business corporate responsibility economics wealth

What the banking system has learned about derivatives: nothing at all

I was tempted to post that headline with a blank space underneath, but I’d better explain. Much of the crisis in the banking sector in 2008 was due to over-reaching in the trade of derivatives. The invention of derivatives allowed banks to transcend their actual assets, and then soar above them in layer after layer of speculation and counter-speculation. As we know, this feat of financial levitation ended badly for all concerned, so you might think that the banks had learned the lesson and scaled back their derivatives trading. Apparently not. This chart shows the growth in the value of derivatives as a percentage of assets, for the three largest banks in the US*:

Both Citi and Bank of America have more liabilities than they did before the crash. And as the Bankwatch blog points out, those figures of 4,000% pale into insignificance when compared to Goldman Sachs’ 33,823%. Our banks failed because finance had disappeared into a fantasy land, a land they have refused to return from. Not only has government policy focused on a return to business as usual, the financial sector is now more concentrated. With fewer, bigger players, any crisis is a big crisis. The four largest banks in the US own 40% of the assets between them, which is a vulnerable position to be in.

Derivatives, you may remember, are sophisticated financial products that are traded between banks. One of these that has been in the news recently is the credit default swap, or CDS. Loans and mortgages are bundled as a kind of package of future money, and sold on, as we now know. Company bonds and national debt are other forms of banking assets, and anyone wanting a share of that income as it rolls in can buy up that debt, with the associated risk that it carries. That makes sense. A CDS however, allows you to invest the other way round. Rather than buy a share of the loans, you pay the bank a fee, and the bank pays you if those loans default.

It sounds complicated, and it is, but it is essentially a form of insurance, a way of recouping costs and minimising risk. The difference is that we buy insurance to protect our own investments, but an CDS can be taken out against other people’s. And that’s where the potential for abuse quickly becomes apparent. Imagine being able to take out insurance on your neighbours, for example. Wouldn’t it be tempting to buy car insurance on the young and reckless driver at the end of the road, since it’s only a matter of time before he has an accident. Or you could take out contents insurance for the house that backs onto the alley, in the secret hope that it gets robbed. Although they were originally devised to spread risk, CDSs are great for speculation of a rather insidious kind.

For example, Goldman Sachs famously survived the financial crisis better than other banks, partly because it had bought credit swaps against its rivals. “In other words,” says the Levy Economics Institute, “Goldman could hold risky securities, purchase “insurance” from AIG on those securities, then make a bet that AIG would fail to honour that insurance—and thereby seemingly protect itself from any risk.”

You can see how this might begin to look rather fragile, especially when you consider that the issuer of the SDC doesn’t have to prove they have the funds to pay out, and that you can buy an SDS against companies and countries. Think of Iceland, and now Greece. I’ve borrowed my metaphors above from Greek PM George Papandreou, who has called for an end to CDS speculation against his country: “a person is not allowed to buy fire insurance on his neighbour’s house, and then burn it down to collect on that insurance.”

What do we do about it? We can break up the banks, get some healthy diversity back in the market. Derivatives should be regulated much more strictly – you’d think this would be obvious by now really. Negative betting such as short selling or CDS shouldn’t be allowed at all, especially against currencies and nations. The whole speculation industry needs to be scaled back, and preferably disconnected from retail banking. And for countries like the UK, who are so dependent on the financial sector, we urgently need to diversify. Most of all, we need to break this mad addiction to speculation, or the next crash will be terminal.

*If anyone has a similar chart for the UK banks, let me know.

7 comments

  1. Excellent post. I also have the belief that what has been wrong with our economy for a long time is businesses doing way more things outside of their core business that they know nothing about. Banks should process and loan money, period. Car dealers should sell and service cars, period. I should not be getting my car loan at the dealership. I should go to the bank for that.

  2. Sad but true.

    John Stewart had a good one the other day, about the whole scam of businesses determining asset values and credits of other businesses. And applying bets and bets on bets on top of the whole thing. No wonder things come crashing down..

    ..and I stumbled upon some quotes from one of the founding fathers, Thomas Jefferson.

    “I sincerely believe, with you, that banking establishments are more dangerous than standing armies; and that the principle of spending money to be paid by posterity, under the name of funding, is but swindling futurity on a large scale.”

    and

    “…the system of banking we have both equally and ever reprobated. I contemplate it as a blot left in all our constitutions, which, if not covered, will end in their destruction, which is already hit by the gamblers in corruption, and is sweeping away in its progress the fortunes and morals of our citizens…”

    1. Yes, Jefferson is really interesting, because he believed in democratic banking as well as democratic politics. He fought hard to get the young United States to adopt democratic money policies, but the final debates were held while he was out of the country. His opponent Alexander Hamilton won that fight, giving the US a model that favoured the elite, based on the British model. You have to wonder what the country would be like if he’d won.

  3. That’s very interesting. I’m watching the HBO-series “John Adams” from 2008, a fantastic show! Last night (ep. 5) was the harsh fighting between Jefferson and Hamilton in the first administration, and president Washington growing increasingly weary and aggressive.

    They portray Hamilton as favouring the british culture and models, as you say, and Jefferson as strongly french-leaning. Somewhat a dark person but extremely intelligent. He also has some thoughts and reluctance about imposing a constitution and form of government on the future generations. That provides some background to the first part of the Dec. of Independence:

    “That whenever any Form of Government becomes destructive of these ends, it is the Right of the People to alter or to abolish it, and to institute new Government”

    A bit off-topic, but things have changed a lot in US society since 1776 and 1789. Population and size perhaps the most obvious.

    1. I watched John Adams too, it was a great series. Unusually intelligent television!
      I read about Hamilton in Thomas Greco’s book ‘The end of money’, which sets out to explore what democratic money might look like.

  4. I always enjoy reading quality articles by an author who is definately up to snuff on their chosen subject. I’ll be following this post with great interest. Keep up the good work, see you next time

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