The very public failure of SVB (Silicon Valley Bank) is raising concerns of a renewed wave of bank failures that threatens Western economies. The subtext is residual fear that the earlier (mid-2000’s) bank crisis was never adequately addressed. The very bankers who sank the banking system back then were handed trillions in public largesse to cover their losses, but the system of Wall Street provision of credit to fuel capitalism was never reconsidered. As then Treasury Secretary Timothy Geithner put it, ‘the US doesn’t do nationalization (of banks).’
Part of the political calculus behind the earlier bailouts was the role of Wall Street in support of American imperialism. Neoliberalism was claimed in a constructive way to be ‘war by other means’ because it transferred wealth from the economic periphery to the center without a shot being fired. Trade was to replace warfare went the theory. That the US has been the most capitalist and the most militaristic nation in the world over the last century has done little to discredit this theory amongst true believers. These true believers now run the US.
Following decades of misleading ‘free market’ rhetoric in the US, the Biden administration is currently basing its economic policies in economic warfare with China and Russia, not ‘free’ trade. In fact, the CIA and the MIC were always in the background softening-up reluctant capitalists with cluster bombs and white-phosphorous. Current American logic likely has the Chinese state’s use of state banks to allocate credit as equivalent to the American practice of handing trillions in bailouts to the American bankers that blew up the Western world in 2008.
The collapse and near instantaneous Federal bailout of uninsured depositors at SVB (Silicon Valley Bank) by the Biden administration provides insight into the ongoing role of technology, finance, and the MIC in American governance. Rhetoric around ‘saving the (banking) system’ is the local truth hidden within the larger problem of the failing neoliberal order. The ‘system’ being saved is directly or indirectly tied to American forever wars, environmental decline, a predatory and extractive economic system, and rising political repression.
So, on the one hand, there was a bank (SVB) whose liabilities exceeded its (the bank’s) value that needed to be resolved. On the other hand, there were questions of the role of the banking ‘system’ economically, as well as the broader role of Wall Street, in American imperialism. Prior to 2008 – 2009 there was a long history of bank crises, as well as a set of rules for determining which banks were viable and which weren’t. In 2009, the Obama administration threw this history, and the rules that had previously led to successful resolution of bank crises, in the trash.
Whether SVB’s woes will turn into a larger bank panic is unknown at present. Regardless, and to a point first raised by Krystal Ball, Joe Biden’s decision to bail out uninsured depositors implicitly guarantees all uninsured deposits held by US banks. The alternative was to seize (put into FDIC receivership) SVB and sell its assets to cover insured and uninsured deposits without a bailout. Uninsured depositors would have received 85 – 95 cents on the dollar in that scenario. In fact, this recovery effort is now underway following the Federal bailout.
In other words, without a bailout, the insured depositors in SVB would have gotten all of their money back and uninsured depositors would have received about 90 cents / dollar. This seems like a small price to pay to instill basic due diligence in financial dealings. But those who would have paid the small price are 1) connected through the power of Big Tech and 2) the future ‘innovators’ and ‘disruptors’ that the American state is counting on to surveil and control the rest of the world. While there is context, it is hardly incidental that American liberals are the most vocal proponents of Federal spying, censorship, and political repression in the present.
Joe Biden’s effort to pre-empt bank contagion risk begs the question of how such risk is even possible after the 2008 – 2009 bailouts? In fact, financial economist Hyman Minsky answered this question so long ago that his work was regularly referenced in the crisis of the late 2000’s. Competition amongst banks and bankers to make loans leads to deteriorating credit quality to the point where creditors begin to default, at which point trust in ‘the system’ implodes and a bank panic sets in. This cycle has played out often enough to give credence to Minsky’s theories.
Minsky wasn’t a Marxist critic of capitalism. He was a financial economist who looked at banking and reported what he found. So, while Marx covered similar territory via his theory of ‘fictitious capital,’ adequate regulation of finance would solve Minsky’s credit conundrum, at least in theory. In fact, following the Obama administration’s delivery of several trillion dollars of free money to Wall Street bankers following the 2008 – 2009 crisis, the Federal Reserve and Treasury Department did everything in their power to start another credit cycle.
