Friday, April 23, 2010

Mysterious X-37B unmanned space shuttle launched by U.S. ... and they won't say what it's for

A top secret space plane developed by the US military has blasted off from Cape Canaveral on its maiden voyage.

Billed as a small shuttle, the unmanned X-37B heralds the next generation of space exploration. It will be the first craft to carry out an autonomous re-entry in the history of the US programme.

But its mission - and its cost - remain shrouded in secrecy. The Air Force said the launch was a success but would give no further details.

The X-37B sits on top of an Atlas V rocket as it's launched at Cape Canaveral Air Force Station in Florida

Lift off: The X-37B sits on top of an Atlas V rocket as it's launched at Cape Canaveral Air Force Station in Florida


Ready for launch: The X-37B rocket in Florida tonight

'Well, you can't hide a space launch, so at some point extra security doesn't do you any good,' said Gary Payton, Air Force deputy under-secretary for space systems.

He remained cagey about what exactly the X-37B is to do.

'On this flight the main thing we want to emphasise is the vehicle itself, not really, what's going on in the on-orbit phase because the vehicle itself is the piece of news here,' was all he would say.

The X-37B Orbital Test Vehicle took a decade to develop and will spend up to nine months in orbit. It will re-enter Earth on autopilot and land like an ordinary plane at the Vandenberg Air Force Base, California.


Mystery: A handout shows scientists working on the prototype for the rocket prior to its launch


A computer graphic shows what the X-37B will look like in space. It's wingspan is a mere 4.5 metres with a length of 8.9 metres

When exactly that will happen, however, even the Air Force can't predict.

'In all honesty, we don't know when it's coming back for sure,' Payton said. 'It depends on the progress we make with the on-orbit experiments and the on-orbit demonstrations.'

The spacecraft will conduct classified experiments while in orbit. The military still has not revealed what those experiments will entail.

Payton said the Air Force's main interest is to test the craft's automated flight control system and learn about the cost of turning it around for launch again.

The X-37B is 9m long (29ft) and has a wingspan of 4.5m (15ft), making it a quarter of the size of a normal shuttle.

It is powered by a solar array and lithium-ion batteries, unlike a traditional craft which is powered by a fuel cell system.The spaceplane is also reusable.


Built by Boeing's Phantom Works division, the X-37 program was originally headed by NASA. It was later turned over to the Pentagon's research and development arm and then to a secretive Air Force unit.

Hundreds of millions of dollars have been spent on the project, but the current total has not been released.

'After a tumultuous history of sponsorship, it's great to see the X37 finally get to the launch pad and get into space,' Payton said.

The Air Force has given a very general description of the mission objectives: testing of guidance, navigation, control, thermal protection and autonomous operation in orbit, re-entry and landing.

However, the ultimate purpose of the X-37B and details about the craft have longed remained a mystery, though experts said the spacecraft was intended to speed up development of combat-support systems and weapons systems.


Secret: It is still unclear what kind of experiments will be conducted onboard

Earth Day

Just need to get something off my chest here.

Your elected officials do not care about the earth. This needs to be reiterated. There is no love for the earth from these individuals. Sure, they come out and say recycle, change your light bulbs, blah blah blah…but it is merely lip service.

These people are against natural law. What am I talking about, you ask. Surely it is good to recycle and do our part.


Natural law is defeated via genetically modified crops and the chemicals used to sustain said crops.

With Tom Vilsack and Islam A. Siddiqui are within the Obama administration, Monsanto has friends in the Obama administration.

You cannot be a friend to the earth and support these policies. You have no labeling, no choice. The food supply is tainted by chemicals and GMO’s…yet they insist on environmental policy. This is a joke. The FDA wants to crack down on salt, which has me laughing and wondering how much more ridiculous this can get.

*Quietly wonders if Monsanto is developing a new form of salt.*

Address the faults of the FDA and USDA regarding GMOs, antibiotics in milk, tainted food…then maybe I can take you seriously.

Until then, this administration is an enemy of the earth, not a friend.

Oh, might want to check up what Monsanto’s Round-Up does to frogs. Yeah, friends of the earth. Quit kidding yourselves. You can recycle all you want to, but the simple fact is that the true, nefarious reasons for the destruction of this planet remain woefully hidden.

Richard Koo Says If Banks Marked Commercial Real Estate To Market,It Would "Trigger A Chain Of Bankruptcies"

Richard Koo's latest observations on the US economy are as always, a must read. The critical observation from the Nomura economist explains why the realists and the naive idealists are at greater odds than ever before: the government continues to perpetuate, endorse and legalize accounting fraud in the hope that covering everything up under the rug will rekindle animal spirits. The truth, as Koo points out, is that were the FASB to show the real sad state of affairs, the two core industries in the US - finance and real estate, would be bankrupt. "If US authorities were to require banks to mark their commercial real estate loans to market today, lending to this sector would be extinguished, triggering a chain of bankruptcies as borrowers became unable to roll over their debt." In other news Citi, Bank of America, and Wells just reported fantastic earnings beats on the heels of reduced credit loss provisions. Nothing on the conference call mentioned the fact that all would be bankrupt if there was an ounce of integrity left in financial reporting, and that every firm is committing FASB-complicit 10(b)-5 fraud. One day, just like Goldman's mortgage follies, all this will be the subject of epic lawsuits. But not yet. There is some more money to be stolen from the middle class first, by these very firms.

Some other observations on the greatest game of extend and pretend from the well-respected economist:

Fed understands risks of too-rapid bad loan disposals

Mr. Bernanke also emphasized that the Fed is making serious efforts to address credit supply problems—ie, the credit crunch.
The Fed chairman understands that an exclusive focus by bank examiners on uncovering bad loans could leave banks reluctant to lend, thereby sparking a “bank inspector recession” and delaying the recovery. To prevent this scenario, Mr. Bernanke says he has instructed Fed bank inspectors to ensure that banks are lending to creditworthy borrowers. In ordinary times, the Fed would seek to have banks write off their non-performing loans as quickly as possible. This is the correct approach when there are only a handful of distressed lenders. But during a systemic crisis, when many banks face the same problems, forcing lenders to rush ahead with bad loan disposals (ie, sales) can trigger a further decline in asset prices, creating more bad loans and sending the economy into a tailspin.

