Why Section 716 is the Indispensable Reform

By Jane D’Arista

This guest post is contributed by Jane D’Arista, a research associate at the Political Economy Research Institute at the University of Massachusetts, Amherst, and co-coordinator of its Economists’ Committee for Stable, Accountable, Fair, and Efficient Financial Reform (SAFER).  She has taught in graduate economics programs at several universities and served on committee staffs of the U.S. House of Representatives.

Dominated by the world’s largest banks, the over-the-counter (OTC) derivatives market has been expanding since the break-down of the Bretton Woods Agreement in the early 1970s privatized the international monetary system by shifting the payments process from central banks to commercial banks. The proliferation of foreign exchange forwards and swaps that followed set in motion an ever-expanding menu of exotic instruments that reached a nominal value of over $600 trillion by the middle of the current decade. Central banks and financial regulators ignored the implications of the growth of this market and ignored warnings from the Bank for International Settlements (BIS) and the International Monetary Fund (IMF) from 2002 forward that OTC derivatives were at the center of what had become a global casino in which the largest international institutions were the biggest speculators.

The large, international institutions that created the OTC market for foreign exchange forwards and swaps were commercial banks. Following established banking practice, they conducted their derivatives business like portfolio lenders rather than broker/dealers, buying and selling forwards and swaps outside of established markets. But OTC derivatives contracts can’t be classified as assets or liabilities until they are settled and can’t be held on banks’ balance sheets the way loans and deposits are held. Instead, they were booked off balance sheet as contingent liabilities. The market structure that emerged in what came to be the largest market in the global economy was one in which non-tradable contracts were bought by and sold to customers without real time information on volume or pricing or the aggregate positions of the dealers themselves. Moreover, the fact that the contracts were illiquid required constant hedging by dealers that expanded their positions and inflated the size of the market relative to all other national and international financial markets. Meanwhile, the commercial bank dealers’ derivatives business was operating with all the implicit guarantees and subsidies that governments put in place to protect this core financial sector. In 2008, those guarantees became explicit and were exercised.

Are there reasons to protect derivatives dealers?

Because the largest U.S. commercial banks were dominant players in the OTC derivatives markets, Federal Reserve lending, FDIC guarantees and taxpayer bailouts during the 2008 crisis gave explicit protection to both bank and non-bank swap dealers and major swap participants. Those protections are not grounded in the traditions and practices of U.S. financial law and regulation. They are no more appropriate than would be an extension of federal protection to financial entities (including bank affiliates) that market and trade corporate stocks and bonds. Recognizing how far the government’s response in 2008 deviated from the existing rational framework for government intervention, Section 716 of the Senate bill makes clear that such protections are not to be given statutory approval; that allowing banks to continue to deal and trade in derivatives would be to accept this egregious violation of prudential standards in legislation intended to reform and strengthen a fragile financial system.

The movement of the largest banks into the business of marketing and trading OTC derivatives occurred during a period when the process of deregulation was sweeping away traditional regulatory barriers and was not challenged. That fact should not, however, lead to the assumption that this is a “normal” banking activity. There is no economic or systemic reason why derivatives should be sold by banks. As the entry of large investment banks into the business in the 1980s suggests, it is not tied to the traditional deposit-taking and lending activities of banks or to the payments system. It is, in fact, so esoteric an activity that, currently, only five institutions account for 90 percent of the market. The remaining 8,000 or so U.S. banks do not sell derivatives or trade them for their own account.

Equally questionable is the assertion that dealing in derivatives is part of banks’ role as intermediaries; that they are helping to meet the hedging needs of their customers. As CFTC Chairman Gary Gensler recently pointed out, BIS data show that sales and trades with commercial end-users account for only eight to nine percent of the OTC market. Over 90 percent of contracts involve transactions between dealers or with other financial institutions. Meanwhile, the events of 2008 have made a mockery of the frequently voiced assertion that derivatives were invaluable in shifting risk to those most able to bear it – unless, of course, the assumption was that those most able to bear it were taxpayers.

Risk and fiduciary responsibility

Housing the business of marketing and trading derivatives in banks intensifies systemic risk and undermines fiduciary responsibility. Buying and selling OTC derivatives contracts is a zero sum game. Unlike portfolio lending that links the fortunes of borrowers and lenders, one party to a derivatives transaction wins while the counterparty loses. Given the nature of the game, dealers must constantly hedge their positions but, unable to do so by trading their side of the contract, their exposures grow higher and higher and include a number of contracts with long maturities. Systemic risk is embedded in this type of market structure – the more so since the buildup in these positions over the decade preceding the crisis depended on short-term borrowing and rising leverage. Touted as a way to defuse risk, the expansion of banks’ derivatives business actually intensified it

The buildup in derivatives positions among the large dealers also created a new and dramatically intense form of systemic risk: interconnectedness. The share of total transactions accounted for by contracts between a relatively small group of dealers resulted in an increasingly symbiotic web of interdependence among the largest institutions in the global market. The size of individual dealers’ positions contributed to systemic risk but interconnectedness was at the epicenter of the problem.

