Something extraordinary is going on with these
government bailouts. In March 2008, the Federal Reserve extended a $55
billion loan to JPMorgan to \"rescue\" investment bank Bear Stearns from
bankruptcy, a highly controversial move that tested the limits of the
Federal Reserve Act. On September 7, 2008, the U.S. government seized
private mortgage giants Fannie Mae and Freddie Mac and imposed a
conservatorship, a form of bankruptcy; but rather than let the
bankruptcy court sort out the assets among the claimants, the Treasury
extended an unlimited credit line to the insolvent corporations and
said it would exercise its authority to buy their stock, effectively
nationalizing them. Now the Federal Reserve has announced that it is
giving an $85 billion loan to American International Group (AIG), the
world\'s largest insurance company, in exchange for a nearly 80% stake
in the insurer . . . .

The Fed is buying an insurance company?
Where exactly is that covered in the Federal Reserve Act? The
Associated Press calls it a \"government takeover,\" but this is not your
ordinary \"nationalization\" like the purchase of Fannie/Freddie stock by
the U.S. Treasury. The Federal Reserve has the power to print the
national money supply, but it is not actually a part of the U.S.
government. It is a private banking corporation owned by a consortium
of private banks. The banking industry just bought the world\'s largest
insurance company, and they used federal money to do it. Yahoo Finance
reported on September 17:

\"The Treasury is setting up a temporary
financing program at the Fed\'s request. The program will auction
Treasury bills to raise cash for the Fed\'s use. The initiative aims to
help the Fed manage its balance sheet following its efforts to enhance
its liquidity facilities over the previous few quarters.\"

Treasury
bills are the I.O.U.s of the federal government. We the taxpayers are
on the hook for the Fed\'s \"enhanced liquidity facilities,\" meaning the
loans it has been making to everyone in sight, bank or non-bank,
exercising obscure provisions in the Federal Reserve Act that may or
may not say they can do it. What\'s going on here? Why not let the free
market work? Bankruptcy courts know how to sort out assets and
reorganize companies so they can operate again. Why the extraordinary
measures for Fannie, Freddie and AIG?

The answer may have less to
do with saving the insurance business, the housing market, or the
Chinese investors clamoring for a bailout than with the greatest Ponzi
scheme in history, one that is holding up the entire private global
banking system. What had to be saved at all costs was not housing or
the dollar but the financial derivatives industry; and the precipice
from which it had to be saved was an \"event of default\" that could have
collapsed a quadrillion dollar derivatives bubble, a collapse that
could take the entire global banking system down with it.

THE ANATOMY OF A BUBBLE

Until
recently, most people had never even heard of derivatives; but in terms
of money traded, these investments represent the biggest financial
market in the world. Derivatives are financial instruments that have no
intrinsic value but derive their value from something else. Basically,
they are just bets. You can \"hedge your bet\" that something you own
will go up by placing a side bet that it will go down. \"Hedge funds\"
hedge bets in the derivatives market. Bets can be placed on anything,
from the price of tea in China to the movements of specific markets.

\"The
point everyone misses,\" wrote economist Robert Chapman a decade ago,
\"is that buying derivatives is not investing. It is gambling, insurance
and high stakes bookmaking. Derivatives create nothing.\"1 They not only
create nothing, but they serve to enrich non-producers at the expense
of the people who do create real goods and services. In congressional
hearings in the early 1990s, derivatives trading was challenged as
being an illegal form of gambling. But the practice was legitimized by
Fed Chairman Alan Greenspan, who not only lent legal and regulatory
support to the trade but actively promoted derivatives as a way to
improve \"risk management.\" Partly, this was to boost the flagging
profits of the banks; and at the larger banks and dealers, it worked.
But the cost was an increase in risk to the financial system as a
whole.2

Since then, derivative trades have grown exponentially,
until now they are larger than the entire global economy. The Bank for
International Settlements recently reported that total derivatives
trades exceeded one quadrillion dollars - that\'s 1,000 trillion
dollars.3 How is that figure even possible? The gross domestic product
of all the countries in the world is only about 60 trillion dollars.
The answer is that gamblers can bet as much as they want. They can bet
money they don\'t have, and that is where the huge increase in risk
comes in.

Credit default swaps (CDS) are the most widely traded
form of credit derivative. CDS are bets between two parties on whether
or not a company will default on its bonds. In a typical default swap,
the \"protection buyer\" gets a large payoff from the \"protection seller\"
if the company defaults within a certain period of time, while the
\"protection seller\" collects periodic payments from the \"protection
buyer\" for assuming the risk of default. CDS thus resemble insurance
policies, but there is no requirement to actually hold any asset or
suffer any loss, so CDS are widely used just to increase profits by
gambling on market changes. In one blogger\'s example, a hedge fund
could sit back and collect $320,000 a year in premiums just for selling
\"protection\" on a risky BBB junk bond. The premiums are \"free\" money -
free until the bond actually goes into default, when the hedge fund
could be on the hook for $100 million in claims.

