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Tracking the new financial WMDs

by danps Sat Nov 20th, 2010 at 06:00:38 AM EST

With reckless behavior by the lords of finance now given the blessing of the government, the big question is not whether the era of bubbles is past but where the next one is being inflated.  The pump of choice may have already been selected.

Cross posted from Pruning Shears.

No Associated Press content was harmed in the writing of this post

Blogger George Washington (emph. in orig.):

Remember, credit default swaps didn't bring down the economy because they are toxic while all other financial vehicles are pure as the driven snow. CDS brought down the economy because they were the choice du jour of the looters.

If we outlaw CDS (which I have argued for in the past), then the looters would create some other instrument for looting.
Given the absence of moral hazard on Wall Street, and the consequent perverse incentives to gamble, it should not be provocative to write that we are most likely just between financial meltdowns.  The US government has formalized what was long merely assumed: that the biggest financial institutions are too big to fail.  The big boys know that when it comes time to pay off losing bets they will be covered by OPM, baby - Other People's Money.

As Washington writes, it is just a matter of seeing what the next game is.  We may be in the middle of one right now with the foreclosure mess (Foreclosure Fraud has done an amazing job documenting and analyzing it).  There are too many stories to keep track of - people without mortgages being foreclosed on, houses getting sold multiple times, people being thrown out of their homes multiple times, it just seems to go on and on.

The best measure of just how much trouble the banks are in may be the tale of H.R. 3808, the Interstate Recognition of Notarizations Act of 2010.  Consider its blink-and-you-missed-it trip through the Senate.  The Senate: the same body that has bottled up 420 (and counting) bills passed by the House, is crippling the judiciary by refusing to confirm judges, and is deliberately, actively harming America's national security by working for months in bad faith on a new arms treaty with Russia - only to sabotage it when it was ready to be ratified.  Read how H.R. 3808 was treated by that Senate:

After languishing for months in the Senate Judiciary Committee, the bill passed the Senate with lightning speed and with hardly any public awareness of the bill's existence on September 27, the day before the Senate recessed for midterm election campaign.

The bill's approval involved invocation of a special procedure. Democratic Senator Robert Casey, shepherding last-minute legislation on behalf of the Senate leadership, had the bill taken away from the Senate Judiciary committee, which hadn't acted on it.

The full Senate then immediately passed the bill without debate, by unanimous consent.
If that does not convince you the fix is in, nothing will.  When they need to straighten up and fly right they do so very prettily, no?

All of this is mostly about trying to once again dump losses on taxpayers, though.  It is post-speculation cleanup.  What about the next bubble; where will it come from?  Commenter gizzardboy very helpfully pointed me to a series of recent articles on exchange traded funds (ETFs).  These are mutual funds based on a basket of stocks in an exchange.  So, for example, you could buy a single "share" in the S&P 500 - something that reflects the value and movement of all 500 stocks - by purchasing it from an S&P 500 ETF.

In an ETF analysis a couple of months ago, Bogan Associates considered the possibility of collapse.  The paper argues that since many ETFs have a great deal more outstanding shares than the underlying value of the funds themselves, a run on one of them would cause it to collapse.  And of course, if that causes other ETFs to take on the stink of death it could spark a chain reaction that would indiscriminately take down whole chunks of the industry - healthy and unhealthy alike.

The paper was noted by Herb Greenberg, which prompted Michael Johnston to jump in to defend them.  He does so with a tone of haughty disdain (people linked to Greenberg "apparently without doing much research," he sniffs) and it actually works against him: Snorting dismissal is the first refuge of unsupported privilege.

He does a good job sketching out the basics of how ETFs operate, but as gizzardboy emailed there is not much discussion of naked short selling.  (Here is a fairly anodyne description of naked shorting; here is a less sanguine take.)  Essentially, ETFs are subject to the same manipulation and speculation as any other financial instrument.  Is it their turn as choice du jour?  We are assured by people in the industry like Johnston that they are solid, safe investments, but such assurances have shaky records of late.  And as Congress has shown, it is more than willing to put taxpayers on the hook for the next bailout before the public even knows it's up for a vote.

by danps (dan at pruningshears (dot) us) on Sat Nov 20th, 2010 at 06:01:21 AM EST
The story of Deep Capture (linked in the last bit about naked shorting) is itself of interest to ETers.

The Deep Capture website was created to bypass the "captured" institutions that mediate our nation's discourse. It was initially funded by Patrick Byrne, CEO of Overstock.com, but it is not part of Overstock. It functions as a separate, limited liability media company, whose co-owners and managers are Evren Karpak and Mark Mitchell (former partner Judd Bagley having left the organization upon returning to work at Overstock.com in 2010) .

Public choice theory describes a phenomenon whereby industries take control of, or "capture", regulators who are supposed to oversee them. The claim of this website is that powerful actors have been able to influence or take control of not just the regulators, but also law enforcement, elected officials, national media, and the intellectual establishment.

It is our mission to expose this "deep capture."

You can't be me, I'm taken
by Sven Triloqvist on Sat Nov 20th, 2010 at 06:11:34 AM EST

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