What section 716 does to alleviate the problem

The most important element in section 716 is the structure it provides – one that makes a clear separation between the business of banking and that of marketing and trading derivatives. This structure makes it possible to protect the core financial functions of banks without extending those protections to cover highly risky derivatives transactions.

By requiring that dealing and trading derivatives move to separately capitalized affiliates that do not have access to Fed lending facilities or FDIC guarantees, section 716 will also contribute to shrinking the size of individual institutions’ positions and the market itself. The huge capital reserves of the five institutions that dominate the U.S. market will no longer be available to support their outsized positions. The capital of derivatives affiliates – even if within the same holding company – will necessarily be much smaller and will limit their aggregate positions. This will create opportunities for non-bank firms to enter the market with capital positions equivalent to those of the affiliates of major institutions.

By shifting the activity to affiliates, section 716 eliminates the burgeoning counterparty risk the largest banks incur through marketing and trading OTC derivatives. Encouraging an expansion in the number of dealers will help reduce the risk to the system as a whole. The intent in both the House and Senate bills to require clearing and trading on exchanges using a central counterparty structure is another critical element for alleviating interconnectedness but only if the pressure to create loopholes is resisted.

Are there other provisions that mitigate these risks if banks are allowed to continue selling and trading derivatives?

There are other provisions in the House and Senate bills that address some aspects of bank exposure to risks involving derivatives but none of them remove the government guarantee backing their marketing and trading by banks. For example, the Volcker Rule in section 619 of the Senate bill deals with the equally important problem of proprietary trading by proposing to bar trading in any financial instrument, including derivatives, for a bank’s own account. The Merkley-Levin amendment strengthens this provision by making the reform a statutory ban rather than leaving it to the discretion of regulators. In addition, it would crack down on trades that conflict with customers’ interests.

But Merkley-Levin is not a substitute for section 716. It would still allow banks to deal and trade on behalf of their clients. Their derivatives business would still be backed and subsidized by Federal Reserve lending and FDIC guarantees and, in the event of another crisis, might require taxpayer bailouts to protect the banking functions of these huge enterprises.

Other sections of the Senate bill – sections 608–611 – address the systemic risk posed by interconnectedness. Section 610 limits a bank’s credit exposure (including derivatives) to another bank or financial institution as a percentage of its capital. This provision will tend to shrink the OTC derivatives market since, as noted, over 90 percent of aggregate transactions involves trades between dealers or with other financial institutions. Another section (608) complements section 716 by limiting a bank’s credit exposure (including derivatives) to affiliates. But, again, banks would still be able to conduct their derivatives business within the bank and the government backing for the bank that constitutes a guarantee and subsidy for selling and trading derivatives would remain.

Both the House and Senate bills authorize regulators to impose aggregate position limits on traded contracts and swaps. These provisions complement both sections 610 and 716 in the Senate bill by allowing regulators to address excesses and imbalances in the derivatives positions of individual institutions and the aggregate market as well. They are a very important tool for strengthening the regulation of derivatives markets but – once more – they do not remove the anticompetitive government support uniquely enjoyed by the derivatives operations of the five largest U.S. financial institutions.

In summary, there are no substitutes for section 716 – no provisions that will accomplish what it does in terms of removing the subsidy enjoyed by (literally) a handful of institutions and ending the ongoing threat to the taxpayer that the guarantee of their derivatives business poses. Ignoring that threat would undermine all the other contributions to reform that the House and Senate bills provide.

70 thoughts on “Why Section 716 is the Indispensable Reform

  1. newsflash: people with no hands on experience of derivative markets should stop writing things that make them look stupid.

  2. A good read.

    However, (like the Volcker Rule) it’s all dancing around the fact that what we need is an updated Glass-Steagall.

    Commercial banks should be restricted to taking deposits and making loans. In exchange they get deposit insurance and access to the Fed discount window. The shadow banking system of money market funds, repos, and commercial paper needs to be brought out of the shadows and regulated as banking.

    Investment banks should be restricted to providing advisory services, underwriting new issues of stocks and bonds, and providing some limited broker/dealer functions to support the issues they underwrite.

    A third category should be created to encompass retail brokerage and mainline asset management, subject to strict regulation.

    Then there is everything else – the hedge funds and prop trading operations. These should be kept as completely separate entities from the above three. They should have no access to commercial bank loans, the commercial paper market, or the public equity and debt markets. They should be free to gamble as they please, but only with their owner’s capital, bot with borrowed funds.

  3. Tell us about your hands on experience and why the commentary above isn’t valid. I’ve been trading in derivatives for a long time, both for banks and as a customer, and everything in this piece looks right to me.

  4. Pete D’s arguments basically equate to a narcotics/drug dealer saying the following: “policemen and the taxpaying public have no right to explain the negative impact on society of drug dealer activities until they have sold a few bags of cocaine or heroin.”

    These arguments of complexity have been trotted out before and shot down easily, and as typical of such lies as “We are Market-makers!!!”, will be trotted out again.

