Special Reports
The world according to derivatives, part 6 of 7: Den of thieves, house of cards
By Geraldine Perry
Online Journal Guest Writer


Nov 20, 2008, 00:17

According to economist and author Michel Chossudovsky, we are facing �the most serious economic crisis in world history . . . [Moreover, this] crisis is the outcome of a deregulated financial architecture.� (Who Are the Architects of the Economic Collapse?, Michel Chossudovsky)

While there is considerable consensus for Chossudovsky�s assertions, too often left unexamined are the underlying mechanisms of the financial architecture itself.

Simply put, this architecture is based on a monetary system in which one man�s savings are in effect another man�s debts, which are ultimately debts to the large financial conglomerates. It is a system mathematically dependent on boom/bust cycles which foster both greed and gluttony -- and facilitates continual redistribution of wealth upwards, and away from the real producers of wealth. The architecture for this system has evolved over centuries as a means by which to moderate speculative activity -- particularly that kind of speculation which involves increasingly sophisticated and complex derivative instruments.

With few exceptions, derivatives today are an exclusive investment tool for very select groups and individuals who have massive financial resources and lines of credit at their disposal. These groups and individuals include large institutional investors, insurance companies, high net worth individual investors and family offices, U.S. endowments, foundations and pension funds, select private banks, sovereign wealth funds and the like -- whose business in turn is handled by a relatively few �high rolling� dealers. Thus, as Warren Buffet wrote, �Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers . . .�

The end result, as Chossudovsky suggests, is that �Federal, State and municipal governments are increasingly in a straightjacket, under the tight control of the global financial conglomerates [where] the creditors call the shots on government reform.� (Who Are the Architects of the Economic Collapse? Michel Chossudovsky)

Because of this rather undemocratic and peculiar set of circumstances it is not unreasonable to conclude that a relatively small handful of select groups and individuals, together with their dealers and financial managers, are able to exert hitherto unimaginable influence over whole economies, governments, and even world events, not the least of which is the current economic crisis. This becomes particularly obvious in view of the explosive growth of the world wide derivatives trade which went from approximately $100 trillion in 2002 to a very shakily estimated $681 trillion by the end of 2007.

No one knows the extent of leveraging that went into that estimated $681 trillion, but even assuming the more conservative -- and traditional 10 to 1 debt-to-asset ratio, this means that potentially some $600 trillion could disappear from the world�s economy. This is due to the fact that collapsing debt means a collapsing money supply, since money is created when banks extend credit through what are loosely termed loanable funds.

The manner in which money is created (as debt) is the real reason why �credit is the lifeblood of the economy.� And it is why governments are rushing to inject liquidity -- aka taxpayer debt -- into their banking systems through a growing plethora of stimulus packages, assisted buyouts, takeovers, and bailouts. As in the case of the U.S. where �fighting the financial crisis has put the U.S. on the hook for some $5 trillion . . . so far� (Washington�s $5 Trillion Tab, Elizabeth Moyer) it is also why bailout and stimulus packages are exploding worldwide.

Perhaps the worst part about all this is that the lure of fast money- together with the pressure of mounting debt and the phenomenon created by counter party risk -- has effectively married all levels of government, non-profits, educational institutions, pension funds and much more to the incredibly risky -- and exclusive -- global derivatives trade. The global derivatives trade has, in other words, become so intertwined with the lives and welfare of governments and ordinary individuals that talk of divorce is studiously avoided, despite the increasingly obvious warning signals.

The current credit crisis, caused by the unwinding of �bad asset� derivatives, is the most evident example of this financial marriage as governments and central banks are called upon to intervene -- and regulate, while taxpayers are called upon to foot the bill for losses incurred in the global casino, where only a select few can enter and signs of corruption are painstakingly overlooked.

How much longer can this fragile house of cards be propped up through abject fear and a total lack of understanding of alternatives? How much longer will ordinary citizens and their elected officials tolerate increasingly obscene levels of wealth redistribution and outright thievery in their midst?

A case in point is JP Morgan Chase, for whom Christmas indeed seems to have come early this year. The first Christmas present came in mid-March in the form of the privately arranged, emergency takeover of the highly respected, privately owned Bear Stearns by the highly respected, privately owned JP Morgan. This takeover was, as you may recall, facilitated by the Fed and the largess of the American taxpayer -- one of many such �deals� in which taxpayers are increasingly getting the short end of the stick.

