The Breaking Point

by James Dale Davidson

  Most investors are bewitched and bewildered over the prospect of tapering. It is a notion that presupposes that the system is strong enough to stand on its own if normal economic behavior set interest rates. It isn’t.

  Think of a clumsy man tottering on a tightrope high above the street. Will he cut the safety line that holds him aloft? Probably not. But if he makes a show of unfastening the line, he will do so tentatively, being sure to hold it close.

  The real issue with QE is far from apparent to most investors, as is usually the case. I doubt 1 in 10,000 realizes that a major reason more than 80 percent of the high-powered money created by QE is not being leant to Main Street but gathering dust as excess reserves is because more than half of those reserves are held by foreign banks.

  To better understand, roll back the clock to October 2008. At that time, the global financial system was in the process of collapsing as the “too-big-to-fail” banks held their collective bad breath over the challenge of covering the collapse of a $1.2 trillion subprime mortgage derivatives market (the most highly leveraged in an alphabet soup of dodgy mortgage exposure).

  As you know, a lot of big banks, along with the world’s largest insurance company, AIG, had written derivative contracts guaranteeing to make good on losses from subprime and other mortgage securities. Quite apart from the specific losses incurred on the various mortgage securities, the problem for the financial system was magnified by the fact that mortgage securities, previously rated AAA by credit agencies, were being used as collateral by investment banks like Lehman Brothers for the overnight borrowing that kept them in business. When that collateral fell to junk status, it triggered a wholesale run on the financial system.

  As had become apparent by September 15, 2008, with the collapse of Lehman Brothers, banks had drastically underestimated the risks that they were incurring (largely because they weren’t taking the risks—you were). They sold cheap insurance against an unraveling of the mortgage market in exchange for a gigantic liability they were cocksure they would never need to meet. In the disaster scenario that actually unfolded (one that I had highlighted in congressional testimony more than a decade earlier), mortgage-backed securities went from AAA credits to the rubbish bin almost overnight. There were no bids. Good or bad, the various mortgage securities all plunged together. The market understood what was going on; AIG stock plunged by 60 percent on September 16, 2008, alone.

  The Federal Reserve stepped in with the first round of QE to save the big banks and insurance companies. They ginned up money out of thin air and improvised bids for mortgage-backed securities. The Fed spent $175 billion buying agency debt securities and $1.25 trillion of mortgage-backed securities.

  This was all done in conjunction with other support from the Federal Reserve and Treasury, amounting to another $180 billion. As lavish as it was, it was not enough to keep AIG, the prime player in the derivatives market, from going belly up. Still, as financial analyst Daniel Amerman put it in a 2013 article for Gold-Eagle, “Absent quantitative easing, it was game over for the financial system.”30

  Naïvely, you might assume that having flirted with collapse, the US government would have made it a first priority to fix the system. Wrong.

  Yes, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act—fourteen thousand pages of barely intelligible rules, many of which are still incomplete, compiled after one thousand meetings between regulators and the big banks. The surest effect of Dodd-Frank is to provide lucrative employment to legions of lawyers for deciphering its occult provisions.

  $561 Trillion in Interest-Rate Derivatives

  Dodd-Frank will not prevent a coming financial collapse. Think of it as the equivalent of climbing to a higher diving board. The irony is that while the first rounds of QE may have forestalled the terminal collapse of the US-led world financial system, the prolongation of QE over the years since 2008 has enlarged the problem.

  The various installments of QE have held interest rates at artificially low levels and therefore made hedging against a rebound in rates to more normal levels a concern of the world’s borrowers. As of November 2013, this had resulted in the accumulation of about $561 trillion of over-the-counter interest-rate derivatives—such as swaps, forward rate agreements, and options—according to the Bank for International Settlements.31 To be clear, banks have entered into derivative contracts, similar to those associated with mortgage-backed securities. The difference is that the new time bomb is almost 450 times the size of the subprime mortgage derivative market that almost overwhelmed the global financial system in 2008.

