The Armageddon Looting Machine: The Looming Mass Destruction from Derivatives

Increased regulation and low interest rates are driving lending from the regulated commercial banking system into the unregulated shadow banking system. The shadow banks, although free of government regulation, are propped up by a hidden government guarantee in the form of safe harbor status under the 2005 Bankruptcy Reform Act pushed through by Wall Street. The result is to create perverse incentives for the financial system to self-destruct.

Five years after the financial collapse precipitated by the Lehman Brothers bankruptcy on September 15, 2008, the risk of another full-blown financial panic is still looming large, despite the Dodd Frank legislation designed to contain it. As noted in a recent Reuters article, the risk has just moved into the shadows:

[B]anks are pulling back their balance sheets from the fringes of the credit markets, with more and more risk being driven to unregulated lenders that comprise the $60 trillion “shadow-banking” sector.

Increased regulation and low interest rates have made lending to homeowners and small businesses less attractive than before 2008. The easy subprime scams of yesteryear are no more. The void is being filled by the shadow banking system. Shadow banking comes in many forms, but the big money today is in repos and derivatives. The notional (or hypothetical) value of the derivatives market has been estimated to be as high as $1.2 quadrillion, or twenty times the GDP of all the countries of the world combined.

According to Hervé Hannoun, Deputy General Manager of the Bank for International Settlements, investment banks as well as commercial banks may conduct much of their business in the shadow banking system (SBS), although most are not generally classed as SBS institutions themselves. At least one financial regulatory expert has said that regulated banking organizations are the largest shadow banks.

The Hidden Government Guarantee that Props Up the Shadow Banking System

According to Dutch economist Enrico Perotti, banks are able to fund their loans much more cheaply than any other industry because they offer “liquidity on demand.” The promise that the depositor can get his money out at any time is made credible by government-backed deposit insurance and access to central bank funding.  But what guarantee underwrites the shadow banks? Why would financial institutions feel confident lending cheaply in the shadow market, when it is not protected by deposit insurance or government bailouts?

Perotti says that liquidity-on-demand is guaranteed in the SBS through another, lesser-known form of government guarantee: “safe harbor” status in bankruptcy. Repos and derivatives, the stock in trade of shadow banks, have “superpriority” over all other claims. Perotti writes:

Security pledging grants access to cheap funding thanks to the steady expansion in the EU and US of “safe harbor status”. Also called bankruptcy privileges, this ensures lenders secured on financial collateral immediate access to their pledged securities. . . .

Safe harbor status grants the privilege of being excluded from mandatory stay, and basically all other restrictions. Safe harbor lenders, which at present include repos and derivative margins, can immediately repossess and resell pledged collateral.

This gives repos and derivatives extraordinary super-priority over all other claims, including tax and wage claims, deposits, real secured credit and insurance claims. Critically, it ensures immediacy (liquidity) for their holders. Unfortunately, it does so by undermining orderly liquidation.

When orderly liquidation is undermined, there is a rush to get the collateral, which can actually propel the debtor into bankruptcy.

The amendment to the Bankruptcy Reform Act of 2005 that created this favored status for repos and derivatives was pushed through by the banking lobby with few questions asked. In a December 2011 article titled “Plan B – How to Loot Nations and Their Banks Legally,” documentary film-maker David Malone wrote:

This amendment which was touted as necessary to reduce systemic risk in financial bankruptcies . . . allowed a whole range of far riskier assets to be used . . . . The size of the repo market hugely increased and riskier assets were gladly accepted as collateral because traders saw that if the person they had lent to went down they could get [their] money back before anyone else and no one could stop them.

Burning Down the Barn to Get the Insurance

Safe harbor status creates the sort of perverse incentives that make derivatives “financial weapons of mass destruction,” as Warren Buffett famously branded them. It is the equivalent of burning down the barn to collect the insurance. Says Malone:

All other creditors – bond holders – risk losing some of their money in a bankruptcy. So they have a reason to want to avoid bankruptcy of a trading partner. Not so the repo and derivatives partners. They would now be best served by looting the company – perfectly legally – as soon as trouble seemed likely. In fact the repo and derivatives traders could push a bank that owed them money over into bankruptcy when it most suited them as creditors. When, for example, they might be in need of a bit of cash themselves to meet a few pressing creditors of their own.

