When Bankers Forge Implements of Mass Destruction
James Mullin
May 06, 2008
Joe Six-Packīs Guide to the Ongoing Financial Crisis - Part II
In the late 1920īs banks fueled much of the hyper-speculation in the stock market. After the crash of 1929, some 11,000 banks closed making their depositors paupers overnight.
Four grim years later, a new administration under President Franklin Delano Roosevelt passed a banking reform law called the Glass-Steagall Act. It set up a firewall between commercial banks and investment (corporate securities, stocks and bonds) banks because the mixture had proven highly volatile.
In 1998, Congress succumbed to wealthy and influential advocates of deregulation, and passed legislation allowing the merging of banks, securities firms, and insurance companies. They repealed Glass-Steagall in 1999 since it was already dead.
In 2000, Congress passed the Commodity Futures Modernization Act, a milestone in deregulation. It effectively made the market for derivatives and other exotic financial instruments off-limits to regulatory agencies.
No harm in that, you might say, and who cares what a derivative is anyway? I am afraid that this really is the crux of the matter.
Derivatives are financial contracts that "derive" their value from an underlying asset or investment, like a stock, bond, currency, equity commodity, or even an index. Some common derivatives are futures, options, swaps and warrants.
Unfortunately, the financial freedom (and secrecy) provided by the Commodities Futures Act produced an explosion of even more complex derivative instruments, like collateralized debt obligations, and credit default swaps. These are some of "Wall Streetīs biggest profit engines".
In a March 23rd NY Times article, "What Created This Monster?", Nelson D. Schwartz and Julie Creswell, point out that the "dizzying array of innovative products"(derivatives) was "hard to understand and even harder to value."
Maybe they are so profitable and so difficult to value precisely because they are "virtually hidden from investors, analysts and regulators".
Wall Street firms who wanted their share of the huge profits being made off the sale of complex derivatives, hired students with doctorates in physics and other mathematical disciplines to design them.
If they are that complex, what mortal can understand them? A former Federal Reserve vice-chairman, Alan S, Binder, who holds a doctorate in economics from M.I. T., told the NY Times (3/23/08) that he has only a "modest understanding" of complex derivatives. "If you presented me with one and asked me to put a market value on it, Iīd be guessing."
Byron Wien, the chief investment strategist at Pequot Capital, says there are plenty of people running Wall Street firms that donīt understand complex derivatives:
"These are ordinary folks who know a spreadsheet, but you put a lot of equations in front of them with Greek letters on their sides, and they donīt know what they are looking at."
How then is their value determined? Itīs simple. Most credit rating agencies are paid by banks to grade their products. And what harm can come from that kind of arrangement?
Moody's Investors Service, for example, gave AAA ratings to collateralized debt obligations (CDOs) tied to $33 billion in sub-prime mortgages. They were forced to downgrade their value when the defaults and foreclosures began to grow. So much the worse for the people and institutions who bought them.
Recently, complex derivatives have been called "toxic" and "radioactive" or "Wall Streetīs version of nitroglycerin". Warren E. Buffet, Forbesī designated "richest man in the world" said in 2003 that derivatives were potential "weapons of mass destruction". Five years later, the language is still cataclysmic:
"The explosion in the use of derivatives has only tightened the global links and made a worldwide meltdown easier to imagine." "Leveraged Planet, Without Borders" (NYT 4/2/08)
Take one more deep breath and consider the following:
A graph provided by the International Swaps and Derivatives Association illustrates the rapid growth of just one type of unregulated derivative, called a credit default swap. It is defined as "a financial contract designed to cover losses to banks and bondholders when companies fail to pay their debts". Sounds simple enough!
In 2001, the "value" of all credit default swaps held world-wide was approximately $700 billion. Thatīs a lot of money, but by June, 2007 the "value" of such contracts stood at $47 trillion! Yep, trillion.
Is it conceivable that financial institutions, once liberated from the shackles of Glass-Steagall regulation, were able to create in six short years over $47 trillion in capital assets? I donīt think so.
What are the holdings of major U.S. banks? The outstanding "value" of credit default swaps held by Bank of America in 2007 was $1.5 trillion thatīs one thousand five hundred billion dollars!
Citibank (owned by Citigroup) held $3 trillion, (3,000 $billion) and JP Morgan held $7.7 trillion. Thatīs seven thousand seven hundred $billion. Together, these three banks own credit default swaps supposedly worth $12.2 trillion! (NYT, 3/23/08)
To gain perspective, consider that the International Monetary Fund (IMF) put the Gross Domestic Product (GDP) of the United States in 2007 at $13.5 trillion. And now we are told that three big U.S. banks hold unregulated credit default swaps worth $12.2 trillion? How is this possible?
Maybe it isn't. Maybe they are worthless.
