The Great Financial Revolution of Our Times

Seven years and twenty days ago, there began a sequence
of terrifying events that changed financial history forever.

Here’s my diary of the events as they unfolded,
beginning on one of the most dramatic days of
that era …

 

Monday, September 15, 2008.

• After weekend emergency negotiations collapse and the Fed declines to participate in a bailout, Lehman Brothers, a Wall Street firm heavily involved in high-risk derivatives transactions, files for bankruptcy.
   
• JPMorgan Chase, the nation’s single biggest player in the market for derivatives, puts up $138 billion to settle Lehman’s outstanding transactions. Nearly all of Lehman’s other assets go into immediate liquidation.
   
• Merrill Lynch, the nation’s largest brokerage firm, is also suddenly bankrupt. It’s abruptly sold to Bank of America in a shotgun transaction engineered by the Fed.
   
• American International Group (AIG), the nation’s largest player in the derivatives markets among insurers, is also broke. But unlike Lehman, it gets an instant $85 billion bailout from the Fed in exchange for an 80% interest in its shares.
   

September 16. A large money fund, Reserve Primary Fund, has big losses in its short-term loans to Lehman. So its share price, which is always supposed to be fixed at $1, suddenly falls below the all-important one-buck level. Within 48 hours, the fund is swamped with a half-trillion dollars in liquidation orders, and soon the contagion begins to spread to other money funds.

September 19. To stem the panic, the U.S. Treasury announces the equivalent of federal deposit insurance for money market funds, transferring still more responsibility from the private to the public sector.

September 21. In order to qualify for government support and bailout funds, America’s two largest investment banks — Goldman Sachs and Morgan Stanley — decide, virtually overnight, to transform themselves into bank holding companies.

Week of September 22. Congress starts to move swiftly to develop an emergency bailout plan, draft legislation, get all the powers behind it, and exert enormous pressure to suppress opposition.

October 3. The Emergency Economic Stabilization Act of 2008 is passed with a 263-171 bipartisan vote in the House. Almost immediately, $700 billion in bailout funds start flowing from the U.S. Treasury Department straight into the coffers of giant U.S. banks on the brink of failure.

But it’s just the first of many actions around the world — mostly in the United States and Western Europe — that help transfer more trillions of dollars in toxic assets from the books of bankrupt corporations to the books of federal governments.

October 7. The global market for short-term corporate IOUs (commercial paper) has sunk into a sudden deep freeze.

This market is the oil that lubricates the industrial and banking operations of the entire world. Without it, the engine of the global economy grinds to a halt.

In response, the U.S. Fed announces a never-before-heard-of “Commercial Paper Funding Facility.” In other words, virtually any major company in the world that cannot roll over its short-term debts coming due is, in effect, invited to stop by the Fed’s offices in downtown Manhattan to pick up all the cash it needs.

Again, the ultimate responsibility for meeting huge amounts of private-sector debt is transferred from the corporate sector to the government sector.

October 8, 11 AM GMT.  It’s rate-cutting time, and it’s big: Almost every major central bank in the world — including the U.S. Fed, the Bank of England, the European Central Bank, plus smaller banks such as the Bank of Canada, Swedish Riksbank and the Swiss National Bank — announce simultaneous, coordinated interest-rate cuts of 0.5%.

For the Fed, it’s the first leg of a 3-step move down to zero percent.

But on the other side of the world, in Tokyo, it leaves the Bank of Japan (BOJ) stranded, virtually alone. Why? Because the BOJ has already cut its interest rates to zero long ago, and it has no more room to cut.

Ironically, for years, Japan’s zero-interest policy has been derided by every other self-respecting central banker in the West as “foolhardy” or “amateurish.” Now, they’re all moving swiftly through exactly the same gateway to the same “other world” — with no plan regarding when or how to get back to normalcy.  

Immediate result: Despite the rate cuts, global stock markets plunge, and Japan is the biggest loser, down more than 9% on the day.

Long-term results:

• Seven years of zero interest rates.
   
• Three rounds of money infusions (QE1, QE2, and QE3) that are a whopping 88 times larger than during the Fed’s prior emergency — to counter the economic paralysis in the wake of 9-11.  (See “The Real Reasons Yellen Didn’t Raise Rates.”)
   
• A virtually risk-free Garden of Eden engineered by the Fed, driving global investors away from low-yielding safety toward higher-yielding risk assets. And …
   
• A series of speculative bubbles, including massive inflows into junk bonds. (See “The Next Big Bubble to Burst.”)

Most important of all, since that fateful day seven years ago, all of the major governments of the world have taken on an unprecedented burden — not only as the biggest debtors on the planet, but also as the lenders of last resort for nearly everyone else.

This is the great, hidden revolution of our times.

And therein lies a powerful build-up of forces that could unravel in ways that few investors understand.

Good luck and God bless!

Martin