Swaps Obligate Each Party to the Contract to Exchange (Swap) a Set of Payments for Another Set of Payments

In addition to forwards, futures, and options, financial institutions use one other important financial derivative to manage risk. Swaps are financial contracts that obligate each party to the contract to exchange (swap) a set of payments (not assets) it owns for another set of payments that are owned by another party. Swaps are of two basic kinds. Currency swaps involve the exchange of a set of payments in one currency for a set of payments in another currency. Interest-rate swaps involve the exchange of one set of interest payments for another set of interest payments, all denominated in the same currency. We focus on interest-rate swaps.

Interest-rate swaps are an important tool for managing interest-rate risk. They first appeared in the United States in 1982, when, as we have seen, demand increased for financial instruments that could be used to reduce interest-rate risk. The most common type of interest-rate swap (called the plain vanilla swap) specifies: (1) the interest rate on the payments that are being exchanged; (2) the type of interest payments (variable or fixed-rate); (3) the amount of notional principal, which is the amount on which the interest is being paid; and (4) the time period over which the exchanges will continue to be made. There are many other, more complicated versions of swaps, including forward swaps and swap options (called swaptions), but here we will look only at the plain vanilla swap. Figure 13-4 illustrates an interest-rate swap between First Trust and the Friendly Finance Company. First Trust agrees to pay Friendly Finance a fixed rate of 7% on $1 million of notional principal for the next 10 years, and Friendly Finance agrees to pay First Trust the one-year Treasury bill rate plus 1% on $1 million of notional principal for the same period. Thus, as shown in Figure 13-4, every year First Trust would be paying the Friendly Finance Company 7% on $1 million while Friendly Finance would be paying First Trust the one-year T-bill rate plus 1% on $1 million.

—Frederic S. Mishkin and Apostolos Serletis, The Economics of Money, Banking, and Financial Markets, 6th Canadian ed. (Toronto: Pearson Canada, 2016), 332.

“Out of the Money” Stock Options VERSUS “In the Money” Stock Options IF You Buy 50 January 30 Call Contracts

Suppose you buy 50 January 30 call contracts. The option is quoted at $6, so the contracts cost $600 each. You spend a total of 50 × $600 = $30,000. You wait awhile, and the expiration date rolls around.

Now what? You have the right to buy AOL stock for $30 per share. If AOL is selling for less than $30 a share, then this option isn’t worth anything, and you throw it away. In this case, we say that the option has finished “out of the money” because the stock price is less than the exercise price. Your $30,000 is, alas, a complete loss.

If AOL is selling for more than $30 per share, then you need to exercise your option. In this case, the option is “in the money” because the stock price exceeds the exercise price. Suppose AOL has risen to, say, $50 per share. Because you have the right to buy AOL at $30, you make a $20 profit on each share upon exercise. Each contract involves 100 shares, so you make $20 per share × 100 shares per contract = $2,000 per contract. Finally, you own 50 contracts, so the value of your options is a handsome $100,000. Notice that, because you invested $30,000, your net profit is $70,000.

—Stephen A. Ross, Randolph W. Westerfield, and Bradford D. Jordan, Fundamentals of Corporate Finance, 6th ed. Alternate ed. (New York: McGraw-Hill Irwin, 2003), 456.

A Simplified Wall Street Journal Quotation for a Chicago Board Options Exchange (CBOE) Stock Option

An option is a contract that gives its owner the right to buy or sell some asset at a fixed price on or before a given date. For example, an option on a building might give the holder of the option the right to buy the building for $1 million anytime on or before the Saturday prior to the third Wednesday of January 2010.

Options are a unique type of financial contract because they give the buyer the right, but not the obligation, to do something. The buyer uses the option only if it is profitable to do so; otherwise, the option can be thrown away.

There is a special vocabulary associated with options. Here are some important definitions:

1. Exercising the option. The act of buying or selling the underlying asset via the option contract is called exercising the option.
2. Strike price, or exercise price. The fixed price specified in the option contract at which the holder can buy or sell the underlying asset is called the strike price or exercise price. The strike price is often called the striking price.
3. Expiration date. An option usually has a limited life. The option is said to expire at the end of its life. The last day on which the option may be exercised is called the expiration date.
4. American and European options. An American option may be exercised anytime up to and including the expiration date. A European option may be exercised only on the expiration date.

