Draft (update 1)

Here is the final draft. The structure is mostly complete, but I still have a lot of work to do (finish explanations, add missing links, shorten things a little, etc).

I will finish editing it over the next few days.

I added some pictures. (update 1)


I. It isn' t about profit!

Conventional explanations to the current financial crisis tend to revolve around bankers' greed. Bankers been made scapegoats. In truth, it is the government which bears responsibility for the current crisis.

Why then have bankers been made scapegoats? Saisman cites a number of cases in which federal legislators, agency heads, and commissioners have led the movement to blame bankers, rather than government policies, for the banking system' s failings. Selfinterest provides an obvious motive. A question that remains to be answered is why the popular press have not been more discerning.

If there is anything more tragic than our current banking crisis, it is that the crisis is being blamed on the wrong group, on the bankers, instead of on the primary culprit, government intervention. The tragedy lies in falling to identify the fundamental cause of the problem, thereby ensuring its continuance. Bankers are not entirely innocent of wrongdoing in the present debacle, but to the extent that bankers have been irresponsible, it has been primarily government intervention that has encouraged them to be so. More widely, it is irresponsible government policy that has made the U.S. banking crises of the past century so frequent and seemingly so inevitable. Government has created these banking crises—sometimes inadvertently, at other times with full knowledge—by making it nearly impossible to practice prudent banking. Having done so, government has then pointed to bad banking practices as sufficient cause for still further interventions in the industry.

Virtually every one of the financial "innovations" which have wrecked the US financial system have been spearheaded by the US treasury (OTC derivatives, securitization, credit enhancements, etc…). These "innovations" were driven by the need to "prevent the collapse of the financial system through any means possible (including fraud)"

the seeds for much of the current crisis were sown in the policy “solutions” to previous financial and economic crises. Any attempt to dissect and understand the current crisis that does not account for the complex history, evolution, and integrated nature of financial regulations will not yield meaningful lessons for today' s policy makers.2

What made the crisis possible were the illusions that key participants held during the years that preceded the meltdown. Financial executives had excessive confidence in mathematical models of risk, in financial engineering, and in the “AAA” designation of credit rating agencies. However, it is misleading to simply write, in the words of one prominent white paper, that “Market discipline broke down as investors relied excessively on credit rating agencies.”3 What this formulation overlooks is the fact that regulators themselves encouraged the reliance on agency ratings, particularly for compliance with bank capital requirements. In fact, we will see that the regulatory impetus to use agency ratings dates back to the 1930s, was reinforced in the 1970s, and was significantly enhanced as recently as January 1, 2002. To ignore these regulatory policies and instead assert that agency ratings were relied on because “market discipline broke down” is to present a distorted view of history.

1) Monetary Policy

In a massive power grab, the treasury drafted a bit of legislation in 1934 called Gold Reserve Act, in which it gave itself tremendous powers at the expense of the Federal Reserve.

The Gold Reserve Act of 1934 hijacked control of the monetary policy by:

A) Transferring possession of all the nations gold to the treasury.

B) Giving the Treasury primary responsibility for official foreign exchange operations.

C) Creating the Exchange Stabilization Fund (ESF), a political slush fund under "the exclusive control of the Secretary of the Treasury" with broad statutory authority "to deal in gold, foreign exchange, and other instruments of credit and securities"

Below is an extract from the transcript of the hearings about the Gold Reserve Act of 1934, which show some of reactions at the time.


Senator TOWNSEND. Would you mind stating what you think the effect of this bill, if passed as it is now written, would be on the Federal Reserve banks?

Mr. STEWART. It seems to me to shift fundamentally the responsibility from the Federal Reserve System to the Treasury in the only matters in which the control of currency and credit really matter, and that is with reference to the convertibility of the currency into gold or in foreign exchange, and to set up a competing influence in the operation of the stabilization fund that is equivalent to an open-market operation. In those two respects it seems to me to nullify, if not to scrap, the Federal Reserve System.

It not only takes that action, but in looking for some executive officer to place the responsibility upon it finds an executive officer which is bound to be subject to popular pressure from time to time, and of course a single lesson which is part of the management of currency is how frequently one has to do an unpopular thing, and the purpose of having a central bank independent is that it should be free from Government control, but it should have some protection in the management of our currency against the emergency of the moment.

I should have thought that any executive officer [ie: secretary of the treasury] faced with the responsibility of raising $6,000,000,000 in 6 months had a sufficient responsibility, without adding others of a somewhat conflicting character. I say " conflicting " deliberately, because he is under the necessity of raising this money, and under this bill under the necessity of maintaining the soundness of the money that he raises. I believe that in public finance it is just as unwise to put a large borrower in control of the currency as it has been demonstrated to be in private finance, and any view which runs to the contrary not only overlooks the entire experience in other countries in this matter but overlooks our own very recent experience.

The CHAIRMAN. DO you see any difficulty in the Reserve bank system operating if this were done, tranfer of the gold to the Treasury?

Mr. STEWART. Yes; I see not only the conflict that it seems to me likely to arise, but apart from the mere shadow of itself a mechanism functioning as a clearing agency which has not any of the authority left for the control of the credit and currency position.

The Gold Reserve Act Of 1934 stripped the Fed of virtually all monetary authority. While it did recover some independence in 1951, the present-day Fed wouldn' t even be unrecognizable to its founders.

The Treasury, on the other hand, has been abusing its new monetary authority since receiving it in 1934, demonstrating for all the folly of putting the nation largest borrower in charge of protecting the value of money.


Looting America' s Gold

The significance of the Treasury' s gold heist can only be appreciated by understanding the importance of the gold standard.

The chart below shows Central Bank and commercial bank gold reserves between 1945 and 1935, when the dollar was still backed by gold in bank vaults.

Timothy Green explains the purpose of these commercial bank gold reserves.

to accommodate the widened standard, central bank stocks of gold rose by 70% during the 1890s. But the banks still seem to have regarded their gold reserve (usually mainly in coin) as cover for their domestic note issue liabilities. Anyone could walk into banks in Britain, France, Germany or the US and exchange a bank note for gold coin at a fixed price. That was the essence of the gold standard.

Under the gold standard, the value of money was derived from the gold in bank vaults, not government credit. If the US had defaulted on its debt in 1890, the value of the dollar and much financial system would have remained intact.

When the US treasury seized control of the nation' s gold reserves in 1934, it was an act of theft. All the US' s monetary wealth was seized and transferred secret to the Treasury' s control for safekeeping.

In March 1941, Lewiston Daily Sun reported that half a billion in gold was secretly removed from New York to Fort Knox

WASHINGTON, The secret movement of $500,000,000 worth of gold from Now York to Fort Knox was completed today. It was learned authoritatively, and the Kentucky vault now holds $14,000,000,000 of the yellow metal [11340 tons of gold] — the largest treasure ever assembled under one roof.

Of course, the problem isn' t that the treasury took control of the nation' s gold. If the treasury could be trusted to be responcible with the US' s monetary wealth, everything would be ok. No, the real problem is that the treasury took the control of the nation' s gold and then spent it, leaving nothing but Treasury IOUs backing the dollar.

The treasury is not big on the whole “saving” thing, and in 1958, it started shipping the gold back out of Fort Knox to pay its bills. This outflow continued steadily for the next two decades.

Gold Moved From Ft. Knox Storage - Sep 6, 1962
4 Truckloads of Gold Move from Ft. Knox - Nov 29, 1967
Ship Gold Secretly to UK Bank - Dec 2, 1967
US sells gold - May 23, 1978

For the US gold reserves to still be intact it would have required that the treasury act RESPONCIBLY over the last thirty years, which is impossible.

The consequences of putting the largest borrower in control of the currency = INFLATION

Lawrence H. White from the Cato Institute explains the consequences of politicizing the money supply better than I could.

What must be recognized as fundamental is how the federal government itself benefits from inflation. The federal government gains from monetary expansion and accompanying rising prices in at least three ways. (1) Inflation under-anticipated by bond-holders erodes the real value of the government's interest-bearing debt. Wealth is transferred from holders of government debt directly to the government, the largest debtor in the economy. (2) Inflation swells federal tax receipts due to "bracket creep." Income taxes are progressive with respect to nominal income, and deductions are nominally defined. Also, inflationary appreciation of business inventories is taxed as profit. The real burden of taxes increases, yet Congress is able to declare a moderating "tax cut." (3) Most importantly, expansion of the money stock itself levies a "tax" on holders of money. By issuing fresh batches of money, the federal government can obtain real resources in exchange. …

The Process of Inflation

the Fed's open-market operations are usually tailored to support the Treasury's funding needs on a month-to-month basis.

The Temptation of Easy Money

That the illusory boom comes first, and the painful readjustment period of the recession comes later, helps explain why a shortsighted monetary authority is tempted by easy money policy. The temporary dip in output and employment associated with the monetary restraint necessary to cool inflation unfortunately comes before any permanent gain. A temporary bulge in unemployment appears well before price stability and productive reintegration can be established. Past expansionary impulses continue to snake their way through the economy, pushing up prices. Restraint reveals the distortions and dislocations due to the previous inflation, and popular analysis mistakenly attributes these troubles to the restraint rather than to the previous inflation. Since the Fed (as Mr. Dooley once said of another political body, the Supreme Court) follows the election returns, shortsightedness is just what we should expect of our monetary authority.

the Federal Reserve Board's pursuit of inflationary policy is the predictable result of the incentive structure surrounding them as an arm of the federal government. We cannot hope to end inflation -- and with it the business cycle -- until we reform our monetary institutions so that the stock of money is no longer subject to manipulation by politicians. As long as the federal government enjoys central control of the money supply, we will find money being turned to political ends. Who manages the money managers?

The bald fact about the Fed is that, like any state-sponsored central bank, it is by nature and origin a parasitic institution. Central banks typically originated as wartime inflationary finance schemes, the Bank of England being the premier example. They exist today primarily to service governments' appetites for spending.

Completely predictedly, (if you could print money, wouldn' t you?)

In the 1960s, around the same time as US gold outflows began, the Federal Reserve yielded to the treasury to keep interest down (by printing money).

in 1964, President Lyndon B. Johnson' s government spending programs for welfare and the Vietnam War again put pressure on the Fed to keep interest rates down. The Fed yielded somewhat to administration pressure. Increases in M1 that had been between 2 and 3 percent in the early 1960s jumped to 5—8 percent from the mid-1960s to early 1970s.

Federal Reserve Policy under Arthur Burns

President Richard M. Nixon appointed ARTHUR BURNS chairman of the Fed Board in 1970. Under Burns' s chairmanship, the Fed continued its policy of “stimulation-accommodation.” When a recession appeared, as occurred in 1969, the Fed increased its open-market buying activity to stimulate spending. Once recovery was in place, Fed policy accommodated revived business spending, again with open-market purchases. ... Fed policy continued in the same pattern, however, through the 1970s, reaching its climax with the inflation spike of 1979—1981.

Burns summed up the Fed' s problems in 1987, as they had appeared during his tenure. …

it is illusory to expect central banks to put an end to an inflation ... that is continually driven by political forces. ... Persistent inflation ... will not be vanquished ... until new currents of thought create a political environment in which the difficult adjustments required to end inflation can be undertaken.
(Arthur F. Burns, “The Anguish of Central Banking,” Federal Reserve Bulletin, September 1987, pp. 695—696)

The chart below compares the Federal Reserve' s balance sheet expansion (the increasing monetary base) against America' s falling gold reserves.

(For a much more detailed look at the Fed' s balance sheet, see A Visual History of the Federal Reserve System)

The impact

The Treasury' s giant hedge fund—The Exchange Stabilization Fund

Most damaging of all, the gold reserve act gave the US treasury control of a giant, unaccountable hedge fund for the purpose of market interventions: the Exchange Stabilization Fund (ESF). The Treasury' s ESF conducts its operations through the Federal Reserve Bank of New York, thereby further masking its activity by using the Fed as a front.

Exchange Stabilization Fund

ESF operations are normally conducted through the Federal Reserve Bank of New York in its capacity as fiscal agent for the Treasury Department.

The Exchange Stabilization Fund (ESF) of the United States Treasury was created and originally financed by the Gold Reserve Act of 1934 to contribute to exchange rate stability and counter disorderly conditions in the foreign exchange market.
The Act authorized the Secretary of the Treasury, to deal in gold, foreign exchange, securities, and instruments of credit, under the exclusive control of the Secretary of the Treasury subject to the approval of the President.

Giving the US Treasury the ability to conduct open market operations (to buy and sell securities, especially derivatives) was one of the worse legislative mistake in US history.

Treasury begins dealing in Over-The-Counter (OTC) derivatives in 1961

When the refusal of the administration of U.S. President Lyndon B. Johnson to pay for the Vietnam War and its Great Society programs through taxation resulted huge budgets deficits and rampant inflation, the treasury began intervening secretly to prop up the dollar using OTC derivatives (forward contracts). The Fed Debate in the 1960s over Sterilized Foreign Exchange Intervention reveals the extent of the Treasury' s forward operations.


In 1961, the Exchange Stabilization Fund (ESF) of the U.S. Treasury began to intervene in the foreign exchange markets. Its ability to intervene, however, was limited by its resources.
In 1934, Congress had created the ESF with the Gold Reserve Act. Congress capitalized it with $2 billion of the profits created by that Act' s revaluation of gold from $20.67 to $35.00 per ounce. It put the ESF under the control of the Treasury and authorized it to intervene in the foreign exchange markets to stabilize the value of the dollar.

Because so much of its resources were tied up, the ESF intervened mainly in the forward markets [The forward market is the OVER-THE-COUNTER (OTC) financial market in contracts for future delivery]. In that way, it would only need foreign exchange if it had to close out a position at a loss. “Reference was made to the extent of operations of the ESF in the forward market, as opposed to spot transactions, and Mr. Coombs [manager of the New York Fed' s foreign exchange desk] said the basic reason was that the ESF was short of money” (Board of Governors 1962, p. 169). The dollar often traded at a large discount in the forward market. The Treasury entered into commitments to furnish foreign currencies in the future in order to reduce this discount. In doing so, it hoped to encourage individuals to hold dollar-denominated assets by reassuring them that the dollar would not depreciate in value.

… In an attempt to encourage Italian commercial banks to hold dollars rather than turn them over to the central bank, the ESF entered into $200 million in forward contracts. The forward commitments of the ESF in lira and Swiss francs amounted to $346.6 million in early 1962.

Forward commitments, however, carried the risk of loss if the dollar did not appreciate. Given the risk exposure due to the size of its forward commitments, the Treasury felt that the ESF had insufficient cash on hand. To provide it with additional cash, the Treasury wanted the Fed to buy the ESF' s foreign currencies such as the deutsche mark… [The Fed agreed to do so]

A Treasury memo (Foreign 1962; U.S. Treasury 1962b, p. 2) noted

Total resources of the Fund at the present time amount to about $340 million. Against these resources there are outstanding $222 million in Exchange Stabilization agreements with Latin American countries, and some additional agreements may be made from time to time. The free resources of the Stabilization Fund are consequently quite small. . . . Spot holdings of foreign exchange now amount to about $100 million . . . . These spot holdings must in general be thought of as providing backing for outstanding forward exchange contracts (currently about $340 million equivalent). The entrance of the Federal Reserve System into foreign exchange operations will therefore provide particularly needed resources.

While $346.6 million forward contracts might not seem like a lot today, back in 1962 it easily made the Treasury/ESF the biggest player of OTC derivative markets.

OTC derivatives are political crack

A determined secretary of the treasury can achieve any economic outcome he wants using OTC derivatives (in the short run). Low inflation, a strong dollar, easy credit, low interest rates… anything is possible. Like crack, OTC derivatives produces a “high” which allows a secretary to (temporarily) defy economic reality.

Predictably, the use of OTC derivatives, like crack, has some rather nasty “withdrawal symptoms”, as was discovered by the treasury in 1978.


A prime contemporary example of the cost of the treasury mindset to the American taxpayer was revealed earlier this year. On 19 April 1978 Anthony M. Solomon, Trilateral commissioner and under secretary of the treasury for monetary affairs went cap-in-hand before the House Subcommittee on International Trade Investment and Monetary Policy, to confess to what Solomon called “some fairly important developments;” that is, the treasury had lost its shirt gambling in Swiss francs since 1961. [By 1979 the Treasury had sustained total losses of $1,134.6 million as a result of its forward operations.]

Leaving the US Treasury in control of with Exchange Stabilization Fund in the presence of an unregulated OTC derivative market with no congressional oversight is like leaving a pile of crack in the room of a drug addict. How can any secretary of the treasury, in seeking to give his president what he wants (low inflation, no recessions, etc), resist the temptation OTC derivatives offer when there is historical precedence to justify their use? After all, dealing with consequences of those OTC derivatives will be the problem of the next secretary of treasury.

On that note I want to look at what happened in the 1990s. The decade began with the apparent collapse of the financial system, as captured by the FDIC chart below showing new bank failures.

Who would have guessed that economy would suddenly start booming, eliminating the financial system insolvency problem? Thanks to the “matchless” performance of Robert Rubin' s Treasury, the 1990s ended up seeing the strongest economy in recent memory.

Strangely enough, the "matchless" performance of Robert Rubin's Treasury coincided with the rapid growth of OTC derivatives during the 1990s.

Also coincidentally, the treasury was the most vehement opponent of derivative regulation in the 1990s.

“[Brooksley] Born' s battle behind closed doors was epic, Kirk finds. The members of the President' s Working Group vehemently opposed [derivatives] regulation — especially when proposed by a Washington outsider like Born.

“I walk into Brooksley' s office one day; the blood has drained from her face,” says Michael Greenberger, a former top official at the CFTC who worked closely with Born. “She' s hanging up the telephone; she says to me: ‘That was [former Assistant Treasury Secretary] Larry Summers. He says, You' re going to cause the worst financial crisis since the end of World War II.”…

To go back to the metaphor above, this is like returning to the drug addict' s room to find several pounds of crack gone and the drug addict bouncing off the walls in a euphoric craze shouting, “don' t touch the crack! It will be a disaster if you touch the crack!”

Finally, in a June 2003 transcript, the Federal Reserve's Trading Desk (which is also used by the Exchange Stabilization Fund) revealed that "Auctioning derivatives is something we already have experience doing." Would it be fair to ask exactly HOW that experience was acquired?

(more about the ESF' s derivative activities later)

Rising Interest Rates

Beginning in the 1960s (despite the Treasury' s efforts to prop up the dollar), inflation pushed up interest rates, as seen below.

Rising interests rates began to wreck havoc in the banking sector when combined with Regulation Q, which imposed interest rate ceilings on certain types of bank deposits. Because regulators were controlling the rates thrifts and banks could pay on savings, when interest rates rose depositors often withdrew their funds and placed them in accounts that earned market rates, a process known as disintermediation.

The chart below shows the difference between the 3-Month Treasury Bill and the ceiling rate on savings deposits at commercial banks.

Every time interest rates rose, disintermediation caused cash shortages at banks/thrifts leading to a series of crisis, one of the first of which changed the .

Stock Certificates

For centuries, Investors who bought shares of stock in corporations had received handsomely engraved certificates as evidence of ownership. Filling in the names, transferring the certificates from one brokerage firm to another, and mailing them to customers was time consuming. The certificates of stocks transferred from customers at one brokerage firm to customers at another were trundled through the streets of downtown.

Below is a Baltimore and Ohio Railroad stock certificate, 1903.

As the Milwaukee Journal explains in 1968, stock and bond certificates are known as "documents of value".

Stock and bond certificates are known as “documents of value” (so are bank notes and stamps) because confidence has been established in their validity. The methods of printing the certificates have been a major element in achieving that validity. Documents of value generally are printed from engravings, which are said to be the most difficult to counterfeit.

