The global financial system
is threatened by the derivatives market, which has created an astronomical bubble
of debt. The total derivatives market was valued at $596 trillion in December
2007, and is growing. The most dangerous ones, Credit default swaps, CDS, lie
at the $23 trillion mark. Barclays Bank holds $2.4 trillion in CDS. If at least
some of the derivatives can be shown to be illegal, the contracts they represent
would be invalid, which could save billions of bank, and therefore taxpayers',
money, and might help to save the financial system from total collapse.
The economist Hyman Minsky1 , was very clear in his classification
"A hedge position is one for which expected cash flows
exceed principal and interest payments for every period;
a speculative position
is one for which near-term cash flows only cover interest, although it is expected
that principal will eventually be paid when cash flows rise at some future time;
a Ponzi position is one in which cash flows do not cover even the interest
payments, hence, interest is capitalized as debt grows.." 2
schemes are a form of pyramid selling, named after an early 20th century swindler,
where profit for the existing subscriber is produced by income expected from new
subscribers to the scheme. It works for a while, then comes up against the limits
to growth, and implodes.
Today, a Ponzi scheme can best be described as
an investment structure that uses further investor capital to pay dividends to
initial investors, creating the false impression of actual profit. By their nature,
the scheme's bubble will always burst, leaving some investors without a profit
and without their initial capital. The investor's only hope of getting their money
back is a suit against the scheme ringleader (if he or she hasn't already skipped
town for the Bahamas), likely for breach of contract or securities fraud. Judgments
won often go unpaid by the schemer, who likely owes money to other investors.
Duped investors are left without much to their name, and curse Ponzi's. (link)
schemes are illegal.
This raises the possibility that the illegality of
third rank derivatives that are threatening the security of the financial markets
could be tested in a court of law. If they are found to be illegal, they would
have no validity. The contracting parties would be under no obligation, and billions
or trillions of debt could be removed from the financial system. A ten-year Depression
(carrying the risk of war) could be averted, the world can power itself out of
the recession with the Green New Deal.
How could such a successful outcome
be realised? We need committed economists of the Minsky school, working together
with company and financial lawyers to work up the preliminary case. This case
should be circulated as widely as possible, primarily to the heads of the judiciary,
to Government law officers, to politicians and the media.
In America, the
judiciary should be the target, because of the separation of powers between judiciary
and executive in that country. In the UK, the Lord Chancellors' office is too
close to the Government, and is likely to dismiss the possibility of legal action.
If this turns out to be the case, we will have to turn to the media.
objections to this course of action:
1. Fatalism: "It will not work".
This is the blanket used to smother all new born projects. The response is to
ask for the fatalists' own remedy. Usually they have none, only a gloomy forecast
of Armageddon, or an unrealistic optimism that the markets will correct themselves.
Fear: "It will upset the City". This will probably be the main response,
based on the financiers' former position Masters of the Universe, but that position
is no longer tenable after the October 2008 bailouts.
Certainly there will
be effects on the financial markets. Minsky identified the third rank of derivatives
as Ponzi. Hedge funds and speculation may be risky, but are not illegal. It is
the third kind, which need persistently increasing prices of the assets they invested
in to keep on refinancing their debt obligations, which are under suspicion. A
court action will therefore have the effect of causing fund managers to avoid
this kind of activity unless and until the court finds them legitimate. Development
of the Ponzi derivative market is likely to freeze, and value of Ponzi derivatives
will fall, due to lack of demand. This will of course affect the balance sheets
of institutions that hold them, but if the holdings are evenly spread, the devaluation
will be balanced among the holders. Institutions that have held back from investment
in these unsafe instruments will have their prudence rewarded.
derivatives can be removed from the financial system in a controlled way by setting
up a clearing house.
Such a clearing house has been mooted several times
in the course of the present crisis. US Treasury Secretary Paulson's $700 billion
Troubled Assets Recovery Plan (TARP) was originally to buy the "toxic assets",
but this aspect has been quietly dropped, probably because he now realises that
the size of the TARP is miniscule compared to the size of the threat.
Buiter has suggested that a Toxic
Asset Dump, TAD, should be set up, to act as a receiving and clearing house
for institutions who have doubts about whether they still wish to hold them on
their books. In this institution the value - or otherwise - of the "assets"
can be analysed, and their legality - or otherwise - can be assessed. From what
we learn in the TAD, ways and means can be devised to subject toxic derivatives
to a controlled deflation.
Optimally, this clearing house should be at World
Bank level, but in practice, in the name of speed of action, they could be set
up at national level, using existing derivatives exchange institutions.
possible layers of control are possible:
1. Voluntary registration. Here, holders
of derivatives who have cause to believe that they may be Ponzi can register them
with the clearing house.
2. Mandatory specific registration. All holdings of
Ponzi-type derivatives must be registered. This assumes that they can be identified
by their terms and design. It is not unreasonable to assume that the holders will
have the competence to identify the characteristics of their holdings. They will
also be motivated to register them if there is the possibility that their obligations
may disappear if their holdings are found to be illegal.
3. Mandatory derivative
registration. This is a longer-term project, not needed in the shorter term because
it might overload the assessment system.
Outcomes: the emphasis should be
on amnesty and neutralisation of the threat, rather than bringing the full majesty
of the Law, with all its duration and costs, to bear on each and every case. If
a scheme is identified as illegal, the obligations of the derivatives are no more.
This is likely to bring about a deflation in the market for Ponzi derivatives.
Many people and institutions are going to lose face and lose money, as is the
case in any Ponzi scheme, but the losses will be proportional to the poor judgement
of the market actors, and will therefore be just. Survival of the financial system
is more likely than if the game is played out, with the calling in of the $23
trillion CDS market accompanying a domino cascade of defaulting banks and institutions.
of reports on lawsuits against hedge funds
1 Minsky, Hyman P., Stabilizing an Unstable Economy. Twentieth Century Fund Report,
Haven and London: Yale University Press, 1986.
2 A fourth level, applicable
to the sub-prime mortgage scandal, is to be found here: McCully, Paul, "The
Plankton Theory Meets Minsky", PIMCO Newsletter, March 2007.