I can calculate the movement of the stars, but not the madness of men. -Sir Isaac Newton

There are five zombie banks that control between 20%-40% of NYSE daily volume. It started earlier this year with Citigroup and Bank of America. They equaled 10% of NYSE total daily volume. Now the trend in High Frequency Trading (HFT) is on the rise. This begs several questions. If this is a healthy bull market, why are just five stocks running the exchange? Is it possible the bailout money is being funneled into just a few stocks? To get a really good answer we’re going to visit London England in the year 1720. Let’s explore how history is repeating itself with the new South Sea Bubble. The goal by the end of this article is to draw connections between the greatest financial bubble of all time and what’s happening today. Hopefully it will be so obvious you’ll feel sick.

One Chart to Rule Them All

There’s actually 315 years of stock market data available. People think DOW 4,000 is impossible, but look at this 315 year chart and how juicy DOW 1,000 is.

Here’s the theory. The country has nearly run out of credit forming the end of a Grand Supercycle. The money issue is obvious with state budget problems. So what is the most expedient way to generate credit in a corrupt system? A Ponzi scheme. Make it really big and complicated so no one can figure it out in time.

Here are some of the basics. The global financial markets, which are primarily run by New York banks, are being propped up by the Federal Reserve selling Treasuries. The money that is placed in Treasuries is then built out with leverage and funneled into the most wounded names in the banking system. These names get pumped up to create a cash machine that is used to cover debts of the United States of America. This is just a basic model, but understanding how this works will open windows into our corrupt financial system. A system designed to tax and steal without our knowledge.

Look at the stocks moving the market:

Volume continues to be concentrated in just a few names. Today, in a universe of over 5,000 stocks in the U.S. equity market, only 4 stocks contributed 20% of the volume.

Citigroup (C), Bank of America (BAC), Fannie Mae (FNM) and Freddie Mac (FRE) traded a total of 2.041 billion shares. Overall volume in the U.S equity market was only 10 billion shares. -Joseph Saluzzi

There is some variation to which names lead volume for the week. The PPT cash machine cycles through several names during the month. Read Themis Trading’s white paper, Toxic Equity Trading Order Flow on Wall Street: The Real Force Behind the Explosion in Volume and Volatility. This gives a concise explanation for current market mechanics. Here’s a section most of us don’t think about:

High frequency trading strategies have become a stealth tax on retail and institutional investors. While stock prices will probably go where they would have gone anyway, toxic trading takes money from real investors and gives it to the high frequency trader who has the best computer. The exchanges, ECNs and high frequency traders are slowly bleeding investors, causing their transaction costs to rise, and the investors don’t even know it.

What HFT Looks Like

The main HFT stocks are C BAC FNM FRE AIG and CIT. During Fed POMO days, where they’ve recently been injecting $30B into the market on a weekly basis, these names will cycle through large cash inflows. This is the new PPT vehicle. Check out the chart of AIG during a heavy week where $197B in Treasuries were on auction.

Note the blue shaded area on the chart. This is classic HFT or program trading where a stock churns shares within a very small range. Liquidity rebates are also happening where dealers like Goldman Sachs earn a quarter penny on every share traded. Everyone gaming the stock makes out. Shareholders looking for organic growth get chopped to pieces. It’s a giant cash machine and the stock goes nowhere, much like the S&P 500 intraday.

Then something happens… The PPT shows up. This move in AIG is a classic PPT push where a massive amount of capital is pumped in during the last hour of the market. HFT algorithms can see it coming and get out of the way. Here’s part of the reason why these moves come at the end of the day:

The directives of the FOMC are carried out in the context of two week maintenance periods. The Manager of the System Open Market Account is charged with achieving those objectives via the daily operations. (source)

Step One (08:30am):

• gather information, macroeconomic news
• desk telephones primary government security dealers
• large banks inform the desk about their reserve needs
• NY Fed gather data to provide forecasts of reserves

Step Two (10:30am):

• call to the Treasury concerning its forecast of its balance for the day

Step Three:

• formulate the actions for the day
• forecasts from Treasury, NY Fed, and Fed BoG combined
• interventions are formulated
• trading plan is formulated

Step Four (11:15am):

• conference call links…
• Manager (and staff)
• Director of the Division of Monetary Affairs at Fed BoG
• a Federal Reserve Bank president who sits on FOMC
• proposed actions for the day are detailed

Step Five (11:40am)

• desk traders contact primary dealers and execute day’s program

See our story Anticipating PPT Days for ideas on what these moves look like and how to trade them. This same move was seen in ABK AIG CIT FRE FNM during the last couple weeks. It is reminiscent of the moves seen prior to the September 2008 market crash. It used to be a safe assumption to put your money where the government puts theirs. Now that money disappears, in more ways than one.

