Mainstream commentators finally noticed.
It’s been a bit lonely sounding the alarm that the next crisis and bailout was on the runway waiting to take off.
That all changed this week as Congress debated whether to extend funding for the “discretionary” chunk of government. You know, stuff like defense department contractors, highway construction and repair, national parks, food stamps, scientific research, border patrols and so on.
Much to my surprise, the long-time policy that derivatives trading is a “Heads – we win; Tales – taxpayers lose” business became an issue that bubbled up to general consciousness.
Here’s what one of our most conservative bank regulators had to say when this bad idea came up:
Statement from FDIC Vice Chairman Hoenig on Congressional moves to repeal swaps push-out requirements
In 2008 we learned the economic consequences of conducting derivatives trading in taxpayer-insured banks. Section 716 of Dodd-Frank is an important step in pushing the trading activity out to where it should be conducted: in the open market, outside of taxpayer-backed commercial banks. It is illogical to repeal the 716 push out requirement. In fact, under 716, most derivatives — almost 95% — would not be pushed out of the bank. That is because interest rate swaps, foreign exchange and cleared credit derivatives can remain within the bank. In addition, derivatives that are used for hedging can remain in the bank. The main items that must be pushed out under 716 are uncleared credit default swaps (CDS), equity derivatives and commodities derivatives. These are, in relative terms, much smaller and where the greater risks and capital subsidy is most useful to these banking firms.
Derivatives that are pushed out by 716 are only removed from the taxpayer support and the accompanying subsidy of insured deposit funding — they will continue to exist and to serve end users. In fact, most of these firms have broker-dealer affiliates where they can place these activities, but these affiliates are not as richly subsidized, which helps explain these firms’ resistance to 716 push out.
To translate, the funding advantage banks have because their credit is ultimately guaranteed is huge. So important, in fact, that the largest banks were willing to call in every political favor they were owed to keep that last 5% of their derivative action inside the insured bank, even though it required a maneuver as visible as pasting it onto a budget bill that keeps the lights on at the US government.
In a rather stunning demonstration of special interest servitude, Congress agreed to shift the ultimate loss from exotic derivatives back to taxpayers by reversing Section 716 of the Wall Street Reform and Consumer Protection Act (Dodd-Frank). That was one of the few actual protections in the Act, though it had loopholes that still left us at risk.
Bear in mind that the four banks with the most derivatives activity hold 92.5% of all derivatives, while the largest 25 banks account for nearly 100% of all contracts, according to the most recent Office of the Comptroller of Currency (OCC) report on derivatives. (Check out Tables 3 and 5 and Graph 4.)
Just to keep this in perspective, the “derivatives used for hedging” include strategies that can wipe out all their earnings in one bad trade, as was demonstrated two years ago by JP Morgan’s infamous “London Whale,” who managed to lose $7 billion before the bank even knew they were losing. Those hedges were already allowed to stay in the banks. So were the “cleared” credit derivatives, the ones that have moved to an exchange for settlement. So were all the foreign exchange and interest rate swaps.
Every financial institution thinks they are above the average in managing their risk (hedging) or judging credit. They all believe their risk is minimal, their books are nearly perfectly balanced, and that their senior managers and top traders can’t possibly make mistakes that would precipitate another crisis.
They even measure their trading risk and report it – just $374 million (with an M) on $237 trillion (with a T) in face amount of derivatives outstanding at insured banks and savings associations.
For those who glaze over when the numbers get big enough (this even catches me sometimes), for every million dollars of derivatives trades on their books, the banks believe they have just $1.58 of risk. To emphasize, that’s a buck and a half of risk for every million dollars of trades. At least that’s what they report to the OCC, and each bank measures that risk in their own unique way. Hmmm...
In my book Finance Monsters I discuss how to mitigate these risks, which I think are much larger than the banks think they are. I can only hope the ideas in the chapters Detoxing Derivatives and The Market is the Solution become part of the mainstream policy discussion.