Derivatives and You

Again and again, the media keeps stating that nobody understands derivatives, that it is too complex for most people to understand, as if as a kind of apology for the market meltdown.

But, derivatives aren't actually that hard to understand.

Which begs the question – why is nobody explaining it? Do they really actually not understand themselves? Do they just accept that they won't understand, and so don't even try? Or are they merely pretending not to understand?

Or maybe no one wants the public to look to closely, because looking closely requires take a look at the structure of loans, and the finance system does NOT want that.

So, everybody kinda knows what loans are to them – you, the lendee receive a bundle of money which you have to pay back, with interest. Or, more basically, a person who earns $1000 a month who takes out a $1000 loan in January (that must be paid back in November) suddenly has $2000 to spend in January, making that person much more wealthy that month. Yet along comes November, and the bill for the $1000 loan, and then that month this person has no income. But that's not all – then the interest bill comes due, so in December this person pays out another $500, leaving them with only half their income.

So, what is a load, really? It's a way of giving banks your money.

Now, the counterargument to that has always been: with that loan money in January, you will buy things (like a TV), and the enjoyment that you receive for having that TV for all those extra months (instead of saving up for it and buying it with your own money) makes up for the extra money that gets paid out in interest – or, in other words, makes up for those later months of being poor while you pay back the loan bills.

Of course, the counter-counterargument to that is: if you'd saved the money, you could buy a TV and Blu-ray player with the money you would have otherwise paid out in interest, and the enjoyment you would receive for BOTH objects over the coming years, as well as the enjoyment of not being in debt, far outweighs the enjoyment for having the TV right NOW.

But, really, that is kind of an aside, because that is what a loan is to the lendee.

What we need to look at is what a loan is to the lender – ie the bank. The bank lends out a bundle of money, making them poorer now, but with the expectation that they will be getting that money back plus a bundle more in interest.

So, for them, a loan is an investment. An investment with potentially high returns these days, what with the abandonment of usury laws.

And, like any potentially profitable investment, there are other folks out they seeking to cut in on a slice of the action, and the banks are willing to do that. They will sell of a share of the loan, say $100 worth, for say $110 – the bank then loses out on the full interest of that share of the loan, but no longer holds any risk for that share if the loan doesn't get paid back, and can then turn around and loan the $110 they just got to someone else.

That's generally how things were done, until recently – a fairly safe, stable system. It has its quirks, but there were a bunch of financial rules preventing most of those quirks from having any major effect on the overall economy.

Now, banks rate each of those loans on the likelihood of their being repaid, basing that rating on a lot of things, such as assets, income, and the like. Triple-A is the best rating, usually reserved for wealthy, stable countries. Major currencies receive Triple-A ratings, in other words, but people don't.

A certain portion of loans fail. That's a given. Which is problem for investors. Lower ranked loans have a higher risk of default, and investors don't like risk. So, banks are forced to sell shares of the loans at a lower price, thus offering higher potential profits, in order to attract interest from investors.

However…now we come to the gimmick.

Through experience, banks have figured out what percentage of loan failures there will be at any given ranking – that's just a matter of adding up all the loans of a given rank for a year and finding out what percentage of those loans failed, and then keeping track of the failure rate year-to year for each rank.

Nothing special about that.

But, knowing the failure rate of each rating, what if you took a $100 share from 100 different loans and combined them together to form a new $1000 piece of loan property. Sure, a certain percentage of the shares of that loan property will fail, but the bulk of the shares it is made up of wouldn't, so the new loan property would earn.

The earnings wouldn't be as high as a successfully paid-back loan, since a certain portion of those shares would fail, draining the income. On the other hand, there would be a lot less risk in the overall loan investment, since most of those shares would earn.

Then, taking that idea a step further, the bankers theorized that an ideal set of shares could be co-mingled from shares of loans from all of the different ratings to make an loan property (or investment vehicle, to put it their terms) that would be guaranteed to earn a profit.

With that theory centermost in their minds, the banks hired some techs to design a computer program that would plot a formula of loan shares that would do just that – and so prove the theory, while also making them a whole lot of money.

And that's a derivative – a thing whose value is derived from something else (a loan), but whole value is not directly affected by that something.

