Hedging & Derivative Risks Becomes Infinite Risk
The $700 trillion derivatives-hedge funds market is leveraged anywhere from 35 to 70 times. Citibank was leveraged at 280:1 The minimum risk of high leverage on a rising market becomes infinite risk as it unwinds rapidly.
As soon as there is a major loss such as Bear Strearns was facing, those investors cannot pay up, hedge costs jump, and that bankrupts more derivative funds. As they are not paid, the intermediary bank cannot pay the winner of that bet so they go broke. The unpaid winners of those bets are on margin so they go broke. Just like Mafia betting, those who loaned the money for those bets go broke because nobody is able to pay them.
Thus the Fed engineered the $30 billion plus rescue of Bear Stearns-JP Morgan to prevent a total meltdown of the then $526 trillion hedge fund-derivatives market which would have extinguished the entire banking structure operating those hedge funds off book.
The little problem at Bear Stearns was just a little bump in the road. Eight months later America’s 20 largest banks were essentially bankrupt and being kept afloat by the Federal Reserve.
The $2 trillion derivatives crisis at Citibank required that they be essentially nationalized. With close to $3 trillion pledged to throw at what could easily be a $10 trillion or even a $30 trillion problem, we have yet to see if money circulation increases or if investors running for the exits reduces the circulation of money (effectively destroying it) faster than money is thrown at the problem.
Options, Futures, other Derivatives, and Hedge funds are Gambling Chips in a Worldwide Casino
The markets for stocks, bonds, commodities, futures, options, currencies, mortgages, money markets, in fact virtually every exchange market anywhere in the world, are now one huge market.
Options, futures, swaps, forwards, other derivatives, all tools of hedge funds, are only the buyer betting that something will go up and the seller that it will go down; neither has a stake beyond the gamble.
They appear to have a legitimate purpose in takeover schemes, but in that role, until a bubble tops out, they are not even gambles. The psychology of the market almost guarantees the stock price will rise when word gets out a takeover is in progress. This increase in valuation backs the money required for the takeover.
The historic speculations in options, futures, and other simple bets are dwarfed by the derivative markets of the late 20th to early 21st century which evolved to bypass the market’s margin limitations.
Long-Term Capital Management’s bankruptcy crisis in 1998 uncovered the unsettling reality that “this small hedge fund with a capital base of only $2 billion had over $1 trillion in bets in the derivatives markets, betting primarily on the Russian Ruble whose value had been successfully destroyed. This was a margin of only 0.02% and many of the estimated 400 other hedge funds then operating would have had similar slim margins bet on similarly volatile currencies.”
By late 2007, derivatives bets by the then 10,000 hedge funds created a $416 trillion house of cards, eight times the GDP of the world economy, which climbed to $526 trillion even as 20 of America’s largest banks were facing insolvency and the world economy was shrinking.
The $200 billion written off by the banking system in February 2008, means roughly a $2 trillion shrinkage in circulating money (circulation of base money is the money supply).
So a financial bubble dependent upon continued expansion can unwind very fast and these same banks are now considered to have at least $800 billion more in bad paper to write down. For that to happen would mean a $20 trillion shrinkage in circulating money (the money supply) which would be a total collapse of the economy.
Thus it is obvious why the Federal Reserve/Treasury is desperately pouring money at those banks and other sectors of the economy.
To avoid throwing “the world’s financial markets into turmoil … bankrupt hundreds of hedge funds … wipe out big-name financial institutions … sabotage the investments of pension funds … and scramble the portfolios of millions of average investors,” the world’s central banks are pushing huge sums of created money at the financial markets.
The world holds their breath as to whether they collectively can keep markets from gridlocking (Google the above quoted phrases). All aspects of the markets “have become chips in a casino game, played for high stakes by people who produce nothing, invent nothing, grow nothing and service nothing.”
The evening news alerted us that “one-third of the cost of oil was due to the speculative buying of oil contracts.” That, and the same trading practices in other markets, is another form of harvesting unearned profits.
Sharp traders have leveraged world markets with stock and currency options, futures on options, meaning options on options, futures on interest rates, warrants, a form of option, and thousands of other similar subdivisions of instruments, called derivatives, designed to lay claim to wealth properly belonging to your, me, and all other productive citizens.
Hedge funds betting on which way everything in the markets, and sometimes outside the market (weather for example) will go, leveraging those bets up to 70 times (meaning betting with borrowed money) and, as said above, doing all this to the tune of $526 trillion worth of derivative bets is what has all markets of the world holding their breath.
The collapse of the huge housing bubble in America triggered the crisis but was not the cause. Interest rates were kept low, borrowers with poor credit or no credit were loaned money on houses that were rapidly appreciating in value due to those lax standards.
Speculators were borrowing against their homes to buy more expensive homes and condominiums which were rising 10 to 20% a year in price. Most of those speculators started out with good credit. But when the rise in home prices topped out and the bubble burst they were stuck with paying mortgages on homes priced higher than their mortgage.
Those who could not afford to pay for their newly-purchased homes and those who will drop into the insolvent class due to the value collapse of their speculations may eventually be four million, far more if this collapses into a depression.
