something old, something new, something borrowed, now we’re blue

Pimco’s McCulley does a rather good dissection of the shadow banking system, and aside for the conclusion that the Fed should be the ultimate controller of everything, we believe it is a worthwhile read. We obviously disagree with McCulley on his view of the Fed – the Chairman is simply far too political, incompetent (don’t make us take out all the clips of Bernanke rehashing the Moody’s model and claiming housing was going up in perpetuity) secretive and in the big banks’ pocket, which explains why Pimco of course is a fan, with its $1 trillion + dollars in AUM. A systemic change in which the precarious financial balance is toppled would simply wipe it off the face of Fashion Island overnight. That said, McCulley’s other points are worth reading as he does the shadow banking system justice, specifically explaining how it is a $3 trillion Frankensteinian time bomb construct of the Keynesian religion that it is just awaiting to go off and wipe out the bulk of US deposits in one fell swoop.

——————————————————————————–

After the Crisis: Planning a New Financial Structure

Based on Comments Before the 19th Annual Hyman Minsky Conference on the
State of the U.S. and World Economies

April 15, 2010

Thank you very much. It is an absolute pleasure and honor to be here. I gave the keynote a couple years ago and it was my first time to be at the Minsky Conference. I feel that I’m part of a church, and it’s a good church in that we’re on the right side of history. And it’s absolutely wonderful to be attending services with you again.
I want to open up with a little story that should make everybody in the room feel particularly good, and then we’ll get into discussing economics. Harry Markowitz has been a friend of mine for about a decade. I became friends with Harry through two channels. Number one, Rob Arnott of Research Affiliates has an Advisory Panel of famous academics, such as Harry and Jack Treynor, that he gets together every year. I’m frequently invited to speak. We spend two or three days over a weekend together. I’ve also gotten to know Harry because he and the late great Peter Bernstein were very close friends. Peter and I were also very close friends.

I’ve been preaching the Minsky Framework at Rob’s event for a number of years. And Harry’s always been very, very polite. I spoke again just this past Sunday morning. After I finished, we had a nice Q&A. And Harry said, “Paul, if I had to read one book by Minsky, which one would it be?” And I said, “Harry, please, tell me that you’ve read at least one book by Minsky.” And he says, “No, I haven’t, but I think I would like to, and I think I’m probably old enough now.”

I promised Harry that I would send him one personally. And I’m quite sure that if I don’t follow up on that, somebody at the Levy Institute would gladly follow up. So, the bottom line is that one of the fathers of the Efficient Market Hypothesis has finally decided to attend services at the Church of Minsky. I think that is a glorious, glorious moment. Don’t you? Harry is an absolutely delightful man.

From the standpoint of what I want to talk about tonight, a great deal of it has already been discussed today. I feel a little bit like St. Louis Federal Reserve President Jim Bullard did at lunch when he said that Paul Krugman, who spoke just before Jim, had already given 90% of his speech. That’s basically true for me as well. Paul’s speech was superb, laying out six possible culprits in the financial crisis.1

I want to focus on Paul’s Number 3, the Shadow Banking System. Paul was drawing a lot of his comments today from the work of Professor Gary Gorton of Yale, which is absolutely fantastic material. Have a lot of you read Gary’s essay, “Slapped in the Face by the Invisible Hand”?2 I see a lot of nods here. That’s where the phrase that Paul used, “Quiet Period,” came from. Gary coined it. He’d be a great person to have here next year at the Minsky Conference.

And one of the fascinating things that he details is the nature of banking. That’s where I want to start tonight. Let’s start with first principles. If we do, then I think we can understand why we shouldn’t look at the conventional banking system and the Shadow Banking System as separate beasts, but intertwined beasts.

The essence, or the genius of banking, not just now, the last century or the century before that, but since time immemorial, is that the public’s ex-ante demand for assets that trade on demand at par is greater than the public’s ex-post demand for these types of assets. Let me repeat this, because this is a first principle: The public’s ex-ante demand for liquidity at par is greater than the public’s ex-post demand. Therefore, we can have banking systems because they can meet the ex-ante demand, but never have to pony up ex-post. In turn, the essence or the genius of banking is maturity, liquidity and quality transformation: holding assets that are longer, less liquid and of lower quality than the funding liabilities.

A second principle: A banking system is solvent only if it is believed by the public to be a going concern. By definition, if the public’s ex-post demand for liquidity at par proves to be equal to its ex-ante demand, a banking system is insolvent because a banking system ends up, at its core, promising something it cannot deliver. Everyone following me here?

Professor Gorton, in his paper, goes through how that promise was dealt with during the 19th century, before the New Deal Era. There were panics all the time, otherwise known as runs, because we didn’t have a lender of last resort and we didn’t have deposit insurance. During the 19th century, the system dealt with its reoccurring panics in lots of novel ways, including clearing houses which would de facto be a central bank, and suspension of convertibility of deposits into cash. So the problems we’ve been dealing with in the last couple of years are not new. They go back to the origin of banking.

The Quiet Period, from the New Deal Era until the Panic of 2007, was actually unique in history. And the Quiet Period came about, I think, for a lot of the reasons that were articulated earlier today in that banks, conventional banks, after the Great Depression, were considered to be special. And, in fact, banks are special. If you think that the banking system can be guided to stability as if by an invisible hand, then you are deluding yourself. But, that is, in fact, what happened with the explosive growth of the Shadow Banking System.

Banking is a really profitable business. In its most simple form, think in terms of a bank issuing demand deposits, which are guaranteed to trade at par because they’ve got FDIC insurance around them and also because the issuing bank can rediscount its assets at the Fed in order to redeem deposits in old-fashioned money, also known as currency.

In fact, let’s take a look at the $1 bill I am holding in my hand. It says right at the very top, “Federal Reserve Note.” It also says right down here, “This note is legal tender for all debts, public and private.” This is what the public ex-ante wants: the knowledge that they can turn their deposits into these Federal Reserve Notes. And if the public knows they can turn them into these notes, they don’t. With me here? If I know I can, I don’t.

Now, this is a unique note. This is a Federal Reserve liability. And, actually, it’s really cool. It’s missing two things. It doesn’t have a maturity date on it. So, it’s perpetual. And it doesn’t have an interest rate on it. I would love to be able to issue these things. It would make me very, very happy to issue these things. But it would be against the law! But, in fact, that’s what banks did in the 19th century. They issued currency. After the creation of the Federal Reserve, it was given monopoly power to create currency, which I think was a pretty bright idea. But demand deposits issued by banks are just one step away from a Federal Reserve Note.

Conceptually, demand deposits have a one-day maturity. I can write a check on it, and it goes out at par tomorrow, if not today. Demand deposits, conceptually, have a one-day maturity. But in aggregate, they have a perpetual maturity. So, therefore, banking can engage in maturity, liquidity and quality transformation: a very profitable business. Banks can issue, essentially, perpetual liabilities – call them demand deposits – and invest them in longer dated, illiquid loans and securities, earning a net interest margin. It’s a really, really sweet business.