Specially made papers are used. Certificates often bear a vignette (an engraver' s term for a small decorative picture), which itself is hard to copy. Certificates also are usually printed with colored borders, which add to their distinction.

These Stock Certificates were falsy bladed for a casualty of the paperwork crisis.

Paperwork Crisis

BLANK reports about the Paperwork Crisis.

One report noted that “[a]s inflation and inflationary expectations rose in recent years, the securities industry was ill-prepared for the unexpected syndrome of go-go speculation for short-term performance. Volume exploded, prices soared, then later plunged, and distortions became alarming as paperjamined the system.” Many NYSE member firms were losing money on their retail commission business, even though trading volume was rising, because the massive volume generated by the bull market in 1968 resulted in a breakdown in the back offices on Wall Street. Clerical personnel were required to work overtime and weekends in order to cope with the paperwork generated by increased volume. Second and third shifts were added by the brokerage firms, and trading hours were even curbed. Those efforts were in vain. Losses from errors were sweeping away profits. Increased volume generated a Large number of “fails” to deliver or receive securities and an increase in “DK” (don' t know) transactions. These were transactions in which the opposite brokers could not agree on the trades. By December of 1968, fails to deliver exceeded $4 billion. This soon created an accounting nightmare.

Two principle causes for paperwork crisis:

1) Shortages of cash at commercial banks

The Montreal Gazette in 1969 reports about a principal cause of delay in processing.

It is no secret that a principal cause of delay in processing many transactions has been a clogging up of the flow of paperwork at the commercial banks when transferring titles to shares from sellers to the new owners.

Yet securities firms, which have to rely heavily on the banks for short-term financing, have been reluctant to put on the banks their full share of blame for the pile-ups. …

The New York Times in an 1967 article also highlights the role of banks in the crisis, “Brokers say part of the tie up may be traced to large banks acting as transfer agents for publicly owned corporations.”

Banks acting as transfer agents DK trade settlements to conserve cash, causing a backlog.

The COD-DK Problem: BASIC spent much staff time considering solutions to the paralyzing and costly “COD-DK problem”. (COD stands for Cash - or Collect - On-Delivery and DK (which clerks used to scrawl, or sometimes stamp with a rubber stamp (!) on each form they rejected) stands for I Don' t Know this incoming delivery and therefore I' m rejecting it back to the sender.) This problem was a major contributor to the paperwork crisis. … BASIC was never able to fully resolve the problem, since “not knowing” a trade” was and still is a ‘legitimate way' not to promptly pony-up money,

2) Abnormal volumes of trading

The abnormal volume of trading in the early and middle sixties- and the boom in stock exchange commissions-had been caused in large part by two simultaneous wars: the Vietnam War and President Johnson's War Against Poverty. The federal government's spending on these wars put billions of dollars into the hands of consumers and investors- which the government did not take away in taxes.

Inflating the money supply did not push consumer prices up much, however, in the early and middle sixties because the Federal Reserve, then chaired by William McChesney Martin, raised interest rates.

But in fiscal 1968-that is, from July 1, 1967, to June 30, 1968-federal expenditures ballooned. The deficit reached a post-World War H record high of $25 billion. It was twice the previous post-World War II record deficit. Twenty-five billion dollars may seem small compared to deficits incurred in the eighties and nineties, but the dollar was worth much more in the sixties and gross domestic product was much smaller. …

The Aftermath of paperwork Crisis

In light of recent event on Wall Street, the Aftermath of paperwork crisis is instructive.

The big jump in government spending [in 1967-8] without a commensurate tax increase scared not only economists but even members of Congress. They feared that interest rates couldn't be raised high enough to prevent an unacceptable rise in the rate of inflation. The economy was already producing nearly as much as it could, so most of the additional money in the hands of consumers would be used to bid prices up.

Congress and President Johnson panicked.
The Congress passed and President Johnson signed a bill that increased taxes in fiscal 1969 enormously. That year the federal government collected more than it spent. And Federal Reserve Chairman William McChesney Martin raised interest rates even higher.

The higher taxes took money out of the hands of investors, thus reducing the demand for securities.

the volume of trading-and accordingly members' commissions-declined precipitously from the record levels of 1968. From nearly 20 million shares on December 19, 1968, volume abruptly declined to 16 million the next day, and 13 million the day after that. And it stayed near or below that level, with few exceptions, for many months afterward…

Very early in 1969, several firms approached bankruptcy.

Behind the statistics were days and nights of horror for hundreds of partners of brokerage firms. Many had invested all their money in their brokerage firms. They had few other assets or none at all They feared not only that they would lose all their own money, not only that they would be forced into immense debt, but that they would also Lose the money that relatives, friends, and clients had lent their firms-people who had trusted them. They, who had always been looked up to, would be disgraced.'

Exchange members had a direct interest in preventing any of their fellow members from actually declaring bankruptcy.
The effect would have been traumatic not only for the customers of the bankrupted firm but for the partners of other member firms of The New York Stock Exchange as well. The news would cause customers who had left cash and securities with other firms to realize the risks they were taking.

An even more important incentive for well-managed firms to prevent the bankruptcies of poorly managed firms was this: The businesses of the firms were (and are) so intertwined that the bankruptcy of one firm could cause the bankruptcy of several other firms.
A trade most often consists of one brokerage firm selling securities to another firm and vice versa, each on behalf of customers. If one firm fails to deliver the cash or securities it owes other firms, it could cause the bankruptcy of those other firms.

This had happened in 1873. The failure of Jay Cooke & Co. caused the demise of 57 other brokerage firms in a few weeks.

Yet investors didn't rush to withdraw their money and securities from brokerage firms in 1969.

In January 1969, a Wall Street Journal story warned investors, "A spectre haunts Wall Street-and if the nation's 26.4 million shareholders are unaware of it, that's only because the securities industry finds It too frightening to discuss openly.

… The problem in 1969 was trading volume so low that many brokerage firms were not profitable.

Furthermore, many stockbrokers, at the behest of their managements, urged their customers to leave their securities with their firms so that the Central Certificate System could function more efficiently.

Investors who bought stocks on margin were required to leave the stocks with the firms that lent them the money, and many other investors left money and stocks with brokerage firms just for convenience. In 1970, Merrill Lynch, for example, held $18 billion worth of customers' securities in so-called safekeeping. Merrill Lynch's capital was a tenth of that-about $1.8 billion.

Some investors were "subordinated lenders"; they agreed to leave their money and/or securities with a firm and not withdraw it without, say, a six-month notice. The investors received interest on their capital on top of the dividends and interest they received on the securities.

Bob Bishop and his boss, Lee Arning, skififully fenced with reporters, leaving them and investors ignorant of the terrifying dimensions of the truth." If a firm went bankrupt, many of its customers risked losing not only much or all of the money they had left on deposit with the firm but also the securities they had left in the firm's "safekeeping."

Bob and Lee knew panic would make matters worse. If brokerage firm customers withdrew their assets, the capital positions of brokerage firms would be weakened even further. Like a run on a bank before bank deposits were federally insured, mob psychology could bring on the very result feared by individuals making up the mob-the loss of their money.

As of March 1, 1970, more than half the 572 member firms of The New York Stock Exchange that dealt with the general public were in danger of bankruptcy.They were losing so much money that, if they continued to do so, they'd be out of business in six months. Six of these firms were among the ten largest.

To prevent failing firms from declaring bankruptcy or liquidation, Chairman Bunny Iasker devoted his abilities, his considerable energy, and his power to arranging for weaker firms to merge with strong ones.
In so doing he was following a practice of the thirties when a number of firms approached bankruptcy. E. A. Pierce & Co., for example, took over so many badly managed firms that it became the country's largest brokerage firm. Eventually E. A. Pierce & Co. itself became so weak that it had to be taken over by the much smaller Merrill Lynch & Co.

En 1970, brokerage firms were on their own, yet most operated with minimum capital-thin and shaky.24 Only the willingness of well-managed, financially strong firms to prevent the bankrupcy of poorly managed firms protected investors who had left cash and/or securities on deposit.

From Google Books:

At the start of December [1970], WaIl Street hung by its fingertips. Roughly one hundred Stock Exchange firms had vanished over the past two years through merger or liquidation. Forty thousand customer accounts were involved in the thirteen cases of liquidation, and most of them were still tied up, the customers unable to get their cash or securities. Commitments to the Stock Exchange' s trust fund from its member firms were approaching the $100-million mark, and some member firms had had about enough; a sauve qui peut sentiment was beginning to spread. Legislation to create a Federal Securities Investor Protection Corporation, on the model of the Federal Deposit Insurance Corporation to protect bank depositors, was before Congress; it had no chance of passage until the present mess in Wall Street was cleared up, and thus, while it might help in future crises, it was powerless in this one. Worst of all, the Goodbody and du Pont deals were interrelated. In its contract to take over Goodbody, Merrill Lynch had insisted on a provision to the effect that, should any other major firm fail before the Merrill Lynch—Goodbody merger became final several months later, then the Merrill Lynch—Goodbody merger would automatically be cancelled.

So a du Pont failure would mean a Goodbody failure; the arch deprived of its keystone would fall, more than half a million customer accounts would be tied up, many perhaps never to be redeemed, and public confidence in Wall Street would end for years to come, if not forever.
In the retrospective opinion of those best situated to know, the fall of the arch would have meant much more than that. Haack said at the time that the consequence of Goodbody' s failure alone would be “a panic the likes of which we have never seen.” Lasker said later: “If du Pont and Goodbody had gone down, a market crash would have occurred, but that would have been only the beginning. There would have been a run on the resources of brokerage firms— partners wanting their capital, customers wanting their cash and securities—causing many new failures. There would have been no federal investor-protection legislation. Mutual fund redemptions would have been suspended, putting fund investors in the same situation as customers of bankrupt brokerage houses. Undoubtedly the Stock Exchange would have been forced to close. All in all, millions of investors would have been wiped out…

It did not happen.[Ross Perot, at Nixon' s urging, bailed out du Pont at a cost of nearly $100 million.]

Fallout of Paperwork Crisis

There were three important fallouts of the Paperwork Crisis

1) Securities Investor Protection Act of 1970 (SIPA).

2) The Depository Trust Company (DTC) was created in 1973
3) National Securities Clearing Corporation Established in 1976

Securities Investor Protection Act of 1970 (SIPA)

Congress first reacted by creating deposit guarantee insurance for retail securities holders through the Securities Investor Protection Act of 1970 (SIPA).


the Securities Investor Protection Act

In the same

the Securities Investor Protection Act of 1970 to provide insurance for customers holding accounts in broker-dealers that became bankrupt.

It is worth noting that SIPA wasn't not popular on Wall Street (among still solvent broker dealers).

At the Senate hearing on Muskie's bill held April 16, 1970, Don Regan, CEO of Merrill Lynch, diplomatically but strongly opposed not just the bill but its concept. Senator Harrison A. Williams, Jr., Chairman of the Securities Subcommittee, asked Don, "Do you prefer self-regulation to the FBDIC?"

Don answered with a flat, "Yes, sir."

Don Regan's opposition was understandable. The bill required brokerage firms to contribute to establish a fund to indemnify customers if a brokerage firm became bankrupt.
If more money were required than was in the fund, the U.S. Treasury could be drawn on-with surviving brokerage firms being assessed to repay the Treasury.

How much each firm would be assessed to build up the fund was vague at this point-but it was dear that each assessment would be based on each firm's size. Merrill Lynch might be forced to pay nearly two million dollars to keep competitors in business.

Don used the Senate hearing as a forum for urging the Securities and Exchange Commission to apply tighter rules regarding the capital of investment firms. He objected to other firms stretching the use of their capital beyond the bounds of prudence, with the result that Merrill Lynch was taxed when they failed.

Many other powerful men in the investment business opposed Muside's bill. The cost, after all, was considerable, limitless, and would fall on investment firms, not on taxpayers.

However, politicians bill anyway.

While SIPA removed the danger of a “run on the bank”, it did absolutely nothing to solve Wall Street' s insolvency problems.

However, SIPA did help brokers by encouraging the practice of holding their securities in street name.


If you purchase stock through a brokerage firm, you usually have several choices on how your stock certificates will be handled. One option will be to receive a certificate made out in your name showing the number of shares purchased. However, if the stock certificate is lost or stolen at your home, SIPC will not provide coverage.

A second option is to have the stock certificate held in street name. This term refers to the brokerage firm being listed as the shareholder of record of the corporation you purchased stock in, although you, the customer, are the actual owner. SIPC provides coverage for stock certificates held in this manner.

The Depository Trust Company (DTC) was created in 1973

The Depository Trust Company (DTC) was created in 1973 as a privately operated 'Federal Reserve for stocks'

The reason the public doesn't know about DTC is that they're a privately owned depository bank for institutional and brokerage firms only. They process all of their book entry settlement transactions. Jim McNeff said "There's no need for the public to know about us... it's required by the Federal Reserve that DTC handle all transactions". The Federal Reserve Corporation, a/k/a The Federal Reserve System, is also a private company and is not an agency or department of our federal government, according to the 1998 Federal Registry. The Federal Reserve Board of Governors is listed, but they are not the owners. The Federal Reserve Board, headed by Mr. Alan Greenspan, is nothing more than a liaison advisory panel between the owners and the Federal Government.
The FED, as they are more commonly called, mandates that the DTC process every securities transaction in the US. It's no wonder that the DTC (including the Participants Trust Company, now the Mortgage-Backed Securities Division of the DTC) is owned by the same stockholders as the Federal Reserve System. In other words, the Depository Trust Company is really just a 'front' or a division of the Federal Reserve System.

The banks and brokers are merely custodians for their clients. By federal law (SEC), they cannot hold any assets in the customer's name. The assets must be held in the name of DTC's holding company, CEDE & Co. That's how DTC has more than $19 trillion dollars of assets in trust... or is it really in "trust" if the private Federal Reserve System is technically holding it in their "unknown" entity's name? Obviously, if stock and bond certificates you've purchased aren't in your name, then the "holder" (the Federal Reserve System) could theoretically refuse to surrender them back to you under a "national emergency" according to the Trading with the Enemy Act (as amended). Is this the collateral being held by the private Federal Reserve System to pay off the national debt owed to them by our federal government, first initiated by Lincoln's debt bonds of 1864?

On March 6, 1933, all bullion gold and gold coins were forcibly taken from the hands of private citizens (see New York Times). … Where did this gold end up? Into the hands of the Federal Reserve System owners. ... Is it any surprise that the DTC physically holds all the remaining non-book entry issued stock and bond certificates in the same place?

If you purchase any stock or bond through a broker, it is being held for you under a "street name" by the DTC unless you have specifically requested to hold the certificate yourself. If you have a book entry stock or bond, you won't be issued a certificate. It's important to note that you have purchased that particular stock or bond without becoming a registered holder of the actual stock or bond certificate. Instead, you have become a beneficial owner. The difference between the two is like night and day. Take the time to absorb and understand the following definitions:

REGISTERED HOLDER- A Registered Holder literally possesses, owns, and holds, his stock or bond with his name appearing on the face of the certificate. The company that issued the certificate has registered the owner's (holder's) name on their official books. This is the safest way to own a paper asset. You literally possess the fully registered certificate and only you can transfer or sell it. By all Rights and definition of law, you are the owner. You have it, you hold it, you possess it, and you keep it. You have the complete control over it.

BENEFICIAL OWNER- A Beneficial Owner is nothing more than a beneficiary, "One who is entitled to the benefit of a contract"- A Dictionary of Law, 1893.
All book-entry stocks and bonds you purchase make you the beneficial owner, not the registered holder. The owner of a book-entry stock or bond is the entity or name that it is registered under.

The DTC owns that bond or stock, not you.
Rather than in your name, it's registered (as the legal Registered Owner or agent) in their "street name", Cede & Company. (In the past, it may have been registered in your broker's street name, but this is no longer allowed). The DTC is the Registered Owner - holder - of your stock or bond. The DTC is the legal property-holder, share-holder, stock-holder, owner and purchaser. Your name appears nowhere on the book entry or certificate as the actual owner. Instead, you have been designated by the legal registered owner, the DTC, as the Beneficial Owner. This means that your lawful Rights in that stock or bond are confined to that of a successor or heir.

Here is detailed description of the Changes in Custody Practices engendered by DTC.

Institutional Changes in Custody Practices

Before 1973, almost all settlements of stock transactions were made by delivery of physical stock certificates. A “stock power” on the back of the certificate would be endorsed in favor of the purchaser. Short sellers typically had to obtain physical certificates to borrow from lenders. Lenders with physical certificates registered in their names had to endorse their stock over to the borrower. This was in accordance with Article 8 of the Uniform Commercial Code.

In the standard Securities Loan Agreements published by the Security Industry Association as well as the standard customer agreements between brokerages and their customers, the parties agree that the lending customer waives his right to vote proxies for any securities that have been lent. The reason for this waiver of the right to vote is operationally critical to the stock loan transaction.

Circumstances changed significantly starting in 1973 because of the adoption of the practice of holding securities in nominee name (“street name”) through intermediaries including brokers, banks and securities depositories. The move to holding securities in street name was part of a wider shift that followed on the securities industry' s paperwork crisis in the late 1960' s, when processing problems associated with the physical certificated transfer of millions of securities caused a major disruption in the financial industry.
The Depository Trust Company (DTC) was created in 1973 as a privately operated ‘Federal Reserve for stocks' designed to provide efficient, secure and accurate central custody and post trade processing services for transactions in the United States securities markets. The DTC is owned by several hundred brokerage firms, financial institutions (collectively, the DTC “participants”), and the New York and American Stock Exchanges. Its vaults in New York contain over $23 trillion of securities, including stocks, corporate bonds, mutual funds, warrants, and municipal bonds and government obligations.

The DTC carries out two major functions. The first is the immobilization of the securities of DTC participants, which reduces the need for participants to maintain their own certificate safekeeping facilities. Second, the DTC maintains a computerized book-entry system in which changes of ownership among participants are recorded. This replaces costly, problem-prone physical delivery of securities for settlement.

The DTC holds all securities in “fungible status”
(also known as “fungible bulk”), with the DTC' s computers recording ownership of aggregate amounts of each security in the name of a participant firm. The DTC does not maintain records describing the ownership of securities by individual customers, other than for the holdings of major institutions that are themselves DTC participants. Instead, the DTC regards the participant firms as the nominal holders, in “street name”, of all their customers' securities. Customer level record keeping is the responsibility of the participant firms.

The DTC' s book entry system allows participants to deposit securities for safekeeping, transfer them conveniently to other participants, collect payment for the securities transferred and withdraw certificates, if desired by a customer.
It is the widespread use of these services by DTC participants that creates economies of scale, permitting low-cost processing and speed without the sacrifice of security and accuracy. In 1999, for example, the DTC processed more than 189 million computer book entry deliveries between brokers and clearing corporations, with a value of over $94 trillion. Today over 72% of all common shares issued by NASDAQ-listed companies are immobilized at the DTC, and not held by the investors themselves.

Not all changes in security ownership result in DTC transfers. The National Securities Clearing Corporation (NSCC) operates clearing, netting and settlement services that assist member firms in processing transactions. The NSCC compares buy and sell transactions and nets them down to reduce the number of transactions requiring a transfer of securities positions on the books of DTC. For example, if, during the same day, customers of Merrill Lynch sell customers of Goldman Sachs 50,000 shares of XYZ stock, and customers of Goldman Sachs sell customers of Merrill Lynch 50,000 shares of XYZ stock in numerous separate transactions, the NSCC will automatically net down the transactions, and no transfers will result on DTC books. In 1999, DTC and NSCC combined together under a new umbrella organization called Depository Trust and Clearing Corporation (DTCC).

