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Return from Fantasy Island
Steve Fischmann
Over the last 30 years, bankers successfully lobbied for a government-supported, loosely regulated Fantasy Island. It turns out Fantasy Island isn’t all that fun for them or for our economy.
Let’s visit a businessman’s Fantasy Island.
The government loans you money interest-free whenever you need it. You can loan some of this money back to the government at a profit, and use the rest for your own operations. The government insures your customers against any losses no matter how risky or imprudent your business practices.
If things happen to sour, the government changes the accounting rules so you still look profitable. If you still manage to become insolvent, they bail you out. If you get caught criminally misrepresenting the value of assets, illegally seizing customer property, or violating fiduciary responsibilities to customers, you don’t go to prison; you negotiate a favorable financial settlement.
Most would call this fantasy world business nirvana. There’s almost no way to mess up and lose money.
Amazingly, Fantasy Island has become the reality for big banks. And, against all odds, they did find a way to mess it up, not only for themselves but for our entire economy. So how have they reacted to their failure? By blaming the very people who’ve bent over backwards to ensure their success.
They conveniently overlook all the perks they receive and blame their woes on misguided government interference. They scream the word “OVERREGULATION” as loud and as long as they can – even as the latest JP Morgan debacle ($2 billion and growing) shows the fallacy of their argument.
Historically proven principles
I’m no fan of complicated rules and bureaucracy in either the public or the private sector. But if ever an industry demonstrated that it needs better regulation to protect the both the public and itself, banking is the one.
Anyone who has gotten the bank runaround on a mortgage problem might be tempted to view the imposition of punitive and confusing regulations as poetic justice. But that would be self-defeating. The truth is that regulation could be greatly simplified, our economy strengthened, consumers and investors protected, and the banking industry stabilized with the reintroduction of a few historically proven principles.
- Return to the practice of providing fair resolutions on troubled mortgages. In the old days, banks maintained ownership of the mortgages they originated and had strong incentive to help homeowners through periods of trouble. Foreclosure was a very expensive last resort. In today’s world, banks routinely sell their mortgages to third-party investors and take a contract to continue servicing the loans. Since banks earn higher servicing fees for a foreclosure than a mortgage renegotiation, foreclosure has become the first option for resolving troubled loans. This practice devastates families, hurts real estate values and imposes needless losses on investors who bought the mortgages. Regulation that requires good-faith mortgage renegotiation by loan servicers prior to foreclosure will protect both borrowers and investors.
- Restore the separation between commercial banking (lenders) and investment banking. Commercial banks should not be allowed to engage in high-risk investment strategies or share any affiliation with investment banks that would put insured deposits at risk. Risky investment banks should not qualify for deposit insurance coverage. Limiting Federal Deposit Insurance coverage to commercial lending banks will help push capital out of speculative financial instruments that do not support job creation and into productive job creating investments that bolster the economy. Forcing commercial lending operations to split from investment banking would also be a constructive first step in alleviating the “too big to fail” syndrome.
- Create the same transparency in derivatives markets as traditional stock, bond and commodities markets. That means providing instant data on trading volumes and price spreads. We can’t and don’t want to stop folks from making risky investments, but they should at least know what they are facing. The lack of information in these markets is simply a license for financial institutions to steal, and to cover up improprieties.
Creating a competitive advantage
Some in the banking industry claim these steps would push our financial institutions offshore where they can compete in lax regulatory environments. This argument rings hollow for two reasons. First, there is no evidence that operating investment and commercial lending banks under one company umbrella creates operating efficiencies. Efforts to do so have not panned out well so far. Second, lax regulation in Europe and Japan has resulted in banks that are even weaker than our own.
Strengthening U.S. financial institutions with commonsense regulation and improved transparency could create a competitive advantage that attracts more capital and financial service business to our shores.
Over the last 30 years, bankers successfully lobbied for a government-supported, loosely regulated Fantasy Island. It turns out Fantasy Island isn’t all that fun for them or for our economy. The last thing we should do is listen to pleas to stay.
Over the long haul, commonsense regulation that protects investors and borrowers will also strengthen our economy and the banks. Don’t let hucksters chasing next quarter’s profit numbers and this year’s outrageous bonuses convince you otherwise.
It’s time to return to the mainland.
State Senator Steve Fischmann, District 37, represents Doña Ana and Sierra counties.
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I’m sorry that your ignorance of financial derivatives has kept you from understanding the recent financial panic.
