Commission's (FCIC) report, which was expected to make recommendations for strengthening existing regulations. Obama torpedoed that effort by coming down on the side of big finance. Now, it's only a matter of time before another crash.

Here's an excerpt from a special report on shadow banking by the Federal Reserve Bank of New York:

"At the eve of the financial crisis, the volume of credit intermediated by the shadow banking system was close to $20 trillion, or nearly twice as large as the volume of credit intermediated by the traditional banking system at roughly $11 trillion. Today, the comparable figures are $16 and $13 trillion, respectively.....The weak-link nature of wholesale funding providers is not surprising when little capital is held against their asset portfolios and investors have zero tolerance for credit losses." ("Shadow Banking", Federal Reserve Bank of New York Staff Report)

So, between $4 to $7 trillion vanished in a flash after Lehman Brothers blew up. How many millions of jobs were lost because of inadequate regulation?  How much was trimmed from output, productivity, and GDP? How many people are now on food stamps or living in homeless shelters or struggling through foreclosure because unregulated financial institutions were allowed to carry out credit intermediation without government supervision or oversight?

Ironically, the New York Fed doesn't even try to deny the source of the problem; deregulation. Here's what they say in the report: "Regulatory arbitrage was the root motivation for many shadow banks to exist."

What does that mean? It means that Wall Street knows that it's easier to make money by eliminating the rules....the very rules that protect the public from the predation of avaricious speculators.

The only way to fix the system is to regulate all financial institutions that act like banks.  No exceptions. 

Pic credit: Evgeni Dinev at freedigitalphotos.net.

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twotraps's picture

great article and great comments.  If the 'exogenous shock' hits the mkt, will it repeat like last time?  Will the first leg down be construed as a healthy pull-back, within acceptable limits percentage-wise?  Will everything move lower as it did before because players need to raise cash?  I think about the toughest scenario...the 'screw the most people trade'...and it might be a gentle trend down, but definitely down, not enough to panic, plenty of time to add to positions...plenty of time to watch them erode.  A long slog down is a tough play for many players, if its still the case that mutual funds have a contractual obligation to be long the mkt.   If there is  a housing mkt reference, people talk about getting a huge deal on homes now, 40% off, and they're right, I tried to offer that they just bought the 'New' price...

So after the first leg or two down in stocks....will it be a nice 20% off sale or just the new price on the way down?

A Man without Qualities's picture

There's a lot of similarity between the shadow banking system creating the bubble in ABS, CDOs etc and the HFTs driving the current equity market.  The first point is that both have hardly any capital and therefore have little loss tolerance.  This creates a bizarre situation where it is in the mutual interest of all the players to keep pushing prices higher (I think of it as a game of prisoner's dilemma).  I well recall the credit markets in 2006/ 2007.  There could be no doubt that the systemic risks were growing, that assets were reaching bubble prices and yet day after day, the bonds were trading tighter and tighter, and seemed to have totally divorced from fundamentals.  It greatly puzzled me at the time, but on reflection, I think there was a collusion between the players that they had no choice but to keep pushing things higher, because they were trapped and would be unable to exit without a total meltdown.  Of course, the weak link was the source of funding for the SPVs was the commercial paper market and as soon as these investors no longer wanted to play the game, the game was over.  What was the trigger for this?  Actually, it was the bank repo desks, who would no longer repo the CP with a ridiculously low haircut.  This was the trigger as it drained liquidity from the system and once this began, there was a snowball effect.  Within weeks, trillions of Dollars worth of M3 vanished.

Now, the Fed knows that to fight the deflationary forces, they need to get M3 up again.  This is why the have been supportive of the HFT cabal (it's like a mutual fund with no equity) and they believe that credit expansion should be correlated with the equity markets.  Trouble is, equities represent stakes in real world businesses and they are in themselves leveraged positions in corporate assets, so they are naturally risky and volatile.  Therefore, a key part of the plan is to kill volatility in equities.

