The credit crisis signals an end to the marriage of American hyper-capitalism and de-regulation. More losses are to be socialized, borne by taxpayers.

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Capitalism has been victimized by a lack of regulatory oversight and its own relentless greed.

As I write, the financial sector is literally disintergrating, with many banks' stock prices collapsing. Desperate to stop the contagion effect, the Federal Reserve has made a $85 billion loan to American International Group, to prevent that multi-line insurance company from defaulting on its loans.

Insurance companies need to maintain a strong balance sheet to pay claims. State regulators typically monitor the type of investments insurers make to make sure risks are not too high. This could explain why New York State Governor David Patterson tried to intervene on AIG's behalf. Should an insurer fail, state government is typically on the hook.

Insurance consumers might have reason to doubt that their insurers will honor claims, a precarious situation that would resurrect memories of the Great Depression, when insurers failed, leading to a myriad of state and federal laws and regulations meant to re-establish public confidence in the industry.

New York State and other entities clearly lacked the ability to make a loan of sufficiently large size to prevent a worst case scenario of a general default or bankruptcy. The Federal Government, on the other hand, seeks to insure the national marketplace for financial products, so losses associated with subprime debt, credit derivates, and other exotic investment vehicles have been socialized in order to stem a broader contagion effect.

The true value of the financial asset is determined in a healthy marketplace. Buyers must have the capital. And buyers are hard to find. After all, if something (a company or the debt it carries) cannot be sold at a given price, it isn't worth that price. The absence of buyers for AIG shows that the company may be worth little, if anything, and AIG certainly isn't the only company in need of more capital.

Unfortunately, our government has chosen to absorb the losses of AIG, after nationalizing Freddie Mac and Fannie Mae. The loan made to AIG may never be repaid, but if the company were fairly valued, no private entity would have bought it. In other words, our government has determined that saving AIG would help more than letting it fail. This can be in no small part due to the speed of the devaluation of bad debts.

Valuations decline rapidly

Within a period of just a few months, huge write-offs like those taken by Merrill Lynch simply couldn't keep pace with the disintegration of the market value of debt securities held in their portfolio.

Merrill Lynch was just sold to Bank of America for about $50 billion, a fraction of that company's stock value just a few months ago. At $20/share now, the company's total market cap is about $29 billion, so BofA bought at a premium. Still, Merrill had been worth at least $60 billion as recently as June, so the company lost in excess of $10 billion in market value, even on the heels of a series of very large write-downs over the past year, which sucked some $25 billion off its balance sheet even before the sale was negotiated.

The decline in Merrill Lynch's market capitalization signals that the write-downs were inadequate and the losses even higher. Trying to free itself of bad debt--by openly admitting and writing them off--actually worsened the company's prospects to resolve the crisis by adding more capital. The more shaky a company's assets are believed to be by the rating agencies, the harder it is to attract new investors and capital. The temptation to understate the problem is therefore very high.

The less transparency provided, the less investors know about a company's situation. Government has a responsibility to counteract the temptation to grease the books. Should a company be able to avoid admitting problems on its balance sheet, the consequences can rapidly snowball, shaking investor confidence about just how much financial companies in the broader market are really worth.

Adequately imposed, transparency prevents investment banks and brokerages from hide facts that might diminish the allure of the financial products they sell. Regulatory efforts--undermined by the laissez faire approach of the Republicans--intend to bring out in the open avoidable mistakes and conflicts of interest, which if kept secret could end up undermining the system of issuing stock and debt itself. The markets are meant to be kept orderly, a process that depends on rigorous adherence to GAAP--generally accepted accounting principles, a set of uniform accounting procedures integral to standardizing investments.

Apparently Lehman Brothers, which declared bankruptcy on Monday, was less willing to write down its bad loans. While on the surface, this avoidance of losses might make the company look good, the lack of transparency ended up masking the scope of the problem until such time as the company's liabilities exceeded their assets.

