It’s the Derivatives, Stupid! Why Fannie, Freddie and AIG All Had to Be Bailed Out

Why the extraordinary bailout measures for Fannie, Freddie and AIG? The answer may have less to do with saving the insurance business, the housing market, or the Chinese investors clamoring for a bailout than with the greatest Ponzi scheme in history, one that is holding up the entire private global banking system. What had to be saved at all costs was not housing or the dollar but the financial derivatives industry; and the precipice from which it had to be saved was an “event of default” that could have collapsed a quadrillion dollar derivatives bubble, a collapse that could take the entire global banking system down with it.

38 Responses

  1. Dear Ellen:

    You wrote, “The Federal Reserve has the power to print the national money supply, but it is not actually a part of the U.S. government. It is a private banking corporation owned by a consortium of private banks.”

    The Federal Reserve Act provides that the Board of Governors of the Federal Reserve System can acquire land “in its own name”. The Board can levy assessments on the Federal reserve banks “and funds derived from such assessments shall not be construed to be Government funds or appropriated moneys.” The Act provides that each of the twelve Federal reserve banks is a “body corporate” but, in contrast, the Board of Governors of the Federal Reserve System is not referred to as a “body corporate.” I am therefore inclined to regard the Board of Governors of the Federal Reserve System as an agency of the Congress, through which Congress exercises its monetary powers.

    I disagree with your description of the Board of Governors of the Federal Reserve System as “a private banking corporation.” I believe that my “Congressional agency” interpretation is correct because Congress does NOT have the authority to delegate its monetary powers to “a private banking corporation.”

  2. Thank you, Ellen, for your cogent explanation of the real financial crisis behind the headlines. Few folks in the MSM are saying much about derivatives, but your information shows we all need to know the truth about the greed and speculation we’re being asked as taxpayers to protect. Bailing out Wall Street’s gamblers feels like such a bad idea. I’m still of the mind to say “Let it all fail, and let’s start over without the Ponzi scheme this time.”

    Funny, I live in Las Vegas, but no casino I know ever returns the money I risk and lose when gambling. Of course, it never occurred to me to ask for its return.

  3. I agree. I’ve been telling people about derivatives, informing them that if the $1 quadrillion in derivatives turn out to be worth a mere 10% less than their nominal value – hugely optimistic – that represents two years of global economic output! Imagine if your investments in the stock market lost the equivalent of two years’ worth of your gross salary, that’s what we’re talking about. That’s the real threat facing the global economy.

    Unfortunately, all the shady, legally-challenged machinations going on today aren’t increasing the value of these derivatives. All that’s happening is that they are being shuffled out of sight, shielded from any discovery of their true value. Now the government is brazenly talking about setting up what is essentially an $800 billion garbage can fund to absorb some of these toxic derivatives. Aside from the question of where the $800 billion is going to come from, that sum represents a drop in the bucket compared to the size of the derivatives market. Eventually these losses will have to be recognized or otherwise become manifest. The longer the losses are kept hidden, the more protracted will be the downturn.

    Derivatives, while they are the biggest problem we face, are also a symptom of a more fundamental problem: our finance-based economy. Over the last 35 years the U.S. has become less and less of a manufacturing – i.e. wealth-creating – economy, and more of a finance-based – i.e. smoke and mirrors – economy. The problem with our finance-based economy is that much of it revolves around leverage, which demands interest. Thus, most “investments” today (all financial in nature rather than productive investments, such as in factories) must generate sufficient returns to cover the interest owed on the debt used to pay for those “investments.” Thus, there is a need to generate exponential growth rates in all kinds of asset prices: housing, stocks and ultimately, risky derivatives. Unfortunately, exponential growth rates are totally unsustainable, which is why the system is breaking down. It started with housing, which stopped going up because despite all the increasingly exotic financing tricks houses finally became unaffordable. Since housing was one cornerstone of the huge and elaborate derivatives house of cards, once physical housing started to buckle, the entire house of cards started to shake as well.


  4. Thanks for the comments! Here’s a question: what would happen if derivatives were declared an illegal form of gambling, and all outstanding derivatives contracts were declared null and void. Might that solve the problem? They would cancel out and no one would owe anyone else on them. All just a dream that went away . . . Or is it I who am dreaming?