And so, the program got made, and they stared earning money with their loan properties. And almost immediately, trouble crept into the system.

Much has been made of the fact the formula thus crafted was a "lab formula," and so could only survive in a completely controlled lab environment, as it took so few real-world factors into account, and that's true.

But that's not where trouble crept in first.

First was how these loan properties got rated. Due to financial deregulation and the usual theories of benefits of lax oversight, these loan vehicles got rated Triple-A, since they "could not fail," making them as good as money. Money being an asset.

And banks loaning their assets to other people for a profit.

You might already see where this is going. Banks make money by making loans with the money that public stores in them in the savings accounts. And one of the causes of the Great Depression was systemic bank failure caused by banks having loaned so much of that money out that they couldn't make pay-outs when the public started demanding their savings, and the banks went belly-up, and everyone who banked there lost everything.

That wasn't exactly an uncommon occurrence before the Great Depression, either – the Great Depression's bank failure was just so much more widespread. And because of it, the government instituted two rules – government-insurance on money that the public placed into a bank, up to a certain point, and a requirement that banks keep a certain percentage of their assets in reserve on their premises, so that they will always have enough money on hand to pay out to people who want their savings back.

The key here is – assets. These new loan properties were considered Triple-A, making them assets, which the banks could then keep instead of real assets, like money, or they could even make new loans based on their new loan properties.

Or, in other words, they started making loans on the promise of earnings from loans that they had made earlier.

Then, on top of that, since the banks were keeping less real assets on hand, in order to cover emergencies, and so that any bank could show real assets when they had to, such as for government inspections, a shadow banking system developed. Again, only because of financial deregulation. The shadow banking system would make overnight loans to any bank that was strapped for cash, and so propped up the thin reserves of the banks.

But, this shadows banking system really only exacerbated the problem, since the shadow banks weren't covered by reserve requirements either, and so they loaned out their assets to a far more extensive degree than even the regular banks were on their new loan properties system.

With everyone that over-extended, no one could survive even the slightest tremor to the system. One hint of trouble, and the over-extended system would collapse. However, the new loan properties were guaranteed to earn, and everyone was making hordes of money, so no one looked too closely at the over-extensions.

But, that's not even all. With so much money being made, crime started to leak into the system, inevitably. And with deregulation, there was no one keeping a close look-out for it. Fraud, among other things, became rampant.

The loan companies needed fresh loans to plug into their loan formula, so they could make new loan properties, but they needed a certain ratio of loans from the different loan ratings in order to obey the formula. After a while, though, they ran out of new loans in certain ratings, even with the newly lax lending laws, and so some people (many people) started fudging their loan packages. Whether out of belief that the system was so perfect it wouldn't matter if a few loans were set into the formula improperly, or more direct fraud, load officers began inflating lendee assets (sometimes conspiring with the lendee, often not) in order to give them a higher rating, and so gather more loans of the right kind in order to make more loan properties.

But if you mess with the formula like that, then more of the shares that make up that loan property are going to fail, which will cause the earnings of the loan property to be weakened, and eventually even to the point that will cause it to go bust.

But, even that is not all. All of these new loans are based on a product, in this case mostly real estate. Which caused a building boom. And people were taking out loans to build vast tracks of property in anticipation of other people taking out loans to invest in the property in anticipation of some future people wanting to purchase that property to live in.

And, well, that ain't gonna work.

Some of those buildings loans are going to go bad. Whether because they were built in the wrong place, or without amenities, or the market changed, or any number of problems, some are going down. Which is going to bring not only the building loan down, but all of the investment loans as well. Which is going to make some of those loan properties go bust. Which, since those loan properties are supposed to be Triple-A, guaranteed, is going to shake the foundations of the system.

And that's still not all. With so many loans being made with so little oversight, and since the loans properties were guaranteed, nobody paid much attention what loans were cut into which properties and where those properties were then sold. It was just cut and sell, as fast as you can. And that means, if any – that's ANY – loan ending up having a problem at some point, nobody could track down who carried the note, who was now responsible for it, who made the error, how to correct the error, or even, sometimes, who was now lawfully in control of the loan.