Write-downs are an important part of cleansing bad loans off the books. The Japanese, who suffered from an extended deflationary period from 1993 to 2001 or so, struggled with this problem. Banks were reluctant to abandon bad loans, in part due to the close relationships between lenders and the banks. By writing the bad loans off, the Japanese economy could have recovered more quickly.

If a huge corporation like Merrill couldn't handle the devaluation of its debt holdings, it's a good bet that the entire financial sector suffers from rapidly declining valuations as well, and will suffer additional losses that could further speed the decline in valuations, making even more companies suffer under tightening credit conditions and dwindling capital reserves.

Background on the Crisis

The repeal of the Glass-Steagall Act was proposed by Travelers CEO Sandy Weill in the late '90s. The idea was to break down the wall between banks and brokerages, allowing cross-marketing of financial services. On one level the concept made a lot of sense: banks could more actively market retirement vehicles whose need was demostrated by the dearth of retirement savings in America among the rapidly aging boomers. Banks had failed to service this market, as securities sales weren't a high profit area; the higher volumes at brokerages, coupled with more lucrative commission models, gave them a competitive advantage.

Weill's Travelers was an insurance company which had expanded into retailing brokerage. By incorporating Smith Barney (Traveler's brokerage arm) to Citibank branches, Weill hoped to build a cross-marketing financial powerhouse that could offer one-stop shopping for mutuals funds, annuities, insurance, stocks, and banking accounts. The overlapping markets meant that customers could be served more efficiently, at lower cost, than had been the case with traditional banks. Things worked well, at first.

Then the end of Glass-Steagall presented its first major challenge in the stock market of late '90s, when stock analysts talked up stocks that their brokerage divisions were eager to sell. The temptation to hype tech stocks was simply too high to resist at the research departments of newly combined bank/brokerages. This conflict of interest was being investigated by the SEC in 2001, when WTC 7 collapsed, perfectly into its footprint, faster than the speed of gravity. Inside WTC 7 were the offices of the Securities and Exchange Commission. Inside their offices was a safe which apparently containing the evidence of wrongdoing by the major brokerages, evidence that the brokers and analysts were misrepresenting stocks to investors, and contributing to the hype. When WTC 7 inexplicably collapsed, somehow vaporizing the safe, thousands of investigations ended (link), although the SEC has not specified which ones.

Despite the investigatory setbacks caused by 9/11--a lot of the SEC's files were paper and apparently unretrievable--reforms were made in the wake of the 2000 stock bubble collapse. Disclosure requirements were instituted so would-be investors could see how much stock the analyst and his company owned, to sniff out any conflict of interest by making cross-ownership transparent.

Once the analysts' conflict of interest had been realized, and reforms enacted, next came the challenge of keeping brokers honest about the debt they were selling. Brokers who sold the stock and debt of the companies their investment banking divisions were underwriting would talk up their new offerings, as to make them more saleable.

The real ghosts haunting the repeal of Glass-Steagall have been the investment banks. In newly merged bank/brokerages, private offerings made by investment banking divisions were channeled through brokers, creating a conflict of interest in understating the risk. Of course the brokers wanted to sell stock and debt, to make more commissions, and the investment bankers were eager to exaggerate the potential profits presented by their new offerings, and diminish the risks to make the offering more successful (and thus entice more would-be issuers to use their services instead of their competitors.)

The bull run in the housing market had opened up huge new opportunities in the bundling of mortgage-backed securities. Derivatives based on these SIVs or "structured investment vehicles" became a huge source of fees for bank/brokerages, who in turn traded derivates and swaps amongst themselves, under the belief that they were reinsuring the risk. While banks did take an extra step of insuring their mortgage-backed securities against default, they relied on other banks for insurance and companies like Ambac and MBIA, who could only do so much to protect defaults in a broad credit crisis like we face.

