Monetary Terrorism
In this fifth edition of Wizards we are going to take a
look at
financial terrorism conducted by western financial
institutions even
as they freeze the assets of a different kind of
terrorist. In the
previous edition of Wizards we discussed the dual role of
the military
system and the financial system in modern empires, and how
both
systems facilitate the appropriation of foreign resources
the
lifeblood of any empire. Today we will explore how certain
currency
regimes have come to dominate in this arena, and take over
from where
various cold-war era military regimes left off.
While the world's eyes are focused on the so-called "war
on terrorism"
and various acts of terrorism that come in the physical
form, the US
dollar and its primary wizards are busy wreaking havoc in
other
nations. As of late October/early November 2001 Argentina
is
struggling under the currency regime of mass destruction
known as the
"Dollar Peg". This is the same mechanism that helped bring
down the
financial and economic infrastructure of Mexico in
1994/95, Thailand
in 1997 and Indonesia in 1998 to name but a few casualties
of this
monetary weapon.
During the current "terror watch" some eyes have been
checking on the
sneaky attempts to pass through the FTAA (Free Trade Area
of the
Americas). But little noticed is the spreading use of
stealth monetary
weapon known as "dollarization", which could have an
effect more
severe than any such trade agreement. On January 1, El
Salvador began
the new-year by taking the drastic step of "dollarization"
- which
means making the US dollar the official currency of their
nation.
Guatemala took steps to do this in May, but is not there
yet. Ecuador
has already dollarized, and now Argentina's government
says it would
rather dollarize - i.e. throw out its own currency - than
devalue it
to see itself out of its current debt crisis. Not only is
Latin
America coming under US monetary rule, but other less
powerful
nations, for example the newly independent nation of East
Timor, are
being pressured to dollarize.
As we saw in Wizards Part 1, even within the United
States, money (or
credit) creation in the US dollar is not democratic, but
rather is the
domain of private bankers and the Federal Reserve. At the
international level dollarization and other monetary
weapons take
credit creation power completely out of the hands of other
nations and
place it entirely with private financial sector of the
United States.
Recall the words of President Garfield shortly before his
assassination as we discussed in Wizards Part 4 - "Whoever
controls
the supply of currency would control the business and
activities of
all the people". If you believe this then it would seem
that once
dollarization is in effect, the highly controversial free
trade
agreements are hardly needed. Dollarization will do the
job of such
agreements without all the hassles and public outcries
associated with
these documents that have to go through a more democratic
process,
little though it may be. Such is the mystery surrounding
money and
monetary policy that lengthy trade agreements get more
attention than
the simple move to formally adopt the currency of, and
relinquish all
credit creation powers to, the super-power.
Dollarization gets little attention here because it can
happen in
foreign countries without any approval of the United
States government
as is required for the international trade agreements, and
it is often
adopted in countries without the approval or even
knowledge of a great
many of its own people. Many countries probably feel that
they are
forced to dollarization because if they do not comply with
the ruling
monetary regime, speculators will eventually attack their
currency
anyway. This is a valid point for its seems that most
nations in the
developing world, other than those cut-off from the
international
markets, have had their currencies attacked by speculators
at some
point in the past decade.
In this way speculators do act like a military force,
going to war
against foreign currencies or monetary systems, and
pounding them with
their might until they win. Just like the US-backed
military forces
before them they have more and mightier weapons. In the
case of a
military action during the cold war US-backed military
forces could
often physically attack a people until they gave up
because the former
had the most access to the most powerful weapons. The same
is true of
currency attacks by Wall Street firms (and their European
counterparts). The major firms that instigate the
speculative attacks
have access to more US dollars (or other hard currency
such as the
Euro) than the central banks of many countries. Remember
that the US
Dollar is the linchpin of the international monetary
system and forms
the "reserve" backing up most foreign currencies. By
having easy
access to tremendous amounts of the mightiest monetary
weapon in the
world, these Wall Street firms have, in almost all cases,
forced
foreign currencies to collapse once they have initiated an
attack.
Faced with problems brought about by overwhelming
speculative attacks,
as with overwhelming military action, countries
increasingly seem to
give-up and go the way of "dollarization" to eliminate the
threat of
currency attacks. This trend has profound implications as
to lost
sovereignty, and a seemingly irreversible acceleration of
the
phenomenon labeled as globalization. To understand this
relatively new
trend it is useful to look back into the history of the
international
monetary system over the past century to discover how
things got to
this point.
Relationship Between
20th Century Money and 20th Century Wars
World War II and the events leading up to it saw profound
changes to
the international monetary system and the mechanisms that
countries
would use to co-ordinate cross-border trade and financing.
The most
famous of these changes came in the form of the Bretton
Woods
agreements (named after the meeting place in the US where
the
agreements were drafted) which created the International
Monetary Fund
and the World Bank. We shall just focus here on the IMF
because this
has more to do with contemporary monetary attacks than
does the World
Bank. Much of what follows comes out of an Economics text
used by many
trainee-Wizards in their studies called "Economics"
written by some
real important Wizards - David Begg (Professor of
Economics,
University of London), Stanley Fischer (from the IMF and
World Bank),
and Rudiger Dombusch (Professor of Economics, MIT), and
translated
into plain language by me.
To understand what the IMF was really created for lets
just take a
peak at monetary arrangements before the Great Depression.
Up until
this time many countries were on the gold standard,
whereby their own
currency was backed by gold reserves at their central bank
(The
Central Bank is the creator of base money for any
currency.), and
paper currency could be converted to gold. Just as in
Roman times this
system meant that whoever had access to the most gold
could do the
most investing and acquire extensive ownership in foreign
resources,
and this was usually perfectly correlated with whoever had
the most
firepower and willingness to use it. This made Britain
both the
primary military and financial power in the 19th and early
20th
century with a late boost coming from its discovery of
gold in South
Africa.
One of the main complexities of the international monetary
system,
which is the mechanism through which all international
trade and
investing happens, is the determination of the value of
one country's
currency against another, known as the exchange rate. For
example the
value of today's Australian dollar to the US dollar could
be expressed
as an exchange rate of almost 2 Australian dollars to 1 US
dollar, or
1 Australian dollar is worth 0.5 USD. Before the Asian
financial
crisis the exchange rate was closer to 1 Australian dollar
for 0.7
USD. So we say the Australian dollar has since been
devalued relative
to the USD - it now buys LESS US dollars. This means that
it is now
more expensive for Australians to buy US products, and
Australian
products are cheaper for US consumers. The problem of
managing
exchange rates has troubled international relations for
the past 2
centuries and so far none of the management regimes have
worked out
very well for the majority of people living outside the
United States
or Western Europe.
Any country involved in international trade would like
their exchange
rate relative to the currency of trading partners to
remain fairly
stable and predictable and not to suffer sudden shocks.
For if their
money suddenly loses value relative to other money their
imports cost
more and if it gains value their exports are less
competitive. The
gold standard provided a way to stabilize exchange rates
because every
currency was convertible into a single common commodity -
gold. Up
until the Great Depression and under the gold standard
there was
allowed a fairly free flow of capital between countries
and this is
what kept exchange rates stable. However, on the downside,
the central
bank or the government of a country weren't easily able to
change
their own money supply to deal with pressing domestic
problems such as
unemployment and price inflation, because this supply was
already
fixed by gold movement. Also, financial panics were more
likely to
collapse the whole system because everyone would rush to
change their
money into gold and the whole banking system would start
to break
down.
For these and other reasons the gold standard for domestic
money
holders was abandoned by most countries after the Great
Depression.
But this meant that there was no longer any natural way to
ensure
stability of the exchange rates between countries. It was
recognized
from the events leading up to the Great Depression and to
World War II
that some international agreement was needed to create a
more stable
international monetary system, and one that was to exist
in the
absence of a gold standard backing each individual
currency. This is
what gave birth to the IMF.
In the aftermath of World War II the United States was the
dominant
economic power because it was basically the child of the
pre-war
powers who had their economic infrastructure destroyed
during the war.
With the gold-standard gone it seemed to make sense to the
powers-that-be for the world to move on to a US Dollar
standard, where
the value of every currency would be set against the value
of the US
dollar. In turn the US dollar was fixed against the value
of real
goods by settings its value against gold as US $35 for an
ounce of
gold. This was called the Adjustable Peg system and the
IMF was
created to administer this system and put out fires as
needed.
Under the Adjustable Peg system then, many countries might
hold US
dollars, US government bonds and gold to back their own
national
currency and keep their exchange rate fixed against the US
dollar.
Central banks could redeem their US dollars for gold at
the fixed
price, and this gold was stored at the famous Fort Knox.
Exchange
rates would be stable as long as demand for US dollars
remained fairly
stable relative to demand for other currencies. Relative
demand for
any country's currency versus others depends on relative
flows of
imports versus exports and desire for investment
domestically versus
abroad. To keep things fairly stable, under the original
Bretton Woods
agreement, there were restrictions on cross-border capital
flows or
investments to help reduce sudden jumps in supply or
demand for a
currency that come with speculative capital flows.
The capital controls were necessary otherwise speculators
could have
had a field day by betting that a certain currency would
go down by
selling it off against the US dollar and thereby forcing
it to go down
purely from their speculative activity. Large financial
firms with
access to lots of US dollars could therefore force a
foreign currency
of a weaker country to collapse as they desired. The
earlier
restriction on capital flows is a key point so please
remember it
because this is a fundamental difference between the
original Bretton
Woods system and the commonly named post-Vietnam
"non-system" that
allowed the sudden attacks on, and collapse of, Mexican,
Asian and
Latin American currencies over the past decade. If a
currency
collapses people of the effected country become a lot
poorer very
quickly and things are much worse if the country has lots
of debt
denominated in, say USD. We have seen that when this
happens economic
policies then introduced normally lead to increased
poverty and
unemployment, or employment at below poverty wages, as
well as a
selling off of natural resources to the west at fire-sale
prices. It
is interesting to note that the two things that brought
down the
stabilizing mechanisms of the original Bretton Woods
system were
America's extensive cold-war military adventures and the
world's lust
for oil (through the 1970s oil shocks).
Under the original Bretton Woods system with capital flow
controls,
the only thing that could change the relative demand for a
currency
against the US dollar peg, was a serious trade imbalance.
That means a
large imbalance between a country's imports and exports.
For example,
if a non-US country's imports from the US exceeded its
exports to the
US by a lot then its demand for US dollars exceeded the US
demand for
its currency. To make things balance it could either
devalue its
currency or get US dollars somehow, say by selling gold or
borrowing
US dollars. If a large temporary trade deficit came about
the IMF
could lend US dollars to the country to stabilize its
currency value
while the deficit existed. But if it was permanent the IMF
would
recommend a currency devaluation.
For informational purposes I should just say that this
issue of
management of trade deficits and barriers to trade, and
associated
demand for currency, provides the link between the IMF and
the
original GATT or General Agreement on Tariffs and Trade,
which later
metamorphosed into the World Trade Organization or WTO. It
is
interesting that both agreements and institutions jointly
deviated
drastically from their original post-WWII mission in the
late 20th
century after the collapse of the original Bretton Woods
system.
Under this original Bretton Woods system countries had
some control
over their own domestic monetary policy so long as it
didn't effect
their balance of payments too much, and under capital
controls they
were protected from excessive speculation. But then
America's
increasing military activity throughout Latin America,
Asia, and
Africa in the 1960's and 1970's followed closely by the
OPEC oil price
shocks radically altered the fundamentals of the monetary
system
throughout the rest of the 20th century. This culminated
in severe
currency attacks on many of the nations already wounded by
the
military apparatus several decades earlier. In fact it is
almost as if
the earlier military efforts laid the groundwork for the
later
monetary attacks.
Break: "Doomsday Lullaby", Wendy Matthews
The "Oil-Standard" Kicks Out the Gold-Link of Money
To understand this point about the monetary attacks let us
first
understand how the original Bretton Woods system
collapsed. Throughout
the 1960s the United States was spending massive amounts
of money (US
dollars) abroad to fund various military operations that,
while under
the guise of the "war against communism", was ultimately
buying
insurance on investments and economic interests abroad.
While certain
capital controls existed to prevent speculative pressure
on currencies
US investors still had many economic interests throughout
these
regions. A rise in democracy may have nationalized natural
resources,
created land reforms and otherwise collapsed the value of
US
investments. In turn this would have had serious
ramifications on the
US stock exchanges and reverberated throughout the whole
financial
system. This big military spending abroad on Vietnam and
other
adventures caused America to have a big and rather
permanent trade
deficit and greatly increased the supply of US dollars
abroad relative
to US gold reserves at home. President Nixon was forced to
break the
peg of the US dollar to the fixed price for gold in 1971
and then the
US dollar kept decreasing in value with respect to gold as
the US
increased its military activities abroad. This caused a
huge
disturbance in the international monetary system and soon
the whole
adjustable peg system had broken down. The IMF should have
disbanded
at this time because its founding mission didn't exist
anymore now
that the Adjustable Peg had broken down. .
Then OPEC came along and presented the world with its oil
price shocks
and a lot of large nations started running significant
trade deficits
with the Middle-East because the price of oil was now so
high. This
might have been oil's way of saying that now that the gold
standard
was completely dead it would take over as the real good
against which
currency value should be assessed, which was appropriate
since much of
the human fighting stopped being about gold and became
about oil. The
oil shocks and America's military spending seem to have
created
pressure to break down the system of earlier capital flow
controls so
that the Western countries could balance their currency
outflow from
trade deficits with some inflow of capital from the OPEC
countries who
were making the big oil profits.
So much money then rushed in to the West as so-called
petro-dollars
that many financial institutions then turned around, in
the absence of
capital controls and the gold peg, and lent the money as
US dollar
denominated debt to many Latin American countries to earn
some higher
returns. Interestingly a lot of this debt incurred in
Latin America
was being used to fund the purchase of military equipment
by the US
favored regimes to assist in the "war on communism". But
the expansion
of the US money supply and the oil-shocks led to such bad
inflation
problems that by the end of the 1970's the US Federal
Reserve decided
to reign them in by spiking up interest rates, which is
the same as
shrinking the US dollar money supply. Many Latin American
borrowers
were on variable interest rates and this spike in interest
rates
forced them to be about to default on their US dollar
loans.
This threat of default marked the rebirth of the IMF, who
had lost its
founding mission upon the collapse of the Bretton Woods
system during
the Vietnam War, into a wholly new entity governing
today's monster of
an international monetary non-system. To prevent financial
panic
spreading to the West upon such defaults the IMF stepped
in as lender
of last resort to protect the Western creditors from
getting hit by
defaults. By giving such a blessing to the reckless
behavior of
international banks the IMF introduced serious distortions
favorable
to these banks in the form of "moral hazard" that is still
with us
today. Moral hazard comes about when large investors are
enticed into
excessive speculation by the knowledge they will get
bailed-out if
their bets go bad.
Under today's international monetary non-system we have
free flow of
capital and persistent speculative attacks against
economically weaker
countries. To make matters worse these countries have
large amounts of
US dollar denominated debt, much of which originated as the
petro-dollars, and the IMF has made itself understood to
be there to
back up the big Western banks who get in trouble while
speculating on
these countries. This Moral Hazard combined with the loss
of the
original capital flow controls has created a very bad
situation for
the majority of people in the developing world.
So, how did a reasonably stable post-WWII international
currency
regime get so nasty? The simple social answer is that too
few people
now have control over it and they are the ones who benefit
from the
stupidity of the system as a whole. The more detailed
technical answer
can be understood by looking at the anatomy of a currency
attack
conducted by Wall Street, and then looking at what is
known as the
Unholy Trinity Dilemma.
The Anatomy of a Currency Attack
Recall that under the pre-depression era gold standard,
exchange rates
were automatically fixed, and there were pretty free
investment
capital flows. But countries couldn't do very much about
their own
money supply to help with domestic policy, unless they
went out and
dug up more gold. Then under the post WWII real Bretton
Woods system
there were fixed exchange rates, and countries had some
ability to
control their money supply for domestic policy purposes
such as
unemployment and inflation. This was possible because
there were
controls on investment capital flows.
But now after the collapse of the real Bretton Woods
system there are
few capital flow controls and many of the smaller
economies have tried
to peg their exchange rate to the US dollar. Smaller
economies try and
fix their currency relative to the US dollar because for
most
countries the US is a major trading partner and because
they want to
attract funds from US investors so they want their
currency to appear
stable relative to the USD. However, Wall Street attacks
have made
this a recipe for disaster and regularly smashed smaller
economies.
Let's see how this happens.
Let's suppose I am the Central Banker of a country called
Ozlet and I
peg my currency, called Ozlettas to the US dollar so that
1 Ozletta =
1 US Dollar. I create and extinguish money in exactly the
same way as
the US Federal Reserve does, and as we spoke abut in
Wizards Part 1.
That is, if I want to issue more Ozlettas in to the
banking system I
go into the open market and buy US dollars or US government
securities. The seller of the dollars or securities gets
Ozlettas in
return and new Ozlettas enter the banking system of Ozlet.
Then the
banks of Ozlet create another, say, ten times this amount
as bank
money denominated in Ozletta just like we spoke about with
the US
Banks and US dollars in Wizards Part 1.
Meanwhile, with free capital flow some US investors are
starting to
buy up stocks and bonds in my country of Ozlet which
brings some more
US dollars into the country. Also the government of Ozlet
and some
banks and traders might be borrowing some US dollars
because of the
lower interest rates on them and to facilitate their own
international
dealings. Over time the borrowings of US dollars from US
banks gets
quite large. Its gets especially large as the western
investors and
the World Bank are encouraging my country to borrow more
money for
infrastructure development so we can catch up with the
West.
Then one day a 25 year old bright-spark called Jimmy, who
just got an
MBA at Harvard and now works with a big Wall Street firm
called
Betters, Inc., heard a rumor about some indigenous people
in Ozlet,
known as the Ozletistas, who were starting to demand land
rights and
better working conditions. Jimmy goes to his boss and says
that
something bad is about to happen to profit potential in
Ozlet. He
says"I think we should start selling our investments
there". In fact,
lets not just sell our Ozlet stocks, lets also sell short
on the
Ozletta's to bet that the Ozletta is going to drop in
value against
the US dollar. Selling a currency short means that
Betters, Inc. will
enter into agreements to sell the currency at the today's
price at
some point in the future - the price is 1 dollar for 1
Ozletta. They
can't lose. If the Ozletta doesn't get devalued they lose
nothing. If
it does get devalued to say 1 Ozletta for 0.5 dollars,
then at the
agreed date in the future they can buy an Ozletta for 0.5
dollars and
sell them for 1 US dollar according to the original
"short-selling" or
forward contract.
Jimmy's boss, who barely remembers who or what Ozlet is,
says "thats a
fabulous idea" after finding out how much money they could
make by
being the first to start the attack. So Betters, Inc sheds
its Ozlet
stocks and enters into contracts going short on the
Ozletta. Other
investors see what's going on and say "Oh - I better get
out of Ozlet
before I lose my money". Once the attack has started the
only two
things that can happen are that eiether the currency stays
the same or
it will lose value. So it's safer for the investors to
start pulling
out and extra profitable for them to also take short
positions on the
Ozletta. As the Ozlet Central Banker I want to prop up the
value of
the currency and give investor's confidence that the
dollar peg can be
maintained, so I might actually be on the other side of
many of the
shorting contracts. All of a sudden demand for the Ozletta
has dropped
drastically versus the US dollars. As central banker the
only way I
can maintain the value of the Ozletta is to keep demand up
by buying
Ozlettas in the open market with my US dollar currency or
bond
reserves.
If the attack continues for long enough I know my US
Dollar reserves
will run out. While I am buying up Ozlettas to keep their
value I am
taking them out of the money supply. The Ozlet money
supply is
shrinking, interest rates are going up, investment is
decreasing and
unemployment has shot through the roof. Riots are breaking
out in the
streets but I can't do anything about it because I have to
use all my
reserves to keep the value of the Ozletta equal to the US
dollar,
especially because our government has all this debt
denominated in US
dollars. But the attacks keep coming. Soon my reserves are
almost
depleted, the Ozletta money supply is shrunk and interest
rates are
sky high. This interest rate differential and the 1:1
ozletta:dollar
peg is encouraging a new type of bet against my country's
currency
that is further draining my reserves. I can't keep the
peg. I have to
devalue my currency by half so that I can justify a
reasonable Ozletta
money supply with my much depleted reserves. Wall Street
wins! Jimmy,
the original instigator of the attack was going on pure
speculation
about my country that may or may not have materialized. He
will get
rewarded for his attack with a promotion, and this will
encourage him
to look for more attack opportunities.
In any case if Jimmy's information about the Ozletistas
was correct
all it is saying is that if my country of Ozletta shows
signs of real
democracy and some redistribution of wealth, well, my
currency will be
brought to its knees. This is exactly why the Zapatista
uprising of
1994 culminated in the Mexican peso crisis. Sounds similar
to the
military attacks of the cold war, called the "war on
communism",
doesn't it? When this happens I am left with a devalued
currency, more
expensive imports, inflation, high interest rates, and
probably
unemployment and a discontented public. But even worse
Ozlet now has a
huge US dollar denominated debt that has essentially
doubled in size
with respect to my country's economy. Either the Ozlet
government will
default on its debt or, as has happened under the IMF
throughout the
past two decades, the IMF will come and help Ozlet
"restructure
things" so we will be able to pay off the debt. Usually
this means
cutting spending on social goods to direct more funds to
the debt that
has doubled in size relative to our own currency. It also
means making
my country more export oriented and attractive to foreign
investors to
attract the US dollars to pay off the debt. Often this
results in
sales of labor and natural resources at fire-sale prices.
The Unholy Trinity
In all of the above examples - under the gold standard,
the original
Bretton Woods systems and the example of Ozlet under
today's
non-system it was clear that the following three things
could not
simultaneously exist for any currency regime:
* Free Investment Capital Flow Between
Countries
* A fixed exchange rate or peg to the US dollar
* Autonomous control over domestic monetary
policy/credit creation
That these three cannot exist simultaneously is known as
the Unholy
Trinity Theorem and it is widely documented throughout the
mainstream
economic literature and I will post some references on the
Wizards of
Money web site www.wizardsofmoney.org.
The Unholy Trinity is not such a big problem for the
developed world
because under free capital flow they just let their
currency exchange
rates float and they don't wobble around too much because
they are the
major industrialized nations. Where the Unholy Trinity has
profound
implications is in the developing world where these
smaller economies
have tried to fix their currencies to the US dollar to
prevent
excessive volatility that would come from constant
speculation. This
has meant that the Central Banks of these countries can
only use
monetary policy to manage the exchange rate and therefore
it cant be
used to deal with pressing internal issues. When these
internal issues
start to arouse suspicions of speculators the currency
gets attacked
with tremendous force from Wall Street and the resulting
devaluation
will be sudden and drastic and so will the IMF austerity
measures that
follow.
The sad facts are that the speculators may have known
nothing about
the country in the first place and/or may just be reacting
to some
emergence of democracy in the developing nation.
Furthermore Wall
Street has ultimate control over credit creation in the
reserve
currency that these countries use to back their own
national currency,
and so it is always guaranteed to win once an attack is
started.
Argentina is now faced with such a crisis with its decade
old dollar
peg of 1 Argentine Peso to 1 US dollar, and over 100
billion of debt
denominated in hard western currency. In order to maintain
the dollar
peg the money supply has shrunk and interest rates are
close to 30%.
Unemployment and poverty have risen, government spending
has been
shaved and the Argentine people are not pleased. In a
classic
demonstration of the complete ignorance about foreign
nations that
Wall Street speculators so happily attack based on their
"wisdom"
about them, the Wall Street Journal ran a rather offensive
article
about the Argentine peso crisis in its October 26th
edition. Typical
of American ignorance about Argentina's history the
article by Michael
Sesit in "The Global Player" section, could do little more
than
compare the current crisis with the famous musical about
the Peron
dictatorship. It is quite frightening that the Wall Street
crowd with
similar ignorance about foreign issues is the same crowd
that gets to
instigate the speculative attacks that collapse currencies.
Even though widely acknowledged as a problem in mainstream
economic
circles the IMF refuses to address the reality of the
Unholy Trinity.
Presumably this is because, while they may admit it
exists, it's
actually been very profitable for Wall Street.
Wall Street's Stealth Fighter - Dollarization
Faced with the harsh reality of the Unholy Trinity, large
outstanding
US dollar denominated debt and the subsequent need for US
capital
flow, coupled with exhaustion from Wall Street speculative
attacks,
many countries' governments are just giving up and letting
Wall Street
have it their way. They are abandoning all hope of
maintaining their
own national currency and passing all monetary decisions
over to the
United States. They are, as the IMF is increasingly
recommending,
agreeing to "dollarization". That is - throwing out their
sovereign
currency and officially adopting the US dollar as their
currency.
This solves the problem of fixed exchange rates and stops
forever the
Wall Street speculative attacks causing devaluation, but
it does so at
tremendous cost to these countries. No longer do they have
any credit
creation or monetary policy powers, or even the ability to
act as
lender-of-last resort to their own banking system. They
cannot use
capital controls to protect themselves from volatile
capital flows
because now all their money is "made in the USA". Rise in
demand for
labor and environmental protections would be instantly met
with a
sucking out of the medium of exchange like a vacuum
cleaner, leaving
only the debt behind. The control of the medium of
exchange that
drives their future economic life belongs in the hands of
the US
banking system and the Federal Reserve. Furthermore US
banks may come
to dominate their banking system and thereby increase
their influence
on national governments. This is certainly not helped by
the fact that
as well as being in control of US Monetary policy the
Federal Reserve
also plays the somewhat conflicting role of umbrella
financial
regulator under the Gramm-Leach-Blily Act.
Its a one way street and it seems headed for disaster. At
this point
it looks like Argentina will either follow this path or
devalue its
own currency and default on its debt, or it will get
bailed out by the
IMF who will then impose worse austerity programs.
On January 1, this year El Salvador took the path to
dollarization.
Only time will tell how this will work, but the immediate
effect was
utter chaos according to an article on CorpWatch's
InterPress Service
on Januray 5. With a great deal of poverty and a high
illiteracy rate,
the people of El Salvador hardly knew what was happening
to them as
the old currency could no longer be used and they didnt
know how to
change into the new one. I guess that just shows how
democratic the
decision was to dollarize.
While the IMF and Wall Street will push for Dollarization
as a way to
deal with the Unholy Trinity dilemma that benefit them,
others must
realize that there are other solutions that are better for
the
majority of the people. One obvious solution is to use
capital flow
controls to ward off speculative attacks from Wall Street,
and this
has been used successfully by Chile and Maylasia recently.
Also
possible is the development of monetary unions for groups
of Asian and
Latin American countries, similar to the European Monetary
Union, but
this requires a Herculean effort in terms of diplomacy and
putting the
long terms interests of these countries against the short
term gains
possible for its leaders.
There is also the possibility of people and communities
and activists
and NGOs creating the ultimate money resistance by setting
up their
very own currency regimes. We shall discuss this further
in the next
edition of Wizards.
Democratizing
the Monetary System
In this sixth edition of Wizards we are going to take a
look at the
growing movement to democratize money - that is people
creating their
own monetary systems and making credit creation and
distribution a
democratic process, which is a radical change from the US
dollar based
mainstream monetary system. In this edition we will hear
some excerpts
from a BBC interview with a reformed currency trader, and
we also
interview the administrator of a small but democratic
version of the
Federal Reserve, where a currency called "Bread Hours" is
growing in
circulation in California.
Let's start this edition of Wizards with a paradox.
Paradoxes make for
excellent exercise for the brain. A paradox is an apparent
contradiction - a conclusion arrived at through logic but
whose end
result doesn't seem to make sense. The resolution of a
paradox often
results in new thinking about an issue and a head on
challenge of the
underlying assumptions.
The Activism-Money Paradox
Suppose you are a non-profit organization that opposes
income
inequality and, in particular, you oppose the structure
through which
that inequality comes about - namely contemporary capital
(or stock)
markets and the international monetary system. The people
you think
you are helping the most are those at the low-income end
of the
spectrum. You probably acquired the status of, or are
sponsored by, a
501 c3 organization that can accept tax-deductible
contributions
primarily in the form of national currency, or simply US
dollars in
this country.
Why does your organization need to raise US dollars?
Because they need
to trade - they need labor, supplies and services to
conduct their
activism and advocacy activities. Much of the labor might
not require
any US dollars, for those people that donate their time.
But usually
there will be some positions and tasks for which US
dollars are
required, else the task will simply not get done. Supplies
and
services that might be needed might come in the form of
travel
expenses, stationary, computer equipment and so forth. The
proper
method for acquiring such goods is through trade and
certainly the
quickest way to complete these transactions is to exchange
US dollars
for the goods and services desired.
So then your organization has to decide how it will raise
US dollars
from the markets of would be philanthropists. These people
would have
to agree with the organization's goals of fighting income
inequality
brought about by contemporary capital and money markets.
Your organization will be most successful and have the
most outreach
in the shortest period of time if it can raise a lot of
money from a
few people. But how did these people get so much excess
money that
they can support you? Well, they are unlikely to be any of
the people
you claim to be helping - that is the low-income people
who probably
dont have too much extra to spare. They are most likely to
be higher
income/wealth people who have benefited greatly from
contemporary
capital and money markets - the very thing your
organization opposes.
So then, if you are very successful and raise lots of
money to meet
your goals - do you think you will smash the system you
oppose and
destroy the system that made your major funders wealthy
enough to be
able to contribute excess cash to you?
No way! All you did was change the path of the flow of
money. The
money bought the goods and services you needed and then
ended up back
in the same system of capital markets and the
international monetary
system you oppose. The same for the money you spent on the
people you
were helping, which also ended up back in the same old
monetary
system. Nothing fundamentally has changed - you might have
raised some
awareness of the problems, and caused some headaches for
the
authorities - but thats all. No doubt if your motives were
genuine
your organization will have made some positive change, but
the
underlying structure of the system - the mechanics of the
capital
markets and the international monetary system - have not
changed.
The contemporary monetary system depends on inequality for
its
survival. Importantly it also depends on confidence that
such
inequality can be increased to bring in desired return on
capital. By
participating in the monetary system and accepting funds
originating
from, and going back to, the capital markets and
international
monetary flows, you support this structure. By continuing
to support
the same monetary system you oppose, you havent really
challenged the
root of the problem.
Break: "Working for the Enemy" Baby Animals
Whose Monetary System?
Whose monetary system is it then? Not yours!
We already discussed this in Wizards Part 1. The basic
building blocks
of contemporary capital and money markets is just plain
money - that
legal tender that can be used in the trade for all goods
and services
and in the repayment of all debts. Plain money is first
created by the
Federal Reserve - who just makes it up "out of thin air",
first as
bank reserves, and then later as currency or Federal
Reserve Notes as
the public demand more cold hard cash. Secondly, and where
most money
is created, the private commercial banks make about 10
times this
amount as deposit or check account money simply through
the loan
creation process, and again, "out of thin air". The public
has no
input into either of these money or credit creation
processes.
Ultimately the decisions on who gets access to credit and
who gets it
on reasonable terms is decided on the basis of what loans
will bring
in to the shareholders of banks a return on their invested
capital at
a level of around 20% in recent years. By this I mean that
for every 1
dollar of stock or equity capital that a shareholder
invests in a bank
they will get back 1.20 after a year. This is called a 20%
return on
equity. While this is simply an accounting profit - which
is a purely
abstract notion - these profits will translate into wealth
in the real
sense of potential to buy goods and services, because
everyone accepts
the US dollar as legal lender - good for all trade and in
the
repayment of all debts. Therefore, in no way shape or form
can the
creation and initial distribution of the money we so
depend on be
considered a democratic process. It is ultimately driven
by the profit
targets desired by the major shareholders of banks, which
is a very
small segment of society.
On top of these money or basic debt markets sit more
complex debt
markets (outside the banking system) and, of course, the
rest of the
capital markets (or stock markets), where shareholders
invest the US
dollars they've accumulated in return for more of these
dollars in the
future. In the case of all entities that raise money on
the public
stock exchanges (known as publicly traded corporations)
all company
decisions will be primarily driven by the need to meet
shareholder
expectations in terms of required return on capital.
Meeting
shareholder expectation is necessary in order to retain
access to the
capital markets. Access to the capital markets is the
"make or break",
the very requirement for survival of a publicly traded
company, and
meeting shareholder expectations therefore drives all
decision making.
Consequently the other main parties of a corporation - the
employees
and the customers and other effected public - only have
say in the
corporation to the extent that they can influence the
shareholders.
The shareholders are mostly concerned with percent return
on
investment.
It is then fair to say that contemporary money and capital
markets
have built into them powerful driving forces that must
undermine
democracy for their very survival. Capital markets, which
depend on
accumulated money, could probably never be democratic
because they are
necessarily driven by the demands of shareholders. But
what about
money or credit - the basic medium of exchange? Can that
be created
democratically and would that lead to a more democratic
society, and a
fairer society where people really did have closer to equal
opportunity? This is the subject of today's Wizards. But
before we
discuss democratic money it is perhaps best to discuss why
we might
need money at all.
Why do we Need Money?
The primary reason we need money is because human
societies have found
it desirable to run themselves using division of labor. In
this way
some people can occupy themselves providing the things
necessary for
survival for the people in the society, such as food and
shelter,
leaving others free to invent and produce things to make
life easier
and more enjoyable in the material sense, such as
electricity,
transportation and so forth.
Without division of labor people would have to produce
their own food,
shelter and warmth within their own family unit or small
community.
This would keep people busy all the time occupied in these
basic
activities. Humans have achieved remarkable progress
through division
of labor, which has been facilitated through some commonly
accepted
medium of exchange, known as money. Money accepted for
trade in all
goods and services facilitates trade with people outside
of your
immediate neighborhood. Without money, and wanting to
trade goods and
services with a broad range of people, humans would revert
back to
barter, which tends to result in very slow trade, small
amounts of
trade and very slow technological developments.
The availability and flow of money seems well correlated
with pace and
direction of technological development. Today,
availability of money
will depend on Federal Reserve and commercial banking
decisions, as
well as the desires of the capital markets. Both
availability and flow
will depend greatly on public confidence in the monetary
system, and
the capital and debt markets built on top of it.
Ideally, in a democracy, the people would decide what pace
and in
which direction technological development should go, and
what
activities should be encouraged and what shouldn't. Then
they could
design their monetary system consistent with these values.
At one
extreme is the system of limited trade and little
technological
development. If people wanted this they could have no
monetary system
and everyone could go back to agrarian-like barter
societies. They
could alternatively have no money and centralized planning
to force
division of labor and development, but this tends to
concentrate power
in too few hands, which is very dangerous and ends up being
undemocratic.
At the other extreme they could have maximum technological
development
and the "fast money" and fast pace of today that will
accumulate lots
of money if invested in such development. However this
will also tend
to concentrate power in too few hands as human activities
get oriented
around ensuring that return on capital is achieved to
maintain
confidence in the system and its underlying monetary
system.
Most likely the majority of humans in the present time
would like a
system somewhere in between. One that provided a more
advanced life
than the agrarian societies and so needed some division of
labor, and
perhaps some monetary system to facilitate such
development and avoid
centralized control. But many would also like a system
that wasn't so
driven by, and dependent on, rapid advancement and rapid
consumption,
but rather tended to promote a more sustainable future.
People all over the world are in fact starting to design
such monetary
systems of their own to help achieve the goals of their
own societies.
We will now listen to some excerpts from the November 11,
2001 edition
of the BBC's Global Business Report where the growth in
democratic
money was being discussed. In this segment the BBC
interviews Bernard
Lietaer, a former and reformed currency trader, who
understands why we
need better money. We mentioned Mr. Lietaer in Wizards
Part 1 as the
author of the book "The Future of Money".
Excerpt: BBC Global Business Report. November 11, 2001
Interview with
Bernard Lietaer. Transcript to be posted soon.
Design and Implications of Democratic Money
There is absolutely no reason why a group of people who
wanted to
trade goods and services amongst themselves couldn't
create their own
monetary system. After all, money is just an arbitrary
accounting
system of credits and debits that we have let the Federal
Reserve and
the private banks design for us, rather than having any
input
ourselves. Using a democratic currency designed for a
local, or
similarly ideologically inclined, group the benefits of
the division
of labor and trade in the group in that new currency would
accrue
entirely to that group and would not be sucked into the
mainstream
capital markets. Furthermore this kind of resistance to
mainstream
money, if conducted on a large enough scale, has potential
to put
significant pressure on the mainstream monetary system and
its
associated capital markets to change its ways. That is -
it has the
potential to force fundamental structural changes.
Contrary to some beliefs, it is not money that makes for
the practical
implementation of capitalism - it is positive return on
capital. The
argument behind having positive return on capital is
"compensation for
financial risk". The capital holder could have realized
the full value
of their capital today by spending it on a real good but
instead they
invested it in something else where they might lose the
value of that
investment, and so the argument goes that they should get
compensated
for this risk. One of the main places where this argument
fails is
that the only risk considered in this equation is
financial risk to
the capital investor. Completely ignored are social or
environmental
risks this investment created which, if factored in and
charged to the
investor (i.e. public risks charged back to the source),
might make
the properly risk-adjusted return unattractive to the
investor so as
to discourage such investment.
A group of people might choose to create their own
currency with zero
interest to remove the incentive and ability to accumulate
excess
capital over labor and goods input into the system. This
would provide
for more equitable distribution and access to the medium
of exchange,
and would remove incentive for excessive appropriation of
natural
resources. Then they may also decide to create money
through various
means such as loans and grants made through some
democratic decision
making process. A new currency could be created for trade
within a
local community, or even across a broader geographic
region with some
other association - such as members of a national
coalition of NGOs
working on similar issues.
We discuss all these issues and more in the following
interview with
Dina Mackin, the main administrator of the Bread-hours
currency. No -
she's not the equivalent of Alan Greenspan for Breadhours,
because
this money is created democratically and it has no duty to
please Wall
Street. The technical and social challenges of implementing
alternative currencies are not insignificant and should
not be
underestimated. Also as we shall see in the following
interview, where
such "currency independence" is most needed - that is, the
developing
world - it has not only been successful but seen as a
threat by the
national central bank and government. As we learn in the
following
interview this was the case with a successful local
currency that
flourished after the 1997 attack on the Thai Baht (see
Wizards 2 and 5
on this) and was shut down by the Thai government in 2000.
Interview with Dina Mackin of the Breadhours Currency.
Transcript to
be posted soon.
The
Money Cycle versus The Water Cycle
In this seventh edition of Wizards we are going to take a
look at the
very intimate and certainly, very troubled, relationship
between money
and water. We will do this by first navigating our way
through a
simple model of money flows - which we shall call the
Money Cycle.
Then we'll circle through the Water Cycle and remind
ourselves of all
that stuff we learned in elementary school plus more of
the stuff they
didn't tell us about.
Then we'll do something you don't see very much - we'll
highlight the
link between money and water by identifying a point on
both cycles
where they are firmly fixed to each other, and where its
easy to see
that what's good for one is normally pretty horrible for
the other.
Throughout this episode of Wizards we'll be hearing some
water-cycle
words of wisdom from Dr Vandana Shiva, Indian scientist
and activist,
who gave a presentation at the Council of Canadians
International
Forum on Conservation and Human Rights in June this year.
Dr Shiva has
a new book coming out called "Water Wars", which is to be
released in
February of next year.
The link between profiteering, corporate globalization and
damage to
the water cycle should be fairly well-known to most
people. Coverage
of issues such as water contamination, salinization of
water supplies,
acid rain and ecological damage caused by dams have
received
widespread attention in recent years. And there is no
doubt these
phenomena are the result of human activities driven by
economic
pressures of paying interest on loans and meeting profit
expectations
of shareholders that is, this damage has been a
consequence of the
pressures of contemporary capital and debt markets. Many
realize that
mainstream economics forgot to factor in the environment
and that
economics must now change.
What we will focus on in this edition is how much such
environmental
destruction is actually built right into the fundamental
building
blocks of the monetary system and their associated capital
markets. In
fact, as we shall see, this link exists right at the point
of money
creation.
The link between water and money was selected for this
discussion
because all of us are made up of about two thirds water,
we can't live
without it and, today, water is our most troubled natural
resource.
Water is shaping up to be the biggest issue of the 21st
century so we
had better understand very well how money works to disturb
the water
cycle. If this disturbance involves something fundamental
to the
mechanics of the monetary system we had better know this
too so we can
think about, as we discussed in Wizards Part 6, designing
more
water-friendly monetary systems.
How Money Flows
Recall in Wizards Part 1 that we discussed how you and I
don't just go
out and make money when we go to work or sell something.
Instead we
are just getting a transfer of already existing money from
people that
have some. Unless these people or companies are a bank
then they
didn't make money either - they also got a transfer of
some money that
already existed. Money, you will recall, is just the
other-side, the
mirror image, of debt. Money is created by the creation of
a
corresponding amount of debt. Money, in its most basic and
spendable
(or liquid) form, is created by banks making loans to the
non-bank
public.
As we discussed in Wizards Part 1, banks make money up
out-of-thin-air
by making a loan to a borrower, which also becomes a
deposit (or
money) to the recipient of these funds (say the seller of
a house). So
this means that when you come by some money, say from your
paycheck or
by selling some furniture at your yard sale, this money
has already
been through some kind of journey to get to you. But at
some time,
maybe last week, or maybe 50 years ago, it started off as
a bank loan
or a bank (or Federal Reserve) purchase of some asset.
Then it has
traveled through many different human interactions of
trade to get to
you. It is interesting to think about this.
Maybe the money you're getting today started its life for
some purpose
you think is quite good. But maybe it started its life as
funding for
a dam or mining project, and here you are with it today.
Maybe it even
started off as the funding for that logging project that
caused your
favorite forest to be clear-cut and which caused you so
much distress.
That seems like money some of us might not like very much.
So we
better have a look at exactly what purposes money is being
created for
and then we'll have a better idea of the history of the
money we are
condoning and accepting today.
This is quite easy to do in a few simple steps.
Step 1: Go to the web site of the Federal Deposit Insurance
Corporation at http://www.fdic.gov. Go to the link to
Historical
Statistics on Banking and then go to Commercial Bank
Reports. Go to
Table CB09, which gives you total assets for Commercial
Banks
(http://www2.fdic.gov/hsob/hsobRpt.asp). Total assets of
commercial
banks at year end 2000 are $6.2 trillion dollars. If you
also went to
the Savings Institutions links on the FDIC website
(http://www2.fdic.gov/hsob/hsobRpt.asp) you would see that
the Savings
Institutions have total year end 2000 assets of $1.2
trillion.
Aside: As an aside heres an interesting way to look at
this data.
Adding up the total Commercial Banks and Savings
Institution Assets
would give a total of $7.4 trillion in bank assets. This
is, of
course, debt of the non-bank public (thats us) owed to the
banks this
is in the form of mortgage, credit card debt and so-forth.
The way
that money works this should mean that the total M3 money
supply in US
dollars (that is the money that we non-banks can use in
the trade for
all goods and services) should be close to this $7.4
trillion in bank
assets. You can check this by going to the Federal Reserve
web site at
http://www.federalreserve.gov, clicking the link to
Research and Data,
clicking the link to Statistics, then go to Table H.6 and
click the
link to money and debt stock measures. Click on Table 1
and look at
the M3 money supply column. (
http://www.federalreserve.gov/releases/H6/hist/h6hist1.txt). At the
end of 2000, this is $7.2 trillion, which is only 2% off
the total
bank assets or debt owed by the public to the banks.
Step 2: Let's just focus on Commercial Banks since thats
where most
money (almost 85%) is being created. This total balance
sheet of the
commercial banks gives us the breakdown of how todays
available bank
money was created. We see that $3.8 trillion, or 60% of
it, is created
as "Loans and Leases". The rest was created for other
assets owned by
the banks such as investment securities and bank real
estate. So lets
drill down into these "Loans and Leases" since they make
up most of
the money thats been created. Go to Commercial Bank table
CB11 and you
will see a breakdown of how this $3.8 trillion dollars was
created.
Almost 50% was created for real estate purposes, mostly
mortgages for
residential and commercial real estate purchases and
development.
Another 30% is for commercial and industrial project
purposes. And
most of the rest is loans to individuals, in the form of
Credit Card
and other personal debt.
Step 3: Combining this information we can see that almost
half of the
money created by banks comes into existence for some kind
of real
estate transaction, commercial or industrial project. We
can
extrapolate and say that about half the money we use today
came into
existence for the purpose of some kind of ALTERATION to
NATURAL LAND
and its associated natural resources. This means the
replacement of
natural land with some kind of human development. The US
dollar based
monetary system as we know it today is heavily dependent
for its
survival on human alteration of the natural landscape.
This provides
the key link between money and water. Break: "Before These
Crowded
Streets" Dave Matthews Band
The Simple Money Cycle Model
Let us build a simple model of the money cycle in our
heads for the
purposes of discussion. The Wizards of Money web site at
http://www.wizardsofmoney.org has a diagrammatic
representation of the
Money Cycle we are about to discuss. Similarly it has a
diagram of the
Water Cycle and of this critical link between the two.
