The Bear-Stearns Fiasco

Commentary by Richard Kotlarz

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Below is a compilation of responses I gave to a stock trader on 3/24/08 and 4/4/08 who submitted inquiries about the recent Bear-Stearns meltdown:

Thanks for the report on the Bear Sterns fiasco from your in-the-trenches perspective.  In response to your questions - “Do you think they all go bankrupt???  Do you think they have a shot in hell in bouncing from all of this???”, I would answer that in a sense they already are bankrupt; they just don’t know it.  This answer may come off as a bit flippant, so permit me to expand on it a bit. 

To start with “bankruptcy” is a micro-economic concept.  The power to issue money is a macro-economic function.  The fact that the Constitutional mandate to issue money has been arrogated by an extra-national cartel has the effect of relegating the self-monetizing (macro-economic) sovereignty known as the United States of America to being a business (micro-economic) enterprise within the portfolio of said cartel.  Any business that cannot manage its cash-flow without going ever further into debt is by definition bankrupt.  The very terms by which this nation obtains its money supply guarantees that it cannot pay its bills without the continuous accretion of ever-more “debt”.  Properly speaking, then, the U.S. economy is in a state of perpetual bankruptcy.  Those elected officials who have been given the fiduciary trust to manage its affair are not, therefore, the legislators and executors of a sovereign state, but the nominated receivers in a perpetual bankruptcy reorganization.  Accordingly, they serve at the behest of the financial interests that have a “claim” against the enterprise known as the U.S. economy.

The very process of building an economy based on “borrowed money” results in the establishment of a crushing number of liens against it.  This can arise through the political process (e.g. social mandates such as Social Security), or the financial process itself (i.e. interest due on financial instruments).  These create what are essentially unfunded claims against the currency which effectively obliges the economy to “grow” in order to keep up.  Stated another way, they are air in a bubble which is attached to the currency.  Failure to keep the air pumped up fast enough would, by the “house rules” of the system, lead to a situation where people would lose confidence in the whole tottering financial edifice (just as when the moment of truth arises for any Ponzi scheme).

Short of changing the principle by which the system operates, there are two ways to cope.  One is to keep “growing” the pyramid (i.e. keep issuing more “debt” money).  This of course depends entirely on keeping confidence in the game pumped up.

The second is to let some air out of the bubble.  One of the great secrets of the system is that it depends on bankruptcy to survive.  This is how air is let out of the bubble.  Otherwise the pressure would build up too quickly for the system to sustain itself.  Indeed, if one were to check the historical record, this is how Capitalism has achieved longevity.  The trick for those players who would survive, and even prosper, is to make sure that the air expended is someone else’s air.  This restores a sort of pseudo-confidence in the system because anyone who “dodges the bullet” experiences a sense of relief, and indeed can feel like a “winner”, and even wax righteous in their faith in the system.  An egregious example of the bankruptcy process has transpired here in the Farm Belt over the century-almost since the establishment of the Fed.

At the time of the passage of the Federal Reserve Act, a third of the people lived on the farm, and at the start of WWII it was still a quarter of the population.  Now less than two percent remain, and it is questionable as to whether many of these are “farmers” in the sense of being independent entrepreneurs (as opposed to subcontractors for the major food cartels).  In the history of the world there has never been a population that has been moved off its land, much less from a plain as fruited as the American Midwest, without enormous trauma.  How then was this fiercely rooted population removed in little over a generation?  The only way it can be done is to create a financial context in which it is not possible for the occupants as a whole to cash-flow their lives, and then let them work it out in a desperate scramble to see who can hang on.  The factor that made their situation untenable was not, as claimed, “over-production” (in a world where 40,000 children starve each day of starvation-related causes), but rather the so-called “debt” against the monetary system that makes it financially “impossible” to clear the market of the aggregate of their production.

