Friday, September 19, 2008



In October, 1994, the US Treasury Department plans to order its bank examiners to conduct much more detailed reviews of bank holdings of derivatives, a senior Treasury official said. But perhaps too little, too late. The fact is, derivatives have become the world's biggest "black market," exceeding the illicit traffic in firearms, drugs, alcohol, gambling, cigarettes, and pirated movies. Like all black markets, derivatives are a perfect way of getting rich while avoiding taxes and regulations.

I came across the following article today & I in general agree with his assessment. You would profit to read it. I have abridged it as it is very long. I have made what I feel are the important parts in BOLD.


Something extraordinary is going on with these government bailouts. In March 2008, the Federal Reserve extended a $55 billion loan to JPMorgan to “rescue” investment bank Bear Stearns from bankruptcy, a highly controversial move that tested the limits of the Federal Reserve Act. On September 7, 2008, the U.S. government seized private mortgage giants Fannie Mae and Freddie Mac and imposed a conservatorship, a form of bankruptcy; but rather than let the bankruptcy court sort out the assets among the claimants, the Treasury extended an unlimited credit line to the insolvent corporations and said it would exercise its authority to buy their stock, effectively nationalizing them. Now the Federal Reserve has announced that it is giving an $85 billion loan to American International Group (AIG), the world’s largest insurance company, in exchange for a nearly 80% stake in the insurer . . . .

The Fed is buying an insurance company? Where exactly is that covered in the Federal Reserve Act? The Associated Press calls it a “government takeover,” but this is not your ordinary “nationalization” like the purchase of Fannie/Freddie stock by the U.S. Treasury. The Federal Reserve has the power to print the national money supply, but it is not actually a part of the U.S. government. It is a private banking corporation owned by a consortium of private banks. The banking industry just bought the world’s largest insurance company, and they used federal money to do it.

…What had to be saved at all costs was not housing or the dollar but the financial derivatives industry; and the precipice from which it had to be saved was an “event of default” that could have collapsed a quadrillion dollar derivatives bubble, a collapse that could take the entire global banking system down with it.

The Anatomy of a Bubble

Until recently, most people had never even heard of derivatives; but in terms of money traded, these investments represent the biggest financial market in the world. Derivatives are financial instruments that have no intrinsic value but derive their value from something else. Basically, they are just bets. You can “hedge your bet” that something you own will go up by placing a side bet that it will go down. “Hedge funds” hedge bets in the derivatives market. Bets can be placed on anything, from the price of tea in China to the movements of specific markets.

“The point everyone misses,” wrote economist Robert Chapman a decade ago, “is that buying derivatives is not investing. It is gambling, insurance and high stakes bookmaking. Derivatives create nothing.”1 They not only create nothing, but they serve to enrich non-producers at the expense of the people who do create real goods and services. In congressional hearings in the early 1990s, derivatives trading was challenged as being an illegal form of gambling. But the practice was legitimized by Fed Chairman Alan Greenspan, who not only lent legal and regulatory support to the trade but actively promoted derivatives as a way to improve “risk management.” Partly, this was to boost the flagging profits of the banks; and at the larger banks and dealers, it worked. But the cost was an increase in risk to the financial system as a whole.2

Since then, derivative trades have grown exponentially, until now they are larger than the entire global economy. The Bank for International Settlements recently reported that total derivatives trades exceeded one quadrillion dollars – that’s 1,000 trillion dollars.3 How is that figure even possible? The gross domestic product of all the countries in the world is only about 60 trillion dollars. The answer is that gamblers can bet as much as they want. They can bet money they don’t have, and that is where the huge increase in risk comes in….

The dominos go down in a cascade of cross-defaults that infects the whole banking industry and jeopardizes the global pyramid scheme. The potential for this sort of nuclear reaction was what prompted billionaire investor Warren Buffett to call derivatives “weapons of financial mass destruction.” It is also why the banking system cannot let a major derivatives player go down, and it is the banking system that calls the shots. The Federal Reserve is literally owned by a conglomerate of banks; and Hank Paulson, who heads the U.S. Treasury, entered that position through the revolving door of investment bank Goldman Sachs, where he was formerly CEO.