    Next time you feel like committing some crime damaging to society or your own customers, before you do it try this:
    Get 40 business cards and have them made out “Market-maker” like so, in large print. Then stuff about 10 of them up your ass so when the police or authorities catch you, you’ve got something to pull out of your ass.

  5. I hadn’t realized, these past two decades, bankers were on a gambling binge shooting craps in the back alley, on credit too boot! WTF 9 to 5 ers!

  6. Please explain why (1) the vast majority of derivitives should not be made illegal. I can’t set up a gambling casino so what is the logic of allowing banks to do so, (2) for those deritivites that would be allowed what is the logic of not having them actuarially sound?

  7. Why didn’t Simon sign the SAFER letter to the reconciliation committee? Best, Aaron

  8. If it is true that 90% of OTC derivatives exposure involves only mega banks trading with one other, there is no conceivable reason why such trading should be permitted. Every defense of the swaps casino always begins with some example relating hedging by participants primarily engaged in non-financial activity.

    A one percent transactions tax on notional value would either close down the casino or raise enough revenue to retire the National Debt. Either result would be a plus.

  9. There’s no surprises in a response like Mr. D’s, least of all in the contempt for anyone who’d call the banks for engaging in this crap. The arrogance is, of course, unbounded and absolutely blind to the brutally perverse nature of what just went down.

    Taxpayers took a hit to the tune of 8+ million jobs and hundreds of billions of dollars, but we’re supposed to let the “smartest guys in the room” go back to their good times now that we saved them from the ash heap of history. According to this logic, all the profits should be privatized, all the risk socialized, and get out of the way. Capitalism indeed.

    The idea that none of us are wise enough to really know what’s special about Mike and his friends, and how unworthy we all are to haul them back into line is par for the course.

    We’ve figured out what’s under the rock now that it’s been turned over. It’s time to call an end to this game. Letting banks structure up such illiquid “assets” while building up more and more risk through long term exposure to the sharks in the casino is complete madness. Having spent seven years in Las Vegas, I can already smell the sweat from the desperation that can be the only result of such perverse gambling activity.

    Shut it down for god’s sake.

  10. “These provisions complement both sections 610 and 716 in the Senate bill by allowing regulators to address excesses and imbalances in the derivatives positions of individual institutions and the aggregate market as well.”

    Question – does it matter whether the law allows regulators, or mandates regulators, to perform a function? If the problem is regulator capture – and surely the lack of SEC activity prior to the crisis and the complicity of the Fed in defending/excusing systemic risk as the outcome of a smarter-than-government market suggests capture of various types is an issue – then do you think section 716 and the other provisions are sufficient?

    Or should the law go further and mandate specific targets rather than give regulators the opportunity to flexibly structure regulations to achieve higher order goals?

    Perhaps I would trust the regulatory institutions more if I had a better idea of how the law was going to align the incentives of the regulators with the public, even as regulators come under pressure from different politicians and administrations and corporate funded “think” tanks…

    Do you have an opinion?

  11. Fed’s Hoenig Backs Spin Off Of Derivatives Trade

    Fri Jun 11, 2010 9:35am EDT – excerpt

    (Reuters) – “President of the Kansas City Fed Thomas Hoenig has given his backing to a controversial proposal to spin off banks’ derivatives trading desks in a move advocates say will reduce systemic risk in the sector.

    Hoenig expressed his support for the proposal in a letter to its originator, Senator Blanche Lincoln, dated June 10 and obtained by Reuters. The proposal is part of the largest overhaul of the financial system since the 1930s.

    A bipartisan group of lawmakers will merge the Senate’s financial regulation bill with a similar measure that passed the House of Representatives late last year. Hoenig is an influential backer for the so-called Lincoln proposal that is facing stiff opposition from the industry. Fed Chairman Ben Bernanke has also opposed the measure.

    “I have been a long-time proponent of limiting the derivative activities of commercial banks to only those designed to mitigate the institution’s balance sheet risk,” wrote Hoenig.

    “Such (derivative trading) activities should be placed in a separate entity that does not have access to government backstops. These entities should be required to place their own funds at risk.”


  12. Great commentary and analysis, contrary to the remarks of “Pete D” — who. presumably, has hands-on experience of these matters. He seems to suggest, strange as it sounds, that those with “hands on” (sic) experience — i.e., the ones who destroyed trading and capital markets worldwide, and then succeeded in transforming themselves into permanent wards of the state — should not only have a voice in this debate, but should actually frame and lead it. This also would imply a belief that these malefactors should frame and lead the discussions (and legislation) that will correct the obvious excess that brought the world’s markets to ruin.

    Pete D and his cohort obviously failed to understand the instruments they create and trade, and the risks they foist on their customers and taxpayers. The only value to society this guy and others of his ilk serve at present is as a contrary indicator — i.e., anything they resist and fight tooth and nail must, prima facie, be presumed to be worthwhile unless PROVED otherwise.

