The Road to Ruin

by James Rickards

  Jamie Dimon, CEO of JPMorgan Chase, learned this lesson the hard way when he publicly criticized Obama’s bank regulatory policy in 2012. Over the course of the next two years, JPMorgan paid more than $30 billion in fines, penalties, and compliance costs to settle a host of criminal and civil fraud charges brought by the Obama Justice Department and regulatory agencies. The Obama administration knew that attacking institutions was more remunerative than attacking individuals as FDR had done. Under this new Black Hand, stockholders paid the costs, and CEOs got to keep their jobs provided they remained mute.

  Fink played the political game more astutely than Dimon. As Fortune magazine reported, “Fink . . . is a strong Democrat . . . and has often been rumored as set to take a big administration job, such as Secretary of the Treasury.” Fink had so far managed to avoid the attacks that plagued his rivals.

  Now Fink confronted a threat greater than targeted prosecutions and West Wing animus. The threat involved the White House, but emanated from the highest levels of the IMF and the G20 club of major economic powers. This threat has an anodyne name intended to confuse nonexperts. The name is G-SIFI, which stands for “globally systemic important financial institution.” In plain English, G-SIFI means “too big to fail.” If your company is on the G-SIFI list, it will be propped up by governments because a failure topples the global financial system. That list went beyond large national banks into a stratosphere of super-size players who dominated global finance. G-SIFI even went beyond too big to fail. G-SIFI was a list of entities that were too big to leave alone. The G20 and IMF did not just want to watch the G-SIFIs. They wanted to control them.

  Each major country has its own sublists of SIFIs, and systemically important banks (SIBs) that are also too big to fail. In the United States, these banks include JPMorgan, Citibank, and some lesser-known entities such as the Bank of New York, the clearing nerve center for the U.S. treasury market.

  I knew this background when I sat down to dinner that evening. The latest development was that governments were now moving beyond banks to include nonbank financial companies in their net.

  Some nonbank targets were easy prey, including insurance giant AIG, which almost destroyed the financial system in 2008, and General Electric, whose credit operations were unable to roll over their commercial paper in the panic that year. It was the General Electric freeze, more than Wall Street bank failures, that most panicked Ben Bernanke, Federal Reserve chairman at the time. The General Electric credit collapse spread contagion to all of corporate America, which led directly to government guarantees of all bank deposits, money market funds, and corporate commercial paper. The General Electric meltdown was a white-knuckle moment that governments resolved never to repeat.

  Once GE and AIG were swept in, the issue was how far to cast the nonbank net. Prudential Insurance was snared next. Governments were moving to control not just banks and large corporations, but the world’s biggest asset managers as well. MetLife Insurance was next on the hit list; BlackRock was directly in the crosshairs.

  I asked my dinner companion, “How’s this whole SIFI thing going? You must have your hands full.”

  Her reply startled me. “It’s worse than you think,” she said.

  I was aware of the government’s efforts to put BlackRock in the nonbank SIFI category. A behind-the-scenes struggle by BlackRock management to avoid the designation had been going on for months. BlackRock’s case was straightforward. They argued they were an asset manager, not a bank. Asset managers don’t fail; their clients do.

  BlackRock insisted size itself was not a problem. The assets under management belonged to the clients, not to BlackRock. In effect, they argued BlackRock was just a hired hand for its institutional clients, and not important in its own right.

  Fink argued that systemic risk was in banks, not BlackRock. Banks borrow money on a short-term basis from depositors and other banks, then loan the funds out for a longer term as mortgages or commercial loans. This asset-liability maturity mismatch leaves banks vulnerable if the short-term lenders want their money back in a panic. Long-term assets cannot be liquidated quickly without a fire sale.

  Modern financial technology made the problem worse because derivatives allowed the asset-liability mismatch to be more highly leveraged, and spread among more counterparties in hard-to-find ways. When panic strikes, even central banks willing to act as lenders of last resort cannot easily untangle the web of transactions in time to avoid a domino-style crash of one bank after another. All of this was amply demonstrated in the Panic of 2008, and even earlier in the collapse of hedge fund Long-Term Capital Management in 1998.

