July 24, 1998, was an epic day for the global financial system. Federal Reserve Chairman Alan Greenspan stood before Congress's Banking and Financial Services and testified. This article and the next part will focus on these two testimony excerpts concerning derivative regulation and the gold market.
by Jake, the Champion of the Constitution
Tuesday, April 7, 2009 from http://www.nolanchart.com/article6266.html
WASHINGTON D.C. - July 24, 1998, was an epic day for the global financial system. Federal Reserve Chairman Alan Greenspan stood before Congress's Banking and Financial Services and testified. This article and the next part will focus on these two excerpts from this testimony.
"In conclusion, the [Federal Reserve] Board continues to believe that, aside from safety and soundness regulation of derivatives dealers under the banking or securities laws, regulation of derivatives transactions that are privately negotiated by professionals is unnecessary."
"Nor can private counterparties restrict supplies of gold, another commodity whose derivatives are often traded over-the-counter, where central banks stand ready to lease gold in increasing quantities should the price rise."
In his testimony, Greenspan recommended to Congress that regulation of Over-The-Counter (OTC) derivatives between private parties was not necessary. These derivatives are referred to as "dark derivatives" as they take place away from exchanges where the terms could be made public and the companies examined by the exchange for counterparty risk – the risk that a company would be insolvent or bankrupted by the time when the derivative comes due. For instance, the metal commodity markets like the NYMEX require a 100% cover of all deliverable contracts (leverage transactions still require a 90% cover per 17 CFR 31.8), and examine the solvency of both parties. The remainder of this article will delve into the consequences of this action.
Less than two months after Greenspan's testimony, the failure of the hedge fund Long Term Capital Management nearly deflated the developing stock market bubble as it took $4.6 billion USD in derivative-based losses. The Federal Reserve leapt to the rescue, leading a cabal of investment banks to pony up $3.6 billion USD. Goldman Sach's CEO Jon Corzine was forced out shortly afterwards by the future Secretary of the Treasury, Henry Paulson. Corzine would move on to become a US senator and is the current governor of New Jersey. Bear Stearns refused to cooperate and later became the first major casualty of the Panic of 2008.
Greenspan's second comment was that central banks would act to suppress the gold price by releasing central bank gold into the market was quite similar to what the London Gold Pool of the 1960s had attempted - and miserably failed – to do: control the price of gold. This is tantamount to stating that the financial "canary in a mine" would be both hooded and castrated in public view. Even in today's troubled economic times, most members of the public are completely unaware that the 2008 daily trading on the London Bullion Market Association exceeded $80 billion USD per trading day, or $20.3 Trillion USD for the year. Part 12 will delve more into the suppression of the gold price, building off of the excellent work put together by the Gold Anti-Trust Action Committee, or GATA.
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Bring Light to Dark Derivatives!
First, let's see what has happened with the OTC derivative market since 1998. The short answer is that the value of the notional amounts exploded from $72 Trillion to $684 Trillion in June 2008 per the data provided from the Bank of International Settlements, or BIS.
Before moving on, let's add one more definition to the list from Part 10, "What the Heck are Derivatives?"
Notional Value - the value of a derivative's "underlying assets" at the spot price. In the case of an options or futures contract, this is the number of units of "underlying assets" specified in the contract multiplied by the spot price of the asset.
Let's say I wanted to speculate on the price of crude oil. I could buy an October 2009 contract to deliver 1000 barrels at $60 a barrel plus exchange fees. The notional value of this contract when purchased is $60,000 but it will not be exchanged until October. In the meantime, if the spot price of the oil drops to $40 per barrel, the notional value drops to $40,000. Furthermore, although the contract gives me the right to buy the oil, I am not the owner of the oil until October arrives and the contract is delivered. The oil is the "underlying asset" of the contract.
The same could be said for a credit default swap on a corporate bond, a swap based on the dollar's interest rate. Or a "mortgage-backed" collection of securities. As you can see, the "underlying asset" can be physical property like the barrel of oil, but it could also be much more nebulous, like a derivative based on the ability of hundreds or thousands of people to collectively pay their mortgage on time. Plus, how much are these written contracts actually worth while they have not been exchanged? Well, the BIS gives this information which I used to make the below chart on "gross market value." This grew from $2.5 Trillion in 2008 to "only" $20.4 Trillion as of June 2008.
