The U.S Financial System, the Debt Bubble and the Cancer of Excessive Deregulation

Chronique de Rodrigue Tremblay

It's... poetic justice, in that the people that brewed
this toxic Kool-Aid found themselves drinking a lot of
it in the end.

Warren Buffett, American investor
By a continuing process of inflation, government can
confiscate, secretly and unobserved, an important part
of the wealth of their citizens.

John Maynard Keynes (1883-1946)
New money that enters the economy does not affect all
economic actors equally nor does new money influence
all economic actors at the same time. Newly created
money must enter into the economy at a specific point.
Generally this monetary injection comes via credit
expansion through the banking sector. Those who
receive this new money first benefit at the expense of
those who receive the money only after it has snaked
through the economy and prices have had a chance to

Friedrich A. Hayek (1899-1992), Austrian economist
When Fed Chairman Ben Bernanke
says the economic situation is worsening, you'd better
believe him. In fact, the U.S. credit markets are
collapsing under our very eyes, and there is no end in
sight as to when this will stop, let alone reverse
for the U.S. economy are falling;
2- [Consumer
sentiment is falling as mortgage equity withdrawals
are drying up;
3- employment
numbers are falling;
4- the [January 2008 report on the
U.S. service economy
indicates that it contracted early in the year for the
first time in 58 months;
5- the [number of new jobless
claims ->] is
still dangerously high;
6- The housing crisis
is getting up steam; banks have to place larger and
larger subprime losses on their balance sheets, thus
undermining their capital bases and bringing many of
them to the brink of insolvency;
7- the [credit-ratings
are under siege;
8- bond guarantee insurance companies
are in the process of loosing their triple-A ratings
and some are on the brink of bankruptcy;
9- the [$2.6
trillion municipal bond market
is about to take a nose dive, if and when the bond
insurers do not pull it through;
10- the [leveraged
corporate loan market
is in disarray;
11- the more than [a trillion dollar
market for mortgage- and debt-backed securities
could collapse completely if the largest American
mortgage insurers continue to suffer crippling losses;
12- large hedge funds are losing
money on a high scale and they are suffering from a
run on their assets;
13- in the U.S., [total debt as a
percentage of GDP
->] is at
more than 300 percent, a record level (N.B.: in 1980,
it was 125 percent!);
14- and, finally, the [worldwide
hundreds-of- trillion dollar derivatives market
->] could
implode anytime, if too many financial institutions go
under during the coming months, as most of these
transactions are inter-institution trades.
There are a few positive straws in the wind, such as
the fact that manufacturing output seems to be holding
up pretty well, as the devalued dollar stimulates
exports, but the overall economic picture remains
bleak. This is a tribute to the U.S. economy's
This mess all begun in the early 2000s, and even as
far back as the early 1980s, when the Fed and the SEC
adopted a hands-off approach to financial markets,
guided by the new economic religion that "markets can
do no wrong." What we are witnessing is the failure of
nearly thirty years of so-called conservative
debt-ridden and deregulation-ridden economic policies.
It must be understood that the [most recent subprime
really began in 2000, when the credit-rating agency of
Standard & Poors issued a pronouncement saying that
"piggyback" mortgage financing of houses, when a
second mortgage is taken to pay the down-payment on a
first mortgage, was no more likely to lead to default
than more standard mortgages. This encouraged mortgage
lending institutions to relax their lending practices,
going as far as lending on mortgages with no
down-payment whatsoever, and even postponing capital
and interest payments for some time. And, with the Fed
and the SEC looking the other way, a fatal next step
was taken. Banks and their subsidiaries decided to
follow new toxic and risky rules of banking.
Indeed, while traditionally banks would borrow short
and lend long, they went one giant step further: they
began transforming long term loans, such as mortgages,
car loans, student loans, etc., into short term loans.
Indeed, they got into the alchemist business of
bundling together relatively long term loans into
packages that they sliced into smaller credit
instruments that had all the characteristics of
short-term commercial paper, but were carrying higher
yields. They then sold these new ["structured
investment vehicles" (SIVs),
for a fee, to all kinds of investors who were looking
for higher yields than the meager rates that
alternatives were paying. And, since banks were behind
these new artificial financial assets, the
credit-agencies gave them an AAA-rating, which allowed
regulated pension funds and insurance companies to
invest in them, believing they were both safe and
liquid. — They were in for a shock. When the housing
bubble burst, the value of real assets behind the new
financial instruments began declining, pulling the rug
out from underneath the asset-backed paper market,
(ABCP) which became illiquid and toxic. With hardly
any trading on the new instruments, nobody knew the
true value of the paper, and thus nobody was willing
to buy it. This crisis of confidence has now permeated
to other credit markets and is threatening the entire
financial system as the contagion spreads.
As late as 2003-04, then Fed Chairman Alan Greenspan
was not the least worried by the
subprime-financed-housing-mortgage bubble but was
instead encouraging people to take out adjustable-rate
mortgages, even though interest rates were at a
thirty-year low and were bound to increase. Even in
late 2006, newly appointed Fed Chairman Ben Bernanke
professed not to be preoccupied by the housing bubble,
saying that high prices were only a reflection of a
strong economy. Mind you, this was more than one year
after the housing market peaked in the spring of 2005.
History will record that the Fed and the SEC did
nothing to prevent the debt pyramid from reaching the
dangerous levels it attained and which is now crushing
the economy.
On a longer span of time, when one looks at a graph
provided by the U.S. Bureau of Economic Analysis (BEA)
and which shows the [relative importance of total
outstanding debt
(corporate, financial, government, plus personal) in
relation to the economy, one is struck by the fact
that this ratio stayed around 1.2 times GDP for
decades. Then, something big happened in the early
1980s, and the ratio started to rise, with only a
slight pause in the mid-1990s, to reach the
air-rarefied level of 3.1 times GDP presently, nearly
200 percent more than it used to be.
The adoption of massive tax cuts
coupled with government deficit spending policies, and
deregulation policies, by the Reagan and
subsequent GOP administrations, all culminating in a
grotesque way under the current administration,
contributed massively to this [unprecedented debt
bubble. ->]
It took many years to build up the debt pyramid, and
it will take many years to unwind it and to reduce
this cumulative mountain of debt to a more manageable
That is the big picture behind this crisis. It is much
bigger than the S&L crisis of the 1980s, which looks
puny in comparison with the current one. That is why I
think this crisis will linger on for at least a few
more years, possibly until 2010-11.

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