FedUpUSA

Archive for August 9th, 2010

Today there is a horrific derivatives bubble that threatens to destroy not only the U.S. economy but the entire world financial system as well, but unfortunately the vast majority of people do not understand it.  When you say the word “derivatives” to most Americans, they have no idea what you are talking about.  In fact, even most members of the U.S. Congress don’t really seem to understand them.  But you don’t have to get into all the technicalities to understand the bigger picture.  Basically, derivatives are financial instruments whose value depends upon or is derived from the price of something else.  A derivative has no underlying value of its own.  It is essentially a side bet.  Originally, derivatives were mostly used to hedge risk and to offset the possibility of taking losses.  But today it has gone way, way beyond that.  Today the world financial system has become a gigantic casino where insanely large bets are made on anything and everything that you can possibly imagine. 

The derivatives market is almost entirely unregulated and in recent years it has ballooned to such enormous proportions that it is almost hard to believe.  Today, the worldwide derivatives market is approximately 20 times the size of the entire global economy.

Because derivatives are so unregulated, nobody knows for certain exactly what the total value of all the derivatives worldwide is, but low estimates put it around 600 trillion dollars and high estimates put it at around 1.5 quadrillion dollars. 

Do you know how large one quadrillion is?

Counting at one dollar per second, it would take 32 million years to count to one quadrillion.

If you want to attempt it, you might want to get started right now.

To put that in perspective, the gross domestic product of the United States is only about 14 trillion dollars.

In fact, the total market cap of all major global stock markets is only about 30 trillion dollars.

So when you are talking about 1.5 quadrillion dollars, you are talking about an amount of money that is almost inconceivable.

So what is going to happen when this insanely large derivatives bubble pops?

Well, the truth is that the danger that we face from derivatives is so great that Warren Buffet has called them “financial weapons of mass destruction”.

Unfortunately, he is not exaggerating.

It would be hard to understate the financial devastation that we could potentially be facing. 

A number of years back, French President Jacques Chirac referred to derivatives as “financial AIDS”.

The reality is that when this bubble pops there won’t be enough money in the entire world to fix it.

But ignorance is bliss, and most people simply do not understand these complex financial instruments enough to be worried about them.

Unfortunately, just because most of us do not understand the danger does not mean that the danger has been eliminated.

In a recent column, Dr. Jerome Corsi of WorldNetDaily noted that even many institutional investors have gotten sucked into investing in derivatives without even understanding the incredible risk they were facing….

A key problem with derivatives is that in the attempt to reduce costs or prevent losses, institutional investors typically accepted complex risks that carried little-understood liabilities widely disproportionate to any potential savings the derivatives contract may have initially obtained.

The hedge-fund and derivatives markets are so highly complex and technical that even many top economists and investment-banking professionals don’t fully understand them.

Moreover, both the hedge-fund and the derivatives markets are almost totally unregulated, either by the U.S. government or by any other government worldwide.

Most Americans don’t realize it, but derivatives played a major role in the financial crisis of 2007 and 2008.

Do you remember how AIG was constantly in the news for a while there?

Well, they weren’t in financial trouble because they had written a bunch of bad insurance policies.

What had happened is that a subsidiary of AIG had lost more than $18 billion on Credit Default Swaps (derivatives) it had written, and additional losses from derivatives were on the way which could have caused the complete collapse of the insurance giant.

So the U.S. government stepped in and bailed them out – all at U.S. taxpayer expense of course.

But the AIG incident was actually quite small compared to what could be coming.  The derivatives market has become so monolithic that even a relatively minor imbalance in the global economy could set off a chain reaction that would have devastating consequences. 

In his recent article on derivatives, Webster Tarpley described the central role that derivatives now play in our financial system….

Far from being some arcane or marginal activity, financial derivatives have come to represent the principal business of the financier oligarchy in Wall Street, the City of London, Frankfurt, and other money centers. A concerted effort has been made by politicians and the news media to hide and camouflage the central role played by derivative speculation in the economic disasters of recent years. Journalists and public relations types have done everything possible to avoid even mentioning derivatives, coining phrases like “toxic assets,” “exotic instruments,” and – most notably – “troubled assets,” as in Troubled Assets Relief Program or TARP, aka the monstrous $800 billion bailout of Wall Street speculators which was enacted in October 2008 with the support of Bush, Henry Paulson, John McCain, Sarah Palin, and the Obama Democrats.

