Could complex financial instruments ruin the global economy or save it?
Edited by Franklin Seiberling
News Items:
World's total wealth has been estimated at about $200 trillion.
[ http://www.theatlantic.com/business/archive/2011/12/the-200-trillion-world-who-owns-all-the-wealth/249788/ ]
The derivatives market is said to be dealing with $700 trillion in speculation on the outcome of other financial instruments.
[ http://dealbook.nytimes.com/2013/05/15/compromise-seen-on-derivatives-rule/ ]
Making Sense of Credit Default Swaps
by Mike Zmolek, PhD
Iowa City – May 27, 2013
Let's say the insurance company that insures your house against fire will also sell me the same policy to dozens of others. They might sell so many insurance policies that what they collect annually is bigger than what they would pay out (one time) if your house burnt down. Let's use numbers. Let's say the (one time) payout would be $100,000 and there are 100 policies owned by 100 people paying $2,000 per year for the policy, so to cover a house valued at $100,000 this company is pulling in $200,000 a year. Sweet deal, so long as your house doesn't burn down, since if it did, the company would be liable to pay out $10 million.
The point here, however, is the other 99 of us holding policies on your house could, if we chose to, declare our policies as assets. In other words, by collecting $200,000 a year from all of us, on paper this company has just created up to $10 million in assets. This is one way the derivatives, specifically credit default swaps (CDSs), operate. The secret to CDSs is that the sellers carefully avoid calling their contracts insurance so as to avoid being regulated as insurance, since if they were regulated, they couldn't pull the scam.
To be "fair", I must point out that banks do something similar all the time. They lend far more than they have in reserve and that is standard practice. Credit cards are but an extension of the practice of lending money in the form of paper notes, since both practices are just mechanisms of expanding the supply of credit and therefore the overall liquidity in the money economy. Capitalism would never have been born without this vast expansion of credit and its use. In the early days, a "run on the bank" could have spelled true disaster, but with today's sophisticated electronic banking systems, banks are too savvy to get caught with their pants down like that. So they do things like lobby for austerity or, as in the case of Cyprus, get the government to agree to pay for the losses in the banking system by raiding the accounts of depositors and forcing all Cypriots to forego a certain percentage of their savings. No longer do people make a run on the banks, now the banks make a run on the people first! (We do, after all, live in the age of the pre-emptive strike.)
Another analogy is the national debt. When European states. Britain foremost among them, began institutionalizing a national debt, meaning they passed the point where no one any longer seriously retained the idea that it would ever by paid back, this enabled governments to virtually expand at will. As we all know, the new "gold standard" for the past 50 years has been and continues to be US Treasury bonds, a/k/a pieces of paper with I.O.U., signed Uncle Sam, written on them.
All these schemes work gloriously so long as the economy expands, and they facilitate ever more rapid expansion, and so who would dare oppose them? The confusion comes when a downturn hits. Now what to do with CDSs? Clearly such mechanisms violate numerous laws at once and the progenitors of them should long ago have been put behind bars. So why did no one go to jail? While this is too simplistic to offer as the only answer, one reason is that by shuttering the offices that wheel and deal in derivatives, CDSs and other toxic assets, in the process the government would not only be directly wiping trillions in paper assets off the books and thus out of the (virtual) economy, but more importantly, indirectly, all those firms and individuals holding CDS agreements with AIG (for example) would have to write those policies off as a loss.
So coming back to the fictional story involving your house, if your city government arrested your insurance broker because he sold you a policy that placed the value of your house at $100,000 when it is only worth $50,000, then the other 99 of us holding the same policy against your house would declare losses closing in on $10 million and so we would cease paying income taxes and maybe even our property taxes would plummet, leaving the your government with a void in its coffers. Marx referred to the precursors of derivatives as "insane forms of capital".
Taking that one step further, CDSs are like capital overdosed on LSD. This ballooning of the CDS and derivatives market to proportions that eclipse the global economy as such exemplifies that, since this bubble of phony insurance credit appears poised to swallow the global economy in one gulp, producing the onset of an economic Armageddon. And yet, since governments appear willing not to be ready to prosecute but rather to go to the opposite extreme: to protect the value of these (insane) assets at all cost, what if the whole crazy fiction can be sustained indefinitely?
Since these complex instruments are in my view mainly scams, they are bound to continue to help the very rich funnel money from the poor into their pockets. But one wonders such astronomical figures could somehow be tapped as forms of credit to help the economy grow again. A far-fetched notion, perhaps, but so was the permanent national debt, once upon a time.
