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When it Comes to Naming Wall Street’s Worst Invention Ever, Credit Default Swaps Continue to Fill the Bill

By Martin Hutchinson
Contributing Editor
Money Morning

When it comes to naming a winner in the competition for “the worst product ever invented by Wall Street,” there is quite a list of worthy candidates. With just the current financial crisis alone there are such “inventions” as subprime mortgages, auction rate preferred stock and asset-backed commercial paper, which all have a good claim to this title.

There’s also the credit default swap (CDS).

While credit default swaps remain in second place to subprime mortgages in terms of total losses caused, there are plenty of reasons to crown these derivative securities as Wall Street’s worst offenders ever.

It won’t take me long to make my case. In fact, for “Exhibit A,” let’s just look at the collapse of U.S. insurance giant American International Group Inc. (AIG).

Misguided Missile
On Monday, the government announced that the already-hard-pressed U.S. taxpayer is being forced to put another $30 billion into AIG, bringing the total rescue package, thus far, to $180 billion.

For those with short memories, by far the largest portion of AIG’s losses has come in the $50 trillion credit default swap market, which was instituted only in 1995. Other Wall Street products have caused huge losses, but have spent decades growing before they did so, producing sober profits for many years before blowing up.

[Just yesterday (Tuesday), in fact, U.S. Federal Reserve Chairman Ben S. Bernanke verbally ripped AIG - saying the insurer operated like a hedge fund, while stating that having to rescue the insurer made him "more angry" than any other episode during the financial crisis - because of how its mishandling of credit default swaps led to the company's implosion.]

It is increasingly clear that CDS’s have produced profits only for the dealing community, and only for a few years. Even by Wall Street’s abominable standards, they thus have a rightful claim to be considered the worst financial “product” ever invented.

Under a credit default swap, if Institutional Investor “A” has a $10 million loan to Megacorp, Institutional Investor “B” can agree to cover the credit in that loan. In other words, if Megacorp defaults, “B” has to cover the debt. But “B” collects a small insurance premium for agreeing to cover the loan - a premium it gets to pocket as income.

Typically, payments under a Megacorp CDS are triggered either by a bankruptcy or by Megacorp failing to pay interest or principal on its debts. Because hedge funds and others gamble with these financial instruments, the problem arises in that the volume of credit default swaps currently outstanding is far greater than the volume of the loans themselves.

The bottom line: The credit risk spawned by the CDS market is much larger than the credit risk of loans on which CDS are written.

It’s no longer a question of hedging. It’s casino capitalism.

Inside View From an Insider
Back in the early days of the derivatives market, I spent five years running my employer’s derivatives desk: It was very simple stuff - mostly small transactions - and while we made money, the trades didn’t make either us or our employers rich.

However, we were always on the lookout for something new, because you can make good money on new types of transactions - without taking big risks. Needless to say, we looked at the possibilities of credit derivatives, for which there was an obvious need among the major international banks.

But there were two problems:

First, there was no obvious way of settling the things - each bankruptcy is unique, and the generally happen gradually, so it was difficult to determine how much to pay and when to pay it.
And second, the cash flows involved were totally skewed - a small annual payment versus the possibility of a huge payout on bankruptcy - so the amount of credit risk you’d build up between the two sides made the whole business uneconomic if you allocated risk correctly.
By the middle 1990s, the capital markets were so exuberant that dealers didn’t bother to solve those problems - they just ignored them. A $50 trillion credit derivatives market means there is $50 trillion of credit exposure on the dealer community, and no amount of collateral arrangements and fancy accounting can eliminate that fact. As for settlement, the dealers came up with an ingenious, but very un-foolproof scheme, whereby a mini-auction of the bankrupt credit would take place, so by buying a million or two in dodgy bonds you could corrupt the pricing of billions in credit default swaps that you held.

There are two other problems with credit default swaps CDS we didn’t think of in the 1980s.

First, AIG stayed almost entirely on one side of the CDS market - selling credit protection - because it believed it could do so, book the premiums up-front as income, collect bonuses based on the total premiums each year and never account for the risks on the actual derivative contracts themselves. After all, the swaps were being AAA-rated mortgage backed bonds.

(It would never have occurred to us in the 1980s that we could do this - we weren’t sufficiently in control of our auditors!).

From the point of view of AIG, the company, this was extremely stupid, though it had its advantages from the traders’ point of view. In the end, of course, it was all of us - the U.S. taxpayers - who were stuck paying the tab for a meal that others got to eat.

However, the second - and most serious - problem with credit default swaps is their potential use by short-sellers to cause bankruptcies.

Short-Sighted, Short-Selling
In the so-called “rational markets” that are so beloved by the textbooks, this should theoretically be impossible. In the real world, however, it would be fairly easy to engineer - especially in a period of uncertainty, such as we have had since 2007 - for a large operator to spread rumors, push down share prices, and thus cause the market to panic.

Richard S. “Dick” Fuld Jr., the former chief executive officer of Lehman Brothers Holdings Inc. (OTC: LEHMQ), the former CEO of Lehman, is convinced this is what happened in Lehman’s case, and it has undoubtedly been tried in several others.

Short-selling of shares was banned for several weeks after the Lehman bankruptcy, the reality is that neither short share sales nor share put options offer anything like the potential of credit default swaps to profit from a bankruptcy - particularly the bankruptcy of a financial institution whose debt is several times its share capital. Citigroup Inc. (C) and JPMorgan Chase & Co. (JPM), for example, each have around $1 billion in short positions outstanding in their shares. In the traded options market, Citigroup has a nominal $1.4 billion worth of put options outstanding while JP Morgan Chase has $2.1 billion - the cash value of those contracts will be a fraction of those figures.

What’s more, there are undisclosed amounts of over-the-counter equity options written between dealers. However, the volumes of credit default swaps were recently $65.7 billion on Citigroup and $62.4 billion on JPMorgan.

Now think about the arithmetic. To sell a share short, you risk all your capital - there’s no limit on how high a share of stock can rise. To buy puts, you deal only in a small market, and most puts are short-dated, so you would have to act quickly. With a CDS, however, you pay only an annual premium that is a small fraction of the principal amount involved, you acquire an asset that typically lasts several years, and you can deal in a market of over $60 billion - enough potential profit for even the greediest hedge fund.

Thus, credit default swaps make causing a “run” on a bank or investment bank enticingly profitable, with a profit potential that far outweighs the cost of undertaking the operation. Because the CDS market is much larger than the market for stock options - or even the share markets themselves - the product is a standing temptation to bad guys, and a danger to the banking system.

By now, it’s easy to see why credit default swaps are Wall Street’s worst invention.

Granted, these particular derivative securities are so far only second in total losses, behind subprime mortgages, but they lack the social purpose of the home loans for borrowers with poor credit, since those mortgages at least had the somewhat redeeming benefit of putting some folks in houses.

While there are a few CDS securities that genuinely hedge credit risk, almost all of them have no such benefit: They are gambling contracts, pure and simple.

For the taxpayer to bail out the victims with self-inflicted CDS wounds is as ludicrous as asking us to bail out the Las Vegas casinos.

But don’t laugh - that may well happen, yet.

[Editor's Note: When it comes to either banking or the international financial markets, there's no one better to hear it from than Money Morning Contributing Editor Martin Hutchinson, for he brings to the table the kind of high-level expertise that our readers have come to expect. In February 2000, for instance, when he was working as an advisor to the Republic of Macedonia, Hutchinson figured out how to restore the life savings of 800,000 Macedonians who had been stripped of nearly $1 billion by the breakup of Yugoslavia and the Kosovo War.

Credit default swaps entered the public lexicon last September, with the collapse of insurer American International Group Inc. But in an article featuring the headline, "Credit Default Swaps: A $50 Trillion Problem," Hutchinson warned Money Morning readers back in April 2008 that these derivative securities were poised to cause big problems for investors.

The tale of Two Worlds:

World # 1) What are we shifting away from? A lot of things, but one of the biggies is a fierce economic cycle that fueled the past decade. It went something like this:

We needed ultra-low interest rates after 9/11.
Those low rates fed insatiable demand for housing (real estate was especially attractive, because investors' fingers had just been burned by the dot-com bubble, so stocks were taboo).
Rising home values led to a surge in consumer spending -- funded by debt, of course.
Spending sprees led to massive trade deficits.
Massive trade deficits led to massive capital inflows by foreign investors.
Massive capital inflows kept interest rates low.
Hey, hey ... low interest rates? We're back to square one!
Repeat cycle until wealthy.

World # 2) A Minsky moment is a phenomenon named after economist Hyman Minsky, which describes what happens when an economy simply can't afford its debt anymore. Think of it in Wile E. Coyote terms: We reach the Minsky moment when, suspended in midair, we realize we've outrun our road, look down, and panic. The dangerous part isn't just that debt becomes a pain in the rear, but that it'll cause our half of the aforementioned cycle to grind to a halt.
That's where it gets ugly. When we can't come through on our half of the deal, things might start to spin in reverse. Events could go something like this:

Lower home and stock prices leads to less consumer spending.
Less consumer spending leads to smaller trade deficits.
Smaller trade deficits lead to less foreign capital inflows.
Less foreign capital inflows lead to higher interest rates.
Higher interest rates cause property and stock values to plunge.
Plunging values leads to less consumer spending.
Less consumer spending ... haven't we been here before?
Repeat cycle until broke. A Minsky moment is a phenomenon named after economist Hyman Minsky, which describes what happens when an economy simply can't afford its debt anymore. Think of it in Wile E. Coyote terms: We reach the Minsky moment when, suspended in midair, we realize we've outrun our road, look down, and panic. The dangerous part isn't just that debt becomes a pain in the rear, but that it'll cause our half of the aforementioned cycle to grind to a halt.
That's where it gets ugly. When we can't come through on our half of the deal, things might start to spin in reverse. Events could go something like this:

Lower home and stock prices leads to less consumer spending.
Less consumer spending leads to smaller trade deficits.
Smaller trade deficits lead to less foreign capital inflows.
Less foreign capital inflows lead to higher interest rates.
Higher interest rates cause property and stock values to plunge.
Plunging values leads to less consumer spending.
Less consumer spending ... haven't we been here before?
Repeat cycle until broke.

John

China’s Premier Wen ‘Worried’ on Safety of Treaseries (Update2)

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By Belinda Cao and Judy Chen

March 13 (Bloomberg) -- China, the U.S. government’s largest creditor, is “worried” about its holdings of Treasuries and wants assurances that the investment is safe, Premier Wen Jiabao said.

“We have lent a huge amount of money to the United States,” Wen said at a press briefing in Beijing today. “I request the U.S. to maintain its good credit, to honor its promises and to guarantee the safety of China’s assets.”

White House National Economic Council Director Lawrence Summers, asked about Wen’s remarks, said overseas “confidence” in Treasuries would be hurt without the administration’s steps to end the economy’s decline. President Barack Obama is relying on China to sustain buying of Treasuries amid record amounts of debt sales to fund a $787 billion stimulus package.

“China’s purchases of American debt have been one of the few bolts keeping the wheels on the global economy,” said Phil Deans, a professor of international affairs at Temple University in Tokyo. “If China stops buying, where does Obama’s borrowing to fund his stimulus come from?”

