Counterfeit Value Derivatives: Follow the Bouncing Ball

This guest essay on derivatives was written by frequent contributor Zeus Yiamouyiannis.

Here is how the counterfeit value derivative con works. It’s a game of “I pretend, you pretend, we all pretend, and the taxpayer will pay in the end”.

1) I’ll create an instrument, say a credit default swap (CDS), an unregulated insurance with no capital requirements, with a certain “notional” value. Notional value is just something I assign. It does not have to be attached to or backed by any real asset or actual money/principal, but I can pretend as if it is. (Notional amount.)

2) As a seller, I will just declare that this swap covers the full value X of this company, contract, etc. if credit event Y happens. I receive lucrative insurance premiums and fees for my unbacked promise. The CDS’s value is based in nothing more than my promise to pay. I don’t have to have adequate capital reserves on hand, but I can pretend as if I do perhaps with some mini-reserves based on objective-seeming risk ratios calculated by my mathematical models. (credit default swap.)

3) As a buyer, you can then buy as many of these CDS’s as you want, even for a single default. If you are really sure something is going to tank you can insure it 30 times over (or a 100 or 1,000) and get 30 (or 100 or 1,000) times the return when it goes bust! In regulated insurance it is unacceptable to insure beyond the full replacement value of the underlying asset. Not so with CDS’s. The seller has gotten 30x the premiums and the buyer gets 30x value in the event of default. As a buyer of this phony “insurance” you don’t have a stake in the affected properties, but you can essentially pretend you do.

4) As buyer and seller of CDS’s either one of us can assign our risks to a third party through another contract, and pretend as if we are covered in case our own game playing blows up in our faces. This allows us to retain even less reserve capital and spend freed-up funds on more high-risk, high-(pseudo) return speculation. (The monster that ate Wall Street.)

5) We can purchase and sell of these derivative contracts to each other at unlimited rates to generate massive volume and huge fees and profits. We can simply hyper-cycle risk and take our chunk each time.

According to the Bank of International Settlements, as of June 2011 total over-the-counter derivatives contracts have an outstanding notional value of 707.57 trillion dollars, ( 32.4 trillion dollars in CDS’s alone). Where does this kind of money come from, and what does it refer to? We don’t really know, because over-the-counter derivatives are not transparent or regulated.

With regulated economic markets, when an underlying real asset is impaired (i.e. the company in question is bankrupt, the mortgage has defaulted, etc.), market value is assessed, default insurance is paid up to replacement or full value, bond holders and stock holders make claims on remaining value and the account is closed. There is no need for bailouts because order and proportion of compensation has been established and everything is attached to the value of the underlying asset.

When the unreal, counterfeit economy intrudes, you now have a situation where a person can put in an unregulated, but recognized, claim to be paid a thousand times over in case of impairment. Say market participants have negotiated for a bankrupt company a 70% payback for bondholders and (36% payback for insurance claims), and I come with not one but rather 1,000 CDS claims demanding to be paid for each CDS.

Where does that money come from? Well if it were regulated insurance, I would have to be invested in the company in some way, my bond or stock payout would be limited by the actual asset value of the company, and my insurance payout would be limited as well. However, since I am unregulated and unrestrained, the money due me has to come from the CDS seller and my contractual agreements with that company (say AIG).

AIG could easily have sold 1,000 different unregulated insurance policies to the same person or a million CDS’s to a hedge fund, and when AIG could not pay up, it was threatened with insolvency, under which both its regulated and unregulated insurance policies and investments would become impaired. In fact there is abundant evidence that hedge funds (i.e. Magnetar) did in fact multi-insure certain portfolios while simultaneously pressuring the portfolio managers to select risky investments to ensure that the portfolios would crash. This is the opposite of a traditional “stake,” and this is the disease that modern derivatives bring—profit from intentional market destruction.

This chaotic state of affairs and its cascading implications for other interlinked parties and counterparties (read “too big to fail banks”), essentially resulted in economic extortion to force a huge public bailout of the whole crooked mess (totaling somewhere in the neighborhood of 10 – 14 trillion dollars in giveaways, loans and guarantees starting in 2008 in the U.S. alone.) Instead of agreeing to the extortion temporarily to prevent collapse and then aggressively pursuing orderly investigation, prosecution, and receivership, regulators and world leaders have simply covered up the events and even rewarded the perpetrators.

No wonder the market goes up dramatically when there is talk about another quantitative easing (Fed bailout) or emergency rescue (government/taxpayer bailout). These financial game players already know that an open public spigot is on its way, pouring real capital directly into their pockets.

