Welcome to Pluto

By Jim Rickards

Plutocracy, rule by the rich, is not named for Pluto, god of death, but his spoiled son, Plutus, the personification of wealth. The juxtaposition of a dead economy and bank billionaires makes this lineage apt.

The failure of Washington and Wall Street to foresee the financial crisis is well known. Less well known is their failure to grasp the depth of the crisis once it began. The crisis did not emerge suddenly in September 2008 with Lehman and AIG; it was in full swing by August 2007 with the Fed’s emergency discount rate cut. Why were our leaders blind not once, at the outset, but twice, after the crisis had begun?

Things got worse than regulators first imagined because of the hidden role of derivatives. A simple example makes the point. In 2007, there were about $1 trillion in subprime and similar risky mortgages outstanding. Historic default rates on mortgages were around 3 percent. It became clear that subprime defaults would be much higher. So assuming some sky-high estimate like a 25 percent default rate meant $250 billion of potential losses on $1 trillion of risky mortgages. A $250 billion loss is a big number but manageable in a $14 trillion economy. In real terms, it was not worse than the S&L crisis of the late 1980’s. Experts thought this was a problem to be managed but not one that threatened the financial system as a whole. This view prevailed through the spring and summer of 2008 as the Bear Stearns, Fannie and Freddie bailouts continued. There was a persistent sense that somehow the crisis was not going away, yet the basic subprime math made it hard to understand why.

Unknown to the public, politicians and bank regulators, a grotesque edifice of credit default swaps had emerged in the shadows of Wall Street. Credit defaults swaps, CDS, are just side bets on whether some normal debt instrument will perform or fail. The size of the CDS market grew from $2.2 trillion in 2002 to $54 trillion in 2006. Not all of these CDS related to subprime mortgages but a large percentage did. If we generously assume half were subprime related, that’s a $27 trillion bet. Now, when we apply the 25 percent default rate we get losses of over $6 trillion; much closer to the actual losses in the collapse of 2007-2008 and over 20 times greater than the $250 billion estimate from subprime mortgages alone.

The subprime market was a scandalous fraud by itself. But the lying borrowers, crooked mortgage brokers, greedy investment bankers, corrupt rating agencies, crony-filled government agencies and ignorant investors combined could only lose $250 billion on their own. It took the quants at Goldman and elsewhere to find a way to lose over 20 times that amount through the magic of derivatives. Who said American technology is dead? It takes genius to turn a quarter-trillion-dollar scam into a $6 trillion catastrophe.

Surely some social good came out of this financial alchemy? After all, isn’t reward half of the risk-reward spectrum? When a city borrows money an airport can be built. When a corporation borrows a new factory rises. When individuals borrow they buy a house or car. Along with debt comes some investment, purchase or savings that helps advance the economy however fitfully. How many airports, roads, factories, farms, houses, cars or other goods fell out of the $27 trillion CDS piñata? I won’t keep you in suspense—the answer is none.

Unlike real banking which raises capital for worthy enterprises, the CDS market is a betting parlor with no social utility. But don’t the bets just change hands between winners and losers with no harm to the rest of us? Not exactly. The winners like Goldman made sure to collect. But the losers, after receiving their personal bonuses on up-front fees and buying houses in Nantucket, walked away and handed society the bill. If you’re wondering who the real losers are and you happen to be a taxpayer just look in a mirror.

Society is so in thrall to Goldman and the other banks that we can’t even hold them accountable. Their critics are accused of using hindsight as if the game wasn’t rigged from the start. Opponents are accused of being anti-free market as if putting horsemeat in hamburgers is a legitimate market activity. As a society, we’ve lost our nerve when it comes to bankers and their lobbyists. The Age of the Plutocrat has well and truly arrived.

Democrats are going through the motions of reform now while Republicans are going through the motions of reform later. There is no reform. The Dodd and Frank bills are shot through with easy loopholes a second-year law student could find. Blanche Lincoln’s bill has teeth, but no hope of passage. The new bank bailout fund is just another wealth transfer from citizens to the banks. The new systemic risk regulator does not understand risk, viewing it as stocks and flows to be dialed up or down rather than the complex nonlinear system poised on the edge of catastrophe, which it really is. Campaign contributions are flowing, lobbyists are high-fiving, journalists don’t get it and the public is confused and disgusted. We are blinded by a so-called free-market ideology subscribed to by politicians and pundits who can’t see the difference between a free-market and a rigged game. Free markets depend on trust and that died a long time ago.

James G. Rickards is a director of Omnis, Inc. and former general counsel of Long-Term Capital Management. Follow him at http://twitter.com/JamesGRickards">twitter.com/JamesGRickards.