The most chilling accomplishment of American capitalist culture is that we have commodified our own consciousness.
I just returned from several months in Central America. And the day I returned I had iguana eggs for breakfast, airline pretzels for lunch and a $7 shot of Jack Daniels for dinner at the Houston Airport, where I spent two hours listening to a Christian religious fanatic tell about Obama running a worldwide child porn ring out of the White House. Entering the country shoeless through airport homeland security, holding up my pants because they don't let old men wear suspenders through security, well, I knew I was back home in the land of the free.
Anyway, here I am with you good people asking myself the first logical question: What the hell is a redneck writer supposed to say to a prestigious school of psychology? Why of all places am I here? It is intimidating as hell. But as Janna Henning and Sharrod Taylor here have reassured me that all I need to do is talk about is what I write about. And what I write about is Americans, and why we think and behave the way we so. To do that here today I am forced to talk about three things -- corporations, television and human spirituality.
No matter how smart we may think we are, the larger world cannot and does not exist for most of us in this room, except through media and maybe through the shallow experience of tourism, or in the minority instance, we may know of it through higher education. The world however, is not a cultural history course, a National Geographic special or recreational destination. It is a real place with many fast developing disasters, economic and ecological collapse being just two. The more aware among us grasp that there is much at stake. Yet, even the most informed and educated Americans have cultural conditioning working against them round the clock.As psych students, most of you understand that there is no way you can escape being conditioned by your society, one way or another. You are as conditioned as any trained chicken in a carnival. So am I. When we go to the ATM machine and punch the buttons to make cash fall out, we are doing the same thing as the chickens that peck the colored buttons make corn drop from the feeder. You will not do a single thing today, tomorrow or the next day that you have not been generally indoctrinated and deeply conditioned to do -- mostly along class lines.
For instance, as university students, you are among the 20% or so of Americans indoctrinated and conditioned to be the administrating and operating class of the American Empire in some form or another. In the business of managing the other 75% in innumerable ways. Psychologists, teachers, lawyers, social workers, doctors, accountants, sociologists, mental health workers, clergy -- all are in the business of coordinating and managing the greater mass of working class citizenry by the Empire's approved methods, and toward the same end: Maximum profitability for a corporate based state. Yet it all seems so normal. Certainly the psychologists who have prescribed so much Prozac that it now shows up in the piss of penguins, saw what they did as necessary. And the doctors who enable the profitable blackmail practiced by the medical industries see it all as part of the most technologically advanced medical system in the world. And the teacher, who sees no problem with 20% of her fourth graders being on Ritalin, in the name of "appropriate behavior," is happy to have control of her classroom. None of these feel like dupes or pawns of a corporate state. It seems like just the way things are. Just modern American reality. Which is a corporate generated reality.
Given the financialization of all aspects of our culture and lives, even our so-called leisure time, it is not an exaggeration to say that true democracy is dead and a corporate financial state has now arrived. If you can get your head around that, it's not hard to see an ever merging global corporate system masquerading electronically and digitally as a nation called the United States. Or Japan for that matter. The corporation now animates us from within our very selves through management of the need hierarchy in goods and information. As students, even in such an enlightened institution as this one, you are being subjected to at least some sort of pedagogy of the corporate management of society for maximum profit. Unarguably your training will help many fellow human beings. But in the larger scheme of things, you are part of an institution, the American Psycho-socio-medical complex, and thus authorized to manage public consciousness, one person at a time. Remember that the entire pedagogy in which you are immersed is itself immersed in a corporate financial state. Even if some of what you do is alternative psychology, that is a reaction to the state, and therefore a result of it. It's still part of the financialization of consciousness. And, I might add that none you expect to work for nothing.
This financialization of our consciousness under American style capitalism has become all we know. That's why we fear its loss. Hence the bailouts of the thousands of "zombie banks," dead but still walking, thanks to the people's taxpayer offerings to the money god so that banks will not die. We believe that we dare not let corporations die. Corporations feed us. They entertain us. Corporations occupy one full half of our waking hours of our lives, through employment, either directly or indirectly. They heal us when we are sick. So it's easy to see why the corporations feel like a friendly benevolent entity in the larger American consciousness. Corporations are, of course, deathless and faceless machines, and have no soul or human emotions. That we look to them for so much makes us a corporate cult, and makes corporations a fetish of our culture. Yet to us, they are like the weather just there.
All of us live together in this corporate fetish cult. We agree upon and consent to its reality, just as the Aztecs agreed upon Quetzalcoatl and the lost people of Easter Island agreed that the great stone effigies of their remote island had significance.
We are not unique
Strangely enough, even as a population mass operating under unified corporate management machinery, most Americans believe they are unique individuals, significantly different from every other person around them. More than any other people I have met, Americans fear loss of uniqueness. Yet you and I are not unique in the least. Despite the American yada yada about individualism, you are not special. Nor am I. Just because we come from the manufacturer equipped with individual consciousness, does not make us the center of any unique world, private or public, material, intellectual or spiritual. The fact is, you will seldom if ever make any significant material or lifestyle choices of your own in your entire life. If you don't buy that house, someone else will. If you don't marry him, someone else will. If you don't become a psychologist, lawyer or a clergyman or a telemarketer, someone else will. We are all replaceable parts in the machinery of a capitalist economy. "Oh but we have unique feelings and emotions that are important," we say. Psychologists specialize in this notion. Yet I venture to say that none of us will ever feel an emotion that someone long dead has not felt, or some as yet unborn person will not feel. We are swimmers in an ancient rushing river of humanity. You, me, the people in my Central American village, the child in Bangladesh, and the millionaire frat boys who run our financial and governmental institutions with such adolescent carelessness. All of our lives will eventually be absorbed without leaving a trace.
Still though, for Western peoples in particular, there is the restless inner cultural need to differentiate our lives from the other swimmers. Most of us, especially as educated people in the Western World, will never beat that one. Fortunately though, we can meaningfully differentiate our lives (at least in the Western sense) in the way we choose to employ our consciousness. Which is to say, to own our consciousness. If we exercise enough personal courage, we can possess the freedom to discover real meaning and value in our all-too-brief lives. We either wake up to life, or we do not. We are either in charge of our own awareness or we let someone else manage it by default. That we have a choice is damned good news.
The bad news is that we nevertheless remain one of the most controlled peoples on the planet, especially regarding control of our consciousness, public and private. And the control is tightening. I know it doesn't feel like that to most Americans. But therein rests the proof. Everything feels normal; everybody else around us is doing the same things, so it must be OK. This is a sort of Stockholm Syndrome of the soul, in which the prisoner identifies with the values of his or her captors, which in our case is of course, the American corporate state and its manufactured popular culture.
When we feel that such a life is normal, even desirable, and we act accordingly, we become helpless. Learned helplessness. For instance, most Americans believe there is little they can do in personally dealing with the most important moral and material crises ever faced, both in America and across the planet, beginning with ecocide, war making, and the grotesque deformation of the democratic process we have settled for. Citizenship has been reduced to simple consumer group consciousness. Consequently, even though Americans are only six percent of the planet's population, we use 36% of the planet's resources. And we interpret that experience as normal and desirable and as evidence of being the most advanced nation in the world. Despite that our lives have been reduced to a mere marketing demographic. Let me digress for just a moment, to tell you about how life is outside the marketing demographic. I live much of the year in the Third World country of Belize, Central America, a nation so damned poor that our cash bounces. True, it ain't Zimbabwe, or the Sudan -- there are no dying people in the streets. But food security is easily the biggest problem and growing by the day.
Yet, despite our meager and diminishing resources down there, and much government corruption, people are still citizens, not marketing demographics, not yet anyway. Citizens who struggle toward a just society. They have made more progress than the United States in some respects. For instance, we have: A level of free medical care for the poor, though we lack much equipment and facilities. Maternity pay if either you or your spouse are employed. Retirement on Social Security at age 60. Worker rights, such as mandatory accrued severance pay for workers, even temporary workers. Most Belizeans own their homes outright, and all citizens are entitled to a free piece of land upon which to build one. Employment is scarce, and that has a down side: Many folks waste a lot of valuable time having sex , perhaps because they have too much time on their hands. The Jehovah's Witnesses missionaries are working hard to fix that problem. Anyway, American and Canadian tourists drive by in their rented SUVs and you can see by their expressions they are scared as hell of those bare footed black folks in the sand around them. Central America sure as hell ain't heaven. But lives there are not what we Americans are told about the Third World either. It's not a flyblown, dangerous place run by murdering drug lords, and full of miserable people. It's just a whole lot of very poor people trying to get by and make a decent society.
I mention these things because it's a good example of how North Americans live in a parallel universe in which they are conditioned to see everything in terms of consumer goods and "safety," as defined by police control. Conditioned to believe they have the best lives on the planet by every measure. So when they see our village and its veneer of "tropical grunge," they experience fear. Anything outside of the parameters of the cultural hallucination they call "the first world" represents fear and psychological free fall. Yet, even if we think in that sort of outdated terminology, first, second and Third World, and most Americans do, then America is a second world nation. We have no universal free health care (don't kid yourself about the plan underway), no guarantee of anything really, except competitive struggle with one another for work and money and career status, if you are one of those conditioned to think of your job and feudal debt enslavement as a "career." High infant mortality rates, abysmal educational scores, poor diet, no national public transportation system, crumbling infrastructure, a collapsed economy, even by our own definition we are a second world nation.
Learning to love shiny objects
But there is a shiny commercial skin that covers everything American, a thin layer of glossy throwaway technology, that leads the citizenry to believe otherwise. That slick commercial skin, the bright colored signs for Circuit City and The Gap (rest in peace), the clear plastic that covers every product from CDs to pre-cut vegetables, the friendly yellow and red wrapper on the burger inside its bright red paper box, the glossy branding of every item and experience. These things are the supposed tangible evidence that the slick conditioned illusion, the one I call The American Hologram, is indeed real. If it's bright and shiny and new, it must be better. Right? It's the complete opposite of tropical grunge. Last week when I got back to the States I took a shower in an American friend's new $30,000 gleaming remodeled bathroom. It felt like a surgical operating room experience, compared to wading into the Caribbean surf in the tropical dusk with a bar of soap. Like a parallel universe straight out of The Matrix.
Meat space versus the parallel universe
So how is it that we Americans came to live in such a parallel universe? How is it that we prefer such things as Facebook (don't get me wrong, I'm on Facebook too), and riding around the suburbs with an iPod plugged into our brain looking for fried chicken in a Styrofoam box? Why prefer these expensive earth destroying things over love and laughter with real people, and making real human music together with other human beings -- lifting our voices together, dancing and enjoying the world that was given to us? Absolutely for free. And the answer is this: We suffer under a mass national hallucination. Americans, regardless of income or social position, now live in a culture entirely perceived inside a self-referential media hologram of a nation and world that does not exist. Our national reality is staged and held together by media, chiefly movie and television images. We live in a "theater state."
In our theater state, we know the world through media productions which are edited and shaped to instruct us on how to look and behave and view the outside world. As in all staged productions and illusions, everyone we see is an actor. There are the television actors portraying what supposedly represents reality. Non-actors in Congress perform in front of the cameras, as the American empire's cultural machinery weaves and spins out our cultural mythology. Cultural myth production is an enormous industry in America. It is very similar to the national projects of pyramid-building in Egypt, or cathedral-building in medieval Europe. And in our obsession with violence and punishment, two characteristics of a consensual police state reality, we are certainly similar to prison camp building in Stalinist Russia. Actually, we're pretty good in that department too. Consider that one fourth of all the incarcerated people on earth are in U.S. prisons. U.S. citizens imprisoned by their own government.
Good guys and bad guys at the chariot races
In any case, the media culture's production of martyrs, good guys and bad guys, fallen heroes and concept outlaws, is not just big corporate business. It is the armature of our cultural behavior. It tells us who to fear (Middle Eastern terrorists, Mr. Chavez in Venezuela, and foreign made pharmaceuticals), who to scorn (again the same candidates, along with Brittney Spears for her lousy child rearing skills). Our daily news is the modern version of Roman coliseum shows. Elections are personality combat, chariot races, not examinations of solutions being offered. None are offered.
What are being offered are monkey models. Man as a social animal necessarily mimics the behavior he sees around him, whether it be by real people or moving images of people. This eye-to-brain to mimicry connection does not care. Consequently, we know how to act and what the things around us are because television and media tell us. Television is the software, the operating instructions for our society. Thus, social realism for us is a television commercial for the American lifestyle: what's new to wear, what to eat, who's cool (Obama), what and whom to fear (that perennial evil booger, Castro) or who to admire (Bill Gates, pure American genius at work). This societal media software tells us what music our digitized corporate complex is selling, but you never see images of ordinary families sitting around in the evenings making music together, or creating songs of their own based upon their own lives and from their own hearts. Because that music cannot be bought and sold, and is not profitable. I think about that when the children and their parents sing and dance on the sand in front of my shack in Central America. We Americans are not offered that choice.
Managing mythology
So instead of a daily life in the flesh, belly to belly and soul to soul, lived out in the streets, and parks and public places, in love and the workplace, we get 40-inch televisions, YouTube, Cineplexes, and the myths spun out by Hollywood. Now for a national mythology to work, it has to be accessible to everyone all the time, it has to be all in one bundle. For example, in North Korea, it is wrapped up in a single man, Kim. In America, as we have said, it is the media and Hollywood in particular. Hollywood accommodates Imperial myths, melting pot myths, and hegemonic military masculinity myths, and glamour myths. It articulates our culture's social imaginary: "the prevailing images a society needs to project about itself in order to maintain certain features of its organization." And the features of our media mythology are terrifying when you think about them. As a writer friend says, It is watching "Man on Fire," with Denzel Washington's tragic pose and his truthful bullets, and his willingness to saw the fingers off of Mexicans to get the information on time to protect us from The Evil. It is the absorption of that electronic mythology that allowed us to co-sign the torture at Abu Ghraib.
Incidentally, speaking of Abu Ghraib, I am a friend of Ray Hardy, lawyer to Lynndie England, the leash girl of Abu Ghraib. He has copies of thousands of other, far more grisly Abu Ghraib photos. Believe me, they picked the gentlest ones to release. Anyway, when the media and government people in power made that selection, they were managing your consciousness. What you know and don't know. Keeping you calmer by withholding the truth. Rather like not upsetting little children so they will continue to quietly behave the way you want.
But, like children, the American public got bored with the subject of torture long ago, so we quit seeing the victims. Plenty of new evidence has been coming out for years since Lynndie's famous pics from Abu Ghraib. But the short American attention span, created by our rapid fire media, says, "Move on to the next hologram please. Whoa! Stop the remote. Nice butt shot of Sarah Palin there!"