In the early years of the Quiet Period, we regulated that really sweet business. I think that was a really bright idea. In order for that business not to be prone to panics and, therefore, financial crises, you needed to have deposit insurance. Deposit insurance, by definition, cannot come about as if by the invisible hand. Deposit insurance cannot be, cannot be a private sector activity. It is a public good. The deposit insurer must be a subsidiary of the fiscal authority. And in extremis, the monetary authority can monetize the liabilities of the fiscal authority. I’m not saying that pejoratively. I’m not being pejorative at all. Just descriptive. Bottom line: Deposit insurance is inherently a public good.

Access to the Fed’s balance sheet is also inherently a public good, because the Federal Reserve is the only entity that can print currency. So essentially, banking has two public goods associated with it. Therefore, naturally, it should be regulated.

That was the Quiet Period Model. And regulation took the form of what you could do, how you could do it and how much leverage you could use in doing it. And, as was mentioned by Paul Volcker a number of times earlier this afternoon, the regulatory burden that has historically come with being a conventional bank has been actually quite high. During the early years of the Quiet Period, however, banking was nonetheless a very profitable endeavor.

There was a quid pro quo, which actually led to the old joke – which was actually said about the savings and loan industry – that banking was a great job: Take in deposits at 3, lend them out at 6, and be on the golf course at 3. 3-6-3 banking was a pretty nice franchise. So, therefore, bankers had a pretty strong incentive not to mess it up. Essentially, there were oligopoly profits in the business. I think Gary Gorton is actually right on that proposition.

The invisible hand, however, naturally wanted to get the oligopoly profits associated with banking while reducing the impact of some regulation. Thus, the Shadow Banking System came into existence, where the net interest margin associated with maturity, liquidity and quality transformation could be earned on a much smaller capital base.

And, in fact, that’s what happened starting essentially in the mid-1970s, accelerating through the 1980s and 1990s, and then exploding in the first decade of this century.

The birth of the Shadow Banking System required that capitalists be able to come up with an asset – which actually for shadow bankers is a liability – that was perceived by the public as just as good as a bank deposit. Remember, the public has an ex-ante demand for something that trades on demand at par. Therefore, shadow bankers had to be able to persuade the public that its asset – which is actually the shadow banker’s liability – was just as good as the real thing. If they could do that, then they could have one whale of a good time.

That asset – which, again, is the bank’s liability – needed, in Gary Gorton’s terms, to be characterized by “informational insensitivity,” meaning that the holder didn’t need to do any due diligence, just taking it on faith that this asset could be converted at par on demand. And, in fact, money market mutual fund shares achieved that status. With one small exception prior to the Reserve Primary Fund breaking the buck, they always traded at par. And if there was any danger they wouldn’t trade at par, the sponsor would step in and buy out any dodgy asset at par. So, essentially, the money market mutual fund industry was at the very core of the growth of the Shadow Banking System.

It created a liability perceived as just as good as a demand deposit wrapped with deposit insurance, issued by a bank with access to the Fed. It was a great game. But in and of itself, that didn’t lead to the explosive growth in the Shadow Banking System. There needed to be another link in the chain. Yes, money market mutual funds needed an asset that the public perceived as just as good as a bank deposit. But they also had to put something on the other side of the balance sheet.

What went on the other side of the balance sheet? Money market instruments such as repo and commercial paper (CP). And under Rule 2a-7, they were allowed to use accrual accounting for their assets. The assets didn’t have to be marked to market. So, therefore, 2a-7 funds could actually maintain the $1 share price, unless they did something really dumb.

At their peak, money market mutual funds were about $4 trillion. They are about $3 trillion now. They interacted with the larger Shadow Banking System. And the largest shadow banks were the vehicles of investment banks, funded heavily with repo and CP. So, explosive growth of the Shadow Banking System was logically the result of the invisible hand of the marketplace wanting to get the profitability of the regulated banking system, but without the regulation. Shadow banks created information-insensitive assets for the public that were perceived as just as good as a demand deposit, and then levered the daylights out of them into longer, less liquid, lower-quality assets. And it all worked swimmingly well, for a while. But then they embarked on the Forward Minsky Journey.3

Shadow banks were the predominant place where securitizations of subprime mortgages were placed, as well as securitizations of other types of assets. So the Shadow Banking System was, essentially, mirroring the banking model, which had deposits and loans.

Turn the deposit into asset-backed commercial paper. Turn the loan into a security. What you end up with is the same vehicle as a bank from a functional standpoint, but you have it outside the conventional bank regulatory structure. Actually, let me correct myself. There was a de facto regulator in the Shadow Banking System. They are called the rating agencies.

In order to do the trick of creating a shadow bank, you had to have the rating agencies declare that your senior short-dated liabilities were just as good as bank deposits. In fact, most money market mutual funds get themselves rated, and S&P, Moody’s, and Fitch do have particular rules for giving a AAA rating to a 2a-7 money market fund, mirroring SEC Rules. But, for the rest of the Shadow Banking System, the rating agency rules evolved on the fly, often under the guidance of shadow bankers themselves. It didn’t work out very well, as the Shadow Banking System became the lead owner of what was created in the originate-to-distribute model of mortgage creation.

On August 9, 2007, game over. If you have to pick a day for the Minsky Moment, it was August 9. And, actually, it didn’t happen here in the United States. It happened in France, when Paribas Bank (BNP) said that it could not value the toxic mortgage assets in three of its off-balance sheet vehicles, and that, therefore, the liability holders, who thought they could get out at any time, were frozen. I remember the day like my son’s birthday. And that happens every year. Because the unraveling started on that day. In fact, it was later that month that I actually coined the term “Shadow Banking System” at the Fed’s annual symposium in Jackson Hole.

It was only my second year there. And I was in awe, and mainly listened for most of the three days. At the end, Marty Feldstein always does the wrap-up. Everybody wanted to talk. And since I was a newbie, I didn’t say anything until almost the very end. I stood up and (paraphrasing) said, “What’s going on is really simple. We’re having a run on the Shadow Banking System and the only question is how intensely it will self-feed as its assets and liabilities are put back onto the balance sheet of the conventional banking system.”

Now, I certainly didn’t anticipate that it was going to lead to the debacle that eventually unfolded. In fact, while the run commenced on August 9th of 2007, it was pretty much an orderly run up until September 15, 2008. And it was orderly primarily because the Fed – and here I give the Fed credit, not criticism – evoked Section 13-3 of the Federal Reserve Act in March of 2008 in order to facilitate the merger of under-a-run Bear Stearns into JPMorgan. Concurrently, the Fed opened its balance sheet to the biggest shadow banks of all, the investment banks that were primary dealers, including most important, the big five. It was called the Primary Dealer Credit Facility.

I’m sure that was an incredibly difficult decision for the Federal Reserve Board to make – to open its balance sheet to borrowers it didn’t regulate. But it was necessary, because runs are self-feeding; you can’t stop them without the aid of somebody with the ability to print legal tender. That’s the only way you can stop it, because only the Fed can create an asset that will definitionally trade at par in real time. During a run, that’s what the public wants. A run turns upside down the genius of banking. A run is when the public’s ex-post demand for liquidity at par equals its ex-ante demand.