Puts and Calls

Options come in two basic types: puts and calls. A call option gives the owner the right to buy an asset at a fixed price during a particular time period. It may help you to remember that a call option gives you the right to “call in” an asset.

A put option is essentially the opposite of a call option. Instead of giving the holder the right to buy some asset, it gives the holder the right to sell that asset for a fixed exercise price. If you buy a put option, you can force the seller of the option to buy the asset from you for a fixed price and thereby “put it to them.”

What about an investor who sells a call option? The seller receives money up front and has the obligation to sell the asset at the exercise price if the option holder wants it. Similarly, an investor who sells a put option receives cash up front and is then obligated to buy the asset at the exercise price if the option holder demands it. An investor who sells an option is often said to have “written” the option.

The asset involved in an option can be anything. The options that are most widely bought and sold, however, are stock options. These are options to buy and sell shares of stock. Because these are the best-known types of options, we will study them first. As we discuss stock options, keep in mind that the general principles apply to options involving any asset, not just shares of stock.

Stock Option Quotations

On April 26, 1973, the Chicago Board Options Exchange (CBOE) opened and began organized trading in stock options. Put and call options involving stock in some of the  best-known corporations in the United States are traded there. The CBOE is still the largest organized options market, but options are traded in a number of other places today, including the New York, American, and Philadelphia stock exchanges. Almost all such options are American (as opposed to European).

A simplified Wall Street Journal quotation for a CBOE option might look something like this:

The first thing to notice here is the company identifier, RWJ. This tells us that these options involve the right to buy or sell shares of stock in the RWJ Corporation. Just below the company identifier is the closing price on the stock. As of the close of business on the day before this quotation, RWJ was selling for $100 per share.

The second column shows the strike price. The RWJ options listed here have an exercise price of $95. Next, we have the expiration months (June, July, and August). All CBOE options expire on the third Friday of the expiration month.

The remaining four columns give volume (Vol.) and price (Last) information for call options and then put options. The volume information tells us the number of option contracts that were traded that day. One contract involves the right to buy or sell 100 shares of stock, and all trading actually takes place in contracts. Option prices, however, are quoted on a per-share basis.

For example, the first option listed would be described as the “RWJ June 95 call.” The price for this option is $6. If you pay the $6, then you have the right anytime between now and the third Friday of June to buy one share of RWJ stock for $95. Because trading takes place in round lots (multiples of 100 shares), one option contract costs you $6 × 100 = $600.

The other quotations are similar. For example, the July 95 put option costs 2⁸⁰, or $2.80. If you pay $2.80 × 100 = $280, then you have the right to sell 100 shares of RWJ stock anytime between now and the third Friday in July at a price of $95 per share.

—Stephen A. Ross, Randolph W. Westerfield, and Bradford D. Jordan, Fundamentals of Corporate Finance, 6th ed. Alternate ed. (New York: McGraw-Hill Irwin, 2003), 454-455.

Margin Requirements and “Marking to Market” Protect a Futures Exchange by Making Trader Default Much Less Likely

To make sure that the clearinghouse is financially sound and does not run into financial difficulties that might jeopardize its contracts, buyers or sellers of futures contracts must put an initial deposit, called a margin requirement, of perhaps $2000 per Canada bond contract into a margin account kept at their brokerage firm. Futures contracts are then marked to market every day. At the end of every trading day, the change in the value of the futures contract is added to or subtracted from the margin account. Suppose that after buying the Canada bond contract at a price of 115 on Wednesday morning, its closing price at the end of the day, the settlement price, falls to 114. You now have a loss of 1 point, or $1000, on the contract, and the seller who sold you the contract has a gain of 1 point, or $1000. The $1000 gain is added to the seller’s margin account, making a total of $3000 in that account, and the $1000 loss is subtracted from your account, so you now only have $1000 in your account. If the amount in this margin account falls below the maintenance margin requirement (which can be the same as the initial requirement, but is usually a little less), the trader is required to add money to the account. For example, if the maintenance margin requirement is also $2000, you would have to add $1000 to your account to bring it up to $2000. Margin requirements and marking to market make it far less likely that a trader will default on a contract, thus protecting the futures exchange from losses.