    There are two (2) key issues here re 716: 1) Chairman Gensler’s observation that 90 percent of (OTC derivatives) “contracts involve transactions between dealers or with other financial institutions,” and, 2) the five (5) largest banks and pseudo-banks represent more than 95 percent of the total notional of all OTC derivatives outstanding.

    The question that must be addressed is: What benefit does the U.S. economy (and, by extension, U.S. taxpayers) derive from providing the full faith and credit of U.S. government support to these very institutions that so completely dominate OTC derivatives trading. These TBTFs created by the government itself.

    This goes to the core of what markets are and what markets do. This is the economic significance of 716: Market structure and the role of markets. What, from an economic and policy perspective, exactly, is the information content of the prices and rates discovered in the OTC derivatives markets dominated by these firms? Given these concentrations in trading volumes, flows, open positions and risks, it is difficult to see the prices and rates emerging from these markets as anything other than the marginal rebalancing of these five (5) banks’ and pseudo-banks’ exposures. The exposures of any one of these firms are exquisitely sensitive to small changes in the exposures of the other four (4), causing any one’s activity that leads to a mark-to-market change to result in a cascade of trading by the others, ad infinitum … . This, I think, is the significance of the point Jane D’Arista is making. At any moment, this cascade can become chaotic, as we saw in ’08. These rebalancing areana — they really cannot be called markets at this point — always are balanced on that instantaneous boundary separating an instantaneous equilibrium in the positions of these five (5) institutions and chaos.

    How, exactly, does the Fed regulate this risk taking and trading-arena structure? Or the SEC? Or the CFTC? How, exactly, can monetary or fiscal policy be implemented in such a setting? How does the Fed signal its intent. What do price changes mean? One cannot call these OTC venues markets. They are risk clusters more amenable to the models developed in astro-physics than finance or economics. These are knots that wrap space and time.

    Thus, the information processing role of markets is completely subverted by thiese concentrations of risk. The disentangling of impacts of policy innovations and discounting of the future at which markets excel cannot occur right now. By definition, successful markets — hence successful information-processing — depend on many buyers and sellers. This is not only definitional, it is necessary and sufficient for successful markets. The concentration risk and, as the above article notes, the inter-connectedness of these institutions, makes these OTC derivs markets black holes of risk and not information-processing engines that can be relied on to convey essential information to the rest of society. Thus monetary and fiscal policy, and the allocation of resources for present and future use, cannot occur because we no longer have efficient markets. The only way to restore markets and markets’ information processing functions is to break up these risk clusters in an orderly manner.

    On a separate note, has there ever been a more complete and perfect capture of government? In all of history? The financial sector already accounts for more than 40% of total profits in the S&P 500 (and that’s net of the bonuses paid out by these firms … think about that for a second). Is it any wonder this is the case, given the massive support extended by our government to these five (5) institutions? Does the concentration of risk under such circumstances come as a surprise to anyone? How are the productive elements of our society supposed to fund R+D and job creation when so much of our resources are devoted to proping up this charade? What of the future? Does the U.S. become a financial services economy devoted to servicing these institutions?

  13. Since 90 % of the trading is between 5 players what would be the net settlement cost if these same 5 players were all recapitalized/ reorganized at the same time. In short, does one of these players going down trigger all going down, even though the net payoff of all 5 combined would be quite nominal? I would love to read some input on this aspect of the problem.

  14. How is having only 5 players not considered a trust, and subject to the appropriate “break them up” laws?

    How do the activities of these 5 players not constitute racketeering?

    And politicians/bankers wonder why people are angry?

  15. I truly believe that President Obama’s WH should cortially invite the “Two Men”, that literally pionerred the original swap’s that flowered into what we call the “Derivatives (CDO’s/CDS’s/R/C- MBS’s/ABS’s) Market’s” today, and pick their brains? Here are the individuals whom I firmly believe (I’m hoping, because there really smart guys),and think would gladly offer up their expertise #1) Mr. Joel Brenner who was head of the mortgage desk at investment bank Solomon Brothers in the 1980’s – creator of the “Mortgage Backed Securities (MBS’s)” & #2) Mr. Laurence Fink who in the (please take note of the timing correlation) 1980’s as a mortgage manager for a Boston Bank created the “Collatoralized Debt Obligation’s (CDO’s)”. Mr Fink currently oversees “BlackRock Global Investors (BGI)” after succesfully purchasing “Barclays Global Investors’s Unit (BGI)” from Barclay’s plc with its own global subsidiary spin-off of BarCap plc (note: this transaction facilitated BarCap’s plc purchasing of Lehman Brothers Trading/Brokerage house 6/09. PS. Mr. Fink can also help on “Prop Trade’s”? Lastly – BGI/Barclays plc pioneered the “Exchange Traded Funds (ETF’s)”, through its “iShare Brand” which is all under the Fink “BlackRock Global Investors, Umbrella”? Hope it helps:^) Absolutely wonderfully written,Bravo! Thanks Simon, James & And Ms. D`Arista

  16. Who is opposed to this, other than the non bank service providers getting free insurance, and their lobbyists/media/politicians?