With so many Collateralized Debt Obligations (CDOs) and unregulated credit default swaps floating about, part of a $600 trillion derivatives market, investment banks were drawn into the lucrative ends of both issuing and insuring debt. Credit default swaps are arrangements between an insurer and purchaser of some form of debt that guarantees payment upon default in exchange for a lucrative fee.

The credit default swaps were supposed to cover the possibility of a default, but became a vehicle for increasing the sales of derivates by reducing the perceived level of risk. Meanwhile, the market grew so huge that one default could trigger a much broader failure as the so-called insurance couldn't cover the costs of multiple, simultaneous defaults, each of which could cause more defaults as borrowers in the first ring default and can't pay their creditors. This is the contagion Paulson and the Fed fear.

How big will it get?

Just how bad could the liquidity crisis become? Well if the banks aren't able to collect on their loans, lending will contract. Also, banks will be paying more interest out to their creditors, which in addition to other banks include foreign investors, who will be reluctant to loan more. Borrowing more from foreigners is the fuel that allows our country to sustain its massive budget and trade deficits. Without their loans, we suffer economically and whatever capital we have available ends up flowing out of the country to pay our creditors (instead of using our new borrowings to cover our interest.)

The big crisis we now face is a combination of the failure of investment bankers to control their greed, accelerated by escalating defaults that weren't anticipated by well compensated Wall Street investment bankers during rosier times.

Subprime securities compromise only a portion of the $600 trillion derivatives market. Here is Daniel Amerman, writing for Safe Haven:
"Welcome to the brave new world of credit derivatives driven collapses. A world that is far more dangerous than the world of subprime mortgage derivatives. A complex world that because of its sheer size can potentially cause more damage in a matter of days than the subprime mortgage derivatives caused in their first year in the headlines."

Amerman's article goes on to describe in detail how commissions are paid--an essential component of understanding how financial markets work. Built into the credit derivatives market is a predisposition to understate risk. Here's Amerman again, form the point of view of an investment banker hungry for a large bonus:
"The key to your bonus this year is the particulars of the assumptions that your group makes about what those expected losses will be in the future. The lower the assumption for expected losses, then either the greater your profits in a given transaction..." See Amerman's chart for an idea how credit derivatives could pay off big.

With so many banks insuring each others' derivatives products, the whole banking industry faces collapse. Unfortunately, risks assessments treated the risk of default of one debt security independent of the risk of other defaults. Amerman explains:
"...this model assumes that each company is an independent risk. Kind of like insuring 50 homes against the chance that an electrical fault will cause one house to burn. But what if the problem is not an electrical fire, but a wildfire burning out of control, and the homes you are insuring are on a bone-dry hillside in Southern California? The risks are no longer independent, and instead of losing on just one insurance contract - you lose on 20 out of the 50 contracts."

Troubling indeed is the size of the loans. Lehman Brothers had debts of $618 billion, which would make it the largest bankruptcy on record. Such a large default will impact many other financial companies and spill over into foreign markets. At the very least it will increase the risk premium associated with any loan. The higher interest rates will slow lending and economic activity, impacting industries unaffected by the initial default.

The more expensive it is to borrow, the less borrowing there is. If interest rates climb, the economy contracts. Therefore to continue economic growth, banks need to be able to loan and financial companies need access to credit. Through a discount window, the Fed has offered to exchange mortgage-backed securities of dubious value for AAA US Treasuries. Apparently that mechanism failed to provide Lehman with enough credit to forstave its bankruptcy. This means that the Fed has really lost control. Acccording to the Chicago Tribune, earlier this year economist David Hale heard Bernanke privately admit that "We have lost control...We cannot stabilize the dollar. We cannot control commodity prices."

Whether Bernanke blinked or not, it is clear that the recent depression in commodity prices may have been fleeting. Gold soared yesterday, along with oil. The Dow has been battered in two huge losses so far this week. The dollar sank against the Yen. These declines attest to the magnitude of the credit crisis, and the broadly held perception that the Fed can't do enough--that simply making more money available to lend and borrow won't head off the cascading consequences of the credit crisis.