—Frederic S. Mishkin and Apostolos Serletis, The Economics of Money, Banking, and Financial Markets, 6th Canadian ed. (Toronto: Pearson Canada, 2016), 320.

Hedging Risk Involves Offsetting a Long Position by Taking an Additional Short Position or Vice Versa

Financial derivatives are effective in reducing risk because they enable financial institutions to hedge, that is, engage in a financial transaction that reduces or eliminates risk. When a financial institution has bought an asset, it is said to have taken a long position, and this exposes the institution to risk if the returns on the asset are uncertain. Conversely, if it has sold an asset that it has agreed to deliver to another party at a future date, it is said to have taken a short position, and this can also expose the institution to risk. Financial derivatives can be used to reduce risk by invoking the following basic principle of hedging: hedging risk involves engaging in a financial transaction that offsets a long position by taking an additional short position, or offsets a short position by taking an additional long position. In other words, if a financial institution has bought a security and has therefore taken a long position, it conducts a hedge by contracting to sell that security (take a short position) at some future date. Alternatively, if it has taken a short position by selling a security that it needs to deliver at a future date, then it conducts a hedge by contracting to buy that security (take a long position) at a future date.

—Frederic S. Mishkin and Apostolos Serletis, The Economics of Money, Banking, and Financial Markets, 6th Canadian ed. (Toronto: Pearson Canada, 2016), 312-313.

The Vast Proportion of Derivatives Are Custom-Made (Not Standardized) and Sold ‘Over-the-Counter’ (OTC) by Banks

There was a time when most such derivatives were standardized instruments produced by exchanges like the Chicago Mercantile, which has pioneered the market for weather derivatives. Now, however, the vast proportion are custom-made and sold ‘over-the-counter’ (OTC), often by banks which charge attractive commissions for their services. According to the Bank for International Settlements, the total notional amounts outstanding of OTC derivative contracts — arranged on an ad hoc basis between two parties — reached a staggering $596 trillion in December 2007, with a gross market value of just over $14.5 trillion. Though they have famously been called financial weapons of mass destruction by more traditional investors like Warren Buffett (who has, nonetheless, made use of them), the view in Chicago is that the world's economic system has never been better protected against the unexpected.

The fact nevertheless remains that this financial revolution has effectively divided the world in two: those who are (or can be) hedged, and those who are not (or cannot be). You need money to be hedged. Hedge funds typically ask for a minimum six- or seven-figure investment and charge a management fee of at least 2 per cent of your money (Citadel charges four times that) and 20 per cent of the profits. That means that most big corporations can afford to be hedged against unexpected increases in interest rates, exchange rates or commodity prices. If they want to, they can also hedge against future hurricanes or terrorist attacks by selling cat bonds and other derivatives.

—Niall Ferguson, The Ascent of Money: A Financial History of the World (New York: Penguin Press, 2008), 227-228.

Closely Related, though Distinct from Futures Contracts, Are the Financial Contracts Known as Options

Closely related, though distinct from futures, are the financial contracts known as options. In essence, the buyer of a call option has the right, but not the obligation, to buy an agreed quantity of a particular commodity or financial asset from the seller (‘writer’) of the option at a certain time (the expiration date) for a certain price (known as the strike price). Clearly, the buyer of a call option expects the price of the commodity or underlying instrument to rise in the future. When the price passes the agreed strike price, the option is ‘in the money’ — and so is the smart guy who bought it. A put option is just the opposite: the buyer has the right, but not the obligation, to sell an agreed quantity of something to the seller of the option.

—Niall Ferguson, The Ascent of Money: A Financial History of the World (New York: Penguin Press, 2008), 227.

