NightBlogger

Martin D. Weiss, Ph.D. writes: On October 11, 2008, a single statement hit the international wire services that provides more specific clues: “Intensifying solvency concerns about a number of the largest U.S.-based and European financial institutions have pushed the global financial system to the brink of systemic meltdown.” This statement was not the random rant of a gloom-and-doomer on the fringe of society. Nor was it excerpted from a twentieth century history book about the Great Depression. It was the serious, objective assessment announced at a Washington, D.C. press conference by the Managing Director of the International Monetary Fund (IMF). The unmistakable implication: So many of the world’s largest banks were so close to bankruptcy, the entire banking system was vulnerable to a massive collapse. The primary underlying cause: Derivatives.

The Mafia knows all about systemic meltdowns of gambling networks. In the numbers racket, for example, players place their bets through a bookie, who, in turn is part of an intricate network of bookies. Most of the time, the system works. But if just one big player fails to pay bookie A, that bookie might be forced to renege on bookie B, who, in turn stiffs bookie C, causing a chain reaction of payment failures. The bookies go bankrupt. The losers lose. And even the winners get nothing. Worst of all, players counting on winnings from one side of their bets to cover losses in offsetting bets are also wiped out. The whole network crumbles — a systemic meltdown. To avert this kind of a disaster, the Mafia henchmen know exactly what they have to do, and they do it swiftly: If a gambler fails to pay once, he could find himself with broken bones in a dark alley; twice, and he could wind up in cement boots at the bottom of the East River.

Unlike the Mafia, established stock and commodity exchanges, like the NYSE and the Chicago Board of Trade, are entirely legal. But like the Mafia, they understand these dangers and have strict enforcement procedures to prevent them. When you want to purchase 100 shares of Microsoft, for example, you never buy directly from the seller. You must always go through a brokerage firm, which, in turn is a member in good standing of the exchange. The brokerage firm must keep close tabs on all its customers, and the exchange keeps close track of all its member firms. If you can’t come up with the money to pay for your shares, the broker is required to promptly liquidate your securities, literally kicking you out of the game. And if the brokerage firm as a whole runs into financial trouble, it meets a similar fate with the exchange. Very, very swiftly!

Here’s the key: For the most part, the global derivatives market has no brokerage, no exchange, and no equivalent enforcement mechanism. In fact, among the $181.2 trillion in derivative bets held by U.S. banks at mid-year 2008, only $8.2 trillion, or 4.5%, was regulated by an exchange. The balance — $173.9 trillion, or 95.5% — was bets placed directly between buyer and seller (called “over the counter”). And among the $596 trillion in global derivatives tracked by the BIS at year-end 2007, 100% were over the counter. No exchanges. No overarching enforcement mechanism. This is not just a matter of weak or non-existent regulation. It’s far worse. It’s the equivalent of an undisciplined conglomeration of players gambling on the streets without even a casino to maintain order. Moreover, the data compiled by the OCC and BIS showed that the bets were so large and the gambling so far beyond the reach of regulators, all it would take was the bankruptcy of one of the lesser derivatives players — such as Lehman Brothers — to throw the world’s credit markets into paralysis.

That’s why the world’s highest banking officials were so panicked when Lehman Brothers failed in the fall of 2008. As the IMF managing director himself admitted, the threat was not stemming from just one bank in trouble; it was from many; and those banks weren’t lesser players; they were among the largest in the world. Which U.S. banks placed the biggest bets? Based on mid-year 2008 data, the OCC provided some answers:

Citibank N.A., the primary banking unit of Citigroup, held $37.1 trillion in derivative bets. Moreover, only 1.7% of those bets were under the purview of any exchange. The balance — 98.3% — was direct, one-on-one bets with their trading partners outside of any exchange.

Bank of America was a somewhat bigger player, holding $39.7 trillion in derivative bets, with 93.4% traded outside of any exchange.

But JPMorgan Chase was, by far, the biggest of them all, towering over the U.S. derivatives market with more than double BofA’s book of bets — $91.3 trillion worth. This meant that JPMorgan Chase controlled half of all derivatives in the U.S. banking system — a virtual monopoly that tied the firm’s finances with the fate of the U.S. economy far beyond anything ever witnessed in modern history. Meanwhile, $87.3 trillion, or 95.7% of Morgan’s derivatives, were outside the purview of any exchange.

One bank! Making bets of unknown nature and risk! Involving a dollar amount equivalent to six years of the total production of the entire U.S. economy! In contrast, Lehman Brothers, whose failure caused such a large earthquake in the global financial system, was actually small by comparison — with “only” $7.1 trillion in derivatives.

The potential havoc that might be caused by a Citigroup failure, with bets that involve five times more money than Lehman’s — and the financial holocaust that might be caused by a JPMorgan failure with close to 13 times more than Lehman — boggles the imagination. How bad could it actually be? No one knows, and therein lies one of the primary dangers. In the absence of oversight, the regulators simply do not collect the needed who-when-what information on these bets. More

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FT.com — Company default rates could rise to levels not seen since the Great Depression because of the rapid deterioration in the global economic outlook since the collapse of Lehman Brothers. The default rate for speculative or junk-grade debt could rise to 14.9 per cent by the end of next year, the highest level since 1932 when it peaked at 15 per cent, according to ratings agency Moody’s Investors Service. This is the agency’s most pessimistic scenario, with the main so-called baseline forecast rising to 10.4 per cent for the end of 2009, a marked jump from a month ago when it was predicted to rise to 7.9 per cent. This jump is a result of expectations of a steeper US downturn, which will undermine growth across the globe. More

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Our economy didn’t melt down, it was taken down the unbridled greed of economic elites, enabled by their political courtesans in Washington.

Jim Hightower
What the hell’s happening here? Why is my bank in the tank? And my house and job? And my retirement money? Even my state’s teetering on the brink of broke! Who did this to us? Fair questions, but we’re not getting honest answers. Last year, at the first signs of the global financial slide toward the abyss, we were told that it’s just a little hiccup caused by something called subprime mortgages. Not to worry, the Powers That Be declared confidently, for we have the damage contained. And rest assured that “the fundamentals of our economy are sound.”

Then, this spring, Bear Stearns cratered, requiring an emergency federal subsidy to cover billions in bad loans. Okay, admitted those in charge, that subprime stuff actually is leveraged on up the financial system, and maybe there’s been a bit of greed among a few of the big players, but we really do have the problem contained now, and, hey, “the fundamentals of our economy are sound.”

But in September–Omigosh!–there went Lehman Brothers, Freddie Mac and Fannie Mae, AIG, Merrill Lynch, Goldman Sachs, Citigroup, WaMu, Wachovia, and others. Well, yes, conceded the now-frazzled financial establishment, but gollies, we’re throwing hundreds of billions of your tax dollars into sandbags to contain the problem, and remember: “The fundamentals of our economy are sound.”

In October, the contagion rolled through Britain, Canada, and Europe; it spread to Brazil and across to China and Japan; and–Holy Schmoly–suddenly all of Iceland was melting in bankruptcy! Stay calm, cried an openly panicked chorus of Washington officials, for we’re holding some big summit meetings soon and consulting our Ouija boards, and…uh…ah…um…y’all just keep clinging to the thought that “the fundamentals of our economy are sound.”

Let’s meet some of the illusionists who are directly responsible for hurling you, me, America, and most of the world into this dark and as-yet unplumbed economic hole. More

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John Sakowicz
Bohemian.com
How prime brokers paved the way for the biggest bank heist in history
Movies by Werner Herzog, Rainer Werner Fassbinder, Margarethe von Trotta, Volker Schlöndorff, Wim Wenders–you know the genre. Their movies are difficult and dense. Mostly, they are horrid. I hate these movies, but have never forgotten one. I make the comparison because Wall Street, like German New Wave cinema, has always featured heroes with impossible dreams or people with unique talents in obscure fields. And like German New Wave, the obsessiveness of Wall Street’s main characters has also always taken the place of plot. The plan of Wall Street’s hot shots has always been that there is no plan. People are on their own. God is absent. Truth is elastic. The important thing is to keep on pushing.