  For reference, $561 trillion is almost thirty-six times the US GDP. Because much of the $561 trillion consists of liabilities of foreign banks, you may wonder if affects the United States. It does. The potential daisy chain of default would almost instantly leap over the oceans and open vast holes in the US financial system. That is why the Federal Reserve initiated QE in the first place. A 2010 Fed audit showed that of the $1.25 trillion of mortgage-backed securities the Fed bought in QE1, $442.7 billion were bought from foreign banks.

  Believe it or not, the record shows that QE1 was the low water mark for the percentage of newly created money lavished on foreign banks.32 Foreign banks were the biggest beneficiaries of the Fed’s QE3 monthly $85 billion bond buying spree. They were also the biggest gainers from QE2. The Fed pumped $630 billion into foreign banks during that phase of its digital money-fabricating extravaganza. If you wonder why domestic banks are not lending more to Main Street, there is your reason. Most of the money the Fed created ended up in foreign banks. Barclays and Deutsche Bank are not big lenders in Nebraska. “Fat, dumb, and happy” US consumers and taxpayers are bailing out not only domestic US banks but big banks around the world.

  In addition to directly shoveling money into the coffers of foreign banks, the Fed has been subsidizing them and buying their cooperation in another way—through the derivatives market. Unlike a normal options market, in which traders may be either long or short, the nature of interest-rate derivatives dictates that the banks will almost always be the party betting on stable or falling rates. The counterparty bet on rising rates will almost always be undertaken by borrowers seeking to hedge their exposure to higher rates. The highly correlated bets that have been placed by inadequately capitalized financial institutions basically doom the US-dominated world financial system.

  To see why, consider that when interest rates rise, they will rise for every borrower. It makes perfect sense for real estate investors, for example, who depend upon borrowed money to finance their projects to seek a way of protecting their position against higher interest costs.

  They can do this with forward rate agreements (FRAs). The usual structure of these derivatives is that the real estate investor would contract with a financial institution for an amount maturing sometime in the future according to the timeline of a project. The FRA is usually geared to the London Interbank Offered Rate or (LIBOR). The real estate investor is thus protected, at least on paper, to a predetermined amount as interest rates rise. The financial institution is short the FRA and stands to profit if interest rates remain stable or decrease.

  Essentially the same thing happens with swaps. The structure and logic of the market dictate that it is always the bank, or other financial institution, that profits when interest rates fall or remain stable, while the other party (the borrower) gains from derivative contracts when interest rates rise. Obviously, borrowers of loans with adjustable rates have an incentive to hedge their exposure to the extra costs that would materialize if interest rates rise.

  So the borrowers enter into derivative hedges against higher rates, while the banks take the opposite side of that trade. To the extent that interest rates remain stable or fall, as they have done since the Lehman collapse, these trades are very profitable for the banks. But if interest rates as expressed in LIBOR were to generally rise, the US-dollar-dominated banking system as a whole would be on the wrong side of tha
t trade—and would therefore be even more insolvent than it is today. (Indeed, the protracted discussion by the Fed of its possible intention to raise rates modestly can be read as a hint to banks to let their bets against higher interest rates run off.)

  Swap hedges aren’t necessarily trivial or small transactions. This was clearly illustrated in 2008–9 in the wake of the subprime meltdown. At that time, news reports circulated documenting how municipalities, states, and other institutions lost billions buying their way out of swaps that turned sour when QE drove interest rates down from already low levels that prevailed on the eve of the crisis. A famous case was that of Harvard University, which spent a billion dollars to buy its way out of a losing swap trade with banks.

  You see what this means for the current situation. It illuminates the mechanism through which QE shovels money into the pockets of banks, foreign as well as domestic. As long as the ZIRP remains in force, foreign banks get paid for going along with the gag and supporting Obama’s lockdown of Americans through FATCA.

