Could Bank Of America And JP Morgan Fail, Leading To Global Depression?

In financial markets there are trends and there are cycles. Just as Marshall McLuhan gave us “The medium is the message” phrase, it is becoming apparent that the cycle has become the trend.

In fact, the frequency and amplitude of the cycle is forcing us to adapt. This development is unsettling to most people because it is human nature to dislike change.

Recently Graeme Wheeler, a World Bank managing director, discussed “Financial Market Cycles, Globalization, and the Current Banking Crisis” at the Sovereign Debt Management Forum in Washington. He talks about the issues of globalization and carry trades. I refer to it as ‘hot money’ that seeks opportunity, which soon leads to greed and speculation, which I refer to as the building and subsequent breaking of balloons.

The breaking of financial balloons is painful. The consequential damage is hard to bear.

The weekly data charts of the credit markets, equity markets and commodity markets all reflect the bursting of balloons.

This particular cycle is unlike any other because debt, equity and commodity markets have never before seen Credit Default Swaps, which are, in effect, the generators of an infinite supply of money - that is until the point that the credit ring breaks.

After the massive run-up in the money supply, which I discussed here every week for the past couple years, that break in the credit ring happened after the bankers who created these instruments recognized their need to rein in the problem, which led to disruptions in the financial system as other financial institutions deemed some of their own to be uncreditworthy.

At the heart of the CDS problem, Bear Stearns was the first to fail, followed by Lehman, and now, possibly, Citi (C). If left unchecked, the next failure would be Bank of America (BAC) and then JP Morgan (JPM), which would quickly lead to liquidity in the capital market system drying up. Credit markets would not be open to companies and individuals who need credit, and equity and commodity prices would collapse in the absence of bids and the presence of forced selling from those who could not get credit.

Unchecked, there would be a global depression.

At this point, the world’s monetary authorities recognize the issues and are addressing them. Much of the solution will come down to the simple matter of attitude and willingness to change those elements in the system that caused the problem.

Executive compensation, foreclosures of loans on homes, cars and other assets, falling house prices, offshoring of jobs, and so forth, are merely symptoms of the problem. In a crisis, not much time should be wasted addressing those issues. The key is to stabilize the CDS problem, so that it can unwind over say ten years instead of one or two.

The monetary authorities cannot permit the liquidity to be squeezed out of markets as fast as is happening.

As a short term approach, I would consider dropping the margins required to trade on the major exchanges, especially commodities, equities and treasuries. I would eliminate the tax rules over short-term versus long-term trading. I would remove the accredited investor rule or else vastly lower the requirements. As CDS contracts came due, I would extend the term if one of the counter-parties was unable to complete the deal. As soon as possible I would require all CDS contracts to trade on the CBOT with the Fed being an active participant to ensure no disruptions. Finally, I would have government for a period of say four years buy all failing banks and have teams of work-out specialists with a two-year mandate to fix them and refloat them on the exchanges or sell them to stronger banks. I would overhaul the SEC and spend billions to beef it up afterwards.

In other words, I’d attack problems not symptoms and I’d put the onus on the free market system to come up with the liquidity needed to ensure a healthy global economy.

Henry Paulson and Ben Bernanke have done none of the above. They are, in my view, part of the problem, and must be replaced as soon as possible.

Posted in Categories: Contributor, Economy, External Research, Financial, Stocks, USA.

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