CRACKERNOMICS 2.0: The Curse of Crackernomics
Information Clearing houseWinner Takes All: The Super-priority Status of Derivatives:Why Derivatives Threaten Your Bank Account
The case against favored treatment of derivatives
May 10, 2011
Thursday May 5, 2011
Mark Roe, Harvard Law School,
I have avoided focusing on the mechanics of derivatives, bankruptcy and regulation by government. This would lead away from the political argument and understanding derivatives in the broader context of the democratisation of money.
There is a real problem in relating the action at ground zero in derivatives to the broader public debate around the Credit Crunch:
‘The case against favored treatment of derivatives’ Robert Teitelman
‘, there are very few signs … that anyone with any clout is suddenly about to ….. simplify bankruptcy treatment. Why?…..because, derivatives remain(s) a mysterious black box to most Americans, …’
The way that derivatives relate to insolvency and what this means for the broader economy is:
‘… a situation of technical interest to only a few, most of whom have their own particular self-interest in mind’
This is the ‘Money Aboriginal Problem’.
But the arrival of a more sophisticated and insidious form of Crackernomics (Crackernomics 2.0) makes it necessary to go into the mechanics of democratised money in more detail.
The fundamental reason that Crackernomics prevents a useful and effective understanding of the Credit Crunch is that it obscures the political context in which the collapse took place. This is because adherents of Crackernomics confuse actors with objects, that is, try to explain the Credit Crunch in terms of individuals and institutions instead of functions and instruments.
In ‘Winner Takes All: The Super-priority Status of Derivatives: Why Derivatives Threaten Your Bank Account’ Ellen Brown takes on the privileged position accorded to derivatives counterparties by the Dodd Frank Act. (The Dodd Frank Act if you don’t know was the main USA government response to the Credit Crunch).
Brown explains that as a result of Dodd Frank and the Bankruptcy Act (2005):
‘Derivatives have “super-priority” status in bankruptcy…..In a big derivatives bust, there may be no collateral left for the creditors who are next in line’.
‘Under both the Dodd Frank Act and the 2005 Bankruptcy Act, derivative claims have super-priority over all other claims, secured and unsecured, insured and uninsured.’
What this means in practical terms is that:
‘Rather than banks being put into bankruptcy to salvage the deposits of their customers, the customers will be put into bankruptcy to save the banks.’
So the next time TSHTF:
‘derivative claimants could well grab all the collateral, leaving other claimants, public and private, holding the bag.’
Why has this subject suddenly become so important? Because of the recent high profile confiscation of deposits in Cyprus and the increasing hints that regulatory authorities are going to replicate what the Cyprus government did all over the world. Brown suggests that confiscations like this will become more and more likely because:
‘Derivatives are sold as a kind of insurance for managing profits and risk; but as Satyajit Das points out in Extreme Money, they actually increase risk to the system as a whole.’
Brown points out that
‘The tab for the 2008 bailout was $700 billion in taxpayer funds, and that was just to start. Another $700 billion disaster could easily wipe out all the money in the FDIC insurance fund, which has only about $25 billion in it.’
Which is not going to go very far when:
‘the cash calculated to be at risk from derivatives from all sources is at least $12 trillion’
(The FDIC is the Federal Deposit Insurance Corporation, which is a payout fund set up by the USA government to pay out depositors in the event of bank collapse)
To make it clear
Section 716 (of Dodd Frank), does not in any way limit the swaps activities which banks or other financial institutions may engage in. It simply prohibits public support for such activities.’
The USA government is not going to restrict the production of derivatives but it is not going to underwrite them either. So where will the banks get the money in the next crisis?
The answer is:
‘The bail-in policy for the US and UK….set forth in a document put out jointly by the Federal Deposit Insurance Corporation (FDIC) and the Bank of England (BOE) in December 2012, titled Resolving Globally Active, Systemically Important, Financial Institutions.’
Brown explains that what this means is
‘Under the guise of protecting taxpayers, depositors of failing institutions are to be arbitrarily, de-facto subordinated to interbank claims, when in fact they are legally senior to those claims!’
