A Meltdown of the System Is Just around the Corner

January 19, 2022

It has now come out that what likely caused the near-meltdown of the financial system in September 2019, avoided only by the Fed “nationalization” of the repo market, was the blowout of a $2.7 billion credit derivative contract owned by insolvent tour operator Thomas Cook. The latter filed for Chapter 15 bankruptcy protection on Sept. 16, triggering a general panic fueled by the fact that nobody knew in detail who was involved and who was not. Interest rates on the repo market jumped to 10%, prompting the Fed to intervene the next day in order to avoid a meltdown.

A few weeks earlier, on Aug. 22-24 at their annual meeting in Jackson Hole, Wyoming, central bankers heard then Bank of England Chairman Mark Carney call for a “regime change” in monetary affairs and for a direct takeover by central banks of government fiscal policy. Certainly, they knew what the state of the system was, as evidenced by the Fed’s prompt intervention on Sept. 17.

“While Thomas Cook may have been the spark that ignited the inferno in the repo market, there were plenty of other problems contributing to a general distrust of each other among global trading houses,” Pam and Russ Martens wrote on their blog. Two such problems involved two of the large borrowers of Fed repo loans, Nomura Securities International and Deutsche Bank Securities, whose shares had plunged previous to Sept. 17 due to several factors, including scandals.

The near-meltdown of Sept. 16 forced the Fed to intervene with one-day to fifteen-day and longer-term loans which were regularly rolled over and totaled cumulatively $11.23 trillion until July 2, 2020, when the program ended. The largest beneficiary of those loans in the weeks and months following Sept. 16 was JP Morgan. JP Morgan has an exposure of $52 trillion in derivative notional value and, together with Goldman Sachs, Citigroup and Bank of America, represents 89.3% of the total notional value of derivative exposure of the entire US banking system.

The Fed takeover of the repo market bailed out those banks which, by the way, are shareholders of the Fed itself. Thus, the Wall Street banks created money through the Fed to bail themselves out.

Meanwhile, the overall debt of the trans-Atlantic economies has increased, while the physical economy has contracted during the lockdowns and has not yet recovered. U.S. industrial production dropped slightly, −0.1% in December, and is just about equal to late 2019 and 3% lower than its level of mid-2018. Manufacturing output fell by −0.3% in December and is about 5% below the mid-2018 level; again, equal to that of late 2019. Construction investment and employment are lower than in 2018, particularly in “public and government structures,” . Retail sales also fell in December, as a reaction to inflation of consumer goods.

Furthermore, a wave of insolvencies is looming as an effect of the hyperinflation in energy prices, especially in Europe. Speaking at the virtual annual meeting of the American Finance Association on Jan. 8, ECB Executive Board member Isabel Schnabel forecast a continuous rise in energy prices due to the green transition: “While in the past energy prices often fell as quickly as they rose, the need to step up the fight against climate change may imply that fossil fuel prices will now not only have to stay elevated, but even have to keep rising if we are to meet the goals of the Paris climate agreement,” she said. A repetition of the Thomas Cook derivative event is just around the corner.