classical economics
for analysis,  forecasting
and policy design

What Causes Great Depres
What Causes A Great Depression?
By Wayne Jett
© February 6, 2009

    A family has a “great depression” when all its money and property are stolen, the robbers get away, and then come back for more every year or so. The family is destitute and impoverished until it stops the robbers and earns enough capital to return to prosperity. A nation experiences a “great depression” when a similar thing happens on a national scale.
The Robbery
    In America, national robbery has been underway for several years, particularly since 2006. In 2007, almost every mortgage company failed. In 2008, very large investment banks, commercial banks, mortgage banks and insurance companies failed or were taken over, with major transfusion of taxpayers’ money required to “save” them. During those two years, the price of crude oil more than trebled and then dropped sharply after global economic growth collapsed.
    Both in 2007 and in 2008, one segment of the U. S. financial sector robbed other parts of it. And, in the process, they robbed the American people.
    Targets of the robberies of 2007-2008 were firms broadly owned by investors holding publicly traded shares. Investors were mutual funds, pension plans, IRA and 401(k) plans, and small retail investors. As the robbery proceeded, values of investors’ accounts were wiped out. Gunmen emptying a vault would be envious.
The Robbers
    The robbers were a different class of financial firm. Almost all were so-called “hedge” funds, “private equity” funds, “leveraged buyout” funds, or investment banks. These are not “everyman’s” type of investment vehicle. They are very large pools of capital operated by and for investors with large pools of capital.
    The robbery in progress in America is an act of class warfare – at least to a point. The robber kingpins are mostly ultra-wealthy in the billionaire or near-billionaire categories. Victims are the great American middle-class, meaning all those who live by a work ethic. Many wealthy people are definitely in the middle-class as so defined, and are among victims rather than perpetrators of the crimes.
    Not all hedge funds are robbers, any more than all robbers are hedge funds. Relatively few of thousands of such firms engage in predatory practices that characterized 2007-2008 and still predominate in 2009. But those which are robbers run together, and successes have increased their strength so much they are capable now of pulling down any and every prey they choose.
The Targets
    Bear Stearns, one of the biggest and “baddest” of the predatory pack, was itself pulled down and devoured in March, 2008. Fannie Mae and Freddie Mac, each a trillion-dollar banker of mortgage loans with federal government sponsorship, had share prices destroyed by naked short selling fueled by put options and credit default swaps, and then were seized by government.
    Lehman Bros., the third largest investment bank on Wall Street, was destroyed by dilution of its share price through the same fraudulent trading practices as Bear, Fannie and Freddie, and was bankrupted. Investors in AIG, the world’s largest insurance company with more than $1 trillion in assets, suffered a similar fate, but the Federal Reserve and Treasury propped up the company with federal funding and guarantees of liabilities.
    The disparate treatment of Lehman and AIG is probably best explained by identifying each firm’s counter-parties: who bought CDS from AIG but not from Lehman? Merrill Lynch, Washington Mutual and Wachovia Bank experienced a little more upside in share price, but essentially had their share prices destroyed by fraudulent trading practices and were losses to shareholders.
The Scheme
    These takings of billions in asset values were as painstakingly planned and deceitfully executed as any heist of jewels or precious artifacts. The ambush of unsuspecting robbery victims was laid by putting in place:
    (1) mark-to-market rule FASB 157 (which hadn’t been used since the last “great depression”),
    (2) easily manipulated ABX index of sub-prime mortgage-backed securities,
    (3) re-designed Credit Default Swap derivatives permitting anyone to bet on performance of debt instruments,
    (4) the SEC green-lighted naked short selling, particularly with the “Madoff exemption” which permitted options market makers to sell short without delivery any shares used as hedging of options, and
    (5) last but not least, the “dark market” for U. S. trading of crude oil futures and “swaps” derivatives.     
    The “dark market” ingredient required all-out lobbying of Congress during the late Nineties to avoid closer regulation, but was passed into law in December, 2000. FASB 157 and CDS were simply a matter of big money influence in private organizations. ABX was simplest of all: merely a “product” of a private venture by the same investment bankers which lobbied for “dark markets.”
Doing the Deed
    All five elements of the ambush were operational at the outset of 2007 when, coincidentally, the Federal Reserve stopped buying Treasury securities, meaning no further injection of new monetary liquidity. In that circumstance, the mortgage industry was easy prey. The ABX index was driven down by purchasing CDS on the 24 bonds named as its references. Each CDS bought caused the seller to hedge the contract by selling short the shares of the bond issuer. Thus, buying CDS on the 24 bonds caused the ABX index to plunge while, at the same time, driving down share prices of bond issuers. Decimated share prices assured the bond issuers could not raise capital and practically assured default.
    FASB 157 then stepped in and pressed auditors to demand write-downs of book values of financial assets including MBS near or to the drastically low ABX index level. The accounting rule required these write-downs to be taken through the income accounts of mortgage firms, reflecting multi-billion dollar current losses although they planned to hold the MBS to maturity in many cases. Write-downs made mortgage firms appear to need more capital, but plunging share prices made sale of shares dilutive. Firms relying on Wall Street for debt capital had credit lines severed, and they were adrift.
    The jaws of FASB 157, ABX and CDS closed upon every firm in the sector and almost none survived. The swift and ugly event might be called a perfect storm, except none of the causes was an act of nature. Each was an orchestrated occurrence.
    Field operations in 2008 required somewhat more capital, although CDS were famously cheap. Because CDS were so cheap, they were the preferred means of taking short positions. As each big firm fell, attacks spread to multiple other firms. With economic growth stopped and demand for oil declining, the fifth ingredient of oil price manipulation kicked in to double the price in 2008. Expensive energy collapsed global economies right on time for a colossal October surprise to voters in U. S. federal elections. Simultaneously, economic collapse severely increased U. S. unemployment and home foreclosures. This provided the perfect cover story for blatantly fraudulent financial raids on corporate share prices that continued throughout 2007, 2008 and into 2009 in U. S. financial markets.
The Victims
    From March, 2008, the robbery extended into the vaults of citizens’ money, as the Federal Reserve and Treasury funded deals for the favored few. In every deal, public discussion focused only upon use of public funds, but not upon the manner in which private parties profited by the turn of events. Many billions were taken by unknown parties dealing in CDS, options and naked short positions in Bear Stearns, Fannie, Freddie and each of the other targets. Losers were not only taxpayers – shareholders were hit severely by the precise manner in which government chose to act, enriching short sellers and impoverishing ordinary investors.
    These financial firms did not fail simply due to bad management or the turn of economic events. They were ambushed and destroyed by design so as to rob their shareholders.
The Enablers
    The criminal design worked only because federal law enforcement did not do its job. As Harry Markopolos testified in the House on February 4, the SEC gives every big player on Wall Street license to do whatever it wishes to other investors. CFTC is no better on commodities, but its jurisdiction is more circumscribed by Congress.
    To stop the crime in progress, Congress must take away tools the culprits use. Prohibit enforcement of any CDS unless the claimant delivers the underlying bond. Reform securities, commodities and derivatives markets and expose them to light. Stop oil price manipulation by “swaps” which pretend to own oil, and put strict limits on all non-user positions. Suspend FASB 157 permanently. Prosecute manipulation of share prices by use of ABX index or otherwise, including naked short selling, wash sales and other such trading practices. Re-instate the “up-tick” rule at the SEC. Require immediate buy-in of all undelivered shares.
    Then abolish the SEC and replace it with a well-designed financial crimes prosecution unit. This must be done at the earliest opportunity, so crimes already committed will not grow cold. Time is wasting, and crimes are on-going. ~