Post-Bear Stearns, financial life regained some sense of normalcy. But then came the run on Lehman Brothers, and the Fed didn’t have the legal power to implement a Bear-like rescue. And then the Reserve Fund broke the buck. That week will be one that we remember for the rest of our lives. It will also be one that we will remember where the Fed was at its finest hour. The Fed created a whole host of facilities to stop the run. In fact, they expanded the Primary Dealer Credit Facility to what are known as Schedule 2 assets, which meant that dealers could rediscount anything at the Fed that they could borrow against in the tri-party repo market.

Concurrently, the FDIC stepped up to the plate, doing two incredibly important things. Number one, they totally uncapped deposit insurance on transaction accounts, which meant that the notion of uninsured depositors in transaction accounts became an oxymoron. If you were in a transaction account, there was no reason to run. And then the FDIC effectively became a monoline insurer to nonbank financials with its Temporary Liquidity Guarantee Program (TGLP) allowing both banks and shadow banks to issue unsecured debt with the full faith and credit of Uncle Sam for a 75 basis points fee. No surprise some $300 billion was issued.

So, bottom line, you had the Fed step up and provide its public good to the Shadow Banking System. You had the FDIC step up and do the same thing with its public good. And as Paul Volcker was noting this afternoon, you had the Treasury step up and provide a similar public good for the money market mutual funds, using the Foreign Exchange Stabilization Fund. It was a triple-thick milk shake of socialism. And it was good. Again, I’m not being pejorative. I’m being descriptive.

Banking is inherently a joint venture between the private sector and the public sector. Banking inherently cannot be a solely capitalistic affair. I put that on the table as an article of fact. And, in fact, speaking at a Minsky Conference, I know I’m preaching to the converted. Big bank and big government are part of our catechism. And, in fact, that’s exactly what came to the fore to save us from Depression 2.0.

Let me draw to a few conclusions. How should we re-regulate the financial landscape – as President Bullard was calling it today – to make sure this doesn’t happen again? We must, because the collateral damage to the global economy has been truly a tragedy.

And I think the first principle is that if what you’re doing is banking, de jure or de facto, then you are in a joint venture with the public sector. Period. If you’re issuing liabilities that are intended to be just as good as a bank deposit, then you will be considered functionally a bank, regardless of the name on your door. That’s the first principle.

Number two, if you engage in these types of activities – call it banking, without making a big distinction here between conventional banking and shadow banking, as Paul Krugman intoned this morning – in such size that you pose systemic risk, you will have higher mandated capital requirements and you will be supervised by the Federal Reserve. Yes, I just told you who I think the top-dog supervisor should be. You will have tighter leverage and liquidity restrictions: You will have to live by civilized norms. In fact, a great deal of what is on the regulatory reform table right now proceeds precisely along those lines. If you’re going to act like a bank, you’re going to be regulated like a bank. That simple. And maybe you just might find the time to go back to working on your golf game at 3. That is the core principle.

There truly is a devil in the details, because it’s quite natural that non-bank levered-up financial intermediaries don’t want to be treated like banks. I wouldn’t either. But the truth of the matter is if you’re going to have access to the public goods associated with banking, then you’re going to be treated like a bank.

In fact, here is an example of this concept in my own life, which I’m sure most of you have experienced who have older children. When my son turned 18, he said, “Dad, I’m now the age of majority and I can do whatever I want.” I said, “Son, that’s absolutely true. However, I still control the Bank of Dad. And if you want to have access to the Bank of Dad, there are going to be rules. If you don’t want access to the Bank of Dad, that’s fine. But if you want access to the Bank of Dad, there are going to be rules.”

The Federal Reserve and the FDIC and the Treasury, together, are the Bank of Dad. And Mom. I expect regulation to be similar to that which I have imposed on my son. It doesn’t mean I want to stifle his innovation. That doesn’t mean I want to stifle his creativity. I want him to be all he can be. But as long as he’s banking at Bank of Dad, there are going to be rules.

So there’s my regulatory framework for you. Yes, think in terms of the Federal Reserve and the FDIC and the Treasury as all providing public goods to banking. But the Federal Reserve has got to be at the top of the totem pole, because the Fed truly is the Bank of Dad. The entity that can print money has got to be the lead supervisor. To me, it’s unambiguously clear. And the fact that it’s being debated actually befuddles me. I operate on the notion that self-evident truths should be self-evident. But apparently Washington doesn’t operate on that thesis.

I’ve talked too long. I promised you I wouldn’t do this. I was going to talk short and then have a long Q&A, but I’m a Baptist minister’s son, and we can’t help ourselves. Regardless of how simple the sermon may be, it always goes on too long because the minister always enjoys giving it more than the audience enjoys receiving it.

Thank you very much.

Paul McCulley
Managing Director
mcculley@pimco.com

take heed: the shadow war

“Shadow War” : mainstream Protestant denominations under seige

Bruce Wilson	print page
Sat Feb 11, 2006 at 01:55:09 PM EST

New Talk To Action anthology:United Methodism Under Attack John Dorhauer’s new weekly series on Talk To Action may be unprecedented : Dorhauer’s series concerns an over two decade long campaign, by the far-right wing financed Institute For Religion and Democracy and so called “renewal” groups advocating literal interpretations of the Bible and far right social and political views, to destroy mainstream Protestant Christianity in America. Operating from within mainline Protestant denominations “renewal” groups work to sow dissension via wedge issues such as gay marriage, incite schisms, and so break apart mainstream and liberal denominations and neutralize them as an effective force in American politics. Before now this campaign has seldom been discussed so publicly, and with John Dorhauer’s series we have an ongoing chronicle from the heart of one embattled denomination, the United Churches of Christ. There are more Christians on the left/liberal side of politics than on the right, observed George Lakoff, but they are not organized to even remotely the same degree as the Christian right. Well, here’s the reason for that. Here are excerpts from the first three parts of a continuing series by John Dorhauer on Talk To Action, along with a related post by retired Methodist Ministers Andrew J. Weaver and Fred W. Kandeler, and a related series – on the takeover of the Southern Baptist Convention – by Dr. Bruce Prescott.

Talk To Action Co founder Frederick Clarksonframes the backdrop of the story for us :

Once upon a time, the member denominations of the National Council of Churchesmaintained a vigorous social witness. That’s what such mainline Protestants as the Presbyterians, United Church of Christ, the Methodists, and the Episcopals called their stands for social justice including such things as civil rights for African Americans, equality for women — including ordination, and opposition to the excesses of American foreign policy from Vietnam to El Salvador. While there was some conservative opposition to these advances over the course of the 20th century, including some schisms, the direction of mainline protestantism was clear.Then, the strategic funders of the Right, such as Richard Mellon Scaife and several others, helped create an agency that would help to network, organize and inform internal opposition groups. That agency is still around and is called the Institute on Religion and Democracy

….Many in the mainline churches are waking up to the simple fact that they have been under attack for more than two decades by rightist interests set on neutralizing their effectiveness — and that the IRD and its allies have had considerable success.

….IRD remains a well-funded and influential agency to this day. It’s minions in the mainline churches are treated as credible spokespersons for conservative dissent by mainstream religion reporters.

A few years ago, the National Council of Churches, faced with budget problems, and political gridlock, almost shut down. It has managed to resurect itself and under the leadership of Rev. Bob Edgar, appears poised to be once again an influential body in American public life.

As the slumbering giant of mainstream protestantism begins once again to stir, and the IRD and it’s rightwing backers scramble to sew division and discord, will anyone be there to help? Or will the voices of mainline Christianity once again be silenced?

