What You Absolutely Need to Know About Money (Part 8)

It all starts with the Arab oil embargo of 1973-74.

The Arab members of OPEC proclaimed an oil embargo to punish the U.S. for aiding Israel. This action quadrupled the price of oil, roiling commodity markets, equities, bonds, and foreign exchange markets.

Energy prices soared. Speculation in oil exploration and production became feverish.

There was money everywhere.

Oil exporters in the Arab states were depositing their windfall "petrodollars" into big U.S. banks, who were in turn lending the money out as fast as they could.

By far, the largest recipients of the flood of money looking to be lent out were Latin American and South American countries. Thus, the new tens of billions of dollars banks had to lend were showered on sovereign states with glaring credit quality blemishes.

In the meantime, banks were lending hand over fist to the energy patch. Small banks were getting into the oil lending game, too - sometimes in spectacular ways.

By 1982, tiny Penn Square Bank, located in the Penn Square Mall in Oklahoma City, Okla., had made over $1 billion dollars of energy loans and resold them to money-center bank Continental Illinois National Bank and Trust Company of Chicago.

The loans went bad, quickly.

That shouldn't have been a problem for Continental Illinois, which had over $40 billion in "deposits." But it was a monumental problem.

That's because only 10% of Continental Illinois' deposits were FDIC insured.

In 1982, depositors were insured up to $100,000; so when news got out that Penn Square had failed and the loans it had sold to Continental were defaulting, Continental depositors began to panic.

Continental had been playing the "hot money" game, very aggressively. To increase its loan portfolio, it needed more capital, or deposits. It got them by offering high-interest CDs and borrowing in the fed funds market for overnight money and in the money markets by issuing commercial paper.

Its deposits weren't "sticky," meaning they weren't going to be left there by folks with savings accounts. They were hot money deposits that were now exiting the bank via electronic transfer at unheard of speeds.

The bank became insolvent in a matter of days.

Depositors who hadn't gotten their money out would lose untold billions if the bank was shut down. The Federal Reserve, the Treasury Department, and the Federal Deposit Insurance Corporation feared a run on other banks, including all the nation's big money-center giants.

The panic unfolded at breakneck speed, and it had to be stemmed.

So the FDIC effectively nationalized Continental, by taking an 80% ownership position, and declared all deposits insured.

In other words, not a single depositor would lose money. The FDIC with the full faith and credit of the government - better known as the American taxpayers - was backstopping the bank.

It seemed like it was over before it started. Everything calmed down; there would be no bank runs. All America's big banks were safe, effectively christened... too big to fail.

But the hits kept on coming.

By September 1982, Mexico had stopped servicing billions in loans it had taken from big New York banks. And Brazil was on the verge of defaulting on its massive borrowings.

The big money-center banks with their billions in petrodollar deposits were now all in big trouble. But they were smart.

The big banks knew full well that they could never sell bonds on behalf of Latin and South American countries with a history of defaults (the high interest the bonds would have to pay to attract investors would be a dead giveaway). So they made syndicated loans, enticing over 700 smaller banks to join them in fueling the profligate spending habits of socialist and mostly commodity-export-driven southern sovereigns.

You see, what the banks had figured out was that their friends in government would never let them fail. They would use the International Monetary Fund as a front to help bail them out.

It worked like a charm, and it's still working today.

The IMF was originally established to help tide over countries with short-term liquidity problems, by providing short-term loans accompanied by reform demands to fix their economies so they could pay back the IMF loans. But at that point, it would be forever transformed into a U.S. government-backed payment enforcer.

The beauty of having a seemingly multi-national enforcer such as the IMF force countries at risk of defaulting on imprudently lent loans to reform their economies to trigger growth again, was that all kick starts would require fuel in the form of IMF loans.

Thus the IMF lends to debtor countries so they can pay off the bankers who they owe and are behind to, so the banks don't have to write off their bad loans, and foreign sovereign nations can keep borrowing in capital markets (and from the same banks) to pay off bankers and the IMF.

It's called "extend and pretend."

Well, it's more formerly known as the Baker Plan, after James Baker III (Ronald Reagan's Chief of Staff and later his Secretary of the Treasury), who originated the game to save the likes of Citibank's then-chairman, Walter Wriston (the co-inventor of CDs and a huge lender to Latin and South America), himself chairman of Reagan's Economic Policy Advisory Board.

Whatever it's called, the extend and pretend game is now an institutionalized national treasure.

Of course it benefits the TBTF banks in yet another cockamamie scheme to make their lending lives eternal.

That's how we got to TBTF and how the TBTF banks get away with piling on more and more debt to borrowers that have no way of ever paying it back.

It's how the banks operate. It's the business they've created.

Next we'll look at how the capital markets are rigged. We'll see how banks manipulate them for massive profits, basically to offset the tiny spreads they make on the loans they will never be repaid on.

Then you'll start to see how the Fed feeds the banks a lifeline to keep their lending going and, as their top regulator, lets them get away with murder in the capital markets, so they can keep on making money (to lend out to consumers and American businesses, of course) to enrich the crony capitalists who suck Americans dry like filthy leeches.

Then I'll tell you how to beat them at their own game. But first, you've got to understand who the players are and how the game is really played.

Welcome to your life...

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About the Author

Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.

The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.

Shah founded a second hedge fund in 1999, which he ran until 2003.

Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.

Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.

Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.

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