However, observed volatility belies the true riskiness of the system, which is always in a critical steady state.  Any exogenous shock could lead to chaos.  Even a sensible action such as raising interest rates could trigger this, so there is a reluctance to raise rates, but then the inflation (esp oil prices) will hit.  Add to that, the traditional bedrock of the equity markets - buy and hold, mutual funds etc - are getting out, value investors are exiting, long/ short etc etc.  Alpha is dead.  

So yes, the Fed has created a monster.  It's almost as if they designed a plan to make the economy look like it had recovered 2 years later, only to finally and utterly collapse 2 years later.

As an old colleague who sits at the top table of a TBTF told me - they're going to have one last try to reflate the bubble, but it's going to blow up again.


falak pema's picture

Cain and Abel, remember : Shadow banking will kill its virtuous half of conventional banking. It's on the cards since they revoked Glass Steagall. The rest is a betrayal of the USA's contribution to the world : entrepreneurial capitalism, transparency, democracy, accountability. Brave New world. Deregulation is the apple whose bite lost the USA its paradise. Now its no more a joy ride.

See how Humpty Dumpty falls. All the king's horses and all the king"s men...


anony's picture

Glass-Steagall repeal was a monstrous betrayal of the people, particularly savers, those who husbanded their resources.

BUT, there is plenty that the SEC and CFTC and other regulatory bodies could have done and still can do to put the brakes on a lot of this financial wizardry.

Like most of our laws, they are only enforced when those who have the most to lose fight with their lives to get the agency responsible for the regulations to do their fucking jobs.  But the lobbyists are organized and making the payoffs while the public is powerless in the extreme because they are not and can not be.

Unless someone bleeds, at the top, copiously, nothing will change.

anony's picture

No Doubt but the most important, indeed the ONLY thing that is missing and essential to making this article of any but informational value is:



Eternal Student's picture

Ilene: I found this article to be a keeper. A superb reminder of the precarious position we are currently in; and something to reflect back upon every time a waft of Hopium drifts near by. I doubt we'll make it to the 2012 elections without something coming apart. But the boys in charge have been surprising in their ability to keep the Great Ponzi alive.

StychoKiller's picture

Amen!  Every time someone gets a hankerin' to actually buy stock(s)/bond(s), they should re-read this article!

ebworthen's picture


Do you know the euphamism that Administrators are taught to employ when speaking with employees who have had no cost of living or merit increases for over four years? 

"Salary Compression"

That salary, by some mysterious force, was "compressed" and now is not as large as it once was. 

We are living Groupthink and 1984.


Grand Supercycle's picture

Interesting chart for anyone who hasn’t seen it yet:

S&P500 monthly chart January 15 2011

anony's picture

It would only be interesting if there was a dash line from nw to se depicting the actual dates of the reversion to the 600 level.

Otherwise we can't use this chart for anything.

Pike Bishop's picture

We will continue to visit this again, and again, and again.

It is a national consciousness caught in arrested development. Cultures have an innate ability to sense when they are stuck in Neutral. They can sense when they aren't moving ahead, no matter how many people tell them to stop believin' their lyin' damned eyes.

There are a lot of words for an "ending". Words like closure, justice, solved, and resolution.

Is there any type of "ending" word in the cultural consensus for the horseshit which rudely presented itself 2 1/2 uears ago?


The short version is that the bill has to be paid. We have to bring out the bad assets and put them on the table. The rule of law has to be reinstituted, and as a standard for everyone.

There is a perception that we are driving out of an extreme dip in the road, with many of us saying that we're using the wrong gas and the transmission ain't lookin' too fuckin' good.

Our problem is that we can't tell the difference between a dip in the road and a cul-de-sac.

Until we admit that, and we will in a generation or two,.. we might stop revisiting it, but it is going to be like a ghost that wants to keep us from movng on.

And we'll just be going 'round, and 'round, and 'round.

hugolp's picture

Ironically, the New York Fed doesn't even try to deny the source of the problem; deregulation. Here's what they say in the report: "Regulatory arbitrage was the root motivation for many shadow banks to exist."