And there\'s the
catch: what if the hedge fund doesn\'t have the $100 million? The fund\'s
corporate shell or limited partnership is put into bankruptcy; but both
parties are claiming the derivative as an asset on their books, which
they now have to write down. Players who have \"hedged their bets\" by
betting both ways cannot collect on their winning bets; and that means
they cannot afford to pay their losing bets, causing other players to
also default on their bets.

The dominos go down in a cascade of
cross-defaults that infects the whole banking industry and jeopardizes
the global pyramid scheme. The potential for this sort of nuclear
reaction was what prompted billionaire investor Warren Buffett to call
derivatives \"weapons of financial mass destruction.\" It is also why the
banking system cannot let a major derivatives player go down, and it is
the banking system that calls the shots. The Federal Reserve is
literally owned by a conglomerate of banks; and Hank Paulson, who heads
the U.S. Treasury, entered that position through the revolving door of
investment bank Goldman Sachs, where he was formerly CEO.

THE BEST GAME IN TOWN

In
an article on FinancialSense.com on September 9, Daniel Amerman
maintains that the government\'s takeover of Fannie Mae and Freddie Mac
was not actually a bailout of the mortgage giants. It was a bailout of
the financial derivatives industry, which was faced with a $1.4
trillion \"event of default\" that could have bankrupted Wall Street and
much of the rest of the financial world. To explain the enormous risk
involved, Amerman posits a scenario in which the mortgage giants are
not bailed out by the government. When they default on the $5 trillion
in bonds and mortgage-backed securities they own or guarantee,
settlements are immediately triggered on $1.4 trillion in credit
default swaps entered into by major financial firms, which have
promised to make good on Fannie/Freddie defaulted bonds in return for
very lucrative fee income and multi-million dollar bonuses. The value
of the vulnerable bonds plummets by 70%, causing $1 trillion (70% of
$1.4 trillion) to be due to the \"protection buyers.\" This is more
money, however, than the already-strapped financial institutions have
to spare. The CDS sellers are highly leveraged themselves, which means
they depend on huge day-to-day lines of credit just to stay afloat.
When their creditors see the trillion dollar hit coming, they pull
their financing, leaving the strapped institutions with massive
portfolios of illiquid assets. The dreaded cascade of cross-defaults
begins, until nearly every major investment bank and commercial bank is
unable to meet its obligations. This triggers another massive round of
CDS events, going to $10 trillion, then $20 trillion. The financial
centers become insolvent, the markets have to be shut down, and when
they open months later, the stock market has been crushed. The federal
government and the financiers pulling its strings naturally feel
compelled to step in to prevent such a disaster, even though this
rewards the profligate speculators at the expense of the Fannie/Freddie
shareholders who will get wiped out. Amerman concludes:

\"[I]t\'s
the best game in town. Take a huge amount of risk, be paid exceedingly
well for it and if you screw up -- you have absolute proof that the
government will come in and bail you out at the expense of the rest of
the population (who did not share in your profits in the first place).\"4

DESPERATE MEASURES FOR DESPERATE TIMES

It
was the best game in town until September 14, when Treasury Secretary
Paulson, Fed Chairman Ben Bernanke, and New York Fed Head Tim Geithner
closed the bailout window to Lehman Brothers, a 158-year-old Wall
Street investment firm and major derivatives player. Why? \"There is no
political will for a federal bailout,\" said Geithner. Bailing out
Fannie and Freddie had created a furor of protest, and the taxpayers
could not afford to underwrite the whole quadrillion dollar derivatives
bubble. The line had to be drawn somewhere, and this was apparently it.

Or
was the Fed just saving its ammunition for AIG? Recent downgrades in
AIG\'s ratings meant that the counterparties to its massive derivatives
contracts could force it to come up with $10.5 billion in additional
capital reserves immediately or file for bankruptcy. Treasury Secretary
Paulson resisted advancing taxpayer money; but on Monday, September 15,
stock trading was ugly, with the S & P 500 registering the largest
one-day percent drop since September 11, 2001. Alan Kohler wrote in the
Australian Business Spectator:

\"[I]t\'s unlikely to be a
slow-motion train wreck this time. With Lehman in liquidation, and
Washington Mutual and AIG on the brink, the credit market would likely
shut down entirely and interbank lending would cease.\"5

Kohler
quoted the September 14 newsletter of Professor Nouriel Roubini, who
has a popular website called Global EconoMonitor. Roubini warned:

\"What
we are facing now is the beginning of the unravelling and collapse of
the entire shadow financial system, a system of institutions (broker
dealers, hedge funds, private equity funds, SIVs, conduits, etc.) that
look like banks (as they borrow short, are highly leveraged and lend
and invest long and in illiquid ways) and thus are highly vulnerable to
bank-like runs; but unlike banks they are not properly regulated and
supervised, they don\'t have access to deposit insurance and don\'t have
access to the lender of last resort support of the central bank.\"

The
risk posed to the system was evidently too great. On September 16,
while Barclay\'s Bank was offering to buy the banking divisions of
Lehman Brothers, the Federal Reserve agreed to bail out AIG in return
for 80% of its stock. Why the Federal Reserve instead of the U.S.
Treasury? Perhaps because the Treasury would take too much heat for
putting yet more taxpayer money on the line. The Federal Reserve could
do it quietly through its \"Open Market Operations,\" the ruse by which
it \"monetizes\" government debt, turning Treasury bills (government
I.O.U.s) into dollars. The taxpayers would still have to pick up the
tab, but the Federal Reserve would not have to get approval from
Congress first.

