Wednesday, March 21, 2012

China Syndrome 2: A Run on the US Treasury. by Gary North

The China Syndrome (1979) was a movie on the threat of a nuclear power plant's core meltdown. The phrase was said to refer to the core of the plant's falling all the way to China. The producers were blessed by the March 28 Three Mile Island nuclear power plant emergency, which for a time looked extremely serious. The movie was released on March 16.
There is another China syndrome, also associated with a meltdown. This would be triggered by the central bank of China's doing nothing.
To understand how this could happen, it is useful to see how a similar scenario took place in 2008.

The bankruptcy of Bear Stearns in March 2008 was a prelude to a wider meltdown. Wikipedia summarizes what happened.

In March 2008, the Federal Reserve Bank of New York provided an emergency loan to try to avert a sudden collapse of the company. The company could not be saved and was sold to JP Morgan Chase for $10 per share, a price far below its pre-crisis 52-week high of $133.20 per share, but not as low as the $2 per share originally agreed upon by Bear Stearns and JP Morgan Chase. The collapse of the company was a prelude to the risk management meltdown of the Wall Street investment bank industry in September 2008, and the subsequent global financial crisis and recession. In January 2010, JPMorgan ceased using the Bear Stearns name.
The parent company the previous June had bailed out two of its hedge funds. It placed $3.2 billion of its own capital on the line for the funds. The funds were leveraged with CDO's: collateralized debt obligations.
Bear Stearns had originally put only $35 million into the fund. The senior managers thought it would tarnish the firm's reputation if it let a hedge fund with its name on it go under. So, they did what was stupid in retrospect. They mortgaged the family jewels.
Next, Richard Marin, the man who was in charge of the two busted hedge funds, was replaced on June 29 by Jeffrey B. Lane, a former Vice Chairman of a rival investment bank, Lehman Brothers. So, in order to bail out a pair of busted, over-leveraged hedge funds, Bear Stearns called in a Lehman Brothers executive. That turned out to be a foretaste of things to come.
In July, the firm announced a total bust. There was no money remaining in either fund. Leverage giveth, and leverage taketh away. There was the predictable class-action lawsuit filed on August 1. Then came another from Barclay's Bank. The company's reputation began to sag.
Things held together until the second week of March 2008. At that point, a bank run began.
In the good old days before the Federal Deposit Insurance Corporation was created by the government, a bank run began when depositors lined up to get their money out. The bank then had to sell assets to get money. In the Great Depression, this took down 9,000 banks, all small. The Federal Reserve protected the big banks. The FDIC stopped these runs by reducing the depositors' fears.
In the modern world, a bank run does not begin in front of a bank. It begins when the bank's big creditors, hedge funds and pension funds, decide not to roll over their short-term credits to the bank.
There are few warnings. Credit lines are short-term. The bank's president gets a call telling him that the creditor intends to take his money and not roll over the loans to the bank.
These funds are not protected by the FDIC. So, the creditors get jumpy when rumors of insolvency spread. That was what happened to Bear Stearns in the second week of March 2008.
Then came the bailout from the Federal Reserve Bank of New York, a private company. Wiki reports:

On March 14, 2008, the Federal Reserve Bank of New York agreed to provide a $25 billion loan to Bear Stearns collateralized by free and clear assets from Bear Stearns in order to provide Bear Stearns the liquidity for up to 28 days that the market was refusing to provide. Then it reversed itself. It decided to set up a sweetheart deal for J. P. Morgan. It told BS that there would be no loan. Instead, it made a $30 billion loan to Morgan, but did not require Morgan to put up any of its own collateral. The NYFED accepted Bear Stearns' assets. This collateral was basically worth nothing in the short-term.
Two days later, on March 16, 2008, Bear Stearns signed a merger agreement with JP Morgan Chase in a stock swap worth $2 a share or less than 7 percent of Bear Stearns' market value just two days before. This sale price represented a staggering loss as its stock had traded at $172 a share as late as January 2007, and $93 a share as late as February 2008. In addition, the Federal Reserve agreed to issue a non-recourse loan of $29 billion to JP Morgan Chase, thereby assuming the risk of Bear Stearns's less liquid assets (see Maiden Lane LLC). This non-recourse loan means that the loan is collateralized by mortgage debt and that the government can not seize J.P. Morgan Chase's assets if the mortgage debt collateral becomes insufficient to repay the loan. Chairman of the Fed, Ben Bernanke, defended the bailout by stating that a Bear Stearns' bankruptcy would have affected the real economy and could have caused a "chaotic unwinding" of investments across the US markets.
That arrangement created a firestorm of protests from Bear Stearns' stock holders. They filed a class action lawsuit. So, Morgan raised the ante to $10 a share. That got them the prize – the FED-bankrolled prize.
Then Wiki gives us this choice bit of information.

