(The following testimony was submitted on April 13, 1994 to the Committee on Banking, Finance and Urban Affairs, of the U.S. House of Representatives. It was written by Christopher White, contributing editor of Executive Intelligence Review [EIR] magazine, and Richard Freeman, of EIR's economics desk.)
[From the May 30, 1994, The New Federalist.]
It is now just over one year ago since Lyndon LaRouche, the editor of our magazine, put forward a March 9, 1993 proposal to levy a 0.1 percent tax on the sale of all the various mutations of financial transactions known as "derivatives."
The intent of this proposal was to permit constitutionally mandated institutional authorities to regain control over "runaway" deregulated electronic financial market places. The proposal will determine what the magnitude of the threat posed to the generality by derivatives is; and, to create the circumstances in which the structure of derivatives markets might be properly investigated. Moreover, the tax constitutes a precise means to surgically lance and dry out the derivatives bubble, to eliminate it within weeks.
The derivatives market, in which there are $16 trillion in derivatives holdings held by commercial banks and financial institutions in the United States, with an annual turnover trading volume of $300 trillion, is the greatest bubble in history. It dwarfs the Mississippi Bubble in France and the South Sea Island bubble in England. This bubble, like a cancer, has penetrated and taken over the entirety of our banking and credit system; there is no major commercial bank, investment bank, mutual fund, etc. that is not dependent on derivatives for its existence. These derivatives suck the life's blood out of our economy. Our farms, our factories, our nation's infrastructure, our living standards are being sucked dry to pay off interest payments, dividend yields as well as other earnings on the bubble.
Need for action has long been evident. In testimony by these two authors to this committee on October 28, 1993, entitled, "Tax and Dry Out the Derivatives Market, Don't Regulate It," we stressed the necessity of the 0.1 percent tax. On March 28, 1994, the chairman of this committee, Rep. Henry Gonzalez [D-Texas], stated, "I think ultimately the only way you could stop, in fact, overnight [derivatives trading activity, is] if you imposed a 1/10th of 1 percent tax on those transactions. You'd see an immediate deflation."
However, what the violent events over the first three months of this year prove, is that while LaRouche's March 9, 1993 proposal is still vitally essential, it, by itself, will not be sufficient to control the emerging situation. Events have far advanced. The derivatives transactions which are subject to taxation are in the process themselves of collapsing. What is needed now is an answer to the question: Is there life after the derivatives bubble has been and gone?
That which was feared, is in progress. That which the proponents of derivatives insisted could not come to pass, because of their sophisticated methods of "risk assessment" has come to pass. The supposed liquidity of the market, allegedly proved by computer simulations, dried up overnight. The mere catalogue of wreckage shows losses of the size that even a few years ago would have been unthinkable: from the $600 million lost by speculator George Soros's Quantum Fund on one day, Feb. 14, 1994; to the $1 billion loss of Steinhardt Management's hedge fund; to the early April bankruptcy liquidation of the entire market holdings of the $600 million in assets, exotic mortgage securities derivatives of the David J. Askin's Hedge Funds. This same process of mega-losses is occurring around the world.
To those who congratulate themselves that they "got through" this period, we offer this timely warning: Those whom the gods would destroy, they first make mad. This is a systemic crisis; we are now in the midst of an ongoing, snowballing systemic collapse, of which the events of the first quarter of 1994 are merely a tiny foretaste.
It is time that Congress, through its appropriate committees, begins to discuss the question of how our national monetary and financial affairs might be reorganized such that national life can continue, after the collapse of the biggest financial bubble in human history has run its course.
For which reason we append to this statement the vitally necessary draft legislation intended to reorganize the Federal Reserve System, through the re-establishment of a National Bank, the Third such National Bank in the history of the Republic. This is the first order of business.
Such a proposal is consistent with Article 1, Section 8 of the Constitution, in which Congress is allotted the power to raise taxes and create money and credit.
With an ongoing financial collapse, the time has come to reappropriate those powers which from the beginning were allocated, for cause, to the constitutionally created branches of government, that the General Welfare provisions of the Constitution might once more inform the laws of the land in substance as well as intent.
What is now under way can only be efficiently addressed by act of government. There is no private agency which can provide the volume of credit required to ensure the continued functioning of national life. There will shortly be no private agency with credit anywhere in any case. Federal government must again become the sovereign source of credit, in the form of Treasury note issues, providing banking agencies with the means of issue to finance the economic activity of the country, thereby eliminating the subversive "discounting" practices of the Federal Reserve, and the so-called "Keynesian multiplier" methods of money creation through manipulation of federal debt.