TIME FOR A 21ST CENTURY NEW DEAL?

Another
hole has been plugged in a very leaky boat, keeping it afloat another
day; but how long can these stopgap measures be sustained? Professor
Roubini maintains:

\"The step by step, ad hoc and non-holistic
approach of Fed and Treasury to crisis management has been a failure. .
. . [P]lugging and filling one hole at [a] time is useless when the
entire system of levies is collapsing in the perfect financial storm of
the century. A much more radical, holistic and systemic approach to
crisis management is now necessary.\"6

We may soon hear that \"the
credit market is frozen\" - that there is no money to keep homeowners in
their homes, workers gainfully employed, or infrastructure maintained.
But this is not true. The underlying source of all money is government
credit - our own public credit. We don\'t need to borrow it from the
Chinese or the Saudis or private banks. The government can issue its
own credit - the \"full faith and credit of the United States.\" That was
the model followed by the Pennsylvania colonists in the eighteenth
century, and it worked brilliantly well. Before the provincial
government came up with this plan, the Pennsylvania economy was
languishing. There was little gold to conduct trade, and the British
bankers were charging 8% interest to borrow what was available. The
government solved the credit problem by issuing and lending its own
paper scrip. A publicly-owned bank lent the money to farmers at 5%
interest. The money was returned to the government, preventing
inflation; and the interest paid the government\'s expenses, replacing
taxes. During the period the system was in place, the economy
flourished, prices remained stable, and the Pennsylvania colonists paid
no taxes at all. (For more on this, see E. Brown, \"Sustainable Energy
Development: How Costs Can Be Cut in Half,\" webofdebt.com/articles,
November 5, 2007.)

Today\'s credit crisis is very similar to that
facing Herbert Hoover and Franklin Roosevelt in the 1930s. In 1932,
President Hoover set up the Reconstruction Finance Corporation (RFC) as
a federally-owned bank that would bail out commercial banks by
extending loans to them, much as the privately-owned Federal Reserve is
doing today. But like today, Hoover\'s ploy failed. The banks did not
need more loans; they were already drowning in debt. They needed
customers with money to spend and invest. President Roosevelt used
Hoover\'s new government-owned lending facility to extend loans where
they were needed most - for housing, agriculture and industry. Many new
federal agencies were set up and funded by the RFC, including the HOLC
(Home Owners Loan Corporation) and Fannie Mae (the Federal National
Mortgage Association, which was then a government-owned agency). In the
1940s, the RFC went into overdrive funding the infrastructure necessary
for the U.S. to participate in World War II, setting the country up
with the infrastructure it needed to become the world\'s industrial
leader after the war.

The RFC was a government-owned bank that
sidestepped the privately-owned Federal Reserve; but unlike the
Pennsylvania provincial government, which originated the money it lent,
the RFC had to borrow the money first. The RFC was funded by issuing
government bonds and relending the proceeds. Then as now, new money
entered the money supply chiefly in the form of private bank loans. In
a \"fractional reserve\" banking system, banks are allowed to lend their
\"reserves\" many times over, effectively multiplying the amount of money
in circulation. Today a system of public banks might be set up on the
model of the RFC to fund productive endeavors - industry, agriculture,
housing, energy -- but we could go a step further than the RFC and give
the new public banks the power to create credit themselves, just as the
Pennsylvania government did and as private banks do now. At the rate
banks are going into FDIC receivership, the federal government will
soon own a string of banks, which it might as well put to productive
use. Establishing a new RFC might be an easier move politically than
trying to nationalize the Federal Reserve, but that is what should
properly, logically be done. If we the taxpayers are putting up the
money for the Fed to own the world\'s largest insurance company, we
should own the Fed.

Proposals for reforming the banking system
are not even on the radar screen of Prime Time politics today; but the
current system is collapsing at train-wreck speed, and the \"change\"
called for in Washington may soon be taking a direction undreamt of a
few years ago. We need to stop funding the culprits who brought us this
debacle at our expense. We need a public banking system that makes a
cost-effective credit mechanism available for homeowners,
manufacturing, renewable energy, and infrastructure; and the first step
to making it cost-effective is to strip out the swarms of gamblers,
fraudsters and profiteers now gaming the system.