Treasuries declined after Wen’s remarks, before recouping the losses later. Yields on benchmark 10-year notes rose as high as 2.96 percent, from 2.85 percent late yesterday, and were at 2.83 percent at 12:27 p.m. in New York.

Loss on Treasuries

Treasuries have handed investors a loss of 2.7 percent in yuan terms this year, according to Merrill Lynch & Co.’s U.S. Treasury Master index. Chinese investors increased their holdings of the bonds 46 percent to $696 billion in 2008, according to U.S. Treasury data.

“Of course we are concerned about the safety of our assets,” Wen said after the annual meeting of the legislature. “To be honest, I am a little bit worried.”

Summers said that taking “austerity” measures would be even worse for the economy and financial markets, which he said he tracks “very closely.” Answering questions after a speech at the Brookings Institution in Washington, he said it’s “fiscally responsible” to implement measures in the near term that will restore longer-term growth.

China should seek to “fend off risks” as it diversifies its $1.95 trillion in foreign-exchange reserves, Wen said. Yu Yongding, a former adviser to the central bank, said in an interview on Feb. 10 that the nation should seek guarantees that its Treasury holdings won’t be eroded by “reckless policies.”

Haven Demand

Demand for the relative safety of Treasuries has been supported in the past two years as finance companies reported $1.2 trillion in credit losses. China boosted holdings of government debt as it lost of more than $5 billion from investing $10.5 billion of its reserves in New York-based Blackstone Group LP, Morgan Stanley and TPG Inc. since mid-2007.

Currency market moves have been more favorable to holding U.S. bonds this year. Chinese investors who bought Japanese government bonds would have lost 7.7 percent so far this year in yuan terms, compared with a 7.3 percent loss for holders of German bunds, according to the Merrill Lynch indexes.

“China won’t sell the U.S. debt now as that will only drive down Treasury prices, hurting not only the U.S. but also the value of its own investments,” said Shen Jianguang, a Hong Kong- based economist at China International Capital Corp., an investment bank partly owned by Morgan Stanley.

G-20 Meeting

U.S. Treasury Secretary Timothy Geithner will defend his spending plans at the Group of 20 meeting near London this weekend. French Finance Minister Christine Lagarde and Germany’s Peer Steinbrueck want the summit to focus on improving regulation and restraints on the finance industry.

The U.S. trade deficit and the government’s “nearly unrestricted” borrowing led to excess liquidity worldwide and “sowed the seeds” of the financial crisis, the People’s Bank of China said in a report today. The dollar has dropped 17 percent against the yuan since China ended a fixed exchange rate in July 2005. It was little changed at 6.8384 yuan today.

“China is worried that the U.S. may solve its problems by printing money, which will stoke inflation,” said Zhao Qingming, a Beijing-based analyst at China Construction Bank Corp., the country’s second-biggest lender. “If the U.S. can make sure this won’t happen, then China will continue to invest.” U.S. Secretary of State Hillary Clinton, while visiting officials in Beijing on Feb. 22, urged China to continue buying U.S. debt, which she called a “safe investment.” She didn’t press China on its foreign-exchange policy, backing away from January comments by Geithner that the Chinese government manipulates its currency to boost exports.

Exchange Rates

China will maintain its policy of seeking a stable yuan, even as gains against the euro and Asian currencies hurt the nation’s exporters, Premier Wen said.

While the yuan has weakened 0.2 percent against the dollar this year, there has been a “drastic depreciation” in the euro and Asian currencies that has put a lot of pressure on Chinese exporters, Wen said. The currency has gained 8.6 percent against the euro this year and 6 percent against the Philippine peso.

“Our goal is to maintain a basically stable yuan at a balanced and reasonable level,” Wen said on the final day of the meeting of the National People’s Congress. “At the end of the day, it is our own decision and any other countries can’t press us to depreciate or appreciate our currency.”

Export Slump

Collapsing exports have dragged China’s economy to its weakest growth in seven years and eliminated the jobs of millions of migrant workers. Wen reaffirmed China’s target of an 8 percent expansion in 2009 as economies from the U.S. to Japan contract, saying the goal was “difficult but possible” to achieve.

China can add “at any time” to 4 trillion yuan ($585 billion) of stimulus measures to revive the world’s third-biggest economy, Wen said. Gross domestic product expanded 6.8 percent in the fourth quarter, compared with 9 percent for all of last year and 13 percent for 2007.

“We have reserved adequate ammunition,” Wen said, adding that the fiscal deficit is under control and the debt level still safe. “At any time, we can introduce new stimulus.”

Delegates of China’s legislative advisory body suggested that the government diversify away from Treasuries into more risky assets. Jesse Wang, executive vice president of China Investment Corp., said on March 4 that the nation’s $200 billion sovereign wealth fund may invest in “undervalued” commodities.

The Reuters/Jefferies CRB Index that tracks 19 commodities dropped 55 percent from a record high of 473.97 reached in July. Oil prices fell 68 percent from July’s all-time peak of $147.27 a barrel.

To contact the reporter on this story: Belinda Cao in Beijing at lcao4@bloomberg.netJudy Chen in Shanghai at xchen45@bloomberg.net

March 13, 2009

Credit Card Cancer

This week, with his pronouncement that “credit is the lifeblood of a healthy economy,” President Obama reiterated what has been one of his most common themes in diagnosing our economic problem. The president has relied on this bedrock belief to propose policies that place the restoration of credit as the highest priority. However, despite his seemingly earnest intentions, the president and his economic advisors have misdiagnosed the ailment. Savings, not credit, is the lifeblood of a healthy economy. When not used properly credit can be like a cancer that sickens an otherwise healthy economy.

What everyone seems to have forgotten at this point is that credit does not come from thin air. Even in a system in which bank reserves are leveraged many times, someone has to put savings in a bank for the bank to turn around and make a loan. As a result, the bedrock is the savings, which allows for the credit to flow. Credit extended without adequate savings inevitably leads an economy into disaster.

The primary mechanism that has injected credit where it does not belong is the massive credit card industry that has developed in the United States over the last generation. The ease with which these cards may be obtained and the degree to which Americans now rely on them for routine purchases has created a culture of credit that simply has no precedent in a healthy economy. Until this culture has been reformed, America’s fight to restore economic vitality will be a lost cause.

However, this week a much discussed opinion piece in the Wall Street Journal by top banking analyst Meredith Whitney, indicated that many Americans besides the president are still looking toward credit as the means of economic salvation. In her piece, Ms. Whitney writes,

“…Undeniably, consumers look at their unused credit balances as a "what if" reserve. "What if" my kid needs braces? "What if" my dog gets sick? "What if" I lose one of my jobs? This unused credit portion has grown to be relied on as a source of liquidity and a liquidity management tool for many U.S. consumers. If credit is taken away from what otherwise is an able borrower, that borrower's financial position weakens considerably. With two-thirds of the U.S. economy dependent upon consumer spending, we should tread carefully and act collectively.”

In order to keep the economy functioning, Ms. Whitney asks the credit card providers and the federal government to keep credit lines open, so that millions of Americans can keep on spending. However, while such actions would certainly keep our phony economy propped up a while longer, it would further weaken the very foundation upon which a real economy will eventually have to be rebuilt.

Without a doubt, Americans, and all other people for that matter, benefit from having access to “rainy day money.” But Americans should be saving for a rainy day, not adopting the attitude that if it rains I’ll whip out my credit card. If Americans need to pay for a suddenly ill dog, to straighten their kid’s teeth, or to pull them through a period of unemployment, they should save some of their present earnings.

But saving money requires a reduction in spending, and that is something that modern economists, within and without the Administration, cannot abide. A drop in spending will create a sharper contraction in our economy – which is now comprised of 70% consumer spending. But this is no reason to discourage the process. The option to go into debt in the event of an emergency is no substitute for building personal savings for such events. Not only does such a strategy jeopardize the solvency of individuals or families when they are at their most vulnerable, but it deprives society of badly needed savings.

Currently, with so many financially strapped Americans looking to draw on their credit lines, the fallacy of this ‘savings substitute’ is easily revealed. With lenders’ capital depleted, and falling home prices, and rising unemployment putting borrowers at greater risk of default, credit is naturally harder to come by. Had only a small percentage of borrowers needed to access their credit card “rainy day funds” there would have been no credit crisis. But with a deluge drenching so many at once, there was simply not enough credit umbrellas to go around. Had Americans actually been saving money instead, everyone would have his own umbrella and would not now be looking to borrow someone else’s.

Most importantly, as savers bank their earnings into “rainy day funds,” in addition to earning interest, those savings are available to businesses to make capital investments, produce goods and services, and provide employment. Without access to those savings, such investments cannot be made, and society is worse off as a result.

Lastly, savings can always be relied upon whereas credit is ephemeral. Remarks this week from the Chinese premier Wen Jiabao should serve notice to all Americans that the day will soon come when the Chinese stop lending us their umbrellas. When that happens, the average American will be soaked to the bone.

For a more in depth analysis of our financial problems and the inherent dangers they pose for the U.S. economy and U.S. dollar denominated investments, read Peter Schiff’s book "Crash Proof: How to Profit from the Coming Economic Collapse".

Is Chrysler Down For The Count

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April 20, 2009

The Alternative to Spending More
By Daniel Hannan MEP

Is there anything - anything at all - that might convince world leaders that they shouldn't respond to the credit crunch by spending more? It may seem common sense that you can't borrow your way out of debt: we all apply that principle to our household budgets. But, since the financial crisis began, states increased their spending despite the plain evidence that stimulus packages have done nothing to ward off the recession.

On most measures, it hasn't worked: the downturn has happened anyway, but we are now drifting into it with an additional debt burden. The trouble is that, politically, stimulus packages take on their own momentum. Leaders cannot go back to their voters and sheepishly admit that the money has been wasted. They have to pretend that they are almost there, that another billion dollars will do the trick. And so, like rogue traders, they end up doubling and doubling in an attempt to move the market.

What's the alternative to spending more? How about this: not spending more. The phrase "doing nothing is not an option" is one of the most pernicious in the political lexicon, and is almost never true. By way of illustration, ponder the way in which New Zealand dealt with an earlier banking crisis two decades ago.

New Zealand was the first major country to withdraw all subsidies from its agricultural sector - a reform that was hugely controversial at the time, but that almost no one now wants to reverse. When the grants were terminated, land values fell, and many Kiwi farmers found themselves in negative equity. The bankers approached the government to demand a bail-out. The government declined to involve itself. The bankers tried again, insisting that, if the state didn't step in, there would be a financial collapse. Ministers politely told them that this was their problem.

Result? The bankers realised that it was their problem. Well aware that the last thing they needed was a series of repossessions and auctions, they allowed farmers to reschedule their mortgage payments. The crisis was averted and, sooner than expected, land prices recovered. It's what economists call "spontaneous order".

The point is that, had the government given in to pressure, it would almost certainly have triggered the collapse that it hoped to avert.

Sadly, it's a brave politician who argues, in a crisis, against state activity. The natural advantage will always lie with the Something Must Be Done crowd. But there are few crises so severe that they cannot be exacerbated by government intervention. I leave you with the words of that most conservative of Conservatives, the third Marquess of Salisbury, spoken about the Bulgarian Crisis of the 1880s, but capable of much wider application: "If anything happens, it will be for the worse, and it is therefore in our interest that as little should happen as possible."

