Have the patience to read this through or go to the middle of the article in bold characters to get to the beef of the argument .

US Fed's move is the bigger problem

By Julian Delasantellis

It couldn't always have been like this. No, the country today would be a far different place if across the span of American history had the nation constantly chosen to focus on the most picayune of arcane and unimportant irrelevancies, as it's doing currently with the AIG bonus controversy, instead of on matters with some actual import.

It's early in the evening of June 5, 1944 - the day before the D-Day landings in Normandy, in Supreme Allied Commander Dwight D Eisenhower's Goodge Street Headquarters in London. The general

is addressing his senior staff.

"Men, we are at a truly momentous crossroads in history. Tomorrow we commence America's crusade in Europe, wherein the New World, fired by the tradition of liberty and justice it inherited from the old, returns to liberate the Old World from the most barbarous brand of tyranny and injustice ever seen by man. We must not fail; or falter, we must ... "
"Excuse me General, but we can't invade tomorrow."
"Can't invade? Why? Will the weather hinder our paratroop landings?"
"No sir, it's not that?"
"Have the Nazis moved Panzers to Caan?"
"No sir."
"Well, what is it man?"
"It's our tanks! They don't have cup holders! We can't invade France with tanks that don't have cup holders!"

And as a two-year debate is initiated over whether the cup holders should be adjacent to the tanker's right or left knee, the Germans construct their atomic bomb, go on to win the war. "For want of a nail ... the battle is lost" an old verse goes, here, for want of a cup holder, the Nazis would have conquered the world.

At occasions like the present, the American people act much like the dyslexic idiot savant Raymond Babbitt in the 1988 movie Rain Man. He couldn't shake a monomaniac fixation on the TV show People's Court or the alleged superiority of his K-Mart underwear; America can't seem to lose its fixation, its rage, over the issue of the US$165 million of bonuses granted to members of the American International Group (AIG) financial products division (AIGFP), the sector of the 90-year-old company that so mismanaged the writing and trading of the newfangled financial product called credit default swaps ( CDS) that the company has been forced to accept $180 billion in Federal Reserve and US Treasury largesse since last autumn.

At a congressional hearing on Wednesday, current AIG chief executive Edward Liddy said he had received a letter advocating that the senior officers of the company be strung up with piano wire - perhaps one of the people who held on to the stock as it declined from its 2001 highs of just under $104 to its lows last month of $0.33 was a music teacher. Another called CNN and said that the company's directors should be shot; who cares if the network can easily find out name-and-address information on every toll-free call it gets and report such information to law enforcement? One observer was more sedate, suggesting that the bonus receivers follow Eastern tradition and commit seppuku, Japanese ritual suicide - then again, this came from an actual 28-year serving US senator, Republican Chuck Grassley of Iowa.

About the hearing itself little needs to be said. I think it most reminded me of the scene in the Iliad, where Achilles exacts his vengeance after the slaying of Hector.

On this he [Achilles in the Iliad; committee chairman Barney Frank at the hearing] treated the body of Hector [Liddy] with contumely: he pierced the sinews at the back of both his feet from heel to ankle and passed thongs of ox-hide through the slits he had made: thus he made the body fast to his chariot, letting the head trail upon the ground. Then when he had put the goodly armor on the chariot and had himself mounted, he lashed his horses on and they flew forward nothing loth. The dust rose from Hector as he was being dragged along, his dark hair [actually, Liddy's was white] flew all abroad, and his head once so comely was laid low on earth, for Jove had now delivered him into the hands of his foes to do him outrage in his own land. Thus was the head of Hector being dishonored in the dust.

Everybody likes simplistic, public passion plays of good and evil - where would the Maury Povich tabloid TV show, now the Maury show, be without DNA tests or lie detectors? But the real scandal here is not the $160 million in AIG bonuses - it's the $180 billion in AIG bailouts, and, unfortunately, very little is being discussed about them.

