By Henry C K Liu http://www.atimes.com/atimes/Global_...

(Part I - Part II to follow)

Free-market fundamentalists have been operating in denial mode for more than a year, since the US financial sector imploded in a credit crisis from excessive debt in August 2007, claiming that the economic fundamentals were still basically sound, even within the debt-infested financial sector.

As denial was rendered increasingly untenable by unfolding events, champions of market fundamentalism began clamoring for increasingly larger doses of government intervention in failed free markets around the world to restore sound market fundamentals. For the market fundamentalist faithful, this amounts to asking the devil to save god.

Aside from ideological inconsistency, the real cause of the year-long credit crisis has continued to be misdiagnosed in official circles whose members had until recently tirelessly promoted the merit of small government, perhaps even purposely by those in the position to know better and in whom society has vested power to prevent avoidable disaster. The diagnosis misjudged the current credit crisis as only a temporary liquidity quandary instead of recognizing it as a systemic insolvency. (See Fed helpless in its own crisis, Asia Times Online, January 26, 2008.)

The misdiagnosis led to a flawed prognosis that the liquidity crunch could be uncorked by serial injections of more government funds into intractable credit and capital market seizure. This faulty rationale was based on the fantasy that distressed financial institutions holding assets that had become illiquid could be relieved by wholesale monetization of such illiquid asset with government loans, even if such government loans are collateralized by the very same illiquid assets that private investors have continued to shun in the open market.

It is not that government officials know more than market participants about the true value of these illiquid assets; it is only that government officials with access to taxpayers' money have decided to ignore market forces to artificially support asset overvaluation, the original root cause of the problem. Instead of being the solution, the government with flawed responses backed by the people's money has become part of the problem.

President George W Bush told the American people on October 10 that "the fundamental problem is this: As the housing market has declined, banks holding assets related to home mortgages have suffered serious losses. As a result of these losses, many banks lack the capital or the confidence in each other to make new loans. In turn, our system of credit has frozen, which is keeping American businesses from financing their daily transactions - and creating uncertainty throughout our economy."

Skipping over the basic fact that the housing market has been declining because of a burst credit bubble, the president went on to identify five problems, the first of which is that "key markets are not functioning because there's a lack of liquidity - the grease necessary to keep the gears of our financial system turning. So the Federal Reserve has injected hundreds of billions of dollars into the system. The Fed has joined with central banks around the world to coordinate a cut in interest rates. This rate cut will allow banks to borrow money more affordably - and it should help free up additional credit necessary to create jobs, and finance college education, and help American families meet their daily needs. The Fed has also announced a new program to provide support for the commercial paper market, which is freezing up. As the new program kicks in over the next week or so, it will help revive a key source of short-term financing for American businesses and financial institutions."

The market responded to the president's speech with a one-day rally before resuming its sharp downward spiral, continuing a response pattern to all previous government announcements of drastic but allegedly necessary measures in recent weeks to stop the financial hemorrhage once and for all. Stocks posted the biggest drop since the 1987 crash two days after the president and Treasury Secretary presented the government's new "comprehensive" program to arrest the financial crisis.

Four levels of the credit crisis
The current credit crunch takes form on four separate but interrelated market levels.

1. On the first level is the banking system which traditionally intermediates credit through deposit taking and conventional lending.

2. A second level is the non-bank credit market via which institutional and corporate borrowers issue commercial paper for short-term funding by borrowing directly from institutions with surplus cash to invest, bypassing banks and using banks only as standbys in case maturing commercial paper cannot be rolled over occasionally.

3. A third level is the structured finance market in which debt securitization provides liberal credit to large pools of high-risk borrowers, with pools of debt structured as unbundled debt instruments of varying but connected degrees of risk, financed by funds from institutional investors with varying appetite for risk commensurate with varying levels of return, thus enabling pension funds and money market funds to invest in the upper tranches of structured debt that are supposed to be safe enough to satisfy conservative fiduciary requirements, but in aggregate adds up to corresponding escalation of systemic risk should any one link in the interconnected system fails.

4. Finally, there is the capital market where companies go to raise new capital in times of need, where in times of sudden and severe need can turn into a market opportunity for vultures. (See The pathology of debt, a five-part series initiated on Asia Times Online, November 27, 2007.)

Central banks around the world, led by the US Federal Reserve, generally have the institutional authority, historical experience and monetary resources to keep the traditional regulated banking system from failing, by nationalization and eventual consolidation.

As currently structured, central banks are not in possession of ready authority, operational experience or financial resources to keep the now vastly larger non-bank credit and capital markets from failing. Under conditions of a liquidity trap, central banks do not even have the means to force banks to lend to credit-unworthy or unwilling borrowers. This is known as the Fed pushing on a credit string. Further, the Fed is approaching the lower end of interest rate cuts, with the Fed funds rate target already at 1.5%. It cannot go below zero.

According to free-market principles, a healthy banking system is supposed to be able to save itself from systemic collapse by allowing individual wayward banks to fail. The fact that increased number of mismanaged banks is threatened with failure does not normally add up to any threat of systemic failure in the banking system. It in fact testifies to the systemic resilience of a healthy banking system.

The current problem arises from intricate and close interconnection among financial institutions and markets, which has made too many financial institutions "too big to fail" because their individual failure can cause systemic collapse through widespread interconnected contagion throughout the market.

For example, the trigger point behind Bear Stearns's near failure came from the repo market, where banks and securities firms routinely extend and receive short-term loans, typically made overnight and backed by top grade securities. Hours before 7:30am on March 14, 2008, Bear Stearns was faced with the problem of not being able to roll over its huge repo debt because its high-rated collaterals had fallen in market value. If the firm did not repay the maturing debt on time with new funds from new repo contracts, its creditors could start selling at fire-sale prices the collateral Bear had pledged to them, to cause substantial loss to Bear Stearns.

The implications would go far beyond losses for Bear Stearns. The sale receipts might not repay all investors and cause losses to conservative institutional investors such as pension funds and money market funds. If investors begin to question the safety of loans collateralized by triple-A securities they make in the repo market that are now worth less than their face value, they could start to withhold funds from the credit market when other investment banks and companies need to roll over their maturing short-term debts.

Hundred of firms would default and fail from a seizure of the $4.5 trillion repo market, bringing down banks that have issued standby credit to them in a financial chain reaction.

The distressing part is that the $4.5 trillion repo market is not an untested novel financial innovation such as subprime-mortgage-backed collateralized debt obligations. It is a decades-old, plain-vanilla debt market where market risk is considered minimal. A major counterparty default in the repo market would have been unprecedented because the collateral accepted in a repo contract is generally considered as triple-A rated, and such a default could have systemic consequences for the entire credit market and even impair the ability of the central bank to maintain the Fed funds rate target, which it normally does by participating in the repo market.