The origin of this “debt” is the interest payment created as an unpayable BUBBLE attached to the money supply through the private bank-loan process.  For reasons that are complex, the shortfall of buying power available to close the market cycle was first directed in a concerted way against the rural sector.  There were policy papers put out by corporate think tanks that spelled this out. 

The farm problem is a monetary problem.  The key to evicting farmers from the land is to hide its true nature within a subterfuge (farmers are being too productive), and set it up so that the collapse plays out over a period of time.  Accordingly, farmers were obliged to go broke at a rate of a percent or so per year.  Those still struggling to not be one of the losers saw no other course but to show up at the auctions for bankrupt farmers to and pick up the equity in their capital supplies and equipment at pennies on the dollar.  Old “debts” (air in the bubble) were wiped out in part because not enough could be salvaged, and the net indebtedness of the countryside experienced some relief, but the growth of the bubble resumed, and eventually virtually everyone went down (except those that had deep enough pockets to pick up the pieces).  This process was wrenching, both for the rural folk involved directly, and the country as a whole. 

The vital rural community is now virtually gone, and what is left effectively are corporate farming contractors (which are now getting good prices and high subsidies), “Wal-Mart” regional commercial strips (to which there adhere increasingly satellite communities), and food imported from “cheap-labor” producers (which is why, precisely, the Mexican countryside is being systematically ruined, driving its victims across the border).

Of course, since the demise of the rural areas, the “bubble-deflation” scheme has been moved to the manufacturing sector, as our industries have been shipped overseas. 

Next, the “service industries” have come under great strain. 

This has all been extremely wrenching, of course, but these “adjustments”, going back to the pre-WWII farm days, still exist in living memory of the people who have lived through them.  Still, we have not noticed the essence of the debt-bubble-deflating (i.e. bankruptcy) game. 

But, for some, no matter.  One could always insure ones financial position via social and political mandates (i.e. pension plans), or by “making money with money” in the financial markets.  This is attitude is by no means limited to financiers alone, as it has become endemic to our culture.  This is why, for example, there has been a political movement to “privatize” Social Security, or why one feels defrauded of one’s due when one’s personal “Enron” (i.e. “bubble”) pops. 

But, the system has to deflate somewhere, and it was inevitable that the game should move at last to the financial markets.  This is what is happening at present.

It should be remembered that the system does in fact depend on most people being able to pay off their loans, or at least roll them over.  Otherwise the economy would come to a halt.  This is not, however, a principle that is applied uniformly.  To understand the variations of the loan default question it is helpful to imagine the loan structure erected by the so-called “fractional reserve system” as a stone wall in the shape of a steep pyramid.   

At the base is a row of foundation stones that is referred to in monetary terms as “high-powered money”.  The portion of the Federal “debt” circulating at any given time constitutes the “high-powered money” or “reserves” which govern how much credit money the banking system can create.

If the “reserve requirement” is 90%, then the system can “loan” out 90 dollars in new money for every 100 on deposit.  In other words, if there are 100 stones at the base of the pyramid, the next course will consist of 90 stones.  When these 90 are re-deposited, the bank can create the next course (8.1 more).  I know you know the routine.  Eventually this results in a very skinny convex pyramid that reaches for the sky, but never quite forms an apex.   
Each course of stone is theoretically the same, but they occupy relatively different positions in the structure.  If a structural failure were to occur in an upper stratum, it would not threaten the integrity of the structure as a whole, as there is little or nothing that it is supporting above it.  If, however, a stone near or at the bottom were to crumble, it would threaten the integrity of the wall as whole.  If a few stone were to disintegrate it would threaten the wall’s very existence. 

Now let us apply this pyramid image to what is happening in the financial market.  The stones in the base stratum of the monetary structure are the bonds supporting the dollar itself.  This indeed is foundational.  It is obvious that, structurally speaking, these are the supports that are most crucial.  Accordingly, these high-powered base strata cannot be allowed to fail without bringing the whole system down.  Consequently, the “full faith and credit of the Federal government” (a nonsense expression), “backed” by the full force of same (a more relevant concept) stands ready to see that this does not happen.  This then makes them the investment of last resort regardless of what else is going on.

