Click amount to donate direct to CounterPunch
  • $25
  • $50
  • $100
  • $500
  • $other
  • use PayPal
Support Our Annual Fund Drive!
CounterPunch’s website is one of the last common spaces on the Internet. We are supported almost entirely by the subscribers to the print edition of our magazine and by one-out-of-every-1000 readers of the site.
FacebookTwitterGoogle+RedditEmail

A Repo Implosion

by MIKE WHITNEY

President Barack Obama is determined to prevail in his battle with GOP congressional leaders on the debt ceiling issue, but not for the reasons stated in the media.  Obama is less concerned with the prospect of higher interest rates and frustrated bondholders than he is with the big Wall Street banks who would be thrust back into crisis if there is no resolution before October 17.  Absent a debt ceiling deal, the repurchase market–known as repo–would undergo another deep-freeze as it did in 2008 when Lehman Brothers defaulted triggering a run on the Reserve Primary Fund which had been exposed to Lehman’s short-term debt. The frenzied selloff sparked a widespread panic across global financial markets pushing the system to the brink of collapse and forcing the Federal Reserve to backstop regulated and unregulated financial institutions with more than $11 trillion in loans and other obligations. The same tragedy will play out again, if congress fails lift the ceiling and reinforce the present value of US debt.

Repo is at the heart of the shadow banking system, that opaque off-balance sheet underworld where maturity transformation and other risky banking activities take place beyond the watchful eye of government regulators.  It is where banks exchange collateralized securities for short-term loans from investors, mainly large financial institutions. The banks use these loans to fund their other investments boosting their leverage many times over to maximize their profits. The so called congressional reforms, like Dodd Frank, which were ratified after the crisis, have done nothing to change the  basic structure of the market or to reign in excessive risk-taking by undercapitalized speculators. The system is as wobbly and crisis-prone ever, as the debt ceiling fiasco suggests. The situation speaks to the impressive power of the bank cartel and their army of lawyers and lobbyists. They own Capital Hill, the White House, and most of the judges in the country.  The system remains the same, because that’s the way the like it.

US Treasuries provide the bulk of collateral the banks use in acquiring their short-term funding. If the US defaults on its debt, the value that collateral would fall precipitously leaving much of the banking system either underwater or dangerously undercapitalized. The wholesale funding market would grind to a halt, and interbank lending would slow to a crawl. The financial system would suffer its second major heart attack in less than a decade. This is from American Banker:

As banking policy analyst Karen Shaw Petrou describes it, Treasury obligations are the “water” in the financial system’s plumbing.

“They’re the global reserve currency and they are perceived to be the most secure thing you can own,” said Petrou, managing partner of Federal Financial Analytics. “That is why it is pledged as collateral. … The very biggest banks fear that a debt ceiling breach breaks the pipes.”….

Rob Toomey, managing director and associate general counsel at the Securities Industry and Financial Markets Association, said institutions are concerned about whether Treasury bonds that default are no longer transferable between market participants.

“Essentially, whatever the size is of the obligation that Treasury is unable to pay, that kind of liquidity would just disappear from the market for whatever time the payment is not made,” Toomey said.”

By some estimates, the amount of liquidity that would be drained from the system immediately following a default would be roughly $600 billion, enough to require emergency action by either the Fed or the US Treasury. Despite post-crisis legislation that forbids future bailouts, the government would surely ride to rescue committing taxpayer revenues once again to save Wall Street.

Keep in mind, the US government does not have to default on its debt to trigger a panic in the credit markets.  Changing expectations can easily produce the same result. If the holders of US Treasuries (USTs) begin to doubt that the debt ceiling issue will  be resolved, then they’ll sell their bonds prematurely to avoid greater losses.  That, in turn, will push up interest rates which will strangle the recovery, slow growth, and throw a wrench in the repo market credit engine. We saw an example of how this works in late May when the Fed announced its  decision to scale-back its asset purchase. The fact that the Fed continued to buy the same amount of USTs and mortgage-backed securities (MBS) didn’t stem the selloff. Long-term rates went up anyway. Why? Because expectations changed and the market reset prices. That same phenom could happen now, in fact, it is happening now. The Financial Times reported on Wednesday that “Fidelity Investments, the largest manager of money market funds…  had sold all of its holdings of US Treasury bills due to mature towards the end of October as a “precautionary measure.”

