By Ilan Moscovitz June 15, 2010 | Comments (25)
Recs
"Any losses [AIG] may realize ... under these derivatives will not be material."
-- AIG, Feb. 12, 2008
We all remember how in late 2008, staggering losses on risky derivatives nearly brought down our entire financial system.
With 43 members of the House and the Senate hammering out a final version of the financial-reform bill, one of the biggest contentions remains what to do about the mind-boggling, vast, and opaque derivatives market owned by the nation's too-big-to-fail megabanks.
The problem is getting worse. Notional amounts of derivatives held by federally insured banks have risen to more than $200 trillion.
Source: Office of the Comptroller of Currency as of Dec. 31, 2009.
The blue line you see is the huge profit center of derivatives casinos and squeezing customers. The yellow one is mostly naked credit default swaps, the same instruments for gambling on the bankruptcy of other companies that blew up AIG (NYSE: AIG). Green is what banks use to actually hedge their risk.
Granted, many of these positions cancel each other out, but even assuming the "netting" works, we're still talking more than $20 trillion.
No matter how you measure it, this is a ton of risk, and it's concentrated in five hands: JPMorgan Chase (NYSE: JPM), Bank of America (NYSE: BAC), Goldman Sachs (NYSE: GS), Citigroup (NYSE: C), and Wells Fargo (NYSE: WFC).
Source: Office of the Comptroller of Currency as of Dec. 31, 2009.
There are at least three problems with this picture:
1. This is crazy. At 14 times the size of the U.S.'s gross domestic product, if even a fraction of these opaque and convoluted instruments blow up, as they did in 1998 and again in 2008, it would be bad news bears for everyone who doesn't live on roots and berries.
2. They're too big to fail. The chief selling point of the financial-overhaul bill is that it somehow reduces the problem of too big to fail. Whether or not you believe that it does (it does not), one thing is for certain: The liquidation authority that is supposed to restore discipline and end moral hazard in financial markets is unlikely to work so long as derivatives traders continue to use American families' deposits as human shields. Derivatives collateral gets paid out before deposits, so the next time a megabank melts down, the Federal Deposit Insurance Corp. could be left holding the bag in liquidation.
3. We're subsidizing them. Market-making can sometimes be socially useful, while gambling billions of dollars on interest-rate movements is probably less so, and given the dangers, may be socially detrimental. But none of these risky activities needs to be subsidized by our FDIC-insured deposits, 0% Federal Reserve liquidity guarantees, and the prospect of future bailouts. Continuing to do so will only encourage the market to grow larger and more dangerous, and siphon capital away from more legitimate activities like, say, lending money to support an economic recovery.
JPMorgan Chase, the largest dealer, borrowed at an average rate of 0.08% in the fourth quarter of 2009 thanks to the aforementioned subsidies, which it has been using to pile up derivatives with a notional value nearing 50 times that of its assets. Ever wonder what banks are doing with all that cheap capital the Federal Reserve provides them in lieu of small business lending? Look no further.
The purpose of FDIC insurance and the Fed discount window is to allow us to know that our deposits are safe, so that banks can convert those savings into loans for businesses and families -- not so they can use our savings as a cheap source of funding for derivatives casinos.
What you can do about it One section of the financial-reform bill being debated now would end subsidies for derivatives trading.
Section 716, "Prohibition Against Federal Bailouts of Swaps Entities," is a flat ban on federal assistance to derivatives casinos. Banks could still use derivatives to hedge their own risk, but they would have to fund derivatives trading operations with their own money instead of ours.
Wall Street is furious. It apparently feels entitled to gamble with our savings.
Because Section 716 is one of the truly meaningful parts of the reform bill, everyone expected it to be defeated. But so far Congress has been too afraid to go along. It's an election year, and members of Congress are feeling pressure from the electorate to get it right this time.
As the conference committee finalizes legislation designed to prevent the next financial meltdown, we should tell the conferees to end subsidies and bailouts for the very same derivatives that led to the last one. If they don't do so, it's likely we'll get the same result.
The fate of section 716 will be decided in just days, and it could really go either way. If you want to end subsidies for derivatives casinos, click here to sign the petition or use the widget below.
Once you're done, you can amplify your voice by calling one of the critical members of Congress listed underneath the petition.
Thanks! Now, do you have a minute to call one or two of these numbers? Just tell the person who answers the phone that you're calling to comment on the financial reform bill, and that you need the representative or senator to oppose attempts to weaken Section 716 of the Senate derivatives chapter that ends subsidies and bailouts for derivatives casinos.
Rep. Barney Frank (202) 225-5931
Sen. Chris Dodd (202) 224-2823
Rep. Paul Kanjorski (202) 225-6511
Sen. Jack Reed (202) 224-4642
Sen. Blanche Lincoln (tell her to stand strong) (202) 224-4843
Fool editor Ilan Moscovitz doesn't own shares of any company mentioned. The Motley Fool is investors writing for investors.
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Wells Fargo does use derivatives to manage interest rate risk, not to trade, as the author of this article inaccurately claims.
The kind of fear-mongering this article contains is not at all constructive.
Hey ron,
Thanks for the comment.
WFC has $4.2 trillion, which puts them in the top 5. It's possible that's all risk hedging, but their 10k doesn't say that:
We use derivatives to manage exposure to market risk, interest rate risk, credit risk and foreign currency risk, to generate profits from proprietary trading and to assist customers with their risk management objectives.
Ilan
While I would prefer an outright ban on all proprietary trading by anyone with access to the FDIC or Federal Reserve funding, I'll take a weak half-measure over nothing. I also still like the idea of instituting the death penalty for suggesting a bailout to Congress, but that only works if you expect the law to be enforced.
It's important to note that some very well informed individuals including Paul Volker are not in favor of this element of the legislation. I would hope that before you sign the petition, you make sure that you know what you are signing.
After doing some research, I can't agree with the author nor sign this petition.
singalls,
Thanks for the comment. Volcker originally didn't support it because he thought it would force banks to spin off their swaps desks, rather than put them into separately capitalized subsidiaries. Since then, it's been clarified that it would not force banks to spin off the desks, and he's since changed his mind. They're probably going to clarify in the legislation that it would only force banks to set up subsidiaries in order to make that crystal clear.
http://news.firedoglake.com/2010/06/14/volcker-softens-on-se...
I need those Fools David and Tom to weigh in on this article... Dave! Tom! Why did you publish this and who are you trying to scare?
I felt the same as previous posters, but then over my screen came the statement that chairman Lincoln clarified that the "push out" of derivative departments could go to an affiliate of the holding company, which would address all of the concerns expressed. So if that happens, I'm satisfied.
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