  Over the longer term, one of the surer results to be expected is that interest rates will return to more normal levels. Looking back at the history of interest rates in the dominant economies of the past millennium, the current interest rates on US government securities have been set at a historically low extreme. In a 2013 article for Business Insider, Bryan Taylor pointed out that the United States continues to issue bonds to cover its expenses, despite bond yields reaching their lowest levels in history in 2012—below 1.5 percent. Taylor puts it this way in “How 3 Countries Lost Their Position as the World’s Dominant Financial Power over the Last 800 Years”:

  Over the past eight centuries, the locus of economic power has gradually shifted from Italy to Spain to the Netherlands to Great Britain and currently to the United States. The country at the center of the world’s power and economy issues bonds to cover expenses. Investors in that country and abroad purchase the bonds because they represent the safest bonds that are available for investment . . . Between 1285 and the mid-1600s, yields on government bonds fluctuated between 6% and 10% and in some cases were around 20%. . . . Since the mid-1600s, the average yield on government bonds has been around 4% . . . Government bond yields reached their lowest levels in history in 2012, dropping below 1.50%.33

  This trend continued into 2015.

  Because the Federal Reserve has pushed interest rates down to the vanishing point, it is now almost impossible for them to go lower. The US government is insolvent according to any serious accounting of its assets and liabilities, but it won’t go out of business quite yet. It may hang around in some shadow form, like the Holy Roman Empire, for centuries to come. But the time of the United States as a hegemonic power is drawing to a close in the current terminal crisis. The United States has already lost its manufacturing, and most of its commercial, predominance. It clings to a precarious predominance in finance. But that can’t last long as chronic trade and budget deficits accumulate. And paradoxically, a sign of the end was the sharp rally of the dollar that presaged a systematic reversal in commodity prices.

  More ominously, the US government has superseded the late Soviet Union as the globe’s most implacable enemy of the free market. The United States has become an obstacle to capital mobility worldwide. This is reflected in FATCA and more. The US government is too big, costly, and complex. Its markets are the most heavily regulated on earth. As Joseph Tainter showed in The Collapse of Complex Societies, complexity inevitably leads to collapse as it engages the temptations of human creativity to find less complex and less costly ways of doing what needs to be done.

  While US authorities may well have bribed the world banking establishment to continue trading in the dollar with QE—which funnels billions into their pockets through direct asset purchases and derivative trades—Obama has offset much of that incentive through his heavy-handed FATCA regulations. Megapolitical conditions now favor lower-scale operations. New technologies, as inadequately expressed in Bitcoin, already threaten the disintermediation of the dollar.

  With the primary scope for dollar interest rate fluctuation to the upside, a concerted pause in QE could trigger a crisis event, like the subprime mortgage meltdown, but many times worse. With the nominal value of interest-rate derivatives now towering at 450 times the mortgage security derivatives that brought the financial system to death’s door in 2008, it is obviously far beyond the scope of bankrupt nation-states to bail out the system when the next crisis inevitably hits.

  They will do what scoundrels always do when faced with the loss of power: print money and repress the population. As reported by the Associated Press, the US Department of Homeland Security has contracts to purchase 1.6 billion rounds over the next five years, including hollow point ammunition—bullets that are banned by international law from use in war, along with massive quantities of bullets specialized for snipers. A March 2013 Forbes article explained that this amount of ammunition would be enough to sustain an active war in America for more than twenty years.34

  In other words, the government is preparing for the collapse of the financial system. They expect to have to create trillions and trillions of new dollars to stuff into the black holes in the balance sheets of banks holding some of the $561 trillion in derivative bets against rising interest rates. Then if you don’t like it, they’ll shoot you.

  Notes

  1 http://www.internationalman.com/articles/the-worst-law-most-americans-have-never-heard-of.

  2 Prior, George, “Interview: James Jatras, Lawyer and Anti-FATCA Lobbyist,” iExpats.com, December 28, 2012.

  3 See http://www.ackselhaus.de/berlin-wall/?hotel-berlin=english.

  4 http://www.historyinanhour.com/2013/06/30/walter-ulbricht-summary/.

  5 Esper et al., Journal of Global and Planetary Change, https://wattsupwiththat.com/2012/10/18/yet-another-paper-demonstrates-warmer-temperatures-1000-years-ago-and-even-2000-years-ago/.

  6 Cook, S. A., et al., eds., The Cambridge Ancient History, XII, 1st ed. (Cambridge: Cambridge University Press, 1971), 268.