That is indeed the question – and the challenge now for Liberal Protestant faith in America.

The efforts of the IRD, and the growing resistance to its suberversionary tactics, has become one of the areas of focus for Talk To Action.

The Role of the Pastor: The Pacifist

[ excerpt: for full story, click on the link above ] In my column last week, I began a conversation about the role the pastor can play when a church has been targeted for takeover. We looked briefly at the “Pastor as Aggressor:” we will return to that subject at another time as there is more to be said about that.But this week I want to write about the Pastor as Pacifist. Other titles come to mind.. Were I to be more clever, I would have entitled this the “Pastor as Passivist.” Its not a word, but it gets across the meaning I am intending: some pastors watch the machinations and ministrations undertaken by activists in their church and choose to remain, well, passive. I could have called this article the “Pastor as Enabler,” for the result of choosing to remain passive is that one further enables the church to continue to be attacked.

I choose the title “Pacifist” because it comes closest to naming the underlying motives of this pastor: keep peace at all costs. For whatever reasons there may be – and there are many (we will explore some of them) – some pastors engage this conflict in their church with a predicated avoidance.

The Role of the Pastor in an Attack: the Aggressor

[ excerpt. full full story, click on link above ] my experience reveals to me that a pastor can play one of three roles once a church has been targeted for an attack: she can be an aggressor, one whose role is central and vital to the orchestrated takeover; he can be a pacifier, one whose role is very dismissive while an attack is going on and who either sits back afraid to take a side, or acts and speaks only to fulfill a desire for his members to just stop fighting; or she can be a protector, one willing to fight and defend her church against all would be attackers in order to preserve the church’s history, vitality, and integrity. Today we look at the Aggressor. ….George is the prototypical aggressor. There are many such pastors serving churches all over the country. They have been trained to deploy tactics and maneuvers designed to divide and conquer congregations. George’s mentor was none other than Mark Friz, formerly a pastor ordained to serve the United Church of Christ and recognized throughout the Mid-West as the one to call when you want to learn how and why to take out a church.

Anatomy of an Attack: Part I

[ excerpt from John Dorhauer's story, linked above ] In the coming weeks, I want to begin to look specifically at local congregations that have been targeted for attack from the right. Each will have its own distinct set of circumstances and characters: but over time patterns will emerge. And if at any point along the way it should dawn on you that something like that is happening in a congregation you know about, then that should be brought to the attention of the church’s pastor, Council, and judicatory offices.On November 16 2003, Evangelical Church of the Redeemer United Church of Christ voted to disaffiliate with the United Church of Christ. Just how that happened is a long and sordid story of deceit, coercion, and manipulation that played out over years. Today we catch just a glimpse of their story. You will soon hear more.

That Which We Call Renewal Groups

[ excerpt from Dorhauer's piece linked above ] Today’s wedge issue is homosexuality, and renewal groups have latched onto it as the most recent evidence of the church’s apostasy. Their mission is to save the church from such heretical practices, and to `renew’ and restore the church to its truer, more historic past.The problem is that these groups have much more nefarious intentions. It is not the `renewal’ of the church that they are interested in, but the destabilization and destruction of what has been throughout the history of the United States the most consistent, courageous, and clear voice of social reform and justice.

Their own words betray them.

In the Mission Statement found on the IRD website we read this lengthy quote:

“The IRD aims its reports and analyses at a broad audience of U.S. Christians. Its organizational work is concentrated in the Oldline Protestant churches and the National Council of Churches, where the problems are most serious. We have committees that unite reform activists in three denominations representing over 12 million persons…. The IRD trains activists, with topics ranging from issues to tactics. At national church meetings, IRD activists assist delegates in drafting legislation and framing arguments for debate. This work is done in cooperation with like-minded groups in seven major denominations (representing nearly 20 million Americans) through our Association for Church Renewal.”

These are not renewal groups: they are trained activists intent on the demise, the destabilization, and the destruction of Mainline Protestant Christianity.

Religion Under Attack

[ excerpt from Dorhauer's first Talk To Action post ] “The creation mandate was precisely the requirement that man subdue the earth and exercise dominion over it. There is not one word of Scripture to indicate or imply that this mandate ever was revoked. There is every word of Scripture to declare that this mandate must and shall be fulfilled. Those who attempt to break it shall themselves be broken.”(Rushdoony, The Institutes of Biblical Law, 1973, p.14)Language about mandate, subjugation, submission, and dominion drive their own ideology, and they proceed from the mouth of a God who for them will never accept compromise, moderation, or tolerance.

Knowing that such ideologies will not yet play well in an America whose genetic material is still replete with the proscriptions for individual liberty, personal choice, and freedom of expression in all things political and religious, most of the work of these extremists is done covertly. Their strategies include an array of clandestine tactics, coded language, and political deception that have gone unnoticed and unchallenged for far too long. Although offered in a much different context, the words of Linda Loman in Arthur Miller’s classic Death of a Salesman seem appropriate here: “Attention must be paid.”

And this is what I propose to do: pay attention. Jesus once disclosed to his disciples: “So do not be afraid of them. There is nothing concealed that will not be disclosed, or hidden that will not be made known.” (Mt. 10.26) Having spent years now tracking the radical religious right; having watched the horrors they have wrought upon otherwise innocent and fruitful congregations; having known first-hand their hatred and vitriol I wish in this space to tell what I have known and experienced. Their attacks, their tactics, their words will be made known: it is my belief that what abides in their darkness cannot long endure the light of day.

Stay in touch. Each Tuesday I will write about those things which I, and others, have experienced watching local churches, judicatory authorities, and entire congregations endure one attack after another. This isn’t right. It needs to stop. “

Retired Methodist Ministers Andrew J. Weaver and Fred W. Kandeler recently wrote the following Talk To Action piece on one of the IRD’s opening red-baiting salvos, in 1983, against the National Council of Churches

Being 60 Minutes Means You Never Have to Say You are Sorry – Except Once

Sixty minutes executive producer Don Hewitt appeared on the December 2, 2002, edition of Larry King Live (CNN) and was asked whether he regretted any shows that he had done in his 36-year career. Hewitt named only one, the 1983 60 Minutes double segment on the National Council of Churches and World Council of Churches. Hewitt told King that;

“We once took off on the National Council of Churches as being left wing and radical and a lot of nonsense. And the next morning I got a congratulatory phone call from every redneck bishop in America and I thought, oh, my God, we must have done something wrong last night, and I think we probably did.”

The broadcast on CBS’s 60 Minutes entitled “The Gospel According to Whom” began with Roman Catholic priest, Richard John Neuhaus, saying, “I am worried – I am outraged when the church lies to its own people.” The camera moved from an offering plate in a United Methodist church in the Midwest to images of the Cuban dictator Fidel Castro and then to marchers in Communist Red Square. The lengthy segment over and over suggested that the National Council of Churches (NCC) was using Sunday offerings to promote Marxist revolution.