  17. And what about the fact that Goldman and Morgan Stanley so quickly became bank holding companies?

    Where is the loophole that will allow the Fed, Treasury, President to do whatever he, and someday she, want?

    Ultimately it is the integrity of the people running the shop who make the decision, and no elected official gets there making the sound, tough choices.

  18. If anyone is interested, the daily machinations of derivatives trading

    (the addition of “details” to the Rube Goldberg cover up contraption)

    was conducted on a couple of quasi-religious website – their very own Navajo “code-talkers”…

    It’s a handful of people and they are EXTREMELY psychotic – medical definition undiluted by nihilism…

    Round them up and lock them up…there shouldn’t even be any discussion in Congress about how to make what they DID – steal 30,000 years of civilization’s currency – LEGAL.

    This kind of psychotic “Gambling” (rigged tables) is a new addition to a list of “governance” that can be added to the Declaration of Independence, I’ll give you that…but as we all know, you can’t LEGISLATE morality…

  19. @ Pete D: It is stupid to derivate most of the universe free, investable capital, towards a derivative universe.

    Not all trading is allowed: for example, one cannot buy and sell people anymore. Although it was long lawful in the USA. Progress is often about making unlawful tomorrow what was lawful, yesterday. Those who don’t understand that are stupid. Ultimately capital represents energy, and deliberately wasting capital in mutual bets in derivative universes is a crime, because, in the fullness of time, we have only that much energy to waste before switching to a more sustainable civilization.

    But of course, some people are so stupid that all they understand is their pocket, and how to fill it.

    A viper’s brain is fast, but it does only one thing really better than any other creatures: inject poison, and swallow. I do not expect vipers to understand much more than that.

  20. It’s basically an oligopoly. I think Miss D’Arista wrote this post superbly, but one small disagreement I have is with her saying 90% of the market is controlled by 5 institutions because it is an “esoteric activity”. I think it has more to due with the fact the derivatives dealer market is controlled by those firms, and those 5 firms put up barriers to entry in the market because of its high profit margins.

  21. Is There A Global War Between Financial Theocracy And Democracy?

    June 11, 2010 08:34 AM – excerpts

    “Senate and House conferees are about to reconcile a financial reform bill that is virtually designed to institutionalize “too big to fail.” And when they do we’ll lose another battle in the ongoing war between global financial markets and democratic nation-states.

    This war has been going on for decades — but democracy hasn’t always been in full retreat….

    We shouldn’t kid ourselves about the pitched battles ahead. Fighting back won’t be easy, and winning will be even harder. People in country after country will have to mobilize themselves in defense of real democracy, in defense of each nation’s right to provide its people with a decent quality of life. In my opinion, that includes sustainable jobs with decent benefits and a solid public infrastructure that promotes equity, protects the vulnerable and enriches the environment.

    Unfortunately, no one can guarantee that democracy will prevail in the war against financial theocracy — just recall the totalitarian chaos in Europe during the Great Depression.

    But don’t count it out, either. It’s true that many of us regular folks have been diverted by the media, distracted by the Internet or lulled into a stupor by pharmaceuticals. But when we realize that we’ve been shoved into a corner with no way out, we’ll act. A popular struggle will begin. And when it does, we’ll at least have a fighting chance to recapture our democratic souls.”


  22. I just appreciate all the intelligent people we have like Ms. D’Arista & Simon who are keeping the heat on these greedy ba$tards.

  23. It is natural to put up barriers. In my business, in almost every market, there are three to five oligopolists that split the market. Usually, each one has a niche they are dominant in and share the other four , or so, major segments. When one oligarch dies a second tier player is informally let in. There really are a Big Three with one or two junior members, in waiting. This is why country clubs and golf are so important for business.

    Why on Earth would anyone not try and isolate a market to their advantage ala Rockefeller? JDR and Henry Flagler were the aces of aces in this area. One does not need a formal trust arrangement to control a market… just a way of marking the deck a wee bit. The best way to deal with competition is to coop it out of being a nuisance.

  24. Ok. I think what Pete D was trying to say: the word “swap” is a little like saying “weapon”. Before you ban something (and 716 does NOT do this) you should at least define what you mean. There are as many kinds of swaps as you can imagine: interest rate, currency, FX, total return, credit default etc. A swap is generally just a contract between 2 parties to
    exchange something and many of them have very legitimate uses for banks. Specifically, hedging interest rate. When the bank lends you a fixed rate 30 yr mortgage, it funds that loan with deposits based upon a floating rate (libor, fed funds). The bank is exposed to the risk that the rate it will pay on its deposits will rise above the rate it receives on the mortgage. To
    fix this problem it enters into an IRS to pay floating rate and receive a fixed rate. 716, I understand it, will make it impossible for banks to centrally hedge their IRR. Instead they will need to do it outside bank chain thus forcing the BHC to incorporate and separately capitalize a nonbank
    sub (something that will be subject to less) in order to manage their IRR.