In regulatory actions and legal courts, unregulated insurance claims should simply be declared null and void when applied to real assets and real compensation. “You have no stake, therefore you have no claim. Your agreement was with a third party that did not have adequate capital to pay for a contract with you. Take them to court.” Or “You have an imaginary claim for imaginary damage. Here’s your imaginary money. Your deal was private and unregulated, then it should be settled in private between companies without public intervention or support.”

Did that happen? No, because AIG had collapsed its unregulated private and regulated public functions and Congress had allowed it to do so with the repeal of the Glass-Steagall Act. Because the wall came down between regulated and unregulated activity, transparent and “shadow” markets, traditional and investment banking, this private fiat virus broke quarantine and the resulting contagion cannot be put back in the lab.

Because world leaders and their regulators blinked and did nothing, counterfeit private fiat (backed by nothing) has metastasized and infiltrated “genuine” public fiat (backed by country’s productivity if not by gold), and more and more actual money and productivity in the form of austerity is being thrown at a gargantuan and unrecoverable sea of counterfeit obligation.

How can you exceed 700 trillion dollars in unregulated derivatives alone? This is easy when market players are buying and selling from each other and when people can buy an infinite number of claims, insurances, and guarantees on credit events rather than assets. When banks are allowed to mark-to-model and then claim somehow that their back-and-forth trading and abstract multiplication of asset value is real, then all bets are off (or “on” depending upon which side of the fence your sitting).

Is it any wonder that the market for derivatives has grown another 100 trillion over the last two years? “We’ll concoct value and you’ll pay us real money for it? Of course we are going to keep doing it! Why not another 100 trillion!”

This probably is not going to stop until there is massive world-wide outcry and political change, a “black swan event,” or both. Let’s hope the first gains steam along with some long-overdue accountability for fraudsters before these nefarious banks destroy the body politic with their hubris and greed.

by Zeus Yiamouyiannis, copyright 2012


Recent related entries:

Fraudulent Debt = Counterfeit Money

Our Counterfeit Economy

Counterfeit Money, Counterfeit Policy.

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Fraudulent Debt = Counterfeit Money

How is borrowing money based on fraudulent claims of asset value and future income any different from counterfeiting money?

Let's compare three financial criminals. The first is an old-fashioned counterfeiter who doctors up paper and runs a printing press to produce fake currency.

The second criminal borrows money based on a fraudulent asset and phantom future income. For example, the criminal might obtain a credit card based on false assets and income, or borrow money against a property that is worth far less than he claims and base his credit on an inflated fantasy income he does not actually receive.

The third criminal borrows money from the Federal Reserve at zero interest and extends a loan to a fraudulent borrower because a government agency has guaranteed the loan. Whatever income the lender receives is pure gravy, and whatever losses are incurred when the fraud is uncovered are made good by the taxpayer.

Since our banking system is based on money being borrowed into existence (i.e. fractional reserve), then how is creating money unsecured by either assets or income any different from actually counterfeiting bills? The outcome is identical: money created out of thin air.

If I fraudulently obtain credit based on bogus claims of future income, borrow a large sum and promptly squander it on consumption, then the lender has no recourse: there are no assets to grab and no income to tap. In effect, I had a good time at the expense of all holders of the currency, as my money-created-from-thin-air diluted the currency without adding any productive value.

The way the debt-counterfeit game is played in the U.S., the lender is also a financial criminal who exploits the moral hazard extended by Federal agencies. If you can't lose money on a loan, then why not give money to fraudulent borrowers? As long as they pay enough interest to cover your origination costs, then the rest is pure profit.

We might also ask: how is writing a derivative based on false claims of asset valuation any different from counterfeiting? Once again the creation of an "asset" that can be sold to unwary investors for cash that is based on fraudulent claims of valuation is the equivalent of counterfeiting currency: both add no productive goods or services to the economy and both are created out of thin air.

Since the Federal Reserve creates money out of thin air to buy assets which can be sold later to credulous investors, then how is the Federal Reserve not counterfeiting dollars? It adds no goods or services to the economy and dilutes the currency, in effect stealing value from all holders of the currency.

The U.S. financial system is one vast, interconnected web of complicity, fraud and counterfeiting.

For more on our counterfeit economy and policies, please see Our Counterfeit Economy and Counterfeit Money, Counterfeit Policy.

If this recession strikes you as different from previous downturns, you might be interested in my new book An Unconventional Guide to Investing in Troubled Times (print edition) or Kindle ebook format. You can read the ebook on any computer, smart phone, iPad, etc.Click here for links to Kindle apps and Chapter One. The solution in one word: Localism.