In the lives of these characters, whether from German New Wave or Wall Street, a lot is improvised. For both groups, life is lived in the theater of the ridiculous. In the Wall Street version, that materializes in statements such as “I am ridiculously rich” or “I am ridiculously lucky.” It’s generally the opposite for characters in German New Wave. In German New Wave movies, chickens often stand in for people. It’s too painful to watch a German New Wave movie without a little existential comic relief every now and then, and the directors know it. There are long shots of chickens on the beach, buried up to their necks in sand, as the tide comes in. Shots of dancing chickens. Hypnotized chickens. Cannibalistic chickens. Dwarves throwing chickens. Chickens talking to themselves. Chickens jumping off of cliffs.

Lately, the chickens have come home to roost on Wall Street. And like German New Wave cinema, the stories coming out of Wall Street this year are touched by the ridiculous, but more fundamentally Wagnerian in scope, influenced by operatic themes. Themes like character, ambition, greed, scandal, disgrace, bankruptcy, ignominy, shame and even justice. Yes, justice.

Bear Stearns Bust

On Thursday, June 19, the FBI made its first big bust since last summer’s subprime mess, the first big bust since the housing and credit crises that followed the subprime mess pushed our country into a recession. Hooray for the FBI. They busted hundreds of housing developers, mortgage lenders and brokers, lawyers, real estate agents and appraisers across the country, while two hedge fund managers on Wall Street were arrested in a separate but related case. (Incidentally, those two guys were referred to, but not named, in our May 28 article, “Secrets and Lies,” about Bear Stearns.)

FBI director Robert Mueller was quick to congratulate himself. “This dragnet operation is an example of our unified commitment to address a significant crime problem,” he told reporters. “The FBI will continue to direct its investigative and analytic resources toward the mortgage fraud and corporate securities fraud that threaten our nation’s economy.” Nice start, Bob.

The fact that the investigation is ongoing underscores that the problems on Wall Street are not isolated to even a few hundred bad apples. “These arrests make it clear that the causes of our credit problems are very broad-based and can’t be put at the feet of any one player,” Mark Zandi of Moody’s said at the same press conference. “It makes it clear that everyone was involved to one degree or another–from lender to investment banker to hedge fund manager–all the way from the bottom to the top.” You forgot to mention someone, Mr. Zandi. You too, director Mueller.

Prime brokers. The new masters of the universe. Among all their colleagues on Wall Street, it is the prime brokers who dream the most impossible dreams and who have the most unique talents in the most obscure fields. If Werner Herzog were to make a movie about Wall Street today, he would be looking into the face of the prime broker. I’m reading from a possible movie review: “The face of the prime broker has the quality of a dream–at once vivid, but vague; easy to touch, but beyond reach; at once scary like science fiction and ethereally lovely like a fantasy. It is a beautiful face, reflected in the eerie blue of a computer screen, but in the end, it is the last face you will see before the market crashes.”

So who are they, these prime brokers? These guys who print the new money in the shadow banking system? These guys who live for all that is unregulated and opaque? First of all, they are not regular people. “They are professional madmen,” said Warren Buffet in his famous 2005 speech to shareholders at Berkshire Hathaway. Except for Warren Buffet, nobody spoke up. Since Buffet’s speech, billions and billions of dollars, perhaps a trillion, were stashed in offshore accounts, as Wall Street managed its own fortune. (It’s a myth that Wall Street manages the fortunes of its clients. It does not. It serves itself the cake. We’re lucky if a few crumbs fall off the plate.) Let’s now break this silence, and with it the omerta of prime brokerage.

‘Unspoken Terror’

It all started innocently enough, generically enough. In the beginning, through the 1980s and ’90s, prime brokers were the guys at big investment banks like UBS, Morgan Stanley, Merrill Lynch, Goldman Sachs, Bear Stearns, Lehman Brothers, etc., who supported the nascent hedge fund industry with basic services. A hedge fund start-up–and there were thousands of them back in the ’80s and ’90s, as many as 8,000 at one time–usually bought a basic package from a prime broker. The core services in the package included global custody (clearing, custody and asset servicing; no problem, all plain vanilla); securities lending (especially for what’s called “naked short sales,” which is illegal); financing (facilitating the crazy extreme leverage at hedge funds, sometimes as high as 40-to-1); customized technology (providing hedge funds with reporting necessary to value positions and risk; this is where things started to get funky); and operational support (prime brokers became the hedge fund’s primary operations contact with all other members of the broker-dealer community, and oh, did this invite abuse).

It is easy to see how young hedge funds became so dependent on prime brokers. Prime brokers served as incubators for hedge fund hatchlings that were proliferating like so many baby chicks at a Tyson chicken farm. In addition to all the above services, prime brokers also provided what is quaintly called “value-added” services in the hedge fund industry, including capital introduction (introductions to the prime broker’s institutional clients and other possible investors, a blatant conflict of interest but nobody in Congress cared); office space leasing and services (read: free or discounted office space, replete with staff and support–a bribe for business? you bet); risk management advisory services (prime brokers advising hedge funds on the very same junk bonds they secretly wanted to dump on them); and something ambiguously called “consulting services” (often focused on how hedge funds could circumvent established regulatory requirements, usually by domiciling operations beyond the jurisdiction of U.S. law).

It got worse after 2000.

Introduce swaps and derivatives into the mix. Yeah, baby. Things suddenly got really interesting. Preserving the integrity of the balance sheet at hedge funds got thrown out the window as swaps and derivatives grew, including the exponential growth of something called “synthetic positions.”

“Synthetic” means fake, bogus, fixed, fraudulent. It’s that simple. Add to synthetic positions the liquidity of the first years of our decade as Alan Greenspan brought interest rates down to almost nothing, and you get the picture. In one year alone, from 2005 to 2006, the market for credit default swaps, just one product, grew from $12.4 trillion to $26 trillion.

Most markets are a zero-sum game, meaning there are an equal number of winners and losers. For every dollar someone makes, someone else loses a dollar. Prime brokers changed all that. Because prime brokers never lost. Prime brokers acting as the hedge fund industry’s only interface with the world (see “operational support,” above) were able to create a shadow banking system where the counterparties to any hedge fund’s trades were unknown, even to the hedge fund. Add to that opaqueness a lack of infrastructure where a lot of trades are unconfirmed or delayed, and there are the makings for greatest bank heist in history.

While the Federal Reserve Bank has since 1996 published reports on these obvious problems, it wasn’t until September 2005 that the Fed addressed what was termed the “unspoken terror” of settlement issues among prime brokers. Funny that it took two more years before Congress noticed. All it took to get their attention were last summer’s subprime mess, the blow-up at Bear Stearns and a country plunged into a recession.

Shadow Masters

Dreamers and those with unique talents in obscure fields are the folks who built the shadow banking system. They are the prime brokers. Like actors in a Werner Herzog movie, they inhabit a strange new world, one as big as the traditional banking system or bigger, but where there are no federally insured deposits and where shadow banks neither have nor want–or even need–access to short-term borrowing from the Fed or any other central bank during times of crisis. It’s a world where no risk is too great, where collateral isn’t necessary, where there are no capital requirements and where counterparties are never identified. Shadow banks are beyond the reach of law, are almost always found offshore and redefine the term “international crime organization.” Indeed, because shadow banks always make money, they would even profit from the collapse of the global financial system. They might even cause it to happen.

Prime brokers have been the new masters, no question about it. But their primacy may finally be threatened. “This bright new financial system–for all its talented participants, for all its rich rewards–has failed the test of the market place,” said Paul Volker, former president of the Federal Reserve, during a speech I attended in April. “It adds up to a clarion call for reform.” Two months later, at a press conference where I was also present, Timothy Geithner, president of the Federal Reserve Bank of New York, answered that call.

“The structure of the financial system changed radically during the boom, with dramatic growth outside the traditional banking system,” Geithner warned in his speech, adding that unregulated growth in opaque assets made the last crisis difficult to manage and could make a future crisis impossible to manage. And two weeks before the FBI busted those two guys at Bear Stearns, U.S. Treasury Secretary Henry Paulson said the Federal Reserve should “be allowed to collect information from large complex financial institutions.” He said, “Regulators should have a clear path toward figuring out how to intervene in a crisis and how to close a failed brokerage firm.”

