Author's website www.webofdebt.com/
When the
smartest guys in the room designed their credit default swaps, they forgot
to ask one thing - what if the parties on the other side of the bet don't
have the money to pay up? Credit default swaps (CDS) are
insurance-like contracts that are sold as protection against default on
loans, but CDS are not ordinary insurance.
Insurance
companies are regulated by the government, with reserve requirements,
statutory limits, and examiners routinely showing up to check the books to
make sure the money is there to cover potential claims. CDS are
private bets, and the Federal Reserve from the time of Alan Greenspan has
insisted that regulators keep hands off.
The sacrosanct free
market would supposedly regulate itself. The problem with that approach is
that regulations are just rules. If there are no rules, the
players can cheat; and cheat they have, with a gambler's
addiction. In December 2007, the Bank for International Settlements
reported derivative trades tallying in at $681 trillion - ten times the
gross domestic product of all the countries in the world
combined. Somebody is obviously bluffing about the money being
brought to the game, and that realization has made for some very jittery
markets.
"Derivatives" are complex bank creations that are very
hard to understand, but the basic idea is that you can insure an
investment you want to go up by betting it will go
down. The simplest form of derivative is a short sale: you can
place a bet that some asset you own will go down, so that you are covered
whichever way the asset moves.
Credit default swaps are the
most widely traded form of credit derivative. They 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 if the
company defaults within a certain period of time, while the "protection
seller" collects periodic payments 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 speculate on market changes. In one blogger's example, a hedge
fund wanting to increase its profits 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 that hardly helps the "protection
buyers" who thought they were covered.
To the extent that CDS are being sold as "insurance,"
they are looking more like insurance fraud; and that fact has particularly
hit home with the ratings downgrades of the "monoline" insurers and the
recent collapse of Bear Stearns, a leading Wall Street investment
brokerage. The monolines are so-called because they are allowed to
insure only one industry, the bond industry. Monoline bond insurers
are the biggest protection writers for CDS, and Bear Stearns was the
twelfth largest counterparty to credit default swap trades in 2006.1 These players have been major protection
sellers in a massive web of credit default swaps, and when the
"protection" goes, the whole fragile derivative pyramid will go with
it. The collapse of the derivative monster thus appears to be both
imminent and inevitable, but that fact need not be cause for
despair. The $681 trillion derivatives trade is the last supersized
bubble in a 300-year Ponzi scheme, one that has now taken over the entire
monetary system. The nation's wealth has been drained into private
vaults, leaving scarcity in its wake. It is a corrupt system, and
change is long overdue. Major crises are major opportunities for
change.
The Wall Street Ponzi Scheme
The Ponzi scheme that has gone bad is not just another
misguided investment strategy. It is at the very heart of the banking
business, the thing that has propped it up over the course of three
centuries. A Ponzi scheme is a form of pyramid scheme in which new
investors must continually be sucked in at the bottom to support the
investors at the top. In this case, new borrowers must continually be
sucked in to support the creditors at the top. The Wall Street Ponzi
scheme is built on "fractional reserve" lending, which allows banks to
create "credit" (or "debt") with accounting entries. Banks are now allowed
to lend from 10 to 30 times their "reserves," essentially counterfeiting
the money they lend. Over 97 percent of the U.S. money supply (M3)
has been created by banks in this way.2 The problem is that banks create
only the principal and not the interest necessary to pay back their loans,
so new borrowers must continually be found to take out new loans just to
create enough "money" (or "credit") to service the old loans composing the
money supply. The scramble to find new debtors has now gone on for
over 300 years - ever since the founding of the Bank of England in 1694 -
until the whole world has become mired in debt to the bankers' private
money monopoly. The Ponzi scheme has finally reached its mathematical
limits: we are "all borrowed up."
When the banks ran out of creditworthy borrowers, they
had to turn to uncreditworthy "subprime" borrowers; and to avoid losses
from default, they moved these risky mortgages off their books by bundling
them into "securities" and selling them to investors. To induce
investors to buy, these securities were then "insured" with credit default
swaps. But the housing bubble itself was another Ponzi scheme, and
eventually there were no more borrowers to be sucked in at the bottom who
could afford the ever-inflating home prices. When the subprime
borrowers quit paying, the investors quit buying mortgage-backed
securities. The banks were then left holding their own suspect paper;
and without triple-A ratings, there is little chance that buyers for this
"junk" will be found. The crisis is not, however, in the economy
itself, which is fundamentally sound - or would be with a proper credit
system to oil the wheels of production. The crisis is in the banking
system, which can no longer cover up the shell game it has played for
three centuries with other people's money.