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Our Counterfeit Economy

The U.S. economy is in effect a counterfeit economy, living on money created from thin air that is unbacked by an equivalent productive expansion of surplus value.

Yesterday we looked at counterfeiting and money printing and discovered they are one in the same: (Counterfeit Money, Counterfeit Policy.) If we apply the same analysis to the U.S. economy, we have to conclude the entire U.S. economy is also counterfeit.

The analysis is not as complicated as store-bought economists would have you think. Much of what passes for "economics and finance" is simply distraction, a sophisticated version of bread and circuses.

Let's start with two basic concepts: productive value and surplus value. The classic example of a productive asset is a factory that produces goods that have a market value that exceed the input (production) costs. In other words, the factory produces surplus value.

We can measure value by any number of means: ounces of gold, quatloos, sea shells, etc. To keep things simple, let's just measure value in units. If it costs 10 units to produce a good (including labor, materials, energy inputs, transportation, and a return on the investment to construct and maintain the factory), then the output (products manufactured by the factory) must fetch 11 units in the open market to create 1 unit of surplus that can be invested or spent on consuming other goods or services.

If it takes 10 units of input costs to make a product that is only worth 9 units, then the process generates a net loss. There is no surplus to spend; rather, there is a loss that must be covered by cash, borrowing or the selling of other assets. When the cash, ability to borrow and assets that can be sold all run out, then the enterprise is recognized as insolvent and it closes.

If the factory's output has little to no market value, then the investment is what we call a mal-investment--an investment that only claimed to be valuable because it was speculative or protected from price discovery in a transparent market.

Our current economic theory holds that any good or service produced has value, which we measure in dollars of gross domestic product (GDP). The intrinsic flaw in this way of assessing value is that it doesn't recognize mal-investments.

Here are some examples.

-- If a military aircraft woefully underperforms and costs so much field commanders dare not risk its combat deployment, then what value was created by its manufacture?

-- If it takes 10 units of input costs to produce a biofuel crop that is processed into fuel worth 9 units, then what value was created by the process of making that biofuel?

-- If a subdivision of new homes is built in the middle of nowhere and finds no buyers, then what value was created by the construction of these houses?

-- If a costly medicine is distributed at great expense in the millions of doses and is discovered to have little to no effect on longevity or other metrics of health, then what value was created by the immense cost squandered on this medication?

In all these cases, the mal-investment was added to the GDP as if it created productive value. The factory and the costly but essentially useless aircraft (think B-1B bomber) were added to the GDP, but they did not create useable military value. The biofuel production facilities were all added to the GDP, even though the process generated a net loss. The homes built in the middle of nowhere were also added to the GDP, along with the costs of the worthless medication.

Consider a financial sector that is declared "too big to fail" and trillions of units are borrowed on the taxpayers' account to bail out the albatross banks. The bailout of banks created no productive value, even as it took money away from potentially productive investments.

Since surplus value is not limitless, the money squandered on these mal-investments was no longer available for productive investments. Rather, these mal-investments sucked up all the surplus generated by the entire economy. Now there is no money left for superior (and cost-effective) military aircraft, medications that actually cure diseases rather than reduce symptoms, homes that are in desirable, cost-effective locales, productive energy investments, and solvent banks.

Let's say an economy required 1 million units of input costs to generate 2 million units of productive value, i.e. goods and services whose price has been discovered by a transparent market. That economy has 1 million units of surplus to spend on consumption, productive investments and mal-investments.

Since everything requires maintenance and infrastructure, then there is no such thing as a steady-state economy: for example, factory machines wear out and have to be replaced. If there is no surplus money left because it has been sunk into mal-investments, then the factory's ability to create productive value and surplus value degrades.

If the mal-investments have been prodigious, at some point the factory is incapable of producing any surplus at all.

There is a "fix": borrow money based on the future surplus. If the amount being borrowed is modest in comparison to the potential surplus created by a refurbished factory, and the borrowed money is productively invested, then this reliance on credit and leverage may pay off.

But if the borrowed money is spent on consumption and mal-investments rather than being invested in productive assets, then the only "fix" left is to borrow more money--not just mortgaging the future surplus of the factory, but leveraging it into a stupendous sum of borrowed money.

At some point the sums being borrowed far exceed the potential surplus generated by the factory, even if the factory amd market are running at optimum levels. If the factory requires 100 units of investment to generate 50 units of surplus, but 1,000 units of money have been borrowed against that future surplus, then the interest payments on that 1,000 will eventually exceed the modest potential surplus value.

