EIR Talks : Hedge Fund Rescue, and What to do With the Blow Out of the Bubble?
Author: mmeCurieTONY PAPERT: Welcome to "EIR Talks." It's Sept. 30, 1998. My name's Tony Papert, and with me in the studio is John Hoefle, EIR's Banking columnist. John, one week ago today, last Wednesday, the Federal Reserve called a secret meeting of 16 bankers and arranged a multi-billion dollar bailout of a hedge-fund called Long Term Capital Management, and since then, this has been the talk of the world's financial press and regular, mainstream daily press. What does it mean?
Date: 1998/10/02
Forums: usa-today.money, misc.invest.stocks, alt.invest, usa-today.invest
JOHN HOEFLE: Well, there's good reason for all the talk, because right now the bankers are in absolute panic. What the Long Term Capital Management affair represents is the disintegration of the financial system. The reason why the bankers had to move in and bail out Long Term Capital -- and they actually didn't bail it out, they {foreclosed} on it -- what they bailed out was the derivatives market, because Long Term had in excess of $1 trillion in derivatives. Some reports say it was as high as $3 trillion, and if Long Term had gone into default, which it would have the next day, it could have triggered a chain-reaction blowout of the global derivatives market, which would have struck very hard at those same banks that participated in the foreclosure.
PAPERT: What is the bailout, or the need for the bailout mean for the whole financial system?
HOEFLE: Well, right now the global financial system is hanging by a thread. The global derivatives market has been hit very hard with losses. The banks have suffered big losses on loans and other financial instruments to Russia, to Asia, growing now in Ibero-America, and also, domestically, in the United States, a lot of this hasn't been reported yet, but there's a meltdown underway globally which is reflected in the drop in the Dow, where the bank stocks, themselves, are down 30-40%.
PAPERT: Let me ask you something that is asked on every show I'm on on the radio: Just what is a derivative?
HOEFLE: A derivative, in the textbook definition, is that it's a financial instrument or contract whose value is based upon the value of something else. Such as, you can buy a contract -- it's a bet that the Dow Jones Industrial average will go up, and it pays off if the Dow goes up, so you're betting on a index, and you're not betting on any actual stocks. So that's the textbook definition of a derivative, and supposedly these derivatives are used for risk-management. But, you have to ask yourself, if there are $140 trillion in derivatives outstanding in the world today, what kind of risk they're managing?
But, the real answer to what a derivative is, is to look at it in terms of a dog and fleas. During the 1980s, you had the creation of a huge financial bubble. This was the miracle, the Reagan-Bush economic miracle. And, you could look at that as fleas who set up a trading empire on a dog. And they're trading more and more -- they build up their trading empires. They start pumping more and more blood out of the dog to support their trading, and then at a certain point, the amount of blood that they're trading exceeds what they can pump from the dog, without killing the dog. The dog begins to get very sick. So being clever little critters, what they do, is they switch to trading in blood futures. And since there's no connection -- they break the connection between the blood available and the amount you can trade, then you can have a real explosion of trading, and that's what the derivatives market represents.
And so now you've had this explosion of trading in blood futures which is going right up to the point that now the dog is on the verge of dying. And that's essentially what the derivatives market is. It's the last gasp of a financial bubble.PAPERT: Can you tell us something about the forms of financial instruments and financial speculation which preceeded derivatives, I mean, how this thing came into existence? I know it's closely connected with the process of deregulation, which now allows banks to do more or less anything, and even to do it off-balance-sheet, without telling their stockholders, or the public as they do with derivatives.
HOEFLE: Well, the U.S. banks have $28 trillion in what the FDIC calls "off-balance-sheet" derivatives versus $5 trillion in assets on their balance sheets. So, most of what goes on in the banking world goes on off-balance-sheet now. And they've placed enormous bets which will destroy them.
Chase Manhattan Bank, for example, has more in derivatives: $8.5 trillion, as of the second quarter, more than the entire gross domestic product of the United States.PAPERT: And I understand Japan banks are even more heavily invested, although perhaps nobody really knows for sure.