I think the Fed’s shift in focus from conventional nonperforming loan disposals to credit crunch prevention is an attempt to avoid this scenario.

Fed retraining bank examiners in bad loan management

Perhaps based on an awareness of Japan’s failures in this area, the US has not only made public a list of items bank examiners are to focus on, but is also retraining its examiners in a bid to keep them on the right track. Roughly 1,000 inspectors have already completed the retraining.

Among other things, the retraining program teaches examiners how to modify loans to troubled borrowers and how to manage distressed commercial real estate loans. In that sense, it is a far cry from traditional training, which emphasized the quick discovery and disposal of nonperforming loans.

Full Koo note:

h/t Jake

Firm used debt proceeds for strippers, payroll?

NEW YORK (Reuters) – The Securities and Exchange Commission filed an emergency enforcement action on Tuesday to halt an alleged fraudulent scheme by two owners of an Albany, New York, brokerage who sold debt in unregistered offerings and used the proceeds for its operations and to hire strippers.

Chairman Timothy McGinn and President David Smith, owners of McGinn, Smith & Co Inc, sold about $120 million in more than 25 unregistered debt offerings, according to a complaint filed in a New York federal court.

The proceeds, not enough to repay investors their principal or interest payments, went to supporting the firm's struggling operations and to meet payroll, the SEC said.

They also used funds to hire strippers for a "sexually themed cruise" and other personal activities.

"McGinn and Smith deceived investors about the true purpose behind these offerings," said Andrew Calamari, associate director of the SEC's New York regional office. "They falsely promised investors a profitable payday but secretly siphoned off money for their own payroll."

No one answered the telephone at the McGinn Smith office.

According to the complaint, debt offerings were sold to hundreds of investors through four funds and at least 18 trusts created by McGinn Smith.

Smith funneled most the proceeds into business entities that he, McGinn or another partner either controlled or in which they had financial interests. Regulators said most of these related companies were in poor financial condition.

Smith allegedly directed $17 million to these related companies and made $34 million in loans, of which $22 million remains unpaid.

Investor funds were used to pay exorbitant commission and transaction fees to their affiliated entities and make interest payments to investors in the other entities.

The SEC's filing comes a day after the Financial Industry Regulatory Authority (FINRA) filed a securities complaint accusing the firm and Smith with fraud in the sale of $89 million in unregistered securities.

The firm and Smith misused investor funds and violated securities registration rules, FINRA said. Smith was charged with misleading investors.

Smith and McGinn moreover were charged with providing FINRA staff with falsified documents. FINRA said that the securities were not registered and were not eligible for an exemption.

Securities regulators have been cracking down on private placement fraud.

(Reporting by Joseph A. Giannone; editing by Carol Bishopric and Robert MacMillan)

How an Economy Grows and Why It Crashes (by Peter Schiff) - Lew Rockwell

Click this link .......

Jim Rogers: Next Recession Will Be Much Worse: Gold: Silver: Dollar

Click this link ......

Paulson's Hedge Fund Made Billions on Subprime Crisis

Hedge fund manager John Paulson’s company reportedly made billions shorting the subprime mortgages packaged and sold by Goldman Sachs — which is now facing fraud charges by the Securities and Exchange Commission.

Paulson began betting against subprime mortgages as early as 2006, setting up two funds focused for that purpose.

At the time, the bet seemed highly contrarian: Big firms like Merrill Lynch and Citigroup were gorging on enormous profits by packaging and trading blocks of risky home loans, The New York Times reports.

According to The Wall Street Journal, two of the points of contention in the SEC's securities fraud charges against the investment bank are whether Goldman misrepresented Paulson's investment objectives, and the extent of Paulson's role in selecting the securities that went into the mortgage-backed product Goldman marketed and sold to investors.

Goldman, the SEC complaint says, "misled ACA into believing that Paulson was investing in the equity of ABACUS 2007-ACI and therefore shared a long interest with CDO investors."

The complaint also alleges that Paulson "heavily influenced the selection of the portfolio" for the CDO. However, Paulson, who isn't charged in the case, said in a statement that portfolio selection agent ACA Management LLC "had sole authority over the selection of all collateral in the CDO."

Those securities were later rated AAA by credit rating agencies.

"Paulson has never misrepresented our positions to any counterparties," the company’s statement said, adding that "the vast majority of people in the market thought we were dead wrong."

© Moneynews. All rights reserved.

Progenitorivox, or, The More I Know About Health In America....

...the funnier this video gets? Or is it actually, 'The Less I Know About...'?

Be seeing you.

U.S. Realeases New $100 Bill (Pics)

The U.S. Treasury refreshes its currency every once in a while to stay a step ahead of counterfeiters, and this time they’re refreshing the new $100 bill. The new bill will contain a security feature called Motion, where each bill will contain up to 650,000 microlenses embedded in the printing which will allow for an underlying image to shift when the bill is moved. Yep, good old Benjamin Franklin is getting a facelift and here it is.

Highlights of the new bill:

- 3-D Security Ribbon
- Bell in the inkwell. When you move the note, the bell changes color from copper to green.
- Portrait watermark
- Security Thread
- Color-shifting “100″

- The new note will be issued on February 10, 2011

Some facts about the U.S. $100 bill:

- There are about 6.5 billion in circulation. That’s $650,000,000,000
- The average $100 bill is replaced every 5 years due to wear
- It is one of only two banknotes that do not feature a president
- The first $100 bill was issued in 1862
- The time on the clock on Independence Hall on the back side of the bill reads 4:10

Civil suit filed against former Hawaii priest for sex assault of teen

A former Roman Catholic priest who was sentenced to 20 years in prison in 2000 for sexually abusing a 13-year-old O'ahu boy is at the center of a civil lawsuit filed yesterday in Denver, Colo.

The lawsuit alleges Mark Matson repeatedly assaulted a 15-year old boy while the teen was attending St. Andrews Seminary in Denver in 1976.

The lawsuit was filed on behalf of the former student, identified only as "John Doe," who is now 49 years old and a resident of the Denver area. The complaint contends that when the student confronted Matson about a series of sexual assaults, the priest claimed to have found marijuana in the boy's belongings and had him expelled from the Denver seminary.

