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Confluence That Caused This Crisis

By    |   Friday, 06 May 2011 07:02 AM

Several years ago, when the financial system imploded, the Clinton Global Initiative (CGI) website proclaimed President Bill Clinton was responsible for 90 percent of the outstanding Community Reinvestment Act loans.

Curiously, this information did not appear at his website several months later.

The reason: that statistic isn’t positive.

The Community Reinvestment Act of 1977 was well intended: to eliminate discrimination when considering mortgage applications. However, in the mid-1990s, President Clinton implemented a policy that used this legislation to promote homeownership based more on demographics than financial affordability (e.g., income and assets).

Roughly five years later, President Clinton signed and enacted The Financial Services Modernization Act of 1999 (Gramm-Leach-Bliley Act) and the Commodity Futures Modernization Act of 2000 (CFMA).

The former permitted commercial banks to participate in additional industries: investment banking, securities, and insurance. The latter permitted derivatives to trade privately on the OTC (Over-the-Counter), which isn’t a public exchange.

These bills enabled financial engineers to camouflage the real risks associated with these mortgages. Ultimately, these undercapitalized debt obligations brought the global financial system to its collective knees.

This explains the absence of President Clinton’s previous pronouncement at his website regarding these loans.

The clearinghouse is the fulcrum that perpetuated the pathology with a four part strategy to optimize profits: high product (derivative) quantity, excessive leverage, large commission spreads, and huge trading volume.

High product (derivative) quantity: The Bank of International Settlements (BIS) indicates the total face value of outstanding OTC derivatives increased from $100 trillion in 2000 to $600 trillion in 2008, when the market crashed.

Excessive leverage: The OTC debt to equity levels increased 3-4 times above normal. Therefore, the potential losses exceeded the available capital by 3 or 4 times (losers may not have funds to compensate the winners).

Large commission spreads: large spreads were achieved, since the buyer and seller are unaware of the negotiated price for the other (only the private clearinghouse this knowledge)

High trading volume: High frequency trading (HFT) increased trading volume by increasing volatility.

High frequency trading was the engine that drove the system.

This methodology is based on optimizing excess demand: the additional price some are willing to pay above and beyond the market price. This system intentionally promotes a price disequilibrium. At the higher price paid by some, aggregate demand becomes less than aggregate supply. As a result, the price ultimately will fall back to its equilibrium.

Therefore, this strategy increases volatility, trading volume, revenue, and profits. The demand initiated by the HFT’s is artificial.

From 2006 through 2009 daily trading volume doubled to 9 billion shares. It has plummeted to 5.8 billion shares today. Gross profit per 100 traded shares fell 50 percent from roughly 12 cents to 6 cents.

The Securities and Exchange Commission (SEC) is considering a limit on equity price movements. As a result, the HFTs are focusing on the futures market, which includes commodities and currencies. According to the Aite Group, a Boston-based research firm, HFTs represent 28 percent of the futures trading volume, up from 22 percent in 2009. The Tabb Group estimates they account for 53 percent of equity trading volume, down from 61 percent in 2009.

Recently, the HFTs have wrought havoc in these markets, creating massive volatility. In one second this past February, sugar fell 6 percent. Later that month, cocoa futures dropped 13 percent in seconds, and within minutes on March 16, the US dollar dropped 5 percent against the Japanese yen.

This volatility has forced the Intercontinental Exchange (ICE), the commodities-markets operator, to implement circuit breakers that halt trading when the price moves beyond a specified range.

The European Commission, the European Union’s antitrust regulator, is investigating potential anti-competitive behavior (collusion) in the OTC derivatives market.

The first involves possible anti-competitive pricing and information gathering in the credit default swap market (CDS). Sixteen banks; Markit, a CDS information provider, and ICE Clear Europe derivatives clearinghouse are being reviewed. The banks include: Bank of America, Barclays, BNP Paribas, Citigroup, Commerzbank, Credit Agricole, Credit Suiss, Deutsche Bank, Goldman Sachs, HSBC, JP Morgan, Morgan Stanley, Royal Bank of Scotland, Societe Generale, UBS, Wells Fargo. The second is examining whether nine of the firms and ICE prevented others from entering the market.

Clearinghouse collusion would certainly contribute to the confluence that caused this crisis.

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Several years ago, when the financial system imploded, the ClintonGlobal Initiative (CGI) website proclaimed President Bill Clinton wasresponsible for 90 percent of the outstanding Community Reinvestment Actloans. Curiously, this information did not appear at his website...
Friday, 06 May 2011 07:02 AM
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