Economic Globalization and Speculation Coming Home to Roost

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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.

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Rowan Wolf is an activist and sociologist living in Oregon. She is the founder and principle author of Uncommon Thought Journal, and a Senior Editor for more...)

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