  5. Ellen, another excellent article on this unbelievably lopsided financials/mortgage meltdown which is and has been happening to the unsuspecting American citizen/consumer for over 200 years. When, I say when does ” Joe Average American” wake the heck up and ask somebody what’s really going on? I’ll tell you, never. “Joe” and “Jane” Average are just too busy working their tails off paying taxes and debt homage to these crooks we call leaders. What can we expect next week to happen in this corrupt world that will rock us on down to our busted bootstraps? At this point in this country, NOTHING WILL SURPRISE ME!! The brightest, most clever scriptwriter in Hollywood couldn’t devise a story of these epic proportions.

  6. Hollywood! That might work, a movie. I agree; thanks.






  9. I am not so sure the perceived need to save the quadrillion dollar derivatives market is any less a ruse than are political claims arguing we should bail out Wall Street for the sake of protecting Main Street.

    Truth is none of the grotesquely leveraged, securitized credit system (which derivatives facilitate) can be saved under the current arrangement. We are, in fact, in the midst of an economic breakdown crisis.

    To wit, the very means of maintaining payment on financial obligations such as mortgages (as well as the derivative securities tied to these loans) has been compromised by the fruits of globalization. As such, then, not even schemes to effectively create markets where deeply discounted financial assets can be absorbed will solve the present dilemma (which is essentially what the monetarist monkeys in Washington say they are attempting to do).

    I find it difficult to believe those in positions of responsibility do not see this as clearly as I do. Surely they must be aware of what happened to the likes of Peleton Partners earlier this year. Deep pockets matter not when the so-called financial assets you hold can find no market willing to pay your asking price. Thus, too, it does not matter the discount at which you acquired these assets.

    As such, then, I find the case of Lehman instructive. Oh, those crafty British! Handing out the rope with which financial institutions can hang themselves — this through their offshore, unregulated financial centers where OTC derivatives originate — then pouncing to pick up the pieces for pennies on the dollar.

    THIS appears to be reflective of the larger agenda underlying what is going on right now with bailouts being orchestrated by that fox in a hen house, Paulson. Truly, those who argue treason might just be spot on.

    Bear in mind, 91% of the assets held by FNM and FRE were current and performing. Thus, someone is licking their chops because, like I said at the start, the securized leverage built upon these assets MUST collapse. Globalization has seen to the fact that, leverage would be challenged by physical constraints threatening its viability right up to the point where confidence irreversibly collapses, which it now has. Yet, the assets upon which this leverage has been built remain.

    I submit the radical adherents of free markets have purposely orchestrated — from seemingly innocuous start to chaotic finish — a financial crisis whose unfolding offers more or the same old, same old as ever is the status quo of the British Empire and their friends here in the U.S.: it is the course wherein very few benefit at the great expense of many.

    If you consider this in the context of the principle stated in the Preamble to the U.S. Constitution, then you begin to understand those charges of treason against the Treasury Secretary.

    There simply is no saving the dead, Mr. Paulson. You are no Jesus and structured finance is no Lazarus. It is dead, dead, dead as Elvis. You cannot save it. Now, rather than bother the Congress with your inane schemes, sir, why don’t you spend the weekend brushing up on your Alexander Hamilton…

  10. Yes, I fear you’re probably right. Good analysis! Barclays got the valuable part of Lehman Bros, but the toxic derivatives still went begging. So wouldn’t that be a major “event of default” that could potentially collapse the system, just as Bear Stearns’ pending bankruptcy supposedly was? So why rescue Bear and not Lehman? Unless Congress just said “no more.” Then the Fed took over with AIG, since the Treasury would have to get authorization first. Here’s a question: what would happen if derivatives were declared an illegal form of gambling, and they were all just voided out? Would that fix the problem, since no one would have to pay anyone else? I suppose the triple-A investments would still lose their triple-A rating and get dumped on the market, which might hurt pension funds, etc. A serious brain teaser! Ellen

  11. Thinking outside of the box . . . could not all CDS’s be mandatorily folded into a one-size-fits-all exchange traded future contract, wherein specific contractual risk deviations from the standard contract be given a fixed premium or discount to same, as appropriate?

