Lunchtime Links 12-27

Dec 27, 2009 15:34 UTC

How overhauling derivatives died (Smith/Lynch, WSJ)

Debt ceiling raised $290 billion (Rogers, Politico) Another Xmas Eve vote. Dems had wanted to raise the ceiling at least $1.8 trillion to avoid having to raise it again before midterm elections, but they didn’t have the votes. Congress has bought itself about 4-6 weeks of breathing room. Senate Repubs made a showing of not voting for the measure, but had they been in the majority, you can bet they’d have done the same to avert default.

At tiny rates, saving money costs investors (Strom, NYT) “Duh” is the obvious response to this piece. Savers have been getting hammered ever since the Fed started dropping rates two years ago. Yet it’s well written and important to see in the paper of record. It makes the point that low rates are forcing many folks to chase risk. Low nominal rates would be fine IF the Fed were allowing the economy to delever/deflate as it clearly needs to. If the cost of goods/services is falling, then rates can be zero and savers still come out ahead. But the CPI has stayed positive, so savers lose. Of course punishing savers is precisely what economists like Paul “paradox-of-thrift” Krugman and Greg “confiscate-cash” Mankiw say is needed for the economy to recover. Krugman wants to steal savings via shock-and-awe deficit spending, i.e. future taxation. Mankiw would literally confiscate a portion of unspent savings.

Good news alert: Hunting trash for cash (Hudak, Orlando Sentinel) The recession is causing us to produce less trash. This is problematic for Covanta, which burns trash to create energy. But it’s great for the environment.

Investors see farms as way to grow Detroit (Huffstutter, LA Times) Urban renewal…

VIDEO: Stopping purse snatchers (LiveLeak)

Alcohol substitute that avoids drunkeness in development (Rodgers/Alleyne, Telegraph)

Japan’s “grass eaters” turn their back on macho ways (McCurry, Guardian) Twenty years of economic stagnation appears to be neutering Japan.

Teflon Buffett (Felix)

Legislation coming to break up big banks?

Nov 5, 2009 14:40 UTC

In a note to clients yesterday, Paul Miller of FBR Capital Markets wrote:

We are hearing that discussion of breaking up large financial institutions that pose systemic risk to the market is gaining traction on the Hill. At this point, discussions are in the early stages, but we understand that an amendment addressing breaking up institutions deemed “too big to fail” could be introduced in the House over the next few days. How does one define “too big to fail” and how would the divestiture process work – these are good questions that Congress will have to address as the discussion moves forward. To our understanding, any amendment that could be introduced in the coming week would likely be vague and would give the regulators discretion to determine which institutions qualify as “too big” and how to address the risk they pose to the system.

[UPDATE: It appears this legislation may be coming from PA's Paul Kanjorski]

Hmmm. A “vague” amendment directing regulators to look into breaking up TBTF banks might not lead to much, not when regulators have made clear they have no interest in breaking up big banks.

[After she gave a speech complaining about TBTF at the Economist's Buttonwood Conference, I asked Sheila Bair if she would favor policies to proactively shrink/break up big banks. She said "no, I don't know how we would do that."]

And breaking up banks is only half the battle. While it’s very important to get commercial banks out of the trading business, if derivative books don’t shrink dramatically systemic risk won’t have gone away.

Neither Bear nor Lehman had a commercial bank. But the size, opacity and interconnectedness of their trading books posed huge risks for the system.

Speaking of the systemic risk posed by derivative books, there’s a very interesting and relevant tidbit in Andrew Ross Sorkin’s new book titled “Too Big to Fail.”

Not long before AIG collapsed, CEO Bob Willumstad went to Tim Geithner — then head of the NY Fed — and asked that AIG be made a “primary dealer,” giving it access to the Fed as its lender of last resort….

He left Geithner with two documents. One was a fact sheet that listed all the attributes of AIG FP [the division run by Joe Cassano that blew the company up] and argued why it should be given status as a primary dealer. The other–a bombshell that Willumstad was confident would draw Geithner’s attention–was a report on AIG’s counterparty exposure around the world, which included “2.7 trillion of notional derivative exposures, with 12,000 individual contracts.” About halfway down the page, in bold, was the detail that Willumstad hoped would strike Geithner as startling: “$1 trillion of exposures concentrated with 12 major financial institutions.”

You will bail me out or I’ll bring the whole system down with me.

Until they neuter the derivatives business by putting all contracts on exchanges, enhanced “resolution authority” will probably be meaningless. Regulators still won’t be able to shutter the largest financials because doing so would cause the systemic event they’re trying to avoid in the first place.


The financial crisis was a result of poor internal operations models that have not been repaired, these operational dysfunctions are more prevelant in larger institutions. There is no need to legislate the break up of large institutions as they will begin to disintigrate on their own whenever the next shoe drops and there is not an extra 4 trillion lying around to support their balance sheets.

Citigroup is looking at writing down 39 billion and Goldman Sachs is taking home a 20 billion dollar bonus year. The market is a Win/Lose Game and when such large institutions are enabled to play the Win/Lose Game with unlimited Federal Funds (which are in fact, not unlimited), then ultimately the pressure on the losers will cause an irreconcilable financial loss to the support mechanism.