A True Futures Contract Is a Standardized Instrument Issued by a Futures Exchange and Hence Tradable

The origins of hedging, appropriately enough, are agricultural. For a farmer planting a crop, nothing is more crucial than the price it will fetch after it has been harvested and taken to market. But that could be lower than he expects or higher. A futures contract allows him to protect himself by committing a merchant to buy his crop when it comes to market at a price agreed when the seeds are being planted. If the market price on the day of delivery is lower than expected, the farmer is protected; the merchant who sells him the contract naturally hopes it will be higher, leaving him with a profit. As the American prairies were ploughed and planted, and as canals and railways connected them to the major cities of the industrial Northeast, they became the nation’s breadbasket. But supply and demand, and hence prices, fluctuated wildly. Between January 1858 and May 1867, partly as a result of the Civil War, the price of wheat soared from 55 cents to $2.88 per bushel, before plummeting back to 77 cents in March 1870. The earliest forms of protection for farmers were known as forward contracts, which were simply bilateral agreements between seller and buyer. A true futures contract, however, is a standardized instrument issued by a futures exchange and hence tradable. With the development of a standard ‘to arrive’ futures contract, along with a set of rules to enforce settlement and, finally, an effective clearinghouse, the first true futures market was born. Its birthplace was the Windy City: Chicago. The creation of a permanent futures exchange in 1874 — the Chicago Produce Exchange, the ancestor of today’s Chicago Mercantile Exchange — created a home for ‘hedging’ in the US commodity markets.

—Niall Ferguson, The Ascent of Money: A Financial History of the World (New York: Penguin Press, 2008), 225-226.

Even at the Height of Classical Liberalism, Governments Did NOT Give Up Trying To Put Easy Money Schemes into Effect

The gold standard was an international standard. It safeguarded the stability of foreign exchange rates. It was a corollary of free trade and of the international division of labor. Therefore those who favored etatism and radical protectionism disparaged it and advocated its abolition. Their campaign was successful.

Even at the height of liberalism governments did not give up trying to put easy money schemes into effect. Public opinion is not prepared to realize that interest is a market phenomenon which cannot be abolished by government interference. Everybody values a loaf of bread available for today’s consumption higher than a loaf which will be available only ten or a hundred years hence. As long as this is true, every economic activity must take it into account. Even a socialist management would be forced to pay full regard to it.

In a market economy the rate of interest has a tendency to correspond to the amount of this difference in the valuation of future goods and present goods. True, governments can reduce the rate of interest in the short run. They can issue additional paper money. They can open the way to credit expansion by the banks. They can thus create an artificial boom and the appearance of prosperity. But such a boom is bound to collapse soon or late and to bring about a depression.

The gold standard put a check on governmental plans for easy money. It was impossible to indulge in credit expansion and yet cling to the gold parity permanently fixed by law. Governments had to choose between the gold standard and their—in the long run disastrous—policy of credit expansion. The gold standard did not collapse. The governments destroyed it. It was as incompatible with etatism as was free trade. The various governments went off the gold standard because they were eager to make domestic prices and wages rise above the world market level, and because they wanted to stimulate exports and to hinder imports. Stability of foreign exchange rates was in their eyes a mischief, not a blessing. Such is the essence of the monetary teachings of Lord Keynes. The Keynesian school passionately advocates instability of foreign exchange rates.

—Ludwig von Mises, Omnipotent Government: The Rise of the Total State and Total War, ed. Bettina Bien Greaves (Indianapolis: Liberty Fund, 2011), 281-282.

Advocates of a New International Currency Think They Can Stabilize Exchange Rates and Capture the Alleged Benefits of Inflation

Some of the advocates of a new international currency believe that gold is not fit for this service precisely because it does put a check on credit expansion. Their idea is a universal paper money issued by an international world authority or an international bank of issue. The individual nations would be obliged to keep their local currencies at par with the world currency. The world authority alone would have the right to issue additional paper money or to authorize the expansion of credit by the world bank. Thus there would be stability of exchange rates between the various local currency systems, while the alleged blessings of inflation and credit expansion would be preserved.