This was referred to at the time as ‘kicking the can down the road,’ a reference to the temporary nature of the reforms amidst the historical guarantee that the next crisis was in the process of being created. The 2016 election of Donald Trump should have indicated a disconnect between what American elites believed about the state of Western economies and their actual states. Tech and finance have been on Federally sponsored methamphetamine- drips as state-sponsored industries that keep profits private, while socializing their losses. While liberals call this ‘lemon socialism,’ most Americans believe from being told so for the last century that it is plain old socialism.
In 2018 the Trump administration, in response to lobbying from connected bankers, signed legislation reducing the regulation of mid-sized banks, the category into which SVB fit. Left unstated in most accounts is that former Representative Barney Frank— the ‘Frank’ in the Dodd-Frank legislation of 2010, lobbied Congress to undermine his own legislation. Mr. Frank had left Congress to act as a Director of Signature Bank, which recently met a fate similar to SVB on misguided ‘bets’ on cryptocurrency.
The point is being made by defenders of the recent bailouts that SVB rendered itself insolvent while putting bank assets into ‘safe’ investments. In fact, the long-dated treasury bonds it reportedly held rise or fall in value inversely to changes in interest rates. While this may seem technical to readers, managing interest rate risk is one of the most basic functions of managing a bank. Was SVB management gambling on the direction of interest rates with a ‘bet’ large enough to sink the bank, this is evidence of both gross incompetence and regulatory failure.
If memory serves, Yves Smith described SVB as acting as a ‘merchant bank’ serving the technology industry, a reference to the regulatory distinction made in the bank reforms of the Great Depression between insured deposit-holding banks and the investment banks commonly known as Wall Street. Readers may recall the rapid conversion around 2009 of Wall Street investment banks into deposit-holding institutions to render them eligible for Federal bailouts. It is quite ominous if Wall Street has been recreated within ordinary insured deposit-holding institutions.
The case of SVB differs in important ways from the 2008 – 2009 bailouts. Joe Biden apparently understood that it was politically infeasible to bail out SVB stock and bond holders— as Obama / Biden did in 2008 – 2009, so it was apparently acceptable for SVB management to pay out large bonuses and sell its bank stock holdings in the days and weeks prior to entering Federal receivership. Like the AIG bonuses paid to the crooks who wrote financial insurance contracts without funding them, SVB can explain the bonuses without legitimating them. That SVB management screwed up a ‘duration’ (interest rate) bet suggests rank incompetence.
As should be evident, these serial ‘system’ bailouts don’t save the system, they create a new one. SVB arose in the aftermath of the 2008 – 2009 bank bailouts, at which time Big Tech was viewed by the Obama administration as an imperial prong. Behind the neoliberal rhetoric of ‘free markets’ is American imperialism, the unity of state with corporate objectives to project ‘American’ power around the world. This worked domestically as long as the New Deal provided a few facts and the appearance of economic unity through ‘nation.’
That accommodation— where working people fought and died for national objectives as long as the bounty from doing so was equitably distributed, disappeared when US imperialism was (once again) turned inward in the late 1970s. Passage of NAFTA (1994), and China being granted full privileges in the WTO (World Trade Organization, 2001), created a new proletariat in the US. Then George W. Bush lied (2003) this new proletariat into killing and dying in Iraq to boost the value of Dick Cheney’s stock options, followed by Barack Obama’s Wall Street bailouts that were inexcusably corrupt by historical standards.
This may read as unduly judgmental absent knowledge of the history of bank crises. The problem from history with ‘saving’ corrupt bankers is that they corrupt the credit allocation function of Western capitalism through fraud and self-dealing. As was the practice with investment banks, SVB reportedly strong-armed the companies it had merchant banking relationships with to hold their deposits at SVB. Assurances from banking industry apologists that SVB management will spend the rest of its life in litigation imagine that the US prosecutes bankers. Not in recent history.
This brief run-down of banking industry travails is an analog to the 1970s television show ‘Lifestyles of the Rich and Famous.’ The question of how actual human beings who weren’t born into the bailout-receiving class are getting by isn’t being asked. In fact, the economic metrics by which the US measures itself are showing signs of age. While running the interest rate desk at Goldman Sachs and working the cash register at Walgreens are both jobs, one pays more than a living wage and the other pays quite a bit less. So, counting ‘jobs’ is less than informative in a world where working doesn’t always pay.