The collapse of . . . Bear Stearns, Lehman Brothers and AIG were all directly because repo and derivatives partners of those institutions suddenly stopped trading and ‘looted’ them instead.

The global credit collapse was triggered, it seems, not by wild subprime lending but by the rush to grab collateral by players with congressionally-approved safe harbor status for their repos and derivatives.

Bear Stearns and Lehman Brothers were strictly investment banks, but now we have giant depository banks gambling in derivatives as well; and with the repeal of the Glass-Steagall Act that separated depository and investment banking, they are allowed to commingle their deposits and investments. The risk to the depositors was made glaringly obvious when MF Global went bankrupt in October 2011. Malone wrote:

When MF Global went down it did so because its repo, derivative and hypothecation partners essentially foreclosed on it. And when they did so they then ‘looted’ the company. And because of the co-mingling of clients money in the hypothecation deals the ‘looters’ also seized clients money as well. . . JPMorgan allegedly has MF Global money while other people’s lawyers can only argue about it.

MF Global was followed by the Cyprus “bail-in” – the confiscation of depositor funds to recapitalize the country’s failed banks. This was followed by the coordinated appearance of bail-in templates worldwide, mandated by the Financial Stability Board, the global banking regulator in Switzerland.

The Auto-Destruct Trip Wire on the Banking System

Bail-in policies are being necessitated by the fact that governments are balking at further bank bailouts. In the US, the Dodd-Frank Act (Section 716) now bans taxpayer bailouts of most speculative derivative activities. That means the next time we have a Lehman-style event, the banking system could simply collapse into a black hole of derivative looting. Malone writes:

. . . The bankruptcy laws allow a mechanism for banks to disembowel each other. The strongest lend to the weaker and loot them when the moment of crisis approaches. The plan allows the biggest banks, those who happen to be burdened with massive holdings of dodgy euro area bonds, to leap out of the bond crisis and instead profit from a bankruptcy which might otherwise have killed them. All that is required is to know the import of the bankruptcy law and do as much repo, hypothecation and derivative trading with the weaker banks as you can.

. . . I think this means that some of the biggest banks, themselves, have already constructed and greatly enlarged a now truly massive trip wired auto-destruct on the banking system.

The weaker banks may be the victims, but it is we the people who will wind up holding the bag. Malone observes:

For the last four years who has been putting money in to the banks? And who has become a massive bond holder in all the banks? We have. First via our national banks and now via the Fed, ECB and various tax payer funded bail out funds. We are the bond holders who would be shafted by the Plan B looting. We would be the people waiting in line for the money the banks would have already made off with. . . .

. . . [T]he banks have created a financial Armageddon looting machine. Their Plan B is a mechanism to loot not just the more vulnerable banks in weaker nations, but those nations themselves. And the looting will not take months, not even days. It could happen in hours if not minutes.

Crisis and Opportunity: Building a Better Mousetrap

There is no way to regulate away this sort of risk. If both the conventional banking system and the shadow banking system are being maintained by government guarantees, then we the people are bearing the risk. We should be directing where the credit goes and collecting the interest. Banking and the creation of money-as-credit need to be made public utilities, owned by the public and having a mandate to serve the public. Public banks do not engage in derivatives.

Today, virtually the entire circulating money supply (M1, M2 and M3) consists of privately-created “bank credit” – money created on the books of banks in the form of loans. If this private credit system implodes, we will be without a money supply. One option would be to return to the system of government-issued money that was devised by the American colonists, revived by Abraham Lincoln during the Civil War, and used by other countries at various times and places around the world. Another option would be a system of publicly-owned state banks on the model of the Bank of North Dakota, leveraging the capital of the state backed by the revenues of the state into public bank credit for the use of the local economy.

Change happens historically in times of crisis, and we may be there again today.