  25. MORE

    “In a letter dated Thursday, Federal Reserve Bank of Dallas President Richard W. Fisher wrote Senate Agriculture Committee Chairman Blanche Lincoln in support of her measure that would significantly change the way Wall Street’s financial behemoths sell and trade a type of financial derivatives product.”

    “Federal Reserve Bank of Kansas City President Thomas M. Hoenig wrote an identical letter Thursday. Hoenig is the Fed’s longest-serving policy maker. He and Fisher are part of a group of Fed officials outside of Washington and New York who support efforts to break up the nation’s biggest banks, a position Obama administration officials are firmly against.”

    READ the letter:

    Richard Fisher on Blanche Lincoln’s derivatives measure

  26. “A swap is generally just a contract between 2 parties …”

    Very good, so can we leave out the federally-funded guarantee, since that would violate your “between 2 parties” principle?

  27. Actually, the article is quite concise, well-conceived, and well, in a word, brilliant. Pete D does need those business cards, Ted (thanks so much for the enjoyable graphic nature of that thought). It’s important to remember that many of the major plutocrats supporting the Wall Street Greed Elites (the 5 playas mentioned) are in the White House. I voted for BO, but when he brought in TG and LS, and nominated BB (brains?) for another term, I shivered and realized that maybe SP would be ok as VP, given the fact that many of HP’s and AG’s old cronies would be at the top of the plutocratic heap. Simon refers to this state of affairs as intellectual capture. I am far more cynical. I call it helping the rich get richer and helping the rest of us into abject poverty.

    If 716 stays without being substantially revised so that GS, BA, CB, et al, stay in the derivatives schmutz shoveling business, I will be so surprised. With half a trillion invested by WS this year and more than a thousand lobbyists working behind the scenes, there is virtually no chance for reform before collapse. And, by the way, something tells me that there are many billions in derivatives now rotting over the BP disaster. The BP problem, in fact, with hundreds of billions at stake being flushed down a Caribean sized toilet, could prove the death knell for lots of economies. Britain and Germany at present are the bulwarks of the European economy. BP could really sink the British economy, their bonds, and all of the gambles of the market place which will soon become as toxic as the waters in the Gulf of Mexico.

  28. Butters,
    That’s a load of crap anyway. If the big banks cared about their IRR they would make sure they had enough capital to cover their derivative wagers, which they obviously don’t. The big banks don’t give 5 seconds time to seeing if they have capital to cover the derivatives or “swaps”, and they don’t give a damn either. 95% of this “hedging” currency risk and interest rate risk is a red herring for what the banks really want to say: “leave us the hell alone on everything and let us keep the profits and the taxpayers bear the risks and losses.”

  29. SG – ….I trust you mean if you had a “better idea of how the law was going to align the incentives of the regulators with the public [interest] ….”? (brackets added)

    If so, I have the same question and concern about the propensity for financial markets to evolve activity beyond regulatory limits. Of course we know those limits can only be effective to the extent their existence is justified by economic theory. And, as has been mentioned before, economics is still unable to adequately represent the linkages between ordinary human beings (who don’t carry money maker business cards) and the financial sector.

    Maybe theory needs to evolve to capture that propensity for excessive innovation on the part of finance…

  30. I guess my response is: how in the hell do you all know all this? Have any of you worked in bank?

    My point is: swaps are like fertilzer. You can either grow crops or make bombs. All 716 does is bans fertilzer outright. Period.

  31. Allowing banks to hedge their interest rate risk is important and is being addressed.

    One major problem is the veracity of this hedging. The rumor had always been AIG was bailed out to bail out the European banks which had hedged through AIG.

    Why do you presume one has to work in a bank to understand banking? Goldman Sachs and Morgan Stanley became “banks” overnight when they wanted Treasury and Feds Lines of Credit.

  32. And, as a resident of Iowa, I must say, seriously, I must say, your analogy is nonsensical.

    Have you ever worked with derivatives? You seem deeply confused.

  33. > Jerry J:

    At some level of the Fed and the Treasury — and likely the SEC, CFTC, and the BIS — there has to be a ledger(s) of all the open positions of these firms. We know there are detailed records at the SEC ( http://www.sec.gov/rules/final/34-49831.htm ) that hold every position and exposure up to the end of 2008, including the notoriously misnamed “risk management” programs at the former investment banks, which are now pseudo-banks. Unfortunately, the SEC did away with this program, so no more of these data are being collected. Not that it served any useful purpose when the program was extant: The SEC failed so completely in monitoring and understanding what was going on in the lead-up to the collapse of global markets. (The program was taken out back and shot in the head with no fanfare or press … funny that, huh?) But at least we know that data’s there, and the reporting formats are there — so the missing bits could readily be filled in, and a complete picture of the risk positions of the pseudo-banks could be cobbled together. The Fed and others have the positions of the used-to-be commercial banks, so their exposures/positions would be known with reasonable certainty.

    No doubt a lot of this is plain vanilla, and can be netted down. In and of itself, this probably is trivial — run them all thru CME Clearing or ICE Clearing, and net it all out.