Simple Model: Lets suppose in our simple model that all
money is
created as real estate loans, either for developers who
initially
built houses, offices and shopping centers, or for those
who end up
buying these buildings. Then money cycles around the
economy as
follows:
Suppose a bank loan first gets made to a developer of 100
units to go
out and develop land. They then develop this land enough
so that they
can sell it at a high enough price that they can both pay
the interest
of 10 units on that loan to the bank as well as make a
profit for
their shareholders (say another 10 units). This need to
return both
interest to the banks and a profit to their shareholders
encourages
development above and beyond what would result in a zero
interest
monetary system (similar to those systems we spoke about
in Wizards
Part 6). Lets say that the developer spent the 100 units
of money he
borrowed on some workers to clear the land and at the
brick store to
buy the bricks for the house.
Lets say that the workers and the brick-store owner spend
all their
money (100 units in total) at the Snazzy Furniture Store
at the local
mall. Snazzy puts this 100 units in its checking account
at the same
bank.
The developer sells the house to a buyer, which is you,
for 120 units.
You borrow this full amount of money from the bank in
order to buy the
house. This money gets put in the developers checking
account. The
developer pays back their 110 (which is the original 100 +
10
interest). The bank makes 10 units in profits which it then
distributes to its shareholders, and the developer makes
10 units in
profits which it also distributes to its shareholders.
These
shareholders then spend all their money at the Snazzy
Furniture Store
which has become very popular. This is also the store
where you work
at as a salesperson.
So at this point, bank loans total 120 to you, and there
is also 120
in checking account money floating around in the economy,
which has
all purchased goods at the Snazzy Store, and is accounted
for in
Snazzys checking account. Over the next few years you will
earn this
120 from your job at the Snazzy store and will be able to
pay off your
loan. Wellsort of. Lets not forget that you need to pay
interest to
the bank as well. So more money must be coming into the
system from
other places that will enable you to get the total money
you need to
pay off the loan plus interest.
To keep everything flowing enough money must be coming in,
or being
created, to enable most people access to enough money to
pay off their
loans. This is not true for all people, as a certain
amount of
bankruptcies are built into the system, but you dont want
too many or
even a few big bankruptcies as this would threaten
confidence in the
system which would collapse it. Well, all this means a
constant supply
of new money must be continuously created, and especially
as others
are paying off their bank loans, and thus making money
"disappear".
Recall that in our simple model we assumed that all money
is being
created by direct land development or alteration, but in
the real
world its more like half, though much of the other half is
indirectly
related to land alteration. So all this means more real
estate
development or land alteration to create this money to
keep things
flowing smoothly, keep confidence in it and keep it from
collapsing.
In a way then, the money machine is sort of "eating up
land" for its
own survival. The survival on the monetary system as we
know it today
depends on land alteration, which in turn disturbs the
water cycle.
But whatever is this going to mean for the water cycle?
Surely the
humans need water more than they need money!
The
Market Meets Real Efficiency - Nature's Water Cycle
Here are some excepts from Dr. Vandana Shiva's water
speech to remind
us first about our relationship to water, and second, some
simple
truths about the water cycle. Excerpt: Dr Shiva Water
Words of Wisdom
Part 1 (vs1.wav) - The water cycle is the thing that links
us together
and Water Profiteers that need to go back to Elementary
School. On the
first topic of how the water cycle links us together over
space, we
must also remember that the water cycle links us together
over time,
and that it doesnt just link humans together, it links
together all
life on earth. Sometimes I like to look at a glass of
water and ponder
whether some of the molecules might have been sweated out
by dinosaurs
millions of years ago, and a few others might have been
used to
refresh a weary statue carrier on Easter Island some 2
thousand years
ago. Whatever we do to the water cycle today our dirty
fingerprints
will be all over whatever the water cycle becomes for
future
generations. Furthermore the water cycle is so complex,
such an
intricate piece of Mothers Natures handiwork that we
barely even
understand it. We are still, and always will be, learning
more. So we
cant possibly know the consequences of significant human
alteration to
the water cycle. On the second topic - the elementary
school water
cycle lessons - well, on the off chance that there are
some water
profiteers out there in the audience I drew on my
elementary school
teaching resources and found this little tune to help us
remember the
water cycle.
The Water Cycle Song
As we know from Grade 4 classes water evaporates from the
ocean,
lakes, rivers, and is sweated out by plants and goes to
the sky as a
gas. Later it falls as rain or snow, gets used by plants
and animals -
including the humans - and then goes running down hills
and mountains
to the rivers and sea to start all over again.
Of course this is a huge oversimplification suitable for a
4th grader
but it doesn't much help us grown-ups see all the links
between money
creation, land alteration and water cycle disturbance.
Lets consider
some other parts of the water cycle that will help.
Nature has figured out some excellent ways to moderate the
flow of
water to manage flood and drought risk and also to clean
water so that
the waste of one process can get all cleaned up and ready
for another
process. This all happens through water's interaction with
the land
and with the ultimate Central Banker - the Central Banker
of Energy,
the Sun.
Humans have absolutely no control over the Energy Central
Banker. All
they can control is the things that store the sun's energy
like plants
and animals that eat plants, and also they can go find the
sources of
other stored solar energy in the form of old squashed dead
plants and
animals, called oil and coal. All these activities plus
all of the
human monetary-system driven development of land effect
the land on
earth, not the Energy Central Banker. So the land is what
we focus on
in considering the link between the water cycle and the
money cycle
that forms the basis of our economy.
The way that nature manages flood and drought risk is
really through
plants and soils which are, of course, the very best of
friends - the
soils being largely made up of decaying leaves and trees,
and the
plants needing the soils for food. The soils store lots of
the rain as
groundwater and they are kept in place by tree roots. Some
of this
water the trees might like for later when they get a bit
thirsty, and
other ground water might fall to an underground aquifer or
run off
slowly into a stream in the watershed.
Having lots of plants and rich soils in a watershed means
that when
there is lots of rain the ground will soak up lots of the
excess water
and this will help mitigate flood risk. When it's been a
long time
between rains you can rely on the groundwater in the
aquifer or the
groundwater gradually seeping into a nearby stream to
provide a steady
flow of water from earlier rains. This helps mitigate
drought risk.
As for natures water cleansing functions the trees keeping
the soils
in place prevent excessive amounts of mud, clay, sand and
salt from
sliding into the stream. The soils and the little
microorganisms
living in them are very fond of waste products that most
other living
things would find rather unappetizing. Them and other
little critters
living in or near the stream often perform water cleaning
and
filtering functions that help to make the water useable
for others.
The trees sweat off some water through evapo-transpiration
helping to
cool the stream area so that all the critters that live
there that
have an important role in the water cycle can stay at a
nice
temperature to do all their work. Having such a water
cycle on our
planet makes a lot of sense given that gravity would
otherwise drain
all the water to the salty sea and sea-water is not very
drinkable.
This whole business of evaporation and rainfall to
replenish all
living things that need fresh water is quite sensible and,
of course,
life as we know it would not exist without an efficient
water cycle. A
prosperous human society cannot exist without an efficient
water
cycle. There's that efficiency word that people would have
us believe
that only markets can provide. Lets have a look at this.
When the
lassaie-faire marketeers go on about the efficiency of the
market they
are talking about what they label as "Pareto Efficiency".
This is a
sort of ideal allocation of resources amongst societal
members that
matches supply to demand within a given set of parameters
set by
society via the governmental body of the imagined
democracy.
But thats all very confusing isn't it. Lets just talk
about efficiency
in plain language that makes sense intuitively. At the end
of the day
markets and the monetary system are all about allocating
energy
amongst the different participants of a society - whether
that energy
be in the form of labor applied to a raw good to make it
into a
product, the raw good itself such as food crops, or stored
energy such
as coal and oil. And we know that all our energy comes
from the sun
and that only plants know how to capture and store that
energy
directly.
All these being the processes of Mother Nature they obey
what we
humans have interpreted to be the natural laws of physics,
most
especially they obey two important energy laws - the First
and Second
laws of Thermodynamics - that have never ever found to be
violated by
any process. Water obeys these natural laws. Money, being
a purely
human abstraction, does not.
Those put off by what sounds to be complex laws invented
by physicists
should not be deterred, for these are simple to understand
laws of
nature that get right to the heart of the conflict between
man and
nature, and specifically to the conflict between money and
water.
The First Law of Thermodynamics is the Law of Conservation
of Energy.
This says that the amount of energy in the universe is
fixed and you
cant create new energy or destroy existing energy. When it
comes to
the planet Earth, we get new energy to the earth from
another source
in the universe, called the Sun. Apart from all the energy
that we
have stored in and on earth and the daily dose of sunlight
we have no
other energy available to us. This is perhaps the primary
reason
humans have seen fit to develop markets - that is, to
allocate this
scarce resource of energy.
If the laws of Thermodynamics had just stopped there, my,
what a
peaceful world we would have! Under the conservation of
energy I could
just fill my car with gas, stick a little collector in the
exhaust
pipe and recycle all the energy I just used and fill my
car back up,
since I know that energy will be conserved. Id only ever
have to buy
one tank of gas in my life. Id only have to buy one load of
electricity to heat my home for my whole life Id just
recycle
everything over and over. Energy companies would go
bankrupt, there
would be no wars in the Middle East, and the stock market
would
collapse because no-one could make money from selling
energy.
OK theres a catch. And thats the very important Second Law
of
Thermodynamics. The ENTROPY Law. The law that sits right
at the heart
of the conflict between man and nature. ENTROPY is a
measure of
disorder we shall talk of it in terms of the usefulness of
energy. Low
entropy means very useful energy. High entropy means quite
useless
energy cant use it for another process, its not organized
enough. The
Second Law of Themodynamics says that Entropy always
Increases as
energy is used. Therefore, once you have used all the gas
in your
tank, even though the driving process left the same amount
of energy
from the gas in the world, that energy has become pretty
useless so
that you cant re-use it. This law then really creates the
scarcity of
energy and the primary motivation for using markets to
allocate it.
The economists tell us that this will be done most
efficiently if the
conditions of a free market are met. Presumably this means
energy will
be distributed more efficiently since that ultimately is
what the
market is distributing. So how does the market deal with
the Entropy
Law? The answer to that would be Not at all! While it is
true that the
Entropy Law contributes greatly to the scarcity that gives
rise to the
need for markets you will not find the Entropy Law
mentioned in
mainstream economics textbooks. Modern money and capital
markets, and
contemporary economics have been built up IGNORING the most
fundamental laws of nature. When it comes to the water
cycle it is
interesting to consider who runs things most efficiently -
the Markets
or Mother Nature? Given that the most desirable outcome of
the water
cycle, even from a human-centered point of view, is a
stable, secure
flow of clean water one would have to conclude that Mother
Nature
arranges the most efficient allocation of energy, for, in
the natural
processes there are no waste products, and solar energy is
used to its
maximum. Every player in the natural water cycle does some
work in the
water cycle and various related nutrient cycles and their
waste
products get used as input into some other process in
these cycles.
Nothing is wasted and everything fits together to form a
whole cycle
that has evolved over millions of years and that we are the
beneficiaries of today. Nature's water cycle seems to have
taken the
Entropy law into consideration and then optimized energy
use within
this boundary condition.
Enter the Humans and Their Crazy Monetary System
But then the Humans come along with their fears of
scarcity, markets
and monetary system that ultimately depends on alteration
of the land
for its survival and for the survival of the markets. But
most
alterations to the natural landscape then disturb Mother
Nature's
maximally energy efficient water cycle in several common
ways. These
are common things that have happened all across the globe:
* First, deforestation exposes soils and
causes soils, sediment and
salt to rush into the stream at
the next rainfall. You end up with
salty water and/or sediment that
kills off lots of the plants and
critters that had important roles
in the water cycle such as water
filtration.
* Second, the loss of soil and vegetation,
coupled with impervious
surface coverage such as roads,
car-parks and buildings means that
water can no longer seep into the
ground as is very important in
mitigating flood and drought risk.
The frequency of flood and
drought increases.
* Human activity in watersheds (real estate,
mining, logging,
intense farming and so forth) and
the loss of filtering systems
through the loss of vegetation and
soils means more and more
pollutants are entering the water
sources.
* The practice of building dams either for
hydropower or for storing
water in a place that doesn't have
enough, and the practice of
channeling water to places that
don't have much, has been
responsible for massive loss of
aquatic life, flooding and drastic
alteration to affected watersheds
and local water cycles.
Then the market-oriented humans come along and say "Well,
now we have
a water problem. Let's use some market mechanisms to fix
it." In fact
a lot of the market-oriented people go so far as to say -
"Let's
privatize water - that pure market solution will fix
everything". And
they say this perhaps forgetting that it was market forces
that got us
into this problem in the first place.
At this point it's worth hearing some more Water Words of
Wisdom from
Dr Vandana Shiva's Canadian water speech.
Dr Shiva Water Words of Wisdom Part 2 (vs2.wav) - Human
alternation of
land and saving the water cycle and (vs3.wav) - Water
Freedom.
Are these market solutions as efficient as Mother Nature's
way of
managing and distributing water? I think not because there
is obvious
waste in these market solutions. For example in order to
clean water
that has been polluted by human activities some
electricity is needed,
and this is extra energy that is simply NOT needed in the
natural
process. Not only is extra energy needed but there are
waste products
produced by the human processes, such as extra water
treatment
chemicals, that cannot be readily absorbed by natural
processes and so
create waste. Add to this the fact that human alteration
of land has
increased flood risk and drought risk that then gets
adjusted for by
all these human constructions - holding ponds, gutters and
so forth -
adding more and more energy input into the water cycle,
that is in
turn further disturbing the water cycle through
channelizing flow,
which causes streambank erosion and the list goes on.
Surely it would be hard to argue that markets can run the
water cycle
- that cycle responsible for the stuff of life we so
depend on - more
efficiently than Mother Nature can. Nature has had the
opportunity to
develop a most energy efficient water cycle millions more
years than
the humans have, and we are after all, creatures of nature
ourselves.
All this is not to say that humans should not have markets
for other
things or should not alter the land. Rather it is to say
that humans
might build a much better world and more efficient use of
energy if
they just leave the water cycle up to the master of it.
Ultimately
this would mean a paradigm shift in the way land is
developed so as to
retain enough natural features in every watershed to
retain Nature's
energy efficient control over the water cycle. Ideally
this need to
retain essential natural functions would enter into the
economy at the
point of credit creation, or equivalently money
origination.
Banks, Land and Water
Excerpt: Dr Shiva Water Words of Wisdom Part 3 (vs4.wav) -
Start off
with some reminders about the World Banks relationship to
land and
water.
So what are the banks and other financial institutions
doing about all
this? In fact it's not just the private financial
institutions who
should be paying attention it's also their regulators and
the central
banks.
On this latter point it is interesting to study the
composition of the
Boards of Directors of the 12 Regional Federal Reserve
Banks to see
what industries and activities might have the most
influence over
central banking practices. Interestingly the highest
concentrations of
representation outside of the bank sector are from the real
estate/development industry, and the energy and
transportation
industries. This is consistent with our earlier
observations of what
activities really drive the monetary system. You can find
a listing of
these directors on-line at www.federalreserve.gov, under
General Info
and List of Directors.
Let us turn our attention to the largest banking
conglomerate of all,
Citigroup. What are they doing about all these
environmental problems?
On September 28, 2001 Citigroup issued a press release
entitled
"Citigroup Selected as Component of Dow Jones
Sustainability World
Indexes". The release goes on to say that "Companies
included on the
DJSI World are leading their industries by setting
standards for best
practices and demonstrating superior environmental, social
and
economic performance." The article then goes on to mention
that
Citigroup serves on the steering committee of the United
Nations
Environment Program or UNEP, and that Citigroup seeks to
"manage
potential environmental issues and find financial value in
environmentally sound business transactions." Their
statements in this
press release are somewhat at odds with their funding of
environmentally destructive projects as documented on the
citiaction.org web site. Citiaction is a project of the
Rainforest
Action Network and various other NGOs.
Citigroup and other large international financial
conglomerates have
been fairly active in UNEP's Finance Initiatives group
established in
1997. You can find more information on this initiative at
unepfi.net.
The Swiss Bankers Association has also come out with some
very nice
statements about doing business in an environmentally
friendly manner.
While all these nice words from the banking sector might
make some
sleep more soundly, others might be concerned about
leaving monetary
system reform up to the bankers themselves. Especially
since land
alteration pressures lie right at the heart of foundations
of our
mainstream monetary system.
Unfortunately the approach of the concerned bankers and
the various
Finance Initiatives groups has been to see everything
through profit
and money tinted glasses. They think of environmental
problems in
terms of dollar cost and often think of solutions in terms
of getting
more profits in monetary terms. Thus, much work in the
field of
sustainable economics often gets reduced to converting all
natural
processes into monetary equivalents. Continuation of this
practice
could very well lead to a situation where economic
sustainability
looks great on paper in terms of long term sustainable
profits but
completely misses the prediction of, say, catastrophic
alteration to
the water-cycle - increasing flood, drought and
contamination risks.
To move from contemporary economics, which has
historically ignored
natural destruction, and to a more ecologically sensitive
"Ecological
Economics" we MUST move away from the practice of
converting anything
and everything to dollars terms in order to analyze them.
The
necessity for this can be seen in the observation that
money is an
abstract human invention that doesn't obey natural laws,
but Nature
does! For example, when it comes to water, the PRIMARY
measure for
analysis should be water indicators - say probability of
flood,
drought, contamination - NOT money. We can also use energy
itself as
an indicator, since distribution of energy is so much of
what our
markets are about.
After such analysis, and given that nature is the most
efficient user
of energy shouldn't we use natural solutions (preservation,
conservation) to complement and mitigate the effects of
human
development, rather than energy intensive human mitigation
efforts.
Having established the right balance between human
development and
natural land features based on purely ENVIRONMENTAL
indicators we can
then bring money into the picture based on ENVIRONMENTAL
CONSTRAINTS
and not the other way around, as happens today. This
approach finally
would constrain the monetary system to recognizing the
Laws of Nature,
which it has never done before. Finally money would begin
to respect
the Entropy Law, the Second Law of Thermodynamics!
In summary, this would result in fundamental changes to
the monetary
system itself right at the point of money origination - a
much more
radical approach than proposed by any of the finance
industry
dominated groups such as the UNEP Finance Initiatives
group. But it is
an approach that seems necessary.
Trading
Nature and "Cooking the Books"
In this, the eighth edition of Wizards, we are going to
take a look at
what drives companies to "cook the books" or lie about
their earnings,
and well investigate just how widespread this problem
might be. How
much of the global economy is based on "smoke and mirrors"
book-keeping wizardry? Is such fake wizardry a genuine
weak spot in
the financial system that could ultimately lead to a
meltdown? These
are interesting questions for people to ask and it is
especially
useful for activists to identify such weak spots. Book
cooking is a
topical issue in the wake of the implosion of the amazing
disintegrating wizard collection known as Enron.
Both inside and outside the financial world people are
asking the
question "How many more Enrons are out there?" In this
episode of the
Wizards of Money we will first look at the pressures behind
book-cooking with a glimpse at the Wonderland of
Accounting. Then well
take a look at the activities of the once mighty Enron
empire, from
its contributions to Americas energy policy to its
attempts to
privatize the worlds water supply, and turn Mother Natures
gifts -
from the weather to forests to wind into tradable
securities. Finally
we look at the mechanics of the accounting trickery that
ultimately
lead to its demise, enriching top executives while
rendering employees
pension plans worthless.
We will look at the Enron collapse from a perspective
thats a bit
different. We will see that one of the primary forces
driving the
Enron collapse was the battle of the Enron giants desire
to privatize
nature and turn all resources into tradable securities
versus the
publics desire for fair access to these goods.
Interestingly one of
the key markets involved was the water market that we
spoke about in
Wizards Part 7 on The Money Cycle versus the Water Cycle.
In this episode we will interview a former Enron Trader
and Risk
Manager, hear some excerpts from a January 2001 interview
with the now
disgraced former CEO of Enron and excerpts from a recent
Congressional
Hearing on the Enron collapse.
Mirror Images and Accounting Basics
Financial accounting runs the world. This is so simply
because money
and finance run the world. And we have learned from our
previous
editions of Wizards that money is just an entry on a
balance sheet.
Base money (currency notes) and bank money (bank deposits)
make up
what we will call the plain money supply of the non-bank
public. As we
saw in Wizards Part 1 plain money is simply the equivalent
of the
liability side of total bank balance sheets. On the other
side of the
banks total balance sheets we have bank assets which
corresponds to
the liabilities of the non-bank public in the form of
house mortgages,
car loans and credit card debts.
And so this process of mirror imaging continues right into
all other
forms of financial asset. Any financial instrument is
simply a balance
sheet entry on two balance sheets a financial instrument
is an asset
of one person and a liability of another. In this fashion
all
financial instruments be it money, stocks, bonds, or
options - have a
mirror image somewhere in some other book or in some other
computer.
All financial instruments exist merely as entries in a
computer or a
book. Even the dollar bills we use have a mirror image
liability on
the Federal Reserves balance sheet. Financial instruments
other than
plain money say stocks and bonds have bookkeeping entries
that are
usually a claim on some other financial instrument often
money at some
date in the future.
Any such bookkeeping entry can be used to generate future
money, or
can be transferred into different bookkeeping entries, or
can
miraculously be transformed into a real good such as food
and clothing
through the process of trade.
This is how the zero sum game financial system works. It
is all based
on the shuffling of mirror-image numbers around on bits of
paper and
as bits and bytes around in computers. It is, of course,
quite bizarre
that this number shuffling governs much of the world order
and defines
social relations and access to the basics of life.
But the reason the number shuffling game has so much power
is because
people have so much confidence in it as a way to define
the social
order and govern the distribution of real goods. Let us
look at this
confidence in the number shuffling that runs the world
from the
perspective of two different groups of people, and how
these two
groups come to have the confidence in this number
shuffling that keeps
the financial system alive.
* For the low wage worker or unemployed person
the dominant
financial instrument in use is
just plain money, the instrument
for which the underlying number
shuffling of mirror image items
around balance sheets is less
obvious. Confidence is maintained in
this number shuffling system
partly through ignorance of the
maneuvering that is actually going
on to create and distribute
credits and debits, but mostly
through sheer necessity. The latter
arises because there are only
limited alternatives to money for
distributing goods, but this is
now changing with the growth in
community currencies as discussed
in Wizards Part 6.
* At the opposite end of the spectrum are the
very wealthy for whom
plain money is much less
significant as a financial instrument.
Plain money for this class is
merely a transitory stage between
transactions in financial
instruments and for converting financial
instruments into real goods and
services. In todays world of very
large wealth gaps, the wealthy
have accumulated lots of excess
financial capital. As in most past
money-dominated empires they
tend to "lend out" this excess to
finance other projects in return
for more money in the future than
they are lending out today. So
they might buy stocks or bonds
which form familiar balance sheet
entries in the form of debt and
equity to the borrower and stock
issuer. The mirror image of these
bookkeeping items are, of
course, assets on the wealthy
persons balance sheet.
For the financial system as we know it to survive it is
this wealthy
class, above all others, that must keep confidence in the
global
number shuffling game. For, if they lost confidence first
they would
try and liquidate or sell all their financial instruments
and hurry
them into safer assets, which would first be plain money.
But there isnt enough money to liquidate all these assets
which are
claims on future money. In this situation of mass selling
the markets
would actually freeze up and cause some kind of financial
meltdown.
This wealthy class can cause a financial collapse more
easily than
others because they have the most financial assets and
access to money
on such a massive scale that they could force change very
quickly.
This means that they must retain confidence in the
bookkeeping
wizardry or number shuffling that goes on to account for
stocks,
bonds, derivatives and so forth.
This need to maintain the confidence of the class that can
most easily
collapse the financial system is what gives the profession
of
accounting its importance in the world. If enough people
decided that
what accountants are doing is fake wizardry and trickery
and not a
true representation of what their investment moneys will
actually
generate, the financial system will disintegrate just as
completely as
Enron did in December 2001.
So its important for us to look at just what is going on
in accounting
wizardry.
The accounting mirror images for stocks and bonds run as
follows. The
holder of a stock or bond will record them as an asset on
their own
balance sheet. This asset represents the value of future
cashflow or
plain money from that stock or bond. The issuer of a bond,
lets say
some corporation, will record the same instrument as a
debt on its
balance sheet and will record the stock as shareholder
equity. For any
corporation the following equality always holds: Total
Assets = Total
Liabilities (or debts) Plus Shareholder Equity. If
shareholder equity
gets too low, meaning that asset values may not be able to
cover
liabilities due, the company may be forced into bankruptcy.
Under both types of instrument both stock and debt - the
balance sheet
items represent a promise to pay out money at certain
dates in the
future. For a bond or other debt instrument these dates
are fixed AND
debt and interest on debt for the company takes priority
over payment
to any shareholders.
The ratings agencies such as Standard and Poors and Moodys
rate
corporate debt according to the risk associated with
repayment. A less
risky bond gets an "investment grade" and risky bonds get
rated as
"junk". On the stock side it is the stock analysts usually
part of the
brokerage firms or investment banks - who assess what a
stock might be
worth, whether its over or under-priced based on
expectations about
future earnings.
Shareholders are entitled to all the money thats left
after all other
expenses and debts are paid which is what we call profits.
The value
of a share in a company to the investor is the expected
value of
future cash to come out of that company. Thus stock prices
wobble
around with expectations of future really true earnings,
in the form
of real cash, anticipated to be generated by a company.
So, no matter
how much accounting wizardry a company has going on to
prop up
confidence in its stock, sooner or later it will have to
demonstrate
that it can actually generate the cold hard cash expected
to be
generated in valuing its stock price.
Stock price levels are all about confidence confidence
that a company
can generate an amount of earnings in the future to
justify paying
this price today. Many companies are valued, often by
stock analysts,
as a certain multiple of current earnings the multiple
being called
the Price Earnings Ratio or PER. The PER is pretty much
set by market
sentiment which is pretty much based on herd mentality.
Company
management therefore tries to "manage earnings" to make
sure investors
dont lose confidence in their stock, though companies
usually dont
like to admit that they "manage earnings" as opposed to
"managing a
business".
Earnings in a period are basically an accounting item, a
bookkeeping
entry. They do not correspond to cash (or plain money)
generated in
that period, because in addition to cash, earnings include
all other
movements in the assets and liabilities of a company. And
these assets
and liabilities are themselves also values of expected
future monetary
cashflows, that may bear no relation to actual money flows
in the
period.
Much accounting creativity goes into coming up with
quarterly earnings
that are reported to the public through the quarterly
company filings
to the Securities and Exchange Commission or SEC. Strong
steady
earnings have a psychological effect on the market of
inspiring
confidence in a company, which leads to a strong stock
value and the
most desired outcome easy access to the capital and debt
markets. Any
company without easy access to the capital and debt
markets is likely
to stumble and fail for, without such access, they may
have problems
growing their business and paying bills as they fall due.
Access to
capital depends entirely on confidence that a company will
ultimately
be able to generate the required returns for the investor
in cold hard
cash.
Once just a bit of confidence is lost in a company,
difficulty in
getting access to capital is often compounded by rating
agencies and
analysts downgrading companies and forcing even more lost
confidence.
Access to capital becomes even more difficult, leading to
more
downgrades and so the cycle continues. This downward
spiral could keep
feeding on itself to ultimately force a company into
bankruptcy. This
is what happened with Enron confidence that its numbers
represented
reality was lost and the market came to the conclusion
that Enron
couldnt generate the future money that investors had
originally
expected. This started the downward spiral to bankruptcy.
These features of the markets, especially the fear of
getting onto
this downward spiral, creates all kinds of pressures for
grooming
quarterly earnings to be just what the market expects. We
already saw
that falling short of market expectations can be quite
disastrous, and
exceeding them too much is also dangerous because it raises
expectations for future earnings. Therefore an ideal world
for
management of a company is to keep earnings growing at a
level exactly
as the market expects. And so we have so-called "managed
earnings".
The challenge then is to make sure the market has
confidence that
those are, in fact, the REAL earnings that they really
represent what
the future holds in terms of generating cold hard cash.
This amazing area of wizardry known as "managing earnings"
seems to be
a luxury reserved only for corporations. You and I dont
have the
luxury of being able to massage our income when we report
to the IRS
or apply for a mortgage. The pale faces of officials seen
on TV after
the Enron implosion after mention that the "Enron problem"
might be
systemic most likely is due to the widespread knowledge
that Yes,
indeed companies do "manage earnings" even though what
they are
supposed to be doing is managing a business. But its just
one of those
things everyone knows, but nobody wants to talk about.
Accounting in Wonderland
To understand this better it is most instructive to run
through the
highlights of an article that appeared in Fortune Magazine
on March 8,
2001 entitled "Accounting in Wonderland" where reporter
Jeremy Kahn
goes down the rabbit hole with GEs (General Electric)
books. Excerpt:
"The Other Side of the Mirror". Stevie Nicks The
"Accounting in
Wonderland" article begins as follows "General Electric is
without a
doubt one of the most beloved stocks in history. About the
worst
criticism ever leveled at the illustrious company is that
its stunning
run of profit growth 101 straight quarters is somehow
artificial, the
result of "managed earnings". After all, the argument
goes, GE never
seems to have had a loss in one division that wasnt
happily offset by
a gain in another. Can such an extraordinary record really
be the
result of an uncannily canny management or is there a bit
of
accounting wizardry going on behind the curtain?" GE
denies such
allegations and the revered Jack Welch, former CEO of GE
always said
"GE manages businesses, not earnings". In some interesting
statements,
that would have been very prophetic if said about Enron at
the time
this article was written, reporter Jeremy Kahn goes on to
say "If the
companys core operations were ever to hit a rough spot
investors might
not discover it until its too late. Until very too late
indeed."
Concerned about this accounting wizardry Kahn says he
"dove into GEs
financial statements and wound up having an adventure
worthy of Lewis
Carroll. When I landed, I was in a place where little was
obvious,
nothing was simple, and no one not even the number
crunchers at GE
seemed to know the difference between reality and
fantasy". "Its an
extremely difficult company to evaluate because there are
so many
moving parts" says a GE analyst at Edmund Jones, ranging
from
television network NBC, to Jet Engines and Light Bulbs, to
the largest
business of all, the financial empire known as GE Capital.
Kahn
thought hed start his investigation there. This
investigation led Kahn
to find a series of transactions and cross-holdings
between GE Capital
subsidiaries that not even the GE analysts on Wall Street
understood.
He goes on to observe that "analysts who cover the stock
are much like
the guests at the Mad Hatters tea party blissfully
oblivious to the
illogic swirling around them." This special practice in
wizardry known
as shuffling numbers around the subsidiaries and
associates to
optimize earnings will be important for us to remember
because its a
key part of the Enron saga. Only in Enrons case its tricks
involved
invisible partnerships that didnt appear on the balance
sheets money
would just appear from them and disappear and reappear
again. Funny,
Kahn found similar phenomena in the GE accounts. In his
review of the
losses emerging from the bursting of the Internet bubble
he noted that
he had no way of figuring out just how much money had gone
down the
tubes. This was "owing to the Chesire Cat Effect: Certain
investments
suddenly appear, disappear, and then reappear in GEs
filing with the
SEC. Meanwhile the value of some investments float,
mischievously
disembodied from reality." Finally he got an admission out
of GE
spokesperson Gary Sheffer who said "There were some errors
in our
methodology for calculating value" and more errors were
found in some
of the mysterious disappearances and reappearances of
certain items.
So how many accountants missed these mistakes he wondered?
LOTS. And
as for the amazing smoothness of earnings, amidst lots of
ups and
downs in each varied business unit, Kahn says he found it
impossible
to understand the so-called once-off charges and gains that
miraculously always offset each other to smooth out
earnings reported
in the SEC filings. It should be noted here that GE has
won all kinds
of awards for disclosure and transparency. But what are we
to make of
all this, when even the analysts and accountants arent
seeming to
understand whats going on in the financial statements? And
what of the
issue of conflict of interest between a company and its
auditors who
review its accounts are they really independent when they
depend on
the same companies for their revenue stream? Lets listen
to some of
the concerns coming out of Congress during the Capital
Markets
subcommittee hearing in the aftermath of the Enron
collapse. This
hearing was on December 12th and in the following you will
hear a
member of this committee ask the Chief Accountant of the
SEC some
pointed questions. Excerpt: Accounting Issues. Capital
Markets and
Oversight Subcommittee Hearings Dec 12th.
The Making of the Enron Energy Empire
Now lets focus on the amazing disintegrating firm Enron,
to study
exactly how its accounting wizardry ultimately led to its
demise.
Before looking into the accounting wizardry lets first
look at what
Enron was and how it grew to such great heights.
To start off lets hear the story straight from one of
Enrons most
revered Wizards at the start of 2001 when Enron was the
darling of
Wall Street. What follows is an excerpt from a Motley Fool
radio show
interview with now-disgraced former CEO of Enron, Jeff
Skilling.
Excerpt: Motley Fool interview with disgraced-wizard
Skilling
This bragging about Enron in the Motley Fool interview is
notable for
what it doesnt say. Notably Mr. Skilling forgets to
mention the
serious problems Enron was facing at the time with its
water
privatizing extravaganza in Europe and its energy
calamities in Brazil
and India. We will come back to this point in a minute but
in order to
understand these troubled areas it is instructive to take
a quick look
at Enrons involvement in the California Energy Crisis,
their attitudes
to any kind of government regulation and public goods, and
their
involvement in shaping the Bush administrations energy
policy. First,
well listen to a bit more of the Motley Fool interview
with the
disgraced Wizard Skilling about the California Energy
Crisis.
Excerpt: Motley Fool interview with disgraced-wizard
Skilling CA
Energy Crisis
On this topic lets hear some more from the December 12
Congressional
Hearing on Enron from a Representative in the State of
Washington,
discussing the need for a better look at Enrons
involvement in shaping
Americas energy policy
Excerpt: Energy Policy Influence. Capital Markets and
Oversight
Subcommittee Hearings Dec 12th.
The Enron board and senior management clearly despised any
kind of
government regulation at all. In the United States,
through Enron
chair Ken Lays close ties with the Bush Administration,
Enron was able
to have troubling rules crushed and eliminated by its
friends in
government. This made all their US investments much more
valuable.
Perhaps it was this ability to steam-roll over democracy
in the United
States that led Enron to believe that it could squash
regulation
everywhere in the world and take over all public goods for
its own
private profit.
Indeed this is the approach that Enron took to water and
there is no
shortage of evidence to suggest that Enron wanted to
privatize the
worlds water recall that we spoke about this water market
logic in
Wizards Part 7. Thankfully, the water investments
ultimately played an
important role in drowning Enron in its own arrogance. Why
those pesky
Europeans considered water to be a public good, even after
Enron went
and spent all this money on water investments there.
Similarly,
politics and the desires of the pesky public played a
significant role
in devaluing Enrons energy investments in South America
and India.
Oh No! Imagine if shareholders found out that all this
money was spent
on water and offshore energy businesses and now these
investments were
proving to be worth not very much. Then Enron would be in
big trouble
and people would realize it wasnt the powerful and
important wizard it
had been claiming to be all these years.
And so the accounting wizardry began!
The Collapse of Enron
A July 30th 1998 article in the Economist entitle "Wet
Behind the
Ears" begins "Allowing electricity to come in contact with
water is
dangerous." The article then goes on to talk about the
huge price that
Enron paid for Britains Wessex Water business and all the
financial
dangers that come with privatizing a good that everybody
else
considers to be public.
A November 2000 edition of Democracy Now! Gave a pretty
thorough
account of the problems that Enron was having with the
government and
people of India in its energy operations there, as well as
the close
ties between Enrons chairman Ken Lay and the Bush Dynasty.
References to both of these sources can be found on the
Wizards of
Money web site for people who want a better understanding
of these
offshore deals and their associated problems.
Both of these sources appear to have identified two key
financially
troubled areas of Enron well before Wall Street did.
Evidently Enron
thought it could carry its power over governments to the
rest of the
world to make them behave the way Enron wanted them to
expecting this
to happen in Europe, South America and India. But Mr. Lays
charms
didnt seem to work so well in these arenas and Enron ended
up having
to stomach democratic forces in its offshore operations
and in the
process was losing pots of money.
Frightened of being found out, frightened of being demoted
from the
throne belonging to one of energys most powerful wizards
Enron decided
that honesty was the worst policy. It then cooked up some
bookkeeping
wizardry to hide the losses and overspending on these
disastrous
offshore investments that had been devalued by democratic
forces.
As documented in the companys Third Quarter 2001 SEC
filing Enron set
up some Limited Partnerships to take the assets so
troubled by
democratic forces off of its books. One partnership was
called
Whitewing Associates and it owned a special entity called
Osprey which
in turn bought Enrons troubled power operations in Europe
and South
America. Enron set up Whitewing to borrow the money from
outside third
parties to buy the troubled offshore assets and thus hide
these
disastrous investments from Wall Street. But the rest of
the market
wasnt as naïve as Enron in assuming that government
regulation would
soon be scuttled to provide necessary returns on capital.
The
investors in Whitewing debt apparently thought the Enron
investments
were pretty dodgy and demanded additional guarantees from
Enron. It is
these guarantees that Enron management seemed to keep
secret from
everyone else and which ultimately contributed to Enrons
demise.
The Whitewing investors whoever they were seem to be
pretty savvy. In
order to invest in the Whitewing debt securities used to
buy Enrons
troubled assets they demanded that Enron agree to issue
them extra
Enron shares if the troubled assets were having problems
generating
the cash needed to pay off the debt. But the investors
wanted to cover
every contingency and they knew that even this guarantee
would not be
good enough if someday Enron wasnt the golden child of
energy anymore
and its stock price plummeted. They demanded the added
guarantee that
if Enron stock fell below a certain price level and if
Enron debt ever
got downgraded to junk, ALL the debt on Whitewings balance
sheet would
become immediately payable by Enron itself.
Enron did EXACTLY the same thing with its troubled water
investments
when the rest of the world was saying that they thought
water should
be a public good. They set up the Atlantic Water Trust and
used it to
set up a special entity called Marlin which was used to
raise funds in
the form of debt securities. This was then used by Marlin
to buy the
troubled European water businesses and take them off
Enrons balance
sheet so that Enron didnt have to reveal these bad bets to
The Street.
In this way Enron avoided taking huge losses on these bad
bets to its
balance sheets and Wall Street continued to think that
Enron was a
powerful energy wizard. But people didnt know about all
these costly
guarantees granted by Enron in order to create the
entities that took
the assets and associated debt off Enrons books. Instead
all they saw
were miraculous gains on these sales to the secret
partnerships.
Little did anyone know that one day the trickery would be
discovered
and the debt was to all land back on Enrons books and
force it to go
bankrupt.
All that it would take to trigger the chain of events was
some small
loss of confidence in the company that could ultimately
send it on the
type of downward spiral we discussed earlier. At some
point on this
downward spiral the "debt trigger" in the secret
partnerships would be
released and things would get much, much worse.
The initial trigger was released around March 2001 when
all the
telecommunications companies were getting into trouble
because of
over-investment in infrastructure. Enron, having invested
so much in
bandwidth trading, had its share-price hit by this markets
down turn
and by the beginnings of a general recession. Also some of
the
brighter analysts were starting to notice that since Enron
was really
mostly a trading company its Price to Earnings ratio
should really be
much lower than it was and this also contributed to the
share prices
downwards direction.
By Summer 2001 Enrons share price had dropped to less than
$40 per
share which was below the trigger thresholds on the
guarantees on some
of the secret partnerships. Enron management was getting
nervous that
these deals might unravel and rear their ugly heads to the
world. CEO
Jeff Skilling quit suddenly. Around the same time it was
revealed that
there was a whole slew of other secret partnerships called
LJM and
LJM2. These were involved in all kinds of mysterious
relationships
with Special Purpose Entities (SPEs) with names like
Raptor, Chewco
and JEDI.
These secret partnerships and SPEs were not on Enrons
balance sheet
but had been run by Enrons CFO Andy Fastow who had been
making
handsome profits from them according to several Wall
Street Journal
articles that ran in October. Enron revealed in its second
quarter SEC
filing that Fastow suddenly got out of the partnerships,
leading many
to wonder not only what these partnerships were but also
what was
going wrong with them that Fastow wanted out and Skilling
had quit
Enron. In retrospect we understand that at this time
certain triggers
had been flipped in the partnerships guarantees and the
deals were
starting to explode all over Enrons balance sheet.
Confidence in Enron was dealt a further blow when these
partnerships
had obviously started falling apart bringing the bad
investments and
associated debts back onto Enrons balance sheet. By
Halloween the SEC
had launched a formal investigation.
Losses were so large and confidence so shot that Enrons
only hope
would have been rescue from the energy company Dynergy.
But as more
losses kept emerging and more injected cash kept
disappearing they too
got nervous and called off the deal.
Standard and Poors finally downgraded Enrons debt to junk
and pushed
all the triggers on the Whitewing and Marlin entities so
that all that
debt on their balance sheets became immediately payable by
Enron.
Enron didnt have the cash to pay the huge debts , nobody
in their
right minds would invest in them, and they were forced to
declare
bankruptcy.
On December 4 about 4,500 employees of its Houston
headquarters were
marched out of their offices and told to go home. For an
inside look
at what this roller coaster ride was like here is an
interview I did
with Ogan Kose a former Enron employee in the Global
Markets and also
the Risk Mangement area of Enron at its Houston
headquarters a few
weeks after the collapse.
Interview with Ogan Kose, former Enron employee.
For the holidays all lots of employees got was
unemployment and
worthless pension plans. The responsible executives have
been found to
have enriched themselves and have declined to present
themselves for
questioning. No justice appears to be on the horizon for
the rest of
the employees. Here is an excerpt from the December 12
Congressional
hearing describing how much the Enron executives made out
of this
extravaganza.
Given the Enron managers fetish for Star Wars characters
such as JEDIs
and Chewbacca, there is some comfort in knowing that this
Evil Empire
was defeated in part by the effect of overseas governments
representing people and people wanting to hold on to
public goods. The
irony is that the home countrys government, which we are
told is the
only good empire these days, was the closest ally of the
evil energy
empire throughout the whole saga.
Jack and the Sweatshop
In this the Ninth Edition of Wizards we are going to take
a look at
the "Manager of the 20th Century" - Jack Welch - GE's CEO
for the 20
years up until Fall 2001. In September 2001 Jack's much
awaited
autobiography entitled "Jack - Straight from the Gut" was
released
with much fanfare. Business professionals are besides
themselves with
praise for the book from Warren Buffett's comments that
"All CEOs want
to emulate him" to the Chairman of SONY corporation's
statement "Jack
Welch, the brilliant business magician, has finally
disclosed his
mysteries of management".
Since Jack is a "brilliant business magician" and since
during his
watch he transformed GE's small credit company into GE
Capital - the
largest non-bank financial institution in the world and
almost half of
the modern GE - he is definitely one of the most important
Wizards of
the 20th Century.
In the midst of the gushing reviews of Jack's book, his
career and
management style it is important to analyze his influence
on corporate
culture in America. From his ability in the 1980's to turn
mass
firings of employees from an attack on communities into an
almost
saintly act of saving companies from inefficiency, to the
1990's trend
of establishing high-tech sweatshops overseas, Jack has
built a new
model of the American corporation. In this new model the
only US
employees are managers. These managers get churned out at
the "People
Factory" in Crotonville, NY (also known as Jack's
Cathedral) and they
manage the overseas units where the real work is done at
optimal cost.
The other key part of the US operation is the Capital
Factory - GE
Capital - the company's own mini-Wall Street.
With most real production done outside the corporation
what does GE
actually produce - what is the measure by which GE is
acclaimed to be
the great success of the 20th century? Is it great light
bulbs, great
engines, great electricity or something else? No it's
EARNINGS - GE is
the best manufacturer of earnings in the 20th century. It
has the
sexiest looking balance sheet and income statement
book-keeping
entries of all. Recall that we spoke extensively about the
earnings
manufacturing business in Wizards Part 8. You can get all
past
editions of the Wizards of Money at www.wizardsofmoney.org
In this edition of Wizards, as we look at the Cathedral
that Jack
built, we will be hearing some excerpts of an interview
Jack did with
Bob Joss at a Commonwealth Club event on November 12, 2001
with an
audience of Stanford business students. At the other end
of the
spectrum we will be hearing an interview I did on January
5, 2002 with
Jessica Lindberg, housewife and mother in Rome, Georgia on
the banks
of the PCB laden Coosa River in Northern Georgia. She has
been busy
trying to get GE to clean up its mess in this North
Georgia town and
she even confronted Jack at his final GE shareholder
meeting as
Chairman about this issue.
To get this episode underway and to give a brief overview
of Jack's
career and what it was all about I found a fictional story
- I'm not
sure where it came from - that has some similarities with
Jack Welch's
story. The main character is also called Jack and a quick
telling of
this fictional story should help you get a handle on Mr.
Welch's saga
in a quick and easy-to-understand way. The fictional story
is called
"Jack and the Corporate Ladder".
Jack and the Corporate Ladder
Once upon a time there was a young man named Jack. He
lived with his
father and mother in Massachusetts and they were a family
of humble
means. Jacks father was a railway conductor and always
very busy
trying to earn a living for his family. So Jack spent a
lot of time
with his mother, whom he adored and who adored him. One
day Jack left
his dear mother and set off for the markets to find a job.
He found
one in the Land of GE. After some years of hard work, some
GE
merchants offered Jack a trade that Jack didn't like - the
same bonus
level as his colleagues so he decided to quit. But then a
more crafty
merchant offered Jack a handful of better treats - a
larger bonus and
some special treatment in return for Jacks future loyalty.