Been awhile hey John?

IMO what they are trying to do is float the Titanic. The system has failed and trying to fix it so it works like it used to is not going to happen. I think they know that they are chucking petrol onto a blazing fire. The supposed wealth was a misnomer. Wealth should stand the test of time but the banks owned everything and nothing at the same time.

Anyone in debt right now is vulnerable.

In the old days, credit was a luxury and usually the items on hire purchase as it was known back then still maintained some intrinsic value. The throw away culture that has developed is such that if you drive a car off the showroom floor and immediately back in and sell, you lose significantly. In the hire purchase era, they repossessed the asset and usually one was blacklisted for a short while but you essentially paid hire for the time you used the asset. Usually these HP's were 6 months and 12 months max financed by the seller and not banks at a huge interest rate.

Then came the no deposit no interest NDNI era with banks financing/guranteeing the transaction. The fees were already built into the floor price. These usually were 12 months to 24 months and of course the cash price was always a huge discount.

Then came credit cards and it all went to shit from there.

The older models spread the risk evenly until the banks decided to become the financiers of everything including your groceries/consumables. The assets values of that being financed was offset by ridiculously high interest rates. When these debts were defaulted on, they invented new ways to offset debt by repackaging the debt and we all know what came next.

The old model, the banks owned the assets like buildings and motor cars and being the sole or majority owners, controlled the market value, hence a house usually appreciated in value and a car depreciated but not so bad that after 5 years was absolutely worthless.

Trust the Americans to find a way to convert debt into an asset and resell it? And the whole world followed suit. One giant ponzi scheme.

Supply and demand used to be the fundamental drivers of the economy but today it is credit.

See the problem?

How is growth measured?

Financial growth should be proportional to population growth. Is it? The driver should be increased demand. Is it?

See they mechanized everything thus labor is no longer a growth factor. The model thus has to change to adapt to the new environment.

This is why China and India kick everyone else's asses. They still utilize cheap labor. Look at their economies. Are we really a 1st world culture or better still what benefit has it brought that is sustainable?

Sad but true.

Hi Bernie,

You are preaching to the choir Bernie. Everything that you say is absolutely true and impeccably accurate, indeed! The False economy that is predicated on credit and consumption without the necessary intermediary steps of production and savings is about to come crashing down. Along with the fait currencies that were the conduit of such a scheme.

I am very much worried that these economic issues will spill over into the political arena and then led to a war or a whole bunch of smaller ones. Then perhaps a big confrontation over dwindling energy reserves.

There is a parallel economic story going on here at the same time as the fait currency one and that is peak oil and the depletion of cheap energy. As you are well aware of, our current population boom is reliant on cheap energy. Roughly 80% of the cost to bring food to the average consumer is in energy. From the sowing to pesticides, fertilizers, harvesting, distribution and refrigeration the survival of the 7 billion people on this planet depend on the flow of cheap "net energy".

These present historically large populations are fast wringing out of the planet the "CHEAP ENERGY" from biomass, coal, oil and natural gas. And most people think that the Titanic is unsinkable. So between what is happening in the world of finance and with the crisis of peak energy it should be an interesting next few years.

John

Look Everybody Bernanke & Paulson Forced Ken Lewis Not to disclose to BoA Share Holders The Financial State of Merrill Lynch - What are Bernanke & Paulson Guilty Of!!!


Washington to B of A: Shareholders be damned!


by Martin D. Weiss, Ph.D.
Dear Subscriber,


Last December, with its stock hovering around $15 per share, Bank of America CEO Ken Lewis made a startling discovery: Merrill Lynch — the giant his bank was in the process of acquiring — was in far worse shape than he had dreamed.

This week, thanks to documents released by New York Attorney General Andrew Cuomo, we discovered new details on what appears to be the real reason Lewis finalized the merger despite Merrill's obvious troubles.

According to Lewis, he had told former Treasury Secretary Paulson and Fed Chairman Bernanke that he wanted to back out of the merger with Merrill. Whether he had the legal ability to do so or not is a separate issue. What matters is that, according to Lewis, Paulson and Bernanke tacitly threatened to fire him and his entire board of directors if they backed out.

Now Lewis has testified that Paulson made it quite clear he was NOT to disclose to his shareholders how troubled Merrill was for fear that they would demand the merger be canceled.

Bottom line: When faced with the choice of saving his own job or saving his shareholders, Lewis decided to keep his mouth shut, go ahead with the merger and save his job.

He had a gun pointed to his head, the classic case of a shotgun merger; and the rest is history...

In January, Bank of America reported a $2.4 billion fourth-quarter loss and Merrill disclosed a $15 billion loss.


Also in January, Washington gave Bank of America $20 billion of your money to offset losses it suffered because of its shotgun marriage with Merrill.


And as of Friday's close, the decision made by Paulson, Bernanke and Lewis has cost shareholders as much as 43 percent of their money in just over four months, even AFTER a vigorous rally.
Even more disturbing: As the details of this latest shotgun marriage continue to emerge, it's becoming clearer than ever that ...

Washington does NOT want us to know the truth.

A disturbing pattern is taking shape here — a pattern of obfuscation and outright deceit that illustrates just how panicked Washington regulators truly are when they discuss this crisis behind closed doors.

On Friday, I posted a new article on my blog showing how Washington's much vaunted bank stress tests have been blatantly rigged to portray our 19 largest banks as being far healthier than they truly are.

Plus, the regulators have authorized accounting rules that allow banks to ...

Inflate the book value of toxic assets they own ...


Miraculously vaporize liabilities they are responsible for, and ...


Magically erase billions of losses in their quarterly reports — treat them like they never even happened.
Let's be clear here: Washington caused this crisis through artificially low interest rates and by blessing go-for-broke speculation by our largest financial institutions.

Now, Washington is making matters worse by playing it fast and loose with the truth — even cajoling CEOs to violate their disclosure obligation to shareholders — and as a result, our leaders are slamming investors for billions of dollars in stock market losses.

Unless we stop them now, Washington will bankrupt us all with massive bailouts of companies like Chrysler and GM that take tens of billions more of our dollars for companies that, in the end, go belly-up anyway.

This is precisely why I've spent the past few weeks urging you to join me in a national grass-roots campaign to make our voices heard in Washington — to sign our petition demanding that our leaders STOP these worthless, useless, pointless bail-outs before they bankrupt our entire nation.

So far, nearly 30,000 taxpayers and investors have signed our petition — but your opportunity to add your voice to ours MUST END NEXT WEEK!

Next week, we will print these petitions and the following week, I will personally deliver these demands to our nation's leaders in Washington D.C.

I sincerely hope that yours is among the nearly 30,000 taxpayers and investors who have already joined me in this campaign. If not, you still have time: Just click here to add your voice and to join this fight to preserve our children's futures. This is the last week to do so before I personally deliver the petitions to Washington.


And to make sure our leaders get the message loud and clear, include a simple note in each package: "Stop the bail-outs before you bankrupt ALL of us!"

Look: It's bad enough that hundreds of thousands of our fellow Americans are likely to lose their jobs when GM and Chrysler fail.

We can NOT allow Washington to add insult to injury by continuing to throw our money at companies that are going to go bust no matter what!

IGood luck and God bless!

Martin

A must See Video

Password is INFLATION


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So very true! Tell me, when will the world wake up and see this?

(quote="Pierac")

So very true! Tell me, when will the world wake up and see this? [/quote]
+++++++++++++++++++++++++++++++++++++++

Probably only after this false financial syetem that inolves
the greater part of the world completely and utterly fails,
there is no way the financial system as it now exsists can continue for long before it goes down, most folks lay up hope in the very people who brought this present financial meltdown to where it is now to bring us out, that is not going to happen because it has been based on an unbalanced, lying, corrupt false foundation to start with,
even those who in earnest believe that it can be balanced back up, it appears to me to be too far beyond that point
without indebting the next five or six generations to even less than third world livings conditions for their whole lives, instead of letting that happen it appears that it would be better to let these big corporate banks fall now and start a better system even though it would be tough in the transistion period, if that is even possible with man in this present world condition it would be better than leaving things go as they are now.

Peace,
Fire Walker

The Size of The US Debt!!!

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May 6, 2009

Global Economics on Tilt - How to Protect Your Ass(ets)
By By Jeff Clark, Editor, BIG GOLD

Gold isn't going to $2,000 an ounce.


Before you gag on your coffee or suffer chest pains, allow me to explain.

We're about eight years into the bull market, and gold has breached the $1,000 level twice and has spent weeks trading above the old high of $850. Some observers are now saying that gold's pretty much had its day and that once the recession is over, it will retreat for good.

However, the four-digit gold price we've seen so far is with no price inflation to speak of, no effects of the atrocious increase in the money supply, and despite a rising dollar. What happens to gold when each of those pictures gets turned upside down - high inflation, excess cash jolting the economy, and a falling dollar? After all, gold's performance to date has been powered only by general anxiety, not by any visible erosion in the dollar's value.

I decided to take a fresh look at calculations that could be used to appraise gold's upside potential. No one of them, by itself, comes with compelling logic. But they all point in the same direction.

Gold's Percentage Rise in the Last Bull Market. What if gold in this bull market repeats the percentage rise in the last bull market? In the 1970s gold rose from $35 to $850, a factor of 24.28. Our low in 2001 was $255.95. Multiply that by 24.28 and you get a gold price of $6,214 per ounce.

U.S. Gold Holdings to Money Supply: The M1 money supply consists of currency and checkable deposits. The U.S. government currently holds 286.9 million ounces of gold. If the government were to make each dollar redeemable by the amount of gold it possesses, we'd arrive at the following price for gold: $1.569 trillion ÷ 286.9 million oz. = $5,468.80 per ounce

Gold/Dow Ratio: The ratio was about "1" when gold peaked in 1980, meaning the Dow and gold were the same price. To restore that relationship at today's stock prices would mean when the Dow is at 6,626, gold should be at $6,626/oz. Of course, we think it likely that the Dow will get a lot lower before gold peaks. But even if it drops all the way to 4,000, that would imply a gold price of $4,000/oz.

All the Money in the World vs. Gold Reserves: If the public eventually sees the paper game being run by the central banks for what it is, governments will be forced to back their currencies with gold (and perhaps other tangibles like silver). Assuming they had to go into the market and buy the gold needed to restore faith in their currencies, the numbers might look like this: Total central banks reserves (including gold holdings) = $4.8 trillion, divided by 929.6 million ounces total gold reserves held by all official institutions that issue currency = $5,246 gold price.

U.S. Gold Holdings to U.S. Foreign Trade Deficit: The size of a country's deficit or surplus would be of no consequence if all currencies were convertible into a fixed amount of gold. However, the dollar is increasingly considered a hot potato, and when the trade balance reverses, as it must, dollars will flow back to the U.S. and fuel domestic price inflation. Based on the cumulative trade deficit of $9.13 trillion (up from $6 trillion since June '07!) and U.S. gold holdings of 286.9 million ounces, the corresponding price of gold would be $31,822 per ounce.