The next row up is made of the blocks that belong to prime financial investors.  These are the people that buy other people’s “debt”.  They include the equity holders of the major banks themselves.  They constitute not the base per se, but are so closely linked to it that for a major bank or banks to fail is deemed to be tantamount to the failure of the system itself.  The net abstract worth of the banks serves as the effective “reserve” that supports the loan structure above.  If a big bank fails, by the rules of the game a lot of other loans that piggy-back off that reserve would theoretically have to be called in.  They don’t have to be “called in”, of course, since the rules are arbitrary and can be changed at once, but then how would the illusions that banks can’t fail be maintained?  In any case, calling in “loans” is not practical in modern practice, so some major source of new money has to be found, ostensibly, to plug the hole in the financial sea wall.  Ultimately that could be done by merely issuing money by fiat, but if the banking system ever resorted to that “desperate measure”, their modus operandi would be exposed as the fraud that it is. 

The “only option”, therefore, is to scramble to find un-committed reserve funds; even unto the ersatz necessity of the Federal government itself “borrowing” the necessary money and sandbagging it into the breach (as, for example, in the current proposal for issuing “rebates” to taxpayers).  In the fog of the prevailing mindset, monetary liabilities for which the large banks are responsible must be honored so as not to precipitate a fatal convulsion of the system.  When that possibility seems to loom, the Federal government intervenes (as with FDR’s “banking holiday” and “reforms”, the Continental Illinois bailout, and the Mexican “debt-restructuring”). 

The next stratum up consists of the smaller banks and the banking system’s biggest customers.  These include large corporations, major public entities (states, cities, bonding districts, etc) and the mega-wealthy.  These are the “important people”, and confidence in the system rests ultimately on their remaining able to pay their debts.  This imperative is not as absolute as for the bottom two strata, but is significant enough, depending upon circumstances and the vagaries of the political process, to warrant, supposedly, government rescue from insolvency (as for the Chrysler Corporation and New York City bailouts). 

Proceeding further up the strata, we encounter the consumer, where the bulk of the inverted pyramid lies.  Ultimately all production is meant for consumption, and the “consumer” in this country is synonymous with “middle class”.  It buys virtually everything that is sold on the market, either directly or indirectly.  Even nominally governmental expenditures are responsive to what the middle class wants, or can be persuaded to think it wants.  If they speak up for a road, the chances are good that a road will be built.  If they clamor for a “war against crime” give them police, courts and prisons.  If the (induced) “political will” is for a war in Iraq, well they can have that too. 

The personal credit of middle-class has been the great engine of monetary growth since WWII.  We have truly established a consumer society, and its dubious glories have become synonymous with the “American Dream”.  The consumer role in money generation can be thought of as operating within the top three strata of the pyramid.  The third from the top is where the most big ticket and durable item purchases are financed.  This consists of major small business loans, education loans, high-end vehicles, personal investments (mostly as real estate), and housing.  The emphasis here is on home loan credit.  This has been seized upon as the great engine of “debt”-creation in the private economy.  A lot of manipulation has gone on behind the scenes to milk this cash-cow to the max, and this is what is driving the phenomenal-beyond-reason escalation of housing prices that we see.  The method of madness is to make available easy credit, GI loans, housing subsidies, and other devices designed to get families into a first home, and then convince them to monetize the growing equity (most of it “debt-money” induced “inflation”) in that structure to bring in more “debt-money” (ergo sub-prime mortgages).  A certain rate of default can be tolerated in this stratum as long as there is enough floating cash or willing creditworthiness in the housing market such that the abstract credit formula by which the wall is constructed is can still be maintained within its limits.  The system itself is soulless, and does not care if a person has a home (to be sure, people in the system may care).  It is effectively concerned that there exists enough solvency in the peoples lives, however desperately obtained, to keep its tottering credit pyramid propped up.

