classical economics
for analysis,  forecasting
and policy design

Big Banks "Big Bang"

America, Not Banks, Set to Blow Up
By Wayne Jett © June 9, 2012

      Why on earth would giant banks like J. P. Morgan Chase “invest” hundreds of trillions of dollars in derivative securities? Ordinary price volatility, it would seem, could wipe out those banks overnight. In a forehead-slapping moment, the answer becomes clear. Effects on America and the world are both diabolical and catastrophic.

     In April, 2011, Classical Capital asked here “is the Federal Reserve selling Treasury puts?” Despite this foreboding alarm, the light did not shine far enough ahead to explain the seemingly irrational conduct of the Wall Street’s big banks. Until now.

                                                                                                Betting the Bank

     Those big banks are exposed to $230 trillion in derivatives risk (some say “bets”). If pictures help, here is an infographic illustration of this amount of risk. Here you will find more data and analysis. J. P. Morgan Chase has $70.2 trillion in derivatives risk, which is 516 times larger than its $136 billion in risk-based capital. An absurdly small adverse move in derivatives value of two-tenths of one percent would wipe out the bank’s capital.

    Goldman Sachs is even more whole-hog than JPMC into the derivatives play. Goldman’s exposure to derivatives risk is $44 trillion, which is 2,295 times its risk-based capital of $19 billion. Again, this apparent irrationality signaled the need to identify the big banks’ true motives.

     Economist Paul Craig Roberts assessed these derivatives holdings of the big banks with considerable insight on June 5. He observes: “Bets on interest rates comprise 81% of all derivatives … [and] support high U. S. Treasury bond prices despite massive increases in U. S. debt and its monetization.” After describing enormous risks to the dollar, government stability and American standard of living by an upward movement in interest rates – a move made inevitable by government deficit spending and Fed monetization of debt – Roberts ends by proposing a solution.

                                                                              Nullify Interest Rate Derivatives?

     Roberts suggests the federal government declare null and void all $230 trillion of the big banks’ derivatives exposure. He reasons that no real assets are involved – only bets – and removing the derivatives would greatly reduce leveraged risk in the financial system. But he must realize his “solution” would spring the debt trap, almost certainly ending hopes for saving the dollar, constitutional government and prosperity.

     As Roberts says, these interest rate derivatives are the instruments by which interest rates have been held artificially low. Declaring the derivatives null and void would release interest rates immediately, and the rise would be sharp. The big banks would be deprived of their “profits,” rising interest rates would make U. S. deficits unserviceable, and the value of bonds (Treasury and corporate) would crash.

     Perhaps dealing with those very difficult and painful realities sooner rather than later is preferable. But examination of existing realities will explain why Roberts’ solution will not be accepted or implemented.

     Experience indicates Roberts’ proposal will not be tried. Classical Capital called for Congress to declare “cash settlement” credit default swaps null and void in December, 2008, as some rank-and-file in Congress had proposed in October. Congressional leadership in both houses blew away that reform effort and passed the Troubled Asset Recovery Program (TARP), giving $700 billion of future taxpayers’ earnings to pay off big banks’ CDS side-bets on private debt.

     Congress is no more likely to nullify interest rate derivatives. The big banks want to play their finance game as they and the Federal Reserve have designed it, as is evident by their conduct. Congress again will do as the big banks wish.

     But there is something else. This derivatives scheme is so big and so consequential, there must be more to it than just another arrangement to shovel profits from taxpayers to big banks.

                                                                                           Why Risk Trillions?

     A Wall Street bank leverages radically to buy assets in only one circumstance: when they have no downside risk and are guaranteed a profit. When the bank is guaranteed profit, the bank exploits the opportunity to the maximum extent possible. This is so especially if the “no downside” is sweetened with potential “very high upside” on profits.

     Who would promise a guaranteed profit with potential high upside? No Wall Street bank would do so. But someone has written and sold guarantees of future low interest rates. Or, as Roberts describes it, someone has been “selling an agreement to pay floating interest rates for fixed interest rates.”  Who has created this gigantic inventory of interest rate derivatives?

     Asking the question answers it. Only the Federal Reserve could do it. The Fed would sell such deals if ordered to do so by the parties who control the Fed through the big banks of Wall Street. The Federal Reserve would do it, most likely after getting the U. S. Treasury to underwrite liabilities at the expense of taxpayers, “to achieve U. S. economic policy.”

     Low interest rates accompanied by plentiful liquidity for big banks are publicly announced policies of the Fed. But achieving them has entailed actions almost surely fatal to the dollar and the central bank itself. Whoever ordered the actions is at least willing to see the demise of the dollar and the Fed, but may have other primary objectives.

     If J. P. Morgan Chase has sold derivatives protecting Treasury bond holders against losses from rising interest rates, the bank must have done so as the Fed’s agent. In that case, the Fed (or Treasury) has underwritten trillions in liabilities on those so-called derivatives. JPMC would buy plenty for its own account, and sell similar derivatives underwritten by the Fed to other big banks: Goldman, Citigroup, Morgan Stanley, UBS, HSBC and others.

                                                                                                   The BIG Upside

     As Roberts says, interest rates will rise inevitably “sooner or later” as owners of dollar assets, including Treasury securities, try to escape the looming currency crisis. What happens then is key to understanding the scheme.

     When interest rates rise, the Fed must pay off as underwriter of the derivatives. To do that, the Fed creates new dollars – hundreds of trillions of dollars – and pays them to the big banks as holders of the derivatives. The enormous money creation will explode interest rates higher, meaning an ever increasing payoff for the banks.

     Hyper-inflation of this magnitude will transfer most of the value of the private economy into the accounts of the big banks by the inflation mechanism which draws value from previously earned dollars into newly created ones. Americans will be impoverished. Government will fall. The dollar and the Fed will end.

                                                                                             Nirvana: Global Rule

     A global government, global central bank and global currency will serve the ruling elite’s agenda more efficiently. Each of these ideas is already on the table, endorsed by multiple organizations, including the United Nations, the Vatican, the Church of England, the World Council of Churches, the International Monetary Fund and the World Bank. With such beneficent organizations involved, why bother with republican democracy?

     This brings us back to the basic question addressed by Paul Craig Roberts. How soon will all this devolve? Consider sometime prior to the federal elections on November 6, 2012. This would outdo even the events of 2008 and, at the same time, save the costs of elections. Global government has no need for such anachronisms as voting.

     If you remain unconvinced that destruction of the productive class is an actual threat in America, consider the remarks last month by Senor Hugo Salinas Price of Mexico. Senor Salinas describes “a very disturbing fact” that the ruling elite have "a plan to rule the world," which entails “inevitable decline of industrial civilization … impoverishment of the world’s population … [and] a decline in the number of people on the earth.”

     The big banks’ derivatives play intends to give the elitist plan a great leap forward, no doubt, unless something can be done to foil it. Perhaps, after all, Paul Craig Roberts’ solution is the best we can do. At least the big banks would not get their horrendous payday.  ~