Jack
thought this was a pretty good deal and so he went home,
banked his
bonus and nurtured his ambition. The next day he went back
to work and
saw a huge Corporate Ladder in sight. An ambitious fellow,
Jack began
the long climb to the top. Jack had heard that there were
giants at
the top of the Corporate Ladder that he might have to
fight. He
considered it all a Big Game and he really wanted to win.
He was
determined to deal with those giants. Along the way up the
Corporate
Ladder Jack bumped into a giantish looking fellow called
Ronnie. Jack
and Ronnie made good friends and both were determined to
kill the
giants when they got to the top. For the giants interfered
with
freedom, they both agreed. However, about a quarter of the
way up,
Ronnie was thrown off the Corporate Ladder. The Land of GE
had
important contracts with the giants and Ronnie's constant
chatter of
giant-killing was messing with these deals. Ronnie was
determined to
get to the top another way - so he started to set his
sites on
becoming the main giant at the top himself. Meanwhile Jack
continued
his journey to the top of the Corporate Ladder. Finally
Jack got to
the top and there he could see huge amounts of riches and
treasures in
this new land that he considered rightfully his. But there
were some
battles to be fought and won in order to claim those
riches for
himself. First there was the issue of giants. Not long
after he
arrived Jack bumped into the leading giant of the land -
only to find
that it was Ronnie, who had also just made it to the Land
of the Top.
Jack couldn't be more pleased. Together Jack and Ronnie
vowed to rid
the land of the rest of the giants so the riches could be
theirs. Only
there were a few other things in the way. Standing between
them and
the riches were thousands of annoying little creatures
that were also
trying to get at bits of the riches for themselves. These
annoying
critters were called jobs and Jack immediately set to
killing the ones
he really didn't like and sending the rest to lands far,
far away.
Subsequent to that Jack thought he better set up a People
Factory so
he could churn out people to behave exactly how he wanted
them to.
Jack used the People Factory to build something of an army
to help him
get across to the riches and wipe out any other unexpected
obstacles
on the way. More trouble arose when Jack and his army got
to the Land
of the Media where nasty stories were spreading about Jack
the
Job-Killer and they even called him Neutron Jack - for his
ability to
kill jobs and leave buildings standing. This really upset
Jack - he
was only trying to get to what was rightfully his. He put
a stop to
all this by invading the Land of the Media and taking over
a good
chunk of it for himself. Over the next few years Jack and
his army
collected a hug amount of the riches for themselves. But
then came the
big river crossing where they met a hostile giant who
wanted to take a
bunch of their riches. Ronnie was no longer around to help
them with
this giant. Jack and his army fought a long, hard, nasty
battle for
more than 20 years but they finally lost and had to
concede some
riches. Never mind, Jack and his army just went and found
other riches
they could take. Jack was getting pretty old by this time
and thinking
about retiring from the Big Game when he came across yet
another
hostile giant. This one was from a land far, far away and
approached
Jack saying "Fee Fi Fo Fum, I smell the makings of a
Vertical
Monopoly". This new giant seemed to exhaust Jack and he
retired from
his life of giant-killing with all the riches he had
accumulated along
the way.
It's all About Winning. Business is a Game
Now back to the real Jack Welch. How does his mind work?
How does he
justify mass layoffs, the pressuring of contractors to
lay-off workers
and move factories to Mexico, the stingy wages in the
high-tech
sweatshops in India, and the constant denial that EPA
rated probable
carcinogens are perfectly safe?
We'll let Jack explain this in his own words. Here is an
excerpt from
the November 12, 2001 Commonwealth Club interview with
Jack Welch.
Excerpt from Commonwealth Club Interview: Jack in his own
words: "Its
all about winning. Business is a Game."
In his own mind Jack is unable to separate what he does
from a
baseball game or a good golf game. Under his logic, the
team can only
do good if it beats everyone else. The scorecard is the
Earnings
Report, the abstract has become the real and the real has
become
completely abstract.
He doesn't know what it feels like to be on the receiving
end of his
business decisions - to be laid-off, to work in an
overseas sweatshop,
or to live in a toxic wasteland that nobody wants to
cleanup. This
"other side" is perhaps the losing team in Jack's mind.
Certainly the
"losing team" in Jack's game doesn't see this business as
a mere game.
Jack never mentions in his book, nor in his interview, the
rather
larger handicap he is given by the American taxpayer in
this game of
business. Tax breaks, subsidies, accounting wizardry,
media ownership
and your very own mini-Wall Street created through years
of favored
access to credit can all help tremendously. To link this
episode in
with Wizards Part 8, let's take a look at the aftermath of
the Enron
collapse for example. In Wizards 8 we touched briefly on
Enron's Power
operations in India. Partners in this operation were none
other than
GE Capital and the Bechtel Corporation. Why them you might
ask?
Well, for many years GE has taken advantage of the
opportunities for
high-tech sweatshops in India. India has millions of
well-educated,
technically trained English speaking people that cost
peanuts compared
to US workers. Consequently GE has now exported all kinds
of technical
operations to India - from data entry, to accounting, to
customer
service, to loans and claims processing and, of course,
computer
programming. But for years Jack was frustrated - he had
the cheap
bodies in India - but he didnt have the electricity to
power the high
tech sweatshops. Similarly Betchel moved engineering
operations to
India and the engineers needed electricity too. On Jack's
September
2000 visit to India he is quoted by the Telegraph as
saying "When you
think of digitizing India there will be a massive amount
of power
required and I pray to this government that you have to
push and push
and push to invest in infrastructure."
The Enron/GE/Bechtel venture into Indian electricity
production seemed
to start off promising enough. But in 2001 the main
purchaser of this
electricity, the Maharashtra State Government, stopped
paying its
bills, partly contributing to Enron's problems.
Then with all its other problems Enron finally collapsed
and things
looked grim for the three patrons of HighTech Sweatshop
Electricity.
Crying over their losses they all went to the US
government last month
to ask for almost a quarter of a billion dollars
compensation from the
US Taxpayer! Yes this is really true! Fact is Stranger
than Fiction. A
December 20, 2001 Dow Jones Newswire article that went
almost
completely unnoticed reported that the three US giants had
made a
claim to the Overseas Private Investment Corporation, an
agency of the
US government, for $200 million dollars in "expropriation
compensation".
Well, that's Globalization for you!
The
Globalization Guru and the Georgia PCB/Dioxin Problem
On the topic of Globalization, at the November 12
Commonwealth Club
event, people were allowed to ask questions. No - not the
questions
they really wanted to ask - don't be silly! When it comes
to questions
to Business Gurus in the Free World the method runs as
follows - you
submit them on paper in advance and then a committee
decides which are
the appropriate questions, and then they get reworded to
optimize
their appropriateness.
And so it was with questions at this Commonwealth Club
event even
though it was a very safe audience - Stanford business
students. But
then Jack had probably thought the audience at the Annual
Shareholders
meeting in Atlanta earlier that year was probably safe
too, but a real
question slipped through the cracks. We'll hear more on
this later.
Anyway the following question on "Globalization versus
Democracy"
posed to Jack at the Commonwealth Club event was probably
the closest
that one came to a real question. Listen carefully to
Jack's response.
Excerpt from Commonwealth Club Interview: Jack in his own
words:
Globalization Rules!
Let us take a good look at this issue of exporting world
class
environmental standards and a little bit of a look at job
exporting.
We will now listen to an interview I did on January 5 this
year with
Jessica Lindberg, mother of two in the town of Rome,
Georgia who
founded a group there called Citizens Action Network. Rome
is in the
Northwest corner of Georgia, between Atlanta GA and
Chattanooga TN. It
is also not far from a town called Anniston in Alabama
that has
received a lot of attention lately.
For about 40 years GE operated a medium transformer
manufacturing
plant in Rome Georgia. For about half of those years it
dumped its
waste products into several landfills and waterways of
Rome. After
NAFTA came into effect GE didnt waste anytime. They
promptly moved
operations to Mexico and left their PCBs (polychlorinated
biphenyls),
dioxins (the killer chemical in Agent Orange) and many
other chemical
cocktails behind as a reminder of their generosity to
communities.
In contrast to Anniston, Alabama, the Husdon River in NY
and
Pittsfield MA, the Rome, GA toxicity problems get scant
media
attention both in the mainstream and in independent media.
Yet this
story is so important.
In the following interview note that the EPD is the
Environmental
Protection Division an environmental enforcement agency of
the GA
STATE government. I started the interview by asking
Jessica Lindberg
how she came to form the Rome, Georgia based Citizen's
Action Network.
Interview with Jessica Lindberg: Founder/Director of
Citizen's Action
Network
That was part of the interview I did with Jessica Lindberg
of
Citizen's Action Nework in Rome, GA. After this interview
I did some
more research into the Atlanta lawyer working for both the
EPD on
water issues and representing GE on the Rome PCB issue. I
found that
this lawyer is from none other than King and Spalding, Sam
Nunn's law
firm. The name of the lawyer in question is Patricia
Barmeyer and
before joining King and Spalding she worked as the
Assistant Attorney
Gerneral for the State of Georgia. Ms Barmeyer of King and
Spalding
does indeed represent GE in fighting EPD and EPA
decisions, and yes
also works as a key advisor to the State of Georgia's EPD
on critical
water issues. Oh yes, and King and Spalding also
represented GE in
squashing two class action lawsuits against them for the
dumping of
PCBs in Rome, GA. So I stand corrected - its not an old
boys network
after all - there's some old girls in it too!
Science, The Well Capitalized Way
With all these environmental problems GE has entered the
business of
funding medical studies in a big way. Miraculously, even
though there
are numerous studies finding a link between PCBs and
serious health
problems in animals all the GE funded medical studies find
that humans
and PCBs get along just fabulously.
Let's here some of Jacks medical words of wisdom:
Jack on PCBs and Cancer
In response let's hear some more from Jessica Lindberg
about the
scientific studies in a world of scarce financial capital:
Jessica Lindberg on Scientific Evidence and Financial
Capital
So while government bodies can somehow find taxpayers
contributions
available for hundreds of millions in "expropriation
compensation" no
government body can find the resources for a health study
desired by
the taxpayers.
Never
mind. After all, It's Just a Game.
Back to
the Twenties Through the Looking Glass - Steagall
In this the 10th edition of Wizards we are going to take a
look at the
parallels between current times and the late 1920s - the
period just
before the great stock-market crash of 1929 and the
subsequent Great
Depression. We will see how it is that much of the
regulation
implemented during the Great Depression to address the
wild and
unregulated behavior of big business during the twenties
has now been
dismantled through de-regulation. Despite industry claims
that such
regulation is out-dated and no longer needed for our fancy
modern
markets, we will see that, not surprisingly, the
dismantling of this
regulation has once again given rise to exactly the
dangerous market
behavior it was designed to stop.
Excerpt FDR Inauguration Speech 1933 - Reign in Bankers
This excerpt from FDR's 1933 speech helps remind us of a
time when
financial collapse caused by unchecked and unregulated
behavior of
Wall Street gamblers forced America's political leadership
to publicly
recognize the danger such activity poses to the public as
a whole. But
how easily we forget these things. In the wake of the
undoing of what
became regulated during the FDR administration the same
old players
are back to their same old tricks of the twenties. Hardly
discussed in
all the coverage of the Enron Saga of the early 21st
century is the
discovery of the extent of the wild and risky behavior of
the biggest
federally insured banks in the US - JP Morgan Chase and
Citigroup. If
their involvement in financing various Enron activities is
an
indication of their wheeling and dealing more broadly then
we have a
lot to be worried about at the heart of the financial
system.
In this highly deregulated market it is appropriate to
look at the
implications for another 1929-style crash and the
potential for a
financial collapse. The 29 Crash followed the high stakes
risk-taking
of lightly regulated powerful industries. One must
consider - Would a
financial collapse of this scale be a good thing? - by
being possibly
the only way to change the global order? Or would the
first such
collapse in the nuclear age bring more violence and
destruction than
any of us ever thought possible? Of course nobody can
answer these
last two questions with any certainty, but it is very
important to
consider what might go into the makings of a global
financial collapse
and to plan for what is eventually going to happen anyway.
It is not a
question of whether or not it will happen - as all
financial systems
eventually collapse, but the question is - when.
To go on this journey we will hear some speeches from
important
figures from this time and we will also visit with some
people that
actually lived through the twenties and are still able to
tell us
about it today.
Regulatory Landmarks of the Great Depression
The Great Depression brought with it numerous regulatory
landmarks
that stayed with us for a long time. Let's just talk about
a sample of
four of the major areas and the status of them today:
* Utilities Regulation: In 1935 the Public
Utilities Holding Company
Act or PUHCA was introduced to
provide national supervision of the
gas and electricity utilities in
order to prevent their excesses
of the 1920s. In the twenties big
utilities had been buying up
smaller ones, hiking up consumer
prices, expanding into unrelated
businesses, loading up on debt,
hiding losses from investors, and
milking their subsidiaries and
affiliates to prop up their own
earnings. Sound familiar? Many
people have reminded us of this law
in the aftermath of the Enron
collapse and Enron's various
exemptions from it amidst recent
recommendations by everyone from
the Senate Banking Committee to
the SEC to have this law repealed.
* Exchange and Accounting Regulation: The
Securities and Exchange
Commission (or SEC) was
established in 1934 under the Securities
Exchange Act. During the 1920s
there was effectively no Federal
oversight of the securities
markets, and with the market rising in
the 1920s, and banks more than
willing to lend for stock
speculation, this created a recipe
for disaster. The SEC was
created to oversee market players
in the securities markets and to
require truthful quarterly
reporting from publicly traded
companies. By 2002 the
effectiveness of the SEC in enforcing
"truth in reporting" is highly
questionable as we have seen. This
is in part due to conflicts of
interest rife throughout the
financial world but also due the
sheer complexity of financial
transactions available to all
companies and the absence of
regulation on the most risky of
financial transactions - those
called derivatives trades.
* The Social Security Act: Before the Great
Depression there was no
federal safety net for unemployed,
disabled or retired persons. As
often happens today the safety net
was usually picked up by
various charities and religious
organizations. But this safety net
collapsed during the Great
Depression because of the collapse in
confidence in the financial
system. By necessity and through
public pressure that had built up
over the years the Social
Security Act was born in 1935 and
provided for old-age and
unemployment benefits. Today, of
course, this depression era
safeguard is under attack with
financial companies pushing for its
privatization.
* The Heart of the Financial System: Finally
the big one - the
regulation of the system that
stands at the heart of the entire
financial infrastructure - the
banking system. The big act
affecting the banks and securities
dealers was the Glass -
Steagall Act of 1933 that brought
radical changes and better
supervision to the banking
industry. This act separated deposit
banks, where depositors expect to
safely park their money, from
more speculative players such as
securities dealers and investment
banks that could make depositors'
money disappear through careless
gambling - and did exactly this in
the 1920s. The Federal
Depository Insurance Corporation
or FDIC was set up in 1933 to
provide insurance on depositors'
funds in the event of bank
failure. This was necessary to
restore confidence in the
foundations of the monetary system
- the banks - that had just
seen run after run, failure after
failure, and depositors had seen
their money disappear right before
their very eyes.
Interestingly, also at this time, various controls and
regulations
were put on the Savings and Loans institutions. This was
all to be
undone when Ronald Reagan began his de-regulation kick in
the 1980s.
As we now know the undoing of these regulatory checks and
balances
precipitated in the Savings and Loans debacle of the 1980s
that could
have brought down the world financial system, except that
the US
taxpayer saved the day with a high priced bailout. That is
what
Federal Insurance means - backed by the US taxpayer. With
the repeal
of Glass-Steagall protections in 1999 nobody seamed to
have remembered
the lessons of the 1980s, let alone the lessons of the
1920s!
These regulations of the banking system - the heart and
soul of the
financial system - will be the focus of our show today. We
will see
how the gradual dismantling of them over the past 20
years, since
Ronald Reagan took office in 1980 and culminating in the
complete
repeal of the once mighty Glass - Steagall Act in 1999, is
sending the
banks straight back to be bigger reflections of their 1929
former
selves. Whatever are the implications of this? As already
noted a
glimpse at what the future might hold already leaked out
amidst the
Enron crisis. We are only just starting to understand the
extent of
the involvement of big federally insured banks in this
scandal,
notably JP Morgan Chase and Citigroup - both of whom were
able to form
banking and securities trading conglomerates after the
repeal of Glass
- Steagall.
A Trip Back to the 1920s
Much of the source material on the 1920s used for this
episode of
Wizards is actually from the web-site of the Library of
Congress. This
site has a very extensive selection of original documents
scanned into
electronic files and posted to the Web. For the 1920s era
there is a
fascinating collection called "The Coolidge Era and the
Consumer
Economy" and links to this are posted to Wizards of Money
Web site at
www.wizardsofmoney.org
Link to the Library of Congress 20s collection
http://memory.loc.gov/ammem/coolhtml/coolhome.html
Now let's get in our time machine and go back to the 1920s
Excerpt - Einstein SpeechLanguage, Science and Goals
This is a rare recording of Albert Einstein. I inserted
these words
from Einstein because, of course, Einstein was becoming a
very famous
person in this period known as the Roaring 20s and he was
traveling in
the US to explain his amazing Theories of Relativity.
These theories
made him the premier Time Traveler of Western History. In
particular,
his Special Theory of Relativity provided the Western
world with a
radical new look at the concept of time, and it implied
strange time
travel and time-space paradoxes. He notes in this speech
the role that
science plays in the world, and that it is leaders who set
the goals
and priorities first and science that follows, rather than
the other
way around.
Now imagine we are back in the twenties World War I is
over, the
Republican Harding is President and the decade started
glumly with
what is known as the Agricultural Depression.
Radio was the new mass communications medium of the 1920s.
The
Westinghouse Company launched the first radio station KDKA
in 1920 in
Pittsburgh, Pennsylvania. Radio brought with it great
promises as the
medium for free speech and democracy but these promises
were never
fulfilled in the twenties, as we shall see.
Campaign finance and corruption scandals rocked the Harding
administration, the most famous being the Teapot Dome
Scandal, whereby
government officials had secretly leased public oil-fields
to private
interests in return for cash and other favors. Harding had
an
unfortunate incident with some foodstuffs in 1923, he
dropped dead and
Calvin Coolidge became president and served as such until
1928.
The Coolidge Administration favored deregulation, industry
self-regulation and brought in tax cuts to stimulate
spending.
ATT, NBC, and CBS built huge radio networks across the
country that
grew rapidly in the last half of the decade. These
networks were all
supported by advertising revenue and this tended to "dumb
down" the
content so as not to offend the major revenue sources.
The public relations industry and major corporate
propaganda campaigns
were launched. Spearheading much of this activity was a
man named
Edward L Bernays who wrote extensively on "The Business of
Propaganda"
and helped Coolidge get elected in 1924. Advertising in
newspapers and
radio claimed unprecedented proportions of print-space and
airtime.
Various movements to encourage ever more spending were
launched - such
as the Better Homes Movement, and various targeted Women's
and Negro
consumer campaigns were launched. Marketing specifically
to children
kicked off with the first annual Macy's parade in NY in
1924. Target
marketing statistical analysis reached new levels of
sophistication
with the introduction of the punch-card system.
America had reached new and amazing heights in consumerism!
Popular radio shows, the new talking movies and song/dance
combos such
as the Charleston engaged millions and helped the decade
become known
as the "Roaring 20s."
The Chain Store was born. Sears, Roebuck and Company
opened 324 stores
nationwide between 1925 and 1929. Woolworths, Krogers, JC
Penney, and
Walgreens all spread stores all over the country. Many
loved the
convenience but hated that the small local merchants were
forced out
of business.
The stock market climbed to new heights in the late 1920s,
the
ordinary American was encouraged to invest their savings
in the stock
market and more Americans owned stock than ever before. At
the same
time the proportion of Americans on incomes below the
poverty line
continued to increase so that this proportion reached
almost 50% by
1929 by some accounts.
Campaign finance was out of control with large companies
like Dupont
and General Motors giving lavish contributions to both
parties. In a
magazine called "The Forum", in a July 1929 issue, a man
called Norman
Thomas wrote an article called "Plutocracy in the Saddle"
about
business domination of government and calling the two
party system the
Tweedleduplicans and the Tweedledeemocrats. He also went
on to say
about this system of two parties in the pockets of big
business "This
is immensely better than having one dictator who might get
shot or one
party which might provoke a rival organization based on
principle. Two
parties to stage a good show annually and a roaring circus
every four
years to divert the people - what could be better? A
devout and
reasonably shrewd "captain of industry" who does not daily
thank God
for this great gift of two parties, both his for the
campaign
contributions, is an ingrate. Indeed its more
sophisticated leaders
may sometimes reflect how much better it is to teach
people how to
read and then give them what they should read, let them
vote but
control the parties through which they vote, [rather]
than, like the
stupid Czar of Russia, to try to keep the masses
illiterate and
voteless."
In the latter half of the 1920s the Public Utilities were
consolidating like crazy through a handful of holding
companies, and
in the process were raising consumer prices. As people
found out later
they were also taking on huge amounts of debt, overvaluing
assets and
hiding losses from investors.
Corporate profits were soaring throughout much of the
twenties
generally thought to be due to increased consumer
spending, credit
availability and increased efficiency.
But there was a large part of this story not being told
lest it would
offend the advertisers providing the revenue to the radio
stations and
newspapers. This was that of the conditions and wages of
the non-union
workers in the many factories - such as garments, candies,
and so
forth. In general union membership declined drastically
during the
1920s.
There were sweatshop activists in those days too. You can
find some of
their reports online at the Library of Congress website.
In one report
by the Consumers League of New York entitled "Behind the
Scenes in
Candy Factories" you can read about the appalling
conditions of women
who worked in these factories and the wages of around
$10-12 a week,
which was considered well below a livable wage. The
authors actually
went to work in these factories in order to learn about
these
conditions. There were also reports documenting abuses in
the garment
industry and a campaign to encourage labeling of garments
with the
conditions they were made in. This was all in stark
contrast to the
glamorous images of these products portrayed in never
ending streams
of advertising.
A network of consumer activism popped up around the
country much of
which was spearheaded by a Nader-type by the name of
Stuart Chase. In
1927 he co-authored a large study called "Your Money's
Worth"
documenting the shoddiness of many mass-produced products,
the false
claims in advertising and the trend for producers to make
sure
products would be replaced at frequent intervals.
Comparing the
consumer to Alice in a nonsensical Wonderland he found
advertising
industry correspondence with corporate clients that
boasted that only
25% of purchases are based on real need - the rest are the
product of
"salesmanship".
On the financial side, Andrew Mellon was Secretary of
Treasury for the
whole decade. He was also one of the original founders of
ALCOA - the
Aluminum Company of America - exactly where our Treasury
Secretary of
2002 - Paul O'Neill - is from. And O'Neill is spookily
sounding a lot
like his predecessor of the 20s!
A fellow named Benjamin Strong, a Morgan man, was the
Director of the
Federal Reserve Bank of New York at the time. His informal
and totally
private agreements with the head of the Bank of England,
Sir Montague
Norman, to help England stay on the gold standard led the
Federal
Reserve to make harmful interest rate cuts in 1927 that
created
excessive stock market speculation. This played a large
part in the
severity of the ultimate crash. This dealings between
Strong and
Norman are documented in the diaries of Federal Reserve
Board member
Charles Hamlin which are also readily accessible on the
Library of
Congress web site.
The British economist John Meynard Keynes was very
critical of this
move of England back to the Gold Standard saying that "In
truth, the
gold standard is already a barbaric relic." This is
because the gold
standard forced prices and wages to be set by
international traders
and speculators, rather than the needs of workers and
consumers.
Today, these are still set by international speculators in
our current
environment of free capital flow and domination by a
single reserve
currency - the USD.
This move by the Federal Reserve in 1927 to lower interest
rates to
help England stay on the gold standard encouraged stock
speculators to
borrow money at these low rates from the banks and then
plow these
borrowed funds into the stock-market. The banks themselves
were
engaged in a lot of these speculative activities because
many of them
also operated investment banking and brokerage businesses.
This
speculation continued until 1929 when in August the
Federal Reserve
raised interest rates.
Stock prices reached their peak in September - the Dow
Jones Index
having doubled in just over a year. But then with the
higher interest
rates on borrowed speculative funds and nervousness that
stocks were
overvalued, stocks started falling in October. Banks
started calling
in the loans used to buy stock. On October 29, 1929 (Black
Tuesday)
the Dow-Jones Industrial Index crashed enough to wipe out
this
doubling of the Dow. The Dow and the markets as a whole
started on a
downwards spiral that bottomed out in 1932. Many people
just couldnt
pay off their loans and banks started going bankrupt all
over the
place from this and from the collapse of their own stock
investments.
There was at this time NO Federal Insurance of bank
deposits and
people saw not only their stock markets investments
disappear, but
also their bank accounts vanish. For, even under the gold
standard,
bank money is nothing but the confidence that it can be
used in trade.
When that confidence disappears, so does money, and so
does everything
you worked for and transferred into those mysterious
make-believe
credits. If you need to refresh you memory about why money
is simply
an abstract notion and how it comes into existence - you
can revisit
Wizards of Money Part 1 entitled "How Money is Created".
America was still on the gold standard. So compounding all
these
problems the massive loss of confidence in the banking
system caused
the worst thing of all for the financial system - a run on
banks -
with people wanting to redeem their bank deposits and
Federal Reserve
Notes for gold. But of course there isn't enough gold
under fractional
reserve banking and such a run on banks will always
collapse it.
Expectation of bank collapse is a self-fulfilling
prophecy, as it is
with the stock markets, and as it is with any currency.
When you have such lost confidence in the financial
system, where
there has just been complete dependence on it, the whole
monetary
system collapses - money disappears because all it was was
confidence
anyway. Everything - markets, trade, business, work - it
all starts to
grind to a halt.
The financial house of cards collapses. And should we be
afraid of
what is - well, just a pack of cards?
Excerpt - Alice and The Pack of Cards
FEAR and BANKERS
Herbert Hoover was President at the time of the 1929
Crash. In the
subsequent depression neither his administration nor the
Federal
Reserve did very much to bring the country out of the
depression. This
helped to get FDR elected and he took office in 1933.
As history goes whenever a famous leader says something
really
important about big business it doesn't get remembered
very well.
Instead the large corporations who run the networks seem
to have an
uncanny knack of extracting only the short phrases that
don't hurt
revenues and playing them over and over again so that
nobody will
remember the important things that were said about their
advertisers.
And so it was with the FDR inauguration speech of 1933
where every man
and his dog remembers:
"The only thing we have to fear is fear itself".
But how many people remember the other parts of the speech
where FDR
is talking about the bankers and the Wall Street
speculators? Such
harsh criticism of the Wizards has never been heard since
from an
American President!
I will play excerpts from this speech about the Wizards,
but since the
sound recording quality is so poor I will then repeat
these sections.
Excerpt from FDR 1933 Speech:
" And yet our distress comes from no failure of substance.
We are
stricken by no plague of locusts. Compared with the perils
which our
forefathers conquered because they believed and were not
afraid, we
have still much to be thankful for. Nature still offers
her bounty and
human efforts have multiplied it. Plenty is at our
doorstep, but a
generous use of it languishes in the very sight of the
supply.
Primarily this is because the rulers of the exchange of
mankind's
goods have failed, through their own stubbornness and
their own
incompetence, have admitted their failure, and abdicated.
Practices of
the unscrupulous money changers stand indicted in the
court of public
opinion, rejected by the hearts and minds of men.
True they have tried, but their efforts have been cast in
the pattern
of an outworn tradition. Faced by failure of credit they
have proposed
only the lending of more money. Stripped of the lure of
profit by
which to induce our people to follow their false
leadership, they have
resorted to exhortations, pleading tearfully for restored
confidence.
They only know the rules of a generation of self-seekers.
They have no
vision, and when there is no vision the people perish.
Yes, the money changers have fled from their high seats in
the temple
of our civilization. We may now restore that temple to the
ancient
truths. The measure of the restoration lies in the extent
to which we
apply social values more noble than mere monetary profit.
Happiness lies not in the mere possession of money; it
lies in the joy
of achievement, in the thrill of creative effort. The joy
and the
moral stimulation of work no longer must be forgotten in
the mad chase
of evanescent profits. These dark days, my friends, will
be worth all
they cost us if they teach us that our true destiny is not
to be
ministered unto but to minister to ourselves and to our
fellow men.
Recognition of the falsity of material wealth as the
standard of
success goes hand in hand with the abandonment of the
false belief
that public office and high political position are to be
valued only
by the standards of pride of place and personal profit;
and there must
be an end to a conduct in banking and in business which
too often has
given to a sacred trust the likeness of callous and selfish
wrongdoing. Small wonder that confidence languishes, for
it thrives
only on honesty, on honor, on the sacredness of
obligations, on
faithful protection, and on unselfish performance; without
them it
cannot live."
"And finally, in our progress toward a resumption of work
we require
two safeguards against a return of the evils of the old
order; there
must be a strict supervision of all banking and credits and
investments; there must be an end to speculation with
other people's
money, and there must be provision for an adequate but
sound
currency."
And so the process for implementing regulation to provide
checks and
balances and bounds on the markets began. For it is only
after such a
collapse that the Wizards actually realize that their
success in their
own game does ultimately depend on the people's
willingness to play in
it. The regulatory blitz included all the landmark laws
described
above plus many more. The regulations, of course, started
first and
foremost with the Rulers of the Exchange of Mankind's
goods and the
Money Changers in their Temple.
The 1933 Glass-Steagall Act built a wall between banks -
which are
essentially the guardians of the publics money and the
brokers and
investment banks - who are the primary gamblers in the
exchanges. This
would prevent privileged bankers from gambling with other
people's
money to make profits for themselves. Glass-Steagall also
separated
these institutions from insurance companies who took on a
completely
different set of risks.
To restore confidence in the banks and therefore rebuild
the monetary
system 1933 also saw the birth of federal deposit
insurance under the
FDIC or the Federal Depository Insurance Corporation. This
insurance
would guarantee that depositors would get all or most of
their money
back in the case of bank insolvency. It was realized that
this
insurance created a moral hazard for banks. Because
deposits were
backed by the Federal Government banks had more of an
incentive to
take more risks. They could get more deposits by promising
a higher
return to depositors. With this money they could invest in
riskier
higher return assets to get higher profits and the
depositors wouldn't
be too worried about this because they knew there was
federal
insurance on their deposits. This realization brought in a
law that
forbade paying interest on checking accounts so that banks
couldnt do
this. The separation of banks and other financial
operations under
Glass-Steagall also helped to prevent this undesirable
risky behavior
of banks.
Now let's fast forward to 2002
The Gambling of the Guardians of the Public's Money
Glass-Steagall protections from bankers gambling with the
public's
money are gone. The restrictions on attracting deposits by
paying
interest on checking accounts are gone. BUT the FEDERAL
INSURANCE and
ASSOCIATED MORAL HAZARD are STILL WITH US.
It is very interesting to study the memory loss that
became evident
during the final 1999 repeal of the 1933 Glass-Steagall
Act that had
built a wall between banking and speculation to protect
depositors. It
must be noted that Glass-Steagall had already been worn
down to a low
level of effectiveness. In years before 1999 financial and
legal
craftiness had exploited every loophole possible to
circumvent
Glass-Steagall. Regular deposit banking and lending,
brokerage,
investment banking, and insurance were already overlapping
by 1999 but
this was still within certain bounds imposed by
Glass-Steagall.
When the Gramm-Leach-Blily Act kicked out Glass-Steagall
it enabled
the formation of financial holding companies that could
have interests
across the spectrum of finance. The walls between the
important public
service of credit creation and safe storage of deposit
moneys, and the
speculative activities of brokerage and investment
banking, were torn
down. Not as far down as they were in the 1920s but
getting there very
fast.
The death of Glass-Steagall enabled the formation of the
financial
holding companies Citigroup and JP Morgan Chase, among
others.
Citigroup formed with the 1999 merger of Citibank and
Travelers, who
also owned the global investment banking and brokerage
giant - Saloman
Smith Barney. JP Morgan Chase & Co. formed with the
2000 merger of
investment banking/brokerage giant JP Morgan and regular
banking giant
Chase Manhattan. These are the largest banking
institutions in the
United States, and their deposits are backed by the US
taxpayer.
In the Savings and Loans Debacle of the 1980s that followed
deregulation of Savings and Loans we learned very well
what happens
when you combine Federal Insurance of deposits, with
deregulation of
the investment activity of banks. The bank is, in essence
loaning out
these deposits to make these investments for their own
profit. In this
case this often involved over-priced speculative, and even
make-believe, real estate. The depositors weren't so
worried about the
risks - the banks offered the potential for nice returns
and well, the
deposits were federally insured. But when the asset side
of the bank
is too risky, or maybe even make-believe, there is little
backing for
the deposit moneys which people think are safe and sound.
These moneys
actually did disappear, just as in the Great Depression,
due to the
risky investments made by banks in what turned out to be
worthless
investments. But because of the Federal Insurance on the
deposits in
the Savings and Loans Debacle, the US taxpayer took on the
responsibility of making sure the depositors got their
money back.
BUT now we enter the 21st century with two financial
giants - JP
Morgan Chase and Citigroup - as busy as ever and the walls
between
safety and soundness in the monetary system, and gambling
in the
equity markets, fading into the distance.
This is the BIG LEAGUES now, and only time will tell what
will happen.
True, financial conglomerates must hold a separated set of
assets
against their banking deposits - i.e. the public's money -
and they
have what is known as risk-based capital requirements on
those assets.
This basically means that they hold an extra safety net of
safe money
and this safety net is commensurate with the riskiness of
the bank's
investments.
BUT - and here is the big BUT that nobody seems to be
noticing or
worried about. Under the new rules being set by the G-10
group of
Central Bankers at the Bank for International Settlements
in Basel,
Switzerland - for the first time since capital
requirements came in
after the S&L debacle - large banks will be able to
set these capital
requirements for themselves within the next few years.
Capital levels or safety nets of banks will be essentially
self-regulated!
These new international bank supervision standards are
called the
Basel Capital Accords and I spoke extensively about them
in Wizards
Part 2 on Financial Risk Transfer. Since that episode came
out the
banks have managed to gain even more ground in their
desire for
self-regulation because the public has taken absolutely no
interest in
this issue, even though it effects the safety of all our
bank
deposits. And it's not as if all this is secret either -
the goings on
have been posted to the Bank for International Settlements
web site at
www.bis.org for years. I think it's just that its hard for
people to
understand. It must be admitted that the Basel Accord is
not an easy
read! I will cover these recent and important developments
in Basel at
the Bank for International Settlements in later editions
of Wizards.
While some concerned European citizens have picked up on
this
tremendous development in bank "un-supervision" this issue
remains
entirely muted in even the progressive and independent
press of the
country that produces the world's reserve currency - the
United
States. Again I suspect its because people don't
understand it. It's
difficult to appreciate such money issues when you've
never been
exposed to a financial collapse or a monetary attack as
most other
countries have in the past few decades.
While you ponder the implications of self-regulation of the
institutions we deposit our money in at a time when they
can both be
banks and be gamblers, please also consider the
revelations of bank
activity made during the Enron Scandal.
The Wall Street Journal reported on Tuesday January 15th
that the SEC
is investigating the role of Citigroup and JP Morgan Chase
in
financing so many of Enron's risky activities and secret
partnerships.
They are examining to what extent these banks help set up
the
partnerships and the lack of disclosure the banks
presented about
their involvement. So far we know that JP Morgan Chase has
almost $3
billion exposure to Enron and Citigroup has disclosed over
$1 billion
exposure but others suspect there is more. Yet not all the
deals
between Enron and the two banking giants, particularly
derivatives
positions, have been fully unraveled and quantified. Other
banks that
were also involved in the riskier securities or
derivatives deals with
Enron and their secret partnerships were Bank of America,
CS First
Boston, Deutsche Bank and BNP-Paribas. In particular JP
Morgan Chase,
Citigroup, CS First Boston and Wachovia were involved in
the financing
of one of the most controversial secret partnerships of
all - the LJM
partnerships - headed by Enron's CFO Andy Fastow and as
reported on
January 14th in the Wall Street Journal. GE Capital was
also involved
in this but they are not a federally insured bank and they
are also
not very much regulated because of this.
A professor at the University of San Diego is quoted in
the January
14th Wall Street Journal article as saying "You can't do
sophisticated
limited partnership and credit derivatives without the
participation
of the major banks".
A so-called sophisticated banker might say that this
concern about
banks self-regulating the level of their own safety net is
ridiculous
because banks have built sophisticated risk management
models to help
them manage their risks in an optimal fashion. Indeed the
leader in
building these sophisticated risk management models is JP
Morgan Chase
who built the widely used and distributed RiskMetrics
system for
managing financial risk. Wait! Then one opens the January
21, 2002
issue of BusinessWeek only to find an article entitled
"The Perils of
JP Morgan - Enron, Argentina, Bear Market - A Year after
the merger
with Chase the bank is racking up losses". The old JP is
in trouble
from extensive exposure to failed internet companies,
teleco
companies, Enron and various foreign gambles. OK - so how
well is this
popular self-regulating risk management software working?
It doesn't
sound good.
Great! Where does that leave the depositor who thought
his/her money
was safe. Where does that leave the taxpayer who would
have to foot
the bill if one of these banks got in trouble? Or what if
the
unthinkable happens - that the gambling activities of the
banks cause
such a huge loss in confidence that bank money disappears
like it did
in the 30s and there isnt taxpayer money to bail out the
banks.
The last scenario might be considered a stretch in this
day and age
because we are not on the gold standard like we were when
the Great
Depression got underway. Roosevelt abolished gold
convertibility in
1933, and the gold standard was only used after that to
set exchange
rates with other countries until 1971, when gold
disappeared
altogether from being a money standard. Without anything
real backing
money, and with the USD as the reserve currency of the
world, the
argument goes that if we ever had another panic like 1929
the Fed
could pump liquidity into the markets as needed. This
means that the
Fed can make money up (as we spoke about in Wizards Part
1) as needed
to avoid massive default on bank loans and the collapse in
bank
investments that can make banks go under and people lose
their
deposits.
But there is no guarantee that this will work. If
confidence in the
markets and the banks is lost to a large enough extent,
the whole
system may very well collapse, even though, actually
BECAUSE, the
credits that make up money are 100% make-believe - the
system only
works because people have confidence in it. Expectation
that the
system could fail is a self-fulfilling prophecy.
OH, And there is one more thing that exists now that didnt
exist in
previous near collapses of the US Banking system - such as
the S&L
debacle, the 1987 Market Crash, and the
Long-Term-Capital-Management
collapse of 1998. This new thing is the called EURO, the
currency of
the European Union - and it gives people somewhere else to
park their
money if they decide the US banks have gotten too risky.
It also gives
countries another reserve currency option, and some are
starting to
take it.
The moral of today's story then...
Think carefully before you bank on the safety and
soundness of the US
banking system. Oh, and maybe start planting some
vegetables in your
backyard.
House
Lever-Edge at the Derivatives Casino
In this, the 11th edition of Wizards, we are going to take
a look at
the wild and crazy world of financial derivatives through
examining
the role and dangers of leverage in our modern society.
Our adventure
will end with a story called "Because a little Bug with
the Asian Flu
went Ka-CHOO". You might have heard a similar story when
you were a
child, but in this case the star of our story is the Long
Term Capital
Management Fund or LTCM. LTCM was an unregulated hedge
fund, addicted
to risk and high on derivatives, that could have easily
sent us
crashing into the next Great Depression in 1998, but for
the
intervention of the Federal Reserve.
The quiet rescue of LTCM by our federally insured banks,
combined with
the fact that LTCM was a private equity fund and hence
shielded from
public scrutiny, aided in this potential catastrophe being
confined to
discussion among the financial elite. That we came very
close to a
global financial collapse went almost unnoticed by the
general public.
The ability to sweep this embarrassing incident, revealing
the true
nature of risks emanating from the derivatives casino,
under the rug
thus prevented the regulatory spotlight from being shone
on either the
casino or its most secretive dealers - the private,
unregulated hedge
funds.
The keeping of the derivatives wizards behind the curtain
has enabled
them to come up with newer, and potentially deadlier,
games. The
newest game on the block is called the Credit Default
Swap. Even the
International Monetary Fund (IMF) is getting a bit worried
about this
one!
But before we step in to discussion of derivatives and
leverage, lets
discuss the "House Edge".
The House Edge
Imagine you are stepping into a Casino in Vegas and
imagine what you
will see. In one section you will walk past the slot
machines and
nearby will likely be the Keno Room with the comfy chairs
and table
for all your free drinks. In a separate section there will
be the
games that are more complex and harder to play such as
BlackJack,
Craps and the like. Secured away upstairs or in some
guarded area are
the rooms for the high rollers. Think of the
socio-economic classes
you are likely to find in each area - in general, lower
income people
will be at the slot machines and in the Keno room and the
highest
income people will be in the High Rollers Room. In the
middle are
those at the regular Black-Jack and Craps tables.
Now ask yourself, given this distribution of class by
game, which
group has the worst odds? Which group is likely to lose
the most of
what they wager? The Answer: The Keno Players and Slot
Machine
Players. And not just by a small amount, by a very large
amount as
evidenced by statistics reflected in what is known as the
House Edge.
I am sure you might be surprised by the differentials if
you haven't
seen them before.
The House Edge is defined as the average amount that a
player will
lose as a percentage of their initial bet in any game.
This average is
always positive by necessity, so that the House can a make
a profit
and thereby stay in business, or, in other words, avoid
collapsing.
The House Edge or Margin on an average bet is positive,
and the rest
of the money wagered is simply redistributed amongst the
casino
players and that is what gambling is all about. Those
players that
lose are simply passing on their funds to those that win.
That the
House Edge is positive simply means that, on the whole,
the losers
lose more than the winners win, and the House takes the
difference for
its efforts in arranging the distribution of wagers.
Without the House
to provide this function there would be no such gambling
on such a
large scale.
I got some data on House Edges from the web site of a
professional
gaming analyst. The web site is called
www.thewizardofodds.com (which
is no relation to the Wizards of Money) and I recommend
you look at it
if you are interested in the most probable amount of money
you will
lose if you hang out at the casino too long. Here's the
house edge
data:
Keno has the worst odds with a House Edge of a whopping
25%-30%! This
means the following - Let's suppose you go to the Casino
one night
with a 1,000 of your closest friends (for statistical
significance),
and you all play Keno all night at a place where the House
Edge is
25%. As a group you will walk out of the Casino with 25%
less than
what you came in with. Some of your friends will lose
everything,
while others may double or triple their money, but on the
whole the
group has lost a quarter of what it started with. You and
your 1,000
friends have simply redistributed money between yourselves
and paid
the house a whopping premium for the privilege of doing it
on their
premises with all the wizardry that masks what is really
going on.
Slot machines are next. You will lose, on average, between
5% and 15%
of what you put into a slot machine, depending on the
Casino and the
type of machine.
Craps is next, where you will lose, on average, between 1%
and 15%
depending on how you play the game.
Your best bet is Black-Jack, as long as you know how to
play, with a
House Edge of less than 0.5%, i.e. One half of one percent.
The very best bets, or best odds, will often be found in
the
High-Rollers room where the House knows it has a smaller
edge on a
much larger base.
In a spooky kind of way, the social and economic relations
of the
seedy casino world mimic the relations between humans and
the
financial markets in the broader world.
Consider the House in the broader world to be the
financial markets
themselves, backed up by the banks and central banks who
create the
most basic forms of money. Consider that for any attempt
to generate
returns a piece of your effort is going off to the
financial markets,
or the House, in order to keep it going.
Consider that the wealthier you are to begin with, the
higher are your
chances of winning more money, and that the more money you
have the
better the House treats you and the better the terms of
credit, should
you wish to borrow from the House. Consider that the
poorer you are
the more expensive it is to play, and the chances of
positive returns
are much lower.
But the real world situation gets worse. Now consider that
the dealers
are incented to win for the House by participating in the
gambles
themselves. If the dealers want to borrow from the House
to play,
thats OK. They will get good terms of credit. If they lose
too much
they get fired and you only keep the dealers that keep
winning. To
attract the very best dealers you decide not to regulate
them and so
you don't keep track of what their betting positions are,
or even how
much they borrowed from the House. Why they are smart
people - the
best - some of them even came up with computer programs to
predict the
unpredictableHow pure chance gambles will come out!
But then one day the smartest, most winningest dealer of
all, a
private equity fund, loses a huge gamble, most of the
wager having
been borrowed from the House. There's no way he can repay
this loan to
the House and the House looks like it could go bankrupt.
But the House can't fail! In order to avoid the Casino
collapsing the
Law of the Land says that all casino players PLUS all
those that have
never been to the Casino in their lives must be charged a
certain
amount to avoid the collapse of the casino. Now that's
what I call a
House Edge!
Leverage
We all have a basic idea of what a lever is and what
leverage is in
the physical world. Generally people will conjure up an
image of
leverage as being the ability to input a small amount of
force or
energy, and get a much larger result at the other end. The
amplification of a small amount of input into a much
larger output is
facilitated by a lever. One of the first levers we come
across as a
child is the seesaw, where you are able to lift a person
three feet
off the ground - a feat you'd never achieve if you tried
to lift them
with your own arms. The seesaw can bring with it great fun
and a great
return on your investment in a visit to the park. But if
it broke
while you were playing on it, both you and your seesaw
partner would
be in a much worse position than if you had simply dropped
the other
person while trying to lift them directly, without
leverage.
So too with any kind of leverage. Leverage can bring great
benefits
and higher expected returns on any effort, but like
anything that can
increase your returns, it also increases your risk. A
sudden switch in
the wrong direction of a highly leveraged system, by
virtue of the
fact that leverage multiplies the force of any input, can
bring
disastrous consequences, way beyond those possible in a
less leveraged
system.
The modern financial system is built entirely on leverage.
The
financial equivalent of physical leverage is the use of
debt to
enhance returns. The whole monetary system has been built
on leverage
ever since the invention of fractional reserve banking in
the 1700s,
whereby banks expanded the money supply by continuously
lending out
deposits backed by a much smaller reserve of real physical
assets such
as gold. But if there was ever a loss of confidence in the
banks, a
run on banks would collapse the whole banking system,
thereby
rendering money worthless. The collapse of the medium of
exchange
would then grind all trade to a halt, plunging people into
immediate
poverty and massively increasing all social tensions. Such
a dramatic
collapse of trade caused by monetary collapse would not be
possible
without the leverage.
Today banking works a bit differently, whereby the amount
of leverage
in the banking system is basically driven by capital
requirements as
we spoke about in Wizards Part 2 in discussing the new
Basel Capital
Accords. Let us suppose you have a $100 to invest by
either depositing
your money in a bank or becoming a shareholder of a bank.
If you just
become a bank depositor you can earn 5% a year on your
$100. But if
you are a bank shareholder, you get to borrow additional
money from
the depositors and lend this money out at a higher rate,
keeping the
difference in interest rates for your own profit. Let's
suppose that
for every $100 of shareholder or equity capital a bank
has, it can
borrow $900 from its depositors and loan out the total
$1,000 at a 7%
interest rate. Then your profit as a shareholder is
calculated as
follows:
INCOME: 1000 * 7% = $70 from people that borrow from the
bank less
OUTGO: 5% * 900 = $45 to go back to depositors, whose
money you just
borrowed, as interest on their deposits.
That leaves you with a clear $25 of profit on your $100
investment
which is a 25% return on investment. That's much better
than the $5 or
5% you would get as a depositor and the reason is quite
simply,
leverage. You could borrow 9 times your own capital
investment to make
a much larger return than you could have done with just
your own
money. We say that your leverage was 9, which is the ratio
of debt to
equity in your total investment.
But such leverage comes with many more risks than if you
just invested
your own $100. One obvious risk is that some of the $1,000
borrowed
from the bank will not be paid back. If this amount is
less than $100
plus any interest profits you make, then the loss simply
hits your
investment, but the bank still has enough money to pay
back the
depositors. But what happens if $100 or more, of the $1000
of bank
loans dont get paid back. Then the bank will be insolvent
or bankrupt
and some of the bank depositors will have lost their
money. Well,
unless there is a government bailout, that is. This is
just the type
of loss that can trigger a further series of loan defaults
and thereby
start a chain reaction of defaults, asset sales, lost
confidence and
mad panic, that can lead to financial collapse.
It is clear that the higher the leverage, or multiple of
your own
investment, you can borrow from depositors to lend out
then the higher
your potential returns, but also the higher the risk of
potential
catastrophe. For example if the bank's leverage was now 19
instead of
9, they could borrow $1,900 from depositors added to your
$100
investment. This huge leverage could bring a 45% return if
nobody
defaults on their bank loans and interest rates stay the
same. But the
risk of losing $100 in the larger pool of bank loans is
now much
greater and it's this loss that can cause bank collapse.
Financial leverage lies at the heart of the development of
modern
societies. It is the great facilitator of our massive
production and
distribution of energy and goods, and our rapid
technological
advancement. Without such leverage there would not have
been enough
money to fuel the industrial revolution or the
technological
revolution as they happened. Without the confidence in
this highly
levered system you would not have the cooperation between
people to
get such big projects completed. Many people in the
developed world
would not want to give up their modern luxuries nor, in
fact, could
many even survive now without them.
But this exposes another danger of financial leverage -
that it has
lead the developed world into complete dependence on
physical leverage
created through financial leverage. In our high-tech world
we are used
to easy access to massive physical energies - food,
electricity,
transportation and so forth - for very little effort of
our own. Not
only does the increased financial leverage increase the
risk of a
breakdown in the system of trade, but a history of
dependence on the
physical leverage brought by financial leverage could
multiply the
physical consequences of a financial collapse many times
over.
One feature of today's financial markets, now that we are
more than a
generation away from the Great Depression of the 1930s, is
that the
thrill of returns from leverage and the excitement of
greater
technological advancement mask the reality of the risks
imposed by
leverage. We have gone so long without a collapse, indeed
partly due
to various innovations that have helped to put out fires
that could
have caused collapse, that potential and systemic risks do
not get the
attention they deserve.
Hedge Funds, Derivatives and Credit Default Swaps
We know the banks are pretty highly leveraged and that
these risks of
leverage must be controlled since the banks lie at the
heart of the
financial system. The way this leverage is controlled so
that risk of
collapse is not too high, is to set limits on leverage
commensurate
with the risks of the loans or investments any bank is
making. This is
what the new Basel Capital Accord being discussed now at
the Bank for
International Settlements (the central bank of central
bankers) in
Basel, Switzerland is all about. These accords specify a
certain
amount of shareholder or equity capital or "safety net"
(from a
depositors perspective) that banks hold as a function of
the riskiness
of their loans or investments. Such a safety net sets a
bound on
leverage and provides protection for depositors and
taxpayers who are
ultimately on the hook for massive bank failure.
But under the current adrenaline-fed mindset of the
capital markets,
even these controls are continuously circumvented. Like I
said
earlier, one of the newest kids on the block, is the
Credit Default
Swap or Credit Derivatives and they are being used to get
around these
safety nets or caps on leverage.
A derivative on an underlying asset basically allows you
to make a bet
on the future price of that underlying asset by betting
just a
fraction of the cost of that asset. The leverage comes
about because
the instrument basically replicates borrowing or lending
of the
underlying asset, without you ever having to physically
own it.
Derivatives can help you manage risk if you already trade
in the
underlying asset. Let's say you are wheat farmer worried
about wheat
prices. Then derivatives can be used to buy insurance on
wheat prices.
Say if wheat prices go down, you can get compensated for
your loss by
buying insurance in the form of something called a futures
contract or
even a a "put option" on wheat. Your outlay for this
protection is
fixed - the cost of the insurance premium - but it has
removed the
potentially larger loss of plummeting prices.
However, like all such things with a good use, there is a
large
downside. That is that the leverage and potential returns
available on
derivatives attract speculators from all over the globe to
play and to
become major dealers at the Derivatives Casino. This
includes what is
known as the Private Equity Hedge Fund, capitalized by
wealthy
investors and then often also borrowing many multiples of
this capital
from federally insured banks. With this highly leveraged
capital base
they then enter into the highly leveraged and potentially
lucrative
world of derivatives gambling. Private hedge funds are not
regulated
on the grounds that their investors are sophisticated, and
that
regulators don't seem to understand or be worried about
the risks that
depositors and taxpayers are exposed to by the largest and
most highly
leveraged of these bodies. In addition the huge
hundreds-of-trillions-sized market known as the
Over-The-Counter (or
OTC) derivatives market is not regulated. Of course, our
banks
themselves are among the major players and dealers at this
Casino.
Consider the young, unregulated credit default swap
market, the
newest, hottest game on the block. This enables
institutions that lend
money to high credit risks to buy insurance on those risks.
For example, a bank with high loan exposures to certain
lenders can
pay a premium to a third party for a credit default swap,
a form of
credit insurance, whereby the bank would get reimbursed by
the credit
swap seller if the borrower defaulted. The bank is thus
able to take
this credit risk OFF its balance sheet and thereby is no
longer
required to hold the regulated amount of equity capital,
or "safety
net", against the risky credit risk. This means that the
bank can
further increase its leverage. If the seller of the credit
default
swap is not a bank, and especially if it is one of the
unregulated
hedge funds, then there may be no capital requirements
(safety nets,
or leverage limits) on such credit exposures. Therefore
through the
use of credit default swaps the overall financial system
safety net
shrinks and leverage and associated risks of collapse are
increased,
as always to be borne by depositors and taxpayers if
things get too
out of hand.
Add to this the fact that banks and others in need of
credit
protection are entering into these swaps through the now
famous
off-balance sheet Special Purpose Vehicles to remove the
underlying
transaction from public and regulator scrutiny. So it's
very difficult
to tell what's going on, and where and what the real risks
are.
On the issue of the private hedge funds, some important
regulators
would argue that hedge fund operators perform an important
function by
helping build the base of counter-parties for valid risk
hedges at the
other end, and by ironing out pricing anomalies. They
argue hedge
funds should not be regulated for fear that this will add
friction to
these functions and/or send them offshore. The same people
often argue
that OTC derivatives also should not be regulated as they
help ensure
capital and risk get allocated efficiently around the
markets, which
facilitates our economic prosperity. But these arguments
always ignore
the larger risks being added to the system as a whole and
the
unfortunate reality that the higher you climb up the
ladder of
leverage, the further you will eventually fall.
Now lets hear from the Great Wizard Greenspan of the US
Federal
Reserve on these issues from a March 7, 2002 report to the
Senate
Banking Committee. He talks first about the risks of the
US economy
becoming increasingly dependent on abstract concepts
rather than on
the production of real goods, and then about the
risk/return trade-off
of derivatives and leverage.
Excerpt: Greenspan Testimony on Concepts, Derivatives and
Leverage.
March 7, 2002
While Wizard Greenspan gives a good picture of the
uncertainty of the
risks of massive leverage he is also, on balance, in favor
of it and
the continued lax regulation of both hedge funds and OTC
derivatives
markets. He argues that derivatives play an important role
of
distributing risk efficiently and this helps build
resilience into the
markets against shocks.
That's true but he forgets that some shocks just can't be
swallowed by
the market and the implications for the market are
catastrophic due to
the size of the underlying leverage involved. How he could
forget this
I just don't know, for one such incident took place just 4
years
earlier with the near collapse of the huge private,
unregulated, hedge
fund known as Long Term Capital Management or LTCM.
Background On the LTCM Saga
That people do not understand the risks exposed by the
LTCM saga is
evidenced by the much greater attention given to a
recently collapsed
derivatives player who did not pose even a sliver of the
threat to the
financial system that LTCM did - that recently collapsed
player being
Enron. LTCM was not allowed to collapse because this could
have
triggered a major global financial collapse. The reason
Enron was
allowed to collapse was because their collapse posed no
such threat.
Since LTCM didn't collapse, because it wasn't allowed to,
the lack of
awareness of the risks exposed by it resulted in their
being nothing
done to prevent another LTCM type calamity.
LTCM was started by 4 smarty-pants wizards with an amazing
betting
program that did the impossible - it predicted the outcome
of
derivatives gambles. Two of the wizards had even won a
Nobel prize for
their derivatives pricing theories that were widely used
to price
transactions. Needless to say The Street thought they were
geniuses
and this gave their hedge fund easy access to credit and
the ability
to borrow at rates of a much less risky operation.
Respectable banks and investors across the country wanted
in on this
action that had returned stellar amounts in its first few
years of
operation. To this day, the fancy bank capital
requirements coming out
of the Bank for International Settlements in Switzerland
still do not
address the risks of lending to these unregulated hedge
funds so the
banks were, and still are, feeding at the trough of all
this gambling
madness.
By mid 1998 LTCM had about $4 billion in equity capital
and borrowed
funds of about $120 billion, a hefty leverage of about 30
times. But,
amazingly, that leverage was compounded further by another
TENFOLD, by
LTCM's off-balance sheet derivatives exposures whose
notional
principle amounted to more than another $ 1Trillion! To be
clear, this
notional principle does not represent the full amount owed
to anyone
but rather the full value of assets underlying various
derivatives
transactions. The biggest bet that LTCM had on its books
in the summer
of 1998 was to do with interest rates on underlying bonds.
The biggest
bet that LTCM had its money on was predicting that the
difference
between interest rates on risky bonds and interest rates
on the safest
of all bonds, US Treasury Securities, would go down in the
near
future.
But in August 1998 Russia unexpectedly defaulted in its
domestic debt,
causing the market to panic, sell off risky assets and
rush into the
safest investment - US Treasuries. This pushed up the
price of US
Treasuries and pushed down the price of riskier bonds
which is the
same as saying that interest rates on US Treasuries went
down while
rates on riskier bonds went up. That is, the spread
between risky
bonds and US Treasuries widened - exactly the opposite of
the LTCM
bets.
When you trade in derivatives and gamble that the price or
rate on an
underlying asset will move in a certain direction you are
said to be
"in-the-money" when the price of that asset is in line
with the
direction of your bet. You are "out-of-the-money" when the
price moves
against the direction of your bet. Counter-parties see how
much they
are in or out of the money by marking their positions to
market on a
regular basis. If you are out-of-the-money your betting
counter-party
to your derivatives transaction, or your derivatives
clearing agent,
will call on you to deposit some type of collateral with
them in line
with the amount your bet is wrong or "out-of-the-money".
This deposit
serves as security toward you being able to settle the full
transaction on the agreed upon date in the derivatives
trade.
When the real world went in the opposite direction to the
massive LTCM
bets, LTCM counter-parties were getting worried about
getting their
money from LTCM, especially since LTCM was so highly
leveraged. LTCM
might be forced to liquidate its assets in a fire sale in
order to
meet margin calls triggered by their sudden slide
out-of-the-money.
Either they would have to sell off a massive amount of
assets quickly
to meet these large calls, or, if they couldn't do this
they would
default. Either way a chain reaction of panic would ripple
through the
markets.
Soon after the Russian default it became clear that LTCM's
positions
were such that it had now lost most of its equity capital
in just a
few days. Not only were its bank loans now at risk but if
LTCM
defaulted on meeting its margin requirements with
derivatives
counter-parties, all counterparties would have immediate
claims on
LTCM and its many derivatives positions would be shut
down. This would
have sent a wave a panic through the derivatives markets
because LTCM
was such a big player, and this would probably bleed into
most other
major financial markets.
If LTCM had to liquidate assets to meet margin calls then,
because of
the size of the assets that needed to be sold, this
massive sell-off
would have depressed prices and caused panic, pushing
asset prices
down even further. In turn, this would have hampered
LTCM's ability to
meet its margin requirements, as well as its ability to
repay the
banks they borrowed their gambling funds from. Compounding
these
problems was the realization that many market players,
including major
banks and securities firms, made "copy-cat" bets and their
positions
would be further harmed by an LTCM fire sale.
The Federal Reserve Bank of New York intervened and called
together a
consortium of banks who were complicit in this hedge fund
madness by
both lending to LTCM for their gambling needs and by being
major
players in the unregulated OTC market themselves.
It was decided that the bank consortium would lend MORE to
LTCM, by
lending them the funds necessary to meet margin calls and
prevent the
massive panic that default and/or massive asset sales
would have
caused. The thinking was that these loans would tide over
LTCM until
its betting positions turned around, so the banks were
thereby also
participating in the gamble (even more!). And therefore,
unbeknown to
all of us, the public was also participating in the
gamble. Who knows
what would have happened if the betting positions
continued to get
worse? The banks, and therefore their depositors, would
have been more
and more on the hook for the LTCM gambles. But as things
turned out,
LTCM gradually came back into the black and, through the
combined
management of LTCM and the bankers, the LTCM gambles were
eventually
wound down in an orderly fashion and a financial
catastrophe averted.
Interestingly the LTCM founders and some of its investors
and
creditors blamed the whole thing on a "distorted market".
Apparently their gambling was perfect except for these
external
forces.
Even more interesting is the fact that the general public
to this day
still has no idea how close their lives came to changing
drastically
overnight in September of 1998, thanks to the extreme
leverage of 4
smarty-pants wizards with easy access to credit. No
safeguards were
ever put in place to prevent future such incidents.
Shall we be content to leave it up to the markets and the
bank
regulators to continue with the adrenaline driven
speculation as is,
and then put out fires as needed?
Of course there is no guarantee that their attempts to put
out such
leverage-induced fires will always work. Indeed in the
case of the
LTCM saga if the betting positions didn't change direction
for an
extended period our lives may well be very different today.
We were, as gambling goes, just plain lucky that it didn't
get worse.
The real problems do not lie in external distortions that
mess up
bets. They lie in the over-confident betting culture that
on the one
hand, has brought great prosperity to a small proportion
of the
world's people. But the danger lies in the inability to
appreciate the
balancing dark side of all this prosperity for the few.
The dark side
includes the lack of prosperity for the many upon which
such levers
are built. But it also includes the huge devastation that
would result
from the collapse of high financial and physical leverage
that we, on
the prosperous side of the fence, are now completely
dependent on.
No treatise on financial leverage would be complete without
appreciation of the fact that human financial and physical
leverage
has another dark side - its effect on the non-humans and
the natural
ecosystems that support us. Always remember that the
leverage that
supports us and benefits us can be turned against us with
just a small
amount of force amplified many times by our own systems of
leverage.
All it requires is a small trigger in the wrong direction,
which may
flip another switch in the wrong direction and before
long, this turn
in an undesirable direction is multiplied by our massive
human created
leverage. With that we go out with a fictional story based
on one you
might recall from your childhood entitled "Because a
Little Bug Went
Ka-CHOO". I consider this book, from the Cat in the Hat
Books, to be
Chaos Theory for Kids.
Story: Because a
Little Bug With the Asian Flu went Ka-CHOO
Chapter 1: The Origins of a Financial Crisis
You may not believe it, but heres how it happened,
One fine summer morning in rural Asia, a little bug with
the Asian
Flu, sneezed.
Because of that sneeze, a little seed dropped.
Because that seed dropped, a worm got hit.
Because he got hit, the worm got mad.
Because he got mad, the worm kicked a tree.
Because of that kick, a nut dropped off the tree.
Because that nut dropped, a turtle got bopped.
Because he got bopped, that Turtle named Jake, fell on his
back with a
splash in the lake.
Because of that splash, a hen got wet.
Because she got wet, that hen got mad.
Because she got mad, that hen kicked a bucket.
Because of that kick, the bucket went up.
Because it went up, the bucket came down.
Because it came down, it hit Farmer Brown.
And that bucket got stuck on his head.
Farmer Brown happened to be the President of the Regional
Farmers
Association.
Just before the bucket landed on his head he was on the
phone to his
banker trying to sort out repayment terms for his fellow
farmers since
the weather had been unkind to the crop yields that
season. But the
bucket slamming onto the farmer's head disconnected the
telephone and
made it impossible for the banker to call back.
The farmer's wife was out gathering up the neighboring
farmers to help
remove the bucket from her husband's head, so the banker
couldn't call
them either. The banker immediately jumped to the
conclusion that the
farmers were all going to default on their loans. Word
spread quickly
around the banking industry and pretty soon the
international
speculators caught wind of this and started selling off
their Asian
currencies and investments for fear that a banking crisis
was looming.
The selling off of Asian currencies put downward pressure
on their
values and soon the Asians had to devalue their
currencies. This
proved disastrous for the Asian banks whose assets were
mostly in
local currencies, but who also had large US dollar
denominated debt.
Almost immediately the major banks were near insolvency
and a run on
banks had started. The expectation of the international
speculators of
a banking crisis was a self-fulfilling prophecy.
The Asian crisis then spilled over to Russia, already in a
precarious
position due to high levels of debt. Before long the
Russian
government defaulted on its debt.
After this series of events the international speculative
community
was in a mad panic and began what is known as a "flight to
quality",
selling down bonds of foreign governments and riskier
firms and buying
up on the safer US government bonds. This pushed down the
prices on
foreign bonds, and pushed up the prices on US treasuries.
This is the
same as saying that interest rates on US bonds went down
and those on
foreign bonds went up. In the financial world we say that
spreads on
foreign debt over US treasuries got bigger, or widened.
Back in the US, if you had been in the upscale town of
Greenwich
Connecticut, you might have been woken by a loud scream
upon news of
the Russian default. For little did anybody know, the
massively
leveraged hedge fund known as the Long Term Capital
Management Fund or
LTCM, had bet a substantial amount of the worlds economy
on the future
narrowing of interest spreads over US treasuries. But with
the Russian
default these spreads just got much, much wider.
In contrast to the Enron case, Federal Regulators and the
US Federal
Reserve realized that a major financial catastrophe may
result from
not intervening in the LTCM case. LTCM's collapse would
have effected
us all and caused the type of collapse that can cause a
major
depression.
In the subsequent months Wizard Greenspan was called
before congress
to discuss the LTCM crisis, why the Federal Reserve
stepped into the
supposed "free markets" and what should be done to prevent
future
LTCMs.. Perhaps one of the most dangerous outcomes of
Wizard
Greenspan's testimony was his support of the continued lax
regulation
of both hedge funds and the derivatives markets. In line
with this, no
regulation of these instruments was forthcoming. Overall,
the wild
derivatives markets and hedge fund players got off
lightly, indeed.
More blame was put on external factors than on the dangers
of the
extreme speculative behavior facilitated by both
derivatives and
private, unregulated hedge funds.
Chapter 2: The Extinction of Sneezing Bugs and
Hot-Tempered Worms
During the grilling of the Chief Wizard of the Federal
Reserve over
the LTCM Crisis and the near collapse of the global
economy, Congress
wanted to know the real cause of the financial crisis.
They wanted to
know the root causes so they could stop the possibility of
any future
such crises.
Recall that our story started with the sneezing bug that
caused a worm
to kick a tree which then triggered a series of events,
that later
ended in financial crisis.
Not wanting to blame the crisis on the unchecked gambling
of
smarty-pants wizards, their hedge funds and derivatives
bets for fear
that this would be detrimental to the lucrative financial
markets, the
Chief Wizard sought to place the blame on just the right
external
factors. He placed blame squarely on the sneezing bug and
hot-tempered
worm that had originated the sequence of events that
triggered the
Russian default, which upset the LTCM bets. He stopped
short of
putting any blame on humans who are, after all, key market
players and
he also didn't want to blame the chicken that kicked the
bucket for
fear that this could trigger massive short selling on
poultry futures
at the Chicago Exchange. Bugs and worms, not having been
commoditized,
securitized and bundled up into neat financial instruments
by
investment bankers, were safe things to blame.
The Great Wizard then proceeded to imply that eradication
of Asian
sneezing bugs and hot-tempered worms would be the most
effective route
to prevention of future financial crises. The leaders of
America,
known to hang on every word of the Great Wizard, put the
following as
the next item on their agenda. "Bring Resolution of
Eradication of
Asian Sneezing Bugs and Hot-Tempered Worms to the next UN
Security
Council Meeting".
This was done and the UN Security Council passed the
resolution
without a peep of dissent. A plan for eradication was
immediately put
into effect. The people of Asia near and dear to the Asian
forests
tried to tell the UN of dire consequences that would come
from this
eradication. But nobody listened. After all, the bugs and
worms were
responsible for a near global financial collapse, and what
could be
worse than that?
Within a few years all the sneezing bugs and hot-tempered
worms of
Asia were gone. The financial markets did tremendously for
the major
gamblers over the next few decades and not a single
negative incident
threatened this blissful state. Everybody assumed that the
markets
would be just fine now that the troublesome bugs and worms
were gone.
But within a few years something funny was happening to
the Asian
forests. You see, the sneezing of bugs was supposed to
make seeds drop
off in order to distribute seeds throughout the forest for
new growth.
And the worms were supposed to be hot-tempered and go
around kicking
trees to distribute their nuts around the forest floor. In
this way,
Nature had built a system of controlled leverage so that a
small force
like a sneezing bug or a worm of short temper could push
the right
levers to keep the forest going.
Mother Nature had been observing the whole human financial
crisis saga
with some amusement knowing that the relatively young
species really
had not learned the art of controlled leverage at all, and
that this
was their real problem. Eventually they would either
figure it out or
wipe themselves out. Either way was quite OK.
Without the bug and worm seed distribution mechanisms the
seeds only
fell off when they were dried up and dead. So the forest
was
essentially "fixed" so it couldn't produce more trees and
shrubbery.
It took about three decades before the urban people
finally realized
the forests were thinning. But it was too late. The
thinning of the
forests left them susceptible to pest and disease
outbreaks, and
pretty soon the forests were collapsing. With forest
collapse came
major climate changes and water related disasters of
floods and
droughts.
Financially these environmental disasters hit the balance
sheets of
the Japanese insurers who had insured a good part of
Asia's physical
economic infrastructure. The problems of the Japanese
insurance
companies then bled into the already troubled Japanese
banking sector,
and soon the whole Japanese investment community was
suffering. The
Japanese, being the world's largest foreign creditors,
then began
liquidating their foreign assets to meet cashflow needs at
home and
stemming from the Asian forest collapse, and related
environmental
disasters.
Included in this sell-off were Japanese holdings of US
Treasury
Securities, which panicked other investors who also
started selling
off US government bonds and rushing into gold. The safest
of the
sovereign bonds had now been put into question. This
pushed down the
price of US government bonds and spiked up the cost of
borrowing for
the US government. Since US government borrowing is more
about funding
the military than anything else, the Pentagon was
essentially shut out
of the credit markets for the first time ever!
Unable to raise capital, the Pentagon was unable to pay
its bills to
its dependent private defense contractors. This then
triggered massive
defaults by huge defense companies on both their corporate
bond issues
and their bank loans. While the Great Wizards had been
claiming that
derivatives built more resilience into the market against
financial
shocks, in this unexpected scenario derivatives made the
problem much,
much worse and triggered additional layers of default
risks and
incredible panic. This panic forced more and more people
away from the
US dollar and into gold. Gold went from $300 per ounce to
$5,000
almost overnight.
The Federal Reserve who, as we know from Wizards Part 1,
just makes
money up out of thin air, couldn't do very much because
the linchpin
of its success, the might of the US dollar, was now
disappearing
before its very eyes. They pooled their gold resources
with the US
Treasury, counted their ounces and then realized they only
had enough
to either keep the Pentagon going, OR to bail out the now
collapsed US
Banking System. But they couldn't do both.
This gave birth to the Great Squabble between the Wizards
of the Great
Empire and its Warlords that, for all we know, could go on
for
hundreds of years.
Meanwhile the people got tired of this squabbling and
developed a
healthy new interest in the important work of worms and
bugs.
Amazingly enough, the Great Wizard of the now collapsed
Central Bank
was rumored to have uttered at a recent party that he
wished they had
had some ecologists on the Federal Reserve Board.
The
Imperial Budget and the Mythical Lock Box
In this the 12th edition of the Wizards of Money we are
going to take
a look at the biggest budget in the whole wide world in
the whole of
history - that is, the $2 Trillion USD budget of the US
Government.
How does such a big Empire spend the money it collects
from residents?
In such a big and complex budget is there any misleading
accounting
wizardry going on? We will look at these and other
questions by
comparing the budget of the US Government to that of its
2,000 year
old ancestor, the Roman Government in the early years of
the Empire.
Then we will look at the role of the US Treasury in
managing the
biggest budget in the world. Finally, we spend some time
dispelling
the greatest Treasury Myth ever conceived of in the
history of
Imperial Budgeting - that myth involving the so-called
Social Security
and Medicare "Lock Boxes". We will see that these Lock
Boxes or safety
trusts do not, and indeed logically cannot, exist by going
back to a
first principles understanding of what our money is. We
will also
discuss how the presentation of these mythical trusts by
various "spin
doctors" has seriously distorted the public's
understanding of the
funding for old age pension, medical and disability
benefits. This has
prevented productive debate and problem solving on what
could prove to
be the very thing that could bring down the Great Empire -
Getting
Old!
But first let's get started with what taxes are and what a
government
budget is, and then talk about how the money we use
relates directly
to our taxation system.
The Role of Taxation
Of course one cannot talk about the role of tax without
talking about
the role of government since tax is what funds everything
a government
decides to do. Regardless of what kind of society you live
in -
dictatorship, communist, capitalist, democracy,
semi-democracy - a
government will spend money on the following in various
orders of
priority:
* Militaries for self defense of the home
country and possibly for
control over other countries,
* Some type of system of law and order in the
home country,
* Infrastructure for economic development,
* Human development - education, healthcare,
and so forth,
* Foreign relations with other countries,
* Redistribution and economic insurance, or
"safety net", for
individual residents.
In the US the main redistribution function and associated
safety nets
look a bit more like a type of "insurance" against
personal economic
disasters, whereby the risks of such events are spread
across the
society as a whole. For example, the risks of no longer
having access
to money due to retirement or disability - which is what
Social
Security covers - are borne by society as a whole, which
has a much
larger capacity to bear that risk, than do the individuals
likely to
experience such events. As we saw in Wizards Part 10, the
drastic
consequences of placing these risks on individuals to bear
became
intolerable during the Great Depression, leading to the
establishment
of the Social Security system in the first place.
The purpose of any insurance is to pool risks so that each
individual
in the pool lowers their own risk of some crippling
disaster for a
small annual fee paid to the pool. Therefore any insurance
mechanism
is necessarily re-distributive. "Insurance like" federal
taxes such as
Social Security are more re-distributive than any private
sector
insurance because those with the highest ability to bear
the related
risks (those with high incomes) get the lowest expected
return on
their contributions to the system. In addition what is
really
happening, as we shall see in the last section, is that
current
workers contributions are always paying for current
retirees in the
system and there really isn't any "saving for the future"
going on, as
is so often presented to the public.Such a progressive
risk sharing
mechanism could not work in the private sector, which is
why it was
founded as a public system in the first place.
Many people in capitalist economies who argue for less
government
intervention in the market economy seem to overlook the
fact that the
government creates the infrastructure for the markets to
function in
the first place. Without government created legal and
judicial
infrastructure, even the most basic contract would not be
enforceable,
except at gunpoint. Since our whole monetary and trade
systems are
built primarily on contracts of agreement (with occasional
input from
firepower), modern markets would not exist, and economic
development
could not happen, without significant government
intervention.
Those who also argue for an end to government sponsored
re-distributive mechanisms either overlook or dismiss the
role of
periodic redistribution in sustaining economic prosperity.
As noted by
John Maynard Keynes in the 1920s, without government
intervention in
redistributing wealth in suitable amounts you step on to a
spiral of
increasing inequality. The following is a quote from
Keynes' book "A
Tract on Monetary Reform", written in the roaring 20's at
a time of a
roaring increase in income and wealth gaps globally, that
covers both
the government's role in market existence and in
redistribution:
"Nothing can preserve the integrity of contract between
individuals
except a discretionary authority in the State to revise
what has
become intolerable. The powers of uninterrupted usury are
too great.
If the accretions of vested interest were to grow without
mitigation
for many generations, half the population would be no
better than
slaves to the other half. Those who insist that the State
is in
exactly the same position as the individual, will, if they
have their
way, render impossible the continuance of an individualist
society,
which depends for its existence on moderation."
Normally the largest and most debated government spending
items in any
country at any time are related to Military Spending,
Social Spending,
and Interest on Government Debt. We discuss the three
further later on
when we compare the Roman Empire's budget to that of the
modern
empire. But first we discuss the very much forgotten,
ignored and
taken for granted relationship between money and tax.
The Relationship Between Tax and Money
Most residents of any country today will be charged taxes
by their
government on any income they make in their private
activities. Tax is
the most common liability all people must meet and
therefore people
like to earn all or some of their income, and accept
payments in, a
medium of exchange, or form of money, that can be used to
meet tax
liabilities. It is also in the government's best interest
that people
get paid in a medium of exchange that it accepts for tax
payments, as
well as in banks' best interests that checks drawn on bank
deposits
are suitable to the State as a form of payment to meet tax
liabilities. Therefore, to the extent that people are
agreeable to a
system of government taxation, everyone's best interests
are served by
a significant proportion of money in circulation being
that which is
acceptable to the State to meet tax liabilities.
This is why our major medium of exchange today, the US
Dollar, is
created through what is really a joint venture between the
Treasury
Department of the US Government, and the private banking
industry
through their bank deposits, and the Federal Reserve's
role in
creating "high-powered money" that we spoke about in
Wizards Part 1.
Federal Reserve Notes created by the Federal Reserve
System and
blessed by the US Treasury as being legal tender for all
debts PUBLIC
and private can be used to pay taxes, but most people use
drawings on
bank balances to pay tax bills instead. The State, through
its role in
issuing banking licenses, regulating banks and being the
ultimate
risk-bearer in the case of bank failure, blesses payments
using
bank-created money, which are just electronic records, as
being good
and well for meeting tax liabilities. Recall that we spoke
about the
creation of both Federal Reserve Notes and bank-created
money (which
is most money) in Wizards Part 1.
The mature development of this system of State-blessed,
bank-created
money really came about with the founding of the Federal
Reserve
System in 1913 and the re-introduction of Federal Income
Tax in this
same year. These events both played a significant role in
financing
America's involvement in World War I. Today's US Dollar
money system,
and the links between the State and the private banking
industry, were
further strengthened by State action, such as Federal
Depository
Insurance, after various learning experiences such as the
'29 Crash
and the Great Depression as we spoke about in Wizards Part
10.
Today, many years later, we don't think about these
interesting ties
between what the State accepts as payment for taxes, the
money that
banks create, and the money we get paid in for our work.
Instead we
just take it for granted that it's all the same "stuff".
But it took
many years and learning from financial collapses to get it
to its
present state and, indeed, part of its success and
stability is the
fact that most people never stop to think about it.
So stable, so unquestioned and so unchallenged is the US
dollar system
today, that the US dollar and promises to pay US dollars
in the future
by the US Treasury are without doubt the safest of all
financial
assets in the world. Hence the US dollar and US Treasury
bonds
(promises by the US Government to pay US dollars in the
future) are
known as the "risk-free" set of financial assets. Risks of
ALL other
financial assets are higher and are measured against this
"risk-free"
benchmark. Of course there are some risks - basically,
that one day
the US could fall off the Empire throne and the USD will
collapse in
value, but there is no expectation of this in the market
so the USD
retains its "risk-free" status.
When you think about saving for future retirement it is
this status of
the USD that is critical to thinking about funding Social
Security and
Medicare. The understanding of State-sanctioned,
bank-created money at
such a fundamental level lies at the heart of the Social
Security/Medicare debate and helps us understand the
reasons that a
publicly funded US pension system CANNOT be pre-funded by
an
investment trust in financial securities. This basic
understanding of
money is achievable for anyone, whether you have studied
finance
theory or not. We will come back to these points in the
last segment
of this Episode, but please keep them in mind throughout
the
discussion of State spending.
Now lets see how the US Government's 21st Century spending
stacks up
against the Roman Empire's 1st and 2nd century spending.
Comparing Imperial Budgets
"The Imperial March"
There appear to be at least as many permutations and
combinations
available for presenting US Federal Budget and Government
Spending
data as there are years that it would take you to count to
$2 Trillion
dollars, which is about 60,000! (Note that [in the US] the
number One
Trillion is One Million times by One Million, or 10 to the
power of
12).[By the way, for the mathematically inclined, the
correct
mathematical definition of One Trillion is One Million to
the power of
3, and the correct mathematical definition of One Billion
is One
Million to the power of 2. BUT in America numbers work
differently,
and so it came to be that One Billion got redefined as One
Million to
the power of 1.5, and One Trillion is redefined as One
Million to the
power of 2. The effect of being the Imperial Power is that
everybody
else in the world has now had to adopt this number
convention].
How you would like to present the Federal Budget depends
entirely on
the bias you start with and the point you are trying to
make.
Therefore it was decided in this episode of Wizards to
admit the bias
up-front and then you can better decide what to do with
the data. My
bias in looking at US federal spending was the thought
that maybe we
might just be the Roman Empire woken up from a 1,500-year
nap after
thoroughly exhausting ourselves last time. To be sure, the
Roman
Empire had many similarities with the modern US Empire -
both being
Empires built on a combination of clever legal systems,
hard-work,
confidence, much brutality in military conquest and
extensive use of
slave labor, coupled with a system of desirable, tempting,
and free
entertainment to warm the masses to the Empire, as well as
erratic
spouts of helpful assistance to the poor. Certainly also,
a widespread
Roman currency and trade system, and an extensive taxation
and
government spending program were just as critical to the
success of
the Roman Empire, as they are to today's American Empire.
We spoke of
many of these parallels in Wizards Part 4.
The comparison of Imperial Budgets started with finding a
Roman budget
at a time around when their leaders stopped being elected
and instead
were "appointed" and when ancestral lines of Emperors
became very
popular. So I started with the early Empire days of the
1st - 2nd
Centuries AD.
A rather technical history book called "Money and
Government in the
Roman Empire" by Richard Duncan-Jones, published by
Cambridge
University Press in 1994 explains an approach, based on
historical
data from those days, to calculating the Roman budget in
this period.
The total Roman budget was about $1 billion sesterces, a
common Roman
currency that started in the BC years as about 1/4 of the
Moneta
denarius that we spoke about in Wizards Part 4. I was able
to get
estimates for the Roman budget in 150 AD broken down into
the
following expenditure categories:
Roman Empire Budget Distribution Source of Roman Data
Expense Item Percent Outgo
Military 70%
Civil Service - Judiciary, Police, Government Departments
10%
Social Spending 5%
Economic Infrastructure 5%
Other - Mostly Foreign Affairs 10%
I then compared this to US Actual Government Spending in
the year 2001
(Total $1.9 Trillion) by first subtracting both Social
Security and
Medicare (Total $0.6 Trillion) which have been more than
fully
self-funded by separate taxes (the FICA taxes) since the
early 1980s
and that we will devote the last section of this episode
to. Then I
also subtracted interest on public debt ($0.2 Trillion)
for comparison
purposes since the Roman Empire did not have a consistent,
well
developed system of Sovereign debt issuance like the
modern Empire
does.
Some other adjustments I made to US Imperial Spending were
to include
Veterans Benefits, Military Retiree benefits and Military
Assistance
to the Provinces (Countries) of Judaea and Egypt (Israel
and Egypt)
with Military Spending. The inclusion of benefits to
ex-military
employees is consistent with the way the Roman data was
derived, and
the inclusion of military aid to Israel and Egypt was done
because
these were the two most expensive outer-Provinces to
maintain under
both Empires.
I came up with the following distribution of expenses on a
comparable
basis derived from Table 26.2 of the full current Budget
of the US
Government, available in Spreadsheet Form by going to the
Office of
Management and Budget Website at www.whitehouse.gov/omb,
click on
Budget link and go to Spreadsheets, then click on Detailed
Functional
Tables (Chapter 26). If you want to see how I categorized
the data,
that will be posted on the Wizards of Money web site at
www.wizardsofmoney.org OR go Directly to US 2001 Spending
Breakdown OR
Go to Directly to OMB Detail Data
American Empire Budget Distribution
Expense Item Percent Outgo
Military 40%
Civil Service - Admin, Justice, Treasury, Fed Civil
Retirees 10%
Social Spending - Medicaid, Food, TANF, Umempl, Housing,
SI 30%
Physical and Economic Infrastructure 10%
Other - Education/Training, Research, Foreign Affairs 10%
Clearly the data indicates that social spending in the
Roman Empire
was generally at a very low level. However social spending
tended to
happen erratically in much larger amounts, depending on
the Emperor of
the day, and the need to win over public opinion.
What is clear from looking at the two budgets is that the
current US
budget has more regular proportions of social spending,
especially in
comparison to military spending. However it should be
noted that the
US budget looked much more Romanesque in earlier decades
of last
century, notably during the 40s for WW2 and during the 50s
in gearing
up for the Cold War, where military expenditures were
close to, and
sometimes even exceeded, the Roman proportion.
The move from a Romanesque budget of the 1950s to the
current US
spending distribution has a lot to do with increased
healthcare
expenditures such as Medicaid, and the introduction of
things like the
Earned Income Tax Credit, and changes to Unemployment,
Housing and
Food Assistance Programs.
Note that most of these social spending items included in
the 30% fall
under the grouping of "Means Tested Entitlements" which
means that
they make up the social safety net for people whose income
and assets
fall below a certain threshold. The other primary social
spending
benefits or social safety net items are Social Security
and Medicare,
which apply to Retired and Disabled Persons and are not
means tested.
As noted earlier these benefits have been self-funded
through separate
employer and employee contributions (known as the "FICA
taxes") for
the past two decades. Because of the unique circumstances
and confused
public debate surrounding Social Security and Medicare,
the last
section of this episode of Wizards is devoted entirely to
them.
In general, rising medical costs affect both Medicare and
the means
tested healthcare entitlements such as Medicaid. In fact,
one of the
Historical Data Tables in the Budget (Table 16.1) shows
total
government spending on all health programs to have
increased from
about 2% of the Imperial Budget in 1962 to just over 10%
by 1980, to
almost 25% or one quarter of the Imperial Budget by the
year 2001! As
anyone with a health insurance policy will also know,
health care
costs under private sector coverage also continue to rise.
Overall, an
increasing amount of America's total Gross Domestic
Product (GDP - a
measure of the total economy) is spent on health care. To
keep score
of the size of an economy and the size of national income
people often
talk about GDP or Gross Domestic Product. This measure of
national
income is also equivalent to Annual Consumption
Expenditure plus
Government Spending plus Investment - which are the only
three places
your money can go. That is, any income you get either goes
to taxes,
you spend it or you invest it. US GDP is about $10
Trillion US
dollars. Consumption Expenditure makes up about 65% of GDP
in total.
Government spending makes up about 20% of GDP or $2
Trillion dollars a
year.
Today healthcare expenditure makes up about 14% of US GDP.
About 30%
of this is picked up in Government Spending, the rest is
in private
spending. By the end of this decade healthcare spending
will be
inching close to almost a fifth of the total Imperial GDP!
America
spends more on healthcare as a percent of GDP than any
other developed
nation, but has less public coverage for this cost and a
large
uninsured population. So the high spending on healthcare
in the US
must be explained by something other than a general
concern that
everyone have adequate care.
To a very large extent the high level of American
healthcare spending
is a result of America becoming victim of its own
technological
success, its sedentary lifestyle and a culture obsessed
with
longevity, overcoming natural cycles and the desire to
"stay young".
The latter appears to be common to inhabitants of Great
Empires of the
past. This cultural obsession, fed by medical technologies
far
superior to those of any other country, may one day suck
up so much of
the US economy that it wont be able to sustain Empire
status. Indeed
it is perhaps the very fear of this that is really driving
the attempt
to redefine Social Security and Medicare that we shall
talk about
later.
Moving on to some of these other expense items, it should
be noted
that "Other Spending" includes Foreign Affairs expenditure
other than
the expenses of maintaining the outer provinces of Israel
and Egypt,
which are included in the Military item. Under both
Empires so-called
"foreign aid" is or was an important part of keeping peace
with
peripheral provinces or countries. Unlike Rome, the US
Empire also
successfully uses loans through various multi-lateral
institutions
such as the IMF, World Bank and Inter-American Development
Bank to
maintain optimal relations with peripheral sovereigns.
This use of
loans gets to one of the fundamental differences between
Rome and
America - the role and leverage of the Empire's financial
system.
Recall that we discussed the role of leverage in our
modern financial
system in Wizards Part 11, and its part in driving both
the industrial
and technological revolutions. The US Empire's success is
largely due
to the success, and complete faith in, its highly
leveraged and purely
fiat (meaning that money has no storage or intrinsic
value) monetary
system. In contrast, the Roman Empire's monetary system
was almost
entirely metal based and while there was easy access to
credit for the
ruling classes this was not true for other classes. There
appears to
be much debate among historians about what stopped the
Roman Empire
from having an industrial revolution. But whatever one's
opinion,
surely a pre-requisite is a highly leveraged, and maybe
purely fiat,
monetary system with sophisticated, widespread access to
credit. But
Rome never got to such sophistication with its financial
system. This
provides us with another reason why its success was always
more driven
by military conquest than anything else. In contrast, for
the modern
American Empire, financial influence is on a par with
military power,
and both feed off each other.
The financial success of the American Empire has also made
its tax
collection process far more efficient than any previous
Empire, the
biggest problem being with collecting from the rich. Since
the
financial system is a fiat system, financial transactions
can be
purely electronic and thus tax payment happens before many
of us even
get our monthly or fortnightly pay. Contrast this with the
resource
intensive system of the old Roman tax collectors having to
go door to
door to collect weighty coins and various goods such as
wheat grains.
Imperial Financial Management
The role of the Treasury Department or Treasurer of any
body is to
deal with financial issues - to collect income, to disperse
expenditures, to maintain the books, see to the investment
of
surpluses and the borrowing necessary to cover shortfalls.
So to with
the US Department of Treasury that oversees the management
of the
biggest account in the world, that of the US Government.
The US
Treasury Department overseas the main governmental revenue
collector,
the IRS or Internal Revenue Service, the Bureau of Public
Debt that
manages government debt issuance, and the US Financial
Management
Service, who manages "The Books".
It is important to appreciate that the accounts of a
government do not
look at all like the accounts of any body in the private
sector, be it
a for-profit or a non-profit organization, or even an
individual.
Indeed if you viewed the US government balance sheet
through a private
sector lens you would immediately declare it bankrupt and
wonder why
US Government Bonds are considered the safest assets in
the world!
However the reason a government's balance sheet doesn't
tell you what
you need to know about the safety of a government
obligation is
because it doesn't place a value on the right of a
sovereign to tax
its residents. This right of the sovereign, held only by
the
sovereign, generally makes obligations of the sovereign a
safer
investment than any private sector body licensed by, or
domiciled in,
that same sovereign nation. Then, the higher the national
income (or
the tax-base) in that country the higher the expected
revenue to the
sovereign body, and the more likely it will be able to
meet its own
obligations (provided its debt levels stays within certain
bounds).
Thus it comes as no surprise that the country with the
largest economy
and national income also issues the least risky type of
debt security
- and in today's world that is the US Government.
The resulting easy ability for the government to both tax
and to
borrow facilitates the type of military expenditure and
infrastructure
spending necessary for empire building and further
economic growth.
Economic growth spurs further access to capital for
military and
infrastructure expansion, and so the cycle continues. Any
empire would
then be very concerned about the following two primary
threats to this
pattern:
1. Growing expenditures that increasingly take money
away from the
primary empire building and
maintenance expenditures (military and
infrastructure investment).
2. Emerging empires with fast economic growth that
could take your
place.
And so it would be that some of the main concerns of
Imperial
Financial Management today are:
1. In the first category of competition for empire
building funds are
two main things: First is
terrorist actions that make economic
infrastructure more expensive to
maintain. The other is the aging
of the US population and
increasing healthcare costs.
2. In the second category of emerging empiresChina.
In this episode of Wizards we are focusing on the demands
on the
Imperial Budget coming from the aging of the population
and society's
increasing medical expenses.
Social Security, Medicare and IOU's from the Government to
the Government
If you have a regular job and you look at your pay-stub
you will see
two deductions for FICA taxes. FICA stands for Federal
Insurance
Contributions Act and covers two basic benefits for
retirees and
disabled persons:
Social Security: Labeled as FICA-OASDI or Old Age and
Survivors
Insurance and Disability Insurance. This provides pension
benefits to
retirees, survivors and disabled persons.
Medicare: Labeled as FICA-HI or Health Insurance. This
provides
medical insurance for retirees, survivors and disabled
persons.
Many people may be aware that the amount of money the
government
collects from us as and our employers as the FICA taxes
has exceeded
the government's obligations in Social Security and
Medicare payments
for the past few decades. This has been true since FICA
taxes were
increased under the Reagan administration in 1983,
curiously at a time
when other Federal Income Taxes were reduced. Then the
question is
"What has the government done with that excess money?" and
many people
have gotten very upset to find out that the answer is that
- its all
been spent on other things. About $1.4 Trillion of Social
Security and
Medicare Surpluses - all spent elsewhere by the US
Treasury.
Lets see why this is. Many people are upset because they
think the
government should have "saved the money" for the future
and often they
are misled to believe this through the existence of what
are called
the Social Security and Medicare Trusts, or sometimes more
snazzily
labeled as the Lock Boxes. In what form could the
government save the
money? Perhaps:
* Keep it as US dollars or deposit it in a bank,
* Invest in the private sector, or
* Buy government bonds. I.e. write IOUs to oneself.
Let's look at the first possibility. If the government
keeps the money
as US dollars this is tantamount to the Treasury
intervening in
monetary policy, which is the job of the Federal Reserve.
The Treasury
would be essentially holding large sums of money out of
the economy
for many years, which would not make sense at all. The
Treasury could
instead decide to deposit the savings in a bank thereby
making the
funds available for use in the economy and draw on its
deposits later
as benefits fall due. But the banking system is backed up
by the
government itself, so the promises of the bank to make
good on
depositors funds is ultimately the promise of the
government to
itself. So why bother with all the banking fees! It makes
more sense
for the government just to scribble a little note to
itself - "I owe
me $x trillions of dollars", which is essentially what it
does.
A similar argument applies to investing the funds in the
non-government guaranteed private sector. The private
sector depends
for its success on the stability and financial security of
the State.
If the State collapses so does the private enterprise
defined by the
rules of the State. If certain private enterprises
collapse it
shouldn't effect the State, except if there is massive
widespread
collapse and then the State would step in to provide as
many
guarantees as possible. So some ultimate risks are still
born by the
State. The main point is that investing in the private
sector carries
with it higher risks than holding a government obligation.
And the
main point of Social Security is to pass risk from those
that can
least bear it over to those that can. Private investing
without
government guarantees completely removes this risk
transfer feature of
Social Security and places private sector investment risks
onto those
who can least afford it.
Therefore, as nonsensical as it sounds, so long as there
is a surplus
collection, the most sensible thing to do is for the
Social Security
and Medicare funds to pass over the excess funds they
collect each
year to the Treasury for it to spend back into the
economy. The
Treasury then writes an IOU to the trust fund to pay back
the amount
it just spent on something else. Basically the Government
is writing
an IOU to itself. The government is writing out some
little pieces of
paper that say "Dear Me, I owe me some money", and then
they put the
paper in a box, lock it up and call it a safe "lock box"
or trust
fund.
Whether intentional or not, what effectively happened to
the Social
Security and Medicare surpluses generated by the Reagan
Era FICA tax
increases and reductions in benefits, was that they helped
fund
Reagan's big military build-up of the eighties. With a
Federal Income
Tax Cut, but an increase in FICA taxes, the tax burden was
made LESS
progressive, and the loss in tax revenues in the general
Treasury
account was somewhat offset by Social Security Surpluses.
This
shifting of funds also enabled the government to replace
borrowing
from the private sector (the markets), which it cannot
default on
without dire consequences, with a promise to "pay back"
the funds to
Social Security and Medicare many years in the future when
needed.
This is a much less serious promise than issuing debt to
the private
sector because future governments may very well get away
with reducing
publicly funded social security benefits if they argue it
effectively
enough. However the government cannot default on debt
issued to the
private sector else it will send the markets into a
tailspin (since it
is the most risk-free asset) and thus send the world's
economy
crashing.
Recently the Bush tax cut has compounded this trend of
borrowing from
Social Security and Medicare to make up for lower general
revenues and
thereby fund other government expenditures, and substitute
borrowing
from the markets with borrowing from Social
Security/Medicare.
Only time will tell if these promises will be broken, but
in the mean
time it is important that people understand the real
funding issues
and not get distracted by Lock Box accounting wizardry.
The Lock Box Myth and the Problems it Generates
Central to understanding the Social Security dilemma is
understanding
what it means for the government to write an IOU to
itself. As
discussed, a US government IOU is the lowest risk asset,
but the
government being able to come good on this obligation
ultimately
depends on its ability to collect taxes in the future to
pay-off all
these IOUs.
In reality, looking right through the wizardry of all
these IOUs from
the government to the government in the so-called Lock Box
or Trust
Fund, what really happens with Social Security funding is
that the
current base of taxpayers always fund the benefits for the
current set
of retirees.
Social Security and Medicare are, as we say in the pension
and
insurance world, funded on a "pay-as-you-go" basis. This
means that
the obligations to be met this year will be funded by
revenues
collected this same year - there is no pre-funding of
benefits, and
there cannot be, as we have just argued. When it comes to
being the
Imperial Government, there is nothing safer to invest in
than
yourself, and this is equivalent to depending on future
tax revenues
to meet all future expenses, which means you fund
everything on a
pay-as-you-go basis. That is, taxes collected from current
workers
always pay for the benefits of current retirees.
In reality the Trust Funds provide a mechanism whereby
future general
income tax revenues of the government can be legally
transferred to
meet social security obligations in excess of Social
Security taxes if
and when needed. It is a legal mechanism to facilitate
possible future
flow of funds and nothing more. But there is no guarantee
on benefits
and current benefits are always set by the law of the land
of the day.
But now we get to the problem of the liability being with
the
government - that is, of course, that the government sets
the law of
the land! And so the government can change the laws that
specify
benefits if it so decides.
Since the elusive Lock Box (or Trust Funds), stuffed full
of
government promises to itself, is little more than a legal
technically
that doesn't get at the real issues of funding Social
Security and
Medicare, it should not be the focal point of discussion.
However, unfortunately some of the leaders at the US
Department of
Treasury still frame discussion around the mythical Trust
Funds.
Treasury Secretary Paul O'Neill: Excerpt from March 26,
2002 Press
Conference after the release of the Social Security and
Medicare 2002
Reports
Now lets hear from another Trustee [aptly named] Tom
Saving, who
correctly describes the real problem that worries the
government, and
it's NOT funding shortfalls in the 2030s or in 2076! What
really
worries the government is that within the next few years
Social
Security and Medicare Costs will start competing for funds
that would
otherwise be spent by the government on other things (say,
military or
other things), rather than supplying extra funds to these
things (as
they have since the Reagan Era).
Social Security/Medicare Trustee Tom Saving: Excerpt from
March 26,
2002 Press Conference after the release of the Social
Security and
Medicare 2002 Reports
An finally we hear from a caller who called into a C-SPAN
show that
Tom Saving was on the day after this press conference. He
pretty much
gets at the cold, hard truth of these trust funds.
C-Span Show with Tom Savings - a caller's explanation of
the Social
Security and Medicare Trust Funds
Cutting through the Trust Fund Accounting Wizardry we
might surmise
that the real Social Security and Medicare funding dilemma
is this:
How do you fund the medical and retirement costs of an
aging society
and still keep being the Great Empire?
As noted, in a pay-as-you-go system the current base of
workers fund
the retirees and the sick. Translated into real goods and
services
this means that the current base of workers produce all
the good and
services, not only for themselves, but also for an
increasing
proportion of non-producers. The demographic trends
driving an
increasing ratio of non-workers needing support to
supporting workers
are:
* Medical advances that mean people live longer, are
retired longer
and have higher medical expenses,
* Lower fertility rates keeping down the supply of new
workers, and
* Impending retirement of the large baby boomers
generation.
In the coming years, more and more of society's resources
will be
going towards supporting retirees and increasing medical
expenses for
society as a whole (both workers and non-workers as we've
already
discussed). This will be true whether benefits are funded
in the
public sector or the private sector, or both. Thus,
Private Savings
accounts and privatizing Social Security cannot solve the
problem and
discussion of these as a solution should also not be
allowed to
distract debate from the real issues. In fact, putting
current
contributions into private accounts will make the current
funding
situation worse, because these funds are now used to pay
for current
retirees and not "saving" for future retirees.
This increasing demand on society's resources creates
great pressure
on funds that might otherwise go towards Empire building
and
maintenance (military and infrastructure), and will likely
lead to
much slower economic growth. This is perhaps the real
dilemma that
keeps the Emperors and their friends up at night.
Since many necessary Empire maintenance and building
expenditures
originate in the public sector there is a very real danger
that a good
chunk of the publicly funded safety net could be cut in
the coming
decades. Economic risks are thus passed back to those who
can least
afford them. There is a very real concern that increasing
total
medical and pension costs will lead to an even worse
situation of
services provided on an ability-to-pay, rather than a
needs basis.
While it is true that both labor force productivity gains
and further
government borrowing from outside the government could
serve to meet
some of these increasing obligations, it is not clear that
these could
be sufficient to solve the problem and both can come with
nasty side
effects.
The point to be made here is that people need to be aware
of what the
real trade-offs are and that public discussion should be
about the
real issues and not about some mythical Lock Box (or Trust
Fund) as is
so often one by the Government's spin doctors.
Furthermore, even more dire a situation than the Social
Security
dilemma is the increasing share of national expenditure
devoted to
healthcare, as alluded to earlier. This effects all of
Medicare
funding, Medicaid funding, private medical funding and the
ability of
society to come up with a solution to the uninsured
problem in the
midst of exploding health costs everywhere else.
Add to that the riskiness of national output, or GDP
itself, with more
and more of it being conceptual and abstract services and
thus able to
disappear from the economy just as surely as Enron
disintegrated.
Recall that in the last episode of Wizards (Wizards Part
11) we
included some words of caution from the Great Wizard
Greenspan about
the risks of the components of GDP becoming increasing
"conceptual".
And the final sting of the dilemma is this - If people
were content
for the projected increase in healthcare and retirement to
eat into
Empire building and maintenance expenses then of course
the Empire
itself is at risk. And when the Empire is a risk, so is
the whole
economic and financial system through which these benefits
are paid
anyway.
So there are no easy answers. Well, except maybe
Perhaps a New Religion is in Order!
In the deteriorating years of its Empire, Rome, ever
practical, saw
fit to rejuvenate its Imperial Power using the cheapest
and most
efficient tactic - a new religion to rally the troops
around.
Though the ruling Emperors and Governors wouldn't have
known it at the
time, Rome's "business-as-usual" termination of a Messiah
provided
tremendous returns 300 years later as the Empire was
collapsing. After
all, if you don't have money to pay soldiers, you can
always rally
them around a new and appealing religion - for free!
In a few years or decades or centuries, the American
Empire might also
try its way out of its dwindling Empire dilemma with a
shot at a new
religion. Apparently the existing dominant religion so
beneficial to,
and kindly handed down from, the Romans themselves, isn't
working too
well and only makes the longevity quest even worse. It
seems that the
"fire and brimstone" warnings have really sunk in and
everyone wants
to delay as long as possible the taking of the inevitable
"perpetual
nap". Perhaps a new religion could help alleviate this
cultural trend
to want to live in one's earthly body well beyond what
nature had
intended for it. Inventing some religious worship methods
that
involved physical exercise would be an added bonus.
The possibilities are endless. In any case, as silly as it
all sounds,
such tactics would probably work much better than a
Mythical Lock Box!
Bankruptcy
Bill's Shoot-Out at the Social Safety Net
In this the thirteenth chapter of Wizards, we are going to
take a look
at another Chapter 13 and a Chapter 7 and a Chapter 11 -
these
chapters are some of the main ways under federal law to
file for
Bankruptcy. Importantly we will look at the strong
relationship
between the non-stop credit offers we find stuffing our
mailbox,
e-mail and voicemail everyday, the innovative financial
Wizardry
behind such offers and the rapid rise in personal
bankruptcies. We'll
examine who does file for bankruptcy and what causes them
to go
bankrupt. Then we'll look at the new Dream Bill of the
Credit Card and
Banking Industries - called "Bankruptcy Bill" - that looks
set to pass
into law soon. Bankruptcy Bill is aimed at thwarting
people's attempts
to be caught in that final, last-resort, safety net, known
as the
bankruptcy court. To help us understand both the credit
offer
onslaught and the salient features of Bankruptcy Bill
we'll talk to
Margaret Howard, a Law Professor at Washington and Lee
University, and
visiting scholar at the American Bankruptcy Institute.
After a look at how people get robbed by credit cards and
Bankruptcy
Bill, we'll look at how a small businesses can get robbed
by a big
bank. In the last section of this Wizards Chapter 13
filing, we'll
talk to Greg Bates at Common Courage Press about how their
money from
book sales was robbed by Bank One, a credit deletion
service provided
to them by the bank even though they're not a customer!
But first lets talk about Bankruptcy Basics and the
invasion of the
Credit Card Monsters.
What Triggers Personal Financial Ruin?
One book that is an excellent source of information for
understanding
bankruptcy in America is a book called "The Fragile Middle
Class,
American's in Debt" by Sullivan, Warren and Westbrook. The
authors
have conducted extensive studies of bankrupt Americans in
one of the
few comprehensive studies not funded by the credit card
industry. Here
is some of what they found:
* Up until the last year of their study
period, which was 1998,
Americans that filed for
bankruptcy were overwhelmingly middle
class - above the bottom 20% but
below the top 20% income earners.
* About 80% were forced into bankruptcy due to
an unforeseen event
such as job loss, sudden illness
or injury, or divorce.
* Excessive credit card debt is increasingly a
primary force
propelling people into bankruptcy.
In the years to come this is
likely to continue as a major
driving force along with a new
partner, the wildly popular Home
Equity loan.
Bankruptcy law is federal law. When someone files for
bankruptcy they
would file under either Chapter 7, whereby many debts are
forgiven,
but many assets are also forgone. This provides relief
from aggressive
creditors and enables the debtor to wipe the slate clean
and start all
over again. Under a Chapter 13 filing, an "automatic stay"
is granted
whereby creditors cant go grabbing at your last bits of
income and
assets, and the court process will assist in coming up
with an agreed
upon repayment plan. Chapter 13 enables a debtor to stop
creditors in
their tracks while they come up with a more feasible
repayment plan so
that desired assets (like a home) can remain with the
debtor. Filing
for personal bankruptcy under both Chapter 7 and 13 is
intended to
provide some relief for debtors, and a chance for a fresh
start, while
it comes at some cost to creditors such as banks and
credit card
issuers.
Over the years personal bankruptcies have been increasing
faster than
the population. On May 16, 2002 the American Bankruptcy
Institute
issued a press release stating that record levels of
bankruptcies had
been achieved for the year ended March 31, 2002. Over that
year a
record 1.5 million American households filed for
bankruptcy.
Several trends are driving this increase. One is the
increasing number
and size of gaps in the social safety net, which one might
otherwise
be caught by on the way to this last resort option. With a
high number
of people without adequate health insurance coverage, a
sudden medical
emergency can push an individual or family over the edge
and into
bankruptcy court. More often, it is unexpected job loss or
disability
that pushes people over the financial edge. Divorce,
especially for
women who then care for children by themselves,
accompanied by
difficulty collecting child support, is another common
trigger. In
fact there is evidence now that suggests that single women
head of
households make up the largest group using the bankruptcy
option. In
the absence of comprehensive publicly funded safety nets
or public
insurance to buffer individuals against these shocks, with
creditors
pounding constantly on the door, and as drastic as it
seems, sometimes
bankruptcy provides the only avenue of some relief.
Middle class debt loads have increased over the years. The
"Fragile
Middle Class" book points out that the amount of debt
relative to
income that usually triggers a bankruptcy has remained
fairly constant
over the years. But the number of bankruptcies is rising
faster than
the population. This is because, on the whole, the middle
class debt
load relative to income is increasing, meaning that more
people are
crossing that threshold that can trigger bankruptcy.
Several decades ago, on average, people didn't accumulate
as much debt
as they do today and so they had more of a safety net of
their own to
weather the storm of any of these common financial ruin
triggers -
which are job loss, sickness and injury, and divorce. But
with the
increasing debt load, personal safety nets are
disappearing right
along with the vanishing public safety nets. The
increasing debt load
has been driven both by increasing credit card debt and by
home equity
loans in the midst of a strong property market. In
addition, the
financial ruin triggers themselves are becoming more
frequent, with
globalization increasing job insecurity, higher divorce
rates, ever
higher medical costs and higher education costs.
Beware the Stranger Bearing Gifts" Invasion of the
Credit Card Industry
The sin of usury is well documented in the guidebooks of
the popular
religions. In the 1980s these chapters of the Good Books
may as well
have been whited out. During the monetary madness of the
eighties and
simultaneous high interest rates, religious warnings faced
the ungodly
power known as "market-discipline". Usury laws of many
states that
capped interest rates charged to consumers disappeared
like magic and
a new religion was born - a full blown, non-stop, nirvana
of credit
accessibility everywhere you looked. The fact that
creditors could now
charge huge interest rates meant that credit suddenly
became widely
available to people who were once considered poor credit
risks. A
billboard here saying "Credit Problems, No Worries!", a
man with
splendid manners on the phone greeting you with "Maam,
you're
pre-approved for $5,000!" and a mailbox chock full of tens
of
thousands of ready made checks and friendly letters saying
"Congratulations, You're Pre-Approved! Sign Here".
And so the man with the nice manners and the friendly
letters came to
take the place of the holes that appeared in the publicly
funded
safety net. If you couldnt afford your medical bills, put
them on a
credit card! Lost your job? Never mind - pay your rent and
buy your
food on credit. Of course, this is one extreme of how
credit is used,
particularly by people in desperate circumstances and with
no other
access to adequate money for the necessities of life.
In addition to this is the much more obvious and
well-documented role
of the credit frenzy in fueling a consumer economy that
grew like
crazy throughout the eighties and nineties, and hasnt
stopped yet.
This widespread credit feeding frenzy feeds the
consumerism that props
up the financial markets and, in turn, leads to greater
capital
accumulation ready to fund even more access to credit for
the poor and
middle class, and so the cycle continues. It is a highly
leveraged
"House of Cards".
Recall that we spoke about the role and dangers of
excessive leverage
in Wizards Part 11. Recall that we also spoke about the
"House Edge" -
the amount that the House makes, on average, in any
betting game. The
"House Edge" for the credit industry comes from the huge
interest
rates it charges, and can get away with, thanks to the
market's
discipline of the bothersome religious rules in the era of
financial
deregulation.
It is instructive to look at trends in the expansion of
consumer
credit over the past several decades. Some good data is
available on
the Federal Reserve's web site at
http://www.federalreserve.gov/releases/g19/hist/cc_hist_mh.html
[Go to www.federalreserve.gov, Click "Research and Data",
"Statistics", G19 - Consumer Credit]. In this data you
will see that
total consumer credit has now grown to $1.7 Trillion
dollars, which
doesnt even include home mortgages and home equity loans.
Provision of consumer credit dates back to the early
1900's when
catalogue stores like Sears, Roebuck and Company enabled
consumers to
buy goods on credit. "The Fragile Middle Class" points to
credit
application forms in 1910 that ask sensible credit risk
assessment
questions such as "How many cows do you milk?". During the
Great
Depression, General Electric or GE's now monstrous unit,
GE Capital -
the largest of the non-bank financial institutions - was
started as a
little consumer credit company to help Depression Era
folks get access
to the necessary appliances for a modern life. In fact, if
you look at
the Federal Reserve's consumer credit data you will see
that right
after the second world war non-financial business,
primarily
department stores, were the largest providers of consumer
credit by
far.
Throughout the 1950's through the 1980's commercial banks
took over as
the primary suppliers of consumer credit. But by 1989 a
new "Wiz-Kid"
emerged on the block and, as of today, the Federal Reserve
data shows
that it has taken over the banks to become the major
vehicle through
which consumer credit is now supplied. This vehicle is the
handiwork
of the bankers and investment bankers themselves. It is
also the one
that snuck into the big hole left in the crumbling social
safety net
while nobody was looking. For, in conjunction with the
high interest
rates permissible today, the new Wiz-Kid invention is
quite likely the
very thing that has enabled the provision of credit to
people who
really can't afford it - those in poverty or very near to
it. These
are generally people least able to resist an offer of
credit. They are
also people who, in a more balanced society, may have
basic needs met
by publicly funded social safety nets, rather than through
high
interest loans.
Key to the profitability of lending to the poor is the
fact that they
desperately need access to credit, often don't understand
the impact
of high interest, and therefore do not act at all like the
much touted
"rational market player". The creditor can always win the
arbitrage
game played against the irrational market player. For
example, many
credit card targets don't realize that under the
attractive minimum
monthly repayment plan, a balance of just $2,500 might
take more than
30 years to pay off! Just like Keno and Slot Machines in
our visit to
the Casino in Wizards Part 11, nowhere is the House Edge
larger in the
financial markets than in lending to the poor without a
usury cap.
If it's got an Income Stream Catch
it, Tame it and Securitize It!
This new Wiz Kid on the credit creation block is called the
Securitized Asset. Included in this same family are the
mortgage-backed siblings known as Fannie Mae, Ginnie Mae,
and Freddie
Mac, who you also may be acquainted with, and who will
likely be
guests on an upcoming episode of Wizards.
To securitize a pool of consumer loans, lets say credit
card debt,
here's what happens:
* First, a bank, a group of banks and/or other
credit card issuers
decide they'd like to sell the
credit card debts owed to them by
their customers. In return they
will get some cash that they can
use for some new Wizard adventures.
* An investment banker packages all this debt
together in a nice
pool of credit card receivables,
using what is known as a Special
Purpose Vehicle, and does some
risk analysis to price the bundled
up debt. Then they sell the neat
new packages of credit card
backed securities for cash in the
markets, with the cash proceeds
going back to the banks and
issuers, less a handsome cut for the
crafty investment banker.
The new securities are then traded around the markets
according to the
whims of Wall Street. This is pretty much what happens
with mortgages
as well. So whether you're paying of your credit card or
your house
you actually never know who you are paying to from one day
to the
next. You are just a little slice of income in a much
bigger security.
The implications of pooling such risks across many issuers
and many
different bases of borrowers are quite profound and
provide many
appealing features for investors in these securities that
are
basically bundles of credit card receivables. By putting a
vast number
of credit card receivables behind a security, risks of
default are
spread across the pool as a whole and the cost of default
is much
easier to estimate. There are bound to be a handful of
credit card
holders who will end up not paying their bills, but in
such a large
pool there will be enough of the ones who keep paying
their bills to
make up for it. The high interest rates charged and paid
by the larger
paying group more than makes up for the defaulters,
leaving a handsome
profit for the investor in the bundled up security.
Thanks to these handsome profits, capital keeps flooding
into these
securities to fund ever more daily credit card
solicitations. Due to
this ability to pool risks via securitization, combined
with
saturation of credit in the middle class and the profits
that come
from uncapped interest rates, credit solicitations are now
flooding
into the poorest of homes, the bottom 20% of income
earners. People in
poverty are less able to resist such access to credit, and
due to
limited experience with it, often dont understand that the
huge
interest is a killer. Over the coming years, it is likely
that those
wishing to file for bankruptcy will increasingly be the
poor, in
addition to the ever increasing stream of middle class
already filing
in.
An important study done by the Federal Depository Insurance
Corporation (FDIC, who we spoke about in Wizards Part 10)
is available
at http://www.fdic.gov/bank/analytical/bank/bt_9805.html.
This study documents the relationship between the removal
of interest
rate caps or usury laws in the 1980s, the subsequent
widespread
availability of credit to all groups, and the resulting
rapid growth
in personal bankruptcy filings since the 1980s.
It also gives us an interesting history of the role of
usury laws. The
FDIC study reports "Usury laws perhaps have a more ancient
lineage
than any other form of economic regulation. The Greek
philosopher
Plato also condemned charging interest because he felt
that it
produced an inequality of wealth and destroyed the harmony
between
citizens of the state. As commerce expanded and money
lending became
increasingly important, opinions about usury changed. The
Romans were
more tolerant of usury and were one of the first societies
to
recognize interest and set maximum legal rates for various
types of
loans. Throughout much of recorded history, societies
around the world
have felt it was important to limit the interest rate that
a lender
can charge in order to restrain lenders from taking
advantage of
borrowers."
Today, the modern American society has taken a step even
beyond what
the Romans would tolerate, by deregulating interest rates
and removing
usury caps.
As a result, the credit monster extends it tentacles ever
further into
society and into that sector that just might need
bankruptcy
protection the most. Just as it does so, the Credit Card
industry has
almost nurtured into existence its Dream Bill - called
Bankruptcy
Bill. The Creditors' Dream Bill makes access to that one
final safety
net, known as declaring bankruptcy, all that tougher to
get to.
Meanwhile, Congressional and public debate over Bankruptcy
Bill has
barely focused on the profound implications of all this.
The end result of making it harder for individuals to
declare
bankruptcy Profit margins of credit issuers, banks and
investors in
asset-backed securities go up, even as their base of
credit is still
growing. Just when you thought it couldn't possibly get
any bigger,
the House Edge Increases!
So that we could get to know Bankruptcy Bill a lot better
I spoke to
Margaret Howard, a Law Professor at Washington and Lee
University in
Washington DC who is an expert in bankruptcy and
commercial law. She
is also visiting scholar at the American Bankruptcy
Institute. I
started by asking her about the news of the record level of
bankruptcies achieved over the past year.
Interview with Margaret Howard, Law Professor at
Washington and Lee
University
(25 minutes)
That was the interview I did with Margaret Howard, a Law
Professor at
Washington and Lee University. Later on in our discussion
Professor
Howard also told me about the controversial provision
known as the
"Homestead Exemption" whereby even after declaring
bankruptcy, under
current law, in some states you can keep your home no
matter what and
creditors can't touch it. This exemption seems to have
come in rather
handy for the Enron executives who recently seem to have
been doing a
lot of home improvement, even as angry investors file law
suits
against them. It might not surprise you to know that one
of the States
the Homestead exemption is available is Texas, and another
is Florida.
Under a compromise reached in Congress, people in these
stated can
still have their Homestead Exemption unless they are
felons or
convicted of financial fraud.
We've seen how individuals and families can get robbed by
banks and
other creditors. Now lets see how a small business can get
robbed by a
bank.
Bank-Robbing Banks
On April 2nd, a book distributor for small independent
publishers,
known as the LPC Group, sent a letter out to its book
publisher
clients informing them that they were filing for Chapter
11 Bankruptcy
because they had just been robbed by a bank! The letter
also told the
publishers that the money that was robbed had been due to
the
publishers for books sold to a wholesaler.
The bank that robbed them is a subsidiary of Bank One, a
very large,
quite profitable and well-off bank, one of the largest in
the country.
LPC group, legally known as Publishers Consortium Inc, is
a customer
of American National Bank and Trust Company of Chicago, a
subsidiary
of Bank One acquired during its merger with First Chicago
NBD during
the late 1990's. They had a business loan from American
National and
also a deposit account. This deposit account was used to
hold and then
distribute funds from book sales of the small publisher
clients. On
April 1, some monies came into this account from a
wholesaler and were
getting ready to be distributed back to LPC Group's small
publisher
clients. But, all of a sudden, through the wizardry
possessed only by
banks, the money vanished. The Bank took it! The money
from the small
publishers' book sales was taken by the bank with
apparently no notice
to LPC or to the small publishers.
One of those small publishers who had their money stolen
is Common
Courage Press. Following is an interview I did with Greg
Bates at
Common Courage Press about this strange Bank Robbery
Interview with Greg Bates at Common Courage Press about
the Bank
Robbery
(10 minutes)
After this interview I spoke with Doug Skalka, a lawyer in
Connecticut
representing the Bank. He didnt want to be recorded but
told me the
following. * The LPC Group Loan from the bank was secured
by the
assets of LPC Group. * The bank had a lien on all assets
including
inventory.
The heart of this bizarre case can be summed up as a
disagreement over
two disputed issues:
1) What caused LPC Group to be in violation of its loan
agreement so
that the bank could call it in? I do not know the answer
to this.
But the more important point for the publishers is:
2) What does the bank have a lien on? What are the assets
of LPC
group? Do they include the proceeds of book sales? The
publishers
claim that such monies belong to them. After all, they
have already
incurred all the expenses of publishing and putting the
books together
for distribution in the first place.
Common sense would say that the money belongs to the
publishers.
Nevertheless, as we already saw with Bankruptcy Bill,
common sense is
quite often set aside in favor of vested interest when it
comes to
setting the Law of the Land under which the markets
operate.
The
Trade Federation and the InterGalactic Banking Clan
In this, the fourteenth edition of Wizards, we are going
to take a
look at the Earthly versions of the Star Wars Movies
troublemakers
known as the Trade Federation and the Intergalactic
Banking Clan,
responsible for starting and financing the Clone Wars. Our
modern
earthly descendants are known as the World Trade
Organization and the
US Coalition of Services Industries, founded by financial
services
giants in the early 1980s. These two bodies have formed
strong
alliances over the past two decades to bring us a very
special and
powerful trade agreement known as the GATS which stands
for General
Agreement on Trade in Services. This agreement is said to
cover
international trade in anything you cant "drop on your
foot" that
means anything from banking to healthcare, childcare and
education to
communications and media to the postal service to water
treatment
services.
As we will see, the GATS agreement poses significant
threats to the
future of critical social services internationally and may
empower
corporations to challenge governments over public funding
of services
such as education and healthcare. In this episode of
Wizards well
examine the implications of all this, see why GATS is now
at a
critical stage of negotiations, and look at some leaked
"shopping
lists" from the European Union that caused quite a stir in
April this
year.
But thenwell also see that the Earthly Trade Federation
and Services
Clans, while demanding a huge grab-bag of goodies of the
"cant-drop-on-your-foot" variety, have ended up shooting
themselves in
the foot. First, recent trade measures implemented by the
US to
protect the steel and farming industries are themselves
probably
illegal under existing trade agreements. Not surprisingly,
the world
outside America is fast losing enthusiasm for lowering
their own trade
barriers further. Second, the recent wave of corporate
scandals across
America has primarily come from the providers of services
you cant
drop on your foot telecommunications (WorldCom and Global
Crossing),
energy and water services (Enron, Dynergy and Vivendi),
education
(Edison Schools), banking and brokerage (well just about
all the big
ones!). The rest of the world is not amused! They
certainly dont want
such shady operators taking over their own services.
To get to know these trade issues better well talk to Dr
Pat Ranald at
the Australian Fair Trade and Investment Network, hear an
excerpt from
an Australian Broadcasting Commission show call Background
Briefing,
and also hear the words of Democract [corrected]
ex-Senator Bob Kerrey
and former US Treasury Secretary Robert Rubin about the
recent
WTO-illegal moves of the US. Well also discuss a brief
chat I recently
had with Ambassador Charlene Barshefsky, former US Trade
Representative under the Clinton Administration, about
particular
trade issues.
But first, to refresh your memory, or in case you thought
the recent
movies too cheezy for your tastes lets see how alliances
between Trade
Federations and Banking Clans can get whole galaxies into
a whole lot
of trouble, based on a story from a galaxy far, far away
The Deterioration of the Galactic Republic and the
Emergence of the Trade
Federation
This is from www.starwars.com/databank/
"The Republic had enjoyed several centuries of growth and
prosperity.
It was inevitable that its wealth would foster those with
greed to
match. The varied instruments of trade and commerce banded
together
into galaxy-spanning organizations meant to aggrandize
their profits.
Coalitions such as the Trade Federation, Corporate
Alliance, Commerce
Guild, Techno Union and the Intergalactic Banking Clan
consolidated
their individual markets under governing bodies of such
size that they
exhibited pull on the actions of the Galactic Senate."
They formed a
separatist movement called the Confederacy of Independent
Systems, and
geared up for war to destroy the Republic "with promises
of reform and
unyielding devotion to capitalism".
"The Trade Federation was a consortium of merchants and
transport
providers that effectively controlled shipping throughout
the galaxy.
It had attained enough clout in the Galactic Senate, as if
it were a
member world".
"Helping control the incredible amounts of credits,
dataries, and
other forms of currency flowing through the galaxy was the
InterGalactic Banking Clan. This business entity allied
itself with
the growing Separatist movement in the Galaxy, and IBC
Chairman San
Hill personally committed his forces to the Confederacy of
Independent
Systems in a non-exclusive pact, of course." After all, he
is a
banker. "The IBC profited from both ends of the clone
wars", financing
the efforts of both the Republic and the Confederacy of
Independent
Systems.
And so began the Clone Wars between the Republic and the
Independent
Systems Movement. These wars eventually culminated in the
destruction
of the Republic and the formation of the Empire managed by
the dark
lord Darth Vader, once a Jedi Knight trained in the
pursuit of peace
but later tempted by all the attractions of the Dark Side.
The Imperial March
A "Background Briefing" on GATS
Now, fast forward to the Trade Wars of the 20th and 21st
centuries on
Earth. Lets go to 1981 when, according to a briefing from
the
Transnational Institute (TNI) based in the Netherlands:
"the Chief
Executive Officers of AIG, American Express and Citigroup
concluded
that there was a need to form a broader business coalition
to push the
demand to include "trade in services" in the GATT agenda.
They
mandated American Express Vice President Harry Freeman to
form a
coalition of services industries that would reach well
beyond New York
financial circles. In 1982 the US Coalition of Services
Industries
(USCSI) was officially launched under Freemans
chairmanship."
Note that the GATT is the General Agreement on Tariffs and
Trade, and
is basically the umbrella agreement covering all these
sub-agreements
like GATS, which covers only trade in services. These
agreements are
administered by the World Trade Organization or WTO.
The TNI document called "Behind GATS 2000" goes on to say
"Between
1982 and 1985 USCSI worked closely with the US Trade
Representative
(USTR) and the Department of Commerce to place services on
the global
trade agenda. In late 1983 the USTR submitted a report to
the GATT on
the growing importance of services in the world economy
and suggesting
possible approaches to a new regime. When the GATT Uruguay
Round was
launched in September 1986 negotiations formally started
on a
multilateral regime for trade in services within the
GATT." This is
the round of trade talks that ultimately gave rise to the
World Trade
Organization (WTO) and the one in which the GATT (the
umbrella
agreement) gave birth to an army of sinister-looking
sub-trade
agreements, one of which was the GATS covering services
and born in
1994.
The US services sector, spearheaded by the financial
sector, had
lobbied hard for this one and they couldnt be more pleased
with their
new baby, who is now eight years old. A few years later
the European
services industries jumped on the bandwagon of lobbying
their
governments hard for favorable provisions under the GATS.
By June 30
this year all WTO member countries had to submit their
shopping "wish
lists" to other member countries. This means that they
submitted a
list of every service in other countries they want their
own
corporations to get access to. The actual responses from
countries
will start in March 2003. To date the discussion on "wish
lists" and
country positions have been between big business and
government, and
definitely behind closed doors, with one exceptional leak
as we see in
a minute.
There are four modes of services provision under the GATS
from
e-commerce across borders to a full commercial presence,
which
includes all foreign dierct investment related to services
provision.
It is all the requests being made under this latter mode
that has lead
many groups to conclude that GATS is largely a reemergence
of the
Multilateral Agreement on Investment (MAI) in a new
disguise. Recall
that the MAI was shot down in flames after the text of it
was released
to the public and spread across the Internet a few years
ago.
A Huge Event in the History of GATS European Union Member leaks
the EUs GATS
"Grab Bag" of Requests to Other Nations
Speaking of leaked documents, the full text of the
European Unions
GATS "wish list" was leaked to the public in April 2002
causing an
absolute uproar in many countries around the world. Even
though the EU
demands on US services industries were pretty heavy, we
hardly heard a
peep about this in the US media.
I found out more about this recently when I visited
Australia. While
there I heard an excellent episode of a show called
Background
Briefing run on the Australian Broadcasting Commissions
Radio
National. The whole hour was devoted to GATS, and here is
an excerpt
from it about the release of the EU GATS shopping list.
Excerpt from
Background Briefing on ABC Radio Nation, produced by Tom
Morton.
3 minutes.
That was an excerpt from ABC Australias show Background
Briefing. That
episode was produced by Tom Morton.
The release of public documents that have come out of
secret
negotiations between publicly funded officials and private
interests
can be quite shocking and can cause quite a stir. They
often get a lot
of attention because of the realization of the extent of
the violation
of the publics trust, and the "giving away" of goods
people thought
were in the public domain. But such leaks play a very
important role
in democracy and the system of checks and balances needed
to make it
work. So too with these recently released documents, which
thoroughly
shocked many and confirmed already existing suspicions of
others.
I will post a link to all these documents on the Wizards
of Money web
site at www.wizardsofmoney.org
One of the guests on this show was Dr Patricia Ranald of
the
Australian Fair Trade and Investment Network. Since I
thought she
provided such good educational material I decided to
interview her for
this Wizards of Money episode. Here is the interview I did
with Pat
Ranald who helps us understand the GATS agreement and the
dangers it
poses in more detail.
Interview with Pat Ranald of AFTINET 20 minutes
The Ongoing Battle Between Corporations and States
Under another agreement, the North American Free Trade
Agreement or
NAFTA, which is already fully implemented, there is a
special
provision known as Chapter 11. This, seemingly obscure,
provision of
NAFTA has received a lot of attention recently and
journalist Bill
Moyers gave it some good coverage in his NOW show that
runs on PBS
back in February of this year. Ill put some links to this
on the
Wizards of Money web site at www.wizardsofmoney.org. In
that show it
was explained that Chapter 11 of NAFTA enables a
corporation to
directly sue a government for regulations or other
government actions
that interfere with investments.
Whatever the intent of this provision its effect has been
to encourage
corporations to sue governments over regulations that harm
profits. To
give you an idea of whats going on and how these
provisions are being
used heres a sample of three cases that have been filed
under NAFTA
Chapter 11.
1. UPS vs Canada Post: As discussed in the earlier
interview, Canada
Post, the Canadian government
funded postal system is being sued
by UPS who claims that Canada Post
engages in a mail monopoly. UPS
claims that Canada Post has an
unfair advantage provided by its
monopoly infrastructure via a
public system of post boxes and post
offices. UPS wants access to that
same system or compensation for
equivalent profits. No ruling has
been made by the 3 member NAFTA
panel.
2. Methanex Corporation vs US Government: This claim
for $1 billion
was brought by the main supplier
of methanol which is used to make
a chemical known as MTBE, which is
a fuel additive. They were
upset because the California State
Government brought in a law
that bans MTBEs in gasoline
because they had been found
contaminating the water supply and
causing health problems. So
they brought a claim under NAFTA
for lost profits. No ruling has
yet been reached in this case.
3. Ethyl Corporation vs Canada: US Ethyl Corporation
claimed that a
Canadian ban on imports of the
gasoline additive MMT for use in
unleaded gasoline was unfair
expropriation. A Canadian court
subsequently found the ban to be
invalid under Canadian law and a
settlement was reached.
Interestingly I had the opportunity to pose some questions
about all
this to Ambassador Charlene Barshefsky, former US Trade
Representative
under the Clinton administration at a meeting on May 30,
2002. I am an
actuary and the Spring Meeting of the Society of Actuaries
was held at
this time. She was the keynote speaker on May 30 and she
spoke
primarily about, you guessed it, GATS! And also she spoke
about how
wonderful it would be for the financial industry and how
we, as
financial professionals, should make it clear what we want
out of
these agreements.
Not only is she a great big advocate of the direction GATS
is taking
but she is also on the board of American Express,
ultimately one of
the founding fathers of GATS through its founding role in
the US
Coalition of Services Industries. At the end of the "Go
GATS" pep talk
I was the first to ask a question, because I really wanted
to know
about Chapter 11 of NAFTA. So I asked if she thought
Chapter 11 was a
big threat to regulation of industry and democratic
accountability.
She replied that it was very controversial but its intent
was
basically to prevent government stealing property. When I
probed
further into this issue using the Methanex versus US case
as an
example of something different than "stolen property" she
responded
that No, that wasnt really a NAFTA case, it had been
settled by state
law.
I was soo confused that I just sat down and shut up at
that point What
was she talking about? It took me many months to find out.
I sought
information on these cases from the Trade Representatives
office to no
avail and then finally discovered that its the State
Department that
usually defends these cases. You find a whole host of all
the legal
filings on the State Department web site hidden away at
www.state.gov/s/l/c3439.htmLooking through these documents
and also
calling the State Department directly I discovered that no
ruling has
yet been made in the Methanex case. In all likelihood,
what Ambassador
Barshefsky did in her answer to me was confuse the
Methanex case with
the Ethyl Corporation case, where the resolution of the
contested law
was purely a matter of Canadian law, regardless of NAFTA.
After all
they both involved gasoline and government names that
start with a
"C".
But my goodness, what is the world coming to when the
former Trade
Federation Chief gets her cases mixed up! I rushed to
order the tape
of the session from the audio company called AVEN, since
the session
was advertised as being one you could buy afterwards. But
they told me
at the last minute Ambassador Barshefsky refused to be
recorded and to
have tapes made available. Ill also put some links to the
brochure for
this session on the Wizards of Money web site.
How Breaking Your Own Rules Can Bite You in the Butt!
May 30, 2002 seemed to be chock full of interesting trade
information.
For, on that very same day I also came across a discussion
between
former Treasury Secretary Robert Rubin, former Nebraska
Senator Bob
Kerrey and former IMF chief Stanley Fischer who were
talking at New
School University in New York. In that session which was
aired on
C-SPAN they basically came right out and said that the US
was breaking
its own trade rules through the recently imposed steel
tariffs and
farm subsidies. They were also quite candid about why the
US will
probably get away with breaking its own rules. Heres an
excerpt Bob
Kerrey followed by Robert Rubin
Robert Rubin and Bob Kerry discuss GATT-illegal steel
tariffs and farm
subsidies
C-SPAN recording at New School University, New York. May
30, 2002
3 minutes
Homeland
Securitizations and Overseas Vacations
A Journey Through the Financial Twilight Zone
In this, the fifteenth edition of Wizards, we are going to
take a look
at the adventures that financial institutions send their
financial
instruments on - both at home and abroad. On this journey
through the
"Financial Twilight Zone" we'll look at some of the
financial tricks
receiving attention in today's corporate and banking
scandals, as well
as the rescue packages available for homeland capital
getting into
trouble in its overseas adventures.
On the issue of "Homeland Securitization" we will first
look at the
process known as "Securitization", whereby anything that
has a stream
of cashflows emerging in the future can be bundled up into
a new
financial security and sold for cash today. And that
literally means
anything with a future stream of cashflows - from home
loan and credit
card repayments, to David Bowie songs and football ticket
sales, to
health club membership fees, to insurance against bad
weather, and to
the delivery of oil and gas by the now famous energy
companies. We
will start with a look at the biggest Homeland
Securitization market
of all - that for home mortgages, and some of its biggest
players,
from the banks to the mysterious bodies known as Fannie
Mae and
Freddie Mac. We will look at the use of securitization and
its
associated "Special Purpose Vehicles" as tools for
regulatory
avoidance and enhanced returns, and as the catalysts for
Urban Sprawl
and daily Credit Card Solicitations. We'll also study the
generation
of what is known as "Toxic Sludge" on federally insured
bank balance
sheets, the relationship between securitization and the
secret
Over-the-Counter Derivatives Casino, as well as the hidden
systemic
risks that don't get much attention.
In studying "Overseas Vacations" we will see how a summer
trip to a
Caribbean Island or a Swiss chalet for the snow season can
provide
great regulatory relief for stressed-out financial
instruments
securitized in the homeland. We take a critical look at
the additional
risks all this regulatory avoidance poses for each of us
as bank
depositors and taxpayers.
The Twilight Zone the "Other
Dimension" of Financial Transactions
To get started we need to cross into a whole new dimension
- the world
in between the two end points of a financial instrument or
transaction. Just like the twilight zone wedged in between
day and
night, this strange world in between a debt on my balance
sheet and an
asset on somebody else's books, is occupied by a cast of
characters
the majority of people just quite can't see. You might
have heard some
of the names, or some rumors about them, but you can never
quite see
them clearly.
Before crossing into this "other world" underlying the
financial
system let's just get a taste of how the regular daytime
world we are
used to interacts with this other dimension we can't see.
We all interact with financial instruments at one end or
another of
this mysterious twilight zone of financial transactions.
We do this by
buying a home, shopping with a credit card, buying an
insurance
policy, having a pension fund, or even going to watch a
movie, or
buying a book or a CD. But few are aware that each such
"every-day"
action triggers a complex chain of events rippling through
the
financial ether world.
For example, your home mortgage may have got bundled up
with thousands
of others, packed in to a Special Purpose Vehicle and
shuttled off to
some remote island, split into 5 different tranches, four
of which
have been bought and sold at least ten times in the market
and one of
which ended up in the pension fund of your cousin in
Chile. Layered on
top of these five tranches are hundreds of derivatives
contracts,
swapped over and again throughout the global financial
markets, one of
whose positions was, quite by coincidence, taken by the
insurance
company you bought a policy with when you took out your
mortgage. In
addition, you might be interested to know that this
insurance policy
is actually no longer with the insurer you bought it from.
It's
already off on a European vacation after being passed to a
pool of
European reinsurers and, in the process of crossing the
Atlantic
Ocean, managed to drop the extra baggage of "safety nets"
required by
US regulators to ensure the security of your future claims.
So what's going on? To get started in understanding this
"other
dimension" you need to get into a Special Purpose Vehicle
to cross
into the Financial Twilight Zone.
A Trip to the Financial Twilight Zone in
a Special Purpose Vehicle
Having passed into the Twilight Zone in the only vehicle
that can get
you there, now you are going to have a look around at the
scenery and
at the main players.
Entering the Twilight Zone, the first thing you will
notice is that
the atmosphere is thick with financial securities and this
takes the
place of the regular air we are used to in the regular
daylight world.
The quality and quantity of this twilight zone atmosphere
is regulated
by the characters known as the investment bankers, who
seem to be
everywhere.
Traveling around the Twilight Zone you see some familiar
faces they
look like the federally insured banks that we are used to
seeing
during our daily lives, except that they are dressed a bit
differently
and look very relaxed. Some - saying they are on a trip to
Bermuda or
the Bahamas - are dressed in their shorts and swimming
outfits.
Others, dressed up in their skiing gear, say they are
touring the
Swiss Alps. All in all, they say that the paths through
places like
the Caribbean Islands and Switzerland make travel through
the Twilight
Zone a lot smoother. And certainly one can easily see
that, in this
environment, the bankers are much more friendly and easy
to get along
with than when you come across them in broad daylight. One
thing
that's a bit unsettling about them though When you look
behind their
banking houses you see piles of "Toxic Sludge" that nobody
in the
Twilight Zone wants to talk about. When you question the
bankers about
whether it's going to get cleaned up, the cheerful
disposition
suddenly vanishes and they give you a look that clearly
says "If you
keep asking questions like that, you'll never make it back
out into
broad daylight."
Excerpt: Closing Statements, Twilight Zone Episode 52
1961. Rod
Serling
Quickly moving on from that tense situation, you come
across the
insurers you are also used to seeing in your daily life.
They are
dressed up in a similar fashion to the bankers though they
are not
exactly as happy, they say, since they don't have the
support of the
federal deposit insurance. However, it's the good deals
from their
mentors, the global reinsurers, that seems to cheer them
up a lot.
Over on the horizon you see two huge bodies, actually
bigger than most
of the bankers and insurers dotting the landscape. You
can't quite
make them out, even when you get up close, but they
introduce
themselves anyway as Fannie Mae and Freddie Mac. It's hard
to tell
what they really are and the information you get from them
is
confusing. You ask them "Are you private bodies or are you
government
bodies?" And you never get a straight answer. In fact
every time you
ask, Freddie says private and Fannie says government. Then
the next
time you ask its the other way around! As always, in
travel throughout
the twilight zone, investors are always whizzing by, but
when you ask
them, they seem just as confused about the status of
Fannie and
Freddie. So its best just to give up and move on.
Usually, if you are confused about the atmosphere of
securitizations
you can go ask one of the investment bankers. For example,
if you are
confused about a certain type of financial instrument you
can ask them
"Is that a debt, or equity, or maybe even a trading
liability?"
They'll usually respond with something like "Well, that
depends What
would you like it to be?" And they can make exactly what
you wish for
- Just like Magic!
Excerpt: Closing Statements, Twilight Zone Episode 48
1961. Rod
Serling
Moving along we can just make out the outlines of some
very dark
objects, never seen in broad daylight, called the Hedge
Funds. They
seem to congregate in and around a great big dark
building, also never
seen in the daytime, called the Derivatives Casino. The
car park at
the Casino is packed full with Special Purpose Vehicles.
The bankers
and insurers are often seen coming and going into and out
of this
building - but only in the twilight zone, never in broad
daylight, of
course, since the Casino doesn't exist in broad daylight.
At the center of the Twilight Zone is a complete black
box, almost
like a black hole. But instead of everything being pulled
towards it,
what happens is that every time there is but a little
ripple emanating
from the black box, it seems to cause a much bigger effect
throughout
the rest of the twilight zone - first hitting the banks
and then
jolting Fannie and Freddie so that they sometimes lose
their balance.
In this way, a little ripple from the black box, once it
passes
through the banks and Fannie and Freddie, gets much
magnified in its
impact on the rest of the players. They call this black
box, of
course, the Central Bank, or sometimes the Federal Reserve.
Such ripples that get magnified many times over can also
come from
other parts of the Twilight Zone. Lots of times you can
even see the
implosion of one of the dark objects known as the Hedge
Funds or the
crash of one of the larger speeding investors cause
massive waves
throughout the Twilight Zone. Interestingly, ripples can
also come
from the daylight world that we all live in, cross into
this other
dimension to cause massive destabilization then ripple
back out to the
daylight world.
Well, I think that's enough of our visit for now. Once you
get back in
your Special Purpose Vehicle and travel back into the
regular daylight
world where the regular people live, this amazingly
intricate "other
world" known as the Financial Twilight Zone completely
disappears from
view but you know its still there.
Now that we are back out and can think clearly, lets talk
in some
detail about what we've just seen starting with the
composition of the
atmosphere - or the securities. But we can't do that
without first
discussing those confusing objects called Fannie Mae and
Freddie Mac
that we just met in the Financial Twilight Zone.
The Birth of the Mae Sisters and Cousin Freddie
Securitization in its modern form was, like many a
financial
invention, initially born out of desperate times. Recall
that in
Wizards Part 10 we spoke of the regulatory blitz of the
1930's during
the Great Depression that brought in many new banking and
stock market
rules, such as the Glass-Steagall Act and the Securities
and Exchange
Commission. Such regulatory blitzes really only come along
in times of
utter desperation, like a complete financial and economic
collapse,
and they only come along because they have to. Because you
cant get
the economy up and running unless you bring in some
regulations to
bring back confidence - the main ingredient for a
functioning economy.
Restoring confidence in the financial system and
stimulating credit
creation was a primary aim of the banking rules and
federal deposit
insurance implemented during the Great Depression that was
discussed
in Wizards Part 10.
This was also the primary aim of another act we did not
get to speak
about in Wizards Part 10 - that is, the National Housing
Act of 1934.
The National Housing Act saw the introduction of the
Federal Housing
Administration, or FHA, whose primary function was to
provide
insurance of home mortgage loans made by private lenders.
This
insurance meant that a lender would be repaid by the
government in the
event of loss on default by mortgagees. During such hard
economic
times this mandate of the FHA would stimulate credit
creation by banks
and other lenders for investment in home building which,
in turn,
would provide more affordable housing and create jobs and
stimulate
further economic growth. Simultaneously, the government
insurance
backing would shore up confidence in the now shaken and
much
mistrusted financial sector.
The practical implementation of this federal mortgage
insurance took
the form of the chartering of a government corporation to
buy and sell
the mortgages that the government would insure. The first
such
corporation was set up in 1938 and called the Federal
National
Mortgage Association, also known simply as "Fannie Mae".
In 1968 they split Fannie in two and made a twin sister
out of her
that they called Ginnie Mae (short for Government National
Mortgage
Association). Ginnie stayed with the government doing what
Fannie used
to do and Fannie ventured off into the private markets.
Fannie became
fully owned by private shareholders, yet with a Charter
and Mandate
specified by Congress. Instead of complying with SEC rules
and other
rules that apply to private enterprises, Fannie is instead
regulated
by the Department of Housing and Urban Development (or
HUD) who tells
her basically what business to be in, and also by the
Office of
Federal Housing Enterprise Oversight who monitors her
financial
stability. Occupying that special area of the Financial
Twilight Zone
that is not quite government, not quite private
enterprise, Fannie Mae
is instead referred to as a Government Sponsored
Enterprise or GSE.
Before long it was thought that the Mae sisters were
lonely and so
they made up a cousin officially called the Federal Home
Loan Mortgage
Corporation, but known as Freddie Mac, who looks a lot
more like
Fannie than Ginnie. Freddie is another GSE or Government
Sponsored
Enterprise, owned by private shareholders but regulated by
HUD.
The job of Fannie and Freddie has been to provide an
active secondary
market for the home mortgages of low to middle income
families. That
is, while they don't make home loans directly themselves,
they buy
individual home mortgages from primary lenders such as
banks and
mortgage companies, package together bunches of these
loans and sell
them back into the capital markets as mortgage-backed
securities. The
primary objective of creating such active secondary
markets for these
mortgages is to make sure that enough capital is available
for
affordable mortgages for families with low to moderate
incomes.
Without the ability to sell off such mortgages for cash to
another
party, banks and other lenders would make less loans in
the low to
moderate income groups and/or charge higher interest rates
for fear of
default and burdensome foreclosures.
Up until the 1980s the mortgage-backed securities issued
by these
entities looked more like what is known as simple
"passthroughs",
whereby an investor in a security issued by Fannie or
Freddie simply
got a share of the interest and principal paid by the
underling group
of mortgagees, with a guarantee on repayment provided by
Freddie Mac
or Fannie Mae. But the deregulatory blitz of the 1980s
ushered in the
rise to power of the investment banking class and the
corresponding
rapid development and population of that parallel world
known as the
Financial Twilight Zone we got to visit earlier. And so
began a
totally new world of asset securitization, the very stuff
underlying
this parallel financial universe
Excerpt: Closing Statements, Twilight Zone Episode 51
1961. Rod
Serling
The
Securitization Atmosphere of the Investment Bankers
One of the problems with the "passthrough" type securities
mentioned
earlier is that the cashflow stream is uncertain. It can
be very long,
with long fixed rate mortgages, and can also change
suddenly if
interest rates drop and mortgagees decide to prepay their
loans. This
can make such investments quite unattractive to say, long
term
investors such as pension funds and insurance companies
who are
looking for guaranteed payments long into the future.
Furthermore,
shorter-term investors might find these instruments
altogether
unattractive.
Investment bankers of the 1970s and 1980s invented a
different type of
mortgage backed security to get around these problems.
Basically,
given a pool of home mortgages, you could come up with a
series of
different tranches of securities or bonds or notes that
you would
issue against that pool. The first, or senior, tranche
from the pool
would have a fixed interest rate and set principle
repayments and be
the first set of cashflows to be paid out of the pool. The
next
tranche might only get interest payments and then start
getting
principle only when the senior tranche is fully paid off,
and so on
all the way down to the Z-tranche or the "toxic sludge" of
leftovers
that only gets repaid once ever other tranche is repaid.
The senior
tranche is the most secure instrument and so gets the
lowest interest
rate. The toxic tranche is more like a speculative
investment and has
a high potential yield but also high risks associated with
it. In this
way, a pool of pretty unglamorous and ordinary mortgages
could give
birth to a smorgasbord of different financial instruments
to suit
anyone's tastes.
The wild capital markets of the 1980s thought this was
just about the
most fantastic monetary invention since fractional reserve
banking and
they were wild about it! Fannie and Freddie alone have
grown to have
trillions of dollars of home loans under their belts using
this new
wizardry. Not only has this invention helped the GSEs -
Fannie Mae and
Freddie Mac - provide ever more capital for home
financing, it has
also facilitated secondary markets in mortgage-backed
securities
issued by various other bank and non-bank entities. This
invention
that was able to turn the humdrum home mortgage into a
slew of fancy
securities to match anyone's desires multiplied the
attractiveness of
mortgage-back securities many times over and,
consequently, capital
has been flooding in to the mortgage market ever since. In
retrospect
then, you might put more blame for the phenomenon of urban
sprawl on
the investment bankers than anyone else!
But the growth of the Financial Twilight Zone did not stop
there! For
it was soon realized that anything with a future stream of
cashflows
could be bundled up in such a fashion and have a set of
designer
financial instruments issued against that bundle. By the
late 1980's
auto loan and credit card receivables were being bundled
up in such a
fashion. By the 1990s the securitization market was
extended to cover
future record and movie sales, health club membership
fees, tax liens,
life insurance policies and catastrophe insurance, to name
a but a
few. Name anything with a future stream of cashflows, and
it can be
securitized! Notably, in the late 1990s we also saw
securitization
become used more and more by banks to sell corporate loans
off to the
capital markets. Citigroup and JP Morgan Chase's
activities in this
area have recently received a lot of attention, as we
shall discuss
later.
Securitization is attractive to both the issuer and the
investor in
the new securities for various reasons. We already talked
about how
these instruments have been designed to be attractive to
the investor.
For the issuer - that is, the one who originated the
mortgages or
first hooked you on a credit card - securitization has
several
attractions. One, especially so for banks, is to free up
regulatory
capital, or the "safety net" for depositors that we spoke
about in
Wizards Part 2 and 11, so it can be used in the next
Wizard adventure.
It should be noted that the current rules specifying the
level of
"safety nets" that bankers must maintain in the form of
shareholder
capital, actually encourage banks to remove low risk
assets from their
books and retain the higher risk assets. Another
attraction of
securitization is the removal of undesirable assets from
the balance
sheet, and into "off balance sheet" vehicles. Other
attractions
include that securitiztions issued through an SPV can be a
cheaper way
of raising capital and increasing liquid assets, rather
than having to
go directly to the capital and debt markets.
What this explosion in securitization has done is to
create an
explosion in the availability of capital for investment in
whatever is
being securitized. Hence we have seen an explosion in
credit card
offers, home equity loans and basic home loans, auto
loans, corporate
financing, media and entertainment financing, and so
forth. Like
placing the blame for the explosion in urban sprawl in the
past
decade, you might also need to credit the innovative
investment
bankers for all the credit card solicitations you get
every day, as
well the design of transactions that have allowed
corporations to hide
debt, and construct other accounting wizardry.
So what does all this have to do with Special Purpose
Vehicles and the
fact that so many characters in the Financial Ether seem
to be hanging
out on Caribbean Islands and Swiss Alps? To understand
this, we better
get back to our Special Purpose Vehicle and look at the
mechanics of
it.
The Mechanics of the Special Purpose Vehicle
The more traditional Special Purpose Vehicles, or SPV
Version 1, work
as follows. The party with the loans or other receivables
to be
securitized is known as the originator and they transfer
these loans
or receivables into a Special Purpose Vehicle to isolate
them from the
originator. The SPV raises funds from the capital markets
to pay for
these transferred assets and this money goes back to the
originator.
The way these SPVs raise funds is by issuing notes or
securities in
the form of bonds to investors. Such notes or bonds then
give these
investors a claim on the assets held by the SPV and, in
theory, the
claim is supposed to stop there. That is, in a true
transfer of risk
via the securitization process there should be no extra
claims on the
originator. Part of the reason for Enron's rapid demise
last year was
that, in this case, there was a contingent claim of the
investors back
on the originator (Enron) in many of their SPV's. Based on
recent
regulatory rulings from the main bank regulators, there
seems to be
some hidden guarantees lurking behind bank
securitizations, too - part
of the "Toxic Sludge" we spotted earlier in the Twilight
Zone.
The notes issued against the assets held in the SPV can be
designed to
give rise to the many types of varieties of instruments to
suit
different types of investor needs, as we spoke about
earlier for
mortgage back securities. But what's interesting here is
that the
highest risk tranche, the equivalent of the Z-tranche for
the
mortgage-backed security, also known affectionately as the
"Toxic
Waste" of the securitization, is often retained with the
originator.
That is, even though it might look like the originator has
gotten the
assets and associated risks off of its balance sheet, they
actually
retain the most risky part! And this is in addition to the
toxic
sludge hidden guarantees we just spoke about that the bank
regulators
have recently issued statements on. The behavior of both
of these
rapidly growing poisonous piles has not yet been tested in
an economic
downturn, and its a hidden risk in the Financial Twilight
Zone that
nobody seems to want to talk about.
To avoid any extra taxes, regulations and disclosure rules
associated
with putting an SPV between the originator and investor,
especially
the more regulated originators such as banks, many SPVs
are set up in
favorable tax and regulatory jurisdictions. Hence the
preponderance of
them in places like the Bahamas, Bermuda, Cayman Islands,
Channel
Islands and so forth. In addition places like Switzerland
and the
Switzerland of Latin American, Uruguay, are favorite
places for
limited taxes, regulatory avoidance and bank secrecy.
Here are some interesting words from Senator Carl Levin of
the
Permanent Subcommittee on Investigations at the July 23,
2002 hearings
on JP Morgan Chase and Citigroup's use of such vehicles.
Excerpt: Senator Carl Levin "Wizards behind the Curtain"
July 23, 2002
Hearing
We'll hear more on this hearing and what happened there a
bit later.
The Special Purpose Vehicles Parked at the Over-the-Counter Derivatives
Casino
Recall on our journey through the Financial Twilight Zone
we could
just make out the figures of the shady Hedge Funds and the
outline of
the Over-the-Counter Derivatives Casino with a lot of
Special Purpose
Vehicles in the parking lot. What was that all about you
might be
wondering?
Recall that we spoke about the OTC Derivatives Casino in
Wizards Part
11. There are several types of derivatives games that
might be played
in conjunction with securitization. Let's just talk about
a couple of
them:
First are the derivatives that might be used in relation
to interest
rates. Take for example the huge pools of mortgages on the
books at
Fannie Mae and Freddie Mac. Fannie and Freddie are buying
pools of
mortgages from banks (who issue the regular mortgages to
regular
people like you and me) and then selling these cashflows
off in the
form of much different securities. The revenue from the
mortgages will
come in over the lives of these mortgages, but their dues
back to the
securities holders is often due in a different pattern,
and often over
a much shorter period than the mortgages. If interest
rates suddenly
change direction Fannie and Freddie could find themselves
in a whole
lot of trouble. So, they say, they hedge this risk by
entering into
some offsetting gambles at the OTC Derivatives Casino. An
interest
rate derivative contract basically says that your
counter-party will
reimburse you if interest rates move in a certain
direction.
But how do we know that this hedging makes them safe and
sound? They
are not regulated by the bank regulators nor by the SEC
because of
their special status in between something that's
government and
something that's private. Furthermore the OTC derivatives
market is
not regulated. How well hedged are Fannie and Freddie, and
who are
their counterparties - the big US banks maybe? After all,
they are the
biggest players at the OTC Derivatives Casino. And what
about credit
risks - Fannie and Freddie basically stand behind all
these mortgages
and bear the risks of default of mortgagees. What
potential risks does
all this impose on the US bank depositor and taxpayer?
On this topic, one of the biggest concerns arises from
Fannie and
Freddie's peculiar status of being mostly private but
partly
government bodies. Therefore there has been a perception
among
investors in their securities, and maybe their derivative
counterparties (the banks) that Fannie and Freddie would
get bailed
out by the US Taxpayer if they ever got in trouble. This
may have lead
some "too-big-fail" players into risks they shouldn't be
taking - but
we have no way of knowing with so much of these markets
permanently
operating in the Twilight Zone and never exposed to the
daylight.
Excerpt: Closing Statements, Twilight Zone Episode 46
1960. Rod
Serling
There is a whole array of other derivatives gambles going
on that,
recently, have been causing alarms to sound in the bank
regulator
circles. This includes the Toxic Sludge generated by
hidden guarantees
(sort of like hidden insurance or derivatives) that can
only be seen
in the Twilight Zone. Similar things reared their ugly
heads in the
Enron scandal, but we have heard much less about them in
terms of what
the banks are doing and what the bank regulators have
lately been
observing on the bankers' books. Shocked by the recent
scandals the
four main US banking regulators issued a series of
"Supervisory
Letters" on May 23, 2002 about the so-called Toxic Sludge
(though they
didn't call it that) they have found on the bankers books.
The press
generally seems to have missed this. I'll post some links
to the
Supervisory Letters and explanations on the Wizards of
Money web site.
To learn more about this aspect of the bankers backyard
toxic sludge
it is informative to read a May 23, 2002 Supervisory
Letter issued by
the Federal Reserve Board saying that over the past few
months the
bank regulatory bodies "have become aware of a number of
instances in
which a banking organization provided credit support
beyond its
contractual obligation to one or more of its
securitizations". The
latter part means that these guarantees have been provided
outside of
legal contracts, and hence away from the view of
regulators and
completely in the Twilight Zone. What this means is that,
while the
banks are acting as if all risks underyling these
securitizations have
been completely removed from their balance sheets (and
hence they hold
NO associated safety net) they are in fact taking on
invisible risks.
In a way these hidden guarantees behave like derivatives
or insurance
on the assets being securitized, and as such hidden
guarantees came
back to haunt Enron, so they could the banks. Just what
banks are
taking these risks, why they are taking them, and how
severe the
problem is, cannot be ascertained from these Federal
Reserve
Supervisory Letters. But this issue should be watched
closely.
The Special Purpose Vehicle - Deluxe Version
and the Banking Scandals
In yet another type of derivative transaction, credit risk
is the main
focus. Not only have banks and others been using Special
Purpose
Vehicles to securitize their corporate bond and loan
portfolios, but
now they have come up with Special Purpose Vehicle Version
100 - the
Virtual Special Purpose Vehicle - to "effectively"
transfer credit
risk. These "synthetic obligations" now come in many forms
- from
Synthetic Corporate Debt Obligations to Credit Linked
Notes to Credit
Default Swaps. Without going into how these work, we just
note that
this is a very new and rapidly growing area of the OTC
derivatives
market and has really caught worldwide financial
regulators by
surprise, and actually made them extremely nervous. This
market is so
new that it has not been tested in a down market and,
already, we saw
two such transactions blow up in the big banks' face
during the Enron
Scandal.
Citigroup had set up a Credit Default Swap transaction
through a
Special Purpose vehicle called Yosemite that was a focus
of the July
2002 US Senate Inquiry into the role of banks in the Enron
Saga. At
the end of the day the transactions through these vehicles
which
appeared to involve oil and gas trades, enabled Enron to
disguise true
debt as the more appealing trading liabilities, and thus
made Enron
look like they were in better financial shape than they
actually were.
Citigroup opted for the Yosemite vehicle structure to
enable it to
pass the credit risks (or risk of default) into the
capital markets -
they surely didnt want to take such risks themselves!
Perhaps they
already knew too much. While the Senate investigations did
a good job
at revealing this accounting wizardry at Enron, so far
neither the
Senate, nor Congress as a whole, nor the general press,
have gotten
themselves worried about the broader risks underlying the
credit
derivatives market as a whole, and its total avoidance of
the daylight
in its five or so years of existence.
The following is an excerpt from the July 23, 2002 Senate
hearing into
Citgroup's role in the Enron Saga. Included is a
description of how
the Yosemite vehicles were set up. What's interesting here
is that,
while Senator Fitzgerald initially addresses his question
to Maureen
Hendricks, a managing director on the Investment Banking
side at
Salomon Smith Barney, it is in fact Mr Richard Kaplan,
head of the
Credit Derivatives division at Citigroup that has to step
in and
explain the structure. After all, as is explained early
on, the
Yosemites were his babies - this invention is only
befitting of the
deepest, darkest warps of the Twilight Zone.
Excerpt: Richard Kaplan, Head of Credit Derivatives at
Salomon Smith
Barney/Citigroup explains the Yosemite Structure. Initial
comments by
Maureen Hendricks of Salomon Smith Barney with some
questions from
Senator Fitzgerald. 5 minutes.
After hearing all this you might be wondering why
investors would be
wanting to take on this credit risk by buying the Yosemite
Notes.
Interestingly, one of the conditions specified in the
offering
prospectus was that investors WOULD NOT KNOW the details
of the assets
underlying the Yosemite Notes. And these investors turn
out be our
trusted banks, insurance companies and pension funds, with
no doubt
some big time hedge funds thrown in for good measure. Its
best to let
the bankers tell this story about the so-called "blind
trust" notes:
Excerpt: Kaplan and Hendricks of Salomon Smith Barney tell
us about
"blind trust" notes in the Credit Derivatives game and our
pension
funds not knowing what they're investing in.
Not to be outdone, JP Morgan Chase offered similar
debt-hiding
transactions to Enron through a vehicle known as Mahonia
based in the
Channel Island Jersey and, as it turns out, owned by a
Charitable
Trust. First we'll let Mr Delappina, Managing Director at
Morgan Chase
Bank NY gives us a little refresher on structured finance,
securitizations and how this applies to their dealings
with the Energy
Companies.
Excerpt:Delappina of JP Morgan Chase Bank NY on Structured
Finance
One of the conditions for Enron being able to treat these
truly debt
transactions as benign trading liabilities for oil and gas
trades, was
that the intermediary Mahonia had to be independent of the
banks and
independent of Enron. While Mr. Delappina dis a splendid
job of
painting us a picture that that actually was the case,
Senator Carl
Levin of the Senate Investigative Committee soon points
out that this
picture is not a very accurate one, and that in fact the
Chase Bank
did have control over Mahonia via the so-called
"Charitable Trust".
Lets listen to this interesting exchange between Delpinna
and Levin at
the July 23, 2002 Senate Hearings.
Exerpt: Senator Levin and Mr Delapinna from JP Morgan
Chase paint
different pictures of the "Charitable Trust" involve in
JP's Enron
dealings.
Note: Due to time contraints on the Audio File, the
following did not
make it into the audio version of Wizards Part 15 but will
be covered
in more detail later...
Securing
Homeland Capital when Overseas Adventures Go Wrong
The July 23, 2002 Senate hearings into the involvement of
the two
largest US banks in financing various Enron scams rippled
throughout
the markets and placed the spotlight on the spookiest
risks these
banks are exposed to, not the least of which being their
massive OTC
derivatives exposures. Not to mention their exposures to
emerging or
developing countries, and large remaining exposures to the
Telecos and
Energy companies.
Weeks after this hearing the country of Brazil, dealing
with a falling
currency, looked like it may default on its debt. Given
the almost $30
billion exposure of the biggest US banks to Brazilian
borrowers its
probable that confidence in these banks would have been
dealt
permanent harm if Brazil defaulted. According to an August
8, 2002
Wall Street Journal article, the banks put a lot of
pressure on the US
administration to push for an IMF bailout of Brazil. Soon
enough a
sizable $30 billion bailout package was offered to Brazil
to help it
stabilize its currency to prevent default on its debt
linked to the
"hard currencies". These are the sorts of events that we
spoke about
in Wizards Part 5. As anticipated by the US banks this
helped restore
confidence in them.
Within days, downward pressure was already back on the
Real, the
Brazilian currency. It will be interesting to see if the
big US banks
reduced their exposure to Brazil following the IMF bailout
announcement, hence helping themselves while compounding
Brazil's
problems. It would also be interesting to know if the
speculative
hedge funds, and the trading arms of the banks themselves,
are back to
their usual tricks in the arbitrage game and attacking
this weak
currency. We spoke about this common play, or form of
monetary attack,
in Wizards Part 5 - called Monetary Terrorism. This
arbitrage game
basically drains out the bailout and other reserve funds
from a
country very quickly and is a primary catalyst for the
collapse of
currencies.
As we've discussed in earlier episodes of Wizards, these
bailouts also
pose significant moral hazard, whereby "too big to fail"
banks take
excessive risks with our deposits, knowing they will
always get bailed
out. Hence the systemic risks throughout the global
financial system
are increased with every bailout.
Whatever happens in Brazil and the rest of Latin America
now, it
certainly appears that much of the rationale for this IMF
bailout was
aimed at financial security for the US Homeland.]
There's a
Generic in my Shark Fin Soup!
In this, the sixteenth episode of the Wizards of Money,
we're going to
take a look at the world of drugs - the legal ones, that
is. The star
of this episode is the only industry more profitable than
the
commercial banking sector throughout the 1990s - and
that's the
pharmaceutical industry, of course.
We'll start with a look at the recent wave of
pharmaceutical
mega-mergers and what's driving them from the ominous
"Shark Fin
Curve", to the search for the elusive "Blockbuster Drug",
to the need
for ever more shelf space. Then we'll look at the battles
between the
brand name drug companies and the generic companies,
governments, and
the other big giants of healthcare - the managed-care
companies.
This journey through the shark-infested world of "legal
drugs" will
give us a good look at the bizarre human behavior that
results from
allowing the capital markets and the patented medicine
model to
dominate decision-making in one of the oldest of human
pursuitsfinding
remedies for human illness. Allowing this behavior to
continue
unfettered may very well end in the capital markets giving
themselves
an incurable disease. For, while the capital that flows
into drug
research and development is obsessed with a couple of
shark fins on
the horizon, it is failing to notice the tidal wave
swelling just over
the horizon. This tidal wave is the global HIV/AIDS
crisis, already
striking at the very thing the capital markets need to
survive.
Far away, in the land where Shark-Fin soup is a
high-priced legacy of
Imperial times, HIV/AIDS is rearing its ugly head. As the
epidemic
rips in to China, will the US be able to continue its
token level
support for this crisis of the developing world? Or will
this threat
to the labor force of a major trading partner provide the
shock
necessary to remind us that illness prevention and cure
is, after all,
a social service that does not fit well into the confines
of 20-year
patent monopolies. And will the exponential growth of
HIV/AIDS in
Eastern Europe and the former Soviet states, right on the
doorstep of
the European Union, wake up the rest of the West to the
need to either
act now, or risk losing their global marketplace?
Let's get started with a discussion of what's been going
on in the
world of patented drug monopolies.
Predator-Prey Dynamics in the Drug Sea
A July 16, 2002 article in "The Economist" announced the
union of the
two drug giants Pfizer and Pharmacia by opening "Depressed,
bald-headed men with erectile dysfunction should be
especially
pleased." The companies that make the world's leading
treatments for
baldness, depression and Mothers Nature's way of telling
gentlemen
their reproductive years are over, have combined to become
the world's
biggest legal drug giant. The Pfizer-Pharmacia combo
boasts over $50
billion in annual drug sales and spends about $7 billion a
year on
Drug R&D (Research and Development), plus another $3 -
4 billion on
drug advertising.
As in most industries, the capital markets drive the
classic
predator-prey dynamics of the pharmaceutical sector. You
either eatOr
you get eaten!
The Pfizer digestion of the smaller Pharmacia, announced
in July 2002,
was just the latest episode in the struggle to the top of
the food
chain. Let's go back to 1995 when much of the mega-merger
madness was
just heating up. In that year, Glaxo Holdings gobbled up
Wellcome Plc
to form Glaxo-Wellcome. The following year the Swiss drug
giant
Novartis was formed out of the merger of Ciba-Geigy and
Sandoz. 1998
saw the creation of Aventis out of the fusion of smaller
drug
companies and AstraZeneca from Astra and Zenenca. About a
year later
Pharmacia & Upjohn thought Monsanto looked pretty
tasty, so they
swallowed them whole, only to spit out the controversial
agribusiness
piece in August of this year. Also in 1999 we saw Pfizer
swallow
Warner-Lambert. Glaxo-Wellcome and Smith-Kline-Beecham
were fused
together to form GlaxoSmithKline in 2000. And just when we
thought the
mergers couldn't get any bigger - Pfizer and Pharmacia
announced their
merger, pending regulatory approval, in July 2002 to
outsize
GlaxoSmithKline, and become the biggest fish in the drug
sea.
And there are rumors of yet more drug mergers on the
horizon!
The modern pharmaceutical industry has its origins in the
late 1800s
when it became possible to mass-produce compounds such as
morphine and
cocaine. By the early twentieth century drugs and
compounds were
patented by various companies to protect their
discoveries. A patent
on a branded drug or chemical gives the company a monopoly
on sales of
that chemical for a specified period, enabling them to set
high prices
in the absence of competition. The argument for patent
protection is
that it enables the developer to recover their investment
in R&D plus
a profit, hence providing incentive to private industry to
find new
cures. However, in order for the company to lure customers
into buying
such a high priced product they also need to spend a lot
of money on
advertising and marketing to convince people that its a
very special
product. There are many arguments both for and against the
patent
model for pharmaceutical development and we shall revisit
these later.
Today, the brand name drug companies look nothing like
their chemical
commodity predecessors of the 1800s. New products require
large
investments in R&D and take a long time to bring to
market. The drug
giants are dependent on patents, marketing and branding to
make a
profit. Consequently, the pharmaceutical sector has more
in common
with the Hollywood movie industry than with any public
service
provider - A new drug must become a profitable
"Blockbuster", or it's
not worth the effort to develop it.
In contrast, generic drug companies spend comparatively
little on R&D
and advertising, existing primarily to compete for market
share based
on price once a patent on a brand name drug has expired.
Once such a
patent expires, generic companies can copy the drug and
can afford to
sell it at a lower price (as low as a quarter of the
branded drug
price) since they don't have as much R&D and
advertising costs to
recoup.
After roaring successes and record high profit levels
throughout the
1990s, today we find that all is not well in the world of
blockbuster
remedies. Ailments in the branded pharmaceutical sector
include
looming patent expiries and the resulting competition from
generic
companies, a drug R&D pipeline that is drying up, and
angry
governments, corporations, consumers and managed-care
companies tired
of high drug prices.
These common enemies are forcing all these unions amongst
the drug
giants who hope that consolidation will allow them to do
more of their
two favorite things at lower cost. These two things are
(1) Advertise
and (2) Produce Blockbusters. The future dangers to the
general public
of all this industry consolidation, in terms of even
higher drug
prices and, more seriously, the lowered ability of the
pharmaceutical
sector to respond to real illness, are not getting much
attention. The
latter is reflected not only in the untreated epidemics
haunting the
developing world, but even here in the US, with increasing
reports of
shortages of basic medicines and vaccines at many
hospitals.
These problems are all compounded by the fact that drug
companies are
fighting dirtier and dirtier to counter the 'Attack of the
Generics'.
Attack of the Generics! Meet the Shark Fin Curve.
A story in the Wall Street Journal in June of this year
about the
birth of the much touted heartburn drug Nexium gave many
people their
first good look at the importance of the "Shark Fin Curve"
haunting
the pharmaceutical industry. You must know the Nexium ads,
with a
bunch of middle aged folks standing around in some canyons
that
presumably represent an eroded esophagus, all mumbling "I
didn't know,
I didn't know, I didn't know".
Insert: Nexium Ad
Well, I bet they didn't know thisThe only reason Nexium
exists is that
its predecessor, Prilosec, which is almost exactly the
same - is
coming off patent. It's sliding right down the other side
of the Shark
Fin Curve. This eroded esophagus business is all about
making the new
patented drug Nexium seem different to the one that will
now be copied
by the generics.
The Wall Street Journal article describes the Shark Fin
Curve as the
Sales versus Time graph of a patented drug. It looks like
an
upside-down "V". As soon as a patented drug is launched,
revenues
generated by it shoot up over time like the rising edge of
a shark
fin. But the minute it comes off patent they plunge just
as quickly as
they rose, as the generic companies come in, copy the
drug, steel
market share and force prices to drop. We'll talk more
about Shark
Fins and eroded esophagi later when we look at some case
studies of
how the big drug companies fight back against generic
competition.
During the roaring 90s the pharmaceutical industry always
seemed to be
topping the charts as the most profitable. We are all
familiar with
the Blockbuster Drugs who made this dream a reality and
have become
celebrities in their own right - there's Viagra, Vioxx,
Celebrex,
Claritin, Nexium, Prilosec, Lipitor, Rogaine, Zocor,
Zoloft, Prozac,
Paxil and Lamisil - to name but a few. Some will be on
patent for many
more years but others are soon scheduled to come off
patent. Many
patented drugs are simply 'me-too' drugs, designed to
achieve the same
effect as other patented drugs, but really add little
value to society
as a whole. To overcome lost revenues from patent expiries
and the
me-too drugs, each drug giant needs a certain number of new
blockbuster drugs emerging from the R&D pipeline every
year. Massive
advertising campaigns are then designed to sell enough of
the drug at
a high enough price to recoup the R&D and advertising
costs plus a
target profit level.
But the big pharmaceuticals, much to their dismay, are
finding that
the blockbuster drug cabinet is bare, even after throwing
piles of
dough into the R&D bucket. Despite the extensive range
of the
silliness of the illnesses for which blockbusters can be
made to
remedy, such as toenail fungus and hair shortfalls, big
pharma is
still finding that it can't find enough new drugs to bring
to market.
This makes them more desperate to maintain high revenues
on existing
patented products, so they pour more and more funds into
advertising
and into fighting the generic companies in court.
End Result: Profits are down in the pharmaceutical
industry and the
near future looks glum. And we get to see even more drug
ads!
Add to all this the following pressures on the drug
giants: * European
governments dare to regulate prices of their precious
Blockbusters, *
US State Governments are now cracking down on some of Big
Pharma's
desperate practices to shut out the generics, * Drug
companies get
pressure from managed-care companies to lower prices, *
Drug companies
now face a whole new set of giants - a coalition of
corporate giants
called "Business for Affordable Medicine" - whose
healthcare expenses
have been shooting up with the cost of prescription drugs.
This
coalition includes such behemoths as General Motors and
Wal-mart (for
example General Motors pays over $50 million a year just
to buy the
heartburn drug Prilosec for its employees and they are not
happy).
It looks like the drug companies, poor things, could use a
dose of
their own anti-depressants!
True to form, however, the pharmaceutical industry is not
one to take
all this lying down. It's fighting back on all fronts, in
a series of
vicious attacks, coupled with consumer manipulation that so
characterize a desperate industry.
Before we study the attack strategy of big pharma, lets
get to know
the industry a little better and the regulation that
defines its
operating parameters.
A Little Bit of US Drug History
Miracle drugs and pervasive drug advertising have been a
staple of the
American diet for both the body and the mind for over a
hundred years.
After more than 30 years of pressure for food and drug
safety laws,
the year 1906 finally ushered in the landmark Pure Food
and Drug Act,
amid shocking disclosures of the use of poisonous food
additives and
cure-all claims for worthless and dangerous patent
medicines.
In 1927 the Food and Drug Administration (FDA) was formed
as the
regulatory arm of the government charged with enforcing
food and drug
law. The pharmaceuticals lost their battle against an
overhaul in drug
regulation in 1937, after a drug known as the Elixir of
Sulfanilamide
killed over a 100 people, including many children. This
paved the way
for the passage of the 1938 Food, Drug and Cosmetic Act
which, among
other things, required new drugs to be shown safe before
they could be
marketed. The Thalidomide scare of the early 1960s put
pressure on
Congress to further strengthen drug regulation. Still, the
brand-name
companies continued to prosper because they could set
whatever price
they wanted on patented drugs.
The year was 1984 when pharmaceutical companies first
started seeing
those shark fins emerge on the horizon, with the passage
of the
landmark Hatch-Waxman Act. Prior to this, generic drug
companies had
to perform the same rigorous testing on generic drugs that
the
companies with the initial patent had to perform. This made
competition from generics virtually a non-issue because
the investment
required to get regulatory approval could only reasonably
be recovered
where the producer could charge a sufficiently high price
for the drug
once approved. In practice, this meant that the
pre-Hatch-Waxman
regulatory structure was heavily biased in favor of the
companies with
drug patents - that is, the brand name drug companies.
The 1984 Drug Price Competition and Patent Term
Restoration Act (often
referred to as the Hatch-Waxman Act) changed the drug
competition
landscape drastically by lowering the regulatory hurdles
for generic
companies. It said that, rather than the generic companies
performing
all the safety tests that the original company with the
patent carried
out, they just had to show that the generic drug was
chemically the
same as the original drug, which had already been tested.
Finally,
there was a feasible economic model for the generic
industry. Once a
patent expired on a drug, they could replicate and sell
that drug for
a lower cost and still make a profit, because their
initial costs to
get the drug to market were now much lower.
Well, that part of the 1984 law sounds pretty good for the
consumer!
But lets be realistic - Do you really expect the
government,
especially during the Reagan administration, to turn its
back so
abruptly on its buddies in the pharmaceutical industry
just to create
a deal for the consumer?
It is one of the oldest tricks in the regulatory book to
create a law
that looks pretty damn good to the general public, but
with some back
door gifts to friendly private interests that are not
obvious to the
general public until many years later. The Trojan Horse
allowed into
the 1984 regulatory regime contained an army of methods
for the
brand-name companies to fight the generics, including: *
Extension of
patent protection to make up for time lost in the FDA
regulatory
approval process (hence the term "Patent Restoration"). *
Ability to
get multiple patents on drugs covering not only the
chemical itself,
but also all kinds of preparation methods and techniques,
making it
harder for the generics to prove they had the same drug.
These patents
could be staggered, such that when the patent on the main
chemical
expired the patents on various methods and techniques were
still in
force. * Wide ranging ability to challenge generic
companies in the
courts for patent infringement.
These back door methods available to keep patents going
form a major
arm of the strategy used by the brand-name companies to
ward off the
threat from generics. And it is these very loopholes that
coalitions
such as "Business for Affordable Medicine" and many
congressional
representatives are trying to close.
In later years the arsenal was to be extended by the
formation of the
World Trade Organization and associated revisions to
international
trade law that further strengthened patent protection of
pharmaceuticals.
Then, starting in about 1994, the brand name companies
launched into a
shameless, near exponential growth in direct-to-consumer
advertising
of prescription drugs for reasons that probably have to do
with
increasing pressure from generic competition and
managed-care
companies. This strategy proved critical in the battle
against the
Shark Fin Curve. Nowadays, barely an hour can go by on the
TV without
us hearing from our friends in Big Pharma.
Meanwhile, in other industrialized nations, the provision
of universal
healthcare means that drug prices are largely controlled by
governments. Drug companies have not been allowed such
freedom to
either set prices for patented drugs or to advertise
directly to the
consumer. Consequently the US consumer ends up not only
paying for the
privilege of being propagandized by the drug companies at
home, they
also subsidize lower drug costs abroad where prices are
regulated by
the government.
Put all these factors together and there's little mystery
as to why
prescription drug costs are spiraling out of control in
this country,
increasing at about 15
The Anatomy of a Counter-Attack from Big Pharma
To understand where some of the most unsavory behaviors of
the branded
drug companies come from, it is instructive to look at
several case
studies. We will look at two of the most frequently
referenced case
studies, whose stories can never be told enough. Be sure
to tell all
your friends, too!
Case Study 1 - Blockbuster Nexium: The marketing of the
heartburn drug
Nexium by AstraZeneca to counter the expiry of its patent
on the
similar drug Prilosec. Schering-Plough is currently using
similar
tactics to convert people from the allergy drug Claritin
coming off
patent, to the almost identical branded drug Clarinex.
Case Study 2 - Blockbuster Taxol: The tactics of
Bristol-Myers Squibb
to keep its monopoly on the cancer drug Taxol, originally
a gift from
the taxpayer funded National Institutes of Health
These case studies come from a very educational series in
the Wall
Street Journal that has been running throughout 2002
documenting the
tactics of the pharmaceutical industry.
Case Study 1: Blockbuster Nexium, by AstraZeneca (WSJ June
6, 2002)
Thanks to their bad eating habits, American are notorious
for stomach
related problems, and this has proved to be a gold mine
for the drug
industry. Stomach ulcer and heartburn drugs like Prilosec,
and Zantac
before it, were the largest selling blockbusters of their
time.
Insert: 1940s "American Stomach" Radio Ad
In 1995 AstraZeneca launched 'Project Shark Fin' to draw
up a battle
plan as its 6 billion-dollar-a-year heartburn drug,
Prilosec, was
going to lose its patent in April 2001. After years of
work, the Shark
Fin team came up with the rather unimaginative solution of
launching a
successor drug that was basically the same as Prilosec,
but would be
under patent when Prilosec lost its patent. They also used
every
loophole available in the Hatch-Waxman Act to construct a
legal
minefield for would-be copy-cats, to extend the Prilosec
patent as
long as possible, and give AstraZeneca more time to
convert Prilosec
users over to Nexium. The related legal battles over the
Prilosec
patents continue to this day and are closely watched by
those that
follow drug prices.
To convert post-patent Prilosec users to its patented
sibling Nexium,
AstraZeneca spends about $0.5 billion a year in adverting
of this
single drug, making it now the most advertised drug in the
US (taking
over from Prilosec a few years ago). And, so far that's
paid off
handsomely, as 60Nexium.