In the part of the US that I inhabit, the Northeast, middle and lower tier house prices have doubled and tripled over the last three years. They have continued to rise despite interest rate increases by the Federal Reserve that historically would have tamped house prices down. Beginning around 2010, Wall Street banks began using nearly free Federal bailout funds to buy the houses then being foreclosed on by their mortgage divisions. Since the mid-2010’s ‘portfolio buyers’ for Wall Street and AIRBNB have bid up house prices beyond the reach of the locals who are their ‘natural’ buyers.
The policy choices that followed the 2008 financial crisis and Great Recession— a decade of the Federal Reserve keeping interest rates below their ‘natural’ or ‘market’ rates through what is called financial repression, created a ‘search for yield’ that led those hoping to invest the new money being created by the Fed (through its support for financial asset prices) to take ever larger risks to find it. The ‘everything bubble’ was the result. Financial asset and house prices exploded higher to surpass what just a decade ago was understood to be the largest and most destructive financial bubble in modern history.
To understand the problem, the Wall Street and ‘portfolio’ buyers of the homes that people need to live in are working from different economics. The Wall Street buyers are looking at thirty-year discounted cash-flow models while ordinary citizens are limited to the amount of credit their incomes are deemed by mortgage lenders to support. A $100,000 house to working people may be worth $250,000 using a discounted cash-flow model. The result: Wall Street (including AIRBNB listers) has bought most of the available housing stock that has been for sale in recent years.
However, the difference in risk of borrowing $250K to buy a house versus $100k is immense when multiplied by the quantity of houses sold in recent years. The capitalist theory that something is worth what someone will pay for it leaves pricing power out of consideration. Wall Street buyers get an ‘inside’ interest rate that is usually very far below that paid by ordinary borrowers despite the regular implosion of Wall Street via bank crises. Absent geographic or sectoral concentration amongst ordinary homebuyers, only Wall Street is subject to the systemic risk that is the target of Federal bailouts.
The point is that facilitating the purchase of critical infrastructure— and housing is critical infrastructure, by Wall Street is predatory, short-sighted, and systemically de-stabilizing. Permitting unlicensed hotels (AIRBNB), unlicensed taxis (Uber), and the systematic refusal to collect state and local taxes for online purchases (Amazon), reflects a contrived and wholly nonsensical ‘individualist’ ethos of capitalism where individuals born into the bailed-out class effectively govern the US. This is the political context in which Joe Biden bailed out corrupt and / or incompetent bank managers and corporate depositors at SVB.
Political architecture where a small group of politicians, oligarchs, and corporate executives erase the lines between corporate and state interests to use state resources for their own benefit while treating the populace as rubes and marks deserving of being preyed upon 1) reasonably well describes the US at present and 2) fits the definition of Italian fascism as state corporatism. Add in unhinged militarism motivated by imperialist objectives and ‘liberal democracy’ looks and feels like fascism to those on its receiving end.
It is clear that this view of the architecture isn’t widely shared, with most Americans relying on the imagined choice that voting for duopoly party candidates provides. Missing from that view is the proletarianization of the US that has taken place over the last five decades, with the exception being the PMC (Professional-Managerial Class), which manages state and corporate affairs for the rich. The genesis of the PMC in service to power has it parroting the logic of the rich in exchange for privileges that the remaining 85% of the population doesn’t receive.
SVB, like SBF (Sam Bankman Fried) of crypto infamy before it, is a weathervane helpful for reading the direction of the prevailing winds, but not a whole lot more. The system that produced it is coming unglued, with mass Covid deaths far out of proportion to the size of the population, failing healthcare and banking systems, a proxy war underway that risks nuclear annihilation, and a government that sees its role as working with corporations to loot the world. Underestimate the risk of truly horrific outcomes at your own peril.
Last, on a personal note, I, and most of the people I know, are so angry about this state of affairs that I don’t see how existing political unions hold. The people running the country never cared much about us, but unity in ‘nation’ led to a sense of shared interests that disappeared with the neoliberal turn. As I’ve written before, revolutionaries don’t make revolutions, existing power does. While I’m not holding my breath, if the current political leadership doesn’t lead to a revolution, revolution isn’t possible.
Why the Banking System is Breaking Up
The collapses of Silvergate and Silicon Valley Bank are like icebergs calving off from the Antarctic glacier. The financial analogy to the global warming causing this collapse is the rising temperature of interest rates, which spiked last Thursday and Friday to close at 4.60 percent for the U.S. Treasury’s two-year bonds. Bank depositors meanwhile were still being paid only 0.2 percent on their deposits. That has led to a steady withdrawal of funds from banks – and a corresponding decline in commercial bank balances with the Federal Reserve.
