Marshall Auerback asks Will we have to blow up a continent (again) before we stop Wall Street?"

If financial markets are melting down, can Wall Street derivatives be far behind?

Will we have to blow up a continent (again) before we stop Wall Street?
by Marshall Auerback
New Deal 2.0
February 15, 2010

Surprise, surprise: Wall Street tactics akin to the ones that fostered subprime mortgages in America have worsened the financial crisis shaking Greece, Spain, Portugal, and undermined the euro by enabling European governments to hide their mounting debts. This has now become front page news in the Sunday New York Times.

According to the Times:

“Even as the crisis was nearing the flashpoint, banks were searching for ways to help Greece forestall the day of reckoning. In early November — three months before Athens became the epicenter of global financial anxiety — a team from Goldman Sachs arrived in the ancient city with a very modern proposition for a government struggling to pay its bills, according to two people who were briefed on the meeting. The bankers, led by Goldman’s president, Gary D. Cohn, held out a financing instrument that would have pushed debt from Greece’s health care system far into the future, much as when strapped homeowners take out second mortgages to pay off their credit cards” (our emphasis).

Sound familiar? This is exactly how AIG built up its credit default swap business, in essence facilitating regulatory arbitrage on behalf of the banks. Basically, banking regulations encouraged companies to buy cheap swaps so that they could treat risk assets as almost risk-free, concealing their toxic nature via the ledger main of financial engineering. This, in turn, allowed them to take money out of their reserves and buy more risky assets, which they then covered up with more credit default swaps. All of this was designed to evade the capital adequacy requirements mandated under the Basel banking accords.

AIG was destroyed, but as the NY Times article illustrates, the practices still persisted. As late as November 2009, Goldman Sachs, its own survival now successfully assured by repeated US government lifelines and guarantees, was seeking to perpetuate a similar kind of ruse over the European Union.

We have railed against the stupidity of the rules underlying the European Monetary Union many times, but poorly thought-out rules do not give a bank the right to destroy an entire continent, even “Government Sachs”. In the words of Simon Johnson,

“These actions are fundamentally destabilizing to the global financial system, as they undermine: the euro zone area; all attempts to bring greater transparency to government accounting; and the most basic principles that underlie well-functioning markets. When the data are all lies, the outcomes are all bad – see the subprime mortgage crisis for further detail.“

But it’s nothing new. Virtually the same thing happened in East Asia during the late 1990s. Most people are now familiar with standard derivative contracts used in hedging risk, such as forwards, futures and options. While foreign-currency forwards remain the province of bank foreign exchange dealers, most basic futures and options contracts are standardized and traded in organized, regulated markets. Banks have also long offered derivative contracts to their clients in what is termed the “over-the-counter” (OTC) market. But, there is no market involved in these contracts, which may involve the stipulation of standard futures and options contracts outside of the organized market on a bilateral basis with individual clients.

The majority of OTC activity involves individually tailored, often highly complex, combinations of standard financial instruments packaged together with derivative contracts designed to meet the particular needs of clients. These kinds of contracts involve very little direct lending by banks to clients, and thus generate little net interest income. But during the 1990s, they had the advantage, given the necessity of meeting the Basel capital adequacy requirements, of requiring little or no capital, or of being classified as off-balance sheet items because they did not represent a direct risk exposure of bank funds. Or so it appeared. And they had the additional benefits to Wall Street of generating substantial fee and commission income.

The volumes of these OTC structured credit notes rose substantially in the mid-1990s. While these derivatives were by no means unique to East Asia (see Orange County in 1993, Mexico in 1994, Long Term Capital Management in 1998), an IMF study from 1998 suggests that most of the initial losses sustained during the initial impact of the Asian crisis were related to derivative-based credit swap contracts. Furthermore, the Bank of Korea reported in March 1998 that trading in financial derivatives by South Korean banks increased by 60.1% in 1997 to $556.5 billion and largely contributed to the virtual nationalization of the entire Korean banking system as these positions blew up. It also helps to explain why heavily exposed banks such as JP Morgan (which had huge exposure via their derivative positions to the Korean banks) were at the forefront of the move to convert Korean banks’ short-term debt into sovereign debt.

Much the same can be said for Thailand, Indonesia, and Malaysia. The crash was even more devastating to people’s living standards and sense of security than the Latin America crash of the 1980s. Indonesia’s real GDP shrank 17 per cent in the first three quarters of 1998, Thailand’s 11 per cent, Malaysia’s 9 per cent, and Korea’s 7.5 per cent. It took nearly two years to reach the bottom. Many millions who were confident of middle class status had their lifetime savings destroyed. Public expenditures of all kinds were forcibly cut as all of the countries fell under the punitive aegis of the IMF. The IMF itself mounted the biggest financial bailout in history — $110bn, almost three times Mexico’s $40bn “rescue” package from the 1994-95 “Tequila crisis”.

Yet the experience of the past 2 years suggests that we have learned nothing and our political leaders seem determined once again to avoid dealing with the problem once and for all. God forbid that Congress should antagonize one of its main funding sources.

Perhaps now that these destructive practices are appearing in Europe’s own backyard, the authorities there may be sufficiently motivated to do something, if one is to judge from the recent comments of French Finance Minister, Christine Lagarde. Of course, cracking down on “currency speculators”, or short sellers, is largely beside the point, when you’ve got clear evidence of a bank deliberately conspiring to hide the true extent of an EU government’s debt. That’s abetting fraud, plain and simple. Jeffrey Skilling, former CEO of Enron, is sitting in jail today for that very offence. By contrast, Gary Cohn’s boss, Lloyd Blankfein, just received a $9m bonus.

It seems more than extraordinary that nothing was done following the economic implosion of East Asia during the 1990s. Eighteen months ago, we experienced the near the near wipe-out of our global banking system, and today we face the threatened destruction of the European Monetary Union. And still all we get is nothing more than the vague threat of action, and feeble efforts at regulatory reform.

Hey, as Jamie Dimon noted at the FCIC hearings a few weeks ago, stuff like this happens every 5 to 7 years, so what’s the big deal? Why bother letting the potential vaporization of a currency stop Wall Street from behaving recklessly and with complete disregard to the basic tenets of international financial stability? Heaven forbid that government should impede something as important as “financial innovation”. Shit happens. That’s no reason to “punish” a growth industry, even one where the main growth component appears to be the perpetuation of financial fraud.