Wally (Wall Street) goes to Smallville (Reagan/Bush/Clinton/Bush Administrations) and talks to the mayor about opening a casino in town. The mayor thinks it is a fantastic idea. Wally says there are a couple of preconditions though, he wants the casino to have special tax breaks for the players and no regulation or interference whatsoever in whatgoes on inside the casino. Fair enough, the mayor and the city council are glad to oblige. In fact, he and a lot of local people want to play too through player-representatives (hedge funds). The mayor and his friends are going to make a killing on the casino coming to town. They want him to run for Governor next term.
The casino Wally is setting up is very different from the traditional casino in that there is no "House" to cover the bets. The role of the traditional casino "House" is taken up by the other party to each bet made at any table (transaction) in the casino. The "House" (Wall Street) is providing the facility and the playing field for the players, who are mostly known to each other and the House anyway. A critical feature of the casino is that bad or good bets at the crap table are covered by another player at the crap table, not the House. Those are the rules. The volume of action in the casino is only limited by the number of IOUs other players are willing to accept. The IOUs are payable in US dollars.
The players adore this game. They walk in with $100 and can buy $5,000 worth of IOUs (chips), "nominally" issued by the House, but only as a custodian for the players; like a private clearing house. The chips are the IOUs (derivatives, CDS contracts, MBSs, etc.) while a player is involved in the game. Winners and losers are made every minute by the action at the various tables, which differ only in the type of game (cards, dice, roulette, slot machine, etc.), not in the substance of an IOU exchanging hands for the right to play.
One day, one of the "high-rollers" at the casino has a few of his IOU's called-in by other players and whoa! He doesn't have the money to cover his IOUs! In fact, it turns out he has big losses already in the game. He starts trying to collect on some IOUs he holds and finds that some of them aren't any good. He was having so much fun playing the game and making so much money for himself and his staff on a current basis, in terms of fees and reporting profits to his friends and shareholders, that that there was no need to think about these details. The casino had everything going for it, political cover, it's own bank creating money, albeit phantom money, private exchange, and a host of "brilliant", credible players with deep pockets.
Now Wally has a problem. Other players are lined-up outside his office wanting to collect on some of their IOUs. Wally doesn't have the money, he's just the casino facilities operator he tells them. "I"m just the clearing house taking a cut. You knew what you were doing when you gave and took those IOUs", he tells them. But they shout, "You have the power and wherewithal to cover us!" Some of us have more IOUs going the wrong way and didn't balance our IOU portfolios, and unpaid IOUs will only make the problem worse! Your reputation is on the line and you are in this too Wally", they plead. So, Wally goes to the mayor of Smallville and suggests that Smallville's citizens need to cover the bets made by the players at the casino. After all, they benefited too, Wally argues. Wally brought in lots of money to Smallville's town council and other politicians. Funds flowed to Smallville and its environs and they also put a lot of money into the mayor's upcoming run for Governor.
The mayor doesn't like it because he knows it is going to be hard to spin to the citizens of Smallville, but the alternatives as explained to him, are bleak indeed. "What else can I do?" he mumbles to himself constantly. The town's economy has become dependent on Wally's business. The local economy will collapse since some of the local commercial banks are carrying some of the high-rollers IOUs. The political pressure is enormous from Wally and his influential friends. The mayor goes along again. "What else can I do? File a law suit? Against whom? For what?", he tells his staff and neighbors.
Finally, an aide in the mayor's office exclaims, "Wait a minute! Why can't the casino patrons get together and cross-eliminate all these bets? Net them out, gains against losses? It's all IOUs anyway. It doesn't matter how many times removed any particular IOU is from one another. They are all holding IOUs transacted at the casino! They put them all together in a big pot and compress them down to the nub, eliminating all of the debits and credits. The last players holding the IOU in excess of someone's else ability to pay take the netted-out loss. That way, the largest players in the game that are still around take their losses. How do we know they don't also have astronomical profits from the casino? And even if they don't, what can they do, sue us to cover their losses? We didn't know anything about their gains and losses. If anyone is going to be sued they will sue each other over not paying their respective IOUs after compressing them to the nub. Why should we and our citizens vouch for the action at the casino?"
Another said, "Even Wally had friends who weren't patrons of the casino, but most of his friends were regulars."
Then, another of the mayors aides said, "I get it. They created a type of currency with these casino chips that were convertible into Smallville dollars." Another said, "Now if only the City Council could understand, but they are only listening to Wally and his friends."
The citizens of this Republic need to understand this. In fact, it is the duty of those of us who do understand it to explain it to them. The substance of the above metaphor accurately reflects the details, regardless of Wall Street lawyers holding up 500-page CDS contracts. That is Wall Street spin. You see, Wall Street lawyers made a fortune in this market as well. And in case you weren't informed, we are too stupid to understand what these "brilliant people" have "created" for our benefit. The "brilliant" people on Wall Street, the likes of Secty. Paulson, the progeny of numerous university business school professors, the main-stream press, et al, is just drivel. Wall-street spin, or as David Reed would say, "failed physicists."
The remaining investment banks and other players want you and I to cover their IOUs and keep the casino in business. If that isn't brazen enough, we don't even get a tax subs idy like they did on their profits, and still are getting!
The correct response of the mayor of Smallville is simple, if someone could inform him and he had any integrity. Let the casino players unsort ("net out", or "compress") the pool of IOUs and sue each other over non-payment of their 500-page CDS contracts. Their shareholders, hedge fund participants and other investors would take the compressed losses, however much it might turn out to be. $1 trillion? $2 trillion? $5 trillion? The shareholders and investors of the regulated and non-regulated financial institutions around the world can absorb those numbers without burdening the already harassed citizens of Smallville. Just Alan Greenspan. If the citizens of Smallville understood that, maybe the mayor would change his mind since he is running for Governnor next year. Maybe he would find the strength to do the right thing, to do his duty by his fellows. The Smallville banks that participated at the casino have to be compressed as well, and some will fail. That's unpopular in some circles of Smallville. Perhaps many will fail, so what? Won't they likely fail anyway? Wasn't the value proposition that Wally came to Smallville with in the first place exactly that, i.e., the IOUs were an elegant, fool-proof way of "spreading the risk" on losses and of collecting on the IOUs? Yes, that's exactly what the physicists, mathematicians and high-rollers that came with Wally to pitch the mayor had said. They said it over and over again as the casino was operating 24x7.
On the contrary, Wally, the mayor and all of their friends in the media frightened the citizens of Smallville into believing that they had to incur further indebtedness and pledge what remains of their vanishing wealth to cover the outstanding IOUs at the casino. No compression is necessary as long as a few of the high-rollers avoid scrutiny and prop-up the IOU market (Goldman Sachs, Morgan Stanley, certain purchased entities of other bankrupt high-rollers), because Wally and the mayor now have everyone convinced that the high-rollers bets need to be made whole, or they will suffer too, even worse. They have been heard to say, "We are all in this together." Yes, but only those who played at the casino, not those who did not.