  BlackRock had none of these problems. It was an asset manager, pure and simple. Clients entrusted it with assets to invest. There was no liability on the other side of the balance sheet. BlackRock did not need depositors or money market funds to finance its operations. BlackRock did not act as principal in exotic off-balance-sheet derivatives to leverage its client assets.

  A client hired BlackRock, gave it assets under an advisory agreement, and paid a fee for the advice. In theory, the worst that could happen to BlackRock is it might lose clients or receive fewer fees. Its stock price might decline. Still, BlackRock could not suffer a classic run on the bank because it did not rely on short-term funding to conduct its operations, and it was not highly leveraged. BlackRock was different from a bank, and safer.

  I said, “Well, I know what the government is doing. They realize you’re not a bank and don’t have funding risk. They just want information. They want you on the nonbank SIFI list so they can come in, poke around, look at your investments, and report the information to Treasury in a crisis. They’ll combine that with information from other sources. The information gives them the big picture if they need to put out a fire. It’s a pain, and it’s expensive, but you can do it. It’s just another compliance cost.”

  My friend leaned in, lowered her voice, and said, “No, it’s not that. We can live with that. They want to tell us we can’t sell.”

  “What?” I replied. I heard her well enough, but the implication of what she said was striking.

  “In a crisis, they want to pick up the phone and order us not to sell securities. Just freeze us in place. I was in Washington last week on this and I’m going back next week for more meetings. You know it’s not really about us, it’s about our clients.”

  I was shocked. I should not have been. BlackRock was an obvious choke point in the global flow of funds. The fact that regulators might order banks to behave in certain ways was not surprising. Regulators can close banks almost at will. Bank management knows that in a match with regulators, the bank will always lose, so they go along with government orders. But government had no obvious legal leverage over asset managers like BlackRock.

  Yet the flow of funds through BlackRock on a daily basis was enormous. BlackRock was a strategic choke point like the Strait of Hormuz. If you stop the flow of oil through the Strait of Hormuz, the global economy grinds to a halt. Likewise, if you stop transactions at BlackRock, global markets grind to a halt.

  In a financial panic, everyone wants his money back. Investors believe stocks, bonds, and money market funds can be turned into money with a few clicks at an online broker. In a panic, that’s not necessarily true. At best, values are crashing and “money” disappears before your eyes. At worst, funds suspend redemptions and brokers shut off their systems.

  Broadly speaking, there are two ways for policymakers to respond when everyone wants his money back. The first is to make money readily available, printing as much as necessary to satisfy the demand. This is the classic central bank function as the lender of last resort, more aptly called printer of last resort.

  The second approach is to just say no; to lock down or freeze the system. A lockdown involves closing banks, shutting exchanges, and ordering asset managers not to sell. In the Panic of 2008, governments pursued the first option. Ce
ntral banks printed money and passed it around to reliquefy markets and prop up asset prices.

  Now it looked like governments were anticipating the next panic by preparing the second approach. In the next panic, government will say, in effect, “No, you can’t have your money. The system is closed. Let us sort things out, and we’ll get back to you.”

  Money locked down at BlackRock is not their money, it’s their clients’. BlackRock manages funds for the largest institutions in the world such as CIC, the Chinese sovereign wealth fund, and CALPERS, the pension fund for government employees in California. A freeze on BlackRock means you are freezing sales by China, California, and other jurisdictions around the world. The U.S. government has no authority to tell China not to sell securities. But because China entrusts assets to BlackRock, the government would use its power over BlackRock to freeze the Chinese. The Chinese would be the last to know.

  By controlling one financial choke point—BlackRock—the U.S. government controls the assets of major investors normally beyond its jurisdiction. Freezing BlackRock was an audacious plan, obviously one the government could not discuss openly. Thanks to my dinner companion, the plan had become crystal clear.

  Ice-Nine

  In the 1963 dark comedic novel Cat’s Cradle, author Kurt Vonnegut created a substance he called ice-nine, discovered by a physicist, Dr. Felix Hoenikker. Ice-nine was a polymorph of water, a rearrangement of the molecule H2O.

  Ice-nine had two properties that distinguished it from regular water. The first was a melting point of 114.4ºF, which meant ice-nine was frozen at room temperature. The second property was that when a molecule of ice-nine came in contact with a water molecule, the water instantly turned to ice-nine.

  Hoenikker placed some ice-nine molecules in sealed vials and gave them to his children before he died. The novel’s plot turns on the fact that if the ice-nine is released from the vials, and put in contact with a large body of water, the entire water supply on earth—rivers, lakes, and oceans—would eventually become frozen solid and all life on earth would cease.

  This was a doomsday scenario appropriate to the times in which Vonnegut wrote. Cat’s Cradle was published just after the Cuban Missile Crisis, when the real world came dangerously close to nuclear annihilation, what scientists later called nuclear winter.

  Ice-nine is a fine way to describe the power elite response to the next financial crisis. Instead of reliquefying the world, elites will freeze it. The system will be locked down. Of course, ice-nine will be described as temporary the same way President Nixon described the suspension of dollar-to-gold convertibility in 1971 as temporary. Gold convertibility at a fixed parity was never restored. The gold in Fort Knox has been frozen ever since. U.S. government gold is ice-nine.

  Ice-nine fits with an understanding of financial markets as complex dynamic systems. An ice-nine molecule does not freeze an entire ocean instantaneously. It freezes only adjacent molecules. Those new ice-nine molecules freeze others in ever-widening circles. The spread of ice-nine would be geometric, not linear. It would work like a nuclear chain reaction, which starts with a single atom being split, and soon splits so many atoms that the energy release is enormous.

  Financial panics spread the same way. In the classic 1930s version, they begin with a run on a small-town bank. The panic spreads until it hits Wall Street and starts a stock market crash. In the twenty-first-century version, panic starts in a computer algorithm, which triggers preprogrammed sell orders that cascade into other computers until the system spins out of control. A cascade of selling happened on October 19, 1987, when the Dow Jones Industrial Average fell 22 percent in one day—equivalent to a 4,000-point drop in the index today.

  Risk managers and regulators use the word “contagion” to describe the dynamics of financial panic. Contagion is more than a metaphor. Contagious diseases such as Ebola spread in the same exponential way as ice-nine, chain reactions, and financial panics. One Ebola victim may infect two healthy people, then those two newly infected persons each infect two others, and so on. Eventually a pandemic results, and a strict quarantine is needed until a vaccine is found. In Cat’s Cradle, there was no “vaccine”; ice-nine molecules were quarantined in sealed vials.

  In a financial panic, printing money is a vaccine. If the vaccine proves ineffective, the only solution is quarantine. This means closing banks, exchanges, and money market funds, shutting down ATMs, and ordering asset managers not to sell securities. Elites are preparing for a financial ice-nine with no vaccine. They will quarantine your money by locking it inside the financial system until the contagion subsides.

  Ice-nine is hiding in plain sight. Those who are not looking for it cannot see it. Once you know ice-nine is there, you see it everywhere. This was the case after my conversation with my insider friend about the BlackRock asset freeze.

  The elite ice-nine plan was far more ambitious than the so-called living wills and resolution authority under the 2010 Dodd-Frank legislation. Ice-nine went beyond banks to include insurance companies, industrial companies, and asset managers. It went beyond orderly liquidation to include a freeze on transactions. Ice-nine would be global rather than case-by-case.

  The best-known cases of elites’ freezing customer funds in recent years were the Cyprus banking crisis in 2012 and the Greek sovereign debt crisis in 2015. These crises had longer-term antecedents, but Cyprus and Greece were where matters came to a head and banks blocked depositors from their own money.