Sounds like Paulson is expecting more trouble. If this were a New Wave German film instead of the banal horror of real life, someone would figure out that it must be time to pull out the chickens.
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John Sakowicz is a Sonoma County investor who was a cofounder of a multibillion-dollar offshore hedge fund, Battle Mountain Research Group. Arianna Carisella contributed research to this article.

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Daily Mail
Goldman Sachs is on course to pay its top City bankers multimillion-pound bonuses - despite asking the U.S. government for an emergency bail-out. The struggling Wall Street bank has set aside £7billion for salaries and 2008 year-end bonuses, it emerged yesterday. Each of the firm’s 443 partners is on course to pocket an average Christmas bonus of more than £3million. The size of the pay pool comfortably dwarfs the £6.1billion lifeline which the U.S. government is throwing to Goldman as part of its £430billion bail-out.

As Washington pours money into the bank, the cash will immediately be channelled to Goldman’s already well-heeled employees. News of the firm’s largesse will revive the anger over the ‘rewards for failure’ culture endemic in the world of high finance. The same bankers who have brought the global economy to its knees seem to pocketing the same kind of rewards they got during the boom years.

Gordon Brown has vowed to crack down on the culture of greed in the City as part of his £500billion bail-out of the UK banking industry. But that won’t affect the estimated 100 London partners working at Goldman Sachs’s London headquarters. The firm - known as Golden Sacks for the bumper bonuses it pay its top bankers - is expected to cut the payouts by a third this year. However, profits are falling much faster. Earnings have plunged 47 per cent so far this year amid the worst financial crisis since the Great Depression.

This has wiped more than 50 per cent off the company’s market value. The news comes after it was revealed that even bankers working for collapsed Wall Street giant, Lehman Brothers, could receive huge payouts. Its 10,000 U.S. staff are expected to share a £1.5billion bonus pool. The payouts were agreed as part of the rescue takeover of Lehman’s American arm by Barclays last month. The blockbuster handouts caused consternation among London employees of the firm, many of whom have now lost their jobs. Even workers at the nationalised Northern Rock will scoop bonuses worth up to £50million over the next three years.

The extraordinary handouts include more than £400,000 for Rock’s boss, Gary Hoffman, who is likely to become Britain’s best-paid public sector worker. The majority of Northern Rock’s 4,000 workers will receive four separate bonus payments - the first of which will be made next March. Staff will get an extra 10 per cent on top of their basic salary. More

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George Washington’s Blog
Forget the stock market gyrations. Forget Bernanke and Paulson’s ineffective, unconstitutional schemes.

Thursday’s auction for Lehman’s credit default swaps (CDS) is much more important.

Why?
Well, if banks are reassured by the CDS auction, it could do more to free up frozen capital than all of the Fed and Treasury’s ill-conceived plans put together.

As Bill Gross, head of $721 billion dollar fund Pimco, says:

Credit markets are based on trust and when there is no trust, markets can freeze up . . . . Imagine yourself at the drive-thru ordering a Big Mac. At one window you order and pay, at the other – 20 feet ahead – you pick up your lunch. What if you thought that after paying at the first window, your 1000 calorie sandwich might not be waiting for you a few seconds later. You might not pay; business as usual might not take place. That is what is happening in the credit markets. They are frozen in “McFear.” After the failure of Lehman Brothers – an investment bank which took orders at one window, and promised to pay at another for trillions of dollars of those CDS, swaps, and other derivative “sandwiches” – institutional investors said that they’d prefer to stay at home and have peanut butter instead of risking their money ordering a Big Mac. And so their money goes into that figurative mattress instead of the register at McDonald’s, people are laid off, profits go down, bank loans become less available, our economic center cannot hold.

An auction occurred today to determine the value of Freddie and Fannie’s CDS. While there were approximately $500 billion in CDS written against Freddie and Fannie, those who issued CDS will be repaid between 91.5 percent and 99.9 percent of protection they sold. In other words, the issuers of such CDS will only have to pay out between .1 and 8.5 cents on the dollar.

For a rough, back-of-the-envelope calculation, let’s split it down the middle and call it 95% of $500 billion, which means that the issuers of Freddie and Fannie CDS will only have to pay out about 5 cents on the dollars, or about $25 billion total. That’s a lot of money, but not catastrophic.

On the other hand, “investors who wrote protection on a Lehman default will have to pay out between 81 and 85 cents on the dollar.”

No one has disclosed how many billions of dollars in Lehman CDSs are out there. And no one knows the exact payout amount which will be determined at Thursday’s auction.

But it is known that “Lehman was one of the 10 largest parties participating in credit default swaps, the New York Times reports. The company’s most recent quarterly filing said it bought and sold $729 billion in derivatives with a fair net value of $16.6 billion.” And a lot of people bought CDS betting on Lehman’s failure in September.

D-Day

So Thursday is D-Day, where “D” is for “derivatives”.

If there are a lot of Lehman CDS out there, and if the auction price comes in high, it could greatly exacerbate the global economic crisis no matter what Bernanke and Paulson do. On the other hand, if there aren’t that many CDS out there, or if the price comes in lower than people expect, it would be a huge sign of stability in the CDS market that could reassure financial institutions and investors worldwide, which could “free up liquidity” and help avert a depression (no matter what Bernanke and Paulson do). More

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Stephen Lendman
… and here’s what we’ve got. A global asset bubble. A predictable crisis allowed to build and mushroom. Begun after Chicago School economics took hold under Ronald Reagan. Continued under GHW Bush. Became religion under Bill Clinton, and ultimately fundamentalism under GW Bush.

The result - a “slow motion train wreck” gaining speed. Banks and other financial institutions failing globally. On September 25, the largest bank failure in US history with Washington Mutual’s collapse. Earlier it was giant insurer AIG. Before that Fannie Mae and Freddie Mac, Lehman Brothers, Bear Stearns, and Merrill Lynch a forced liquidation to Bank of America.

Others are now teetering on the edge. Strapped by toxic debt. The result of out-of-control greed for easy profits. Massive fraud to get them. Thinking they’re the best and brightest, and only mere mortals mess up. Knowing Fed moral hazard will cushion them if they do. True for some. Not for others, and learning that the Federal Reserve (the world’s key central bank) failed in its primary job. To protect the country’s financial system from insolvency. By contributing to a financial crisis and one of confidence. By creating near-limitless amounts of capital. Fueling a housing bubble. Outsized consumer debt, and irresponsible investments free from government oversight. Fraudulent ones involving multi-trillions of dollars.

Partnering with government to make it easy. Risking a global economic meltdown as a result. Scrambling to find solutions. Unsure if there are any. The present crisis is unparalled. Maybe it can be fixed, and maybe not. The problem is multi-fold. A perfect storm involving:

– residential housing;

– commercial real estate;

– consumer over-indebtedness;

– unknown amounts of toxic debt (in the multi-trillions);

– affecting world finance and economies;

– causing bankruptcies;

– many more will follow;

– selected ones bailed out;

– the entire system endangered;

– consumer money market, bank accounts and private pension funds as well; government backing is needed to protect them; there’s not enough money to do it; and

– the contagion is spreading; threatening world economies and people everywhere.

This time is really different. A $700 billion bailout (called the Emergency Economic Stabilization Act of 2008 - EESA) is just a down payment. Trillions will be needed in the end. Other nations contributing to help. The problems are deeper and more intractable than anyone expected. Before this ends, unimaginable amounts of capital will be written off. Too much to even contemplate. Bad investments contaminating good ones. Threatening world financial structures with paralysis. Severe economic damage to their economies as a result. Eroding industrial capitalism as we know it. At best managing a short-term fix and delaying a final denouement for a later time. Under new management with the current and past ones claiming no responsibility. And unmindful of millions of homeowners facing foreclosure and bankruptcy. One in ten currently behind in their payments. Others losing their jobs and way of life. They’re the most vulnerable. Least able to cope, and for some their ability to survive.