Instead, third-party institutions were put into place to administer the loan properties that they weren't in any other way responsible for. Which just added another layer of chaos to an already unmanageably hard to administer system, which should never have been allowed to even have arisen in the first place.

And all of that is on top of the structural problems of the loan formula itself. Not only did the formula not take into account systemic failures, such as downturns in the economy, it didn't even take into account local and quite visible downturns in real estate, in places such as Detroit, where real estate was going for 1/100th of its original sales value. Nor did it take into account the actual effect of averages – that formula did make a much safer loan property, but ALL loans have the potential to go bad, and it was just going to happen – even in an ideal non-fraud-based situation – that one loan property was going to have enough shares go bad that it was going to go bust. The only reason that this hadn't happened yet was the fact that the loan properties were such a hot commodity that they were inflating the appearance-value of even horrid-looking loans and not quite enough time had passed yet for the first un-refinanceable loan to come due. But it was coming.

With all that over-extension, fraud, and lab-only-formulas, it isn't actually a question of whether or not the derivatives market was going to collapse, it was a question of which part of the whole house-of-cards was going to fall first.

And that's what the derivatives-market was: a weak, overloaded, logically-bankrupt, and sometimes even fraudulent idea destined to fall apart in the first slight wind of trouble.

America in Decline? - Conclusion

So, with all of those things out, what should one look for to determine the decline of an empire?

As I said, that is a huge topic, and one that I'm not sure has ever been satisfactorily answered by anyone. The best things, possibly, to do, though, would be to take a historical look at the decline of the other large empires. Not an interpretive look, but a historical one.

The Greek Empire: It's difficult to say this far out and with as few resources as there are, but the current best guess was that when the alliance between Athens and Sparta died, the Greek Empire died with it. The Empire existed as a unity between various city-states, with Athens and Sparta as the mind and the backbone respectively. The Empire couldn't survive with one of each of those things.

So, to relate that to today – if the US states start to break off, the US empire would come to a crashing end. Which seems eminently logical.

The Roman Empire: Despite the Church's gentle re-writing of history, it wasn't hedonism that brought down the Empire, and it wasn't really barbarian attacks either. It was the structure of the Empire itself. The Roman Empire was made Christian and split by Emperor Constantine into two halves, and the eastern half survived intact well into the Age of Imperialism, and an argument can be made that they survived very nearly to the modern day. The western side, what some call True Rome, did break apart, bit by bit, but there is one part still with us even today – the city of the Roman Catholic Church. The Church ruled medieval Europe as much as, maybe even more than, the Empire did, and it is a strong influence on the nations of the world today. So, in a way, the Roman Empire is STILL with us.

But what made its military control break apart? The Romans never had that large a military. Unlike the peoples around them, every male person of a certain age who could wield a sword wasn't a warrior. The Romans had an army. Which does add a great deal of skill and professionalism to your warriors, but it also means that only a narrow fraction of your available populace fight. So, the Roman Empire hired mercenaries, and mercenaries have to be paid. Which aggravated an already sore problem.

The Empire was based not on conquest, but on loot. Every country that Rome invaded was subsequently looted of the treasure, and then also had to pay a tribute of (lesser) wealth every year. All those new territories have to be governed, though. Which costs money. And all of their rebellions have to be put down, which costs even more money. And the administration of such a vast empire causes the need for an equally vast bureaucracy back home to administer it, which costs even still more money. Which is fine as long as new conquests are rolling in every generation to pay for the empire. But eventually, you run into the difficulty of having too much of your army and wealth occupied controlling the territory you've got, and no one close who's wealthy enough to bother conquering. And then your empire starts to starve for money.

Which was a problem made even worse by debt. The Roman Empire ran on debt, especially when no new conquests were rolling in, and the costs of Empire never went down, and the non-unified and fractious peoples of the west were an ever-rebellious drain on Roman coffers.

Due to the tax structure and the powerful and controlling financial system of the Roman Empire, Rome essentially went bankrupt. It decided it couldn't afford maintaining all those rebellious – and now rather poor, after all the looting – colonies any more, and so it began to retreat. Not all at once, but bit by bit, letting the more costly and distant countries go, until it retreated altogether.