The lawsuit was filed by Mermelstein & Horowitz, a Miami law firm specializing in representing child sexual assault victims.

Matson was a chaplain at Tripler Army Medical Center before the Hawai'i crimes occurred in August 1998.

During his criminal trial in Honolulu, the victim testified Matson was showing him magic tricks about levitating when he started fondling him. Matson denied molesting the boy.

Matson remains behind bars at the Halawa Correctional Facility and is scheduled for release in 2020.

Are Interest Rate Derivatives a Ticking Time Bomb?

Derivatives are the world's largest market, dwarfing the size of the bond market and world's real economy.

The derivatives market is currently at around $600 trillion or so (in gross notional value).

In contrast, the size of the worldwide bond market (total debt outstanding) as of 2009 was an estimated $82.2 trillion.

And the CIA Fact Book puts the world economy at $58.07 trillion in 2009 (at official exchange rates).

Interest rate derivatives, in turn, are by far the most popular type of derivative.

As Wikipedia notes:

The interest rate derivatives market is the largest derivatives market in the world. The Bank for International Settlements estimates that the notional amount outstanding in June 2009 were US$437 trillion for OTC interest rate contracts, and US$342 trillion for OTC interest rate swaps. According to the International Swaps and Derivatives Association, 80% of the world's top 500 companies as of April 2003 used interest rate derivatives to control their cashflows.
So interest rate derivatives are the world's largest market.

The largest interest rate derivatives sellers include Barclays, Deutsche Bank, Goldman and JP Morgan. While the CDS market is dominated by American banks, the interest rate derivatives market is more international.

In comparison to the almost $500 trillion in interest rate derivatives, BIS estimates that there were "only" $36 trillion in credit default swaps as of June 2009. Credit default swaps were largely responsible for bringing down Bear Stearns, AIG (and see this), WaMu and other mammoth corporations.

Where's the Danger?

In 2003, John Hussman wrote:
What is not so obvious is the extent to which the U.S. economy and financial markets are betting on the continuation of unusually low short-term interest rates and a steep yield curve. This doesn't necessarily resolve into immediate risks, but it could profoundly affect the path that the economy and financial markets take during the next few years, by making the unwinding of debt much more abrupt.

In response to very low short-term interest rates, many U.S. corporations have swapped their long-term (fixed interest rate) debt into short-term (floating interest rate) debt, to the extent that an increase in short-term rates could substantially raise default risks. Similarly, a growing proportion of homeowners have refinanced their mortgages into adjustable rate structures that are also sensitive to higher short-term yields. Finally, profitability in the banking system is unusually dependent on a steep yield curve, with a widening net interest margin (the difference between long-term rates banks charge borrowers and the lower short-term rates they pay depositors) ...


According Bank for International Settlements, the U.S. interest rate swap market [has] nearly doubled in size in the past two years. The reason this figure is so enormous is that there are usually several links in the chain from borrower to investor. A risky borrower may enter a swap with bank A, which then takes an offsetting swap position with bank B (earning a bit of the credit spread as its compensation), and so on, with a cheerful money market investor at the end of the chain holding a safe, government backed security, oblivious to the chain of counterparty risk in between.

Aside from the risk that any particular link in this chain might be weak (know thy counterparty), the U.S. financial system has gone one step further. In order to hedge against the risk of defaults, banks frequently lay credit risk off by entering “credit default swaps” with other banks or insurance companies. These swaps essentially act as insurance policies for credit risk.


In short, the U.S. financial system is in a delicate balance. On the issuer side, a great many borrowers have linked their debt obligations to short-term interest rates. This is tolerated by the financial system because the debt has been swapped out through financial intermediaries, so investors get to hold relatively safe instruments like bank deposits and Fannie Mae securities. This mountain of debt in the U.S. financial system - tied to short-term interest rates - is ultimately and perhaps somewhat inadvertently backed by the U.S. government.

On the investor side, Asian governments intent on holding their currencies down relative to the U.S. dollar have purchased a great deal of U.S. government and agency debt – effectively “buying dollars.” ... A reduction of demand for U.S. short-term debt, either by foreign governments (particularly in the event that Asian governments decide to revalue their currencies) or by U.S. investors, could have very undesirable consequences.

All of which is why the U.S. is now extremely dependent on short-term interest rates remaining low indefinitely.

In March 2009, Martin Weiss wrote:

Until the third quarter of last year, the banks’ losses in derivatives were almost entirely confined to credit default swaps — bets on failing companies and sinking investments.

But credit default swaps are actually a much smaller sector, representing only 7.8 percent of the total derivatives market.


Thus, considering their far larger volume, any threat to interest rate derivatives could be far more serious than anything we’ve seen so far.

And Monday, Jerome Corsi argued that cities, states and universities might be wiped out by changes in interest rates:

As interest rates begin to rise worldwide, losses in derivatives may end up bankrupting a wide range of institutions, including municipalities, state governments, major insurance companies

, top investment houses, commercial banks and universities.

Defaults now beginning to occur in a number of European cities prefigure what may end up being the largest financial bubble ever to burst – a bubble that today amounts to more than $600 trillion.


A popular form of derivative contracts was developed to permit one money manager to "swap" a stream of variable interest payments with another money manager for a stream of fixed interest payments.

The idea was to use derivative bets on interest rates to "hedge" or balance off the risks taken on interest-rate investments owned in the underlying portfolio.

If an institutional investment manager held $100 million in fixed-rate bonds, for example, to hedge the risk, should interest rates rise or fall in a manner different than projections, a purchase of a $100 million variable interest rate derivative could be constructed to cover the risk.

Whichever way interest rates went, one side to the swap might win and the other might lose.

The money manager losing the bet could expect to get paid on the derivative to compensate for some or all of the losses.

In the strong stock and mortgage markets experienced beginning in the historically low 1-percent interest rate environments of 2003 through 2004, the number of hedge funds soared, just as the volume of derivative contracts soared from a mere $300 trillion in 2005 to the more than $600 trillion today.