These plans fail, however, to take account of the crucial point. In every instance of inflation or credit expansion there are two groups, that of the gainers and that of the losers. The creditors are the losers; it is their loss that is the profit of the debtors. But this is not all. The more fateful results of inflation derive from the fact that the rise in prices and wages which it causes occurs at different times and in different measure for various kinds of commodities and labor. Some classes of prices and wages rise more quickly and to a higher level than others. While inflation is under way, some people enjoy the benefit of higher prices on the goods and services they sell, while the prices of goods and services they buy have not yet risen at all or not to the same extent. These people profiteer by virtue of their fortunate position. For them inflation is good business. Their gains are derived from the losses of other sections of the population. The losers are those in the unhappy situation of selling services and commodities whose prices have not yet risen at all or not in the same degree as the prices of things they buy for their own consumption. Two of the world’s greatest philosophers, David Hume and John Stuart Mill, took pains to construct a scheme of inflationary changes in which the rise of prices and wages occurs at the same time and to the same extent for all commodities and services. They both failed in the endeavor. Modern monetary theory has provided us with the irrefutable demonstration that this disproportion and nonsimultaneousness are inevitable features of every change in the quantity of money and credit.

—Ludwig von Mises, Omnipotent Government: The Rise of the Total State and Total War (Indianapolis: Liberty Fund, 2010), 253-254.

After the First Default of the Greek State, Large Corporations Were Suddenly Safer Than Their Countries’ Governments

We are so accustomed to see government representatives and activities around us—in taxes, regulations, assistance, enforcement, and so on—that the state seems to be omnipresent and immortal. The state is naturally deemed to be a solid institution, the most solid of all. Everybody is supposed to trust it. This is why the sovereign debt is, or was, supposed  to be totally safe. Those who continue to buy government securities still seem to think so. As The Economist writes with a whiff of British humor: “If governments aren’t safe, after all, what is?” Many people were surprised when, in 2009, the sovereign debt crisis appeared in Europe. Suddenly, the state itself looked fragile. After the first, disguised default of the Greek state, large corporations in many countries were suddenly considered safer than their countries’ governments: in February 2012, the cost of insuring bonds (through financial instruments called “credit default swaps” or CDSs) was lower for ENI (an Italian multinational corporation in oil and gas), for Telefónica (a Spanish telecom multinational), for Danone (a French food product multinational), for Bayer (a German pharmaceutical multinational), for IBM (an American computer service multinational), than for their respective home governments.

Thus, there is a sovereign risk, a risk that states will not reimburse their debts, as happened often historically, although we seem to have forgotten it. The world of trusted state securities is over. “Sovereign risk is out of the bottle,” wrote The Economist in early 2010. “There is no easy way of putting it back in.”

—Pierre Lemieux, The Public Debt Problem: A Comprehensive Guide (New York: Palgrave Macmillan, 2013), 6-7.

“Vulture Funds” Have Tried to Seize Money Held by the Argentine Central Bank at the NY Fed and at the BIS

If the Argentine government decides not to pay the money it owes you, you will not be able to persuade its domestic courts to dissolve it, and to reimburse you with bankruptcy proceeds. You cannot hope to be reimbursed with government buildings, public roads, army equipment, police stations, and so forth. You may sue the Argentine government before the courts of your own country or a third country, but you will not be able to have the judgment enforced against a foreign sovereign. As an American judge reminded plaintiffs in the Argentine case, “You have rights but may not have remedies.” Hence the hurdle faced by holdouts on Argentine sovereign debt.