The result is that Americans cannot achieve the cathexis we need. Cathexis is the ground zero psychic and emotional attachment to the world that cannot be argued. It is "beyond ideological challenge because it is called into existence affectively." Americans are conditioned to reject any affective attachment that does not have a happy ending. And in that, we remain mostly a nation of children. We never get to grow up. So we tell ourselves the Little Golden Book fairy tales -- that we are a great and compassionate people, and that we are personally innocent of any of our government's horrific crimes abroad. Guiltless as individuals. And we do remain innocent, in a sense, as long as we cannot see beyond the media hologram. But it is a terrible kind of self-inflicted innocence that can come to no good. We are a nation latch key kids babysat by an electronic hallucination, the national hologram.
The TV goldfish bowl
You may or may not watch much television, but the average American spends almost one-third of his or her waking life doing so. The neurological implications of this are so profound that they cannot even be comprehended in words, much less described by them. Television constitutes our reality in the same fashion that water constitutes the environment in a goldfish bowl. It's everywhere and affects everything, even when we are not watching it. Television regulates our national perceptions and our interior ideations of who we Americans are. It schedules our cultural illusions of choice. It pre-selects candidates in our elections. By the way, as much as I like Obama, I fully understand he is there because he was selected by the illusion producing machinery of television, and citizens under its influence. It is hard to underestimate the strength of these illusions. TV regulates holiday marketing opportunities and the national neurological seasons. It tells us, "It's Christmas! Time to shop!" Or "it's election season, time to vote." Or "it's football season, let us rally passions and buy beer and cheer." Or that America's major deity, "The Economy," is suffering badly. "Sacred temples on Wall Street make great sickness upon the land!" Or most ominous of all, "It's time to make war! Again."
It is fair to say that television and the American culture are the same thing. More than any other factor, it is the glue of society and the mediator of our experience. American culture is stone cold dead without it. If all the TVs in America went black, so would most of America's collective consciousness and knowledge. Because corporate media have replaced nearly all other previous forms of accumulated knowledge. Especially the ancient forms, such as contemplation of the natural world, study and care of the soul. And I do not mean soul in the religious sense either. I mean the deeper self, the one you go to sleep with every night. The media have colonized our inner lives like a virus. The virus is not going away. This commoditization of our human consciousness is probably the most astounding, most chilling accomplishment of American capitalist culture.
Escape from the zombie food court
Capitalist society however, can only survive by defying the laws of thermodynamics, through endlessly expanding growth, buying and using more of everything, every year and forever. Thus the cult of radical consumerism. It has been the deadliest cult of all because, so far, it has always triumphed, and has now spread around the earth and its nations. Why has it been so viral, so attractive to so many for so long? How did it come to grip the consciousness of so much of mankind, from Beijing to Bangladesh? Thuggish enforcement accounts for part of it, of course. But it has succeeded too because it requires no effort. No critical thinking. Not even literacy. Just passive consumption. That the easy addiction to consumption is probably hard wired into us. Every one of us will go right out this door tonight and continue to play out our lives as contributors to ecocide and global warming, mainly because it's easier. And besides, we are not offered any other real options, and we don't know any other way. Nor can we ever know any other way without making a great effort.
How to make that effort? (Assuming you even want to.) As we said, consuming images, goods or buying your identity at Old Navy or a retro clothing shop takes no real effort or thought. Just money. Text messaging your whereabouts at the mall may be a technological wonder, but you're still absolutely nowhere if you are just one more oral grooved organism in the food court at the mall moving in a swarm toward Quiznos. So how do you escape the programming of the food court, and, I might include, escape even those parts of this school that may serve more to indoctrinate than enlighten you? All pedagogy, even the best, is nevertheless about control. How does one escape such a total system?
In a word, service. Humble and thoughtful service to the world. It is heartening that we do have concerned Americans studying to alleviate the great suffering of so much of humanity. I have no proof of it, but it seems like earnest idealism is making a comeback since its decline following the optimistic 1960s. People and institutions such as this one are attempting to move American society forward again, heal us of our national sickness to the extent you can, after decades of regression, not to mention repression. Of course, to solve problems you must first identify them. Let me say here that one of the most profound things I have learned from the Third World, perhaps the only thing I have learned, and as psychologists you've surely heard it before, is this: The diagnosis is not the disease. Which is why our prescribed treatment never seems to work in places like Africa. Or even in the Bronx or South Philly.
Even our most well intentioned thinking and study of the afflictions of Africa and Latin America, American inner cities or Appalachia, suffers from hubris, because they are necessarily the products of western propertized and monetized thinking that cause the problem. So now we study our victims with great piety. And supposedly teach them solutions to the problems we continue to cause for them. Western people studying globalization's horrific effects, or rape in Africa, or world poverty are doing so under the assumption that such things can be dealt with through some social mechanistic means, through analysis and unbiased reason and rational value-free science. Or by a network of officially sanctioned agencies. For years I have wanted to see the opposite take place. To see well fed, educated Americans learn from the poor of the earth. Do what Gandhi advised, let the poor be the teachers. Go among them with nothing, one set of clothing and no money, keep your mouth shut, and do your best not to affect anything (which is impossible, I know. But you can come, as they say, "close enough for government work.")
Then just let the world happen to you, like they do in the so-called "passive societies," instead of trying to happen to it in typical Western fashion. Not trying to "improve" things. Maybe practice milpa agriculture with Mayans on the Guatemalan border, watching corn grow for three months. Fish in a lonely dugout, sun-up to sun-down, in the dying reefs of the Caribbean, with only a meal or two of fish as your reward. Do such things for a month or two. First you will experience boredom, then comes an internal psychic violence and anger, much like the experience of zazen, or sitting meditation, as the layers of your mind conditioning peel away. Don't quit, keep at it, endure it, to the end. And when you return you will find that deeply experiencing a non-conditioned reality changes things forever. What you have experienced will animate whatever intellectual life you have developed. Or negate much of it. But in serious, intelligent people, experiencing non-manufactured reality usually gives lifelong meaning and insight to the work. You will have experienced the eternal verities of the world and mankind at ground zero. And you will find that the healthy social structures our well intentioned Western minds seek are already inherent in the psyche of mankind, but imprisoned. And the startling realization that you and I are the unknowing captors.
In conclusion, I would point out that the high technological imprisonment of our consciousness has been fairly recent. There are still those among us who remember when it was not so entrapped. A few of us still know what it was like to experience non-manufactured realities -- life outside our mass produced kitsch culture. Particularly some aging Sixties types, who sought to pass through the doors of perception. Many made it through. But in my travels to places such as this one, I also meet a new breed of younger people, who get it completely. I meet them in the more advanced psychological venues such as Adler. And especially in the ecological movement. They seem to already know what it took me a lifetime to learn: that each of us is but one strand in the vast organic web of flesh and blood chlorophyll. All things and all beings are inextricably connected at the most profound level. Any physicist will confirm this. We are bound by its every wave and particle, all of us -- the lonely night clerk at Motel 6 and the leviathans of the deep, the sleeping grandmother in New Haven, Connecticut and the maimed Iraqi child in Kirkuk. It can be understood by anyone though, simply by owning one's own consciousness. And in doing so we find that ownership and domination are both temporary and meaningless. And that the animating spirit of the earth is real and within us and claimable.
The purpose of life is to know this. Einstein glimpsed it. Lao-Tzu knew it. So did St. Francis. But you and I are not supposed to. It would shatter the revered, digitized, super-sized, utterly meaningless hologram. The one that mesmerizes us, and mediates our every experience, but isolates us from universal humanness and its coursing energies. Such as love. Or mercy. Compassion. Existential pain. Hunger. Or the unmitigated joy of simply being alive one finds in children everywhere, even among the poorest. Most of the human race still lives in that realm. Blessed is the one who joins them. Because he or she learns that the truth is not relative, and that because the human mind seeks balance, social justice is not only inescapable in the long run, but inevitable. I won't be around for that, but on a clear day if I squint real hard I can see down that road ahead. And on that road I can see the long chain of decent human beings like yourselves walking toward the light. And for your very presence on this earth and in this room, I am grateful. Thank you all from the bottom of my heart.
dinsdag 7 april 2009
vrijdag 3 april 2009
Before Credit Default Swaps, There Was Reinsurance
For some time now, we have been trying to reconcile the apparent paradox of American International Group (NYSE:AIG) walking away from the highly profitable, double-digit RAROC business of underwriting property and casualty (P&C) risk and diving into the rancid cesspool of credit default swaps ("CDS") contracts and other types of "high beta" risks, business lines that are highly correlated with the financial markets.
In our interview with Robert Arvanitis last year, "'Bailout: It's About Capital, Not Liquidity; Seeking Beta: Interview with Robert Arvanitis', September 29, 2008," we discussed the difference between high and low beta. We also learned from Arvanitis, who worked for AIG during much of the relevant period, that the decision by Hank Greenberg and the AIG board to enter the CDS market was, at best, chasing revenue. No rational examination of the business opportunity, assuming that Greenberg and his directors were acting based on a reasoned analysis, could have resulted in a favorable decision to pursue CDS and other "high beta" risks, at least from our perspective.
In an effort to resolve this conundrum, over the past several months The IRA has interviewed a number of forensic experts, insurance regulators and members of the law enforcement community focused on financial fraud. The picture we have assembled is frightening and suggests that, far from just AIG, much of the insurance industry has been drawn into the world of financial engineering and has thus become part of the problem. Below we present our preliminary findings and invite your comments.
One of the first things we learned about the insurance world is that the concept of "shifting risk" for a variety of business and regulatory reasons has been ongoing in the insurance world for decades. Finite insurance and other scams have been at least visible to the investment community for years and have been documented in the media, but what is less understood is that firms like AIG took the risk shifting shell game to a whole new level long before the firm's entry into the CDS market.
In fact, our investigation suggests that by the time AIG had entered the CDS fray in a serious way more than five years ago, the firm was already doomed. No longer able to prop up its earnings using reinsurance because of growing scrutiny from state insurance regulators and federal law enforcement agencies, AIG's foray into CDS was really the grand finale. AIG was a Ponzi scheme plain and simple, yet the Obama Administration still thinks of AIG as a real company that simply took excessive risks. No, to us what the fraud Bernard Madoff is to individual investors, AIG is to the global financial community.
As with the phony reinsurance contracts that AIG and other insurers wrote for decades, when AIG wrote hundreds of billions of dollars in CDS contracts, neither AIG nor the counterparties believed that the CDS would ever be paid. Indeed, one source with personal knowledge of the matter suggests that there may be emails and actual side letters between AIG and its counterparties that could prove conclusively that AIG never intended to pay out on any of its CDS contracts. The significance of this for the US bailout of AIG is profound. If our surmise is correct, the position of Feb Chairman Ben Bernanke and Treasury Secretary Tim Geithner that the AIG credit default contracts are "valid legal contracts" is ridiculous and reveals a level of ignorance by the Fed and Treasury about the true goings on inside AIG and the reinsurance industry that is truly staggering.
Does Reinsurance + Side Letters = CDS?
One of the most widespread means of risk shifting is reinsurance, the act of paying an insurer to offset the risk on the books of a second insurer. This may sound pretty routine and plain vanilla, but what most people don't know is that often times when insurers would write reinsurance contracts with one another, they would enter into "side letters" whereby the parties would agree that the reinsurance contract was essentially a canard, a form of window dressing to make a company, bank or another insurer look better on paper, but where the seller of protection had no intention of ever paying out on the contract.
Let's say that an insurer needs to enhance its capital surplus by $100 million in order to meet regulatory capital requirements. They can enter into what appears to be a completely legitimate form of reinsurance contract, an agreement that appears to transfer the liability to the reinsurer. By doing so, the "ceding company" - an insurance company that transfers a risk to a reinsurance company - gets to drop that $100 million in liability and its regulatory surplus increases by $100 million.
The reinsurer assuming the risk does actually put up the $100 million in liability, but with the knowledge that they will never have to actually pay out on the contract. This is good for the reinsurer because they are paid a fee for this transaction, but it is bad for the ceding company, the insurer with the capital shortfall, because the transaction is actually a sham, a fraud meant to deceive regulators, counterparties and investors into thinking that the insurer has adequate capital. Typically the fee is 6% per year or what is called a "loan fee" in the insurance industry.
When it operates in this fashion, the whole reinsurance industry could be described as a "surplus rental" proposition, whereby an insurer literally loans another insurer capital in the form of risk cover, but with a secret understanding in the form of a side letter that the loan will be reversed without any recourse to the seller of protection. You give me $6 million in cash today, and I will give you a promise that we both know I will never honor. Does this sound familiar? What our contacts in the insurance industry describe is almost a precise description of the CDS market, albeit one that evolved in the reinsurance industry literally decades ago and has been the cause of numerous insurance insolvencies and losses to insured parties. Or to put it another way, maybe the inspiration for the CDS market - at least within AIG and other insurers -- evolved from the reinsurance market over the past two decades.
As best as we can tell, the questionable practice of using side letters to mask the economic and business reality of reinsurance transactions started in the mid-1980s and continued until the middle of the current decade. This timeline just happens to track the creation and evolution of the OTC derivatives markets. In particular, the move by AIG into the CDS market coincides with the increased awareness of and attention to the use of side letters by insurance regulators and members of the state and federal law enforcement community. Keep in mind that what we are talking about here are not questionable risk management policies but acts of deliberate and criminal fraud, acts that often result in jail time for those involved. As one senior forensic accountant who has practiced in the insurance sector for three decades told The IRA:
"In every major criminal fraud case in which I have worked, at the center of the investigation were these side letters. It was always very strange to me that on-site investigators and law enforcement officials consistently found that these side letters were being used to mask the true financial condition of an insurer, and yet none of the state regulators, the National Association of Insurance Commissioners (NAIC), nor federal law enforcement authorities ever publicly mentioned the practice. They certainly did not act like the use of side letters was a commonplace thing, but it was widespread in the industry."
It is important to understand that a side letter is a secret agreement, a document that is often hidden from internal and external auditors, regulators and even senior management of insurers and reinsurers. We doubt, for example, that Warren Buffet or Hank Greenberg knew the details of side letters, but they should have. Just as a rogue CDS trader at a large bank like Societe General (NYSE:SGE) might seek to hide losing trades, the underwriters of insurers would use sham transactions and side letters to enhance the revenue of the insurer, but without disclosing the true nature of the transaction.
There are two basic problems with side letters. First, they are a criminal act, a fraud that usually carries the full weight of an "A" felony in many jurisdictions. Second, once the side letter is discovered by a persistent auditor or regulator examining the buyer of protection, the transaction becomes worthless. You paid $6 million to AIG to shift risk via the reinsurance, but the side letter makes clear that the transaction is a fraud and you lose any benefit that the apparent risk shifting might have provided.
As the use of these secret side letters began to become more and more prevalent in the insurance industry, and these secret side deals were literally being stacked on top of one another at firms like AIG, the SEC began to investigate. And they began to find instances of fraud and to crack down on the practice. One of the first cases to come to the surface involved AIG helping Brightpoint (NASDAQ:CELL) commit accounting fraud, a case that eventually led the SEC to fine AIG $10 million in 2003.
