Bloomberg has two articles that reveal much about the causes of our economic problems, and show Washington has yet to address the real sources of the rot. Unless and until it does, things are not going to get better and they may very well get much worse. In the first, Myron Scholes, the Nobel prize-winning economist who with Fisher Black and Robert Merton invented a model for pricing options and who also was a partner of Long-Term Capital Management, the hedge fund that lost 4 billion bucks in 1998 and had to be rescued by a Fed orchestrated bailout of 14 other lenders to keep the markets from crashing then, advocated “blowing up” or “burning” over-the-counter derivative trading markets.
Scholes got a lot of heat for the 1998 fiasco, which in hindsight looks like smashing a piggy bank in comparison to today’s excesses.
To compare, Bernie Madoff stole 50 billion outright and "Sir" Stanford another 8-10 billion. And what is even harder to comprehend now, after LTCM was rescued instead of allowed to fail, Congress led by Phil Gramm went on to deregulate even more. In other words, Scholes appears to have learned something from his experience while Congress, particularly the Republicans but also many Democrats, and the rest of the industry did not, and still apparently have not.
While not as bad as CNBC or the Wall Street Journal in distorting reality and pimping for traders and CEOs, Bloomberg certainly bears cautious use. But the two articles worth reading and commenting on are here: "Sholes Advises ‘Blow Up’ Over-the-Counter Contracts” is at http://www.bloomberg.com (Couldn't get the Kos publisher to accept the full address in html for some reason. Sorry!) The second article is “Minnesota Bank Asks Why It Pays for Wall Street Greed” (again, no joy from the site software on the html address for some reason.)
Scholes proposes regulation and transparency, but first the gigantic white elephant in the room has to be dealt with:
“The markets have stopped functioning and are failing to provide pricing signals, Scholes, 67, said today at a panel discussion at New York University’s Stern School of Business. Participants need a way to exit transactions and get a “fresh start,” he said. The “solution is really to blow up or burn the OTC market, the CDSs and swaps and structured products, and let us start over,” he said, referring to credit-default swaps and other complex securities that are traded off exchanges. “One way to do that, through the auspices of regulators or the banking commissioners, is to try to close all contracts at mid-market prices.”
In effect Scholes is pushing something akin to Roosevelts “Bank Holiday” with a twist. He wants to freeze in place all the trillions of derivatives contracts, fix their values at a mid point (not sure how he gets this reliably without market pricing signals) and allow the contracts to be closed at that price. This limits losses and gains to all players, supposedly.
Then the regulation and transparency:
"Scholes also recommended moving the trading of credit- default swaps, asset-backed securities and mortgage-backed securities to exchanges to allow for “a correct repricing” of the assets. The securities are currently traded between banks and investors, without any price disclosure on exchanges.“
In effect, much of the shadow banking that is causing the real problems will be brought out into the sunlight by forcing them to list prices on exchanges. Why is this so important?
”A total of $531 trillion in outstanding derivatives contracts traded over-the-counter as of June, according to the International Swaps and Derivatives Association. They were mostly interest-rate swaps, but also included CDS and equity derivatives. “Take the pricing mechanism from the desks in banks, which have made a huge amount of profits over the last number of years, and facilitate price discovery,” Scholes said.
In effect, without an open market pricing mechanism, it was all insider trading. No one was supervising the markets, thus the “values” of the contracts could be negotiated by the primary parties and then sold on or used as alleged collateral for other ventures. The 531 trillion dollars in outstanding derivatives in June thus formed a large part of the illusory “equity” value of the firms involved. The “real” underlying assets for many, not all of these swaps and derivatives, if only leveraged 30 times their nominal value, was in June perhaps 17.7 trillion. This 30 times leveraging is just a very rough estimate. Now that banks are required to report fair market values far less than the book value of the assets, these derivatives are likely far more leveraged than just 30 times. Regulated banks should have a minimum of 8 percent of their equity held back, as it were, to cover their loan book, but “investment banks” and the investment and asset management arms of banks were, under Phil Gramm’s legislation, permitted to leverage to a far greater degree, and without a market to reveal the real value of their derivative contracts, could pump the “value” of their derivatives even more. That’s why, despite perhaps 2 trillion dollars put into the banks and insurers deeply mired in the the derivatives trade through various means, Fed guarantees, the TARP, the home loan relief program and so on, we have yet to see any effect on lending or confidence. These guys simply don’t know whether their credit default swaps and other derivatives actually have a value, and they can’t know now that none of the inside traders trusts any of the other inside traders, and the suckers they have been passing these onto no longer believe their spiels and aren’t buying any more. Just to compare, that 17 trillion in supposed underlying value (if only 30 times leveraged) is larger than the entire US GNP for a year.
