Derivatives To Be Spun Off?


Derivatives To Be Spun Off?

Posted by Karl Denninger

Am I dreaming? 

In an agreement struck Sunday, Banking Committee Chairman Chris Dodd agreed to replace his proposed restrictions on derivatives with those of the Senate Agriculture Committee, chaired by Arkansas Democrat Blanche Lincoln. 

If you remember, I wrote about this a few days ago

Along with forcing commercial banks to spin off their swaps dealers to a different corporate entity, Lincoln’s derivatives legislation would bar dealers, exchanges, clearinghouses and other swaps-market participants from being able to take advantage of emergency lending from the Fed, according to the aide. 

Ding ding ding ding. 

Give this lady a cigar! 

Look folks, we can’t fix what’s broken if we don’t do this. 

Let’s boil it all down to the simple when it comes to banks and their operations: 

It is essentially impossible for us to have meaningful reform if institutions with access to government backstops and privileges, including but not limited to the ability to fractionally reserve, access to The Fed window and FDIC insurance, are able to trade in the derivatives business. 

Banks inherently exist to collect deposits and make loans.  In doing the latter they allocate credit.  But when you take deposits and make loans you are effectively exercising the privilege of the sovereign (the government), because you are able to “recycle” lent money over and over again via fractional reserve policies. 

This is a major problem when you also have access to the securities markets, because you no longer need to make prudent loans to make money

Instead, you can make trash loans, sell them to someone and at the same time buy or sell derivative contracts on far more paper than you own (if you own any at all!)  

This, indeed, is what happened during the Housing Bubble.  Goldman and other banks “funded” huge tranches of “liar loans” and other lending that had no reasonable relationship between the interest rate charged and the risk.  Liars loans in all their forms will always blow up – they “work” only so long as the “asset” being purchased continually increases in value, allowing them to be rolled over.  

No bank in its right mind will make these loans and sit on the paper, because if they do eventually they will detonate.  This is not speculative, it is not a “might”, it is in fact a mathematical certainty that these loans will blow up.   The only speculative element is timing, not outcome.  As soon as the assets underlying those loans stop appreciating the paper all detonates – every time. 

This is the inherent fraud in these sorts of financing deals, and it’s not just in home mortgages.  Indeed, while home mortgages were ridiculous the more serious problem is in fact in commercial real estate and “deal-based” lending, which in many cases makes home mortgages look positively safe by comparison. 

For the bank, however, they don’t care, because with access to the derivatives markets they can make all the crappy loans they want on purpose and then short them at 2 or even 5x what they wrote! 

Since they know factually that these deals are no good, this is a no-lose proposition for them.  But the taxpayer, indirectly (or directly) gets screwed – these so-called “good” loans that were in fact trash were sold on to pension funds and other institutions who then lose all their money.  If the bank bet on the implosion it cleans up too – or as Goldman said, “we managed our way through the crisis.”  If not then the taxpayer gets hosed, as the Washington Mutual or IndyMac goes out of business. 

The base problem here is fraud.  Bill Black was on Bill Moyers Journal this weekend and he laid it all out, as I have in the past (and as he has in the past); this is a must-see interview.  The key quote is right here: 

WILLIAM K. BLACK Not even necessarily that, because most of these are liar’s loans, again. And they will not pay, right? It’s not an issue of liar’s loans, will it work or will it not work. It’s only when will it blow up. A liar’s loan will blow up. If housing prices keep going up for three years hugely, then they will blow up in the fourth year.

But they will blow up. So he was betting against something that he knew was going to blow up. 

There’s nothing wrong with betting against something you know is going to blow up. 

What is fraudulent is creating something you know is going to blow up and selling it to people as “good” paper

Look folks, The Fed didn’t give a damn and neither did the SEC.  When Lehman was on the brink of bankruptcy The Fed sent two people to oversee the firm.  Two!  This, for a risk that could, in their own words, take down the entire financial system. 

We also learned late last week that the banks intentionally gamed the ratings agencies.  During testimony late last week the ratings agencies stated that they gave their models to the banks.  The banks then cheated, using that data, by omitting or structuring the securities they submitted to get the desired “grade” – in this case, “AAA”. 

Of course if you have the answer key to a test before you take it you will always get a score of 100, right? 

This behavior isn’t an accident, it isn’t circumstance and it isn’t “impossible to foresee.”  It is fraud, pure and simple, and it is a crime. 

This sort of behavior, by the way, is exactly why we had Glass-Steagall.  The banks did the same damn thing during the 1920s too.  Oh sure, they didn’t have fancy computer models, but they were involved in making trash loans and then betting against them just the same.  When they failed they dragged the entire financial system into the toilet with them. 

