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GM Debt Triggers Derivatives Bubble Implosion
The New Bretton Woods Campaign

GM Debt Triggers Derivatives Bubble Implosion—

Financial System on "Red Alert"; Governments Must Adopt National Banking NOW

"GM Earthquake Shatters Hedge Fund Industry"
Switzerland's Neue Zuercher Zeitung, May 12

"The last time hedge funds communicated early with their investors was back in 1998" [when LTCM collapsed]
Sol Waksman, Barclay Group.

"The Tick, Tick of GM in Hedge Fund Derivatives"
Bloomberg wire, May 13

"This is the perfect storm to implode some hedge funds"
Independent market analyst Dennis Gartman, May 11.

"We expect a rush to the door to be painful"
Merrill Lynch & Co., May 10.

"City Hedge Funds Head for Domino Collapse"
London Sunday Times, May 15.

This could be it. More than a decade after Lyndon LaRouche first warned that a collapse of the speculative bubble in "derivatives" was inevitable, and it would crash the global financial system, the General Motors/Ford debt downgrade appears to have dealt a savage blow to the main players in the derivatives bubble, global hedge funds, with as-yet unmeasurable consequences.

This is not just another event in the zero-sum-game that is the financial system; as LaRouche said on May 14, "We are sailing into uncharted waters."

Over the past decade, since LaRouche's June 1994 "Ninth Forecast", the global financial system has been under severe strain, but distinguishable from the ever-present audible groans of a system under strain, have been occasional decisive cracks, which have indicated definite downward shifts somewhere in the system.

Perhaps the most significant of those cracks to date, was the collapse of the Long Term Capital Management (LTCM) hedge fund in 1998, which sparked a full-scale mobilization by Wall Street, the U.S. Federal Reserve and the rest of the world's central banks to throw what financier George Soros called a "wall of money" at the system to keep it propped up.

It wasn't until six months after that event, that main players like Federal Reserve Chairman Alan Greenspan admitted that LTCM almost caused the global financial system to "meltdown"—their words.

Now, all of the indications are, that the GM crisis has triggered another decisive crack of the LTCM variety, but this time on a much larger scale, and without the obvious means to bail out the system.

"Red Alert"

On May 10, stock and corporate bond markets worldwide suffered massive losses, after several traders pointed to evidence of severe problems at several large hedge funds, as a direct consequence of GM's and Ford's downgrading. The hedge funds mentioned in this respect included Highbridge Capital in the US, GLG Partners in London, Singapore-based Asam Capital Management, and Sovereign Capital. The "LTCM" word was in everybody's mouth during trading that day. The stocks of the same large banks that participated in the 1998 LTCM bailout and which are known for their giant derivatives portfolio—including Citigroup, JP Morgan Chase, Goldman Sachs, and Deutsche Bank—were subjects of panic selling.

Typical Collapse Function

The unprecedented downgrading to junk of almost half a trillion dollars in corporate debt, which actually doubled the total volume of US junk bond debt, had devastating consequences for different kinds of derivatives bets. In particular collateral debt obligations (CDOs) and similar credit derivatives were affected. Recently, hedge funds sharply increased their exposure to such financial instruments, as other investments did not promise sufficient profits. CDOs are pools of loans, bonds, and other debt titles from hundreds of different corporations, which are bundled together and then sold to investors. Speculative investors can buy just the so-called "equity" tranche of a CDO, which includes almost the entire default risk of the underlying debt. It offers the highest returns. However, in case of a default or a significant downgrading of the underlying debt, the hedge fund will have to come up with large cash payments that could easily surpass the fund's entire capital. The fund then can try to stay alive for a while by selling off any kind of liquid assets. Such "distress selling" was actually observed by several hedge funds on May 10 and the following days.

On May 13, an international financier told the Executive Intelligence Review news service that the financial system was facing a derivatives crisis "orders of magnitude beyond LTCM". The source observed you can be certain the U.S. Federal Reserve, the President's Commission on Financial Markets (the so-called "plunge protection team"), and major central banks around the world will be on "emergency red alert mobilization" throughout the weekend. Undoubtedly, the central banks have responded by pouring liquidity into the system, covertly, which will not become public for several weeks, when the central banks are next obliged to report on the money supply.

According to this source, one of the signs of the severity of the crisis, was the number of hedge funds which publicly denied reports of derivatives losses. They are forced to issue pre-emptive denials, because any bank or hedge fund that admitted such losses without first working out a bail-out scheme would instantly collapse.

Two days after this source's report, London's Sunday Times gave a dramatic status report: "Bad investments by some of the biggest hedge funds in London have triggered unprecedented losses, record demands for money back, and talk of a death spiral weighing heavily on stocks and bonds." The whole hedge fund operation is under pressure, the Sunday Times wrote, "as rumours of a big hedge-fund blow-out grip the industry." It lists the losses of a series of funds after the GM-Ford debacle: London-based Cheyne fund, down at least 10%; Ferox, down nearly 20%. Bailey Coates, Polygon, Rubicon, Vega, Moore Capital, and Brevan Howard are all nursing heavy losses of about 5% each in April. Many funds "were wrongfooted" by GM and Ford, when "bond prices fell and share prices rose, the opposite of what fund managers thought would happen. Hedge funds that specialise in convertibles—bonds investors can exchange for shares—have also had a hard time. Funds had bought up nearly 80% of all convertibles, so when their prices fell it turned into a stampede."