An engineered crisis?

The current crisis seems to have its roots in systemic failure, rather than willful manipulations by company owners hell-bent on getting out before their companies self-destruct as a result of their mismanagement. Yet as we saw in the case of Enron, those at the top typically do escape comparatively less well damaged than the stockholders, who in this more recent crisis are the last to receive any compensation for their losses.

One consequence of the government providing bridge loans has been that shareholders of distressed financial service stocks sell their stock and instead choose to purchase bonds issued by the troubled company, as bondholders are typically farther up in line to receive the assets of a company as it liquidates. The share price then falls, which makes attracting capital that much harder.

Could this current financial crisis be engineered? Probably not. The impact to the superwealthy appears to be sufficiently bad as to disprove any hypothesis of a willfully contrived crisis--always an intriguing possibility to a conspiracy theorist like me. What is suggestive of a conspiracy is the amount of federal money being dispensed to protect wealthy individuals and corporations.

Unlike Naomi Klein's Shock Doctrine, private players aren't going to end up controlling financial companies--or are they? The Federal Reserve is a privately owned corporation. By providing the necessary capital for the bailout, the Fed has increased the amount of debt carried by the US government to unprecedented levels. As anyone who follows Ron Paul knows, public taxes that Americans pay go directly to the Federal Reserve. The Treasury is little more than a money-printing extension of the Fed who simply forwards our tax payments to the Fed to pay for the interest on our government's borrowings. What a system!

Unfortunately, our monetary system is based purely on IOUs, the promise to pay, and we measure wealth by how much of someone else's debt--be it the Federal Reserve's or someone else's--we own. The great Achilles Heel of such a system occurs when borrowers default, which happens because they aren't accumulating enough of someone else's debt fast enough.

Essential, fiat currencies are a constantly eroding store of value. It's just a question of cui bono, who profits, from the business cycle. After every economic calamity in the past century, the wealthy end up wealthier. Investment incomes increase quicker than do salaries. So as the working class buys less and less in times of inflation, wealthier types make more and more, their incomes exceeding the inflation rate. The poor end up making less in real terms while the rich accumulate more capital, although each dollar buys less.

Without investors willing to put capital in, and extend loans--this most definitely includes overseas sovereign wealth funds that prop up our dismal balance-of-payments, our debt-based capital system unwinds. Money lent which goes uncollected--bad debts--represent a massive destruction of capital. The good side is that inflation may be slowed--the bad side is that capital is not available to lend and the economy slows, perhaps quite quickly and radically.

Essentially the only thing propping up the industry is the addition of more money--liquidity. Sadly, in our commeditized financial markets, money has become debt and debt money. When we collect Federal Reserve Notes, we assemble someone else's debt, a promissary note. To assemble wealth, we assert a claim to being owed more. To create more wealth and money, we simply get our government to borrow more, through the Fed, and lend it out. If the interest the banks charge doesn't cover their defaults, they can't stay in business and lending slows or ends altogether. In such a crisis government becomes the lender of last resort, creating money from bonds it sells to the Fed. The Fed, in turn, absorbs interest from the loans they make to our government, which is making interest-only payments back to the Fed in the form of taxes. So more money lent out means more interest income for the banks. Now if interest rates make borrowing too expensive, the US government will find it harder and harder to bear the payment of interest alone.

Oops, we screwed up. Now bail us out

The absence of adequate regulation is highly suspicious. In the Bush era of lax regulations, a financial crisis could have easily been anticipated, and was, at least outside the mainstream media.

Regulatory circumventions from the subprime lending fiasco presaged the broader crisis. Eliot Spitzer had been trying to enforce mortgage regulations but had been actively inhibited by George Bush's Department of Justice. In an article written in March, Greg Palast explains:
"Instead of regulating the banks that had run amok, Bush's regulators went on the warpath against Spitzer and states attempting to stop predatory practices. Making an unprecedented use of the legal power of "federal pre-emption," Bush-bots ordered the states to NOT enforce their consumer protection laws."