Wayne M. Carlin, Regional Director of the SEC's Northeast Regional Office, said of the settlements: "In this case, AIG worked hand in hand with CELL personnel to custom-design a purported insurance policy that allowed CELL to overstate its earnings by a staggering 61 percent. This transaction was simply a 'round-trip' of cash from CELL to AIG and back to CELL. By disguising the money as 'insurance,' AIG enabled CELL to spread over several years a loss that should have been recognized immediately."
Another case involved PNC Financial (NYSE:PNC), which used various contracts with AIG to hide certain assets from regulators, even though the transaction amounted to the "rental" of capital and not a true risk transfer. As the SEC noted in a 2004 statement: "The Commission's action arises out of the conduct of Defendant AIG, primarily through its wholly owned subsidiary AIG Financial Products Corp. ("AIG-FP"), (collectively referred to as "AIG") in developing, marketing, and entering into transactions that purported to enable a public company to remove certain assets from its balance sheet." Click here to see the SEC statement regarding the AIG transactions with PNC.
The SEC statement reads in part: "In its Complaint, filed in the United States District Court for the District of Columbia, the Commission alleged that from at least March 2001 through January 2002, Defendant AIG, primarily through AIG-FP, developed a product called a Contributed Guaranteed Alternative Investment Trust Security ("C-GAITS"), marketed that product to several public companies, and ultimately entered into three C-GAITS transactions with one such company, The PNC Financial Services Group, Inc. ("PNC"). For a fee, AIG offered to establish a special purpose entity ("SPE") to which the counter-party would transfer troubled or other potentially volatile assets. AIG represented that, under generally accepted accounting principles ("GAAP"), the SPE would not be consolidated on the counter-party's financial statements. The counter-party thus would be able to avoid charges to its income statement resulting from declines in the value of the assets transferred to the SPE. The transaction that AIG developed and marketed, however, did not satisfy the requirements of GAAP for nonconsolidation of SPEs."
In both cases, AIG was engaged in transactions that were meant not to reduce risk, but to hide the true nature of the risk in these companies from investors, regulators and the consumers who rely on these institutions for services. Keep in mind that while the SEC did act to address these issues, the parties involved received light punishments when you consider that these are all felonies that arguably would call for criminal prosecution for fraud, securities fraud, conspiracy and racketeering, among other things. Indeed, this is one of those rare cases where we believe AIG itself, as a corporate person, should be subject to criminal prosecution and liquidation.
Birds of a Feather: AIG & GenRe
Click here to see a June 6, 2005 press release from the SEC detailing criminal charges against John Houldsworth, a former senior executive of General Re Corporation ("GenRe"), a subsidiary of Berkshire Hathaway (NYSE:BRKA), for his role in aiding and abetting American International Group, Inc. in committing securities fraud.
The SEC noted: "In its complaint filed today in federal court in Manhattan, the Commission alleged that Houldsworth and others helped AIG structure two sham reinsurance transactions that had as their only purpose to allow AIG to add a total of $500 million in phony loss reserves to its balance sheet in the fourth quarter of 2000 and the first quarter of 2001. The transactions were initiated by AIG to quell criticism by analysts concerning a reduction in the company's loss reserves in the third quarter of 2000."
But the involvement of the BRKA unit GenRe in the AIG mess was not the first time that GenRe had been involved in the questionable use of reinsurance contracts and side letters. Click here to see an example of a side letter that was made public in a civil litigation in Australia a decade ago. The faxed letter, which bears the ID number from the Australian Court, is from an insurance broker in London to Mr. Ajit Jain, a businessman who currently heads several reinsurance businesses for BRKA, regarding a reinsurance contract for FAI Insurance, an affiliate of HIH Insurance.
Notice that the letter states plainly the intent of the transaction is to bolster the apparent capital of FAI. Notice too that several times in the letter, the statement is made that "no claim will be made before the commutation date," which may be interpreted as being a warranty by the insured that no claims shall be made under the reinsurance policy. By no coincidence, HIH and FAI collapsed in a $5.3 billion dollar fiasco that ranks as Australia's biggest ever corporate failure. Click here to read a March 9, 2009 article from The Age, one of Australia's leading business publications, regarding the collapse of HIH and FAI.
In 2003, an insurer named Reciprocal of America ("ROA") was seized by regulators and law enforcement officials. An investigation ensued for 3 years. According to civil lawsuits filed in the matter, GenRe provided finite insurance to ROA in order to make the troubled insurer look more solvent than it was in reality. Several regulators and law enforcement officials involved in that case tell The IRA that the ROA failure forced insurers like AIG and Gen Re to start looking for new ways to "cook the books" because the long-time practice of side letters was starting to come under real scrutiny.
"These reinsurance deals made ROA look better than it really was," one investigator with direct knowledge of the ROA matter tells The IRA. "They went into the ROA home office in VA with the state insurance regulators and law enforcement, and directed the employees away from the computers and records. During that three-year investigation, GenRe learned that local regulators and forensic examiners had put everything together and that we now understood the way the game was played. I believe the players in the industry realized that that they had to change the way in which they cooked the books. A sleight- of-hand trick that had worked for 25 years under the radar of regulators and investors was now revealed."
Several senior officials of ROA eventually were prosecuted, convicted of criminal fraud and imprisoned, but DOJ officials under the Bush Administration reportedly blocked prosecution of the actual managers and underwriters of ROA who were involved in these sham transactions, this even though state officials and federal prosecutors in VA were anxious to proceed with additional prosecutions.
AIG: From Reinsurance to CDS
While some reinsurers are large, well-capitalized entities that generally avoid these pitfalls, AIG was already a troubled company when it began to write more and more of these risk-shifting transactions more than a decade ago. It is easy to promise the moon when people think that they can deliver, but because AIG and their clients saw how easy it was to fool regulators and investors, the practice grew and most regulators did absolutely nothing to curtail the practice.
It was easy for AIG to become addicted to the use of side letters. The firm, which had already encountered serious financial problems in 2000-2001, reportedly saw the side letters as a way to mint free money and thereby help the insurer to look stronger than it really was. AIG not only helped banks and other companies distort and obfuscate their financial condition, but AIG was supplementing its income by writing more and more of these reinsurance deals and mitigating their perceived exposure via side letters.
A key figure in AIG's reinsurance schemes, according to several observers, was Joseph Cassano, head of AIG-FP. Whereas the traditional use of side letters was in reinsurance transactions between insurers, in the case of both CELL and PNC neither was an insurer! And in both cases, AIG used sham deals to make two non-insurers, including a regulated bank holding company, look better by manipulating their financial statements. Falsifying the financial statements of a bank or bank holding company is an felony.
AIG-FP was simply doing for non-insurers what was common practice inside the secretive precincts of the insurance world. The SEC did investigate and they did finally obtain a deferred prosecution agreement with AIG, which was buried in the settlement with then-New York AG Elliott Spitzer.
The key thing to understand is that if you look at many of these reinsurance contracts between ROA and Gen Re, they look perfect. They appear to transfer risk and seem to be completely in order. But, if you don't get to see the secret agreement, the side letter that basically says that the reinsurance contract is a form of window dressing, then you cannot understand the full implications of the transaction, the reinsurance agreement. Not, several experts speculate, can you understand why AIG decided to migrate away from reinsurance and side letters and into CDS as a mechanism for falsifying the balance sheets and earnings of non-insurers.
Several observers believe that at some point in the 2002-2004 period, Cassano and his colleagues at AIG began to realize that state insurance regulators and the FBI where on to the reinsurance/side letter scam. A number of experts had been speaking and writing about the issue within the accounting and fraud communities, and this attention apparently made AIG move most of its shell game into the world of CDS. By no coincidence, at around this time side letters began to disappear in the insurance industry, suggesting to many observers that the industry finally realized that the jig was up.
It appears to us that, seeing the heightened attention from regulators and federal law enforcement agencies such as the FBI on side letters, AIG began to move its shell game to the CDS markets, where it could continue to falsify the balance sheets and income statements of non-insurers all over the world, including banks and other financial institutions.
AIG's Cassano even managed to hide the activity in a bank subsidiary of AIG based in London and under the nominal supervision of the Office of Thrift Supervision in the US, this it is suggested to hide this ongoing activity from US insurance regulators. Even though AIG had been investigated and sanctioned by the SEC, Cassano and his colleagues at AIG apparently were recalcitrant and continued to build the CDS pyramid inside AIG, a financial pyramid that is now collapsing. The rest, as they say is history.
Now you know why the Fed and EU officials are so terrified about an AIG liquidation, because it will result in heavy losses to or even the insolvency of banks and other corporations around the globe. Notice that while German Chancellor Angela Merkel has been posturing and throwing barbs at President Obama, French President Nicolas Sarkozy has been conciliatory toward the US.
But for the bailout of AIG, you see, President Sarkozy would have been forced to bailout SGE for a second time in two years. So long as the Fed and Treasury can subsidize AIG's mounting operating losses, the EU will be spared a financial bloodbath. But this situation is unlikely to remain stable for long with members of the Congress demanding an investigation of the past bailout, a process that can only result in bankruptcy for AIG.
Are the CDS Contracts of AIG Really Valid?
The key point is that neither the public, the Fed nor the Treasury seem to understand is that the CDS contracts written by AIG with these various non-insurers around the world were shams - with no correlation between "fees" paid and the risk assumed. These were not valid contracts as Fed Chairman Ben Bernanke, Treasury Secretary Geithner and Economic policy guru Larry Summers claim, but rather acts of criminal fraud meant to manipulate the capital positions and earnings of financial companies around the world.
Indeed, our sources as well as press reports suggest that the CDS contracts written by AIG may have included side letters, often in the form of emails rather than formal letters, that essentially violated the ISDA agreements and show that the true, economic reality of these contracts was fraud plain and simple. Unfortunately, by not moving to seize AIG immediately last year when the scandal broke, the Fed and Treasury may have given the AIG managers time to destroy much of the evidence of criminal wrongdoing.
Only when we understand how AIG came to be involved in CDS and the fact that this seemingly illegal activity was simply an extension of the reinsurance/side letter shell game scam that AIG, Gen Re and others conducted for many years before will we understand what needs to be done with AIG, namely liquidation. Seen in this context, the payments made to AIG by the Fed and Treasury, which were then passed-through to dealers such as Goldman Sachs (NYSE:GS), can only be viewed as an illegal taking that must be reversed once the US Trustee for the Federal Bankruptcy Court for the Southern District of New York is in control of AIG's operations.
(Editor's note: Officials of BRKA and GenRe did not respond to telephonic and email requests by The IRA seeking comment on this article. An official of AIG did respond but was not willing to comment on-the-record for this report. We shall be happy to publish any written comments that BRKA, AIG or GenRe have on this article.)
In our interview with Robert Arvanitis last year, "'Bailout: It's About Capital, Not Liquidity; Seeking Beta: Interview with Robert Arvanitis', September 29, 2008," we discussed the difference between high and low beta. We also learned from Arvanitis, who worked for AIG during much of the relevant period, that the decision by Hank Greenberg and the AIG board to enter the CDS market was, at best, chasing revenue. No rational examination of the business opportunity, assuming that Greenberg and his directors were acting based on a reasoned analysis, could have resulted in a favorable decision to pursue CDS and other "high beta" risks, at least from our perspective.
In an effort to resolve this conundrum, over the past several months The IRA has interviewed a number of forensic experts, insurance regulators and members of the law enforcement community focused on financial fraud. The picture we have assembled is frightening and suggests that, far from just AIG, much of the insurance industry has been drawn into the world of financial engineering and has thus become part of the problem. Below we present our preliminary findings and invite your comments.
One of the first things we learned about the insurance world is that the concept of "shifting risk" for a variety of business and regulatory reasons has been ongoing in the insurance world for decades. Finite insurance and other scams have been at least visible to the investment community for years and have been documented in the media, but what is less understood is that firms like AIG took the risk shifting shell game to a whole new level long before the firm's entry into the CDS market.
In fact, our investigation suggests that by the time AIG had entered the CDS fray in a serious way more than five years ago, the firm was already doomed. No longer able to prop up its earnings using reinsurance because of growing scrutiny from state insurance regulators and federal law enforcement agencies, AIG's foray into CDS was really the grand finale. AIG was a Ponzi scheme plain and simple, yet the Obama Administration still thinks of AIG as a real company that simply took excessive risks. No, to us what the fraud Bernard Madoff is to individual investors, AIG is to the global financial community.
As with the phony reinsurance contracts that AIG and other insurers wrote for decades, when AIG wrote hundreds of billions of dollars in CDS contracts, neither AIG nor the counterparties believed that the CDS would ever be paid. Indeed, one source with personal knowledge of the matter suggests that there may be emails and actual side letters between AIG and its counterparties that could prove conclusively that AIG never intended to pay out on any of its CDS contracts. The significance of this for the US bailout of AIG is profound. If our surmise is correct, the position of Feb Chairman Ben Bernanke and Treasury Secretary Tim Geithner that the AIG credit default contracts are "valid legal contracts" is ridiculous and reveals a level of ignorance by the Fed and Treasury about the true goings on inside AIG and the reinsurance industry that is truly staggering.
Does Reinsurance + Side Letters = CDS?
One of the most widespread means of risk shifting is reinsurance, the act of paying an insurer to offset the risk on the books of a second insurer. This may sound pretty routine and plain vanilla, but what most people don't know is that often times when insurers would write reinsurance contracts with one another, they would enter into "side letters" whereby the parties would agree that the reinsurance contract was essentially a canard, a form of window dressing to make a company, bank or another insurer look better on paper, but where the seller of protection had no intention of ever paying out on the contract.
Let's say that an insurer needs to enhance its capital surplus by $100 million in order to meet regulatory capital requirements. They can enter into what appears to be a completely legitimate form of reinsurance contract, an agreement that appears to transfer the liability to the reinsurer. By doing so, the "ceding company" - an insurance company that transfers a risk to a reinsurance company - gets to drop that $100 million in liability and its regulatory surplus increases by $100 million.
The reinsurer assuming the risk does actually put up the $100 million in liability, but with the knowledge that they will never have to actually pay out on the contract. This is good for the reinsurer because they are paid a fee for this transaction, but it is bad for the ceding company, the insurer with the capital shortfall, because the transaction is actually a sham, a fraud meant to deceive regulators, counterparties and investors into thinking that the insurer has adequate capital. Typically the fee is 6% per year or what is called a "loan fee" in the insurance industry.
When it operates in this fashion, the whole reinsurance industry could be described as a "surplus rental" proposition, whereby an insurer literally loans another insurer capital in the form of risk cover, but with a secret understanding in the form of a side letter that the loan will be reversed without any recourse to the seller of protection. You give me $6 million in cash today, and I will give you a promise that we both know I will never honor. Does this sound familiar? What our contacts in the insurance industry describe is almost a precise description of the CDS market, albeit one that evolved in the reinsurance industry literally decades ago and has been the cause of numerous insurance insolvencies and losses to insured parties. Or to put it another way, maybe the inspiration for the CDS market - at least within AIG and other insurers -- evolved from the reinsurance market over the past two decades.