Next:
Part III: The World as We Donīt Know It, or
What Bear Stearns tried to say before it got whacked
In the late 1920īs banks fueled much of the hyper-speculation in the stock market. After the crash of 1929, some 11,000 banks closed making their depositors paupers overnight.
Four grim years later, a new administration under President Franklin Delano Roosevelt passed a banking reform law called the Glass-Steagall Act. It set up a firewall between commercial banks and investment (corporate securities, stocks and bonds) banks because the mixture had proven highly volatile.
In 1998, Congress succumbed to wealthy and influential advocates of deregulation, and passed legislation allowing the merging of banks, securities firms, and insurance companies. They repealed Glass-Steagall in 1999 since it was already dead.
In 2000, Congress passed the Commodity Futures Modernization Act, a milestone in deregulation. It effectively made the market for derivatives and other exotic financial instruments off-limits to regulatory agencies.
No harm in that, you might say, and who cares what a derivative is anyway? I am afraid that this really is the crux of the matter.
Derivatives are financial contracts that "derive" their value from an underlying asset or investment, like a stock, bond, currency, equity commodity, or even an index. Some common derivatives are futures, options, swaps and warrants.
Unfortunately, the financial freedom (and secrecy) provided by the Commodities Futures Act produced an explosion of even more complex derivative instruments, like collateralized debt obligations, and credit default swaps. These are some of "Wall Streetīs biggest profit engines".
In a March 23rd NY Times article, "What Created This Monster?", Nelson D. Schwartz and Julie Creswell, point out that the "dizzying array of innovative products"(derivatives) was "hard to understand and even harder to value."
Maybe they are so profitable and so difficult to value precisely because they are "virtually hidden from investors, analysts and regulators".
Wall Street firms who wanted their share of the huge profits being made off the sale of complex derivatives, hired students with doctorates in physics and other mathematical disciplines to design them.
If they are that complex, what mortal can understand them? A former Federal Reserve vice-chairman, Alan S, Binder, who holds a doctorate in economics from M.I. T., told the NY Times (3/23/08) that he has only a "modest understanding" of complex derivatives. "If you presented me with one and asked me to put a market value on it, Iīd be guessing."
Byron Wien, the chief investment strategist at Pequot Capital, says there are plenty of people running Wall Street firms that donīt understand complex derivatives:
"These are ordinary folks who know a spreadsheet, but you put a lot of equations in front of them with Greek letters on their sides, and they donīt know what they are looking at."
How then is their value determined? Itīs simple. Most credit rating agencies are paid by banks to grade their products. And what harm can come from that kind of arrangement?
Moody's Investors Service, for example, gave AAA ratings to collateralized debt obligations (CDOs) tied to $33 billion in sub-prime mortgages. They were forced to downgrade their value when the defaults and foreclosures began to grow. So much the worse for the people and institutions who bought them.
Recently, complex derivatives have been called "toxic" and "radioactive" or "Wall Streetīs version of nitroglycerin". Warren E. Buffet, Forbesī designated "richest man in the world" said in 2003 that derivatives were potential "weapons of mass destruction". Five years later, the language is still cataclysmic:
"The explosion in the use of derivatives has only tightened the global links and made a worldwide meltdown easier to imagine." "Leveraged Planet, Without Borders" (NYT 4/2/08)
Take one more deep breath and consider the following:
A graph provided by the International Swaps and Derivatives Association illustrates the rapid growth of just one type of unregulated derivative, called a credit default swap. It is defined as "a financial contract designed to cover losses to banks and bondholders when companies fail to pay their debts". Sounds simple enough!
In 2001, the "value" of all credit default swaps held world-wide was approximately $700 billion. Thatīs a lot of money, but by June, 2007 the "value" of such contracts stood at $47 trillion! Yep, trillion.
Is it conceivable that financial institutions, once liberated from the shackles of Glass-Steagall regulation, were able to create in six short years over $47 trillion in capital assets? I donīt think so.
What are the holdings of major U.S. banks? The outstanding "value" of credit default swaps held by Bank of America in 2007 was $1.5 trillion thatīs one thousand five hundred billion dollars!
Citibank (owned by Citigroup) held $3 trillion, (3,000 $billion) and JP Morgan held $7.7 trillion. Thatīs seven thousand seven hundred $billion. Together, these three banks own credit default swaps supposedly worth $12.2 trillion! (NYT, 3/23/08)
To gain perspective, consider that the International Monetary Fund (IMF) put the Gross Domestic Product (GDP) of the United States in 2007 at $13.5 trillion. And now we are told that three big U.S. banks hold unregulated credit default swaps worth $12.2 trillion? How is this possible?
Maybe it isn't. Maybe they are worthless.
Next:
Part III: The World as We Donīt Know It, or
What Bear Stearns tried to say before it got whacked
Print
Email