U.S. Gold to U.S. Government Liabilities: Finally, the GAO (Government Accountability Office) calculates an income statement and balance sheet for the U.S. government. As you'd suspect, it is dominated by future liabilities for Medicare and Social Security. What if they had to be backed by the supply of gold? Official U.S. government liabilities now ring in at an incredible $55.2 trillion. To make good on that would require a $192,401 gold price.

No, we don't think gold will hit $192,000 or even $32,000. And there really isn't any surefire way to forecast the eventual high. But it's clear that every weathervane is pointing in the same direction. So, yes, gold isn't going to $2,000; it's going higher.

Witness the Breakdown

When determining how to keep your wealth safe, the state of global affairs can be a powerful reminder that gold should be part of the strategy. And today our world, essentially, is on fire.

Eastern Europe borders on bankruptcy. Brazil's economy is falling off a cliff. Ditto Mexico.
Protests have erupted in Latvia, Chile, Greece, Bulgaria, Iceland, Dublin, and parts of the U.S. Workers have gone on strike in Britain and France.
In the U.S., 36 states and the District of Columbia have proposed or implemented reductions in the civil workforce. (You think customer service is poor now...)
An astounding one in nine homes, 14 million, sits empty in the U.S. The December median price of a home sold in Detroit was $7,500. More than 8.3 million homeowners were upside down on their mortgage in the fourth quarter. Freddie Mac's new CEO resigned after six months on the job.
Last quarter, 12 U.S. banks failed, bringing the 2008 total to 25, the highest one-year death rate since 50 failed in 1993. More foreboding, another 252 banks joined the FDIC's "problem list." So far this year, 19 banks have failed.
The central bank of Ukraine banned the early redemption of term deposits, the most popular form of savings in the country. Bank deposits have dropped 20% since September, as bank customers dodge the risk of getting locked in.
The projected US$1.75 trillion federal budget deficit is almost four times the nation's previous record-high budget deficit. The Times Square debt clock reads over $11 trillion. Japan's now reads $7.8 trillion.
High unemployment has become a worldwide epidemic, with the infection spreading.
With world economies taking it on the chin, it's little wonder that investor interest in gold as a safe haven is growing - a trend we expect to continue. And just wait until the dollar resumes its slide, the expanding money supply jolts the real economy, and inflation kicks in.

Both Hands on the Wheel

Given the ongoing turmoil and the swallowing darkness at the end of the crumbling economic tunnel, our recommended BIG GOLD strategy remains keeping one-third in cash, one-third in physical gold, and one-third in our selected gold stocks. New money for investment should be split among the same three categories; we just don't see any safer places to be.

As economies around the world continue to shrink and governments continue administering larger doses of the wrong medicine, we'll sit in relative comfort with our gold for protection and our stocks for profit. We expect the prices of both to rise as others join us.

***

Even though some of the mainstream media are already popping the champagne, cheerfully pronouncing the end of the crisis, we beg to differ. The economic quagmire the U.S. and much of the developed world is in is far from over… so be right and sit tight, as we at Casey Research like to say. And find out how you can make the most out of gold as a safe-haven investment, by clicking here.

Any Ideas How We Can Waste Allot of Money



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Don’t Be Fooled by Inflation

Strike up the band, boys, happy days are here again! Recently released short-term economic data, including unemployment claims, non-farm payrolls, home sales, and business spending, which had been so unambiguously horrific in February and March, are now just garden-variety awful. With the Wicked Witch of Depression now apparently crushed under the house of Obamanomics, the Munchkins of Wall Street have sounded the all clear, pushing the Dow Jones up 25% from its lows. But the premature conclusion of their Lollipop Guild economists, that the crash of 2008/2009 is now a fading memory, is just as delusional as their failure to see it coming in the first place.

Once again, the facts do not support the euphoria. Over the past few months, the government has literally blasted the economy with trillions of new dollars conjured from the ether. The fact that this “stimulus” has blown some air back into our deflating consumer-based bubble economy, and given a boost to an oversold stock market, is hardly evidence that the problems have been solved. It is simply an illusion, and not a very good one at that. By throwing money at the problem, all the government is creating is inflation. Although this can often look like growth, it is no more capable of creating wealth than a hall of mirrors is capable of creating people.

We are currently suffering from an overdose of past stimulus. A larger dose now will only worsen the condition. The Greenspan/Bush stimulus of 2001 prevented a much needed recession and bought us seven years of artificial growth. The multi-trillion dollar tab for that episode of federally-engineered economic bullet-dodging came due in 2008. The 2001 stimulus had kicked off a debt-fueled consumption binge that resulted in economic weakness, not strength. So now, even though the recent stimulus administered a much larger dose, we will likely experience a much smaller bounce. One can only speculate as to how much time this stimulus will buy and what it will cost when the bill arrives.

My guess is that, at most, the Bernanke/Obama stimulus will buy two years before the hangover sets in. However, since this dose is so massive, the comedown will be equally horrific. My fear is that when the drug wears off, we will reach for that monetary syringe one last time. At that point, the dosage may be lethal, and the economy will die of hyperinflation.

As always, the bulls fail to understand that investors can lose wealth even as nominal stock prices rise. As a corollary, the bearish case is not discredited by rising stock prices. While there are some bears that mistakenly cling to the idea that deflation will cause the dollar to rise, those of us in the inflation camp understand that the opposite will occur.

In the meantime, stocks are not rising because the long-term fundamentals of our economy are improving. If anything, the rise in global stock prices is due to investors realizing that cash is even riskier then stocks. The massive inflation that is the source of the stimulus is essentially punishment for those holding cash. To preserve purchasing power, investors must seek alternative stores of value, such as common stock.

It is important to point out that despite an impressive rally, U.S. stocks have substantially underperformed foreign stocks. In the past two months, while the Dow Jones has risen 30%, the Hang Seng and the German DAX have risen by over 50% in U.S. dollars. Commodity prices are also rising, with oil hitting a five-month high. And gold is shining as well, with the HUI index of gold stocks up 30% during the past two months, and 2/3 of those gains occurring in the past month. If this rally really were about improving economic fundamentals, gold stocks would not be among the leaders. Further, during those two months, the U.S. dollar index fell by 7%, with commodity-sensitive currencies such as the Australian and New Zealand dollars surging 20%.

To me, the relative strength of foreign stocks and currencies indicates that perhaps the global economy is not as impaired as many have feared. It has been my view all along that after the initial shock wears off, the world will be better off – once it no longer subsidizes the American economy. The shrinking U.S. current account deficit is evidence of this trend in action. Renewed strength in foreign stocks and weakness in the dollar may indicate that not only is the world decoupling from the U.S., but benefitting as a result.

So let the Munchkins dance for now. But remember, the Witch is not dead; only temporarily stunned by an avalanche of fake money.

Peter Schiff

Five Economic Storms Raging NOW!


by Martin D. Weiss, Ph.D.
Dear Subscriber,


Any economist fixated on so-called "signs of a recovery" needs to have his head examined.

As I'll prove to you in a moment, the hard-nosed reality is that five major economic cyclones are in progress at this very moment.

The storms are not abating. Nor are they changing direction. Quite the contrary, what you see today is, at best, merely a deceptive calm before the next, even larger tempests.

For investors who follow Wall Street, it could be fatal.

For contrarian investors, however, this insanity opens up some of the greatest opportunities in many years: Precisely when we see plunging barometers all around us, we also have a new surge of hype on Wall Street, driving stock prices higher.

Result: The rally has lowered the cost of contrary investments precisely when their prospects are best. Consider the five storms, and you'll see exactly what I mean ...

Storm #1.
Plunging Jobs

On Friday, the Bureau of Labor Statistics announced that job losses were running at a slightly slower pace than in the first quarter. So Wall Street cheered.

But it's a joke, and the 539,000 additional Americans out of work aren't laughing.

Nor are the 23 million people — 15.8 percent of the work force — who are officially unemployed ... are struggling with lower paying part-time jobs ... or have given up looking for work entirely.


Look. In December 2007, there were 138.1 million jobs in America. Now, there are only 132.4 million.

So even if you accept the government's tally of the narrowest unemployment measure, 5.7 million jobs have been lost.

Plot those figures on a chart and the picture is absolutely unambiguous: Jobs in America are collapsing. Right here and now!

Where's that "slightly slower pace of collapse" they're raving about? You'd need a microscope to see it.

Storm #2
U.S. Housing Starts Down 77.6 Percent!

Housing is the nation's largest industry. With it, the entire global economy boomed in the mid-2000s. Without it, a recovery is next to impossible.


The big picture: Housing starts, the best measure of the industry's health, peaked at an annual pace of 2.3 million units in early 2006.

Now, they're running at barely more than a 0.5 million units.

That's a decline of 77.6 percent — three-quarters of America's largest single industry wiped out.

Yes, back in February, there was a tiny uptick: Starts rose from 488,000 to 572,000. And everywhere we heard voices cheering the "spectacular" jump in housing starts.

What they didn't tell you is that the so-called "jump" was actually smaller than six of the seven minor upticks we've seen in housing starts since 2006. Nor did you hear them say much when this measure fell anew in March.

Subscriber, this industry is not recovering. It remains in a state of near total collapse.

The only major change: Lenders have given up waiting for a recovery that never comes. So they're throwing in the towel, unloading huge inventories of foreclosed properties at fire-sale prices. And they're calling that a "recovery"?


Storm #3
Auto Sales Down 44 Percent!

At their peak in February 2007, U.S. and foreign-owned companies sold automobiles in America at an annual pace of 16.6 million units.

Last month, their sales pace plunged to 9.3 million, a decline of
44 percent (including the best performers like Toyota and Honda).

Again, as with housing, we saw a tiny uptick in the prior month, hailed by high officials as a "sign" of improvement. Yet, as with housing, it was weaker than all prior "signs of a turn" over the past 26 months — each of which was followed by a sharper plunge.

Any lights at the end to Detroit's dark tunnel? Only those of three speeding freight trains:

The Chrysler bankruptcy, despite all the talk of a "quick and easy" procedure, is not only frightening U.S. car buyers away from the Chrysler brand, it's also scaring them from other U.S. and foreign makers. And it's not only hurting auto dealers and parts suppliers, but also smacking auto lenders. Meanwhile ...


GMAC, the nation's largest auto lender, is already in its death throes, with the government now estimating it could suffer additional losses of a whopping $9.2 billion over the next two years. Will the Obama administration bail it out? Perhaps. But it would still have to downsize its operations, throwing another monkey wrench into General Motors' sales. Meanwhile ...


General Motors is now sinking even more rapidly toward bankruptcy than it was just a few months ago. According to last week's New York Times column, G.M., Leaking Cash, Faces Bigger Chance of Bankruptcy ...
"Even after receiving $15.4 billion in federal loans, General Motors is once again on the brink of financial collapse.

"The automaker's first-quarter earnings released Thursday showed that G.M. was losing more money and sales than it was in late December, when the government began its bailout.

"With its cash reserves down to the bare minimum and its revenue plunging, G.M. seems more certain each day to be heading toward a bankruptcy filing. ...

"The company's chief financial officer, Ray Young, called the drop ... 'a staggering number,' and said consumers were showing increasing concern about G.M. products because of the potential for bankruptcy."