As best as we can tell, the questionable practice of using side letters to mask the economic and business reality of reinsurance transactions started in the mid-1980s and continued until the middle of the current decade. This timeline just happens to track the creation and evolution of the OTC derivatives markets. In particular, the move by AIG into the CDS market coincides with the increased awareness of and attention to the use of side letters by insurance regulators and members of the state and federal law enforcement community. Keep in mind that what we are talking about here are not questionable risk management policies but acts of deliberate and criminal fraud, acts that often result in jail time for those involved. As one senior forensic accountant who has practiced in the insurance sector for three decades told The IRA:
"In every major criminal fraud case in which I have worked, at the center of the investigation were these side letters. It was always very strange to me that on-site investigators and law enforcement officials consistently found that these side letters were being used to mask the true financial condition of an insurer, and yet none of the state regulators, the National Association of Insurance Commissioners (NAIC), nor federal law enforcement authorities ever publicly mentioned the practice. They certainly did not act like the use of side letters was a commonplace thing, but it was widespread in the industry."
It is important to understand that a side letter is a secret agreement, a document that is often hidden from internal and external auditors, regulators and even senior management of insurers and reinsurers. We doubt, for example, that Warren Buffet or Hank Greenberg knew the details of side letters, but they should have. Just as a rogue CDS trader at a large bank like Societe General (NYSE:SGE) might seek to hide losing trades, the underwriters of insurers would use sham transactions and side letters to enhance the revenue of the insurer, but without disclosing the true nature of the transaction.
There are two basic problems with side letters. First, they are a criminal act, a fraud that usually carries the full weight of an "A" felony in many jurisdictions. Second, once the side letter is discovered by a persistent auditor or regulator examining the buyer of protection, the transaction becomes worthless. You paid $6 million to AIG to shift risk via the reinsurance, but the side letter makes clear that the transaction is a fraud and you lose any benefit that the apparent risk shifting might have provided.
As the use of these secret side letters began to become more and more prevalent in the insurance industry, and these secret side deals were literally being stacked on top of one another at firms like AIG, the SEC began to investigate. And they began to find instances of fraud and to crack down on the practice. One of the first cases to come to the surface involved AIG helping Brightpoint (NASDAQ:CELL) commit accounting fraud, a case that eventually led the SEC to fine AIG $10 million in 2003.
Wayne M. Carlin, Regional Director of the SEC's Northeast Regional Office, said of the settlements: "In this case, AIG worked hand in hand with CELL personnel to custom-design a purported insurance policy that allowed CELL to overstate its earnings by a staggering 61 percent. This transaction was simply a 'round-trip' of cash from CELL to AIG and back to CELL. By disguising the money as 'insurance,' AIG enabled CELL to spread over several years a loss that should have been recognized immediately."
Another case involved PNC Financial (NYSE:PNC), which used various contracts with AIG to hide certain assets from regulators, even though the transaction amounted to the "rental" of capital and not a true risk transfer. As the SEC noted in a 2004 statement: "The Commission's action arises out of the conduct of Defendant AIG, primarily through its wholly owned subsidiary AIG Financial Products Corp. ("AIG-FP"), (collectively referred to as "AIG") in developing, marketing, and entering into transactions that purported to enable a public company to remove certain assets from its balance sheet." Click here to see the SEC statement regarding the AIG transactions with PNC.
The SEC statement reads in part: "In its Complaint, filed in the United States District Court for the District of Columbia, the Commission alleged that from at least March 2001 through January 2002, Defendant AIG, primarily through AIG-FP, developed a product called a Contributed Guaranteed Alternative Investment Trust Security ("C-GAITS"), marketed that product to several public companies, and ultimately entered into three C-GAITS transactions with one such company, The PNC Financial Services Group, Inc. ("PNC"). For a fee, AIG offered to establish a special purpose entity ("SPE") to which the counter-party would transfer troubled or other potentially volatile assets. AIG represented that, under generally accepted accounting principles ("GAAP"), the SPE would not be consolidated on the counter-party's financial statements. The counter-party thus would be able to avoid charges to its income statement resulting from declines in the value of the assets transferred to the SPE. The transaction that AIG developed and marketed, however, did not satisfy the requirements of GAAP for nonconsolidation of SPEs."
In both cases, AIG was engaged in transactions that were meant not to reduce risk, but to hide the true nature of the risk in these companies from investors, regulators and the consumers who rely on these institutions for services. Keep in mind that while the SEC did act to address these issues, the parties involved received light punishments when you consider that these are all felonies that arguably would call for criminal prosecution for fraud, securities fraud, conspiracy and racketeering, among other things. Indeed, this is one of those rare cases where we believe AIG itself, as a corporate person, should be subject to criminal prosecution and liquidation.
Birds of a Feather: AIG & GenRe
Click here to see a June 6, 2005 press release from the SEC detailing criminal charges against John Houldsworth, a former senior executive of General Re Corporation ("GenRe"), a subsidiary of Berkshire Hathaway (NYSE:BRKA), for his role in aiding and abetting American International Group, Inc. in committing securities fraud.
The SEC noted: "In its complaint filed today in federal court in Manhattan, the Commission alleged that Houldsworth and others helped AIG structure two sham reinsurance transactions that had as their only purpose to allow AIG to add a total of $500 million in phony loss reserves to its balance sheet in the fourth quarter of 2000 and the first quarter of 2001. The transactions were initiated by AIG to quell criticism by analysts concerning a reduction in the company's loss reserves in the third quarter of 2000."
But the involvement of the BRKA unit GenRe in the AIG mess was not the first time that GenRe had been involved in the questionable use of reinsurance contracts and side letters. Click here to see an example of a side letter that was made public in a civil litigation in Australia a decade ago. The faxed letter, which bears the ID number from the Australian Court, is from an insurance broker in London to Mr. Ajit Jain, a businessman who currently heads several reinsurance businesses for BRKA, regarding a reinsurance contract for FAI Insurance, an affiliate of HIH Insurance.
Notice that the letter states plainly the intent of the transaction is to bolster the apparent capital of FAI. Notice too that several times in the letter, the statement is made that "no claim will be made before the commutation date," which may be interpreted as being a warranty by the insured that no claims shall be made under the reinsurance policy. By no coincidence, HIH and FAI collapsed in a $5.3 billion dollar fiasco that ranks as Australia's biggest ever corporate failure. Click here to read a March 9, 2009 article from The Age, one of Australia's leading business publications, regarding the collapse of HIH and FAI.
In 2003, an insurer named Reciprocal of America ("ROA") was seized by regulators and law enforcement officials. An investigation ensued for 3 years. According to civil lawsuits filed in the matter, GenRe provided finite insurance to ROA in order to make the troubled insurer look more solvent than it was in reality. Several regulators and law enforcement officials involved in that case tell The IRA that the ROA failure forced insurers like AIG and Gen Re to start looking for new ways to "cook the books" because the long-time practice of side letters was starting to come under real scrutiny.
"These reinsurance deals made ROA look better than it really was," one investigator with direct knowledge of the ROA matter tells The IRA. "They went into the ROA home office in VA with the state insurance regulators and law enforcement, and directed the employees away from the computers and records. During that three-year investigation, GenRe learned that local regulators and forensic examiners had put everything together and that we now understood the way the game was played. I believe the players in the industry realized that that they had to change the way in which they cooked the books. A sleight- of-hand trick that had worked for 25 years under the radar of regulators and investors was now revealed."
Several senior officials of ROA eventually were prosecuted, convicted of criminal fraud and imprisoned, but DOJ officials under the Bush Administration reportedly blocked prosecution of the actual managers and underwriters of ROA who were involved in these sham transactions, this even though state officials and federal prosecutors in VA were anxious to proceed with additional prosecutions.
AIG: From Reinsurance to CDS
While some reinsurers are large, well-capitalized entities that generally avoid these pitfalls, AIG was already a troubled company when it began to write more and more of these risk-shifting transactions more than a decade ago. It is easy to promise the moon when people think that they can deliver, but because AIG and their clients saw how easy it was to fool regulators and investors, the practice grew and most regulators did absolutely nothing to curtail the practice.
It was easy for AIG to become addicted to the use of side letters. The firm, which had already encountered serious financial problems in 2000-2001, reportedly saw the side letters as a way to mint free money and thereby help the insurer to look stronger than it really was. AIG not only helped banks and other companies distort and obfuscate their financial condition, but AIG was supplementing its income by writing more and more of these reinsurance deals and mitigating their perceived exposure via side letters.
A key figure in AIG's reinsurance schemes, according to several observers, was Joseph Cassano, head of AIG-FP. Whereas the traditional use of side letters was in reinsurance transactions between insurers, in the case of both CELL and PNC neither was an insurer! And in both cases, AIG used sham deals to make two non-insurers, including a regulated bank holding company, look better by manipulating their financial statements. Falsifying the financial statements of a bank or bank holding company is an felony.
AIG-FP was simply doing for non-insurers what was common practice inside the secretive precincts of the insurance world. The SEC did investigate and they did finally obtain a deferred prosecution agreement with AIG, which was buried in the settlement with then-New York AG Elliott Spitzer.
The key thing to understand is that if you look at many of these reinsurance contracts between ROA and Gen Re, they look perfect. They appear to transfer risk and seem to be completely in order. But, if you don't get to see the secret agreement, the side letter that basically says that the reinsurance contract is a form of window dressing, then you cannot understand the full implications of the transaction, the reinsurance agreement. Not, several experts speculate, can you understand why AIG decided to migrate away from reinsurance and side letters and into CDS as a mechanism for falsifying the balance sheets and earnings of non-insurers.
Several observers believe that at some point in the 2002-2004 period, Cassano and his colleagues at AIG began to realize that state insurance regulators and the FBI where on to the reinsurance/side letter scam. A number of experts had been speaking and writing about the issue within the accounting and fraud communities, and this attention apparently made AIG move most of its shell game into the world of CDS. By no coincidence, at around this time side letters began to disappear in the insurance industry, suggesting to many observers that the industry finally realized that the jig was up.
It appears to us that, seeing the heightened attention from regulators and federal law enforcement agencies such as the FBI on side letters, AIG began to move its shell game to the CDS markets, where it could continue to falsify the balance sheets and income statements of non-insurers all over the world, including banks and other financial institutions.
AIG's Cassano even managed to hide the activity in a bank subsidiary of AIG based in London and under the nominal supervision of the Office of Thrift Supervision in the US, this it is suggested to hide this ongoing activity from US insurance regulators. Even though AIG had been investigated and sanctioned by the SEC, Cassano and his colleagues at AIG apparently were recalcitrant and continued to build the CDS pyramid inside AIG, a financial pyramid that is now collapsing. The rest, as they say is history.
Now you know why the Fed and EU officials are so terrified about an AIG liquidation, because it will result in heavy losses to or even the insolvency of banks and other corporations around the globe. Notice that while German Chancellor Angela Merkel has been posturing and throwing barbs at President Obama, French President Nicolas Sarkozy has been conciliatory toward the US.
But for the bailout of AIG, you see, President Sarkozy would have been forced to bailout SGE for a second time in two years. So long as the Fed and Treasury can subsidize AIG's mounting operating losses, the EU will be spared a financial bloodbath. But this situation is unlikely to remain stable for long with members of the Congress demanding an investigation of the past bailout, a process that can only result in bankruptcy for AIG.
Are the CDS Contracts of AIG Really Valid?
The key point is that neither the public, the Fed nor the Treasury seem to understand is that the CDS contracts written by AIG with these various non-insurers around the world were shams - with no correlation between "fees" paid and the risk assumed. These were not valid contracts as Fed Chairman Ben Bernanke, Treasury Secretary Geithner and Economic policy guru Larry Summers claim, but rather acts of criminal fraud meant to manipulate the capital positions and earnings of financial companies around the world.
Indeed, our sources as well as press reports suggest that the CDS contracts written by AIG may have included side letters, often in the form of emails rather than formal letters, that essentially violated the ISDA agreements and show that the true, economic reality of these contracts was fraud plain and simple. Unfortunately, by not moving to seize AIG immediately last year when the scandal broke, the Fed and Treasury may have given the AIG managers time to destroy much of the evidence of criminal wrongdoing.
Only when we understand how AIG came to be involved in CDS and the fact that this seemingly illegal activity was simply an extension of the reinsurance/side letter shell game scam that AIG, Gen Re and others conducted for many years before will we understand what needs to be done with AIG, namely liquidation. Seen in this context, the payments made to AIG by the Fed and Treasury, which were then passed-through to dealers such as Goldman Sachs (NYSE:GS), can only be viewed as an illegal taking that must be reversed once the US Trustee for the Federal Bankruptcy Court for the Southern District of New York is in control of AIG's operations.
(Editor's note: Officials of BRKA and GenRe did not respond to telephonic and email requests by The IRA seeking comment on this article. An official of AIG did respond but was not willing to comment on-the-record for this report. We shall be happy to publish any written comments that BRKA, AIG or GenRe have on this article.)
Did the ECB save COMEX from gold default?
On Tuesday morning, gold derivatives dealers, who had sold short in the face of a fast rising gold price, faced a serious predicament. Some 27,000 + contracts, representing about 15% of the April COMEX gold futures contracts remained open. Technically, short sellers are required to give “notice” of delivery to long buyers. However, in reality, buyers are the ones who control the amount of gold to be delivered. They “demand” delivery of physical gold by holding futures contracts past the expiration date. This time, long buyers were demanding in droves. In normal times, very few people do this. Only about 1% or less of gold contracts must be delivered. The lack of delivery demand allows the casino-like world of paper gold futures contracts to operate. Very few short sellers actually expect or intend to deliver real gold. They are, mostly, merely playing with paper. It was amazing, therefore, when March 30, 2009 came and passed, and so many people stood for delivery, refusing to part with their long gold futures positions.
On Tuesday, March 31st, Deutsche Bank amazed everyone even more, by delivering a massive 850,000 ounces, or 850 contracts worth of the yellow metal. By the close of business, even after this massive delivery, about 15,050 April contracts, or 1.5 million ounces, still remained to be delivered. Most of these, of course, are unlikely to be the obligations of Deutsche Bank. But, the fact that this particular bank turned out to be one of the biggest short sellers of gold, is a surprise. Most people presumed that the big COMEX gold short sellers are HSBC and/or JP Morgan Chase. That may be true. However, it is abundantly clear that they are not the only game in town.
Closely connected institutions, it seems, do not have to worry about acting irresponsibly, in taking on more obligations than they can fulfill. Mysteriously, on the very same day that gold was due to be delivered to COMEX long buyers, at almost the very same moment that Deutsche Bank was giving notice of its deliveries, the ECB happened to have “sold” 35.5 tons, or a total of 1,141,351 ounces of gold, on March 31, 2009. Convenient, isn’t it? Deutsche Bank had to deliver 850,000 ounces of physical gold on that day, and miraculously, the gold appeared out of nowhere.
The announcement of the ECB sale was made, as usual, dryly, without further comment. There was little more than a notation of a sale, as if it were a meaningless blip in the daily activity of the central bank. But, it was anything but meaningless. It may have saved a major clearing member of the COMEX futures exchange from defaulting on a huge derivatives position. We don’t know who the buyer(s) was, but we don’t leave our common sense at home. The ECB simply states that 35.5 tons were sold, and doesn’t name any names. Common sense, logic and reason tells us that the buyer was Deutsche Bank, and that the European Central Bank probably saved the bank and COMEX from a huge problem. What about the balance, above 850,000 ounces? What will happen to that? I am willing to bet that Deutsche Bank will use it, in June, to close out remaining short positions, or that it will be sold into the market, at an opportune time, if it hasn’t already been sold on Tuesday, to try to control the inevitable rise of the price of gold.
Circumstantial evidence has always been a powerful force in the law. It allows police, investigators, lawyers and judges to ferret out the truth. Circumstantial evidence is admissible in any court of law to prove a fact. It is used all the time, both when we initiate investigations, and once we seek indictments and convictions. We do this because we deal in a corrupt world, filled with suspicious actions and lies, and the circumstances are often suspicious enough to give rise to a strong inference that something is amiss. Most of the time, when the direct evidence is insufficient to prove a case beyond a reasonable doubt, or even by a preponderance of direct evidence, circumstantial evidence fills the void, and gives us the conviction. We even admit evidence of the circumstances to prove murder cases. In light of that, it certainly seems appropriate to use circumstantial evidence in evaluating possible regulatory violations. The size and timing of the delivery of Deutsche Bank’s COMEX obligation is suspicious, to say the least, when taken in conjunction with the size and timing of the ECB’s gold sale. It is circumstantial evidence that the gold used by Deutsche Bank to deliver and fulfill its COMEX obligations, came directly or indirectly, from the ECB.
I’d sure like to know what the ECB’s “alibi” is. If I were an investigator for the Commodities Futures Trading Commission (CFTC), assigned to determine whether or not gold short sellers are knowingly violating the 90% cover rule, I’d be questioning the hell out of the ECB staffers, as well as employees in the futures trading division of Deutsche Bank. There is certainly enough evidence to raise “reasonable suspicion”. Reasonable suspicion is all that one needs to start a criminal investigation. It should be more than sufficient to prompt the CFTC, as well as European market regulators, to start a commercial investigation of the potential violation of regulatory rules by both the ECB and one of the world’s major banking institutions. That is, of course, if and only if, the CFTC staff really wants to regulate, rather than simply position themselves for more lucrative jobs inside the industry they are supposed to be regulating, after they leave government service.
It is quite important to determine whether or not Deutsche Bank was bailed out by the ECB because that will answer a lot of questions about allegations of naked short selling on the COMEX. If the ECB knew that its gold would be used as post ipso facto “cover” for uncovered shorting, staffers at the central bank might be co-conspirators. At any rate, if the German bank did sell short on futures contracts without having enough vaulted gold it sold a naked short. It also means that the ECB has facilitated a major rule violation in a jurisdiction (the USA) with which Europe is supposed to have extensive joint regulatory agreements, any number of which may have been violated by this action of the ECB. At the very least, naked short selling is a blatant violation of CFTC regulations, which require 90% cover of all deliverable metals contracts. If the delivered gold came directly, or indirectly, from the ECB, it means that Deutsche Bank’s gold short contracts were “naked” at the time they were entered into.
The 90% cover rule is very old rule, designed to prevent fraud on the futures markets. Its origin dates back into the 19th century. Farmers, in that simpler age, were complaining that big bank speculators were downwardly manipulating grain prices on the futures exchanges. Nowadays, the CFTC has a predilection toward categorizing banks as so-called “commercials” or “hedgers”, rather than as the speculators that they really are. Traditionally, only miners and gold dealers whose business involves a majority of PHYSICAL trade in gold should qualify as commercials. However, the CFTC has ignored this for a long time, and qualified numerous banks and other financial institutions, whose main gold business is derivatives, as “commercial” entities, immunizing them from position limits and other constraints. As a result, just like the farmers of the 19th century, today’s gold “cartel” conspiracy theorists revolve their theory around an allegation of downward manipulation, and heavy short selling concentration.
Manipulation can only take place when there is a disconnect between supply, demand, and trading activity on the futures exchanges. The 90% cover rule attempts to force a direct tie between the futures market and the availability of particular commodities, so that supply and demand become primary even on paper based futures markets, just as it is in trading the real commodity. Unfortunately, the modern CFTC has ignored or misinterpreted the purpose of the 90% cover rule for a very long time. This regulatory failure has allowed the current free-for-all “casino-like” atmosphere that now prevails at futures exchanges. It would be helpful if some of my colleagues, within the public prosecutor and securities regulatory offices, in Europe, as well as the CFTC in America, filed complaints for discovery, to ferret out the truth. In the interest of transparent markets, the ECB should be forced to disclose who purchased the gold they sold in the morning of March 31, 2008 and why the sale was timed in a way that corresponded to the exact moment in time that Deutsche Bank had a desperate need for gold bullion.
Was it yet another bank bailout? Has another bank sucked up precious resources belonging, in this case, to the people of Europe? Gold is needed to bring confidence to the Euro currency, as often noted by Germany’s Bundesbank, which seems to be less kind to German banks than the ECB. Why should the ECB be permitted to sell gold to closely connected derivatives dealers, if the primary purpose is to save those dealers from the bad decisions they have made, and the end result is to reinforce moral hazard? Should banks like Deutsche Bank be allowed to take on more derivative risk than they can afford without involving publicly owned assets? Did Deutsche Bank issue naked short positions? Have innocent European citizens now had their currency placed at more risk, and some of their gold stolen from them, simply to enrich private hands? All of these questions are begging for answers.
European regulators are quick to condemn the Federal Reserve for its incestuous relationship to client “primary dealer” banks, special treatment of favored institutions at the expense of other non-favored institutions, propensity toward injecting dollars to artificially stimulate the stock market, seemingly endless bailouts of closely connected banks, and, now, the seemingly unlimited printing of new dollars. I’ll not attempt to excuse the Fed for its failures. Indeed, I believe that it is in the best interest of the American people to close down that malevolent institution, permanently. However, if any of the questions I have posed are answered in the positive, people might begin to understand that special favors, nepotism, corruption, and a failure to properly regulate are not confined to America. The real estate bubble, for example, was allowed to become much bigger in the U.K., Ireland, Spain, and eastern Europe, than it ever was in the USA. The collapse of real estate, in those countries, is going to be more severe, even though it is more recent in origin than the pullback in the USA. America happened to be the first nation affected, but it did not cause the world economic collapse. That was caused by the joint irresponsible policies in almost every major nation in the world.
Those who rely on the good faith of Angela Merkel, to keep the Euro inviolate, certainly have a right to get answers from the ECB and from Deutsche Bank. The answers will tell us a lot about the real proclivities of the ECB. As the U.S. dollar is progressively debased, in coming years, will the Euro be any better? Is the ECB merely a European copy of the Federal Reserve “slush fund”, utilized by well connected European banks, for the purpose of private financial gain, much as the Federal Reserve’s assets are utilized by its primary dealers? If the ECB is willing to bail out a major trading institution from the mismanagement of its derivatives operations, who could honestly claim that it would hesitate to competitively debase the Euro against the dollar? Having the answers to the questions I have posed would give everyone the knowledge needed to make important decisions. That is exactly the reason that, in all likelihood, we will never get these answers. Maybe, Europeans and others ought to be dumping Euros just as fast as they are now dumping dollars, and buy gold and silver, instead.
Aside from the regulatory issues, if we did discover that Deutsche Bank got its gold from the ECB, one glaringly strong inference arises. When a major derivatives dealer goes begging for gold, to the ECB, it is very strong circumstantial evidence that not enough physical gold is available for purchase on the OTC wholesale market. Up until now, bearish gold commentators have steadfastly denied that wholesale gold shortages exist. Instead, they have insisted that all shortages are confined to retail forms of gold. Now, when combined with the circumstantial evidence, however, common sense tells us that they are wrong. Decision: There is sufficient evidence for this case to go to a full scale investigation. The CFTC and similar securities regulators in Europe need to properly investigate the gold conspiracy allegations. That has never been done to date. They must determine who is buying central bank gold and whether or not it is simply being sold into the open market, or channeled into the hands of favored financial institutions who then use it to cover naked short selling. The investigation must include detailed vault audits and explore all paper trails.
On Tuesday, March 31st, Deutsche Bank amazed everyone even more, by delivering a massive 850,000 ounces, or 850 contracts worth of the yellow metal. By the close of business, even after this massive delivery, about 15,050 April contracts, or 1.5 million ounces, still remained to be delivered. Most of these, of course, are unlikely to be the obligations of Deutsche Bank. But, the fact that this particular bank turned out to be one of the biggest short sellers of gold, is a surprise. Most people presumed that the big COMEX gold short sellers are HSBC and/or JP Morgan Chase. That may be true. However, it is abundantly clear that they are not the only game in town.
Closely connected institutions, it seems, do not have to worry about acting irresponsibly, in taking on more obligations than they can fulfill. Mysteriously, on the very same day that gold was due to be delivered to COMEX long buyers, at almost the very same moment that Deutsche Bank was giving notice of its deliveries, the ECB happened to have “sold” 35.5 tons, or a total of 1,141,351 ounces of gold, on March 31, 2009. Convenient, isn’t it? Deutsche Bank had to deliver 850,000 ounces of physical gold on that day, and miraculously, the gold appeared out of nowhere.
The announcement of the ECB sale was made, as usual, dryly, without further comment. There was little more than a notation of a sale, as if it were a meaningless blip in the daily activity of the central bank. But, it was anything but meaningless. It may have saved a major clearing member of the COMEX futures exchange from defaulting on a huge derivatives position. We don’t know who the buyer(s) was, but we don’t leave our common sense at home. The ECB simply states that 35.5 tons were sold, and doesn’t name any names. Common sense, logic and reason tells us that the buyer was Deutsche Bank, and that the European Central Bank probably saved the bank and COMEX from a huge problem. What about the balance, above 850,000 ounces? What will happen to that? I am willing to bet that Deutsche Bank will use it, in June, to close out remaining short positions, or that it will be sold into the market, at an opportune time, if it hasn’t already been sold on Tuesday, to try to control the inevitable rise of the price of gold.
Circumstantial evidence has always been a powerful force in the law. It allows police, investigators, lawyers and judges to ferret out the truth. Circumstantial evidence is admissible in any court of law to prove a fact. It is used all the time, both when we initiate investigations, and once we seek indictments and convictions. We do this because we deal in a corrupt world, filled with suspicious actions and lies, and the circumstances are often suspicious enough to give rise to a strong inference that something is amiss. Most of the time, when the direct evidence is insufficient to prove a case beyond a reasonable doubt, or even by a preponderance of direct evidence, circumstantial evidence fills the void, and gives us the conviction. We even admit evidence of the circumstances to prove murder cases. In light of that, it certainly seems appropriate to use circumstantial evidence in evaluating possible regulatory violations. The size and timing of the delivery of Deutsche Bank’s COMEX obligation is suspicious, to say the least, when taken in conjunction with the size and timing of the ECB’s gold sale. It is circumstantial evidence that the gold used by Deutsche Bank to deliver and fulfill its COMEX obligations, came directly or indirectly, from the ECB.
I’d sure like to know what the ECB’s “alibi” is. If I were an investigator for the Commodities Futures Trading Commission (CFTC), assigned to determine whether or not gold short sellers are knowingly violating the 90% cover rule, I’d be questioning the hell out of the ECB staffers, as well as employees in the futures trading division of Deutsche Bank. There is certainly enough evidence to raise “reasonable suspicion”. Reasonable suspicion is all that one needs to start a criminal investigation. It should be more than sufficient to prompt the CFTC, as well as European market regulators, to start a commercial investigation of the potential violation of regulatory rules by both the ECB and one of the world’s major banking institutions. That is, of course, if and only if, the CFTC staff really wants to regulate, rather than simply position themselves for more lucrative jobs inside the industry they are supposed to be regulating, after they leave government service.
It is quite important to determine whether or not Deutsche Bank was bailed out by the ECB because that will answer a lot of questions about allegations of naked short selling on the COMEX. If the ECB knew that its gold would be used as post ipso facto “cover” for uncovered shorting, staffers at the central bank might be co-conspirators. At any rate, if the German bank did sell short on futures contracts without having enough vaulted gold it sold a naked short. It also means that the ECB has facilitated a major rule violation in a jurisdiction (the USA) with which Europe is supposed to have extensive joint regulatory agreements, any number of which may have been violated by this action of the ECB. At the very least, naked short selling is a blatant violation of CFTC regulations, which require 90% cover of all deliverable metals contracts. If the delivered gold came directly, or indirectly, from the ECB, it means that Deutsche Bank’s gold short contracts were “naked” at the time they were entered into.
The 90% cover rule is very old rule, designed to prevent fraud on the futures markets. Its origin dates back into the 19th century. Farmers, in that simpler age, were complaining that big bank speculators were downwardly manipulating grain prices on the futures exchanges. Nowadays, the CFTC has a predilection toward categorizing banks as so-called “commercials” or “hedgers”, rather than as the speculators that they really are. Traditionally, only miners and gold dealers whose business involves a majority of PHYSICAL trade in gold should qualify as commercials. However, the CFTC has ignored this for a long time, and qualified numerous banks and other financial institutions, whose main gold business is derivatives, as “commercial” entities, immunizing them from position limits and other constraints. As a result, just like the farmers of the 19th century, today’s gold “cartel” conspiracy theorists revolve their theory around an allegation of downward manipulation, and heavy short selling concentration.
Manipulation can only take place when there is a disconnect between supply, demand, and trading activity on the futures exchanges. The 90% cover rule attempts to force a direct tie between the futures market and the availability of particular commodities, so that supply and demand become primary even on paper based futures markets, just as it is in trading the real commodity. Unfortunately, the modern CFTC has ignored or misinterpreted the purpose of the 90% cover rule for a very long time. This regulatory failure has allowed the current free-for-all “casino-like” atmosphere that now prevails at futures exchanges. It would be helpful if some of my colleagues, within the public prosecutor and securities regulatory offices, in Europe, as well as the CFTC in America, filed complaints for discovery, to ferret out the truth. In the interest of transparent markets, the ECB should be forced to disclose who purchased the gold they sold in the morning of March 31, 2008 and why the sale was timed in a way that corresponded to the exact moment in time that Deutsche Bank had a desperate need for gold bullion.
Was it yet another bank bailout? Has another bank sucked up precious resources belonging, in this case, to the people of Europe? Gold is needed to bring confidence to the Euro currency, as often noted by Germany’s Bundesbank, which seems to be less kind to German banks than the ECB. Why should the ECB be permitted to sell gold to closely connected derivatives dealers, if the primary purpose is to save those dealers from the bad decisions they have made, and the end result is to reinforce moral hazard? Should banks like Deutsche Bank be allowed to take on more derivative risk than they can afford without involving publicly owned assets? Did Deutsche Bank issue naked short positions? Have innocent European citizens now had their currency placed at more risk, and some of their gold stolen from them, simply to enrich private hands? All of these questions are begging for answers.