Under the standard arrangements between customers and their brokerage and banking firms, the securities held in brokerage accounts are commingled in a single fungible mass.
Consequently, where securities are held in street name, the task of keeping records as to which individual customer owns how much of which security is the responsibility of the brokerage firm. In the absence of paper shares, the only written evidence that an individual customer has of his or her holdings are brokerage statements or trade confirmation slips.

The typical brokerage customer margin account agreements allow the brokerage to hypothecate or lend the customers' securities without notice or benefit to the customer. It is the brokerage that earns interest on the loan, and not the shareholder, and this fact is acknowledged in the account agreement. When brokerage firms lend their customers' stock, they do so out of the general pool of marginable fungible securities held by the firm. Having deposited all of their customers' securities into a fungible mass, they cannot and do not keep records documenting the ownership of the securities that have been lent. Brokers cannot tell their customers when their stock has been lent (or returned) because it is the fungible pool of stock that serves as the source of the loans. In fact, this pool of stock has no identifying characteristics linking it to particular customers, because it is simply an electronic entry at the DTC and the brokerage.

For those of you who are interest in actually owning your stocks, Schwab apparently offers to transfer stocks to customer name and to hold them in safekeeping.

Safe­keep­ing by bro­ker — a real-life example.

Schwab is one of the few large bro­ker­age firms that does pro­vide the option to trans­fer stocks to cus­tomer name and to hold them in safe­keep­ing.
We actu­ally used the ser­vice recently when we assisted a friend to move their account from street name to cus­tomer name in March this year. In the first instance, it was telling that the bro­ker knew noth­ing about his option to do this, and he con­fi­dently assured us that they did not pro­vide such a ser­vice! The ser­vice is rarely used and is both cum­ber­some and expen­sive. Hav­ing said all that, it is still infi­nitely prefer­able to street name and rehypothecation.


National Securities Clearing Corporation Established in 1976

Wapedia reports that the National Securities Clearing Corporation was established in 1976.

National Securities Clearing Corporation (NSCC) - The original clearing corporation, it provides clearing and serves as the central counterparty for trades in the US securities markets.

Established in 1976, it provides clearing, settlement, risk management, central counterparty services, and a guarantee of completion for certain transactions for virtually all broker-to-broker trades involving equities, corporate and municipal debt, American depositary receipts, exchange-traded funds, and unit investment trusts. NSCC also nets trades and payments among its participants, reducing the value of securities and payments that need to be exchanged by an average of 98% each day. NSCC generally clears and settles trades on a "T+3" basis. NSCC has roughly 4,000 participants, and is regulated by the U.S. Securities and Exchange Commission (SEC).

Unhealthy Impact of Net Settlement and Clearinghouse guarantees

Net Settlement helps weak or insolvent firms survive. In fact, preventing settlement failures (ie: the collapse of these insolvent institutions) has been the driving force behind the move towards net settlement.

1) Clearinghouse guarantee allowed insolvent broker-dealers to continue operating.

Normally weak or insolvent financial institutions become insolated as counterparties refuse to do business, causing them to fail. This is healthy. However, Net Settlement eliminates the need for firms to assess the credit of each of their counterparties through its clearinghouse guarantee.

2) “Looting” customer brokerage accounts

Net Settlement allows and encourages broker dealers (especially insolvent broker dealers) to loot their customers' brokerage accounts take the opposite side of trades. Take an insolvent firm (Lehman, Bear Stearns, etc) which is critically short of cash and is finding it impossible to obtain unsecured financing. For this firm desperate firm, there is an easy (and incredibly reckless) solution: trade on its own accounts to zero out all its net derivative positions. For example, if its customers are net long gold futures, the firm can take a short position in gold futures matching the size of the long position. Since the clearinghouse now sees an equal number of long and short contracts, margin backing gold futures will be returned.

Visible impact of NSCC netting

Now have a look at what happened to broker-dealer short positions after NSCC started netting equity trades in 1976.

In 1970, broker-dealer short positions in securities and commodities totaled 707 million. In 2004, these broker-dealer short positions grew to 558 billion. That is a 78,956% increase.

By the late 1960s, restrictions on interstate banking and Regulation Q (as discussed above) created a shortage of mortgage funds in fast-growing regions, particularly in California. Rather than fix this problem by addressing the regulatory causes, Congress chartered Freddie Mac to do what it had forbidden the S&Ls; to do: raise funds in one part of the country to finance mortgage lending elsewhere. Freddie Mac created a secondary market in mortgages, in which mortgages could be pooled together and sold as securities.

Home ownership becomes an “emergency”

Federal involvement in housing

Prior to the 1930s, there was little federal involvement in housing.

The federal government has played an active role in residential mortgage finance since the Great Depression. Prior to that time, mortgages typically had short terms (often less than five years), carried variable rates, and required final “balloon” payments that were generally refinanced. In the early 1930s residential real estate values (and financial asset values generally) fell dramatically. Coupled with limited refinancing opportunities, this decline generated a wave of mortgage defaults and foreclosures, further depressing the housing market. The federal government responded to this crisis by creating several financial institutions to promote the use of long-term, fixed-rate, fully amortizing residential mortgages. The first of these new institutions was the Federal Home Loan Bank System (FHLB System), which was created in 1932 as a collection of cooperatively owned wholesale banks.

Regulators created a housing system extremely vulnerable to interest rate spikes.

Securitization has continued to thrive because it is highly efficient at converting illiquid balance sheet assets into capital market securities.

The key point about housing market is that weak lenders equals lower prices.

Almost all residential real estate transactions depend directly or indirectly on lending. Those who pay cash for a property usually sold a previous property to someone who used financing to buy their property.

Houses in the US are generally worth what a lender will lend. If the lender can't or won't lend, they aren't worth much. If lenders have become weakened by previous reckless lending, other things being equal, they will be forced into lending lower amounts on properties, since they have much less capital to risk, and are forced to be far more conservative with what they do have left.

1) Houses in the US are generally worth what a lender will lend

1) If the flow of mortgage money into housing dries up, prices collapse.

1) Plummeting housing prises generates a wave of mortgage defaults and foreclosures, further depressing the housing market.

1) Since the 1930s, the federal government has had a growing exposure to housing.

The federal government isn't a disinterested party. It is no accident that GSE involvement has grown rapidely.


The US government securitized mortgage loans and put them in off balance sheet vehicle DECADES before Wall Street started doing it.

Mortgage securitization did not emerge organically from the market. Instead, it was used by policy makers to solve various short term problems.

Securatization is another “financial innovation” pioneered by the federal government.

the mortgage securities market was initially a government-created phenomenon. In 1968, Congress created the Government National Mortgage Association (CNMA) to sell securities backed by mortgages guaranteed through government programs of the Federal Housing Administration (FHA) and the Veterans Administration (VA). One purpose was to get these mortgages off the books of the Federal government so that the Administration would not have to keep coming back to Congress to request increases in the debt ceiling, for these requests created opportunities for Congress to express frustration with the Vietnam War as part of this process of trying to trim the government' s balance sheet, Fannie Mae was sold to private investors.

By the early 1980s, S&Ls; needed a new source of funds. They could not sell their mortgages without incurring losses that would have exposed their insolvency. Instead, with the approval of regulators, investment bankers concocted a scheme under which a savings and loan would pool mortgages into securities which would be guaranteed by Freddie Mac. The S&L; would retain the security and use it as collateral to borrow in the capital market. However unlike an outright sale of the mortgages, the securitized mortgage transaction would not trigger a write-down of the mortgage assets to market values. The accounting treatment of mortgage securities, in which they were maintained at fictional book-market values, enabled the S&Ls; to keep a pretense of viability as they borrowed against their mortgage assets, Fannie Mae soon joined Freddie Mac in undertaking these transactions,

Thus, from the largely by anomalies in accounting treatment and regulation. GNMA was developed in order to move mortgages off the government' s books, even though government was still providing guarantees against default. Congress created Freddie Macto work around the problems caused by regulation Q and interstate banking restrictions. And the growth in securitization by Freddie Mac and Fannie Mae was fueled by the desire of regulators to allow S&Ls; to raise funds using their mortgage assets without having to recognize the loss in market value on those assets. Mortgage securitization did not emerge organically from the market. Instead, it was used by policy makers to solve various short term problems.

Securitization failed to prop up the S&L; industry.

Simply put, securitization was designed as a mechanism for transferring illiquid mortgages from balances sheet of insolvent institutions to investors. It NEVER was about “home ownership”, but always about bailing out financial institutions (as well as the federal government' s growing exposure to the mortgage/housing market). The real purpose of housing legislations is as clear as day is when considering be found in their names:

The Emergency Home Finance Act of 1970

The Emergency Housing Act of 1975

The Emergency Housing Assistance Act of 1983

The Emergency Housing Assistance Act of 1988

Is home ownership an emergency?


NRSRO ratings

By incorporating Nationally Recognized Statistical Rating Organization (NRSRO) ratings into formal capital requirements, bank regulators effectively outsourced critical oversight functions to the credit rating agencies.


1975 — Ratings Agencies Formalized. The Securities and Exchange Commission (SEC) creates rules that form Nationally Recognized Statistical Rating Organizations (NRSRO). These companies are paid by a securities issuer such as Fannie Mae to provide a rating on a security (i.e. a ‘AAA bond' ) that helps investors price the security. This market structure is both highly regulated and contains an inherent conflict-of-interest. The bond rating system is vastly different from the private rating system for equities, where dozens of analysts compete to rate stocks.


APRIL 15, 2009
A Triple-A Idea
Ending the rating oligopoly.

Virtually everyone who has reviewed the causes of the meltdown has concluded that credit ratings were a major factor. Yet most in Washington now claim the core problem is that issuers of securities pay the major rating agencies for their analysis.
Regulators now focus on managing this conflict of interest, but they appear unwilling to address the much larger conflict of interest: To wit, that the major ratings firms assess the creditworthiness of the U.S. government, even as they depend for their profits on the special status bequeathed by the government.

Since 1975, the SEC has anointed a small group of firms as Nationally Recognized Statistical Rating Organizations (NRSROs), and money market funds and brokerages have no choice but to hold securities rated by them. To this day, the Fed will only accept assets as collateral if they carry high ratings from S&P;, Moody's and Fitch.

We aren't urging the Big Three to yank the U.S. Government's AAA rating as a show of independence. But we are suggesting that
the SEC and Fed get out of the business of dictating which firms may judge credit risk.

The rating agencies were originally research firms. They were paid by those looking to buy bonds or make loans to a company. If a rating company did poorly it lost business. If it did poorly too often it went out of business.

Low and behold the SEC came along in 1975 and ruined a perfectly viable business construct by mandating that debt be rated by a Nationally Recognized Statistical Rating Organization
It originally named seven such rating companies but the number fluctuated between 5 and 7 over the years.

A (Very) Brief History Of The Credit Rating Industry

The credit rating industry can trace its history back to 1909, when John Moody published the first publicly available bond ratings, mainly concerning railroad bonds.1 In 1936, bank regulators issued a requirement prohibiting banks from investing in speculative securities that were below "investment grade," as determined by recognized rating manuals. As banks began relying on credit agency determinations in making investment decisions, so did many other market participants. And so began what some have termed the delegation or "outsourcing" by regulators of judgments concerning the creditworthiness of bonds, with the result that judgments rendered by CRAs regarding which bonds were "investment grade" and could be properly included in the portfolios of financial institutions, arguably attained the force of law.

The SEC vastly enhanced the standing of the CRAs in 1975 when, in connection with setting minimum capital requirements for securities firms, it created an entirely new category known as the "nationally recognized statistical rating organization" ("NRSRO"). The three major CRAs (Moody's, Standard & Poor's and Fitch) were immediately granted NRSRO status, and the SEC required that NRSRO ratings be used in determining the capital requirements of all broker-dealers. The SEC effectively insulated the three major CRAs from competition by acting as a barrier to NRSRO eligibility, while simultaneously mandating reliance by securities firms on the ratings promulgated by those same CRAs. In addition, the CRAs changed their business model from "investor pays" to "issuer pays," requiring those entities issuing bonds to pay the CRAs to rate their products. This change created an obvious conflict of interest, whereby entities that were not happy with an agency's bond rating could shop their bonds to another agency.


In the most general terms, the surge of thrift failures in 1981—82 can be attributed to interest-rate risk.' By funding Long-term fixed- rate mortgages with short-term deposits, thrifts were implicitly betting heavily against a large rise in interest rates. They lost the bet. The average explicit interest cost of savings deposits in FSLIC insured institutions rose from 6.6% in 1978 to 11.2% in 1982 (Kane 1989, 12—13, table 1—2). Although interest rates on new mortgages also rose, the thrifts' assets consisted largely of conventional fixed-rate mortgage loans made in the 1960s and ‘70s, paying between 6% and 9%. Borrowing at 11% to fund old mortgages paying 6 to 9%, hundreds of thrifts soon found their equity consumed by negative income flows.

The S&L; Debacle

The disaster of the savings and loan industry during the
1980s was caused by a series of policy mistakes of unprecedented proportions—mistakes that nearly destroyed the U.S. financial system. The S&Ls; were not just comfy isolated institutions where small-town moral dramas played themselves out, as in the movie It' s a Wonderful Life; they were also an integral part of the flow of savings and investments that powers our national economy. They were the main engine of the housing industry, which is as large and important as the automobile business, farming, or practically any other industry you can think of. We at the FDLC had no direct responsibility for insuring or supervising the runaway S&L; industry. This was done through the Federal Home Loan Bank Board. But because of the nation' s closely integrated financial system. we were dose observers of what was happening in the industry, for several very good reasons.

When inflation drove interest rates through the roof, S&Ls;' interest expenses far exceeded their interest income from home mortgages. The fatal defect of the S&Ls; was fully revealed. Their industry was on the way to insolvency.

How to remedy this problem without blowing the federal budget
for government assistance or closing down an industry that provided most home mortgages was the political question of the day. In deadly concert, the lobbyists for the S&L; industry, the Democratic congressional partisans of federal help for housing at any price, and the ideologues of the Reagan administration concocted a witch' s brew consisting of four equal portions of misguided policy.

First, the S&L; industry was permitted, even urged, to move into unfamiliar territory and diversify its investments, collect higher returns on riskier projects, and earn its way out of its interest rate dilemma.

Second, the regulators papered over the industry' s bankrupt condition by substituting for traditional Generally Accepted Accounting Principles (GAAP), a new and more lax set of Regulatory Accounting Principles (RAP) designed to accomplish an accounting miracle. Insolvent S&Ls; were turned into solvent ones by a number of accounting tricks, such as deferring for years losses on loans sold, and after a merger, writing up goodwill on the books chai clearly wasn' t there. The government examiners who had to apply these principles did not like them at all; they started calling them Creative Regulatory Accounting Principles (CRAP).

Third, the regulators were ordered to get off the backs of the S&Ls.; As a result, not only were the investment and accounting rules relaxed, but supervision was as well. If regulators had been looking more closely at the books, the damage at least might have been controlled.

Fourth, Congress increased the amount of the government' s full faith and credit support by moving the deposit insurance limit up from $40,000 to $100,000 for each account, thereby allowing the industry to attract additional funds to lend to new get-rich-quick enterprises. This in effect made the government a full partner in a nationwide casino, first speculating mainly in real estate, later in extremely volatile mortgage securities, junk bonds, futures and options, and similar Wall Street exotica.

The Depository Institutions Deregulation and Monetary Control Act act of 1980 that increased the amount of money insured to $100,000 per account really started the ball rolling. It gave the S&Ls; practically unlimited access to funds through a $100,000 “credit card” issued by Uncle Sam. Investment bankers jumped on board to divide up their clients' money and farm it out to S&Ls; offering the highest return. This system of brokered deposits, as they were called, meant that anyone with a spare million or so could spread it around in government-guaranteed packages of $100,000 to some of the riskiest institutions in the country. He could then sit back and collect the high interest payments without worrying, because the full faith and credit of Uncle Sam was behind his money. This was the exact opposite of the original intent of deposit insurance, which was to protect small savers and make them feel secure enough not to yank their money out of the bank whenever they worried about it.

High-flying speculators did not take long to realize that owning an S&L; was a key to the Treasury. The S&Ls; were an invitation to gamble with someone else' s money—the taxpayers of the United States. As a lawyer as well as an accountant, if I had been asked to defend these gamblers in court, I might well have used the defense of entrapment (as some did): a honey pot had been officially created that was irresistible to ordinary mortals.

The S&L; crisis was born in the economic climate of the times. It was nurtured, however, in the fertile ground of politics as usual and the political mentality of “not on my watch.”

the "substandard accounting creep."


As the problems of insolvent S & Ls mounted, the Federal Savings and Loan Insurance Corporation (FSLIC), the insurer of depositor's accounts, attempted by all means possible to rescue ailing institutions by merging them with healthy ones. The inducement offered to healthy S & Ls so that they be persuaded to absorb the insolvent ones consisted of a variety of "regulatory assistance" incentives, among these were schemes for the debasement of accounting which were designed to help the healthy merging S & Ls to hide the effects of the deficits which they were induced to acquire.

In the case of the S & L merger, such accounting abuses are more obvious and reached new heights of daring. A merged S & L was insolvent because its portfolio of mortgage loans was worth, as an example, $700 when its obligations to depositors remained at $1,000. The income statement, and related cash flows, validated this predicament when revenue from mortgage interest fell far short of the market rate interest payments required to hold on to deposits.

What to do? By simple extension of the mechanical goodwill rule cited above, the $300 deficit (obligations of $1,000 minus fair value of mortgage $700) was labeled goodwill to be written-off over an extended period of time. In effect, a cardinal and long standing rule of quality accounting was broken, to wit: "thou shallst recognize thy losses currently as they occur and not defer them into the future."

Instead, sham assets in the many millions were booked, thus disguising the thin capital bases of many of the S & Ls. Accountants who knew better looked the other way and regulators did not find this debasement of accounting to be too high a price to pay for the temporary rescue of the deposit insurance fund.

In 1987, Arthur R. Wyatt, one of the most astute members of the Financial Accounting Standards Board (FASB) stepped down because, as he put it, he was losing sleep over the situation at the Board. Among the issues troubling him was the S & L industry accounting.

In an interview in Barron's September 1987 issue, he stated, "The thrift industry is no different from many others in the sense that it does not want to have market values drive the reported earnings. And, also, in recent years it has worked very hard to find ways to delay the recognition of losses, spread losses out over a period of years... There have been pressures by regulations in the savings and loan industry to not recognize losses in order to keep the businesses alive."


Explicit Forbearance

Forbearance is a self reinforcing phenonmenon. It increases resolution costs, and those Higher resolution costs mean either that authorities were slower to close banks after their economic net worth crossed into the negative region

One consequence of the FHLBB's lack of enforcement abilities was the promotion of deregulation and aggressive, expanded lending to forestall insolvency. In November 1980, the FHLBB lowered net worth requirements for federally-insured S&Ls; from 5% of deposits to 4%. The FHLBB further lowered net worth requirements to 3% in January 1982. Additionally, the agency only required S&Ls; to meet these requirements over a 20-year period. This phase-in rule meant that S&Ls; less than 20 years old had practically no capital reserve requirements. This encouraged extensive chartering of new S&Ls;, because a $2 million investment could be leveraged into $1.3 billion in lending.

Early 1980s


Prior to the passage of AMTPA, banks were barred from making anything but the conventional fixed-rate, amortizing mortgages.