    The contract would be listed upon an existing USA based futures exchange, for initially just floor broker/locals trading, then combined partially with electronic trading, wherein the human floor broker/locals function will never be diminished nor replaced by mindless 100% automation.

    In addition, a clearing house would be established that would be fiscally the ultimate deep $pocket for all defaults, backed by, say, a few hundred financial & other business institutions, incl. central banks initially into a sunset period for them.

    Such futures contracts have worked well since the 1850’s, and it is time to regulate, standardize, collectively guarantee, and make all such trade obligations transparent upon a world recognized futures exchange.

    Sheldon Jacobs
    former member: NY Cocoa Exchange [Coffee, Sugar & Cocoa Exchange]

  12. I’ll have to study that. You’ve actually played in those markets; I just research them! Thanks.

  13. re prior posting clarification:

    “could not all CDS’s be mandatorily folded into a one-size-fits-all exchange traded future contract”

    Day one, would be automatically pre-exchanged for a contract, immediate creatation of open interest, wherein the long & short legs of each contract would initially be owned by current cash market owners. When the bell rings day one, they can respectively trade out of such positions as they desire wherein the free marketplace will determine price.

  14. Furthermore, this contract is not the same as mandatory exchanging CDS’s into open interest:

    CBOT® Liquid 50 Credit Default Swap Index Futures

    Click to access NPadv07-14.pdf

  15. Proclamation on the Federal Reserve System of the United States of America

    March 2008

    WHEREAS, Article I, Section 8 of the Constitution of the United States of America authorizes Congress “To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures”;

    WHEREAS, on December 13th, 1913 the US Congress enacted the Federal Reserve System;

    WHEREAS, the Federal Reserve System is considered an independent agency within the federal government, with oversight of Congress and containing appointed public officials on its board of directors;

    WHEREAS, the Federal Reserve System Controls the Federal Reserve Note, the official currency of the great nation of the United States of America;

    WHEREAS, there may be controversies regarding the legality and constitutionality of the Federal Reserve System, it is recognized that the said system has operated continuously as the central banking system of the United States since the inception of the Federal Reserve Act of 1913;

    WHEREAS, the Constitution of the United States of America granted Congress the authority to create the current Federal Reserve System, it also does grant Congress the authority to modify or revoke the Federal Reserve System;

    WHEREAS, the actions of the Fedreral Reserve System represent the credit and currency of the United Stated of America to the citizens of this great nation and to the world;

    WHEREAS, the Federal Reserve System, acting independently within the federal government allowed, supported, and even promoted parasitical and non-productive uses of the money and credit of the United States of America;

    WHEREAS, the United States and likely the entire world’s financial system is undergoing massive de-leveraging of the said parasitical and non-productive uses of the credit and money of the United States of America (as well as other nations’ currencies);

    WHEREAS, the US dollar, the “Federal Reserve Note” is declining in value due to these parasitical activites, as well as potentially other causes;

    WHEREAS, it is recognized that the citizens of the United States and other nations did willingly participate at some level in the creation and propogation of said parasitical activities;

    WHEREAS, it is also recognized that the United States of America, a sovereign nation, has the legal, moral, and God given authority to take actions to benefit its citizens and to protect its good name, credit and money in times of difficulty;

    WHEREAS, it is recognized that the current time is such a time of great difficulty;

    WHEREAS, it is recognized the parasitical financial institutions and their activities are at odds with citizens of the United States of America and the good credit and money thereof;

    WHEREAS, the current indications are that the Federal Reserve System is acting to preserve the financial system currently flooded with the parasitical activities;

    WHEREAS, the current indications are that the neither the Federal Reserve System, nor the Congress of the United States, nor the people of the United States have access to the books of the institutions being preserved by the Federal Reserve, and therefor the degree of inter-connectivity and risk associated with the institutions and other entities cannot be determined;

    WHEREAS, the Federal Reserve System is accepting non-performing assets as collateral for credit with ultimate taxpayer responibility to entities not under its constitutional mandate;

    IT MUST BE CONCLUDED, that the Federal Reserve System is not acting to the benefit of the people of the United States of America, its credit, money, and good name;

    WHEREAS, it is recognized that the political will and capability of the government of the United States of America may not be up to the task of prosecuting this proclamation ; It is also recognized that this may be the only hope for the continued survival of the United States of America as the great nation as it has historically existed.