Methodism Under Attack 

[ source] Andrew Weaver: “…although the United Methodist Church, the Presbyterian Church USA, and the Episcopal Church total only about 14 million in membership, they have been and remain a powerful and influential voice for moderate and progressive social values in American society. Almost 30 percent of the members of the U.S. Congress belong to one of these three denominations as well as disproportionate numbers of well-educated and progressive leaders who advocate for the poor, civil and human rights, environmental protection, and a responsible foreign policy. The activities and leadership of mainline Protestant churches are linked to the social conscience of the nation and contribute to civil discourse. The political right seeks to gain top leadership positions in the church by spreading misleading information and incendiary allegations against organizations and individuals. These groups employ the propaganda method of “wedge issues” like abortion and homosexuality to cause confusion, dissension, and division. Irving Kristol, father of William Kristol, editor of The Weekly Standard and one of the “godfathers” of the political right, summed up this strategy in the Wall Street Journal: “Attack the integrity, not the words, of those with whom you disagree.” More recently, Grover Norquist, a conservative activist and long-time friend of top presidential aide Karl Rove, was even more blunt when he told the Denver Post that civility is out and nastiness is in among conservative activists. According to Mr. Norquist, “bipartisanship is another name for date rape.” By contrast, Methodists and other mainstream Protestants have held proudly to the “extreme middle” during most of their history, recognizing that self-righteousness is the bane of religion, be it the ideology of the left or right. Unless progressive and moderate members in the mainline churches muster the will to organize and battle for what they believe is fair and just, they are in danger of losing the historical values of these traditions to a determined cadre of ideological advocacy groups. It is time, in other words, for “fighting Methodists” to make a comeback lest their tolerance and Christian charity be turned against them and used to undermine their churches and further the social ends of the right wing’s radical ideology.

FURTHER READING : see United Methodism @ Risk: A Wake-Up Call by By Leon Howell and the Information Project for United Methodists:

“Organizations leading an ultra-conservative effort to control and reshape The United Methodist Church to fit their agenda are the focus of a book released today by active United Methodist lay and clergy leaders. United Methodism at RISK: A Wake-Up Call shares extensive research to show who is behind the campaign to force the denomination into a narrow political and theological framework. The book was published by the Information Project for United Methodists, co-chaired by Bishop C. Dale White, widely known for his leadership on peace issues, and New York attorney and well-known United Methodist lay leader Beth Capen. Veteran Christian journalist Leon Howell is the author. The books close to 200 pages detail the rise of conservative renewal groupswithin United Methodism and sister denominations, and link their activity to right-wing activity in society. “All United Methodists need to read this book to be fully informed on the tactics, ideological bias and theological restrictions evidenced in the life and work of the conservative renewal groups,” Bishop White said in announcing the books release. The direction they would take our church demeans clergy and laity, he said.”

Information on Ordering the Book[ see bottom of linked page ]

Talk To Action writer Dr. Bruce Prescott has also written a series on the takeover of the Southern Baptist Convention :

On Restoring AmericaLearning to be Patient Revolutionaries

From Reconstructionism to Dominionism, Part I

From Reconstructionism to Dominionism, Part II

Another Reconstructionist/Dominionist Distinction

SBC Takeover Leaders and the CNP

Additionally, a recent Talk To Action post by Jonathan Hutson drew in this eye opening comment, by Talk To Action member tikkun :

I returned 20 minutes ago from a diocesan church leadership workshop for the Episcopal Diocese of Albany. What I heard and observed there was an Institute of Religion and “Democracy” exhortation. The bishop used the phrase, One Church, (an IRD phrase) over and over again. His audience moaned, cried hallalujah, and murmured Amen. A local leader in the Cusillo movement was given 15 minutes to describe the success of the movement in the New York Capital district. We were sternly warned to pray ceaselessly to keep evil and Satan from entering our churches.There was not one word about valuing diverse voices in the Episcopal Church In America. The Episcopal Book of Common Prayer, which is treasured by American Episcopalians, was held up before the audience as a laughable relic of the past by the bishop. My husband, a cradle Episcopalian moderate who has been fairly ignorant about this issue till today, came away offended by the inherent censorship of the One Church (IRD) diatribe and the inherent insult of people who love Episcopal tradition.

When I asked someone who was involved in the planning of the event about diocesan connection to the IRD, they said they didn’t know if it was directly connected but “…isn’t Diana Knippers our Anglican leadership in the IRD?” (Rarely do moderate and progressive laymen and clergymen know the term IRD, or the name, Diana Knippers)

Tikkun has begun a series on the campaign against the Episcopalian Church in the Albany Area :

Report From The Belly of The Beast Resistance In The Diocese of Albany Goes Public: The Times Union newspaper of Albany, New York on Sunday, February 12, 2006, ran a huge front page article, byline, Marc Parry, regarding questionable use of diocesan funds by the Bishop of Albany, Daniel Herzog.

Support the clergy letter project !: science and religion are compatible !

watching ohio

 

Election protection in Ohio (and America) isn’t over

Election Integrity

by Harvey Wasserman | November 18, 2008 – 9:21am

by Bob Fitrakis & Harvey Wasserman

As the sun sets on Bush 2, it is clear that a very thin line of electoral protection preserved Barack Obama’s victory in Ohio–and the nation.

And it’s no accident the vote count battle for a Columbus-area Congressional seat still rages.

The GOP’s 2008 electoral strategy again emphasized massive voter disenfranchisement and rigging the electronic vote count. The twin tactics very nearly gave Ohio to McCain/Palin, and threatened to set precedents capable of winning them the national election.

Prior to the 2004 vote, Republican Secretary of State J. Kenneth Blackwell stripped some 308,000 Ohio citizens from the registration rolls in heavily Democratic districts. This mass disenfranchisement alone may have accounted for the 118,000-plus official margin that gave George W. Bush a second term in the White House.

After the 2004 vote, Blackwell disenfranchised another 170,000 voters in heavily Democratic Franklin County (Columbus).

But in 2006, Democrat Jennifer Brunner was elected to replace Blackwell. Ironically, the King-Lincoln-Bronzeville federal civil rights lawsuit filed against Blackwell over 2004 election irregularities has carried over, making Brunner the defendant (we are plaintiff and defendant in that suit). As a result, negotiations between Brunner and election protection attorneys have been on-going since she took office.

In the lead-up to the 2008 elections, the GOP tried yet another massive voter purge. Through the “caging” technique of sending unsolicited “do not forward” junk mail, GOP operatives obtained by returned mail the names of some 600,000 registered Ohio voters. Some were serving in Iraq. Also, the GOP once again fought to purge voters for “inactivity” as they sought to eliminate voters who hadn’t voted in four-years as opposed to eight, even if they voted in state and local eletions..

The GOP demanded the right to disenfranchise these voters. But Brunner directed that each was entitled to notice and an individual in-person hearing.

As Greg Palast and Robert F. Kennedy, Jr., have reported, the GOP used similar caging throughout the US, aimed at millions of likely Democratic voters.

The GOP also went after 200,000 new Ohio voters whose registrations showed minor discrepancies. Included were variations in social security and drivers’ license numbers, or changes in middle names, nicknames and addresses.

But Brunner fought to protect these names from GOP challenge, and was upheld by the US Supreme Court, who refused to hear the GOP case prior to the election.

