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Tuesday, June 15, 2010

Collateral for Derivatives (The Volcker Rule)

The proposed banking "reform" bill had an interesting provision, regarding restricting banks from speculating in derivatives. This is the "Volcker Rule". However, the banksters shot it down and eliminated it. Either it's in the process of being removed from the "reform" law, or it was removed already.

The proposed law would require banks to spin off their derivatives trading desk as a separate business. Any bank with a derivatives desk would lose its perk of borrowing cheaply from the Federal Reserve, at the Fed Funds Rate or Discount Rate. This would force banks to split their derivatives trading desk as a separate business.

This reminds me of an interesting story. A corporation had a commodity hedging desk. The corporation was an airline or food manufacturer; they were hedging the commodity they were actually using. (The actual industry was irrelevant. It was the hedging desk for a business that had a useful end-product.)

One year, the hedging desk was ridiculously profitable! (If your hedging desk is profitable, you're doing it wrong.) The executives decided to spin off the hedging desk as its own separate business.

As a standalone business, the hedging desk couldn't make any profits! When they were one division of a huge corporation, the hedging desk could borrow at cheap AA rates. As a standalone business, the hedging desk could only borrow at C/junk rates. They could no longer profitably finance their trades.

In effect, the whole large corporation was collateral for the hedging desk! If the hedging desk gambled and won, the traders kept the profits. If they lost, the rest of the corporation was collateral for their gamble!

Via fancy derivatives transactions, it's relatively easy to construct a trade where you make $1B 99% of the time, but lose $1T the remaining 1% of the time. When you're right you pocket a huge bonus. When you're wrong, you declare bankruptcy or get a bailout. The "too big to fail" principle encourages this behavior. Limited liability incorporation gives management a free put option to declare bankruptcy and cheat creditors, leading the creditors to lobby for a bailout.

That's the reason the banksters blocked this law. By itself, a derivatives trading desk isn't profitable. Derivatives trades are only profitable when you can borrow at preferred interest rates, either directly from the Federal Reserve or by placing a "too big to fail" business as collateral.

AIG's credit default swap trading desk would not have been profitable as a standalone business. There would not have been any collateral. All of AIG was placed as collateral for the credit default swap trades. When there were no payouts, the traders got huge profits and bonuses. During an inflationary boom, AIG's credit default trading desk was pocketing free money. They were collecting premiums, but had no payouts or collateral requirements.

When the housing market crashed, all of AIG was collateral for the losses. AIG was "too big to fail". In effect, everyone who purchased credit default swap insurance from AIG actually bought it from the government. The profits in the boom years were paid out as bonuses to executives. The bailout of AIG was really a bailout of AIG's creditors.

When you buy credit default swap insurance, one of the risks is supposed to be "The risk that the business I bought insurance from goes broke." The "too big to fail" principle made that default risk zero, *PROVIDED* you bought credit default swap insurance from a huge corporation like AIG. In effect, the law is "Only a 'too big to fail' institution may sell credit default swap insurance." You'd be stupid to buy credit default swap insurance from someone who isn't "too big to fail".

The derivatives market didn't take off until after 1971. Once all pretense of a gold standard was abandoned, the banksters could inflate at will. Negative real interest rates feed derivatives transactions. Complicated derivatives hide what's actually happening.

Suppose Bank A can borrow at the Fed Funds Rate, currently 0.25%. Suppose Corporation B can normally borrow at 6.25%. Bank A enters a derivative contract with Corporation B. Suppose the implied interest rate of the derivative is 3.25%.

Both parties to the derivative trade can claim an immediate profit! Bank A is borrowing at 0.25% and lending at 3.25%. Corporation B is borrowing at 3.25% while they normally pay 6.25% to borrow. It pays for Corporation B to borrow, because true inflation is 20%-30% or more. The bank uses its cheap borrowing power to finance the hedge of the derivative trade.

In this manner, negative real interest rates fuel derivative trades. There's usually also a leverage component implied in the derivative contract, amplifying the benefit. This also means that the derivatives contract has a small chance of a huge loss.

Banks don't want to spin off their derivatives trading desks. Unable to borrow cheaply, that wouldn't be profitable anymore!

It's interesting that some Congressman proposed this reasonable restriction on abuse of leverage and cheap interest rates. However, lobbyists for the banksters removed this part of the "reform" law.

In the US economic system, the banksters literally have the power to print money. With the power to print money, the banksters have a virtually unlimited lobbying budget. They can always profitably lobby to block reform.

No matter what regulation you have, there will be loopholes. The loopholes are usually put there by lobbyists from the regulated industry! Government regulation always fails, due to the "captured regulators" problem.

The financial "reform" law is designed to provide the illusion of reform, while allowing insiders to continue to steal.

The financial crisis was entirely caused by the Federal Reserve credit monopoly. It's meaningless to discuss financial "reform" without also mentioning "The Federal Reserve is one big price-fixing cartel! The Federal Reserve is immoral and should be eliminated!"

1 comment:

Scott said...

I really enjoy these articles.

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