Interestingly enough, the BIS also placed a "market value" on "gross credit exposure" of $3.9 Trillion in June 2008. This is the leftover amount after taking into account all contracts that offset each other. Theoretically there is a long contract for every short, but per the BIS this is not always the case. (I do not have specifics yet but this may involve leveraged transactions). So this amount signifies the "market value" of those derivatives where there is a possibility of totally unhedged losses. I must state it's not appropriate to do so other than to obtain a rough idea, but if the percentage of the gross credit exposure could be estimated as proportional to the nominal value, this would work out to a whopping $130 Trillion.
However, how can you place a "market value" on all the various types of derivatives? Most especially, how can you call this a MARKET value if there is NO market for these contracts – remember that all OTC derivative transactions take place directly and privately between a buyer and seller.
The Paper Property System and Derivatives
This requires us to look at the derivatives problem in a new light. The crux of the matter is that OTC derivatives have an unknown worth – the BIS "gross market value" calculation is, in my humble opinion, nonsense. Let me explain.
First one should understand that our entire property system is founded on paper documents. If one owns a car or a house in the United States, one must also have a deed or title to that property. If one buy goods from a store, there is a paper record – a receipt – that serves to transfer ownership of the good from the store to the individual. Online transactions merely substitute screens for this paper record. Whether a corporation or an individual, one typically has to prove their identity in some way based on paper – a passport or driver's license or business license – before doing business with each other. The vast quantity of transactions we execute are done with unseen other entities. Also recognize that when you purchase or sell a stock share or mutual fund share you are selling it to an unknown person, usually via some exchange that you trust to transfer your property – which is really just a paper document.
This system of property identification and organization is founded on our rule of law. However, many fail to realize that this link of property to paper documentation does not exist in many places in the world – many Latin American and Third World countries do not have a very clear, transparent property system setup. However, the size of the OTC derivative market has led the modern-day United States into a similar Third World scenario! We do not understand (and have lost) the link between the paper derivative contract and real assets.
Furthermore, we no longer know if these pieces of paper has any worth and are tethered to real assets with actual value. All derivatives are really instruments of quasi-property. These credit instruments pretend to be based on (fiat) money, but they are not really anchored to anything!! They masquarade as real property, but at best are just forms of quasi-property.
Remember, we live in a paper property system. Without the knowledge on what these investment bankers and their financial engineer assistants have done, there is no way to know if they are bankrupt. Let me repeat. THERE IS NO WAY TO KNOW FOR SURE IF THESE COMPANIES ARE SOLVENT. There is no way to know if its even POSSIBLE for the government or FED to help a few banks or companies if we do not understand what these troubled companies really possess. Executing on eco-political policies and ideas like one "big, bad toxic bank" is an inane idea since – I cannot stress this enough - we do not have the information to know whether these actions will help or not. Which derivative contracts are the "toxic" assets? Where are they? Exactly what assets are they based on? Who owns them? Which counterparties are solvent?
The Pregnant Economy's Credit "Baby"
Think of the world economy as a pregnant woman. From the outside, we can examine its monetary structure and all the goods and services it produces, but we cannot view the credit hidden inside the woman's belly. (photo from petercanfail)
Without testing with an ultrasound or checking for movement, we do not know anything about the baby.
Perhaps the baby is in perfect health.
Perhaps the baby's head is too large and Caesarian needs to be performed or perhaps the umbilical cord is wrapped around the baby's neck and will choke it if delivered normally.
Perhaps the baby has already died. (I hope not!)
The horse I am beating to death is that it's impossible to know if a cure is needed and what the cure should BE if the information of this "shadow economy" is not being shared. When $684+ Trillion dollars (possibly past $1 Quadrillion as this is based on September 2008 numbers) is involved, we simply must have the information if we are to move forward.
There is no way for the economic crisis to end without understanding the actual worth of these derivatives. Let me repeat again. THERE IS NO WAY FOR THIS CRISIS TO END WITHOUT UNDERSTANDING THE TRUE WORTH OF THE DERIVATIVES MARKETS. Light must be brought to dark derivatives because there is no confidence in the value of both the derivatives but to some extent even to all assets. Mark my words, the world will remain in a state of unease, in a state of endless price discovery, until light is brought to the OTC derivative mess.
