Exclusively in the new print issue of CounterPunch
HOW DID ABORTION RIGHTS COME TO THIS?  — Carol Hanisch charts how the right to an abortion began to erode shortly after the Roe v. Wade decision; Uber vs. the Cabbies: Ben Terrall reports on the threats posed by private car services; Remembering August 1914: Binoy Kampmark on the enduring legacy of World War I; Medical Marijuana: a Personal Odyssey: Doug Valentine goes in search of medicinal pot and a good vaporizer; Nostalgia for Socialism: Lee Ballinger surveys the longing in eastern Europe for the material guarantees of socialism. PLUS: Paul Krassner on his Six Dumbest Decisions; Kristin Kolb on the Cancer Ward; Jeffrey St. Clair on the Making of the First Un-War; Chris Floyd on the Children of Lies and Mike Whitney on why the war on ISIS is really a war on Syria.
Debt Ceiling Doomsday

Shadow Banking and the Repo Market

by MIKE WHITNEY

“International markets are absolutely on tenterhooks, because up until now there really has been a pretty blithe assumption that sooner or later politicians would strike a deal, and it would probably be last-minute, but a deal would be done before Aug. 2.

What is really starting to think in right now is that not only is there a growing risk the rating agencies could downgrade U.S. debt, even if there is some kind of short-term Band-Aid solution, but secondly there may not even be a deal by August the 2nd. And so a lot of people in the financial markets right now are starting to look at what-if scenarios and creating plans for what they half-jokingly call doom day, potential — or D-day, potential default day.”

— Gillian Tett, editor Financial Times, PBS Newshour

Okay, so we all knew that the cultists and screwballs who run the GOP were going to take this to the 11th hour, right? But who knew that once they got us out on the ledge, they wouldn’t know how to cut a deal? Instead, Tea Party confederates seem determined to make sure the US plunges into the abyss. They want to add a balanced budget amendment to the current legislation which has no chance of getting it passed. President Barack Obama has already promised to veto the bill.

So, here we are, just 4 days away from the August 2 deadline, and no closer to a budget agreement than we were two months ago when this whole fiasco started. Only now, Wall Street is worried, the public is pissed off, and anyone holding US Treasuries around the world is starting to rethink their portfolio. On top of that, the markets have been pounded for 4 days straight, futures are falling like a stone, and the economic data is getting weaker and weaker all the time. (BEA reports that 2nd Quarter GDP came in at an anemic 1.3%) The last thing the country needs is another crisis to send the economy sprawling back into recession. Here’s a clip from an article in the Financial Times:

“Wall Street’s leading chief executives intervened in the US debt debate on Thursday, writing to President Barack Obama and Congress to warn of “very grave” consequences of a default and urging them to cut a deal “this week”.

Lloyd Blankfein of Goldman Sachs and Jamie Dimon of JPMorgan Chase were among 14 chief executives of banks and insurers who signed the letter, along with Rob Nichols, the head of the Financial Services Forum, the umbrella association for the biggest financial groups in the US.

The letter said a default, which is still perceived as unlikely, or a downgrade from a triple-A credit rating, which analysts believe is increasingly likely, “would be a tremendous blow to business and investor confidence – raising interest rates for everyone who borrows, undermining the value of the dollar, and roiling stock and bond markets”….

Banks are concerned about a wide range of operational issues as well as the broader question of how the Fed would support the financial system if there were disruption caused by a failure to raise the debt ceiling…. they would like to know whether the Fed will support the refinancing of Treasury securities by stepping in and buying any unsold stock at auctions…. (“Bank chiefs send US debt default warning”, Financial Times)

So, finally, the truth begins to emerge. The reason the debt ceiling has been headline news 24-7 is not because Granny might not get her Social Security check on time, but because Wall Street fatcats might lose some dough if a deal isn’t worked out pronto. But doesn’t suggest that the final outcome is not yet certain? In other words, if the Tea Party contingent refuses to fall in line behind Boehner, then August 2 might come and go with no deal, and that could trigger another Lehman Bros-type meltdown. Here’s an excerpt from an article in the New York Times:

“The reverberations of Washington’s impasse over a debt deal are already being felt in the short-term credit markets, a key artery of the economy that daily supplies trillions of dollars of credit. Over the last week, big banks and companies have withdrawn $37.5 billion from money market funds that invest in Treasury debt and other ultra-safe securities, the biggest weekly drop this year.

Meanwhile, in the vast market for repurchase agreements, in which many financial firms make short-term loans to one another, borrowers are beginning to demand higher yields.