General Motors' CFO added: "Once you start losing revenues, you get yourself into a vicious cycle from which you cannot recover."

Sound familiar? It should. It's the same vicious cycle I've been warning about for many moons — falling revenues prompting mass layoffs, and mass layoffs driving down revenues.

Storm #4
Biggest Decline in Consumer
Credit Ever Recorded!

Any economist counting on the consumer to get things going again had better go back for some more Rorschach tests ...

... because you don't need a therapist to interpret the image depicted in my chart below. It shows very clearly how the nation's lenders are dumping consumers and making a mad dash for the exits:


In the third quarter of 2007, banks dished out $44 billion in net new loans on credit cards, autos, and other consumer credit (excluding mortgages).

Then, just 12 months later, in the third quarter of 2008, that giant credit machine collapsed to a meager $8.7 billion, a decline of 80 percent!

But the collapse didn't end there. In last year's fourth quarter, not only did new credit disappear, but lenders actually pulled out of the consumer credit market to the tune of $19.5 billion.

And they did it AGAIN in the first quarter of this year, pulling out another $12.2 billion.

It is the biggest collapse in consumer credit ever recorded.

Now do you see why I'm recommending a shrink for any economist fixated on a recovery?

They know how important credit is. They know that few Americans have the savings to splurge on consumer goods. And they're tired of knowing that a recovery is virtually impossible without credit.

And yet here we are, with the biggest-ever collapse in consumer credit — and they're still searching for the "signs"!

Storm #5
Big Banks!

Whether the government lets big banks fail or not, the impact on the economy is similar: A massive contraction of bank loans and credit, sabotaging attempts to revive credit flows and stimulate the economy.

Reason: These banks must build capital quickly, and the only realistic way to do so is by cutting back on their lending.

The official stress test results released Thursday on 19 U.S. bank holding companies were supposed to help determine exactly how much capital they'll need, and the total came to $75 billion.

That's no small amount. But the stress tests will go down in history as the world's most elaborate effort to paint lipstick on a pig.

To show you why, first, let me provide our analysis based on data from TheStreet.com Ratings, the Comptroller of the Currency (OCC), and the banks' first-quarter financial statements. Then I'll show you why I believe the official results grossly underestimate how much capital the banks will need and how much pressure they'll be under to slash lending.

We find that ...

Seven institutions — JPMorgan Chase & Co., Citigroup, Wells Fargo & Co., Goldman Sachs Group, GMAC LLC, SunTrust Banks, Inc., and Fifth Third Bancorp — are at risk of failure and may have to cut back lending dramatically to stay alive.


Eight institutions — Bank of America, Morgan Stanley, PNC Financial Services Group, US Bancorp, BB&T Corp., Regions Financial Corp., American Express Co., and Keycorp — are borderline, meaning they could be at risk of failure with worsening economic or financial conditions and will also have to cut back on lending.


Only four institutions — MetLife, Bank of NY Mellon Corp., Capital One Financial Corp., and State Street Corp. — appear to have adequate capital to withstand worsening conditions. But even they may voluntarily cut back their lending in an attempt to maintain their current financial health.
Moreover, of the $11.6 trillion in assets held by the 19 institutions, those likely to cut back dramatically represent $6.56 trillion, or 56.5 percent, of the assets; while borderline institutions hold $4 trillion, or 34.7 percent.

Only $1 trillion — just 8.8 percent — of the assets are held by institutions with adequate capital, based on our analysis.

In contrast, the government is trying to persuade us that most have plenty of capital ... the rest can easily raise it ... and none will have to slash lending in a way that would sabotage the prospects for an economic recovery.

So what explains this vast discrepancy between the official conclusions and ours?

The simple answer: Three unmistakable deceptions in the government's stress tests ...

First deception: The assumptions.

To come up with estimates of future losses, the government assumed what they call "a more adverse" scenario. But their more adverse scenario is actually less adverse than the current reality!

Hard to believe? Then just look at their own numbers in the chart the Fed published recently:



Their "more adverse" scenario is predicated on the presumption that the GDP will contract no more than 3.3 percent this year. But in actuality, the GDP is already contracting at an annual pace of 6.1 percent!


Their "more adverse" scenario also assumes that unemployment will average 8.9 percent this year. But unemployment has already reached 8.9 percent in April, and no one — not even economists fixated on recovery signs — is anticipating anything but a further rise.
Either they're delusional. Or they're cheating at solitaire.

Second deception: No mention of systemic risk!

The banking regulators have published two major white papers on the stress tests — "Design and Implementation" plus "Overview of Results." However, in these papers, they have failed to even mention the greatest risk of all: systemic risk.

This is the risk that ...

A few key players in highly leveraged instruments like derivatives could default on their trades.


These defaults could set off a series of failures, with the most severe impacts felt by banks that hold the largest share of the derivatives in the country.
This is the giant risk that the Government Accountability Office (GAO) wrote about in its landmark 1994 study, "Financial Derivatives: Actions Needed to Protect the Financial System," warning of "a chain reaction of market withdrawals, possible firm failures, and a systemic crisis."

This is the giant risk that triggered the collapse of Bear Sterns, the failure of Lehman Brothers, and the $180 billion bailout of America's largest insurer, AIG.

It's the giant risk that AIG executives themselves wrote about in their recent memorandum, "AIG: Is The Risk Systemic?," warning of a "cascading impact on a number of life insurers already weakened by credit losses" ... and "a chain reaction of enormous proportion."

It's the giant risk that the International Monetary Fund is most concerned about when it warns of another $3 trillion in global losses due to the banking crisis.

It's the giant risk that prompted former Treasury Secretary Henry Paulson to literally drop to his knees last September, begging Congress for $700 billion in bailout funds for the banking industry.

Since that day, the U.S. economy has suffered the worst back-to-back GDP declines in over 50 years, burning the nation's fuse even closer to a blow-up.

And yet, suddenly, in a massive undertaking that was supposed to accurately evaluate the banks' exposure to these dangers, it's also the giant risk that has been scrupulously scrubbed from 59 pages of official white papers, a half dozen press releases, plus multiple public pronouncements — all about the stress tests, all without a single mention of systemic risk.

This omission is both deliberate and unforgivable.

It means the stress tests have failed to fairly evaluate the credit exposure of each bank to defaults by their trading partners. And it means the tests are creating a false sense of security for investors and the public that can only lead to greater mistrust, more loss of confidence, even panic.

The omission is especially misleading for large banks that dominate the derivatives market ... would be at ground zero in any meltdown ... and would therefore be among the first to suffer massive losses.

The prime example: The OCC reports that, at year-end 2008, JPMorgan Chase (JPM) held $87.4 trillion in notional value derivatives, including $8.4 trillion in credit default swaps.

(To see for yourself, click here to download the OCC's latest report; scroll down to page 22; and check out the top line "JPMorgan Chase Bank NA." Note: The next to the last column "Total Credit Derivatives" is 99 percent made up of credit default swaps, according to the OCC.)

Why is this such a big problem? For several reasons:

Although it's cut back a bit, JPM still has 43.6 percent of all the derivatives held by all U.S. commercial banks, or $17 trillion more than Bank of America and Citibank combined. Among the 19 bank holding companies in the stress tests, that puts JPM closer to ground zero than any other bank.


It's well known that credit default swaps are the highest-risk sector of the derivatives market. And yet, in this sector, JPM has 52.8 percent of the total held by all U.S. commercial banks, or nearly double the total held by BofA and Citi. This puts JPM even closer to ground zero.
JPM execs insist they're smart and know how to handle their risks very neatly. But if that were the case, why did they suffer a whopping $2.5 billion loss in their credit default swaps in the fourth quarter? (OCC, page 27, Table 7, line 1, last column.)


The OCC also reports that, for each dollar of capital, JPM still has $3.82 in total credit exposure. Mind you, that's JPM's exposure to just one kind of risk (defaults by trading partners) in just one kind of instrument (derivatives). In addition, JPM is also assuming market risks in derivatives plus a series of risks in its other investing and lending operations. (OCC, page 13, table at bottom of page, line 1, last column.)


Despite all this, in their "more adverse" scenario, the banking regulators estimate JPMorgan Chase's total "counterparty and trading losses" will not exceed $16.7 billion, a fraction of the true potential losses in a financial crisis.
With the fatal omission of systemic risk from their analysis, the government concludes that JPMorgan Chase is in good shape and does not need any additional capital.

The same omission leads to a similar conclusion for Goldman Sachs, despite the fact that Goldman has over $10 in total credit exposure per dollar of capital, or nearly triple the credit risk of JPMorgan Chase.

The only realistic conclusion: Both these institutions will need huge amounts of capital, driving them to cut back massively on new lending.

Systemic risk is the elephant in the room. Everyone knows it's there. Everyone understands the dangers. But they're afraid of the answers. So they dare not ask the questions.

The fundamental answer, though, is clear: Systemic risk is what drove the financial markets into a deep freeze seven months ago; and it was that storm which helped drive the economy into a tailspin.

Today, systemic risk is not gone. If anything, it's far worse.

Third Deception: Improper influence.

In its white paper, the Federal Reserve admits that the stress tests were based, to a large extent, on each bank's self-evaluation — not only for loan loss estimates that can be derived from past data, but also for the future performance of trading accounts, which can be far more subjective.

Moreover, each institution was allowed to appeal the final results, and several banks strenuously negotiated for more favorable grades. They even got regulators to accept their projections of future revenues, treating those future revenues almost as if they were cash in the kitty.

In contrast, we never permit the companies we evaluate to influence our evaluation process or our results. To do so would defeat the entire purpose of the exercise. But much like conflicted Wall Street rating agencies, that's essentially what the bank regulators have done — from start to finish.

Put simply, the stress tests were too easy; the banks took the exams home with cheat sheets; and if they didn't like their final grade, they could get the examiners to give them a better one.

Yet despite all these fudge factors, the government still estimates these institutions could suffer $600 billion in additional losses over the next two years.

And this is being portrayed as another "sign" of recovery?!

My view: We will have a recovery someday. But only AFTER we honestly recognize the grave mistakes of the past and own up to the hard sacrifices still ahead.

Until that happens, I'm staying the course, investing my own money in a way that protects me from the dangers and gives me an opportunity to profit from the next decline ... which, by the way, promises to be the biggest of all.

If you want to follow along with me, check your inbox for an alert that I'll soon be sending you personally — with the sender name "Martin D. Weiss, Ph.D."

Good luck and God bless!

Martin

Some of this makes sense - the timing of events is always suspect - such as the summer of 2009. But this WILL HAPPEN eventually!!!


Thought you might find this interesting. Europe wants nothing to do with Obama's failed policies. The US thinks that it is in good shape and the rest of the world must follow its policies to get out of this grave difficulty. I hope Canada can remain strong through all this and resist these ridiculous "stimulus packages' that rape the treasury!

I will send along a video by Peter Schiff and you can see a matching analysis of this story in Peter's words.
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John




The international monetary system’s breakdown is underway


- Public announcement GEAB N°34 (April 15, 2009) -




The next stage of the crisis will result from a Chinese dream. Indeed, what on earth can China be dreaming of, caught – if we listen to Washington – in the “dollar trap” of its 1,400-billion worth of USD-denominated debt (1)? If we believe US leaders and their scores of media experts, China is only dreaming of remaining a prisoner, and even of intensifying the severity of its prison conditions by buying always more US T-Bonds and Dollars (2).