Unsophisticated Entities Getting Taken by Interest Rate Derivatives Salesmen

In 2008, Bloomberg pointed out that the SEC was investigating shady interest rate derivatives sales by JP Morgan and Morgan Stanley to school districts.

In 2009, New York Times writer Floyd Norris noted:

On the front page of The Times today, Don van Natta Jr. has a good article about the woes of little towns and counties in Tennessee that bought interest-rate derivatives sold by Morgan Keegan, an investment bank based in Memphis.

It turns out that these municipalities did not understand the risks they were taking. The derivatives have now blown up, and the officials are blaming the bank.

Matt Taibbi also recently noted that JP Morgan used interest rate swaps to decimate a small Alabama town:

The initial estimate for this project was $250 million. They ended up spending about $3 billion on this. And they ended up owing about $5 billion in the end, after you look at all the refinancing and the interest rate swaps and everything.
As the Bloomberg, Times and Taibbi stories hint, many unsophisticated schools, cities, states and universities were played by the big interest rate derivatives sellers, just as many people were played by the CDS sellers. So the fallout will likely be substantial.

Indeed, Larry Summers lost virtually all of Harvard University's endowments using interest rate swap derivatives. Summers is the guy who is now running the U.S. economy.

But Aren't Interest Rate Derivatives Straightforward and Useful?

You might assume that interest rate derivatives appear to have a much more straightforward, legitimate business purpose than credit default swaps.

Interest rate derivatives certainly help many individual businesses control and hedge their costs. And they may be more straightforward and transparent than CDS.

But people tend to overestimate their ability to understand complex financial instruments. For example, the credit default swap salespeople and their bosses didn't really didn't understand CDS.

And - because the market for interest rate derivatives dwarfs the market for CDS - the reduced risks of each transaction might be collectively offset by the tremendous number of transactions and the gigantic size of the market as a whole.

In addition, when a bunch of individuals all attempt to reduce their risks at the same time in the same way, it can increase the risk to the overall system.

As George Soros pointed out in 1994, the excessive use of hedging can and often does backfire:

I must state at the outset that I am in fundamental disagreement with the prevailing wisdom. The generally accepted theory is that financial markets tend toward equilibrium and, on the whole, discount the future correctly. I operate using a different theory, according to which financial markets cannot possibly discount the future correctly because they do not merely discount the future; they help to shape it. In certain circumstances, financial markets can affect the so-called fundamentals which they are supposed to reflect. When that happens, markets enter into a state of dynamic disequilibrium and behave quite differently from what would be considered normal by the theory of efficient markets. Such boom/bust sequences do not arise very often, but when they do they can be very disruptive, exactly because they affect the fundamentals of the economy…

The trouble with derivative instruments is that those who issue them usually protect themselves against losses by engaging in so-called delta, or dynamic, hedging. Dynamic hedging means, in effect, that if the market moves against the issuer, the issuer is forced to move in the same direction as the market, and thereby amplify the initial price disturbance. As long as price changes are continuous, no great harm is done, except perhaps to create higher volatility, which in turn increases the demand for derivatives instruments. But if there is an overwhelming amount of dynamic hedging done in the same direction, price movements may become discontinuous. This raises the specter of financial dislocation. Those who need to engage in dynamic hedging, but cannot execute their orders, may suffer catastrophic losses.

This is what happened in the stock market crash of 1987. The main culprit was the excessive use of portfolio insurance. Portfolio insurance was nothing but a method of dynamic hedging. The authorities have since introduced regulations, so-called 'circuit breakers', which render portfolio insurance impractical, but other instruments which rely on dynamic hedging have mushroomed. They play a much bigger role in the interest rate market than in the stock market, and it is the role in the interest rate market which has been most turbulent in recent weeks.

Dynamic hedging has the effect of transferring risk from customers to the market makers and when market makers all want to delta hedge in the same direction at the same time, there are no takers on the other side and the market breaks down.

The explosive growth in derivative instruments holds other dangers. There are so many of them, and some of them are so esoteric, that the risks involved may not be properly understood even by the most sophisticated of investors. Some of these instruments appear to be specifically designed to enable institutional investors to take gambles which they would otherwise not be permitted to take ....

Doug Noland wrote an intriguing article in 2001 - based on the research of Bruce Jacobs (doctorate in finance from Wharton, co-founder of Jacobs and Levy Equity Management) on portfolio insurance - arguing that interest rate derivatives were widely being used without understanding the risks they create for the system (warning: this is long ... go get some caffeine, sugar, nicotine or exercise, and then come back and keep reading):

I would like to suggest moving Bruce Jacobs' excellent book, Capital Ideas and Market Realities to the top of reading lists. From the forward by Nobel Laureate Harry M. Markowitz: "Many observers, including Dr., Jacobs and me, believe that the severity of the 1987 crash was due, in large part, to the use before and during the crash of an option replication strategy known as 'portfolio insurance.' In this book, Dr. Jacobs describes the procedures and rationale of portfolio insurance, its effect on the market, and whether it would have been desirable for the investor even if it had worked. He also discusses 'sons of portfolio insurance," and procedures with similar objectives and possibly similar effects on markets, in existence today."

From Dr. Jacobs' introduction: "This book ... examines how some investment strategies, especially those based on theories that ignore the human element, can self-destruct, taking markets down with them. Ironically, the greatest danger has often come from strategies that purport to reduce the risk of investing.


"In 1987, as in 1998, strategies supported by the best that finance theory had to offer were overwhelmed by the oldest of human instincts - survival. In 1929, in 1987, and in 1998, strategies that required mechanistic, forced selling of securities, regardless of market conditions, added to market turmoil and helped to turn market downturns into crashes. Ironically, in 1987 and 1998, those strategies had held out the promise of reducing the risk of investing. Instead, they ended up increasing risk for all investors."


I would like to explore the concepts behind the current dangerous fad of derivatives as a mechanism to insure against rising interest rates, as well as the momentous ramifications to both financial market and economic stability from these instruments that rely on dynamic hedging strategies. From Jacobs: "Option replication requires trend-following behavior - selling as the market falls and buying as it rises. Thus, when substantial numbers of investors are replicating options, their trading alone can exaggerate market trends. Furthermore, the trading activity of option replicators can have insidious effects on other investors."