AMTPA, the 1982 law

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CREDIT MARKETS Long-Term Bond Prices Surge; Higher Prices at Opening Amazement Expressed

Top of Form

Bottom of Form

November 19, 1980, Wednesday

Section: Business & Finance, Page D7, 842 words

Long-term bond prices rose as much as three points yesterday, a move that startled many securities dealers, who said that the amount of investor buying was not so great as the higher prices would indicate. [ END OF FIRST PARAGRAPH ]

CREDIT MARKETS Long-Term Bond Prices Surge; Higher Prices at …

$3.95 - New York Times - Nov 19, 1980
Some buying of Treasury bonds was related to the higher prices on bond futures contracts, which rose to such levels that brokers were able to lock in ...

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S&Ls;' Role Widened in Futures Trading

Pay-Per-View - Los Angeles Times - ProQuest Archiver - Jul 3, 1981
Popejoy said futures trading isa tool that s&ls; should familiarize themselves with to help hedge against future fluctuations in inter est ratesbut it is a ...

US keeps watch as S&Ls; pray for interest rate drop

Pay-Per-View - Chicago Tribune - ProQuest Archiver - Jun 7, 1981
Regulatory officials, who take pains to paint a picture that s not unnecessarily alarming, concede that the number of S&Ls; on the regulatory "problem" list ...

S&Ls; a step closer to broker services

Pay-Per-View - Chicago Tribune - ProQuest Archiver - Jul 8, 1982
The Federal Hore Loan Bank Board, the regulatory agency for S&Ls;, ... in its approach," avoiding such speculative in- vestments as commodity futures. ...

S&Ls; Seek Right to Enter Stock Brokerage Business

Pay-Per-View - Los Angeles Times - ProQuest Archiver - Aug 26, 1981
The S&Ls; have been badly stung by the traditional brokerage indus- try, ... nation s 14th largest "This is one way S&Ls; can compete head on with the Merrill ...

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Accounting Fiction



Second Thrift Crisis

The thrift crisis continued (or a second thrift crisis arose), despite the fall in interest rates after 1982, because the regulators' failure to close literally hundreds of insolvent thrifts created an army of institutional “zombies,” economically dead but not yet buried, that rationally gambled for “resurrection.” In general terms, unclosed thrifts substituted credit risk for interest-rate risk. Long-odds gambling in the form of high-risk lending offered the owners of insolvent thrifts their best hope of getting back into the black, making their shares worth something again. The downside risk fell entirely on the FSLIC: the owners of thrifts with zero net worth had literally nothing to lose.

The S & L insurance mess: how did it happen? - Google Books Result

Edward J. Kane - 1989

Insolvency in the thrift industry is now a major national embarrassment.

the root cause of the crisis is neither a few specific regulatory mistakes nor corruption by a group of unscrupulous people in the Savings and Loan industry. The problem is the result of structural flaws in the system. Because of these flaws, the industry and its regulators, which include the United States Congress, are faced with virtually irresistible incentives to ignore signals of pending insolvency, and to postpone the inevitable day of reckoning until “someone else” takes over and becomes responsible.

Congress has repeatedly let the serious financial shortages at FSLIC and many individual deposit institutions ride. Rather than submitting the bill that FSLIC has run up to taxpayers for immediate payment, Congress has been hoping for insured institutions' imbedded losses to be cured by various lucky movements in real estate, farm, energy, and bond prices and in the economies of less developed countries. The Federal Home Loan Bank Board (FHLBB), the General Accounting Office (GAO), and private experts all agree that since 1983 FSLIC and the FDIC have lost billions of dollars while waiting for their luck in high-risk financial enterprises to change.

Since about 1984, between 600 and 800 thrift institutions have been hopelessly insolvent. This amounts to about 25 percent of the number of firms in the thrift industry. The net value of these crippled firms' assets has stink so far under water that their managers' only hope of becoming profitable again has been to expand their firms' funding base and to invest the new funds they raise in a speculative manner. The idea is to “grow out of their problems” by undertaking longshot new lending and funding activities that essentially renew and expand (or “double up”) the lost bets of the past. If their bets pay off, these firms regain solvency. If they lose, their problems belong to FSLIC.

An apt name for these insolvent hellbent-for-leather thrifts is institutional zombies. The economic life they enjoy is an unnatural life-in-death existence in that, if they had not been insured, the firms' creditors would have taken control from stockholders once it became clear that their enterprises' net worth was exhausted. In effect, a zombie has transcended its natural death from accumulated losses by the black magic of federal guarantees.

… rather than taking the proverbial ounce of prevention by corralling zombie institutions, authorities at the FHLBB and at its GAO auditor have systematically used accounting discretion to understate the depth and breadth of industry problems.
Hiding individual firms' economic insolvencies from the public temporarily makes federal officials appear to be more successful regulators than they truly are. However, it also permits zombie firms to continue to issue more deposits and to collateralize other forms of debt. Delaying the resolution of their insolvency encourages them to take deep risks with the funds they do attract.

These policies of coverup and delay amount to a possibly unconscious form of longshot regulatory gambling that closely parallels the gambling in which the zombie firms themselves are engaged. Deferring action allows authorities to shift formal recognition of the industry' s ongoing problems to someone else' s watch.


It is instructive to compare a zombie thrift institution with an illegal Ponzi or pyramid scheme. The name Ponzi commemorates the brainstorm and abbreviated financial career of an infamous conman, Charles Ponzi, who operated in Boston around 1920. In a Ponzi scheme, a fund-raising enterprise operates with little or none of the earning assets that a sound enterprise requires to generate a projected stream of cash flows with which to service lenders and investors. Instead, the enterprise relies on expanding its liabilities faster than its interest and dividend payments expand. The enterprise pays interest or dividends each period to its old clients—not from earnings but from funds that are provided by new lenders and investors. As long as new funds can be attracted into the scheme fast enough, the enterprise' s managers can meet corporate obligations as they come due and pay themselves handsomely at the same time. This can only be done, of course by making seductive promises of high returns and making the scheme' s subscribers believe these promises to be reasonable.

The flaw in any Ponzi scheme is that in the end the promises being made have no collective chance of being kept. Until a day of reckoning dawns, however, the sponsors' false promises are mistaken for truth and participants in the scheme appear to prosper. The apparent prosperity of the enterprise tends to disarm critics of the scheme by giving them the appearance of individuals who lack imagination or vision.

A Ponzi scheme is a classic case of value created in the marketplace by asymmetries in the distribution of information. The scheme' s sponsors know that they are running a con game, but subscribers do not. Keeping subscribers and potential critics from learning or guessing this hidden information becomes increasingly difficult the longer the scheme goes on. Once economically unsound elements in the scheme begin to surface—as inevitably they must—public confidence and the value of subscribers' claims to future cash flows can collapse rapidly.


Federal inaction worsened the industry's problems. Responsibility for handling the S&L; crisis lay with the Cabinet Council on Economic Affairs (CCEA), an intergovernmental council located within the Executive Office of the President. At the time, the CCEA was chaired by Treasury Secretary Donald Regan. The CCEA pushed the FHLBB to refrain from re-regulating the S&L; industry, and adamantly opposed any governmental expenditures to resolve the S&L; problem. Furthermore, the Reagan administration did not want to alarm the public by closing a large number of S&Ls.; These actions significantly worsened the S&L; crisis.

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Bank security lending

David S. Ruder, Chairman of States Securities and Exchange Commission, remarked in 1988, the barriers to securities activities by banks was significantly eroded by new interpretations of Glass-Steagall during the 1980s.

Originally the Glas-Steagall Act, enacted in 1933, strictly limited the extent to which banks could engage in securities broker-dealer, underwriting, or investment advisory activities. However, during the 1980s the barriers to securities activities by banks have been significantly eroded as a result of new interpretations of Glass-Steagall by banking regulators and by courts. Glass-Steagall — once thought to be an impenetrable barrier to such activities — is today a barrier full of gaping holes.

… investors will be better protected with the S. 1886 compromise legislation than by continuation of the de facto circumvention and creative regulatory interpretation that has eroded Glass-Steagall. To my mind, it has not been a healthy development for the Commission to lose control over the banking segment of the securities industry -- not healthy, that is, if you want securities regulation to do the job intended by Congress.

bank securities activities (including security lending) are not subject to broker-dealer regulation. This means that when banks lend securities to other broker-dealers in exchange for cash, only one side of the exchange gets reported to the SEC. In essence, since the 1980s, banks have been operating as unregulated, “invisible” broker-dealers.

By knowing that banks are engaging in unreported/unregulated securities lending, it is possible to determine the extent of this activity by looking at SEC broker dealer data.

To put this in perspective, the ultimate cost of the S&L; crisis is estimated to have totaled around only $160.1 billion, about $124.6 billion of which was directly paid for by the US government. By 1994, banks had used securities lending to raise over $200 billion in cash.

The Star Tribune reports about Wells Fargo's securities-lending program.

Lending began in the 1980s

Wells Fargo began promoting securities lending to larger institutional investors, such as foundations and insurance companies, in the early 1980s,
when it was still Norwest Corp. in Minnesota.

Under its program, Wells Fargo would lend out the securities held by institutional clients for temporary periods to broker-dealers who like to borrow securities for short-selling. (Short-sellers try to profit by selling borrowed shares in the anticipation that the stock will fall, hoping to buy them back later at a lower price and pocket the difference.) Wells Fargo would ask for cash collateral for the loaned securities, then invest that cash to generate a small return, splitting those returns with its institutional clients.

the bank invested in securities, some backed by subprime mortgages, with maturities "that reach out nearly 40 years," according to the suit. …

Federal bank regulators led the push to repeal glass steal, and the reason is obvious. Banks were able to use the cash obtained through securities lending to bailout themselves out

Broker dealers are completely insolvent, as they are owed 1 trillion dollars from insolvent banks.


Securities Lending


The 1983 Amendments and the Social Security Trust Fund

Looting Social Security

Below is a chart of the


The steady accumulation of treasuries by government retirement funds has helped absorb the supply of treasury bonds over three decades. This accumulation of government debt to secure the retirement of baby boomers helped drive down treasury yields and fund US deficit spending. As of September 2008, the four biggest of these funds held 3.3 trillion treasuries:

2203 billion (Federal old-age and survivors insurance trust fund)
615 billion (Federal employees retirement fund)
318 billion (federal hospital insurance trust fund)
217 billion (federal disability insurance trust fund) (for more on these four funds, see where social security tax amounts deposited)

Today, the accumulation of treasuries by government retirement funds is now over. Baby boomers are beginning to retire, increasing outflows, and unemployment is rising, cutting inflows. More importantly, the 3.3 trillion already accumulated in these funds provides an enormous political incentive to prevent treasury prices from collapsing. Faced with a run on treasuries, politicians, rather than explaining to baby boomers that their retirement savings are gone, will instruct the fed to monetize treasury bonds. This alone will prevent the fed from reversing its current balance sheet expansion.

Ever since the passage of the unified budget act, the government has had the privilege of looting the Social Security funds by transferring the money into the general fund, from which Congress can spend on whatever pork projects they wish. This ingenious way of raising taxes without explicit legislation has allowed the president and the Congress the use of an extra $2 trillion over the years.

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Managed Futures

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money in circulation overseas

Since at least the mid-1980s, more than half of the money in circulation has been traveling overseas. "We estimate that roughly 60 percent is now out of the

The resulting decline in inflation rates has prompted foreigners to hold a large but immeasurable quantity of U.S. dollars. The world' s increased demand for U.S. money helped reduce inflation by decreasing the velocity of money on both M1 and M2. By 1986, inflation in the United States had ended.

Between 1985 and 1990, however, Fed policy increased the base by 9 percent per year (from $201 billion to $290 billion), while M1 increased by 7.5 percent per year (from $591 billion to $810 billion). The result was robust revenue for the U.S. Treasury, but also a resurgence of inflation by the end of the decade to annual rates of 4—5 percent.



Too Big to Fail Doctrine


[Former FDIC Chairman William M. Isaac] has doubts about the [Continental] rescue. "I wonder if we might not be better off today if we had decided to let Continental fail, because many of the large banks that I was concerned might fail have failed anyway," he said. "And they probably are costing the FDIC more money by being allowed to continue several more years than they would have had they failed in 1984."
-- William Isaac, quoted in Robert Trigaux, "Isaac Reassesses Continental Bailout," American Banker, p. 6 (July 31, 1989).

I. Origins of the Modern Too Big to Fail Doctrine

The FDIC alone is not to be credited or blamed for this evolution of the too big to fail doctrine. During the First Pennsylvania rescue (1980), Sprague reports that "there was strong pressure from the beginning not to let the bank fail ... [from] the other large banks, ... the comptroller, ... [and] frequently from the Fed." (Sprague [1986], p. 88). The following passage is particularly telling in regard to how the "domino theory of banking" (precursor of too big to fail) first appeared in policy-making circles:

I recall at one session [in 1980, regarding the First Pennsylvania [which received an $8 billion bailout]], Fred Schultz, the Fed deputy chairman, argued in an ever rising voice, that there were no alternatives -- we had to save the bank. He said, "Quit wasting time talking about anything else!" Paul Homan of the Comptroller's office was equally intense as he argued for any solution but a failure. … (Sprague [1986], pp. 88-89).

The conception of interbank exposure encountered most frequently in policy discussions is the reduction of risk in Federal Reserve-operated and some private-sector payments networks. This risk arises from intraday or daylight overdrafts due to the posting of debit and credit entries for transfers of funds and securities over those networks. By far the greater part of such transfers arises from government securities and foreign exchange trading activities.
The volumes of these transfers in recent years, $183 trillion over Fedwire (1989) and $32 trillion over CHIPS (1988), have dwarfed the relevant measures of real economic activity ($5.2 trillion of U.S. gross national product [1989] and $2.7 trillion of gross world trade [1988] for all countries.). A variety of risk-reduction measures have been proposed and implemented in recent years, including institution-specific net debit and net credit limitations, or caps per sender, and the planned imposition of a 25 basis points per annum fee for intraday overdrafts on Fedwire in excess of 10 percent of each sending institution's risk-adjusted capital. Because most payments network transfers are initiated by or paid to money center institutions that are clearing or settling securities or foreign exchange trades (Federal Reserve Bank of New York [1987-88]), the 15 or so largest U.S. banks probably will account for nearly 90 percent of the planned intraday overdraft fees. However, trading (and the magnitude of intraday overdrafts) has become large enough to create Federal Reserve concern only since the 1970s. The failure of Bankhaus l.G. Herstatt during the U.S. banking day in 1974 also increased regulatory concern regarding intraday interbank exposure (Spero [1980], pp. 108-114). Since intraday interbank exposure became a significant Federal Reserve concern during the early 1980s, it has become one of the driving factors behind the too big to fail doctrine
* * *

All these forms of interbank exposure lie at the heart of the too big to fail doctrine. Fears of retail depositors' "cash-over-the-counter" runs on banks are not really the driving factor in the regulators' decisions to protect the largest banks from failure. That is because it takes a very long time to count and disburse large amounts of cash. In Ohio in March 1985, it was unusual for any one banking office to be able to pay out more than $1 million to $2 million of cash to retail depositors in a single day. At that rate, it would take up to 43,000 banking-office days to pay off the $43 billion of domestic deposits of Citibank (1989) in cash to retail customers. The real danger that concerns federal regulators is institutional or electronic runs on banks. When funds leave a bank at the rate of from $100,000 to $5 million per electronic transfer, it then becomes possible to empty even a large bank like Citibank (which had about $115 billion of total deposits at year-end 1989) in only a day or two.

Martin Mayer ... argued in a Financier article in late 1985 that the FDI Act "almost certainly does not permit what the FDIC did" at Continental. He simply did not accept the attorney general's opinion that the transaction was legally structured.
Mayer observed correctly that the real difficulty was that foreign holders of debt securities and commercial paper in the holding company would have yanked their $17 billion in Eurodeposits out of the bank if the securities holdings were not fully protected in the bailout. If the holding company was not saved, the bank could not be rescued.

…, the type of indirect and irrational systemic risk usually discussed by bank regulators today to justify increased regulatory discretion in applying the too big to fail doctrine never actually existed in the United States, except possibly during the Great Contraction of 1929-1933. Instead, the type of contagion or systemic risk that actually has existed and still exists is both direct and rational. That is, banks providing funds to a bank in trouble rationally might conclude that they were unlikely to recover those monies and therefore might attempt to remove great quantities of those funds electronically (Thomson [1990]; Kaufman [1988]).


Finally, operational risks may be illustrated with the following incident that occurred in 1985. The Bank of New York, acting as a clearing bank for book-entry Treasury securities, had an internal computer problem that allowed the bank to accept securities but not to process them for delivery to dealers, brokers, and other market participants. The bank's reserve account was debited for the amount of the securities, but the bank was unable to re-send them and collect payment. The result was a growing daylight overdraft in the Bank of New York's reserve account. As it became increasingly clear that the problem would not be fixed by close of business, the bank borrowed from the discount window. The problem was fixed during the night so the loan was repaid the following day.


1970s, 1980s
Discount Window Lending

The Misuse of the Fed's Discount Window

The Misuse of the Fed's Discount Window
Anna J. Schwartz


In the United States, with federal spending budgeted at an all-time high, policy makers see the discount window as a mechanism for providing funds off budget. Legislation is necessary to authorize the Fed to provide assistance to favored nonbanks, so the use of the window isn't kept secret, but it may seem a cost-free way of funding them because repayment can be rolled forward indefinitely. This may explain the recent spate of efforts to use discount window assistance for nonbanks.

Since the 1970s, the Federal Reserve has extended long-term discount window assistance to depository institutions that by objective standards were likely to fail. It has done so in the belief that, in the absence of such assistance, contagious effects would spread from the troubled institutions to sound ones. The belief is particularly entrenched for large troubled intermediaries, reflecting an apprehension that halting the operation of such institutions would have dire unsettling effects on financial markets. Before 1985, the goal of such discount window assistance was a restructuring of the problem institution as a viable entity with both insured and uninsured deposits made whole.

Since 1985, prolonged discount window assistance has generally terminated not with restructuring but with closure of the insolvent banks. When banks are known to be insolvent, postponement of recognition of losses that have occurred might well have increased current losses. Uninsured depositors have more time to, withdraw their funds. The insurance agency, which is to say the taxpayer, ultimately bears any added costs of delayed closure.


…In a significant number of cases, market reports of difficulties at an institution have led to heavy outflows of uninsured deposits and to application for credit from the Discount Window. More often than not, the Fed has responded in the spirit of "Treat the patient first and ask questions about solvency later." Even then the question was not, "Is the institution solvent now?" but rather -- "With reformed management and, perhaps, some capital infusion, does the bank stand a fair chance of becoming solvent at some point in the not-too-distant future?" [no]

Since 1985, prolonged discount window assistance has generally terminated not with restructuring but with closure of the insolvent banks.

1) The FDICIA of 1991 made it very difficult for regulators to delay the closing of failing DIs unless the danger of a systemic risk can be shown

Discount window lending to insolvent banks might cease if, under the terms of the FDIC Improvement Act of 1991, the Fed no longer advanced funds to keep critically undercapitalized institutions in operation


Washington is bailing itself out

Prime brokers

1) Prime brokers channel money to insolvent zombie banks

2) Prime brokers market treasury debt

3) Prime broker are a crucial counterparty to the Fed/Treasury fraud

Allowing the failure of a primedealer would undoubtedly expose information the


Congress tries to limit TBTF in 1991

FDICIA as enacted essentially took this road, attempting to place limits on regulatory activities associated with TBTF but still leaving regulators the ability to invoke it under certain circumstances. FDIC resolutions were now required to proceed according to a “least cost” test, which would mean that uninsured depositors would often have to bear losses. The FDIC was prohibited from protecting any uninsured deposits or nondeposit bank debts in cases in which such action would increase losses to the insurance fund. One important effect of the least-cost provision was that the FDIC would not be able to grant open-bank assistance unless that course would be less costly than a closed-bank resolution; thus FDICIA limited the discretion the agency had exercised under the old cost test and essentiality provisions of the FDI Act.