The claim that this takeover -- quietly arranged behind closed doors on a Sunday when no one could effectively object -- was done in order to avert a seize-up of the entire global derivatives market is not of course without merit or significance. Although Ben Bernancke maintained in testimony to Congress that the Fed�s intervention was done to prevent a seize-up of American financial markets he also disclosed that another major factor was Bear Stearns� �interconnectedness with thousands of counter parties� which of course are based all around the globe.

Importantly, as analyst Mike Whitney points out, �Bear Stearns had total (derivatives) positions of $13.4 trillion. This is greater than the US national income, or equal to a quarter of world GDP -- at least in �notional� terms. The contracts were described as �swaps,� �swaptions,� �caps,� �collars� and �floors.� This heady edifice of new-fangled instruments was built on an asset base of $80bn at best . . . On the other side of these contracts are banks, brokers, and hedge funds, linked in destiny by a nexus of interlocking claims. This is counter party spaghetti.� (The Bernanke Politburo�s Next Big Plan, Mike Whitney)

As reported by Mortgage News Daily the demise of Bear Stearns was not entirely unanticipated since it �had been one of the biggest gamblers (although we were calling them �investors� at the time) in the mortgage securities business.� The price tag on the other hand was a �real stunner.� Although later forced by irate shareholders to up the ante fivefold (to $10 per share), the initial deal struck in secret negotiations on Sunday March 16 for $2 per share essentially handed over the 85 year-old Bear Stearns to JP Morgan for about $236 million. This was a fraction of Bear Stearns� market value of $3.5 billion on Friday, when its shares had plummeted to $30 a share at Friday�s close from a high of $170 per share one year earlier. To facilitate the deal, the Federal Reserve provided �as much as $30 billion of taxpayer monies in financing for Bear Stearns� less-liquid assets such as mortgage securities. [So] If these assets lose even more value it will be the Fed [and the taxpayer via the government] that will take the hit, not JP Morgan.� (Stockholders Socked as J.P. Morgan Acquires Bear Stearns in Weekend Rescue. Mortgage News Daily )

Curiously, JP Morgan itself held some $77 trillion worth of the exact same kinds of �less liquid� and highly leveraged derivatives contracts that brought down Bear Stearns. Curiouser still is the fact that that Jamie Dimon, CEO of JP Morgan, also sits on the board of the New York Fed.

And one does have to wonder -- just what might be the real reason that Michael Alix, chief risk officer for Bear Stearns from 2006-2008 and global head of credit risk management from 1996-2006, has recently been named a senior vice president in the Bank Supervision Group of the Federal Reserve Bank of New York -- to �supervise bank soundness.� As one blogger points out: �Who would know better what was in the dreck pool that the Fed has parked over at BlackRock than the former chief risk officer? If Alix knows a few embarrassing things, might be wise to give him an incentive not to talk them up.� (Fed Hires Bear Stearns Chief . . . To Supervise Bank Soundness. naked capitalism)

To this growing list of curiosities we can add what can fairly be described as another early Christmas present for JP Morgan. This particular present came a mere six months after the Bear Stearns deal -- this time with timely assistance from the FDIC in a brokered sale of Washington Mutual. WaMu, as it was affectionately known, represented the largest bank failure in U.S. history. Happily for JP Morgan, this deal made it the largest U.S. depository institution -- with over $900bn of customer deposits.

Sebastian Hindman, an analyst at SNL Financial describes the WaMu acquisition as a �definite win for JP Morgan. They are only paying $1.9 billion to the FDIC, and they are getting this incredible expansion into a lot of solid markets.� Unfortunately, �[t]he seizure by the government means shareholders� equity in WaMu was wiped out. . . . Some bondholders will also be wiped out by the deal. [Additionally] JP Morgan Chase is not acquiring any senior unsecured debt, subordinated debt or preferred stock of Washington Mutual�s banks, or any assets or liabilities of the holding company, which will be left in the receivership. The government [courtesy of the taxpayer] will be left to sell the soured mortgage assets of the holding company . . .� (JPMorgan Chase Buys WaMu Assets After FDIC Seizure, Marcy Gordon, Sara Lepro and Madlen Read)

Coincidentally (or not) and less than three weeks after the September 25 WaMu acquisition, JP Morgan got yet another early Christmas present. As reported by Joe Nocera of the New York Times, JP Morgan CEO Jamie Dimon �agreed� to take a $25 billion capital injection courtesy of the United States government -- and the Fed. No surprise then that �[t]he U.S. government�s $160 billion handout to banks from Niagara Falls to Beverly Hills is going mostly to lenders that need it least, putting weaker rivals at risk of being shut down or taken over . .� (U.S. Treasury Program Shuns Banks That Need Cash Most, David Mildenberg and Linda Shen. Bloomberg)

