What the Big Banks Have Won
by Mike Whitney
The trouble started 24 months ago, but
the origins of the financial crisis are still disputed. The problems
did not begin with subprime loans, lax lending standards or shoddy
ratings agencies. The meltdown can be traced back to the activities
of the big banks and their enablers at the Federal Reserve. The
Fed's artificially low interest rates provided a subsidy for risky
speculation while deregulation allowed financial institutions
to increase leverage to perilous levels, creating trillions of
dollars of credit backed by insufficient capital reserves. When
two Bear Stearns hedge funds defaulted in July 2007, the process
of turbo-charging profits through massive credit expansion flipped
into reverse sending the financial system into a downward spiral.
It is inaccurate to call the current slump
a "recession", which suggests a mismatch between supply
and demand that is part of the normal business cycle. In truth,
the economy has stumbled into a multi-trillion dollar capital
hole that was created by the reckless actions of the nation's
largest financial institutions. The banks blew up the system and
now the country has slipped into a depression.
Currently, the banks are lobbying congress
to preserve the "financial innovations" which are at
the heart of the crisis. These so-called innovations are, in fact,
the instruments (derivatives) and processes (securitization) which
help the banks achieve their main goal of avoiding reserve requirements.
Securitization and derivatives are devices for concealing the
build-up of leverage which is essential for increasing profits
with as little capital as possible. If Congress fails to see through
this ruse and re-regulate the system, the banks will inflate another
bubble and destroy what little is left of the economy.
On June 22, 2009, Christopher Whalen,
of Institutional Risk Analysis, appeared before the Senate Committee
on Banking, Housing and Urban Affairs, and outlined the dangers
of Over-The-Counter (OTC) derivatives. He pointed out that derivatives
trading is hugely profitable and generates "supra-normal
returns" for banking giants JP Morgan, Goldman Sachs and
other large derivatives dealers. He also noted that, "the
deliberate inefficiency of the OTC derivatives market results
in a dedicated tax or subsidy meant to benefit one class of financial
institutions, namely the largest OTC dealer banks, at the expense
of other market participants." As Whalen testified:
"Regulators who are supposed to protect
the taxpayer from the costs of cleaning up these periodic loss
events are so captured by the very industry they are charged by
law to regulate as to be entirely ineffective....The views of
the existing financial regulatory agencies and particularly the
Federal Reserve Board and Treasury, should get no consideration
from the Committee since the views of these agencies are largely
duplicative of the views of JPM and the large OTC dealers."
Whalen's complaint is heard frequently
on the Internet where bloggers have blasted the cozy relationship
between the Fed and the big banks. In fact, the Fed and Treasury
are not only hostile towards regulation, they operate as the de
facto policy arm of the banking establishment. This explains why
Bernanke has underwritten the entire financial system with $12.8
trillion, while the broader economy languishes in economic quicksand.
The Fed's lavish gift amounts to a taxpayer-funded insurance policy
for which no premium is paid.
"In my view, CDS (credit default
swaps) contracts and complex structured assets are deceptive by
design and beg the question as to whether a certain level of complexity
is so speculative and reckless as to violate US securities and
anti-fraud laws. That is, if an OTC derivative contract lacks
a clear cash basis and cannot be valued by both parties to the
transaction with the same degree of facility and transparency
as cash market instruments, then the OTC contact should be treated
as fraudulent and banned as a matter of law and regulation. Most
CDS contracts and complex structured financial instruments fall
into this category of deliberately fraudulent instruments for
which no cash basis exists."
No one understands these instruments;
they are deliberately opaque and impossible to price. they should
be banned, but the Fed and Treasury continue to look the other
way because they are in the thrall of the banks. This phenomenon
is known as "regulatory capture".
Credit default swaps (CDS) are a particularly
insidious invention. They were originally designed to protect
against the possibility of bond going into default, but quickly
morphed into a means for massive speculation which is virtually
indistinguishable from casino-type gambling. CDS can be used to
doll-up one's credit rating, short the market or hedge against
potential losses. CDS trading poses a clear danger to the financial
system (The CDS market has mushroomed to $30 trillion industry)
but the Fed and other regulators have largely ignored the activity
because it is a cash cow for the banks.
"It is important for the Committee
to understand that the reform proposal from the Obama Administration
regarding OTC derivatives is a canard; an attempt by the White
House and the Treasury Department to leave in place the de facto
monopoly over the OTC markets by the largest dealer banks led
by JPM, GS and other institutions....
The only beneficiaries of the current
OTC market for derivatives are JPM, GS and the other large OTC
dealers.... Without OTC derivatives, Bear Stearns, Lehman Brothers
and AIG would never have failed, but without the excessive rents
earned by JPM, GS and the remaining legacy OTC dealers, the largest
banks cannot survive and must shrink dramatically." (Statement
by Christopher Whalen to the Committee on Banking, Housing and
Urban Affairs, Subcommittee on Securities, Insurance, and Investment,
United States Senate, June 22, 2009)
The Geithner-Summers "reform"
proposals are a public relations scam designed to conceal the
fact that the banks will continue to maintain their stranglehold
on OTC derivatives trading while circumventing government oversight.
Nothing will change. Bernanke and Geithner's primary objective
is to preserve the ability of the banks to use complex instruments
to enhance leverage and maximize profits.
The banks created the financial crisis,
and now they are its biggest beneficiaries. They don't need to
worry about risk, because Bernanke has assured them that they
will be bailed out regardless of the cost. Financial institutions
that have explicit government guarantees are able to get cheaper
funding because lending to the bank is the same as lending to
Mike Whitney lives in Washington state.
He can be reached at firstname.lastname@example.org