The Tattered Illusions Of Knowledge

It is often said that "a little knowledge can be a dangerous thing", and this was never more in evidence than with the recent article "The Tattered Illusions of Power" by Iloilo Marguerite Jones. Indeed, most of the piece could be dismissed as laughable if not for the fact it's written with such serious intent.

On page 1 Jones exposes her position by averring: "In this nation's history, the illusion of security has inexorably and viciously replaced the truth of individual rights and liberty"

Which I reply, "horse pockey"!

In fact, liberty cannot truly exist without a measure of security. A man compelled to dig in a dumpster for his next meal is not free, he is governed by compulsion and the pure need to survive from day to day. He will, in this landscape, not make any decisions that promote his own long term freedom or welfare or that of his neighbors. Perhaps for this reason, it was FDR who once noted: "Necessitous men cannot be free men".

When I visited Germany (Bielefeld, Dissen, Waldbrohl) in May, 1985 to commemorate the end of the Second World War, I had occasion to converse with three former Wehrmacht soldiers who were members of the Schildesche choir, which had invited my wife and I to Germany that year.

The former soldiers related how the Weimar Republic fell as hyper-inflation struck and the poor, working class and even middle class people ended up paying over a million Deutsche marks just for a loaf of bread. As the economic disaster metastasized, those at the lower end of the economic totem pole grasped for security at any cost. Bread, a job anything! Der Fuhrer provided it, or claimed he would, and they flocked to him with enough votes that Paul von Hindenburg had no choice but to name him Chancellor by 1933.

The rest, as they say, is history. As one of those former Wehrmacht soldiers (Hans Borchers) told me: "Don't let anyone ever tell you that economic security isn't important! If average people don't have it they will eagerly search for a leader who promises it! This is what happened to us!"

The downfall of the Weimar Republic and the economic catastrophe in its wake, remains to this day a template for how a people can be perturbed into the orbit of jackbooted fascism. But it is a history lesson typical libertarians - like Ms. Jones - touting their market salvation bunkum seem to ignore.

Prof. Ernest Partridge writes ("A Society Is More than the Sum of Its Parts" on Ernest Partridge's Blog): "The free market," that cornerstone of libertarian theory, cannot survive without a governmental referee, for the unconstrained and unregulated "free market" contains the seeds of its own destruction. Though free market theorists are reluctant to admit it, capitalists are not fond of free markets, since open and fair competition forces them to invest in product development while they cut their prices. Monopoly and the elimination of competition is the ideal condition for the entrepreneur, and he will strive to achieve it unless restrained not by conscience but by an outside agency enforcing "anti-trust" laws."

But my biggest bone of contention vis-a-vis Ms. Jones is her claim (page 1 bottom): "Government officials hope we will adopt the new meme 'toxic debt' - as though the concept of debt is somehow a poison that could kill individual humans or any living thing"

This is more nonsense, as Jones willfully (it seems) conflates an appropriate metaphor ("toxic debt") for certain financial instruments known as credit default swaps - which played a major role in the mortgage and credit mess, with actual debt that is valid (e.g. a real mortgage owed on a home). This mistake alone makes a mockery of her entire piece and places it in the realm of sophist buffoonery rather than a serious treatise.

Let us examine this contention further. This entails understanding what this term "toxic debt" means and how it factors into the unfolding economic catastrophe that we behold. Almost all of it is tied up in obscure instruments called "credit default swaps". The sum total of these esoteric financial "black holes" is now estimated to be no less than $55 TRILLION. (See,e.g. 'AIG's Complexity Blamed for Fall' in The Financial Times, Oct. 7, 2008 and 'The $55 TRILLION QUESTION' FORTUNE, October, p. 135).

Try to process that for one instant! It is more than all the current unfunded entitlements and other debt combined!

Quoted in the FORTUNE piece, a University econ professor cum Morgan Stanley derivatives salesman (Frank Partnoy) notes: "The big problem is there are so many public companies- banks and corporations, and no one really knows how much exposure they have to CDS (credit default swap) contracts."

Since most credit default swaps contracts are made "on the fly", in no formal mode, and often by word of mouth on cell phones (ibid.) no one even knows where all the $55 trillion of this toxic waste is buried.