What makes this $25 billion present particularly interesting is revealed by Nocera�s report of a portion of a private, recorded conference call in which one JP Morgan executive disclosed that the $25 billion was less likely to be used to create loans to help an ailing economy than it was to help JP Morgan take advantage of �opportunities�:

�Twenty-five billion dollars is obviously going to help the folks who are struggling more than Chase,� he began. �What we do think it will help us do is perhaps be a little bit more active on the acquisition side or opportunistic side for some banks who are still struggling. And I would not assume that we are done on the acquisition side just because of the Washington Mutual and Bear Stearns mergers. I think there are going to be some great opportunities for us to grow in this environment, and I think we have an opportunity to use that $25 billion in that way and obviously depending on whether recession turns into depression or what happens in the future, you know, we have that as a backstop.�(So When Will Banks Give Loans, Joe Nocera)

The hubbub over JP Morgan�s current good fortunes, controversial though they may be, almost too conveniently obliterates a 2002 Congressional investigation concerning allegations that JP Morgan helped Enron and similar corporations defraud their shareholders. According to analyst Adam Hamilton, by July 23, 2002 -- the day its stock took an historic nosedive, JP Morgan�s name was not only �suspiciously popping up in virtually all the major corporate scandals in the States� but �JPM control[ed] 51 percent of the total notional value of all the derivatives of all the US banks playing the incredibly dangerous derivatives game [while it commanded just] 11 percent of the total assets of all the banks dabbling in derivatives. [JPM was looking] more like a hedge fund gone mad than a commercial bank, a vast Frankenstein�s Monster created by the hasty stitching together of countless cryptic off-balance sheet OTC derivatives contracts.�

Amazingly says Hamilton, the bad news for JP Morgan was not of a derivatives implosion but rather that �United States Congressional investigators told the media that JPM specifically structured deals explicitly designed to mislead the investors in major public US corporations by almost magically erasing unfavorable numbers from corporate balance sheets . . . US Senator Carl Levin, the Chairman of the Senate Permanent Subcommittee on Investigations, actually released an excerpt from an incredibly damning e-mail from a JPM executive. It said, �Enron loves these deals as they are able to hide funded debt from the equity analysts.� [Moreover and] according to the US media, the Congressional subcommittee has audiotapes . . . where JPM officers are telling accountants exactly how to structure offshore entities so they appear independent.� (JPM Derivatives Monster Crashes, Adam Hamilton)

The investigation into JP Morgan�s relationship with Enron dealt with commodity-related trades between JP Morgan, Enron and an offshore vehicle called Mahonia that was set up a decade before by Chase Manhattan, the bank that JP Morgan had merged with 18 months before the Congressional investigation was launched. Unhappily for JP Morgan, this investigation came on the heals of reports concerning JP Morgan�s heavy exposure to the financial crisis in Argentina as well as the then looming threat of heavy losses on loans extended to Global Crossing, the collapsed telecoms group which at the time was itself subject to numerous regulatory investigations. (Enron Crisis Grips JP Morgan, David Teather and Jill Treanor)

The news of JP Morgan�s relationship with Enron and its offshore vehicle was accompanied by revelations that energy giant Enron actually made the bulk of its money in OTC derivatives. Moreover, the size and scale of Enron�s derivatives business dwarfed that of the leveraged and derivatives-heavy Long Term Capital Management which just four years before had caused the New York Fed to quietly engineer a bailout. In 2002 testimony to Congress, law professor and attorney Frank Partnoy provides the following details, and a conclusion about the role of derivatives in Enron�s collapse:

Enron has been compared to Long-Term Capital Management, the Greenwich, Connecticut, hedge fund that lost $4.6 billion on more than $1 trillion of derivatives and was rescued in September 1998 in a private bailout engineered by the New York Federal Reserve. For the past several weeks, I have conducted my own investigation into Enron, and I believe the comparison is inapt. Yes, there are similarities in both firms� use and abuse of financial derivatives. But the scope of Enron�s problems and their effects on its investors and employees are far more sweeping.

