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Kabuki on the Potomac: Reforming Credit Default Swaps and OTC Derivatives + Kirby Comments

Posted By Chris Whalen On May 19, 2009 @ 10:40 am In BP Cafe,Think Tank | Comments Disabled

Here is an excerpt from our latest issue of The Institutional Risk Analyst [1] comment and some additional thoughts since we’ve published.  Got some very good responses/retorts that we’ll share with with la famiglia ritholtz as with previous comments.

“Kabuki on the Potomac: Reforming Credit Default Swaps and OTC Derivatives” [2]
The Institutional Risk Analyst
May 18, 2009
“Kabuki is classical ancient Japanese folk theater performed broadly and loudly for the general public. I became familiar with it when I lived in Tokyo years ago. Kabuki on the Potomac this week fit Kabuki’s theatrical definition with lawmakers wailing loudly, uttering angry threats, and rhythmically pounding podiums in a performance of mangled metaphors and fantasy.”

The Rag Blog
March 22, 2009

We gratefully acknowledge contributions for today’s comment from members of the Herbert Gold Society, an informal group of current and former employees of the U.S. Treasury and the Federal Reserve System.

Despite bringing the world economy to its knees and costing taxpayers hundreds of billions of dollars in bailouts for events such as Bear Stearns, Lehman Brothers and American International Group (NYSE:AIG), the Masters of the Universe who run the largest Wall Street firms of have learned not a thing when it comes to credit default swaps (“CDS”) and other types of high-risk financial engineering. Indeed, not only are the largest derivative dealers fighting efforts to reform the CDS and other derivative instruments that caused the AIG fiasco, but regulators like the Federal Reserve Board and US Treasury are working with the banks to ensure that a small group of dealers increase their monopoly over the business of over-the-counter (“OTC”) derivatives.

Why such a desperate battle for the OTC derivatives markets? For the world’s largest banks, the OTC derivatives markets are the last remaining source of supra-normal profits – and also perhaps the single largest source of systemic risk in the global financial markets. Without OTC derivatives, Bear Stearns, Lehman Brothers and AIG would never have failed, but without the excessive rents earned by JPMorgan Chase (NYSE:JPM) and the remaining legacy OTC dealers, the largest banks cannot survive. No matter how good an operator JPM CEO Jamie Dimon may be, his bank is DOA without its near-monopoly in OTC derivatives — yet that same business may eventually destroy JPM.

The key thing for the public and the Congress to understand is that the “profits” earned from these unregulated derivatives markets are illusory and do not cover the true risk of OTC derivatives. Put another way, on a systemic basis, risk-adjusted profits from OTC derivatives are not positive over time. As with the current crisis, the net loss from the periodic collapse of what is best described as gaming activity gets off-loaded onto the taxpayer, thus OTC derivatives must be seen as any other speculative activity, namely a net loss to the economy and society. But unlike taking a punt on a pony at the racetrack, bank dealings in OTC derivatives vastly increase systemic risk, make all banks unstable and threatens the viability of the real economy.

As we told Tim Rayment of The Times of London in his article, “Joseph Cassano: the man with the trillion-dollar price on his head,” [3] in our view AIG never had the possibility of generating sufficient income to cover its CDS contracts, thus honoring these gaming debts of AIG at face value as Tim Geithner, Ben Bernanke, et al., have done using public funds is ridiculous, even criminal. As we’ve said before, AIG should be in bankruptcy so that all creditors may be treated fairly – but “fairly” means a steep discount to par value without the subsidy from the Fed.

Click here to read the rest of this issue of The Institutional Risk Analyst [2]

We got a number of very good comments on this post, including one from Ron Kirby of Kirby Analytics, who argues that interest rate contracts, not CDS, are were the big lie truly resides.  Ron was a little excited, but he makes good points.  To me, though, CDS is an order of magnitude different problem because there is no visible “basis” for the pricing, thus most of the contracts never reflect true P(d) risk.  This C is still < 1,000bp over the curve.  Chris

Christopher;

Your article mistakenly cites CDSs as the epi-center of the derivatives mess.  The rest of the derivatives are only referred to as “other OTC derivatives”.

Despite bringing the world economy to its knees and costing taxpayers hundreds of billions of dollars in bailouts for events such as Bear Stearns, Lehman Brothers and American International Group (NYSE:AIG), the Masters of the Universe who run the largest Wall Street firms of have learned not a thing when it comes to credit default swaps (“CDS”) and other types of high-risk financial engineering. Indeed, not only are the largest derivative dealers fighting efforts to reform the CDS and other derivative instruments that caused the AIG fiasco, but regulators like the Federal Reserve Board and US Treasury are working with the banks to ensure that a small group of dealers increase their monopoly over the business of over-the-counter (“OTC”) derivatives.