Obviously the Fed is going to blame deregulation. It does not matter that regulation has increased during the last decade. Facts dont matter, deregulation! deregulation!


Its the perfect scapegoat to cover the fact that cheap credit its the best incentive for banks to misbehave. The Fed is giving the banks access to lend more than they could from savings scaping consumer control and regulations have increased constantly, but hey dregulation! deregulation! Lets keep the game going, baby!

anonnn's picture

"banking without rules"

Cf. St.Paulson...spouter of lies, mover of boundaries, ...


MGA_1's picture

And jailtime for fraud?

time123's picture

Crises have been happening throughout history, so yet another one will be part of the norm. They create opportunity for those prepared. We should enjoy the stock market ride while it lasts.



timer at http://invetrics.com

raya123's picture

The markets may not like Ron Paul's "QE2 Bashing" hearing tomorrow...


London Banker's picture

I can remember Gerry Corrigan talking about the Shadow Banking System back in the 1980s when he was president of the New York Fed.  The idea that McCulley made up the term in August 2007 is delusional.  Shadow banking - described as such - has been around as long as securitisation.

What is true is that deregulation created hugely profitable arbitrage in ill-transparent markets, driving more and more finance into the shadows, off balance sheet, over the counter, etc.  And yes the industry has pretty well evaded any serious reforms, which means more problems ahead.

savagegoose's picture

no its easier to let ther banks fail and print blue backs and start a new money system

onoly the depositors in gov guaranteed bank accounts that had followed the ruiles, get blue backs, everone else gets to trade in their green bvacks at what ever the exchange rate is determined ot be.


any assets in greenies get traded at the excahge rate as well,  bee it 5 grreenies get you 1 bluey. or what ever. would make all the bankers with theirr million dopllar payouts stuffed in exotic trades vomit with rage while savers get to party onnnn,

pods's picture

Easier to let it all collapse and let the chips fall where they may.  Let some kind of market currency rise from the ashes.

Let's not pretend that this system will work "if we do it right".  The system is designed to work like this.  That way, through compound interest, the bankers end up with all the credit, and all the property.


Coldfire's picture

Investors discovered that many of the subprimes were based on fraud, so billions of dollars were quickly withdrawn from money markets and commercial paper, and the Fed had to step in to keep the system from collapsing.

The Federal Reserve "had" to step in to keep the USD Ponzi from collapsing and thereby expanded it. Ponzientially. Well done, Bermonkey.

ebworthen's picture

Yes, such genius, a PhD in it no less.

Reese Bobby's picture

Angelo Mazilo says he doesn't understand what all the fuss is about...

Oracle of Kypseli's picture

Can someone bitch slap Angelo please! 

malek's picture

So BNP was the 2007's Waddell & Reed?
Crucify them! Prosecute them! Let them testify before congress! (in that order)

ebworthen's picture


Punish the criminals or the responsible populace will revolt and collapse the system; in which the criminals, the politicians, AND innocent people die.

Let's hang the criminal and malfeasant now and spare the death of innocents; especially considering that the responsible innocents have already been bankrupted.


"Hang 'em, hang 'em, hang 'em high

Let their widows and Orphans cry.

The bastards sold their souls for cash

Their bodies swingin' are just bones 'n ass"


Ned Zeppelin's picture

the e coli still infects the MBSs - it has just gone underground like the coal fires in Centralia, PA. 

mynhair's picture

Or Centralia, WA.  Oh, wait, that place was by St. Helens.  Above ground.

mynhair's picture

Whoa, Cdad must be awake.  The junks are flying as fast as farts outta his azz.

Can tell cuz there's no rebuttal.

Dick Buttkiss's picture

Yes, by all means, more government regulation. Anything but confront the real problem: the monetary fascism of the Federal Reserve and the resultant free-for-all that makes a mockery of free markets. 