HOEFLE: Yeah, it's not quite clear. I'd say they have at least $15 trillion in derivatives, maybe more. I suspect they've been trying desperately to unwind some of their derivatives exposure, as their system melts down.
PAPERT: Now what the most naive say is that for each derivatives loss, there is somebody who is making a profit at the other end of the transaction, so where's the danger?
HOEFLE: Well, the danger is that the system as a whole will collapse, is one. And also, the very existence of this bubble depends upon looting the physical economy. So in a sense, you have to kill people to keep the bubble going.
PAPERT: Right. You're listening to EIR Talks, and we'll be back in a moment.
[commercial break] PAPERT: We were talking about the bail-out, or what John characterizes as the "repossession" of Long Term Capital Management, a gigantic hedge fund, with perhaps $1 trillion, or perhaps even $3 trillion, in derivatives. Now, was it just that the people at Long Term Capital Management made the wrong bets? I mean, many of these bets have been spelled out in the press, like they bet on the fact that the volatility on Wall Street would subside when in fact it increased, and so forth. Is that the nature of the problem?
- Long Term Capital: Very Good at What They Did - HOELFE: No. Not really. This is a very interesting case, because what happened to Long Term was not so much that they made bad bets, but that the financial system is disintegrating out from underneath them. Long Term Capital had -- they were very good at what they did. What they were doing was wrong, but they were very good at it. They had two Nobel Prize winners in economics, Merton and Sholes, who actually got the Nobel Prize in 1997 for the mathematical formulas that they did for the derivatives market, which Long Term was actually using. So, in effect, the firm got the Nobel Prize for the derivatives bets it was placing.
And what happened is that the economic models -- of course they're all based upon an exhaustive analysis of the {past} as a way to predict the future. And that doesn't work. When you introduce some discontinuity, like the meltdown of the financial system, these models can't handle that.
So their bets, which made perfect sense inside the virtual reality world of international banking from the standpoint of the continuous growth of the bubble, blew up when reality diverged from their virtual reality, and that's what caused them to collapse. Which also means that there are a lot of others out there who are using similar models, who have similar losses which haven't been reported yet.PAPERT: Now, as I understand, the derivatives mania is just the latest in a long series of financial bubbles that have been built up, one on top of another, which was preceeded by the junk-bond bubble, and really, the October '87 crash was the takeoff point for derivatives. Isn't that true?
HOEFLE: Yes. During the 1980s, when the banks couldn't collect their Latin American debt, the decision was to form a new bubble, and they started heavily into junk bonds. This is when Michael Milken set up his operation, and was using dirty money to issue junk bonds to run corporate takeovers to not only attack and dismantle the productive side of the U.S. economy, but at the same time, to create this enormous bubble, and to send everybody who wasn't being taken over into the arms of their investment bankers, as a way of protecting themselves. So it caused a real shift towards the financial. And then when the junk bond market blew up, then you had, also at the same time you had the real estate market in the United States blew up. You had an enormous real estate bubble, and then real estate values started to drop, and all of these banks which had speculated so heavily on real estate took big hits. This is what the two, the junk bonds, and the real estate, is what caused the collapse of Savings and Loans. The S&Ls couldn't operate in the speculative environment, and the speculative S&Ls blew up.
But behind that was the collapse of the U.S. banking system. And in fact, in late 1990, the Federal Reserve secretly took over Citibank and ran it for several years, and quote-unquote, nursed it back to health, but the way they nursed it back to health, and nursed the other banks back to health, was the creation of this huge derivatives bubble. So, in effect, they switched to blood futures. And that is now what is now blowing up.
So it's a case where every step along the way, you create a new bubble in order to save the system, and ultimately, the rescue effort turns into a bigger disaster than the problem you were trying to solve in the first place. So what could have been managed rather easily in 1980, is now an enormous problem. A global derivatives bubble that, if measures aren't taken to put it into receivership, and shut it down gracefully, it will -- this system will just disintegrate.PAPERT: It'll blow up the whole world financial system. Now, how long have Mr. LaRouche and you and others of his associates been warning about this problem?