According to The New York Times, here’s how the Paulson scheme helps them: “it requires the government to use its new role as owner of distressed mortgage-backed securities to make ‘more aggressive’ efforts to prevent home foreclosures.” Weasel words. No specifics. No assurances, and nothing apparently for homeowners already in foreclosure.

On September 22, ahead of the announced agreement, American Research Group (ASG) published its latest public sentiment poll results, and they were stunning. At 19%, George Bush scored lowest ever for a US president, surpassing Harry Truman at the depth of the Korean War and Richard Nixon during Watergate. It came at a time ASG’s results showed 82% of Americans believe the economy is getting worse, and only 17% approve of how Bush is handling it. Among registered voters, the number is 18% at a time no one surveyed (zero percent) said the economy is improving and 68% say it’s in recession. True or false, it’s how they feel. How the crisis affects them, and that’s what counts most.

Yet on September 24, the president addressed the nation audaciously. Callously dismissing public pain and anger. Deceitfully stating outright lies. A typical performance. Demanded that Congress give the treasury secretary carte blanche authority over $700 billion to address “a serious financial crisis.” Asked taxpayers to pay for corporate fraud. Reward criminals and ignore their crimes. Said nothing about the root cause. The effect on ordinary people, or how Paulson’s scheme will help them. Ignored growing public opposition. Large numbers of credible observers believing the proposed solution is worse than the problem. The most honest of them saying it will enrich fraudsters and offer no help for homeowners.

Yet Bush concluded that “democratic capitalism (is the) best system the world has ever devised” in spite of clear evidence that it’s broken and corrupted. Exploits people for profit. Enriches the few at the expense of the many. Rewards criminals for their crimes. Protects the rich from beneficial social change.

Ahead of the president’s address on September 24, The New York Times showed a rare display of candor in a critical Timothy Egan opinion piece. About “nearly nationalizing the banking system and giving the treasury secretary more power than a king….whose decisions may not be reviewed by any court of law or any administrative agency.” He asked readers to remember “where the biggest heist took place, and how Wall Street dragged down the rest of the country once before,” referring to the Great Depression but leaving out everything in between.

He stressed, however, “how Wall Street brought down main street,” and things have now come full circle. Deregulation unleashed casino capitalism, and bankers made a killing. Now they’re in trouble and Bush demands “the biggest bailout in American history….or the world will crumble. He said the a similar thing in the run-up to war” so who can believe him now. Egan quotes a dirt farmer asking why not the same “concerns (for) average Americans.” Because “we the people” Bush speaks for are them, not us.

As for Paulson’s plan, here’s what the Financial Times writer Martin Wolf said on September 23. He called it “not a true solution to the crisis.” It doesn’t address the “fundamental problem.” It’s “neither a necessary nor an efficient solution. It is not necessary because the (Fed can) manage illiquidity through its many lender-of-last resort operations. It is not efficient because it can only deal with insolvency by buying bad assets (overpriced junk) at far above their true value, thereby guaranteeing big losses for taxpayers and providing an open-ended bail-out to the most irresponsible investors.”

Wolf also objects to Paulson getting unchecked powers. Providing little or no help to the poor and “ill-informed” (read duped) borrowers, and lists other operational suggestions “essential for the long-run health of any financial system” without needing “a penny of public money.” Among them, forcing creditors to take losses and not taxpayers.

Unmentioned in his article is the underlying fraud behind the crisis and a lack of regulatory oversight that made it easy. Also, omitted was what’s covered in the section below.

The 1937 Housing Act’s Empowering Section 8 Authority

One Section 8 sentence provided the basis for the treasury secretary’s empowerment. It reads:

“Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administration agency.”

In other words, unchallengeable czarist powers. In contrast to the 1930s Reconstruction Finance Corporation’s (RFC) closely supervised operations. That era’s Home Owners’ Loan Corporation (HOLC) that refinanced homes to prevent foreclosures. And the 1980s Resolution Trust Corporation (RTC) mandate to liquidate assets from failed S & Ls. Not dispense free money for bad investments unchecked. The above authorities subject to judicial review. Not governed by a financial boss to run as he pleased.

The Announced “Bailout” Deal - The Emergency Stabilization Act of 2008 (ESA)

According to The New York Times, EESA calls for “strict oversight of the program by a Congressional panel and conflict-of-interest rules for firms hired by the Treasury to help run the program.” Also “a change in the bankruptcy laws sought by some Democrats to give judges the authority to modify the terms of first mortgages.”

Given the bipartisan blame for today’s crisis. The post-9/11 willingness to give the administration near-carte blanche authority across the board. Eight years of indifference to social needs and public welfare. Who now believes that policy going forward will change and that the agreed-on scheme will protect people or curb the secretary’s authority. On his own initiative, George Bush usurped supreme power post-9/11 while few in Congress blanched. None in leadership positions. Little today has changed.

Disclaimers notwithstanding from both sides of the aisle, Wall Street is pleased. Paulson got what he wanted. The plan’s fine print will assure it. Public money. Far more, if needed, than $700 billion. The power to dispense it freely. With weak at best oversight and judicial review, and the ability to conceal fraud and malfeasance. In short, the between-the-lines meaning of Paulson saying: “We have made great progress toward a deal, which will work and be effective in the marketplace.”

The same one that fleeced the nation and betrayed the public trust. Now empowered to take more with the full faith and blessing of the government from both sides of the aisle. Belying George Bush’s insult that “The rescue effort….is not aimed at Wall Street; it is aimed at your street.” And Nancy Pelosi’s hypocrisy that: “All of this was done in a way to insulate Main Street and everyday Americans from the crisis on Wall Street….I want to congratulate all of the negotiators for the great work they have done.” Who in banker boardrooms would disagree.

Some Relevant Facts

Clearly the present crisis is unprecedented. As stated above, maybe it can be fixed and maybe not. No one is sure because no one understands it fully. Where all the problems lie. To what degree can they be contained. How great their fallout may be. Their full effect on world economies. How bad things may get before they stabilize and improve, and the way the world will look like when they do.

Whatever’s coming, industrial capitalism is eroding. A kleptocracy replaced it. If the system is saved, it will be temporary, and an even greater one will emerge. Why this article is called Grand Theft America. A criminal class runs it, and they’re rewarded for their crimes. Backed by the full faith and credit of the government with taxpayer money. A near-limitless amount created and borrowed. Who said crime doesn’t pay!

For over 30 years, an unimaginable wealth transfer to the rich has been ongoing. To the top 1% and corporate America from most others. It proves the failure of a system that rewards the few at the expense of the many. Licenses greed and creates this kind of global financial crisis so far uncontained. It begs the questions: what caused it and what’s the fallout:

– the ruinous effects of militarization; insane amounts of spending on it; “military Keynesianism;” believing capitalism thrives on foreign wars; “Global Wars on Terrorism” currently; their costs are unsustainable and are heading the nation toward bankruptcy;

– the drain on an already weakened economy;

– maxed out consumers now debt slaves;

– so is government from unrepayable obligations in the tens of trillions; not the fictitious “official” reported numbers;

– the possibility of future default; hyperinflation; national bankruptcy, and the demise of the republic;

– human default as well: mass bankruptcies; home foreclosures; rising unemployment; increased poverty; and growing numbers of families unable to survive;

– the subprime crisis is just part of it; seven million mortgages sold to the unwary; the idea was to criminally defraud them; offer two-year teaser rates; then reset them higher semi-annually based on an interest rate benchmark; payments soared as much as 30% and became unaffordable; the scheme was to cash in at the expense of mortgage holders, and five million risk losing their homes and life savings;

– an “economic Pearl Harbor” for Warren Buffett; for Senator Chris Dodd a “50-state Katrina;” a “house of cards (built on) reckless finance” for author Kevin Phillips; Frankenstein finance; casino capitalism; for most Americans, a human catastrophe;

– the demise of our manufacturing base; letting malls replace factories as the economy’s engine;

– permitting the financialization of the economy; speculative finance writ large; replacing productive investment; totally deregulated; run by fraudsters; free from government oversight; letting investment banks game the system at up to 40 to 1 leverage; until 2004, 12 to 1 was the maximum;

– a government - business conspiracy for global dominance and the single-minded pursuit of profit; unfettered amounts of it through cleverly manipulated schemes; transferring multi-trillions of dollars from workers to the most wealthy; doing it without people even noticing;

– creative destruction to let giant businesses grow larger by removing and devouring smaller ones; even large ones;

– permitting and/or ignoring massive fraud; involving multi-trillions of dollars; the largest ever Ponzi scheme; a calculated crime with media complicity through silence; not reporting a growing problem as it emerged; waiting until it mushroomed and still not explaining it accurately and honestly; and

– wondering won if the best and brightest can fix things or if no amount of money or ingenuity can do it.

