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The Chicago Fed states that if business is active, the banks with
excess reserves will probably have opportunities to lend these reserves.
But if the banks do not have willing borrowers (indeed, even if they
do), they can choose to invest the money. In effect, they are borrowing
money created by themselves with accounting entries and investing it
for their own accounts. The Chicago Fed states:
Deposit expansion can proceed from investments as well as loans.
Suppose that the demand for loans . . . is slack. These banks
would then probably purchase securities. . . . [Most] likely, these
banks would purchase the securities through dealers, paying for
them with checks on themselves or on their reserve accounts. These
checks would be deposited in the sellers™ banks. . . . [T]he net
effects on the banking system are identical with those resulting from
loan operations.
The net effect when banks make loans is to expand their deposits,
so this must also be the net effect when they invest the money for their
own accounts: they expand the level of deposits, or create new money.
How much of a bank™s allotted “reserve balance” is invested rather
than lent? Pirritano cites “Federal Reserve Statistical Release (H.8)”
detailing the assets and liabilities of domestic banks, which puts the
ratio of loans to investments at 7 to 3. Thus in the hypothetical given
by Murray Rothbard, in which $10 million was created by the Fed
and was fanned into $100 million as the money passed through the

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banking system, the $100 million would have created $70 million in
loans to customers and $30 million in investments for the banks.

Banks as Traders

Commercial banks have traditionally invested conservatively in
government securities, but that is not true of investment banks. The
Glass-Steagall Act requiring commercial banking and investment
banking to be conducted in separate institutions was repealed in 1999,
following assurances that these banking functions would be separated
by “Chinese walls” within the organizations.i But Chinese walls are
paper thin, and there are significant differences between commercial
and investment banks that make them uneasy partners.6 Commercial
banks have traditionally taken in deposits, issued commercial loans,
and otherwise served their customers. Investment banks are not
allowed to take in deposits or make commercial loans. Rather, they
raise money for their clients by overseeing stock issuance and sales.
Their more important business today, however, is something called
“proprietary trading.” An entry by that name in Wikipediaii defines
proprietary trading as “a term used in investment banking to describe
when a bank trades stocks, bonds, options, commodities, or other items
with its own money as opposed to its customers™ money, so as to make a
profit for itself.” The entry states:
Although investment banks are usually defined as businesses
which assist other business in raising money in the capital mar-
kets (by selling stocks or bonds), in fact most of the largest invest-
ment banks make the majority of their profit from trading activities.
The potential for conflicts of interest was evident in 2007, when
investment bank Goldman Sachs made a killing betting its own money
against the subprime mortgage market at the same time that it was

i “Chinese walls” are defined in Wikipedia as “information barriers imple-
mented in firms to separate and isolate persons within a firm who make invest-
ment decisions from persons within a firm who are privy to undisclosed material
information which may influence those decisions . . . to safeguard inside infor-
mation and ensure there is no improper trading.”
ii The reliability of Wikipedia has been questioned, since it is researched by
volunteers, but defenders note that inaccurate information is quickly corrected
by other researchers; and it is an accessible online encyclopedia that gives infor-
mation not readily found elsewhere.

Chapter 18 - A Look Inside the Fed™s Playbook

selling “structured investment vehicles” laced with subprime debt to
its clients.7
The conflicts of interest problem was discussed in a June 2006 article
by Emily Thornton in Business Week Online titled “Inside Wall Street™s
Culture of Risk: Investment Banks Are Placing Bigger Bets Than Ever
and Beating the Odds “ At Least for Now.” After discussing the new
boom in bank trading, Thornton observed that investment bank
wizards have so consistently beaten the odds that “[s]uspicions are
rising that bank traders are acting on nonpublic information gleaned
from their clients.” Trading for the banks™ own accounts has been
criticized not only for suspected ethical violations but because it exposes
the banks to enormous risks. Thornton writes:
This trading boom, fueled by cheap money, is fundamentally
different from the ones of the past. When traders last ruled
Wall Street, during the mid-™90s, few banks put much of their
own balance sheets at risk; most acted mainly as brokers,
arranging trades between clients. Now, virtually all banks are
making huge bets with their own assets on many more fronts, and
using vast sums of borrowed money to jack up the risk even more.
Where do these “vast sums of borrowed money” come from?
Although investment banks are not allowed to take in deposits or make
loans of imaginary money based on “fractional reserves,” commercial
banks are. Now that the lines between these two forms of banking
have become blurred, it is not hard to envision bank traders having
ready access to some very favorable loans.
Thornton continues:
[M]any investment banks now do more trading than all but the
biggest hedge funds, those lightly regulated investment pools
that almost brought down the financial system in 1998 when
one of them, Long-Term Capital Management, blew up. What™s
more, banks are jumping into the realm of private equity, spending
billions to buy struggling businesses as far afield as China that they
hope to turn around and sell at a profit.
Equity is ownership interest in a corporation, and the equity market
is the stock market. These banks are not just investing in short-term
Treasury bills on which they collect a modest interest, as commercial
banks have traditionally done. They are buying whole businesses with
borrowed money, and they are doing it not to develop the productive poten-
tial of the business but just to reap a quick profit on resale.

