It’s Looking A Lot Like 2008 Now…

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by Chris Martenson, Peak Prosperity:

Did today’s market plunge mark the start of the next crash?

Economic and market conditions are eerily like they were in late 2007/early 2008.

Remember back then? Everything was going great. 

Home prices were soaring. Jobs were plentiful.

The great cultural marketing machine was busy proclaiming that a new era of permanent prosperity had dawned, thanks to the steady leadership of Alan Greenspan and later Ben Bernanke.

And only a small cadre of cranks, like me, was singing a different tune; warning instead that a painful reckoning in our financial system was approaching fast.

It’s fitting that I’m writing this on Groundhog Day, as to these veteran eyes, it sure has been looking a lot like late 2007/early 2008 lately…

The Fed’s ‘Reign Of Error’

Of course, the Great Financial Crisis arrived in late 2008, proving that the public’s faith in central bankers had been badly misplaced.

In reality, all Ben Bernanke did was to drop interest rates to 1%. This provided an unprecedented incentive for investors and institutions to borrow, igniting a massive housing bubble as well as outsized equity and bond gains.

It’s worth taking a moment to understand the mechanism the Federal Reserve used back then to lower interest rates (it’s different today). It did so by flooding the banking system with enough “liquidity” (i.e. electronically printed digital currency units) until all the banks felt comfortable lending or borrowing from each other at an average rate of 1%.

The knock-on effect of flooding the US banking system (and, really, the entire world) in this way created an echo bubble to replace the one created earlier during Alan Greenspan’s tenure (known as the Dot-Com Bubble, though ‘Sweep Account’ Bubble is more accurate in my opinion):

The above chart shows the Fed’s ‘reign of error’. It began with the deeply unfortunate sweeps program initiated at the end of 1994 (described below), proceeded to the echo bubble that itself broke in 2008 with even greater damage done, and all of which has led us to where we are today.

Note the twin panics of 2016 on the above chart.  Panic #1 occurred when our current bubble threatened to burst — that scared the living daylights out of the Big 3 central banks: the Fed, the ECB and the BoJ. So they colluded to juice the markets and boy, did they succeed.  Panic #2 was the surprise election of Donald Trump.  So much thin-air currency was created and dumped into the markets after that unpredicted event that we got that the markets have pretty much gone vertical ever since (note the protractor in the chart above).

When this current bubble pops, the one that I’ve repeatedly described as The Mother Of All Financial Bubbles, the ensuing damage will be many multiples of that caused by the bursting of the bubbles that preceded it.  That’s the nature of these things: you either take your lumps when you should, or you pay a far steeper price later on.

So far, we’ve done all we can to postpone any consequences as far into the future as possible. Someday, maybe someday very soon, those consequences will arrive. And, at our unprecedented extremes in (over)valuation, the price we will have to pay then will be very steep indeed.

Swept Away

One of Greenspan’s biggest sins while at the helm of the Federal Reserve was allowing the banks to implement “sweep accounts” for retail deposit accounts.

Banks are required to hold some of your deposited money ‘”in reserve”, commonly around 10%, to act as a cushion against insolvency risk.  This means that if you have $1,000 on deposit at a bank, it’s supposed to have $100 of that in cash on hand in case you unexpectedly walk in and demand some of your money back. 

Since it’s only during a bank run that everybody wants 100% of their money back, the Federal Reserve only required banks to keep just 10% of depositor money on hand at any given time. They rest can be loaned out. (That’s why this is called ‘fractional reserve lending’).

Banks don’t make very much money by holding onto your money.  They want to “put it to work”.  Through the miracle of fractional reserve banking (at 10% in reserve) your deposited $1,000 can be turned into $9,000 of new loans. 

Instead of offering you 0.5% on your savings while getting 1.5% on a Treasury bond (booooooring!) and pocketing the 1% spread, banks would prefer to lend out 90% of your deposit to a homeowner while charging 4% and pocketing a whopping 3.5% spread.

In Scenario A the banks make $10 from their 1% spread on $1,000. In Scenario B they make $355 in net interest profits on your same $1,000 deposit. That’s a big difference.

But what if even that’s not enough to sate the banks’ hunger for greater profit? What if the banks feel overly hamstrung by that pesky 10% reserve requirement?  What if they only had to hold 5% in reserve? 

Well, then $20,000 in loans can be made against your $1,000 deposit.  If we call this Scenario C (again at a 4% loan rate,) then banks can make $755 in net interest profit on the back of your $1,000 deposit.  Now that’s more exciting!

But how to get around that pesky 10% reserve requirement?  This is where Alan Greenspan stepped in back in 1994. Facing unwanted tightness in the corporate bond market, an effort was made to inject more liquidity into the system. Greenspan’s solution for where that new money should come from was to allow the extension of sweep accounts into retail banking.

Now, what’s a sweep account? Good question.

If you have a checking account with a bank, you very likely also have a corresponding sweep account (also in your name) that you probably never knew was there. 

Each night, right before the bank’s reserve snapshot is taken, all of the money in your checking account is briefly “swept” into a special sweep account which has no reserve requirements. So, when the reserve snapshot is taken for your bank, presto!, there’s no money in your checking account — so, as far the regulators are concerned, your bank need not hold any money in reserve for that account.

And right after the reserve snapshot is taken, presto again!, your money is swept right back into your checking account.

Sounds crazy or, at least, illegal — right? But it’s real.

From the Federal Reserve itself we get this description of sweep accounts:

Since January 1994, hundreds of banks and other depository financial institutions have implemented automated computer programs that reduce their required reserves by analyzing customers’ use of checkable deposits (demand deposits, ATS, NOW, and other checkable deposits) and “sweeping” such deposits into savings deposits (specifically, MMDA, or money market deposit accounts). Under the Federal Reserve’s Regulation D, MMDA accounts are personal saving deposits and, hence, have a zero statutory reserve requirement.

(Source)

The result of this program effectively removed reserve requirements altogether, allowing a flood of new lending to proceed. Sure, that fixed the corporate bond market tightness; but it also gave rise to the massive stock bubble of the late 1990s (see the red arrow pointing upwards on the above chart).

So why focus so much on the creation of the sweep accounts program?

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