Myth of Savings Accounts

Citibank (and many others) have a program called Deposit Reclassification. This is a relatively new financial scheme you won’t find on Wikipedia. It was invented for credit unions and banks to put dead money to use. That dead money comes from your savings accounts.

For accounting purposes, all Citibank consumer checking accounts consist of two sub-accounts; a transaction sub-account to which all financial transactions are posted; and a holding sub-account into which available balances above a pre-set level are transferred daily. (source)

What this means is banks using this program do not have to maintain a 10% deposit reserve on cash in savings accounts. So how do they guarantee cash that isn’t there? Banks use this sub-account loophole to circumvent all retail deposit reserve requirements. Under normal Federal Reserve System rules banks can leverage $100 in deposits into $1,000 of credit based on a 10% reserve. This is virtually free money for them. The more deposits they have the more credit they can create out of thin air.

With a 0% actual reserve–who knows? This nullifies what the FDIC says about the safety of the banking system and deposits. What deposits? Check out this presentation by the New Jersey League of Community Bankers on how it’s done.

Note that in July 2008, the banking system’s vault cash EXCEEDED both required and total reserves. [Vault cash is the physical banknotes that banks keep on hand to meet withdrawals; the vast majority of dollars exists in the form of electrons, and only a tiny sliver is metal coinage.] Now, in July 2009, the required reserves and vault cash have been relatively unchanged.

Over the same period, the monetary base has almost doubled from $847 billion to $1,681 billion while reserves grew by about the same amount, from a scant $45 billion to $803 billion. Where did this money come from? It is likely just FED “liquidity” or newly created currency. We would need to audit the FED to really be sure, but the timing and amount coincides with the Banker Bailout of October 2008. (source: Jake Towne for Congress)

Software also exists that allows banks to move money on a whim. There’s SWIFT that nearly everyone uses and fi-linx for Deposit Reclassification. These systems run a, “Now you see it. Now you don’t!” form of financial engineering. They can move money undetected in and out of accounts. One day the bank will have 0.6% cash on reserve, and the next they exceed the Fed 10% requirement. This is part of the reason bankers do not want the Fed to be audited. It’s also part of the reason we’re seeing enormous credit injections.

Banks and Bubbles

Current HFT names could be a modern version of the South Sea Company. In 1720 Britain had the equivalent of roughly $2T in debt and was nearly bankrupt. The South Sea Company was used to service that debt. Roll all of the debt into private stock, dupe everyone and their grandmothers into buying it, then sell for a profit. The public gets left holding the bag. Sound familiar?

A senior Bank of England official today compared the banking system over the last 20 years to the South Sea bubble of the early 18th century and said bankers had merely “resorted to the roulette wheel” to keep up with each other. (Guardian UK)

The South Sea Bubble was an enormous scam conceived after a costly war where Spain and France tried to control all of Europe. The stock became a vehicle for Britain to offloaded their war debt upon a naive investing public. Even Isaac Newton got soaked speculating in this stock. The South Sea Company was a Ponzi scheme. They were initially slave traders with one boat that did one trip a year. They never turned a legitimate profit. It is the original event that coined the term “bubble.”

Here’s some more good stuff from Ashley Seager at the guardian.co.uk:

The Bank’s executive director for financial stability, Andy Haldane, said in a speech in Chicago that having been stable over much of the 20th century, returns in the banking system relative to the wider stockmarket shot up after 1986 until 2006.

“Banking became the goose laying the golden eggs. There is no period in recent UK financial history which bears comparison,” he said. He said bankers and policymakers became seduced by the excess returns available: “Banks appeared to have discovered a money machine, albeit one whose workings were sometimes impossible to understand.

“One of the South Sea stocks was memorably ‘a company for carrying out an undertaking of great advantage, but nobody to know what it is’. Banking became the 21st-century equivalent.”

“For a number of diseases, 20% of the population account for around 80% of the disease spread. The present financial epidemic has broadly mirrored those dynamics,” he said, adding that the failure of a core set of large, interconnected institutions such as Fannie Mae, Freddie Mac, Bear Stearns, Lehman Brothers and AIG contributed disproportionately to the spread of financial panic.

How the South Sea Company Operated

Keep the Fed pumped AIG chart in mind while reading the following. Excerpts from Harvard Magazine’s “The Damn’d South Sea” by Christopher Reed:

On January 1, 1720, the price of a share of South Sea stock stood at £128. On June 24 it hit £1,050. In September came the crash. By December the stock had returned to £128. Thousands declared themselves ruined. Banks could not collect loans on inflated stock and failed. Specie was in short supply. Work stopped on half-built homes. Investigations and revenge ensued, and a long struggle to restore stability.

