Banks Are Setting Us Up For Economic Problems Again

This time the fall could be $2.6 trillion or more

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Banks Are Setting Us Up For Economic Problems Again

The Biggest Margin Call of All Time

Here’s where we get to the meat of the matter.

As part of new rules driven by the 2010 Dodd-Frank Act, traders will have to drive the majority of privately-traded derivatives contracts through clearing houses like the Chicago based CME or the London based LCH.Clearnet, which was formerly known as the London Clearing House.

Previously they didn’t because upwards of 90% of the derivatives were privately negotiated and therefore exempt from centralized exchange requirements, including margin.

In the process, they’ll have to post additional collateral that can be “perfected,” meaning seized and converted to cash, in the event of a counterparty failure or default.

As reported by Bloomberg, estimates from Morgan Stanley (NYSE:MS) suggest the new requirements could mean the banks trading in derivatives have to come up with $481 billion in top-rated collateral on the low side to $2.6 trillion on the high side, which is what the Massachusetts-based Tabb Group projects.

My own estimate is somewhere in the $4-5 trillion range, because I believe the total value of the derivatives markets is still being understated by banks and trading houses not keen to let skeletons out of the proverbial closet.

And therein lies the problem. Neither the trading firms nor their clients have the additional collateral.

What’s more, they likely won’t be able to get it because the vast bulk of the $33 trillion in worldwide top-tier AAA- or AA-rated debt is already pledged as collateral or otherwise accounted for in separate transactions.

Were these banks and their clients living like the rest of us, they’d simply conclude they were “tapped out” and their resources exhausted because there would be nothing left.

But noooooo…… Under the terms of both the JPMorgan and Bank of America programs, clients not meeting the new collateralized quality standards can pledge other less-than-treasury-quality assets to the bank against a “loan” of Treasuries from the trading firm that’s then posted by the trading firm as collateral acceptable to the clearing houses.

In other words, the trading firms are going to loan treasuries to clients who are incapable of meeting liquidity requirements while accepting lower grade assets in exchange. Details are hard to come by at the moment with regard to the fees they’ll rake in, but you can bet “transforming” lemons into lemonade won’t be cheap.

This is similar to what happens in the commercial “repo-market” where banks and trading firms temporarily pledge their assets in exchange for cash loans. Nor is it much different than pledging your paycheck at an instant loan store. In both cases, you are pledging assets against transactions that you wouldn’t otherwise be able to conduct.

The fundamental question boils down to this: If we know that billions in improperly assessed risks led to the first blowup in 2007, how on earth could this be any different– especially with trillions now on the line?

You can’t wave your hand over a pile of less-than-treasury-quality assets and have them suddenly, miraculously become treasury quality because they are grouped together.

Yet, this is exactly what Wall Street is doing here.

And just like before, Wall Street’s latest scheme is expressly intended to disguise risk and circumvent the specific rules about to be put in place to prevent excess leverage from potentially destroying the world’s financial system.

Is there a fix?

I can think of one, but it’s from a source you’d never believe in a million years would come out of my mouth: Fed Chairman Ben Bernanke.

Congress can’t balance its checkbook. Our politicians can’t make tough decisions. Our regulators are out-lobbied and outmaneuvered at every turn. No president can ask his nation to take its medicine regardless of party affiliation.

But Bernanke can. Supposedly – — emphasis on supposedly — he’s apolitical.

Acting under the Fed’s dual mandates of maintaining “monetary and credit aggregates commensurate with the economy’s long-run potential,” Chairman Bernanke could bypass the entire political, regulatory and lobbyist morass in one fell swoop by declaring that the United States government will not back any derivatives trades — or any firm that engages in them — worldwide in the event of default.

Not only would this re-introduce the concept of failure into capital markets but it would do what neither Congress nor our regulators have been able to do — put an immediate end to the kind of “profit at all cost regardless of risk behavior” that exemplifies everything wrong with Wall Street.

I can only imagine the disclaimer on one of those Uncle Sam posters more commonly associated with wartime military recruiting. It might read: “Counterparty Beware.”

Until then, it’s investors who should be “aware.”


Article printed from InvestorPlace Media, http://investorplace.com/2012/09/banks-are-setting-us-up-for-economic-problems-again-jpm-bac-ms/.

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