Based on projected demographic and voter turnout statistics, the elimination of these four-fifths of a million voters (some 5.4 million votes were counted in Ohio 2008) could have shifted a 200,000-vote victory for Obama to a 40,000-vote triumph for McCain. This projection is based on a conservative estimate that 80% of these targeted voters vote Democratic and 50% would have turned out to vote.

Partly in response to pressure from election protection activists, Brunner also facilitated early and absentee voting. Polling stations opened by September 30 throughout the state. Despite GOP efforts, a full week was available to those who wished to register and vote at the same time. As least 25% of Ohio’s voters cast their ballots prior to Election Day. By most accounts these votes went overwhelmingly for Obama. The Columbus Dispatch reported that Democrats outvoted Republicans 12-1 in early voting.

Brunner also tried to make paper ballots available to all voters who wanted them. Under often dubious financial arrangements with a direct conflict of interest as a stockholder, Blackwell installed Diebold electronic voting machines designed to account for as many as half Ohio’s 2008 votes.

But the GOP-controlled legislature manipulated the finances behind the push for paper ballots. Ohio’s 88 counties eventually provided enough of them for at least 25% of the voters. But so many voted early that reports now indicate there were ultimately enough paper ballots at the Election Day polling stations for nearly all who wanted them.

Other GOP attempts at disenfranchisement also fell flat. When the Republican sheriff of Greene County attempted to prosecute 304 students (many of them African-American) for “voter fraud” he ignited a massive public outcry. At issue was the common confusion over whether a student will vote at home or at college. Under widespread attack, the sheriff backed off. But students at public universities and liberal arts colleges throughout the rest of the state reported GOP harassment.

Despite widespread attempts to avoid them, there were 186,000 provisional ballots cast in Ohio 2008, some 40,000 more than the 141,000 cast in 2004 (16,000 of which have never been counted). Independent observers reported on-going confusion about the use of provisional ballots, largely attributed to poor pollworker training.

A federal database used to check driver’s license information went down for nearly three hours on Election Day due to what the Ohio Department of Public Safety said was “a large fiber-optic cable being cut in Texas.”

Despite an increase of 319,000 registered Ohio voters in 2008 over 2004, the official turnout was actually lower. Barack Obama received 22,000 fewer votes than John Kerry. John McCain got 317,000 fewer than Bush. Election protection experts attribute this to a selective GOP padding of the 2004 vote count, especially in three heavily Republican southwestern counties where irregularities and improbabilities abounded.

An observer in Miami County reported that a Republican election director illegally forced recently-moved citizens to vote provisionally. In Franklin County, pollbooks wrongly identified 35,000 voters as provisional. Four black voters in Fairfield County reported being purged despite stable long-term residencies. The Republican-connected company Triad, infamous for its secretive work on central tabulators in 2004, emerged in the majority of Ohio counties as the keeper of electronic pollbooks for the boards of elections.

While these and other irregularities bruised the election, there were far fewer than reported in 2004. The presence of hundreds of well-trained and equipped election protection volunteers throughout the state seem to have staved off any GOP attempt to repeat the massive disenfranchisement that gave the 2004 Ohio vote count to George W. Bush. Key Ohio polling stations were graced with independent election observers appointed by the Green Party. Independent video-the-vote teams, nonpartisan election observers, and Obama supporters were placed outside the polls documenting all that happened. With an apparently workable distribution of voting machines and sufficient paper ballots as a backup (along with a clear sunny day) the horrors of long lines in Ohio’s 2004 election were avoided in 2008.

The Ohio vote count also seems to have been successfully protected. In Licking County, a voter reported that his paper ballot was put in a bag without an envelope. In Youngstown, Joyce Stewart reports being given a paper ballot that had no place to choose a president.

E-voting machines in three Columbus precincts double-counted votes. In heavily Democratic Lucas County, four out of eight e-voting machines in precinct 20, recorded no votes for president, while recording far higher vote counts for such minor offices as county coroner.

The poll judge in Columbus precinct 25G tried to have legitimate exit pollers arrested. In Trumbull County, Warner Lange observed that “all of the votes cast using a paper ballot between the hours of 6:30am and 8:15 am are invalid because none of the voters were asked, as required, to sign the pollbook.”

In Hamilton and Franklin Counties (Cincinnati and Columbus) early and absentee ballots were not counted on Election Night, as originally planned. It took three hours after the polls closed for Union County election officials to get their ballots scanned. Terry Grimm reported that “everything was wrong” coming from the Summit County town of Barberton, causing a delayed tabulation.

Kevin Egler in Portage County reported that after 2800 votes were scanned on election night, a “corrupted card signal” came out, forcing election officials to start the vote count over.

Ultimately, despite Brunner’s attempts to get rid of them, hundreds of thousands of votes were again cast and counted on electronic voting machines with no paper trail and no way to do a reliable recount.

But missing this time was an electronic theft apparatus under the control of Blackwell and Karl Rove.

On Election Night 2004, Blackwell e-mailed Ohio’s electronic vote count to a basement in Chattanooga, Tennessee that also housed the servers for the Republican National Committee. The tally “miraculously” shifted from Kerry to Bush between 12:30 and 2 am, ultimately giving Bush a second term.

The data was handled under a state contract funneled by Blackwell to Michael Connell, a shadowy Bush family IT specialist who programmed the official Bush-Cheney website in 2000 and 2004.

On the day before the 2008 election, Connell was forced to testify under oath under cross-examination by King-Lincoln-Bronzeville attorneys Cliff Arnebeck and Bob Fitrakis. Among the questions at issue was whether Connell left any “Trojan Horse” programs in place in the Ohio electronic vote count structure through which he could have hacked the 2008 outcome.

There has yet to be a definitive answer to that question, or to what he actually may have done to the 2004 vote count. But, for what it’s worth, Karl Rove did shift his predictions from a McCain victory to one for Obama shortly after the federal court agreed to force Connell to testify.

There may be much to celebrate in the apparent legitimacy of the Ohio 2008 vote count.

But half the state’s ballots are still slated to be cast on electronic voting machines whose source codes remain under private lock and key. There is no guarantee Ohio voters will have universal access to paper ballots in future elections. In direct violation of federal law, no fewer than 56 of Ohio’s 88 counties destroyed all or most of their federal election records after the 2004 election, making a definitive recount impossible. There have been no state or federal prosecutions.

The “minor” irregularities and attempted voter disenfranchisements observed in Ohio 2008 were repeated throughout the US, and could easily resurface in future elections if they are not again thoroughly observed.

And in Columbus, the Republicans are right now suing Brunner to throw out thousands of provisional ballots cast in a Congressional race still in hot dispute. Incredibly, the GOP is operating on inside information fed it by Franklin County assistant BOE director Matt Damshroder.

Damshroder accepted a $10,000 check in his BOE office from a Diebold representative. The check was made out to the Republican Party. Damshroder was given a one-month paid suspension for this in 2005. With Democratic assent, he remains a key player in the vote count that will determine whether heavily Democratic Franklin County could be stopped from sending its first Democrat to Congress since 1980.

Nationwide the GOP successfully disenfranchised millions of likely voters in Election 2008. Easily hacked, un-monitorable e-voting machines are still spread throughout the United States. The opportunities to steal future elections that are certain to be far tighter than 2008 remain readily available.

