Neutralising the Toxic Assets


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 of derivatives.
"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

Ponzi 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)

Ponzi 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.

Anticipated 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.
2. 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.

Next, Ponzi 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.

Willem 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.
Several 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.


URLs of reports on lawsuits against hedge funds

1 Minsky, Hyman P., Stabilizing an Unstable Economy. Twentieth Century Fund Report,
New 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.

© 2001 R. Lawson