_______________

Ellen Brown is an attorney, president of the Public Banking Institute, and author of twelve books including the best-selling Web of Debt. In The Public Bank Solution, her latest book, she explores successful public banking models historically and globally. Her websites are http://WebofDebt.comhttp://PublicBankSolution.com, and http://PublicBankingInstitute.org.

46 Responses

  1. It appears that some evils have been made necessary in “the script”. Something has to bring people to gold-as-currency whether it be a carrot or a stick. Unfortunately, carrots don’t always work. Do not store your treasures up in heaven. Gold is real-time money. Gold in circulation purges debt right back to its nothingness.

  2. Please consider: You are correct. Please reconsider your solution. “Public Bank” is also correct but it would still be dependent upon ‘legal tender issuance’ . Please consider, the only real solution is ‘ A one and only ‘sovereign currency’ issuer that being A Public Central Bank.
    What if the Federal Reserve was a central bank owned and operated FOR, OF, and BY the people. A correction of the error made that of a central bank that is owned, operated FOR, OF, and BY private for profit banks.
    Please any profound response and please read:
    #OWS. OCCUPY FINANCE – now on scribd!!. .

    • No need for centralization of the currency. The mines and minters do that. The FED’s role is important to maintain the legacy system and to contribute to the real-time measure. Gold is a market “add on”. Nothing is being destroyed. Debt-currency’s biggest travesty may be that it has had no real competitive forces to keep its stewardship in line and acting responsibly. The measure and the weight can be a hybrid that never lets debt get out of hand. The market component acts as the arbitrator, but in real-time as never done before.

      • “Debt-currency’s biggest travesty may be that it has had no real competitive forces to keep its stewardship in line and acting responsibly.” Wake up, Rooster!The idea that the market is self-regulating has been PROVEN WRONG. Greenspan confessed to this mistake. Summers made a total ass of himself with his STUPID idea that there would be no fraud because all the players are sophisticated high-IQ people. Read Bill Black. Read James Galbraith. Left to itself unregulated, “the market” is criminogenic. That’s why 2008 happened.

    • and how politically do you expect to make that happen?…public banks on local, state, regional basis have much more chance of being political accepted, created into law than changing Fed. Once public banks prove themselves in smaller cases, then the idea will have legs to spread. But to try to win popular opinion on a finance issue that completely uproots entrenched interests that will fight the complicated subject is too much in my mind. Better to plant thousands of seeds, so the all the produce gained and ask for more and more acreage.

      • Karen …. that’s a good point. If legal tender was not an issue , such as in the case of a market currency, these “crutches” for legal tender would be a non-issue. Novel, isn’t it? Market currency as per market law. Who woulda thunk ?

  3. […] WHY $1.2 QUADRILLION should keep you awake at night. […]

  4. i love your articles. i have your latest two books. i am writing to most of my representatives with the information you provide. i am so hopeful of the future after reading the public bank solution. but i can’t seem to get your blog to post to Facebook.

  5. For your information..

  6. When the inevitable collapse takes place it appears there will not be enough money, bail in or otherwise, to re float the financial sector. These criminal enterprizes will quickly move to frame the solution. A return to a standard like gold seems unlikely so my guess is the various national fiat currencies will be pegged to the bankers international currency, the special drawing rights of the BIS, further consolidating their grip over national money supplies at an unimpeachable international level. The question is how to voice an alternative option at the time of crisis that will be heard by both the government and more importantly the people? The MSM will not be accomidating but rather anything but. I know my efforts to educate those around me are meet with blank expression or viewed as some mad conspiracy theory. With the larger public I drop off “literature” by the auto tellers, but I have no way of knowing if this effort bears any educational headway. Anyway what savings I have are “under the mattress” as I don’t believe even the credit unions would survive unscathed when the “looting” begins.

  7. […] Ellen Brown Writer, Dandelion Salad The Web of Debt Blog September 17, […]

  8. I had not heard of “Safe Harbour”, nor of the work of Mr Perotti. I have now. Thank you.

    I wondered if you would like to say hello? I would enjoy making contact with a like mind. Though I would quite understand if you would rather not.