In fact, everyone knows what prisoners dream of? They dream of escaping of course, of getting out of prison. LEAP/E2020 has therefore no doubt that Beijing is now (3) constantly striving to find the means of disposing of, as early as possible, the mountain of « toxic » assets which US Treasuries and Dollars have become, keeping the wealth of 1,300 billion Chinese citizens (4) prisoner. In this issue of the GEAB (N°34), our team describes the “tunnels and galleries” Beijing has secretively begun to dig in the global financial and economic system in order to escape the « dollar trap » by the end of summer 2009. Once the US has defaulted on its debt, it will be time for the « everyman for himself » rule to prevail in the international system, in line with the final statement of the London G20 Summit which reads as a « chronicle of a geopolitical dislocation », as explained by LEAP/E2020 in this issue of the Global Europe Anticipation Bulletin.




Quarterly Chinese foreign exchange reserves growth - Source: People’s Bank of China / New York Times, 04/2009
Behind London’s « fools’ game », where everyone pretended to believe that an event of « historical » international co-operation (5) took place, the G20 summit in fact revealed major divisions. The Americans and British (followed by a compliant Japan) desperately tried to preserve their capacity to maintain control over the global financial system, freezing or diluting any significant reform granting more power to the other players, but in fact no longer powerful enough to enforce their aims. The Chinese, Russians, Indians, Brazilians,… strove to change the balance of the international monetary and financial system in their favour, but were unable (or maybe, deep down, unwilling (6)) to impose their reforms. The Europeans (the EU without the United Kingdom) proved incapable of making up their minds between the only two options available: duplicating US and UK policies and sinking along with them, or questioning the very roots of the current monetary and financial system in partnership with the Chinese, the Russians, the Indians and the Brazilians. Today the Europeans have avoided following Washington and London in their endless reproduction of failed past policies (7), but they do not yet dare to prepare for the future.



The ongoing collapse of world trade growth cannot be explained by past relationships – Quarterly growth rates annualized - Source: OECD, March 2009
The Europeans can be held accountable if, in the remaining small window of opportunity (less than 6 months now), they fail to undertake the necessary steps to avoid a 10 year-long tragic crisis (8). Indeed they have the technical know-how that can help to create an international currency based on a basket of the world’s most important currencies, and they know which political approach is required to best combine the various strategic interests of a group of countries whose currencies would comprise the new international reserve currency. Unfortunately, EU leaders (namely Eurozone ones) clearly seem unable to face their responsibilities today, as if they preferred to let the Western system break down (though claiming the contrary) rather than fight to turn it into a bridge leading to a new global system. It may be a choice (LEAP/E2020 does not believe so); it may also be the result of the pusillanimity of EU leaders selected on the basis of their docility (vis-à-vis Washington and major European financial and economic players). In any event, this neutrality is dangerous for the world because it prevents the launch of an effective process to avoid a decade-long tragic crisis to unwind (9).

In this issue of the GEAB, our researchers anticipate the different forms a US default will take at the end of summer 2009, a US default which can no longer be concealed concealable from this April (most taxes are collected in April in the US) onward (10). The perspective of a US default this summer is becoming clearer as public debt is now completely out of control with skyrocketing expenses (+41%) and collapsing tax revenues (-28%), as LEAP/E2020 anticipated more than a year ago. In March 2009 alone, the federal deficit has nearly reached USD 200-billion (way above the most pessimistic forecasts), i.e. a little less than half of the deficit recorded for the entire year 2008 (a record high year) (11). The same trend can be observed at every level of the country’s public organisation: federal state, federated states (12), counties, towns (13), everywhere tax revenues are vanishing, suffocating the whole country with spiraling debts that no one can control anymore (not even Washington).




US tax receipts on corporate income (1930 – 2009) - Sources: US Department of Commerce / Saint Louis Federal Reserve (Q2-Q3 2009 projection by EconomicEdge)
In this issue of the GEAB (N°34), our researchers focus on how to explain the « mystery of gold price ». Indeed, our seekers (of information, not gold) identified a number of interesting leads to understand why (14) the price of gold has been fluctuating around the same level for months when the number of gold buyers is constantly increasing and demand for coins and bars far exceeds available supply in many countries.

Finally, our team gives recommendations on how to prepare for the crisis in the coming months, with particular regard to savings and life-insurance.



---------
Notes:

(1) Total Chinese foreign exchange reserves amount to USD 2,000-billion, of which USD-denominated assets are 70 percent maximum, equal to USD 1,400 billion. The remaining 30 percent mainly consists of EUR-denominated assets.

(2) Most of the time, the same « experts » predicted that global economy would benefit from banking deregulation, that the Internet economy was opening up an era of endless growth, that US deficits were a sign of strength, that US house prices would always go up, and that taking on debt was the modern way to get rich.

(3) The message on the necessity to switch international reserve currency, sent out by Beijing to the world – to US authorities in particular –, on the eve of London’s G20 Summit, was not intended to merely test the waters nor was it some vague attempt with no hope of success. The Chinese leaders had no illusion on the chances for this topic to be actually addressed in the G20 Summit, but they wanted it to be discussed in the backrooms, because they wanted to send an unofficial signal to all the players of the international monetary system: in Beijing’s mind, the Dollar system is over! If no one wishes to prepare for a common alternative system, the alternative system will be built some other way, knowing that the actions the Chinese are currently taking corroborate this intention. For instance, precisely these days (random political schedule is rare in Beijing) a book is being published, entitled « Unhappy China », arguing that Chinese leaders should stand up and impose their choices on the international arena. Source: ChinaDailyBBS, 03/27/2009

(4) This link gives the figures to the last cent: ChineInformation.

(5) Angela Merkel was closest to the truth about the G20 summit when she called it « an almost historical event ». The word “almost” is emblematic of what happened in London: the G20 leaders “almost” created a framework for a joint action programme, they “almost” launched new stimulus plans and new international financial rules, they “almost” banned tax-havens, and they “almost” convinced everyone that it would happen. “Almost” but not “really”, will make a big difference for the next stages of the crisis.

(6) In the previous issue of the GEAB (N°33), our team explained this dilemma for the “international system” today. At some point, it is in the interests of new players to simply wait for the current system to break down in order to build a new one, rather than strive to reform it, and suffer a long period of uncertainty.

(7) In particular, outrageous government borrowing - also called « economic stimulus » in Washington and London.

(8) The decisions taken at London’s G20 summit directly contribute to the long-term crisis scenario.

(9) As regards the EU, LEAP/E2020 emphasizes the inanity of all those economic and political « analyses », produced by leading economists and experts close to the American Democrats, and circulated by all the largest international mainstream media, blaming the Europeans for not following in Washington’s footsteps. Paul Krugman in mind for instance, these « very good friends » of Europe, who like it so much that they think they know better than Europe what is best for it (and what it should become, as indeed the same experts usually advocate its extension to Turkey, see Israel and Central Asia), whereas they would be best giving some quality advice to their own party and their new President to prevent their own country from collapsing, as this is what is really at stake today. It is beyond belief that a panel of experts, who, in all these years, sang the praises of a system which is today collapsing under everyone’s nose, still dares give lessons to the rest of the world. Basis decency suggests only one course of conduct worldwide: silence. In Europe, this position, despite the fact that it still enjoys its usual academic and media support, is too outdated to be accepted. LEAP/E2020 believes it is necessary and legitimate to cast a critical eye on the EU, its leaders and its policies; but doing so on the sole criteria of its conformity or otherwise with Washington’s (or London’s) stance is no longer acceptable. In the same way as financiers and business leaders obviously failed to understand that times had changed regarding their stock-options and “golden parachutes”, a number of intellectuals and politicians have not yet fully understood that their points of reference, values and theories now belong to the past. They should think of the elites of the Soviet bloc and they would understand how and how fast a thought system can become obsolete.

(10) Besides collapsing tax revenues, a protest movement has started in the US against using taxes to save Wall Street and against further deficits, blaming the country’s entire leading class. Sources: USAToday, 04/13/2009; MarketWatch, 04/16/2009

(11) Sources: USAToday, 04/11/2009; MarketWatch, 04/10/2009

(12) In California for instance, the first days of April suggested revenues far lesser than the worse forecasts, likely to result in multiplying two-fold California’s debt anticipated a few months ago. A similar trend is under way at the federal level, making it possible to imagine that the annual federal deficit reaches above USD 3,500 billion, i.e. 20 percent of US GDP. Source : CaliforniaCapitol, 04/08/2009

(13) Some towns, like Auburn near Seattle for instance, are compelled to ban trucks from their major freight routes by lack of maintenance financial means. Source: SeattleBusinessJour nal, 04/10/2009

(14)Thus enabling to anticipate upcoming trends.

China Becomes More Picky About Debt


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The Start of a Declining U.S. Dollar


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To all,

I thought I would post twice on my birthday. All I have to say is, that sixty-one years goes by in a blurr. Glad this isn't all that there is to it!

John

The Dethroning of THE U.S. Dollar


By Keith Fitz-Gerald
Investment Director
Money Morning/The Money Map Report

China has taken yet another step to transform the yuan into the dominant global currency, a long-term initiative that could ultimately dethrone the dollar as the world’s top unit of exchange.

In the last four months alone, China has signed currency swap agreements worth more than $95 billion (650 yuan) with an array of nations - including: Argentina, Brazil, South Korea, Indonesia, Malaysia, Belarus and Hong Kong - that are only too glad to move away from the increasingly shaky U.S. dollar.

For Westerners who are struggling to come to terms with the notion of a disarrayed dollar, the thought of oil, gold or other commodities being priced in yuan instead of dollars has to seem about as likely as having another country put a man on the moon.

But the Chinese yuan is already well on its way to becoming that globally accepted standard unit of exchange and the proverbial genie, as they say, is out of the bottle. In fact, I’d even go so far as to say the dollar’s days of dominance are numbered and with each new round of bailout chicanery, the clock is winding down ever faster.

Asia’s Long-Term View
In such Asian markets as Japan, Hong Kong and Mainland China, the long-term planning that’s an anathema to Corporate America is actually standard fare. During the height of Japan’s dominance in the 1980s, the Western business press - with a touch of derision - wrote about how some Japanese companies routinely formulated business plans with durations of 100 years or more (while working in Asia early in my career, I actually even contributed to several such plans … but that’s another story for another time).

That’s neither here nor there to most people who note smugly that Japan is getting its comeuppance. But what they don’t understand is that Japan is not alone. In fact, many people I talk with are shocked to learn that at a time when the West is still busy handing out Band-Aids in an attempt to deal with the greatest financial crisis on record, China has been quietly and shrewdly reinventing itself with the same kind of long-term vision.

Take commodities, for example. While companies in the United States, Great Britain and Europe are being forced to shed promising assets in order to compensate for massive losses or to pay down debt, cash-rich China has been able to operate as a buyer in a buyer’s market. While the rest of the world has interpreted this as a sign that China’s interested in buying the things it needs to grow, what they have not understood is that China’s also interested in using physical assets as a source of “currency” that offsets an increasingly eviscerated U.S. dollar.