But wasn’t the financial reform law that Congress just passed supposed to fix all this?

Well, the truth is that you simply cannot “fix” a 1.5 quadrillion dollar problem, but yes, the financial reform law was supposed to put some new restrictions on derivatives.

And initially, there were some somewhat significant reforms contained in the bill.  But after the vast horde of Wall Street lobbyists in Washington got done doing their thing, the derivatives reforms were almost completely and totally neutered.

So the rampant casino gambling continues and everybody on Wall Street is happy.

For now.

One day some event will happen which will cause a sudden shift in world financial markets and trillions of dollars of losses in derivatives will create a tsunami that will bring the entire house of cards down.

All of the money in the world will not be enough to bail out the financial system when that day arrives.

The truth is that we should have never allowed world financial markets to become a giant casino. 

But we did.

Soon enough we will all pay the price, and when that disastrous day comes, most Americans will still not understand what is happening.

The Economic Collapse

Chris Whalen provides a devastating analysis of the Financial Reform legislation, and then goes on to eviscerate the Federal Reserve as regulator.

“Even as the big banks make a public show for the media of implementing the new Dodd-Frank law with respect to limits on own account trading and spinning off private equity investments, these same firms are busily creating the next investment bubble on Wall Street — this time focused on structured assets based upon corporate debt, Treasury bonds or nothing at all — that is, pure derivatives.”

What I resent most about this current climate are the whispering campaigns and not so subtle attacks on the whistleblowers and victims: the unemployed, the homeless, the dislocated. These use stereotypes, character assassination, prejudice, and the darker elements of the human soul.

The better educated and fortunate members of the middle class are too often too willing to stand by and permit this without lifting a finger or saying a word, sometimes because it is to their benefit, or so they think. That is a mistake, because as history as shown, it is only a matter of time before the predators come for them.

Enjoy.

Institutional Risk Analyst
Is Fed Supervision of Big Banks Really Changing?
By Chris Whalen

With the passage of the Dodd-Frank Wall Street reform legislation, many financial analysts and members of the press believe that investment banking revenues and resulting earnings are in danger, but nothing is further from the truth. The Volcker Rule and other limitations on the principal trading and investment activities of the largest universal banks.

It is not own account trading but the derivatives sales desks of the largest BHCs whence the trouble lies. Even as the big banks make a public show for the media of implementing the new Dodd-Frank law with respect to limits on own account trading and spinning off private equity investments, these same firms are busily creating the next investment bubble on Wall Street — this time focused on structured assets based upon corporate debt, Treasury bonds or nothing at all — that is, pure derivatives. Like the subprime deals where residential mortgages provided the basis, these transactions are being sold to all manner of investors, both institutional and retail. It is the perverse structure of the OTC markets and not the particular collateral used to define these transactions that creates systemic and institution specific risk.

One risk manager close to the action describes how the securities affiliates of some of the most prominent and well-respected U.S. BHCs are selling five-year structured transactions to retail investors. These deals promise enhanced yields that go well into double digits, but like the subprime debt and auction rate securities which have already caused hundreds of billions of dollars in losses to bank shareholders, the FDIC and the U.S. taxpayer, these securities are completely illiquid and often come with only minimal disclosure.

The dirty little secret of the Dodd-Frank legislation is that by failing to curtail the worst abuses of the OTC market in structured assets and derivatives, a financial ghetto that even today remains virtually unregulated, the Congress and the Fed are effectively even encouraging securities firms to act as de facto exchanges and thereby commit financial fraud. Allowing securities firms to originate complex structured securities without requiring SEC registration is a vast loophole that Senator Christopher Dodd (D-CT) and Rep. Barney Frank (D-MA) deliberately left open for their campaign contributors on Wall Street. But it must be noted these same firms have a captive, client relationship with the Fed and other regulators as well, thus a love triangle may be the most apt metaphor.

Of course retail investors love the higher yields on complex structured assets. Who can blame them for trying to get a higher yield than available on treasuries, while the Fed keeps rates at historic lows to, among other things, re-capitalize the zombie banks. The only trouble is that the firms originating these ersatz securities, as with the case of auction rate municipal securities, have no obligation to make markets in these OTC structured assets or even show clients a low-ball bid. And because of the bilateral nature of the OTC market, only the firm which originates the security will even provide an indicative valuation because the structures and models behind them are entirely opaque.

