Madoff et consortes

The sentencing of Bernard Madoff to 150 years in prison and confiscation of his wealth deserves a thought. Madoff's financial empire was a pyramid scheme. However there is nothing special or unique about it. In fact the entire financial system was turned into a giant global pyramid scheme. (This has been proved in the first article on this blog: ”The Largest Heist in History".) What Madoff was doing was not practically different from the way the entire global financial system was operated.

From Madoff’s case perspective, thousands, if not tens of thousands, of financiers, basically a huge number of "who-is-who" of the financial world who were authorising and overlooking lending with loan to deposit ratio above 100%, should be jailed like Madoff (and their wealth should be confiscated too). Lending with loan to deposit ratio above 100% was the mechanism that turned the financial system into a giant, global, pyramid scheme, i.e. it was a global equivalent of the Madoff business modus operandi.

Similarly regulators and politicians responsible for overseeing the financial markets must be treated in the same way as Madoff. All that the District Judge Denny Chin said about Madoff apply also, literally, to the entire financial establishment.

However the financial and political establishments feel comfortable. They are "saving the world" now. Why can "poor" Madoff not get away with a simple and relatively small (compared to the financial system) case of pyramid scheme, whilst individuals that engineered, operated and overlooked a massive global pyramid scheme walk free with little prospect of being brought to book? Maybe, in this context, it is not completely incidental that whilst bankers, regulators and politicians have been presiding over the financial pyramid scheme that has been defrauding "the little people", Madoff applied the same financial practices to "the rich and powerful".

(Subsequently on 7 July 2009, Dr Vincent Cable MP published in The Daily Mail an article "Thinking of turning to crime? Become a fat-cat fraudster and the law will leave you alone". It is strongly recommended.)

Credit Default Swaps (CDS) – a financial pyramid stabilisation system

As it has been proven in the first article of this blog, "The Largest Heist in History", the current financial and resulting economic crises are the effects of turning the financial system into a global pyramid scheme. The mechanism of this pyramid building was lending by financial institutions with loan to deposit ratios above 100%. This destroyed a long standing and proven practice of fractional reserve banking that was used to control credit supply. With loan to deposit ratio above 100%, a money multiplier was infinity (and the multiplication was happening with exponential pace). This resulted in a pyramid scheme that depleted the banking system from cash reserves and ballooned the banks balance sheets. These sheets represented bogus assets of ultimately very little, if any, market value, having been the product of pyramid scheme building process. Pyramids are bound to collapse as otherwise the banks' balance sheets would have grown unrestricted extremely quickly to massive numbers.

Credit Default Swaps are good examples of financial pyramid stabilisation system that lets it grow bigger than it would have otherwise and delays the collapse. In practical terms this risk management instrument, together with lending with loan to deposit ratio above 100%, is a lethal combination. A financial nuclear bomb. This comparison is particularly representative since similarly to chain reaction, a pyramid growth has exponential characteristics.

When a financial institution buys CDS' (from various other institutions) as an insurance against defaults on credits it granted, it spreads the risk of default on these credits amongst those institutions. When they resell them further in whole or in part, again to various other institutions, they propagate the risk further. At the limit, this way the entire system is covered by every single institution for a default on every single credit. It looks almost an ideal scenario: whenever any creditor, large or small, defaults everyone is coughing up a little bit to cover for it according to its committed resources and adopted risk profile. This way the financial pyramid grows being stabilised in the process. Whenever in multiple deposit creation cycle a default occurs on any credit, the entire system intervenes and absorbs it and the pyramid keeps on growing at exponential pace. Together with it, the value of CDS' sold keeps growing too. Even perversely, at times, over-supply of CDS’ onto the market was, in part, also driving supply of cheap, subprime, credit thereby accelerating a pyramid growth.

However since any financial pyramid is bound to collapse, at some point a default or a sequence of defaults becomes too big even for the entire system to absorb. One can say that a default size exceeds a critical mass which triggers a chain reaction of collapse. In the context of the current financial crisis, it appears that it was Lehman Brothers default that provided critical mass for chain reaction of the current liquidity crisis leading to the economic crisis as the banks stopped lending and the governments pumped enormous amounts of monies. Time will only show whether this huge money sarcophagus over the financial pyramid will stop the chain reaction inside or whether the chain reaction was simply slowed for the time being and will gather the pace again. In any event, not dissimilar to Chernobyl, the world will live with the consequences for many years ahead.

Financial non-reality

In the recent articles on the current financial crisis, The Economist moved into a realm of non-reality. It is assessing the state of the world economy through a debt lens. Indeed normally it would have been a prudent and respectable approach. However with the current state of financial markets it simply does not make sense as banks’ books are over-flooded with toxic waste. And, for instance, the British government does not even know the scale of this.

The current financial crisis was caused by a collapse of the giant global pyramid scheme. Its collapse triggered a liquidity crisis and governments pumped trillions of dollars to plug a liquidity whole. There is a very sexy name for describing this action: a stimulus package. In fact it was no different than if the Albanian government had subsidised their own gangsters when their pyramid collapsed in 1996 – 1997. Yet the global pyramid, or rather a network of interconnected banking pyramids, did not collapse completely. There are still a few (at least one, most likely around five to six) quadrillions of dollars of toxic waste which at present are as much of the liability to the global economy as world’s debt. Therefore for The Economist’s analysis to make sense, one has to add at least one or two quadrillions of dollars to the world debt data.

The world’s GDP is just over $50 trillion. Hence it is completely unrealistic to exect that the world will ever be able to catch up with a few quadrillions. Quantitative easing (i.e. printing money) is only shifting the problem into the future and onto the consumers markets. It may be possible to print enough cash to plug the liquidity hole but then that cash would have flooded the markets triggering a hyperinflation.

However for the time being, the financiers, i.e. pyramid purveyors, seem to understand this game. That is why they limit the volume of toxic waste they convert into cash. And financial markets look seemingly quite stable. They know that if they cashed too much of the worthless papers too quickly, another liquidity crisis, like the ones in October 2008 or January 2009, would have happened. The corollary is that now these financiers control the world taxpayers in the same way as loan-scammers control their “debtors”. The toxic waste allows them the pump out as much money from the economy as they wish, but at the same time they know that they must not go into excess so as to keep it optimally going for them. Similarly the aim of a loan-scammer is not to finish off a “debtor” but to make him pay forever as much as possible. It appears that in this spirit, or maybe in a state of sheer oblivion, The Economist is arguing for less wasteful economic system that would ultimately benefit the pyramid purveyors.

In theory such arrangements can go on forever. There are many “debtors” trapped by scammers for life. In time the financial system, through financial instruments, will be as much of the public expenditure round as health, defence, education, etc. putting a massive squeeze on them. However this would not be legitimate public expenditure. This would be money extorted by pyramid purveyors. In practice however they must realise that in democratic societies such arrangements are unlikely to go on forever. Therefore it is quite likely that sooner rather than later, a financier, from one bank or another, is going to lose his nerves – or will want to be ahead of others, or just get better year-end bonus - and will trigger another liquidity crisis. This may be one too many.

The 1930’s crisis ended in 1939. The current crisis is also going to end at some point. It is not so much interesting when, but how. Especially that it also appears that the US might have its cunning plan.