The vulture funds and a few other holders of defaulted Argentine debt have been fighting hard. Their strategy was to buy the bonds cheap and redeem them at a higher price. They have obtained hundreds of judgments against the Argentine government. Two vulture funds are sitting on $3-billion worth of favorable rulings. Since the Argentine government will not reimburse them, they have tried to seize money held by the Argentine central bank at the Federal Reserve Bank of New York, at the Bank of International Settlements (BIS), which is the central bankers’ bank, and in private banks outside Argentina. The lawyers of one hedge fund apparently served a subpoena to the BIS’s general manager just as he was about to speak at a public event. “His Excellency” was probably not happy! But all these efforts have failed. The creditors have had only symbolic successes, such as seizing $90 million from a New York trustee who was holding shares of a privatized Argentine bank, or seizing a few million dollars that the Argentine science ministry had deposited in an American bank account in order to buy telescopes. However, this activism probably means that the Argentine government cannot return to international financial markets until it reaches an agreement with its disgruntled creditors, as proceeds from the sale of Argentine bonds issued in an international financial center would likely be seized.

—Pierre Lemieux, The Public Debt Problem: A Comprehensive Guide (New York: Palgrave Macmillan, 2013), 2-3.

When a Government Does Default, Getting your Money Back Is Not Easy—“Vulture Funds” Can Try To

When a government does default, getting your money back is not easy. Ten years after the government of Argentina defaulted on $81 billion of bonds issued in dollars and sold to international investors, some creditors have still not agreed to the loss that was imposed on them. The government of Argentina had made a take-it-or-leave-it offer: accept 35 cents on the dollar, or you will get nothing. Some 93 percent of the bondholders ended up accepting the offer: better a 35 percent settlement than nothing. The remaining 7 percent rejected the offer, and have been trying since then to force the government to pay the full principal of the bonds plus accrued interest. Some of the original holders have chosen to sell their bonds, so that the current holders are not always among the original 7 percent. Many bonds were sold on the secondary market to so-called vulture funds, which have spent millions trying to get a full reimbursement from the Argentine government. Vulture funds are hedge funds (more risky investment funds) that buy distressed assets that have fallen to a fraction of their value, wait for the issuer to go bankrupt, seize its other assets, and try to make a profit by reselling them. The problem is that nobody can force sovereign states to go bankrupt and to be sold in pieces.

—Pierre Lemieux, The Public Debt Problem: A Comprehensive Guide (New York: Palgrave Macmillan, 2013), 2.

Hedge Funds Attacked Iceland’s Banking System by Shorting the Currency (the Króna) and Bonds Using Credit Default Swaps

In the Geyser crisis, international hedge funds attacked Iceland’s leveraged and mismatched banking system, as well as its government, by shorting the currency and the bonds of the banks via credit default swaps. Even the government’s own bonds were not immune to this attack. Iceland became an international headline. Banks tried to defend themselves against the distrust by pointing to their stellar ratings from the rating agencies. Yet high default swap spreads indicated a general distrust of the Icelandic financial system. Newspaper articles about the faltering currency and the widening CDS spreads further eroded confidence in the banks, causing the spreads to widen. The króna weakened, making the situation a focal point of media attention. The market view that the Icelandic banks would not be able to refinance themselves turned into a self-fulfilling prophecy, but only because the financial system was vulnerable due to its mismatching and credit expansion. Credit default swaps would eventually reach almost 1,000 basis points; the cost to insure $1,000 of debt was almost $100.

Yet Iceland’s time had not yet run out. As Armann Thorvalddsson, himself a leading Icelandic banker, recognizes, “What eventually got us out of the situation was the fact that the world was still drowning in liquidity. Although the European bond market had had its fill of Icelandic bank exposure, money was available from other markets at a price.” Market participants realized that Icelandic banks still had access to funding and would not yet become illiquid. Moreover, the CBI increased interest rates (from 9 to 12.75 percent) to attract foreign funds and raise confidence. The króna stabilized and CDS spreads narrowed gradually, though they never reached their previous low levels. The collapse was prevented for the time being. Thanks to the ample liquidity in the interbank markets, the party could continue. From 2006 to 2007, asset prices soared, for everything from companies to wine to fine art. Everyone in Iceland seemed to become a millionaire. Even so, Icelandic banks became somewhat more cautious and tried to improve their liquidity situation. Landsbanki tried to increase its access to wholesale funding markets by tapping the internet deposit market with Icesave, an online retail bank that attracted billions of pounds when it opened in the UK. Kaupthing followed suit with its own internet deposit platform, Kaupthing Edge.