Much has been learned in the Bush era of the Unelected President. There is simply no doubt that the thousands of volunteers who worked tirelessly to protect the election of 2008 in Ohio and throughout the nation in fact prevented the GOP from stealing yet another one.

But unless this administration implements automatic voter registration, universal hand counted paper ballots, the total elimination of electronic voting machines, expanded windows for voting and a far more secure system of impartial citizen observation, the specter of still more stolen elections will haunt our democracy.

Indeed, we will still have to wonder if that’s what we really have here.

Bob Fitrakis & Harvey Wasserman’s four co-authored books on election protection include HOW THE GOP STOLE AMERICA’S 2004 ELECTION & IS RIGGING 2008, and AS GOES OHIO, both available at www.freepress.org, where this article first appeared. Their next and final book and movie on the topic are in the works. Their radio shows are broadcast at WVKO 1580AM, central Ohio’s Air America affiliate.
_______

About author

Harvey Wasserman is co-author, with Bob Fitrakis and Steve Rosenfeld, of WHAT HAPPENED IN OHIO?, just published by the New Press. He is author of SOLARTOPIA! and HARVEY WASSERMAN’S HISTORY OF THE U.S., available at www.harveywasserman.com.

 

is the party over at AIG?

AIG Party Watch: This time a resort in Phoenix

Tracy Coenen
Nov 11th 2008 at 11:00AM

AIG executives may not be making better business decisions while they’re asking the federal government for more money, but at least they’re getting sneakier! An ABC News investigation has revealed that a conference last week at the Pointe Hilton Squaw Peak Resort in Phoenix was another chance for AIG executives to frolic (on the taxpayers’ dime).

The conference was called the Asset Management Conference, and hotel personnel were ordered to not mention AIG either verbally or on signage. An AIG spokesperson told ABC News that there was no AIG signage because they wanted to lower the company’s profile. As consumers, I think we’re a little too smart to believe that. Something tells me that the company executives knew they’d get heat for another luxury trip.

There were 150 independent financial planners present at the conference, in addition to several top AIG executives. Yet hidden cameras caught top executives not attending sessions, and also captured images of limousines, fancy cocktail parties, and expensive dinners out.

Probably the biggest financial faux pas was booking former NFL quarterback Terry Bradshaw to speak at the event, at a fee of $40,000. AIG says that a sponsor was paying the fee, but they canceled his appearance. In total, AIG has said that the conference was to cost $343,000, with $320,000 of that covered by sponsor fees.

I understand the sponsorship dollars, and the attendance of the independent agents (who aren’t on AIG’s payroll, but are independents who only get paid when they sell something), and the continuing education aspect (many professions required continuing education). I just can’t help but feel that these events at expensive resorts are in poor taste… Especially as the federal money demanded by AIG has almost doubled since the original $85 billion plan was announced. The tab for AIG bailout dollars is now up to $150 billion.

Tracy L. Coenen, CPA, MBA, CFE performs fraud examinations and financial investigations for her company Sequence Inc. Forensic Accounting, and is the author of Essentials of Corporate Fraud.

democracy and liberty

Democracy is two wolves and a lamb voting on what to have for lunch.
Liberty is a well armed lamb contesting the vote.

Benjamin Franklin,
1759

john mccain’s morality and self-interest record

Rosa Brooks:

Keating 5 ring a bell?

McCain’s past collides with the present Wall Street debacle.

Rosa Brooks
September 25, 2008

Once upon a time, a politician took campaign contributions and favors from a friendly constituent who happened to run a savings and loan association. The contributions were generous: They came to about $200,000 in today’s dollars, and on top of that there were several free vacations for the politician and his family, along with private jet trips and other perks. The politician voted repeatedly against congressional efforts to tighten regulation of S&Ls, and in 1987, when he learned that his constituent’s S&L was the target of a federal investigation, he met with regulators in an effort to get them to back off.

That politician was John McCain, and his generous friend was Charles Keating, head of Lincoln Savings & Loan. While he was courting McCain and other senators and urging them to oppose tougher regulation of S&Ls, Keating was also investing his depositors’ federally insured savings in risky ventures. When those lost money, Keating tried to hide the losses from regulators by inducing his customers to switch from insured accounts to uninsured (and worthless) bonds issued by Lincoln’s near-bankrupt parent company. In 1989, it went belly up — and more than 20,000 Lincoln customers saw their savings vanish.

Keating went to prison, and McCain’s Senate career almost ended. Together with the rest of the so-called Keating Five — Sens. Alan Cranston (D-Calif.), John Glenn (D-Ohio), Don Riegle (D-Mich.) and Dennis DeConcini (D-Ariz.), all of whom had also accepted large donations from Keating and intervened on his behalf — McCain was investigated by the Senate Ethics Committee and ultimately reprimanded for “poor judgment.”

But the savings and loan crisis mushroomed. Eventually, the government spent about $125 billion in taxpayer dollars to bail out hundreds of failed S&Ls that, like Keating’s, fell victim to a combination of private-sector greed and the “poor judgment” of politicians like McCain.

The $125 billion seems like small change compared to the $700-billion price tag for the Bush administration’s proposed Wall Street bailout. But the root causes of both crises are the same: a lethal mix of deregulation and greed.

Today’s meltdown began when unscrupulous mortgage lenders pushed naive borrowers to sign up for loans they couldn’t afford to pay back. The original lenders didn’t care: They pocketed the upfront fees and quickly sold the loans to others, who sold them to others still. With the government MIA, soon mortgage-backed securities were zipping around the globe. But by the time many ordinary people began to struggle to make their mortgage payments, the numerous “good” loans (held by borrowers able to pay) had gotten hopelessly mixed up with the bad loans. Investors and banks started to panic about being left with the hot potato — securities backed mainly by worthless loans. And so began the downward spiral of a credit crunch, short-selling, stock sell-offs and bankruptcies.

Could all this have been prevented? Sure. It’s not rocket science: A sensible package of regulatory reforms — like those Barack Obama has been pushing since well before the current meltdown began — could have kept this most recent crisis from escalating, just as maintaining reasonable regulatory regimes for S&Ls in the ’80s could have prevented that crisis (McCain learned this the hard way).

But, despite his political near-death experience as a member of the Keating Five, McCain continued to champion deregulation, voting in 2000, for instance, against federal regulation of the kind of financial derivatives at the heart of today’s crisis.

Shades of the Keating Five scandal don’t end there. This week, for instance, news broke that until August, the lobbying firm owned by McCain campaign manager Rick Davis was paid $15,000 a month by Freddie Mac, one of the mortgage giants implicated in the current crisis (now taken over by the government and under investigation by the FBI). Apparently, Freddie Mac’s plan was to gain influence with McCain’s campaign in hopes that he would help shield it from pesky government regulations. And until very recently, Freddie Mac executives probably figured money paid to Davis’ firm was money well spent. “I’m always in favor of less regulation,” McCain told the Wall Street Journal in March.

These days, McCain is singing a different tune.