Those subprime loans were sold to Fannie Mae and Freddie Mac, the primary financing for home loans, and others. The two FMs, banks, and other traders packaged those subprime loans in with prime loans, gave them a triple A rating, and sold those bundled debt instruments, collateralized debt obligations (CDOs) and structured investment vehicles (SIVs), etc, on the markets. Those toxic debt instruments functioning as bonds were bought by investors worldwide.
Problems arose when word leaked out that many of the debts within those bonds were uncollectable. Quickly the markets seized up. The forced revaluations became the first $200 billion dollar write down of major banks addressed above.
Central bank funds pouring $2 trillion to $3 trillion at the ethereal world of high finance instead of at the real economy indirectly includes those hedge funds.
If these publicly provided trillions of dollars do not turn the financial markets around, those central banks will have to loan directly to the real economy, a right that, in an emergency, the U.S. Federal Reserve has always had.
If investor and consumer confidence collapse, those funds distributed, not loaned, directly to consumers—as outlined in The simplicity of eliminating poverty and war will stun you—may be required to restart the economies.
On a very small scale, $165 billion, has already been distributed directly to the consumers. With a sharp drop in the service sector indexes, an ethereal world of high finance leveraged from 35:1 to 70:1 can unwind very fast.
A short summary: Far more wealth is appropriated from the citizenry than is necessary to operate the economy. Even then—after honest investment—extravagant living, waste within the economy, and wars to protect it all, there are, in the expanding phase of a cycle, still massive investment funds left over.
Inevitably the inscrutable games within the ethereal world of high finance are created so as to have a place to invest. But these self delusions collapse when reality bursts that bubble which is where the world is at today.
As outlined on pages 38-50, 119-20, 143-51 of Economic Democracy: A Grand Strategy for World Peace and Prosperity, and in the conclusion of Money: A Mirror Image of the Economy—demonstrating that 40% of today’s finance capital can operate the economy at double the efficiency—such strategies to lay claim to others wealth can never evolve in a fully transparent economy with full and equal rights.
Japan Pays Back Wall Street
Wall Street bankers used the above described derivative tools to crash the Japanese land and market bubbles and vulture funds bought up Southeast Asian properties, the purpose of those engineered crashes. By printing ¥35 trillion in 2003-04, equaling $50 for each person on earth, which was converted to dollars to buy US treasuries, Japan partially evened the score.
It is important to understand where derivatives and hedge fund monies come from. One must start after the last financial crash which typically destroys massive sums of unearned wealth.
Here we will be challenged because entrenched wealth has a larger share of a nation’s wealth than in normal times. But entrenched wealth owners are essentially non-producers. It is the knowledge and talents of productive manager-owners and labor who rebuild a society after a financial crash. In that process, they own the largest share of increased wealth.
After the the Great Depression, entrenched wealth slowly increased their excess rights and kept claiming a larger and larger share of the wealth produced. In fact between 1974 and 2000 entrenched wealth claimed all the wealth created by efficiencies of technology, about 30% gain per decade, plus a part of what once went to labor. Labor was lower paid in 2000 while entrenched wealth had increased their annual profits by roughly 75%.
Under current property rights law as applied to nature’s resources and technologies, denying others their rightful share, unearned finance capital piles up higher and ever higher.
Much is exported buying up properties around the world. Much of it bids stocks up higher and ever higher. And there is still more unearned finance capital than can be safely invested.
More gambling games must be devised to absorb all that massive finance capital that has no place to be safely invested. Thus hedge funds and the derivatives market, totally zero sum games, meaning they produce no wealth, grew like mushrooms.
Before an economy can rebalance and care for everyone somewhat equally, an economy must crash and destroy massive sums of that unearned wealth. That is happening in the current, 2008-09, financial crash.
Protecting their wealth and power, private bankerss, having control of Federal Reserve policy even though it is socially owned and are pointing all created money at that unproductive ethereal world of high finance.
If this financial collapse is stopped, oversight of financial institutions tightened, and restrictive laws (such as the withdrawn Glass Steagle act) reenacted, financial balance may be regained with massive wealth retained by the powerful and massive poverty still the lot of the politically weakest.
But that financial balance cannot last long. Wealth has not been redistributed, massive finance capital with no safe to invest still exists, and these massive unearned sums will resume accumulating. Hedge funds, derivatives, and other non-productive endeavors–will rapidly expand, and another financial crisis will be upon us.
We have yet to see if the enormous sums of accumulated unearned capital in the imperial centers of capital will weather this latest storm, create another bubble and crash, whether it will be used to build even more industrial capacity to service a shrunken world consumer market and crash from that excess capacity, whether a fascist financial and military fix will protect the current monopolizers of capital, or whether the oppressed world will break free as the ongoing worldwide populist revolutions build strength.
We now turn to Market Bubbles and Crashes that occurred earlier in history.
Those crucial 170 words describing an honest, efficient, capitalist economy. Does anyone have the ear of President Barack Obama’s Economic Recovery Team?
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 Ellen Hodgson Brown, Web of Debt (Baton Rouge, Third Millennium Press, 2007) pp. 253-54, 387-89, primarily on the crash in Japan and Southeast Asia.