The ancient Greek philosopher, Plato, constructed a political theory based on the royal lie or myth. As described in Plato's Republic, the ruling elites of a political entity have the right to lie to their citizens-but not vice versa. The rationalization is that a royal lie and deception maintains social cohesion and prevents the collapse of the state. Thus platonic logic gives rise to the so-called stress test for American banks, the royal myth conceived by Treasury Secretary Timothy Geithner and Fed Chairman Ben Bernanke, in order to deceive investors, market sentiment and the American people as to the true state of the nation's financial institutions.
When Congress approved the massive $700 billion bailout of U.S. banks and Wall Street firms last October, the justification was that without this massive indebtedness being incurred by the American taxpayer, the U.S. and even global financial system would collapse. Yet, from this perilous state of only a few months ago, a stress test is concocted by the Obama administration to "prove" that these same banks are relatively healthy, well capitalized, with only a few banks requiring a collective total of $75 billion to cover probable losses that can be anticipated during the months ahead as unemployment continues to rise. Furthermore, this $75 billion capital infusion can be generated directly from private investors, without the injection of additional taxpayer support, so says Geithner & Company.
What is going on here? I think the prophet of doom of this unprecedented global financial and economic crisis, NYU economics professor Nouriel Roubini, summed it up best when he wrote recently, "Geithner's hope is that he can subsidize banks long enough for them to earn their way back to health. But the public isn't keen on more bailouts, so Geithner's challenge is to convince us that banks are solvent."
However, as Roubini and other economists and financial analysts have pointed out, much of the U.S. banking sector is functionally insolvent, stress test or no stress test. Roubini himself estimated that U.S. financial institutions will incur $3.6 trillion in losses from the ongoing economic crisis, while the IMF calculates that global exposure to toxic assets is over $4 trillion, more than half this sum related to losses in the United States. These figures far surpass the current capitalization of U.S. banks, making Geithner's $75 billion figure a fantasy number, unrelated to actual economic and financial realities. In other words, a royal lie, straight out of Plato's Republic, with suitable accoutrements customized for the Global Economic Crisis.
The stress test is a public relations exercise on a grand scale. Originally, word "leaked" out that all the major U.S. banks would pass the stress test. Markets reacted skeptically, leading Treasury and the Federal Reserve to come up with a compromise number; big enough to look credible yet not so large as to suggest there is an insolvency danger afflicting the nation's banks.
A mythological approach towards the Global Economic Crisis, especially as it relates to financial institutions, will insure that an already dire situation becomes inevitably calamitous. The most dangerous flaws in the U.S. and global banking system are not even hinted at with Treasury's stress test. They have to do with a volatile man-made financial toxin, otherwise known as derivatives.
The oracle of Omaha, billionaire investor Warren Buffet, once described derivatives as "financial weapons of mass destruction." As regards the world of credit and finance, he is absolutely correct. What exactly are these nefarious derivatives? Though conceived of as complex financial instruments, in essence they are private contracts between financial counterparties, which have the characteristics of a bet, in effect gambling on a range of financial and economic activity. This can include price direction of commodities, equity markets and global currencies, among many other "derivatives" of financial and economic activity. Banks, investment firms and insurance companies loaded up on derivatives until their balance sheets choked on them, driven by what was seen as an easy way to generate cash flow-and significant cash bonuses for the supposed geniuses who devised these monstrosities. Then came the collapse of the subprime mortgage market in the United States, and the fragile derivatives empire began to unravel.
AIG was the first demonstration of how dangerous derivatives had become to the global financial system. A small branch of the insurance giant, based in London, bet heavily on a form of derivatives paper known as a credit default swap, in effect insurance based on gambling about the stability of securitized mortgages. When the U.S. housing market collapsed, AIG lacked the capital to pay off the bets it had lost heavily on with its CDS paper, forcing the U.S. government to come to the rescue. The tab so far, just for this one company, is nearly $200 billion. I would not be surprised if AIG's credit default swap losses ultimately top half a trillion dollars, all of which the American taxpayer will be expected to make whole. And by no means is AIG the only derivatives bomb waiting to explode, a terrifying truth completely veiled by the mythology of the stress test.
How dangerous is the derivatives toxin to the U.S. and global banking system? To give just one example, Geithner's stress test claims that Citigroup, the country's third largest bank, only requires a mere $5 billion in additional capitalization to maintain its financial health under the worst anticipated economic storms that may still arise. However, Citigroup has a derivatives exposure equal to nearly three times its total assets of $1.2 trillion. Most of the other U.S. banks have equally threatening levels of derivatives exposure; in the case of J.P. Morgan Chase its exposure is nearly four times its assets of $1.7 trillion.
What makes derivatives so frighteningly dangerous is that they are almost totally devoid of government regulation. Their opacity makes it virtually impossible to gauge the exposure of U.S. and foreign banks to these destructive financial instruments with any degree of precision. However, it is currently estimated that the combined value of all derivatives contracts in the world equals a sum of money that seems impossible to fathom: $1.2 quadrillion! That number exceeds the total GDP of the entire planet by many dozens of times. In effect, the developed world, led by the United States, has created a vast, unregulated shadow economy based entirely on risky paper and exotic casino-style capitalism, with actual bets being placed by the major actors within the U.S. and global banking system as though they were roulette wheel patrons in Las Vegas.
It is the fear of the derivatives toxin that has frozen credit markets, leading to the Global Economic Crisis. Geithner's stress test, along with the phony Q1 "profits" reported by these same insolvent U.S. banks, can in no way alter the darkening truth about the calamitous state of the U.S. banking sector.
It appears, unfortunately, that the Obama administration has bought into the royal lie as the best solution to the nation's perilous financial and economic crisis. They are desperately playing for time, hoping somehow that markets will be fooled into regaining confidence, and that things will revert to some level of normalcy, without the added expense of further bank bailouts and nationalization of key financial institutions. Sadly, by taking what appears to be the easy way out, I fear that the economic policymakers in Washington have embarked on path that can only offer a financial and economic apocalypse that may defy our worst nightmares.