. . .Derivatives counterparties, . . . unlike most other secured creditors, can seize and immediately liquidate (my emphasis) collateral, readily net out gains and losses in their dealings with the bankrupt, terminate their contracts with the bankrupt, and keep both preferential eve-of-bankruptcy payments and fraudulent conveyances they obtained from the debtor, all in ways that favor(sic) them over the bankrupt’s other creditors.’
Essentially Brown is arguing that the holders of derivatives, financial institutions enjoy a privilege over ordinary depositors when it comes to getting paid out from insolvent banks. Brown spends some indignation pointing out the:
‘..brutal, unjust irony of the entire proposal ‘
But in case anyone should think this position too partisan she casts around for a more widely acceptable argument against derivatives. In an effort to raise the tone a little Brown enlists Harvard Law professor Mark Row:
‘(W]hen we subsidize(sic) derivatives and similar financial activity via bankruptcy benefits unavailable to other creditors, we get more of the activity than we otherwise would. Repeal would induce these burgeoning financial markets to better recognize the risks of counterparty financial failure, which in turn should dampen the possibility of another AIG-, Bear Stearns-, or Lehman Brothers-style financial meltdown, thereby helping to maintain systemic financial stability’.
‘The derivatives and repo players’ right to jump to the head of the bankruptcy repayment line, in ways that even ordinary secured creditors cannot, weakens their incentives for market discipline in managing their dealings with the debtor because the rules reduce their concern for the risk of counterparty failure and bankruptcy’
‘More generally, when we subsidize derivatives and similar financial activity via bankruptcy benefits unavailable to other creditors, we get more of the activity than we otherwise would’
So the argument is that when government protects derivatives holders from the consequences of their decisions it encourages them to be reckless and it encourages more of them to be reckless than would otherwise be the case, Roe then goes on to make a slightly more sophisticated point.
‘Chapter 11 bars bankrupt debtors from immediately repaying their creditors, so that the bankrupt firm can reorganize without creditors’ cash demands shredding the bankrupt’s business. Not so for the bankrupt’s derivatives counterparties’
This asserts that allowing derivatives counterparties to dip into a bankrupted company straight away prejudices the chances of that company being rescued under Chapter 11 bankruptcy and so causes bank collapses that could otherwise be avoided.
So here are two core arguments for Crackernomics 2.0 plainly designed to garner maximum support among ‘middle of the road’ stakeholders in the Great Credit Crunch debate:
1. The bankruptcy privileges Dodd Frank gives to derivatives holders discourages due diligence.
2. The bankruptcy privileges Dodd Frank gives to derivatives holders confers may actually cause more collapses.
This high economic tone does not last for long and soon Brown is soon drawn to more familiar Crackernomics territory:
“the Lehman myth,” (which) blames the 2008 banking collapse on the decision to allow Lehman Brothers to fail. …. the Lehman bankruptcy was actually orderly, and the derivatives were unwound relatively quickly. Rather than preventing the Lehman collapse, the bankruptcy exemption for derivatives may have helped precipitate it’.
The ‘Lehman myth’ is rapidly becoming to Crackernomics what 9/11 is to ‘Libertarians’- a definitive divergence in the way that recent history is understood. Depending on what side you are on, Lehman either means that the regulatory authorities tried a standard insolvency but drew back in panic when they looked over the abyss or it was a bankers coup that allowed ‘banksters’ to take over the bail out.
But what both side hold in common is the belief that it is the fate of institutions that determined what happened. The corporates believe the whole financial and governmental system was at stake, the insurgents believe it was the fate of corporate fat cats at the top that was in the balance.
Underpinning Crackernomics is the assumption that banks and financial institutions are preserved or privileged by legislation such as the Dodd Frank Act and more importantly, this is the purpose of the legislation.
Based on this assumption, Crackernomicists are now making arguments against what they see as unfair preference given to the bankers and other derivatives counterparties in insolvency, characterising it as evidence of general preferential treatment.