This is actually a double-whammy of sorts, for while the rest of the world has been grappling with the global slowdown, China has been locking up supplies of commodities that are only going to become more scarce (and more valuable) as global demand escalates.

In fact, as I’ve suggested for months, now, China isn’t just going to consume those assets; it’s going to use them as part of the same long-term vision it’s been staking out with regard to its own currency, the yuan, which it fully intends to boost in status to the point where it becomes an internationally accepted currency.

The Once-Dominant Dollar
That’s quite a turn of events.

Even now, despite the travails of the U.S. economy, the dollar remains the world’s most widely held reserve currency and, as such, is the standard unit of exchange in most international transactions. In fact, many non-U.S. firms (such as Airbus SAS) actually price their manufactured products in dollars. And the dollar is the de facto unit of pricing for such commodities as oil (hence the term “petrodollar“). Several countries even use it as their “official” currency.
But the global financial crisis is threatening that dominance.

The United States has already “injected” into the world economy trillions of dollars that are collectively worth more than 60% of this country’s entire gross domestic product (GDP). And the prospect of still more injections for California, GMAC LLC and other “national” interests is extremely worrisome - and not just to millions of Americans, either. If Washington stays on this path, the result will be a currency crisis the likes of which few are capable of imagining and a near-complete devaluation of the once-almighty U.S. dollar.

Ironically, both events will only further embolden China, speeding up its efforts to boost the yuan’s international acceptance.

The “New” Yuan
While some experts may question Beijing’s motives, it’s hard to question China’s long-term strategic vision, since the country is actually being forced to take these steps that ensure its own survival. Unfortunately, our leaders in Washington don’t seem to understand this, so they’re only making matters worse - when they instead could be actively working with China and the world community on this instead of summarily ignoring the fact that the yuan may well be the world’s next reserve currency.

At the very least, China’s currency is likely to be granted a global status on par with the current major currency trading pairs for purposes of settling international transactions, whether the West wants that to happen or not.

I’ve outlined this scenario many times in recent years and, quite frankly, too often received blank stares in return. Most folks here in the West just aren’t prepared to deal with the idea that the U.S. dollar could be finished and that another currency could replace it after more than 60 years of global dominance. But they better get used to the idea - and in a hurry.

China is acutely aware that not having international currency convertibility hampers both its development and - thanks to the ongoing financial crisis - its potential survival. Not only has China been forced to accept huge reserves built upon previous trade growth (its $2 trillion in reserves is an all-time record), but its own policies have contributed to its relative inability to flex its capital-market muscles. That’s especially true in transactions involving U.S. dollar/yuan exchange rates.

What for us sounds quite theoretical in nature represents a very real problem for businessmen such as Dong Xianbin, the chairman of the Guangxi Sanhuan Enterprise Group Holding Co. Ltd. He estimates that he’s lost more than 150 million yuan (about $22 million at current exchange rates) on international trade in the past three years alone because of exchange rate changes between the dollar and the yuan. So he’s keen to see yuan-based transactions that will reduce exchange-rate risks, or eliminate them entirely. And he’s not alone. Thousands of Chinese companies are chomping at the bit for the same reasons.

As a nation, not having a universally accepted currency is a huge issue. China’s record reserves are now at risk thanks to the U.S. government’s bailout boondoggle, because each new greenback printed debases the value of every other dollar out there, including the ones China holds.

Historically, Beijing sought to mitigate that risk by diversifying its holdings into other currencies most notably the European euro and the Swiss franc, for instance. But now China’s facing the kinds of problems that massive mutual funds closer to home must deal with when they hold a disproportionately large amount of money: China’s reserve fund is so massive that there’s literally no other single currency that can absorb all that liquidity. So even if China wanted to diversify more aggressively, it’s going to be hard pressed to do so.

Incidentally, this is precisely why China’s so-called “nuclear option” will never become more than a theory bandied about by conspiracy buffs. Under such a scenario, China will either “dump” its dollars, and/or stop buying them, causing the value of the greenback to plummet. China might start selling, but there literally is not another currency on the planet that could absorb a wholesale liquidation.

Therefore, the reality is that China needs to have the U.S. boost the value of the dollar - even as the United States needs to have China do all it can to maintain the dollar’s value.

Shopping for Commodities
At this point in time, China essentially has two alternatives:

It can seek out other stores of value, such as natural resources, which are highly liquid and reasonably “deep” in global markets, but which can also be very volatile from a pricing standpoint.
Or it can elevate the credibility of its own currency in the international financial markets and effectively remove the exchange rate risks associated with its own partially blocked yuan.
Never one to leave anything to chance, China is pursuing both strategies. For instance, China’s been buying gold like there’s no tomorrow - and is looking to add to its holdings. Since 2003, China has boosted its holdings of gold by 73% to an estimated 1,054 metric tons, with an approximate value of $31.3 billion. This makes China the fifth-largest holder of gold on the planet, followed by the United States, Greater Europe, and Switzerland.

China’s also gone global in its hunt for oil - which, of course, is the only other global “currency” truly in international demand.

While there’s a real benefit to having locked up supplies of commodities, they aren’t an ideal store of value. And that suggests that what China really needs to do is elevate the global prominence of its own currency at the same time, whether U.S. leaders aid the process or not.

History shows that strong economies tend to have strong currencies. And the actions that I’ve reported on recently from China - the cross-Straits agreements reached between China and Taiwan, the Hong Kong yuan-trade agreements and the “yuan carry trade,” to name a few - only reinforce the effort China is putting forth to achieve this goal.

Speaking of goals … there are obviously plenty of Doubting Thomases on this issue - but they were around years ago before China announced that it wants to put a man on the moon by 2020.

The Death of Israel


Sunday, May 24, 2009 5:31 PM

By: Dick Morris & Eileen McGann Article Font Size

From Caroline Glick, deputy editor and op-ed writer for the Jerusalem Post, comes alarming news. An expert on Arab-Israeli relations with excellent sources deep inside Netanyahu's government, she reports that CIA chief Leon Panetta recently took time out from his day job (feuding with Nancy Pelosi) to travel to Israel to "read the riot act" to the government warning against an attack on Iran.


More ominously, Glick reports (likely from sources high up in the Israeli government) that the Obama administration has all but accepted as irreversible and unavoidable fact that Iran will soon develop nuclear weapons. She writes, "...we have learned that the [Obama] administration has made its peace with Iran's nuclear aspirations. Senior administration officials acknowledge as much in off-record briefings. It is true, they say, that Iran may exploit its future talks with the US to run down the clock before they test a nuclear weapon. But, they add, if that happens, the U.S. will simply have to live with a nuclear-armed mullocracy."


She goes on to write that the Obama administration is desperate to stop Israel from attacking Iran writing that "as far as the [Obama] administration is concerned, if Israel could just leave Iran's nuclear installations alone, Iran would behave itself." She notes that American officials would regard any harm to American interests that flowed from an Israeli attack on Iranian nuclear facilities as Israel's doing, not Iran's.


In classic Stockholm Syndrome fashion, the Obama administration is empathizing more with the Iranian leaders who are holding Israel hostage than with the nation that may be wiped off the map if Iran acquires the bomb.


Obama's end-of-the-year deadline for Iranian talks aimed at stopping its progress toward nuclear weapons is just window dressing without the threat of military action. As Metternich wrote, "diplomacy without force is like music without instruments." By warning only of possible strengthening of economic sanctions if the talks do not progress, Obama is making an empty threat. The sanctions will likely have no effect because Russia and China will not let the United Nations act as it must if it is to deter Iranian nuclear weapons.


All this means is that Israel's life is in danger. If Iran gets the bomb, it will use it to kill six million Jews. No threat of retaliation will make the slightest difference. One cannot deter a suicide bomber with the threat of death. Nor can one deter a theocracy bent on meriting admission to heaven and its virgins by one glorious act of violence. Iran would probably not launch the bomb itself, anyway, but would give it to its puppet terrorists to send to Israel so it could deny responsibility. Obama, bent on appeasement, would likely not retaliate with nuclear weapons. And Israel will be dead and gone.


Those sunshine Jewish patriots who voted for Obama must realize that we, as Jews, are witnessing the possible end of Israel. We are in the same moral position as our ancestors were as they watched Hitler’s rise but did nothing to pressure their favorite liberal Democratic president, FDR, to take any real action to save them or even to let Jewish refugees into the country. If we remain complacent, we will have the same anguish at watching the destruction of Israel that our forebears had in witnessing the Holocaust.


Because one thing is increasingly clear: Barack Obama is not about to lift a finger to stop Iran from developing the bomb. And neither is Hillary Clinton.


Obama may have held the first White House seder, but he's not planning to spend next year in Jerusalem.

The North Korean Nuclear Test and Geopolitical Reality


May 26, 2009

By Nathan Hughes

North Korea tested a nuclear device for the second time in two and a half years May 25. Although North Korea’s nuclear weapons program continues to be a work in progress, the event is inherently significant. North Korea has carried out the only two nuclear detonations the world has seen in the 21st century. (The most recent tests prior to that were the spate of tests by India and Pakistan in 1998.)

Details continue to emerge through the analysis of seismographic and other data, and speculation about the precise nature of the atomic device that Pyongyang may now posses carries on, making this a good moment to examine the underlying reality of nuclear weapons. Examining their history, and the lessons that can be drawn from that history, will help us understand what it will really mean if North Korea does indeed join the nuclear club.

Nuclear Weapons in the 20th Century
Even before an atomic bomb was first detonated on July 16, 1945, both the scientists and engineers of the Manhattan Project and the U.S. military struggled with the implications of the science that they pursued. But ultimately, they were driven by a profound sense of urgency to complete the program in time to affect the outcome of the war, meaning understanding the implications of the atomic bomb was largely a luxury that would have to wait. Even after World War II ended, the frantic pace of the Cold War kept pushing weapons development forward at a break-neck pace. This meant that in their early days, atomic weapons were probably more advanced than the understanding of their moral and practical utility.

But the promise of nuclear weapons was immense. If appropriate delivery systems could be designed and built, and armed with more powerful nuclear warheads, a nation could continually threaten another country’s very means of existence: its people, industry, military installations and governmental institutions. Battlefield or tactical nuclear weapons would make the massing of military formations suicidal — or so military planners once thought. What seemed clear early on was that nuclear weapons had fundamentally changed everything. War was thought to have been made obsolete, simply too dangerous and too destructive to contemplate. Some of the most brilliant minds of the Manhattan Project talked of how atomic weapons made world government necessary.

But perhaps the most surprising aspect of the advent of the nuclear age is how little actually changed. Great power competition continued apace (despite a new, bilateral dynamic). The Soviets blockaded Berlin for nearly a year starting in 1948, in defiance of what was then the world’s sole nuclear power: the United States. Likewise, the United States refused to use nuclear weapons in the Korean War (despite the pleas of Gen. Douglas MacArthur) even as Chinese divisions surged across the Yalu River, overwhelming U.S., South Korean and allied forces and driving them back south, reversing the rapid gains of late 1950.