—Philipp Bagus and David Howden, Deep Freeze: Iceland’s Economic Collapse (Auburn, AL: Ludwig von Mises Institute, 2011), 75-76.

A Credit Default Swap (CDS) Is a Form of Insurance to Compensate for a Loss If a Debtor Defaults

Icelandic banks had no difficulties as long as international liquidity was ample and they could easily renew their short-term foreign-denominated debts. In early 2006, however, problems in the interbank market surfaced, in what would later be called the “Geyser crisis.” Price inflation increased and the króna depreciated as foreign money started getting nervous about the sustainability of the Icelandic boom.

Credit default swaps written on Icelandic banks soared. A credit default swap (CDS) is a form of insurance that investors buy to compensate for a loss if a particular debtor defaults on its obligation. Thus, when an investor holds a million-dollar bond issued by Glitnir and the insurance premium is twenty-five basis points or 0.25 percent, he can insure himself against a default by paying an annual fee of 0.25 percent of one million, i.e., $2,500. An intriguing aspect of credit default swaps is that you may buy them even though you do not own any debt issued by the company, Glitnir in this example. Lacking ownership in the underlying company, you are just betting that Glitnir will default on its obligation. By paying just $2,500 a hedge fund could make a gross profit $1 million if Glitnir defaulted on its obligations. Funds could bet on the downfall of Icelandic banks by buying credit default swaps, and by the very act of buying the swaps they could hope to undermine confidence in the banks and promote their own investment. The CDS spread on a bond is like an insurance premium in that it indicates the confidence in the bond. At the beginning of 2006 investors started to bet against Icelandic banks because of the banks’ high dependence on wholesale short-term funding and their burgeoning size, which made them too big to be bailed out by the Icelandic government. As foreign investors increased their demand for protection against defaults by Icelandic banks, the price of the insurance increased in CDS markets; that is, spreads on the banks rose.

—Philipp Bagus and David Howden, Deep Freeze: Iceland’s Economic Collapse (Auburn, AL: Ludwig von Mises Institute, 2011), 73-74.

Axel Leijonhufvud Says the Subprime Crisis of 2008 More Closely Fits the ABCT than the Keynesian Framework

Axel Leijonhufvud, an economist known internationally for his work on the literature of John Maynard Keynes and Keynesianism, has suggested that the subprime crisis of 2008 more closely fits the Austrian business cycle theory of Ludwig von Mises and Friedrich Hayek, than the Keynesian framework.

In this paper, we provide evidence for that claim. More specifically, we assert the following: 

1. that the subprime crisis, or the “housing-bubble” is not an isolated incident. Rather, it is one of a number of related events whose origins can be found in the monetary policy that the Fed has adopted at least since 1980;
2. that when we concentrate on the most recent cycle, (Krugman, 2002), we find that the Fed intentionally replaced the dot-com bubble with a housing bubble, expanding the money supply at a rate of 10 percent (measured by M2), and reducing real interest rates too low for too long; 
3.  that Greenspan-Bernanke, on behalf of the Fed, asserted, without foundation and contrary to the evidence, that the crisis was not rooted in the politics of the institution they lead, but was rather a global phenomenon, a “savings glut,” which reduced the long-term interest rate naturally; 
4.  that the popular explanation that blames the deregulation of markets as a cause of the crisis, is also unfounded. In fact, the banking system is one of the most regulated sectors in the U.S. economy. It was, in fact, the excessive regulation of the system, which channeled the easy money policy of the Fed into real estate, thus distorting the physical capital structure of the economy;
5.  that the boom we have seen in the housing sector started between 2001 and 2004, and could only have persisted as long as the Fed was able and willing to keep interest rates low, a policy which risks the precipitation of general price inflation. In the face of this threat, the Fed finally raised interest rates, bowing to market pressure as the demand for loanable funds increased. This produced the inevitable deflating of the bubble and the onset of crisis and recession, not only in the real-estate sector, but also in the banking-sector which supported it during the boom;  
6.  that the long-term adjustment process involving as it does adjusting fundamental macroeconomic variables to underlying economic realities has real and enduring consequences. These effects are not “neutral.” Real capital value has been destroyed in the process;
7. that while there is a consensus among economists about expanding the monetary-base as the best “emergency strategy” when facing a possible secondary contraction, Bernanke could have avoided micro-engineering and the favoritism and moral hazard that it implies, and opted for open market operations, rather than the selective rescue of some large companies (those that were “too big to fail”); 
8. that accompanying the Fed’s monetary policy, the U.S. Treasury followed an expansionary fiscal policy in an effort to boost employment and thus mitigate recessionary expectations. But the fiscal deficits that the federal government and state-governments has and are accumulating have not delivered the promised employment increases. The fiscal crisis they have produced portend painful, but inevitable, adjustments—expansionary fiscal policies cannot continue and will have to be reversed. We conclude that it should be no surprise if the U.S. economy should fall into a new cycle in the coming years, even though economics does not provides the tools to predict the precise timing of it.