    Either way, I enjoy your writing and just wanted to say thank you.

    • Very interesting, I surfed from Zerohedge, to Golemxiv, to GEAB, to asia times to ellen brown and here you are…so I must contribute, very humbly: read ‘welcome to the Machine’ by Vermont Trotter @
      chinkinthearmor.net……a simple, clear lesson how Safe Harbour has impacted us all via Lehman, MF Global, 2008 bailouts, and god help us, the new, improved housing market recovery. (Acknowledgment for lessons and wake-up call to Anne Barnhardt at barnhardt.biz re: MF Global and the SBS in action.)

  9. Reblogged this on wchildblog.

  10. Has anyone noticed that all the fiat currency based fears are on the basis that these instruments are viewed only by the application of their use as currency, meaning as a settlement instrument ? Maybe they should be viewed as something else. This can be looked upon as “what you may not not know that you don’t know”. Let’s take the dollar as an example. The dollar is more than just a currency. It’s a debt based currency within the debt-currency paradigm, only, but it also has a 2 edged purpose. It also doubles as a real-time component within the real-time measurement tool of “USD/oz”. The development of that floating relationship was an absolute MUST if gold was ever going to enter the monetary arena as a competitive currency versus debt. The FIXED peg between dollars and bullion had to be severed in order to set gold’s trade value free, for the sake of scalable liquidity, given that bullion’s weight is relatively rare and definitely finite. Fact : Gold’s liquidity as a currency is completely scalable now that it has been assigned market driven trade value. Gold is money that purges debt out of existence thanks to real-time applications and the development of the real-time conversion capability of “USD/oz”. You cannot pour new wine into old wine skins.

  11. Ellen, That article is a bit technical for those not acquainted with Wall Street jargon. Any chance of you doing a non-technical version?

    • Hi Ralph, the places I post to generally like 1200 words and this one was already at 1700, so I used links to my earlier articles for explanations. Maybe I could redo it to be more explicit on the references though; e.g. “See my earlier article here.”

    • if i may summarize: the upshot is…:

      (1) the term shadow banking includes “collateralized lending” and margins (down payments) paid on derivatives trades. These forms of lending have a peculiar characteristic {unlike say 30 yr fixed mortgages}…the shadow loans can be CALLED back (by the shadow bank itself) at whim!

      (2) all “banking” shadow or regular requires cheap inputs (money borrowed at lower rates) to produce more expensive outputs (money lent at higher rates). This is profit.

      (3) regular “banking” has the FDIC which allows those banks to borrow from mom n pops cheaply (“hey you, it’s insured by FDIC, don’t expect to receive high interest rates on safe investments!”).

      (4) who takes care of “shadow banks”? Answer: legislation…”Safe harbor act”.

      (5) Safe harvor says….any collateral or margin (the down payment) gained in shadow banking can be “confiscated freely” without having to go through bankruptcy court and administration formalities. So becasue of safe harvor, the “shadow banks” ALSO have access to CHEAP funding…ka-ching…they are in business to lend now…their funding is protected by the law and can be obtained on the cheap.

      When you combine the meaning of (5) with the peculiar characteristics of shadow lending in (1)….you see the frightening implications of Ms Brown’s argument!

      B/C shadow banking also has long chains of knock on effects througout the “real economy” so this unregulated debt orgy continues like before 2007. Nothing has changed.

      Cheers.

  12. This article is MUST READ for anyone who follows society today!!
    Neat summary of complex and unmentioned trends.

  13. @Ellen Brown – Are you aware of this private funding proposal for infrastructure in U.S. It is touted as not costing taxpayer dollars and being funded by private funds, but its just a tax break for corporations to repatriated their funds. Buy at “bond” at 1 percent interest and save billions in taxes.

    The scary thing is an article in Civil Engineering magazine said that principal forgiveness would be prohibited by AIF.

    I don’t know how giving giant tax breaks for repatriated wealth isn’t costing the taxpayers. Also, its giving corporations a tax break for something we should be able to do for ourselves.