As another hedge fund operator (Chris Wolf) quoted in the article put it: "This has become essentially the dark matter of the financial universe" - comparing it to the dark matter discovered in astrophysics.

Most apropos, as the FORTUNE piece observed: "You can guess how Wall Street's cowboys responded to the opportunity to make deals that: 1) can be struck in a minute, 2) require little or no cash upfront and 3) can cover anything."

To comprehend why these CDSs comprise toxic debt we need to delve into some financial history. In particular, a move made in the 1980s known as "securitization". Up until then, the banks were the primary holders of mortgage debt. With a government deregulating "green light", however, banks were able to offload these mortgages (whose defaults always cost the banks dearly) to Wall Street. There, clever people gathered millions of mortgages from across the country and repackaged them into entities called "collateralized mortgage obligations" or CMOs.

These were then inserted into bond funds which were sold to cautious investors as "safe" instruments. After all, bonds are supposed to be safer than stocks, right? Wrong! Bonds, such as U.S. Treasurys are - by virtue of having the name and backing of the U.S. government behind them. But not bond funds, which can be loaded with all manner of financial tripe that can engender losses over the short or long term.

As an example, most bond funds in the 1980s and 1990s were loaded with IOs, or inverse only strips, as well as inverse floaters, and CMOs (referred to as "toxic waste" in bond trader parlance). The IOs pay only mortgage interest. Inverse floaters, meanwhile, pay more when interest rates FALL than when they rise. All these tricks were used to try to juice up yields to lure investors. That, along with touting them as "government securities" - since legally speaking mortgage securities are "government-backed" but that doesn't mean your investment is FDIC-insured! In this way, the bond fund purveyors could get people to think they were making safe investments when nothing could be further from the truth.

My own wife was in one of these bond funds as part of a 401k "Life cycle" fund about ten years ago. I noticed every quarter, despite being in "bond funds", she was losing more than $800 each quarter and getting no company match (because they aren't obliged to match in the case of losses). Upon further scrutiny, I discovered the bond funds were laden with IOs and inverse floaters as well as CMOs. I immediately had her exit the Life Cycle thing and put all her 401k money into fixed income assets. Fortunately, she acted in time - as otherwise she likely would have lost more than 30% with the post-9-11 downturn.

We now move ahead to the late 1990s, and CMOs have transmogrified into CDOs (collateralized debt obligations) though the basic meaning is the same. Again, these represented millions of repackaged mortgages now sold as "securities" as part of bond funds.

Sometime in the early 2000s, a gaggle of "quants" - gifted mathematical types based in investment banks - got the idea for a creation that could juice up huge profits for their banks, and based on unregulated derivatives. Thus were born the "credit default swaps". These were basically devised as "side bets" made on the mortgage securities market and the performance of the CDOs therein.

We all know what a "side bet" is. For example, if you travel to a Vegas Sports book, say the Bellagio, you will find you can not only make bets on a particular game, say Giants beating the Patriots in the Super Bowl - but also ancillary happenings to do with the game. For example, one can bet on: how many first downs the Giants will make in the first quarter, or how many sacks the NE defenders will make in the game, or how many rushing first downs a particular player will make - say Sammy Morris of the Pats. Any and all side bets are feasible.

In the case of the CDS realm, side bets were allowed on all sorts of things, such as whether particular CDOs would lose money, or the interest rate (average) on a segment of them would drop one half percent, or whether there would be at least 100,000 foreclosures in the third quarter of the financial year.

In the case of the credit default swap, all that was needed to make the bet formal was a counter-party. Thus, the "party" renders the bet and the amount wagered, and the counter-party takes the bet. The actual exchange, as already noted, was often done on cell phones and no formal records other than what the cell phone statement showed were available.

Now, the investment banks' quants realized that the bets as such might not grab the interest of the mainstream banks they needed to buy into them. After all, the banks could LOSE on many of these bets and it would be to their unending detriment. Thus, the quants took the CDSs and repackaged them along with regular mortgage securities - with CDOs, into what they called "structured investment vehicles". Or SIVs.