Again and again, the situations nuclear weapons were supposed to deter occurred. The military realities they would supposedly shift simply persisted. Thus, the United States lost in Vietnam. The Syrians and the Egyptians invaded Israel in 1973 (despite knowing that the Israelis had acquired nuclear weapons by that point). The Soviet Union lost in Afghanistan. India and Pakistan went to war in 1999 — and nearly went to war twice after that. In none of these cases was it judged appropriate to risk employing nuclear weapons — nor was it clear what utility they might have.

Enduring Geopolitical Stability
Wars of immense risk are born of desperation. In World War II, both Nazi Germany and Imperial Japan took immense geostrategic gambles — and lost — but knowingly took the risk because of untenable geopolitical circumstances. By comparison, the postwar United States and Soviet Union were geopolitically secure. Washington had come into its own as a global power secured by the buffer of two oceans, while Moscow enjoyed the greatest strategic depth it had ever known.

The U.S.-Soviet competition was, of course, intense, from the nuclear arms race to the space race to countless proxy wars. Yet underlying it was a fear that the other side would engage in a war that was on its face irrational. Western Europe promised the Soviet Union immense material wealth but would likely have been impossible to subdue. (Why should a Soviet leader expect to succeed where Napoleon and Hitler had failed?) Even without nuclear weapons in the calculus, the cost to the Soviets was too great, and fears of the Soviet invasion of Europe along the North European Plain were overblown. The desperation that caused Germany to seek control over Europe twice in the first half of the 20th century simply did not characterize either the Soviet or U.S. geopolitical position even without nuclear weapons in play. It was within this context that the concept of mutually assured destruction emerged — the idea that each side would possess sufficient retaliatory capability to inflict a devastating “second strike” in the event of even a surprise nuclear attack.

Through it all, the metrics of nuclear warfare became more intricate. Throw weights and penetration rates were calculated and recalculated. Targets were assigned and reassigned. A single city would begin to have multiple target points, each with multiple strategic warheads allocated to its destruction. Theorists and strategists would talk of successful scenarios for first strikes. But only in the Cuban Missile Crisis did the two sides really threaten one another’s fundamental national interests. There were certainly other moments when the world inched toward the nuclear brink. But each time, the global system found its balance, and there was little cause or incentive for political leaders on either side of the Iron Curtain to so fundamentally alter the status quo as to risk direct military confrontation — much less nuclear war.

So through it all, the world carried on, its fundamental dynamics unchanged by the ever-present threat of nuclear war. Indeed, history has shown that once a country has acquired nuclear weapons, the weapons fail to have any real impact on the country’s regional standing or pursuit of power in the international system.

Thus, not only were nuclear weapons never used in even desperate combat situations, their acquisition failed to entail any meaningful shift in geopolitical position. Even as the United Kingdom acquired nuclear weapons in the 1950s, its colonial empire crumbled. The Soviet Union was behaving aggressively all along its periphery before it acquired nuclear weapons. And the Soviet Union had the largest nuclear arsenal in the world when it collapsed — not only despite its arsenal, but in part because the economic burden of creating and maintaining it was unsustainable. Today, nuclear-armed France and non-nuclear armed Germany vie for dominance on the Continent with no regard for France’s small nuclear arsenal.

The Intersection of Weapons, Strategy and Politics
This August will mark 64 years since any nation used a nuclear weapon in combat. What was supposed to be the ultimate weapon has proved too risky and too inappropriate as a weapon ever to see the light of day again. Though nuclear weapons certainly played a role in the strategic calculus of the Cold War, they had no relation to a military strategy that anyone could seriously contemplate. Militaries, of course, had war plans and scenarios and target sets. But outside this world of role-play Armageddon, neither side was about to precipitate a global nuclear war.

Clausewitz long ago detailed the inescapable connection between national political objectives and military force and strategy. Under this thinking, if nuclear weapons had no relation to practical military strategy, then they were necessarily disconnected (at least in the Clausewitzian sense) from — and could not be integrated with — national and political objectives in a coherent fashion. True to the theory, despite ebbs and flows in the nuclear arms race, for 64 years, no one has found a good reason to detonate a nuclear bomb.

By this line of reasoning, STRATFOR is not suggesting that complete nuclear disarmament — or “getting to zero” — is either possible or likely. The nuclear genie can never be put back in the bottle. The idea that the world could ever remain nuclear-free is untenable. The potential for clandestine and crash nuclear programs will remain a reality of the international system, and the world’s nuclear powers are unlikely ever to trust the rest of the system enough to completely surrender their own strategic deterrents.

Legacy, Peer and Bargaining Programs
The countries in the world today with nuclear weapons programs can be divided into three main categories.

Legacy Programs: This category comprises countries like the United Kingdom and France that maintain small arsenals even after the end of the threat they acquired them for; in this case, to stave off a Soviet invasion of Western Europe. In the last few years, both London and Paris have decided to sustain their small arsenals in some form for the foreseeable future. This category is also important for highlighting the unlikelihood that a country will surrender its weapons after it has acquired them (the only exceptions being South Africa and several Soviet Republics that repatriated their weapons back to Russia after the Soviet collapse).
Peer Programs: The original peer program belonged to the Soviet Union, which aggressively and ruthlessly pursued a nuclear weapons capacity following the bombing of Hiroshima and Nagasaki in 1945 because its peer competitor, the United States, had them. The Pakistani and Indian nuclear programs also can be understood as peer programs.
Bargaining Programs: These programs are about the threat of developing nuclear weapons, a strategy that involves quite a bit of tightrope walking to make the threat of acquiring nuclear weapons appear real and credible while at the same time not making it appear so urgent as to require military intervention. Pyongyang pioneered this strategy, and has wielded it deftly over the years. As North Korea continues to progress with its efforts, however, it will shift from a bargaining chip to an actual program — one it will be unlikely to surrender once it acquires weapons, like London and Paris. Iran also falls into this category, though it could also progress to a more substantial program if it gets far enough along. Though parts of its program are indeed clandestine, other parts are actually highly publicized and celebrated as milestones, both to continue to highlight progress internationally and for purposes of domestic consumption. Indeed, manipulating the international community with a nuclear weapon — or even a civilian nuclear program — has proved to be a rare instance of the utility of nuclear weapons beyond simple deterrence.
The Challenges of a Nuclear Weapons Program
Pursuing a nuclear weapons program is not without its risks. Another important distinction is that between a crude nuclear device and an actual weapon. The former requires only that a country demonstrate the capability to initiate an uncontrolled nuclear chain reaction, creating a rather large hole in the ground. That device may be crude, fragile or otherwise temperamental. But this does not automatically imply the capability to mount a rugged and reliable nuclear warhead on a delivery vehicle and send it flying to the other side of the earth. In other words, it does not immediately translate into a meaningful deterrent.

For that, a ruggedized, reliable nuclear weapon must be mated with some manner of reliable delivery vehicle to have real military meaning. After the end of World War II, the B-29’s limited range and the few nuclear weapons the United States had on hand meant that its vaunted nuclear arsenal was initially extremely difficult to bring to bear against the Soviet heartland. The United States would spend untold resources to overcome this obstacle in the decade that followed.

The modern nuclear weapon is not just a product of physics, but of decades of design work and full-scale nuclear testing. It combines expertise not just in nuclear physics, but materials science, rocketry, missile guidance and the like. A nuclear device does not come easy. A nuclear weapon is one of the most advanced syntheses of complex technologies ever achieved by man.

Many dangers exist for an aspiring nuclear power. Many of the facilities associated with a clandestine nuclear weapons program are large, fixed and complex. They are vulnerable to airstrikes — as Syria found in 2007. (And though history shows that nuclear weapons are unlikely to be employed, it is still in the interests of other powers to deny that capability to a potential adversary.)

The history of proliferation shows that few countries actually ever decide to pursue nuclear weapons. Obtaining them requires immense investment (and the more clandestine the attempt, the more costly the program becomes), and the ability to focus and coordinate a major national undertaking over time. It is not something a leader like Venezuela’s Hugo Chavez could decide to pursue on a whim. A national government must have cohesion over the long span of time necessary to go from the foundations of a weapons program to a meaningful deterrent capability.

The Exceptions
In addition to this sustained commitment must be the willingness to be suspected by the international community and endure pariah status and isolation — in and of themselves significant risks for even moderately integrated economies. One must also have reasonable means of deterring a pre-emptive strike by a competing power. A Venezuelan weapons program is therefore unlikely because the United States would act decisively the moment one was discovered, and there is little Venezuela could do to deter such action.

North Korea, on the other hand, has held downtown Seoul (just across the demilitarized zone) at risk for generations with one of the highest concentrations of deployed artillery, artillery rockets and short-range ballistic missiles on the planet. From the outside, Pyongyang is perceived as unpredictable enough that any potential pre-emptive strike on its nuclear facilities is too risky not because of some newfound nuclear capability, but because of Pyongyang’s capability to turn the South Korean capital city into a proverbial “sea of fire” via conventional means. A nuclear North Korea, the world has now seen, is not sufficient alone to risk renewed war on the Korean Peninsula.

Iran is similarly defended. It can threaten to close the Strait of Hormuz, to launch a barrage of medium-range ballistic missiles at Israel, and to use its proxies in Lebanon and elsewhere to respond with a new campaign of artillery rocket fire, guerrilla warfare and terrorism. But the biggest deterrent to a strike on Iran is Tehran’s ability to seriously interfere in ongoing U.S. efforts in Iraq and Afghanistan — efforts already tenuous enough without direct Iranian opposition.

In other words, some other deterrent (be it conventional or unconventional) against attack is a prerequisite for a nuclear program, since powerful potential adversaries can otherwise move to halt such efforts. North Korea and Iran have such deterrents. Most other countries widely considered major proliferation dangers — Iraq before 2003, Syria or Venezuela, for example — do not. And that fundamental deterrent remains in place after the country acquires nuclear weapons.

In short, no one was going to invade North Korea — or even launch limited military strikes against it — before its first nuclear test in 2006. And no one will do so now, nor will they do so after its next test. So North Korea – with or without nuclear weapons – remains secure from invasion. With or without nuclear weapons, North Korea remains a pariah state, isolated from the international community. And with or without them, the world will go on.

The Global Nuclear Dynamic
Despite how frantic the pace of nuclear proliferation may seem at the moment, the true pace of the global nuclear dynamic is slowing profoundly. With the Comprehensive Test Ban Treaty already effectively in place (though it has not been ratified), the pace of nuclear weapons development has already slowed and stabilized dramatically. The world’s current nuclear powers are reliant to some degree on the generation of weapons that were validated and certified before testing was banned. They are currently working toward weapons and force structures that will provide them with a stable, sustainable deterrent for the foreseeable future rooted largely in this pre-existing weapons architecture.

New additions to the nuclear club are always cause for concern. But though North Korea’s nuclear program continues apace, it hardly threatens to shift underlying geopolitical realities. It may encourage the United States to retain a slightly larger arsenal to reassure Japan and South Korea about the credibility of its nuclear umbrella. It also could encourage Tokyo and Seoul to pursue their own weapons. But none of these shifts, though significant, is likely to alter the defining military, economic and political dynamics of the region fundamentally.

Nuclear arms are better understood as an insurance policy, one that no potential aggressor has any intention of steering afoul of. Without practical military or political use, they remain held in reserve — where in all likelihood they will remain for the foreseeable future.