Dr. Jacobs adeptly makes the important point that the availability of portfolio insurance during the mid-1980s played a significant role in fostering speculation that led to the stock market bubble and the crash that followed in October 1987. "Rather than retrenching and reducing their stock allocations, these investors had retained or even increased their equity exposures, placing even more upward pressure on stock prices. And, of course, as equity prices rose more, 'insured' portfolios bought more stock, causing prices to rise even higher…Ironically, the dynamic trading required by option replication had created the very conditions portfolio insurance had been designed to protect against - volatility and instability in underlying equity markets.And, tragically, portfolio insurance failed under these conditions (because…it was not true insurance). The volatility created by the strategy's dynamic hedging spelled its end."


"In the months following the (1987) crash, a number of investigative reports examined the trading data for the crash period. The Securities and Exchange Commission and the Brady Commission (the Presidential Task Force), for two, found that the evidence implicated portfolio insurance as a prime culprit." ...

Dr. Jacobs' wonderful effort explains ... the potential dangers of a complex financial theory taken up with little appreciation of its suitability for real-world conditions and applied mechanistically with little regard for its potential effects. It is a story about how a relatively small group of operators, in today's complicated and interconnected marketplaces, can wreak havoc out of all proportion to their numbers…it is a story of unintended consequences. For synthetic portfolio insurance, although born from the tenets of market efficiency, affected markets in very inefficient, destabilizing ways. And option replication, although envisioned as a means for investors to transfer and thereby reduce unwanted risk, came to be a source of risk for all market participants."

Unfortunately, this language seems at least as applicable to today's interest rate derivative market as it was for equity portfolio insurance. It is certainly our view that the contemporary U.S. and global financial system characterized by unfettered money, credit and speculative excess creates unprecedented risk for all market participants, as well as citizens both at home and abroad. Not only have flawed theories prevailed and past crises been readily ignored, derivatives (interest rate in particular) have come to play a much greater role throughout the U.S. and global financial system. The proliferation of derivative trading is a key element fostering credit excess and a critical aspect of the monetary processes that fuel recurring boom and bust dynamics, as well as the general instability wrought by enormous financial sector leveraging and sophisticated speculative strategies. This certainly makes the proliferation of interest rate derivatives significantly more dangerous than stock market derivatives. Under these circumstances, it does seem rather curious that more don't seriously question the soundness of this unrelenting derivative expansion. Unfortunately, ignoring the dysfunctional nature of the current system does not assist in its rectification - anything but. Indeed, it is my view that these previous market dislocations will prove but harbingers of a potentially much more problematic crisis that is quietly fermenting in the U.S. (global) credit system.


Clearly, the gigantic interest rate derivative market should be recognized as a very unusual beast. Instead of providing true interest rate hedging protection, this is clearly the financial sector having created a sophisticated mechanism that, despite its appearance, is limited to little more than "self insurance" - "The Son of Portfolio Insurance." I have written repeatedly that markets cannot hedge themselves, and that derivative "insurance" is different in several critical respects from traditional insurance. From Dr. Jacobs: "Synthetic portfolio insurance differs from traditional insurance where numerous insured parties each pay an explicit, predetermined premium to an insurance company, which accepts the independent risks of such unforeseeable events as theft or fire. The traditional insurer pools the risks of many participants and is obligated, and in general able, to draw on these premiums and accumulated reserves, as necessary, to reimburse losses. Synthetic portfolio insurance also differs critically from real options, where the option seller, for a premium, takes on the risk of market moves." Such exposure to unrelated events is far different from exposure to a market dislocation. Quoting leading proponents of portfolio insurance from 1985, "it doesn't matter that formal insurance policies are not available. The mathematics of finance provide the answer…The bottom line is that financial catastrophes can be avoided at a relatively insignificant cost."

Amazingly, such thinking persists to this day. The above language, of course, is all too similar to the flawed analysis/erroneous propaganda that is the foundation for the proliferation of hedging strategies and the explosion of derivative positions. Dynamic hedging makes two quite bold assumptions that become even more audacious as derivative positions balloon: continuous markets and liquidity. As writers of technology puts ...experienced, individual stocks often gap down significantly on earnings or other disappointing news, not affording the opportunity to short the underlying stock at levels necessary to successfully hedge exposure. And when the entire technology sector was in freefall, market illiquidity made it impossible for players to dynamically hedge the enormous amount of technology derivatives (put options) that had been written over the boom (especially during the final stage of gross speculation). The buying power necessary to absorb the massive shorting necessary for derivative players to offload exposure (through shorting stocks or futures) was nowhere to be found - so much for assumptions.

Granted, derivatives can be a very effective mechanism for individual participants to shift risk to others, but a proliferation of these strategies significantly influences their effectiveness and general impact. The availability of inexpensive "insurance" heightens the appetite for risk and exacerbates the boom. This characteristic has significant ramifications for both the financial system and real economy. It also creates completely unrealistic expectations for the amount of market risk that can be absorbed/shifted come the inevitable market downturn. Many adopt strategies to purchase insurance at the first signs of market stress. Once again, the market cannot hedge itself, and the tendency is for derivative markets operating in a speculative environment to transfer risk specifically to financial players with little capacity to provide protection in the event of severe financial market crisis.


There is another key factor that greatly accentuates today's risk of a serous market dislocation, that was actually noted by the BIS: "Net repayments of US government debt have affected the liquidity of the US government bond market and the effectiveness of traditional hedging vehicles, such as cash market securities or government bond futures, encouraging market participants to switch to more effective hedging instruments, such as interest rate swaps."

This is actually a very interesting statement from the BIS. First, it is an acknowledgement that "liquidity" and the "effectiveness of traditional hedging vehicles" have been impaired, concurrently with the exponential growth of outstanding derivative positions. This is not a healthy divergence. We have posited that the explosion in private sector debt, having been the leading factor fueling U.S. government surpluses, has produced The Great Distortion. As such, the viability of hedging strategies such as those that entailed massive Treasury securities sales in 1994 is today suspect. There are fewer Treasuries and a much less liquid Treasury market, in the face of unimaginable increases in risky private-sector securities and hedging vehicles. And while this momentous development has not yet created significant market disruption, the true test will come in an environment of generally increasing interest rates. Rising market rates will dictate hedging-related securities sales, and will test the liquidity assumptions that lie at the heart of derivative strategies. It is certainly my view that models that rely on historical relationships between public and private debt are increasingly inappropriate in today's bubble environment, as are the associated assumptions of marketplace liquidity. Importantly, dynamically shorting securities in the liquid Treasuries market is no longer a viable method for the financial sector to hedge the enormous interest rate risk that they have created. The "answer" to this dilemma, apparently, has been an explosion of "more effective hedging instruments, such as interest rate swaps (from the BIS)." We very much question the use of the adjective "effective." ...