These were then sliced and diced and sold to the mainstream, Main Street banks as safe securities. To make this "kosher" so to speak, bond rating companies (like AIG) were asked to give a bond rating and preferably the safest (AAA) to signal to the mainstream Banks these were A-OK purchases.

Despite the fact that the rating agencies had not the faintest or foggiest clue what the SIVs contained, they sold the things to the banks and the banks happily bought them up unaware of what was actually in them. By 2003 the total of credit default swaps in the financial system was estimated to be around $6 trillion. By August of this year, it had reached $55 trillion.

That is, $55 trillion in hidden and subjective financial BETS buried into mortgage securities as SIVs, with no formal tracer available! Couple this now to a bona fide debt, such as a car loan or mortgage from approved bank or mortgage loan company. Everything is spelled out in detail so that even a person of average intelligence can see what he or she is getting into.

In the case of the mortgage, for example, a full amortization schedule - table is available to show monthly payments, and the principal vs. interest. There is no guessing, no doubt. The debtor knows his obligations and what he has to do to make good on them.

By contrast, with the CDS (credit default swaps) nothing is known other than that the instrument has some subjective worth at one time. But HOW MUCH? TO WHOM? We have no clue since none of the esteemed quants who invented them knows where the "bodies are buried" so to speak! I am not even sure, if they were compelled to complete a typical ISO-9000 process form, they could replicate exactly HOW their esoteric instruments were created!

What we see here, and which is abundantly evident even to the most hard-core libertarian ideologue, is that credit default swaps and the instruments into which they have been buried and disseminated are indeed "toxic waste" by any rational financial measure. I am not even sure one can call them "debt" - although to the banks that now have them on their books they represent humongous debt! Since each quantity of these things lowers the value of the bank's assets by some factor, and increases its liability.

To make this more understandable consider two banks with roughly the same volume of assets, but different equities - since one bank (A) has fewer CDS. Now, since banks owning the instruments into which credit default swaps have been buried will not readily disclose their extent, then it stands to reason one bank - say Bank A - cannot know how much "bad debt" or "toxic assets" the other one owns or has on its books. If this is the case, a bank with relatively higher equity will be unwilling to lend capital to a bank for which the toxic asset volume is unknown. After all, if it lends in good faith then the other banks fails because of the higher CDS proportion, it will have only itself to blame.

It is this unknown which has directly engendered the current credit freeze. Because no bank knows the volume of CDS any other holds, it cannot know any other bank's equity position or credit worthiness. Thus, has the LIBOR rate recently exploded - this is the London Interbank Offered Rate - which is a measure of bank to bank lending confidence. It most certainly will not begin to go down, reflecting higher lending confidence, until some agent steps in and proceeds to buy all the CDS now on the banks' books.

WHO is in the position to do this? Well, certainly no private entity has the resources! The only one is the government, and more specifically the quasi-governmental entity known as the Federal Reserve which can, if it must, create enough money by fiat to buy all the CDS and get rid of this toxic sludge once and for all.

Now, some libertarians will no doubt exclaim 'Why not just do nothing?' but in asking that they are clearly not cognizant of the degree of financial collapse that would precipitate from such folly (as Ms. Jones clearly is not!). We are talking here of the seizing up of all credit, everywhere! No more money for student loans, at any price, no loans for businesses to meet payroll or plant improvement and you can forget about any expansions! No money for home construction, to purchase new cars, to do home renovations, to refi a mortgage...NADA! In effect, as Nobel Prize winning Princeton economist Paul Krugman has noted, one would usher in a Second Great Depression - and this one - by virtue of the global banking effects, would make the first look like the proverbial walk in the park.

Hence, bottom line, there is no option. The $55 trillion must be purged and it must be done before banking collapses proceed like falling dominoes. Now, no one is arguing here that full value must be paid for all those toxic assets, I mean even 20 cents on the dollar would be better than nothing – though even that would add $11 trillion to the existing bailout deficit. But doing nothing is not an option, and only the most financially obtuse, who have no remote clue of what is transpiring now, would even propose it. Perhaps a person like Ms. Iloilo Marguerite Jones and her friends.