… In addition, FDICIA establishes a relationship between a bank' s capitalization and the Federal Reserve' s ability to provide assistance through the discount window: for critically undercapitalized banks, the Federal Reserve has to demand repayment within no more than five days, and if that limit is violated the Federal Reserve is liable for increased costs to the FDIC.


FDIC resolution methods

The guaranteed deposits at economically insolvent banks are effectively implicit off-budget liabilities of the government that should more appropriately be recorded as explicit on-budget government debt obligations.'

Further evidence of increased bank gambling can be seen in the rising cost of resolving failed institutions:

10.2% of deposits for 1985 failures

20.3% of deposits in 1989 failures

100% of deposits for 2009 failures

FDIC liability

There are two common ways that the FDIC takes care of bank insolvency and bank assets. The first is the Purchase and Assumption method (P&A;), where all deposits are assumed by another bank, which also purchases some or all of the failed bank's loans or other assets. The assets of the failed bank are put up for sale and open banks can submit bids to purchase different parts of the failed bank's portfolio.
The FDIC will sometimes sell all or a portion of assets with a put option, which allows the winning bidder to put back assets transferred under certain circumstances. All asset sales are done to reduce the net liability to the FDIC and Insurance fund for bank losses.

Deposit Insurance and Other Liability Guarantees

a. How does the “clean” P&A; differ from the “total bank” P&A;?

Under a clean P&A; the good assets and all deposits of a failed institution are assumed by another bank. The difference between the total value of the deposits (larger) and the value of the good assets (smaller) is paid in a cash infusion by the FDIC. Under the total bank P&A; [purchase and assumption], all assets are transferred to the assuming bank with the option that the bank could put back to the FDIC at a later date those assets that were identified to be questionable from a credit perspective. This method required a smaller cash infusion by the FDIC at the time of the assumption.

By guaranteeing assets

The FDIC purchase and assumption agreement (P&A;) is often enhanced by government guarantees. These often take the form of putbacks, whereby the government promises to buy back the assets. This guarantee is essentially a put option issued by the banking authorities.

Now look at the graph below. The FDIC, when closing all those banks and thrifts, wrote a butch of puts on a mountain of bad debt. If the US had experienced a severe recession, defaults would have magnified the cost of the S&L; crisis several times because of these guarantees.



Loss-Share Questions and Answers

What is loss sharing?

Loss sharing is a feature that the Federal Deposit Insurance Corporation (FDIC) first introduced into selected purchase and assumption (P&A;) transactions in 1991. Under loss sharing, the FDIC agrees to absorb a portion of the loss on a specified pool of assets in order to maximize asset recoveries and minimize FDIC losses. Loss sharing reduces the immediate cash needs of the FDIC, is operationally simpler and more seamless to failed bank customers and moves assets quickly into the private sector.

Does loss sharing put the taxpayer on the hook for additional losses down the road?

When the FDIC calculates the estimated cost of a failure, it takes into account all expected losses on the assets covered in loss share agreements. These current market assumptions are built into the cost of failure at resolution. Thus the cost of all expected future payments are recognized at the time of bank failure and no losses are deferred. Any loss sharing payments are made from receivership funds from the specific failed bank or thrift or, if those are insufficient, from the FDIC's Deposit Insurance Fund. The Deposit Insurance Fund is funded by assessments paid by insured banks and thrifts. It is not taxpayer funded.

How does loss sharing work?

The FDIC uses two forms of loss sharing. The first is for commercial assets and the other is for residential mortgages.

For commercial assets, the agreements typically cover an eight-year period with the first five years for losses and recoveries and the final 3 years for recoveries only. FDIC will reimburse 80 percent of losses incurred by acquirer on covered assets up to a stated threshold amount (generally FDIC's dollar estimate of the total projected losses on loss share assets), with the assuming bank picking up 20 percent. Any losses above the stated threshold amount will be reimbursed at 95 percent of the losses booked by the acquirer.

For single family mortgages, the length of the agreements tend to run for 10 years and have the same 80/20 and 95/5 split as the commercial assets. The FDIC provides coverage for four basic loss events: modification, short sale, foreclosure, and charge-off for some second liens. Loss coverage is also provided for loan sales but such sales require prior approval by the FDIC. Recoveries on loans which experience loss events are shared in the same proportion as the original loss.

All of these events led to a 50% increase in loan charge offs and the failure of 42 banks in 1982. An additional 27 commercial banks failed during the first half of 1983, and approximately 200 had failed by 1988. For the first time in the post-war era, the FDIC was required to pay claims to depositors of failed banks and refueled the importance of the FDIC and deposit insurance. Other significant events during this period include:

1983: Deposit insurance refunds are discontinued.
1987: Congress refinances the Federal Savings and Loan Insurance Corp. ($10 billion).
1988: 200 FDIC-insured banks fail; the FDIC loses money for the first time.
1989: Resolution Trust Corp. is created to dissolve problem thrifts; OTS opens to oversee thrifts.
1990: First increase in FDIC insurance premiums from 8.3 cents to 12 cents per $100 of deposits.
1991: Insurance premiums hit 23 cents per $100 of deposits. FDICIA legislation increases FDIC borrowing capacity, least-cost resolution is imposed, too-big-to-fail procedures are written into law and a risk-based premium system is created.
1993: Banks begin paying premiums based on their risk.
1996: The Deposit Insurance Funds Act prevents the FDIC from assessing premiums against well-capitalized banks if the deposit insurance funds exceed the 1.25% designated reserve ratio.
2006: As of April 1, deposit insurance for Individual Retirement Accounts (IRA) is increased to $250,000.00.
2008: The Emergency Economic Stabilization Act of 2008 is signed on October 3, 2008. This temporarily raises the basic limit of federal deposit insurance coverage from $100,000 to $250,000 per depositor. The legislation provides that the basic deposit insurance limit will return to $100,000 on December 31, 2009.

In 2006, the Federal Deposit Insurance Reform Act was signed into law. This act provides for the implementation of new deposit insurance reform as well as merging two former insurance funds, the Bank Insurance Fund (BIF) and the Savings Association Insurance Fund (SAIF) into a new fund, the Deposit Insurance Fund (DIF). The FDIC maintains the DIF by assessing depository institutions and assessing insurance premiums based on the balance of insured deposits as well as the degree of risk the institution poses to the insurance fund. At the end of 2007 the DIF had a balance of $52 billion.

FDIC Insurance

Insurance premiums paid by member banks insure deposits in the amount of $250,000 per depositor per insured bank. This includes principal and accrued interest up to a total of $250,000. In October 2008, the protection limit was raised from $100,000 to $250,000. The new limit will remain in effect until December 31, 2009. Depositors can increase their insurance by having accounts in other member banks or by making deposits into different account types in the same bank. The FDIC insures member banks and savings institutions and the following items:

All types of savings and checking deposits including NOW accounts Christmas clubs and time deposits.

All types of checks, including cashier's checks, officer's checks, expense checks, loan disbursements, and any other money orders or negotiable instruments drawn on member institutions.

Certified checks, letters of credit and travelers checks when issued in exchange for cash or a charge against a deposit account.

The FDIC does not insure:

Investments in stocks, bonds, mutual funds, municipal bonds or other securities
Life insurance products even if purchased at an insured bank
Treasury bills (T-bills), bonds or notes
Safe deposit boxes
Losses by theft (although stolen funds may be covered by the bank's hazard and casualty insurance)

(For more information, read
Bank Failures: Will Your Assets Be Protected?)

Federal law requires the FDIC to make payments of insured deposits "as soon as possible" upon the failure of an insured institution. Depositors with uninsured deposits in a failed member bank may recover some or all of their money depending on the recoveries made when the assets of the failed institutions are sold. There is no time limit on these recoveries, and it sometimes takes years for a bank to liquidate its assets. If a bank goes under and is acquired by another member bank, all direct deposits, including Social Security checks or paychecks delivered electronically, will be automatically deposited into the customer's account at the assuming bank. If the FDIC cannot find a bank to assume the failed one then it will try to make temporary arrangements with another institution so that direct deposits and other automatic withdrawals can be processed until permanent arrangements can be made. (For more insight, read
9 Tips For Safeguarding Your Accounts.)

There are two common ways that the FDIC takes care of bank insolvency and bank assets. The first is the Purchase and Assumption method (P&A;), where all deposits are assumed by another bank, which also purchases some or all of the failed bank's loans or other assets. The assets of the failed bank are put up for sale and open banks can submit bids to purchase different parts of the failed bank's portfolio. The FDIC will sometimes sell all or a portion of assets with a put option, which allows the winning bidder to put back assets transferred under certain circumstances. All asset sales are done to reduce the net liability to the FDIC and Insurance fund for bank losses. When the FDIC does not receive a bid for a P&A; transaction, it may use the payoff method, in which case it will pay off insured deposits directly and attempt to recover those payments by liquidating the receivership estate of the failed bank. The FDIC determines the insured amount for each depositor and pays him or her directly with all interest up to the date of failure.

Merging banks together

Loss sharing is a feature that the FDIC first introduced into selected purchase and assumption transactions in 1991.

Since the creation of the FDIC and until the 1982 Penn Square Bank failure, all depositors of failed banks with over $60 million in total deposits have not incurred any losses as a result of the bank's closing, since in each case failures have not been handled by direct payments to only insured depositors. Thus it is very likely that uninsured depositors, particularly those in the largest banks, have come to view their deposits to be risk-free in terms of default, and thus have probably not demanded much, if any, risk premium in lending their funds to these banks.

Studies by the FDIC and Federal Home Loan Bank Board (FHLBB), which were mandated by the Garn -St. Germain Depository Institutions Act of 1982, have proposed that greater degrees of "market discipline" rather than direct regulatory controls be used to restrain a bank's possible incentive toward excessive risk taking that would increase the deposit insuring agency's liability. The FDIC states that reforms could be made by discontinuing the practice of purchase and assumption transactions that de-facto insure officially uninsured liabilities of hanks. While failures of large banks could still be handled by arranging mergers with a stronger acquiring bank, it is recommended that uninsured depositors would only recover a portion of their claims on bank assets, losing a portion of their deposits equal to the FDIC's estimate of the negative net worth of the failed institution.

Two court decisions, along with a lawsuit over the same issue filed by First Republic bondholders, helped the FDIC garner support for two provisions that were included in the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989. First, the FDIC as receiver was permitted to treat like classes of creditors differently as long as every creditor received at least its pro rata share of receivership proceeds. Second, the FDIC was granted “cross guarantee” authority requiring solvent affiliated banks to support insolvent affiliated banks within a holding company.

As a result of the MCorp experience, the FDIC pushed for cross guarantee legislation. Unlike the situation in First Republic, where the subsidiary banks had guaranteed the interim assistance notes, the FDIC was unable to obtain any of the value of the solvent MCorp banks to offset its losses. In 1989, FIRREA granted the FDIC cross guarantee authority. The FDIC could assess its financial costs for handling failed banks against other insured institutions controlled by the same holding company.44 Table II.7-2 MCorp Resolution Costs ($ in Thousands) FDIC' s Expenses Purchase of preferred stock $416,250 Bridge bank operating losses 556,000 Mark-to-market adjustment—special asset pool assets 1,065,000 Mark-to-market adjustment—nonspecial asset pool assets 1,013,000 Separate asset pool costs 545,000 Dividends to MBank creditors 33,000 Total FDIC Expense $3,628,250 FDIC' s Recoveries Deferred settlement $235,000 Post-commencement settlement 72,000 Sale of preferred stock 481,736 Total FDIC Recovery $788,736 FDIC' s Total Resolution Costs $2,839,514 Sources: FDIC, The Cost of Large Resolution Transactions, March 12, 1996; FDIC Division of Finance; and FDIC Division of Research and Statistics.


The Six Trillion Dollar Debt Iceberg; A Review of the Government's Risk Exposure

June 28, 1990
The Six Trillion Dollar Debt Iceberg; A Review of the Government's Risk Exposure
by Utt, Ronald

In a congressional floor speech last spring decrying the cost of the savings and loan (S&L;) bailout, now estimated at between $150 billion and $300 billion, Representative Major Owens, the New York Democrat, declared that he believed there had never been a single item in peacetime that cost the government so much money. Owens raised an intriguing question, and research into federal budget history reveals that he was right. Only World War II cost more than the S&L; bailout, at least in nominal dollars. But an examination of the finances of other government-backed agencies indicates that the bailout may be just the tip of a fiscal iceberg about to strike the American taxpayer. The total financial obligation of agencies underwritten by the federal government is now some $5.8 trillion and much of that obligation is in bad shape.

The S&L; disaster represents an staggering breakdown of government, and the hidden costs to Americans likely will turn out to be several times the amount that the hapless taxpayer is scheduled to pay directly in extra taxes. It will take years to unravel what really happened and why. But one thing is clear: the governments mega-billion dollar commitment to guarantee the deposits of the savings and loans insured by the Federal Savings and Loan In surance Corporation (FSLIC) was grossly mismanaged, and these perverse incentives offered by the insurance program led to the wholesale looting of hundreds of thrift institutions.

Worsening Daily. As the S&L; bailout legislation went through Congress most lawmakers tried to convince Americans that the crisis was just an isolated incident, however costly, and that the vast bulk of the government credit programs are well-managed and pose little risk to the taxpayer. While taxpayers may wish for this to be so, a cursory examination of the federal governments vast credit empire actually reveals repeated instances of huge financial risks that are worsening by the day. In fact, the $958.9 billion in S&L; deposits insured by the FSLIC at the end of 1989 represents just a small fraction of the financial liabilities the federal government has assumed through its many direct lending, loan guarantee, and insurance programs. The $4.2 billion loss at the Federal Housing Administration revealed in May 1989 in a General-Accounting Office.(GAO) audit and the Office of Management and Budgets Om) projection that the losses continue, are just among the latest hint of a vast liability that could land in the lap of taxpayers. The governments total risk exposure of nearly $6 trillion dollars is more than twice the national debt held by the public and more than five times the annual federal budget.

Comprehensive Effort Needed. A number of these programs already are encountering serious financial problems.
Others could join them over the next year, depending upon how the economy performs. Like the FSLIC, some of these programs require immediate attention to stanch enormous losses and limit potential future claims on the taxpayer. Unfortunately, no such comprehensive effort is under way in Congress or the White House. Worse still, to the extent that credit-related legislation is being considered by Congress some of it would make the situation even worse.


The vast system of federal credit programs, with their $5.8 trillion in outstanding obligations is in serious trouble. It costs-the taxpayers billions of dollars a year in bailouts, defaults, and unneeded subsidies. Beyond these direct costs to American taxpayers is a host of indirect costs due to the disruption they cause to U.S. financial markets and the country' s ability to deploy its capital resources in an efficient and productive fashion.

Facing the Fact.
This national embarrassment and potential catastrophe must be brought under control as swiftly as possible through an Omnibus Credit Reform Bill that makes fundamental changes in the way these programs are structured and operated. Many of the reforms that should be contained in such a measure already have the support of the Administration and in Congress. Unfortunately, the reform approach to this date has been piecemeal, and thus misses the opportunity to achieve comprehensive reform, dealing with problems before they worsen. Congress must at last face up to the fact that the savings and loan crisis, and the other emerging problems associated with federal credit and guarantee programs, are not isolated and unconnected. Rather, they indicate systemic flaws. The solution is system-wide reform.

The US government had a strong incentive not to let the country fall into a deep recession, which would have triggered loses.

“A number of these programs already are encountering serious financial problems. Others could join them over the next year, depending upon how the economy performs”


The Industry' s and the FDIC' s Troubles Are Large

The Industry' s and the FDIC' s Troubles Are Large

a sense of déjà vu accompanied news reports, beginning in late 1990, that the Federal Deposit Insurance Corporation, the agency that now guarantees both thrift and bank deposits, would soon run out of money without taxpayer assistance. ...

An authoritative study of the FDIC' s condition appeared in a report by James R. Barth, R. Dan Brumbaugh, and Robert E. Litan, dated December 1990, … concluded that the BIF at the end of 1990 appeared to be where the FSLIC was in the mid-1980s, “without sufficient resources to pay for its expected caseload of failed depositories.”

A major source of concern is that larger banks have begun to appear on the FDIC' s list of “problem banks.” The list numbered 975 banks at the midpoint of 1991, slightly fewer than in the immediately preceding years, but the aggregate assets of problem banks had increased.

In fact some of the very largest U.S. banks are teetering. The Economist commented in December 1990: “Nobody knows just how much rubbish EU.S.1 banks have on their books, or how many loans might become rubbish if a recession deepens. Among the banks that fail may be prominent money-centres.”6 Barth, Brumbaugh, and Litan (1990, 13) commented that as of the end of 1990 “most” of the nation' s largest banks were “on—or conceivably over—the edge of insolvency.... Many of these banks not only currently have weak balance sheets by any reasonable standard, but they also are highly exposed to additional deterioration in their capital positions from their significant involvement in high-risk lending. …
FDIC call reports show that the large banks (those with more than $10 billion in assets) as a size class have the weakest loan portfolios. Across most categories of loans, the large banks have the highest percentages of loans past due or noncurrent, and the highest percentage of loan charge-offs (FDIC 1991, 3). In recent years the class of large banks has had the highest percentage losing money. In the first half of 1991, 11.2% of all banks (1,361 of 12,150) lost money, while 19.6% of large banks (9 of 46) did so (FDIC 1991, 5).

With the FDIC running out of cash, there is a great danger that the agency is neglecting to close insolvent banks, just as the FSLIC neglected insolvent thrifts for years. “Zombie” institutions (economically “dead” but still operating) may be afoot, piling up obligations that will eventually be laid at the doorstep of taxpayers. …

Bank Failures Still Minimal Compared to Early 1990s but FDIC Watch List is Growing


central banks gold leasing

BLANK reports that central banks gold leasing.

Fool`s Gold? Bad Debts Lead Nations To Reconsider Loans
March 17, 1990Boston Globe

NEW YORK -- Some of the world`s central banks are leasing their gold reserves to Wall Street`s investment banks and commercial banks in unregulated financial transactions worth billions of dollars.

The practice enables the central banks, arms of foreign governments, to earn money on their gold reserves while supplying cheap financing to Wall Street traders for their commodities and securities operations.

``This sounds like another excess of the 1980s combined with further evidence that greed can be a characteristic of central banks and governments as well as of financiers,`` said James Stone, a former chairman of the Commodity Futures Trading Commission and a fierce opponent of unregulated commodity markets.

http://articles.sun-sentinel.com/images/pixel.gifAnd it is ``another example of how Wall Street has leveraged itself without any supervision at all,`` said Henry Kaufman, the former chief economist at Salomon Brothers and now president of Henry Kaufman & Co., an economic consulting firm.

The vast global market in gold trading was brought to light by the bankruptcy of Drexel Burnham Lambert, one of Wall Street`s major firms. Drexel owes several European central banks, among them the Banco de Portugal, and a Japanese trading company about $500 million worth of gold that it may not be able to pay back, say sources close to Drexel. These debts are not secured by assets or letters of credit.

``Drexel took the $500 million proceeds from the gold sales to finance its junk-bond portfolio. It turned gold into junk,`` said Barry J. Dichter, a bankruptcy specialist and partner of Cadwallader Wickersham & Taft, the New York law firm representing Portugal`s central bank. ``We will consider carefully what remedies we must pursue to get our gold back.``

The revelation of these bad debts to central banks has caused many other national banks to terminate their loans and demand their gold back, regulators familiar with the situation say. Substantial monetary losses stemming from the leasing of gold could prove embarrassing to foreign governments.

Central banks also may come in for criticism from their governments for endangering the gold reserves that support their national currencies. The U.S. Federal Reserve does not engage in such lending of gold.