The next stratum up consists of small business and consumer loans for mid to minor capital items (cars, appliances, furniture).  The consequences of loan default at this level with respect to the economy are less severe simply because credit-money at this level is not supporting much of a credit structure above it.  If the failures are massive lesser banks could be in trouble, but that is not a great threat to the system itself.  Shady dealers, then, can afford to advertise “No credit? – No problem!”

The highest stratum is composed mainly of the “revolving-debt” instruments of the consumer culture; most specifically credit cards, credit lines and payday lenders.  These financial devices (especially credit cards) may act as be conveniences for the well-to-do (those that can afford to pay them off each month), but for those financially vulnerable souls finding themselves in a position of depending on them, they are trapdoors to a financial purgatory.  For the “middle class” they can also act as means to keep up lifestyles, and thereby stay in denial about one’s deteriorating financial condition.  This in itself can quickly turn into a slippery slide out of the middle class, and into underclass finances as a way of life. 

As to whether consumers default on these “debts”, it is of little consequence to the system to as a whole.  Business at this level is all gravy to the banking system, with little cost, except printing and postage on the billions of “new offers” they send out in the mail each year to anyone with a pulse (and some without).  These are legalized loan-sharking operations, seeking whom they may suck dry.  That specifically is why those with a major credit-card “debt” crisis continue to have their mailboxes stuffed with new offerings, even from the same companies they are in arrears to. 

Traditionally, if the consumer went bankrupt, the “debt” on these cards would lapse; but that was ok – fresh credit “debt-money” out of thin air could be safely issued again.  The cycle of exploitation is to lure the vulnerable into unpayable revolving “debt”, raise the rates of servicing it to obscene levels to insure that they can’t pay, squeeze all the financial blood out of them that is possible, ruin their “creditworthiness”, let them go bankrupt if it comes to that, extend to them new credit thereafter on expropriative terms, and leave them with no recourse.  The game has taken a particularly cruel twist with passage of the 2005 bankruptcy law that disallows much even of the relief this extremity might offer. The credit-card companies howl that this new statute was needed to protect their “debt-paying” customers from being saddled with the cost of the deadbeats.  This is a lie.  It is tantamount to saying that the Mafia loan shark needs a law to prevent the unpaid “debts” of his “irresponsible customers” from falling on the shoulders of his “honest clientele”.

It is meet at this point to inject a note on personal responsibility.  There are those who say that many revolving-“debt” holders brought on their financial problems through their own profligacy.  There is a large element of truth to this, and it is also an apt commentary on a society that has given itself over to material wants.  Moreover, the same spirit of irresponsibility that drives the imprudent actions of many of the “underclass” also infects a social order that even allows a usury-based monetary system to exist.  There is plenty of blame here to go around if that is what one is looking for.  The truth is that we need to quit scapegoating the “losers” in a monetary order that mathematically guarantees that a large and growing portion of the populace will become such.

For a system that depends ostensibly on the ability of people to pay their “debts”, the controlling factor in the pressure-relieving bankruptcy game is not as simple as “loan repayment, or no”, but rather the stratum in which any default occurs.  At the base strata of the monetary pyramid loan default will convulse and even threaten the existence of the system itself (so the deluded thinking goes).  As one moves up the strata, this default-phobic reflex becomes progressively less operative to the point were at the top the banking system does not even want its customers to pay up.  Privately credit card companies refer derisively to their customers who do pay their bills in a timely manner as “deadbeats”.  They are more interested are in keeping the consumer’s life pinned down in revolving credit at increasingly harsh terms.  At its uttermost the game amounts to little more than driving the citizenry into indentured slavery.

 It should be noted that the soundness of the financial blocks on the bottom row still depend, however indirectly, on the performance of some of the lesser grade courses on top.  Their portfolios are still ultimately “debt”-based, and so depend on real people being able to “perform” on their financial obligations.  A certain amount of rot can be tolerated, but let that be the problem of the middle managers in the upper layers.  Of late, however, these prime players have had to reach further up into the realms of “dodgy debt” in an attempt to keep their stones in the “fractional reserve” wall pumped up; never mind the mental subterfuge in casting them as “Structured Investment Vehicles”.  They are finding it increasingly difficult to keep themselves insulated from the rot in the sub-prime levels.