The Plan’s Architect - Henry Paulson

From a Nixon administration staff assistant to the assistant secretary of defense. To assistant to key Watergate official John Erlichman. To Goldman Sachs in 1974. To a partnership in the firm in 1982. Then Chief Operation Officer (COO) in 1994 and CEO in 1998 by a palace coup against co-chairman and now New Jersey governor Jon Corzine, according to New York Times columnist Floyd Norris.

Even before the current crisis, Goldman was the preeminent Wall Street firm. A survivor. The largest, and along with Morgan Stanley, the remaining two Street giants left standing. But no longer as investment banks after the Federal Reserve’s September 21 announcement that both companies will become bank holding companies after a mandatory five-day waiting period, now over.

In theory, they’ll be under stricter Fed oversight but will get Fed help to complete their transition and thereafter. As a well-connected financial powerhouse, whatever Goldman wants, Goldman gets. Always in the past by recycling top executives into Democrat and Republican administrations, and now more than ever given Henry Paulson’s extraordinary financial czar powers.

Before his $700 billion giveaway plan, the 2008 Housing and Economic Recovery Act gave him authority to fleece taxpayers by rescuing Fannie Mae and Freddie Mac as well as raise the national debt by over $5 trillion dollars. He also orchestrated the demise of Bear Stearns, Lehman Brothers and Washington Mutual. The forced sale of Merrill Lynch, and arranged the government takeover of AIG.

He has near-open checkbook authority to reward close allies with loans and free money and let them acquire troubled assets on the cheap. This from a man with much responsibility for today’s crisis. A June 12, 2006 Business Week cover story titled “Mr. Risk Goes to Washington” called him “one of the key architects of a more daring Wall Street, where securities firms are taking greater and greater chances in their pursuit of profits.” Such as assuming huge amounts of debt and “placing big bets (with their own money) on all sorts of exotic derivatives and other securities.” Advising clients to do the same. Casino capitalism at up to 40 to one leverage. Hugely profitable in up markets. Disastrous in down ones.

Paulson earned millions and now has an estimated $700 million + net worth. For 2007 overall, according to Bloomberg.com, “Wall Street’s five biggest firms (paid out) a record $39 billion in bonuses (and did it in) a year when three of the companies suffered the worst quarterly losses in their history and shareholders lost more than $80 billion.”

Speculative finance pays well, even in down years, and it even raised Bloomberg’s ire in a Michael Lewis September 24 commentary titled “America Must Rescue the Bonuses at Goldman Sachs.” It reflected on a possible global financial collapse but sacrificing Goldman bonuses is another matter. If firm “employees (take) pay cut(s), it will be (tantamount to failure and) our country may never recover.” How will the company induce new talent to come aboard. Goldman is well-positioned to get maximum gain from its former CEO’s $700 billion handout.

Why else would Warren Buffett bet $5 billion on the firm! For preferred shares paying an annual 10% dividend. Warrants as well to buy $5 billion in common stock at a $115 a share strike price. Well off its $251 peak and below the latest September 26 $138 a share.

Joseph Stiglitz on the Economy

Stiglitz was formerly part of the system he now criticizes. Free market fundamentalism in its most extreme form. For many months, he warned about a worsening global economy and growing financial crisis that’s as bad or worse than the Great Depression.

He sees similar problems now as then:

– outsized speculation through excessive leverage;

– pyramid schemes;

– multiple bubbles through so-called Wall Street innovations; and

– a lack of transparency and government oversight.

Combined they created a crisis “so great that no one knows exactly the magnitude of the risk they face. It is particularly bad because our financial institutions are based on trust. You put money in the bank and you trust that you can get (it) out, so trust is absolutely essential for the functioning of our financial markets and economy.”

The problem is exacerbated by those providing the news. The dominant media and frequent spokespeople. Industry representatives like Lehman Brothers CEO saying last April that “we turned the corner, and the economy is on the uptick.” Also from the president, treasury secretary and others in government as things keep worsening.

Stiglitz calls this a “top down crisis.” The “$3 trillion cost” of foreign wars a key. Creating huge deficits and consuming vital resources needed for growth. “This is the first war in American history that has been totally financed on the credit card. For the last five years….we have been a debt economy.” Not since the Revolutionary War have “we have had to turn to foreigners,” so now “40% of our national debt is financed by (them). Even as we went (to war) we had a big deficit, and yet the president called for tax cuts for upper middle class Americans.” Insane but we did it.

Another factor is other countries trusting that our economy is working well, and when the president says it is he’s believable. “This administration burned that trust….no wonder everybody around the world is losing confidence.” Even worse is that the administration isn’t dealing responsibly with these problems, mostly because they’re of our own making.

Stiglitz worries about the “real economy:” home prices dropping; owners forced into foreclosure; more financial firms in crisis; and a good many won’t survive. He sees a weakening financial system unable or unwilling “to provide credit (the lifeblood of the economy for) loans, mortgages,” and that means lower home prices, contracting businesses, rising unemployment, and a “downward vicious cycle. You have to be in fantasy land to say that everything is fine (or even) that we have turned the corner.” He sees at least another 18 months of pain. Maybe longer. Who can know or how much.

For sure, real economic stimulus is needed. Productive investment. Not the phony “bailout” kind proposed. Aiding state and local governments. Better unemployment insurance and more for infrastructure. Providing a basis for long-term growth. Not feeding markets and starving the hungry, as one writer put it. Not believing markets on their own will fix things.

Understanding that government must intervene. Responsibly. Facilitate job creation. End casino capitalism. Provide incentives for real economic growth. Let foreclosed and threatened homeowners stay in their homes. Work out an equitable way to do it. “We learned a painful lesson in the 1930s and today: The invisible hand often seems invisible because it’s not there.” It led to the kind of predicament now confronting the country. The solutions proposed will just compound it.

Ones that Can Fix It

Good ones not considered. From figures like Dean Baker of the Center for Economic and Policy Research. Others as well with solid advice to:

– make fraudsters eat the bulk of their losses;

– use public funds only “to sustain the orderly operation of the financial system;”

– minimize speculative finance; the root of the current problem;

– “minimize moral hazard” - the Paulson (and Bernanke) “put” picking up where Greenspan left off;

– let delinquent homeowners stay in their homes and pay rent;

– curtail executive compensation for companies getting government aid;

– make a key Fed responsibility the prevention of asset bubbles; reinstitute regulations to do it; Glass-Steagall for starters that prohibited commercial and investment banks and insurance companies from combining;

– impose a modest financial transactions tax to curb excesses and raise revenue;

– trade assets, like credit default swaps, openly on exchanges to establish fair value for them;

– impose strict limits on leverage;

– keep Fannie and Freddie public institutions; their status before being privatized in 1968; and

– restructure the Fed democratically; a far better solution is abolish it and let government control its own money; use it responsibly for all Americans, not just the privileged few.

Other recommendations recognize no quick or easy solutions to problems this great. Economist James Galbraith says borrowers need collateral. A new Home Owners Loan Corporation to rewrite mortgages. Manage rental conversions, and decide what degraded properties should be demolished. Which ones to save and refurbish. Set it up in communities under federal guidelines and do it quickly. Help state and local governments strapped for cash. Reestablish federal revenue sharing. A National Infrastructure Bank making capital available for infrastructure. Put people to work building it. Protect seniors and near-retirees from wealth loss. Extra Social Security, Medicare and Medicaid revenue will help. Get money in the hands of people who’ll spend it.