They do not need to regulate the size of the institution but regulate the size of the TRADING POSITIONS of any one institution and its related entities.

This will cause a natural divestiture of TBTF’s into smaller enterprizes that can war with each other for trading profits without causing the extreme damage to the countries core that is done lately.

Regulating Proprietary Trading Positions of Commercial Banks is the answer.

This will reduce systemic risk while not reducing service delivery to customers.

Sure, they’ll complain but hey, glad its not my job.

Why privilege derivatives?

Oct 6, 2009 17:23 UTC

Goldman Sachs has done it again, deftly navigating markets to maximize its own returns and leave others nursing losses.

The deal in question is a loan Goldman made to the troubled lender CIT. The loan was dressed up as a derivative, which means Goldman can extract payments it is owed outside of the normal bankruptcy process.

Nothing wrong with that; Goldman has made another great trade. But is the exemption it exploited worth closing?

At issue is the integrity of the bankruptcy process.

By calling a time-out on creditors, bankruptcy offers the opportunity to reorganize and rehabilitate troubled companies, which is often in creditors’ best interest. A debtor’s assets often have more value if they keep generating cash flow, if the company in question continues as a going concern.

But if certain creditors get to pick off assets when a time-out is called, bankruptcy itself may be undermined. Such is the luxury of holding derivatives, which thanks to a 2005 bankruptcy reform, are exempt from the automatic stay that prevents creditors fleeing with their cash. Derivative holders also enjoy netting and close-out privileges that aren’t available to other creditors. And as we learned in the Lehman bankruptcy, derivative traders may make off with cash that isn’t rightfully theirs, forcing other creditors to chase them down.

Because Goldman’s loan to CIT was structured as a derivative — specifically, a “total return swap” — Goldman’s claim won’t be stayed along with others’ if CIT files for Chapter 11. The filing would trigger a $1 billion payment to Goldman.

Spying an opportunity to arbitrage regulation, smart lenders are doing the same as Goldman, structuring loans as “swaps, currency exchanges or securities deals,” according to bankruptcy lawyer Harvey Miller of Weil, Gotshal & Manges. Many are doing whatever they can to “put transactions beyond the control of bankruptcy courts.”

Why exempt derivatives from bankruptcy rules? A chief reason, according to proponents, is systemic risk. Derivative markets are just too volatile. You can’t force traders to sit on their positions through a lengthy bankruptcy process without breaking the daisy chain that connects counterparties.

First off, according to a paper by Robert Bliss and George Kaufman, it’s possible that the protections afforded derivatives actually increase systemic risk.

But for the sake of argument, let’s assume they’re necessary. Then we have another case of the tail wagging the dog, of reorganizing our financial markets around the needs of derivatives traders.

For what? The increased “liquidity” that derivative traders are so fond of reminding us they provide? CIT might not have been able to secure extra financing a year ago had Goldman not been able to structure its deal as a derivative. But maybe that would have been a good thing. If a company can’t secure financing via conventional lending sources, that’s probably a great sign the balance sheet needs to be restructured.

And I wonder: has total liquidity, in fact, increased? If conventional lenders see that their claims are increasingly superseded by derivative deals, will they be less inclined to offer financing?

In the end we could end up with another race to the bottom as bad financing options chase away good ones. Borrowers may sacrifice the protection of bankruptcy tomorrow for cash needed to survive today.

The CIT loan illustrates the need for change. To be sure it would be too disruptive to roll back the bankruptcy exemption for derivatives all at once. Still, it’s yet another reason we must shrink the derivatives market dramatically. Increasing capital requirements and migrating trades to exchanges would be a good place to start.


>>> derivatives are a pure gambling tool.

Wrong. Gambling is creation of new, artificial risks. It apparently doesn’t bother you when folks do that in Las Vegas, or in office football pools.

Derivatives are the instrument by which one party assumes someone else’s risk, in exchange for payment received. Fundamentally the same as health insurance or fire insurance.

No one was held at gunpoint and forced to sign papers with Goldman Sachs. They did these deals because they wanted high rates of return. Now they’ve lost their retirements because they were too greedy, and asleep at the wheel. GS wasn’t asleep at the wheel.

We can also note that even guys who ===were== outright dishonest, like Bernie Madoff, didn’t use advertising. They got their suckers by word of mouth from other “satisfied customers”, apparently mostly from within his own ethnic circle. Famous, prestigious people like Elie Weisel lost millions becuase they never did basic due-diligence. In 20-20 hindsight, we now now that those who did even rudimentary due-diligencing on Madoff, who telling anyone who would listen that this was a rotten fish.

If Eli Weisel had bought a used yugo, then complained afterwards that it isn’t “just like” the BMW as he was promised by the used-car salesman, you wouldn’t have much sympathy for him.

So why should we have sympathy for his financial losses which followed from his zombie-like devotion to a snake-oiler peddler?

The folks and the outfits who lost big bucks to Goldman Sachs, all had accountants and lawyers handy. If they weren’t too cheap to pay for a basic investigation of the risky paper they were lining up to buy, they wouldn’t have gotten hurt.

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