The destruction of inflated financial assets over the first three months of the year to date exceeds the havoc wrought by the stock market crash of October 1987. The nominal bill for such "losses" during the first quarter will, in the not-too-distant future, be confirmed to start at about $2 trillion. Such "losses," under detailed investigation, will turn out to be about 14-15 percent of the notional value of all derivatives contracts traded, swapped, or whatever else it is they do with them.
If we, as a country, were not so idiotically attuned to the day- by-day, minute-by-minute jerking around of the "Down-Jones" Index as our basic indicator of the economic health of the universe as a whole, this elementary reality would have been grasped already.
The initial losses of the first quarter are only the beginning. There is the proverbial other shoe left to drop. The "blow off" of the remainder of the bubble is going to make clear that this country has been living in the equivalent of "loud cuckoo land" for about a generation. Over the course of that generation, there have been no "recoveries," there has been no "rebuilding of competitiveness."
There has been looting and asset stripping. There has been economic depression. That is shortly to come to the fore in the kind of rude way which our accumulated national fantasy life, and its televised mirror image, will find impossible to ignore. Obviously those who most violently dispute this now will soon find themselves among the ranks of the most rudely shocked.
The turmoil of the last three months is not a "market correction," despite all the analysts and investment strategists who proclaim about their proverbial 10-15 percent decline blowing the froth off an over-heated "bull-run." Nor is it merely a matter internal to the market. What is going on is without precedent in human history.
There is a global financial collapse in progress -- a global financial collapse which was already in progress before the beginning of the year. From 1993 onward, from Chile, and the case of the Codelco raw materials company; to Argentina, and its bond and stock market; to Venezuela and the case of Banco Latino; to Spain and the multi-hundreds of millions loss of that country's fourth-largest bank, Banesto; to the United Kingdom and the Hong Kong and Shanghai Bank-owned Midland Bank; to France and the case of the multi-billion dollar loss at Credit Lyonnais; to Germany and the $1 billion plus loss at Metallgesellschaft; to the reputed several billion dollar losses at Malaysia's central bank, and the banks of Indonesia.
What is developing is global in scope. The losses are all related to derivatives trading. Sound companies and industrial concerns are being sacrificed to the vagaries of derivatives. Germany's Metallgesellschaft, the country's 14th largest industrial concern, will now lay off one-fifth of its work force, and asset- strip its operations to pay for the loss.
This committee is correct to highlight the activities of the hedge funds. They engage in the most wildly speculative behavior. Hedge funds are, for the most part, offshore, unregulated gambling casinos, relying on mountains of leverage. They are specifically constituted, by having 99 or fewer U.S. investor partners, to circumvent the Investment Company Act of 1940, which would otherwise regulate them. Hedge funds work on anywhere from 5 to 1, up to 50 to 1 leverage. That means for every $1 billion of the hedge fund's own money which it has under management, it borrows from $5 to $50 billion. The over-300 hedge fund's have $75 billion in assets under management, meaning they could control an astounding amount of publicly traded bonds and stocks of anywhere from $375 billion to $3.75 trillion in value. By comparison, the average trading volume on the New York stock exchange is but $11 billion daily.
But every congressman should ask the obvious question: If for every $1 billion the hedge fund puts up, the hedge fund is getting from $5 to $50 billion from someone else, isn't that other party, lending the $5 to $50 billion, far more important? The answer is, of course. The committee must note the dominant role of the commercial banks, especially the Morgan banking group, and the investment banks, who lend the money to the hedge funds, and use the hedge funds as their "bird dogs," having the hedge funds make the speculations that the commercial and investment banks would be too embarrassed to make on their own. Not only that, but every congressman should know that the commercial banks put money from their own accounts into these hedge funds, and it is claimed, put money from the banks' trust departments into these hedge funds.
The largest derivatives trading banks are: Chemical, Citicorp, J.P. Morgan, Bankers Trust, Bank of America, Chase Manhattan, First Chicago, and Republic National Bank of Edmund Safra. Morgan Bank, and the Bankers Trust which it set up in the 1903-07 period, and controls to this day, control together 31 percent of the $12 trillion of derivatives holdings of the major commercial banks. Morgan dominates derivatives trading. Among the investment banks, the largest derivatives traders are: Morgan Stanley; Goldman Sachs; Salomon Brothers; Lehman Brothers and Merrill Lynch. These are the institutions that control the hedge funds. These are the institutions whose activities, above all, must be investigated and controlled.
Moreover, there is an equally huge scandal. It is open knowledge that the entire financial market structure of the United States has been artificially rigged for the last three and a half years. Short-term interest rates were set at 3 percent and long term rates at 6.5 to 7 percent, the largest spread in post-World War II history, to benefit and enrich the commercial and investment banks who made derivatives plays on this spread. The losers on this operation were the American population, which paid dearly to "bail out" the banks.