ADDED NOTE: See "How Paulson Used AIG To Throw Goldman A Big Old Bone" today by boloboffin, one of the rescued Kos diaries today that I missed in writing mine up. It details exhaustively some of the shennanigans and insider dealing on credit default swaps and collateralized debt obligations (CDOs, usually the real estate secured instruments sold on to other investors now in trouble because of the mortgage meltdown). An excellent piece that just backstops the call here for investigations and specific regulation of these ticking timebombs, as Buffet called them.
Scholes also said:
“Among other recommendations, Scholes urged changes to the accounting rules to give better disclosure on risks, said that banks should focus on their return on assets instead of return on equity, and said central bankers shouldn’t try to quell market volatility, which provides a natural brake on risk- taking.”
This is where the second article comes in. There are hundreds, if not thousands, of FDIC insured community banks that have been responsible lenders. Many Kossacks may be banking at just such institutions. Bloomberg reports:
"TCF Financial Corp., the Wayzata, Minnesota-based bank that never made a subprime loan and hasn’t lost money since 1995, is asking why it should help clean up the mess made by Wall Street.
“I’m kind of bitter,” said William Cooper, chief executive officer of the 448-branch bank, adding that over the years TCF has invested about $1 billion in the Federal Deposit Insurance Corp.’s fund that guarantees bank deposits. “We pay for the excesses of our competitor over and over again.”
TCF is among more than 8,300 banks and lenders insured by the FDIC facing increased fees and a one-time “emergency” charge designed to raise $27 billion this year for the agency’s depleted coffers. Community banks may take a 10 percent to 20 percent hit to 2009 earnings even if the FDIC halves that charge, said Camden Fine, president of the Independent Community Bankers of America.“
Responsible investors who have distrusted derivatives altogether (disclosure, I’m one of those) and who invested in firms who refused to engage in the practice, are now also taking a big hit for being responsible and prudent. The hit on earnings of responsible firms from these extra fees is going to be steep, and thus anyone on fixed income relying on interest and dividends from such investments with such firms will be hit hard too. All is not lost, however, Dodd and Barney Frank have proposed some actions to relieve this, but it is still not directly addressing the issue which is allowing the irresponsible bankers to continue on their merry way, many still in the same jobs they used to perpetuate this insider scam.
”U.S. Senate Banking Committee Chairman Christopher Dodd said he plans to introduce legislation that would temporarily raise the FDIC’s $30 billion borrowing authority with the Treasury to $500 billion, with a permanent increase to $100 billion. The change may give regulators room to reduce the emergency fee, FDIC Chairman Sheila Bair said.
U.S. Representative Barney Frank, a Massachusetts Democrat and chairman of the House Financial Services Committee, said on March 5 that there is legitimate concern about FDIC fees among community banks, which the ICBA defines as “locally owned” with assets ranging from less than $10 million to “multibillion dollar institutions.” “A number of members have been concerned about the increased assessment that’s hit community banks from the FDIC in part because of failures to which they did not contribute,” Frank said yesterday on the House floor. “So voting for this bill will be an important step to lowering the assessment on community banks.”
The House approved a measure yesterday increasing the borrowing authority to $100 billion and making permanent the $250,000 deposit-insurance limit in the financial bailout measure enacted in October. FDIC-insured banks lost $26.2 billion in the fourth quarter, the first loss for a three-month period since 1990. U.S. banks and other financial companies have reported about $800 billion in writedowns and credit losses since 2007 in the worst financial crisis since the Great Depression.“
That 800 billion in writedowns and losses is still not anywhere near the outstanding liabilities hidden in the derivatives still on the books of the largest banks and asset managers like AIG. Until Congress digs into this shadow banking and addresses it, things will remain very shaky and as in the LTCM aftermath, subject to terribly misguided notions that dominate among Republicans and many people on the Democratic side like Robert Rubin. President Obama should appoint a blue ribbon commission of folks like Scholes to come up with recommendations to bring shadow banking under regulation and to establish derivative markets with open listings and clear rules, and folks like De Fazio and Franks in the House should hold hearings on whether the insider traders and Bush era regulators were guilty of breaking any currently existing laws as well as hearings on new laws to prevent a recurrence. These articles show there are many people out there, some in the banking industry that have been responsible and prudent, who have good ideas about what should be done and who have an interest in seeing it done right.
What do you think about a blue ribbon commisson to come up with recommendations on fixing or abolishing the derivatives trade? What about hearings and investigations of the insider trading world of derivatives? Can and should we do both at the same time? This is my inclination, but I’d like to hear some intelligent discussion from fellow Kossacks. And does anybody know of rumblings in the government along any of these lines? What's happening out there in the states to investigate and regulate derivatives?
On the diary rescue list for the first time. Thanks to ybruti for the rescue! Derivatives trading can be extremely complex, but as you can see from the numbers (531 trillion bucks) this is a trading area that absolutely must be regulated and transparent. The insider trading (mislabelled over the counter) of trillions in derivatives imperils everyone's economic well being. It has to be investigated and properly regulated, or as Buffet advocated, abolished.