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Economic Globlization and Speculation Coming Home to Roost

With the current economic crisis which seems to be spreading across the world we are dealing with far more than a “subprime” crisis, or an attempt to “quarantine “toxic debt.”

There is a much bigger avalanche waiting to come tumbling down. Namely the derivatives market now estimated to be over $1 quadrillion (that is 1,000 trillion) in global derivatives holdings. That makes the current $700 billion bailout look like less than a drop in a very large bucket.

As the long predicted crash started unfolding, I have been nagged by a long sequence of events that seem to be culminating at the current moment. There have been significant structural changes in the U.S. and elsewhere that have impacted both labor markets, and capital. In terms of labor markets (also known as workers) the transitions have been stark. In the United States we have watched the long term decimation of the manufacturing sector and a transition to a "service" economy. I remember the concerns in the 1980's about the transformation of the U.S. economy from a production economy to a consumer economy. This trend was accelerated with broad implementation of corporate-driven globalization and formalized by the passage of NAFTA (North American Free Trade Act) and the rewriting of GATT (General Agreement on Tariffs and Trade).

These two international trade agreements were structured along similar philosophies. Namely the removing of "boundaries" to trade, and enhancing the "boundaries" around workforces. Those boundaries were national boundaries and national sovereignty. We saw the exportation of U.S. job (outsourcing and off-shoring) accelerate. We also started seeing the merger mania of the 1980s which have continued to the present. In fact, they are a prominent feature of the current crisis.

Other nations, in a competitive and revolving fashion, became the cheap, exploitable labor force for a global economy. China, maximizing on its single most abundant resource (people) successfully positioned itself as the cheap workforce for global corporations searching to always maximize profit. (Now they too import even cheaper labor).

All along this path towards removal of boundaries, there has been increasing financial and investment penetration in an increasingly intertwined global financial market.

Facilitating what might be framed as an integration of financial and corporate markets, the U.S. (and other nations) have engaged in almost three decades of deregulation and the removal of other boundaries and barriers - particularly in the "financial" areas. Insurance companies become investment marketers, banks become investment bankers, banks cash in on the lucrative credit market, credit card companies start offering mortgage financing. Functions and institutions that once had high barriers between them with regulation and oversight, became increasingly deregulated and shadowy. They pushed for, and got passed, barriers against predatory lending - like those pesky bankruptcy laws.

I can't help but thinking that (in part) we are seeing the "jobless recovery" of the 2001 recession coming home to roost. Lots of folks wrote about the jobless recovery including myself (What Jobs? What Recovery?) and even Ben Bernake (The Jobless Recovery). Most of us, myself included, focused on the restructuring of the economy at that time as a major component of what was going on. However, it was also clear that money was flowing from somewhere into the financial markets. Wall Street was recovering - the people (and workers) were not. This money flowing around was symptomatic of the liberalization of investment restrictions which was a major feature of international globalization.

Unfortunately while there was money being brought into the market, much of it was "little people's" money (i.e. money from state and corporate retirement funds). The little people's money provided grease for much bigger financial fish, and "derivatives" took a whole new life and growth spurt.

What the Hell are "Derivatives?"

Wikipedia defines derivatives:

Derivatives are financial instruments whose values depend on the value of other underlying financial instruments. The main types of derivatives are futures, forwards, options, and swaps.

The main use of derivatives is to reduce risk for one party. The diverse range of potential underlying assets and pay-off alternatives leads to a wide range of derivatives contracts available to be traded in the market. Derivatives can be based on different types of assets such as commodities, equities (stocks), residential mortgages, commercial real estate loans, bonds, interest rates, exchange rates, or indexes (such as a stock market index, consumer price index (CPI) -- see inflation derivatives -- or even an index of weather conditions, or other derivatives). Their performance can determine both the amount and the timing of the pay-offs. Unregulated Credit derivatives have become an increasingly large part of the derivative market.

If you don't feel particularly enlightened, you are not alone. One off the best articles I have found on the current derivative situation was written by Ellen Brown and published at Global Research. In "It's the Derivatives, Stupid! Why Fannie, Freddie, AIG had to be Bailed Out," Brown states:

The Anatomy of a Bubble

Until recently, most people had never even heard of derivatives; but in terms of money traded, these investments represent the biggest financial market in the world. Derivatives are financial instruments that have no intrinsic value but derive their value from something else. Basically, they are just bets. You can "hedge your bet" that something you own will go up by placing a side bet that it will go down. "Hedge funds" hedge bets in the derivatives market. Bets can be placed on anything, from the price of tea in China to the movements of specific markets.