The Best Game in Town

In an article on on September 9, Daniel Amerman maintains that the government’s takeover of Fannie Mae and Freddie Mac was not actually a bailout of the mortgage giants. It was a bailout of the financial derivatives industry, which was faced with a $1.4 trillion “event of default” that could have bankrupted Wall Street and much of the rest of the financial world. To explain the enormous risk involved, Amerman posits a scenario in which the mortgage giants are not bailed out by the government. When they default on the $5 trillion in bonds and mortgage-backed securities they own or guarantee, settlements are immediately triggered on $1.4 trillion in credit default swaps entered into by major financial firms, which have promised to make good on Fannie/Freddie defaulted bonds in return for very lucrative fee income and multi-million dollar bonuses…

Desperate Measures for Desperate Times

It was the best game in town until September 14, when Treasury Secretary Paulson, Fed Chairman Ben Bernanke, and New York Fed Head Tim Geithner closed the bailout window to Lehman Brothers, a 158-year-old Wall Street investment firm and major derivatives player. Why? “There is no political will for a federal bailout,” said Geithner. Bailing out Fannie and Freddie had created a furor of protest, and the taxpayers could not afford to underwrite the whole quadrillion dollar derivatives bubble. The line had to be drawn somewhere, and this was apparently it.

Or was the Fed just saving its ammunition for AIG? Recent downgrades in AIG’s ratings meant that the counterparties to its massive derivatives contracts could force it to come up with $10.5 billion in additional capital reserves immediately or file for bankruptcy. Treasury Secretary Paulson resisted advancing taxpayer money; but on Monday, September 15, stock trading was ugly, with the S & P 500 registering the largest one-day percent drop since September 11, 2001. Alan Kohler wrote in the Australian Business Spectator:

“[I]t’s unlikely to be a slow-motion train wreck this time. With Lehman in liquidation, and Washington Mutual and AIG on the brink, the credit market would likely shut down entirely and interbank lending would cease.”5

Kohler quoted the September 14 newsletter of Professor Nouriel Roubini, who has a popular website called Global EconoMonitor. Roubini warned:

“What we are facing now is the beginning of the unravelling and collapse of the entire shadow financial system, a system of institutions (broker dealers, hedge funds, private equity funds, SIVs, conduits, etc.) that look like banks (as they borrow short, are highly leveraged and lend and invest long and in illiquid ways) and thus are highly vulnerable to bank-like runs; but unlike banks they are not properly regulated and supervised, they don’t have access to deposit insurance and don’t have access to the lender of last resort support of the central bank.”

The risk posed to the system was evidently too great. On September 16, while Barclay’s Bank was offering to buy the banking divisions of Lehman Brothers, the Federal Reserve agreed to bail out AIG in return for 80% of its stock. Why the Federal Reserve instead of the U.S. Treasury? Perhaps because the Treasury would take too much heat for putting yet more taxpayer money on the line. The Federal Reserve could do it quietly through its “Open Market Operations,” the ruse by which it “monetizes” government debt, turning Treasury bills (government I.O.U.s) into dollars. The taxpayers would still have to pick up the tab, but the Federal Reserve would not have to get approval from Congress first.

Time for a 21st Century New Deal?

Another hole has been plugged in a very leaky boat, keeping it afloat another day; but how long can these stopgap measures be sustained? Professor Roubini maintains:

“The step by step, ad hoc and non-holistic approach of Fed and Treasury to crisis management has been a failure. . . . [P]lugging and filling one hole at [a] time is useless when the entire system of levies is collapsing in the perfect financial storm of the century. A much more radical, holistic and systemic approach to crisis management is now necessary.”6 …

Proposals for reforming the banking system are not even on the radar screen of Prime Time politics today; but the current system is collapsing at train-wreck speed, and the “change” called for in Washington may soon be taking a direction undreamt of a few years ago. We need to stop funding the culprits who brought us this debacle at our expense. We need a public banking system that makes a cost-effective credit mechanism available for homeowners, manufacturing, renewable energy, and infrastructure; and the first step to making it cost-effective is to strip out the swarms of gamblers, fraudsters and profiteers now gaming the system.

No comments: