By Ellen Brown / Original to ScheerPost

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Reading the tea leaves for the 2024 economy is challenging. On January 5^th, Treasury Secretary Janet Yellen said we have achieved a “soft landing,” with wages rising faster than prices in 2023. But critics are questioning the official figures, and prices are still high. Surveys show that consumers remain apprehensive.

There are other concerns. On Dec. 24, 2023, Catherine Herridge, a senior investigative correspondent for CBS News covering national security and intelligence, said on “Face the Nation,” “I just feel a lot of concern that 2024 may be the year of a black swan event. This is a national security event with high impact that’s very hard to predict.”

What sort of event she didn’t say, but speculations have included a major cyberattack; a banking crisis due to a wave of defaults from high interest rates, particularly in commercial real estate; an oil embargo due to war. Any major black swan could prick the massive derivatives bubble, which the Bank for International Settlements put at over one quadrillion (1,000 trillion) dollars as far back as 2008. With global GDP at only $100 trillion, there is not enough money in the world to satisfy all these derivative claims. A derivative crisis helped trigger the 2008 banking collapse, and that could happen again.

The dangers of derivatives have been known for decades. Warren Buffett wrote in 2002 that they were “financial weapons of mass destruction.” James Rickards wrote in U.S. News & World Report in 2012 that they should be banned. Yet Congress has not acted. This article looks at the current derivative threat, and at what might motivate our politicians to defuse it.

What Regulation Hath Wrought

Derivatives are basically just bets, which are sold as “insurance” — protection against changes in interest rates or exchange rates, defaults on loans and the like. When one of the parties to the wager has a real economic interest to be protected – e.g. a farmer ensuring the value of his autumn crops against loss — the wager is considered socially valuable “hedging.” But most derivative bets today are designed simply to make money from other traders, degenerating into what has been called “casino capitalism.”

In 2008, derivative trading brought down investment bank Bear Stearns and international insurer A.I.G. Both institutions could not be allowed to fail, because the trillions of dollars in credit default swaps on their books would have been wiped out, forcing their counterparty banks and financial institutions to write down the value of their own risky and now “unhedged” loans. Bear and A.I.G. were bailed out by the taxpayers; but the Treasury drew the line at Lehman Brothers, and the market crashed.

Under the rubric of “no more bailouts,” the Dodd Frank Act of 2010 purported to fix the problem by giving derivatives special privileges. Most creditors are “stayed” from enforcing their rights while a firm is in bankruptcy, but many derivative contracts are exempt from these stays. Counterparties owed collateral can grab it immediately without judicial review, before bankruptcy proceedings even begin. Depositors become “unsecured creditors” who can recover their funds only after derivative, repo and other secured claims, assuming there is anything left to recover, which in the event of a major derivative crisis would be unlikely. We saw this “bail-in” policy play out in Cyprus in 2013.

That’s true for deposits, but what of stocks, bonds and money market funds? Under the Uniform Commercial Code (UCC) and the Bankruptcy Act of 2005, derivative securities also enjoy special protections. “Safe harbor” is provided to privileged entities described in court documents as “the protected class.” Derivatives enjoy “netting” and “close-out” privileges on the theory that they are a major source of systemic risk, and that allowing claimants to jump ahead of other investors in order to net and close out their bets reduces that risk. However, critical analysis has shown that derivative “super-priority” in bankruptcy can actually increase risk and propel otherwise viable financial entities into insolvency.

It is also highly inequitable. The collateral grabbed to close out derivative claims may be yourstocks and bonds. In a 2016 American Banker article called “You Don’t Really Own Your Securities; Can Blockchains Fix That?”, journalist Brian Eha explained:

In the United States, publicly traded stock does not exist in private hands.

It is not owned by the ostensible owners, who, by virtue of having purchased shares in this or that company, are led to believe they actually own the shares. Technically, all they own are IOUs. The true ownership lies elsewhere.

While private-company stock is still directly owned by shareholders, nearly all publicly traded equities and a majority of bonds are owned by a little-known partnership, Cede & Co., which is the nominee of the Depository Trust Co., a depository that holds securities for some 600 broker-dealers and banks. For each security, Cede & Co. owns a master certificate known as the “global security,” which never leaves its vault. Transactions are recorded as debits and credits to DTC members’ securities accounts, but the registered owner of the securities — Cede & Co. — remains the same.

What shareholders have rather than direct ownership, then, “is a [contractual] right against their broker…. The broker then has a right against the depository institution where they have membership. Then the depository institution is beholden to the issuer. It’s [at least] a three-​step process before you get any rights to your stock.”This attenuation of property rights has made it impossible to keep perfect track of who owns what.

Fifty Years of “Dematerialization”

In a 2023 book called The Great Taking (available for free online), Wall Street veteran David Rogers Webb traces the legislative history of these developments. The rules go back 50 years, to when trading stocks and bonds was done by physical delivery – shuffling paper certificates bearing titles in the names of the purchasers from office to office. In the 1970s, this trading became so popular that the exchanges could not keep up, prompting them to turn to “dematerialization” or digitalization of the assets. The Depository Trust Company (DTC) was formed in 1973 to alleviate the rising volumes of paperwork. The DTCC was established in 1999 as a holding company to combine the DTC and the National Securities Clearing Corporation (NSCC).

The DTCC is a central clearing counterparty (CCP) sitting at the top of a pyramid of banks, brokers and exchanges. All have agreed to hold their customers’ assets in “street name,” collect those assets in a fungible pool, and forward that pool to the DTCC, which then trades pooled blocks of stock and bonds between brokers and banks in the name of its nominee Cede & Co. The DTCC, a private corporation, owns them all. This is not a mere technicality. Courts have upheld its legal ownership, even in a dispute with client purchasers. According to the DTCC website, it provides settlement services for virtually all equity, corporate and municipal debt trades and money market instruments in the U.S., and central safekeeping and asset servicing for securities issues from 131 countries and territories, valued at $37.2 trillion. In 2022 alone, the DTCC processed 2.5 quadrillion dollars in securities.

The governing regulations are set out in Uniform Commercial Code (UCC) sections 8 and 9, covering investment securities and secured transactions. The UCC is a set of rules produced by private organizations without an act of Congress. It is not itself the law but is only a recommendation of the laws that states should adopt; but the UCC has now been adopted by all 50 U.S. states and has been “harmonized” with the rules for trading securities in Europe and most other countries.

The Wikipedia summary of the relevant UCC provisions concludes:

The rights created through these links [up the collateral chain] are purely contractual claims ….  This decomposition of the rights organized by Article 8 of the UCC results in preventing the investor to revindicate [demand or take back] the security in case of bankruptcy of the account provider [the broker or bank], that is to say the possibility to claim the security as its own asset, without being obliged to share it at its prorate value with the other creditors of the account provider.

You, the investor, have only a contractual claim against your broker, who no longer holds title to your stock either, since title has been transferred up the chain to the DTCC. Your contractual claim is only to a pro rata share of a pool of the stock designated in street name, title to which is held by Cede & Co.

Rehypothecation: The Problem of Multiple Owners

The Wikipedia entry adds:

This re-characterization of the proprietary right into a simple contractual right may enable the account provider [the “intermediary” broker or bank] to “re-use” the security without having to ask for the authorization of the investor. This is especially possible within the framework of temporary operations such as security lending, option to repurchase, buy to sell back or repurchase agreement.

“Security lending” by your broker or other intermediary may include lending your stock to short sellers bent on bringing down the value of the stock against your own financial interests. Illegal naked short selling is also facilitated by the impenetrable shield of the DTCC, and so is lending to “shadow banks” for the re-use of collateral. As Caitlin Long, another Wall Street veteran, explains:

 [T]he shadow banking system’s lifeblood is collateral, and the issue is that market players re-use that same collateral over, and over, and over again, multiple times a day, to create credit. The process is called “rehypothecation.” Multiple parties’ financial statements therefore report that they own the very same asset at the same time. They have IOUs from each other to pay back that asset—hence, a chain of counterparty exposure that’s hard to track. Although improving, there’s still little visibility into how long these “collateral chains” are.

It is this reuse of the collateral to back multiple speculative bets that has facilitated the explosion of the derivatives bubble to ten times the GDP of the world. It should be the collateral of the actual purchaser, but you, the purchaser, are at the bottom of the collateral chain. Derivative claims have super priority in bankruptcy, ostensibly because the derivative edifice is so risky that their bets need to be cleared.

What About the “Customer Protection Rule”?

Broker-dealers argue that their customers’ assets are protected under the “Customer Protection Rule” of the Securities Investor Protection Corporation (SIPC). The SIPC provides insurance for stocks similar to FDIC insurance for bank deposits, maintaining a pool that can be tapped in the event of a member bankruptcy. But a 2008 memorandum on The Customer Protection Rule from the law firm Willkie Farr & Gallagher asserts:

With respect to cash and securities not registered in the name of the customer, but held by the broker- dealer for the customer’s benefit, the customer would receive a pro rata portion of the aggregate amount of the cash and securities actually held by the broker- dealer. If there is a remaining shortfall, SIPC would cover a maximum of $ 500,000, only $ 100,000 of which may be a recovery for cash held at the broker- dealer.

… [M]ost securities are held by broker-dealers in street name and would be available to satisfy other customers’ claims in the event of a broker- dealer’s insolvency.

If the member has a large derivatives book (JPMorgan holds $54.4 trillion in derivatives and a mere $3.4 trillion in assets), derivative customers with priority could wipe out the pool and the SIPC fund as well.

What Webb worries about, however, is the bankruptcy of the DTCC itself, which could wipe out the entire collateral chain. He says the DTCC is clearly under-capitalized, and that the startup of a new Central Clearing Counterparty is already planned and pre-funded. If the DTCC fails, certain protected creditors can take all the collateral, upon which they will have perfected legal control.

Defensive Measures

In the event of a cyberattack that destroys the records of banks and brokers, there could be no way for purchasers to prove title to their assets; and in the event of a second Great Depression, with a wave of 1930s-style bank bankruptcies, derivative claimants with super-priority can take the banks’ assets without going through bankruptcy proceedings. In today’s fragile economy, these are not remote hypotheticals but are real possibilities, which can wipe out not just the savings of middle class families but the fortunes of billionaires.

And there, argues Webb, is our opportunity. The system by which Cede & Co. holds title to all “dematerialized” securities is clearly vulnerable to being exploited by “the protected class,” and Congress could mitigate those concerns by legislation. If our representatives realized that they are not the owners of record of their assets but are merely creditors of their brokers and banks, they might be inspired to hold some hearings and take action.

The first step is to shine a light on the obscure hidden workings of the system and the threat they pose to our personal holdings. Popular pressure moves politicians, and the people are waking up to many issues globally, with protests on the rise everywhere — economic, political and social. Possible action that could be taken by Congress includes reversing the “special privileges” granted to the derivatives casino in the form of “super priority” in bankruptcy. A 0.1% Tobin tax or financial transaction tax is another possibility. For protecting title to assets, blockchain is a promising tool, as discussed by Brian Eha in the American Banker article quoted above. These and other federal possibilities, along with potential solutions at the local level, will be the subject of a followup article.

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First published on ScheerPost.com.

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By Ellen Brown / Original to ScheerPost
12 March 2023

On Friday, March 10, Silicon Valley Bank (SVB) collapsed and was taken over by federal regulators. SVB was the 16^th largest bank in the country and its bankruptcy was the second largest in U.S. history, following Washington Mutual in 2008. Despite its size, SVB was not a “systemically important financial institution” (SIFI) as defined in the Dodd-Frank Act, which requires insolvent SIFIs to “bail in” the money of their creditors to recapitalize themselves.

Technically, the cutoff for SIFIs is $250 billion  in assets. However, the reason they are called “systemically important” is not their asset size but the fact that their failure could bring down the whole financial system. That designation comes chiefly from their exposure to derivatives, the global casino that is so highly interconnected that it is a “house of cards.” Pull out one card and the whole house collapses. SVB held $27.7 billion in derivatives, no small sum, but it is only .05% of the $55,387 billion ($55.387 trillion) held by JPMorgan, the largest U.S. derivatives bank.

SVB could be the canary in the coal mine foreshadowing the fate of other over-extended banks, but its collapse is not the sort of “systemic risk” predicted to trigger “contagion.” As reported by CNN:

“Despite initial panic on Wall Street, analysts said SVB’s collapse is unlikely to set off the kind of domino effect that gripped the banking industry during the financial crisis.

‘The system is as well-​capitalized and liquid as it has ever been,’ Moody’s chief economist Mark Zandi said. ‘The banks that are now in trouble are much too small to be a meaningful threat to the broader system.’

No later than Monday morning, all insured depositors will have full access to their insured deposits, according to the FDIC. It will pay uninsured depositors an ‘advance dividend within the next week.’”

A fuller report on the collapse of SVB will have to wait on developments that occur over the weekend and soon thereafter.

This column, meanwhile, focuses on derivatives and is a followup to my Feb. 23  column on the “bail in” provisions of the 2010 Dodd Frank Act, which eliminated taxpayer bailouts by requiring insolvent SIFIs to recapitalize themselves with the funds of their creditors. “Creditors” are defined to include depositors, but deposits under $250,000 are protected by FDIC insurance. However, the FDIC fund is sufficient to cover only about 2% of the $9.6 trillion in U.S. insured deposits. A nationwide crisis triggering bank runs across the country, as happened in the early 1930s, would wipe out the fund. Today, some financial pundits are predicting a crisis of that magnitude in the quadrillion dollar-plus derivatives market, due to rapidly rising interest rates. This column looks at how likely that is and what can be done either to prevent it or dodge out of the way.

“Financial Weapons of Mass Destruction”

In 2002, mega-investor Warren Buffett wrote that derivatives were “financial weapons of mass destruction.” At that time, their total “notional” value (the value of the underlying assets from which the “derivatives” were “derived”) was estimated at $56 trillion. Investopedia reported in May 2022 that the derivatives bubble had reached an estimated $600 trillion according to the Bank for International Settlements (BIS), and that the total is often estimated at over $1 quadrillion.  No one knows for sure, because most of the trades are done privately.

As of the third quarter of 2022, according to the “Quarterly Report on Bank Trading and Derivatives Activities” of the Office of the Comptroller of the Currency (the federal bank regulator),  a total of 1,211 insured U.S. national and state commercial banks and savings associations held derivatives, but 88.6% of these were concentrated in only four large banks: J.P. Morgan Chase ($54.3 trillion), Goldman Sachs ($51 trillion), Citibank ($46 trillion), Bank of America ($21.6 trillion), followed by Wells Fargo ($12.2 trillion). A full list is here. Unlike in 2008-09, when the big derivative concerns were mortgage-backed securities and credit default swaps, today the largest and riskiest category is interest rate products.

The original purpose of derivatives was to help farmers and other producers manage the risks of dramatic changes in the markets for raw materials. But in recent times they have exploded into powerful vehicles for leveraged speculation (borrowing to gamble). In their basic form, derivatives are just bets – a giant casino in which players hedge against a variety of changes in market conditions (interest rates, exchange rates, defaults, etc.). They are sold as insurance against risk, which is passed off to the counterparty to the bet. But the risk is still there, and if the counterparty can’t pay, both parties lose. In “systemically important” situations, the government winds up footing the bill.

Like at a race track, players can bet although they have no interest in the underlying asset (the horse). This has allowed derivative bets to grow to many times global GDP and has added another element of risk: if you don’t own the barn on which you are betting, the temptation is there to burn down the barn to get the insurance. The financial entities taking these bets typically hedge by betting both ways, and they are highly interconnected. If counterparties don’t get paid, they can’t pay their own counterparties, and the whole system can go down very quickly, a systemic risk called “the domino effect.”

That is why insolvent SIFIs had to be bailed out in the Global Financial Crisis (GFC) of 2007-09, first with $700 billion of taxpayer money and then by the Federal Reserve with “quantitative easing.” Derivatives were at the heart of that crisis. Lehman Brothers was one of the derivative entities with bets across the system. So was insurance company AIG, which managed to survive due to a whopping $182 billion bailout from the U.S. Treasury; but Lehman was considered too weakly collateralized to salvage. It went down, and the Great Recession followed.

Risks Hidden in the Shadows.

Derivatives are largely a creation of the “shadow banking” system, a group of financial intermediaries that facilitates the creation of credit globally but whose members are not subject to regulatory oversight. The shadow banking system also includes unregulated activities by regulated institutions. It includes the repo market, which evolved as a sort of pawn shop for large institutional investors with more than $250,000 to deposit. The repo market is a safe place for these lenders, including pension funds and the U.S. Treasury, to park their money and earn a bit of interest. But its safety is insured not by the FDIC but by sound collateral posted by the borrowers, preferably in the form of federal securities.

As explained by Prof. Gary Gorton:

“This banking system (the “shadow” or “parallel” banking system) – repo based on securitization – is a genuine banking system, as large as the traditional, regulated banking system. It is of critical importance to the economy because it is the funding basis for the traditional banking system. Without it, traditional banks will not lend and credit, which is essential for job creation, will not be created.”

While it is true that banks create the money they lend simply by writing loans into the accounts of their borrowers, they still need liquidity to clear withdrawals; and for that they largely rely on the repo market, which has a daily turnover just in the U.S. of over $1 trillion. British financial commentator Alasdair MacLeod observes that the derivatives market was built on cheap repo credit. But interest rates have shot up and credit is no longer cheap, even for financial institutions.

According to a December 2022 report by the BIS, $80 trillion in foreign exchange derivatives that are off-balance-sheet (documented only in the footnotes of bank reports) are about to reset (roll over at higher interest rates). Financial commentator George Gammon discusses the threat this poses in a podcast he calls, “BIS Warns of 2023 Black Swan – A Derivatives Time Bomb.” Another time bomb in the news is Credit Suisse, a giant Swiss derivatives bank that was hit with an $88 billion run on its depositsby large institutional investors late in 2022. The bank was bailed out by the Swiss National Bank through swap lines with the U.S. Federal Reserve at 3.33% interest.

The Perverse Incentives Created by “Safe Harbor” in Bankruptcy.

In The New Financial Deal: Understanding the Dodd-Frank Act and Its (Unintended) Consequences, Prof. David Skeel refutes what he calls the “Lehman myth”—the widespread belief that Lehman’s collapse resulted from the decision to allow it to fail. He blames the 2005 safe harbor amendment to the bankruptcy law, which says that the collateral posted by insolvent borrowers for both repo loans and derivatives has “safe harbor” status exempting it from recovery by the bankruptcy court. When Lehman appeared to be in trouble, the repo and derivatives traders all rushed to claim the collateral before it ran out, and the court had no power to stop them.

So why not repeal the amendment? In a 2014 article titled “The Roots of Shadow Banking,” Prof. Enrico Perotti of the University of Amsterdam explained that the safe harbor exemption is a critical feature of the shadow banking system, one it needs to function. Like traditional banks, shadow banks create credit in the form of loans backed by “demandable debt”—short-term loans or deposits that can be recalled on demand. In the traditional banking system, the promise that the depositor can get his money back on demand is made credible by government-backed deposit insurance and access to central bank funding. The shadow banks needed their own variant of “demandable debt,” and they got it through the privilege of “super-priority” in bankruptcy. Perotti wrote:

“Safe harbor status grants the privilege of being excluded from mandatory stay, and basically all other restrictions. Safe harbor lenders, which at present include repos and derivative margins, can immediately repossess and resell pledged collateral. This gives repos and derivatives extraordinary super-priority over all other claims, including tax and wage claims, deposits, real secured credit and insurance claims. [Emphasis added.]”

The dilemma of our current banking system is that lenders won’t advance the short-term liquidity needed to fund repo loans without an ironclad guarantee; but the guarantee that makes the lender’s money safe makes the system itself very risky. When a debtor appears to be on shaky ground, there will be a predictable stampede by favored creditors to grab the collateral, in a rush for the exits that can propel an otherwise-viable debtor into bankruptcy; and that is what happened to Lehman Brothers.

Derivatives were granted “safe harbor” because allowing them to fail was also considered a systemic risk. It could trigger the “domino effect,” taking the whole system down. The error, says Prof. Skeel, was in passage of the 2005 safe harbor amendment. But the problem with repealing it now is that we will get the domino effect, in the collapse of both the quadrillion dollar derivatives market and the more than trillion dollars traded daily in the repo market.

The Interest Rate Shock.

Interest rate derivatives are particularly vulnerable in today’s high interest rate environment. From March 2022 to February 2023, the prime rate (the rate banks charge their best customers) shot up from 3.5% to 7.75%, a radical jump. Market analyst Stephanie Pomboy calls it an “interest rate shock.” It won’t really hit the market until variable-rate contracts reset, but $1 trillion in U.S. corporate contracts are due to reset this year, another trillion next year, and another trillion the year after that.

A few bank bankruptcies are manageable, but an interest rate shock to the massive derivatives market could take down the whole economy. As Michael Snyder wrote in a 2013 article titled “A Chilling Warning About Interest Rate Derivatives:”

“Will rapidly rising interest rates rip through the U.S. financial system like a giant lawnmower blade? Yes, the U.S. economy survived much higher interest rates in the past, but at that time there were not hundreds of trillions of dollars worth of interest rate derivatives hanging over our financial system like a Sword of Damocles.

“… [R]ising interest rates could burst the derivatives bubble and cause “massive bankruptcies around the globe” [quoting Mexican billionaire Hugo Salinas Price]. Of course there are a whole lot of people out there that would be quite glad to see the “too big to fail” banks go bankrupt, but the truth is that if they go down, our entire economy will go down with them. … Our entire economic system is based on credit, and just like we saw back in 2008, if the big banks start failing, credit freezes up and suddenly nobody can get any money for anything.

There are safer ways to design the banking system, but they are not likely to be in place before the quadrillion dollar derivatives bubble bursts. Snyder was writing 10 years ago, and it hasn’t burst yet; but this was chiefly because the Fed came through with the “Fed Put” – the presumption that it would backstop “the market” in any sort of financial crisis. It has performed as expected until now, but the Fed Put has stripped it of its “independence” and its ability to perform its legislated duties. This is a complicated subject, but two excellent books on it are Nik Bhatia’s Layered Money (2021) and Lev Menand’s The Fed Unbound: Central Banking in a Time of Crisis (2022).

Today the Fed appears to be regaining its independence by intentionally killing the Fed Put, with its push to raise interest rates. (See my earlier article here.) It is still backstopping the offshore dollar market with “swap lines,” arrangements between central banks of two countries to keep currency available for member banks,  but the latest swap line rate for the European Central Bank is a pricey 4.83%. No more “free lunch” for the banks.

Alternative Solutions.

Alternatives that have been proposed for unwinding the massive derivatives bubble include repealing the safe harbor amendment and imposing a financial transaction tax, typically a 0.1% tax on all financial trades. But those proposals have been around for years and Congress has not taken up the call. Rather than waiting for Congress to act, many commentators say we need to form our own parallel alternative monetary systems.

Crypto proponents see promise in Bitcoin; but as Alastair MacLeod observes, Bitcoin’s price is too volatile for it to serve as a national or global reserve currency, and it does not have the status of enforceable legal tender. MacLeod’s preferred alternative is a gold-backed currency, not of the 19^th century variety that led to bank runs when the banks ran out of gold, but of the sort now being proposed by Sergey Glazyev for the Eurasian Economic Union. The price of gold would be a yardstick for valuing national currencies, and physical gold could be used as a settlement medium to clear trade balances.

Lev Menand, author of The Fed Unbound, is an Associate Professor at Columbia Law School who has worked at the New York Fed and the U.S. Treasury. Addressing the problem of the out-of-control unregulated shadow banking system, he stated in a July 2022 interview with The Hill, “I think that one of the great possible reforms is the public banking movement and the replication of successful public bank enterprises that we have now in some places, or that we’ve had in the past.”

Certainly, for our local government deposits, public banks are an important solution. State and local governments typically have far more than $250,000 deposited in SIFI banks, but local legislators consider them protected because they are “collateralized.” In California, for example, banks taking state deposits must back them with collateral equal to 110% of the deposits themselves. The problem is that derivative and repo claimants with “supra-priority” can wipe out the entirety of a bankrupt bank’s collateral before other “secured” depositors have access to it.

Our tax dollars should be working for us in our own communities, not capitalizing failing SIFIs on Wall Street. Our stellar (and only) state-owned model is the Bank of North Dakota, which carried North Dakota through the 2008-09 financial crisis with flying colors. Post-GFC (the Global Financial Crisis of ’07-’09), it earned record profits re-investing the state’s revenues in the state, while big commercial banks lost billions in the speculative markets. Several state legislatures currently have bills on their books following the North Dakota precedent.

For a federal workaround, we could follow the lead of Jesse Jones’ Reconstruction Finance Corporation, which funded the New Deal that pulled the country out of the Great Depression. A bill for a national investment bank currently in Congress that has widespread support is based on that very effective model, avoiding the need to increase taxes or the federal debt.

All those alternatives, however, depend on legislation, which may be too late. Meanwhile, self-sufficient “intentional” communities are growing in popularity, if that option is available to you. Community currencies, including digital currencies, can be used for trade. They can be “Labor Dollars” or “Food Dollars” backed by the goods and services for which the community has agreed to accept them. (See my earlier article here.) The technology now exists to form a network of community cryptocurrencies that are asset-backed and privacy-protected, but that is a subject for another column.

The current financial system is fragile, volatile and vulnerable to systemic shocks. It is due for a reset, but we need to ensure that the system is changed in a way that works for the people whose labor and credit support it. Our hard-earned deposits are now the banks’ only source of cheap liquidity. We can leverage that power by collaborating in a way that serves the public interest.

First published on Scheerpost.com.

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Bank Runs, Bail-Ins and Systemic Risk

By Ellen Brown / Original to ScheerPost

Financial podcasts have been featuring ominous headlines lately along the lines of “Your Bank Can Legally Seize Your Money” and “Banks Can STEAL Your Money?! Here’s How!” The reference is to “bail-ins:” the provision under the 2010 Dodd-Frank Act allowing Systemically Important Financial Institutions (SIFIs, basically the biggest banks) to bail in or expropriate their creditors’ money in the event of insolvency. The problem is that depositors are classed as “creditors.” So how big is the risk to your deposit account? Part I of this two part article will review the bail-in issue. Part II will look at the derivatives risk that could trigger the next global financial crisis.

From Bailouts to Bail-Ins.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 states in its preamble that it will “protect the American taxpayer by ending bailouts.” But it does this under Title II by imposing the losses of insolvent financial companies on their common and preferred stockholders, debt holders, and other unsecured creditors, through an “orderly resolution” plan known as a “bail-in.”

The point of an orderly resolution under the Act is not to make depositors and other creditors whole. It is to prevent a systemwide disorderly resolution of the sort that followed the Lehman Brothers bankruptcy in 2008. Under the old liquidation rules, an insolvent bank was actually “liquidated”—its assets were sold off to repay depositors and creditors.

In an “orderly resolution,” the accounts of depositors and other creditors are emptied to keep the insolvent bank in business. And even if you are getting only a few cents a month on your deposits, you are a creditor of the bank.  As explained in a December 2016 article in the University of Chicago Law Review titled “Safe Banking: Finance and Democracy:”

A general deposit is a loan made to a bank. This means that the bank is the general depositor’s debtor, but that the bank has legal title to the funds deposited; these funds may be commingled with the bank’s other funds. All the general depositor has is a general, unsecured claim against the bank …. [T]he bank is free to use the deposit as it sees fit. [Emphasis added.]

Fortunately, bail-ins do not apply to deposits under $250,000, which are protected by FDIC insurance. That is true in theory, but as of September 2021, the FDIC had only $122 billion in its insurance fund, enough to cover just 1.27% percent of the $9.6 trillion in deposits that it insures. The FDIC also has a credit line with the Treasury for up to $100 billion, but that still brings the total to just over 2% of insured deposits.

If just one or a few banks become insolvent, the FDIC fund should be sufficient to cover the insured deposits (those under $250K). But under the 2005 Bankruptcy Act, derivatives creditors (which are considered “secured”) are first in line to recover the assets of a bankrupt bank; and the Dodd-Frank Act followed that practice. So if a bank with major derivatives risk collapses, there might be no bank assets left for the non-insured creditors; and a series of major derivative cross-defaults could wipe out the whole FDIC kitty as well.