The Derivatives Chernobyl
The latest jolt to the massive derivatives edifice came
with the collapse of Bear Stearns on March 16, 2008. Bear Stearns
helped fuel the explosive growth in the credit derivative market, where
banks, hedge funds and other investors have engaged in $45 trillion worth
of bets on the credit-worthiness of companies and countries. Before
it collapsed, Bear was the counterparty to $13 trillion in
derivative trades. On March 14, 2008, Bear's ratings were downgraded
by Moody's, a major rating agency; and on March 16, the brokerage was
bought by JPMorgan for pennies on the dollar, a token buyout designed to
avoid the legal complications of bankruptcy. The deal was backed by a
$29 billion "non-recourse" loan from the Federal
Reserve. "Non-recourse" meant that the Fed got only Bear's shaky
paper assets as collateral. If those proved to be worthless, JPM was
off the hook. It was an unprecedented move, of questionable legality;
but it was said to be justified because, as one headline put it, "Fed's
Rescue of Bear Halted Derivatives Chernobyl." The notion
either that Bear was "rescued" or that the Chernobyl was halted,
however, was grossly misleading. The CEOs managed to salvage their
enormous bonuses, but it was a "bailout" only for JPM and Bear's
creditors. For the shareholders, it was a wipeout. Their stock
initially dropped from $156 to $2, and 30 percent of it was held by the
employees. Another big chunk was held by the pension funds of
teachers and other public servants. The share price was later raised
to $10 a share in response to shareholder outrage, but the shareholders
were still essentially wiped out; and the fact that one Wall Street bank
had to be fed to the lions to rescue the others hardly inspires a feeling
of confidence. Neutron bombs are not so easily contained.
The Bear Stearns hit from the derivatives iceberg
followed an earlier one in January, when global markets took their worst
tumble since September 11, 2001. Commentators were asking if this was
"the big one" - a 1929-style crash; and it probably would have been if
deft market manipulations had not swiftly covered over the approaching
catastrophe. The precipitous drop was blamed on the threat of
downgrades in the ratings of two major monoline insurers, Ambac and MBIA,
followed by a $7.2 billion loss in derivative trades by Societe Generale,
France's second-largest bank. Like Bear Stearns, the monolines serve as
counterparties in a web of credit default swaps, and a downgrade in their
ratings would jeopardize the whole shaky derivatives edifice. Without
the monoline insurers' traiple-A seal, billions of dollars worth of
triple-A investments would revert to junk bonds. Many institutional
investors (pension funds, municipal governments and the like) have a
fiduciary duty to invest in only the "safest" triple-A
bonds. Downgraded bonds therefore get dumped on the market,
jeopardizing the banks that are still holding billions of dollars worth of
these bonds. The downgrade of Ambac in January signaled a
simultaneous downgrade of bonds from over 100,000 municipalities and
institutions, totaling more than $500 billion.3
Institutional investors have lost a good deal of money in
all this, but the real calamity is to the banks. The institutional
investors that formerly bought mortgage-backed bonds stopped buying them
in 2007, when the housing market slumped. But the big investment
houses that were selling them have billions' worth left on their books,
and it is these banks that particularly stand to lose as the derivative
Chernobyl implodes.4
A Parade of Bailout Schemes
Now that some highly leveraged banks and hedge funds have
had to lay their cards on the table and expose their worthless hands,
these avid free marketers are crying out for government intervention to
save them from monumental losses, while preserving the monumental gains
raked in when their bluff was still good. In response to their pleas,
the men behind the curtain have scrambled to devise various bailout
schemes; but the schemes have been bandaids at best. To bail out a
$681 trillion derivative scheme with taxpayer money is obviously
impossible. As Michael Panzer observed on SeekingAlpha.com:
As the slow-motion train wreck in our financial system
continues to unfold, there are going to be plenty of ill-conceived rescue
attempts and dubious turnaround plans, as well as propagandizing,
dissembling and scheming by banks, regulators and politicians. This is all
happening in an effort to try and buy time or to figure out how the losses
can be dumped onto the lap of some patsy (e.g., the taxpayer).