Why such a desperate battle for the OTC derivatives markets? For the world’s largest banks, the OTC derivatives markets are the last remaining source of supra-normal profits – and also perhaps the single largest source of systemic risk in the global financial markets. Without OTC derivatives, Bear Stearns, Lehman Brothers and AIG would never have failed, but without the excessive rents earned by JPMorgan Chase (NYSE:JPM) and the remaining legacy OTC dealers, the largest banks cannot survive. No matter how good an operator JPM CEO Jamie Dimon may be, his bank is DOA without its near-monopoly in OTC derivatives — yet that same business may eventually destroy JPM.

Your article asks about or suggests that there was a desperate “battle” in the OTC derivatives market, but then speaks in terms of it being about J.P. Morgan wanting or needing to earn excessive rents to survive?

This completely misses the mark.  You have not identified “the major” contributor of this excess AT ALL.

Look at the concentration of derivatives as reported by the OCC:

66+ of 91 Trillion notional at J.P. M. is interest rate exposure.  22+ of 34 Trillion at Citi the same.  16+ Trillion of 32 at BofA.  And all your article mentions is CDS???

Much of these interest rate derivatives are interest rate swaps [IRS].  IRS > 3yrs. duration typically have U.S. government bond trades embedded in them.  Total outstanding U.S. debt is 11 or so Trillion.  So, ask yourself why all this trading when there is DEMONSTRABLY NO end user demand for this crap:

If you follow John Williams’ work – www.shadowstats.com [4] you know that official inflation reporting is “jacked beyond belief”.  The interest rate FRAUD goes hand-in-hand.

The creation of this interest rate DEBACLE is tantamount to the GROSS mis-pricing of capital which all other economic excess [including the tech boom, real-estate boom and CDS extravaganza] stemmed from.

Additionally, given the size of J.P. Morgan’s derivatives book and the fact that the contents thereof have crippled or killed other institutions with fractions of their exposure, other BIGGER questions should be asked.  When you read the following – given what is already known – it should make one wonder if accounting even happens at J.P. Morgan:

First reported by Dawn Kopecki back in 2006 when she reported in BusinessWeek Online in a piece titled, Intelligence Czar Can Waive SEC Rules [5],

“President George W. Bush has bestowed on his [then] intelligence czar, John Negroponte, broad authority, in the name of national security, to excuse publicly traded companies from their usual accounting and securities-disclosure obligations. Notice of the development came in a brief entry in the Federal Register, dated May 5, 2006, that was opaque to the untrained eye.”

What this means folks, if institutions like J.P. Morgan are deemed to be integral to U.S. National Security – they could be “legally” excused from reporting their true financial condition.

The entry in the Federal Register [6] is described as follows:

The memo Bush signed on May 5, which was published seven days later in the Federal Register, had the unrevealing title “Assignment of Function Relating to Granting of Authority for Issuance of Certain Directives: Memorandum for the Director of National Intelligence.” In the document, Bush addressed Negroponte, saying: “I hereby assign to you the function of the President under section 13(b)(3)(A) of the Securities Exchange Act of 1934, as amended.”

A trip to the statute books showed that the amended version of the 1934 act states that “with respect to matters concerning the national security of the United States,” the President or the head of an Executive Branch agency may exempt companies from certain critical legal obligations. These obligations include keeping accurate “books, records, and accounts” and maintaining “a system of internal accounting controls sufficient” to ensure the propriety of financial transactions and the preparation of financial statements in compliance with “generally accepted accounting principles.”

J.P. Morgan “IS” the Federal Reserve in drag.

The CDS Fraud that your article identifies is a “side show” which deflects attention away from the more heinous crime committed with “neutering usury” thereby allowing the U.S. Treasury and Private Federal Reserve to “scapegoat” mostly non-bank entities like AIG, Bear, Lehman and YOUR grandmother as soon as they figure out a way to blame her too!

Best,

Rob Kirby


Article printed from The Big Picture: http://www.ritholtz.com/blog

URL to article: http://www.ritholtz.com/blog/2009/05/kabuki-on-the-potomac-reforming-credit-default-swaps-and-otc-derivatives-kirby-comments/

URLs in this post:

[1] The Institutional Risk Analyst: http://us1.institutionalriskanalytics.com/pub/IRAMain.asp

[2] “Kabuki on the Potomac: Reforming Credit Default Swaps and OTC Derivatives”: http://us1.institutionalriskanalytics.com/pub/IRAstory.asp?tag=360

[3] “Joseph Cassano: the man with the trillion-dollar price on his head,”: http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article6281953.ece

[4] www.shadowstats.com: http://www.shadowstats.com/

[5] Intelligence Czar Can Waive SEC Rules: http://www.businessweek.com/bwdaily/dnflash/may2006/nf20060523_2210.htm?campaign_id=rss_daily

[6] Federal Register: http://edocket.access.gpo.gov/2006/pdf/06-4538.pdf

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