HOEFLE: We started warning about it back in 1993. Mr. LaRouche issued a pamphlet on the collapse of the derivatives market and made the comment that if aliens were to come in from outer space, and look at this planet, and saw that we tolerated a derivatives market, that they'd probably turn around and leave, figuring that we were insane.
And then we submitted testimony to Congress on the matter. So, we've been pushing this hard. We lobbied Congress very hard. We've been pushing this {very} hard since 1993.PAPERT: In fact, you're largely responsible for the fact that many Congressmen know what a derivative is, to the extent that they do, I think.
HOEFLE: I think so. You don't get much of this in the mainstream press, because they're mostly propaganda outlets.
PAPERT: Now, you testified before Congressman Gonzales's Banking Committee in Sept. of '93, among other things, on this very problem. So, why don't we turn and look at that testimony now, in our next segment.
[video of Hoefle testimony]
- A Movement is Building to Defend the President - PAPERT: Welcome back. We're going to turn briefly now to another subject. There is a movement building in this country to defend President Clinton so that he can do what he has to do as the leader of the world's leading democracy to rescue the world's economy, whose problems we've just been discussing. This movement was launched and led by Lyndon LaRouche and the Schiller Institute, but it's taking off nationwide. People are having the courage to come out, in spite of the media, and defend their President. And what I'd like to show you now is just one small example of a great change which is taking place in the country, is a rally which occurred this past Monday, in the Rotunda of the state capital of Pennsylvania at Harrisburg was addressed by the leader of the state Democratic Party, the leader of the state AFL-CIO, leaders of other unions, and many other prominent Pennsylvanians, and attended by many other prominent Pennsylvanians.
So, let's switch to that Monday Harrisburg rally.
[video of rally] PAPERT: Welcome back to EIR Talks. This is Tony Papert, and with me is John Hoefle, EIR's banking columnist. John, yesterday, Sept. 29, Charles Dallara, the managing director of the International Institute for Finance -- which is, in effect, a thinktank for the big banks -- gave a press conference unveiling a letter that his outfit had sent to the IMF, on the occasion of their meeting, and Angela Vullo of EIR got the occasion to ask him some questions. Why don't we turn and look at that exchange now.
[video of Angela asking questions] PAPERT: That raises a number of issues. What's your comment on the exchange?
HOEFLE: Well, I think it's entirely lawful that he would be defending the derivatives market. And I think that -- you called them a thinktank, but I think there's not a lot of thinking that goes on here, and they are tanking, so that's appropriate. But the problem that they faced was the same problem facing the bankers who were summoned by the Fed to discuss what to do with Long-Term Credit, which is, that either you continue to roll over the derivatives market, bail it out, pump more money into it, or the whole thing collapses, because it's just a giant pyramid scheme. And that's the nature of a pyramid scheme -- you have to keep pouring more and more money into it.
PAPERT: Like a chain letter.
HOEFLE: And the problem is that there's not enough money. It's starting to starve for cash, because there's not enough loot left in the world to suck up into this scheme, and it's starting to break apart.
PAPERT: Hence Greenspan's lowering of interest rates at the same time that he was secretly arranging the rescue of the Long Term Capital.
HOEFLE: Sure, because it's all about increasing the leverage, increasing the size of the bubble, creating more money to pump into it. I mean, it's also interesting that one of the people who was involved in these negotiators was Travelers' chairman Sandy Weill, who gave a spirited defense of the need to rescue the money at Long-Term Capital, and it just so happened that it was at the same time that he was doing this that the Federal Reserve was approving his takeover of Citibank, to form this new monstrosity called Citigroup. So, there's all sorts of inside dealings, and funny business going on.
Basically, they had a choice. Either they bail out the derivative market, once again, or they watch the whole thing disintegrate in a chain reaction which will wipe them all out.PAPERT: And Angela asked about the role of the IMF. Dallara said, well the very stockholders of the IMF are not sure what its function should be, but it shouldn't be changed too much from whatever it's doing. What's your comment on that aspect?