"The point everyone misses," wrote economist Robert Chapman a decade ago, "is that buying derivatives is not investing. It is gambling, insurance and high stakes bookmaking. Derivatives create nothing."1 They not only create nothing, but they serve to enrich non-producers at the expense of the people who do create real goods and services. In congressional hearings in the early 1990s, derivatives trading was challenged as being an illegal form of gambling. But the practice was legitimized by Fed Chairman Alan Greenspan, who not only lent legal and regulatory support to the trade but actively promoted derivatives as a way to improve "risk management." Partly, this was to boost the flagging profits of the banks; and at the larger banks and dealers, it worked. But the cost was an increase in risk to the financial system as a whole.2

Since then, derivative trades have grown exponentially, until now they are larger than the entire global economy. The Bank for International Settlements recently reported that total derivatives trades exceeded one quadrillion dollars - that's 1,000 trillion dollars.3 How is that figure even possible? The gross domestic product of all the countries in the world is only about 60 trillion dollars. The answer is that gamblers can bet as much as they want. They can bet money they don't have, and that is where the huge increase in risk comes in.

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

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

The dominos go down in a cascade of cross-defaults that infects the whole banking industry and jeopardizes the global pyramid scheme. The potential for this sort of nuclear reaction was what prompted billionaire investor Warren Buffett to call derivatives "weapons of financial mass destruction." It is also why the banking system cannot let a major derivatives player go down, and it is the banking system that calls the shots. The Federal Reserve is literally owned by a conglomerate of banks; and Hank Paulson, who heads the U.S. Treasury, entered that position through the revolving door of investment bank Goldman Sachs, where he was formerly CEO.

Now the picture becomes a bit clearer ... and more dire. John Maggs, writing "Derivatives: The Other Shoe Waiting To Drop" for the National Journal quotes Warren Buffett:

Billionaire investor Warren Buffett has been calling these derivatives a "mega-catastrophe" waiting to happen since the 1990s, when they began to proliferate. Buffett warned in May 2007 that a crisis in the derivatives market wasn't just a possibility--it was an eventuality. "The introduction of derivatives has totally made any regulation of margin requirements a joke," he said, referring to the amount of borrowed money normally required to buy stocks and bonds. "We don't know when it will end precisely, but ... at some point some very unpleasant things will happen in the markets."

John Riley, Chief Strategist for Cornerstone Money Management, notes that the derivatives market has grown dramatically. To wit, there has been a derivative growth of 473% for the top 25 U.S. banks since 1999.

So the derivative "bomb" is being mentioned quietly, but there is yet another troubling part of this scenario and the big players chew up and swallow whole other big players (with the help of the Federal Reserve and the Treasury). Buyouts, derivatives, and risk become a not so hidden story in a recent report from the Comptroller of the Currency, administrator of National Banks "OCC's Quarterly Report on Bank Trading and Derivatives Activities First Quarter 2008." I truly struggled to make deep sense of this report, but much of it is beyond me. However, a couple of important things leap out.

First is the chart on page 6 of the report which shows that 98.8% of the credit derivatives for the first quarter of 2008 were "Credit Default Swaps." My understanding is that "swaps" are a primary tool of financial "speculation" - or crassly, financial gambling.

Page 9 of the report show a chart of the growth of derivatives among commercial banks from 1990 to 2008. The chart shows the grow from somewhere less that $10 trillion in 1990 to north of $160 trillion in the first quarter of 2008. Further, and confirming my suspicion that financial speculation played an important role in "jobless recovery," is that derivatives took off in 2002. They climbed from approximately $50 trillion to the current amount held by commercial banks (an increase of over 300% in less than 6 years).

If you continue trudging through this (almost incomprehensible to the lay person) report, you will come to Graph 4 on page 12. There you discover that five commercial banks have the lions share of derivatives - almost 97% of derivatives held by commercial banks. Continue reading through graphs and charts, and you arrive at page 17 which finally tells who those five derivative holding institutions are - the five largest commercial banks in the United States (in order of size): JPMorgan, Bank America, Citibank, Wachovia, and HSBC.

Keep going and one comes to a startling piece of information . Table 1 on page 22 is a listing of the "notional amount of derivative contracts." The top five banks (followed by 20 others) are right there at the top of the chart. JP Morgan shows total assets of $1.4 billion with total derivatives of almost $90 billion. This is a difference of almost 90 to 1, and most of those are those "swaps" discussed above. Anyone want to talk exposure and risk? For the entire group of top 25 commercial banks, the assets are roughly $10 billion with derivatives of $180 billion. Funny money ... a whole lot of funny money.