So, if the US government ever becomes financially exhausted, in debt way over their head to the uncaring financiers, with no ability to print money to inflate that debt away, then the US Empire will break apart due to inability to pay for it. Which would likely happen even faster than it did for Rome, since the loot of the US Empire (of which there is great deal, by the way), doesn't get distributed to the US much at all.

Many people site the Roman Empire in comparisons to the US Empire, drawing many parallel conclusions therein, but a far better comparison would be the Spanish Empire. The Spanish Empire was founded on looting a vast overseas network of colonies, taking both the wealth, goods, and labor of many different peoples and enriching a very few merchant-lords.

Interestingly enough, even with all that loot rolling in, the Spanish Empire only grew more mired in debt. The larger the Empire, the more enemies it made, but also the more arrogant it became, losing what allies it had already won, until it was all alone. The nature of its army allowed it survive, alone and in debt like that, its soldiers often unpaid and even unfed, for a very long time.

But the loot rolling in didn't do much for the rest of Spain, either. It made a few people very rich, but in doing so, it utterly ruined the Spanish economy. The loot was often in the form of large amount of gold, which was essentially money, which essentially worked about the same as if the government had started printing hoardes of money. Those who were part of the looting did well, often very well, but everyone else ended up starving, and with so much work being done out in the colonies, unable to find much work to stave off the hunger. All that, with a growing number of enemies who attacked Spain wherever they could, who then had to be fought, which wars had to be paid for by ever-more borrowing, but also thus needing a great many more soldiers, which, being the only work available, they could have, but that just left an increasing large number of trained soldiers loose and hungry in the cities whenever there wasn't a war on, and an ever-increasing number of maimed citizenry, who usually had to subsist as beggars. It wasn't pretty, and it went down hard, riddled on every side by enemies attacking it from every direction, until it started losing territory, and losing it all fast.

The US Empire is structured quite similarly to the Spanish Empire, so if the war merchants and the colonizers ever end up being completely divorced from the economy, and the US ends up still paying to defend all of that group's interests without sharing in the loot, with an increasingly poor and unemployed populace back home, but still arrogantly making enemies abroad until all it faces is a sea of enemies on every side, attacking it from every direction, then the US Empire will collapse, yanked out of its hands by all of the others peoples of the world.

So, look most of all to the level of US arrogance and its number of enemies that it thusly engenders. Therein will you likely see the US Empire's fall.

America in Decline? - Answers Part V

Declining wages and an addiction to beauty.

It might seem disingenuous to put those two things together, but it isn't. The theory, as the media define it, is that as a culture declines, there is a concurrent rise in fascination and preoccupation with beauty and entertainment - a kind of sap to the ego, if you will.

The media's foremost example of this is actually quite ahistorical, but still widely believed - the Christian explanation for the fall of the Roman Empire. But, we don't even have to get into the theories behind the fall of empires in order to break this argument, because America is NOT currently addicted to beauty.

Do we even need to go beyond beauty contests?

Beauty contests, which only a few decades ago America was inundated with, can't even buy an audience today. The most famous of them all, the Miss America Pageant, is no longer even on network TV, and was only barely saved from oblivion.

But, what about the plastic surgery shows that the media cite so often and with such vigor. I don't know what fascination these shows have with the media, but for people they are actually part of the currently widespread culture of self-improvement. Though cult might be a better word.

Psychological remodeling. Attitude remodeling. House remodeling. Fashion remodeling. Health remodeling. Physical remodeling. Wealth remodeling.

Remodeling. That is the real addiction. Even the shows about models, which you'd think would only be about beauty, are watched by an audience primarily of women, and most of those shows have a hard time surviving without involving a more-than-healthy dose of game-show competition and soap-opera intrigue.

Movies these days have to have character arcs, but, like a lot of terms these days, the term no longer has anything to do with character or arcs, but now means a 'journey of self-improvement.' Some people these days say that written art without a character arc isn't a story at all, but is instead an essay. That is how dominant the culture of self-improvement has become.

It isn't about beauty. It is about being the perfect being, in all aspects. Of course, this is one single idea of what a perfect being is that has been defined by a small subset of the world population, which has certain other connotations to it, but that is another essay.

