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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   (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?  

Consider this:
”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.

Originally posted to monkeybrainpolitics on Sat Mar 07, 2009 at 08:39 PM PST.


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Comment Preferences

  •  The solution: (1+ / 0-)
    Recommended by:

    has already been laid out here

    If Obama does not hear the growing chorus of discontent with those who voted for him, he will quickly lose the support he enjoys.

    I voted out one 9incompetent0enabler, I will not take kindly to another four years of deceit and failure.

    Those who survive are those who adapt.

    by donailin on Sat Mar 07, 2009 at 08:51:05 PM PST

    •  Your solution is NOT the solution... (4+ / 0-)

      it does not deal with the root causes of the financial meltdown - deregulation. It calls for more public financing and simply replacing current "failing managers" with new management with "qualified and specialized expertise".

      It assumes that there is sufficient regulation and the problem was caused by a lack of oversight and poor mangement.

      The Federal Reserve Bank IS the head of this gorilla. It is the brains and brawn behind the whole mess.

      The Federal Reserve Bank is nothing more than a collection of the very institutes that are being bailed out at this very moment.

      In effect, the Feds are borrowing the money from the banks they are giving it too. In the process, the future wealth of the nation is being transferred to the people who control the industry.

      This is arguably the greatest transfer of wealth from the poor and middle class to the rich the world has ever seen. And, it is continuing at an alarming and increasing rate.

      if liberty undermines their security, you will not have to take it away; they will gladly renounce it. Saving America

      by Claudius Bombarnac on Sun Mar 08, 2009 at 08:46:51 AM PDT

      [ Parent ]

  •  Thanks for this excellent and well written (2+ / 0-)
    Recommended by:
    princesspat, Coastrange

    overview of a complicated matter.  I pretty much agree with all of your points.  

    Our government infusions should be focused on maintianing leanding to consumers, and business investing in real productive operations.

    We should not attempt to prop up these artificially inflated speculative CDS and other swap deals, and should liquidate those banks and other institutions that are insolvvent because of them.

    Including Citi and the very large ones.  We will only be throwing good money after bad if we try to guareentee such vast amounts -- many times our total GNP, and even perhaps real wealth.

    Folks have to realize that our governments' ability to "bailout" these institutions is not infinite.

    These government expenditures raise our debt, which we will eventually have to be paid back.

    Let' speculators take their losses.

    And focus government intervention on stimulated demand, and keeping real business lending going.

    The means is the ends in the process of becoming. - Mahatma Gandhi

    by HoundDog on Sat Mar 07, 2009 at 08:55:33 PM PST

  •  You may find this article and 100 year (0+ / 0-)

    time series plot of normalized housing prices supports your argument.
    businessinsider plot

    The means is the ends in the process of becoming. - Mahatma Gandhi

    by HoundDog on Sat Mar 07, 2009 at 08:58:58 PM PST

  •  Thanks for the Hoenig and business insider pieces (4+ / 0-)

    Both were very helpful and had some very good data and recommendations, but neither deals with derivatives, directly.  The run up in home prices surely has some connection to the derivatives market, after all, derivatives as collateral for loans allowed the money supply to rocket and that is what boosted real estate prices and stock market prices.  The M1 to M6 money supply figures are truly frightening, and the Feds stopped publishing the full range of money supply assessments under Bush, back in 2006 I think, because it was becoming truly frightening how much money in various forms was being created.  I think Hoening has basic approaches right, but he says nothing about shadow banking and derivatives and all the ways the money supply can now be manipulated which are off the books, as it were.  Obama has moved to book all budget expenditures openly.  The same needs to be done with money supply in all forms and derivatives especially (and their role in creating money/credit outside Treasury control).

  •  Scary stuff! (1+ / 0-)
    Recommended by:

    Hey, I'm just a civilian in all this, and, admit to having a hard time following the sausage making.

    That said, if there's this much smoke there must be a huge fire buring somewhere. Call out our elected representatives and the President -- the Fire Dept. if you will -- and "fire!" whoever started it!!  

    Regards, Andrew Gross Chairman/CEO Automotive Consulting Services (An Oregon Corporation)

    by The Car Czar on Sun Mar 08, 2009 at 12:51:52 AM PST

  •  Notice Comment on Stock Market Risk (1+ / 0-)
    Recommended by:

    One interesting comment from Scholes is: central banks should not try to quell market volatility, which provides a natural brake on risk-taking.

    Unfortunately, the Fed was at the beck and call of the stock market.  This was further encouraged by the 401(k) which put many more people in stocks than was typical.  We not only had a real estate bubble, we had a stock bubble that has blown up twice in the past decade.  Both bubbles created a vast amount of money for the derivative traders to play with.

    Government has to stop taking its directions from the swing in stock prices.    

  •  The housing market meltdown is nothing... (2+ / 0-)
    Recommended by:
    ybruti, monkeybrainpolitics

    more than a boil on the ass of the derivatives gorilla.

    So, until the derivatives markets are dealt with, any money thrown at the banks and investments houses will disappear into a bottomless black hole.

    Here's how the gorilla was let out of it's cage:

    ICE, ICE, Baby One piece of legislation is why the price of everything is going through the roof

    May. 19, 2008
    Professor Michael Greenberger of the University of Maryland, a former board member of the Commodities Futures Trading Commission, testified in front of the House Committee on Energy and Commerce on December 14 of last year (2007). Under discussion that day was the manipulation of the energy markets and prices, but Professor Greenberger added these comments: "Three, four months from now, you’re going to have a hearing on the subprime meltdown, and you’re going to find that the very same legislation [deregulating energy] deregulated something called collateralized debt obligations, CDOs." That legislation, friends, directly ties the mortgage meltdown to the high price of energy today.

    ICE, ICE, Baby, conclusion

    Lay, DeLay, Gramm, Gramm & Clinton

    The late, infamous Enron head, Ken Lay, realized in the eighties that he could make more money bidding up energy in the futures market than by actually creating and selling energy. But, under then-current rules, how much you could make swapping paper was limited. Fortuitously, Lay had excellent Texas political connections; and in November of 1992, the head of the Commodities Futures Trading Commission moved to exempt energy-derivative contracts and related swaps from any government oversight.

    A vote was hurriedly put together before the Clinton White House would take over, and so Lay could finally start "dark" – unregulated – futures trading. The head of the CFTC was Wendy Gramm, wife of Texas Senator Phil Gramm; five weeks after she left, she became a board member of Enron in Houston.

    Fast-forward to late 2000 and H.R. 5660, the Commodity Futures
    Modernization Act of 2000, sponsored by Republican Congressman Thomas Ewing of Illinois. That bill went nowhere, even though Tom Delay’s wife Christine was then working for a Washington lobbying firm, Alexander Strategies – which Enron had paid $200,000 to push through legislation for permanent energy deregulation in these "dark" markets.

    Six months later came Senate Bill 3283, also named the Commodity Futures Modernization Act of 2000. This time around the sponsor was Republican Sen. Richard Lugar of Indiana, and now Phil Gramm was listed as one of the bill’s co-sponsors. Like it had in the House, this bill was destined to go nowhere until, late one night, it was attached as a rider to an 11,000-page appropriations bill – which was signed into law by President Clinton.

    Now traders had an officially deregulated market for energy futures. Worse, that bill also deregulated many financial instruments – including the collateralized debt obligations that are at the center of today’s mortgage crisis, which may well cost us more than $1 trillion before it’s over.

    if liberty undermines their security, you will not have to take it away; they will gladly renounce it. Saving America

    by Claudius Bombarnac on Sun Mar 08, 2009 at 08:19:19 AM PDT

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