Address other crucial issues like energy conservation, reconstruction and renewable power. Infrastructure overall. Tuition help for students. Another GI bill. Credit card and mortgage interest rate caps. Rescind anti-consumist laws like the misnamed 2005 Bankruptcy Abuse Prevention and Consumer Protection Act. A boon for credit card companies and other businesses. Unfairly burdensome to the public.

A whole range of other projects and ideas to redirect the economy away from speculative finance and militarism and toward high-return public investment. Do it before it’s too late. Recognize that the present course is unsustainable. Imagine a government working for everyone and not just the privileged few. Imagine it not tolerating fraud and malfeasance.

Instead, Congress agreed to a “bailout” and passed a record $634 billion omnibus spending bill (to run the government through March 6, 2009) to include a record Pentagon budget; $25 billion in low-interest auto industry loans; maybe with no provision for repayment; lifting a quarter-century ban on Atlantic and Pacific off-shore drilling; billions more in earmarked pork; and likely more coming later for the airlines and other endangered companies. Taxpayers for Common Sense criticized the bill at the same time it noted that government “bailout” appropriations will reach about $1.2 trillion with the $700 billion Paulson scheme. Others put the total above $1.5 trillion, and many say it’s only for starters.

Paying “hold-to-maturity” prices compounds the fraud. For securitized assets worth a fraction of full value. Much of it pennies on the dollar, if anything. Trillions of dollars of toxic ones. All sorts of them. Newly invented ones. Structured finance and insurance. Asset-backed securities. Repackaged into marketable pools. Sold to investors. It’s been done for decades but only recently so out of hand. Greed and deregulation created an alphabet soup of levered-up, high-risk securitized assets. Financial alchemy. Largely outright fraud, including:

– collateralized debt obligations (CDOs), including auto loans, credit and corporate debt;

– collateralized (asset-backed home) mortgage obligations (CMOs);

– commercial mortgage-backed securities (CMBS);

– mortgage-backed securities (MBS) and levered loans;

– structured investment vehicles (SIVs);

– special purpose vehicles (SPVs);

– pass-through securities;

– credit and interest rate default swaps;

– commercial paper and more;

– repackaged arcane stuff most people don’t understand; even investors who bought them; like eating a stew with no idea what’s in it; a recipe with no list of ingredients; learning too late it’s toxic and you’re in trouble;

Credit card companies as well from growing amounts of unrepayable credit card debt. The auto industry already assured of a low-interest $25 billion loan (or maybe handout) for starters. Airlines coming next. Select homebuilders and troubled companies called too big to fail. If they’re too big to fail, says one observer, they’re too big to exist.

EESA will give the treasury secretary near-carte blanche powers to conceal fraud and help the fraudsters, including his former company, Goldman Sachs, now in trouble. Pick and choose among others. Which will survive, and what less favored ones will go on the block at fire sale prices or disappear. Today there are 9000 banks in the country. In a decade, half or more of them may be gone.

Economist Michael Hudson calls EESA “cash for trash” and a “giveaway,” not a bailout. A “transfer of wealth to insiders.” A financial coup d’etat. The “largest and most inequitable (kind) since the (19th century) land giveaways to the railroad barons.”

In this case, socializing losses to let fraudsters “sell out all their bad bets.” Junk of all sorts: a stew of securitized assets, bad mortgages, car loans, credit card loans, student loans, anything for insiders stuck with too much of them.

A doomed scheme that will raise the debt level instead of lowering it. Enrich fraudsters with taxpayer funds. Stick the public with toxic junk. Maybe buy time before more people and markets catch on, but, in the end, cripple the economy and erode industrial capitalism with it.

Hudson is justifiably angry given the amount of fraud and deceit. The government-concocted scheme to whitewash it. Reward criminals. Harm most others, and wreck the country at the same time. He says a “kleptocratic class has taken over the economy to replace industrial capitalism….’banksers’ ” for FDR and earlier condemned by Jefferson with this stinging comment:

“I sincerely believe that banking institutions are more dangerous to our liberties than standing armies. Already they have raised up a money aristocracy that has set the government at defiance. The issuing power should be taken from the banks and restored to the people to whom it properly belongs.”

A half century later Lincoln said:

“I see in the near future a crisis approaching that unnerves me and causes me to tremble for the safety of my country….corporations (including bankers) have been enthroned and an era of corruption in high places will follow, and the money power of the country will endeavor to prolong its reign by working upon the prejudices of the people until all wealth is aggregated in a few hands and the Republic is destroyed.”

Lincoln refused to pay bankers usurious rates to finance the Civil War and got Congress to pass the 1862 Legal Tender Act. It empowered the US Treasury to issue “greenbacks” that were interest-free because government printed its own money. When Lincoln was assassinated in 1865, the “Greenback Law” was rescinded. A new national banking act was passed, and the government once again had to pay interest to bankers.

On June 4, 1963, President Kennedy issued executive order (EO) 11110 giving the president authority to issue currency. He ordered the treasury to begin printing “United States (Treasury) Notes” to replace “Federal Reserve Notes.” He began a process to let government control its own money and no longer private bankers under the guise of the Federal Reserve. Months later, Kennedy was assassinated. Once Lyndon Johnson took office, he rescinded EO 11110 and reestablished the current system. More on that below.

The Two Greatest Ever Financial Crimes - Today’s Fraud and the 1913 Federal Reserve Act’s Privatization of Money Creation

Most people think the Federal Reserve is a government agency, subject to its control. It’s sometimes mistakenly called a quasi-governmental decentralized central bank to disguise its real identity and purpose. Its Eccles building headquarters compounds the subterfuge. Below it’s stripped away.

The Federal Reserve is a private for-profit banking cartel. Owned and run by major banks and Wall Street in each of its 12 Districts. It was created and operates in violation of Article 1, Section 8 of the Constitution that states that Congress alone shall have the power to create money and regulate its value. In 1935, the Supreme Court ruled that Congress cannot constitutionally delegate this power to another authority, but, in fact it did.

On December 22, 1913, between 1:30 - 4:30 AM, the Federal Reserve Act was shepherded through a special Congressional Conference Committee. Then voted on and passed the next day. Two days before Christmas with many members gone and most others with no time to read or consider this momentous document.

By enacting this law, Congress and President Woodrow Wilson defrauded the public. Wilson later said (when it was too late to matter) he made a mistake and “unwittingly ruined my country.” This from a man who was an intellect. Trained in the law. A PhD in political science and president of Princeton University in his earlier years.

The Federal Reserve Act gives private bankers the most important of all powers. The one most of all that governments should never relinquish. The authority to print money. Control its supply. Its price through the Fed Funds rate and how it influences the whole yield curve. Loan it out for profit, and charge government interest on its own money. It’s later returned minus operating expenses and a guaranteed 6% profit. Taxpayers foot the bill. An early and continuing example of wealth transfer from the public to powerful bankers. Illegally sanctioned by Congress and the president.

The Fed literally creates money out of nothing. Expands or contracts its supply as it wishes - with no government oversight or control. Gold once backed it until Nixon closed the gold window in August 1971. Suspended dollar convertibility into the metal, and ended compliance with the Bretton Woods core provision. The US dollar became fiat currency. Mere paper. Backed by nothing except the faith of the issuing authority.

Given today’s crisis, that faith is fast eroding and is to blame for dollar weakness. Mostly because of profligate policies by private bankers running the country’s monetary policy for their own gain. The grandest of grand thefts along with today’s all-consuming fraud. Backed by the full faith and credit of the government, and up to now at least, with most people none the wiser.

A Growing Public Response to the Crisis

For how long is the question given growing public anger and people expressing it publicly. It has administration officials worried enough to order what Michel Chossudovsky wrote in his September 26 article titled “Pre-election Militarization of the North American Homeland.”