On March 20, Securities and Exchange Commission Chairman Christopher Cox said the collapse of Bear Stearns was due to a lack of confidence, not a lack of capital. Cox noted that Bear Stearns's problems escalated when rumors spread about its liquidity crisis which in turn eroded investor confidence in the firm. "Notwithstanding that Bear Stearns continued to have high quality collateral to provide as security for borrowings, market counterparties became less willing to enter into collateralized funding arrangements with Bear Stearns," said Cox. Bear Stearns' liquidity pool started at $18.1 billion on March 10 and then plummeted to $2 billion on March 13. Ultimately market rumors about Bear Stearns' difficulties became self-fulfilling, Cox said.
This was a CMA announcement. Translated, it meant that the SEC was not derelict in its duties by failing to see this coming. Bear Stearns was technically insolvent, but not really. It became insolvent only because of rumors.
Notice what this really means. A company with $18 billion in liquidity on March 10 lost $16 billion of this liquidity in three days.
Welcome to bank runs of the twenty-first century.
Six months later, a similar scenario played out with Lehman Brothers, a $600 billion investment bank. Does this sound familiar?

Lehman borrowed significant amounts to fund its investing in the years leading to its bankruptcy in 2008, a process known as leveraging or gearing. A significant portion of this investing was in housing-related assets, making it vulnerable to a downturn in that market. One measure of this risk-taking was its leverage ratio, a measure of the ratio of assets to owners equity, which increased from approximately 24:1 in 2003 to 31:1 by 2007. While generating tremendous profits during the boom, this vulnerable position meant that just a 3 – 4% decline in the value of its assets would entirely eliminate its book value or equity. Investment banks such as Lehman were not subject to the same regulations applied to depository banks to restrict their risk-taking. In August 2007, Lehman closed its subprime lender, BNC Mortgage, eliminating 1,200 positions in 23 locations, and took a $25-million after-tax charge and a $27-million reduction in goodwill. The firm said that poor market conditions in the mortgage space "necessitated a substantial reduction in its resources and capacity in the subprime space".
Bear Stearns' two leveraged funds went down in June, 2007. The class action suit began on August 1. That same month saw the loss of the Lehman subprime fund. Then came the decline. "In the first half of 2008 alone, Lehman stock lost 73% of its value as the credit market continued to tighten. In August 2008, Lehman reported that it intended to release 6% of its work force, 1,500 people, just ahead of its third-quarter-reporting deadline in September."
It took a year for the rumors to spread. The stock price continued down. But Lehman was too big to fail. A lot of investors hung on. Then came Armageddon. The company had been heavily invested in subprime mortgages. Henry Paulson on September 7 unilaterally announced the nationalization of Freddie Mac and Fannie Mae. He called the new government-ownwd system a "conservatorship."
On September 9, Lehman shares fell another 45%. On September 13, Timothy Geithner, who was then president of the Federal Reserve Bank of New York, called a meeting on the future of Lehman, which included the possibility of an emergency liquidation of its assets. The weekend meeting began. Note: the head of a private owned firm called the meeting. The Secretary of the Treasury showed up.
The weekend deal between Treasury Secretary Henry Paulson persuaded the Bank of America to buy Merrill Lynch for $50 billion. (That was later cut to $20 billion.) But there was no bailout of Lehman.
Then came the next deal.

