Are we headed for a repeat of 1930s-style bank failures?

There is almost too much news going on in the financial world to even begin to try to analyze and discuss these days. I was watching financial cable news this weekend on Fox, who are usually cheerleaders for the market, and the mood is extremely pessimistic. I was amazed. So rather than comment on the 10 ongoing crisis at the moment, I've been thinking about some specific terms that should be defined... words we will soon hear a lot in the future. What's a systemic margin call? What is a cascading cross-default and why should you care?

Margin Call

So, let's say you put up $10 billion as colatoral so you can borrow $85 billion in order to invest in $95 mortgage backed securities. You do this cuz in the future you think those investments will be worth $100 billion. Once it hits that point you sell for that price, pay your broker back the $85 you borrowed, you recover your $10 billion in collateral and you pocket that $5 billion spread as profit. That is how you leverage and that is how you go "long" in a market.

So, what happens if those investments go to $70 billion instead of $100 billion as you hoped? Well, your broker or bank will notice that and will demand you put up more collateral. Because, after all, if you were to sell at $70 billion, instead of $100 billion, you'd end up losing $25 billion, which is more that what you put up to begin with. Your credit worthiness is now being challenged. So, the bank issues a margin call and demands you put up more money, maybe another $10 billion. But you don't have the money. So you sell your assets. You may have to sell stock that you'd like to keep in order to support the margin call, thus driving down demand (and price) of the stock. But what if you don't own enough stock, or what if there is ZERO demand for the debt you are holding? Then you become insolvent and the monetary base shrinks.

Systemic Margin Call

JPMorgan has issued a warning about what it calls a "systemic margin call":

NEW YORK (Reuters) - Wall Street banks are facing a "systemic margin call" that may deplete banks of $325 billion of capital due to deteriorating subprime U.S. mortgages, JPMorgan Chase & Co, said in a report late on Friday.

JPMorgan, which sent a default notice to Thornburg Mortgage Inc. after the lender missed a $28 million margin call, said more default notices and margin calls were likely. The Carlyle Group's mortgage fund also failed to meet $37 million in margin calls this week.

Yes, that Carlyle Group. Even the insiders are even in trouble. So what about all this? The risk is that one failure will lead to another, which leads to another, causing a general change in psychology where leveraged positions have to be unwound in order to raise capital to maintain solvency. Each liquidation leads to additional stock market losses and thus more margin calls and thus more liquidations -- this is what would be known as a "deflationary spiral."

Cascading Cross-Defaults

Given Bernake's studies of the 1929-1933 financial crisis, he is aware of the risks and has been taking actions to prevent the above from happening. One mechanism has been the TAF, which allows banks to anonymously trade mortgage back security and US Treasuries for cash, in order to maintain reserve requirements. The Federal Reserve is essentially turning bad debt into money and nationalizing vast sums of private real estate in the process, thus inflating the currency in an effort to maintain the monetary base in the face of the feared downward spiral. Every attempt by a central bank to avoid a debt-induced credit collapse in the past has met with hyperinflation (which I personally would define as > 100% per year in inflation).

By inflating the money supply, this will provide enough liquidity to the system in order to avoid what is known as a "cascading cross-defaults." Its a situation where banks call in loans they've made to each other, or various other financial/corporate entities, and the borrower doesn't have the money. This, in turn, would cause another entity to not have needed cash flow and thus be put at risk of also defaulting on an obligation. In such a scenario, one bank after another would fall like a domino causing an even further collapse of markets and pretty much every asset class. What would this mean for you? It would all end with you coming back to your office to find out that two other co-workers also had ATM cards that didn't work. On the third day of such a scenario the nation would have a full understanding of what was happening and then, the American public would handle however they would handle it. It would probably involve angry crowds at banks and the National Guard. It wouldn't be pretty -- and it would be just the beginning of a nightmare.

The Panic of 2008

The Fed, given Bernake's understanding of the 1929-1933 panic in US markets is trying to address this and prevent the above scenario from happening. Without a sudden reversal in the markets or a solution to mounting credit worries or a change in psychology, I'd put the chances of the above scenario working itself out over the next 18 months at about 35% The way the Fed is acting is entirely consistent with a program one might be tempted to undertake to stop the panic and problems of the aforementioned scale.

Deflation Death Match & What Now?

Essentially, this a Death Match for the central bank. The last time the Fed dropped rates twice in 10 days was the Panic of 1914. That year the New York Stock Exchange ceased trading for four and a half months. Many forsee deflation as the great evil that lies ahead. Yes, that's what *should* happen if the system were allowed to correct intself, but I expect a large amount of governmental intervention, which would probably lead to an attempt to inflate our way out of the problem. Its possible they may find somehow a way to actually do that.

Given the speculation in commodities and panic buying of contracts in a manner that is inconsistent with demand, I sense smart money is quickly moving to tangible assets (like gold). If we have a sudden crash in prices of commodities, I'd interpret that to mean investors are liquidating anything they possibly can in order to meet obligations and the Fed's attempt to inflate is failing. Or, prices could keep precipitously rising as an early warning sign of pending monetary inflation brought on by the Fed's policies. We'll be looking at 10% monthly inflation in 12 months or half of all banks will be out of business. Or nothing will happen. Either way, we'll have a much better idea of where things are going soon enough.

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