Now we add the scenario that these banks are eating up other institutions (JP Morgan scooped up Bear Sterns and Lehmans; Citibank swallowed Washington Mutual and is fighting over number four Wachovia with number six Wells Fargo). As they concentrate their holdings into a smaller and smaller group of mega-institutions, they also increase their holding to the questionable - and not regulated - derivatives. What happens if the over the top holding of derivatives flips the iceberg upside down? It is a frightening thought. It is particularly frightening since the trend seems to be that the treasury (and us the tax payers) are going to stand surety for "arcane financial instruments" which have no real value.

So the U.S. is pushing "bail, bail, bail" for an economic boat which essentially has no hull. There is a very real problem here that has governments scrambling. Historically financial recovery strategies have been dealt with on a national basis (often reaching out to exploit "undeveloped nations") to achieve economic recovery. However, there is now no real national boundaries to the financial markets. Everybody's ass is blowing in the wind to one extent or the other, and the markets have been given virtually total control. While the US and European nations seem to be nationalizing the losses to one extent or another, no one seems to have any ideas of how to put the unruly borderless market horse back in the paddock - much less in the barn.

I think it is very important to not be lead astray by the claims of "corruption and greed." While it is certainly true that these unflattering character traits were (and are) present, the systems have been restructured to reward avarice and illegal activity. Global investment and finance has become the biggest (and most rewarding) gambling venture ever known. It has been structured as a "money machine" that utilizes the labor and resources of the planet to extract every drop of wealth, and then protects the gamblers so that the big ones win regardless of whether those markets go up ... or down.

The current insane situation we are in, and the reality of over the (unimaginable) sum of a QUADRILLION dollars hanging over us with nothing but air supporting it is more than a daunting prospect. But this was an environment that was created and facilitated by "decision makers" in and out of governments across the planet. Now it is has gotten so big and so precarious that its monstrous head is coming into the view of "the people."

There hangs the question of what to do about it. My gut response is to slam the door. Put a wall around the real economies and the people in them, and declare derivatives and other "arcane" instruments and markets illegal. Shut them down and keep them shut down. Some how, some way, economies have to get back to real value. That value resides in the people, not in the Casino Royale of financial wizardry.

Posted by Rowan Wolf at October 7, 2008 7:52 PM
Comment #266119

Excellent article Rowan, thanks. I wish either presidential candidate could be as informative.

Posted by: googlumpugus at October 7, 2008 11:14 PM
Comment #266129

Good work. It’s a complex topic. Most people still do not realize what is happening. Most people think this is about Fannie or Freddie or because poor people didn’t make their payments.

The real problem is with these huge markets which most people have never heard of, and even fewer understand or use.

If I understand it correctly, the users of CDS contracts were not exactly speculating; they were ‘managing risk’ by hedging, by locking in prices on both the upside and the downside, and thereby maximizing their return, and the predictability of their return. However, they messed up. They did not correctly assess risk. In fact, despite the use of fairly complex mathematical equations, the assessors of risk were dumb as rocks, because they made assumptions.

For mortgages, 2.7% went through foreclosure. But given the failure to correctly assess risk, almost any downturn of the real estate market would have had the same catastrophic result, and destroyed credit markets.

Posted by: phx8 at October 8, 2008 12:38 AM
Comment #266153

Rowan: An excellent article. However, this pea brain does need some clarification.

In your third from last paragraph, you say that “I think it is important to not be lead astray by claims of ‘corruption and greed.’” But, your description of the systems seems to indicate, at least to me, that the systems were designed for the specific purpose of “corruption and greed.”

When wealth has the privilege of influencing or as is often the case, writing the rules and regulations that govern the systems, one has to expect that they would write a win, win senario for themselves, especially when they have an abundant supply of palm grease.

Follow the trail of cause in any direction that you chose, it always leads back to the politicians and the people who vote them back into office time and time again.

Posted by: jlw at October 8, 2008 8:40 AM
Comment #266158

I am not an economist. Nor am I a “sophisticated” investor in exotic financial instruments. That notwithstanding, I find this financial disaster an absurdity almost beyond comprehension. Particularly egregious is the complete failure of government oversight. The financial equivalent of the government’s response to Katrina.

The practice of allowing mega institutions to “hedge” risky investments with illusory CDS “insurance” was bad enough but to allow a speculative CDS market on the securities is way beyond the pale. The idea that the principals in these transactions didn’t appreciate the risks begs common sense. Short term profit and vulture speculation drove this market. The idea that government regulators didn’t appreciate the risks to our economy equally begs common sense. They have been sticking their finger in the dam hoping that it will hold but realizing that it wouldn’t. Their failure to raise a red flag earlier and more decisivley demands explanation.