Edited by Franklin Seiberling
News Items:
World's total wealth has been estimated at about $200 trillion.
[ http://www.theatlantic.com/business/archive/2011/12/the-200-trillion-world-who-owns-all-the-wealth/249788/ ]
The derivatives market is said to be dealing with $700 trillion in speculation on the outcome of other financial instruments.
[ http://dealbook.nytimes.com/2013/05/15/compromise-seen-on-derivatives-rule/ ]
Making Sense of Credit Default Swaps
by Mike Zmolek, PhD
Iowa City – May 27, 2013
Let's say the insurance company that insures your house against fire will also sell me the same policy to dozens of others. They might sell so many insurance policies that what they collect annually is bigger than what they would pay out (one time) if your house burnt down. Let's use numbers. Let's say the (one time) payout would be $100,000 and there are 100 policies owned by 100 people paying $2,000 per year for the policy, so to cover a house valued at $100,000 this company is pulling in $200,000 a year. Sweet deal, so long as your house doesn't burn down, since if it did, the company would be liable to pay out $10 million.
The point here, however, is the other 99 of us holding policies on your house could, if we chose to, declare our policies as assets. In other words, by collecting $200,000 a year from all of us, on paper this company has just created up to $10 million in assets. This is one way the derivatives, specifically credit default swaps (CDSs), operate. The secret to CDSs is that the sellers carefully avoid calling their contracts insurance so as to avoid being regulated as insurance, since if they were regulated, they couldn't pull the scam.
To be "fair", I must point out that banks do something similar all the time. They lend far more than they have in reserve and that is standard practice. Credit cards are but an extension of the practice of lending money in the form of paper notes, since both practices are just mechanisms of expanding the supply of credit and therefore the overall liquidity in the money economy. Capitalism would never have been born without this vast expansion of credit and its use. In the early days, a "run on the bank" could have spelled true disaster, but with today's sophisticated electronic banking systems, banks are too savvy to get caught with their pants down like that. So they do things like lobby for austerity or, as in the case of Cyprus, get the government to agree to pay for the losses in the banking system by raiding the accounts of depositors and forcing all Cypriots to forego a certain percentage of their savings. No longer do people make a run on the banks, now the banks make a run on the people first! (We do, after all, live in the age of the pre-emptive strike.)
Another analogy is the national debt. When European states. Britain foremost among them, began institutionalizing a national debt, meaning they passed the point where no one any longer seriously retained the idea that it would ever by paid back, this enabled governments to virtually expand at will. As we all know, the new "gold standard" for the past 50 years has been and continues to be US Treasury bonds, a/k/a pieces of paper with I.O.U., signed Uncle Sam, written on them.
All these schemes work gloriously so long as the economy expands, and they facilitate ever more rapid expansion, and so who would dare oppose them? The confusion comes when a downturn hits. Now what to do with CDSs? Clearly such mechanisms violate numerous laws at once and the progenitors of them should long ago have been put behind bars. So why did no one go to jail? While this is too simplistic to offer as the only answer, one reason is that by shuttering the offices that wheel and deal in derivatives, CDSs and other toxic assets, in the process the government would not only be directly wiping trillions in paper assets off the books and thus out of the (virtual) economy, but more importantly, indirectly, all those firms and individuals holding CDS agreements with AIG (for example) would have to write those policies off as a loss.
So coming back to the fictional story involving your house, if your city government arrested your insurance broker because he sold you a policy that placed the value of your house at $100,000 when it is only worth $50,000, then the other 99 of us holding the same policy against your house would declare losses closing in on $10 million and so we would cease paying income taxes and maybe even our property taxes would plummet, leaving the your government with a void in its coffers. Marx referred to the precursors of derivatives as "insane forms of capital".
Taking that one step further, CDSs are like capital overdosed on LSD. This ballooning of the CDS and derivatives market to proportions that eclipse the global economy as such exemplifies that, since this bubble of phony insurance credit appears poised to swallow the global economy in one gulp, producing the onset of an economic Armageddon. And yet, since governments appear willing not to be ready to prosecute but rather to go to the opposite extreme: to protect the value of these (insane) assets at all cost, what if the whole crazy fiction can be sustained indefinitely?
Since these complex instruments are in my view mainly scams, they are bound to continue to help the very rich funnel money from the poor into their pockets. But one wonders such astronomical figures could somehow be tapped as forms of credit to help the economy grow again. A far-fetched notion, perhaps, but so was the permanent national debt, once upon a time.