    NOW THEREFORE, it is PROCLAIMED by those supporting this Proclamation that the Congress of the United States of America FULLY NATIONALIZE the Federal Reserve System, and take full control of the credit and money of our great nation; The Congress must take whatever action necassary to seperate out, sequester, disown, or otherwise neutralize the effect of the parasitical financial activities which led to the current crisis; The Congress of the United States of America must reorganize, replace, or terminate the Federal Reserve System as appropriate; or otherwise devise a system for creation of the national currency.

    IT IS FURTHER PROCLAIMED, that the Congress of the United States of America in cooperation with the Executive of the United States of America contact allied nations and any other nation willing to participate in the overhaul of the failing and parastical financial sytem currently in operation and create new treaties and alliances as necassary to create a sane and productive system of finance with the express goal of supporting a productive national, and by extension and through voluntary cooperation, world economy;

    FURTHERMORE, it is PROCLAIMED that it should be the goal of such an international effort to maintain fair international trading practices allowing for protection in national interest of labor, resources, and productive capabilities;

    WHEREAS, it is recognized that such a move on the part of the United States of America may result in the necessity of an isolationist policy IF the other developed nations do not follow our lead; If such occurs, so be it.


  16. The Federal Reserve, “a congressional agency” or “a private banking organisation”? As always, Follow The Money. Who get’s the benefits/profits?

  17. If all money was wiped out tomorrow we’d still have all the assets.

    In order to save America we must take back our money system from the rich and greedy. Here’s a compromise solution that let’s the winners walk away from the table with what they have now. Do they really NEED any more???

    I propose an American Jubliee.

    Let’s let everyone wipeout their current US-based liabilities and keep the US-based assets they have now. Everyone in the US gets a one-time running start into the future with a $50,000 line of credit that must be used for productive investment (starting a business, going to college, etc) and gets paid back at 2% interest into a fund used for SOCIAL PROGRAMS, INFRASTRUCTURE AND POSITIVE PRO-HUMAN ENDEAVOURS.

  18. This is the best explanation I’ve seen on our economic collapse yet…..I’ve been spreading this like wild fire…Thank you.

  19. Well researched, informative article. Perhaps the greatest misdirection of all time is the Federal Reserve’s ploy to trick the American public into thinking the Fed is a gov’t entity.
    This house of cards is on the verge of collapsing, but I fear, once again, the wealth of the middle class and poor will be stripped from them.
    It’s very likely the savings and pensions of the public will be wiped out.

    God help us all.

  20. Thanks for all the comments. To Dan who writes, “All over the world countries have central banks under their direct control and they still have inflation! When ever fiat money was used throughout history, governemets alwasy created it out of thin air to finance their excess expenditures.” This isn’t true. Virtually ALL governments now BORROW money from central banks that create it and lend it to the government, putting the government in debt for its own national credit. They’re financed by debt. China used to issue its own money, but it has now come around to our way of accounting, just so it could join the World Trade Organization. Not that I’m advocating a communist system; I’m not. I’m advocating something we have NEVER had in the U.S., except for a few years during the Civil War — money actually issued by the government rather than by private banks. It was the system of the American colonists. Some of those WERE inflationary, but some weren’t. The one I’m advocating is the one that worked best — the Pennsylvania system, where the government printed money and LENT it into the money supply. It returned to the government, preventing inflation. Free unregulated markets have gotten us where we are today — it’s a license to steal. You need rules, so that people can compete freely in a fair game.

  21. But wasn’t this exactly what Cecil Rhodes’ plan was from the beginning…..To collapse America so that a move toward one world central bank and government (which would be set up by the bank) could be ushered in….The problem reaction solution mindset….The solution being one central bank and world control?