Finally, in the wake of this catastrophe which will probably take four to five more years to unfold, it is clear that all the credit default swaps which caused this mess need to be outlawed. Further, all derivatives - irrespective of where or how they are used, need to finally come under SEC regulation. We cannot afford another event like the credit default swap mess, ever again!

Editor's comments...

You make a number of interesting points, but I doubt they were the ones you intended.

You start out with the arguably true adage that "a little knowledge can be a dangerous thing". You then proceed to provide a clear example of this adage in your attempt to disparage the profound truths presented by Ms. Jones in her article "The Tattered Illusions of Power".

Your repeated misrepresentations of libertarianism demonstrate that you have little knowledge of libertarian principles. Unfortunately your lack of knowledge hasn't restrained you from falsely attributing to libertarianism the very flaws against which it has historically proven to be the best defense.

You make references to "deregulation" in an attempt to demonize the free market, but your examples were actually examples of regulatory corruption not an unregulated free market. Real deregulation would require the actual restoration of a functional free market, not the crippled false facade you point to as a "free market".

Within the modern corruption of the term, "deregulation" is all too commonly used to refer to superficial regulatory changes that facilitate abuses of the market by those with political influence. Real "deregulation" is extremely rare - to the degree that it may only exist as a theoretical possibility. Governments don't willingly give up power and control.

There hasn't been any meaningful deregulation of the American economy in at least the last half century. What has been claimed to be "deregulation" has been at best partial relaxations of selected market distorting regulations. The intention has never been to actually allow the free market to function, but rather to create artificial conditions that will serve short term political objectives. The result has generally been the elimination of the few benefits of regulation while preserving the adverse effects - with the consequences falsely blamed on the free market.

There is a well established definition for the market abuses you describe - fraud. The intentionally deceptive derivatives that you attempt to portray as examples of a free market at work, are actually creatures of a corrupt government regulated market. These were government regulator facilitated crimes, not functions of a free market. They were only possible because of the artificial conditions created by the inconsistencies, failures to perform, and outright criminal complicity of government regulators.

You pointed out that the victims who bought them didn't know what they were buying – but were willing to buy them based on the values falsely assigned to them by authorized authorities. Their sole value was the perceived value of government approval and guarantees. Hardly a free market of voluntary transactions based on real value and personal accountability.

These derivatives were nothing but willful intentional fraud perpetrated with the connivance of government regulators. They only occurred because government regulators abused their powers in an attempt to violate the basic principles of economics - otherwise known as reality. Eventually reality imposed itself on the illusions of substance created by impenetrable tangles of byzantine regulations, and the fraud was recognized for what it really was. More regulators wouldn't have changed the outcome - reality can only be denied for so long.

The worst response to an evil is to replace it with an even worse evil. The worst possible "solution" to an economic crisis created by government imposed market distortions is more government imposed market distortions.

The Weimar Republic suffered from aggressive interference in its economy by a socialist populist government. The economic disaster was caused by the ever expanding efforts of government regulators to "fix" the adverse effects of previous government economic abuses. During the same time the socialist New Deal corruption of the American economy was turning what would have been a short term recession into the Great Depression.

In what should be a powerful lesson of history, the citizens of the Weimar Republic failed to understand that their crisis was the result of government inflicted corruption of the free market. They were deceived into believing that the free market was the cause of their economic crisis, and that an authoritarian government would provide them with economic security. My reading of history indicates that this was a bad decision. It certainly appears to me that the "solution" turned out to be far worse than the problem it was intended to solve.

The conclusions of your article and the recent American election do demonstrate the validity of your initial point - that a little knowledge can be a dangerous thing. You obviously know of the terms libertarian and free market, but apparently don't know much about what they mean.

Lacking a meaningful understanding of libertarianism and free markets, you advocate an authoritarian response to the economic crisis created by authoritarianism. Deceived into believing that the current economic crisis was the result of a "too free deregulated market", America has elected an authoritarian president who promises to provide economic security by greatly expanding government imposed distortions of our once free market.

The last time the world learned this lesson, America got FDR and a decade of government caused depression. The authoritarian who promised to provide the citizens of the Weimar Republic with economic security caused the deaths of over 50 million and the total destruction of Germany.

How much will it cost the world to relearn the lesson this time?