European regulators are quick to condemn the Federal Reserve for its incestuous relationship to client “primary dealer” banks, special treatment of favored institutions at the expense of other non-favored institutions, propensity toward injecting dollars to artificially stimulate the stock market, seemingly endless bailouts of closely connected banks, and, now, the seemingly unlimited printing of new dollars. I’ll not attempt to excuse the Fed for its failures. Indeed, I believe that it is in the best interest of the American people to close down that malevolent institution, permanently. However, if any of the questions I have posed are answered in the positive, people might begin to understand that special favors, nepotism, corruption, and a failure to properly regulate are not confined to America. The real estate bubble, for example, was allowed to become much bigger in the U.K., Ireland, Spain, and eastern Europe, than it ever was in the USA. The collapse of real estate, in those countries, is going to be more severe, even though it is more recent in origin than the pullback in the USA. America happened to be the first nation affected, but it did not cause the world economic collapse. That was caused by the joint irresponsible policies in almost every major nation in the world.
Those who rely on the good faith of Angela Merkel, to keep the Euro inviolate, certainly have a right to get answers from the ECB and from Deutsche Bank. The answers will tell us a lot about the real proclivities of the ECB. As the U.S. dollar is progressively debased, in coming years, will the Euro be any better? Is the ECB merely a European copy of the Federal Reserve “slush fund”, utilized by well connected European banks, for the purpose of private financial gain, much as the Federal Reserve’s assets are utilized by its primary dealers? If the ECB is willing to bail out a major trading institution from the mismanagement of its derivatives operations, who could honestly claim that it would hesitate to competitively debase the Euro against the dollar? Having the answers to the questions I have posed would give everyone the knowledge needed to make important decisions. That is exactly the reason that, in all likelihood, we will never get these answers. Maybe, Europeans and others ought to be dumping Euros just as fast as they are now dumping dollars, and buy gold and silver, instead.
Aside from the regulatory issues, if we did discover that Deutsche Bank got its gold from the ECB, one glaringly strong inference arises. When a major derivatives dealer goes begging for gold, to the ECB, it is very strong circumstantial evidence that not enough physical gold is available for purchase on the OTC wholesale market. Up until now, bearish gold commentators have steadfastly denied that wholesale gold shortages exist. Instead, they have insisted that all shortages are confined to retail forms of gold. Now, when combined with the circumstantial evidence, however, common sense tells us that they are wrong. Decision: There is sufficient evidence for this case to go to a full scale investigation. The CFTC and similar securities regulators in Europe need to properly investigate the gold conspiracy allegations. That has never been done to date. They must determine who is buying central bank gold and whether or not it is simply being sold into the open market, or channeled into the hands of favored financial institutions who then use it to cover naked short selling. The investigation must include detailed vault audits and explore all paper trails.
zaterdag 21 maart 2009
Bernanke Fires Up the Printing Presses
Wham! For a while, investors didn’t seem to know what had hit them. They were dazed…dumbfounded…awe-struck…
The Bernanke Fed announced a “stunning” plan to save the world from depression on Wednesday.
The numbers were hard to follow, but they were big:
$300 billion, was the number Bloomberg reported
$1 trillion, said the New York Times.
$1.2 trillion, countered the Washington Post.
It turned out that all these numbers were correct. The Fed was going to buy $300 billion of U.S. Treasury bonds…and more of other securities – notably bonds from Fannie and Freddie.
“Quantitative easing,” the papers called it.
“What’s that?” investors wanted to know.
So, it took them a while to put two and two together. But when they’d done the math they began to see what we’ve been warning about.
“This is a very powerful and aggressive move,” said the chief economist at Bank of New York Mellon Corp., speaking with Bloomberg Television. “One of the reasons I’ve been arguing we won’t have a depression is we’ve got a Fed chairman who understands the problem and is going to come with the right diagnosis and the right medicine.”
Bloomberg continues: “With the purchases of Treasuries and housing debt, Bernanke is effectively using the Fed’s powers to print money and aim it where he and other officials believe it will have the greatest impact in lowering borrowing costs.”
What do we know? Maybe Ben Bernanke will be able to do what no central banker has ever done before: put in just the right amount of inflation…not too much, not too little. In the past, they tended to overdo it. There are not many examples. France, England and America in the 18th century. Practically no examples we know of in the 19th century (they’d learned their lesson!). And in the 20th century – only marginal countries…or countries with nothing left to lose…engaged in ‘quantitative easing.’ Germany did it in the 1920s, because her war reparations burden was greater than she could sustain. Argentina did it in the 1980s, because it owed too much money to too many foreigners. And Zimbabwe did it in 2003-2009, for reasons of its own.
There are not many examples because the consequences of over-doing it are so horrible, central bankers have generally not done it at all. Quantitative easing was always a possibility…but it was always a last resort…like blowing up the powder and spiking the guns; it was something you did when you knew you’d lost the battle already.
But here is the world’s biggest economy and its oldest (arguably) and most successful government…doing something that used to be done only by desperadoes…
What does it mean? Where does it lead?
We don’t know. But we don’t think we want to go there.
Investors didn’t seem to want to go there either. They sold off stocks and bought gold.
Gold shot up on Wednesday, after the Fed announcement. Then, it just kept going…adding another $70 yesterday. We wondered why the price hadn’t already hit $1,000. It looks like it soon will…this morning it is back over $960 an ounce.
Meanwhile, oil rose above $50, the dollar took a big drop and the Dow finished down 85 points. The greenback slipped to $1.36 per euro.
As to the stock market, whether this is a pause in the rally…or a reversal, caused by the Fed announcement…we don’t know. Our guess is that it’s just a pause. The rebound is still unfinished business. Besides, investors aren’t running scared like they were a few weeks ago. Sentiment seems more relaxed. “We’ll muddle through this somehow,” investors tell themselves.
And the news appears more positive…at least, if you stand on your head and look up it.
Jobless benefits, for example. They’re getting paid out to a record number of recipients. But not as many as economists had expected.
The leading indicators are down 0.4% in February – but not as much as expected.
And consumers are spending less money – but not as much less as expected.
And, of course, there’s the money flowing from Washington. The auto suppliers just got $5 billion. Obama’s budget will probably reach $2 trillion in deficit this year. And this extra $1.2 trillion from the Fed is not exactly small change. And that’s in addition to the $11.7 trillion the feds have already ponied up in their fight against a free market. Investors are going to look at this flood of cash from the Fed and figure that it has to go somewhere. Some of it is bound to go into the stock market.
Now, we turn to our friends in Baltimore to see what the have in store for us…
“The larger [monetary] story,” opines Rob Parenteau, lending a The 5 Min. Forecast a hand today, “can be found in the deleveraging effort of households, which accelerated in the fourth quarter of 2008.
“We have never seen such a sustained buildup of credit flows to the U.S. household sector like the one that began in the late ’90s. Nor has the U.S. economy experienced such a reversal of household credit flows since the Great Depression.
“Policymakers, investors and entrepreneurs need to grasp this essential piece of the puzzle:
“There are good reasons why the household sector is are paying down debt in an environment of declining asset prices and personal income. Falling asset prices reduce wealth faster than households can pay down debt.
“We believe this has a number of very important implications, not the least of which is for the restructuring of global growth away from a growing dependence on consumer debt binges in Anglo-American developed nations. Not to mention the policy objective of renewing lending to the private sector… it’s misguided.”
And yet, it’s the very core of the justification for the TARP bailout and the broader Congressional stimulus plan. Rob unpacks this phenomenon in the latest issue of the Richebächer Letter entitled “Deleveraging Demystified”.
The 5 Min Forecast is an executive series e-letter that provides a quick and dirty analysis of daily economic and financial developments – in five minutes or less.
And back to Bill with more thoughts…
“Fed’s decision to put more money into the financial system reflects its worry that the U.S. economy is plagued by excess capacity,” says the Wall Street Journal.
And back to Bill with more thoughts…
“Fed’s decision to put more money into the financial system reflects its worry that the U.S. economy is plagued by excess capacity,” says the Wall Street Journal.
As we keep saying, the economically correct thing to do would be to let the excess capacity sort itself out. People lose their jobs – and get new ones. Factories close down…and open up again, producing something else. Companies go broke…and new companies spring up to take their places. That’s what needs to happen. Then, after this restructuring, the economy can begin rebuilding on a more solid foundation.
But the Fed doesn’t listen to us. Ben Bernanke is determined to stop a Japan-style depression from happening in the United States – at all costs. And the only way he can possibly stop it – by his logic – is by increasing demand. Putting more money into circulation gives people more money to spend. It also raises prices – giving them a reason to spend it now.
“Will it work?” was the question put to our little band of analysts this morning.
“It depends on what you mean by ‘work’,” was the answer.
Bernanke has set the blaze…broken the glass…and pulled the alarm. Now, the sirens whine and the crowds form. He has no choice but to follow through. What that means is that he must continue fanning the flames…inflating the money supply (monetizing the debt)… until consumer prices rise (reflecting an increase in demand).
We don’t know how long that will take. But in that sense…it will work…sooner or later. Prices will rise…people will spend.
But what else? Do prices suddenly go wild? Or, do they gently rise…giving the feds time to get out the fire extinguishers before the whole economy burns down?
We don’t know. But here is a guess: between the time the flames shoot up out of the roof…and the time the feds have the conflagration under control…you’ll see gold over $2,000 an ounce.
*** Poor Tim. The U.S. Treasury Secretary is “out of the loop,” says one source. He’s “on thin ice,” says a member of Congress.
He appeared on TV and said he couldn’t stop the AIG bonuses. Then, the next day, his boss goes on the air: “Yes we can!” says he.
“US moves to take back bonuses,” says today’s Wall Street Journal headline.
Geithner has only been on the job a couple of months. And he’s had to deal with bailouts, meltdowns, regulatory restructuring. It’s a “crushing workload,” says the New York Times.
But it’s the bonus sideshow that gets people’s attention. And poor Tim is on the wrong side of the story.
Enjoy your weekend,
Bill Bonner
The Daily Reckoning
woensdag 11 maart 2009
Why You Should Pray for Inflation
So there I was on Tuesday, pondering how far the absurdity of the rally would go and straightening out a few problems here and there for clients and what happens? The phone rings and it’s my friend The Bond Dude.
hadn’t heard from him for a while and what followed was about a 45-minute lecture on why my praise of Nobel Prize winner Joseph Stiglitz last week - remember Stiglitz is the guy saying that big banks were not really too big to fail, and that there were ways out of the present disaster in financial markets - was all wrong because I hadn’t considered the Federal Reserve’s Z-1 (Flow of Funds) Report.
Upon admitting I hadn’t read it since the December Z-1 report came out - it’s a quarterly - and why couldn’t my scolding be delayed until tomorrow when the next Z-1 comes out, TheBondDude launched into his scary explanation of why Stiglitz is wrong, and why the big banks really do have to be saved. Virtually no one understands this mess better than TBD…maybe even better than Ben Bernanke and Time Geithner, which is going a fair piece….so I paid close attention.
I’ll paraphrase best I can:
“The problem with the Stiglitz approach is that if you try to protect only the small depositors, you will have all that money (brokered CD’s and such) which is on deposit from other banks and big players to deal with. Say you’ve got major bank A and it is holding as part of its asset base certificates of deposits issued by bank C. You see what can happen? See what happens if the banks are allowed to fail? As soon as banks start to lose any confidence in one another’s paper, then you get something like the Herstatt effect where counterparties fail to perform and we get a Depression overnight.”
But Stiglitz, I argued, would do a better job of keeping Main Street’s money whole and the public wouldn’t be left holding the bag for the bankster’s bad behaviors and gambling addictions. But TBD persisted…and he insisted that there’s only one answer: Inflation, and just as fast as we can get it. If housing prices are down 20%, a bout of inflation would blow housing prices back up and fewer people would be ‘upside down’. “Would you miss a $1,500 payment on $100,000 of equity?”
That’s obviously what all the spending frenzy has been about in Washington - getting all that money borrowed and spent into the system. But TBD is not impressed.
‘Look: the problem is that what the government is doing now will work…but it won’t work until we are two or three years down the road…and by then, the whole country will be beggared.”
“We agree that the only way to fight incipient deflation is with a countermeasure of slightly greater inflation but all the spending coming out of Washington so far has been far to slow-acting to save us - 18-months at best. You saw what happened in the mortgage bonds last week?”
Since I don’t sit on a trading desk, and I’ve had the good sense to be parked in Treasuries, I had to answer “No.”
“Well, we had about a billion dollars worth of mortgage bonds come through and even though they were mostly option ARM’s, the yields were pushing 25%. Remember where they were the last time we talked?”
“Yeah…weren’t option ARM’s down around between 15 and 20 percent?”
“Exactly. And that was what, two months back? You see what’s happening? Things are getting worse, not better in the market.
I’ll give you and even more frightening example…let’s look at triple A commercial paper…uh…here’s an 8 1/2 at 196 over credit swaps…that works out to a 22% yield. 22% for triple A commercial, got it? And it gets worse as you go down the ratings… here’s a single A commercial for 48% yield.
You see how much worse things have gotten?”
Oh, boy, did I ever. “So the market rally on Tuesday isn’t real because if the single A commercial yield translates to a market P/E of what, for the hot money? A P/E of 2 maybe on the S&P 500?
“OMG, so we’d be looking at an S&P down around 200 and at those levels, we might really be back in breadlines and our 401(k)’s and even phat public pension funds would be toast…is that it?”
“You’re close. But in fairness, that single A 48% yield probably has some defaults priced in, so maybe after those, the market’s thinking the yield will be more like 33%.”
“But that still means a price/earnings ratio equivalent for the major stock indices around 3 in order to compete with the fixed income gang! I haven’t looked at the P/E of the Dow lately, but I’d bet it’s still north of 15 since everybody and their grandmother has been whacking earnings forecasts. Have we, like, passed the point of no return where it blows up into Depression 2.0 no matter what the policrats do?”
“Basically, unless they follow the plan I’ve laid out - and do so instantly, yes.
The only way to really fix this is for the President to declare a financial emergency and give mandate everyone in the whole country gets a 10% mandatory wage increase for all workers….
Of course, there would be hardship exceptions for businesses with a high labor component, so outfits like restaurants could lose money and bill the government for their losses and make a little dough. But we need money in the system yesterday to spin around from the developing deflation dynamics.”
“Hold it…Bond Dude…the last time you pitched me this idea a couple of months back it would only take a 5% mandatory wage hike. What happened?”
“Things have gotten worse. The fixed income yields are still climbing, as I explained, and thanks to government doing the wrong thing, the cost of saving the system keeps going up. Two months ago my solution would have cost maybe $100-150-billion - and it would have saved a pile of foreclosures because home prices would be stabilized and climbing again.
Since no one is paying attention and the interest clock is ticking, the cost has probably doubled to the $300 - $350-billion range. And it’s spreading into the primes now because banks aren’t lending, and with home values falling, the 5% of the prime pool that has to move every year for work reasons, can’t do so.