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Leading the attack in this lucrative new field, says Thornton, is the
very successful investment bank Goldman Sachs, headed until recently
by Henry Paulson Jr. Paulson left the firm to become U.S. Treasury
Secretary in June 2006, but neither Goldman nor its cronies, Thornton
says, are showing signs of easing up:
With $25 billion of capital under management, Goldman™s private
equity arm itself is one of the largest buyout firms in the world . . . .
All of them are ramping up teams of so-called proprietary traders
who play with the banks™ own money. . . . Banks are paying up,
offering some traders $10 million to $20 million a year.8
The practice of buying whole corporations in order to bleed them
of their profits has been given the less charitable name of “vulture
capitalism.” Why the term fits was underscored in a January 2006
article by Sean Corrigan called “Speculation in the Late Empire.” He
When the buy-out merchants and private equity partnerships
can borrow what are effectively limitless sums of cheap, tax-
advantaged debt with which to buy out corporate shareholders
(not all of them willing sellers, remember); when they can then
proceed to ruin the target business™ balance sheet in a flash, by
ordering payment of special dividends and by weighing it down
with junk debt, in order to return their funds at the earliest
juncture; when their pecuniary motives are mollified by so little
pretense of undertaking any genuine entrepreneurial
restructuring with which to enhance economic efficiency; when
they can rake in an even greater haul of loot by selling the firm
smartly back to the next debt-swollen suckers in line (probably
into the little man™s sagging pension funds via the inevitable,
well-hyped IPOiii); when they can scatter fees and commissions
(and often political “contributions”) liberally along the way “
then we™re clearly well past the point of reason or endorsement.9
Noting the “outrageously skewed” incomes made by bank traders
at the top of the field -- including Henry Paulson, who made over $30
million at Goldman Sachs the previous year -- Corrigan asks
Why train to be a farmer or a pharmacologist, when you can
join Merrill Lynch and become a millionaire in your mid-20s,

Initial public offering.

Chapter 18 - A Look Inside the Fed™s Playbook

using someone else™s “capital” and benefiting from being an
insider in the great Ponzi scheme in which we live?
All major markets are now thought to be subject to the behind-
the-scenes maneuverings of big financial players, and these
manipulations are being done largely with what Corrigan calls
“phantom money.” A June 2006 article in Barron™s noted that the
bond market today is dominated by banks and government entities,
and that they are not buying the bonds for their interest income. Rather,
“The reality is that [they] are only interested in currency manipulation and
market contrivement.”10
To understand what is really going on behind the scenes, we need
to understand the tools used by Big Money to manipulate markets. In
the next chapter, we™ll take a look at the investment vehicle known as
the “short sale,” which underlies many of those more arcane tools
known as “derivatives.” A massive wave of short selling was blamed
for turning the Roaring Twenties into the Great Depression. The same
sort of manipulations are going on today under different names . . . .

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Chapter 19

“Lions, and tigers, and bears “ oh my! Lions, and tigers, and
“ Dorothy lost in the forest, The Wizard of Oz

T he “Crash” that initiated the Great Depression wasn™t a one-
time occurrence. It continued for nearly four years after 1929,
stoked by speculators who made huge profits not only on the market™s
meteoric rise but as it was plummeting. “Unrestrained financial
exploitations have been one of the great causes of our present tragic
condition,” Roosevelt complained in 1933. A four-year industry-wide
bear raid reduced the Dow Jones Industrial Average (a leading stock
index) to only 10 percent of its former value. A bear raid is the practice
of targeting stock for take-down, either for quick profits or for corporate
takeover. Whenever the market decline slowed after the 1929 crash,
speculators would step in to sell millions of dollars worth of stock they
did not own but had ostensibly borrowed just for purposes of sale,
using the device known as the “short sale.” When done on a large
enough scale, short selling can actually force prices down, allowing
assets to be picked up very cheaply.
Here is how it works: stock prices are set on the trading floor by
traders (those people you see wildly yelling, waving and signaling to
each other on TV), whose job is to match buyers with sellers. Short
sellers willing to sell at any price are matched with the low-ball buy
orders. Since stock prices are set according to supply and demand,
when sell orders overwhelm buy orders, the price drops. The short
sellers then buy the stocks back at the lower price and pocket the
difference. Today, speculators have to drop the price only enough to

Chapter 19 - Bear Raids and Short Sales

trigger the automatic stop loss orders and margin callsi of the big mutual
funds and hedge funds.ii A cascade of sell orders follows, and the price
The short sale is explained by market analyst Richard Geist using
a simple analogy:
Pretend that you borrowed your neighbor™s lawn mower, which
your neighbor generously says you may keep for a couple of weeks
while he™s on vacation. You™re thinking of buying a lawn mower
anyway so you™ve been researching the latest sales and have seen
your neighbor™s lawn mower on sale for $300, marked down
from $500. While you™re mowing your lawn, a passerby stops
and offers to buy the lawn mower you™re using for $450. You
sell him the lawn mower, then go out and buy the same one on
sale for $300 and return it to your neighbor when he returns.
Only now you™ve made $150 on the deal.
Applying this analogy to a hypothetical stock trade, Geist writes:
You believe Amazon is overvalued and its price is going to fall.
So as a short seller, you borrow Amazon stock which, like the
lawn mower, you don™t own, from a broker and sell it into the
market. . . .You borrow and sell 100 shares of Amazon at $50
per share, yielding a gain, exclusive of commissions, of $5,000.
Your research proves correct and a few weeks later Amazon is
selling for $35 per share. You then buy 100 shares of Amazon
for $3500 and return the 100 shares to the broker. You then
have closed your position, and in the meantime you™ve made
$1500. 1

A stop loss order is an order to sell when the price reaches a certain threshold.

A margin call is a demand by a broker to a customer trading on margin (trading on
credit or with borrowed funds) to add funds or securities to his margin account
to bring it up to the percentage of the stock price required as a down payment by
federal regulations. Most traders sell rather than pay the additional money.
A mutual fund is a company that brings together money from many people

and invests it. Hedge funds are investment companies that use high-risk tech-
niques, such as borrowing money and selling short, in an effort to make extraor-
dinary capital gains for their investors.

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