These moves underscore how companies and big financial institutions are beginning to rethink their traditional view that notes issued by the United States Treasury are indistinguishable from cash, even though many experts say they think it is unlikely that the government would miss payments on its obligations…. (“Debt Ceiling Impasse Rattles Short-term credit markets”, New York Times)

Sound familiar? This is what ignited the Crash of ’08. There was a downgrading of mortgage-backed securities (MBS) and other structured debt instruments, liquidity vanished overnight, and, before you knew it, the markets were in freefall. And it all started with a run on the shadow banking system. And, that’s what’s happening right now. Here’s a sampling of some of the articles popping up in the financial media.

Financial Times:

“US money market funds are stockpiling cash in case Congress fails to raise the debt ceiling, distorting the short-term market for US government debt and raising borrowing costs for banks and other financial institutions….

Banks are also holding more cash and US corporations are postponing decisions due to uncertainty about where to invest cash amid fears that a failure to raise the debt ceiling would trigger a credit rating downgrade and possible default….

Money market funds, which hold $338bn of US government debt, according to Citigroup, are also reducing the amount of time they are willing to lend. This could raise funding concerns for banks, as they are reliant on short-term borrowing in the repurchase or repo market.” (Financial Times)

And this is from Naked Capitalism:

“…the Merc (more formally, the Chicago Mercantile Exchange) …. announced an increase in haircuts on Treasury and agency securities today…. But it increased haircuts even more on foreign sovereign debt. This will force players who have been using any of these assets as collateral that are also pretty fully leveraged to either cut their positions or put up more cash or other collateral.” (Naked Capitalism)

And, lastly, from the New York Times:

“…In the commercial paper market, where companies raise funds for their short-term borrowing needs, buyers are also seeking shorter-term paper…

While money market fund managers say they are not seeing a sizable wave of redemptions yet, they are setting aside more cash, leaving it at custodial bank accounts in case investors demand their money back.” (“Debt Ceiling Impasse Rattles Short-term credit markets”, New York Times)

So there’s a lot of hunkering down going on, which means that Wall Street isn’t really sure how this thing is going to shake out. If there is a default on August 2, the US’s debt would be downgraded requiring more collateral on roughly $4 trillion in Treasuries. Does anyone believe that the maxed out, capital-starved banks have that kind of money laying around?

Not likely. The Fed would have to step in a wrap its arms around the whole financial system again, like it did after Lehman blew up. Only this time, the rest of the world might not buy it. They might see that America’s dysfunctional political system and it’s bankcentric beggar-thy-neighbor monetary policy makes it an unsuitable steward of the global economic system. At the very least, the dollar’s exalted position as the world’s reserve currency would be called into question. Is that such a bad thing?

Presently, US Treasuries play a crucial role in short-term funding markets providing the bulk of Triple A collateral in the repo (repurchase agreement) market. If Treasuries are downgraded, then money markets, commercial paper, and interbank lending will all feel the stress. That will make borrowing more expensive causing a slowdown in credit. The knock-on effects will be felt throughout the economy. Another recession will be unavoidable.

Ironically, the Financial Stability Oversight Council, which was created by Dodd-Frank legislation, issued a report last week which pointed out the vulnerabilities in the current system. The FSOC warned that it “cannot predict the precise threats that may face the financial system” emphasizing much of what we have been talking about here. Here’s a clip from the Wall Street Journal which explains what they found:

“In particular, the FSOC said weaknesses exist in the “triparty repo” market, in which banks make and receive short-term loans on a day-to-day basis. The repo market temporarily froze during the financial crisis, drying up a key source of funding for many Wall Street firms. The FSOC said critical overhauls are needed, including strengthening the collateral practices backing the securities that are being loaned and borrowed…

Regulators also warned risks still exist in money-market funds, which are used by individuals and corporations as a low-risk place for parking cash. To increase stability and reduce the funds’ “susceptibility to runs,”…. (“Watchdog Sees Financial Weak Spots”, Wall Street Journal)

What the report is saying is that nothing has been fixed. Obama’s efforts to reform the markets (and avert another bank run) has amounted to nothing. Shadow banking and the repo market are just as unstable and risky as ever. And that’s what the debt ceiling flap is really all about. It’s about a deregulated system that’s been preserved because, well, because some very rich people like the way things are right now and to hell with the rest of us. That’s why.

Mike Whitney lives in Washington state. He can be reached at fergiewhitney@msn.com