    However, it does talk about “leverage” so it may be using some banking powers to public good. And given tax breaks to these corps to onshore their money is likely evitable, I guess its better than nothing.

    But it sounds like a set-up without a bankruptcy provision, principal forgiveness.

    http://delaney.house.gov/media-center/press-releases/delaney-introduces-bipartisan-infrastructure-bill

  14. […] posted the latest Ellen Brown, Web of Debt examination of the financial […]

  15. […] The Armageddon Looting Machine: The Looming Mass Destruction from Derivatives […]

  16. […]  The Armageddon Looting Machine:  The Looming Mass Destruction from Derivatives […]

  17. Oh, very well done. You mean, the global crisis wasn’t caused by badly underwritten million dollar loans made to people with no income? Really , you don’t say. Lol.

  18. Oh, very well done. It wasn’t the loans that caused the crisis? Well, that’s not going to make you very popular with anyone… believe me. And now if we could only figure out how to keep people awake long enough to learn what repos and derivatives are, we might just get somewhere. And then there were two.

  19. […] The Armageddon Looting Machine:  The Looming Mass Destruction from Derivatives!  by Ellen Brown, http://www.ellenbrown.com/  Increased regulation and low interest rates are driving lending from the regulated commercial banking system into the unregulated shadow banking system. The shadow banks, although free of government regulation, are propped up by a hidden government guarantee in the form of safe harbor status under the 2005 Bankruptcy Reform Act pushed through by Wall Street. The result is to create perverse incentives for the financial system to self-destruct. – Five years after the financial collapse precipitated by the Lehman Brothers bankruptcy on September 15, 2008, the risk of another full-blown financial panic is still looming large, despite the Dodd Frank legislation designed to contain it. As noted in a recent Reuters article, the risk has just moved into the shadows: – [B]anks are pulling back their balance sheets from the fringes of the credit markets, with more and more risk being driven to unregulated lenders that comprise the $60 trillion “shadow-banking” sector. – Increased regulation and low interest rates have made lending to homeowners and small businesses less attractive than before 2008. The easy subprime scams of yesteryear are no more. The void is being filled by the shadow banking system. Shadow banking comes in many forms, but the big money today is in repos and derivatives. The notional (or hypothetical) value of the derivatives market has been estimated to be as high as $1.2 quadrillion, or twenty times the GDP of all the countries of the world combined. – According to Hervé Hannoun, Deputy General Manager of the Bank for International Settlements, investment banks as well as commercial banks may conduct much of their business in the shadow banking system (SBS), although most are not generally classed as SBS institutions themselves. At least one financial regulatory expert has said that regulated banking organizations are the largest shadow banks. – The Hidden Government Guarantee that Props Up the Shadow Banking System According to Dutch economist Enrico Perotti, banks are able to fund their loans much more cheaply than any other industry because they offer “liquidity on demand.” The promise that the depositor can get his money out at any time is made credible by government-backed deposit insurance and access to central bank funding.  But what guarantee underwrites the shadow banks? Why would financial institutions feel confident lending cheaply in the shadow market, when it is not protected by deposit insurance or government bailouts? – Perotti says that liquidity-on-demand is guaranteed in the SBS through another, lesser-known form of government guarantee: “safe harbor” status in bankruptcy. Repos and derivatives, the stock in trade of shadow banks, have “superpriority” over all other claims. Perotti writes: – read more! […]

  20. […] Five years after the financial collapse precipitated by the Lehman Brothers bankruptcy on September 15, 2008, the risk of another full-blown financial panic is still looming large, despite the Dodd Frank legislation designed to contain it. As noted in a recent Reuters article, the risk has just moved into the shadows: The Armageddon Looting Machine: The Looming Mass Destruction from Derivatives | WEB OF DEBT BLOG […]

  21. […] Anwältin und Finanzmarkt-Kritikerin Ellen Brown erläutert auf ihrem äußerst lesenswerten Blog, warum die Banken-Regulierung eine der raffiniertesten Täuschungen der Anleger und […]

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