Lehman Brothers filed for Chapter 11 bankruptcy protection on September 15, 2008. According to Bloomberg, reports filed with the U.S. Bankruptcy Court, Southern District of New York (Manhattan) on September 16 indicated that JPMorgan Chase & Co. provided Lehman Brothers with a total of $138 billion in "Federal Reserve-backed advances." The cash-advances by JPMorgan Chase were repaid by the Federal Reserve Bank of New York for $87 billion on September 15 and $51 billion on September 16.
So, the big winner was J. P. Morgan, just as it had been the winner in the Bear Stearns deal six months before.
The lesson: bad news can hit a year or more before the collapse. It is like a fuse being lighted. Confidence erodes, but it does not collapse. Then, overnight, it does.
The People's Bank of China owns almost $1.2 trillion in U. S. Treasury debt. It is the largest holder. Close behind is Japan. You can see which nation owns how much of U.S. Treasury debt in the Treasury Department's monthly TIC report.
Take a look at the report. China held a maximum of a little over $1.3 trillion in July 2011. Then it began to reduce its holdings by about $140 billion by January. The official policy of the bank is for greater diversification. This is a code phrase for "selling Treasury debt." But there has been no timetable. There have been no official targets.
We know this: by mid-2011, China had gotten rid of almost all of its T-bills, meaning 90-day IOUs. It was holding U. S. bonds. So, when it ceases to buy bonds that come to maturity, its holdings fall. It does not have to sell T-bonds. It simply lets them mature. The U.S. Treasury must then credit China's account with this money. The central bank takes the money and runs.
This is what happened to Bear Stearns. The creditors refused to roll over their loans. These were short-term loans. But China's loans to the Treasury are longer-term loans.
The quiet way to get out of the dollar is to do nothing. Just take the dollars from the Treasury and invest them elsewhere in U.S. markets, or sell them for other currencies.
It is not clear that China has begun a bank run on the Treasury. But word is beginning to get out. If the bank's present policy continues – a refusal to roll over maturing debt – the Treasury Department will have to find new buyers.
China is Keynesian. It uses monetary inflation to fund spending, including the purchase of Treasury IOUs. It can spend this on domestic purchases. It will take time to shift from its export-driven policy to a domestic-driven economy. But, either way, it is demand-side economics: Keynesianism.
China ran a slight trade deficit in February. Oil imports were the main reason. Experts in China's trade say that this was temporary. But they do admit that the surplus this year will be lower. I think the trend is toward a smaller surplus. China needs energy to sustain its growth. It will have to pay for this.
For as long as the dollar remains the primary currency of oil-exporting nations, oil-importing nations will buy dollars. There is an incentive to get dollars by selling to the USA. But the risk of continuing to hold T-debt is growing.
There will come a day, just as it came to Bear Stearns, when the refusal of creditors to roll over the debt will increase. Then, without warning, the rollovers will cease. The creditors will decide to keep their dollars and forgo the rollover. On that day, the Treasury will have to go to the FED and demand that the FED buy its debt. That's the supplement benefit of a central bank from the politician's perspective. This will create a moment of truth for American politicians.
The first indications of a bank run by China have begun. There is no panic yet. The system is bumping along. But if China does not reverse itself soon, it will become clear that the U.S. Treasury is over-leveraged. It has more debt than its income can sustain.
That is when the Secretary of the Treasury will call the chairman of the Federal Reserve System and ask for a bailout. He will get it, but its effects will not last. There will be another call. As surely as Bear Stearns was followed by Lehman Brothers, so will there be more calls from the Treasury Secretary to the chairman of the FED.
There will come a day when the FED's chairman treats the Secretary of the Treasury the way that Paulson treated Lehman's Dick Fuld. Let us not forget what happened next.
Close to 100 hedge funds used Lehman as their prime broker and relied largely on the firm for financing. In an attempt to meet their own credit needs, Lehman Brothers International routinely re-hypothecated [borrowed against – just as MF Global did] the assets of their hedge funds clients that utilized their prime brokerage services. Lehman Brothers International held close to 40 billion dollars of clients assets when it filed for Chapter 11 Bankruptcy. Of this, 22 billion had been re-hypothecated.
As administrators took charge of the London business and the U.S. holding company filed for bankruptcy, positions held by those hedge funds at Lehman were frozen. As a result the hedge funds are being forced to de-lever and sit on large cash balances inhibiting chances at further growth. This in turn created further market dislocation and over all systemic risk, resulting in a 737 billion dollar decline in collateral outstanding in the securities lending market.
That will be played out again on a vastly larger scale when the Treasury's checks bounce. The U. S. Treasury is to Lehman what Lehman was to Bear Stearns.
When the bank run begins – "Sorry, we have decided not to roll over the debt," the bankruptcies will begin.
China can trigger it. China Syndrome 2 will come at long last.

No comments: