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Guest Post: The Collapse Of Our Corrupt, Predatory, Pathological Financial System Is Necessary And Positive
Submitted by Charles Hugh Smith from Of Two Minds
The Collapse of Our Corrupt, Predatory, Pathological Financial System Is Necessary and Positive
We are being throttled by the Big Lie: we're told that if the predatory financial system implodes, we'll all be ruined. The opposite is true: the only way to save our economy is to let the corrupt, pathological and flawed financial system implode.
I was recently challenged by a contributor to write something positive, and so I decided to write about the single most positive outcome of the current financial crisis in Europe: the complete collapse of the corrupt, predatory, pathological global banking sector and its dealers, the central banks. Exploring why this is so reveals the insurmountable internal conflicts in our current financial system, and also illuminates the systemic political propaganda which is deployed daily to prop up a parasitic, corrupting, pathologically destructive financial system.
Our first stop is modern finance itself. Modern financial "products" and "instruments" are often highly complex and abstract, but the entire edifice can be distilled down to this: the system is based on the assumption that all risk can be hedged, and the difference between the initial position's yield/gain (i..e. placement of capital at risk for a gain) and the cost of hedging the risk of the wager to zero can be skimmed from the system risk-free.
That is the entire system in a nutshell, and we can immediately see the advantages of this system over traditional Capitalism, where risk can be hedged but never to zero, and the return is correlated to the risk taken on.
In modern finance, high-risk "investments" (wagers) with high returns can be taken on without worry because any and all risk can be hedged to zero, even in super high-risk wagers.
And since even high-risk positions can be seamlessly hedged to zero, then there is no reason not to borrow money to increase the size of your wagers: since you can't lose, then why not? Wagering in risk-free skimming with borrowed or leveraged money is simply rational.
Put these together and we see how a system based on risk-free skimming eventually leverages itself to the point that the slightest disruption can bring down the entire over-leveraged, over-extended system.
Why is this so? Every hedge has a counterparty who is supposed to pay off if the initial wager blows up. A system based on risk-free hedging is ultimately a self-organizing system which maximizes return by increasing bet sizes, leveraging/borrowing to near infinity and hedging every hedge as well as every wager.
This creates long chains of hedges and counterparties. Here's an example based on an asset we all understand, a house. Let's say someone buys a house for $1,000 down, something that was common in the housing bubble. That $1,000 is leveraged up to buy a $200,000 house via a $200,000 mortgage.
The "owner" of the house then buys a hedge to protect himself from the house losing value, so the risk is reduced to zero: if the value rises, the owner reaps the gain and if it declines, then he collects the payoff of the hedge from the counterparty, for example, a Wall Street investment firm.
The counterparty calculated the risk of real estate declining and then priced the hedge accordingly. There is some small risk that the loss will exceed the cost of the hedge, so the issuer of that hedge bundles similar bets and then buys a hedge or "insurance" from another player, who makes the same calculations of risk and return.
Meanwhile, the mortgage has been tranched (sliced into principal and interest and into various pools of risk) and bundled with other "low-risk" mortgages and sold to investors, who also buy a hedge against any loss in the tranch, for example, a credit default swap (CDS) which pays out if a borrower defaults. Those hedges are sold or "insured" with another hedges.
All of this debt and all of these hedges are based on a mere $1,000 of actual capital. The players who originated each hedge are similarly leveraged, because since risk can be lowered to zero, who needs capital?
So what happens when one counterparty (issuer of a hedge) somewhere in the chain runs into trouble? The entire chain collapses. With razor-thin capital to cover any losses, then each link in the chain dissolves into insolvency if their counterparty fails to pay off.
This is how we get hundreds of trillions of dollars in "notational" derivatives: every hedged is hedged with another "instrument," "products" are bundled and insured, and so on. The system is based on the principle that risk can be reduced to zero, and so there is no need for capital.
Unfortunately, that premise is demonstrably false. Benoit Mandelbrot dismantled the notion that risk can be reduced to zero in his prescient masterpiece, The (Mis)behavior of Markets. The founder of fractal geometry showed that markets are fractal in nature, and are thus intrinsically prone to unpredictable disruptions. Simply put, risk cannot be massaged away.
Thus the fundamental premise of all modern finance is flat-out wrong, and this explains why systemic risk, rather than being eliminated, actually rises with every ratchet up in debt, leverage and counterparty hedging.
The entire global financial system is thus based on the equivalent of a perpetual motion machine: money can be borrowed or leveraged into existence in essentially unlimited quantities, and then deployed in risk-free skimming operations to harvest unlimited wealth.
What does this promise of using leveraged capital to skim risk-free fortunes do to the "real economy" of production and investment in plant and technology? It guts it. The risk of industrial Capitalism is real and cannot be hedged away; high-risk investments may blow up or they may return high yields. It literally makes no sense to risk real capital in productive Capitalism when a zero-risk skimming operation can be developed that essentially needs near-zero capital.
Thus financial capital has come to completely dominate industrial or productive capital. The pernicious consequences of this dominance have poisoned the economy and culture on multiple levels.
In the political sphere, the aggregation of hundreds of billions of dollars in skimmed profits gave Wall Street and the banking sector unlimited budgets to buy political influence. This created a monstrously pathological feedback loop: the more political influence Wall Street bought, the higher their returns on financialization skimming.
Consider housing as an example. Housing was once a simple, barely profitable long-term investment for both the buyer, who had to place substantial capital at risk (20% down payment) and the holders of mortgages, who took a modest yield for 30 years in trade for low risk.
Wall Street and the banks financialized housing via political influence. opening up a vast new territory to be exploited via skimming. Since capital wasn't necessary in no-risk skimming, then down payments were dispensed with to increase the pool of debtors, as they are the foundation of all skimming operations.
the cost of servicing that debt was manipulated via "teaser rates" and "interest only" loans, further leveraging up American home buyers' modest income streams. Mortgages were bundled, tranched and hedged, and the mortgage-backed securities (MBS) and collateralized debt obligations (CDOs) were sold to trusting investors aroudn the world.
It was a bonanza of unprecedented wealth creation from financial skimming. $1,000 down and a few hundred dollars a month for a "teaser rate" interest-only loan was leveraged into a global chain of "products" and counterparties that could be skimmed all along the chain.
That deepened the political corruption that fed the skimming operation, and introduced the "no risk" pathology into Mainstream America. Since real estate never went down in value, then buying a second, third or fourth home on leverage was simply rational; in a Federal Reserve-controlled world of near-zero yields on cash, it was irrational not to.
But there were two intrinsic flaws in the skimming operation: while the Wall Street players were hedged (or so they reckoned), the average Americans buying homes with near-infinite leverage were not hedged. That meant that when their razor-thin capital went to zero, they were insolvent. Once they defaulted, then the income stream feeding the chain of skimming went away and the chain collapsed.
Once one counterparty failed in the chain, the entire chain collapsed as well. As Mandelbroit explained, such disruptions were an intrinsic feature of the system; though the timing of a systemic disruption could not be predicted, the fact that disruptions would occur on a regular basis could be predicted.
Some players knew this, of course, but that led to another pathology: those investment players who avoided the "no risk" skimming casino could not generate the yields being "earned" by the leveraged skimmers with legitimate investing, and so their investors abandoned them for the fully rational reason that "no risk" yields were higher elsewhere.
This too created a feedback loop, where the capital available to be leveraged grew rapidly, while the pool of capital available for "patient" risky investments in actual productive assets declined. Capital available for productive investment thus became costly and scarce, while capital available for leveraged skimming became cheap and abundant.
The Federal Reserve bankrolled the skimming to the hilt. Indeed, the entire pathology of low-interest, unlimited leverage skimming was based on the Federal Reserve's manipulation and intervention. That remains true today.
What happens when the whole chain blows up and the foundation of debt is impaired? Since the whole system is based on the debt and the income streams devoted to servicing it, the entire edifice collapses when the debt is impaired--debtors default and the system clogs with bad debt, i.e. uncollectable debt.
In a transparent Capitalist system, the debt would be written down and all the insolvent borrowers, lenders and counterparties would be wiped out. But the political corruption that enabled modern finance to poison the American economy and culture has stopped that cleansing from occurring.
Such a systemic writedown of bad debt in a system with only razor-thin capital to support a mighty edifice of leverage and debt would wipe out Wall Street and the banks and reveal the skimming operation of modern finance as an impossible perpetual motion machine rigged to enrich a thin crust of citizenry at the expense of the rest. And since they skim enough money to buy political protection, Capitalism has been strangled and tossed in a shallow grave lest it disupt the skimming and the political corruption that keeps the machine running.
What we end up with is artificial valuations, endless propaganda and a zombie economy. When borrowers are left dangling in default and the assets left on the books at full value, you end up with zombie debtors, zombie lenders, a zombie government that only has one lever to pull to keep the whole corrupt pathology going--borrow and squander more money-- and ultimately a zombie economy, drifting and decaying in a fetid pool of lies, shadow banking, ceaseless official propaganda, jury-rigged "fixes," manipulated statistics, corruption, predation, exploitation and pathology.
That's the U.S. economy, and indeed, the economies of the E.U., China and Japan in a nutshell.
The only way to clear a zombie economy is to write off uncollectable debt and liquidate all the assets, loans and hedges. That would collapse our financial system, but since it is the cause of our political and economic dysfunction, that would be the highest possible good and extremely positive.
There is a great final irony in the scare-mongering threats of the skimmers and their political toadies. If the taxpayers don't bail out the skimmers, then we'll have martial law by the weekend, the smouldering fires of Europe will rekindle into open warfare, and so on.
The irony is the propping up of a deeply, intrinsically pathological and destructive financial system is not saving the economy, it's the reason the economy is imploding. The Big Lie technique of propaganda is to reverse the polarity of reality: we are told up is down until we believe it.
We are told that liquidating the overhang of bad debt, leverage and hedges would "destroy the world as we know it." The truth is that keeping the zombie system from expiring and covering up the corruption with propaganda is what's actually destroying the world as we know it.
Thus the collapse of the current financial system of central banks, pathological Wall Street and insolvent banks would be the greatest possible good and the greatest possible positive for the global economy and its participants.
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One of your bests Chuck
Angst, hatred, and revenge are what should be doublechecked in every Zher's MO...It's all impersonal at this point...Blythe, Dimon, Lloyd Blank, Corzine etc...Who gives a hairy rat's...It's all about finding rational ways around all this and creating communities that are not affected by their actions...I would bet a mint roll of 1/10 oz Au Eagles that if all the negativity were removed to the garbage can and start anew would create do wonders for any groups that come out of ZH together...I seriously doubt the realization is present most of the time here on this awesome blog we all take part...Taking 10, 15, 50 of us together would be a formidable commitee...and worthy of much good and capable beyond any of us could imagine separately and isolated............
EO Wilson in Sociobiology shocked the 'mainstream biologists' of the time when he (paraphase) stated that individuals vs individuals do not have much lasting effect concerning survival...The real battle ground will always be groups vs groups that define survival...Come together as this ZH demographic obviously attract the strong and intelligent...That need not be proven but is self evident...Yet we all remain somewhat alone and isolated against an all powerful control machine...Must it be and remain so...God I hope not......
We'll throw off the yoke of anonymity in time. It's an inevitable and necessary progression IF we are to bring about change. How to resolve the dichotomy of loathing the industry that you feed through your efforts (trading in these crooked markets)? Are any of you professional traders hedged for if/when "it all comes down"?
Being nimble and taking small positions has been working well for traders. Volitality is good from their perspective..
Problem is, since the 'flash crashes' started happening, hedging is not so comfortable or easy. After all, if your hedges work 'most of the time', are you truly hedged? What happens when the market flashes down, but fails to flash up?
And now....
Want to get arrested?
Try to withdraw your money from a bank in N.Y.C.
http://www.guardian.co.uk/commentisfree/cifamerica/2011/oct/27/goldman-sachs-occupy-wall-street?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+theguardian%2Fcommentisfree%2Frss+%28Comment+is+free%29&utm_content=Google+Reader
The Fed can expand its balance sheet to infinity.
The Fed can print money to infinity.
The Fed can support the status quo as long as the majority of folks agree that the status quo is better than an alternative.
People fear change.
This can go on for a LONG time.
a jew explains the transfer of wealth. see how they are now? they tell you right up front what they are doing. they don't care. they have the power now. they are not afraid of you.
http://www.youtube.com/watch?v=mOwZwkhFemQ
ps. notice the look on those student faces. i think they are smelling the coffee. party time is sbout over. now then what are they going to do about it? let it happen or take care of business. many out here in flyover country await the order to come down but we need help. they are the young. it is their world now. either we shit or get off the pot. many vietnam veterans are angry till this day and are ready to do the thing. they have useful skills. either we stop this or we are finished. listen to the yid telling them what the plan is. as an american i beseech you. as an american i say to you. what shall you do? it is your world. shall you stand by and allow this to happen. the founding fathers speak to us from the their graves.......
absolutely one of the best post i've read in months - Bravo, Charles -
and thankyou tyler
ps. i like to add a little dessert to your fantastic mindfeast,...
ref: http://www.macroresilience.com/2011/11/02/innovation-stagnation-and-unem...
by Ashwin* [11/2/11/]
ps2. **gloss over highlights___various sections that are extremely relevant for today's telling post
los angeles radio talk show host bill handel of kfi radio 640 am ...........says that he is not angry with wall street because his tribe owns wall street...........hmmmm............comment available at about 24:50 on the audio clip....so we see what the mindset is here don't we. its like hpd always has said. its all about tribe ladies and gentlemen. its all about tribe...........
http://21pronto.com/handel_on_the_news.mp3
Very well stated. I am starting to hope for collapse, as it's product would be a refreshing change from the culture of greed & corruption that is rampant throughout wall street.
http://online.wsj.com/article/SB1000142405297020380420457701616035457190...
Please correct me if I am missing something, but, it sounds to me like ultimately, as long as the politicians are willing to backstop the counterparties with taxpayer money, including leveraged future taxpayer money, borrowed against future taxpayers, the system can and will go on indefinitely...or until there is some sort of taxpayer revolt.
@" ..taxpayer revolt."
or economic collapse or tax base collapse. will the system
tolerate the monetization of interest payments? who qualifies
for those loans? absurdity in bloom.
And a systemic collapse would likely be the favorable option, as large scale war is the other...
Thank you Tyler and associates. i have learend alot form ZH and also from several books such as the ones by Greider, Moffitt, Schiff and the Mises web site. I may not be able to do much about the screw jobs I get but at least I'll understand and maybe prepare better.
Cheers!
AMEN
US Demise: As Hugh Hendry said in spite of all the negative news the optomists have profited. I have almost grown implatient for the EOTW but I check pre market each day and the damn thing is green and up 100 points in spite of a cornucopia of breath takingly disasterous news on zero hedge early morning threads. I have been reading zero hedge since it was a lowly upstart blog. Now it is establishment. Doom and Gloom porn is seductive because we all - or at least a majority of commentators - would like to see justice - whatever that means anymore.
I just wonder sometimes - is zerohedge with it mercurial rise - like Obama - from obscurity another red herring? I would hate to believe it but not every bit of new is bad news.
Now is it the People's Front of Judea or the Judean Peoples Front that are the enemy?
Quick!! Somebody pull up the interwebs! There has to be some cheat codes posted somewhere that will get us past this zombie level. Then we can live happily ever after. MOM!! More cheezits!!
Holy fucking Ponzi,Batman,weez been hood winked.
With the blessing of the goverment.
If the Shit don't hit the fan, the bastards and satanic whores will never be prosecuted. No one will survive a Nuclear war. Not even these POS with all their bunkers.
Careful With That Axe Eugene.
The positivity that desperate people prefer is produced at Morningstar.com. What good it will do them is no matter. You can't convince that person the system is anything like you describe, not in 5 minutes, not in a lifetime.
They live with confirmation bias same as the common'tater on Zero Hedge who licks his lips in anticpation of pointing his gold plated shotgun at a sick, starving neighbor.
Collapse and reconstruction occur simultaneously.
Like it or not, it is the readers at Morningstar and the angry mobs that OccupyPlaces that are manning the reconstruction while too many others are silently felling trees in a forest that few others can see.
Build. or Lease. Bitchez.
Nice Pink Floyd reference.
Anagram: End the Fed = Deft end, eh?
Government debt is the source of money. Government debt is mandatory. Socialism and wars are mandatory. Peace and prosperiy is forbidden. Must not be allowed to pay off the national debt and or the Fed would be out of business. Resist we much.
It won't be long now. Of course I have been saying that for awhile, but it seems to be accelerating.
Once upon a time, in 1993, a couple of economic Nobel Laureates got together and formed a hedge fund. They had a brilliant foolproof plan to make money using derivatives. It requried a lot of leverage, but that was OK because it was a foolproof plan. And who should know about foolproof better than two princes who were Nobel Laureates in the Kingdom. It was all good and the Kingdom was happy.
In just 5 years, these Nobel Princes had assets of $5 billion, controlled $100 Billion and had investments of $1 Trillion. Everyone was happy.
But one day, in 1998, the Russian economy collapsed. And that caused the two laureate's Kingdom, called Long Term Capital Management, to collapse as well and almost collapsed the world economy with it.
Who coulda seen that one coming 13 years ago?
Answer: Brooksley Born. And she was dragged through congress by Rubin, Summers, and Greenspan before being kicked out of Washington for saying the dark market of derivatives needed to be transparent.
For all LTCM's faults that was financial capitalism at its best. they had a smart idea, they played it, they crashed and ate their losses.
as a hedge fund they were supposed to be highly speculative anyway, and I see nothing wrong with this. it's a different matter
if institutionals threw your retirement savings funds in such a venture, however. so the real question is the proper separation of
fiduciary responsibility. now as for transparency: yes indeed. note that some of their arbitrage was in listed equity derivatives
(mostly options), a lot of it was not (fixed income derivatives, ie IRS). but the thing to remeber is that LTCM's crash did not
ricochet and cause a systemic risk in the rest of the system. it was just a normal failure in the regular risk-reward scenario.
but yes, if russia bonds, rates and IRS had been on listed exchanges, perhaps they would have seen the russian collapse or
may have even hedged with CDS on russia; perhaps they would have walked (assuming the counterparty held good on that).
You are either stupid or ignorant.
Their losses were much more than they had capital, but still the head figures got out with a few million left to them - less than the billions they were worth before, but not dirt poor either.
Also the LTCM collapse would have brought down the system back then, if Greenspan hadn't jumped in with money and by forcing all the numerous counterparties to unwind the trades over several months in backroom negotiations through netting.
It is great that it worked then, but nobody learned any lessons because nobody took real pain - and no plans were put in place to prepare for another such big unwind, which was guaranteed to happen therefore.
but that was normal failure at work. not public money bailout, but rightful haircuts and firesale aquisitions.
that's how it's supposed to work. Greenspan was there too make sure Pauson, Corzine and GS didn't blow up.
Years later, Lehman was left to die
A-men, brother. Amen.
Michael -
"I just thank God every day for the complete and total worldwide economic collapse, because I know the result."
The "Final" result , would be more appropriate. It is very interesting to see this unfold , however slowly . Collapse will occur in ONE DAY . That day the banskter/speculators get theirs "materially" (losing all ) . Until then , wash rinse repeat . Poor blind fools .
REV. 3:17-18
"You say, 'I am rich; I have acquired wealth and do not need a thing.' But you do not realize that you are wretched, pitiful, poor, blind and naked.
I counsel you to buy of me gold tried in the fire, that you may be rich; and white clothing, that you may be clothed, and that the shame of your nakedness does not appear; and anoint your eyes with eye salve, that you may see."
great article.... i wish our uk politicians would read it... I will close my rbs account this week move into a credit union... and keep stacking the shiney... these are the best things to do whilst we wait for other people to catch up with ZH....NO ONE WHO PROFESSES TO BELIEVE IN CAPITALISM CAN POSSIBLY HAVE AN ACCOUNT WITH THE BIG BANK MARKET KILLERS...
Obama's ringing campaign pledge was to fundamentally transform America.
And I think to simply look at the occupiers as an aberation is dangerous.
As a society, we have not come to grips with the financial shell game that has been perpetrated by the pols and the banksters.
There is a great vested interest to keep the present system afloat. I agree a if we cleanse the system the way it was cleansed in the great depression with bank failures and deposits just disappearing. It is too unbearable.
But the fundamental transformers can point to this corrupted capitalism that has been foisted on we the people by the banksters and pols. And make a case to the majority that capitalism has had its run but is a failure.
Unfortunately, the fundamental transformation will likely not include property ownership, freedom of speech, or religion, or rule of law. To say nothing of the pursuit of happiness by each individual. (happiness as defined by the founding fathers is not a free vacation to Atlantic City to stimulate the economy)
Since 50% of the American public does not pay taxes, you don't have to convince many more that a fundamental change is needed.
And they don't have to explain the change, either because our crony capitalism stopped explaining because lying is easier.
this mirrors another zerohedge post about the efficiency of leveraged money having deteriorated in terms of actual capital formation and growth.
in otherwords: you can buy prospecting rights forever but at some point it's more efficient to actually pick up the shovel and start digging for known ore.
this lowered leverage return also created the impetus behind the fraud we are seeing, encouraging liquidity providers to cheat clients on fees and spreads.
a lot of these issues can fixed, which seems like a paradox, by restoring the regulations governing a true free market. notably the reinstatement of
glass steagal separation, forcing derivatives on listed exchanges, forcing all instruments to imply skin in the game (banning naked shorts for one).
this is especially true of highly leveraged credit derivatives, insurance products, and most collaterised debt and structured products. ie knowing volume
on for instance, the total amount of credit default insurance already written on Lehman, AIG, MF Global, could have more prevented systemic risk.
another big one is restoring honest price discovery by removing the intermediated otc junk and the moral hazard and middlemen peddling it.
we need better regulations and math to make heterogenous products more fungible, thereby opening them up to listed exchanges, and scrapping
obvious robber/broker/dealer traps like sales road shows, primary dealers, ratings agencies, and all that crap. Any time I need an agent, broker,
middleman my hackles go up: it means the market is inefficient at this point and the third party controls liquidity and has an interest in fleecing me.
this will be difficult, but for example, everybody does their own counterparty due dilligence anyways, so we can start with the ratings agencies and
replace credit ratings with a listed credit exchange, much more granular, where 1.0 == AAA investor grade and 0.0 == immediate 100% default.
Great article. Best reference to Mandelbrot and the fractal nature of a leveraged system I've read in some time. Thx.