In fact, post Credit Crunch legislation such as Dodd-Frank is there to preserve derivatives as a class of financial instruments not the organisations that issue them.
Why do governments want to preserve the act of issuing derivatives?
Because they have no choice, or rather they have gone past the point where choice was an option- the point of no return.
What is, or rather was, the point of no return?
The point at which governments in the Germanic empire were willing and able to countenance the derivatives market collapsing. And this is not hyperbole. Derivatives are a zero sum game- it’s all or nothing.
Once derivatives have been issued they are intractable, which is to say they cannot be liquidated in the traditional manner. Derivatives cannot be directly compared to other classes of debt because all derivatives are abstracted and dependent on conditions. Therefore they form a separate class of liability. They cannot be lumped in with other claims whether secured or unsecured, against an insolvent company.
There is no acceptable way to assign derivatives to assets. There is no acceptable way to compare the claims of derivatives to other claims. Effectively, derivatives are worth face value or they are worth nothing. Or to put it another way either derivatives trump other claims or other claims trump derivatives. Derivatives go to the very top of the list for payment or fall off the very bottom.
No matter what happens derivatives and other claims cannot co-exist together in insolvency.
In dealing with derivative counterparty claims Dodd Frank explicitly recognises that derivatives cannot be collectively assigned to assets in the same way other instruments of credit are. There was no legal framework that would have allowed the USA government to do anything other than what it did.
THE HISTORY OF THE POST CREDIT CRUNCH PERIOD IS THE STORY OF GOVERNMENTS TRYING TO CREATE THIS LEGAL FRAMEWORK ON THE FLY WHILE DEALING AT THE SAME TIME WITH THE FALLOUT FROM THE CREDIT CRUNCH.
All of which seems to suggest that I am implying that this process has become inevitable. Well, what if it is not? What would happen if derivatives were legally abolished or allowed to collapse as Crackernomics advocates?
Let us go to the mountain and ask the Moses of Crackernomics:
‘As noted by Paul Craig Roberts, “the only major effect of closing out or netting all the swaps (mostly over-the-counter contracts between counter-parties) would be to take $230 trillion of leveraged risk out of the financial system.”
So most, if not all of these pesky derivatives will simply vanish in a puff of smoke if only we have the courage to close our eyes very tightly and say:
‘I BELIEVE, I BELIEVE IN FREE ENTERPRISE!’
And who is to say? It might even have a chance of working if it were not for the political and economic history of the past century or so.
There is a reason that the Commodities Exchange Act and Glass-Steagall Act came into existence. The enactment of these laws represents a political victory for one group of people and a political defeat for another. There is a reason these laws were repealed fifty years on. Repeal represents a political victory for one group of people and a political defeat for their opponents. These historical events are not just enacted on some kind of political whim or a meaningless experiment; they represent conflict between real social forces over the recent past.
But any serious attempt to examine and understand who these social forces are and what their purpose is, would prove too uncomfortable not only for the ‘fat-cat banksters’ but for the so called ‘progressives’ and libertarians on the other side as well!
Consider the role that Paul Craig Roberts played in creating Reganomics-the political wing of the Monetarist takeover. Do you really think he is prepared to undertake any historical examination of the Credit Crunch that would expose his role in bringing the disaster about?
The idea is laughable and yet Crackernomics simply ignores this glaring contradiction right at its heart.
This is the Curse of Crackernomics; it does not, it cannot, really examine the forces that were in play leading up to the credit crunch and beyond it.
There is no way to wish derivatives and the democratisation of money away. There is no way to persuade Democratisers to abandon their project of NGM (Non Governmental Money), by complaining it is ‘not fair’ or ‘too risky’. They have calculated the risks; risk is what this is all about. They don’t give a damn if you or anyone else does not think it is fair.
Crackernomics and New! Improved! Crackernomics 2.0 wants to fight the Corporates with one hand tied behind your back. It must lose.
‘One might think of favored (sic) treatment of derivatives in bankruptcy as a kind of litmus test of our seriousness to wrestle with these issues. As long as we just let this one rest, we’re really not very serious at all. ‘ – Robert Teitelman