  7 Ibid., 264–68.

  8 Ibid., 268.

  9 Peck, Don, “Why So Many Americans Are Leaving the U.S.—in 1 Big Chart,” Chartist, July/August 2013.

  10 http://www.csmonitor.com/Business/The-Daily-Reckoning/2010/0501/As-illegal-immigration-falls-is-America-in-decline.

  11 Grennstone, Michael, and Michael Loney, “The Uncomfortable Truth about American Wages,” New York Times, October 22, 2012.

  12 See Hudgins, Colby, “The Great American Migration,” The Daily Caller, May 5, 2013, http://dailycaller.com/2013/05/05/the-great-american-migration/#ixzz2mqYq14El.

  13 Adams, Bob, “The Great Escape,” Barron’s, November 26, 2011.

  14 Leonhardt, David, “The Idled Young Americans,” New York Times, May 3, 2013.

  15 http://www.nola.com/business/index.ssf/2011/09/census_numbers_show_recession.html.

  16 “Majority Disapprove of Health Care Law; Believe Their Costs Will Rise and Quality Will Fall,” Institute of Politics, Harvard University, http://www.iop.harvard.edu/majority-disapprove-health-care-law-believe-their-costs-will-rise-and-quality-will-fall.

  17 http://www.cnsnews.com/news/article/irs-cheapest-obamacare-plan-will-be-20000-family.

  18 https://www.cia.gov/library/publications/the-world-factbook/rankorder/2102rank.html.

  19 http://wondacharts.williamoneil.com/et/dfs/2008/910329/0001144204-08-015754/v107110_10k.htm.

  20 https://srxawordonhealth.com/tag/robert-wood-johnson-foundation/.

  21 See https://www.oecd.org/els/health-systems/48723982.pdf.

  22 Traynor, Ian, and Paul Lewis, “Merkel Compared NSA to Stasi in Heated Encounter with Obama,” The Guardian, December 17, 2013, https://www.theguardian.com/world/2013/dec/17/merkel-compares-nsa-stasi-obama.

  23 WashingtonBlog, “Americans Are the Most Spied On People in World History,” December 5, 2012; see also http://www.wnyc.org/story/241328-somebodys-watching-you/.

  24 http://x2
2report.com/how-the-nsa-hacks-your-iphone/.

  25 http://www.washingtonsblog.com/2013/12/former-top-nsa-official-now-police-state.html.

  26 Ibid.

  27 Slater, Dan, Wall Street Journal Law Blog, http://blogs.wsj.com/law/2008/03/13/alan-dershowitz-on-spitzergate-what-is-this-russia/.

  28 http://www.wnd.com/2012/07/feds-label-liberty-lovers-terrorists-again/.

  29 http://www.storyleak.com/official-complaining-tap-water-act-of-terrorism/.

  30 http://danielamerman.com/articles/2013/QErealityD.html.

  31 Gyntelberg, Jacob, and Christian Upper, “OTC Interest Rates Derivative Market in 2013,” BIS Quarterly Review, December 2013, 70.

  32 http://www.zerohedge.com/article/exclusive-feds-600-billion-stealth-bailout-foreign-banks-continues-expense-domestic-economy.

  33 Taylor, Bryan, “How 3 Countries Lost Their Position as the World’s Dominant Financial Power over the Last 800 Years,” Business Insider, December 8, 2013, http://www.businessinsider.com/700-years-of-government-bond-yields-2013-12#ixzz2nTRGGFBQ.

  34 Benko, Robert, “1.6 Billion Rounds of Ammo for Homeland Security? It’s Time for a National Conversation,” Forbes, March 11, 2013.

  Chapter Nine

  Beyond Kondratiev

  Secular Cycles and the Breaking Point

  The Treasury opened up its window to help and pumped $105 billion into the system. And it quickly realized it could not stem the tide. We were having an electronic run on the banks. They decided to close down the operation . . . to close down the money accounts . . . If they had not done so, in their estimation, by 2 p.m. that day $5.5 trillion would have been withdrawn . . . Within 24 hours, the world economy would have collapsed . . . People who say we would have gone back to the 16th century were being optimistic.