Monday, December 22, 2008

We're All Madoff

A must-read post.


See, evil requires secrecy.

Theoretically, banks are supposed to hold reserves of about 8% against their deposits, and therefore are limited to roughly 12:1 leverage against their asset base. Investment banks had a similar limit explicitly codified in the law, because as non-depository institutions they had no deposits against which to measure these ratios. In fact, up until 1998, all such "demand accounts" - that is, those in which you could walk into the bank and demand your money immediately (e.g. checking accounts and similar) were subject to these reserve requirements. This put an effective cap on leverage and thus risk - and the otherwise-unbridled growth of commercial and bank credit.

But starting in 1998 this changed. This Treasury Department OTS memorandum outlines a number of bills that were put forward by Senators and Representatives that, in many cases, still sit in our Congress. Senators Shelby, Hagel and Reid are explicitly named, along with the infamous Representative Leach of Gramm-Leach-Bliley. That memorandum also effectively eviscerated the reserve requirements that formerly kept our banking and thrift system safe and sound.

Between this change in policy, The Federal Reserve's intentional refusal to act to stop what amounted to infinite leverage, Treasury Secretary Paulson's (successful) entreaty to ease leverage limits on investment banks in 2004 (when he was running Goldman Sachs) and other similar actions taken by our government, we have in fact created the largest bubble ever blown in economic history throughout our banking and credit systems.

Now that bubble has popped.

In 2000, the damage done by the 1998 and 1999 decisions (which just happened to coincide with the final "blow off" top in the Nasdaq!) put our GDP approximately 10% "out of balance" with our actual productive capacity.

That is, the debt taken on during that bubble in excess of GDP growth represented about a 10% "premium" to a sustainable GDP level. Were we to simply wave a wand and make that debt (credit) disappear, GDP would have been 10% below where it was in 2000.

2000 GDP was approximately $10 trillion, so we would have suffered a $1 trillion contraction in GDP to bring the system back into balance, along with whatever business and banking failures which would have come along with that adjustment. Those failures would have resulted in an "overshoot" of some amount - perhaps another $500 billion.

Note that a total "peak to trough" contraction of 10% is generally thought of as a Depression. Not a "Great Depression", but an "ordinary" Depression.

Therefore, the economy in 2000 faced an economic Depression. To put this in perspective, in the post-war era the worst Recession on record was the 1973-75 event which recorded a 4.9% contraction in real GDP.

George Bush, our Congress and Alan Greenspan, however, refused to accept their responsibility in 2000 and 2001 for the economic policies of this nation and its banking regulators that led to the final blow-off top in the Internet Bubble.

In fact, Gramm-Leach-Bliley along with the sweep account changes were responsible for about half of the excess leverage of the Internet Bubble, and thus about half of the economic correction made necessary by its final blow-off top.

That's right - had those changes not been made we would have faced a 1973-74 style recession, but with those changes we were guaranteed a depression as the economic "just desserts" of the Internet Bubble era.

Being that this was deemed "unacceptable" Alan Greenspan along with Congress and the other regulatory bodies in Washington DC responsible for banking (and general credit system) safety and soundness undertook an intentional course of action to "paper over" the losses.

But wait! How can you do that?

You can't - except through fraud.

That is, you cannot prevent a loss from appearing and being recognized unless you allow people to lie about the value of securities, place them off-balance-sheet in opaque containers where nobody can see what's inside (and thus how they're performing) and "lever up" to issue yet more debt (credit) to cover the cash flow that should be happening but isn't.

As the embedded (and fraudulently-concealed) debt continued to mount banks and other institutions found themselves performing a Madoff - that is, issuing new credit (debt) to be able to "show earnings" that in fact were a phantom. Unlike Madoff they did not have to go find someone new to put money in to be able to issue the checks to existing investors, since a bank that can operate with no reserve requirements imposed on it is capable of issuing as much credit as it wants, effectively "printing money."

Regulations and leverage limits are supposed to prevent this, but they were systematically and intentionally dismantled in the name of "financial innovation."

In truth they were dismantled in the name of a massive financial fraud that permeated every corner of our credit system, from credit cards to student loans to automobiles to housing.

This ponzi scheme even extended to individual consumers - that is, you.

If you HELOC'd out money and paid down your credit cards with it, then charged anew or cash-out refinanced, you were a Madoff. If you bought a house with an Option ARM, knowing full well you could not make make a fully-amortized "recast" payment, you were a Madoff. If you played the balance transfer game with your credit cards, rolling balances from one zero-interest offer to another, you were a Madoff. Tens of millions of Americans did one or more of these things - and each and every one of them - if not you then someone you knew - was running a personal version of Madoff's scheme...

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