Banking regulation with Chris Whalen and others
Posted in Uncategorized by demandside on June 27th, 2009 Plus the incredible climbing savings rate … or is it so incredible? And Idiot of the Week. Bank of Tokyo Mitsubishi is going to send their economists in waves until we pick one. So we do. Ellen Zentner!
Before we get to that and the rest, a dip into the week’s happenings in the nation’s capitol. The inestimable Barney Frank introduced the concept of weaponized Keynesianism in this segment from a Boston radio show.
FRANK
Weaponized Keynesianism indeed.
The president doesn’t need much cover. The next day he announced a veto threat. As contexted by Stan Collender:
The White House yesterday did something that should truly warm the hearts of deficit hawks everywhere: it threatened to veto the 2010 military authorization bill over two big spending issues — the F22 and the alternate engine for the F35.
Although both of these programs were questioned for years by the Bush White House, Congress kept insisting that the Pentagon spend the money anyway and the president always went along. This year, The F22 was a target of Secretary of Defense Robert Gates ….
The Obama veto threat is a much bigger deal than it seems.
First, the White House didn’t have to do it. It’s threatening to veto an authorization bill that, even if it’s adopted, won’t actually spend any money. That will happen later in the year with the appropriation. That means that the administration is drawing the line now and trying to stop the spending for both programs from gaining any momentum. That’s a good sign…. Second, the veto threat came in the midst of the much bigger fight for the White House on health care. The White House could have backed away so that it didn’t antagonize the members who support these programs… but it didn’t. Again, another good sign for deficit hawks who want proof of the president’s devotion to reduced spending…
Now , we decry the flagellation of the American saver
The citizen has taken a beating from the self-righteous in recent days for not saving in the 1990s and the first part of this decade. Americans became profligate in their own eyes and the eyes and the eyes of many at the same time their incomes were stagnating. But is that the real story? Jan Hatzius, chief economist at the great evil, Goldman Sachs, had this to say to Tom Keene on Bloomberg.
HATZIUS
Indeed. Big new investment in stocks and housing exactly corresponds to the decline in savings. In fact, (blush) many people thought they were being smart savers. And many who sold the stocks or houses agreed. Remember the piggy bank for retirement the house was supposed to be? Remember how if you took any period of seven consecutive years, stocks never went down. Well, both turned out to be false promises and — not coincidentally, we would argue — disappointed at precisely the wrong time.
Equity peddlers made this explicit pitch — save in your stocks. Your portfolio, as it were. Your house.
Now you have to deal with us. The demand siders. We look at the savings rate as the inverse of the consumption function. When the savings rate goes up, the consumption function goes down. But it is only in a private goods first society that you get beaten up for not spending. From the demand side, saving is not bad news if that savings is captured and turned into investment. It is bad news if it is not, it just turns things into even more sluggish growth.
Unfortunately, much of the so-called saving is de-leveraging. That is, payilng down debts. And as such it does nothing to create investment. Credit and money taken together produce demand. If credit is contracting and money is expanding, demand is not going to set records.
But that is another story. And we already have another story. The derivatives market and banks focusing on the testimony of Chris Whalen, of Institutional Risk Analytics. First, however, Idiot of the Week!
ZENTNER
No, Ellen, it does not take one quarter of zero point two percent growth to mean the end of the Great Recession. If employment is collapsing at 300,000 plus. That is contraction. We don’t care if it is not one of your coincident components. Ellen Zentner. Bank of Tokyo Mitzubishi! Idiot of the week!
Now to Chris Whalen. Whalen testified before the Senate Committe on Banking, Housing and Urban Affairs last week and I spent a good deal of time isolating those remarks for you. Because I read his testimony beforehand. Unfortunately, he did not stick to his script. Here’s a capsule of what he said. I’ll come back and flesh it out with a bit of his prepared testimony.
WHALEN
That is Chris Whalen, who is as good as there is on banks. When he strays into economics, like most bankers, he gets lost. But here he is very good.
Now from his prepared testimony, link here: http://banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=1f354557-7b1f-4ffd-9014-e80435bc55b8
quoting:
2) Bank Business Models & OTC
Perhaps the most important issue for the Committee to understand is that the structure of the OTC derivatives market today is a function of the flaws in the business models of the largest dealer banks, including JPMorgan Chase (NYSE:JPM), Bank of America (NYSE:BAC) and Goldman Sachs (NYSE:GS). These flaws are structural, have been many decades in the making, and have been concealed from the Congress by the Fed and other financial regulators.
The fact that today OTC derivatives trading is the leading source of profits and also risk for many large dealer banks should tell the Congress all that it needs to know about the areas of the markets requiring immediate reform. Many cash and other capital markets operations in these banks are marginal in terms of return on invested capital, suggesting that banks beyond a certain size are not only too risky to manage – but are net destroyers of value for shareholders and society even while pretending to be profitable.
Simply stated, the supra-normal returns paid to the dealers in the closed OTC derivatives market are effectively a tax on other market participants, especially investors who trade on open, public exchanges and markets. The deliberate inefficiency of the OTC derivatives market results in a dedicated tax or subsidy meant to benefit one class of financial institutions, namely the largest OTC dealer banks, at the expense of other market participants. Every investor in the global markets pay the OTC tax via wider bid-offer spreads for OTC derivatives contracts than would apply on an organized exchange.