Most media reports reflect a prayer that the bank runs will be localized, as if there is no context or environmental cause. There is general embarrassment to explain how the breakup of banks that is now gaining momentum is the result of the way that the Obama Administration bailed out the banks in 2009. Fifteen years of Quantitative Easing has re-inflated prices for packaged bank mortgages – and with them, housing prices, stock and bond prices.
The Fed’s $9 trillion of QE (not counted as part of the budget deficit) fueled an asset-price inflation that made trillions of dollars for holders of financial assets, with a generous spillover effect for the remaining members of the top Ten Percent. The cost of home ownership soared by capitalizing mortgages at falling interest rates into more highly debt-leveraged property. The U.S. economy experienced the largest bond-market boom in history as interest rates fell below 1 percent. The economy polarized between the creditor positive-net-worth class and the rest of the economy – whose analogy to environmental pollution and global warming was debt pollution.
In Killing the Host I wrote about what seemed obvious enough. Rising interest rates cause the prices of bonds already issued to fall – along with real estate and stock prices. That is what has been happening under the Fed’s fight against “inflation,” its euphemism for opposing rising employment and wage levels. Prices are plunging for bonds, and also for the capitalized value of packaged mortgages and other securities in which banks hold their assets on their balance sheet to back their deposits.
The result threatens to push down bank assets below their deposit liabilities, wiping out their net worth – their stockholder equity. This is what was threatened in 2008. It is what occurred in a more extreme way with S&Ls and savings banks in the 1980s, leading to their demise. These “financial intermediaries” did not create credit as commercial banks can do, but lent deposits out in the form of long-term mortgages at fixed interest rates, often for 30 years. But in the wake of the Volcker spike in interest rates that inaugurated the 1980s, the overall level of interest rates remained higher than the interest rates that S&Ls and savings banks were receiving.
Depositors began to withdraw their money to get higher returns elsewhere, because S&Ls and savings banks could not pay their depositors higher rates out of the revenue coming in from their mortgages fixed at lower rates. So even without fraud Keating-style, the mismatch between short-term liabilities and long-term interest rates ended their business plan.
The S&Ls owed money to depositors short-term, but were locked into long-term assets at falling prices. Of course, S&L mortgages were much longer-term than was the case for commercial banks. But the effect of rising interest rates has the same effect on bank assets that it has on all financial assets. Just as the QE interest-rate decline aimed to bolster the banks, its reversal today must have the opposite effect. And if banks have made bad derivatives trades, they’re in trouble.
Any bank has a problem of keeping its asset valuations higher than its deposit liabilities. When the Fed raises interest rates sharply enough to crash bond prices, the banking system’s asset structure weakens. That is the corner into which the Fed has painted the economy by QE.
The Fed recognizes this inherent problem, of course. That is why it avoided raising interest rates for so long – until the wage-earning bottom 99 Percent began to benefit by the recovery in employment. When wages began to recover, the Fed could not resist fighting the usual class war against labor. But in doing so, its policy has turned into a war against the banking system as well.
Silvergate was the first to go, but it was a special case. It had sought to ride the cryptocurrency wave by serving as a bank for various currencies. After SBF’s vast fraud was exposed, there was a run on cryptocurrencies. Investor/gamblers jumped ship. The crypto-managers had to pay by drawing down the deposits they had at Silverlake. It went under.
Silvergate’s failure destroyed the great illusion of cryptocurrency deposits. The popular impression was that crypto provided an alternative to commercial banks and “fiat currency.” But what could crypto funds invest in to back their coin purchases, if not bank deposits and government securities or private stocks and bonds? What is crypto, ultimately, if not simply a mutual fund with secrecy of ownership to protect money launderers?
Silicon Valley Bank also is in many ways a special case, given its specialized lending to IT startups. New Republic bank also has suffered a run, and it too is specialized, lending to wealthy depositors in the San Francisco and northern California area. But a bank run was being talked up last week, and financial markets were shaken up as bond prices declined when Fed Chairman Jerome Powell announced that he actually planned to raise interest rates even more than he earlier had targeted. Rising employment rates make wage earners more uppity in their demands to at least keep up with the inflation caused by the U.S. sanctions against Russian energy and food and the actions by monopolies to raise prices “to anticipate the coming inflation.” Wages have not kept pace with the resulting high inflation rates.
