It's the Derivatives, Stupid! Why Fannie, Freddie and AIG Had to Be Bailed Out

"I can calculate the movement of the stars, but not the madness of men."

       – Sir Isaac Newton, after losing a fortune in the South Sea bubble

Something extraordinary is going on with these government bailouts.  In March 2008, the Federal Reserve extended a $55 billion loan to JPMorgan to "rescue" investment bank Bear Stearns from bankruptcy, a highly controversial move that tested the limits of the Federal Reserve Act.  On September 7, 2008, the U.S. government seized private mortgage giants Fannie Mae and Freddie Mac and imposed a conservatorship, a form of bankruptcy; but rather than let the bankruptcy court sort out the assets among the claimants, the Treasury extended an unlimited credit line to the insolvent corporations and said it would exercise its authority to buy their stock, effectively nationalizing them.  Now the Federal Reserve has announced that it is giving an $85 billion loan to American International Group (AIG), the world's largest insurance company, in exchange for a nearly 80% stake in the insurer . . . .

The Fed is buying an insurance company?  Where exactly is that covered in the Federal Reserve Act?  The Associated Press calls it a "government takeover," but this is not your ordinary "nationalization" like the purchase of Fannie/Freddie stock by the U.S. Treasury.  The Federal Reserve has the power to print the national money supply, but it is not actually a part of the U.S. government.  It is a private banking corporation owned by a consortium of private banks.  The banking industry just bought the world's largest insurance company, and they used federal money to do it.  Yahoo Finance reported on September 17:

"The Treasury is setting up a temporary financing program at the Fed's request. The program will auction Treasury bills to raise cash for the Fed's use. The initiative aims to help the Fed manage its balance sheet following its efforts to enhance its liquidity facilities over the previous few quarters."

Treasury bills are the I.O.U.s of the federal government.  We the taxpayers are on the hook for the Fed's "enhanced liquidity facilities," meaning the loans it has been making to everyone in sight, bank or non-bank, exercising obscure provisions in the Federal Reserve Act that may or may not say they can do it.  What's going on here?  Why not let the free market work?  Bankruptcy courts know how to sort out assets and reorganize companies so they can operate again.  Why the extraordinary measures for Fannie, Freddie and AIG? 

The answer may have less to do with saving the insurance business, the housing market, or the Chinese investors clamoring for a bailout than with the greatest Ponzi scheme in history, one that is holding up the entire private global banking system.  What had to be saved at all costs was not housing or the dollar but the financial derivatives industry; and the precipice from which it had to be saved was an "event of default" that could have collapsed a quadrillion dollar derivatives bubble, a collapse that could take the entire global banking system down with it.

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.  

The Best Game in Town 

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