Market collapse and large-scale federal intervention seems followed deregulation in the home lending industry just as it has for banking. Spitzer's fall from grace came the day after a huge bailout was announced as part of the Countrywide deal--kind of like how 9/11 came the day Rumsfeld spoke about $2.3 trillion that had gone missing from the Pentagon. Did Spitzer's humiliation serve as a shock meant to send a warning to other would-be regulators of the mortgage industry (which included all 50 Attorneys General.)

In a letter Spitzer wrote just before he was outted, he said that the Feds has "preempt(ed) all state predatory lending laws, thereby rendering them inoperative" and "prevented states from enforcing any of their own consumer protection laws against national banks." In response to Spitzer's effort to fight the deregulation, he was sued by the federal government.

The predatorial lending was a faxsimile of the broader derivatives crisis. In both cases, the Federal government changed long-standing regulations. Here is Patrick Wood, editor of The August Review, writing in his article "Globalist Ultimatum: Pay up or collapse":
"On March 31, 2008, Paulson quietly released a 200 page document titled, "Blueprint for a Modernized Regulatory Structure" that he and Bernanke are now actively pushing Congress to adopt. It basically calls for the complete restructuring of U.S. markets and their regulatory structures to meet new “global standards”. After all, [their position is that] our regulatory bodies have been created over the last 75 years and are not compatible with today’s financial challenges. In addition, the Blueprint calls for much more self-regulation by the banking/securities industry itself. The very people who brought us this financial chaos in the first place, want us to let them do whatever is in their self-perceived best interest to protect and increase their profits. Meanwhile, Paulson recently demanded and received from Congress a blank check for the bailout of Fannie and Freddie. The alternative, he boldly claimed, was the further meltdown of the U.S. housing market and likely destruction of the economy."

The "Blueprint" makes an effort to accomodate regulatory challenges that have risen with the increasing complexity of financial services products. The document advocates making changes in the regulatory framework in recognition of the internationalization of the financial markets. In essence, this means that foreigners will do as they wish with their money, and if the US doesn't do enough to placate them, their money will stay offshore.

Paulson's plans reflect a changing world, but they don't exactly elevate the rights of the American purchaser of financial products to the top of the pyramid. It's hard to see how the Paulson/Bernanke model for financial modernization will protect the interests of individual investors. Instead the document hints at the goals of the New International Economic Order that groups like Bilderberg and the Trilateral Commission have been trying to implement.

Creating uniformity in international standards appears to be about paving the way for transnational entities to buy and sell financial products at the lowest possible risk. If anything, this crisis and the Blueprint show just how dangerous implementing a new financial order is, and highlights the transference of risk from the institutions to the government, who is to be held responsible for whatever losses and problems occur as a result of the changes, all in the name of stabilizing the markets, a euphemism for bailing out its biggest players, it would appear.

End of an error

The gilded age of American supercapitalism appears to have reached its end.  De-regulation has its limits, and if government wants to intervene, it needs to learn from past mistakes and economic disasters like the Great Depression, and enforce the laws created in its wake rather than plow vast sums into the parched soils of the financial sector.

In trying to accomodate business, the US government under Bush has simply expended nearly infinite amounts of taxpayer money with little resulting benefit to the American public, markets, or the consumer. Corporate largesse benefits corporations and a small group of businessmen, but little of the electorate--or both of the current Presidential candidates wouldn't now be calling for more regulation. As the financial markets begins to quiver under the strain of trying to make too much, too fast, for too long, resistance to the lax regulatory environment has strengthened as the consequences of de-regulation make themselves known.

