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A Financial Road to Nowhere

By Barry Elias   |   Friday, 14 Jan 2011 08:24 AM

Last month, I discussed the huge risks undertaken by the financial community and the severe mistrust it has breed.

An unlimited ability to lend, even if you don’t have the money: sounds too good to be true.

Or is it?

Manmohan Singh and James Aitkin authored a recent International Monetary Fund (IMF) working paper, which describes the mechanics that realized this objective.

When a financial institution lends funds, it typically secures collateral to compensate for potential liabilities or losses. Think of it as a catastrophic insurance policy.

Yet, the United Kingdom permits unlimited use of the same collateral for additional lending. This is the equivalent of enabling an infinite amount of credit and debt. In financial parlance this is termed: rehypothecation. The same applies to specific products in the United States, such as futures, derivatives, and repurchase agreements.

Rehypothecation created $4 trillion in lending with only $1 trillion in collateral (a churn or collateral velocity of 4). With the click of a mouse, the financial community gave themselves $3 trillion to lend.

By November 2007, outstanding loans by non-bank entities such as hedge funds were believed to be $6 trillion. This amount has been revised to $10 trillion. Coincidentally, this $4 trillion difference was equal to the amount outstanding at hedge funds.

The New York Times reports that the face (notional) value of all derivatives increased six fold from $100 trillion in 1998 to $600 trillion in 2008. Most of this trading was controlled by several financial institutions including Goldman Sachs, JP Morgan, Morgan Stanley, and Deutsche Bank.

This trading is unusual in that the price spread between buyer and seller is known only to the clearing institution. This means the buyer knows the price it paid, but it does not know the price the seller received. The same applies to the seller. Moreover, much of this trading did not possess the adequate collateral (capital) to offset losses.

This off-exchange derivative transaction was primarily the result of two pieces of legislation signed by President Clinton: Gramm-Leach-Bliley Act of 1999, which permitted banks to perform investment services (partial repeal of Glass-Steagall Act of 1933), and The Commodity Futures Modernization Act of 2000. These acts were sanctioned by the 1999 Presidential Working Group on Financial Markets. The participants included Federal Reserve Board Chairman Alan Greenspan, Securities and Exchange Commission Chairman Arthur Levitt, and Treasury Secretary Lawrence Summers (and against the better judgment Commodities Futures and Trade Commission Chairwoman Brooke Bornsley).

Andrew G Haldane, Executive Director of Financial Stability at the Bank of England, suggests economies of scale and return on investment diminish when deposits at a financial institution reach tens of billions of dollars. During the past several decades a few banks have accumulated hundreds of billions of dollars in assets. At this level, profit margins were eroding, and banks developed creative methods to increase revenue and profit.

Most of the growth in assets and excess risk taking was the result of the deregulation of the derivatives market, not interstate banking. In 1982, the Garn-St. Germain Act allowed any bank holding company to acquire failed banks and thrifts, and in 1997 the Riegle-Neal Act of 1994 took effect, which permitted interstate branching for domestic bank holding companies and foreign banks.

Assets at top three U.S. banks actually declined from 10 percent in 1982 to 7 percent in 1992. By 1997, when interstate banking was permitted, this figure reached 15 percent, and in 1999 it stood at 20 percent. In 1999, Glass-Steagal was partially repealed, allowing banks to enter the securities industry more readily, and in 2000, derivatives were further deregulated. These two pieces of legislation helped propel that figure to 40 percent.by 2008.

Hence, we saw the exponential risk taking implied in off-exchange trading and rehypothecation (reusing the same collateral). These mechanisms also formed the template for opaque, misleading asset securitization (i.e., subprime loans purchased and implicitly guaranteed by Government Sponsored Entities such as Fannie Mae and Freddie Mac).

The result was cataclysmic.

According to Haldane, the financial crisis has far reaching implications.

While U.S. government losses may total hundreds of billions (possibly more in my view), global GDP has underperformed significantly and will continue to do so. The first year following the crisis, global GDP (income) was 6.5 percent lower than the projected path, representing a $4 trillion loss. Over time the projected loss to global income may $60 trillion — $200 trillion (annual world GDP is $60 trillion).

Essentially, the financial community engineered a tremendous transfer of wealth from society to themselves: not a positive return on investment for the U.S., nor the world.

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Last month, I discussed the huge risks undertaken by the financial community and the severe mistrust it has breed. An unlimited ability to lend, even if you don t have the money:sounds too good to be true. Or is it? Manmohan Singh and James Aitkin authored a recent...
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2011-24-14
 

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