This is what happens when people start to doubt that US Treasuries will be liquid cash equivalents in the future. They ditch them. And when they ditch them, rates go up and the economy slips into low gear.  (Note: “China and Japan together hold more than $2.4 trillion in U.S. Treasuries” Bloomberg)

Now the media has been trying to soft-peddle the implications of the debt ceiling standoff by saying, “No one thinks that holders of USTs won’t get repaid.”

While this is true, it’s also irrelevant. The reason that USTs are the gold standard of financial assets, is because they are considered risk-free and liquid. That’s it. If you have to wait to get your money, then the asset you purchased is not completely liquid, right?

And if there is some doubt, however small, that you will not be repaid in full, then the asset is not really risk free, right?

This is what the Fidelity flap is all about. It’s about the erosion of confidence in US debt. It’s about that sliver of doubt that has entered the minds of investors and changed their behavior. This is a significant development because it means that people in positions of power are now questioning the stewardship of the present system. And  that trend is going to intensify when the Fed begins to reduce its asset purchases later in the year, because winding down QE will precipitate  more capital flight, more currency volatility and more emerging market runaway inflation. That’s going to lead to more chin scratching, more grousing and more resistance to US stewardship of the system. None of this bodes well for Washington’s imperial aspirations or for the world’s reserve currency, both of which appear to be living on borrowed time.

The media has done a poor job of explaining what’s really at stake. While, it’s true that higher interest rates would make consumer loans more expensive and put the kibosh on the housing recovery, that’s not what the media cares about. Not really. What they care about is the looming massacre in shadow banking where USTs are used as collateral to secure short-term loans by the banks so they can increase their leverage by many orders of magnitude. In other words, the banks are using USTs to borrow gobs of money from money markets and financial institutions so they can finance their other dodgy investments, derivatives contracts and ancillary casino-type operations. If there’s a default, the banks will have to come up with more capital for their scams that are leveraged at 40 or 50 to 1. This systemwide margin call would trigger a deflationary spiral that would domino through the entire system unless the Fed stepped in and, once again,  provided a giant backstop in the form of blank check support.   Here’s how Tim Fernholz sums it up over at Daily Finance:

“…Many informed people are worried” (about) “A freeze in the tri-party repo market, akin to the cascade of troubles that followed the Lehman Brothers bankruptcy in 2008.”….

In 2008, more than a third of that collateral was mortgage-backed securities. When Lehman went bankrupt, its lenders began a “fire sale” of the securities it used as collateral, which drove down the value of other mortgage-backed securities, which led to more fire sales. This dynamic would eventually lead to a freeze in the repo markets, which, at the time, provided $2.6 trillion in funding to the banks each day…..

Today, most of the collateral in use is U.S. Treasuries and “agency securities” — mortgage-backed securities guaranteed by the U.S. government:

… if the ugly day of a default comes, lenders may simply stop accepting U.S. debt as collateral. That will have the effect of sucking some $600 billion in liquidity out of the banking system. Unable to get funding for Treasurys, securities dealers would be pressured to sell them-or other assets-to find new funding, creating a fire sale dynamic…..

And, of course, this scenario is only about how the Treasurys work in the repo markets. U.S. debt is used as collateral for derivatives swaps and numerous other transactions; if they are suddenly worth less than expected, lenders can be expected to demand more collateral up front, putting even more pressure on the financial system. That’s why pressure is building to raise the ceiling before the world’s largest economy enters a scenario with so much uncertainty.”

Repeat: “That’s why pressure is building to raise the ceiling before the world’s largest economy enters a scenario with so much uncertainty”.

So the Obama team isn’t worried that Joe Homeowner won’t be able to refi his mortgage or that the economy might slip back into recession. They just don’t want to see Wall Street take it in the shorts again. That’s what this is all about, the banks. Because the banks are still up-to-their-eyeballs in red ink.  Because they still don’t have enough capital to stay solvent if the wind shifts. Because all the Dodd Frank reforms are pure, unalloyed  bullsh** that haven’t fixed a bloody thing. Because the risks of another panic are as great as ever because the system is the same teetering, unregulated cesspit it was before. Because the banks are still financing their sketchy Ponzi operations with OPM (other people’s money), only now, the Fed’s over-bloated balance sheet  is being used to prop up this broken, crooked system instead of the trillions of dollars that was extracted from credulous investors on subprime mortgages, liars loans and other, equally-fraudulent debt instruments.

Can you see that?