Now, if the OTC derivative market did not have high degrees of insolvency, it stands to reason that all information would already haven been available – and the world would not be in crisis, Lehman Brothers and Bear Stearns would not have failed, the major banks like Citigroup and Bank of America would not have been halfway nationalized, and the remaining investment bankers and commercial banks like Merrill Lynch, Goldman Sachs, JPMorgan Chase, and HSBC would have been able to carry on business pretty much as usual, regardless of the subprime mortgage crisis. Therefore, the credit "baby" is not in perfect health.
Therefore, the question becomes how bad is this insolvency? Can the credit "baby" survive with an operation or not? Is it "just" several mega-banks that will be insolvent? Or is the credit "baby" dead-on-arrival and the entire financial system will come crashing down, as was feared during LTCM in 1998, and during the Lehman Brothers/Bear Stearns aftermaths of 2008?
Of course, we have made a bit of a circle, as there is no way to know the answer to this question without the information. My opinion is that what seems to have occurred is that the banking cartel is attempting to weather the storm by frantically repairing its balance sheets with bailout money from a compliant Congress or bailout money from the FED. However, the problem does appear to be fairly catastrophic as the losses for certain banks are most likely too large to paper over with bailout money, and credit extended from by other banks has dried up as they are (rightly) extremely worried about counterparty risk.
No Relief from Past or Future Banker Bailouts
Let me repeat. The bailout money issued by Congress to the AIG, Citigroup, etc. is almost certainly too small to have any effect on the derivatives problem. $750 Billion, $787 Billion, $2 Trillion bailouts are like throwing pebbles into the ocean when compared with $500 Trillion to $1 Quadrillion. Look at their asset to nominal value ratios and percentage of OTC "dark" derivatives below and please inform me if you come to a different conclusion and why. (Data from Department of Treasury's December 2008 OCC report, page 24/33)
Transferring enough paper dollars from hard-working taxpayers either in the present or in the future to these ill-run banking companies can only result in a dollar currency crash similar to what happened in Iceland or many Latin American countries during the '80's and '90's, and hence the (further) impoverishment of the American people. As others have written, this is truly a privatization of the 1998-2007 gains and socialization of 2008-and-onward losses for the banking and investment banking cartels.
The Future
Obviously for a future resolution to occur, Greenspan's actions should be reviewed in hindsight, the informational deficiency needs to be made transparent, and companies that survive and have not committed fraudulent acts should be penalized by the marketplace for carrying out too sizeable over-the-counter deals without seeking an exchange to verify and secure the counterparty risk. Turning to the future, all involved should consider instead to focus on the true wealth production of goods and services, not questing in search of "riskless" paper-shuffler profits like the financial engineers of the past decade.
Of course, this discovery will eventually happen naturally in the United States - unless we enter a totalitarian society and are led to war by our leaders to either control or confiscate even more of the world's wealth but also to refocus the populace on both interior and exterior scapegoats for our fiscal problems. Again, there is simply no other way for our economy to function again on a non-war footing without this information from the financial companies. Of course, the wars will do nothing except worsen the state of economic suppression everywhere in the world, including for most Americans, except for the few elite who may prosper.
Taking the optimistic view, there is no way to know when this discovery will happen, and as much as I believe in the "separation of business and state" the fact of the matter is that the political will of Congress must be brought to bear on the banking cartel led by the FED. There are some encouraging signs. In early April, the FED urged its major cartel members and hedge funds to list their credit derivatives on an exchange in New York City. Congressman Ron Paul's Federal Reserve Transparency Act of 2009, HR 1207, has now reached 58 co-sponsors. This act will enable the American people to audit the FED.
Answering Questions Posed from Part 9
Q: Although many Austrian economists makes perfect economics sense from the standpoint of monetary economics, do their analyses hold up from the standpoint of credit economics?
My answer: Not necessarily. In fact, credit economics most likely answers why their predictions of hyperinflation and massive dollar devaluation have not yet occurred.
Q: What occurs when credit contracts, causing credetary deflation, while monetary inflation continues?
