IT’S THE DERIVATIVES, STUPID!

Ellen Brown, September 18, 2008
www.webofdebt.com/articles/its_the_derivatives.php

“I can calculate the movement of the stars, but not the madness of men.”
– Sir Isaac Newton, after losing a fortune in the South Sea bubble

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.  Yahoo Finance reported on September 17:

“The Treasury is setting up a temporary financing program
at the Fed’s request. The program will auction Treasury bills to raise cash for
the Fed’s use. The initiative aims to help the Fed manage its balance sheet
following its efforts to enhance its liquidity facilities over the previous few
quarters.”

Treasury bills are the I.O.U.s of the federal government. 
We the taxpayers are on the hook for the Fed’s “enhanced liquidity facilities,”
meaning the loans it has been making to everyone in sight, bank or non-bank,
exercising obscure provisions in the Federal Reserve Act that may or may not
say they can do it.  What’s going on here?  Why not let the free market work? 
Bankruptcy courts know how to sort out assets and reorganize companies so they
can operate again.  Why the extraordinary measures for Fannie, Freddie and
AIG? 

The answer may have less to do with saving the insurance
business, the housing market, or the Chinese investors clamoring for a bailout
than with the greatest Ponzi scheme in history, one that is holding up the
entire private global banking system.  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.   

Credit default swaps (CDS) are the most widely traded form
of credit derivative.  CDS are bets between two parties on whether or not a
company will default on its bonds.  In a typical default swap, the “protection
buyer” gets a large payoff from the “protection seller” if the company defaults
within a certain period of time, while the “protection seller” collects
periodic payments from the “protection buyer” for assuming the risk of
default.  CDS thus resemble insurance policies, but there is no requirement to
actually hold any asset or suffer any loss, so CDS are widely used just to
increase profits by gambling on market changes.  In one blogger’s example, a
hedge fund could sit back and collect $320,000 a year in premiums just for selling
“protection” on a risky BBB junk bond. The premiums are “free” money – free
until the bond actually goes into default, when the hedge fund could be on the
hook for $100 million in claims. 

And there’s the catch: what if the hedge fund doesn’t have
the $100 million?  The fund’s corporate shell or limited partnership is put
into bankruptcy; but both parties are claiming the derivative as an asset on their books, which they now have to write down.  Players who have “hedged
their bets” by betting both ways cannot collect on their winning bets; and that
means they cannot afford to pay their losing bets, causing other players to
also default on their bets. 

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 FinancialSense.com 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.  The value of the vulnerable bonds plummets by 70%, causing $1 trillion
(70% of $1.4 trillion) to be due to the “protection buyers.”  This is more money,
however, than the already-strapped financial institutions have to spare.  The
CDS sellers are highly leveraged themselves, which means they depend on huge
day-to-day lines of credit just to stay afloat.  When their creditors see the
trillion dollar hit coming, they pull their financing, leaving the strapped
institutions with massive portfolios of illiquid assets.  The dreaded cascade
of cross-defaults begins, until nearly every major investment bank and
commercial bank is unable to meet its obligations.  This triggers another
massive round of CDS events, going to $10 trillion, then $20 trillion.  The
financial centers become insolvent, the markets have to be shut down, and when
they open months later, the stock market has been crushed.  The federal
government and the financiers pulling its strings naturally feel compelled to
step in to prevent such a disaster, even though this rewards the profligate speculators
at the expense of the Fannie/Freddie shareholders who will get wiped out. 
Amerman concludes:

“[I]t’s the best game in town. Take a huge amount of
risk, be paid exceedingly well for it and if you screw up -- you have absolute
proof that the government will come in and bail you out at the expense of the
rest of the population (who did not share in your profits in the first place).”⁴

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 21^st 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

We may soon hear that “the credit market is frozen” – that
there is no money to keep homeowners in their homes, workers gainfully
employed, or infrastructure maintained.  But this is not true.  The underlying
source of all money is government credit – our own public credit.  We
don’t need to borrow it from the Chinese or the Saudis or private
banks.  The government can issue its own credit – the “full faith and credit of
the United States.”  That was the model followed by the Pennsylvania colonists
in the eighteenth century, and it worked brilliantly well.  Before the
provincial government came up with this plan, the Pennsylvania economy was
languishing.  There was little gold to conduct trade, and the British bankers
were charging 8% interest to borrow what was available.  The government solved
the credit problem by issuing and lending its own paper scrip.  A
publicly-owned bank lent the money to farmers at 5% interest.  The money was returned
to the government, preventing inflation; and the interest paid the government’s
expenses, replacing taxes.  During the period the system was in place, the
economy flourished, prices remained stable, and the Pennsylvania colonists paid
no taxes at all. 
(For more on this, see E. Brown, “Sustainable Energy Development: How
Costs Can Be Cut in Half,” webofdebt.com/articles, November 5,
2007.) 

Today’s credit crisis is very similar to that facing
Herbert Hoover and Franklin Roosevelt in the 1930s.  In 1932, President Hoover
set up the Reconstruction Finance Corporation (RFC) as a federally-owned bank
that would bail out commercial banks by extending loans to them, much as the
privately-owned Federal Reserve is doing today.  But like today, Hoover’s ploy
failed.  The banks did not need more loans; they were already drowning in
debt.  They needed customers with money to spend and invest.  President Roosevelt
used Hoover’s new government-owned lending facility to extend loans where they
were needed most – for housing, agriculture and industry.  Many new federal
agencies were set up and funded by the RFC, including the HOLC (Home Owners
Loan Corporation) and Fannie Mae (the Federal National Mortgage Association,
which was then a government-owned agency).  In the 1940s, the RFC went into
overdrive funding the infrastructure necessary for the U.S. to participate in
World War II, setting the country up with the infrastructure it needed to
become the world’s industrial leader after the war. 

The RFC was a government-owned bank that sidestepped the
privately-owned Federal Reserve; but unlike the Pennsylvania provincial government,
which originated the money it lent, the RFC had to borrow the money first.  The
RFC was funded by issuing government bonds and relending the proceeds.  Then as
now, new money entered the money supply chiefly in the form of private bank
loans.  In a “fractional reserve” banking system, banks are allowed to lend
their “reserves” many times over, effectively multiplying the amount of money
in circulation.  Today a system of public banks might be set up on the model of
the RFC to fund productive endeavors – industry, agriculture, housing, energy
-- but we could go a step further than the RFC and give the new public banks the
power to create credit themselves, just as the Pennsylvania government did and
as private banks do now.  At the rate banks are going into FDIC receivership,
the federal government will soon own a string of banks, which it might as well
put to productive use.  Establishing a new RFC might be an easier move politically
than trying to nationalize the Federal Reserve, but that is what should properly,
logically be done.  If we the taxpayers are putting up the money for the Fed to
own the world’s largest insurance company, we should own the Fed.

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.

Ellen Brown, J.D., developed her research skills as an
attorney practicing civil litigation in Los Angeles. In Web of Debt, her
latest book, she turns those skills to an analysis of the Federal Reserve and
“the money trust.” She shows how this private cartel has usurped the power to
create money from the people themselves, and how we the people can get it back.
Her eleven books include the bestselling Nature’s Pharmacy, co-authored
with Dr. Lynne Walker, and Forbidden Medicine.