“There are no atheists in foxholes and no ideologues in financial crises,” Fed Chairman Ben Bernanke said last week, explaining the sudden mass conversion of so many onetime free marketeers into champions of robust government intervention. Fair enough. But as you try to figure out what and who can get us out of this mess, beware of those who now embrace regulation with the fervor of new converts.

wall street monster

The Monster That Ate Wall Street

 

They’re called “Off-Site Weekends”—rituals of the high-finance world in which teams of bankers gather someplace sunny to blow off steam and celebrate their successes as Masters of the Universe. Think yacht parties, bikini models, $1,000 bottles of Cristal. One 1994 trip by a group of JPMorgan bankers to the tony Boca Raton Resort & Club in Florida has become the stuff of Wall Street legend—though not for the raucous partying (although there was plenty of that, too). Holed up for most of the weekend in a conference room at the pink, Spanish-style resort, the JPMorgan bankers were trying to get their heads around a question as old as banking itself: how do you mitigate your risk when you loan money to someone? By the mid-’90s, JPMorgan’s books were loaded with tens of billions of dollars in loans to corporations and foreign governments, and by federal law it had to keep huge amounts of capital in reserve in case any of them went bad. But what if JPMorgan could create a device that would protect it if those loans defaulted, and free up that capital?

What the bankers hit on was a sort of insurance policy: a third party would assume the risk of the debt going sour, and in exchange would receive regular payments from the bank, similar to insurance premiums. JPMorgan would then get to remove the risk from its books and free up the reserves. The scheme was called a “credit default swap,” and it was a twist on something bankers had been doing for a while to hedge against fluctuations in interest rates and commodity prices. While the concept had been floating around the markets for a couple of years, JPMorgan was the first bank to make a big bet on credit default swaps. It built up a “swaps” desk in the mid-’90s and hired young math and science grads from schools like MIT and Cambridge to create a market for the complex instruments. Within a few years, the credit default swap (CDS) became the hot financial instrument, the safest way to parse out risk while maintaining a steady return. “I’ve known people who worked on the Manhattan Project,” says Mark Brickell, who at the time was a 40-year-old managing director at JPMorgan. “And for those of us on that trip, there was the same kind of feeling of being present at the creation of something incredibly important.”

Like Robert Oppenheimer and his team of nuclear physicists in the 1940s, Brickell and his JPMorgan colleagues didn’t realize they were creating a monster. Today, the economy is teetering and Wall Street is in ruins, thanks in no small part to the beast they unleashed 14 years ago. The country’s biggest insurance company, AIG, had to be bailed out by American taxpayers after it defaulted on $14 billion worth of credit default swaps it had made to investment banks, insurance companies and scores of other entities. So much of what’s gone wrong with the financial system in the past year can be traced back to credit default swaps, which ballooned into a $62 trillion market before ratcheting down to $55 trillion last week—nearly four times the value of all stocks traded on the New York Stock Exchange. There’s a reason Warren Buffett called these instruments “financial weapons of mass destruction.” Since credit default swaps are privately negotiated contracts between two parties and aren’t regulated by the government, there’s no central reporting mechanism to determine their value. That has clouded up the markets with billions of dollars’ worth of opaque “dark matter,” as some economists like to say. Like rogue nukes, they’ve proliferated around the world and now lie hiding, waiting to blow up the balance sheets of countless other financial institutions.

It didn’t start out that way. One of the earliest CDS deals came out of JPMorgan in December 1997, when the firm put into place the idea hatched in Boca Raton. It essentially took 300 different loans, totaling $9.7 billion, that had been made to a variety of big companies like Ford, Wal-Mart and IBM, and cut them up into pieces known as “tranches” (that’s French for “slices”). The bank then identified the riskiest 10 percent tranche and sold it to investors in what was called the Broad Index Securitized Trust Offering, or Bistro for short. The Bistro was put together by Terri Duhon, at the time a 25-year-old MIT graduate working on JPMorgan’s credit swaps desk in New York—a division that would eventually earn the name the Morgan Mafia for the number of former members who went on to senior positions at global banks and hedge funds. “We made it possible for banks to get their credit risk off their books and into nonfinancial institutions like insurance companies and pension funds,” says Duhon, who now heads her own derivatives consulting business in London.

Before long, credit default swaps were being used to encourage investors to buy into risky emerging markets such as Latin America and Russia by insuring the debt of developing countries. Later, after corporate blowouts like Enron and WorldCom, it became clear there was a big need for protection against company implosions, and credit default swaps proved just the tool. By then, the CDS market was more than doubling every year, surpassing $100 billion in 2000 and totaling $6.4 trillion by 2004.

And then came the housing boom. As the Federal Reserve cut interest rates and Americans started buying homes in record numbers, mortgage-backed securities became the hot new investment. Mortgages were pooled together, and sliced and diced into bonds that were bought by just about every financial institution imaginable: investment banks, commercial banks, hedge funds, pension funds. For many of those mortgage-backed securities, credit default swaps were taken out to protect against default. “These structures were such a great deal, everyone and their dog decided to jump in, which led to massive growth in the CDS market,” says Rohan Douglas, who ran Salomon Brothers and Citigroup’s global credit swaps research division through the 1990s.

Soon, companies like AIG weren’t just insuring houses. They were also insuring the mortgages on those houses by issuing credit default swaps. By the time AIG was bailed out, it held $440 billion of credit default swaps. AIG‘s fatal flaw appears to have been applying traditional insurance methods to the CDS market. There is no correlation between traditional insurance events; if your neighbor gets into a car wreck, it doesn’t necessarily increase your risk of getting into one. But with bonds, it’s a different story: when one defaults, it starts a chain reaction that increases the risk of others going bust. Investors get skittish, worrying that the issues plaguing one big player will affect another. So they start to bail, the markets freak out and lenders pull back credit.

The problem was exacerbated by the fact that so many institutions were tethered to one another through these deals. For example, Lehman Brothers had itself made more than $700 billion worth of swaps, and many of them were backed by AIG. And when mortgage-backed securities started going bad, AIG had to make good on billions of dollars of credit default swaps. Soon it became clear it wasn’t going to be able to cover its losses. And since AIG’s stock was one of the components of the Dow Jones industrial average, the plunge in its share price pulled down the entire average, contributing to the panic.

The reason the federal government stepped in and bailed out AIG was that the insurer was something of a last backstop in the CDS market. While banks and hedge funds were playing both sides of the CDS business—buying and trading them and thus offsetting whatever losses they took—AIG was simply providing the swaps and holding onto them. Had it been allowed to default, everyone who’d bought a CDS contract from the company would have suffered huge losses in the value of the insurance contracts they hadpurchased, causing them their own credit problems.

Given the CDSs’ role in this mess, it’s likely that the federal government will start regulating them; New York state has already said it will begin doing so in January. “Sadly, they’ve been vilified,” says Duhon, who helped get the whole thing started with that Bistro deal a decade ago. “It’s like saying it’s the gun’s fault when someone gets shot.” But just as one might want to regulate street sales of AK-47s, there’s an argument to be made that credit default swaps can be dangerous in the wrong hands. “It made it a lot easier for some people to get into trouble,” says Darrell Duffie, an economist at Stanford. Although he believes credit default swaps have been “dramatically misused,” Duffie says he still believes they’re a very effective tool and shouldn’t be done away with entirely. Besides, he says, “if you outlaw them, then the financial engineers will just come up with something else that gets around the regulation.” As Wall Street and Washington wring their hands over how to prevent future financial crises, we can only hope they re-read Mary Shelley’s “Frankenstein.”

© 2008