All the same, the interest rate swaps market remains Wall Street's favorite "Son of Portfolio Insurance." A similar pre-'87 Crash perception of a "free lunch" conveniently opens the door to playing aggressively in a speculative market. But an interest rate swap is only a contact to exchange a stream of cash flows, generally with one party agreeing to pay a fixed rate and the other party a floating rate (settling the difference with periodic cash payments). With characteristics of writing an option, the risk of loss is open ended for those taking the floating side of the swap trade. There's no magic here, with one party a loser in this contract in the event of a significant jump in market rates. In such an event, this "loser" will certainly plan to dynamically hedge escalating exposure. If you are on the "winning" side, you had better accept the fact that the greater your "win," the higher the probability of a counterparty default. Somewhere along the line, these hedging strategies must be capable of generating the necessary cash flow to pay on derivative "insurance" in the event of higher interest rates. Obviously, the highly leveraged and exposed financial institutions that comprise the swaps market have little capacity to provide true insurance. In a rising rate environment, these players will have enough problems of their own making as they are forced to deal with their own bloated balance sheets, mark-to-market losses [what a quaint notion], and other interest rate mismatches, let alone enormous off-balance sheet exposure. As I have written previously, purchasing large amounts of protection against sharply higher interest rates from the U.S. financial sector makes about as much sense as the failed strategy of contracting with Russian banks for protection against a collapse in the ruble. Sure, one can play this game, but we are all left to hope that the circumstances never develop where there is a need to collect on these policies.

At some point, higher interest rates will force the financial sector to short securities to dynamically hedge the massive interest rate exposure that has been created. What securities will be sold and from where will buyers be found with the necessary $100s ($ trillion plus?) of billions of liquidity? Will agency securities be aggressively shorted? What are the ramifications of such a development to a market that is almost certainly highly leveraged with enormous speculative trading? I can assure you that these are questions that the derivative players would rather not contemplate, let alone discuss. ...

The problem is that the strong perception that has developed that holds that the Fed will ensure that interest rates and liquidity conditions remain market friendly is actually the key assumption fostering the explosion in interest rate derivatives and reckless risk-taking. It should be clear that the assumptions of liquidity make no sense whatsoever without the unspoken assurances from the Federal Reserve. The resulting proliferation of derivatives, then, has played a momentous role in the intermediation process whereby endless risky loans are transformed into "safe" securities and "money." The credit system's newfound and virtually unlimited capability of fabricating "safe" securities and instruments is the mechanism providing unbounded availability of credit - the hallmark of "New Age Finance." It is the unbounded availability of credit that, at this very late stage of the cycle, that creates extreme risk of dangerous financial and economic distortions, including the distinct possibility of heightened inflationary pressures. Ironically, the proliferation of interest rate derivatives has created the very conditions that they had been designed to protect against - volatility and instability in the underlying credit market, as well as acute vulnerability to the real economy.


The bad news is that there sure is a lot riding on what appears to be one massive and increasingly vulnerable speculation and derivative bubble that fuel the perpetuation of the historic U.S. Credit Bubble. I have said before that I see the current bets placed in the U.S. interest rate market as probably "history's most crowded trade."


Most economists and financial institutions assume that interest rate derivatives help to stabilize the economy.

But cumulatively, they can actually increase risky behavior, just as portfolio insurance previously did. As Nassim Taleb has shown, behavior which appears to decrease risk can actually mask long-term risks and lead to huge blow ups.

Moreover, there is a real danger of too many people using the same strategy at once. As economist Blake LeBaron discovered last year, when everyone is on the same side of a trade, it will likely lead to a crash:

During the run-up to a crash, population diversity falls. Agents begin using very similar trading strategies as their common good performance is reinforced. This makes the population very brittle...

Given that the market for interest rate derivatives is orders of magnitude larger than credit default swap market - let alone portfolio insurance - the risks of a "black swan" event based on interest rate derivatives should be taken seriously.

Anything that is orders of magnitude larger than the global economy could be risky - one unforeseen event and things could destabilize very quickly. Too much of anything can be dangerous. Water is essential for life ... but too much and you drown.

But I am confident that no one - even the people that design, sell or write about the various interest rate derivatives - really know how much of a danger they do or don't pose to the overall economy. In addition to all of the other complexities of the instruments, the very size of the market is unprecedented. Independent risk analysts would do a great service if they quantified and modeled the risk.

Finally, even if the widespread use of interest rate derivatives does not harm the economy as a whole, it will certainly harm the cities, states and other governmental and quasi-governmental entities which are on the wrong side of the trade. My hunch is that - just as the fraud in the CDO and CDS markets was exposed when the "water level" of the economy fell, exposing the rocks underneath - rising interest rates will reveal massive fraud in the interest rate derivative market.

Now we know the truth. The financial meltdown wasn't a mistake – it was a con

Hiding behind the complexities of our financial system, banks and other institutions are being accused of fraud and deception, with Goldman Sachs just the latest in the spotlight. This has become the most pressing election issue of all

Goldman Sachs DC Offices protest
Goldman Sachs was in the spotlight last November when demonstrators protested outside its Washington offices against executive bonuses. Photograph: Andrew Harrer/Bloomberg via Getty Images

The global financial crisis, it is now clear, was caused not just by the bankers' colossal mismanagement. No, it was due also to the new financial complexity offering up the opportunity for widespread, systemic fraud. Friday's announcement that the world's most famous investment bank, Goldman Sachs, is to face civil charges for fraud brought by the American regulator is but the latest of a series of investigations that have been launched, arrests made and charges made against financial institutions around the world. Big Finance in the 21st century turns out to have been Big Fraud. Yet Britain, centre of the world financial system, has not yet levelled charges against any bank; all that we've seen is the allegation of a high-level insider dealing ring which, embarrassingly, involves a banker advising the government. We have to live with the fiction that our banks and bankers are whiter than white, and any attempt to investigate them and their institutions will lead to a mass exodus to the mountains of Switzerland. The politicians of the Labour and Tory party alike are Bambis amid the wolves.