The focus on this gold trading may add pressure to congressional and regulatory demands that the major securities firms` holding companies, the parents of their brokerage and commodity operations, finally be placed under the supervision of government agencies in Washington, D.C. A bill to accomplish this has been introduced by Rep. Edward Markey, D-Mass.

Regulators and sources in the financial community say that many nations, such as Portugal, Austria, Sweden, Denmark, South Africa and the Soviet Union, have made it a standard practice for several years to lend gold to major securities firms like Salomon Bros., Goldman Sachs, Morgan Stanley, Bankers Trust and Citibank, as well as several leading West German and Japanese banks.

In return, these nations receive interest income that ranges from one-half of a percent to 2 percent, depending on the length of the lease.


How gold leasing operates:

-- CENTRAL BANKS lease the gold by exchanging telexed messages with the investment bank borrowers. The telexes give the due date for the return of the gold and the interest rate that will be paid the central bank for its use.

-- THE NATION may keep physical possession of the gold, but delivers documents of title to the investment bank.

-- THE INVESTMENT BANK usually sells the gold in the market for cash and uses the cash proceeds in its commodity operations. To protect itself from price fluctuations, the investment bank purchases an option to buy gold or gold futures. These options require the cash investment of only up to 5 percent of the face value of the gold.

-- WHEN THE GOLD LEASE comes due, the investment bank often has these options: paying the remainder of the purchase price for the delivery of gold, exercising the option and buying the gold in the market, or arranging for a new lease.


Market Place;1996's gold-price rise sets bulls, bears and bankers to predicting.
By Paul Lewis
Published: February 27, 1996

THIS year's mini-gold rush has opened a split of Klondike proportions between the precious metal's bulls and bears.

To the bulls, it suggests that the market is finally awakening to a fundamental imbalance between rising world demand and falling production that points to a further sustained rise in price. And that belief was supported by a sharp rally in gold that took it from $388.10 at the end of last year to $417.70 on the Commodity Exchange in New York earlier this month, its highest price in more than five years.

But the bears worry that one way or another the vast hoard of gold that central banks sit on -- about 35,000 tons, or roughly one-third of all that mankind has ever found -- is going to spoil the party, particularly as these supplies pass into the hands of a new generation of central bankers, trained in portfolio management and less sensitive to gold's mystique.
And they may be feeling better now, as the price of gold slipped below $400 in New York on Friday and closed yesterday just above that, at $400.60 an ounce.

"This is temporary," said Bette Raptopoulos, a gold analyst at Prudential Securities. "We could still see gold reach $450 to $460 this year."

"Its just a blip," added Sam E. K. Jonah, chief executive of Ashanti Goldfields Company Ltd., the world's seventh-largest producer, based in Accra, Ghana, which this month listed its shares on the New York Stock Exchange.

"The fundamentals are good," Mr. Jonah said. "There is tremendous demand potential in Asia linked to the new middle class."

"Gold is more likely to end the year at $365," countered Andy Smith, precious-metals analyst for the Union Bank of Switzerland, who said that declining mine output would have the market impact of "a small cream bun on the Empire State Building."

Explanations abound
why gold finally smashed its $400-an-ounce ceiling of recent years after shrugging off the Persian Gulf war, the collapse of the Soviet Union and the Mexican peso crash.

Technically, the scene for a rally was set late last year, when South Africa moved to sell about 300 tons, which it had not yet mined, for future delivery so as to lock in the then-current price.

The South African forward sales coincided with a shortage of lendable gold to cover the sale,
which helped push the current price of gold higher and caused a spike in the cost of leasing the gold to cover a forward sale.

Then, late in January, the Barrick Gold Corporation of Toronto announced that it was cutting its forward gold-selling by one-third in a move that some analysts expect other miners to follow. "We've become inactive as a forward seller, too," Mr. Jonah of Ashanti Goldfields said, "because we don't want to take the steam out of the rally."

Any suggestion that miners will stop selling gold they have not yet dug lifts market prices. And as prices rise, miners have even less incentive to sell forward because they might get more for their gold by waiting.

Many other factors contributed to the price rise. Although inflation is low, the weakened state of the German, French and Japanese economies suggests to some that a renewal of inflation rather than austerity lies ahead. "If Europe gives up on its single currency, there will be more inflation," said Ian McDonald of Credit Suisse.

In the meantime, generally high stock prices and relatively low bond yields encourage investors to look at other markets, and the continuing budget standoff between the White House and Congress unnerves many.

"If U.S. leaders cannot come to any kind of agreement over something as important as the budget deficit, confidence is bound to take a knock," said Rhona O'Connell, gold analyst with T. Hoare & Company of London, who expects gold to trade between $385 and $440 this year.

there is the underlying gap between production and demand. Mine output has been falling since 1993, reaching 2,268 tons last year, according to Gold Fields Mineral Services, a London analyst, with 590 more tons entering the market as scrap. But demand from the jewelry and electronics industries, as well as that for coins and ingots, is rising, reaching 3,550 tons last year, or more than 700 tons above supply.

Central banks have been filling this gap and holding the price steady by both selling gold directly and leasing bullion to cover forward mine sales.

What will determine the future price of gold, analysts agree, is how much metal the central banks will make available to the market and whether mining companies continue to sell unmined gold for future delivery.
The imbalance between mine and scrap supply, and the demand, should have forced the price up over the last two years. But it held remarkably steady because of the central bankers' involvement.

Some major central banks, including the United States Federal Reserve and the banks of France, Switzerland, Germany and Japan, have already made clear that they will neither sell nor lease their gold.

in a 1993 study of the gold-leasing market, Ian Cox, a British expert, reckoned that 45 to 50 central banks were lending some of their gold, seeing this as a profitable way to earn a return on what would otherwise be a sterile asset.

Certainly, all the signs are that central banks are now managing their gold reserves more actively. The cost of leasing has slipped back from November's high. And
since 1983, gold held by the Federal Reserve Bank of New York for foreign central banks has fallen sharply -- to 6,360 tons from 10,619, probably in part because of transfers to London, where most leasing takes place.

Those who doubt that gold will go much higher believe that central banks are likely to become even more active in the gold market and that this will encourage a return to forward selling by mining companies. "Barrick was temporary," Mr Cox said. "Hedging growth will continue."

"A new generation of central bankers is coming along who will be net sellers of gold," predicted Mr. Smith of the Union Bank of Switzerland, adding: "They understand modern portfolio-management theory. They know they are overweight in gold. That is the threat to the price."

Talking about gold manipulation isn' t the realm of conspiracy theories anymore.

Gold “hedging” and official sales during last twenty five years


Producer hedging

If there is any doubt that the US, consider the fact that all of America's closest allies are SOLD OUT of gold.


Gold loans or deposits are undertaken by monetary authorities to obtain a non-holding gain return on gold which otherwise earns none. The gold is “lent to” (or “deposited with”) a resident or nonresident financial institution (such as a bullion bank) or another party in the gold market with which the monetary authority has dealings and confidence and which is probably acting as an intermediary for a gold dealer or gold miner which has a temporary shortage of gold.
The intermediary will, in turn, “lend” the gold to the dealer or miner — in effect, a change in ownership of nonmonetary gold then occurs. In return, the borrower may provide the monetary authorities with high quality collateral, usually securities (frequently, but not necessarily, substantially in excess of the value of the gold provided) but not cash, and will pay a “fee” thereby increasing the return from holding gold. The collateral does not change ownership and is treated as an off-balance sheet holding of the monetary authority.

The nature of gold swaps and gold loans/deposits is similar to that of repos and securities lending in that the market risk toward the underlying asset (in this case, gold) remains with the original holder: if gold prices increase, the volume of gold returned is the same as that swapped, while the same value of the foreign exchange (as defined at the time of the initiation of the swap, plus any accrued interest) is returned.



Using derivatives to drive down interest rates


Credit Enhancement (turning toxic debt into AAA securities)

Credit Enhancement refers to the process of “transforming” high risk, impaired, loans into low risk investment grade bonds. It was the Treasury' s “Brady Bonds” which provided Wall Street the recipe for credit enhancement.

It was the creation of the Brady Bond that provided the recipe for the extension of many of these structured loans to emerging markets. A Brady Bond is a variety of structured derivative package in which the developing country (Mexico was the first) uses foreign exchange reserves as equity capital to create an investment company.

... It was only the interest payments to be paid after the second year thatcarried foreign exchange and sovereign credit risk. The Brady structure thus provided complicated market valuation, it also provided an infinite number of possibilities for rearranging the various pieces of the bond into more attractive cash flow structures.

… the final result would be to transform high risk, impaired, syndicated loans of banks to Latin American governments into low risk investment grade bonds that could be sold to institutional investors, with a profit from the credit rating differential as well as fees and commissions.
This is called credit enhancement, and investment banks quickly extended the Brady principle to other types of developing country debt.

… Again, the result was that US institutional investor funds were being invested in emerging market debt, earning above market interest rates, without their balance sheets necessarily reflecting the actual risk involved.

It was the Brady Bond which provided the recipe for credit enhancement and Structured Credit Derivatives.

Mr. Brady's Banking Dilemma

1) Banks and other institutions helping to finance the $400 billion federal budget deficit cannot also lend money to private borrowers.

2) To make new loans to Americans for cars and homes, banks must sell the Treasury paper now on their books, forcing long-term interest rates higher

3) The Office of Management and Budget reportedly believes that some of the nation's largest banks are insolvent and likely to fail.

4) at least one money center bank is now on the government's death watch.

5) struggling behemoths such as Chemical Bank, Citicorp, Chase, Wells Fargo and other banks cannot raise the billions of dollars more in new capital they need to survive

6) Mr. Brady and other monetary accommodationists grope for the impossible: lower rates on Treasury debt, increased availability of credit for the private sector, and all this with stable prices and low inflation.

7) Fed has already expanded its holdings of Treasury paper apparently in response to Mr. Brady's public demand for lower long interest rates.

8) Mr. Brady thinks he can provide covert assistance to dying institutions to prevent a pre-election crisis (what one federal official privately calls a "managed collapse" of the banking industry).

9) the monetary policy correction necessary to restrain price increases during even a moderate recovery could exceed the harsh tightening seen during the early years of former Fed Chairman Paul Volcker (unless the Treasury manipulates gold and the dollar).

Structured Derivatives

1) Majority of OTC activity involves individually tailored, often highly complex, combinations of standard financial instruments packaged together with derivative contracts.

2) They involve very little direct lending by banks to clients, and thus generate little net interest income.

3) The role of most derivative packages is to mask the actual risk involved in investment, and to increase the difficulty in assessing the final return on funds provided.

4) Global financial institutions no longer seek the maximization of profits through channeling the lowest cost funds to the highest risk-adjusted return

5) The major objective of the active global financial institutions is now the identification of riskless "trades" that produce large, single payments, with all residual risks the responsibility of the purchasers of the package.

Us Institutional Investors

1) Most US institutional investors are restricted to investments in "investment grade" assets.

2) They can' t invest in emerging markets or in particular asset classes such as foreign exchange.

3) Structured derivative packages provided the means by which these restrictions could be overcome.

The Brady Bond Provided The Recipe For Credit Enhancement

1) The Brady structure provided complicated market valuation, with an infinite number of possibilities for rearranging the various pieces of the bond into more attractive cash flow structures.

2) The final result of the Brady Bond was to transform high risk, impaired, syndicated loans of banks to Latin American governments into low risk investment grade bonds that could be sold to institutional investors

3) The Brady principle was called credit enhancement and was quickly extended by investment banks to other types of developing country debt.

4) Thanks the efforts of the US treasury, US institutional investor funds were being invested in emerging market debt, earning above market interest rates, without their balance sheets necessarily reflecting the actual risk involved.

----------- ----------- -----------

Total securitization

The government's desire to patch up the banking sector has been the leading force behind securitization. In the early 1990s, the Resolution Trust Corp (RTC), created to deal with the Savings & Loan Crisis, took this packaging of loans to a new extreme.

The federal government is turning increasingly to Wall Street to unload the enormous loan portfolio it has inherited from failed savings and loans, a strategy that some experts say looks good now but could cost taxpayers billions of dollars over the next few years if it backfires. Instead of selling the loans directly to investors, the Resolution Trust Corp. is packaging loans together and selling bond-like securities backed by income from the loans. The difference is, when the government sells a loan, it usually takes a loss on the transaction but it also washes its hands of the problem. Under the new plan, called "securitization," there is a greater risk that losses could continue to show up years from now.

The investments the RTC is creating are modeled after the securities sold by institutions such as the Federal National Mortgage Association (Fannie Mae), which are backed by conventional home mortgages, with the monthly payments providing income to the investors.

The RTC, however, is taking this approach in an entirely new direction with its offerings of securities backed by large commercial loans of varying quality.

Even riskier are soon-to-be marketed RTC securities backed by problem loans whose borrowers are not making payments or have defaulted. Dubbed "Ritzy Maes" by Wall Street because of their resemblance to Fannie Mae securities, the RTC bonds pay a higher rate of return than U.S. Treasury securities.

----------- ----------- -----------


Eliminating reserve requirements

Understates the level of insured deposits


Risky derivatives provide big losses for US agencies .

Toledo Blade - Google News Archive - Jan 25, 1995
Structured notes issued by the Federal Home Loan Bank System and other federal ... Among other things, the contro versy over structured notes has ex posed a ...


Government agencies pioneer structured notes


August 23, 1994
Fleet Injected $5 Million To Prop Up Fund Prices

Some of the best-performing investments in three of the Fleet Financial Group's money market mutual funds went so awry that the banking company had to inject $5 million into the funds in July to keep their share price constant at $1.

In 1992, the managers of Fleet's money funds, which have about $1.9 billion in assets, sought to protect the funds against rapidly declining interest rates. So, they bought $260 million of securities known as structured notes, which carried a floating interest rate that changed more slowly than most other rates.

As rates continued to fall through last year, those notes paid Fleet's shareholders a yield that was above the average available on comparable investments.

But this year, as the Federal Reserve moved to raise interest rates quickly, Fleet's securities remained at the lower rates. As a result, the prices of the notes fell, putting the mutual funds' share price in danger of falling below $1.

Unlike most types of mutual funds, which have share prices that fluctuate, money market funds attempt to keep shares at exactly $1, so customers can use them as a substitute for a bank account. Volatile Prices

"In 1992 and 1993, these were valuable investments that provided a good yield," said Thomas Lavelle, a spokesman for Fleet. "But when interest rates went up, they lagged and became less attractive."

Meanwhile, the Securities and Exchange Commission began to tell money funds that they should not invest in structured notes because their prices could be too volatile.

A structured note is a security that has a term linked to some sort of formula, so its value can move with certain interest rates, stock prices or other assets that may appeal to an investor. Structured notes are a category of the broad class of financial arrangements known as derivatives, because their value is derived from another asset or index.

For example, Fleet's funds had bought two notes that had interest rates that changed every three months to an interest rate that was linked to the London interbank offered rate, a very common short-term interest rate, Mr. Lavelle said. The twist on those notes was that their rates could not change by more than one-quarter of a percentage point in each three-month period. That meant the rate was high in a period of declining rates, but it lagged when rates rose.

Similarly, the funds owned three notes linked to an index of interest paid on deposits by West Coast savings institutions, known as the cost of funds index. This rate, which is used on many variable-rate mortgages in the West, moves more slowly than money market interest rates. Compensating for Loss

All the notes that Fleet's funds bought were issued by Government agencies like the Federal Home Loan Bank system or the Federal National Mortgage Association (Fannie Mae), Mr. Lavelle said.

In June, the management of Fleet decided to sell its portfolio of structured notes, but it received prices ranging from 96 to 99 cents for every dollar of face value. Then it donated $5 million to the fund to compensate for the loss.

Fleet, based in Providence, R.I., disclosed the $5 million infusion in its second-quarter earnings released last month. It was reported yesterday in The Wall Street Journal.

Mr. Lavelle said the prices received for the notes were depressed in part because other funds were selling similar securities at the same time, partly because of pressure from the S.E.C.

"We have imposed some additional controls and procedures that will cause us to model how any securities such as this will perform in the future," Mr. Lavelle said.

Fleet's bailout was similar to the $68 million the BankAmerica Corporation injected into two of its money market funds because of losses related to structured notes. Several other money fund groups -- including Paine Webber and Piper Jaffray -- have run into difficulty recently from mortgage-backed securities that also reacted badly to the rise in interest rates.

"The factor that ties all of these situations together is the fund managers were blinded by higher yields." said Barry Barbash, the head of the investment management division of the S.E.C. "They did not think in terms of what could happen in a rising-rate environment.".

The S.E.C. is developing rules that will further restrict the instruments in which money funds can invest. Still, Mr. Barbash said he did not believe that many other money funds had experienced similar problems, noting that Fleet's bailout occurred in June and July, just as the S.E.C. was raising the issue.



Subprime lending industry

Subprime lending industry (1994)

Figure 12: Percentage Held of Household Mortgage Debt, 1971-2006


As the secondary mortgage market continued to grow,
lending institutions began to sell the loans they originated rather than keeping them in their own portfolios. The banks began to make money by originating and servicing loans rather than by keeping them and earning interest. This was a radical change in lending practices and incentives; lending institutions stopped being concerned with the quality of the loans because they did not keep them, and instead they became very concerned with the volume of loans originated and the fees these generated. The originators were only concerned with meeting the parameters set forth by buyers of mortgage backed securities in the secondary market. When the parties purchasing these loans reduced standards to the point where everyone qualified, loan originators gave everyone loans. Lower lending standards opened the door for lenders to provide loans to those with low FICO scores in great volume: subprime borrowers. When combined with the widespread belief that home prices would never go down, the combination inflated the Great Housing Bubble.

Figure 13: Subprime Originations, 1994-2006


Subprime lending as an industry barely existed prior to 1994.
There were few lenders willing to loan to people with poor credit, and there was no secondary market to purchase these loans if they were originated. The growth of subprime was the direct result of the lowering of lending standards created by the change of incentives brought about by the creation of the secondary market. These factors alone were not enough to create the Great Housing Bubble, but they provided the basic infrastructure to allow the delivery of capital that caused house prices to take flight. The catalyst or precipitating factor for the price rally was the Federal Reserve' s lowering of interest rates in 2001-2004.

Many mistakenly believe the lower interest rates themselves were responsible by directly lowering mortgage interest rates. This is not accurate.
Mortgage interest rates declined during this period, and this did allow borrowers to finance somewhat larger sums with the same monthly loan payment, but this was not sufficient to inflate the housing bubble. The lower Federal Funds rate caused an expansion of the money supply, and it lowered bank savings rates to such low levels that investors sought other investments with higher yields. It was this increased liquidity and quest for yield that drove huge sums of money into mortgage loans.

Structured Finance

Structured finance is an innovation of the
[US Treasury]
finance industry on Wall Street. It is a method of redistributing risk based on complex legal and corporate entities such as corporations, limited liability companies or some other kind of legal entity capable of entering into contracts.

The real magic of structured finance is its ability to take assets of low investment quality and turn it into something viable.
George Soros aptly titled his book, “The Alchemy of Finance.” [iv] Like the alchemists of medieval Europe, modern investment bankers try to turn lead into gold. The syndicators who create and manage collateralized debt obligations assess the risk of loss on the underlying asset and break it down into three categories corresponding to the three tranches. The equity tranche in a CDO assumes the expected risk of loss. For example, if subprime loans expect an 8% loss from defaults, then the equity tranche will be 8% of the CDO. The syndicator typically keeps this equity tranche as part of their incentive fee, but practically speaking, the discount would be so steep it is hardly worth selling. If defaults losses are less than 8%, they see tremendous profits, and if it is over 8%, they see nothing. The Mezzanine tranche assumes the risk beyond the expected risk. If the average default loss is around 8%, and the highest default loss ever recorded is 24%, the mezzanine tranche exists to take on this risk. There is a very good chance they will see most or all of their money because the average default loss is being absorbed by the equity tranche. The senior tranche is supposed to have no risk from default loss. The line between mezzanine and senior is at or beyond the highest default loss rate ever recorded. This is not to say there is no risk, but it would take an unprecedented event to see any losses in this tranche—something like the collapse of the Great Housing Bubble.