So here’s the hard part: what do you want? The alternatives are mandate 10% inflation now and that gets us further on the road to socialism on the one hand, or would you prefer to have the deflation dynamic build for another 18 to 24-months, have all those foreclosed homes picked up for pennies on the dollar and have a kind of New Landlord Feudalism on the other? Maybe those new Landlords will be Chinese repatriating some of their Treasuries, you think?”
Sadly, he’s probably right. If interbank holdings are large enough, then yes, maybe ‘too big to fail’ just might be true…
“And you know that would impact every bank, insurance company, and pension fund, which would then have to be made whole, too, right?
That’s the problem: Government’s doing something - it’s just the wrong something because it’s going to be too slow. We need inflation right now and without it, deflation is going to keep whacking us…”
“In spite of markets like today’s?”
“Yup.”
I then asked The Bond Dude why his helicopter and Gulfstream class friends haven’t sent him to DC to fix the problem. But I already knew the answer: Like me, he’s probably offended both sides of the political aisle to such an extent that they won’t return calls…even though more often than not, we turn out being right in the end.
—-
Having gotten thoroughly bummed out by that call, I dialed my friend Robin Landry who manages his client accounts from his office sensibly located in Shawnee Oklahoma, to see how his trip out to Vegas was last week and to ask him is this our long awaited rally catching fire?
“Probably not. This looks like it’s just Wave 4 of the 5th wave down which should still reach my target around 6,000 plus or minus a couple of couple points. The thing to watch as the next decline starts is if the breadth indicators get worse than they were in the preceding rally. If so, then even the 6,000 +/- 200 area will not hold.
The concern rises because some of the indicators that I use are not confirming that the wave that we’ve just had, before this rally, is really the third wave. Thus, leaving open the possibility that the market decline is extending itself to the downside.”
“So if that his how it unfolds, how soon would we be able to see it, and just how far down is do we go… I’m asking because the predictive linguistics guys are hinting that we may not see much of a rally this spring…and I’ve been watching since mid-December hoping to make a whole pile of money in gold and oil options in what should be a rally real quick, or to play some long-side stock index options…”
“If the indicators do show that the market is extending downward, then the possibility is that the rally from the November low of ‘08 to January ‘09 was not a fourth wave, but was in fact B wave or a wave 2, and we are already in the larger third wave down.
If that is the case, and by the way, even though I don’t think so — yet — but the concern is there due to some of the indicator readings — there really is no stopping point until the 4,300-4,400 line in my (Dow) work, and that would just be an area where we would get another bounce before working even lower from there.
The danger on the downside I believe is not understood by 99% of the investing public. There is still too much faith in the government’s ability to manage the economy and the stock market.
The psychological aspect that I believe is in charge here, of what we are going through right now, is that the average citizen has seen so much wealth destroyed that they are reverting back to using common sense in their day-to-day activities, i.e. buying only what they can afford and heaven forbid, starting to save money, instead of spending it. …the exact opposite of what the government is trying to tell you to do.
Thus the government policies, in my humble opinion, are doomed to fail and are like pushing on the proverbial string. Self-survival will cause people to do what’s best for them and not what the government wants them to do.”
So this morning, taking in all the inputs: Frank on the up-tick rule, The Bond Dude on competing yields for ‘hot money’ going into fixed incomes, and Landry’s system of analyzing markets which he’s been perfecting since 1976…it all smells like a little follow through at the open and a run this morning toward 6,979 plus or minus a Happy Meal, and then I’d expect another free-fall.
Or, we could go to 7,404 before free-falling again. But, it would take a day or two over 7,404 to convert Landry - or me for that matter - into believing the alternate wave count that would label the last week or two’s downside as a failed fifth and we are going into the long awaited (since mid-December) Fourth Wave.
If it turns out to be a failed fifth, I will have missed my ideal long side entry. But I don’t think so…at least not yet. So I will sit back and watch and wait; glad I’m not in the business of giving investment advice on your own there. Mid-session reversals, anyone?
For what it’s worth, Pacific Investment Management (PIMCO) has joined Warren Buffett and Dr. Doom Marc Faber is predicting an uptick for inflation.
But the problem is, like The Bond Dude explained, it’s probably too little inflation to keep us out of the soup lines. So for now, you might be praying for inflation and be pleased when you get it because it will keep your home price from collapsing and (if you’ve been paying attention) that garden I told you to plant this year will hedge you against higher food prices when inflation arrives and might even get you a little exercise for a change.
dinsdag 3 maart 2009
How to survive the coming century
Alligators basking off the English coast; a vast Brazilian desert; the mythical lost cities of Saigon, New Orleans, Venice and Mumbai; and 90 per cent of humanity vanished. Welcome to the world warmed by 4 °C. Clearly this is a vision of the future that no one wants, but it might happen. Fearing that the best efforts to curb greenhouse gas emissions may fail, or that planetary climate feedback mechanisms will accelerate warming, some scientists and economists are considering not only what this world of the future might be like, but how it could sustain a growing human population. They argue that surviving in the kinds of numbers that exist today, or even more, will be possible, but only if we use our uniquely human ingenuity to cooperate as a species to radically reorganise our world.
The good news is that the survival of humankind itself is not at stake: the species could continue if only a couple of hundred individuals remained. But maintaining the current global population of nearly 7 billion, or more, is going to require serious planning. Four degrees may not sound like much - after all, it is less than a typical temperature change between night and day. It might sound quite pleasant, like moving to Florida from Boston, say, or retiring from the UK to southern Spain. An average warming of the entire globe by 4 °C is a very different matter, however, and would render the planet unrecognisable from anything humans have ever experienced. Indeed, human activity has and will have such a great impact that some have proposed describing the time from the 18th century onward as a new geological era, marked by human activity. "It can be considered the Anthropocene," says Nobel prizewinning atmospheric chemist Paul Crutzen of the Max Planck Institute for Chemistry in Mainz, Germany.
A 4 °C rise could easily occur. The 2007 report of the Intergovernmental Panel on Climate Change, whose conclusions are generally accepted as conservative, predicted a rise of anywhere between 2 °C and 6.4 °C this century. And in August 2008, Bob Watson, former chair of the IPCC, warned that the world should work on mitigation and adaptation strategies to "prepare for 4 °C of warming". A key factor in how well we deal with a warmer world is how much time we have to adapt. When, and if, we get this hot depends not only on how much greenhouse gas we pump into the atmosphere and how quickly, but how sensitive the world's climate is to these gases. It also depends whether "tipping points" are reached, in which climate feedback mechanisms rapidly speed warming. According to models, we could cook the planet by 4 °C by 2100. Some scientists fear that we may get there as soon as 2050. If this happens, the ramifications for life on Earth are so terrifying that many scientists contacted for this article preferred not to contemplate them, saying only that we should concentrate on reducing emissions to a level where such a rise is known only in nightmares.
"Climatologists tend to fall into two camps: there are the cautious ones who say we need to cut emissions and won't even think about high global temperatures; and there are the ones who tell us to run for the hills because we're all doomed," says Peter Cox, who studies the dynamics of climate systems at the University of Exeter, UK. "I prefer a middle ground. We have to accept that changes are inevitable and start to adapt now." Bearing in mind that a generation alive today might experience the scary side of these climate predictions, let us head bravely into this hotter world and consider whether and how we could survive it with most of our population intact. What might this future hold? The last time the world experienced temperature rises of this magnitude was 55 million years ago, after the so-called Palaeocene-Eocene Thermal Maximum event. Then, the culprits were clathrates - large areas of frozen, chemically caged methane - which were released from the deep ocean in explosive belches that filled the atmosphere with around 5 gigatonnes of carbon. The already warm planet rocketed by 5 or 6 °C, tropical forests sprang up in ice-free polar regions, and the oceans turned so acidic from dissolved carbon dioxide that there was a vast die-off of sea life. Sea levels rose to 100 metres higher than today's and desert stretched from southern Africa into Europe.
While the exact changes would depend on how quickly the temperature rose and how much polar ice melted, we can expect similar scenarios to unfold this time around. The first problem would be that many of the places where people live and grow food would no longer be suitable for either. Rising sea levels - from thermal expansion of the oceans, melting glaciers and storm surges - would drown today's coastal regions in up to 2 metres of water initially, and possibly much more if the Greenland ice sheet and parts of Antarctica were to melt. "It's hard to see west Antarctica's ice sheets surviving the century, meaning a sea-level rise of at least 1 or 2 metres," says climatologist James Hansen, who heads NASA's Goddard Institute for Space Studies in New York. "CO2 concentrations of 550 parts per million [compared with about 385 ppm now] would be disastrous," he adds, "certainly leading to an ice-free planet, with sea level about 80 metres higher... and the trip getting there would be horrendous."
Half of the world's surface lies in the tropics, between 30° and -30° latitude, and these areas are particularly vulnerable to climate change. India, Bangladesh and Pakistan, for example, will feel the force of a shorter but fiercer Asian monsoon, which will probably cause even more devastating floods than the area suffers now. Yet because the land will be hotter, this water will evaporate faster, leaving drought across Asia. Bangladesh stands to lose a third of its land area - including its main bread basket. The African monsoon, although less well understood, is expected to become more intense, possibly leading to a greening of the semi-arid Sahel region, which stretches across the continent south of the Sahara desert. Other models, however, predict a worsening of drought all over Africa. A lack of fresh water will be felt elsewhere in the world, too, with warmer temperatures reducing soil moisture across China, the south-west US, Central America, most of South America and Australia.
All of the world's major deserts are predicted to expand, with the Sahara reaching right into central Europe. Glacial retreat will dry Europe's rivers from the Danube to the Rhine, with similar effects in mountainous regions including the Peruvian Andes, and the Himalayan and Karakoram ranges, which as result will no longer supply water to Afghanistan, Pakistan, China, Bhutan, India and Vietnam. Along with the exhaustion of aquifers, all this will lead to two latitudinal dry belts where human habitation will be impossible, say Syukuro Manabe of Tokyo University, Japan, and his colleagues. One will stretch across Central America, southern Europe and north Africa, south Asia and Japan; while the other will cover Madagascar, southern Africa, the Pacific Islands, and most of Australia and Chile.
The only places we will be guaranteed enough water will be in the high latitudes. "Everything in that region will be growing like mad. That's where all the life will be," says former NASA scientist James Lovelock, who developed the "Gaia" theory, which describes the Earth as a self-regulating entity. "The rest of the world will be largely desert with a few oases." So if only a fraction of the planet will be habitable, how will our vast population survive? Some, like Lovelock, are less than optimistic. "Humans are in a pretty difficult position and I don't think they are clever enough to handle what's ahead. I think they'll survive as a species all right, but the cull during this century is going to be huge," he says. "The number remaining at the end of the century will probably be a billion or less."
John Schellnhuber of the Potsdam Institute for Climate Impacts Research in Germany is more hopeful. The 4 °C warmer world would be a huge challenge, he says, but one we could rise to. "Would we be able to live within our resources, in this world? I think it could work with a new division of land and production."
In order to survive, humans may need to do something radical: rethink our society not along geopolitical lines but in terms of resource distribution. "We are locked into a mindset that each country has to be self-sustaining in food, water and energy," Cox says. "We need to look at the world afresh and see it in terms of where the resources are, and then plan the population, food and energy production around that. If aliens came to Earth they'd think it was crazy that some of the driest parts of the world, such as Pakistan and Egypt, grow some of the thirstiest crops for export, like rice."
Taking politics out of the equation may seem unrealistic: conflict over resources will likely increase significantly as the climate changes, and political leaders are not going to give up their power just like that. Nevertheless, overcoming political hurdles may be our only chance. "It's too late for us," says President Anote Tong of Kiribati, a submerging island state in Micronesia, which has a programme of gradual migration to Australia and New Zealand. "We need to do something drastic to remove national boundaries." Cox agrees: "If it turns out that the only thing preventing our survival was national barriers then we would need to address this - our survival is too important," he says.
Imagine, for the purposes of this thought experiment, that we have 9 billion people to save - 2 billion more than live on the planet today. A wholescale relocation of the world's population according to the geography of resources means abandoning huge tracts of the globe and moving people to where the water is. Most climate models agree that the far north and south of the planet will see an increase in precipitation. In the northern hemisphere this includes Canada, Siberia, Scandinavia and newly ice-free parts of Greenland; in the southern hemisphere, Patagonia, Tasmania and the far north of Australia, New Zealand and perhaps newly ice-free parts of the western Antarctic coast.
If we allow 20 square metres of space per person - more than double the minimum habitable space allowed per person under English planning regulations - 9 million people would need 18,000 square kilometres of land to live on. The area of Canada alone is 9.1 million square kilometres and, combined with all the other high-latitude areas, such as Alaska, Britain, Russia and Scandinavia, there should be plenty of room for everyone, even with the effects of sea-level rise.
These precious lands with access to water would be valuable food-growing areas, as well as the last oases for many species, so people would be need to be housed in compact, high-rise cities. Living this closely together will bring problems of its own. Disease could easily spread through the crowded population so early warning systems will be needed to monitor any outbreaks.
It may also get very hot. Cities can produce 2 °C of additional localised warming because of energy use and things like poor reflectivity of buildings and lower rates of evaporation from concrete surfaces, says Mark McCarthy, an urban climate modeller at the UK Met Office's Hadley Centre. "The roofs could be painted a light, reflective colour and planted with vegetation," McCarthy suggests. Since water will be scarce, food production will need to be far more efficient. Hot growing seasons will be more common, meaning that livestock will become increasingly stressed, and crop growing seasons will shorten, according to David Battisti of the University of Washington in Seattle and his colleagues. We will need heat and drought-tolerant crop varieties, they suggest. Rice may have to give way to less thirsty staples such as potatoes.
This will probably be a mostly vegetarian world: the warming, acidic seas will be largely devoid of fish, thanks to a crash in plankton that use calcium carbonate to build shells. Molluscs, also unable to grow their carbonate shells, will become extinct. Poultry may be viable on the edges of farmland but there will simply be no room to graze cattle. Livestock may be restricted to hardy animals such as goats, which can survive on desert scrub. One consequence of the lack of cattle will be a need for alternative fertilisers - processed human waste is a possibility. Synthetic meats and other foods could meet some of the demand. Cultivation of algal mats, and crops grown on floating platforms and in marshland could also contribute.
Supplying energy to our cities will also require some adventurous thinking. Much of it could be covered by a giant solar belt, a vast array of solar collectors that would run across north Africa, the Middle East and the southern US. Last December, David Wheeler and Kevin Ummel of the Center for Global Development in Washington DC calculated that a 110,000-square-kilometre area of solar panels across Jordan, Libya and Morocco would be "sufficient to meet 50 to 70 per cent of worldwide electricity production, or about three times [today's] power consumption in Europe". High-voltage direct current transmission lines could relay this power to the cities, or it could be stored and transported in hydrogen - after using solar energy to split water in fuel cells.
If the comparatively modest level of solar installation that Wheeler and Ummel propose were to begin in 2010, the total power delivery by 2020 could be 55 terawatt hours per year - enough to meet the household electricity demand of 35 million people. This is clearly not enough to provide power for our future 9 billion, but improving efficiency would reduce energy consumption. And a global solar belt would be far larger than the one Wheeler and Ummel visualise.