If you are a leftist never much enamored of what was up until then the dominant political economy philosophy of market suprematism, September 2008 must seem like something of a blur to you, like the mad, happy, chaos that precedes a girl's wedding.

First Fannie and Freddie went down the tubes, then, in the space of a few hours on a weekend, Merrill Lynch was consumed by Bank of America and then Lehman Brothers went bust. By the end of the month, market capitalism's reigning chief lackeys, George W Bush-appointees Ben Bernanke at the Federal Reserve and Treasury secretary Henry Paulson were begging the US Congress for $700 billion or so - what later became the Troubled Assets Relief Program - of taxpayer money to pull the financial system out of the mess it had created for itself.

Less noticed at the time was what was happening with the American Insurance Group, or AIG. There, in exchange for stock warrants representing 79.6% of the company's equity, the Federal Reserve Bank agreed to provide AIG with $85 billion; further cash injections by the Fed and Treasury in October, November, and just a few weeks ago put the total amount the government was on the hook for with AIG at $180 billion.

Clearly, AIG needed a whole lot more work on its business plan.

Last summer (see Jaws close in on Bernanke, Asia Times Online, July 16, 2008), I described how, where once US mortgages were ultimately guaranteed by government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, the mortgage guarantee function during the glory days of this decade's credit boom up to 2007 was mostly performed by something called credit default swaps (CDS), private, unregulated, non-exchange traded derivative instruments that allowed two parties to come together to place bets on the health of a bond, the company that issued it, even the sovereign debt of whole countries.

What we are gradually learning is just how central CDS became to the great expansion, and now deflation, of the credit bubble. As the securitization craze deepened and expanded, as everything from loans for houses, cars, office buildings and credit cards got rolled up and then sliced off into ever- and ever-larger successive rounds of debt issuance, CDS were always there, providing the participants in this market the false sense of security that whoever was on the other side of the debt security they had just bought or sold could fulfill their commitment to make good on their obligation. In essence, the $62 trillion market in CDS became the enablers of the entire shadow banking system that provided the liquidity for the whole real estate and other asset boom.

But it's not like there was not even more opportunities for mischief. CDS betting on a company's decline could be bought for very little, if any, initial investment in this non-exchange traded market. Many are saying that much of the crashing decline in the shares of the financial system occurred when people bought CDS that would increase in value if a company foundered; whoever was the market maker on that side of the trade would, if at all prudent, enter the market to either short the stock or buy its puts - thus, a very small initial investment could have a large and wholly disproportionate effect on the stock price.

On the other side of the trade, the selling of CDS has a payoff profile much like that of selling options - an up-front payoff received for the seller bearing risk. If you do this on an established exchange you either have to put up an initial margin to prove that you can fulfill your part of the deal if it turns against you, or have an underlying ownership of the stock that roughly corresponds to your covered call option position.

CDS were totally unregulated; one could sell and sell and sell them for premium - as AIG did with CDS on the mortgage-backed securities that came out of the subprime boom - and just hope that the prices of the underlying mortgages, and the real estate that backed them up, held up.

If they didn't, it's a mad dash to find Ben Bernanke's phone number.

The free-market advocates of this system, most prominent among them former Federal Reserve chairman Alan Greenspan, blessed this system, for it seemed to allow risk to be transferred from those who didn't want it to those who were comfortable with it. However, once this system was utilized to make it appear that it was much safer to issue and hold much higher levels of debt than was previously considered prudent, that logic was turned on its head. As risk got shuffled and dealt around like playing cards, what financial regulators did not realize until it was too late was that the total amount of risk the system was bearing was, if anything, exploding.

At the center of it all was AIG. The essence of insurance is the measurement of risk - that's why a teenager with a Corvette pays a lot more in car insurance premiums than a grandmother with a station wagon. AIG thought that this experience provided background in pricing CDS risk.