It looks like Silicon Valley Bank will have to liquidate its securities at a loss. Probably it will be taken over by a larger bank, but the entire financial system is being squeezed. Reuters reported on Friday that bank reserves at the Fed were plunging. That hardly is surprising, as banks are enjoying record interest rate spreads. No wonder well-to-do investors are running from the banks.
The obvious question is why the Fed doesn’t simply bail out banks in SVB’s position. The answer is that the lower prices for financial assets looks like the New Normal. For banks with negative equity, how can solvency be resolved without sharply reducing interest rates to restore the 15-year Zero Interest-Rate Policy (ZIRP)?
There is an even larger elephant in the room: derivatives. Volatility increased last Thursday and Friday. The turmoil has reached vast magnitudes beyond what characterized the 2008 crash of AIG and other speculators. Today, JP Morgan Chase and other New York banks have tens of trillions of dollar valuations of derivatives – casino bets on which way interest rates, bond prices, stock prices and other measures will change.
For every winning guess, there is a loser. When trillions of dollars are bet on, some bank trader is bound to wind up with a loss that can easily wipe out the bank’s entire net equity.
There is now a flight to “cash,” to a safe haven – something even better than cash: U.S. Treasury securities. Despite the talk of Republicans refusing to raise the debt ceiling, the Treasury can always print the money to pay its bondholders. It looks like the Treasury will become the new depository of choice for those who have the financial resources. Bank deposits will fall. And with them, bank holdings of reserves at the Fed.
So far, the stock market has resisted following the plunge in bond prices. My guess is that we will now see the Great Unwinding of the great Fictitious Capital boom of 2008-2015. So the chickens are coming home to roost – with the “chicken” being, perhaps, the elephantine overhang of derivatives fueled by the post-2008 loosening of financial regulation and risk analysis.
The Looming Quadrillion Dollar Derivatives Tsunami
“Financial Weapons of Mass Destruction”
By Ellen Brown
On Friday, March 10, Silicon Valley Bank (SVB) collapsed and was taken over by federal regulators. SVB was the 16th largest bank in the country and its bankruptcy was the second largest in U.S. history, following Washington Mutual in 2008. Despite its size, SVB was not a “systemically important financial institution” (SIFI) as defined in the Dodd-Frank Act, which requires insolvent SIFIs to “bail in” the money of their creditors to recapitalize themselves.
Technically, the cutoff for SIFIs is $250 billion in assets. However, the reason they are called “systemically important” is not their asset size but the fact that their failure could bring down the whole financial system. That designation comes chiefly from their exposure to derivatives, the global casino that is so highly interconnected that it is a “house of cards.” Pull out one card and the whole house collapses. SVB held $27.7 billion in derivatives, no small sum, but it is only 0.05% of the $55,387 billion ($55.387 trillion) held by JPMorgan, the largest U.S. derivatives bank.
SVB could be the canary in the coal mine foreshadowing the fate of other over-extended banks, but its collapse is not the sort of “systemic risk” predicted to trigger “contagion.” As reported by CNN:
“Despite initial panic on Wall Street, analysts said SVB’s collapse is unlikely to set off the kind of domino effect that gripped the banking industry during the financial crisis.
‘The system is as well-capitalized and liquid as it has ever been,’ Moody’s chief economist Mark Zandi said. ‘The banks that are now in trouble are much too small to be a meaningful threat to the broader system.’
No later than Monday morning, all insured depositors will have full access to their insured deposits, according to the FDIC. It will pay uninsured depositors an ‘advance dividend within the next week.’”
A fuller report on the collapse of SVB will have to wait on developments that occur over the weekend and soon thereafter.
This column, meanwhile, focuses on derivatives and is a followup to my Feb. 23 column on the “bail in” provisions of the 2010 Dodd Frank Act, which eliminated taxpayer bailouts by requiring insolvent SIFIs to recapitalize themselves with the funds of their creditors. “Creditors” are defined to include depositors, but deposits under $250,000 are protected by FDIC insurance. However, the FDIC fund is sufficient to cover only about 2% of the $9.6 trillion in U.S. insured deposits. A nationwide crisis triggering bank runs across the country, as happened in the early 1930s, would wipe out the fund. Today, some financial pundits are predicting a crisis of that magnitude in the quadrillion dollar-plus derivatives market, due to rapidly rising interest rates. This column looks at how likely that is and what can be done either to prevent it or dodge out of the way.