Nuclear, wind and hydropower could supplement output, with additional power from geothermal and offshore wind sources. Each high-rise community housing block could also have its own combined heat and power generator, running on sustainable sources, to supply most household energy.
If we use land, energy, food and water efficiently, our population has a chance of surviving - provided we have the time and willingness to adapt. "I'm optimistic that we can reduce catastrophic loss of life and reduce the most severe impacts," says Peter Falloon, a climate impacts specialist at the Hadley Centre. "I think there's enough knowledge now, and if it's used sensibly we could adapt to the climate change that we're already committed to for the next 30 or 40 years." This really would be survival, though, in a world that few would choose to live. Large chunks of Earth's biodiversity would vanish because species won't be able to adapt quickly enough to higher temperatures, lack of water, loss of ecosystems, or because starving humans had eaten them. "You can forget lions and tigers: if it moves we'll have eaten it," says Lovelock. "People will be desperate."
Still, if we should find ourselves in such a state you can bet we'd be working our hardest to get that green and pleasant world back, and to prevent matters getting even worse. This would involve trying to limit the effects climate feedback mechanisms and restoring natural carbon sequestration by reinstating tropical forest. "Our survival would very much depend on how well we were able to draw down CO2 to 280 parts per million," Schellnhuber says. Many scientists think replanting the forests would be impossible above a certain temperature, but it may be possible to reforest areas known as "land-atmosphere hotspots", where even small numbers of trees can change the local climate enough to increase rainfall and allow forests to grow.
Ascension Island, a remote outpost buffeted by trade winds in the mid-Atlantic, may be a blueprint for this type of bioengineering. Until people arrived in the 17th century, vegetation was limited to just 25 scrubby species. But plantings by British servicemen posted there produced a verdant cloud forest. "It shows that if you have rainfall, forest can grow within a century," says ecologist David Wilkinson of Liverpool John Moores University in the UK, who studied the phenomenon. Even so, the most terrifying prospect of a world warmed by 4 °C is that it may be impossible to return to anything resembling today's varied and abundant Earth. Worse still, most models agree that once there is a 4 °C rise, the juggernaut of warming will be unstoppable, and humanity's fate more uncertain than ever. "I would like to be optimistic that we'll survive, but I've got no good reason to be," says Crutzen. "In order to be safe, we would have to reduce our carbon emissions by 70 per cent by 2015. We are currently putting in 3 per cent more each year."
The good news is that the survival of humankind itself is not at stake: the species could continue if only a couple of hundred individuals remained. But maintaining the current global population of nearly 7 billion, or more, is going to require serious planning. Four degrees may not sound like much - after all, it is less than a typical temperature change between night and day. It might sound quite pleasant, like moving to Florida from Boston, say, or retiring from the UK to southern Spain. An average warming of the entire globe by 4 °C is a very different matter, however, and would render the planet unrecognisable from anything humans have ever experienced. Indeed, human activity has and will have such a great impact that some have proposed describing the time from the 18th century onward as a new geological era, marked by human activity. "It can be considered the Anthropocene," says Nobel prizewinning atmospheric chemist Paul Crutzen of the Max Planck Institute for Chemistry in Mainz, Germany.
A 4 °C rise could easily occur. The 2007 report of the Intergovernmental Panel on Climate Change, whose conclusions are generally accepted as conservative, predicted a rise of anywhere between 2 °C and 6.4 °C this century. And in August 2008, Bob Watson, former chair of the IPCC, warned that the world should work on mitigation and adaptation strategies to "prepare for 4 °C of warming". A key factor in how well we deal with a warmer world is how much time we have to adapt. When, and if, we get this hot depends not only on how much greenhouse gas we pump into the atmosphere and how quickly, but how sensitive the world's climate is to these gases. It also depends whether "tipping points" are reached, in which climate feedback mechanisms rapidly speed warming. According to models, we could cook the planet by 4 °C by 2100. Some scientists fear that we may get there as soon as 2050. If this happens, the ramifications for life on Earth are so terrifying that many scientists contacted for this article preferred not to contemplate them, saying only that we should concentrate on reducing emissions to a level where such a rise is known only in nightmares.
"Climatologists tend to fall into two camps: there are the cautious ones who say we need to cut emissions and won't even think about high global temperatures; and there are the ones who tell us to run for the hills because we're all doomed," says Peter Cox, who studies the dynamics of climate systems at the University of Exeter, UK. "I prefer a middle ground. We have to accept that changes are inevitable and start to adapt now." Bearing in mind that a generation alive today might experience the scary side of these climate predictions, let us head bravely into this hotter world and consider whether and how we could survive it with most of our population intact. What might this future hold? The last time the world experienced temperature rises of this magnitude was 55 million years ago, after the so-called Palaeocene-Eocene Thermal Maximum event. Then, the culprits were clathrates - large areas of frozen, chemically caged methane - which were released from the deep ocean in explosive belches that filled the atmosphere with around 5 gigatonnes of carbon. The already warm planet rocketed by 5 or 6 °C, tropical forests sprang up in ice-free polar regions, and the oceans turned so acidic from dissolved carbon dioxide that there was a vast die-off of sea life. Sea levels rose to 100 metres higher than today's and desert stretched from southern Africa into Europe.
While the exact changes would depend on how quickly the temperature rose and how much polar ice melted, we can expect similar scenarios to unfold this time around. The first problem would be that many of the places where people live and grow food would no longer be suitable for either. Rising sea levels - from thermal expansion of the oceans, melting glaciers and storm surges - would drown today's coastal regions in up to 2 metres of water initially, and possibly much more if the Greenland ice sheet and parts of Antarctica were to melt. "It's hard to see west Antarctica's ice sheets surviving the century, meaning a sea-level rise of at least 1 or 2 metres," says climatologist James Hansen, who heads NASA's Goddard Institute for Space Studies in New York. "CO2 concentrations of 550 parts per million [compared with about 385 ppm now] would be disastrous," he adds, "certainly leading to an ice-free planet, with sea level about 80 metres higher... and the trip getting there would be horrendous."
Half of the world's surface lies in the tropics, between 30° and -30° latitude, and these areas are particularly vulnerable to climate change. India, Bangladesh and Pakistan, for example, will feel the force of a shorter but fiercer Asian monsoon, which will probably cause even more devastating floods than the area suffers now. Yet because the land will be hotter, this water will evaporate faster, leaving drought across Asia. Bangladesh stands to lose a third of its land area - including its main bread basket. The African monsoon, although less well understood, is expected to become more intense, possibly leading to a greening of the semi-arid Sahel region, which stretches across the continent south of the Sahara desert. Other models, however, predict a worsening of drought all over Africa. A lack of fresh water will be felt elsewhere in the world, too, with warmer temperatures reducing soil moisture across China, the south-west US, Central America, most of South America and Australia.
All of the world's major deserts are predicted to expand, with the Sahara reaching right into central Europe. Glacial retreat will dry Europe's rivers from the Danube to the Rhine, with similar effects in mountainous regions including the Peruvian Andes, and the Himalayan and Karakoram ranges, which as result will no longer supply water to Afghanistan, Pakistan, China, Bhutan, India and Vietnam. Along with the exhaustion of aquifers, all this will lead to two latitudinal dry belts where human habitation will be impossible, say Syukuro Manabe of Tokyo University, Japan, and his colleagues. One will stretch across Central America, southern Europe and north Africa, south Asia and Japan; while the other will cover Madagascar, southern Africa, the Pacific Islands, and most of Australia and Chile.
The only places we will be guaranteed enough water will be in the high latitudes. "Everything in that region will be growing like mad. That's where all the life will be," says former NASA scientist James Lovelock, who developed the "Gaia" theory, which describes the Earth as a self-regulating entity. "The rest of the world will be largely desert with a few oases." So if only a fraction of the planet will be habitable, how will our vast population survive? Some, like Lovelock, are less than optimistic. "Humans are in a pretty difficult position and I don't think they are clever enough to handle what's ahead. I think they'll survive as a species all right, but the cull during this century is going to be huge," he says. "The number remaining at the end of the century will probably be a billion or less."
John Schellnhuber of the Potsdam Institute for Climate Impacts Research in Germany is more hopeful. The 4 °C warmer world would be a huge challenge, he says, but one we could rise to. "Would we be able to live within our resources, in this world? I think it could work with a new division of land and production."
In order to survive, humans may need to do something radical: rethink our society not along geopolitical lines but in terms of resource distribution. "We are locked into a mindset that each country has to be self-sustaining in food, water and energy," Cox says. "We need to look at the world afresh and see it in terms of where the resources are, and then plan the population, food and energy production around that. If aliens came to Earth they'd think it was crazy that some of the driest parts of the world, such as Pakistan and Egypt, grow some of the thirstiest crops for export, like rice."
Taking politics out of the equation may seem unrealistic: conflict over resources will likely increase significantly as the climate changes, and political leaders are not going to give up their power just like that. Nevertheless, overcoming political hurdles may be our only chance. "It's too late for us," says President Anote Tong of Kiribati, a submerging island state in Micronesia, which has a programme of gradual migration to Australia and New Zealand. "We need to do something drastic to remove national boundaries." Cox agrees: "If it turns out that the only thing preventing our survival was national barriers then we would need to address this - our survival is too important," he says.
Imagine, for the purposes of this thought experiment, that we have 9 billion people to save - 2 billion more than live on the planet today. A wholescale relocation of the world's population according to the geography of resources means abandoning huge tracts of the globe and moving people to where the water is. Most climate models agree that the far north and south of the planet will see an increase in precipitation. In the northern hemisphere this includes Canada, Siberia, Scandinavia and newly ice-free parts of Greenland; in the southern hemisphere, Patagonia, Tasmania and the far north of Australia, New Zealand and perhaps newly ice-free parts of the western Antarctic coast.
If we allow 20 square metres of space per person - more than double the minimum habitable space allowed per person under English planning regulations - 9 million people would need 18,000 square kilometres of land to live on. The area of Canada alone is 9.1 million square kilometres and, combined with all the other high-latitude areas, such as Alaska, Britain, Russia and Scandinavia, there should be plenty of room for everyone, even with the effects of sea-level rise.
These precious lands with access to water would be valuable food-growing areas, as well as the last oases for many species, so people would be need to be housed in compact, high-rise cities. Living this closely together will bring problems of its own. Disease could easily spread through the crowded population so early warning systems will be needed to monitor any outbreaks.
It may also get very hot. Cities can produce 2 °C of additional localised warming because of energy use and things like poor reflectivity of buildings and lower rates of evaporation from concrete surfaces, says Mark McCarthy, an urban climate modeller at the UK Met Office's Hadley Centre. "The roofs could be painted a light, reflective colour and planted with vegetation," McCarthy suggests. Since water will be scarce, food production will need to be far more efficient. Hot growing seasons will be more common, meaning that livestock will become increasingly stressed, and crop growing seasons will shorten, according to David Battisti of the University of Washington in Seattle and his colleagues. We will need heat and drought-tolerant crop varieties, they suggest. Rice may have to give way to less thirsty staples such as potatoes.
This will probably be a mostly vegetarian world: the warming, acidic seas will be largely devoid of fish, thanks to a crash in plankton that use calcium carbonate to build shells. Molluscs, also unable to grow their carbonate shells, will become extinct. Poultry may be viable on the edges of farmland but there will simply be no room to graze cattle. Livestock may be restricted to hardy animals such as goats, which can survive on desert scrub. One consequence of the lack of cattle will be a need for alternative fertilisers - processed human waste is a possibility. Synthetic meats and other foods could meet some of the demand. Cultivation of algal mats, and crops grown on floating platforms and in marshland could also contribute.
Supplying energy to our cities will also require some adventurous thinking. Much of it could be covered by a giant solar belt, a vast array of solar collectors that would run across north Africa, the Middle East and the southern US. Last December, David Wheeler and Kevin Ummel of the Center for Global Development in Washington DC calculated that a 110,000-square-kilometre area of solar panels across Jordan, Libya and Morocco would be "sufficient to meet 50 to 70 per cent of worldwide electricity production, or about three times [today's] power consumption in Europe". High-voltage direct current transmission lines could relay this power to the cities, or it could be stored and transported in hydrogen - after using solar energy to split water in fuel cells.
If the comparatively modest level of solar installation that Wheeler and Ummel propose were to begin in 2010, the total power delivery by 2020 could be 55 terawatt hours per year - enough to meet the household electricity demand of 35 million people. This is clearly not enough to provide power for our future 9 billion, but improving efficiency would reduce energy consumption. And a global solar belt would be far larger than the one Wheeler and Ummel visualise.
Nuclear, wind and hydropower could supplement output, with additional power from geothermal and offshore wind sources. Each high-rise community housing block could also have its own combined heat and power generator, running on sustainable sources, to supply most household energy.
If we use land, energy, food and water efficiently, our population has a chance of surviving - provided we have the time and willingness to adapt. "I'm optimistic that we can reduce catastrophic loss of life and reduce the most severe impacts," says Peter Falloon, a climate impacts specialist at the Hadley Centre. "I think there's enough knowledge now, and if it's used sensibly we could adapt to the climate change that we're already committed to for the next 30 or 40 years." This really would be survival, though, in a world that few would choose to live. Large chunks of Earth's biodiversity would vanish because species won't be able to adapt quickly enough to higher temperatures, lack of water, loss of ecosystems, or because starving humans had eaten them. "You can forget lions and tigers: if it moves we'll have eaten it," says Lovelock. "People will be desperate."
Still, if we should find ourselves in such a state you can bet we'd be working our hardest to get that green and pleasant world back, and to prevent matters getting even worse. This would involve trying to limit the effects climate feedback mechanisms and restoring natural carbon sequestration by reinstating tropical forest. "Our survival would very much depend on how well we were able to draw down CO2 to 280 parts per million," Schellnhuber says. Many scientists think replanting the forests would be impossible above a certain temperature, but it may be possible to reforest areas known as "land-atmosphere hotspots", where even small numbers of trees can change the local climate enough to increase rainfall and allow forests to grow.
Ascension Island, a remote outpost buffeted by trade winds in the mid-Atlantic, may be a blueprint for this type of bioengineering. Until people arrived in the 17th century, vegetation was limited to just 25 scrubby species. But plantings by British servicemen posted there produced a verdant cloud forest. "It shows that if you have rainfall, forest can grow within a century," says ecologist David Wilkinson of Liverpool John Moores University in the UK, who studied the phenomenon. Even so, the most terrifying prospect of a world warmed by 4 °C is that it may be impossible to return to anything resembling today's varied and abundant Earth. Worse still, most models agree that once there is a 4 °C rise, the juggernaut of warming will be unstoppable, and humanity's fate more uncertain than ever. "I would like to be optimistic that we'll survive, but I've got no good reason to be," says Crutzen. "In order to be safe, we would have to reduce our carbon emissions by 70 per cent by 2015. We are currently putting in 3 per cent more each year."
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