As of May 2022, according to the most recent data from the Bank for International Settlements (BIS), the total notional amounts outstanding for contracts in the derivatives market was an estimated $600 trillion; and the total is often estimated at over $1 quadrillion.  No one knows for sure, because many derivatives are “over the counter” (not traded on an exchange). In any case it is a bubble of ominous size, and pundits warn it is about to pop. Topping the list of U.S. derivatives banks are J.P. Morgan Chase ($54.3 trillion), Goldman Sachs ($51 trillion), Citibank ($46 trillion), Bank of America ($21.6 trillion), and Wells Fargo ($12.2 trillion). A full list is here.

The FDIC and Disclosure.

On Nov. 9, 2022, the FDIC held a 3.5 hour webcast discussing the bail-in process among other topics. In a clip raising alarm bells in the alternative media, Donald Kohn, former vice chairman, Board of Governors of the Federal Reserve System, said, “…it’s important that people understand they can be bailed in. But you don’t want a huge run on the institution. But they’re going to be…”

Richard J. Herring, co-director of The Wharton Financial Institutions Center said, “I would think your strategy ought to be to disclose as much as possible to people who professionally need to know about it …”

Gary Cohn, former director of the National Economic Council, said, “I almost think you’d scare the public if you put this out — like, ‘Why are they telling me this? Should I be concerned about my bank?’ … I think you’ve got to think of the unintended consequences of taking a public that has more full faith and confidence in the banking system than maybe people in this room do …we want them to have full faith and confidence in the banking system. They know the FDIC insurance is there, they know it works, they put their money in, they get their money out…”

This was followed by some laughter, which critics have interpreted as a cynical agency warning the wealthy while leaving the smaller investors to eat the losses, similar to the phone calls to the favored few before the 1929 stock market crash. But the clips have to be taken in context. Here is that whole section (taken from the video transcript beginning at 1 hr. 15 min):

SUSAN BAKER (Division of Complex Institution Supervision and Resolution): … So what we want to think about today is, “What should we be transparent about now that would help improve confidence in the event that we’re called to use our Title II authorities?”…

RICHARD J. HERRING (Co-Director, The Wharton Financial Institutions Center and Professor of Finance, The Wharton School, University of Pennsylvania): I would think your strategy ought to be to disclose as much as possible to people who professionally need to know about it, and that would certainly include the ratings agencies and the people within the banks who are responsible for these judgments, and simply have publicly available a place where people can go if they need to know more; because we’re dealing with a society where people are getting their information in tweets. There’s just no patience I think for going through the elaborate and careful planning that has gone on. It should be accessible when people need to know but I don’t think you have much hope of reaching a public that doesn’t have a professional need to know.

MEG E. TAHYAR (Partner and Co-head of Financial Institutions, Davis Polk LLP): … I do think there’s more that could be put out in the public … in a way that isn’t scary to folks. I mean … There’s a timing question, right? We’re at a delicate moment now, so if it goes out tomorrow it might have a different impact than if … it goes out as we’re moving out of the recession. But I’m very big on transparency. I think transparency leads to accountability.

DONALD KOHN (Former Vice Chairman, Board of Governors of the Federal Reserve System and Senior Fellow, Economic Studies Program, Brookings Institution): … It’s a little bit conflicted, right? I mean it’s important that people understand they can be bailed in, but you don’t want a huge run on the institution. But … they’re going to be ….

MICHAEL J. HSU (Acting Comptroller of the Currency): … I think we have to sit down and talk to long-term debt investors and make sure that they as a stakeholder group fully understand. Bank debt today is not what it was before. It is not principal protected, by design.

The FDIC staff were engaged in the delicate act of balancing the need to inform the public against the risk that the disclosure itself could trigger a systemic collapse due to widespread bank runs. The “need to know” stakeholders were the long-term investors with more than $250,000 in the bank, whose funds would be at risk. But smaller depositors, who would be protected by FDIC insurance, might panic from mischaracterized tweets and precipitate the very run the FDIC staff were trying to avoid. To their credit, they were trying to be transparent and accountable; it does seem the public should know what risks are hidden in the economy. The first step to solving the problem is understanding what is going on.

Bank Runs and Systemic Risk.

Not just the speculative investments of the SIFIs but bank runs themselves are systemic risks.  Nationwide bank runs were the sort of “disorderly resolution” seen in the Great Depression of the 1930s.

In 1913, the Federal Reserve became the settlement agent for private banks, and settlement funds for clearing transactions were held in gold. The Fed was required to hold gold reserves valued at 40% of the Federal Reserve Notes (paper dollars) it issued, and to redeem withdrawals in gold at a fixed price. The reserves were sufficient to backstop withdrawals in normal times, but the years following the 1929 stock market crash were not normal times. Domestic and foreign depositors rushed to withdraw their gold; the banks ran out; and they had to close their doors.

In 1933, Pres. Franklin D. Roosevelt declared a national bank holiday; and when the banks reopened, domestic deposits were no longer backed by gold. They were backed only by the “full faith and credit of the United States.” But that is actually quite solid backing, something neither gold nor cryptocurrencies can claim to have. You can’t pay your electric bill or your credit card bill with gold or cryptocurrency. People are willing to accept dollars in payment because they know vendors will take them, and so will the IRS.

After 1933, the funds held at the Fed for settling transactions became simply data entries called “reserves,” which were created by the Fed and held by the banks in Fed accounts. Most of the circulating money supply is now created by private banks by writing loans as deposits into the accounts of their borrowers. But banks cannot create the reserves needed to clear withdrawals through the central bank. Those reserves must be acquired from the Fed, either directly or from another financial institution that has acquired them. Besides the bank’s own incoming deposits, options include borrowing from other banks in the fed funds market, the Fed discount window, or the repo market. Until recently, depository banks could borrow from each other or the Fed at 0.25%. That rate has now gone up to 4.5-4.75%. The only cheap, readily available source of liquidity left to a bank today is its own pool of incoming deposits, from paychecks, credit card payments, mortgage payments and the like.

Traditionally, banks had to hold only about 10% of their deposits in reserve. That percentage was considered sufficient to cover transfers and withdrawals because most people left their money in the bank, and withdrawals were largely netted against incoming deposits. In March 2020, the Fed removed the reserve requirement altogether; but banks still need to hold enough reserves to meet withdrawals. With a reserve of only the standard 10%, however, they will not have enough liquidity (readily accessible funds) to meet a nationwide bank run of the sort seen in the early 1930s.

The FDIC is therefore right to be concerned about warnings that can be misinterpreted. Distrust of big banks is rampant today, but collapsing them suddenly through a “disorderly” nationwide bank run would be as catastrophic as it was in the 1930s. Before the FDIC was founded through the Banking Act of 1935, depositors routinely lost their money when their banks went bankrupt. But we don’t want to lose our deposits to a bail-in either. Better would be for the regulators to unwind the speculative SIFI bets in a “soft landing” if possible. More on that in Part II of this article.

Meanwhile, the banks clearly need our deposits, and today they are scrambling to compete for deposits and reserves. According to a Feb. 7 article on Wall Street on Parade, Goldman Sachs is now offering an interest rate on its savings accounts that is 350 times the interest rate being offered by JPMorgan Chase and Bank of America. Why isn’t stated, but both of those major competitors have already amassed huge deposit bases. When the Global Financial Crisis hit in 2008, Goldman was an investment bank like Lehman Brothers, which barely escaped Lehman’s fate by becoming a bank holding company. This allowed it to acquire deposits and gave it access to the Fed’s discount window, but it obviously came in late to the deposit-collecting game.

How, Then, to Protect Your Deposits? 

One popular alternative is to move your money to a credit union. With respect to deposit insurance, according to the FDIC, credit unions are no safer than banks, but they are also no less safe. Whether the institution is insured by the FDIC or by the National Credit Union Share Insurance Fund (NCUSIF), your deposits are guaranteed up to the $250,000 limit per depositor. More to the point here, credit unions and other small local banks are not subject to bail-ins.

Some commentators recommend moving your money out of the banking system altogether – into cash, cryptocurrencies or precious metals. Having enough cash on hand to cover perhaps three months’ worth of expenses in a crisis is certainly a good idea. But many people don’t have even that much in savings, and people with large sums in the bank probably won’t be able to withdraw them all at once. Changing banks is also a slow and cumbersome process. Many people won’t do it or will be caught unaware when the next crisis hits.

In theory, the Federal Reserve could step in as lender of last resort to save the creditors and depositors if necessary, calling on the same emergency powers it exercised for the SIFIs in 2008-09. It could provide cheap liquidity for the banks in the form of quantitative easing, alleviating the need to bail in depositor funds. The Fed is not required to act – it is “independent” – but that means it does not need authorization from Congress, and it does not need taxpayer funds. It can create its own reserves.

The question is whether the Fed would see depositors as “systemically important,” but the rush to compete for deposits shows that they are. Arguably deposits are the people’s weapons of mass destruction: pull them and the banks go down. The banks need our deposits; and we need the sort of self-sustaining financial system in which money, credit and banks are treated as public utilities, accessible by and accountable to the people whose full faith and credit backs them.

Part II of this article will look at the systemic risks currently facing the banking system, and at how it could be re-engineered to deal with those risks and restore the trust of the people sustaining it.

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First published on Scheerpost.com.

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Shared via Creative Commons.