Oversight on the markets must begin with how the Federal Reserve Board of Governors, and the Federal Reserve Bank of New York, working with the Treasury Department, starting in the Bush administration, rigged this hideous operation.
Thus, the danger of derivatives trading and its damage is not limited to headline catching speculative excesses, and failures, of some outfits like the now notorious, U.S. legal-code-evading "hedge funds." There may be the financial, or electronic, equivalent of dead bodies left by the side of the financial version of the electronic superhighway. But they are the result of a pile-up, not its cause.
The cited cases all involve the use of financial derivatives.
Our estimate of losses sustained during the first quarter of 1994 is not, however, based on adding up reports of losses sustained by individual banks, corporations or funds. The whole so-called asset base on which the derivative bubble depends has been devalued. The ongoing devaluation of assets has set in motion a collapse which proceeds as the so-called leverage, or pyramiding, of the derivatives transactions unwinds. In this it is not only the most egregious which are affected, but all, for all financial assets are being devalued.
The ongoing financial collapse is characterized by the application of "reverse leverage" against those institutions and banks which had resorted to the use of leverage or pyramiding to inflate their so-called gains, or nominal so-called assets.
The increase of interest rates, long-term as well as short-term, has been the trigger for the process by which the bubbled assets have been deflated, and the effects of reverse leverage, unleashed.
For example, there are over $3 trillion of U.S. government securities held by what the Treasury and the Office of Management and the Budget are accustomed to call the "public." Bond yields have risen by almost 20 percent since the beginning of the year, 25 percent since October 1993. Since prices and yields move inversely, it is merely conservative to assume that the face value of the bonds has shrunk by as much as the yields have increased -- $600 billion on that account alone. This would be 100 times what George Soros's Quantum Fund reported its losses to be over the days between Feb. 10 and Feb. 12.
The same approach can be taken to inspect "collateralized mortgage obligations" in their "principal only" and "interest only" strip form. Mortgage rates have risen as fast as have the yields on the Treasury's debt. Municipal bonds, too, and more exotic such instruments as, for example, the secondary market in so-called "emerging country" debt.
Now, U.S. Treasury bonds, whose world-wide daily trading volume was estimated at $300 billion one year ago, increasing by 100 percent and more in the twelve months to February and March in exchanges in Chicago, London and Paris, are the core of the "hedging" operations undertaken by derivatives dealers. Borrow, against bonds, borrowed or held, to finance positions for or against various currencies, "hedged" back into something else, and so on.
It was less than one year ago that the International Swap Dealers' Association began to insist that "notional value" was not a useful way of looking at derivative exposure. Better, they insisted then would be "replacement" cost. This because, even a year ago, the notional sums that had been generated out of whatever electronic device they employ had grown to mind-boggling proportions. "Replacement cost" shrank the numbers back to more manageable proportions.
The difference between the two was a measure of the leverage, or pyramiding, applied from original "position," at cost, borrowed or not, to notional value.
The 20 percent increase in bond yields has undone a lot of the accumulated leverage that has been built into the world monetary system. For example, "hedge funds" can be leveraged up to 100 times, in which case, a 1 percent movement is sufficient to wipe out the collateral or "margin" position. "Hedge funds" disposing, according to "Mar- Hedge" and others, of around $100 billion in total assets, are typically leveraged 10 to 15 times. A movement against them of 6.6 percent to 10 percent on the notional values at stake, wipes out all their margin or collateral.
The matter is not the unwinding of leverage against hedge funds alone, but the whole accumulated mass of some $16 trillion notional so-called value in the United States -- and $25 trillion worldwide -- unwinding against everything else.
The bubble has been premised on a perpetuated fraud about the growth of the earnings of the U.S. economy. There has been no growth in the earnings of the U.S. economy. There has been no growth, not in the U.S. economy, not in the world economy, since the period 1967-70.
The country needs a reorganized, constitutional credit system. It needs such, so that we can begin to do the things which most living Americans are too young to remember their country ever having done. We need to create qualified employment for our people, through rebuilding our basic economic infrastructure in transportation, power generation, and water supply, and in our attenuated capabilities for capital goods production.
Credits issued for such purposes will generate more wealth than their original cost. We can create 6 million productive and decent-paying jobs in infrastructure and manufacturing and agriculture. The world economy must likewise be reorganized around development programs, which Mr. LaRouche has specified. This includes the "Productive Triangle" for the development of the Eurasian land mass, and the "Oasis Plan" for the development of the Middle East. This latter plan, which includes irrigation, and cheap abundant nuclear power, would provide the rock-solid basis for the praiseworthy Israeli-PLO peace process to succeed.
The collapse of the biggest financial bubble in history requires urgent action; it also provides the opportunity to put the country back on its feet, and under its own law.
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