This is why the media is pushing so hard to end the debt ceiling standoff; to preserve this mountainous stinkpile of larceny, greed and corruption run by a criminal bank Mafia and their political lackeys on Capital Hill. That’s what this is all about.

MIKE WHITNEY lives in Washington state. He is a contributor to Hopeless: Barack Obama and the Politics of Illusion (AK Press). Hopeless is also available in a Kindle edition. Whitney’s story on declining wages for working class Americans appears in the June issue of CounterPunch magazine. He can be reached at fergiewhitney@msn.com.

MIKE WHITNEY lives in Washington state. He is a contributor to Hopeless: Barack Obama and the Politics of Illusion (AK Press). Hopeless is also available in a Kindle edition. He can be reached at fergiewhitney@msn.com.

More articles by:

2016 Fund Drive
Smart. Fierce. Uncompromised. Support CounterPunch Now!

  • cp-store
  • donate paypal

CounterPunch Magazine

minimag-edit

September 26, 2016
Diana Johnstone
The Hillary Clinton Presidency has Already Begun as Lame Ducks Promote Her War
Gary Leupp
Hillary Clinton’s Campaign Against Russia
Robert Crawford
The Political Rhetoric of Perpetual War
Howard Lisnoff
The Case of One Homeless Person
Michael Howard
The New York Times Endorses Hillary, Scorns the World
Russell Mokhiber
Wells Fargo and the Library of Congress’ National Book Festival
Chad Nelson
The Crime of Going Vegan: the Latest Attack on Angela Davis
Colin Todhunter
A System of Food Production for Human Need, Not Corporate Greed
Brian Cloughley
The United States Wants to Put Russia in a Corner
Guillermo R. Gil
The Clevenger Effect: Exposing Racism in Pro Sports
David Swanson
Turn the Pentagon into a Hospital
Ralph Nader
Are You Ready for Democracy?
Chris Martenson
Hell to Pay
Frank X Murphy
Power & Struggle: the Detroit Literacy Case
Chris Knight
The Tom and Noam Show: a Review of Tom Wolfe’s “The Kingdom of Speech”
Weekend Edition
September 23, 2016
Friday - Sunday
Andrew Levine
The Meaning of the Trump Surge
Jeffrey St. Clair
Roaming Charges: More Pricks Than Kicks
Mike Whitney
Oh, Say Can You See the Carnage? Why Stand for a Country That Can Gun You Down in Cold Blood?
Chris Welzenbach
The Diminution of Chris Hayes
Vincent Emanuele
The Riots Will Continue
Rob Urie
A Scam Too Far
Pepe Escobar
Les Deplorables
Patrick Cockburn
Airstrikes, Obfuscation and Propaganda in Syria
Timothy Braatz
The Quarterback and the Propaganda
Sheldon Richman
Obama Rewards Israel’s Bad Behavior
Libby Lunstrum - Patrick Bond
Militarizing Game Parks and Marketing Wildlife are Unsustainable Strategies
Andy Thayer
More Cops Will Worsen, Not Help, Chicago’s Violence Problem
Louis Yako
Can Westerners Help Refugees from War-torn Countries?
David Rosen
Rudy Giuliani & Trump’s Possible Cabinet
Joyce Nelson
TISA and the Privatization of Public Services
Pete Dolack
Global Warming Will Accelerate as Oceans Reach Limits of Remediation
Franklin Lamb
34 Years After the Sabra-Shatila Massacre
Cesar Chelala
How One Man Held off Nuclear War
Norman Pollack
Sovereign Immunity, War Crimes, and Compensation to 9/11 Families
Lamont Lilly
Standing Rock Stakes Claim for Sovereignty: Eyewitness Report From North Dakota
Barbara G. Ellis
A Sandernista Priority: Push Bernie’s Planks!
Hiroyuki Hamada
How Do We Dream the Dream of Peace Together?
Russell Mokhiber
From Rags and Robes to Speedos and Thongs: Why Trump is Crushing Clinton in WV
Julian Vigo
Living La Vida Loca
Aidan O'Brien
Where is Europe’s Duterte? 
Abel Cohen
Russia’s Improbable Role in Everything
Ron Jacobs
A Change Has Gotta’ Come
Uri Avnery
Shimon Peres and the Saga of Sisyphus
Graham Peebles
Ethiopian’s Crying out for Freedom and Justice
Robert Koehler
Stop the Killing
FacebookTwitterGoogle+RedditEmail