Just consider the roll call beyond Goldman Sachs. In Ireland Sean FitzPatrick, the ex-chair of the Anglo Irish bank was arrested last month and questioned over alleged fraud. In Iceland last week a dossier assembled by its parliament on the Icelandic banks – huge lenders in Britain – was handed to its public prosecution service. A court-appointed examiner found that collapsed investment bank Lehman knowingly manipulated its balance sheet to make it look stronger than it was – accounts originally audited by the British firm Ernst and Young and given the legal green light by the British firm Linklaters. In Switzerland UBS has been defending itself from the US's Internal Revenue Service for allegedly running 17,000 offshore accounts to evade tax. Be sure there are more revelations to come – except in saintly Britain.

Beneath the complexity, the charges are all rooted in the same phenomenon – deception. Somebody, somewhere, was knowingly fooled by banks and bankers – sometimes governments over tax, sometimes regulators and investors over the probity of balance sheets and profits and sometimes, as the Securities and Exchange Commission (SEC) says in Goldman's case, by creating a scheme to enrich one favoured investor at the expense of others – including, via RBS, the British taxpayer. Along the way there is a long list of so-called "entrepreneurs" and "innovators" who were offered loans that should never have been made. Lloyd Blankfein, Goldman's CEO, remarked only semi-ironically that his bank was doing God's work. He must wake up every day bitterly regretting the words ever emerged from his mouth.

For the Goldmans case is in some ways the most damaging. The Icelandic banks, Anglo Irish bank and Lehman were all involved in opaque deals and rank bad lending decisions – but Goldman allegedly went one step further, according to the SEC actively creating a financial instrument that transferred wealth to one favoured client from others less favoured. If the Securities and Exchange Commission's case is proved – and it is aggressively rebutted by Goldman – the charge is that Goldman's vice-president Fabrice Tourre created a dud financial instrument packed with valueless sub- prime mortgages at the instruction of hedge fund client Paulson, sold it to investors knowing it was valueless, and then allowed Paulson to profit from the dud financial instrument. Goldman says the buyers were "among the most sophisticated mortgage investors" in the world. But this is a used car salesman flogging a broken car he's got from some wide-boy pal to some driver who can't get access to the log-book. Except it was lionised as financial innovation.

The investors who bought the collateralised debt obligation (CDO) were not complete innocents. They had asked for the bond to be validated by an independent expert into residential mortgage-backed securities – a company called ACA management. ACA gave the bond the thumbs-up on the understanding from Fabrice Tourre that the hedge fund Paulson were investing in it. But the SEC says Tourre misled them, a pivotal claim that Goldman denies. The reality was that Paulson was frantically buying credit default swaps in the CDO that would go up in price the more valueless it became – a trade that would make more than $1 billion. Worse, Paulson had identified some of the dud sub-prime mortgages that he wanted Tourre to put into the CDO. If the SEC case is true, this was a scam – nothing more, nothing less.

Tourre could see what was coming. In one email in January 2007 he wrote: "More and more leverage in the system. The whole building is about to collapse anytime now… only potential survivor, the fabulous Fab[rice Tourre] .. standing in the middle of all these complex highly leveraged exotic trades he created without necessarily understanding all of the implications of those monstrosities". Fabulous Fab, like his boss, will not be feeling very fab today.

The cases not only have a lot in common – using financial complexity allegedly to deceive and then using so-called independent experts to validate the deception (lawyers, accountants, credit rating agencies, "portfolio selection agents," etc etc ) – but they also show how interconnected the financial system is. In Iceland Citigroup and Deutsche Bank covered the margin calls of distressed Icelandic business borrowers, deepening the crisis. Lehman uses the lightly regulated London markets and two independent British experts to validate that their "Repo 105s" were "genuine" trades and not their own in-house liability. The American authorities pursued a Swiss bank over aiding and abetting US nationals to evade tax.

Bankers will complain these cases all involve one or two misguided individuals, but that most banking is above board and was just the victim of irrational exuberance, misguided belief in free market economics and faulty risk management techniques. Obviously that is true – but, sadly, there is much more to the crisis. Andrew Haldane, executive director of the Bank of England, highlights the remarkable reduction in the risk weighting of bank assets between 1997 and 2007. Put simply, Europe's and the US's large banks exploited the weak international agreement on bank capital requirements in the so-called Basel agreement in 2004 to reclassify the risk of their loans and trading instruments. They did not just reduce the risk by 5 or 10%. Breathtakingly, they claimed their new risk management techniques were so wonderful that the riskiness of their assets was up to half of what it had been – despite property and share prices cresting to new all-time highs.

Brutally, the banks knowingly gamed the system to grow their balance sheets ever faster and with even less capital underpinning them in the full knowledge that everything rested on the bogus claim that their lending was now much less risky. That was not all they were doing. As Michael Lewis describes in The Big Short, credit default swaps had been deliberately created as an asset class by the big investment banks to allow hedge funds to speculate against collateralised debt obligations. The banks were gaming the regulators and investors alike – and they knew full well what they were doing. Simon Johnson's 13 Bankers shows how the major American banks deployed vast political lobbying power and money to create the relaxed regulatory environment in which all this could take place. In Britain no money changed hands. Gordon Brown offered light-touch regulation for free – egged on by the Tories, who wanted to go further.

This was the context in which Goldman's Fabulous Fab created the disputed CDOs, Sean FitzPatrick allegedly moved loans between banks and Lehman created its Repo 105s along with the entire "debt mule" structure revealed this weekend of inter-related companies to shuffle debt around its empire. London and New York had become the centre of an international financial system in which the purpose of banking became making money from money – and where the complexity of the "innovations" allowed extensive fraud and deception.