He cites an Army Times article saying that the 3rd Infantry’s 1st Brigade Combat Team is coming home (in October) from Iraq as (according to the Times) “an on-call federal response force for natural or manmade emergencies and disasters, including terrorist attacks.” Perhaps with a manufactured incident as pretext. To defend the homeland against ourselves. Be deployed against dissent. Erupting public anger. On city streets like in Denver and St. Paul. Displaying civil disobedience. Defiance against fraud, deceit, illegal foreign wars, and nearly eight intolerable years under George Bush and a complicit Congress. Capped by the current financial crisis touching everyone while government rewards crime and hangs its victims out to dry.

Chossudovsky is blunt about the possibilities. The 3rd Infantry’s 1st Brigade is for combat. It’s not the National Guard or local police. It’s trained for war. “Equipped to kill people” with potent weapons, and a last hurrah scheme may be planned to divert public attention from the financial crisis. A “terrorist” attack with “chemical, biological” or other dangerous weapons. A possible pretext for martial law at a time the administration and Congress are vulnerable. When people are angry about Washington protecting the privileged. Partnering with them in crime. Defrauding the public and stifling dissent. Moving one step closer to tyranny and away from silly notions about democracy. Proving crime indeed does pay and awfully well on Wall Street. “It’s the economy, stupid.” Theirs, not ours. More

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Wall Street Journal
Federal investigators have opened preliminary probes into the financial troubles of four high-profile companies that are at the center of the current financial turmoil that the Bush administration says requires an unprecedented proposed taxpayer-funded bailout to clean up. The Federal Bureau of Investigation’s preliminary inquiries are focusing on whether fraud helped cause some of the troubles at Fannie Mae, Freddie Mac, Lehman Brothers Holdings Inc. and American International Group Inc., according to senior law-enforcement officials. More

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(Bloomberg)
U.S. Treasury three-month bill rates dropped to the lowest since World War II as a loss of confidence in credit markets worldwide prompted investors to abandon higher-yielding assets for the safety of the shortest- term government securities. Investors pushed down the rate to 0.0203 percent on concern that credit market losses will widen after the bankruptcy of Lehman Brothers Holdings Inc. and the federal takeover of American International Group Inc. In a sign of banks’ reluctance to lend, the rates charged for short-term loans relative to Treasury bill rates rose to the highest at least since the stock market crash of 1987. “It’s scary,” said E. Craig Coats Jr., who co-heads fixed income at Keefe, Bruyette & Woods Inc. in New York and started trading bonds in 1969. “This is the worst it’s ever been since I’ve been in the business. Nobody knows what’s really going on. Systemic risk is here and there and everywhere.” More

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nytimes.com
When Lehman Brothers filed for bankruptcy on Monday, it became the latest but surely not the last victim of the subprime mortgage collapse. Lehman owned more than $600 billion in assets. Financial institutions around the world have already reported more than half a trillion dollars of mortgage-related losses and that figure will most likely double or triple before the crisis exhausts itself. But there is a bigger potential failure lurking: the American International Group, the insurance giant. It poses a much larger threat to the financial system than Lehman Brothers ever did because it plays an integral role in several key markets: credit derivatives, mortgages, corporate loans and hedge funds. More

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Nils Pratley
The Guardian
If this is the death of Wall Street as we know it, the tombstone will read: killed by complexity. The complexity lies in modern markets’ love affair with derivatives - the financial contracts sold to the world as a way to reduce risk. Got too many mortgages on your balance sheet? No problem, slice them up, package them, sell them on. Worried about your trading partner defaulting? Buy some insurance. The possibilities are almost endless.

The gross value of outstanding derivatives is now counted in tens of trillions of dollars. A traditional backwater of the investment banking business has become a principal activity. The underlying philosophy behind derivatives sounds terrific. The weak can get rid of risks they can’t handle and the financial system should be stronger as a result. In the right hands, derivatives can perform this role.

But the general practice is very different, as the great investor Warren Buffett worked out years ago. His 2002 letter to his Berkshire Hathaway shareholders made headlines by condemning derivatives as “financial weapons of mass destruction”. They were “time bombs, both for the parties that deal in them and the economic system”. The passage comprised only a couple of pages of a lengthy letter but read it again today - it is the best guide to understanding how Wall Street has arrived at today’s mess.

Here is Buffett on General Re Securities, a derivatives dealer that Berkshire inherited with its purchase of insurer General Re. “At year-end (after 10 months of winding down its operation) it had 14,384 contracts outstanding, involving 672 counterparties around the world. Each contract has a plus or minus value derived from one or more reference items, including some of mind-boggling complexity. Valuing a portfolio like that, expert auditors could easily and honestly have widely varying opinions.”

Now take a look at Lehman Brothers’ balance sheet. On page 62 of last year’s accounts, under the heading “off balance sheet arrangements” you will find a staggering figure. Lehman had derivative contracts with a face value of $738bn. The notes, fairly, make the point that the fair value is smaller than the notional amount - Lehman believed the figure was $36.8bn. Even so, “mind-boggling complexity” perfectly describes Lehman’s accounts. How can you hope to sell such a business over a weekend? You can’t, unless the state is willing to underwrite the risk. This time, the US Treasury said no.

Corporate meltdown

Complexity breeds other faults, as Buffett described. Derivatives, because they are so hard to value, make it easier for traders and chief executives to inflate earnings. They exacerbate problems if a company, for unrelated reasons, suffers a credit downgrade that requires it to post collateral with counterparties - “a spiral that can lead to a corporate meltdown”, he wrote. They create a “daisy chain” of risk as the troubles of one company infect another because, ultimately, the value depends on the creditworthiness of the other party.

Buffett made a gloomy prediction half a decade ago. “The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear,” he said. “Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts.”

That event has duly arrived. Lehman Brothers has declared bankruptcy. Merrill Lynch has rushed into the arms of Bank of America to avoid the daisy chain of risk. The fate of AIG, once America’s biggest insurer, lies in the hands of the Fed - the company has been caught by the fear that it will have to post collateral, the spiral Buffett described.

Unwinding a big derivatives book is no easy task - like Hell, derivatives are easy to enter and impossible to exit, said Buffett. That is why the failure of a firm the size of Lehman, Wall Street’s fourth largest investment bank, presents such a risk to the financial system - we don’t know how many other firms will be brought down as the body is extracted from the financial web.

Hedge funds can be heard complaining that they don’t know what will happen to trades they executed with Lehman last week.

Financial regulators have huffed and puffed for years about the possible dangers posed by derivatives. Timothy Geithner, the Fed’s man in New York and the official who chaired the weekend crisis summit on Lehman, wondered a couple of years ago whether their use might make financial crises less common, but more severe. He was right about the second bit.

There are, of course, many other contributors to the current financial crisis - years of cheap money, a housing bubble, and so on. But derivatives have helped to inflate these pressures because they have grown without proper rules on disclosure. They have allowed junk to accumulate in the system.

But financial regulators must now know what must happen in the long term. It’s time for them to force better disclosure. They didn’t last time, when hedge fund Long-Term Capital Management collapsed in 1998. This time really has to be different.

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(Reuters) - Insurer American International Group Inc struggled for survival a day after a financial tsunami swept away investment bank Lehman Brothers and forced the sale of rival Merrill Lynch in the biggest financial industry shake-up since the Great Depression. AIG scrambled for a financial lifeline on Monday after investment bank Lehman Brothers Holdings Inc failed to find a rescuer and Merrill Lynch & Co Inc agreed to be taken over by Bank of America Corp. The U.S. Federal Reserve has hired investment bank Morgan Stanley to review options for AIG — which has lost some 92 percent of its value so far this year — a person familiar with the situation said Monday.

AIG’s precipitous stock decline has led ratings agencies to threaten downgrades that could force it to post more collateral and nullify insurance contracts, possibly setting in motion a chain reaction that could threaten its survival. In an ominous sign, two ratings agencies went ahead with downgrades after the market closed on Monday. “AIG seems to be the next guy on the chopping block,” said Tom Sowanick, chief investment officer at Clearbrook Financial LLC in Princeton, New Jersey.

