This was done by investment bankers and the so-called “shadow banking system.” It was here, outside the view of credit markets and regulators, where leverage was secretly applied to bonds.

The primary tool used was derivatives. This “financial innovation,” essentially broke the direct link of bonds to capital. In AIG’s case, for example, the “insurable interest” connection to loans was breached. Third parties without any insurable interest, via derivatives, were able to leverage the credit capital and turn it into, for all practical purposes, equity. In many cases, these derivatives were “traded” on Over The Counter markets where, in some cases, the ownership of a derivative was not even known. Just like a bearer bond.

Zombie banks are, in effect, banks where it has not been legally realized that credit instruments on their balance sheets are actually equity instruments. They are stuck, in effect, because they have to work off “risk” contained in their credit assets. Risk which, if acknowledged for the equity it really is, would simply be marked down like a stock.

And the government complicitly allows this because the alternative is insolvency, pure and simple. The first thing the FDIC does, in effect, is acknowledge that the debt is equity. Once that is acknowledged, it becomes clear whether the bank is alive or not. If not the bondholders get wiped out for what they really are: stockholders.

The folks who created this breach in fiduciary responsibility were paid handsomely. But inevitably the credit markets discovered they’d been buying equity all along, not bonds. Although short term “gamers” with these new “financial innovations” made lots of money, many participants in these markets got crushed alongside more traditional credit market investors. Hedge funds, for example, lost more than 50% of their capital, and many have gone out of business.

As long as the derivative markets exist in their current state, the credit markets will not recover enough to power any real economic recovery. Many of the derivative markets have collapsed, of course. No one’s going back there, regulation or no.

The real “lack of confidence” cited in articles is this one: Credit markets. The fundamental understanding of debt was breached. Bond traders became bond traitors. Until the losses created by this betrayal are unwound, the market will suffer under “no confidence.”