Now it has all collapsed, to be bailed out by western taxpayers. The banks are resisting reform – and want to cling on to the business practices and business model that has so appallingly failed. It is obvious why: it makes them very rich. The politicians tread carefully, only proposing what the bankers say is congruent with their definition of what banking should be. Labour and Tories alike are united in opposing improved EU regulation of hedge funds, buying the propaganda those operations had nothing to do with the crisis. Perhaps Paulson's trades at Goldman, and the hedge funds' appetite for speculating in credit default swaps, may disabuse them.

It is time to reframe the question. Banks and financial institutions should do what economy and society want them to do – support enterprise, direct credit to where it is needed and be part of the system that generates investment and innovation. Andrew Haldane – and the governor of the Bank of England – are right. We need to break up our banks, limit their capacity to speculate and bring them back to earth. Britain should also launch an official investigation into what went wrong – and hand the findings to the Serious Fraud Office. This needs to become this election campaign's number one issue – not one which either a compromised Labour party or a temporising Conservative party will relish. The Lib Dems, the fiercest critics of the banks, have begun to get very lucky.

High-Frequency Trading: High-tech highway robbery

The Securities and Exchange Commission (SEC) knows that High-Frequency Trading (HFT) manipulates the market and bilks investors out of tens of billions of dollars every year. But SEC chairman Mary Schapiro refuses to step in and take action. Instead, she's concocted an elaborate "information gathering" scheme, that does nothing to address the main problem. Schapiro's plan--to track large blocks of trades by large institutional investors-- is an attempt to placate congress while the big Wall Street HFT traders to continue to rake in obscene profits. It achieves nothing, except provide the cover Schapiro needs to avoid doing her job.

High-frequency trading (HFT) is algorithmic-computer trading that finds "statistical patterns and pricing anomalies" by scanning the various stock exchanges. It's high-speed robo-trading that oftentimes executes orders without human intervention. But don't be confused by all the glitzy "state-of-the-art" hype. HFT is not a way of "allocating capital more efficiently", but of ripping people off in broad daylight.

It all boils down to this: HFT allows one group of investors to see the data on other people's orders ahead of time and use their supercomputers to buy in front of them. It's called front-loading, and it goes on every day right under Schapiros nose.

In an interview on CNBC, HFT-expert Joe Saluzzi was asked if the big HFT players were able to see other investors orders (and execute trades) before them. Saluzzi said, "Yes. The answer is absolutely yes. The exchanges supply you with the data, giving you the flash order, and if your fixed connection goes into their lines first, you are disadvantaging the retail and institutional investor."

The brash way that this scam is carried off is beyond belief. The deep-pocket bank/brokerages actually pay the NYSE and the NASDAQ to "colocate" their behemoth computers ON THE FLOOR OF THE EXCHANGES so they can shave off critical milliseconds after they've gotten a first-peak at incoming trades. It's like parking the company forklift in front of the local bank vault to ease the transfer of purloined cash. Due to the impressive research of bloggers like Zero Hedge's, Tyler Durden and Market Ticker's, Karl Denniger, many people have a fairly good grasp of HFT and understand that the SEC needs to act. But Schapiro has continued to drag her feet while issuing endless proclamations about pursuing the wrongdoers. Baloney. She needs to stop yammering and shut these operations down.

In a recent posting, Market Ticker explained some of the finer-points of high-frequency trading, such as, how the banks/brokerages probe the exchanges with small orders in order to find out how much other investors are willing to pay for a particular stock. Here's a clip:

"Let's say that there is a buyer willing to buy 100,000 shares of Broadcom with a limit price of $26.40. That is, the buyer will accept any price up to $26.40. But the market at this particular moment in time is at $26.10, or thirty cents lower.

So the computers, having detected via their "flash orders" that there is a desire for Broadcom shares, start to issue tiny "immediate or cancel" orders - IOCs - to sell at $26.20. If that order is "eaten" the computer then issues an order at $26.25, then $26.30, then $26.35, then $26.40. When it tries $26.45 it gets no bite and the order is immediately canceled.

Now the flush of supply comes at $26.39, and the claim is made that the market has become "more efficient."

Nonsense; there was no "real seller" at any of these prices! This pattern of offering was intended to do one and only one thing - manipulate the market by discovering what is supposed to be a hidden piece of information - the other side's limit price!

With normal order queues and flows the person with the limit order would see the offer at $26.20 and might drop his limit. But the computers are so fast that unless you own one of the same speed you have no chance to do this - your order is immediately "raped" at the full limit price!

The presence of these programs will guarantee huge profits to the banks running them and they also guarantee both that the retail buyers will get screwed as the market will move MUCH faster to the upside than it otherwise would.

If you're wondering how Goldman Sachs and other "big banks and hedge funds" made all their money this last quarter, now you know." ("High-Frequency Trading is a Scam", Market Ticker)

The HFT uber-computers are able to find out the highest price that traders will pay in a millisecond and then extort that full amount millions of times to maximize profits. Clearly, this has nothing to do with efficiency or innovation. It's high-tech highway robbery; institutional bid-rigging on a grand scale, tacitly sanctioned by industry lackeys operating from within the administration. Schapiro was picked by Team Obama for this very reason; because she was known as a regulator with a "light touch" when she headed Finra the financial industry's self policing agency. As Finra's chief, Schapiro managed to keep her head in the sand during the Madoff scandal and the auction-rate securities flap. She also issued far fewer fines and penalties than her predecessor. Here's an excerpt from the Wall Street Journal which sums up Schapiro's regulatory doctrine:

"The Financial Services Institute, a trade group, was meeting, and Ms. Schapiro addressed the crowd about Finra’s efforts to fight frauds aimed at senior citizens. Frank Congemi, a financial adviser, asked what Finra was doing to regulate “packaged products” such as complex mortgage securities. Mr. Congemi says that Ms. Schapiro replied: “We have rating agencies that rate them.” The credit-rating agencies, by this time, were being heavily criticized for having given triple-A ratings to mortgage bonds that became unsalable as foreclosures rose." (Wall Street Journal)

If the financial crisis has taught us anything, it's that the system is NOT self-correcting. And it takes more than just rules. It takes regulators who are willing to regulate.
Mike Whitney

Nearly 9 years later, no justice

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