Many in the media say that the abundant use of sex on television, billboards, magazines, and movies is another aspect of the growing addiction to beauty. But this is a use of sex that is foisted on America by the media. That media culture might one day permeate the culture of the common America, but it has not yet done so. While people are more open to talking about sex than they have been, they are less prone to doing it than they were even a few decades ago, and they are still much less open to talking about it than people are in Europe.

So, as wages (and therefore personal power) falls, America is supposed to become more and more addicted to beauty. It hasn't, so the arguement need go no further. But I will discuss wages anyway.

Wages have gone down. That is an undeniable, recorded fact. The thing is, Alan Greenspan stated that he believed American wages were too high. So too did Reagan and Bush Jr. and Rubin and Clinton (sorta) and Gingrich and Cheney and.... Well, you get the picture.

All of these people in charge of the Treasury and the government, as well as a good chunk of the Senators and Representatives in the House, all believed that American wages were too high, that it was making America uncompetitive, and they stated that they wanted to change that.

And they did.

Which I point out because, if the powers that be systematically reduce the wages of a nation, that is a CHOICE. And the fact that it was a CHOICE, means it has nothing to do with decline.

And so, the whole statement is false from start to finish. Wages aren't lower because of decline, but because of choice. And there is no addiction to beauty caused by the decline in wages and power. There is no addiction to beauty at all. Just an addiction to business and self-improvement.

America in Decline? - Answers Part IV

Collapsing bridges, collapsing dikes, falling buildings, eroding roads. America's infrastructure is crumbling. How do these things happen in a wealthy, advanced country?

The advocates of decline state that crumbling infrastructure is a result of corruption - political, corporate, and religious. They declare that a disease of greed and corruption has claimed all of the powers of America, and that everyone else has succumbed to a malaise.

However, crumbling infrastructure actually is nothing new in the US. From railroads to dikes to bridges, things get built cheap, they aren't maintained properly, and then they break down.

The first large-scale railroad ties laid down were fashioned of poor material and were poorly fitted, causing them to bend into 'U's when heavy loads were run across them, inevitably leading to derailments and death.

The Hanford Nuclear Reactor is a disaster area because its pieces fit together so poorly.

There are bridges that didn't survive their first windstorm, much less their first earthquake.

Things get built on the cheap. Why? Because the builder gets paid on the margin between what it costs to build and what the buyer is paying. So the builder gets more profit with cheaper materials. And the builder gets more work with cheaper bids. So, low-quality materials, low-skilled labor, and corner-cutting become the norm rather than an aberration.

But there's more.

Once the infrastructure gets built, it often is poorly maintained or not maintained at all. Why? Because, while roads and other infrastructure are highly useful to people once they're built, to the government that had them built, infrastructure is just endless seas of red ink going on forever.

As soon a road or a bridge or anything like that gets put in, it immediately starts to weather and degrade, which means it has to be maintained. However, roads and bridges never earn any money to pay for their maintenance, they just keep having to be paid for, forever. The more roads and bridges that get built, the more that has to be paid out to maintain them.

Well, unless your constituency lets you put in those ever-popular toll booths, or something like them.

That's why governments don't really like to build roads. There's just no money in it. Unlike say re-development projects. There isn't even any prestige, such as there are with vanity projects (name in the papers, bumps in the polls - vanity).

Infrastructure also tends to stick around for a while, even when it's poorly built, as weathering and decay is a slow, decades-long process. So, for a government looking to make a profit (and the philosophy of the last few decades was everything has to make a profit), it is actually quite cost-effective in the short term to short infrastructure maintenance and apply all those saved funds to development or vanity projects. Things with money or prestige involved.

And you keep putting it off. And then your successor puts it off, because he doesn't want to look like he can't do as much as you did. And then, eventually, the unmaintained infrastructure start to break down.

It's all part of the fast-buck. The fame game. The culture of NOW. i.e. America. America as it is as it always has been. And so, declining infrastructure has nothing do with any mark of decline. It is only another blow to the illusion so many had of a special, infallible, and benevolent race of people in America.