Note that future surpluses are all imaginary; it could turn out that the market for the factory's goods declines and there will be little to no surplus value created in the future.

Borrowing money based on imaginary future surpluses is a higher form of counterfeiting. And that is precisely what the U.S. is doing, borrowing immense sums at every level, private, corporate and State/Federal, all leveraged against phantom future surpluses, even as the economy requires some 10% of its supposed output (GDP) to be borrowed and spent on consumption each and every year just to run in place, i.e. the Red Queen's Race (Bernanke, Goldilocks and The Red Queen January 10, 2011).

In other words, the U.S. economy is running a massive deficit, and squandering the vast sums being borrowed on consumption and mal-investments. Once you rely on more borrowing against imaginary future surpluses to fund your current expenses, then eventually the costs of servicing that debt exceeds any possible future surplus.

The last-ditch "fix" is to simply print units of money (or borrow it into existence like the Federal Reserve)--counterfeiting, pure and simple-- and deceive the market for a time via the illusion that the freshly printed units of money are actually backed by productive value or surplus.

As history has shown, eventually the market discovers the actual value of this counterfeit money, i.e. near-zero, and the system implodes.

Alternatively, the credit markets grasp that there is no way the economy can pay the interest on its monumental debts, never mind pay back the principal, and then the number of people willing to lend surplus capital to the economy declines to zero, as does the economy's ability to sustain itself with leveraged debt.

The system then implodes as the "free money machine" of ever-expanding debt breaks down. Once there is no more "free money" to fund consumption and mal-investment, then the reality of systemic insolvency is revealed to all.

You cannot counterfeit actual surplus value generated by productive assets, you can only counterfeit proxy claims on future surplus. That is the U.S. economy in a nutshell: we are counterfeiting claims on our future surplus, even as we squander vast sums on horrifically obvious mal-investments and wasteful, cost-ineffective consumption.

If this recession strikes you as different from previous downturns, you might be interested in my new book An Unconventional Guide to Investing in Troubled Times (print edition) or Kindle ebook format. You can read the ebook on any computer, smart phone, iPad, etc.Click here for links to Kindle apps and Chapter One. The solution in one word: Localism.

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Counterfeit Money, Counterfeit Policy

What is the difference between printing money and counterfeiting? There is none.

Counterfeiting is illegal because it is the false creation of value. The counterfeiter takes low-value paper and turns it into high-value money, which is fundamentally a claim on the real productive value of the economy that issues the currency and recognizes it as a proxy means of exchanging that productive value.

Counterfeiting is illegal because the counterfeiter creates no additional value--he creates only the proxy for value. Creating real value--adding meaningful goods or services to the economy--is tedious, hard work. How much easier to simply transform near-worthless paper into a claim on actual goods and services.

If this is illegal, then would somebody please arrest the Board of the Federal Reserve for counterfeiting? The Fed has blatantly printed money without creating any real value to back up their added claims on productive value. Hence they are counterfeiting, pure and simple. A government based on rule of law would arrest these fraudsters and cons at the earliest possible convenience.

And while you're drawing up the indictment, can you also charge them with counterfeiting competence and policy, as they have demonstrated the Peter Principle par excellence: the Board has risen to its highest level of incompetence. Their counterfeit policies have wreaked incomparable damage on the real productive economy.

The essence of counterfeit policy--a fake policy that claims to be something it is not--is "extend and pretend." And the sole goal of "extend and pretend" is self-preservation and the preservation of the Financial Elite which has tightened its grip on the nation's throat as a direct consequence of Federal Reserve policies--notably "extend and pretend."

"Extend and pretend" extends the "too big to fail" Financial Sector's licence to mask its insolvency and its licence to continue issuing debt, leverage and derivatives under false pretences, i.e. that the risk and market value of these instruments are transparent. They are not.

In effect, the banks are also counterfeiters, as they are issuing debt--a claim on future productive value--without adding any actual value to the economy.

Thus the Fed and the Financial Sector are both diluting the base of actual real value with ever-expanding claims on real productive value by printing money and issuing debt. If an economy creates 100 units of productive value, and issues 100 units of currency as a proxy claim on that value to be used as a means of exchange, then there is a 1-to-1 correspondence with the money claim on productive value and the actual value.

If someone prints another 100 units of money and starts buying assets with that money, then they are claiming 1 unit of money still equals 1 unit of production though they have debased the currency so that it actually takes 2 units of money to represent 1 unit of productive value.