Ah, but the Ron Paul Show begins tomorrow.  Must See TeeVee.

traderjoe's picture

Yea I thought the article was going to be about the privately held Fed / banking cartel illegally counterfeting the people's money in contravention of the Constitution. But all I got was 'more regulation'. There hasn't been a single prosecution. More regulation?

pods's picture

I agree.  Unless we look at the root of the problem (fiat credit at interest) we are not looking at the problem, just another symptom.

It is akin to putting cover up on a bullet hole in your chest and ignoring air rushing out as you breathe.


CH1's picture

Regulation is magic! It solves all problems! The regulators are infallible!

Didn't you get the memo?

mynhair's picture

Ron:  is your name the Bernank?

Bernank: yes

Ron:  I yield my time to that HuffPo bitch.

mynhair's picture

yada, yada yada, the Pig Market crashes tomorrow.

What do you call a woman with no arms or legs against a wall?


Screw the dip, buy AVL, while you can.  8.33 is goodbye territory.

max2205's picture

Why are we bringing up old news and pouring salt into wounds that the feds will not fix. Fuck the FED

Scisco's picture

What is the point of more regulation when we don't enforce the ones we have. There are so many clear cut examples of fraud and yet not one major conviction. Go after the crooks and strike fear into those that commit  fraud. Without fear there is only greed.

TBT or not TBT's picture

The NRA gives a similar answer to new gun control regulations proposed every time some nutter shoots a lot of people:   Enforcing the existing gun laws is the way forward.    But no one gets fired in government, for anything.    9/11?   Nothin.   Madoff?  Nothin.   GS gets no haircut on AIG paper?   Nothin.    

Being a federal employee is like being in a union so powerful it can prevent people being fired for the most rank material incompetence at their actual jobs.    This kind of job should be paid a lot less, in a sane labor market, because such a cushy setup would attract "workers" at a lower price than a risky private sector job.   But what we see on the ground out there, is federal employees paid twice what the private sector does, and they're set on benefits, working hours, and pensions too, above and beyond their being unfirable.  

And the latter is why existing regulations aren't enforced.  Duh.

AssFire's picture

What is the point of Border Control, FBI, CIA, NTSA etc? They all seem to fail continually, but just grow-  the Goobermint -that is the common thread.. Many laws are in place so that the goobs can pursue a fully littany of charges once they decide to remove you. You see, they need not be perfect- just you; even if you don't know about their capriciously enforced laws.

Scisco's picture

I completely agree with you. I was attempting to refute the author's argument that we need more regulation to fix the problems in the economy.

Future Jim's picture

Exactly. It is unnecessary to force regulation, and it leads to a false sense of security. It is sufficient to simply punish fraud. In fact, it is sufficient to simply expose fraud.

nohweh's picture

I wish it would be so easy. Is the exposure of " foreclosure fraud" sufficient. The British Empire operates on a system of retroactivity whereby any act can later be legalised, and usually has been.

Minge's picture

I love the e coli analogy.  Such a simple and accurate way of explaining the crux of the crisis.  I also like the use of "Minsky Moment."  Good ol' Hymen Minsky.  Tee Hee.  I said "Hymen."  Anyway...he was just another Keynesian whom I could do without.

Oracle of Kypseli's picture

Bookmark this.

Obummer will crash the markets if he sees that his chances of reelection are slim to none and orchestrate a fascist takeover.


antidisestablishmentarianismishness's picture

I don't need to bookmark it.  I can tell you right now it's the most idiotic comment I've seen around here in at least a week.  And that's really saying something.

TBT or not TBT's picture

And in any case a fascist takeover is different from a communist one mainly in how they treat private companies.  Fascists whip the private sector into alignment with the program, in return for the benefits of being aligned to the state.   They care about the health of the nations businesses to a fault.    Commies want to make private business part of the government formally.   

Barack knows what side his bread is best buttered on.  The GM takeover, the student loan take over, the mortgage takeover, and the health care takeover are all fascist style interventions which he does not want to see fail in some type of "crash," so much as bend entirely to the will of the state.

StychoKiller's picture

Just because you're NOT paranoid (enough!), doesn't mean that they're NOT out to get you!