The ambitions of a handful of very powerful corporations have been contained, limited by the limitless greed of its principal players. The idea of a super-state that transcends national boundaries is on hold, if not utterly refuted by the economic distress that globalization--coupled with de-regulation--appears to have brought. The idea of creating a single North American Union may have to wait. Still, the greed that inspires multinational corporations won't go away.

It's only through the ongoing efforts of a participatory and informed citizenry--acting like sentinels--that perversions of the law and regulatory framework can be avoided. It could take a whole 'nother Depression to brand into Americans' brains the reality of the struggle workers face--Marxian--in their economic self-interest opposing the owners of the means of production.

After each bout of class warfare comes a period of economic introspection which sees the passage of laws and protections which in time are labelled economic impediments by the "pro-business" Right.

Maybe our lesson--a repeat--will be better learnt this time. Or maybe the credit crisis will just keep unfolding until the economy corrects, causing a good deal of "creative destruction" that will undermine our standard of living. Sadly, every economic calamity seems to povertize the middle and working classes, and the rich invariably end up wealthier. This most recent crisis will be no different.

I'll admit a sense of schadenfreude as the investment banking industry crashes. Reading through the alumni magazines of the illustrious institutions I attended, I've been jealous to see how many work in the investment banking business. These highly successful individuals have explained on several occasions just what it is they do, coupled with a thinly veiled effort to rationalize the vanity of their obscene profits. Maybe my inability to understand how my classmates made their money in that industry served well as an advance warning device--Peter Lynch's axiom that people should buy what they know still holds. If I could have figured out what all these exotic derivatives really were then I would have been far more confident in their ultimate viability.

With investment bankers collapsing now, it's clear that greed, coupled with inadequate regulation, meant that (MY) short-term profits were more important than the long-term viability of the industry. Without regulations, as it turns out whatever profits--obscene though they were--brokerages made in the run-up will be erased by the collapse not only in the stock of banks and investment banks, but the entire financial industry as we know it. Whatever gains circumventing Glass-Steagall may have provided--which went to a well placed and politically influential few--will be dwarfed by the contagion effect.

The point of government regulation is not to pointlessly reduce the growth of the economy, although this is how the issue has been framed on the political front, in terms that clearly favor the Right's quid pro quo with the business leaders who've pledged their support in return. The myth that regulation can only inhibit growth is being proven wrong as the consequences of inadequate regulation by the government of American style capitalism (hyper-capitalism/capitalism on steroids) are doing far more damage than any regulatory impediments could have.

If the accumulation of money--capital--is the ideal, our society isn't better off through de-regulation. Short-cuts were taken so some people could make a lot of money for themselves, whatever the cost to society, no matter how unsustainable. Net-net, the amount of taxpayer funds spent on bailouts in the wake of the speculative craze far exceeds whatever profits the investor class and their corporate actors made in their speculations, once the scope of losses are known.

The taxpayer isn't off the hook, even if the worst of the excesses have passed. The corporate agenda now dominating the Washington consensus is to privatize profits, and socialize losses (to quote NYU economist Nouriel Roubini) in some crazy backwards Robin Hood, and so the taxpayers and their grandchildren will be paying for the regulatory lapse.

Sure some speculators have gotten rich, and greed is good according to this philosophy, but how good is it that some have gotten obscenely wealthy by not actually creating anything, but simply profitting from the labor of others? Just how American is that? To further slap the American middle class, alongside their troubled mortgages and worsening job market, the tax burden on the ultra-rich has fallen to the point Warren Buffet pays less on every dollar he earns in taxes than does his maid. So not only will the taxpayer bail out those responsible, they'll be given a tax break!

Authors Bio:

The author lives in Colorado, photographing the natural beauty of the Rocky Mountains.

Politically, John's an X generation independent with a blend of traditional American and progressive values. He is fiscally conservative and believes in small but efficient government.

He opposes all hard power intervention in the Middle East unless the U.S. faces a direct security threat. Peace between Muslims and non-Muslims will be necessary to achieve peace in the region.