“Well written and an interesting perspective.” Clan Rossi --- “Your article is too good about Japanese business pushing nuclear power.” Consulting Group --- “Thank you for the article. It was quite useful for me to wrap up things quickly and effectively.” Taylor Johnson, Credit Union Lobby Management --- “Great information! I love your blog! You always post interesting things!” Jonathan N.

Friday, February 15, 2013

On the Futurization of Swaps: Systemic Risk Evading Financial Reform

According to the Dodd-Frank financial reform Act of 2010, financial firms are required to set aside higher reserves to cover losses on trades of derivative securities, including those that “swap” the risk of default in the basis of a given security, such as mortgages. As if drug addicts or alcoholics shirking boundaries, traders set about getting around the “margin requirements” by treating “swaps” as futures, which do not require the higher reserves. Whereas a futures contract for corn to sell at a certain price limits residual risk, swaping the risk of the default of an investment puts a party on the line for the entire investment. Moreover, unlike futures contracts, swaps have significant systemic risk because claims can all be made at once, overwhelming the parties assuming the liability in the swaps (e.g. AIG in September 2008). Wall Street over-discounts such high-risk, low-probability outcomes.  Less in reserve means more money is available to put into high-risk investments—hence more profit today. Accordingly, the trajectory already as of the beginning of 2013 was toward yet another systemic collapse of the financial system.
“As the market gravitates to the cheaper platform -- and it’s cheaper because it’s unsafe—that creates risk for everyone,” James Cawley, CEO of trade execution firm Javelin Capital Markets, told The Huffington Post.  Put another way, market participants were operating according to the greatest profit, the greater risk notwithstanding. “In a distress scenario, you basically have what you had from AIG in 2008,” Cawley said. “Then someone has to step in, and we all know who that someone is: the U.S. taxpayer.” So the question is perhaps that of whether the SEC has the taxpayer’s back or is enabling a cozy revolving door with Wall Street firms.
Lest it be supposed that the U.S. Treasury Department would see to it that the Dodd-Frank reserve requirements would not be circumvented during President Obama’s second term, Senator Hatch speaking at Jack Lew’s confirmation hearing in early 2013 raised the question of whether Lew would act to constrain banks’ risky proprietary trading, given that he had headed units at Citigroup that were involved in just such practices that would violate the Volcker Rule in Dodd-Frank.
 
Wall Street holding on in Washington. Jack Lew at his confirmation hearing for Treasury Secretary. Lew had been the chief operating officer at units at Citibank.     NPR
 
For example, Lew was COO of Alternative Investments at Citi. MAT and Falcon investment funds were sold there as low-risk. Yet those funds were actually hedge funds with high risk.  Lew, who was COO of the unit by the time of the implosion, refused to offer the misled customers full refunds.  At least fourteen arbitration panels subsequently gave the customers the full refunds they sought. If Lew was not willing to right matters then, how could the taxpayer have faith in his willingness as Treasury Secretary to go up against his prior world to protect the public? Although he had not been involved in selling the funds, he did manage units that engaged in risky proprietary trading and he failed to right the wrong done to customers. The public would be justified in wondering if they too would be left on the hook rather than protected by their government should Wall Street once again get out of hand.
One of the downsides of plutocracy, or the rule of wealth, is that the excesses of reckless greed are not met by a viable exogenous constraint from the state because the government is the agent rather than master of wealth. As Senator Dick Durbin had said after the banks’ complicity in the financial crisis of 2008, “Congress is owned by the banking lobby.” As long as this condition holds, Wall Street will have the edge in circumventing even regulations that are in its own systemic interest.

Sources:

Eleazar Melendez, “Wall Street Setting Itself Up For Next Derivatives Crisis, Market Participants Warn,” The Huffington Post, February 14, 2013.