Plunge Protection Team
Open Interest for S&P; 500 Stock Index Futures

The Too-Big-Too-Fail (TBTF) doctrine is the result of unwillingness of any administration to deal the economic fallout which would result from a major institution failure. TBTF

In 1984 the largest bank insolvency in US history threatened, the failure of Chicago's Continental Illinois National Bank, the nation's seventh largest, and one of the world's largest banks. To prevent that large failure, the Government through the Federal Deposit Insurance Corporation stepped in to bailout Continental Illinois by announcing 100% deposit guarantee instead of the limited guarantee FDIC insurance provided. This came to be called the doctrine of “Too Big to Fail” (TBTF). The argument was that certain very large banks, because they were so large, must not be allowed to fail for fear of the chain-reaction consequences it would have across the economy. It didn't take long before the large banks realized that the bigger they became through mergers and takeovers, the more sure they were to qualify for TBTF treatment. So-called “Moral Hazard” was becoming a prime feature of US big banks.

That TBTF doctrine was to be extended during Greenspan's Fed tenure to cover very large hedge funds (LTCM), very large stock markets (NYSE) and virtually every large financial entity in which the US had a strategic stake. Its consequences were to be devastating. Few outside the elite insider circles of the very large institutions of the financial community even realized the doctrine had been established.

As part of the expanding TBTF doctrine, the Treasury has been heavily intervening in the stock market since the crash in 1987. As in 1962, the favored tool for market manipulation remained derivatives.

The October 27, 1997 mini-crash provides a perfect example of the Treasury's stock market manipulation.

Below is a chart open interest in S&P; stock index futures which shows a clear example of the treasury's ESF buys equity futures to reverse stock market crashes.

Open Interest for S&P 500 Stock Index Futures

The reason for the huge spike in open interest in S&P; stock index futures was a market crash caused by Asia' s economic crisis in October 1997.

Buying equity futures is an effective means of reverse such market crashes because of the way Wall Street banks balanced their derivative books. When a firm (ie: Goldman, JPMorgan, etc) sells S&P; futures to the treasury's ESF, it is establishing a short position or a liability in the stock market, and balancing this short position requires buying stocks. So when the ESF bought 30,000 S&P; 500 futures contracts from Wall Street firms in October 1997, those firms then had to go out and buy an enormous quantity of stocks to bring their books into balance. This buying is what preempted a politically undesirable crash.

With data like the S&P; open interest graph above, how can there be doubt about official stock market manipulation? Is there any other factor that account for this? (for more on this manipulation, see *****The Flagrantly Visible Hand*****)

The US financial institutions have a history of using short-selling as an instrument to attack foreign currency. For example, Stephanygj.net reports about the naked short selling of Brazilian bonds.

The Russian debt payment moratorium caused deep financial turbulence in other emerging markets, including Brazil, and had a larger impact on Brazil than the 1997 East Asian financial crises. The fact that Russia had defaulted implied a radical reassessment by different investors about risks of investing in developing economies. In these circumstances of significantly increased risk aversion by international investors, Brazil was seen as especially vulnerable given its exchange rate (which was seen as overvalued), large and growing current account deficit, deteriorating fiscal position and short maturity of its public debt. It could be argued that the lessons of the Mexican crisis, which had showed that the costs of currency appreciation increase slowly, but explode suddenly, were to some extent ignored by the Brazilian economic authorities (Cardoso, 2000).

However, Brazil was also deeply affected by the fact that it represented around a 40% share in emerging market portfolios, as well as by specific hedging strategies used by investors suffering losses in Russia and elsewhere. A new unanticipated channel for contagion — not too much discussed in the literature — was through the Brady bonds. Goldfajn and Gupta (2003) gives econometric evidence that the most likely location of transmission of contagion from Russia to Brazil was the short-selling in offshore Brady markets. An interesting parallel can be drawn with Hong Kong, where short-selling in the stock exchange by offshore speculators was used as an instrument to attack the currency during the East Asian financial crisis.

Goldfajn and Gupta (2003) also shows that foreign investors' withdrawals from Brazil played a major role during the Russian crisis, and that they were not reversed; this was in contrast with the period during the Asian crisis where withdrawals from Brazil by foreign investors were smaller and reversed a few months later.

Important regulatory points can be made drawing on this Brazilian experience. Though US securities law includes restrictions on repeated use of short-selling by a broker by limiting the price (“tick”) at which the second short sale of a security can be made (through the “Tick Rule”), this could not be applied off-shore, as no reference price is fixed to any exchange. Similarly, margins on short sales, also repeatedly tend not to apply to offshore trading. This creates, as Franco highlights, a specific regulatory asymmetry, between domestic and offshore markets that amplified contagion from the Russian crisis.

Further, the aggregate short-selling of Brazilian bonds seemed very high relative to amounts of bonds available. Indeed, reportedly a number of actors — including large international banks — were selling short bonds that they did not have. Brazilian investment banks complained that when they attempted to follow provisions approved under International Securities Market Association Rules to force delivery — which would imply short sellers having to buy the bonds to cover their positions,- they were threatened by these large international banks that if they did this, their credit lines would be cut. It can be argued that another regulatory asymmetry arises here as a large market maker (an international bank) is favored over a small player (a national bank) challenging a short sale that was damaging to market integrity.

Below is a good quick summary of some of the important events in gold during the 1990s.

The story begins in 1995. Gold is slumbering as it has for some time around US$375/oz. Japan's economic situation is worsening, and in mid-1995 the Japanese cut interest rates sharply. Gold begins to stir, jumping over $400 in early 1996, propelled in part by Japanese interest rates so low that they force yen denominated gold futures on the TOCOM into backwardation (i.e., when prices for future delivery are lower than spot). The yen is falling; gold lease rates are rising. From the U.S. perspective, an economic collapse in Japan threatens to exacerbate the U.S. trade deficit and possibly trigger massive dishoarding of Japan's large holdings of dollar denominated debt, including U.S. Treasuries.

The G-7 central banks and finance ministers cobble together a plan to support Japan, including a strategy for controlling the gold price through anti-gold propaganda backed by small but highly publicized official gold sales augmented by leasing of official gold in large quantities at concessionary rates. For Belgium and the Netherlands, the largest European sellers, gold sales also help to meet the Maastricht Treaty's criteria for the euro.

Gold analysts, who at the beginning of 1996 were almost unanimous in predicting a new bull market for gold, are blind-sided.
Virtually none foresaw such a coordinated official attack on gold, and many are slow to recognize its broad scope. The gold price steadily declines from over $400 in early 1996 to well under $300 in early 1998, and stays under $300 for most of 1998 and into early 1999. Every time gold looks to rally, it is slammed on the LBMA or COMEX by the same small group of well-connected bullion banks. Particularly notable in these attacks are Goldman Sachs, Chase and Mitsui, which regularly runs by far the largest net short position on the TOCOM.

On May 7, 1999, the British announce that the Bank of England on behalf of the British Treasury will sell 415 tonnes of gold in a series of public auctions ostensibly to diversify its international monetary reserves. The manner of the British sales -- periodic public auctions instead of hidden sales through the BIS -- belie any effort to get top dollar and smack of intentional downward manipulation of the gold price. All indications are that these sales were ordered by the British government over the objection of BOE officials. Palpably spurious and inconsistent reasons for the sales are offered, but no persuasive ones. There is only one logical conclusion: the gold sales were directly ordered by the Prime Minister for unknown political or other reasons. What is more, his reasons are unlikely to have been frivolous. As leading supporters of the proposed IMF gold sales, the British clumsily put themselves in the position of front-running them, and ultimately the British sales are an important catalyst in forcing the IMF to change tack.

For most knowledgeable gold market participants and observers, the British announcement is the smoking gun -- proof positive that the world gold market is being manipulated with official connivance and support. But what none yet suspects is that the BIS, the ECB and the central banks of the EMU countries are having serious second thoughts about the gold manipulation scheme.

On September 26, 1999, 15 European central banks, led by the ECB, announce that they will limit their total combined gold sales over the next five years to 2000 tonnes, not to exceed 400 tonnes in any one year, and will not increase their gold lending or other gold derivatives activities.
Besides the ECB and the 11 members of the EMU, Britain, Switzerland and Sweden are parties. The 2000 tonnes include the remaining 365 tonnes of British sales and 1300 tonnes of previously proposed Swiss sales, leaving only 335 tonnes of possible new sales. The announcement, made in Washington following the IMF/World Bank annual meeting, is ironically christened the "Washington Agreement" although the government in Washington played no role. However, the BIS, IMF, U.S. and Japan are all expected to abide by it, and the BIS is expected to monitor it.

The effect in the gold market is quick and dramatic.

When gold threatened to explode over $300 in early May, and with IMF's proposed gold sales in trouble, the ESF found itself in much the same position as that of Ashanti and Cambior after announcement of the Washington Agreement. Gold call options previously sold for a few dollars an ounce threatened to cause losses many multiples of these amounts if the gold price jumped by $50 to $75.
If settled in cash, exploding volatility premiums would add hugely to the loss, putting the effective strike price far above the nominal one. On the other hand, if settled in gold at the strike price, the ESF would have to deliver gold from U.S. reserves or go into the market to cover, adding more upward pressure to the gold price.

Worse, unlike the modest premium income from sales of options, huge losses could not be hidden from Congress in the monthly financial reports to the House and Senate Banking Committees.
Not to panic. The ESF, being under the direct control of the Secretary and the President, has an option not available to others.
Call the British Prime Minister and arrange for a very public official gold sale designed to kill the incipient gold price rally. And for God's sake don't let the BOE or the Fed know what is really afoot. If some of their inflation hawks knew the real situation in the gold market, they might be more inclined to raise interest rates.

Gold lease rate is an indicator of how much central bank gold is being leased out. The higher the lease rate, the more leased gold is being sold.

Naked short selling

October 2006

One problem common to both equity and bond market settlement failures is the use of customer funds between the settlement date and the date when securities are eventually delivered (the close-out date).
Fleming and Garbade (2004) explain it this way in the case where the trading is among dealers:

“Because the buyer does not pay the seller until the seller delivers the securities. the seller loses (and the buyer gains) the time value of the transaction proceeds over the fail interval.
... The prospect of losing the time value of the transaction proceeds provides an incentive for the seller to make delivery on the settlement date or as soon as possible thereafter

Unfortunately, individual investors (customers) are not included in this reciprocal arrangement. Retail investors are charged the cash portion of their transaction on settlement date regardless of whether or not the seller fails to deliver securities to the buyer' s broker (Alsin 2006). The vast majority of bond trades involve non-dealers (customers). According to SEC (2004). 87.5% of trades in municipal bonds in 2000 involved customers. While the buyer' s broker may enjoy the proceeds of investing the purchase price of the bonds, the individual investor does not. Furthermore, industry practice, supported by the Uniform Commercial Code, allows the executing broker to credit the customer account with an “entitlement” so that the investor is not informed that the broker is using the proceeds of the trade without compensation. Unlike securities lending, this does not require that the investor has a margin account agreement, whereby they are made aware when the account is opened that the broker may profit from funds and/or securities left in their account. Every customer account is vulnerable to this practice.

Regulators turn Wall Street into a giant bucket shop

Congress preempting state laws.

Uncle Sam Knows Best about the Economy — Except When He Doesn' t
By jmalmberg
14 months ago

March 5, 2009 — Most people are familiar with the Great Depression, but many don' t realize that this was not the only financial calamity the US went through in the early 1900' s. By the time of the market crash in 1929, the federal government had already made a number of regulatory decisions that were designed to promote market stability. When these didn' t work, the government assumed an even greater role in regulating the economy. What is remarkable about this period is the fact that federal regulations — as many of them as there were — appear to have had much less impact on economic stability than regulations that were imposed at the state level. In fact, it can be argued that state regulatory authority was largely responsible for providing businesses and consumers a stable economic environment for roughly 50 years. But beginning in the 1970' s Congress decided that it would preempt certain state laws, and by the beginning of this decade they had pretty well decimated state authority to regulate businesses in the financial sector. We' re going to take a little time to examine why now is the time to return to a period of state' s rights and limited federal regulation.

Over the past few days I've been beating up Congress and the President over their spending bills. My frustration has been that the folks in our capital have no problem talking about who to blame for the economy but that there is no message coming out of Washington to tell me that the cavalry has arrived. That we now have a plan to win our economic battle.

Then last night, I was on the phone with a person in the financial services industry whom I know and respect and she said something interesting — and frightening. She said that we wouldn' t be hearing a detailed plan - what I was looking for - any time soon because the people in DC don' t know how to stop the bleeding. It' s easy to talk about blame, stimulus and spending on individual issues. It' s not so easy to fix a problem that took years to create.

She' s right. So maybe its time for those of us who follow history — economic history at that — to put forth some plans of our own. We can start with the issue of state's rights.

State' s Rights and the Economy

To understand how preemption of state' s rights undermined the US economy, you don' t have to look far. A great example comes from state Bucket Shop laws.

If you have never heard of a bucket shop, don' t feel left out. Bucket shops sprang up all around the country in the late 1800' s. They were essentially betting parlors that allowed you to bet on stock prices. You could walk into a bucket shop and place a bet that a particular stock would go up or down without every buying the stock.

By 1929, bucket shops were illegal in virtually every state in the country. The states had outlawed them for two reasons. One was that bucket shops could buy or sell large blocks of stock and manipulate stock prices. This meant that if a lot of their clients were betting on a stock going up in price, they could sell a large block of stock in that company. This would cause the stock price to fall and allow them to keep all of their investors' money. In other words, they were fraudsters. They could do the same thing if investors were betting a stock would fall in price.

Secondly, the market manipulation that bucket shops were responsible for had been blamed for destabilizing the markets, and had caused many investors to lose large sums of money. Simply put, the only people that benefited from bucket shops were the people that ran them.

What the bucket shops were selling are what we commonly refer to as derivatives. Another phrase for them is Credit Default Swaps — just like the mortgage credit default swaps that started the market meltdown last year. These are the worthless securities that have caused banks to go broke, and made the US government the largest stockholder in AIG.

So how is that even though bucket shops are against the law in most states that companies like AIG were able to sell Credit Default Swaps? The answer is one simple word. Congress.

Nine years ago, Congress passed a law called the Commodity Futures Modernization Act of 2000. On December 21, 2000, then President Bill Clinton signed the law which contained a preemption of state enforcement of bucket shop laws by including a line that reads, “This Act shall supersede and preempt the application of any state or local law that prohibits or regulates gaming or the operation of bucket shops.”

But that was not enough for Congress. They wanted to make sure that everyone understood their intent. So they also added language that amended the Securities and Exchange Acts of 1933 and 1934 to make sure that the definition of a “security” didn' t include “credit default swaps” or certain other swap agreements, and they forbid the SEC from any such regulation.

With the stroke of a pen, President Clinton and Congress used their regulatory authority to completely deregulate a large market. In fact, it was a market that had been considered so important to financial stability that a century earlier it had been regulated out of existence entirely. Ahh, but those who don' t study history are doomed to repeat it!

Had Congress simply allowed the states to continue to regulate this area of the market, it' s a fairly safe bet that the economy would still be humming along quite nicely.

US treasury market is reaching the breaking point.

US treasury market reaches breaking point
Helen Avery
Tuesday, November 25, 2008

the settlement system has broken down. Following the collapse of Lehman Brothers in September, fails to deliver among the 17 primary dealers in the US treasury market have rocketed to more than $2 trillion over a period of weeks and still lie above $1.3 trillion. Broker/dealers have stopped delivering bonds.

As a result of fails to deliver, the most transparently priced instrument available now has investors scratching their heads. The natural balance of supply and demand has been altered and the true price of treasuries has become obscured. The effects are being seen across other bond markets. “The TIPS (Treasury Inflation Protected Securities) market is also clearly broken,” says Pond. “An obvious trade right now would be to go long TIPS where real yields are high and short the nominal bond in a breakeven inflation trade but hedge funds are fearful that if they go through the repo market the borrow could fail. So we have a situation now in the 10-year TIPS where the market is pricing in zero or negative average inflation for the next 10 years. Inflation has not been that low since the 1930s.” Economists also claim that fails have spread across to other bond markets such as municipals, agencies, mortgage-backed and corporate bonds.

Why the Federal Reserve is not urgently considering regulation is bewildering. As yet, the US Treasury has merely asked for market participants to sort out the situation themselves. That might help reduce fails but it will not eliminate them, and in panic periods they will simply creep back up.

Fails to deliver in the treasury markets are not a new phenomenon. There is data for fails for treasuries, agencies and mortgage-backed securities as far back as 1990, says Susanne Trimbath, an economist, and former employee of the Depository Trust Co, a subsidiary of Depository Trust and Clearing Corp.

Back then, though, there would be $50 billion of fails in a whole year, she says. That figure has grown enormously.

This failure to deliver also has the effect of creating phantom securities — a higher number in the system than actually exist. “In a sense, the repo market is like a Ponzi scheme,” says Jonas. “If no delivery is forced then that bond can be lent over and over again. One security can underlie a hundred trades. So the amount of securities traded is far more than exists. That is the way the world works today. If it doesn' t break, that' s great. But when one link in that system breaks, those trades have to be unwound...”

Trimbath, however, is less sanguine about the impact that phantom bonds have on the financial system. She compares the situation to musical chairs. “Who is going to get the chair when the music stops? It' s not the individual investor. I' ve seen positions just deleted from people' s statements without investors even knowing as the security they supposedly owned turns out to not exist.

Trimbath is less optimistic that something will be done to prevent fails to deliver from continuing. “This issue has gone unanswered for years. What is going on is simple stealing. We don' t need new laws against that, we already have them. If the Fed won' t step in, then the Department of Justice has to.”

The inaction has led to the build-up of $2 trillion in undelivered bonds. Moreover, the number of fails is almost certainly higher than is being reported, claim insiders, possibly substantially so. The $2 trillion in fails fell to $1.3 trillion at the week ending 5 November, according to the New York Fed but Trimbath points out this is only data volunteered by about 17 primary dealers. The fail rate by those dealers in US treasuries hit 30% one week in October. By 11 November it was still at 22%. “And what about the two to three hundred bond dealers who settle through the DTCC? The DTCC does not reveal publicly the fails to deliver there. Imagine the magnitude of the true amount of fails to deliver,” she says.

The former Treasury employee also explains that the Fixed Income Clearing Corp (part of the DTCC) started netting fails in 2005/06, whereby FICC uses bonds due to a participant to offset bonds due from the same participant in the same security. “The actual amount of true fails appears to be less, therefore. You can' t compare the figures now with historical fails.”

[Key point: Investors think they own treasuries, but what they really own is an IOU from their broker. When the dollar and Wall Street collapse, these investors will find themselves general creditors to bankrupt financial institutions. This will probably come as a pretty big shock to those investors…]

Since they have lost access to the credit markets, brokerages are funding themselves through selling imaginary assets, including treasuries.]

9/11 as proof that US mainstream media is broken

How many skyscrapers collapsed on September 11? If you answered two, you are wrong.

World Trade Center Building 7, a massive 47-story high-rise in downtown Manhattan (not hit by any airplane), crumbled to the ground in a neat foot-print at free-fall speed in the manner of a controlled demolition because of damage sustained solely from fire. Below is a CNN news clip confirming the collapse of this third skyscraper, one hour before it happened.

