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Short selling is the modern version of the counterfeiting scheme
used to bring down the Continental in the 1770s. When a currency is
sold short, its value is diluted just as it would be if the market were
flooded with paper currency. The short sale is the basis of many of
those sophisticated trades called “derivatives,” which have become
weapons for destroying competitor businesses by parasitic mergers
and takeovers. Billionaire investor Warren Buffett calls derivatives
“financial weapons of mass destruction.”12 The term fits not only
because these speculative bets are very risky for investors but because
big institutional investors can use them to manipulate markets, cause
massive currency devaluations, and force small vulnerable countries
to do their bidding. Derivatives have been used to destroy the value of
the national currencies of competitor countries, allowing national assets
to be picked up at fire sale prices, just as the assets of the American
public were snatched up by wealthy insiders after the crash of 1929.
Defenders of free markets blame the targeted Third World countries
for being unable to manage their economies, when the fault actually
lies in a monetary scheme that opens their currencies to manipulation
by foreign speculators who have access to a flood of “phantom money”
borrowed into existence from foreign banks.
To clarify all this, we™ll to take another short detour into the shady
world of “finance capitalism,” to shed some light on the obscure topic
of derivatives and the hedge funds that largely trade in them.




The term “Third World” is now an anachronism, since there is no longer a
i

“Second World” (the Soviet bloc). But the term is used here because it has a
popularly understood meaning and is still widely used, and because the alterna-
tives “ “developing world” and “underdeveloped world” “ may be misleading.
Citizens of ancient Third World civilizations tend to consider their cultures more
“developed” than some in the First World.

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Chapter 20
HEDGE FUNDS
AND DERIVATIVES:
A HORSE OF A
DIFFERENT COLOR

“What kind of a horse is that? I™ve never seen a horse like that
before!”
“He™s the Horse of a Different Color you™ve heard tell about.”
“ The Guardian of the Gate to Dorothy,
The Wizard of Oz




J ust as a painted horse is still a horse, so derivatives and
the hedge funds that specialize in them have been called merely
a disguise, something designed to look “different enough from the last
time so no one realizes what is happening.” John Train, writing in
The Financial Times, used this colorful analogy:
[I]t is like the floor show in a seedy nightclub. A sequence of
girls trots on the scene, first a collection of Apaches, then some
ballerinas, then cowgirls and so forth. Only after a while does
the bemused spectator realize that, in all cases, they were the
same girls in slightly different costumes. . . . [T]he so-called hedge
fund actually was an excuse for a margin account.1
Hedge funds are private funds that pool the assets of wealthy in-
vestors, with the aim of making “absolute returns” -- making a profit
whether the market goes up or down. To maximize their profits, they
typically use credit borrowed against the fund™s assets to “leverage”
their investments. Leverage is the use of borrowed funds to increase
purchasing power. The greater the leverage, the greater the possible
gain (or loss). In futures trading, this leverage is called the margin.
Leveraging on margin, or by borrowing money, allows investors to
place many more bets than if they had paid the full price.
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Chapter 20 - Hedge Funds and Derivatives

In the 1920s, wealthy investors engaged in “pooling” “ combining
their assets to influence the markets for their collective benefit. Like
trusts and monopolies, pooling was considered to be a form of collu-
sive interference with the normal market forces of supply and demand.
Hedge funds are the modern-day variants of this scheme. They are
usually run in off-shore banking centers such as the Cayman Islands
to avoid regulation. Off-shore funds are exempt from margin require-
ments that restrict trading on credit, and from uptick rules that limit
short sales to assets that are rising in price.
Hedge funds were originally set up to “hedge the bets” of inves-
tors, insuring against currency or interest rate fluctuations; but they
quickly became instruments for manipulation and control. Many of
the largest hedge funds are run by former bank or investment bank
dealers, who have left with the blessings of their former employers.
The banks™ investment money is then placed with the hedge funds,
which can operate in a more unregulated environment than the banks
can themselves. Hedge funds are now often responsible for over half the
daily trading in the equity markets, due to their huge size and the huge
amounts of capital funding them.2 That gives them an enormous
amount of control over what the markets will do. In the fall of 2006,
8,282 of the 9,800 hedge funds operating worldwide were registered
in the Cayman Islands, a British Overseas Territory with a population
of 57,000 people. The Cayman Islands Monetary Authority gives each
hedge fund at registration a 100-year exemption from any taxes, shel-
ters the fund™s activity behind a wall of official secrecy, allows the
fund to self-regulate, and prevents other nations from regulating the
funds.3
Derivatives are key investment tools of hedge funds. Derivatives
are basically side bets that some underlying investment (a stock,
commodity, market, etc.) will go up or down. They are not really
“investments,” because they don™t involve the purchase of an asset.
They are outside bets on what the asset will do. All derivatives are
variations on futures trading, and all futures trading is inherently
speculation or gambling. The more familiar types of derivatives include
“puts” (betting the asset will go down) and “calls” (betting the asset
will go up). Over 90 percent of the derivatives held by banks today,
however, are “over-the-counter” derivatives “ investment devices
specially tailored to financial institutions, often having exotic and
complex features, not traded on standard exchanges. They are not
regulated, are hard to trace, and are very hard to understand.4 Some

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critics say they are impossible to understand, because they were
designed to be so complex and obscure as to mislead investors.5
At one time, tough rules regulated speculation of this sort. The
Glass-Steagall Act passed during the New Deal separated commercial
banking from securities trading; and the Commodities Futures Trad-
ing Commission (CFTC) was created in 1974 to regulate commodity
futures and option markets and to protect market participants from
price manipulation, abusive sales practices, and fraud. But again the
speculators have managed to get around the rules. Derivative traders
claim they are not dealing in “securities” or “futures” because noth-
ing is being traded; and just to make sure, they induced Congress to
empower the head of the CFTC to grant waivers to that effect, and
they set up offshore hedge funds that remained small, unregistered
and unregulated. They also had the Glass-Steagall Act repealed.

A Bubble on a Ponzi Scheme

Executive Intelligence Review (EIR), The New Federalist and The
American Almanac are publications associated with Lyndon
LaRouche, a political figure who is personally controversial but whose
research staff was described by a former senior staffer of the National
Security Council as “one of the best private intelligence services in the
world.”6 Their writings on the derivatives crisis are quite colorful and
readable. In a 1998 interview, John Hoefle, the banking columnist for
EIR, clarified the derivatives phenomenon like this:
During the 1980s, you had the creation of a huge financial bubble.
. . . [Y]ou could look at that as fleas who set up a trading empire
on a dog. . . . They start pumping more and more blood out of
the dog to support their trading, and then at a certain point, the
amount of blood that they™re trading exceeds what they can
pump from the dog, without killing the dog. The dog begins to
get very sick. So being clever little critters, what they do, is they
switch to trading in blood futures. And since there™s no
connection “ they break the connection between the blood
available and the amount you can trade, then you can have a
real explosion of trading, and that™s what the derivatives market
represents. And so now you™ve had this explosion of trading in
blood futures which is going right up to the point that now the
dog is on the verge of dying. And that™s essentially what the
derivatives market is. It™s the last gasp of a financial bubble.7

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Chapter 20 - Hedge Funds and Derivatives

What has broken the connection between “the blood available and
the amount you can trade” is that derivatives are not assets. They are
just bets on what the asset will do, and the bet can be placed with very
little “real” money down. Most of the money is borrowed from banks
that create it on a computer screen as it is lent. The connection with
reality has been severed so completely that the market for over-the-
counter derivatives has now reached many times the money supply of
the world. Since these private bets are unreported and unregulated,
nobody knows exactly how much money is riding on them. How-
ever, the Bank for International Settlements (BIS) reported that in the
first half of 2006, the “notional value” of derivative trades had soared
to a record $370 trillion; and by December 2007, the figure was up to
a breathtaking $681 trillion.8
The notional value of a derivative is a hypothetical number described
as “the number of units of an asset underlying the contract, multi-
plied by the spot price of the asset.” Synonyms for “notional” include
“fanciful, not based on fact, dubious, imaginary.” Just how fanciful
these values are is evident from the numbers: $681 trillion is over 50
times the $13 trillion gross domestic product (GDP) of the entire U.S.
economy. In 2006, the total GDP of the world was only $66 trillion --
one-tenth the “notional”value of derivative trade in 2007. In a Sep-
tember 2006 article in MarketWatch, Thomas Kostigen wrote:
[I]t™s worth wondering how so much extra value can be squeezed out
of instruments that are essentially fake. . . . Wall Street manufactures
these products and trades them in a rather shadowy way that
keeps the average investor in the dark. You cannot exactly look
up the price of an equity derivative in your daily newspaper™s
stock table. . . . [I]t wouldn™t take all that much to create a domino
effect of market mishap. And there is no net. The Securities
Investor Protection Corporation, which insures brokerage
accounts in the event of a brokerage-firm failure, recently
announced its reserves. It has about $1.38 billion. That may
sound like a lot. Compared with half a quadrillion, it™s a
pittance. Scary but true.9
How are these astronomical sums even possible? The answer,
again, is that derivatives are just bets, and gamblers can bet any amount
they want. Gary Novak is a scientist with a website devoted to simpli-
fying complex issues. He writes, “It™s like two persons flipping a coin
for a trillion dollars, and afterwards someone owes a trillion dollars


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which never existed.”9 He calls it “funny money.” Like the Missis-
sippi Bubble, the derivatives bubble is built on something that doesn™t
really exist; and when the losers cannot afford to pay up on their
futures bets, the scheme must collapse. Either that, or the taxpayers
will be saddled with the bill for the largest bailout in history.
In a report presented at the request of the House Committee on
Banking, Finance and Urban Affairs in 1994, Christopher White used
some other vivid imagery for the derivatives affliction. He wrote:
The derivatives market . . . is the greatest bubble in history. It
dwarfs the Mississippi Bubble in France and the South Sea Island
bubble in England. This bubble, like a cancer, has penetrated and
taken over the entirety of our banking and credit system; there is no
major commercial bank, investment bank, mutual fund, etc. that
is not dependent on derivatives for its existence. These
derivatives suck the life™s blood out of our economy. Our farms,
our factories, our nation™s infrastructure, our living standards are
being sucked dry to pay off interest payments, dividend yields as well
as other earnings on the bubble.11
How speculation in derivatives draws much-needed capital away
from domestic productivity was explained by White with another
analogy:
It would be like going to the horse races to bet, not on the race,
but on the size of the pot. Who would care about what™s involved
with getting the runners to the starting gate?
Since the gamblers don™t care who wins, they aren™t interested in
feeding the horses or hiring stable hands. They are only interested in
money making money. Today more money can be had at less risk by
speculation in derivatives than by investing in the growth of a business,
and this is particularly true if you are a very big bank with the ability
to influence the way the bet goes. The Office of the Comptroller of the
Currency reported that in mid-2006, there were close to 9,000
commercial and savings banks in the United States; yet 97 percent of
U.S. bank-held derivatives were concentrated in the hands of just five
banks. Topping the list were JPMorgan Chase and Citibank, the citadels
of the Morgan and Rockefeller empires.12




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Chapter 20 - Hedge Funds and Derivatives

Derivative Wars

The seismic power of the new derivative weapons was demon-
strated in 1992, when George Soros and his giant hedge fund Quan-
tum Group, backed by Citibank and other powerful institutional specu-
lators, used derivatives to collapse the currencies of Great Britain and
Italy in a single day. The European Monetary System was taken down
with them. According to White:
They showed that day that the speculative cancer that had been
unleashed had grown beyond the point that monetary authorities
could control. Farmers who have been ruined by short-sellers
on commodities markets know what this is all about: selling what
you do not own in order to buy it back later for less. . . . These are
instruments of financial warfare, deployed against nations and the
populations in much the same way the commodity market short-seller
has been deployed to bankrupt the farmer.13

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