My answer: They act as opposing forces. When both credit and money supply inflation were occuring during the earlier part of this decade, price inflation was indeed seen. In fact, up until July 2008 commodities were on an upward parabola. Credetary deflation may have caused commodity price deflation. In our contemporary time of near-zero or dropping interest rates, definite and measurable monetary inflation, and continued (but unmeasurable) credetary deflation, it is easy to predict plummeting manufacturing and service-related job losses. Consumers have slowed purchases of homes, autos, and non-essential goods since many are uncertain in what the future will bring. Economists cannot make meaningful predictions without bringing light to the dark derivative market, but even then numerical answers will not exist due to the Misesian theory of human action.
Q: What happens when we lose track of the value of these paper credit instruments that are in fact forms of quasi-money?
My answer: Historically, when property, money, and credit become out of balance, panics or depressions occur. Again, we will likely stay mired until this quasi-money is fully or mostly accounted for.
Q: What can the average citizen do?
My answer: Well, besides continuing to read the Money Matrix series (grin) it's important to stay optimistic, educate yourself, become politically-active if you wish and enjoy life. In uncertain times, its best to conserve funds as much as possible, and it's never to late to start saving if you plan a future for yourself and your family. Any private debt needs to be dealt with in a rational manner. If continued price inflation or even hyperinflation (subject for another article) appear imminent (it does not appear so to me at present), what is slightly paradoxical is that being in debt will be of great advantage as currency devaluation reduces the principal of the debt's purchasing power. In the meantime, private individuals should consider diversifying savings from the fiat dollar currency into hard money, namely gold and also silver to avoid fiat currency risks. As explained in this series "The End for the Dollar and all Fiat Currencies (1/5)", the derivatives market sets the market prices for gold and silver, but if this crisis of confidence worsens, these assets are by far the best money to hold.
Postscript - I was delighted to hear South American economist Hernando de Soto discuss this at mcalvany.com and has published several articles on this subject, including this one from the Wall Street Journal as well. It may not take a genius to realize that Greenspan made a big mistake, but its nice to hear a fairly mainstream guy recognize this as well. In particular I recommend the McAlvany audio as de Soto is far more knowledgeable, educated, and easier to understand on this subject than me.
"Some say the end is near.
Some say we'll see armageddon soon.
I certainly hope we will.
I sure could use a vacation from this!!"
- Tool, "Aenima" - Time to end the wait to see which of the dark derivatives will hold water and which will need to, as Tool puts it, "learn to swim."
The Money Matrix Series
- America, Were Michael Phelps' Eight Olympic Gold Medals Worth Winning?
- The Money Matrix - Prelude (PART 1/15)
- The Money Matrix - What is a Dollar Bill Worth? (PART 2/15)
- The Money Matrix - What Makes Money Money? (PART 3/15)
- The Money Matrix - What is Honest Money? (PART 4/15)
- The Money Matrix on the Grand Deception of Seigniorage (PART 5/15)
- The Money Matrix - How the FED Works (PART 6/15)
- The Money Matrix - Who Owns the FED (PART 7/15)
- The Money Matrix on "Credetary" Inflation and Deflation (PART 9/15)
- The Money Matrix - What the Heck Are Derivatives? (PART 10/15)
- Save Ron Paul's Voice - A Money Matrix Addendum
- A Money Matrix Addendum: Citigroup and GATA Call for an End to the Suppression of the Gold Market
- MY PROPHECY - The Federal Reserve Will End! A Money Matrix Addendum
- Silver and Gold ARE Money (PART 1/2)
Tu ne cede malis sed contra audentior ito. Do not give in to evil but proceed ever more boldly against it.
[Reach the Author Here!] www.CampaignForLiberty.com (Banner courtesy Mike Burke)
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We the People of the United States, in Order to form a more perfect Union, establish Justice, insure domestic Tranquility, provide for the common defence, promote the general Welfare, and secure the Blessings of Liberty to ourselves and our Posterity, do ordain and establish this Constitution for the United States of America.
As always, unlike the NFL, the author grants full permission to allow any accounts of, rebroadcasts, retransmissions, repostings in part or full of this article to your blog or anywhere else in order to promote the Restoration of our Republic.
Veritas numquam perit. Veritas odit moras. Veritas vincit. Truth never perishes. Truth hates delay. Truth conquers.
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Summary of Articles and Bibliography for Jake, the Champion of the Constitution (4/4/2009)
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