As He died to make men holy, let us live to make men free, While God is marching on.

“Battle Hymn of the Republic”

Julia Ward Howe

Christ was crucified in the same city where, in Jewish, Christian, and Islamic tradition, God stopped Abraham from sacrificing his son, Isaac. Christianity holds that God allowed Jesus to be crucified as the grant of universal forgiveness to mankind. The stage for that act of sacrifice was set by Christ’s declaration that freedom would overpower both a brutal Roman dictatorship and the economic fraud of a high priest that violated many laws of his own faith. In death Christ made us holy, and, in resurrection, showed the path to freedom, forgiving even His murderers.

Today, technology allows precise calculation of the greater value of freedom over dictatorship and fraud. We are certainly not holy; by combining the ancient laws of Moses and mathematics with modern data (see Charts 9.1, 9.2, and 9.3 and Chapter 9), however, this book shows:

1. In the crisis of 2007–2009, a modern day worldwide money changers’ fraud caused investors to lose $67 trillion ($30 trillion in the United States alone).
2. By 2013, the 2009–2012 recovery of free markets was rebuilding wealth at $34 trillion per year ($17 trillion in the United States).

With the United States as the guarantor of freedom following World War II, Germany has chosen almost 70 years of peace and prosperity over the powers of a king and a dictator that led it to pursue the two most widespread wars in history. Germany stood with the United States early in 2014 to challenge a Russian menace over Ukraine. Measured by similar principles, the cost to Russia of Vladimir Putin’s pursuit of new dominion in Ukraine was a more than 50 percent devaluation of Russian wealth.

Using rates for 10-year bonds as the metric, the value of each dollar of U.S. cash flow (over 30 years) is now more than twice that of Russian cash flow. Because it can rely on U.S. production for assistance in defense (as Russia did when Germany attacked it in World War II), the value to Germany of its cash flows is now 2.4 times that of Russia’s. That’s the merit of living “to make men free” versus today’s cost of aggression.

Experience is knowledge gained through our blunders; wisdom is knowledge gained by understanding others’ blunders. The United States is the world’s oldest democratic republic, but also is still a very young nation. We blundered along for nearly 175 years before our Constitution and courts finally granted universal suffrage: one person, one vote. Americans are still trying to understand how free markets operate. We will try not to bore readers as we describe our experiences and repeat the wisdom of others that developed today’s U.S. financial markets, the world’s best. Few subjects, however, are more likely to induce boredom than the details of finance.

Fraud was defined in the laws of Moses. It was only in response to the 1929 market crash, however, that the United States finally ended some of the off-balance sheet liability frauds of the Gilded Age and the robber barons. Before the United States enacted revolutionary banking and securities laws in 1933 and 1934, speculators used parent company–only financial statements to hide fraudulent schemes under pyramids of subsidiaries and trusts. Mandatory accounting consolidation ended many such practices, but it did not stop the frauds that hid the manipulations and speculations that burst into new financial crises decades later.

This book describes some of the many blunders that are now part of the U.S. financial market experience. The financial crisis of 2007–2009 proved, for example, why we must end the use of all off-balance sheet liabilities. In this book we’ll explain why that is and how to do financial transactions properly. Investors now know that by the time the subprime crisis had exploded, gigantic bubbles of unreported liability had grown, over the course of several decades, to $67 trillion worldwide and $30 trillion in the United States alone. In 2007, that accumulated megabubble burst upon an unsuspecting world. That $67 trillion of unreported claims against shareholder equity nearly destroyed all the wealth created since Moses. Some people still wonder how that hidden fraud triggered a massive flight to quality in 2008. It was a bubble hidden in fraudulent off-balance sheet transactions and made viral by accumulated megablunders.

The last time a similar financial crisis occurred, Franklin Roosevelt said: “The only thing we have to fear is fear itself.” Because of technology and the disclosure requirements that have been in existence since 2005, the United States now precisely measures the level of U.S. corporate bond investors’ fear on a daily basis. Daily disclosure of corporate bond spreads allows leaders to know whether investors deem their daily decisions to be wisdom that will attract new money or blunders that will drive investors away. Before they sit down to dinner, leaders in the United States can now know the actual benefit or cost of their actions with respect to the free market.

The Enron debacle caused the United States to perfect the measures of fear that are contained in bond spreads. These measures are not available at a similar level of precision anywhere else. Except for Ben Bernanke and a few others, however, U.S. leaders largely ignored the new indicators until September 2008. By then the bubble of fraud had burst. It was too late to fine-tune a response. So the United States and its allies were compelled to employ an age-old process: nationalization cum monetization. That expedient saved the financial world by creating a temporary bridge of disclosed liquidity to aid us as we try to convert the experience of our 1998–2008 blunders into wisdom for the future.

Whether other nations elect the path of wisdom over the harder path of experience is up to them. On March 3, 2014, available measures of investor fear warned Vladimir Putin that it was a blunder for Russia to intervene in the free-market development of Ukraine, just as Adam Smith warned King George III that it would be better to trade amicably with Britain’s American colonies than to try to dominate them.

To its initial credit, Russia seemed to show wisdom. It backed away from overt threats, but the choice of learning by the experience of repeating its blunders still seems to guide Russia. During the period of perestroika, Mikhail Gorbachev lamented the servile patience of many Russians. Far too many people, there and elsewhere, seem willing to wait, perhaps forever, for personal and economic freedom. While Jesus lived, Hillel the Elder is credited with saying: “If not us, who, and if not now, when?” We hope wisdom, and the peace and prosperity it offers, will prevail in the world and believe now is as good a time as any to cultivate it. When peace wins, as George Marshall showed Russia after World War II, it can redeem all its current losses. We submit that financial stability is vital to that success.