The idea seems to be to keep the violins playing while
the Big Money Boys slip into the mist and man the lifeboats. As was
pointed out in a blog called "Jesse's Café Americain" concerning the
bailout of Ambac:
It seems that the real heart of the problem is that AMBAC
was being used as a "cover" by the banks which originated these bundles of
mortgages to get their mispriced ratings. Now that the mortgages are
failing and the banks are stuck with them, AMBAC cannot possibly pay, they
cannot cover the debt. And the banks don't wish to mark these CDOs
[collateralized debt obligations] to market [downgrade them to their real
market value] because they are probably at best worth 60 cents on the
dollar, but are being held by the banks on balance at roughly par. That's
a 40 percent haircut on enough debt to sink every bank involved in this
situation . . . . Indeed for all intents and purposes if marked to
market banks are now insolvent. So, the banks will provide
capital to AMBAC . . . [but] it's just a game of passing money around. . .
. So why are the banks engaging in this charade? This looks like an
attempt to extend the payouts on a vast Ponzi scheme gone bad that is
starting to collapse . . . .5
The banks will therefore no doubt be looking for one
bailout after another from the only pocket deeper than their own, the U.S.
government's. But if the federal government acquiesces, it too could
be dragged into the voracious debt cyclone of the mortgage mess. The
federal government's triple A rating is already in jeopardy, due to its
gargantuan $9 trillion debt. Before the government agrees to bail out
the banks, it should insist on some adequate quid pro quo. In
England, the government agreed to bail out bankrupt mortgage bank Northern
Rock, but only in return for the bank's stock. On March 31, 2008,
The London Daily Telegraph reported that Federal Reserve
strategists were eyeing the nationalizations that saved Norway, Sweden and
Finland from a banking crisis from 1991 to 1993. In Norway, according
to one Norwegian adviser, "The law was amended so that we could take 100
percent control of any bank where its equity had fallen below zero."6 If their assets were "marked to
market," some major Wall Street banks could already be in that
category.
Benjamin Franklin's Solution
Nationalization has traditionally had a bad name in the
United States, but it could be an attractive alternative for the American
people and our representative government as well. Turning bankrupt
Wall Street banks into public institutions might allow the government to
get out of the debt cyclone by undoing what got us into it. Instead
of robbing Peter to pay Paul, flapping around in a sea of debt trying to
stay afloat by creating more debt, the government could address the
problem at its source: it could restore the right to create money to
Congress, the public body to which that solemn duty was delegated under
the Constitution.
The most brilliant banking model in our national history
was established in the first half of the eighteenth century, in Benjamin
Franklin's home province of Pennsylvania. The local government created its
own bank, which issued money and lent it to farmers at a modest interest.
The provincial government created enough extra money to cover the interest
not created in the original loans, spending it into the economy on public
services. The bank was publicly owned, and the bankers it employed
were public servants. The interest generated on its loans was
sufficient to fund the government without taxes; and because the newly
issued money came back to the government, the result was not
inflationary.7 The Pennsylvania banking scheme was a
sensible and highly workable system that was a product of American
ingenuity but that never got a chance to prove itself after the colonies
became a nation. It was an ironic twist, since according to Benjamin
Franklin and others, restoring the power to create their own currency was
a chief reason the colonists fought for independence. The bankers'
money-creating machine has had two centuries of empirical testing and has
proven to be a failure. It is time the sovereign right to create
money is taken from a private banking elite and restored to the American
people to whom it properly belongs.
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, which has sold 285,000
copies. Her websites are www.webofdebt.com and www.ellenbrown.com .
NOTES
1 "Credit Swap Worries Go
Mainstream," nakedcapitalism.com (February 17, 2008); Aline van Duyn,
"CDS Sector Weighs Bear Stearns Backlash," Financial Times (London)
(March 16, 2008).
2 See Ellen Brown, "Dollar Deception:
How Banks Secretly Create Money," webofdebt.com/articles (July 3,
2008).
3 "Monoline Insurance," Wikipedia.
4 Jane Wells, "Ambac and MBIA: Bonds,
Jane's Bonds," CNBC (February 4, 2008).
5 "Saving AMBAC, the Homeowners, or the
Banks?", Jesse's Café Americain (February 25, 2008).
6 Ambrose Evans-Pritchard, "Fed Eyes
Nordic-style Nationalisation of US Banks," International Business Editor
(March 31, 2008).
7 See Ellen Brown,
Web of Debt (Third Millennium Press, 2008), chapter
3.