Rowan’s suggestions of closing down the CDS market seems to me to merit consideration. Much of that market is pure speculation. The value of the outstanding CDSs far exceed the value of the underlying securities. Declaring CDS contracts held by parties unrelated to the underlying transaction as illegal gambling instruments and void against public policy is a start. Stabilize the underlying securities to avoid default on the remaining CDSs. Capitalize the “real economy” while the bubble is reduced. It will take an extraordinary amount of money. But what choices do we really have?

Posted by: Rich at October 8, 2008 10:09 AM
Comment #266159

The mantra of the capitalists is that markets, corporations, and “capital” are amoral. Greed and corruption are moral valuations and apply to individual “bad actors.” What we are watching is a system that was restructured in such a way that “do anything” was the path to success.

That restructuring involved removing national controls on flow of capital, removing the boundaries between different industries and financial institutions, removing official oversight and controls. In other words, it has been an experiment in unfettered capitalism.

Winners in this environment were “creative” and (from what I can tell) deceptive. But isn’t that what we have been told over and over with “caveat emptor” (the buyer beware)? In other words, if folks got “cheated” in this environment, it was not the fault of the mortgage marketer, or investment firm, it was buyer who is at fault.

The “belief” of capitalists has been in the “wisdom” of the market. That wisdom met some resistance when the Department of Defense started their terrorism futures market. Folks participating in the exchange would predict where the next terrorist attack would be. After public outrage, the program was quietly put to bed. However, the terrorist exchange was an example of belief in the wisdom of the markets to predict anything - including terrorist attacks.

By claiming that current problems were caused by “greed and corruption” it moves the focus and responsibility off the real failures and problems. It is an attempt to shift blame. Even more problematic, if people buy the greed and corruption accusations, the wrong problems get solved and the real problem of the ideology that created the restructuring passes by unscathed and unchanged.

Posted by: rowan at October 8, 2008 10:10 AM
Comment #266161

1 quadrillion? If every human on the face of the planet comes up with $160,000 to contribute we’re free and clear of this mess. Why aren’t the candidates coming up with solutions like this?

Posted by: Schwamp at October 8, 2008 10:24 AM
Comment #266229

dammit, I knew I shouldn’t have blown it on a Ferrari!

Posted by: googlumpugus at October 8, 2008 9:18 PM
Comment #266264

Rowan, greed and corruption are exactly what has happened here. How would it be possible in any system which values integrity for a CEO of Goldman Sachs to become Secretary of the Treasury? A child could see the conflicts of interest. The problem is that, as someone once said, “the business of America is business”. Let me add my two cents worth and say that the religion of America is unfettered red in tooth and claw capitalism. Or more recently, gangster crony capitalism.

That’s at the elite level. The politicians are in the pockets of the money men. At the ground level, the problem is the American dream. Joe sixpack doesn’t want any restrictions of getting rich, as it might spoil his dreamy chances if he ever makes it. As George Carlin said, the reason they call it the American dream is because you have to be asleep to believe in it. For this reason, Joe Sixpack keeps voting in the same venal bloodsuckers, who keep pocketing the spoils from the rich to game the system. I’m dumbfounded that the likes of McCain can still be talking about free markets and minimal regulation and still be in the game, even if he is falling behind. But let’s not fool ourselves, Obama is the other side of the same coin. The system is rigged, heads they win, tails you lose. There’s only one party, the War Party. And it doesn’t matter who you vote for, the government always wins. Fiat justitia, ruat coelum. Tear the temple down and start over.

Posted by: Paul in Euroland at October 9, 2008 9:57 AM
Comment #266326

Just when we were getting comfortable talking about trillions, you have to up it to quadrillions. It looks like people were trying to buy insurance against the boogey man, and effed up the world financial system in the process.

We need to just say no to Citi, and hope for better from Wells Fargo, but this is no way getting solved by big guys eating each other up. Some financial experts are talking about recapitalization.

On blaming the poor, you give them a nice bowl of gruel, and they just ask for “more please”, the greedy bastards

The son of the former chief of FirstChicago, now Chase, is running for Congress in the Illinois 16th, most likely a sacrificial lamb, but he’s the mayor of the wealthiest community in the district, and a DEMOCRAT. Vote Green!

Posted by: ohrealy at October 9, 2008 4:29 PM
Comment #266430

Rowan excellent article. Very informative and educational.

Posted by: j2t2 at October 10, 2008 9:44 AM
Comment #266621

If you continue trudging through this (almost incomprehensible to the lay person) report, you will come to Graph 4 on page 12. There you discover that five commercial banks have the lions share of derivatives - almost 97% of derivatives held by commercial banks.

Posted by: Rob at October 12, 2008 8:00 AM
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