—Adrian Ravier and Peter Lewin, “The Subprime Crisis,” Quarterly Journal of Austrian Economics 15, no. 1 (Spring 2012): 46-47.

State Debt Since 2008 Has Exploded — and Hovers over us Like the Sword of Damocles

But it was not just the real economy that got into trouble. The bursting of the real estate bubble caused extreme losses for the banks. But these losses were also only partly recognized, and banks were saved all over the world by their respective national governments. As a result, the bad debt was transferred from the banks to their governments, but this does not mean that these debts have disappeared. Or do you believe that a hot potato just disappears when it is handed off? Someone has it. Ultimately it is all of us who have it, as will become obvious sooner or later. In the meantime, additional bad state debt has been added: for example through the increase in “social expenditures” in the form of support for the unemployed and through numerous economic programs meant to jump start the economy. State debt since 2008 has exploded — and hovers over us like the Sword of Damocles.

In other words: The losses stemming from malinvestments were to a large part just shifted to the nation-states and to the balance sheets of the central banks. Neither the original investors nor the bank shareholders nor the bank creditors nor the holders of government bonds have yet written off the losses. The bad debt just keeps piling up in the form of national debt. But shifting around bad debts does not bring back lost wealth. The debts remain. When and how do you think the debt will catch up to us?

—Andreas Marquart and Philipp Bagus, Blind Robbery! How the Fed, Banks and Government Steal Our Money (Munich: FinanzBuch Verlag, 2016), e-book.

The State Money System Makes It Possible to Hide the True Costs and Losses which the System Itself Creates

The cycles of artificial booms and recessions caused by the privileged banking system bring immense suffering to people. The financial crisis of 2008–2009 revealed the enormous amount of resources that disappeared into the chasm of the money system. Forever.

Was it really so bad, you think? Certainly you are overstating what happened!

The 2008 bailout orgy was without historical precedent. Banks, businesses, and even governments were rescued. Without pain, right? But have you noticed something strange? Did you lose your job or your savings? Were your taxes brutally increased in the past few years? Did your tax burden double? Probably not. How is the ongoing bailout financed? You already know: by new debt, by new money. This is what is so insidious about the state money system: it makes it possible to hide the true costs and losses which the system itself creates. It lulls people into a false sense of security. This false sense of security has been taken away from you. We warned you in the introduction to this book that unpleasant realities awaited you.

The big collapse did not happen in 2008. After the collapse of Lehman Brothers and the subsequent financial crisis, only part of the malinvestments were liquidated. Enterprises such as the troubled auto manufacturers and mortgage banks were rescued by the state; either by direct capital injections or indirectly through subsidies and state orders for goods and services. Bad private investments were turned into bad public debt — the process silent and lubricated with new money. This is because the state debt was financed indirectly with new money production. Central banks created new money with which the (commercial) banks and other economic “agents” then bought government bonds.

—Andreas Marquart and Philipp Bagus, Blind Robbery! How the Fed, Banks and Government Steal Our Money (Munich: FinanzBuch Verlag, 2016), e-book.