Again seeking a private solution to Wall Street’s woes, the Fed had asked JPMorgan Chase & Co and Goldman Sachs Group Inc to explore arranging $70 billion to $75 billion in loans to support AIG, among other financing options, another person familiar with the situation said. Fearing a financial meltdown, the U.S. presidential candidates sparred Monday over who could best restore the system’s health, with Republican John McCain pledging reform and Democrat Barack Obama saying hands-off Republican policies were the problem. More

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New York Times
A lot of smart people have tried to call the bottom on Wall Street this year. So far, they have all been wrong. Since the financial crisis first hit in August 2007, markets — and the financial industry — have gone through a series of swoons, each more dizzying than the last. Last week, the crisis reached a new pitch, as Lehman Brothers, the fourth-largest United States investment bank, struggled to avoid joining Bear Stearns on the trash heap, and Washington Mutual, the largest savings and loan, saw its shares briefly fall below $2. Now even Wall Street’s professional optimists have given up predicting exactly when their industry might stabilize. One senior executive at a top investment bank, speaking anonymously so he could speak freely, recently observed that the crisis was entering its “19th inning,” with no ending in sight. More

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Source: Forbes.com
Citigroup and Bank of New York Mellon are trustees to $138 billion of Lehman Brothers’ bonds, the biggest on the list of unsecured creditors, according to a petition filed in New York bankruptcy court on Monday. Banks are trying to calm employees and clients in the wake of Lehman’s bankruptcy filing Monday. which is also reeling from exposure to mortgage securities and rising loan losses, said in a memorandum Monday by CEO Vikram Pandit that the firm had strong liquidity and capital positions. Pandit also wants to motivate them to focus on business. “It is important that we maintain our unrelenting focus on the needs and concerns of our clients and shareholders,” Pandit said in the memo. “We are confident about the future despite a very challenging time.” Citi also had a $275 million bank line out to Lehman (nyse: LEH - news - people ), according to the bankruptcy filing. Bank of New York Mellon is exposed to $17 billion of bond debt.

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The Market Ticker
Lehman Brothers has gone down and Bank America has forcibly swallowed Merrill Lynch. Forced by The Fed, one assumes - they surmised (correctly) that come Monday shorts would attack Merrill immediately and in force, thrusting them to the bottom of the pool if they did not first insure that they couldn’t be attacked. So a deal was brokered, and now we have gone from five investment banks to two, with the count decreasing by fifty percent in one day. That’s right - Morgan Stanley and Goldman Sachs are all that’s left, and they won’t last long. Say good-bye to the last pieces of the Depression-era legislation that prohibited the co-mingling of investment and commercial banking, the hard way.

ALL investment and commercial banking is now in the hands of a very small number of institutions, with the key players being JP Morgan and Bank of America. This is not a good thing folks. Not at all. At the same time The Fed orchestrated this they also announced that the “23A Exemptions” that limit to 10% the “passthrough” financing to affiliates was being “temporarily suspended” on a blanket basis. In addition, The Fed has announced that it will take equities as collateral for loans. “Equities” is a fancy name for stocks. That’s right - for the first time in history, now banks can take stocks to the discount window. Maybe even their own stocks. The Fed has gone from taking only the highest-quality securities - “AAA” rated debt instruments - to taking everything up to and including the most dangerous (common stock) all at once!

…this effectively makes The Fed a margin lender on the equity markets! You think they don’t have a reason to interfere in the market eh? Oh boy, now they have billions of reasons, all of them sitting on their balance sheet! Fair and open markets? Bah! Note carefully folks - this effectively makes The Fed LONG (that is, a “buyer”) of STOCKS. What’s even better is that they don’t eat their own losses if there are any - they’re yours! That’s because The Federal Reserve Act says that the profits (or losses) from The Fed flow through to the Treasury (after operating expenses) which means that now, suddenly The Federal Government is potentially directly exposed to losses in the stock market!

Now it has always been true that The Government “loses” when the market goes to hell as it gets less in the way of tax receipts. But that’s different than suffering an actual capital loss - and that is now possible. You think you’ve seen “intervention” in the stock market in the past? Bah! You’ve seen nothing yet; now we have The Fed going entirely outside of the boundaries of The Federal Reserve Act and literally making things up as they go along. More

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Markert Ticker
When The Fed summarily declared the financial system in “crisis”, thereby granting itself powers that it arguably did not have (including lending to non-banks acquiring equity interest!) the markets roared with thunderous applause, and Congress clucked with approval. The people yawned and reached for another beer. When the TAF, PDCF, and TSLF, all “alphabet soup” means of pumping extra liquidity into a financial system that was in trouble as a direct consequence of previous excess liquidity fed into it by Alan Greenspan, the market roared with thunderous applause. When Treasury instantaneously doubled the federal debt, we heard the roar of thunderous applause.

And last afternoon, when a rumor started floating around that The Fed was going to once again intervene, this time to “take under” Lehman Brothers, we once again heard the market roar with thunderous applause, rising by more than 1% in - literally - less than 5 minutes. We are truly an idiot nation. The Truth is that these institutions - all of them - got in trouble by writing paper in an imprudent manner. They loaned money to people who couldn’t pay it back. As bankers, it is their job to know whether their customer can in fact pay, but that all went out the window in the “New Era of Finance”, where you can shovel off your crap to someone else, forcing them to be the bagholder when it all goes “boom” rather than you.

What these geniuses forgot is that in real life it doesn’t work this way, even if you think it should or might. What happens in real life is that people get greedy, and this is shortly followed by a bout of stupidity, where you lend out money on looser and looser terms, until finally you reach the point that the only real qualification is that you have a pulse. At the same time there is always a backlog of this paper in your shop, and when the inevitable gravy train of suckers runs out, you find yourself sitting on a sizable number of these nuclear weapons - and they’re all ticking.

Never mind that there’s a matter of ethics here, in that these bankers knew the paper was bad. This no different, really, than selling Pintos that you know will explode if struck from behind. It was and is a defective product, and whether it “booms” on you or someone else the fact remains that these bankers knew these loans were unsound when they wrote them. They simply didn’t care. More

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(Bloomberg)
Merrill Lynch & Co., Wachovia Corp., Lehman Brothers Holdings Inc. and the rest of the U.S. finance industry are about to find out how expensive credit has become. Banks, securities firms and lenders have a record $871 billion of bonds maturing through 2009, according to JPMorgan Chase & Co., just as yields are at their most punitive compared with Treasuries. The increase in yields may cost them as much as $23 billion more in annual interest versus a year ago based on Merrill Lynch index data. Higher refinancing expenses will restrict the ability of banks to borrow in the capital markets and lend, further cutting off credit to consumers and businesses and curbing what is already the slowest growing economy since 2001. Standard & Poor’s said last week that it had a “negative” outlook on almost half of the 50 highest-rated financial institutions in the U.S. as of June 30, the highest proportion in 15 years.

“The gears of capitalism are grinding to a halt,” said Mirko Mikelic, senior bond fund manager at Grand Rapids, Michigan-based Fifth Third Asset Management, which oversees $21 billion in assets. “There is a tremendous concern over the banking sector and a scramble right now for capital.” The Federal Reserve’s quarterly lending survey released Aug. 11 said that more banks tightened credit for consumers and business borrowers. About 65 percent indicated they tightened standards on credit card loans over the previous three months, up “notably” from about 30 percent in the April survey.

Investors on average demand yields of 4.14 percentage points more than what they can get on Treasuries to purchase bank bonds, up from the low last year of 0.76 percentage point in January, according to Merrill Lynch index data. Spreads on investment- grade rated bonds overall average about 3.14 percentage points. “The credit crunch is only now beginning because bank capital is so constricted by losses to date, that they will have to begin shutting off credit to households and corporations and that’s when we get the defaults,” David Goldman, the former head of fixed-income research at Bank of America Corp.’s securities unit in New York, said in a Bloomberg Radio interview. Goldman, who is now an investor, said he shut down a fund he ran because the markets are likely to become “brutal.” Interest-rate derivatives imply that banks are even becoming hesitant to lend to each other amid the flood of maturing debt. More

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PETER S. GOODMAN