They weren't even close. In exchange for premium, and not necessarily a lot of premium., they sold every CDS they could beg borrow or steal. As Gillian Tett put it in the Financial Times:

On paper, banks ranging from Deutsche Bank to Societe Generale to Merrill Lynch have been shedding credit risks on mortgage loans, and much else. Unfortunately, most of those banks have been shedding risks in almost the same way - namely by dumping large chunks on to AIG. Or, to put it another way, what AIG has essentially been doing in the past decade is writing the same type of insurance contract, over and over again, for almost every other player on the street. Far from promoting "dispersion" or "diversification", innovation has ended up producing concentrations of risk, plagued with deadly correlations, too. Hence AIG's inability to honor its insurance deals to the rest of the financial system, until it was bailed out by US taxpayers. "

In other words, risk, far from being diversified across the world, was highly concentrated, in AIG's computers. This would be a far more productive focus for the public's outrage than the bonuses, but there's no investigation of this, as opposed to the bonuses, which all have a face and, probably a very exclusive address.

The issue of who loosed the shadow banking/CDS

financial system onto the world is mostly uninvestigated. There was the

Commodity Futures

Modernization Act of 2000, pushed through the Congress with no debate in either chamber, mostly by Republicans such as Phil Gramm of Texas, and signed into law by president Bill Clinton a month before the end of his term. It removed private party derivatives from regulation by the US Commodity Futures Trading Commission; as applied to CDS, that was what allowed one to hold so many of them without posting a margin.

On April 28, 2004, the US Securities and Exchange Commission approved a rule that permitted major investment banks to operate

with much higher leverage ratios, allowing for up to $40 in

loans for each dollar in capital. Explaining his vote for the change, SEC commissioner Rod Campos is heard on the tape of the meeting saying that "I keep my fingers crossed for the future".

We now see that more in terms of prudent regulation was needed than just what could be provided for by commissioner Campos' digits.

Asking how the shadow banking system grew these past years is like asking why plants grow in highly fertile soil; no one in authority had to take a lot of positive action - it just did.

Specifically, the conception of government as a negative, inhibiting force, and the freedom of private finance to dream up and create just any financial product they could think of, led to this circumstance. Those who knew, like the Greenspan Fed, and the bankers themselves, were either profiting from the experience or expected to profit from it once they left government service. If you knew what was going on and objected, you were a veritable spoilsport at the orgy; if you came all this way to understand what was going on, why not go one more penultimate step, take off your clothes and morals, join the fun?

AIG used to be a pure insurance company. General Electric used to sell good toasters, Sears clothed the backs of Middle America. In one way or the other, all three staid-and-true American commercial names have recently allowed themselves to roll down the road to ruin and turn their companies into hedge funds.

That, the recent obsession over manipulating leveraged finance instead of actually producing something to be successfully sold in the markets of commerce, is something that aches for a public debate it will never see. (Consider Sears: majesty to hedge fund dust, Asia Times Online, May 14, 2008.)

But if the public is getting the AIG story wrong, it's also now getting an even bigger story wrong.

An addicted cigarette smoker might deny that his nagging cough and scratchy throat was the onset of the lung cancer or emphysema he was so often warned about; "It's just a cold or allergy, right, Doc?" So seems to be happening with America's addiction to foreign capital.

The first article I ever wrote for Asia Times Online, (US living on borrowed time - and money" March 28, 2006), introduced readers to the US Treasury's monthly Treasury International Capital (TIC) report, a compendium of how much investment

or short-term capital the US receives from foreign sources every month. Back then, the US was quite the popular parking spot for foreign capital, frequently drawing in over $100 billion a month.

That worm has certainly turned; the US in January, the last month data is available, was actually net drained of foreign capital, to the tune of $150 billion. On his blog at the Council of Foreign Relations, economist Brad Setser interpreted the data this way.

Today's TIC January data was a disaster. $150 billion in (net) capital outflows (negative $148.9 billion to be precise) cannot sustain even a $40 billion trade deficit.

Obviously, the concern is that those with still the capital to lend to the US, primarily China, seeing the huge increase in US government demand for borrowed funds with its now huge and ever-burgeoning budget deficits being used to finance the economic crisis recovery programs, will fear that the US dollars they use to buy US

debt will depreciate in value, devastating the value of their investments.