The Mother of all Bubbles

To appreciate the seriousness of these events unleashed by GM's credit downgrade, and not have a desensitized response that this is "just another event", it is important to understand what has transpired in the past decade, since LaRouche issued his dire "Ninth Forecast".

It was first in 1993, that LaRouche warned of the threat posed by derivatives, the exotic "side-bets" which had quickly come to dominate the casino of the global financial system under the deregulation policies of Alan Greenspan. In 1993, global turnover in derivatives was US$300 trillion, compared to global GDP of US$40 trillion. The January 29, 1994 Australian Financial Review ran a feature on derivatives, which opened with the following coverage of LaRouche: "We are, according to the American polemicist Lyndon H. LaRouche Jr, facing a 'derivatives bubble', a threat of enormous magnitude. '[The bubble] grows like a cancer at the expense of its host, at the same time that its appetite is growing, while the means of satisfying the appetite are collapsing,' he explained in a special edition of a New Federalist pamphlet.

Cover of the pamphlet—1993

While LaRouche's views represent the extreme position they are not atypical of the attitude of a number of particularly American, political figures, and will no doubt be felt soon enough elsewhere, including Australia."

In the year or so following LaRouche's Ninth Forecast, a number of derivatives-triggered bankruptcies rocked the financial system, including one of America's richest municipalities, Orange County, California, and one of the world's oldest and richest banks, Barings Bank in London. In 1997, hedge funds played a major role in the Asia Crisis, when hundreds of billions of dollars was pulled out of the so-called Asian Tiger economies overnight, bankrupting Indonesia, Malaysia, the Philippines, Thailand, and South Korea. The most notable hedge fund was the Quantum Fund of megaspeculator George Soros. In that year, Lyndon LaRouche first issued his call for a New Bretton Woods international monetary system, to re-regulate the global economy through fixed exchange rates and capital controls, and stop hedge funds speculating in national currencies. By September that year, Malaysia's Prime Minister, Dr Mahathir bin Mohammed, heeded LaRouche's advice and put capital and exchange controls in place, an act which saved the Malaysian economy, and earned Mahathir the eternal enmity of the IMF and international speculators (and the Australian establishment).

Not Banks Anymore Then, in 1998, LTCM went bankrupt, after suffering $2 billion in losses on bond markets. (Ironically, LTCM was founded and operated by a winner of the Nobel Price for Economics.) The LTCM crash was one of a wave of crises at the time, which included meltdowns in South Korea, Brazil and Russia. George Soros called for a "wall of money" to be thrown at the crisis, to keep the system afloat, and the world's central banks obliged. Under the pretext of the Y2K bug, governments pumped hundreds of billions of dollars into the computer software industry, launching the late-90s dot.com bubble, which inflated the NYSE's Dow Jones index to over 12,000 points by the year 2000. When the dot.com bubble crashed in 2000, central banks pumped even more liquidity into the system, via virtually zero interest rates in Japan and the US, which was invested in property markets, creating the still-enormous property bubbles in most western countries.

Meanwhile, with all of this liquidity being pumped into the system, trading in derivatives over this decade exploded. In 2004, the Bank for International Settlements reported annual global turnover in derivatives had reached US$2 quadrillion ($2 thousand trillion). The magnitude of this trade is incomprehensible—it is the mother of all bubbles—but it is this bubble that the GM credit downgrade has pricked. Something big has gone down—we are yet to see the full consequences—but it is imperative in the days and weeks ahead that governments, finally, act, in the way LaRouche has prescribed.

What Governments Must Do

There are two tools immediately available to governments to deal with this crisis—regulation, and national banking. This week, LaRouche reiterated his 1993 call for a 0.1% tax on derivatives transactions, as a means to impose a form of regulation on the trade so it is forced to be transparent. This measure is necessary, for governments to know what they are dealing with in order to dismantle it. Derivatives could never exist in a regulated financial system.

Since George Shultz dismantled the post-war Bretton Woods system in 1971, and launched the speculative floating exchange rate system, privately-controlled central banks have starved industry and infrastructure of investment, to inflate their speculative bubbles. This has bankrupted the physical economy, and will only be redressed by governments using national banking policies to direct long-term, low-interest credit into a large-scale reconstruction program of new power plants, water systems and transportation infrastructure to revive the economy. Just as the U.S. Constitution gives the Congress power over money (see Strategic Bankruptcy) so does the Australian Constitution. Part V of the Australian Constitution, Powers of the Parliament, specifies, under "Section 51". The Parliament shall, subject to this Constitution, have power to make laws for the peace, order and good government of the Commonwealth with respect to:

(xii) Currency, coinage, and legal tender;

(xiii) Banking, other than State banking; also State banking extending beyond the limits of the State concerned, the incorporation of banks, and the issue of paper money."

These clauses emphatically establish the responsibility of Parliament for national banking and the issuance of currency/credit, and that responsibility has never been greater, in the face of this unprecedented crisis.

 

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