  22. Ellen:

    Thanks so much for this sum up on derivatives, I have been reading about the coming collapse of our economy due to housing bubble bursting for over 18 months but never much understood the derivative thing and how much of a worse mess that is/was. I had heard of the stunning size of the CDS market compared to the much smaller US mortgage market and Us stock market on Market Place on NPR in April. Without any economic of financial background, the existence of such a huge market that was unregulated and not transparent seemed like a very very bad thing and I kept telling people about it. But your explanation really sums it up so well. Anyone who does not care about long term health of a company or an industry but would rather reap immediate profits would certainly love to collect premiums for “insurance” that they never plan to make good on. This is something most folks, even libertarians, can understand must be transparent and regulated to avoid all too tempting outright fraud.

    Is their a specific demand we can make around this derivative, a specific source, originator of this mess that can be straightforwardly made to account for setting up such system ripe for misuses and such huge risks?

    Finally a scary note from the most recent bailout bill (I can’t keep track of them and what was going to cost 500 bill on Friday seems to have morphed to 750 bill). A portion of the draft apparently reads , in regards to Paulson:

    Sec. 8. Review. Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

    So does “any court” include the SCOTUS? How ridiculous is it that they think this is acceptable provision, that they dare even putting it in there, but they know our Congress too well and have a “crisis” to scare people on their side

  23. Thanks. That is an alarming provision! I’ll have to look into that.

  24. Chris Cox versus Alan Greenspan on derivatives

    Listening to Chris Cox, the chairman of the Securities and Exchange Commission, giving evidence to Congress a few minutes ago, I was particularly struck by his assault on the lack of regulation of the over-the-counter derivatives market.

    Mr Cox described the unregulated $58,000bn credit default swaps market as “ripe for fraud and manipulation”, saying that it was a forum for the shorting of corporate debt without the oversight imposed on cash markets.

  25. I have a question. Considering the bailout this year and most commentators still think its only the tip of the iceberg, would the Fed keep bailing out other institutions in the future? While answering this, please look into the tax angle as well.

  26. Ellen, left a note over on the main blog about Kucinich’s plan for an “American Monetary Act” as part of his 16-point “Main Street Recovery Plan” published on his website yesterday. As a P.S., David Korten has this comment in his “Main Street Before Wall Street” article posted on the Common Dreams website today (

    “Perhaps the most important of all the needed reform measures is to make money creation a public function and strip private banks of their ability to create money out of nothing by issuing loans at interest against unsecured demand deposits.”

  27. I also posted this on the main blog, but I think it needs emphasizing that a public monetary system and a public banking system are complimentary, not identical;

    The assumption seems to be that government is a monolith and therefore it will be dictatorial. The monetary system needs to be national in order to provide the connectivity of an effective monetary system in which all parts of the economy and the country can trade, using a common currency, but it seems that a banking system should be incorporated at all levels of government, with small banks serving towns and counties, medium banks at the city and state level and large banks serving various national and international purposes. Since they would be a functioning part of their local governing structure and feeding profits directly back into the levels of the economy from which they are drawn, there would be no mechanism to incorporate into ever larger banks, as local businesses would have the strongest initiative to deal with local banks, as the profits would support the infrastructure on which these local businesses depend.
    The fact is that there are any number of services which are administered as public utilities, from roads to courts, water systems, etc. The private sector doesn’t insist that only they are able to run those services, which they can’t draw a profit from, yet they do manage to be administered effectively. As a medium of exchange, money is a public utility, but it does suffer from being a potential source of profit and thus tempting to those who have limited scruples.
    Political power started as private initiative and over the millennia into various forms of monarchy before we finally managed to make it a public trust. There are few people who wish to return to monarchy. Maybe we will eventually find ways to make economic power a public trust as well. It is a convective cycle of rising assets and precipitating benefits. When we slow that precipitation to a trickle, it only creates large storm clouds of marginally productive wealth hanging over a parched economy.
    Money is a form of public commons to which we are all responsible, therefore the profits from administering it should be community income.

  28. Ellen,


    I’ve been linking to your monetary proposal wherever possible.

  29. Ellen,
    Great article and I loved your book. Just wanted to make a couple points:

    1) You were plugged in a Reuters article today:

    2) You need to blog more often. 😉

    3) You need to accept your Digg friend requests. 😉


  30. Extremely interesting article.

    Basically what this means is this whole problem is exposed because of sub prime mortgages, not created because of sub prime mortgages.

    I will provide link to your blog on my blog. Hope you don’t mind.

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