  Cyprus was known as a conduit for Russian flight capital, some illegally obtained by Russian oligarchs. In the Cyprus crisis, the two leading banks, Laiki Bank and the Bank of Cyprus, became insolvent. A run on the entire banking system ensued. Cyprus was a Eurozone member and used the euro as its currency. This made the crisis systemic despite the Cypriot economy’s small size. A troika consisting of the European Central Bank (ECB), the European Union (EU), and the IMF had fought hard to preserve the euro in the 2011 sovereign debt crises and did not want to see that work undone in Cyprus.

  Cyprus did not have the clout to drive a hard bargain. It had to take whatever assistance it could get on whatever terms it could get it. For its part, the troika decided the days of too-big-to-fail banks were over. Cyprus was where they drew the line. Banks were temporarily shut down. ATM machines were taken offline. A mad scramble for cash ensued. Those who could flew to mainland Europe, returning with wads of euros stuffed in their luggage.

  Laiki Bank was closed permanently, and Bank of Cyprus was restructured by the government. Bank deposits in Laiki above the insured limit of €100,000 were dumped in a “bad bank” where the prospects of any recovery are uncertain. Smaller deposits were transferred to the Bank of Cyprus. At the Bank of Cyprus, 47.5 percent of the uninsured deposits over €100,000 were converted into equity of the newly recapitalized bank. Precrisis stock- and bondholders took haircuts and received some equity in the bank in exchange for their losses.

  The Cyprus model was called a “bail-in.” Instead of bailing out depositors, the troika used depositors’ money to recapitalize the failed banks. A bail-in reduced rescue costs to the troika, especially Germany.

  Investors around the world shrugged and treated Cyprus as a one-off event. Cyprus is poor. Depositors in more advanced countries forgot the incident and adopted an attitude that said, “It can’t happen here.” They could not have been more wrong. The 2012 Cyprus bail-in was the new template for global bank crises.

  A G20 summit of world leaders including President Barack Obama and German chancellor Angela Merkel met in Brisbane, Australia, on November 15, 2014, shortly after the Cyprus crisis. The meeting’s final communiqué includes reference to a new global organization called the Financial Stability Board, or FSB. This is a global financial regulator established by the G20 and not accountable to the citizens of any member country. The communiqué says, “We welcome the Financial Stability Board (FSB) proposal . . . requiring global systemicall
y important banks to hold additional loss absorbing capacity. . . .”

  Behind that bland language is a separate twenty-three-page technical report from the FSB that provides the template for future bank crises. The report says bank losses “should be absorbed . . . by unsecured and uninsured creditors.” In this context “creditor” means depositor. The report then describes “the powers and tools that authorities should have to achieve this objective. These include the bail-in power . . . [and] to write down and convert into equity all or parts of the firm’s unsecured and uninsured liabilities . . . to the extent necessary to absorb losses.”

  What the Brisbane G20 summit showed was that the ice-nine policy as applied to bank depositors was not limited to out-of-the-way places like Cyprus. Ice-nine was the policy of the largest countries in the world, including the United States.

  Bank depositors received another harsh lesson in governments’ ability to lock down banks during the 2015 Greek debt crisis. Greek sovereign debt was a persistent problem beginning in 2009, and the crisis ran hot and cold over the intervening years. The crisis came to a head on July 12, 2015, when Germany ran out of patience with the Greeks and presented a financial ultimatum at a Brussels summit, to which Greece finally agreed.

  The typical Greek citizen may or may not have followed the high-stakes drama in Brussels, yet the fallout was unavoidable. It was unclear if Greek banks would survive or whether depositors would be bailed in under the Brisbane rules. The banks had no choice but to shut down access to cash and credit until their status was clarified.

  ATMs stopped providing cash to Greek cardholders (travelers with non-Greek debit cards could get some cash at Athens International Airport). Greek credit cards were declined by merchants. Greeks drove to neighboring countries and returned with bags full of large-denomination euro notes. The Greek economy reverted to cash-and-carry and quasi-barter almost overnight.