Banks and the derivatives scam

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John Kenneth Galbraith famously described financial genius as "a rising market." This was on display in the expansionary era of the 1950s and 1960s. New bank credits funded growing businesses. Investment bankers injected their own capital into initial share offerings of "public" companies, allowing businesses to grow by taking in shareholders as partners. Finance flourished.

Expansion slowed with the inflationary 1970s, and ended in the early 1980s recession. However, in the stagnating markets that have prevailed in the West for the last 30 years, high finance has still found ways to turn a profit. For decades Monthly Review economists have been showing how the growth of finance has far exceeded the growth of the overall economy.

Financial products known as derivatives are at the heart of what explains the now out-of-control growth of finance in stagnant economic times. The Bank for International Settlements estimates the total amount of outstanding derivative products to be US$647.8 trillion. That compares with an estimate (nominal) of total world GDP of $69.6 trillion by the IMF. Thus, measured as the amount of notional financial claims -- we owe you, you owe us -- the stock of derivatives is over nine times greater than the market value of goods and services produced around the world in one year.

The derivatives story began in earnest when the fixed foreign exchange rates era ended in the early 1970s. Banks began to trade currencies the way commodities had been traded, as "futures." Instead of selling U.S. dollars today and taking a commission for the trade, banks would sell you a promise to deliver U.S. dollars in six months or a year, and charge you a fee.

In essence, a financial derivative is a contract that entitles the holder to a claim on an asset. It is not the asset itself, it is the right to buy or sell the asset. Banks created the markets for financial derivatives, and took fees from buyers and sellers alike. The business of finance came to revolve around making markets in new forms of derivatives.

Beginning with commodities, and currencies, derivatives trading expanded to include interest rates, equities and credit derivatives, including the infamous credit default swaps and collateralized debt obligations or CDOs that led to the financial collapse of 2008, and required the bailouts of major banks around the world by national governments.

What investment bankers had discovered was a way around the Galbraith dictum. Not a rising market? Then in a downturn, take bets on the downside, and the upside.

Any person holding an asset, be it funds in a bank account, a residence, a painting, or a stock portfolio has established a "long" position favouring that asset. There is no obvious need to "hedge" each long position by artificially creating a "short" position, in effect betting banks will fail, mortgages will default, a painter go out of fashion, or stock collapse. Yet that mentality is what credit derivatives trades feed upon, and what giant hedge funds exploit.

Bond vultures are active as short sellers specializing in Eurozone sovereign bonds. Highly leveraged hedge funds are making downside bets, with the assistance of the banks that brought the bonds to the markets in the first place, and still carry substantial amounts on their balance sheets.

Just last week, the giant JPMorgan Chase announced losses of at least $2 billion in derivatives trading. Chief Executive Jamie Dimon had been a leading critic of U.S. legislative attempts to rein in out-of-control finance by banning the kind of trading on the house account that led to the London losses. With life imitating art, the female vice-president walked the plank, just like in the film Margin Call, while the JPMorgan Chase CEO kept his job.

Basic policy options for controlling derivatives markets include disallowance of deduction of trading losses against bank income when calculating taxes; requiring separate ownership for commercial lending and deposit banks, and securities dealers; and severely limiting the extent of secondary derivatives markets. Finance ministries and central banks should be shutting off the growth of hedge fund finance at its source, by limiting loans from banks.

Banks should be expected to assess loans on their merits, and stand behind them. Instead, financiers re-package loans as securities, and then sell credit default protection, so others can short the products the bank is selling to its sucker clients. This totally irrational scenario should be outlawed. Instead, financial manipulators -- not a genius in sight -- have made themselves the mostly richly rewarded individuals in human history. In 2009, the top 25 hedge fund managers' earnings totalled $25.3 billion.

Those who believe the financial meltdown was a one-off fluke, and that lessons have been learned and absorbed to prevent a re-occurrence need to think again. Derivatives operations bedevil the world economy today.

Duncan Cameron is the president of and writes a weekly column on politics and current affairs.

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