Today In Silver

It is incredible to me that only a few people seem to realize just how close to a total banking collapse we are. Even more incredible is that among those who “get it” are George Bush, Henry Paulson and some Senators and (fewer) Congressmen. Rumors are flying wild (some in the comment section of this site) that a banking holiday is imminent.

There hasn’t been much focused on this, but Washington Mutual actually failed due to a bank run ($18 billion in deposits withdrawn within a few days). Wachovia was close to the same situation before it was sold out of desperation to Citigroup. These were the 4th and 6th largest U.S. banks by asset size! Will the bailout package, even if it passes, restore enough confidence that the 1st (JPMorgan Chase), 2nd (Citibank), 3rd (Bank of America) and 5th (Wells Fargo) largest U.S. banks can avert similar bank runs? These 4 banks now hold over $5 trillion of bank assets and over $2 trillion in deposits.

If the following missive from Jim Sinclair is any guide, the answer might be a “no”:

Dear CIGAs,

I have no doubt that $1650 will come. My concern is not that it will not happen, but that I am much too conservative in my long-term price objective since 2000.

If major banks can be torn apart how can we have faith in the small local institutions that hold most of your ready cash?

When I said ?This is IT,? it is not something that I take lightly. Never in 49 years in finance have I seen a set of circumstances so challenging to the man in the street.

What I am getting at is a simple question. Are you prepared? You have heard us talk repeatedly on removing financial intermediaries between you and your assets, but the time has come for us to recommend going one step further:

Hold enough cash at your household to last you a month or two. It may be largely unnecessary for the majority, but what do you have to lose? If your bank should fail this will save you a lot of grief in the short term. If they do not, you still have all your cash that can easily be deposited back into your account.

Regards,
Jim

I know Mr. Sinclair means well and is simply trying to watch out for the best interests of his readers, but this is precisely the type of thing that can start or add to an ongoing bank run. In other words, this is a self-fulfilling prophesy. It would only take a few percent of bank deposits to be withdrawn and the whole house of cards would come crashing down. Or would it? It is not entirely clear given some of the recent programs that have been announced (see below)

In any case, Bernanke and the Fed know there is a significant chance that things could blow up and thus the helicopter engine is already being warmed up. I know some people have talked about the Fed already dropping money from helicopters but in reality that has not been the case (except as I discuss below). So far, all that has taken place with the various “credit facilities” and bailouts is a substitution of assets. No new money was created as a result. For example, when a bank borrows under a credit facility, it is exchanging an illiquid asset (such as certain agency MBS securities) for Treasury securities held by the Fed. The bank then goes into the market to sell the Treasury securities and uses the cash proceeds to meet liquidity needs.

But at this point it is no longer enough. A not-so-secret secret of our monetary system is that most Federal Reserve Notes — the actual paper money that people are now trying to withdraw in larger and larger droves — are physically held offshore (presumably by foreigners). Indeed, this statement on the FRB New York website is pretty shocking in light of what could imminently happen:

The Federal Reserve estimates that the majority of the cash in circulation today is outside the United States.

As an aside, the latest Factors Affecting Reserve Balances report (from Sep 25) indicates that an absolutely massive $472.8 billion of Federal Reserve Notes (59%) are now collateralized by non-federal (federal includes Freddie Mac, Fannie Mae, Federal Home Loan Bank, etc.) securities. In effect, this means the Federal Reserve itself is virtually bankrupt and the U.S. government will likely need to soon provide direct backing for Federal Reserve Notes if there is any hope of saving the monetary system. When considering this, it seems pretty silly that people are actually withdrawing Federal Reserve Notes from the banking system to hide under the mattress. And in fact, the Federal Reserve looks to continue even further along the current path to insolvency with the announcement just this Monday (virtually ignored by the media due to the focus on the $700 billion bailout plan) that the Term Auction Facility will be doubled from $150 billion to $300 billion.

But now let me discuss the first real preview of what a helicopter operation involving the Fed and Treasury will look like. This seems to have gone unnoticed by the media, but the U.S. Treasury Dept. has started to lend directly to the Fed under its Supplementary Financing Program. The way this program is explained is that the U.S. Treasury issues Treasury securities to the public and deposits the cash proceeds with the Fed. But in reality, what seems to be happening is that the U.S. Treasury is issuing Treasury securities to the Fed and then the Fed is exchanging these Treasury securities with banks for non-federal debt securities. In just the first week of operation, the U.S. Treasury Department has in essence loaned $160 billion directly to the Fed. Sure sounds like insolvency to me!

Given a bank run where people are withdrawing Federal Reserve Notes (remember, most of these Notes are offshore and not available according to the Fed’s own admission) from their checking and savings accounts, it will not be enough to simply have the Fed and banks exchange Treasury securities for illiquid securities. What the banks will need is actual bona fide Federal Reserve Notes. At present, the Federal Reserve has about $190 billion in Federal Reserve Notes that could be made available to the banking system, but any issuance will require the banks to pledge certain bank assets as collateral (most likely performing loans). Unfortunately, doing so will create a deduction against bank capital since it is presumed the Federal Reserve Notes will be withdrawn as soon as they are made available at a branch or ATM, and at the same time the pledged loans (which must be performing) cannot be counted in capital ratios. This is the quandary that makes Ben’s helicopter so difficult to fly, but I believe soon we could see a decision to take off anyway.

What this would look like is the Fed aggressively bidding for Treasury securities in the secondary market (Open Market Operations) and at the same time the U.S. Treasury Department issuing a massive tranche of Treasury securities directly to the Fed in exchange for newly printed Federal Reserve Notes. The U.S. Treasury would then use the Federal Reserve Notes to buy bank assets directly, presumably under the $700 billion bailout program (should it pass Congress) or even an emergency presidential declaration (should it not pass Congress). The combined effect would be to put into circulation the $190 billion of Federal Reserve Notes currently held in the Fed’s vaults as well as introduce an additional supply of Federal Reserve Notes as the Treasury conducts its bailout. The result would be the dreaded helicopter operation whereby deflation would be fought using hyperinflation (of money supply; hyperinflation of prices would come later).

The mess that a helicopter operation would cause is a key reason why many economists believe the only way to save the banking system at this point is through a direct recapitalization (buying preferred shares in the bank). Yet if the U.S. government were to do this (which is very possible given nobody else wants to step up to the plate), it would be the equivalent of nationalizing the U.S. banking system (hello France). An alternative that Professor Fekete may be working on is a recapitalization using gold (and silver). More on this later. Also more on my alternative to use the U.S. Gold Reserves to create a second currency to help the U.S. dollar avoid collapse and instead die a slow, manageable death.

silverax Windbag Wisdom