“Financial Weapons of Mass Destruction”
In 2002, mega-investor Warren Buffett wrote that derivatives were “financial weapons of mass destruction.” At that time, their total “notional” value (the value of the underlying assets from which the “derivatives” were “derived”) was estimated at $56 trillion. Investopedia reported in May 2022 that the derivatives bubble had reached an estimated $600 trillion according to the Bank for International Settlements (BIS), and that the total is often estimated at over $1 quadrillion. No one knows for sure, because most of the trades are done privately.
As of the third quarter of 2022, according to the “Quarterly Report on Bank Trading and Derivatives Activities” of the Office of the Comptroller of the Currency (the federal bank regulator), a total of 1,211 insured U.S. national and state commercial banks and savings associations held derivatives, but 88.6% of these were concentrated in only four large banks: J.P. Morgan Chase ($54.3 trillion), Goldman Sachs ($51 trillion), Citibank ($46 trillion), Bank of America ($21.6 trillion), followed by Wells Fargo ($12.2 trillion). A full list is here. Unlike in 2008-09, when the big derivative concerns were mortgage-backed securities and credit default swaps, today the largest and riskiest category is interest rate products.
The original purpose of derivatives was to help farmers and other producers manage the risks of dramatic changes in the markets for raw materials. But in recent times they have exploded into powerful vehicles for leveraged speculation (borrowing to gamble). In their basic form, derivatives are just bets – a giant casino in which players hedge against a variety of changes in market conditions (interest rates, exchange rates, defaults, etc.). They are sold as insurance against risk, which is passed off to the counterparty to the bet. But the risk is still there, and if the counterparty can’t pay, both parties lose. In “systemically important” situations, the government winds up footing the bill.
Like at a race track, players can bet although they have no interest in the underlying asset (the horse). This has allowed derivative bets to grow to many times global GDP and has added another element of risk: if you don’t own the barn on which you are betting, the temptation is there to burn down the barn to get the insurance. The financial entities taking these bets typically hedge by betting both ways, and they are highly interconnected. If counterparties don’t get paid, they can’t pay their own counterparties, and the whole system can go down very quickly, a systemic risk called “the domino effect.”
That is why insolvent SIFIs had to be bailed out in the Global Financial Crisis (GFC) of 2007-09, first with $700 billion of taxpayer money and then by the Federal Reserve with “quantitative easing.” Derivatives were at the heart of that crisis. Lehman Brothers was one of the derivative entities with bets across the system. So was insurance company AIG, which managed to survive due to a whopping $182 billion bailout from the U.S. Treasury; but Lehman was considered too weakly collateralized to salvage. It went down, and the Great Recession followed.
Risks Hidden in the Shadows
Derivatives are largely a creation of the “shadow banking” system, a group of financial intermediaries that facilitates the creation of credit globally but whose members are not subject to regulatory oversight. The shadow banking system also includes unregulated activities by regulated institutions. It includes the repo market, which evolved as a sort of pawn shop for large institutional investors with more than $250,000 to deposit. The repo market is a safe place for these lenders, including pension funds and the U.S. Treasury, to park their money and earn a bit of interest. But its safety is insured not by the FDIC but by sound collateral posted by the borrowers, preferably in the form of federal securities.
“This banking system (the “shadow” or “parallel” banking system) – repo based on securitization – is a genuine banking system, as large as the traditional, regulated banking system. It is of critical importance to the economy because it is the funding basis for the traditional banking system. Without it, traditional banks will not lend and credit, which is essential for job creation, will not be created.”
While it is true that banks create the money they lend simply by writing loans into the accounts of their borrowers, they still need liquidity to clear withdrawals; and for that they largely rely on the repo market, which has a daily turnover just in the U.S. of over $1 trillion. British financial commentator Alasdair MacLeod observes that the derivatives market was built on cheap repo credit. But interest rates have shot up and credit is no longer cheap, even for financial institutions.
