Shadow Financing

The American financial system has been in terrible? For me and most people this means our financial situation is in terrible and the reason why, are difficult to comprehend.

They involve Derivatives, Credit Defaults Swaps, Hedge Funds and all sorts of complicated trades that are unlike Stocks and Bonds.

How did we get into this miss?

Why is part of finance system by most people called Shadow Financial System

The Shadow. It has a conspiratorial tone to it! Doesn’t it?

Most people know about stocks and bonds. They can open their newspaper and check the latest value of stocks and bonds, or get on the internet and find out where the price value of certain stock is.

It’s a transparent market and the information is easily available to most people, but since 1980 a much more powerful system has been developed by the banks which are called the Complex Derivatives.

Believe it or not there are more money invested in these Derivatives than stocks and bonds.

These Derivatives are essentially bets that certain events will take place in the future. Most popular is the interest rate. Betting on whether the fed will reduce the rates or increase it and by how much.

These are private transactions. You can not open the newspaper easily and find out what’s going on. That’s why they are called Shadow Market or Dark Market.

Unlike stocks and bonds there is no regulations for the Shadow Market.

No regulations? How did this happen?

In December 2000, right before Christmass, a bill was passed by the Congress called Commodity Future Modernization Act (CFMA).

I assure you that the drafter of the bill were not the member of the congress. Who were they? Bankers and their lawyers.

They convinced senator Phil Graham to introduce this bill and freed the system from any regulations and we’ve been embarking on this financial fiasco ever since. BTW, Phill Graham is the economic advisor of senator John McCain.

What are these Complex Credit Derivative/Credit Default Swaps? Here is a simple analogy. It’s like this – Say if you want to invest in a basketball team, the Stock Market way of doing this would be to invest in the team, but the Derivate way of doing it would be just betting on whether this team will win or lose. Another word, Instead of owning the team, you go find a gambling operation and bet whether the team will win or lose!

One of the bets we have now is whether homeowner will pay their sub-prime mortgage off or not. For the most part the banks thought those mortgages would be paid off. Because they thought they are risk-less investments.

So when you hear the banks are losing money, it basically means that those bets went bad. The other thing the banks did was that they added this bets to their books as assets. But, now these valuable assets as they thought, are liabilities.

Now there was some financial prudence to this. For instance, in regard to sub-prime loans, the investors wanted some kind of insurance to protect themselves against losses.

So, the bank told the investors: No problem, we’ll insure these investments.

They went to insurance companies and asked them to insure the loans. However, on the documents the banks did not want to use the word insurance. Because once they used the word insurance, State Insurance Commissions would get involve and they wouldn’t like any regulation by the State Insurance Commission.

So, what the banks did was – instead of using the word insurance they used the phrase Credit Default Swap.

The insurance companies thought these are risk free transactions. So, they gave out billions and billions of dollars worth of insurance…faster than they could write it!

Now, we have been hearing about these insurance companies that are beginning to fail.

You probably heard about the Bern Stern and other corporations bail out by federal government.

The question is – Is Bern Stern the end or is it the beginning. If it’s the beginning, we are going back to 1920s. Time will tell.

Ladies and gentlemen, Should we have an economy based on whether people make good or bad bets or should we have an economy where people do inventions, build factories, build companies, advance American society and make it more productive?

This economy is based on people sitting at their computer making bets all day long.

We are rewarding people sitting at their computer doing bets, and India, China and Russia building real businesses are going to eat our lunch unless American public wakes up and put a stop to making heroes out of speculators.

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