The perverse logic of this whole scheme is that if the common man goes bankrupt, even if millions do so, it is no big deal because their “debt instruments” are not strategic stones in the wall, but if a major bank fails it threatens to bring down the whole credit structure.  The crazy upshot of this situation is that this is true; as long, that is, as our heads stay trapped in this nonsense (this nonsense being manifest in the “fractional reserve” formulas by which the banking system is structured and controlled).  And so We the People acquiesce, albeit under noisy protest, to these bailout schemes.

This brings us back to the Bear Stearns fiasco.  The “investment firm” was bought out for a dime on the dollar, and the latest stories over the wire sing the praises of how the situation has been redeemed.  The generosity of J.P. Morgan does not go unlauded (especially after manipulating perception with their two-dollars-a-share feint).  In the euphoria, the stock market even experiences a bounce.

There are many questions we should be asking here.  One is – “Whose bubbles got deflated?”  The immediate answer is that it was those of players whose financial holdings exist in the upper courses of the “fractional reserve” pyramid.  (In any case, that was last week’s market; we’re bullish this week).  This includes, no doubt, many retirees.  The next is – “Whose bubble got saved?”  Clearly, it was those privileged to hold the stones that make up the foundation of the “fractional reserve” pyramid.  To be sure, there is much public wailing and gnashing of teeth about how the lesser folk are coming out on the short end yet as usual.  But, “all was not lost”.  Much of the gas was salvaged and pumped into the balloons of the privileged “investors” whose stones lie at the “fractional reserve” base of the wall.  The foundation of the monetary system is thus secured, and made ready to go another round.

So, why does this go on?  Most people would say that it is because the powerful simply have too much power.  Closer to the truth is that we the lesser folk have allowed ourselves to be co-opted, against our own better angels, into the perverse game.  We wring our hands in sympathy when someone else’s bubble bursts, and breathe an inner sigh of relief that ours is still hanging in there.  We may even cling to the delusion that we are the smart ones, and so become shills for the game.  These evil wrongdoers have to be brought to justice, so we say, but are slow to admit out that we have been spared (for now) by little more than the caprice of the same system.  Our turn will come.  It didn’t end with the farmers on the Great Plains.  Nor will it end here.  The beast wants everything.

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You ask “. . . Where did all that money go???”  The answer is “It didn’t go anywhere; It wasn’t money; It was air in a speculative bubble.”  Let me explain.

Let us suppose that shares of BS stock are at the moment trading for $60 each.  This represents a “net worth” for each share then of $60.  The next question is “Where is the $60?”.  The simple answer is that it is a speculative abstraction that is “back-calculated”, in a manner of speaking, off an anticipated price-earnings ratio, much as the “value” of bonds, bundled mortgages, or other investment vehicles are reckoned respectively from their “discount rate”, “interest rate” or “rate of return”.

Note that none of these things are money.  They are only promises (or anticipations in the case of stocks) to pay at some point in the future.  It may have the illusion of money because while there is still life in the game one can redeem one’s stock for cash.  This is essemtially a away of saying that there is someone out there who is willing to bet his own cash-in-hand against the dubious prospects that the bubble will continued to expand without popping before he can cash in and get out.  Within a market that imagines it can expect a “10% return on investment”, for a share stock in BS to be “worth” $60, there must exist momentarily in the trading culture an anticipation that it will be paying out $6 at the end of the fiscal year.  This is affected by many factors, of course, but as a rule it governs.