    This would still leave all of the ugly parts that are one-offs, ungodly complex or, worse still, vanilla credit products that, depending on whether the particular institution is long or short, still are being carried at widely divergent marks at each of the five (5) institutions. AIG and GS got into a pissing match over this very thing, with GS ultimately prevailing, not so much because they were correctly marked to market as they stuffed the other four (4) institutions with so much drek they had to capitulate.

    These institutions cannot be forced to accept a regulator’s mark at which to liquidate — there would be contract-dispute cases that go on for years — although, as an 80-percent owner of AIG and guarantor of every one of these firms, the U.S. government could start looking for and enforcing its contract rights with greater vigor.

    We have massive and, ultimately, lethal regulatory forbearance that prevents the banks and pseudo-banks and their regulators from taking any action to set things right. Thus the marginal re-balancing among these institutions continues. And the economies saddled with the task of keeping these institutions afloat continue to atrophy.

    It is mystifying why this state of affairs persists. We’re getting ready to go into another comp cycle, in which JP, GS, MS, even BoA and C will be thumping their chests and talking about how successfully they navigated another tumultous year and made tons of money doing so. Pres. Obama will once again express his extreme displeasure over the ungodly comp being handed out. Geithner and Bernanke will again talk about how distasteful it all is. But at the end of the day, the banks and pseudo-banks will have bought another year and will have siphoned off another $140 billion to $150 billion from the American taxpayer and will have enriched themselves. So, net net, a little bad press is endured, everyone’s richer, and another year gets going so it can all be done one more time.

    What we really need is for the Obama administration to do another victory lap saying they prevented the collapse of market economies. And the Fed’s thinking they finally hae things under control.

  34. Re: @ Butters___Fertilizer is wonderful only if used in fertile soil producing a socially viable crop – not too be layed to waste, as in blowing in the wind! Think of “AIG” as the wind – “TARP” as the fertilizer, eg. ~$52bn. given @ 100% on the dollar to European Banks – no questions asked – funded by the american taxpayer! ie.) Societe` Generale` of France had recieved $11.9bn. ($6.9bn Maiden Lane III counterparty bailout) 2009? Just recently in the French (6/2010) News, there is talk of a $8.9bn Euro (equates to ~ $12.0bn USD shortfall – hedgefunds/swaps?) loss on Societe` Generale’s ledgers. Let’s just put a hypothesis to this rumor, as it might be only that, and say that the accumulated losses to Societe Generale (over the past two-years) because of the derivative swaps market is in the mid- thirty billion euro’s! So, “Bombs Away”?

  35. Mea Culpa, Slightly Off-Topic

    Oh My … !

    N.Y. State “Classic Budgetary Sleight-Of-Hand”

    6/12/2010 08:38:00 AM – by CalculatedRisk – excerpt

    From Danny Hakim at the NY Times: New York Plan Makes Fund Both Borrower and Lender

    “Gov. David A. Paterson and legislative leaders have tentatively agreed to allow the state and municipalities to borrow nearly $6 billion to help them make their required annual payments to the state pension fund.

    And, in classic budgetary sleight-of-hand, they will borrow the money to make the payments to the pension fund — from the same pension fund.

    Oh my … ”


    “Bill McBride is an American blogger who founded the economics and finance blog Calculated Risk. A former technology executive, in early 2005 McBride believed that the housing market in the United States was near its peak, and he posted articles and statistics (anonymously, under the pseudonym Calculated Risk) to his blog to support his argument.[1] Bill McBride was soon joined by his co-blogger, Doris Dungey, who wrote under the pseudonym Tanta until her death on November 30, 2008.[2][3][4][5]
    As an early predictor of the US housing bust, Calculated Risk gained influence and by January 2009 it was the top economics blog by traffic statistics.[6]”


  36. Jane D’Arista wrote:

    “The proliferation of foreign exchange forwards and swaps that followed set in motion an ever-expanding menu of exotic instruments that reached a nominal value of over $600 trillion by the middle of the current decade.”

    Your cogent observations are very much appreciated.

  37. Miss d’Arista’s analysis might have been influenced
    by the ‘trading in the dark or ” trading in the shadows’ expressions used in the Matt Taibi’s article in Rolling Stone “Wall Street Wars”

  38. You blinked, Earle, and missed the gear that moves to deposit the “bubble”…unemployed people’s savings into “health insurance” grind…

  39. Yeah…the guys with all the experience have done such a bang-up job. I welcome any comment, from anyone with a cogent thought on how to fix this mess. I really don’t think relying on the bulls that wrecked the china shop, are the go-to people here.

  40. The regulators are tools of the ruling class. I’ll trust them after their political patrons have been arrested and tried in peoples’ courts.

  41. Obama does the bidding of those who own him, that nothing more or less. He is a creature of the interests and will share their fate when the people have seen to the restoration of their democracy.

  42. @ StatsGuy

    Good question, it is in part why I think current regulation is toxic for issuers, intermediaries, and investors et.al.