This is a con of the first order, which is why counterfeiting is illegal. If counterfeiting is illegal because it is a con, a fraudulent claim on real goods, services and assets, then how can money printing by the Fed (a private bank, mind you) be legal?

It can only be legal in a kleptocracy ruled by a Financial Elite bent on political and financial dominance, a Plutocracy whose wealth is all skimmed from the productive economy via ever-expanding issuance of money and debt.

When corporations and the State are one, we call it fascism. In the U.S., it has taken the form of financial fascism, and the Federal Reserve and Federal agencies (Treasury, Freddie Mac, FHA, etc.) are the handlers and enablers of this kleptocratic financial fascism. They add no value, they only steal value from those who create it.

If this recession strikes you as different from previous downturns, you might be interested in my new book An Unconventional Guide to Investing in Troubled Times (print edition) or Kindle ebook format. You can read the ebook on any computer, smart phone, iPad, etc.Click here for links to Kindle apps and Chapter One. The solution in one word: Localism.

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One Dam Metaphor for the 2012 Global Financial System

What do you do when flood waters threaten the dam? If you're the Federal Reserve, you close the floodgates and let the water rise.

Metaphors have an uncanny ability to capture the essence of complex situations. Here is one dam metaphor that distills and explains the entire global financial system in 2012. The way to visualize the current situation is to imagine a dam holding back rising storm waters.

The dam is the regulatory system, the rule of law, trust in the transparency and fairness of the system and the machinery of perception management. All of these work to keep risk, fraud and excesses of speculation and leverage from unleashing a destructive wave of financial instability on the real economy below.

As legitimate regulation and transparency have been replaced with simulacra and manipulated data, the dam's internal strength has been seriously weakened.

Depending on how you date various rivers of financialization, water has been piling up behind the dam since either 1982, 1992 or 2000. In this metaphor, the water is comprised of multiple sources of destabilization: rising money supply, debt, speculation, leverage, fraud, shadow banking and lax regulation.

Common sense suggests that water rising to dangerous levels would trigger an official response of opening the floodgates to relieve the pressure. Unfortunately for the real economy, common sense has nothing to do with the official response of central governments and banks. Their entire raison d'etre (reason to be) is self-preservation and the preservation of the financial Elites that set the context and policy of the State and central bank.

In effect, the State and central bank recognize that it is highly dangerous to let any water out, lest the toxic waste of fraud, speculative incentives, excessive leverage, etc. corrode the spillway and cause the entire dam to give way.

The official rationalization for keeping the gates closed even as the water is rising to the very lip of the dam is that the flood water released might harm the real economy downstream.

The truth is less savory: letting any water out might reveal the vulnerability of the entire system to collapse and the complicity of the official State agencies and central bank in the decades-long process of piling up too much debt, leverage, fraud and speculation in the first place.

To avoid the exposure of their own complicity and incompetence, the officials would rather risk systemic collapse of the dam. The global exercise of masking the true risks in the system can be summarized as "extend and pretend," and for the the past four years, officials have promised that closing the floodgates and keeping all the toxic debt, leverage and fraud safely behind the dam is the "solution" to rising floodwaters.

That "solution" was temporary, and 2012 is the year that the water reaches the lip of the dam and starts spilling over. The only question for those in the real economy downstream is whether this spillage will be enough to relieve the mounting pressure or whether the dam will suddenly give way.

If the rivers of toxic debt, leverage and fraud continue flowing into the system, then the only way to relieve the pressure is to release more of the debt, leverage, risk and fraud than is entering the system. "Extend and pretend" does nothing to limit the inflow of toxic debt, leverage, fraud, etc., nor does it release any bad debt or shut down the sources of toxic flodwaters, i.e the shadow banking system and the Financial Elite perpetrators of fraud.

Will the dam of extend and pretend hold another year? Perhaps, but I suspect the toxic waters have corroded the spillways of trust and resiliency to the point that any official attempt to relieve the pressure will trigger the dam's collapse.

Either way, the dam collapses.

If this recession strikes you as different from previous downturns, you might be interested in my new book An Unconventional Guide to Investing in Troubled Times (print edition) or Kindle ebook format. You can read the ebook on any computer, smart phone, iPad, etc.Click here for links to Kindle apps and Chapter One. The solution in one word: Localism.

Readers forum: DailyJava.net. 

Order Survival+: Structuring Prosperity for Yourself and the Nation (free bits) (Kindle) orSurvival+ The Primer (Kindle) or Weblogs & New Media: Marketing in Crisis (free bits)(Kindle) or from your local bookseller.

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