In fact, we already know of two hedge funds that are being established specifically to buy this crap from distressed retail investors as an when rates start to rise. The sponsors expect to make returns in high double digits by making a market for the clients of large BHCs who want to get out of these illiquid assets. But the one thing that you can be sure of is that nobody at the Fed or the other bank regulatory agencies know anything about this new bubble. As with the early warnings brought to the Fed about private loan origination and securitization activities as early as 2005, the central bank and other regulators are so entirely compromised by the political pull of the large banks that they will do nothing to get ahead of this new problem.

Consider a specific example:

Shall We Reward Incompetence? The Case of Sarah Dahlgren and the Fed of New York

Despite initial indications that Congress would reduce the scope of Federal Reserve’s financial company supervision, in the end the Dodd-Frank legislation substantially increases the Federal Reserve’s responsibility. Chairman Ben Bernanke and other Federal Reserve officials made the argument that the Fed’s supervision function didn’t do any worse than any other financial regulators — an assertion we cannot validate. This combined with heavy lobbying by other Reserve Bank Presidents and the grudging acknowledgement to the Congress by Fed Chairman Bernanke and Fed Governor Daniel Tarullo that significant improvements are necessary ultimately won the day.

Given its second lease on regulatory life, one might expect that the Fed’s bank supervision function would be gearing-up to take a fresh, smart, and tough line with respect to financial company oversight. However, a recent key supervisory officer appointment by the Federal Reserve Bank of New York (FRBNY) indicates this may not be the case. The largest and most important of regional Reserve Banks appears to be going back to the future with its choice of Sarah Dahlgren as Head of Supervision. See FRBNY press release link.

If the name sounds familiar, that’s because Ms Dahlgren has been at the center of many of the Federal Reserve’s most embarrassing failures in the area of bank supervision and in particular with respect to the failure of American International Group (AIG). Going back in time now and remembering the period before the crisis, Dahlgren typified the arrogance and refusal of Fed officials to acknowledge warnings from various members of the financial community that the subprime mortgage market was melting down after years of unsafe and unsound lending and underwriting practices by the largest banks. Roger Kubarych, a former economist for the FRBNY, described the refusal of Fed officials to acknowledge the crisis in a 2008 interview with The IRA (‘Fed Chairmen and Presidents: Roundtable with Roger Kubarych and Richard Whalen’, October 30, 2008).

“It makes me so mad to think back how ignorant, arrogant, and dismissive she was with people who knew what they were talking about pre-crisis,” one former Fed colleague told The IRA. Dahlgren was running the AIG show for the FRBNY. She ignored the recommendations from the Fed’s own advisors and the Board of the FRBNY that AIG counterparties be forced to take haircuts. For her to ignore good advice on AIG and then deliberately take steps to hide that decision from the Congress and the public, and then be rewarded with a promotion, is quite disheartening…”

Read the rest here.

Jesse’s Cafe Americain

I shouldn’t be surprised at the spin that is put on the annual Social Security report, nor by the “advocacy” that so-called “Grass Roots” organizations like Move On (in reality funded by folks like George Soros, directly and indirectly) put out on this topic.

But occasionally, something stinks so badly that it demands response.  Like this, for instance:

In recent years, during which conservatives have intensified their efforts to destroy one of the few U.S. government programs that actually works as intended, the report’s publication has become an occasion for hand-wringing and crocodile tears over the (supposedly) parlous state of the system’s finances.

Ok, I’m game.  Let’s talk about what’s “intended.”

For example, a black male has a life expectancy (as of 2007, at birth) of 68.8 years.  A white woman has a life expectancy of 81 years.

So a black man could be expected to live 3.8 years post-retirement at 65.  A white woman, 16 years.  Put another way, if a white woman and a black man have exactly the same earnings history in their lifetime, the white woman will receive 4.21 times the Social Security “income” as will the black man.

(Incidentally, if you’re a native-American man you’re in worse shape than the black man – the only ethnic group that is.)

Those who want to talk about Social Security’s purposes never want to discuss this little bit of rather intentional and institutionalized racism.  And incidentally, this is the biggest argument for Social Security (in whatever form it is) being an individual trust fund and being an accumulated asset over one’s work life.  While such would not prevent you from dying before you received “all your benefits” (whatever they may be) it sure would prevent the government from stealing them – at least your children would get the money!