According to a December 2022 report by the BIS, $80 trillion in foreign exchange derivatives that are off-balance-sheet (documented only in the footnotes of bank reports) are about to reset (roll over at higher interest rates). Financial commentator George Gammon discusses the threat this poses in a podcast he calls, “BIS Warns of 2023 Black Swan – A Derivatives Time Bomb.” Another time bomb in the news is Credit Suisse, a giant Swiss derivatives bank that was hit with an $88 billion run on its deposits by large institutional investors late in 2022. The bank was bailed out by the Swiss National Bank through swap lines with the U.S. Federal Reserve at 3.33% interest.
The Perverse Incentives Created by “Safe Harbor” in Bankruptcy
In The New Financial Deal: Understanding the Dodd-Frank Act and Its (Unintended) Consequences, Prof. David Skeel refutes what he calls the “Lehman myth”—the widespread belief that Lehman’s collapse resulted from the decision to allow it to fail. He blames the 2005 safe harbor amendment to the bankruptcy law, which says that the collateral posted by insolvent borrowers for both repo loans and derivatives has “safe harbor” status exempting it from recovery by the bankruptcy court. When Lehman appeared to be in trouble, the repo and derivatives traders all rushed to claim the collateral before it ran out, and the court had no power to stop them.
So why not repeal the amendment? In a 2014 article titled “The Roots of Shadow Banking,” Prof. Enrico Perotti of the University of Amsterdam explained that the safe harbor exemption is a critical feature of the shadow banking system, one it needs to function. Like traditional banks, shadow banks create credit in the form of loans backed by “demandable debt”—short-term loans or deposits that can be recalled on demand. In the traditional banking system, the promise that the depositor can get his money back on demand is made credible by government-backed deposit insurance and access to central bank funding. The shadow banks needed their own variant of “demandable debt,” and they got it through the privilege of “super-priority” in bankruptcy. Perotti wrote:
Safe harbor status grants the privilege of being excluded from mandatory stay, and basically all other restrictions. Safe harbor lenders, which at present include repos and derivative margins, can immediately repossess and resell pledged collateral. This gives repos and derivatives extraordinary super-priority over all other claims, including tax and wage claims, deposits, real secured credit and insurance claims. [Emphasis added.]
The dilemma of our current banking system is that lenders won’t advance the short-term liquidity needed to fund repo loans without an ironclad guarantee; but the guarantee that makes the lender’s money safe makes the system itself very risky. When a debtor appears to be on shaky ground, there will be a predictable stampede by favored creditors to grab the collateral, in a rush for the exits that can propel an otherwise-viable debtor into bankruptcy; and that is what happened to Lehman Brothers.
Derivatives were granted “safe harbor” because allowing them to fail was also considered a systemic risk. It could trigger the “domino effect,” taking the whole system down. The error, says Prof. Skeel, was in passage of the 2005 safe harbor amendment. But the problem with repealing it now is that we will get the domino effect, in the collapse of both the quadrillion dollar derivatives market and the more than trillion dollars traded daily in the repo market.
The Interest Rate Shock
Interest rate derivatives are particularly vulnerable in today’s high interest rate environment. From March 2022 to February 2023, the prime rate (the rate banks charge their best customers) shot up from 3.5% to 7.75%, a radical jump. Market analyst Stephanie Pomboy calls it an “interest rate shock.” It won’t really hit the market until variable-rate contracts reset, but $1 trillion in U.S. corporate contracts are due to reset this year, another trillion next year, and another trillion the year after that.
A few bank bankruptcies are manageable, but an interest rate shock to the massive derivatives market could take down the whole economy. As Michael Snyder wrote in a 2013 article titled “A Chilling Warning About Interest Rate Derivatives:”
Will rapidly rising interest rates rip through the U.S. financial system like a giant lawnmower blade? Yes, the U.S. economy survived much higher interest rates in the past, but at that time there were not hundreds of trillions of dollars worth of interest rate derivatives hanging over our financial system like a Sword of Damocles.
… [R]ising interest rates could burst the derivatives bubble and cause “massive bankruptcies around the globe” [quoting Mexican billionaire Hugo Salinas Price]. Of course there are a whole lot of people out there that would be quite glad to see the “too big to fail” banks go bankrupt, but the truth is that if they go down, our entire economy will go down with them. … Our entire economic system is based on credit, and just like we saw back in 2008, if the big banks start failing, credit freezes up and suddenly nobody can get any money for anything.