Nexium is one-half the Prilosec molecule and works pretty
much the
same, but it is just chemically different enough to win a
patent of
its own. The marketing spin that Nexium is better at
dealing with
eroded esophagus is good for converting Prilosec users
that watch
prime time TV over to Nexium but, according to the Wall
Street Journal
article, is built on very shaky scientific foundations.
According to
this article, four studies were commissioned to see if
Nexium was
better at healing eroded esophagus. Two studies found it
wasn't any
better at all and the other two found it was better only
by a smidgen.
Based on that piddling bit of evidence we all get to hear
about eroded
esophagi and purple pills with racing stripes on a daily
basis!
Such tactics form a common strategy for maintaining
revenue as drugs
come off patent. A similar strategy is being employed to
convert users
of the allergy drug Claritin to the new patented Clarinex.
Case Study 2: Blockbuster Taxol, by Bristol Myers Squibb
(WSJ June 5,
2002)
Bristol-Myers Squibb is currently being sued by 29 states
for
illegally delaying generic competition of its blockbuster
cancer drug
Taxol and costing governments and consumers billions of
dollars, as
well as costing lives. The basis of the suit is the claim
that
Bristol-Myers Squibb misled the US Patent Office to delay
generic
competition on Taxol.
But it gets more offensive than this! You see, Taxol is
derived from
the bark of the Pacific Yew tree and its pharmaceutical
benefits were
discovered not by Bristol-Myers but by the taxpayer-funded
National
Institutes of Health. The NIH handed Taxol over to
Bristol-Myers in
1991 as a big gift. In return Bristol-Myers, who charges a
hefty price
for Taxol, has acted like a badly spoiled child not
wanting to share
this gift with anyone, even ten years later.
Bristol-Myers Squibb, similar to what AstraZeneca did in
setting up
its minefield around Prilosec, has used the trick of
staggered patents
of every technique and methodology used to serve up Taxol
to maintain
its monopoly on the taxpayers' gift to them.
This is such a common strategy of counter-attack by the
brand name
companies against the generics that state governments,
consumers,
companies and health insurers that end up footing the bill
for
prescription drugs are themselves challenging it at every
turn.
Poor Bristol-Myers Squibb! In addition to these lawsuits
and angry
governments, the planned heir to the cancer drug throne, a
drug known
as Erbitrix, developed in a joint venture with ImClone
Systems, was
rejected by the FDA and wound up in a sordid scandal with
the queen of
good cooking - Martha Stewart. What are they going to do
with the
Shark Fin now?
These case studies were selected to give an idea of the
desperate
tactics used by the drug industry to boost sales revenues.
But, of
course, the tactics dont stop there. Following is a small
sampling of
other techniques employed to keep sales revenues and drug
prices high.
* Marketing to the medical profession. (Source: Kaiser
Foundation
Study, 11/2001) Drug companies spend the vast majority of
their direct
marketing budgets (about 85% of them) not on marketing
directly to the
public, but on marketing directly to doctors. This
consists mostly of
giving doctors buckets full of free samples - about $8
billion worth
in 2000 - noting that patients who start on free samples
often convert
to paying customers. It also includes giving doctors free
dinners,
sports tickets and other gifts, sponsoring conventions for
them, and
advertising in medical journals. In all, marketing to the
medical
profession costs the drug industry about $14 billion a
year. *
Advertising to consumers through pharmacies. (Source: WSJ
5/1/2002)
This newest form of direct-to-consumer advertising comes
in the form
of what looks like an educational booklet from the
pharmacy about
various treatments for your particular condition. It's
provided for
free when you purchase your prescription drugs, and looks
like a
public service provided by your trusted pharmacy. The
targeted
consumer would have to get their magnifying glasses out to
see that
these are actually advertisements from the branded drug
companies. The
trusted pharmacies are, of course, amply compensated for
their
distribution efforts and access to their databases for
target
marketing purposes. * Advertising Agencies Participating
in Clinical
Trials: (Source: WSJ 6/3/2002) Believe it or not, those
same drug
agencies that bring us the subliminal messages of eroded
esophagi
using big canyons, are entering the business of performing
clinical
trials for their clients. This should lower both
advertising costs and
expenses of clinical trials, for there is every incentive
for the
advertising agency to find that their tested drug is just
fantastic.
After all, they will have an exclusive on the advertising
account once
the product is launched.
As noted, these case studies and other techniques are just
a small
sampling of the techniques the branded drug companies use
to stay
alive and profitable in the face of competition, decreased
innovation
and increasing opposition from many quarters. There are
many more
strategies employed and if you read the business press you
can
probably read about a new one just about every day.
Indeed, it is
remarkable that the granting of 20-year monopolies and the
gifts of
publicly funded research can't even help this industry
solve its
profitability problems, let alone that it increasingly
fails to
provide value-added service to the public. Surely it is
time to
re-think the viability and sustainability of the branded
drug sector
in its current form.
The following Section 6 was deleted from the audio version
for
continuity reasons, but you might find it interesting...
The Next
Blockbuster Drug - What will it be? A "Youth Pill"
As we've already seen, the blockbuster cabinet is
currently looking
pretty bare, and big pharma is getting nervous. Many recent
blockbusters act on certain enzymes to inhibit their
production of an
undesired chemical that causes problems like high
cholesterol. But the
enzymes available for such targeting are pretty much used
up by now by
all the existing blockbusters. In addition, it will be
hard to improve
on existing treatments for the 5 main ailments that
currently dominate
the top 20 drug lists - heartburn, arthritis, high
cholesterol, high
blood pressure and low spirits (depression). So what next?
Operating in the favor of big pharma profitability is the
aging of the
rich world populations with money to buy prescription
drugs. This
aging in the West will drastically increase per capita
spending on
prescription medicines in the coming years. Finding
effective
medication for the degenerative altzheimers disease or even
osteoporosis would be like hitting the jackpot. But with
few warm
leads on such cures, investing R&D monies in this area
is certainly
very risky.
In it's efforts to produce a blockbuster for the over 65s,
the biggest
drug giant Pfizer has recently been working on the elusive
"fountain
of youth" pill, also known as the "frailty pill". By
stimulating the
pituitary gland to produce more growth hormone, this drug
aims to
reverse the degenerative process that comes with aging and
make old
people feel young again. Taking the trend set by drugs
such as Viagra,
Rogaine and Paxil to a whole new level, this drug promises
to be the
ultimate "lifestyle drug" for the baby boomer generation.
But so far
the clinical trials have not produced the desired results.
Nevertheless, if the drug companies could get the youth
pill to work
then, by playing on one of the deepest of human fears,
they will have
struck gold. Consumers might start taking such medications
at the
first signs of old age and then be taking them for the
next 50 years!
Another strategy we are likely to find followed more is
the use of
'gene hunting', where researchers try to discover the
genetic roots of
chronic diseases and thereby devise treatments. But
payoffs from gene
technology are not expected for another decade or so.
In the midst of this current drought in the blockbuster
drug pipeline,
many industry watchers have noted that increasing
consolidation has
actually made the drug industry less efficient at
producing more
drugs.
But that's not the worst of it, by far. The patented
medicine model,
while contributing much to the welfare of the western
world over the
past century, has itself aged and entered a seriously
degenerative
phase. It is not making much sense in our globalized
markets, and
maybe it's time for it to die out. Today, people all over
the world,
regardless of nationality, political ideology, or wealth,
should
seriously be questioning the suitability and
sustainability of the
contemporary patented medicine model.
Market failure of the Patented Medicine Model. HIV/AIDS Rips in
to China and
Russia.
The following, seemingly prophetic, quote from an 1851
edition of the
The Economist describes perfectly the degenerative phase
the patented
medicine model has reached by the start of the 21st
century:
"The public will learn that patents are artificial stimuli
to
improvident exertions; that they cheat people by promising
what they
cannot perform; that they rarely give security to really
good
inventions, and elevate into importance a number of
trifles...no
possible good can ever come of a Patent Law, however
admirably it may
be framed."
This 1851 quote gives a good description of what has
become of today's
pharmaceutical sector when viewed from a global
perspective. Patents
have certainly provided "artificial stimuli to improvident
exertions"
or, put another way, wasteful spending. And there is no
question that
we have seen the elevation "into importance a number of
trifles",
namely the blockbuster lifestyle drugs such as Viagra,
Rogaine, and
various anti-depressants, as well as unnecessary drugs
that are
virtually the same as a host of other drugs already on the
market. All
this takes places against the backdrop of a developing
world HIV/AIDS
crisis that has resulted in up to 40in some African
counties, and is
now starting its exponential growth throughout Eastern
Europe, the
former Soviet states, China and the rest of South-East
Asia.
The West has remained largely unconcerned with the
HIV/AIDS crisis in
Africa. There have been some nice efforts from various
quarters but so
far the response has been woefully inadequate from those
that can most
afford to help. To put it bluntly, this is because the
"self-interest"
component just isn't there. Africa is only a minor trading
partner
with the West, and the West has relatively little economic
interest in
Africa. So far, all the help adds up to not enough, and
the disease
continues to outpace efforts to stop it. Out of a $10
billion-a-year
request from the UN, the West can only bare to part with
$2 billion to
assist in dealing with the problem of HIV/AIDS in the
developing
world. And, compared to other drug investment, relatively
little goes
into finding a vaccine. If and when a vaccine is available,
distribution of it will pose the next major hurdle.
But now, there are increasing reports detailing the spread
of HIV/AIDS
throughout the former or semi-communist, now
market-directed, nuclear
powered giants - Russia and China. A startling report from
UNAIDS,
released in June 2002 entitled "HIV/AIDS: China's Titanic
Peril"
reveals the state of the problem of HIV/AIDS in China.
With 1-2
million people infected today, infection rates have been
increasing at
more than 502010 range between 10 and 20 million. The
former Soviet
states have seen a five-fold increase in infections in the
past three
years, have more than 1 million people infected, and the
fastest
spreading epidemic of all, according to a September 2002
UN Report. A
survey from British scientists released in June predicts
that within 5
years, 1 in every 20 Russian adults will be infected.
Both China and Russia are rapidly developing market
economies. One is
a major trading partner of the United States, the other
set to become
one of the European Union. Lest you think this development
will help,
think about the African nation of Botswana. Botswana was
the golden
child of economic development of sub-Saharan Africa,
financed largely
by its mining industry after it gained independence. Its
first AIDS
case was detected in 1985, then HIV/AIDS built slowly for
several
years. By the 1990s it was spreading furiously throughout
the general
population so that by 2002 it affects almost 40population.
Why so much
worse than the less developed sub-Saharan region, you
might be
wondering? Largely because of the rapid economic
development itself.
The road networks that come with development, the mobility
of labor
away from home and families that comes with globalization,
and men
leaving wives to get work, all sped up the spread.
Now, many people in Africa think China and Russia look a
bit like
their countries did five to ten years ago. But there's
more. With
Western style development comes rapid growth in drug use,
teenage sex,
commercial sex and poverty. These increases are being
observed across
China, Eastern Europe and Russia and the relevant
populations are
showing huge increases in infection. In addition, the old
social
safety nets and health care systems have largely
collapsed. In rural
China, the poverty of farmers has forced them to sell
their blood for
trade on the lucrative national and international plasma
markets.
Millions of rural people participated in these
plasmapheresis programs
in return for cash payments to supplement their
ever-dwindling
incomes. In this process their blood was taken, pooled
with that of
lots of other people, and the plasma separated from the
red blood
cells. The plasma is sold on the plasma market and the now
pooled red
blood cells are then re-infused back into the pool of
donors so that
they can keep giving blood at a high frequency. In such a
process, all
it takes is for 1 person in a pool of 100 to have HIV and
all 100 get
it. This has greatly increased China's HIV problem. Add
this to the
fact that population pressures and the preference for male
children
has created a dangerously high and unnatural male to
female ratio,
plus the big taboo on discussion about sex in eastern
cultures, and
you see a growing number of catalysts for disease spread.
China is currently the forth-largest trading partner of
the US, likely
to be the number 2 or 3 before too long, and with a strong
chance of
becoming number 1. With China joining the World Trade
Organization
there's tons of capital wanting to invest in China. As
residents and
consumers in the US, our lives are undeniably intertwined
with those
of the Chinese. So much of our own purchasing power and
hence, quality
of life, is a direct result of the relatively low cost of
labor in
China. As our population ages, more and more of the
productive labor
force we depend on will be in countries like China. In
this case, the
economic interests of the US are very much tied up with
the well being
of the labor force of China. If the US does for China's
emerging
epidemic what it did for Africa, which was not very much,
the
consequences on the US economy could be quite severe.
Maybe this
self-interest component is the only thing that can get the
US to do
what it can well afford to do about this crisis in the
developing
world. Then, I am sure, a vaccine could be found and
distributed in no
time at all.
Similar arguments apply about the relationship between
Western and
Eastern Europe. The European Union has an added incentive.
Since this
is all happening right next door, the epidemic may very
well stretch
into Western Europe if they don't help do something about
it in a
hurry.
A Remedy for the Ills of the Current Medicine Model
There is no point asking the branded drug industry for
help. They just
wont budge without a monopoly and a profit stream, neither
of which is
a suitable incentive model for this global crisis. It is
heartbreaking
to see the present $8 billion shortfall in the UN requests
for
HIV/AIDS assistance, compared to the many tens of billions
spent by
the pharmaceutical giants on advertising nonsense pills to
us daily,
suing the generics at every turn and developing medicines
that aren't
really necessary. And we end up footing the bill for all
this, be it
in the form of our taxes, higher health premiums or direct
prescription purchases.
If global capitalism wants to save itself from its own
worst enemy -
which is itself - it better act quick smart. Following is a
prescription for the capitalists to save their global
markets...
(1) Since the branded drug industry is wasting our time
and our money
and they are not helping to solve the really big and
important health
problems, we can conclude they are a big inefficient
sector of the
markets due to too many years of monopolies and taxpayer
subsidies.
They are fired! That should make the markets more
efficient. We will
keep the generics, though.
(2) The generics can keep producing all existing FDA
approved drugs in
a patent free environment. This should lower our total
annual drug
costs by about $80 billion a year.
(3) We will use about $15 billion of this for a
prescription drug
benefit for seniors (whose costs are now much lower
because all drugs
are generics) and put some $15 billion towards insuring
the uninsured.
(4) We will set aside $30 billion for drug research and
development in
the public sector, to replace what the private sector used
to do,
except with a more needs oriented approach. All the
scientists,
researchers and administrative workers from the now
extinct brand name
companies get new jobs at the new publicly funded research
centers.
Realizing that the biggest needs are in the developing
world and that
our own economy is intimately tied to their well being in
this
globalized world, we set the first $15 billion aside
exclusively for
HIV/AIDS vaccines and treatments. The next $5 billion goes
on tropical
diseases, tuberculosis and so forth. Then the other $10
billion will
go into the most important things at home.
We still have $20 billion left.
(5) Of the people that used to work for the branded drug
companies, we
still have the marketing people and lawyers sitting around
idle, which
is worrisome. Since the marketing people are always
telling us that
they are not annoying and that they are instead providing
the social
service of distributing important information, we have
just the job
for them! First they will be put in decompression chambers
and then
some training will take place to retool them for a more
wholesome
career. They will each be provided with 10,000 packets of
condoms and
sent all over the world from India to the Congo to Russia
to China to
Brazil. Their job will be to sell the use and advantages
of condoms
and safe sex to as many people in the developing world as
possible.
This should be right up their ally. For years they have
been walking
into doctors offices with free samples to give away and
stories to
tell. They will get compensated based on the preventative
practices
adopted in their region. The total cost of the global
prevention plan
will be about $10 billion.
(6) The lawyers will be left on their own. They are
inventive enough
to find other ways to occupy their time.
(7) Well, there's lots that can be done with the remaining
$10 billion
and I'll just leave that up to your imagination.
Caught
Between and Dock and a Sweatshop
As the Holiday Season of 2002 approaches, this 17th
edition of the
Wizards of Money will look at the path taken by the
goodies that will
end up under the Christmas Tree.
We start with the following analysis of Santa's Business
Model...
Although nobody really wants to tell their kids this,
Santa does not
start his journey at the North Pole in December. He starts
in China in
about June. The majority of the elves making the holiday
gifts are
migrants from rural China who Santa lures to the factory
cities by the
millions. Despite its mythical appeal, Santa knows that
carrying all
this cargo by air is not economically feasible, so the
flying reindeer
carrying the presents are really giant ships crossing the
Pacific
Ocean. The ships get unloaded by the tallest breed of
elves who, much
to Santa's irritation, use their height to make demands on
Santa. Once
Santa gets past that barrier and the goods are trucked
inland, they
end up getting stocked to the shelves by some of the
lowest paid elves
in this land of holiday cheer. Since Santa is too fat to
squeeze down
the chimney he instead offers credit to tempt people into
the stores
to get the goodies themselves. Finally, all this credit
plus a bit
more, goes back to Santa in his home at the heart of the
capital
markets.
This snapshot of Santa's business model provides a glimpse
of some of
the primary battles being waged today in the ages old war
between
labor and capital. This episode will focus on the
following three
contemporary battle-zones along Santa's journey. 1.
Chinese Toy
Factories, 2. The Pacific Coast docks, and 3. Wal-Mart.
The laborers in these three regions of Santa's journey -
the start,
the middle and the end - sit at opposite ends of the
spectrum in terms
of securing a reasonable share of the fruits of their
labor. The
laborers at the start and the end of the journey traveled
by
internationally traded goods have almost no power to
bargain with
their employers, and consequently, are not getting their
fair share.
The start of the journey is the manufacturing end, which
is made up
primarily of factories in China. The end of the journey is
the US
retail stores, increasingly dominated the biggest retail
giant in
history - Wal-Mart.
In the middle of the journey sit the Pacific Coast
longshoreman - some
of the highest paid laborers today thanks to the gains
made by the
International Longshore & Warehouse Union (ILWU) over
several decades.
Given the triumph of capital over labor at the retail and
manufacturing end-points of Santa's journey, it is hardly
surprising
to see the forces of capital now pulling out all stops to
bring this
middle point into line.
A "Toy Story"
Millions of us have to go through the process of shopping
for holiday
gifts for kids around this time of year. Last week I went
to Wal-Mart
to buy some little trinkets that will delight my nieces
and nephews.
One toy was a Matchbox SUV. This cost only $1.47. Another
toy was a
''Bob the Builder'' ball since that's a favorite of on...
... nephews.
The Bob the Builder ball was more pricey than the Matchbox
SUV, at $
1.76. And, finally the most expensive item of all, a fancy
little
Barbie out-fit for one of my nieces at $1.84. In all, it
cost me $
5.07 (before tax) to complete my holiday shopping for two
nephews and
one niece.
But that's not all they'll be getting. You see, when me
and my
purchases got home, I couldn't shut them up! Busting to
share their
experiences, but too afraid to talk in the Wal-Mart store,
they gave a
detailed account of their long journey from China, across
the Pacific,
and into the Wal-Mart shelves. They told me of the things
they saw
along the way, while some companies thought no one was
looking.
First, the Barbie dress burst into tears when she recalled
the
conditions in the factory in China where she was made. She
said that
most of the ladies there would never be able to afford
something as
fancy as she, and yet they were working non stop with
hardly any days
off since the busy season started in about June. One young
lady in a
factory was literally worked to death, and the Barbie
dress reminded
me that this incident was covered in the Washington Post
on May 13
this year. She said I better look it up.
The "Bob the Builder" ball, a young ball with a keen
interest in
unions, said that while he was being stitched up he tried
to find out
something about attempts to organize unions in China. But
there was no
talk on the job, so he waited till he saw something in the
news when
he got to the US about how China's ruling Community Party
had just
ordered the extinction of something that was starting to
look like an
independent labor union, since the only official unions in
China are
operated by the Party run All-Trade Federation of Trade
Unions. And
Bob added, very disappointed, this government union is
about as
corrupt as can be.
Pretty soon, the Matchbox SUV chimed in and stated that
both he and
the Barbie dress were Mattel products and that I could
find the
Consumer Information number on their backs. He urged me to
call Mattel
at this number to ask them some questions about their
factories in
China. I did just this. However, when you call the Mattel
Consumer
Information number, where you are supposed to be able to
ask any
question whatsoever about a Mattel product you bought,
there is
apparently one question you can't ask. And that's about
the conditions
under which these products were made. In no time at all I
was whisked
over to the Mattel Public Relations department and got to
speak with a
Public Relations Vice President. The dress suspected it
was Barbie
herself, but I wasn't quite sure. Anyway she was extremely
nice and
assured me that all the information I needed was on the
Mattel web
site.
So me, the Barbie dress and the Matchbox SUV hopped on the
internet
and looked up Mattel's site. We soon found that the Barbie
Vice
President at Mattel had told us a bit of a fib. The only
information
on the Mattel site about its operations in China were two
years
outdated and also there was no information about how its
so-called
"independent monitoring team" was selected or compensated.
We wanted
to know these things and also wanted more up-to-date
information about
the factories. So we spoke to the Barbie VP again and she
said she
would investigate the matter and then get back to us. To
this day she
still hasn't called back and the poor little Barbie dress
sits by the
phone in silence with a forlorn look, like she's been
betrayed by one
of her heroes or something.
The toys later told me that their trip across the sea was
pretty
humdrum since they were stuffed in containers in the dark.
But when
they got to the docks on the West Coast of the US all hell
had broken
loose. There they bobbed up and down for 10 days without
moving
because the shipping companies had locked out the
dock-workers. After
this long delay, the Bob the Builder ball managed to pop
himself out
of the container long enough to ask a dock-worker what was
going on.
He heard about their concerns that their union was under
the attack of
some very powerful business interests, and some very
crafty PR people
who actually made it seem like the workers had been on
strike.
Finally, the toys made it to my local Wal-Mart store.
After hearing
all this stuff about freedom and democracy in the
Wonderland of
America, boy, were they disappointed when they saw what
kind of lives
some of the Wal-Mart workers had. And, after being in
China for so
long they certainly recognized propaganda when they saw it.
I told the toys that I couldn't believe they were so
cheap! Altogether
they only cost me $5. But then I realized this was not a
very nice
thing to say, even to a toy. So I didn't discuss their
cost with them
anymore. Instead, later that week, I got some
clarification on this
issue from Bill Meyer at the United Food and Commercial
Workers union
in Las Vegas, epicenter of labor organizing for Wal-Mart.
Excerpt from Interview with Bill Meyer. UFCW Local, Las
Vegas.
We'll hear more of this interview later on, along with an
interview
with Mike Leonard at UFCW in Washington DC, heading up the
National
Wal-Mart Campaign.
But first, the little toys asked me to do a little history
lesson on
labor issues. So I thought I'd start at a point in time a
few thousand
years ago.
The "Spartacus Problem"
Excerpt: Spartacus "March on Rome"
Big capital has been using two primary weapons against
organized labor
consistently for thousands of years, namely propaganda and
intimidation. The third - physical force - fell out of
favor in the
20th Century as the other two became increasingly
effective and as the
excesses of physical force sometimes led to too much
sympathy for
labor and thereby undermined the propaganda efforts. In
the lands
where electronic communications media are pervasive, this
third arm of
Capital's army is barely needed anymore.
Modern capital learned many lessons from the leaders of
the great
Roman Empire, built largely upon the complete submission
of labor.
While Rome did not have unions to contend with, there
arose the
occasional force that Rome feared most on the homefront -
solidarity
of the slaves, spearheaded by the rare charismatic leader.
The most
famous slave organizer of Roman times was, of course,
Spartacus. Rome
went to great trouble to use all these strategies to deal
with the
organized slave problem.
Excerpt: Spartacus - Closing Crassus Speech
For intimidation purposes, the crucifixion of thousands of
slaves from
the Spartacus army along the Appiann Way was remarkably
effective. But
even following the death of Spartacus, Rome still had
something of a
"Spartacus problem" on its hands. After all, they didn't
want slaves
or cheap labor to get ideas about organizing, or to get
high hopes
that they actually could achieve a better life. For this
reason, Rome
most probably went to a lot of trouble to eliminate the
legend of
Spartacus.
So too it would seem for the great labor organizers that
would emerge
in the 20th century under the American Empire. One of
these was the
Australian born Pacific Coast longshoreman Harry Bridges,
who was to
have a profound influence on the improvement of labor
conditions for
American workers, and whose union was to be one of the
pioneers in
getting benefits like healthcare and pensions for workers.
Yet, how
many people have ever heard of him?
Eliminating the Legacy of Harry
Harry caused something of a modern day "Spartacus
Problem". The first
president of the International Longshore and Warehouse
Union, Bridges
was one of the 20th century's most effective labor
leaders; a key
figure in the General Strike of 1934 and in the lead-up to
the
breakthrough National Labor Relations (or "Wagner") Act of
1935. His
work in the ILWU and other organizing bodies inspired a
lot of workers
to fight for a better life. Naturally, work begun almost
immediately
to tarnish his name. Bridges was to suffer constant
attacks and many
attempts at deportation, leading up to and during the
McCarthy era.
And today, in line with the general decline of union
power, his legend
lives on only in the margins. Furthermore, many of gains
in getting
benefits for workers pioneered by his union are now either
not
available for non-union sectors or becoming a thing of the
past in
union sectors.
In order to understand the contemporary dispute on the
Pacific Coast
docks that President Bush recently stepped into, and its
significance
well beyond these docks, we first go back in time to the
days of the
Great Depression. In our trip back in time we will hear
some excerpts
from a documentary called "From Wharf Rats to Lords of the
Docks", a
radio documentary produced by the Harry Bridges Institute
and Public
Radio International about the life of Harry Bridges. A
link to this
show will be placed on the Wizards of Money web site at
[8]www.wizardsofmoney.org.
Back to the Docks of the 1930s
The docks that my little toys from China got unloaded on
were
certainly a tough place to work at the start of the 1930s.
Not only
was pay lousy and the hours long, but the safety
precautions in place
were dismal. To make matters worse, the way that workers
got work was
mostly through a system of favoritism by the employers
based on bribes
and kickbacks. Men who hadn't participated in this corrupt
process may
stand in line for hours a day and not get any work. And,
certainly
anyone known to be an organizer, or have an interest in
unions, could
easily be passed over for work. In that time at the start
of the Great
Depression the shippers had all the power and the
dock-workers had
none.
Fed up with this situation and to put pressure on their
employers for
a fairer slice of the shippers profits, the dock-workers
up and down
the Pacific coast, along with many other maritime workers,
went on
strike in 1934. Harry Bridges, a dock-worker in his early
thirties,
was appointed Chairman of the Joint Strike Committee of
Maritime
Workers.
A turning point came a day after Independence Day 1934
when two
striking longshoremen were killed by the San Francisco
police. After
this and a solemn funeral procession including tens of
thousands of
workers across the city, public sympathy swayed towards the
longshoremen. Not too long afterwards, this evolved into a
general
strike in San Francisco, with many other unions showing
their
solidarity with the longshoremen and also going on strike.
Bringing
commerce to a screeching halt certainly put the national
spotlight on
the longshoremen's issues. Armed with the support of the
public and
the other unions, the longshoremen had bargaining power
and were
finally able to negotiate a contract that included better
pay, and
more reasonable hours. Very importantly, it also included
some control
over the hiring process so that employers couldn't just
pick and chose
employees based on their corrupt selection process. Later
they would
form a new union called the International Longshore and
Warehouse
Union, with Harry Bridges as its first president.
The mid-1930's, in the midst of the Great Depression, was
a time when
the power of capital was greatly weakened, and a chance
for labor to
make gains. And so it did. The victory of the longshoremen
and other
maritime workers in the General Strike of 1934 was one
example. But
perhaps the most significant national victory of that time
was the
passage of the landmark National Labor Relations Act (also
known as
the Wagner act) of 1935.
The Wagner Act (or the original National Labor Relations
Act) for the
first time guaranteed employees the right to
self-organization, to
form, join, or assist labor organizations, to bargain
collectively
through representatives of their own choosing, and to
engage in
concerted activities for the purpose of collective
bargaining or other
mutual aid and protection. To implement and uphold these
rights, the
act created the National Labor Relations Board (NLRB).
Before the
enactment of the NLRA, the federal government had
refrained almost
entirely from supporting collective bargaining over wages
and working
conditions and from facilitating the growth of trade
unions. This Act
facilitated the growth in trade unions and union
membership over the
next two decades, which peaked sometime in the 1950s.
Never one to sit idly by and watch its power be weakened,
the forces
of capital and big business set to work the day the Wagner
Act came
into force to dismantle the power of unions. The old
tricks of
propaganda and intimidation were back in full force. And
capital was
back to full strength by the end of World War II. And so
the
Taft-Hartley Act, an amendment to the National Labor
Relations Act in
favor of big business was passed in 1947, even over the
objections of
President Truman.
At this point the anti-union propaganda and activities of
business of
the past few decades culminated in the frightening
full-blown McCarthy
era. For decades, successful union leaders like Harry
Bridges, who
represented the best interests of their rank and file
members, were
constantly under surveillance and investigation, harassed,
intimidated, and of course, called Communists. In
addition, Bridges
suffered numerous attempts to deport him back to Australia.
Nevertheless, through all this, Harry and the ILWU
continued their
work on behalf of the rank and file longshoremen and today
they are
some of the most well compensated union workers. According
to the
documentary "From Wharf Rats to Lords of the Docks", Harry
and the
ILWU pioneered the establishment of employer sponsored
benefits such
as healthcare, dental care, pensions and paid vacations.
Excerpt: "From Wharf Rats to Lords of the Docks"
Finally, as the McCarthy era was coming to a close and
after 21 years
of constant harassment, Harry became a US citizen and the
constant
attempts to deport him came to a halt. Here's Harry
Bridges ...
Excerpt: Harry Bridges Speech
Apart from its tools of propaganda, intimidation and the
constant
whittling down of the effectiveness of the National Labor
Relations
Act, organized capital still had two more powerful weapons
up its'
sleeve - ones that Organized Labor still has no
counteroffensive for.
These are (1) Technology and (2) Overseas Labor.
By the nature of its work, the ILWU never really faced the
latter to
any great extent. But it has faced the former on two major
occasions.
The first in the 1950s when "containerization" technology
entered
shipping, culminating in the 1960 Mechanization and
Modernization
Agreement between the shippers and the dock-workers. The
ILWU dealt
with this entry of technology by acknowledging that the
number of
available jobs would decrease, ensuring that new
technology jobs would
remain in the union and that workers who would be retired
would
receive reasonable benefits. Overall there was an increase
in wages
and benefits. In this way the current generation of
workers shared in
the gains made through the implementation of technology,
but they also
passed on less union jobs to the next generation.
Excerpt: Harry Bridges Speech on Technology
The second major time the ILWU has faced the Technology
issue is now,
with the implementation of technology to make the labeling
and
identification of cargo, and data entry more efficient.
Only now,
organized labor has been under such fierce attack for so
many years,
that the general power of unions is much weakened. Now it
is harder
even for the historically stronger unions such as the ILWU
to bargain
with employers, and, as we shall see when we get to the
Wal-Mart
issue, the National Labor Relations Act has become
something of joke
in terms of protecting the worker's right to organize and
bargain
collectively.
It would seem that the ILWU would have liked to resolve the
contemporary technology issue using a compromise similar
to the "M&M
Act" as it is known, of 1960. But the shippers don't seem
to want to
come to such a compromise. Regardless of the claims on
either side
about what lead to the closing of the docks in October
this year,
there are two things that seem clear. 1. It was the
Pacific Maritime
Association, the association of employers, who instigated
the lock
out. It was not a strike! However, it sometimes seems that
this is how
the media portrays it, and, indeed many people seems to
think this is
what happened. 2. The ILWU appeared to have no intention
of striking.
The business press claims that the ILWU might initiate a
slowdown
rather than strike, because their compensation is already
so high that
they would not win public support, and this slowdown led
to the
lockout. The union claims that the PMA (i.e. the shippers
and port
operators), possibly with the help of the big retailers
(like
Wal-Mart) who import their Asian made goods through the
West Coast
ports, are trying to bust or weaken the union.
Both arguments have merit. But it is the argument of the
union that I
find worthy of much attention. For, if it is true then the
implications are profound. The ILWU's arguments also
deserve more
attention because they seem to have gotten so little press
coverage.
Few people seem to have considered the broader
implications of this
case if indeed it is an attempt to weaken or bust the
ILWU. To
understand this side of the story I recommend a radio show
produced by
People Tribune's radio recently and I will post a link to
this on the
Wizards of Money web site.
It will be very interesting to see what happens next. Will
the ILWU,
for decades one of the leading trendsetters in
establishing gains for
workers, come out of this process significantly weakened?
And how much do the big retailers, who import an
increasing amount of
their manufactured goods from the newest member of the
World Trade
Organization through these docks, have to do with all this?
A weakening of the ILWU would certainly deal a huge blow
to the labor
movement at a time when it is battling the trend of the
big retailers
at home to lower standards in the ever growing retail
sector.
On that note, lets now take a good look at the biggest one
of these
retailers - Wal-Mart.
Life at the World's Largest Retail Giant and the Biggest Importer
from China
Interview: Mike Leonard. National Wal-Mart Campaign
Organizer. UFCW
Interview: Bill Meyer. Las Vegas UFCW Wal-Mart Organizer.
Where
Wall Street Crosses Auburn Avenue
In this, the eighteenth edition of the Wizards of Money,
we're going
to look at what's driving today's record rate of home
foreclosures -
from sub prime lending to abuses of the homeownership
programs
initiated during the Great Depression.
Home foreclosure is the process whereby a mortgage lender
takes over a
property when a borrower is late on loan payments. To
study today's
alarming trends, we'll need to follow the capital being
pumped into
various lending abuses all the way back through the
predatory
pipeline, and ending at the major Wall Street players.
We'll examine
the roles played by major financial institutions, and those
unregulated and mysterious things known as "Hedge Funds"
and "Special
Purpose Vehicles".
We start our journey through the predatory pipeline in the
city of
Atlanta, one of the major accumulation points for
predatory capital,
primarily in low income and minority neighborhoods. We'll
go back to a
time when capital flows in this area worked very
differently. Then
we'll come back to the present to follow the modern
capital flows back
to their source.
To understand the driving forces behind today's record
foreclosure
rates nationwide, we'll talk with Charles Gardner,
Director of the HUD
Homeownership Center for the Southeastern United States
and we'll talk
to Bill Brennan, Director of Atlanta Legal Aid's Home
Defense Program.
But first, let's start with a walk around downtown Atlanta.
Atlanta's "Freedom Walk"
In December of 2002 there was much celebration in Atlanta
over the
fact that Georgia has now produced two Nobel Peace Prize
winners -
Martin Luther King Jr and, most recently, former president
Jimmy
Carter. In fact, the King Center and the Carter Center,
dedicated to
both the memory and missions of these two Peace Prize
winners, lie
only about one mile apart and there is a walking path
connecting the
two. This walk, starting on Auburn Avenue, birthplace of
King and home
to the King Center, has been described as that from "Civil
Rights to
Human Rights" in the local Atlanta news and follows a road
called
"Freedom Parkway".
"What a lovely walk!" I thought to myself on a recent
sunny winter's
day. So I started walking along Auburn Avenue, ready for
my Freedom
Walk. However, somewhere along the way I messed up and
took a wrong
turn. Pretty soon, none of the streets I was walking down
looked very
much like a Freedom Parkway to me. Certainly financial
freedom was not
evident - instead, foreclosure was, with some streets
dotted with
several homes in foreclosure.
Perhaps I was walking in circles, but later on in the day
I ended up
on the steps of the Fulton County Courthouse in downtown
Atlanta.
Lining the steps throughout the day were a bunch of
mumbling lawyers
with piles of papers that they were reading, one after the
other just
like this:
Excerpt: Fulton County Courthouse January 2003 Foreclosure
Sale
These lawyers were auctioning off the thousands of Atlanta
homes in
foreclosure that hit their books in the month of December.
Most of the
homes were going straight back to the banks. Don't be
fooled by the
location of the auction - just because it takes place
outside the
courthouse, "outside" is the operative word. There's none
of this
"getting your day in court" when it comes to foreclosure
here.
I got some foreclosure statistics from the Atlanta
Foreclosure Report
and did a little analysis on where most of these homes
were that were
being auctioned off by the collection of mumbling lawyers
on the
courthouse steps. Consistent with studies done on
foreclosure in other
cities, the data showed the highest rates of foreclosure in
predominantly African American neighborhoods. Pondering
all this, I
departed the courthouse steps and headed back towards
Auburn Avenue.
The Almost Forgotten History of
Black-Owned Financial Institutions
Back along Auburn Avenue, I passed by the modern Atlanta
Life
Insurance Company building and then, heading east towards
the King
Center, passed by many buildings in disrepair. You can
just make out
the words on the signs of some of the buildings, and, if
you know your
history, you can try and imagine what was going on in and
around them
years ago - for Auburn Avenue was once the hub of black
economic
activity in Atlanta and a key source of capital for
African Americans.
Along this stretch of Auburn you pass by the Apex Museum,
and you can
watch a movie called Sweet Auburn - Street of Pride.
Here's an
excerpt:
Excerpt: Sweet Auburn - Street of Pride.
That excerpt from the Apex Museum's video "Sweet Auburn -
Street of
Pride", narrated by Cicely Tyson and Julian Bond, includes
a short
history of some of the major black-owned financial
institutions that
emerged during the early twentieth century, some of which
are still
with us today. (The web site of the Apex Museum is
www.apexmuseum.org.)
It's definitely not easy to read about the history of
black owned
financial institutions, for not very much history has been
written
about them. Professor Alexa Benson Henderson at
Clark-Atlanta
University wrote a book in 1990 called "Atlanta Life
Insurance
Company: Guardian of Black Economic Dignity" where she
described this
hole in American history as follows ... "I was
discouraged...by the
dearth of sources, printed or otherwise, on many of the
significant
individuals, groups and organizations that have been
associated with
black business development in Atlanta and elsewhere.
Sadly, many of
these inspiring stories are lost forever."
The Atlanta Life book opens a window to a whole branch of
US financial
history that has been largely ignored. Black-owned
financial
institutions sprung up in many places following the end of
slavery,
initially taking the form of community and church-based
mutual aid
associations. In the late nineteenth and early twentieth
centuries
there was no federal tax and no such thing as social
security,
unemployment insurance, Medicaid and so forth. As always,
those at the
bottom of the economic ladder were the most vulnerable to
the
contingencies of sickness, accident, job loss, death or
imprisonment
of a breadwinner.
Out of this environment and out of necessity grew a slew
of mutual aid
associations in black communities. In such a mutual aid
group the cost
of these risks is pooled by everyone paying a small weekly
or monthly
premium. Out of this pool are paid the costs of the few
that
experience the covered contingencies, such as death
benefits to widows
and orphans and weekly payments if you get sick and can't
work. In
this way the community as a whole bears these risks. This
arrangement
is more conducive to community development than having
every member
bear risk individually, which would tend to bankrupt whole
segments of
society.
Out of this collection of mutual aid societies in the
South ultimately
grew several extremely successful life insurance companies
that,
despite tremendous obstacles, are still with us today,
including
Atlanta Life on Auburn Avenue and North Carolina Mutual,
born in
another hub of black capital accumulation - Durham, North
Carolina.
These institutions have performed the near impossible -
surviving for
a whole century and through a period of brutal segregation,
discrimination, the Great Depression and through having to
win the
confidence of their own communities in black owned and
operated
financial institutions.
Around the time these insurance companies were starting to
grow,
another key segment of black finance was emerging - the
black owned
banks. For example, Citizens Trust Bank opened up on
Auburn Avenue in
1921 to meet the credit needs of the black community, to
promote
savings and the old-fashioned principles of "thrift", and
to promote
homeownership. Through all that happened in the twentieth
century,
Citizens Trust Bank is also still with us today.
These and other black-owned institutions played a
significant role in
the accumulation and distribution of capital in African
American
communities throughout the twentieth century. It is no
coincidence
that the communities around them, such as the Auburn
Avenue area,
developed into economic hubs. Banks and insurance
companies pool
deposits and premiums and then invest them in things like
home
mortgages, office buildings and business loans. To the
extent these
pooled funds were invested back into local communities,
further
economic development of the communities was assured.
Physical Desegregation, Financial Segregation
Well, as the years went by and even as segregation
continued, white
financial institutions began to see that money could
indeed be made
off black customers and they began to compete fiercely for
this
business. Ronald H. Bayer's book "Race & the Shaping
of Twentieth
Century Atlanta" sums up this situation as follows: "The
success of
these black institutions had proved to the white financial
community
that blacks were good mortgage, bank and insurance risks.
... The
decisive factor has not been the [white] citizenry's
quickened sense
of charity or prosperity. As the men along Auburn Avenue
often murmur
wryly ... "Dollars, you see, are not segregated".
Often with deeper pockets, bigger marketing budgets, more
experience
and privileged access to the legislature, white financial
institutions
had many advantages in acquiring black customers, to the
detriment of
the customer base of the black institutions.
As the era of state sanctioned segregation was coming to
an end in the
South in the 1960s and 70s, a different form of
segregation was
already rampant in both the North and South - financial
segregation.
The dominance of white institutions providing financial
services to
black customers soon led to a situation where accumulated
capital from
premiums and deposits were not being reinvested back into
those
communities but, rather, flying away to ventures in other
areas. In
such a situation capital is increasingly drained out of
the local
community.
1968: Dr King's Death and Ginnie Mae's Birth
Social tensions in the aftermath of the assassination of
the civil
rights leader from Auburn Avenue, Dr Martin Luther King
Jr., created
the necessary pressure for the passage of the Fair Housing
Act (also
called the Dr. Martin Luther King Jr. Civil Rights Act) in
1968. This
act outlawed most housing discrimination and gave HUD, the
US
Government Department of Housing and Urban Development,
responsibility
for enforcement.
On a related issue, this year also saw the birth of the
government
corporation known as Ginnie Mae, the Government National
Mortgage
Association, who we met in Wizards of Money Part 15.
Ginnie was
charged with a very important task - to facilitate the
flow of capital
into home loans for low and moderate income neighborhoods.
How did she do this, you might ask?
Well in 1934, during the New Deal regulatory blitz of the
Great
Depression, the National Housing Act came into effect.
This act
established the Federal Housing Administration or FHA to
insure home
mortgages. What this means is that the government provides
a guarantee
to mortgage lenders in low-to-moderate income
neighborhoods that they
will get their money back if a borrower defaults. These
government
guaranteed loans, known as FHA loans, encouraged banks to
make loans
in many low-to-moderate income, and minority,
neighborhoods, and this
loan program is administered by HUD.
Let's here some background on the FHA loan program from
Charles
Gardner, the Director of HUD's Southeast Region
home-ownership
program. Since the current statistics show so many FHA
loans in
foreclosure, we'll also hear about what happens when an
FHA loan goes
into default, and the home is foreclosed on.
Excerpt from HUD Interview 1. 0.00 -3.00 & 12.30 -
15.00 (5.0)
As things turned out, the FHA loans by themselves still
didn't
encourage enough capital to flow into home loans in these
under-served
neighborhoods and so Ginnie Mae was created in 1968. As
noted in
Wizards Part 15, Ginnie would buy up lots of government
insured
mortgages, mostly from the FHA program, and pool them
together to
create new securities known as mortgage backed securities.
Then she
guaranteed timely payment of principal and interest to the
investors
in these new securities. These new, pooled securities were
very
attractive lots of investors with lots of capital to
invest, such as
insurance companies and pension funds.
And so Ginnie Mae began to facilitate the flow of more and
more
capital into the FHA loan program serving low-to-middle
income and
minority communities. Her relatives known as Fannie Mae
and Freddie
Mac were created as privately owned counterparts to
facilitate the
flow of capital into conventional loans requiring a 20and
not insured
through a government program.
Ginnie, Fannie and Freddie started something pretty
revolutionary but,
unknowingly, they had also created a Monster! Before long
the
Investment Bankers along Wall Street caught on to the art
of doing
what Fannie, Freddie and Ginnie had done and began pooling
and making
new securities out of everything and anything that had
cashflows that
moved.
Securitization is the process of pooling together lots of
individual
debts like mortgages or credit card debt or auto loans,
and bundling
them altogether to create new securities called
asset-backed
securities. These new securities, backed by the cashflows
generated
from the pool, are more attractive to investors than
investing
directly in individual mortgages and credit card debt.
The process of securitization has taken the financial
world by storm
and its rapid development is perhaps the most important
development in
finance in a century.
Coming into the 21st century, securitization has been
responsible for
exponential growth in the financing of things that
otherwise may have
only gotten dribbles of capital - from non-stop credit
card offers to
predatory mortgages and home equity loans, to FHA loans -
the list
goes on and on.
To understand how securitization has facilitated predatory
lending, we
must travel along the securitization pipeline and trace a
home loan
from the unsuspecting home buyer through the mortgage
broker, all the
way back to Wall Street, the banking giants, the secret
hedge funds,
the insurance companies and other investment funds.
We start our journey with a borrower in a low to middle
income
community. There are two types of customers: Those that
already have a
mortgage and some equity in their homes, and first time
homebuyers.
The Predatory Pipeline: From
the Home Buyer Back to Wall Street
First we'll hear about the first type of borrower, the
most likely
target of the predatory lending pipeline, from Bill
Brennan, the
Director of Atlanta Legal Aid's Home Defense Program.
Excerpt 1 from Bill Brennan Interview on Sub-Prime Lending
(0-8.33)
8.5
The sub-prime loans we were talking about here should not
be confused
with FHA loans, which are very different and which we will
talk about
separately.