Sir Isaac Newton, scientist, master of the mint, and a certifiably rational man…sold his £7,000 of stock in April for a profit of 100 percent. But something induced him to reenter the market at the top, and he lost £20,000. [roughly £3 million today]

To put these sums in perspective, Carswell points out that a middle-class family could live very comfortably at the time on £200 a year.

The maxim that credit was not wealth unless it rested on a wealth-producing asset had been ignored…,” writes Carswell (former secretary of the British Academy). Greed blinded many, but not all. One unidentified observer saw clearly: “The additional rise of this stock above the true capital will be only imaginary; one added to one, by any rules of vulgar arithmetic, will never make three and a half; consequently, all the fictitious value must be a loss to some persons or other, first or last.

“In order to pay out profits, the South Sea Company needed both to raise more capital and to have the price of its stock moving continuously upward,” writes the economist and MIT professor emeritus Charles P. Kindleberger in his classic work Manias, Panics, and Crashes: A History of Financial Crises (Wiley, third edition, 1996). “And it needed both increases at an accelerating rate, as in a chain letter or a Ponzi scheme.” The company repeatedly raised cash through new issues of stock as its price spiraled upward in the summer of 1720.

“It was clear that the Company could only pay the £7,500,000 to the government if they exchanged South Sea stock for government obligations at prices far above par 100. And, the higher the price of stock at the time of conversion, the greater the profits which would accrue to the Company. In addition to the profits the directors could make by holding South Sea stock were those available through stock manipulation which, in this case, included transactions in non-existent stock. The directors could create and purchase stock at a low price and sell it for an inflated price. It was a foolproof way of making a large fortune and it proved to be an irresistible temptation.

“Carswell employs a hydraulic metaphor to describe the action. The company first created £2 million in new South Sea stock, at £300 a share, and let investors pay for it in installments. Subscribers eagerly bought it up, and the company covertly issued £250,000 more for good measure. Then it announced that its cash position was so strong that it could lend shareholders money on the security of their South Sea stock. The price of the old stock at once rose to £325. The company issued yet more stock and made more loans, again and again.

“So Blunt…had constructed a financial pump,” writes Carswell, “each spurt of stock being accompanied by a draught of cash to suck it up again, leaving the level higher than before.” Success required that the level keep rising.

The South Sea Company was a confection of politics, commerce, and finance. None of its governors or directors had any experience of trade with the New World, but John Blunt, who wrote the charter and was the company’s dominant director, had been a scrivener and then director of the Sword Blade Bank. He and cohorts had a fine understanding of financial manipulation.

The company had the further splendid purpose of relieving the government of its burdensome unsecured public debt–obligations for which Parliament had assigned no funds–which then amounted to £9,000,000. South Sea was organized under the newish joint-stock principle, as a corporation with transferable shares. Holders of the national debt were obliged to exchange their government securities for shares at par in the company. The company could raise working capital–a huge amount of it–by borrowing on the security of the debt due from the government. In addition to its trade monopoly, the company would get an annual payment from the Exchequer of £568,279 10s., or 6 percent of the debt taken over. Stockholders had no promise that they would see any of this as dividends, but who could blame them for thinking that capital gains based on trading profits were a certainty?

Final Thoughts

Fortunately we now have technology that can dig under the surface. What does it mean again when the stock goes up while institutions are bailing?

A quick review of why the South Sea Company stock failed and why it’s like AIG C BAC etc:

1. Government funded stock secured by government debt
2. Stock operates in a monopoly environment
3. Corrupt system with unknown sums and fake shares
4. Depends on an infinite increase in value

What’s amazing is the South Sea Company stayed in operation for almost 100 years. However, the South Sea Bubble ended with purges, the Napoleonic wars, and about sixty years of total misery. It is partly responsible for the U.S. emerging as a new world power though. Here is some parting irony:

Historians wishing to study the company and the era can be awash in source material if they go to the right place–the Kress Library, Harvard Business School’s rare-book collection, housed in Baker Library.

Almost all of it was assembled by Hugh Bancroft, A.B. 1897, A.M. ’98, LL.B. ’01, president of Dow, Jones and Company. After his death in 1933, his wife presented the Bancroft collection to Harvard. It offers true value to scholars wishing to explore a seminal lunacy.

Lastly, Robert Prechter is very vocal about these connections. Check out the July issue of The Elliott Wave Theorist.