There are safer ways to design the banking system, but they are not likely to be in place before the quadrillion dollar derivatives bubble bursts. Snyder was writing 10 years ago, and it hasn’t burst yet; but this was chiefly because the Fed came through with the “Fed Put” – the presumption that it would backstop “the market” in any sort of financial crisis. It has performed as expected until now, but the Fed Put has stripped it of its “independence” and its ability to perform its legislated duties. This is a complicated subject, but two excellent books on it are Nik Bhatia’s Layered Money (2021) and Lev Menand’s The Fed Unbound: Central Banking in a Time of Crisis (2022).
Today the Fed appears to be regaining its independence by intentionally killing the Fed Put, with its push to raise interest rates. (See my earlier article here.) It is still backstopping the offshore dollar market with “swap lines,” arrangements between central banks of two countries to keep currency available for member banks, but the latest swap line rate for the European Central Bank is a pricey 4.83%. No more “free lunch” for the banks.
Alternatives that have been proposed for unwinding the massive derivatives bubble include repealing the safe harbor amendment and imposing a financial transaction tax, typically a 0.1% tax on all financial trades. But those proposals have been around for years and Congress has not taken up the call. Rather than waiting for Congress to act, many commentators say we need to form our own parallel alternative monetary systems.
Crypto proponents see promise in Bitcoin; but as Alastair MacLeod observes, Bitcoin’s price is too volatile for it to serve as a national or global reserve currency, and it does not have the status of enforceable legal tender. MacLeod’s preferred alternative is a gold-backed currency, not of the 19th century variety that led to bank runs when the banks ran out of gold, but of the sort now being proposed by Sergey Glazyev for the Eurasian Economic Union. The price of gold would be a yardstick for valuing national currencies, and physical gold could be used as a settlement medium to clear trade balances.
Lev Menand, author of The Fed Unbound, is an Associate Professor at Columbia Law School who has worked at the New York Fed and the U.S. Treasury. Addressing the problem of the out-of-control unregulated shadow banking system, he stated in a July 2022 interview with The Hill, “I think that one of the great possible reforms is the public banking movement and the replication of successful public bank enterprises that we have now in some places, or that we’ve had in the past.”
Certainly, for our local government deposits, public banks are an important solution. State and local governments typically have far more than $250,000 deposited in SIFI banks, but local legislators consider them protected because they are “collateralized.” In California, for example, banks taking state deposits must back them with collateral equal to 110% of the deposits themselves. The problem is that derivative and repo claimants with “supra-priority” can wipe out the entirety of a bankrupt bank’s collateral before other “secured” depositors have access to it.
Our tax dollars should be working for us in our own communities, not capitalizing failing SIFIs on Wall Street. Our stellar (and only) state-owned model is the Bank of North Dakota, which carried North Dakota through the 2008-09 financial crisis with flying colors. Post-GFC (the Global Financial Crisis of ’07-’09), it earned record profits reinvesting the state’s revenues in the state, while big commercial banks lost billions in the speculative markets. Several state legislatures currently have bills on their books following the North Dakota precedent.
For a federal workaround, we could follow the lead of Jesse Jones’ Reconstruction Finance Corporation, which funded the New Deal that pulled the country out of the Great Depression. A bill for a national investment bank currently in Congress that has widespread support is based on that very effective model, avoiding the need to increase taxes or the federal debt.
All those alternatives, however, depend on legislation, which may be too late. Meanwhile, self-sufficient “intentional” communities are growing in popularity, if that option is available to you. Community currencies, including digital currencies, can be used for trade. They can be “Labor Dollars” or “Food Dollars” backed by the goods and services for which the community has agreed to accept them. (See my earlier article here.) The technology now exists to form a network of community cryptocurrencies that are asset-backed and privacy-protected, but that is a subject for another column.
The current financial system is fragile, volatile and vulnerable to systemic shocks. It is due for a reset, but we need to ensure that the system is changed in a way that works for the people whose labor and credit support it. Our hard-earned deposits are now the banks’ only source of cheap liquidity. We can leverage that power by collaborating in a way that serves the public interest.
Ellen Brown is an attorney, chair of the Public Banking Institute, and author of thirteen books including Web of Debt, The Public Bank Solution, and Banking on the People: Democratizing Money in the Digital Age. She also co-hosts a radio program on PRN.FM called “It’s Our Money.” Her 400+ blog articles are posted at EllenBrown.com. She is a regular contributor to Global Research.