The home loan process starts with the mortgage originator
or broker.
Many of these originators are "fly by night" shops, often
smaller
operations, or seedy subsidiaries of the big banks. In
cases of
fraudulent sales - falsified loan applications and the
like - it's
these players who are often directly responsible for the
fraudulent
act. What many of these predatory loans have in common is
that the
borrower finds an offer of credit attractive but does not
understand
the mathematics behind the transaction. They mistakenly
trust the
lender to do the calculations for them and do not realize
they are
paying too much for credit. When they can't afford their
payments a
few years down the track, they will lose their home.
The shady originators are generally not well capitalized
nor
regulated, which is why so much fraud happens at this
point. Their
primary sources of capital are the mortgage subsidiaries
of the big
banks that buy the mortgages from these small operators.
The mortgage subsidiaries of the big banks, such as Chase
Manhattan,
Wells Fargo, Citigroup, Deutsche Bank and Washington
Mutual, buy up
these mortgages in bulk and bundle them together to create
pools out
of them in things called Securitization Vehicles or
Special Purpose
Vehicles (SPV). The cashflows from the SPV, or pool, are
then used to
make new financial instruments called asset-backed
securities.
These asset-backed securities issued against a single pool
of home
loans come in several varieties known as "tranches". The
securities
known as the senior tranches are the first to get paid out
of the home
loan payments coming out of the pool. Then there are the
most junior
tranches that get paid last. Hence the senior tranches are
very safe
investments and it's really the junior tranches that bear
the risk of
default by borrowers and losses realized on foreclosure.
Because the
senior tranches are safer investments they are very
attractive to
insurance companies and the like. Because the junior or,
sometimes
called toxic, tranches are very risky and bear most of the
risks of
default in the pool, they must offer very high returns to
attract
investors. This is exactly what the investment vehicles
known as the
"hedge funds" love.
Hedge funds are unregulated, managed investment vehicles
funded by the
capital of the extremely wealthy and designed to earn
super returns
for them. They are not regulated because of the so-called
sophistication and wealth of their investors. Because of
this, they
have no capital requirements or safety net requirements -
like the
type of safety net that banks are required to hold to
protect
depositors funds, and that we discussed in Wizards Part 2.
The role of hedge funds, and other investors who take up
the risky
tranches of securitizations, is critical. Without them,
securitizations would not be as prevalent as they are
today because,
in order for the banks to reduce their own risks and front
their
profits on mortgage lending, they have to be able to sell
these risky
tranches. The fact that both hedge funds and others in
this pipeline
are not regulated means that safety and soundness of
mortgage
financing overall is reduced, and that the profitability
of it is
greatly increased.
This system design, and its extraordinary profitability,
have
facilitated massive flows of capital into sub-prime and
predatory
lending in the past decade. Ultimately, the primary
reasons for the
high profitability of predatory lending are:
1) The information gap between the two ends of the
pipeline. At one
end you have the borrower who knows little to nothing
about the
mathematics of finance. At the other extreme, unbeknown to
most
borrowers, you have the masters of the most sophisticated
financial
system that has ever existed. Such information gaps mean
huge profits.
This translates into extra shareholder returns, over and
above normal
returns, of 20calculations to the Wizards of Money web
site at
www.wizardsofmoney.org
2) Loan Values Less than Value of Home: This means that
the lender
really can't lose on default and foreclosure and, again,
risks are
lower than what's priced into the interest rates on these
loans. In
many cases the borrowers themselves are the primary
bearers of risk,
but the pricing of the loans rewards lenders for the risk.
3) Avoidance of Legal Liability and Regulatory Restraints:
Because
most of the fraud happens with the small mortgage
originators, the big
suppliers of capital are not held accountable for it, and
capital
continues to flow to the next dodgy operator. Also,
because banks
securitize the bulk of these loans they can profit from
them up-front
and sell the securities to unregulated entities with no
capital or
"safety net" requirements. This makes the market more
profitable.
Here's Bill Brennan again...
Excerpt 2 from Bill Brennan Interview on Sub-Prime Lending
(20.25-20.55)
In the recent set of national and local foreclosure
statistics it is
clear that foreclosures related to sub-prime loans are on
the rise.
And so are those related to FHA loans. Let's turn our
attention to
what's going on in the FHA loan market.
The FHA Loan Pipeline
In the statistics for Atlanta, FHA loans in foreclosure
account for
about one third of all recent foreclosures. Interestingly,
I also
noted that almost 20subsidiaries of JP Morgan Chase &
Co. Not only is
Chase Manhattan one of the largest issuers of the Ginnie
Mae
securities made from FHA loans, but JP Morgan Chase has
been employed
by the government for years as the main pooling and
banking agent for
the whole Ginnie Mae program.
This reminded me of an article I read recently in the Wall
Street
Journal about a home loan scam in Pennsylvannia where
homes were being
over-appraised by fraudulent appraisers and ultimately
facing
foreclosure because people couldn't afford the loans. The
supplier of
capital here was Chase Manhattan Mortgage who claimed no
knowledge of
what was going on.
Over-appraising the value of homes lies at the heart of
many FHA loan
program abuses. You see, in this case, the FHA insurance
program
guarantees that the lender will get all their money back
if they lose
money on foreclosure, so over-appraising and over-lending
that leads
to foreclosure can be very profitable.
I decided to ask HUD about what was going on with the high
rates of
FHA loan foreclosures in Atlanta. Here's Charles Fowler:
Excerpt 2 from HUD Interview (4.13 - 5.20)
Bill Brennan at Atlanta Legal Aid had a lot more to say
about what's
going on:
Excerpt 3 from Bill Brennan Interview on Sub-Prime Lending
(9.39
-12.31 & 13.30 - 15.05) 4.5
Then I asked HUD about why Chase Manhattan was such a
popular name
with the FHA loans in foreclosure:
Excerpt 3 from HUD Interview (10.40-12.00) 1.5
Again, Bill Brennan had a lot more to say
Excerpt 4 from Bill Brennan Interview on Sub-Prime Lending
(15.26-20.25)5.0
Well, in the fight to stamp out both predatory lending and
FHA loan
abuses, some progress is being made.
Progress in Clamping Down on Predatory Capital
On the HUD side of things, Charles Fowler told me about
the HUD loss
mitigation program on FHA loans:
Excerpt 4 from HUD Interview (12.08 - 12.40)
Also, the day I visited HUD they released a new rule about
holding
lenders accountable for the work of appraisers, which
should help
reduce over-valuations and the FHA abuse known as "asset
flipping".
Bill Brennan told me about some of the good lenders:
Excerpt 5 from Bill Brennan Interview on Sub-Prime Lending
(20.56 -
22.58) 2
Finally, we also discussed the new Georgia Predatory
Lending Law, the
toughest in the country and revolutionary in that it
creates legal
liability all the way up the predatory lending pipeline to
the big
financial players and capital suppliers. Here's Bill
Brennan
discussing the law that he worked with others for many
years:
Excerpt 5 from Bill Brennan Interview on Sub-Prime Lending
(23.50-27.55 & 28.50-29.50) 5
Finally, here's some words of advice:
- If someone offers credit aggressively, it's probably a
great deal
for them and a bad deal for you.
- Get to know your own credit score (known as the FICO
score) and get
a copy of your own credit report form someone like
Equifax, so that
you known exactly what creditors know about you.
- Don't think of the mathematics of finance as a humdrum
and dreary
topic - because that type of thinking is exactly what
makes the
predatory pipeline work! If people thought finance was as
exciting as
the superbowl the dodgy sectors of finance would be
devastated!
The Education
Sweepstakes
In this, the nineteenth edition of the Wizards of Money,
we are going
to take a look at the funding of education and the rise of
the slot
machine. With more federal dollars being diverted to
overseas
conquests and the US states experiencing a severe budget
crisis, some
things have to suffer. And one of these somethings happens
to be
education. "Never mind", say some states, let's just get
those lotto
balls rolling and slot machines ringing.
Insert: Casino/Slots/Governors Meddly (1minute)
Compulsory primary and secondary education in the United
States is
funded mainly by state and local governments. Higher
education is
funded through a combination of state and federal aid
programs, rich
parents, and overwhelmingly by the educated getting into a
whole lot
of debt. And for those shut out of funding options in the
civilian
markets, education funding and job training have become
the primary
reasons why people join the US military.
The squeeze on state and local budgets, compounded by the
diversion of
federal spending to war and homeland security, seems to be
turning the
education system into a great big game of chance - the
"Education
Sweepstakes". If you don't come to the market with
accumulated wealth,
even something as simple as getting good healthcare is a
bit like
winning the lottery, and so is getting a good education.
Small wonder
then, that the lotteries and casinos the states are
expanding to plug
their budget holes are attracting more and more of those
who can least
afford to play.
Without a good education, it is much harder to face the
daily battle
with the trickster who lies at the heart of both
capitalism and the
slot machines - RISK. The shifting nature of government
spending is
turning the economists' favorite theoretical relationship
between risk
and return on its head. For the markets to work
efficiently, an
investor should only get high returns if they are taking
on lots of
risk, and conversely they should expect low returns where
risk is
minimal. But increasingly, certain market players can get
huge returns
by taking hardly any risk, simply by playing against
others facing
huge risks for low or negative returns. Now government
bodies, in
their desperation, seem to be making this problem worse.
Sometimes
they're even the ones running off with the public's money!
Insert: "Mass Cash" Song
The constant marketing of gambling and lotteries, whether
it be over
the internet, the television, the radio or at the local
store is the
stuff of "genies and magic lamps, rooted in hopes, dreams
and
suspicions", so said a report on gambling commissioned by
the
government as the last century came to a close. In this
edition of the
Wizards of Money, we'll speak to one of the authors of
this report, as
well as an investment banker in Maryland about the slot
machine
business, and a professor at the University of Nevada in
Las Vegas.
But first, speaking of that rascal called risk, let's
delve into the
history of risk and why the business of risk management is
so
important.
The Remarkable Story of Risk - From the Halls of Baghdad
to Twenty First
Century Risk Management
Ask yourself "What is the defining feature that lies at
the heart of
capitalism?" To that question many people would probably
answer
"profits". But it may be more correct to say that it is
"RISK".
Profits are compensation for taking risk. In a capitalist
economy,
individuals with accumulated capital either spend it on
something real
or invest it, which really means lending it to some
economic venture.
When you invest your money, you are putting your capital
at risk for
you might lose some or all of it. Investors are
compensated for this
risk-taking by the potential for profits. This potential
for return
provides the incentive for risk-taking, and it is this
risk-taking
that has lead to phenomenal economic growth in market
economies. One
of the downsides of this system is that individuals are
required to
bear many of the risks of daily living themselves - the
risks of
devastating events like unemployment, sickness, accident
and loss of
housing. In our current economy, some if this is
alleviated through
government safety nets and the insurance markets, where
risks can be
transferred, but for a price. As government safety nets
shrink and
more people find adequate insurance coverage prohibitively
expensive,
it becomes increasingly important for individuals to
develop their own
contingency plans. In a market economy then, each player
would do very
well to understand how to manage his or her risks, and how
to take
calculated risks.
Amazingly, many people do not pay much attention to this
ever-changing, ever-elusive beast who runs so much of our
lives. Risk
is sneaky - it likes to influence everything, but let
something else
take the credit (or the blame!) for it. For thousands of
years, much
to its delight, Risk evaded human scrutiny as the humans
worshipped
the sun, then the gods, then a single god, and, of course,
the two
permanent occupiers of the human mind - fate and destiny.
But over the
past thousand years various tools developed to measure
risk and for
humans to take some control of this wild beast. These
capabilities are
ultimately what lead to our capital markets, and our
modern monetary
system and it's financing of the industrial and then
technological
revolutions.
Developments in Mathematics and developments in finance
have been
inseparable since the days when merchants would use an
abacus to
calculate their trading gains.
But perhaps the real turning point occurred somewhere
along the halls
of Baghdad about a thousand years ago. While Europe was
still bumbling
through the Dark Ages, an Arab mathematician named
Al-Khowarizmi laid
the foundations for the basic arithmetic and algebra we
use today,
upon which most subsequent mathematical theory would later
be based.
And part of his motivation was quite simply practical - to
facilitate
trading. Imagine how things would have progressed if,
instead of this
development, the world had stayed on the old Roman and
Greek numbering
systems, adding them up with an abacus or pebbles in the
sand! It must
have been at this point that risk was getting nervous that
soon, not
only would it be noticed, but the humans might try and use
it to their
advantage.
As Europe woke up from its dark era and the renassaince
began, the
Europeans built on these developments from the Arab
Mathematicians and
the equipment for dealing with risk and the mathematics of
finance
began to develop. Initially, probability theory was born
mainly as a
result of wealthy men's fascination with games of chance.
Accounting
theory developed in Italy and facilitated the flow of
capital into
business ventures. Then the mathematics behind insurance
(or actuarial
science) began to develop to help manage the risks of
overseas trade
and financing vehicles such as annuities issued by the
English
government to finance their budget deficits. Over the
centuries the
mathematics behind trade and finance has developed as a
tool to help
investors take calculated risks and get capital to flow in
the
direction of economic development, rather than
catastrophic loss.
Finally, the late twentieth century saw the ultimate
formalization of
the practice of "risk management", and today there are
tools to help
us manage the risk/return trade-off for just about any
risk we can
imagine.
Risk has been caught and tamed for economic growth. (At
least up till
now. There's no telling what's around the corner!).
The Skills for Playing in a Market Economy
For a market economy to be somewhat fair in providing
opportunity, all
market players must know how to play and must be able to
make sensible
risk-return trade-off decisions. Where you have large
segments of
society that participate but never really learn how to
play, then they
will be preyed upon by the more knowledgeable players.
"Even more important than money itself is information
about money", so
said a past CEO of Citigroup a few years ago. Just as in a
sports game
it's important for each player to know the rules of the
market game
and to learn some skills and strategies to get to their
desired
outcome. Also of paramount importance is to have some
information on
how other players are going to play the game.
Deregulation in both the financial and gaming sectors over
the past
few decades has created a situation where the more
sophisticated
players can play directly against those that never even
learned the
rules of the game, let alone strategy. And so over the
past two
decades we have seen the rapid rise of things such as
predatory
lending, credit cards, and the focus of this Wizards
episode -
lotteries, slot machines and casinos. All of these create
a transfer
of wealth from the poorer to the richer, based on the
knowledge gaps
between the two groups, and at a time when government
safety nets at
the federal, state and local levels are in pretty bad
shape.
Capitalist economies have tried to prepare people for a
life in the
market economy through their education systems. They have
also tried,
in varying degrees, to provide a safety net for those who
do not have
the ability to withstand the risks of disability, illness,
unemployment and so forth, to prevent them from being shut
out of the
economy.
But the government funding for this safety net for
handling risk and
for the education system is shrinking as states face
budget crises and
as federal spending is increasingly diverted to war and
homeland
security. And more and more it seems that the funding gaps
are to be
funded by the winnings of this market game played by the
skilled
players against the less educated players, just as the
latter becomes
more tempted towards games of pure chance to change their
situation.
Insert: Peron Lottery Song (0.5 minutes)
State of State Finances
As you may have heard, most US states now face something
of a budget
crisis totaling almost $100 billion dollars in the coming
year. Making
matters worse, the Bush Administration, wanting to create
more room in
the Federal Budget for war expenses, is imposing greater
financial
burdens on the states.
Unlike the Federal Government, the states are bound by
their own
constitutions to "balance the budget", meaning that they
must bring in
enough revenues through taxes and other means to match
their expenses.
As we all know from arranging our own personal finances,
to make these
two sides match, states must raise revenues or cut
expenses, or both.
Here's Jeff Hooke, an investment banker in the state of
Maryland
discussing how that state is going about tackling its
budget crisis:
Insert: Jeff Hooke 1 (2.5 minutes)
Economic Development and Slot Machines
The states must be looking upon slots as a gift from
heaven. And so
too are the private interests that run the slots. Nowhere
is the
risk-return relationship more upside-down than in the slot
machine
business.
So enticing is the Slot Machine - it's the perfect
candidate for a tax
you have when you're not having a tax. They have become so
charming!
And the closer you put the slots to large urban and
suburban
populations, the more dollars the slots generate. Jeff
Hooke helps us
understand the economics of the slot machine business:
Insert: Jeff Hooke 2 (7 minutes)
Bill Thompson, a professor from the state whose primary
export is slot
machines, helps us understand the impact of the gaming
business on
local communities:
Insert: Bill Thompson Vegas1 (3 minutes)
And while the huge returns from the low-risk slot business
are
attracting those with degrees from the Ivy leagues and
lots of capital
to invest at one end, at the other end we have the slot
player who, on
average, will, of course, lose money. That is, their
expected
financial return is negative. The so-called "House Edge"
on slot
machines ranges from about 5This House Edge is the
proportion of money
that you will lose, on average, if you keep pumping
dollars into the
slot machine. It's the pure profit cleared by the slot
machine for its
owners. Here's the Maryland investment banker Jeff Hooke,
talking
about this guest at the other end of the slot machine.
Insert: Jeff Hooke 3 (1 minute)
And Bill Thompson talks about national trends in this area
Insert:
Bill Thompson Vegas 2 (6 minutes)
No question, slots are bad bet if you're the one putting
the dollars
in. But the worst odds of all and the most regressive tax
of all,
meaning that it's a much higher tax for the poor than the
rich, is, of
course, the State Lottery system. Insert: CA Lottery Full
+ Song
(1minute)
The Lotto Sweepstakes Sweeping the States
The history of lotteries is an interesting one and perhaps
longer and
more volatile than you might be thinking. Recorded history
shows that
lotteries date back at least to the time of Julius Caesar.
Around 100
BC the Chinese created Keno, and more than a thousand
years later
Europe came out of the Dark Ages and monarchies and
governments set
the trend of using lotteries to fund government spending.
Believe it or not, in the 1600s the English kings ran
lotteries in
London to help fund early colonies in America. Later,
lotteries were
used by the founding fathers of America to fund the
Revolutionary War.
In 1776, in France, Louis XV appears to have started the
trend for
states to have a monopoly on lotteries for reducing state
deficits. In
the 1700s and 1800s, in the absence of an income tax
system and a
Federal Reserve System, lotteries were a standard source
of revenue
for public and private spending. Fifty colleges and 300
schools were
constructed with the help of lottery proceeds, including
even Harvard,
Yale and Princeton.
But these lotteries, unregulated as they were, were a
breeding ground
for corruption and fraud. State and federal governments
decided to
shut them down. By the end of the nineteenth century
lotteries were
banned in most states, not to be seen again for many
decades to come.
During the 1960s and 1970s lotteries began sneaking their
way back
onto the scene and lottery sales reached about $1 billion
by 1976. In
the late 1980s multi-state lotteries emerged and today 38
states have
lotteries and total US lottery sales are now at about $ 40
billion and
growing fast. The majority of these states use the bulk of
their
lottery proceeds to fund education.
No doubt about it, your expected return from playing the
lottery is
very negative. First the House Edge - or the amount that
goes into
state coffers - is a whopping 50chance game. And your odds
of winning
the mega-millions prize are lower than the possibility
that Martians
with land on your doorstep tomorrow. Of course, you
wouldn't know this
if you listened to the States advertising their lottery
wares...
Insert: WA State Lotto
Here's Bill Thompson on Lottery Advertising and the
Education
Sweepstakes:
Bill Thomson Vegas 4 (2 minutes)
In 1999 the National Gambling Impact Study Commission put
in place by
the US Government, commissioned a study on Lotteries
entitled "State
Lotteries at the turn of the Century". A section of that
report reads
as follows "Promoting lotteries does more than persuade
the pubic that
playing is a good investment. At one level the sales job
may be viewed
as values education, teaching that gambling is a benign or
even
virtuous activity that offers a desirable escape from the
dreariness
of work and the confines of limited means. Not only does
lottery
advertising endorse gambling per se, it may also endorse
the dream of
easy wealth that motivates most gambling. Many ads are
unabashedly
materialistic with winners basking in luxury and lives
transformed.
Yet this is not the materialism of hard work and
perseverance but
rather of genies and magic lamps, rooted in hopes, dreams
and
suspicions".
Ironically it is the state governments, who we elect to
represent us,
who are responsible for feeding this message of myths and
magic back
to us.
I spoke to Philip Cook at Duke University, one of the
authors of the
National Gaming Impact Study Commission Lottery Study
about the
capital flows of the lottery..
Insert: Cook1 (6 minutes)
Then there is another question about lotteries and gaming
in general,
and that is whether cuts in the social safety nets will
actually drive
people further into the gambling trap. Here's Philip Cook
again...
Insert: Cook2 (4 minutes)
The Other Mae Family - Sallie, Nellie et al.
If you've watched any of the business and finance shows on
TV lately,
and seen the "quick picks" of the wealthier players,
you'll certainly
notice that the gaming sector has become popular amongst
the stock
picks.
And there is another big favorite that's emerged from the
state budget
crisis. And that's the student loan market players - that
is, the
originators of student loans, and those that buy and sell
student
loans in the secondary market and bundle them up into neat
financial
securities through the securitization process, as we
talked about in
Wizards Part 15.
In most states the first expense item on the budget
chopping block has
been college education, passing more and more tuition
costs onto
students themselves. Consequently, the student loan
business is
booming. And here the major player is Sallie Mae, close
friend and
relative of Fannie Mae, Ginnie Mae, Freddie Mac, Farmer
Mac and that
whole clan. And she's yet another one of those
semi-government,
semi-private so called "Government Sponsored Entities" we
discussed in
Wizards Part 15. Similar to what other members of her
family do in the
home loan market, Sallie Mae originates and buys a huge
proportion of
student loans. Banks and other financial institutions are
also major
players in the student loan market.
Through the Federal Family Education Loan Program, private
investors
get nice government guarantees on the capital they invest
in student
loans. Here again is another example of the risk-return
trade-off
being all upside-down. For no risk, private investors in
these
guaranteed loans can get a guaranteed return, while the
student taking
out the loan bears the risk that they wont get a job with
a high
enough salary to repay their skyrocketing tuition costs.
The Ultimate Risk Bearers
As bad as all this is, when it comes to getting a good
education, the
ultimate risks are born by those who, for whatever reason,
don't have
access to education funding in the civilian financial
markets. A
number of studies in recent years have demonstrated that
the majority
of people entering the military do so for the benefits of
education
funding and job training. But they go for this promising
return by
taking on the ultimate risk.
The Battle
of the Dragons - Oil vs Insurance
In this, the twentieth edition of the Wizards of Money,
we're going to
look at why it's not easy being green when everybody wants
to be in
the black! We'll discuss the relationship between black
gold, the
future of the world's most powerful cartel, the changing
climate and
the powerful industry that loses big bucks on bad weather.
First we'll discuss that ever important "oil price range"
- that
target price range per barrel of oil within which both
producers and
consumers are happy to continue "business as usual". But
we can't
discuss that without also talking about that thing at the
heart of the
oil markets so despised in all our free market teachings -
the cartel
- in this case, the OPEC cartel, of course. Given what's
happened in
Iraq and continuing US policy towards OPEC countries,
we'll see where
OPEC might be headed in the future.
We'll look at the indications that the OPEC cartel may
face tough
times ahead and the outlook for the fossil fuel industry
in general.
For, while they might be thinking their future looks
pretty rosy, they
may be just about to meet their match.
You see, what has now become "old Europe" is also the home
of another
fearsome and ancient creature of the capital markets that
is none too
pleased about the world's use of fossil fuels. Despite all
the denials
in the US media, the huge global insurers and reinsurers
accept
climate change as fact. Furthermore, they accept that
climate change
is induced by human activity. And, climate change is
costing them big
bucks! As powerful advocates of the Kyoto Protocol and
with Trillions
of dollars to vote with in the capital markets, the
insurance industry
has both the motive and the power to do something about
climate
change.
For this journey though the oil and insurance markets
we'll speak with
an executive at the world's largest reinsurer (Munich Re),
with
several oil markets consultants in the oil state of Texas,
and with
the head of research at Greenpeace, who just had a party
at the Exxon
Mobil shareholders meeting in Dallas Texas.
The Holy Cartel and the Magical Price Range
A cartel is formed when a dominant group of suppliers or
producers of
a product conspire to keep prices artificially high.
Basically, they
conspire to hold back supply so that prices are held above
where they
would fall if you allowed full competition between these
producers.
The most powerful cartel in the world is, of course, OPEC
- the
Organization of Petroleum Exporting Countries. It consists
of 11
countries altogether and these are Saudi Arabia, Iran,
Iraq, Qatar,
UAE, Kuwait, Nigeria, Algeria, Lybia, Indonesia and
Venezuela.
For various reasons, OPEC does not want the price of oil
to get too
high, either. And so the price of oil ends up being
managed within a
certain magical price range. I asked Professor Dermot
Gately,
Professor of Economics at New York University to explain
this magical
price range:
Insert: Professor Gately Interview Segment 1
But the natural question to ask about OPEC these days is
"What will
happen to it now that America - the worlds largest oil
consumer - is
running the place?" Isn't it bizarre that, for the first
time ever in
the history of big cartels, the biggest customer of the
cartel, the
United States, actually has a seat at the table of the
cartel? The
cartel is supposed to be in a conspiracy against its
customers! Often,
when you have serious questions like this about oil, you
find yourself
going to Texas for the answers. I posed this question to
Professor
Michael Economides, Professor of Chemical Engineering and
consultant
to the oil industry, at the University of Houston:
Insert: Professor Economides Segment 1
I also decided to pose this question to a finance
professor -
Professor Craig Pirrong- at the University of Houston, to
see how the
oil state's financial world feels about this tricky
situation
Insert: Professor Pirrong Segment 1
A Party in Dallas
Well, while I was talking to these Oil State professors
about the
State of Oil, something especially interesting was taking
place in
Dallas, Texas at the headquarters of Exxon Mobil. Here
were some
different opinions about the future state of oil. I
decided I better
find out what was going on, so I spoke to Kert Davies, the
head of
research at Greenpeace about the party they were having in
Dallas in
the last week of May 2003.
Insert: Greenpeace Segment 1
These days, it's not just the environmental movement and
some
concerned shareholders going into battle against the oil
giants.
Another set of equally formidable industry giants - the
global
reinsurance companies - are starting to flex their muscles
in this
global battle for green fuels over fossil fuels.
The Ancient Creature
of "Old Europe" vs Fossil Fuel Industry
Reinsurance companies basically provide insurance to the
direct
insurance companies that we are more familiar with, who
insure our
houses, cars and businesses. The two biggest of these -
the European
based Swiss Re and Munich Re - provide insurance to
insurance
companies all over the world, to limit the losses of those
insurance
companies, just like we limit out losses by buying
insurance on our
house. Just like you have to go to Texas to talk oil, you
have to go
to Switzerland and Germany to talk about important worldly
insurance
issues. I asked Thomas Loster in the Geo Risks Research
division at
Munich Re in Germany what they think about climate change.
Insert: Munich Re Segment 1
Apparently, not all insurers are quite so active in this
mission to
stem climate change, and it seems that some of the US
insurance
companies are not so serious about slaying the fossil fuel
dragon:
Insert: "Young Ones" Hippie Knight
Kert Davies from Greenpeace gives a summary of their
experiences in
working with the insurance sector.
Insert: Greenpeace Segment 2
Energy Outlook
Quite undeterred by the finding of the UN Panel on Climate
Change and
the 30 years of study at the big reinsurers, some
consultants and
researchers in the oil industry are determined to believe
that fossil
fuels do not cause climate change. Here's Professor
Economides from
University of Houston again.
Insert: Professor Economides Segment 2
Many oil industry analysts see the demand for, and use of,
oil
continuing to increase for decades to come and can't see
how
transportation can get away from the fossil fuels. But,
then again, so
people with wood chip cars and buses early in the
twentieth century
might have once thought about their dependence on chopping
down trees
for transport. Like many people my age, I've leant all I
know about
cars from the radio program "Car Talk" including the
following:
Insert: CarTalk CLASSIC "Woodchip Burning Engines"
If people can go from using woodchip cars to gasoline
cars, then who
knows what could be next?
Professor Economides argues that much of the worlds
current energy
problems will be solved by Natural Gas and Hydrogen fuels.
Insert: Professor Economides Segment 3
Professor Gately at NYU was a little more hopeful about
the so-called
"renewables".
Insert: Professor Gately Interview Segment 2
In the next part of this series we'll investigate [well,
maybe] where
the status of renewable really stands and learn more about
how, much
to some people's amazement, the environmental community is
starting to
work more with the investment community in the battle
against fossil
fire.
That's all for Wizards of Money Part 20. Note that the
Wizards of
Money has a web site at www.wizardsofmoney.org where you
can get the
text of all episodes and further references.
Insert: Stevie "The Battle of the Dragon"
Playing
Russian Roulette in the Carbon Markets
Introduction 1. Global Carbon Flows BC (Before Coal) 2.
How the Carbon
Accounts become Unbalanced 3. The World's First
International Carbon
Market 4. A Market Miracle? 5. English Ambitions 6. Tree
Farms and Cow
Farts "Down Under" 7. Back to the Dark Ages to See What
the US is Up
To 8. The Pivotal Role of Russia 9. Stuffing Your Wastes
Under the
Ground 10. Will the US be Left Out of Emerging Financial
and Energy
Markets?
In this, the twenty first edition of the Wizards of Money,
we're going
to look at the hottest market on the globe. Well, it's
actually the
market designed to cool things down a bit - the global
carbon market.
While the US has developed a sudden fascination with the
so-called
"Dark Ages", a time when the earth was much toastier than
it is today,
the rest of the world is looking forward and has decided
to do
something about man-made weather impacts.
Most developed nations have now ratified the Kyoto
Protocol of the
United Nations Framework Convention on Climate Change,
including all
25 member states of the European Union, as well as Canada
and Japan.
By ratifying the Kyoto Protocol on climate change, these
countries
have pledged to reduce their greenhouse gas emissions by a
significant
amount over the next decade. This pro-Kyoto world has
given up on the
main country that refused to ratify the Protocol - the
USA, who
doesn't seem the least bit embarrassed by their noticeable
gaseous
emissions.
Forging ahead, the Kyoto team holds out hope that Russia
will join
them by year-end 2003, which would finally bring the Kyoto
Protocol
officially into effect. In anticipation, this pro-Kyoto
world is
gearing up for compliance and is implementing new
regulations, markets
and market mechanisms - indeed a whole new way of doing
business
globally - that the US is now being left out of.
This episode of the Wizards of Money will explore the
developments in
the global carbon markets that have taken place mostly
outside of the
United States, and get very little attention in this
country. These
developments include the world's first international
market in
carbon-based financial instruments, national taxes and
levies on
corporate energy use, and even a tax on cow farts and
burps in New
Zealand!
To get to know these new markets we'll talk to the
director of global
operations at CO2e.com in London, the carbon emissions
trading
subsidiary of Cantor-Fitzgerald, to an energy specialist
for the
Climate Action Network in Brussels and to the head of the
Australian
Petroleum Cooperative Research Center.
But first, we'll start with a refresher on the cycle we
can't afford
to ignore anymore - the global carbon cycle.
Song: "Carbon is a Girl's Best Friend"
Global Carbon Flows BC (Before Coal)
Just like with the water cycle that we spoke about in
Wizards Part 7,
in the carbon cycle, only a tiny fraction of carbon on
earth actually
participates in the carbon cycle relevant to us
terrestrial creatures.
And just like the water cycle, any carbon we have in our
bodies today
has certainly done the rounds over thousands or millions
of years:
through plants, soils, other animals, the ocean and the
atmosphere.
And you can forget property rights when it comes to
carbon! When the
carbon in us is ready to depart, it will just go off and
be somewhere
else.
Before the industrial revolution got underway, global
carbon flows ran
as follows: Carbon in the air, stored as carbon dioxide
(amongst other
gases), is used by plants in photosynthesis and becomes
part of the
plant. Some of these plants get eaten by animals and the
carbon in
them is then used in various molecules to make body tissue
and to burn
up energy. Other plants, or parts of them, like leaves,
just get old
and die. This decomposition releases some carbon back to
the
atmosphere, as does the process of respiration by animals.
The other
99.9 Before fossil fuel use by humans entered the scene,
losses of
carbon from the earth and into the air from decaying
vegetation and
animal respiration, in the form of various gases such as
carbon
dioxide and methane, were pretty much balanced by carbon
storage or
"sequestration" by plants during photosynthesis. The
carbon cycle
chugged along in this balance between about 1000 AD and
the early
1800s, and so the amount of carbon in the air stayed
pretty constant
over this time period since the middle ages. To give you
an idea of
magnitude, this annual exchange was about 100 million
gigatons of
carbon (where a gigaton is a billion tons), from the earth
into the
atmosphere, balanced by an equal exchange from the
atmosphere back to
the earth.
Insert: Treebeard (LOTR, "The Two Towers")
How the Carbon Accounts become Unbalanced
But then came the industrial revolution, powered by the
burning of
carbon rich fossil fuels, and accompanied by massive
clearing of
forest land for agricultural and other purposes. These two
activities
have extracted another 7-8 gigatons of carbon out of the
earth's
sources per year, of which the oceans and the world's
forests have
decided to absorb just over half of this release. So the
remaining 3-4
gigatons of carbon has nowhere to go but into the air.
Over the past
200 years, the level of carbon dioxide in the atmosphere
has risen by
30 An excess of carbon gases, like carbon dioxide and
methane, are
known to trap heat in the biosphere, making things
toastier for all of
us. This so-called "global warming" has many known and
unknown impacts
on climate.
That humans have significantly increased the amount of
carbon gases in
the atmosphere, and that these gases do contribute to
temperature
increases is generally not in dispute between the two main
parties on
either side of the Kyoto Protocol. What is under debate is
the degree
to which global warming is caused by natural versus
man-made factors.
The fairly recently discovered indications that the middle
ages may
have been warmer than the current ages, has the leadership
in the US
scrambling to promote studies to show that natural causes
are a
primary contributor to climate change.
Satisfied that human activities are contributing to
climate change,
the countries that have now ratified the 1997 Kyoto
Protocol on global
warming are trying to do what they can to get as much as
possible of
this excess carbon out of the atmosphere by implementing
mechanisms
designed to reduce overall carbon emissions.
The naysayers team, reluctant to give up their high carbon
diets, led
by the United States and Australia, are diverting
significant
resources into figuring out how carbon wastes can be buried
underground or in the sea in a process known as artificial
carbon
sequestration. The US has also developed a sudden interest
in the
climate endured by King Arthur and his Knights of the
Round Table -
when temperatures were much warmer than they are today. If
only they
can understand why the mythical Knights were so toasty,
they can cast
doubt on the idea that human induced greenhouse gases are
largely
responsible for climate change.
Insert: Camelot
The World's First International Carbon Market
Sure, international markets for various forms of carbon
products
already exist. Why, there are markets for diamonds,
graphite, wood
products and, of course, fossil fuels themselves. But now
there's a
new carbon market.
In this new carbon market a monetary value is assigned to
a carbon gas
emission allowance. Such an allowance could only have a
monetary value
if there are a finite number of such emission allowances
and the total
amount allowed in the market is close to, or even below,
the total
amount that is currently being emitted. For this market to
exist in
the first place there must be someone or some body, most
likely a
government body, that sets the total number of allowances
for the
market.
This is exactly what the European Union has done. It has
used the "cap
and trade" approach to moving towards Kyoto targets, which
for the EU,
requires greenhouse emissions to get to 92 As announced on
July 23rd
2003, the European Commission has formally adopted a
market structure
for a "cap and trade system" for carbon dioxide emissions
that will
begin operations at the start of 2005. Under the EU
emissions trading
scheme the EU member states will set limits on carbon
dioxide
emissions from energy intensive companies by issuing
allowances for
the amount of gas each is allowed to emit. The total
number of
allowances will reduce each year until the final target is
reached.
This list of companies includes approximately 10,000
companies
accounting for about half of the EU's cabon dioxide
emissions and
encompasses the following industries: steel, power
generation, oil,
paper, glass and cement.
A company that is able to lower its emissions at
relatively low cost,
may sell its excess allowances and hence, the argument
goes, the
emissions market will act as a catalyst towards finding
lowest cost
emissions reduction solutions. Other companies that have
difficulty
meeting their targets inexpensively can buy these excess
credits in
the market, at whatever the prevailing market price is. In
effect
then, they are providing the financing to the seller of
the credits
for the seller's emissions reductions efforts, since this
was cheaper
than reducing emissions in their own operations. And, if
companies
decide to neither meet their targets nor buy credits in
the market to
offset their excess, they will have to pay large fines to
the
government, well in excess of the market price of credits.
Hence the
incentives are there for companies to either comply or buy
credits,
thus ensuring that the total amount of emissions will
remain below the
target.
This method of allowing the market to cut emissions
quickly where it
is cheapest and easiest to do will presumably have the
least
detrimental effect on the health of the economy, an issue
largely
driving the US "flat-earth believer" approach to man-made
climate
change.
Insert: CO2e.com Interview
A Market Miracle?
It does seem like some kind of miracle that a bunch of 25
countries as
diverse as the European Union and who were at war with
each other not
so long ago, could unite over a proposal that is bound to
bring some
shocks to their local economies. Even the European
environmental
community seems fairly pleased with the EU's approach to
global
warming. But, like all such complex agreements
involving so many and
varied parties and lots of different political interests,
this one is
not without controversy or room for abuse.
During the discussions leading up to the 1997 Kyoto
Protocol, some of
the most controversial provisions had to do with the ways
in which
companies and/or countries could accumulate excess
greenhouse gas
credits other than by cutting emissions below their target
level. Some
of these so-called "Kyoto Mechanisms" included:
- Creating "Carbon Sinks": Such as
planting new forests, or even
certain types of timber farming - Joint
Implementation Projects:
Which means funding emission reductions projects in other
industrialized nations - Clean
Development Mechanisms: Which means
funding "clean energy" projects in developing nations.
Many people fear that credit accumulation or emissions
offsets gained
under these methods may be the most wide open for abuse
and therefore
may not bring about real change in the battle to stem the
release of
greenhouse gases into the atmosphere.
The recently approved EU Emissions Trading Scheme, set to
begin
trading in 2005 did not provide for these Kyoto Mechanisms.
However, a recent Directive proposes an amendment allowing
two of
these mechanisms - Joint Implementation and Clean
Development
Mechanism Projects in other countries - as methods to
accumulate
carbon emissions credits. Climate Action Network in
Brussels discusses
their concerns about these mechanims:
Insert: Climate Action Network
Nevertheless, these developments in Europe have really
made the EU the
world leader in trying to stem man-made contributions to
climate
change, and without these efforts it is possible that the
Kyoto
process would have collapsed after the US took its
sabbatical to study
the Knights of the Round Table.
English Ambitions
Even though they will be able to participate in the EU
emissions
markets, in 2002 the United Kingdom set up the first
national
emissions market of its own, similar to the EU "cap and
trade"
mechanism. The UK actually plans to significantly exceed,
or do better
than, its Kyoto targets by the end of the decade and they
have gone
further than just capping, trading and fining violators.
In 2001 the British government imposed a Climate Change
Levy in the
form of a tax on business use of fossil fuel based energy
sources.
Relief on this tax can be gained by meeting certain
targets in the
emissions trading program.
Insert: CO2e.com Director
Tree Farms and Cow Farts "Down Under"
Different countries face very different challenges in
meeting their
Kyoto targets. For less populated and more
agricultural-dependent
countries like Australia and New Zealand, carbon dioxide
emissions
from fossil fuel use are not the main problem areas.
Though one doesn't like to talk about these things in
polite company,
believe it or not, cow and sheep burps and farts are a
much bigger
problem! Cattle and sheep grazing and their subsequent
emissions of
smelly gases as by-products of the digestive process,
contribute an
abundance of the most potent of the greenhouse gases -
methane. In
fact, farm animal farts and burps account for about one
half of all
greenhouse gas emissions in New Zealand.
Unlike its less cooperative neighbor Australia, the
country of New
Zealand has ratified the Kyoto Protocol and had to do
something about
these smelly air bubbles. In a move that was far less
socially
acceptable than either the pops themselves or Britain's
Climate Change
Levy, the New Zealand government took the drastic step of
taxing
farmers for the natural bodily functions of their farm
stock - they
introduced the world's first tax on farting! A farmer's
rebellion got
underway immediately and it is unclear what will happen
next.
Insert: Cow Farts and Burps (maybe)
Across the Tasman pond, Australia has some similar
problems, but more
broadly faces the reality that greenhouse emissions have
increased
over the last decade primarily due to land use changes,
including
deforestation and agricultural practices. As forest land
is cleared
and burned to make way for agricultural and other uses,
and under
certain types of agricultural practices, much carbon that
was stored
in plants and soils is released back into the atmosphere.
This feature of Australia's greenhouse gas profile
appeared to be
partly responsible for a flurry of activity witnessed at
the Sydney
Futures Exchange in the late 1990s as Australia was about
to develop
the world's first derivatives market for carbon credits.
Working with
the State of New South Wales Forestry Department and also
closely with
the forest investment divisions of global financial
institutions such
as the US-based John Hancock Insurance Company, the stage
was set for
the first international market in carbon futures, backed
by the trees
in new and growing forests in Australia.
These carbon-based instruments were to be based on the
quite
controversial provision in the Kyoto Protocol whereby
"Carbon Sinks"
such as certain forests and forest management practices,
can be used
to accumulate credits in carbon emissions trading
programs. However,
this world-first futures market collapsed by the year
2000, mainly due
to the controversial nature and uncertainties surrounding
the
definition of Kyoto Forests and Carbon Sinks. It also
didn?t help
matters that Australia failed to ratify the Kyoto Protocol.
Back to the Dark Ages to See What the US is Up To
In the final week of July 2003, while the EU was busy
putting its
final touches on the world's first international carbon
emissions
market, certain high profile leaders in the US were
continuing to
emphasize the importance of the climate of the middle ages
and
labeling the pro-Kyoto team as "environmental extremists".
Perhaps the man most enamoured with the Dark Ages, is one
Senator
James Inhofe, a Republican Senator from Oklahoma. He
Chairs the
Environmental and Public Works Committee. He spoke on the
Senate floor
on Monday, July 28th, 2003 and here is some of what he had
to say:
Inhofe on Senate floor
Later he had some extra words of wisdom about this big UN
Conspiracy
to share with CSPAN.
Insert: Inhofe on C-SPAN
Senator Inhofe is primarily funded by energy companies.
In his efforts to bring ocean views to his inland voters,
President
Bush ignores the absolute cuts in greenhouse gases
mandated by the
Kyoto Protocol and has instead produced his own
definitions of what it
means to cut greenhouse emissions.
Insert: Bush on GHG
The Pivotal Role of Russia
The Kyoto Protocol will become official international law
when the
emissions levels of countries that have ratified the
protocol amount
to at least 55 Now, Kyoto targets are based on 1990
greenhouse gas
emission levels, and this benchmark year is the year
before the
collapse of the Soviet Union. The subsequent economic
collapse in this
region has meant that, today, Russia's emission levels are
actually
about 30 By ratifying Kyoto, the Protocol would become
International
Law and Russia would then be able to start making money by
trading its
excess emission allowances on the new international carbon
markets.
Many people view this as a sufficient incentive for Russia
to ratify
the protocol. However they had been counting on US
companies to be
among the buyers in the markets, to help push up the
prices of these
credits. And these buyers won't be there. Furthermore, it
is possible
that Russia may make its ratification of the Protocol
contingent upon
entry into the World Trade Organization. So some very
interesting
dynamics are playing out between the US, Russia and the EU
on these
critical issues over the next few months.
Stuffing Your Wastes Under the Ground
If the investigations of the warm temperatures in the Dark
Ages bear
no fruit, the US has at least a Plan B and a Plan C. As
the EU was
announcing its implementation of the world's first
International
Carbon Markets, the Bush Administration on July 25, 2003
("Wall Street
Journal") announced a new $100 million climate change
research plan.
This project will deploy satellites and other technology
to primarily
study natural causes of climate change, particularly the
role of
clouds.
If this fails to prove that global warming is all Mother
Nature's
fault, well, there is one more thing you can do without
having to cut
down on fossil fuels - and that's to bury the extra
greenhouse gases.
A collection of countries, led by the US and Australia, are
cooperating on finding ways to sweep our extra greenhouse
gases under
the proverbial rug. You can expect
to hear a lot more about this
solution to global warming in the coming months and years.
Insert: APCRC
Will the US be Left Out of
Emerging Financial and Energy Markets?
As the carbon markets emerge in other countries, you can
expect to see
the US-based investment banks and brokers getting
involved, despite
the fact that the US is not a signatory to the Kyoto
Protocol. You can
also expect some rumbles from multi-national companies
based in Europe
that also do a lot of business in the US. Furthermore, the
companies
that have to start complying with the European rules and
who are
spending money to comply, will be able to green-wash their
image with
some legitimacy. This, in conjunction with growing
shareholder
activism on climate change in the US may apply significant
pressure
for change in this country.
It is likely that even US based companies across the
financial,
energy, and other sectors will be significantly impacted
by the Kyoto
Protocol, even without ratification by the US. There may
also be a
concern from many companies that they are missing out on
opportunities
in new markets, such as the carbon markets and new energy
markets,
because the US is not a party to the agreement.
Perhaps the US may end up stuck in the Dark Ages after
all, if the
rest of the world moves ahead quickly without it.
_________________________________________________________________
Mark Heily 2003-10-03
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