Previously, China has tried to give messages that slowly pulling out of its dollar positions was exactly what it wanted to do, but America's cherished habit of ignoring anything that foreigners say to it had it lending a stone-deaf ear to the warnings.

Last week, as detailed on this site with W Joseph Stroupe's three-part series (see Dollar crisis in the making Asia Times Online, March 14-18, 2009) and by Olivia Chung's article on Chinese Premier Wen Jiabao's warning to the US to maintain the value of its currency as a matter of national honor, (see Wen puts US honor on the debt line Asia Times Online, March 14, 2009) the message seemed to be being sent as loudly and clearly as possible. Still, the US stockmarket ran true to form - it ignored Wen's warnings, and continued its recent bounce off the lows.

So Ben Bernanke decided to give America's Chinese and other foreign investors a good swift kick in the keyster as they headed out the door.

Meetings of the US Federal Reserve's interest-rate setting Open Markets Committee used to be a lot more interesting back when there were actually interest rates to set. Now, with rates at zero, the Fed has to work extra hard to get the markets to take notice. At Wednesday's meeting, they did.

After committing another $750 billion for purchases of mortgage-backed securities as part of its program of adding liquidity to the system through "quantitative easing", the Fed had this for those foreigners who apparently think that they can put America over a barrel by refusing to buy its debt.

To help improve conditions in private credit markets, the committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.

That's supposed to inspire confidence?

The potential drawbacks to this approach are obvious. Does Bernanke really think he can convince foreign investors to make new investments in US government securities by threatening the dollar value of their existing securities? The last thing the recovery effort needs is long-term interest rates in an uncontrolled rise.

A key factor currently holding down inflation in the face of the incredible monetary expansion recently has been a decline in what is called monetary velocity, the rate of which money circulates in the economy. Nothing will ramp up velocity faster than a falling dollar; people will want to get rid of that accursed green thing as soon as possible, before it falls even further.

In the markets, the effect of the Fed announcement has been entirely predictable. Although yields on 10-year US government securities fell to 2.5% from near 3% before the announcement (entirely expected, what with $300 billion of new buying to hit this market) they were back on the rise by late Thursday.

With the US dollar, there's been no such ambiguity of effect. The euro rose from 1.31 against the dollar to 1.37 immediately after the announcement, its highest level against the greenback since early January. The dollar also fell five cents against the yen, to under 0.93 cents/yen. Other inflation-sensitive markets also fell in line: crude oil broke above $50 per barrel for the first time since the New Year; gold takes the cake for sounding the alarm bell, up over $77 per ounce just since the announcement.

But this collective 5% impoverishment of America drew no notice on Capitol Hill. The House of Representatives, in the very rare mode of considering themselves and acting as servants of the plebeians, overwhelmingly voted to seize the AIG bonuses through confiscatory taxation; to have a similar beneficial effect with the currency markets might require a repeal of the laws of gravity.

I almost get the impression that, like a child with too many toys and who has become bored with his most recent one, the public is tiring of AIG rage. Will they now turn their focus to an actually important public issue?

Doubtful.

"Next, on PowerCableNews, we'll have the experts debating President Barack Obama's NCAA basketball picks!"

Julian Delasantellis juliandelasantellis@yahoo.com.


(Copyright 2009 Asia Times Online (Holdings) Ltd. All rights reserved. Please contact us about sales, syndication and republishing.)
is a management consultant, private investor and educator in international business in the US state of Washington. He can be reached at

In other words - foreigners, we don't need your money; we'll print our own! That's what's essentially been done with the short end of the Treasury yield curve since the Fed's rescue operations from last September; it was probably only a matter of time before they would attempt the same with longer-term securities.

What will this do to the Fed's balance sheet? It will cause it to grow - a lot. From being virtually non-existent a few years ago, the Fed has it soon growing to almost $4 trillion - more than 25% of the country's gross domestic product.