The taxpayers in the industrial nations also pay a tax through periodic losses to the system caused by the failure of the victims of OTC derivatives and complex structured assets such as AIGs and Citigroup (NYSE:C). And most important, the regulators who are supposed to protect the taxpayer from the costs of cleaning up these periodic loss events are so captive by the very industry they are charged by law to regulate as to be entirely ineffective. As the Committee proceeds in its deliberations about reforming OTC derivatives, the views of the existing financial regulatory agencies and particularly the Federal Reserve Board and Treasury, should get no consideration from the Committee since the view of these agencies are largely duplicative of the views of JPM and the large OTC dealers .
3) Basis Risk & Derivatives:
The entire family of OTC derivatives must be divided into types of contracts for which there is a clear, visible cash market and those contracts for which the basis is obscure or non-existent. A currency or interest rate or natural gas swap OTC contract are clearly linked to the underlying cash markets or the “basis” of these derivative contracts, thus both buyers are sellers have reasonable access to price information and the transaction meets the basic test of fairness that has traditionally governed American financial regulation and consumer protection.
With CDS and more obscure types of CDOs and other complex mortgage and loan securitizations, however, the basis of the derivative is non-existent or difficult/expensive to observe and calculate, thus the creators of these instruments in the dealer community employ “models” that purport to price these derivatives. The buyer of CDS or CDOs has no access to such models and thus really has no idea whatsoever how the dealer valued the OTC derivative. More, the models employed by the dealers are almost always and uniformly wrong, and are thus completely useless to value the CDS or CDO. The results of this unfair, deceptive market are visible for all to see – and yet the large dealers, including JPM, BAC and GS continue to lobby the Congress to preserve the CDS and CDO markets in their current speculative form.
In my view, CDS contracts and complex structured assets are deceptive by design and beg the question as to whether a certain level of complexity is so speculative and reckless as to violate US securities and anti-fraud laws. That is, if an OTC derivative contract lacks a clear cash basis and cannot be valued by both parties to the transaction with the same degree of facility and transparency as cash market instruments, then the OTC contact should be treated as fraudulent and banned as a matter of law and regulation. Most CDS contracts and complex structured financial instruments fall into this category of deliberately fraudulent instruments for which no cash basis exists.
What should offend the Congress about the CDS market is not just that it is deceptive by design, which it is; not just that it is a deliberate evasion of established norms of transparency and safety and soundness, norms proven in practice by the great bilateral cash and futures exchanges over decades; not that CDS is a retrograde development in terms of the public supervision and regulation of financial markets, something that gets too little notice; and not that CDS is a manifestation of the sickly business models inside the largest zombie money center banks, business values which consume investor value in multi-billion dollar chunks. No, what should bother the Congress and all Americans about the CDS market is that is violates the basic American principle of fairness and fair dealing.
…
To that point, consider the judgment of Benjamin M. Friedman, writing in The New York Review of Books on May 28, 2009, “The Failure of the Economy & the Economists.” He describes the CDS market in a very concise way and in layman’s terms. I reprint his comments with the permission of NYRB:
“But what makes credit default swaps like betting on the temperature is that, in the case of many if not most of these contracts, the volume of swaps outstanding far exceeds the amount of debt the specified company owes. Most of these swaps therefore have nothing to do with allocating genuine losses of wealth. Instead, they are creating additional losses for whoever bet incorrectly, exactly matched by gains for the corresponding winners. And, ironically, if those firms that bet incorrectly fail to pay what they owe-as would have happened if the government had not bailed out the insurance company AIG-the consequences might impose billions of dollars’ worth of economic costs that would not have occurred otherwise.
“This fundamental distinction, between sharing in losses to the economy and simply being on the losing side of a bet, should surely matter for today’s immediate question of which insolvent institutions to rescue and which to let fail. The same distinction also has implications for how to reform the regulation of our financial markets once the current crisis is past. For example, there is a clear case for barring institutions that might be eligible for government bailouts-including not just banks but insurance companies like AIG-from making such bets in the future. It is hard to see why they should be able to count on taxpayers’ money if they have bet the wrong way. But here as well, no one seems to be paying attention.”
4) CDS & Systemic Risk
While an argument can be made that currency, interest rate and energy swaps are functionally interchangeable with existing forward instruments, the credit derivative market raises a troubling question about whether the activity creates value or helps manage risk on a systemic basis. It is my view and that of many other observers that the CDS market is a type of tax or lottery that actually creates net risk and is thus a drain on the resources of the economic system. Simply stated, CDS and CDO markets currently are parasitic. These market subtract value from the global markets and society by increasing risk and then shifting that bigger risk to the least savvy market participants.
Seen in this context, AIG was the most visible “sucker” identified by Wall Street, an easy mark that was systematically targeted and drained of capital by JPM, GS and other CDS dealers, in a striking example of predatory behavior. Treasury Secretary Geithner, acting in his previous role of President of the FRBNY, concealed the rape of AIG by the major OTC dealers with a bailout totaling into the hundreds of billions in public funds.
Indeed, it is my view that every day the OTC CDS market is allowed to continue in its current form, systemic risk increases because the activity, on net, consumes value from the overall market - like any zero sum, gaming activity. And for every large, overt failure in the CDS markets such as AIG, there are dozens of lesser losses from OTC derivatives buried by the professional managers of funds and financial institutions in the same way that gamblers hide their bad bets. The only beneficiaries of the current OTC market for derivatives are JPM, GS and the other large OTC dealers.
My takeaway from this is that banks involved in this sort of gaming are not producing anything or supporting production, but are simply a drain on the rest of the economy. Supporting them in this effort is only stretching out the problem.