WTC 7 Foreknowledge

Next is a clip of Niels Harrit being interviewed on Danish TV2 News about finding nano-thermite in the dust from the World Trade Center. Again, I would be amazed if anyone in the US has heard anything about this.

If anyone in the US media, reading this, feels like doing their job, here are a couple of questions I would love to have answered:

Why did Building 7 collapse? (Seriously, have you ever hear of a skyscraper collapsing because of a fire?)
Why did CNN predict this collapse one hour before it happened?
Why are scientists finding nano-thermite in the dust from the World Trade Center?

To read more, see *****America's Broken Media And The Collapse Of World Trade Center 7*****


market manipulation

Such market manipulation, not just in gold but all financial markets, were officially endorsed in the U.S. when the "The President's Working Group on Capital Markets" (aka the PPT) was established in 1987 as a response to the stock market crash. However, the 'spirit' of these tactics turned to the 'dark side of the force' in 2001, essentially at the time of 9/11.

In other words, what was once a defensive, overt policy created to enable action in the face of near-term issues, at that point morphed into a 24/7 covert action targeting the long-term manipulation of public perception.

And it's no surprise that under this ruse a monstrous housing bubble was born, as well as the birth of the financial engineering (such as OTC derivatives) that has directly caused the economic calamity we are facing today. With the "gold alarm bell" turned off by its illegal suppression, the capping of interest rates, the support of stock markets (via the PPT), and unending bailouts of insolvent entities, the resulting financial imbalances have pushed the U.S. into an economic abyss that it will likely never re-emerge from.

Naked short selling — redefining systemic risk



Euro FX Futures and Options

8) The liquidation of the 8 Trillion dollar holdings of overleveraged European banks

European banks increased their dollar assets sharply in the last decade which help drive down US interest rates
and absorbed a large portions of America's growing debt. Their combined long dollar positions grew to more than $800 billion by mid-2007. This $800 billion was then leveraged into $8 trillion in US assets. The low capital ratios of these dollar positions were acceptable to regulators because European banks are allowed to apply a lot more leverage as long as they are buying exclusively AAA rated securities.

Unfortunately, as we have learned over the past 18 months, AAA is not always AAA. While much of the AAA rated securities bought by European banks were treasuries and agencies, some of these AAA rated securities were senior securitized loans that are still marked close to par on the balance sheet of European banks despite the fact they trade around 70 cents on the dollar in the markets. The enormous unrealized losses of their US holdings are only one of the problems facing European banks.

The other is the loss of their dollar funding. The enormous leverage employed by European banks to purchase toxic AAA rated US assets was funded in great part by loans from US money market funds. After Lehman's default led to massive withdrawals from money market funds, European banks lost access to dollar financing to billions in dollar funding.

If European banks are forced to sell their 8 trillion US assets, it will crash the credit markets, and they will have to recognize enormous losses. Since the fed is desperate to prevent the collapse of the US financial system, it lent those European banks 600 billion dollars so that they wouldn't be forced to sell. Meanwhile, European banks accepted this 600 billion because they don't want to recognize losses on their toxic US securities.

What is going to happen next with these overleveraged European banks?

Well, if history is any guide, the outlook isn' t good for the US financial system:

“When the American economy fell into depression, US banks recalled their loans, causing the German banking system to collapse”

The same thing will happen in 2009, except the roles will be reversed. It will be European banks that will recall their loans and sell off dollar assets, causing the US banking system to collapse.

What could convince European banks sell off their US assets at firesale prices?

The answer is simple: fear of a dollar collapse. With the fed increasing the monetary base 15-fold, the strategy of waiting for impaired assets to recover becomes meaningless: if European banks fear the dollar might lose nine tenths of its value in the next year, then waiting for assets trading 70 cents on the dollar to recover is a senseless venture.


The recourse rule

How a secret rule caused the crisis
Monday, 22nd February 2010
Allister Heath


SLOWLY but surely, some economists are beginning to piece together the real causes of the crisis. And as you might imagine, their findings are strikingly at odds with the conventional explanations, which tend to revolve around greed, bankers' animal spirits and deceit.

One brilliant new paper shows how
an obscure regulation deliberately encouraged US retail banks to buy CDOs — supposedly safe bundles of mortgages that lost most of their value in 2008 — and to get rid of safer assets. It is an astonishing tale, wonderfully retold by Jeffrey Friedman and Vladimir Kraus and published by the American Enterprise Institute.

Banks are required to set aside specified amounts of capital against their assets to protect themselves against possible losses; some assets require more capital and others less, dependent on perceived riskiness. Holding back capital is expensive for the banks but it is useful when things go wrong.

The Basel Accords govern banks' capital; in 2001, the US amended the Accord with its so-called “recourse rule”. US retail banks were required to retain just $2 in capital for every $100 invested in AAA or AA-rated CDOs (or any asset-backed security issued by the state-sponsored Fannie Mae and Freddie Mac), compared to $5 for the same amount in actual mortgage loans and $10 in commercial loans.
The recourse rulepushed through by the Fed and other regulatorswas deliberately designed to steer banks' funds into CDOs — and it worked a treat. The banks gorged on them. No fewer than 93 per cent of their holdings of mortgage-backed securities were either AAA-rated or were issued by Fannie or Freddie, as stipulated by the regulations; as far as the banks were concerned, they were merely following the new best practice.

Because they owned so many CDOs, retail banks suffered more than any other investors — except investment banks, which packaged mortgages into CDOs and were caught out with stocks of both when the music stopped. The recourse rule only covered commercial banks; hedge funds, insurers and others were not cajoled into buying CDOs.
It is clear that the US authorities were therefore not only complicit but also directly responsible for the destruction of the US banking system. Their rule also helped inflate the demand for CDOs, securitisation and even sub-prime mortgages, especially when Wall Street had run out of mainstream mortgages to bundle up.

Naked Short Selling again

Ms. Florence Harmon Acting Secretary Securities and Exchange Commission 100 F. Street, NE Washington, DC 20549-9303 Re: Release No. 34-58773; File No. 87-30-08 Amendment to Regulation SHO Interim Final Temporary Rule

Dear Sirs,


As many of you know the single most important deterrent to abusive naked short selling crimes is the FEAR of an untimely buy-in. Qualifying as an “untimely” buy-in would be one executed in the midst of a “short squeeze”. The “buy-in” is also the ONLY cure available when the seller of securities absolutely refuses to deliver to the buyer that which he sold. The “buy-in” or the fear thereof is the ultimate provider of investor protection and market integrity when it comes to abusive naked short selling frauds.

Over the years the NSCC management has rather curiously attained a monopoly on 15 of the 16 sources of empowerment to execute buy-ins. The 16th source of empowerment belongs to the brokerage firm of the buyer that failed to get delivery of that which he paid for. Unfortunately for investors NSCC policies essentially “bribe” the buying brokerage firm into NOT opting to exercise his empowerment to execute a buy-in when he does not receive delivery of that which his client purchased. This is done via allowing the buying brokerage firm to earn interest off of the funds of the investor UNTIL delivery occurs. This makes the buying brokerage firm the last party in the world wanting to execute a buy-in of a fellow NSCC participant.

Further to this the NSCC has introduced a failsafe mechanism to further circumvent buy-ins. They expressly forbid their participants from executing open market buy-ins on fellow NSCC participants. What they do is to mandate any NSCC participating brokerage firm contemplating executing a buy-in to file an “Intent to buy-in” with NSCC management. Management than has the right to deal with this “Intent” filing in any manner they so choose. They could deal with the associated delivery failure by utilizing their self-replenishing “stock borrow program' s” lending pool of securities. They could also just “RECAP” the delivery failure out of existence as if by magic. They could also opt to just sit on it and do nothing.

Why is this THEORETICAL “securities cop” known as the NSCC management so obsessed with circumventing buy-ins?
The 2003 study of Evans, Geczy, Musto and Reed revealed that only one-eighth of 1% of even mandated buy-ins ever occurs on Wall Street.

Another consequence of this heinous behavior is that U.S. corporations SELECTIVELY have become singled out as the targets for worldwide abusive naked short selling attacks as the clearance and settlement systems in use in other countries have not yet been “captured” by the insatiable greed of their Wall Street “bankster” counterparts to the degree that ours has. The clearance and settlement systems in almost every other country still follow the foundational tenet recommended by IOSCO and the Bank for International Settlements (BIS) namely that the seller of securities is not allowed to access the funds of the purchaser of securities UNTIL “good form delivery” has been accomplished. This is also referred to as “delivery versus payment” or “DVP”.

The foundation for the DTCC-administered clearance and settlement system in use in the U.S. has been illegally converted to one based upon mere “collateralization versus payment” or “CVP” wherein the seller of securities is only asked to collateralize the monetary amount of the failed delivery obligation on a daily marked to market basis. This policy invites abusive naked short selling activity in that the failures to deliver shares results in the procreation of what are referred to as “securities entitlements” that are allowed to be readily sellable as if they were legitimate “shares” of a corporation due to the wording unfortunately incorporated into the text of UCC Article 8-501.

As these readily sellable “securities entitlements” invisibly accumulate in the share structure of U.S. corporations targeted for destruction then the share price by definition must tumble due to the interaction of supply and demand forces. This drop in share prices then results in a lessening of the collateralization requirements which in turn unconscionably allows the investment funds of unknowing U.S. investors to flow into the wallets of those that sold nonexistent securities and of course refused to deliver that which they sold.

The net result is that the share prices in certain U.S. corporations deemed to be an easy prey unfortunate enough to have been targeted for an abusive naked short selling attack have been essentially “rigged” to go nowhere but down.

The DTC nightmare

Reconciling who owns what shares in the DTC is going to be an absolute nightmare, far worse than the paperwork crisis,

A comment letter to the SEC explaining the abysmal failure of Regulation SHO to date.

(emphasis mine) [my comment]

OT..Subject: File No. S7-12-06

Subject: File No. S7-12-06
From: Lynn Keith September 15, 2006
September 15, 2006
Ms. Nancy M. Morris, Secretary
Securities and Exchange Commission
100 F Street, NE
Washington, DC 20549-0609

Re: Amendments to Reg SHO Release No. 34-54154
File No. S7-12-06

Secretary Morris:

Thank you for the opportunity to comment on the abysmal failure of Regulation SHO to date, and specifically on the amendments the SEC is proposing to fix it.

As other commenters have pointed out, Section 17A of the 1934 Securities Exchange Act is very clear in mandating "prompt and accurate clearance and settlement of securities transactions, including the transfer of record ownership..."

Wall Street has become very adept at the "clearance" part of the transaction -- that is, the taking of a customer's money for the purchase of securities and the charging of commissions and fees for the purchase of securities. But Wall Street has more and more ignored its fiduciary duty in completing the "settlement" part of the transaction that is, delivering the securities the customer has paid for...even though non-delivery of stock is expressly forbidden by Section 9 of the Securities Exchange Act. More often than not, what is "delivered" is an electronic entry in the customer's account representing an IOU for the security they purchased -- an IOU the customer is completely unaware he holds, and which too often is unsupported by any underlying share certificate.

This delinking of the clearance and settlement of transactions has resulted in
hundreds of millions of undelivered equity securities being outstanding on any given day in the U.S. equities markets. This is blatant and outright fraud -- the taking of money for a product which is never delivered.

As far as elimination of the Grandfather Exception to Reg SHO,
I find it ironic that the SEC would even ask for comment on something which is so clearly illegal and in such obvious violation of Section 17A of the 1934 Securities Exchange Act to begin with. The SEC does not now, nor has it ever, had the authority to exempt illegal behavior. Period. What on earth was the SEC thinking when it allowed implementation of the Grandfather Exception? Section 36 of the 1934 Act specifically prohibits the SEC from creating any exceptions to the 1934 Act except "...to the extent that such exemption is necessary or appropriate in the public interest, and is consistent with the protection of investors."

Allowing Wall Street firms to continue to NOT deliver the securities their customers have already paid for -- which is what the Grandfather Exception to Reg SHO does -- is nothing more than condoning and institutionalizing fraudulent activity and theft which has already taken place. The Grandfather Exception must be eliminated. DTCC participants and options market makers have had well over a year and half to close out the fails which existed when Reg SHO was first implemented. If they have not done so by now, they obviously don't intend to, and these fails should be immediately bought-in. That the grandfathered fails have not been closed out by now is testament to the confidence naked short sellers and their facilitators have that their powerful allies at the DTCC will continue to protect them from any enforcement of SEC delivery rules.

It is noted that
this blatantly illegal "grandfathering" provision was NOT part of the proposed Reg SHO language which was originally put out for public comment prior to Reg SHO implementation. No wonder. I guess even the SEC was too embarrassed to risk doing that.

One can only assume that the SEC was convinced by
DTCC participants--i.e., powerful Wall Street interests--that the fail-to-deliver problem was so pervasive and so systemic in the U.S. markets that there was risk of a market meltdown if they were actually forced to deliver all the securities they had fraudulently created out of thin air and "sold" to their unsuspecting customers over the years. And as they so often have over the last 35 or so years, the SEC caved in and did what Wall Street wanted

the 11,000 DTCC participants are able to loan out over and over and over again the same shares, and are able to sell shares which don't exist, much of the time never delivering to buyers the securities they thought they had bought, but instead are allowed to deceitfully mark their customer account statements as if they had delivered the sharesto the clear detriment of investors' retirement and investment accounts.

By whatever name you call it -- market manipulation, naked short selling, failing to deliver, or stock counterfeiting [selling imaginary shares] -- it all describes fraudulent stock trades that have become a spreading cancer in the system -- a malignancy that threatens to bring down the entire U. S. equity market.

As a long-time observer and investor in the U.S. markets, it appears to me that
the "...prompt and accurate clearance and settlement of security transactions..." mandate of the 1934 Securities Exchange Act began to unravel about the time of the formation of the DTC and the NSCC--and later, the DTCC. These organizations, formed in response to the paperwork crisis of the late Sixties, were staffed and advised by people who had Wall Street's best interests at heart -- not investors. …

For the SEC to remain true to its Congressionally mandated mission, it must realize that the
DTCC is not its friend. It is not the friend of investors. Its sole motivation is to increase and protect the profits of its 11,000 participant firms. Asking--or assuming--that this organization will adhere to the investor protection mandates of the 1933 and 1934 Securities Exchange Act on the "honor system" will not work.

I note with shame--as should the SEC--
the comment letter from Research Capital Corporation (RCC), a Canadian brokerage firm that has tried to "buy-in" failed deliveries of Overstock.com on 39 separate occasions. In each attempted buy-in, the failed delivery has simply been replaced by another delivery commitment which also fails. [a "buy-in" is basically a process to force delivery of securities.]

This brokerage firm also states it has requested proxies for its clients which it is not receiving -- which reveals another problem engendered by naked shortselling. That is,
the massive over-voting of proxies. A number of independent studies, as well as work done by the Securities Transfer Association, has revealed that over-voting has taken place in every single company studied. Such over-voting means only one thing: That there are far more people and institutions who think they own shares than there are legitimate shares to go around, and that there are millions of "phantom" or "counterfeit" shares in clients' accounts -- IOU's with no underlying stock certificates supporting them. ADP actually has an algorithm that "adjusts" shareholder votes by throwing out votes, making a mockery of the shareholder rights which are supposed to attach to share ownership.

As Frank Partnoy, law professor at the University of San Diego, has noted, "It might seem incredible, but
shareholder voting in developed countries is more tainted than voting in undeveloped ones. Some shareholders' votes are counted, others are not."

Since the clearance and settlement system of the U.S. securities markets has been so badly corrupted and is currently dysfunctional, RCC suggested in its comment letter that the SEC review the buy-in rules of other countries, including those used in Canada. They could also have suggested Australia, Japan, Euronext, the London Stock Exchange, Singapore, Austria, and Germany. All of these countries and exchanges have strict share delivery requirements, and all function very well without the numerous delivery "exceptions" allowed by the SEC for certain favored Wall Street groups.

Is it not embarrassing that the capital markets of all these other countries are more honest in their clearing and settlement processes than the United States?
[DTCC is bringing the America' s “clearing and settlement processes” to Europe through its subsidiary, the EuroCCP]

Unfortunately, RCC is not the only foreign company to see the U.S. securities market for the way it is.
While Wall Street/DTCC interests have been successful in having most New York financial publications--which they largely control--downplay the magnitude of the fail-to-deliver problem, a perusal of foreign media and investor message boards and internet blogs, all with an international audience, clearly shows that the perception is growing all over the world that the U.S. equity securities markets are as crooked, corrupt and manipulated as those of any third world country...and that the SEC is doing nothing about it.

[Read entire letter here]


Credit Default Swaps

as one former Treasury official told The IRA: "You can't reiterate enough the point that DTCC is owned by the dealer firms and thus the NY Fed is actively and purposefully aiding and abetting the continued OTC monopoly at the expense of real reform."




April 2005
Naked shorting: Stung by the German connection
by Peter Koh

Thousands of US stocks are being traded on a little-known Berlin exchange, without the knowledge of many of the companies involved. Have the naked short sellers exported their practice overseas?

A YEAR AGO Ted Noble, chief financial officer at Advanced ID Corporation, a Calgary-based microchip-tracking company, received some surprising news.

"We were congratulated by a third party who saw that our shares were trading on the Berlin Stock Exchange," he recalls. "That came as news to us because we'd not done anything to get listed in Germany. I talked to a few people and we couldn't figure out whether it was good or bad."

Noble soon found out when his company's shares started behaving oddly on the US OTC bulletin board. "April 29 [2004] was a slow day, and only about 10,000 of our shares had traded. Then 370,000 shares traded in the last 20 minutes before the close. It knocked our stock price down from 58 cents to 41 cents, before closing nearly 20% down at 48 cents. That was very unusual for our stock. I'd never seen anything...


Vault Cash leasing


Dark pools of liquidity


Defrauding unwitting investors around the world with "structured notes"



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12 Responses to Draft (update 1)

  1. Robert says:

    Hey Eric, check this out:


    Maybe the Kenyans got sprayed with fungus like the Afghan poppy farmers did.

  2. george says:

    very interesting draft Eric!!Well done!

  3. Sam says:

    i like to say that ur efforts are fantastic.

    your way of presentation is simply awesome.

    best of luck for ur future.

    thanks metrogyl

  4. SummerRain says:

    Unbelievable how much work you put into this work of art. Great job!!

  5. Trader says:

    By the way Eric, anybody who listen to you and bet against USD is in painful situation right now.

    Hope you know it..

  6. Dave Narby says:

    Some great info in here. Not a blog post to digest at one sitting!

    But why screw it up with conspiracy theories? (building 7 http://www.debunking911.com/pull.htm )

    Seems like complete dereliction of duty in permitting abysmally lax security is enough to charge the government regarding 9/11...

  7. Sebastian says:

    By the way Eric, anybody who listen to you and buy gold is laughing all the way to the bank right now.

    Hope you know it..

  8. Robert says:

    Good article. I'm not sure it makes much sense to differentiate between bankers and the government though. Key individuals routinely switch back and forth between both.

  9. kean says:

    W. Cooper didn't think it was about the money either! Behold!

  10. Mark says:

    Does anyone else have the problem I have?

    The column on the right side of the screen is cutting off some of Eric's text - it looks like it is slightly out of position.

  11. Bob says:

    I also have the same problem. The gray boxes holding text are too wide. After investigation, the former posts are OK, the post that says The Unseen Wall Street...is the last post that seems to display fine.

  12. Eric,

    I see that you corrected the margins on one of your other articles but not on this one. Please correct the margins for this article also. It looks like it it is a very informative article, but it is very difficult to read without seeing the last word or words on each line.

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