HOEFLE: Well, the IMF is irrelevant at this point. All of its bail-outs.... It used to be that the IMF was one of the most feared institutions in the world, that when the IMF spoke, nations shuddered, they jumped. But the IMF has proven to be a complete failure. If you look at all of the bailouts that it's handled over the last year, through Asia and now Russia, everything they touch blows up in their face.
And that's because the system itself is in the process of disintegrating. And the IMF has no way to handle that. So now they've spent all of their money, and it's unfortunate that President Clinton continues to defend the IMF, because this policy of bailing out the bubble by rolling everything over, this has come to an end. And they can keep trying the same old thing. Greenspan can hyperinflate if he wants. You could say that the good news that we'll all be trillionaires by the end of the year. The bad news is that a loaf of bread will cost $2 trillion if you can find it.PAPERT: Right. So you're saying that Greenspan is pursuing a hyperinflationary, 1923 Weimar policy, which actually the present administration, through Secretary Rubin, has said he disagrees with ... and I think also implicitly Clinton in his call for this 22-nation group to redesign the International Monetary System.
HOEFLE: The bankers have a real problem, because the system that built them, this bubble that spawned so many powerful financial institutions, is coming down. And some of the smarter among them are beginning to realize that when this bubble pops, they're gone.
Now, there are those in the oligarchy who would be happy to see this bubble pop, and happy to see the world collapse. The Prince Philip chaos faction, who just wants to wind up on top of whatever pile of rubble is left, with all the nation-states smashed.PAPERT: Which, in my opinion, it's that faction which is responsible for the lynching, basically, of President Clinton, because there's no surer way to guarantee chaos than to have the world's most powerful country without a leader.
HOEFLE: And then you have the bankers who are now trying to save the system, using the same methods which built the bubble. And that won't work, because you've reached the end of that line. And some of them are issuing statements saying we need re-regulation, certain things ... some of the things that sound very similar to what we're calling for. Although a lot of them are calling from a different perspective. You have people like George Soros, who's calling for a global financial dictatorship, for example, in order -- But the main battle is, either sovereign nation states, or the financial bubble. And people like Greenspan and the bankers are committed to saving the money, no matter the cost to the real economy.
PAPERT: Right. And the IMF is the biggest, even though you say it's now irrelevant, is one of the biggest enemies of national sovereignty in existence.
So, we'll be returning to this kind of topic later in the show, but what must governments do now?HOEFLE: Well, governments must, first of all, assert their sovereignty over the financial markets. The markets are not sovereign, the governments are. And nations must act in concert, as sovereign nations, to put this bubble into receivership. You have to, basically, admit that all of these IOUs that are floating around out there, can't be paid. They don't really exist; the money doesn't exist to pay them, so you shut them down, and you protect the productive side of the economy, you protect your population -- certain pensions, and things like that, you have to save, but the mass of all of the speculative betting that goes on -- you shut down the casino.
And then you start rebuilding the productive side of the economy. If you do that, we can pull out of this. If we don't do that, we will collapse into a New Dark Age.PAPERT: And what do you say to the people who say, the average man in the street, is told by the media to say, that it's impossible to turn back the clock to the period before floating exchange rates, globalization, and so forth?
HOEFLE: Well, I think if we don't intervene, we're going to turn back the clock a lot farther than that. We're going to go back to the days of feudalism, because civilization itself will disintegrate. So ... And there's no reason why you can't have sovereign governments put this bubble back under control.
The derivatives market is a lot like the old mafia protection racket, in which you throw a brick through someone's window, and then you go around the next day, and sell them insurance against the last breakage. And you de-link the currencies, you take away the fixed exchange rates and let them float, and that's like throwing the brick. You have these wild interest rates -- it's the same thing. So you create this very volatile environment, and then you say, in order to protect yourself, you need derivatives. But you don't actually need any of that stuff. All you need to do, is have sound regulation, and keep these speculators under control.PAPERT: Get rid of the mafia.
HOEFLE: Right.
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