Let us say that BS is one of those major investment banks whose financial structure constitutes one of the blocks in the lower foundational strata of the “fractional reserve” pyramidal wall (as described in previous letter).  In a sense, then this expectation of a $6 return for each share represents a claim (if not contractually, at least psychologically) against the whole investment brokerage “industry”.  If the pressure on one of those stones could be relieved, and the reduced stress redistributed, that would in effect create new room to breathe for the aggregate of firms that share this “market”.  That is no small consideration when the whole speculative edifice is under stress.

It makes a certain perverse sense, then, to let one of them go down, and have one or more of those still standing pick up the pieces on fire-sale terms.  The net effect is that there will be effectively less of a claim on this sector (e.g. $1-vs-6 per share on the same BS stock), and newly freed up room for gain. 

So who loses?  The answer is that it will be those stock holders who occupy financial niches further up the wall.  If they go broke “at least” the foundation of the pyramid (our very “financial system”) will be “saved”.  Many of them will likely resort to borrowing against home equity or relying on credit cards to survive for a time, but hey, the banking structure that we all rely upon is “sound”.  In a month their plight will be old news anyway, and our lives can move on.  On the “bright” side, their newly urgent economic travails in the sub-prime belly of the beast represent fresh new meat to feed its debt-money maw.

It should also be noted that ultimately the value of stocks, bonds and other investment vehicles depends upon there being some actual enterprise out there in the real world that gives substance to their “value”.  The problem for the financial sector is that the relentless demand for interest payments against the money supply is the engine that constantly discounts the financial “value” of these enterprises.  In time, the gap between physical reality and mathematical fantasy cannot be sustained.  The problem for the mavens of the market then becomes, how can this pressure be relieved, the system “saved”, and a margin for speculative gains be restored?

The answer is largely psychological; in a phrase – “restore confidence in the market”.  In a sense this becomes the ultimate moral hazard, as artificially induced expectations drive traders (and other players in the economy) at all levels.  As people act under its influence, a lot of air is pumped into the speculative balloon.  This is not simply a matter of winners and losers.  The system itself cannot contain this pressure indefinitely.  Someone’s bubble has to be popped.

It is no longer feasible to bring this about via a general collapse as in the Great Depression.  To preserve the Capitalist edifice itself, the deflation has to be managed.  Now selected sectors must make the sacrifice, whether they be the farming community in the Midwest, the Industrial sector in the Rust Belt, the governmental sector, or the financial community itself.  The situation has evolved to the point where the big traders can no longer keep the wolf that it birthed and nurtured forever away from their own door.  Hence the “sacrifice” of BS.  One would think that the collapse of one of their major players should reduce confidence in the market and thereby negate the scheme, but you saw what happened.  When you control the money, and in turn the organs of the system itself, you can make lemonade out of BS.

In a dark sort of way, the elegance of this scheme is exquisite.  The ultimate question, therefore, is – “How consciously is it being played out?”  God only knows the definitive answer to that.  In my estimation, the players involved are not nearly as conscious of what they are doing as it might appear.  Money has come to do business of its own account, and it is out of everyone’s control.  Surely one could find in the unfolding of this story avarice and mendacity aplenty.  After all are these not human beings dealing with vast sums of money?  I think though that if one could break the problem down office-by-office and cubicle-by-cubicle, one would find human beings struggling to make sense of it all, and survive in whatever fashion is meaningful to them.  This may be more-or-less true all the way to the top.  Moreover, if one traces carefully what has played out here, one could find fault at all levels, including the decent, hardworking, God-fearing middle-American that accepts their winnings in this casino of a monetary order as their due, and their losses as someone else’s ill-gotten gain.  We have virtually all in our respective spheres succumbed to the wiles of debt-money acculturation, and have acted at their behest against the better angels of our nature.  We are fools, every one.  The only way out is to confess it, and then move on.

There is currently a surfeit of hand-wringing in the public domain about how corrupt the system is.  What I do not detect (beyond the blame games) is a dialogue that holds the seeds of an answer.  Permit me to offer one.  There is attached a treatise which describes the root of the current economic chaos, and delineates a proposed solution.  As usual it is offered freely with no expectations attached.