Letter 2 America for August 15, 2014

Dear America,

Regulators are attempting to amend the rules followed by banks--the term "bank" now has a meaning that departs dramatically from the meaning we used to attribute to it--when they begin to fold their tents in the derivatives market.  You may remember derivatives from the beginning of 2008 when Lehman Brothers collapsed, as did Bear Stearns, that latter being bailed out by J.P. Morgan and incorporated therein.  Derivatives are what sank both institutions, and the way in which they did so was that the underlying property for the huge volume of derivatives they had sold became semi-worthless and both "banks" had to make good on them...that is pay out on what are essentially insurance policies against financial reversal.  Derivatives as such are nothing but financial instruments by which people with enormous amounts of money bet on whether the rest of us will succeed or fail in doing what we set out to do, whether that is buying a house and paying for it over time or running a business on credit necessary to get it started.  There are even derivatives related to consumer credit, such as that you take advantage of every time you use your credit card.  Derivatives fall into two categories however, and one of the two is useful.  When a farmer needs seed money, he sells his crop in advance as a future contract.  He gets paid now and delivers his crop to the owner of that contract later on, thus being financed by his success in growing something.  Without those futures, American agriculture in particular would suffer enormously.  But the mortgage backed derivatives..."swaps" as they were called then and still are...are nothing but wagers made by bankers and their customers.  Banks bundle mortgages into large groups and create "securities" that represent those bundles.  Then, they sell "tranches" (slices or pieces) of them to their investing customers.  As that practice makes it apparent, these erstwhile banks are really primarily brokerage houses dealing in hypothetical property, and sometimes in pieces of bets on that hypothetical property's durability.  The derivatives market stretches far out beyond the horizon of its true utility to the point at which it becomes nothing more than financial debauchery, and that is what financial regulators are now trying to protect us against in a way that points out how decayed our financial system is.

When Lehman Brothers failed, someone lost a lot of money, but if you want to gamble, that is the risk you take, and that is how the federal banking authorities viewed it.  Lehman failed and our government didn't step in to save it.  But within days, Bear Stearns was in the same straits, and the feds did step in by engineering the take over of the firm by J.P. Morgan with some federal assistance as an inducement for J.P. Morgan.  The tide of failures that they all claimed was imminent was staunched and we suffered the worst financial crisis since the depression, but we didn't actually have a depression, and that was the point.  All of this happened in the course of days, and one of the contributing factors was that when the derivatives house of cards started to fall, some people who had trades in the pipeline cancelled them, leaving the sellers in the lurch and precipitating runs of various derivatives, and thus various banks.  That's a major component of the mechanism by which we came to our current sorry pass, and regulators want to prevent it by preventing those last minute cancellations of derivatives trades when it is obvious that catastrophe is just around the corner.  But the banks are fighting it.  They fear that it will put them at a trading disadvantage because people will feel insecure about doing business with American banks that will be required to make them follow through when they buy or sell, no matter how imminent losses seem to be.  To the banks, the concern isn't whether the market in derivatives is secure for investors...and for their shareholders as well.  What they want is as much business as they can get, no matter how unsavory, risky or outright outrageous it is.  The 2010 Dodd-Frank Act addressed some of the banks' avarice in this and many regards, but it was no substitute for the Glass-Steagall Act, the repeal of which President Clinton signed into law during his administration on the advice of Larry Summers.  I mention their names because the ignominious behavior of banks today, which is a continuation at perhaps an even greater fever pitch than before 2008, is largely attributable to those two men, and their names should be mentioned in that connection.  But what about what is happening now; how can we ensure that 2008 doesn't descend upon us again in 2018.

Well, what regulators are trying to do now is at least a small step intended to decelerate the failure of banks doing risky business with our society's wealth.  It is a minimal step, but it seems the least we can ask of them, and the only reason I can fathom for opposing the proposed regulations is sheer greed.  What bothers me right now is that none of our legislators are talking about all this anymore.  You don't hear the words "bailout" and "derivative" in political conversation these days, but the issue of financial industry profligacy isn't dead, and it may be just waiting in the weeds to bite us again.  Remember that the next time your congressman or senator comes back to his district or state office.  Maybe we should be reminding them that they haven't done the necessary job quite yet.

Your friend,

Mike