The Primary Dealer System is Deadly

Below is the entire text of an article I found on Zero Hedge. Here is a link to the post on ZH. I want to capture this article for future reference because it does a good job of describing the Primary Dealer system which is a giant financial squid that has its grip on the throat of the governments around the world and has supported financial corruption in the developed economies in the world. No editorial changes, it is copied as published at ZH.

"Yesterday I noted that the “addict/ dealer” metaphor for the Fed’s intervention in the markets was in fact not accurate and that the Fed’s actions would be more appropriately described as permitted cancerous beliefs to spread throughout the financial system, thereby killing Democratic Capitalism which is the basis of the capital markets.

Today I’m going to explain what the “final outcome” for this process will be. The short version is what happens to a cancer patient who allows the disease to spread unchecked (death).

In the case of the Fed’s actions we will see a similar “death” of Democratic Capitalism and the subsequent death of the capital markets. I am, of course, talking in metaphors here: the world will not end, and commerce and business will continue, but the form of capital markets and Capitalism we are experiencing today will cease to exist as the Fed’s policies result in the market and economy eventually collapsing in such a fashion that what follows will bear little resemblance to that which we are experiencing now.

The focus of this “death” will not be stocks, but bonds, particularly sovereign bonds: the asset class against which all monetary policy and investment theory has been based for the last 80+ years.

Indeed, basic financial theory has proposed that sovereign bonds are essentially the only true “risk-free” investment in the world. While history shows this theory to be false (sovereign defaults have occurred throughout the 20^th century) this has been the basic tenant for all investment models and indeed the financial system at large going back for 80 some odd years.

The reason for this is that the Treasury (US sovereign bond) market is the basis of the entire monetary system in the US and the Global financial system in general. Indeed, US Treasuries are the senior most assets on the Primary Dealers’ (world’s largest banks) balance sheets. To understand why this is as well as why the Fed’s policies will ultimately destroy this system, you first need to understand the Primary Dealer system that is the basis for the US banking system at large.

If you’re unfamiliar with the Primary Dealers, these are the 18 banks at the top of the US private banking system. They’re in charge of handling US Treasury Debt auctions and as such they have unprecedented access to US debt both in terms of pricing and monetary control.

The Primary Dealers are:

1. Bank of America
2. Barclays Capital Inc.
3. BNP Paribas Securities Corp.
4. Cantor Fitzgerald & Co.
5. Citigroup Global Markets Inc.
6. Credit Suisse Securities (USA) LLC
7. Daiwa Securities America Inc.
8. Deutsche Bank Securities Inc.
9. Goldman, Sachs & Co.
10. HSBC Securities (USA) Inc.
11. J. P. Morgan Securities Inc.
12. Jefferies & Company Inc.
13. Mizuho Securities USA Inc.
14. Morgan Stanley & Co. Incorporated
15. Nomura Securities International Inc.
16. RBC Capital Markets
17. RBS Securities Inc.
18. UBS Securities LLC.

Bank Credit Ratings Reviewed by Moody's

Bloomberg is reporting today that Moody's has lowered its credit ratings for both Bank of America and Well's Fargo debt.

On BofA: "The government is “more likely now than during the financial crisis to allow a large bank to fail should it become financially troubled, as the risks of contagion become less acute,” Moody’s analysts wrote in a report today on the Charlotte, North Carolina-based lender.
The ratings were cut to Baa1 from A2 for long-term senior debt and to Prime-2 from Prime-1 for short-term debt. The outlook on long-term senior ratings remains negative."

On WF: "Moody’s downgraded the long-term ratings of the holding company’s senior debt to A2 from A1, according to a statement today. The outlook remains negative on the senior long-term ratings, indicating another cut may be ahead for the San Francisco-based lender."

There was also a Citigroup rating review at Moody's released today. Here is Moody's comment: "Moody's Investors Service confirmed the A3 long-term rating of Citigroup and the A1 long-term and Prime-1 short-term ratings of Citibank N.A. At the same time, Moody's downgraded the short-term rating of Citigroup (the holding company) to Prime-2 from Prime-1. The actions conclude a review for possible downgrade announced on June 2, 2011. The outlook on the long-term senior ratings remains negative."

All of these banks have seen their 'too big to fail' status enable them to take on excessive risk and transfer their losses to taxpayers, while also shielding bondholders and preventing shareholders from appropriate losses. The low credit ratings issued by Moody's is, they said, a reflection of "a decrease in the probability that the US government would support the bank, if needed".

Moody's further explains that "Moody's continues to see the probability of support for highly interconnected, systemically important institutions in the United States to be very high, although that probability is lower than it was during the financial crisis. During the crisis, the risk of contagion to the US and global financial system from a major bank failure was viewed as too great to allow such a failure to occur -- a view borne out in the aftermath of the Lehman failure. This led the government to extend an unusual level of support to weakened financial institutions and Moody's to incorporate the expectations of such support in its ratings. Now, having moved beyond the depths of the crisis, Moody's believes there is an increased possibility that the government might allow a large financial institution to fail, taking the view that contagion could be limited."

I personally believe that there is a political story behind this move. Maybe there is now a degree of separation between the interconnected banks that would retard a spread of a crisis within the banking system. The level of concern about this possibility is still so high globally that, IMHO, it seems silly to place confidence in the existence of any new protection from a bank/credit crisis.

Lending and Bank Solvency

This wholesale trade summary posted earlier today tells me that there is weak momentum behind the growth we have in our US economy. Reliant on consumers for nearly 70% of US GDP, there is still too much potential for another housing price collapse due to the number of homeowners who are underwater, the number of homes repossessed and held back from the market in support of prices of houses already listed, and the Fed is no longer providing liquidity. I expect home loans will get more difficult to qualify for than they are now. That seems to be born out in the graph from the St Louis Fed below.