The old age and disability trust funds, which hold the system’s surplus, grew in 2009 by $122 billion, to $2.5 trillion. The program paid out $675 billion to 53 million beneficiaries — men, women and children — with administrative costs of 0.9% of expenditures. For all you privatization advocates out there, you’d be lucky to find a retirement and insurance plan of this complexity with an administrative fee less than five or 10 times that ratio.

Well yes, when I can stick a gun up every employer’s nose and force them to pay, it’s rather easy to have a low expense ratio.  Let’s be realistic – this is hardly an indicator of anything other than the fact that government is efficient in extracting money.

The guys with the most guns usually are.

Despite what Social Security’s enemies love to claim, the trust fund is not a myth, it’s not mere paper. It’s real money, and it represents the savings of every worker paying into the system today.

Oh no it’s not.

So I’m going to train a microscope on it.

Your argument (and credibility) is about to be destroyed.

Most Americans pay more payroll tax than income tax. Not until you pull in $200,000 or more, which puts you among roughly the top 5% of income-earners, are you likely to pay more in income tax than payroll tax.

That’s not true at all.  Social Security (legally called OASDI or FICA) is a “first-dollar” payroll tax of 12.4%.  You pay all of it, despite the claims of many who say “half is the employer’s.”  Uh, no, he pays you 6.2% less than he would have otherwise, and remits it to the government, along with “your half.”  It is not possible to tax a company – all taxes are paid by people (think about it.)

Most middle-class people have an effective Federal Tax Rate of significantly higher than 12.4%.  It is certainly true that for those people who are in the lower-income brackets their federal income tax burden is near or at zero – especially for those who qualify for the EIC.  But a 12.4% effective federal income tax rate typically shows up for a single person with income around $50,000, and for a married couple in the $60-80,000 bracket.  This hardly qualifies them as “Rich” or “in the top 5%.”

Since 1983, the money from all payroll taxpayers has been building up the Social Security surplus, swelling the trust fund. What’s happened to the money? It’s been borrowed by the federal government and spent on federal programs — housing, stimulus, war and a big income tax cut for the richest Americans, enacted under President George W. Bush in 2001.

Really?  The “big income tax cut for the rich” is the primary cause?

War, yes.  Housing?  Yes.  “Stimulus” (mostly hiring government hacks of various sorts)?  Yes.

But, if George W. Bush was so horrifyingly bad, how is it that President Clinton also stole the Social Security surplus – and claimed “budget surpluses” that didn’t exist?  Was his social spending not part of the picture? 

Never mind that the real budget ball-buster in the 2000s wasn’t war and wasn’t tax cuts for the rich – it was Medicare Part D, which was sold as and in fact IS a huge giveaway to Americans of reasonably-modest means, since the wealthy can (and do) pay cash for “better” care than Medicare will provide.

The interest on those bonds, and the eventual redemption of the principal, should have to be paid for by income taxpayers, who reaped the direct benefits from borrowing the money.

No they didn’t.  Oh, and incidentally, your housing bubble out in LA?  Guess who profited from that?  It wasn’t the rich who were buying houses in a bidding frenzy for $800,000 when they worked at Cost Cutters for $8/hour.  That was middle and lower-class folks buying crack-shacks that were sold as mansions, living large on phony “appreciation” in their value.

Indeed, that was the primary “beneficiary” of the “easy money” programs.  While it is certainly true that the Blankfein’s and Lewis’ of the world skimmed off billions, in the grand scheme of things we’re talking tens of trillions of fake wealth here, and those Escalade “pimp-mobiles” were, by and large, being “bought” and “enjoyed” by people who simply couldn’t afford them – and they weren’t, for the most part, banksters.

So all the whining you hear about how redeeming the trust fund will require a tax hike we can’t afford is simply the sound of wealthy taxpayers trying to skip out on a bill about to come due. The next time someone tells you the trust fund is full of worthless IOUs, try to guess what tax bracket he’s in.

The money isn’t there and can’t be raised.  We’re talking about close to one hundred trillion dollars between Social Security and Medicare.  This exceeds (several times over) all of the wealth of those “fat cats” you’d like to tax.

Why?  Because your premise is a lie – the “fat cats” sure did skim off what they could, but the biggest beneficiaries of these programs were in fact the so-called “middle class” that lived like Gods, despite having a laborer’s wage.  Now the bill is on the table and they, like you, are screaming about it.