According to Enron�s most recent annual report, the firm made more money trading derivatives in the year 2000 alone than Long-Term Capital Management made in its entire history. Long-Term Capital Management generated losses of a few billion dollars; by contrast, Enron not only wiped out $70 billion of shareholder value, but also defaulted on tens of billions of dollars of debts. Long-Term Capital Management employed only 200 people worldwide, many of whom simply started a new hedge fund after the bailout, while Enron employed 20,000 people, more than 4,000 of whom have been fired, and many more of whom lost their life savings as Enron�s stock plummeted last fall.

In short, Enron makes Long-Term Capital Management look like a lemonade stand. It will surprise many investors to learn that Enron was, at its core, a derivatives trading firm . . .

I believe there are two answers to the question of why Enron collapsed, and both involve derivatives. . . . My testimony -- and Enron�s activities -- involve the OTC derivatives markets. (Testimony of Frank Partnoy Professor of Law, University of San Diego School of Law, Hearings before the United States Senate Committee on Governmental Affairs, January 24, 2002)

Some may recall that a mere few weeks before the very controversial, taxpayer-assisted JP Morgan takeover of Bear Stearns we witnessed the abrupt implosion of derivatives-heavy Carlyle Capital. In the case of Carlyle Capital, the unheeded pleas of its parent company, The Carlyle Group went out to involved banks to hold off on margin calls and liquidation of mortgage assets. Led by Deutsche Bank and JP Morgan, the group of �the world�s biggest banks� that had lent Carlyle Capital about $21 billion -- or $20 for every dollar of initial capital -- quickly moved to seize and sell what was left of the fund�s assets. It is interesting to note that as of the end of 2007, counter parties for Carlyle Capital�s repurchasing agreements included Bear Stearns, Citigroup, Deutsche Bank, and JP Morgan among several other big banks.

In the midst of the furor created by Carlyle Capital came wind of the Bears Stearns takeover. Incredibly, as journalist Marine Cole pointed out, �The government-supported sale of Bear Stearns announced last week may have halted a run on investment banks, but its pending acquisition by JP Morgan Chase would increase the buyer�s already hefty exposure to possible failures by other banks and financial institutions, an exposure known as counterparty risk. . . .� (Bear Churns: Bear Stearns Deal Boosts JP Morgan�s Derivatives Exposure, Marine Cole)

So we might ask, what is the difference between JP Morgan, Enron, Carlyle Capital, LTCM and Bears Stearns -- or for that matter Washington Mutual and Lehman Brothers? Why did our government and the Fed see fit to ignore signs of conflicts of interest and malfeasance on the part of JP Morgan and facilitate the takeover or rescue of Bear Stearns, Washington Mutual and LTCM, while Carlyle Capital, Lehman Brothers and Enron were allowed to implode? Certainly all were very highly leveraged, and all were heavily involved in the mortgage securities/derivatives market. Could the difference simply be the counter parties involved?

Whatever the case, it is more than a little problematic that Bear Stearns, Carlyle Capitol and JP Morgan all had leverage ratios of about 32 to 1 (according to published estimates) at the time of the Bear Stearns crisis. Worse still is the nagging suspicion that the implied derivatives leverage on equity may have been far, far greater than what has been reported. (JPM Derivatives Monster Grows, Adam Hamilton )

JP Morgan is of course still standing, but both it and other financial institutions -- including the giant government-sponsored entities Fannie Mae and Freddie Mac -- have required massive amounts of taxpayer assistance and perhaps not a small amount of favoritism to boot. How many more such rescues remain in the pipeline is almost too chilling a thought to contemplate -- particularly if you happen to be a taxpayer. Hopefully sooner rather than later, we might actually get some answers to some very troubling questions, beginning with why it is that �[t]he Federal Reserve is refusing to identify the recipients of almost $2 trillion of emergency loans from American taxpayers or the troubled assets the central bank is accepting as collateral . . .�(Fed Defies Transparency Aim in Refusal to Disclose, Mark Pittman, Bob Ivry and Alison Fitzgerald)

But in the final analysis, we have to ask ourselves -- in an artificial world where risk is limited by governments willing to overlook blatant evidence of malfeasance and instead resort to using their citizens to subsidize business failures, and where the opportunity for financial gain is exaggerated by extreme levels of leveraging and non-transparent bets on bets otherwise known as derivatives -- why wouldn�t financial heavyweights of all stripes engage in these types of bookie transactions -- Faustian Bargains though they may be?

Next, Part 7: The Place Where Industry, the Military and Government Meet