Glass-Steagall prevented it from happening again for nearly 50 years. We started dismantling it in the 1980s and yet despite the written testimony of two of the forensic examiners in the S&L debacle, despite the warnings from Brooksley Born (who was run out of town on a rail), in fact, despite the following precise prediction of what would happen, Glass-Steagall was in fact repealed – first by making it a non-existent law through illegal and outrageous waivers granted by Alan Greenspan, and then finally by formal legislation.  The warning, which I referenced on July 7th 2008, while there was still time to shut Lehman down and stop the cascade, I said: 

Congress was warned.  Repeatedly.  In written testimony that is STILL, to this day, available to every single member of Congress. 

The Fed supported the repeal of Glass-Steagall.  In fact, Greenspan was strongly in favor of it. 

Today, Congress again sits on its hands and does nothing about rampant, blatant, admitted fraud in the banking system. 

Yes, admitted. 

That testimony?  Here is what was submitted in 1991: 

If Congress again opens up banking to Wall Street speculation, as it opened up S&Ls and banks to real estate speculation, regulators will quickly lose control over the complex series of events that a pervasive marketplace will immediately set in motion. Insider abuse, self-dealing, and back scratching relationships between institutions will run rampant.

While speculators play an important role in a free market economy, their instincts and perspectives are exactly the opposite of those we want in our bankers. Wall Street investment bankers are to commercial bankers what fighter pilots are to airline pilots. One takes risks, the other avoids them. Investment bankers put their investors’ money at total risk. On this high wire, there is no collateral and no federal insurance net below. An unlucky investor can take a plunge – not only to the floor but right through it, in some cases losing far more than just the money he invested. This is the world that commercial bankers want to re-enter.

And the Bush administration wants to accommodate this wish, hoping the repeal of the Glass-Steagall Act will attract new money to the banking industry, so the government won’t have to recapitalize failing banks itself. Treasury Secretary Nicholas Brady is almost giddy over the prospect of merging banks and Wall Street. It makes sense, he says, because investment banking shares a “natural synergy” with commercial banking.

Sound familiar? The same argument was used a decade ago when savings and loans wanted to get into the construction and development business. Developers needed loans – thrifts made loans. Bingo. Natural synergy. Regulations prohibiting such joint ventures were abolished, and sure enough private capital poured into the thrift industry as developers bought thrifts and thrifts acquired their own construction companies.

“My God! This is what I’ve been waiting for all my life!” gasped the owner of (now defunct) San Marino Savings and Loan.

Almost immediately the predictable happened. The historical arms-length relationship that had existed between lender and borrower vanished, and with it went due diligence, common sense and, in too many cases, ethics. Thanks to facilitating that bit of synergy the taxpayer is stuck with $300 billion dollars worth of repossessed real estate from failed thrifts. If we sold $1 million worth of this stuff a day, it would take 3OO years to sell it all.

Deregulated banks can look forward to a similar script, with some of the same bad actors. U.S. Attorney Joe Cage in Shreveport,Louisiana, told us, “Some of the same people who took down savings and loans, are out in the securities business and banking now, already in place. And they’re just waiting for Congress to abolish the Glass-Steagall Act. If that happens I’m afraid they’ll take the banks just like they did the savings and loans.”  

There were right in 1991, I was right in 2008, and you, Congress, Treasury, Bernanke and the SEC were all wrong. 

Re-instate Glass-Steagall.  17 pages of law that kept the banking system safe for 50 years. 

Prosecute all the fraudsters that blew up the system this time.  These are easy cases to bring and win, as you need show only one thing: they lied. 

Rule 10b(5) is the 900lb Gorilla here.  It says: 

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, 

  1. To employ any device, scheme, or artifice to defraud,
  2. To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
  3. To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,

in connection with the purchase or sale of any security. 

All you need to show is an untrue statement was made or information was withheld that was material, and which made the material facts, as evident to the listener, misleading. 

Whether the buyer of the security is “sophisticated” doesn’t matter and whether the person committing the fraud lost money themselves doesn’t matter.  

Drain the swamp.  Yes, I know these are “the favored ones.” 

If Congress doesn’t do so – and do so now – we will get another collapse in the markets, and with interest rates near zero while we’ve blown over $3 trillion in “borrow-and-spend stimulus” measures, we will be unable to respond this time around. 

Congress simply must act now and any institution or organization that resists, including OTS, OCC, or The Fed must be de-funded and disbanded and/or replaced.