Incidentally, one of the other claims raised by MoveOn is related to this:

Reality: Social Security doesn’t need to be fixed. But if we want to strengthen it, here’s a better way: Make the rich pay their fair share. If the very rich paid taxes on all of their income, Social Security would be sustainable for decades to come.⁵ Right now, high earners only pay Social Security taxes on the first $106,000 of their income.⁶ But conservatives insist benefit cuts are the only way because they want to protect the super-rich from paying their fair share.

Uh huh.  Social Security benefits are capped.  That is, your Social Security wage base (what you pay taxes on) are all that goes into the computation of benefits.  Further, benefits are REGRESSIVE with increasing income in that wage base: You get 90% of your first $761 in monthly indexed earnings, 32% of that over $761 and under $4,586 and just 15% of that over $4,586 – until you hit the tax cap, at which point it goes to zero.

What MoveOn doesn’t want to talk about is that if you remove the cap on taxation then you also remove the cap on Social Security payments.  Yes, I’m sure they’ll bend it (and you) once again, so that you can only be credited for some small part (if any) of that additional tax.  In other words, contrary to the claim that Social Security is a pension into which one pays, it is clear that it is no such thing – you only get full benefit for the first $9,132 in income in a year – that which doesn’t even get you to the poverty line!  For the rest, your benefit base falls off to only 15% of what you earn over $4,586 monthly (that is, an annual income of $55,000) up to the cut-off, at which point you neither pay more tax nor do you get more benefit.

The last time I checked $55,000 wasn’t exactly a “rich man’s” salary, and yet that middle-class taxpayer is literally bent over the table in that his benefit calculation is only 15% of the money he’s earning.

The rest of the arguments there are equally-bereft of legitimacy; indeed, MoveOn is counting on you not to understand fifth-grade math.  That allegedly-intelligent people actually read and believe that bilge says more about the failure of our educational system than anything else.

Social Security doesn’t contribute a dime to the federal deficit, and in these days of market stagnation and cutbacks in pensions, it has never been more important to millions of Americans.

Oh yes it does, and yes it will.  Shuffling around paper to hide a deficit doesn’t make it disappear – it just changes the optics of the matter.

Those “IOUs” issued to OASDI are not marketable paper.  This is a clever trick; see, if they were marketable bonds then the Social Security trustees could sell them to anyone they wished.  That, of course, would bring market discipline to stealing the so-called “surplus”, because the trustees could always sell out to meet their obligations and in so doing, interest rates would rise – probably a hell of a lot.

But instead they’re “specials” – they are, in fact, IOUs.  They can only be sold back to Treasury, which is then obligated to issue real bonds into the real market in order to obtain the funds that the trustees need to pay benefits.

Treasury and Social Security did this, incidentally, because doing so protects the face value of those “special IOUs.”  If they were instead issued as marketable securities their market value would rise and fall with interest rates.  Fiscal profligacy would thus tend to punish the Social Security fund in times when rates were high, and help it when rates are low (like now.)  But by making them non-marketable this is avoided, and as such the trustees can claim “stability.”

Such claims are a chimera as they are entirely reliant on the government being able to issue into the private market Treasury securities to pay off the IOUs as needed.  Should rates rise due to unreasonable amounts of issuance, Treasury would find itself in a debt-spiral where issuing the required bonds causes funding costs to rise faster than the sold bonds raise revenue.  From that spiral there is no escape – indeed, it is precisely the threat of that outcome that led to the Greek panic earlier this year.

Social Security was always a sort of Ponzi Scheme, albeit one with long lead times and big up-front banked “surpluses.”  The fiscal reality of that Ponzi is what led the government to make big changes to how “inflation” (CPI) are calculated, since that’s how benefits are indexed.  Rather than admit the ponzi then, they decided to screw literally everyone and send bad price and demand signals into the market.  This in turn was a major driving force in the credit bubble.

The Social Security trustees were right in the 1980s – the system was broke.  The problem is that the so-called “fixes” were nothing other than papering over insolvency in a puerile attempt to shift the damage to society generally via manipulated government statistics.

Unfortunately Ponzi Schemes can’t be made viable with tricks.  They can only be repudiated, or they will eventually collapse, with the only unknown being time.

It is well-past the time when we should recognize the truth about Social Security – including the intentional institutionalized racism that was present at its inception and continues today, along with the fact that one cannot “jigger” so-called “benefits” via manipulated inflation statistics and receive a positive outcome over time.

The Market-Ticker