This book began as a way to thank Robert M. Fisher, a lawyer and economist at the SEC who, 11 years ago, listened patiently for five hours as Fred Feldkamp explained a process some clients had perfected to generate stand-alone financial transactions that create risk-free arbitrages for financial assets, such as home mortgages and automotive loans. Done correctly, that private sector innovation, collateralized mortgage obligations (or CMOs), was the process by which the United States finally brought equilibrium to bond markets. Created in 1983 for residential mortgage markets, and spreading to other financial asset markets in 1993, the CMO expanded sources of finance and economic opportunities in an economy that for decades had been dominated by strictly controlled commercial banks. Similar processes to create financial arbitrage were used by central banks to bring financial markets out of crises in 2009–2013. In the hands of private-sector investors, riskless financial arbitrage is the foundation on which investors can sustain financial stability and economic prosperity around the world.

After listening for all those hours, Mr. Fisher looked at Fred and said, “You’ve just described the solution for financial stability, the last unsolved problem of macroeconomics.”

About two years after that meeting, the SEC insisted that pricing, size, and other details of all U.S. corporate bond trades be immediately reported via the TRACE (Trade Reporting and Compliance Engine) system. Soon thereafter, a self-regulatory group called the Financial Industry Regulatory Authority, or FINRA, used that data to begin publishing daily real-time yield indices that allow all investors to see each day’s movements in credit spreads, information bankers regularly and carefully hid from competitors in the past.

Credit spreads measure the difference in yield between corporate bonds of different grades. They reflect the precise fear response of investors to daily changes in (1) U.S. market policy and (2) all other events with market implications for investors in corporate bonds. Charts 9.1, 9.2, and 9.3 in Chapter 9 show how credit spreads moved up and down in U.S. markets between 2007 and the writing of this book. Table 9.1 translates that data to reveal the macroeconomic impact of changes in credit spreads.

This book thanks Mr. Fisher for the countless hours of fun—and profit—Fred has enjoyed using credit spread data to anticipate market events and to commend or criticize policy actions since retiring in 2006 from his active law firm partnership.

By noting U.S. bond investors’ actual cash trading patterns in response to events each day, and by aggregating that data in a few simple charts, politicians and regulators were able to accurately observe investors’ reactions to each step leading to the worldwide financial collapse of 2007–2009. When the dust settled, they were likewise able to track the success and failure of each step to reform U.S. markets and to observe the rise and fall of credit spreads during each of several lesser crises that have affected worldwide investors since 2009.

Each business day, this bond data is published about 90 minutes after the closing bell rings at the New York Stock Exchange. Each evening after the market close, therefore, everyone who is interested in the reaction of the bond market to what transpired that day can learn whether U.S. leaders succeeded or failed. The data allows for instant course corrections, or celebrations, as applicable.

For the first time in the history of finance, everyone has real-time data, generated by actual cash trades, to understand whether policy actions impress or disgust millions of bond investors who vote with trillions of dollars every single day in response to the actions of world leaders. This data provides the facts needed to replace political rhetoric with knowledge, whether acquired by wisdom or blunder.

Everyone can and should vote at elections. Between those events, however, every economist worth hearing or reading understands, generally speaking, that it is only investors’ votes that determine the success or failure of leaders’ actions. Market indicators like the Dow Jones Industrial Average, the Federal funds rate, and the yield on the 10-year Treasury bond are, after all, the ultimate barometers of political as well as financial success for any U.S. president, Federal Reserve Board chairman, or congressional leader.

As research for this book progressed Fred realized that, when looking at bond spreads, we are not just observing events that impacted the last decade in the United States. Over the centuries, most economic observers had no idea how to generate an accurate and instantaneous daily measure of the fear that drives capital markets. So, this project grew a little bit. As Fred researched the subject further, he began to discuss his findings with Chris Whalen, his friend and coauthor.

Over years of friendship and collaboration, it occurred to the authors that the ebb and flow of confidence and fear in all markets is the essential quality that determines financial and economic stability, and, ultimately, the wealth of nations. The United States is the only nation that has institutionalized the measurement of financial stability by making daily credit spread and other corporate bond market information widely available.

What we observe as daily problems in U.S. corporate bond markets (before, during, and after the Great Recession) has caused crises and wars for perhaps 4,000 years. In A History of Modern Europe: From the Renaissance to the Present, John Merriman notes that “Early in the sixteenth century, an Italian exile told the king of France what the monarch would need to attack the duchy of Milan: ‘Three things are necessary, money, more money and still more money.’” He was describing the relationship between currency debasement and military conflicts (Merriman 2010).

Until 1776, when Adam Smith won praise for publishing a treatise that differentiated central banking from reserve banking, brave individuals who openly opposed their rulers’ use of monetary policy to maintain power and fund wars were regularly executed. In the twentieth century, the expanding use of finance to create new economic opportunities democratized the money game. The fact that investors can vote with their money now empowers individuals to curb bad policy decisions by their leaders.

The solution to financial instability has been sought for at least 2,000 years. We submit that it lies in the public reporting of credit spreads and other bond market data, and in the use of financial structures that contain spreads. Hopefully the financial crisis of 2007–2009 will move us closer to a true democratization of finance and lessen the possibility of future economic dislocations and wars. If we implement the solution correctly, the world can anticipate when the system is beginning to fall out of balance (due to fraud or other sources of instability) and invest whatever it takes to save the world. Once saved, we can sort out a cure that addresses the cause of the crisis.

Central bankers in the United States, United Kingdom, Europe, and Japan have proven that they understood what had to be done in the wake of the financial crisis to raise the value of the economies they guide and restore investor confidence. The question is whether we can institutionalize this knowledge to limit market swings between fear and euphoria and thereby greatly increase the economic well-being of all free people.

Frederick Feldkamp

Christopher Whalen

June 2014