    If you advocate segmenting the economic structure for:

    • Firm where there is a clear separation between the business of banking and that of marketing and trading derivatives; and,

    • Market where there are exchange order-driven platform and market-maker quote-driven platforms.

    Doesn’t logic argue that the one-size-fits-all deterministic governance should be segmented into determinate and indeterminate regimes?

    How can there be transparency which leads to regulatory trust when we use one governance metric for different underlying economic environments?

    Stephen A. Boyko

    Author of “We’re All Screwed: How Toxic Regulation Will Crush the Free Market System” and a series of articles on capital market governance.


  43. Just like Saddam Hussin in the first Iraq/Kuwait War, we left the villian standing. And it will take another 10 years of trauma and trouble before there is a movement, ligitmate this time, to move in and stop it. The big problem is that there may not be a world left to save after those next ten years.

  44. “HATEronics” – the derivatives schmaltz shoveling business – is made up crap.

    People really are incapable (brain juice not there) of comprehending what has just happened in the Gulf of Mexico….

    Be that as it may, it is 100% obvious to LUCID minds that BP can survive and even thrive with an immediate investment in developing alternate sources of energy.

    Scheesh, just go pick out a couple of those plans buried back in the 1970s and start building…most of those hippies are dead now from the drugs they took to deal with the “pain” of oil suffocation in that decade…

  45. Can’t imagine what could be more clear than that Israel and its more-than-simply influential lobby in this country learned their National Socialism well from their German teachers. How does one say it, imitation is the sincerest form of flattery? That’s bad enough, I suppose, but for them actually to have situated an agent at the heart of our policy making is really quite something else, however:


  46. Bayard Waterbury wrote:

    “The BP problem, in fact, with hundreds of billions at stake being flushed down a Caribean sized toilet, could prove the death knell for lots of economies.”

    Sunday 13 June 2010 – The Observer – excerpt

    “Robert Reich, a labour secretary under President Bill Clinton, has gone as far as to call for Obama to take BP’s North American operations over in a manner similar to that of stricken insurer AIG at the height of the financial crisis. “We have a national emergency on our hands,” Reich said. “No president would allow a nuclear reactor owned by a private for-profit company to melt down in the United States while remaining under the direct control of that company. The meltdown in the Gulf is the environmental equivalent.”


  47. “Why do you presume one has to work in a bank to understand banking?”

    No particular reason.

    Except, what is your field? Do you not believe that you know more about your field (I assume you have a field in which you are demonstrably expert) than others who are only too willing to express an opinion?

    I advocate, as has been expressed in these pages, the break up of the TBTF. But that doesn’t mean that Joe and His Dogs are qualified to take deposits from anyone and lend them to anyone.

    Don’t just assume that you are omniscient and have some understanding that entitles you to go to the front of the pack when evaluating banks and bankers.

    In the interest of comity in these pages, no offense.

  48. People working in the “field” of financial derivatives should observe the havoc the industry has wrought and be humbled by their own enormous mistakes.

  49. I couldn’t agree more with Robert Reich. The sooner BPs operations are taken over, the sooner somebody can start paying back these poor people in the Gulf states what they are owed.

  50. How will the oil effect the nuclear power plant south of Miami and the desalintion plants along the coast?

  51. For the sake of fantasy, let’s pretend they have been “humbled”…

    And so now what? What’s Plan B?

    The Jim Jones Jonestown solution? Mass injections for the “believers” in his goodness who were duped…?

    Once “Wall St” took over Vegas…well, Number One State in bankruptcy and foreclosures…

    Good read – “The Wrecking Crew” – thanks for the recommendation :-)

    Seriously, had at least 20% more of the USA population with the capacity to understand MOST of the real scientific principles utilized on a daily basis in all our technocratic lives

    had KNOWN about the “zero risk” LIE

    the “whistle blowers” would have taken on – mano et mano, if necessary – the criminally insane.

    We all have the RIGHT to protect ourselves against untimely deaths at the whims of racketeering “business models”…

    Too few KNEW that we were heading to the destruction of ALL LIFE dependent on a major planetary body of water…

    I would have shot myself out of a canon to get the attention…and now, a “Kennedy” moment in the works?!

    Gee, why is there so much “suffering” in the world, huh?

    It’s a FULL ON WAR against everything beautiful and good – people, land, civilization…

    Insane. Period.

  52. Exactly KV, remember how it works – always back a horse called ‘Self-Interest’ …

  53. For anyone still believing that it registered with Obama to have about one million faces in D.C. watching his oath taking meant “change”…they have a new 911 to exploit – watch ME so you don’t watch this:

    June 15, 2010 – “Members of the House-Senate Conference Committee on financial regulation today started debate and voting on sections of the Restoring American Financial Stability Act of 2010. The 43 committee members, or conferees, have started work on credit rating agencies and hedge funds. The bill contains 12 major sections and spans almost 2000 pages.

    The committee hopes to have a bill approved by both chambers of Congress and signed into law by President Obama by July 4th.

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