Which derivates markets is he referring to with his blanket assertion …
To learn about CDOs, CDO Squared, CDSs, MBSs and all the other opaque unregulated unreported derivatives that were instrumental in the mess you might do what I did: Get a copy of McLean & Nocera’s All The Devils Are Here and read it.
http://www.amazon.com/All-Devils-Are-Here-Financial/dp/1591843634?tag=duckduckgo-d-20
I have little faith in Mr. Fischmann’s financial expertise and experience …
You don’t need faith if you get some knowledge instead. It’s true that Mr. Fischmann wasn’t as detailed as one might wish in his short column, but he’s not suggesting anything that a hundred others haven’t also suggested – so I can’t really fault him for being a bit telegraphic and omitting details.
For further knowledge you might do another thing I did, which is to sit thrrough the lectures from this course:
http://itunes.apple.com/itunes-u/economics-1-001-spring-2012/id496401496
At least the macro part is well worth the time. I think it starts around lecture 20.
For more on non-energy derivatives and why we might or might not want to regulate them, there’s always Wikipedia for a quick outline:
https://en.wikipedia.org/wiki/Subprime_mortgage_crisis_solutions_debate#Derivatives_regulation
Now we are making progress Mr. Schneider, since you now understand that derivates includes commodity futures contracts and that market, as diverse and huge as it is (the largest of the derivatives markets in $$), actually exists we can debate transparency. But I get back to my original question to Mr. Fischmann, which you answered, not him. Which derivates markets is he referring to with his blanket assertion above:
“3. Create the same transparency in derivatives markets as traditional stock, bond and commodities markets. That means providing instant data on trading volumes and price spreads. We can’t and don’t want to stop folks from making risky investments, but they should at least know what they are facing. The lack of information in these markets is simply a license for financial institutions to steal, and to cover up improprieties.”
I would opine that the energy derivatives markets are open, transparent, and have much instant data on trading volumes and price spreads, thus my original link to the real time market board for an example. If he is talking about exotic, custom under the counter trades and bets on financial conditions, rates, credit spreads, etc., I would say he is correct. But I guess I have little faith in Mr. Fischmann’s financial expertise and experience that he knows all the differences in the derivatives markets and is just pandering to the common man who is also clueless about them by making broad, blanket statements with little appreciation of the complexity and diversity in the markets. Maybe he has more experience in financial markets and trading than I am aware of.
Try reading the original post carefully, J. It says:
Create the same transparency in derivatives markets as traditional stock, bond and commodities markets.
Clearly the author is making a distinction between one class of derivatives (traditional commodities and presumably commodity futures) that are transparent, and another class (presumably credit default swaps and such) that are opaque and traded OTC.
For you to keep repeating that OTHER things which you want to call derivatives ARE transparent completely misses the point. There are, in fact, a lot of derivatives that are opaque and not publicly traded – as the post and I have been repeatedly showing you.
As your own link says: The choice of instrument, and whether to deal on regulated exchanges or use OTC contracts, is one of convenience.
And as usual, the link you give doesn’t really support your claim. First, there’s no indication that IAS 39 requires the individual reporting of all derivatives. It looks like a company must just report a total for the category, as is done with (for examples) depreciated equipment. Without info on individual contracts, there’s no transparency. Second, it’s also clear that energy derivatives are not quite the same thing as financial derivatives, which was the subject of the original post.
So, you say: ”Now it’s true that there are some people who want to use “derivatives” to include futures contracts such as puts and calls (where there is, in fact, a physical commodity underlying the futures transaction, at least in potentio) but that’s not how most people use the term, ”
Then you mean all the monthly and quarterly reports I get as a board member and audit committee member for some of the companies on which I am on the board, concerning our energy futures contracts that are REQUIRED by FASB and GAAP rules from the federal government are wrong? They are really not “derivates as most people use the term”? So the accounting industry norms and government regulators are not using the term “derivatives” as “most people do”? Please educate yourself once again:
http://accounting-financial-tax.com/2009/04/accounting-treatment-for-derivatives-gaap-under-ifrs/
The banks
http://www.guardian.co.uk/global/2009/dec/13/drug-money-banks-saved-un-cfief-claims
“Antonio Maria Costa, head of the UN Office on Drugs and Crime, said he has seen evidence that the proceeds of organised crime were “the only liquid investment capital” available to some banks on the brink of collapse last year. He said that a majority of the $352bn (£216bn) of drugs profits was absorbed into the economic system as a result.
This will raise questions about crime’s influence on the economic system at times of crisis.
It is understood that evidence that drug money has flowed into banks came from officials in Britain, Switzerland, Italy and the US.”
Mostly still wrong, J.
commodity puts and calls and swaps are derivatives, just as credit swaps are, there is no physical ownership involved,
If you go to the link you gave, and follow it to the link it cites as a definition of “derivatives”, you find this:
However, the strong creditor protections afforded to derivatives counterparties, in combination with their complexity and lack of transparency, can cause capital markets to underprice credit risk. http://en.wikipedia.org/wiki/Derivative_contract
See that phrase about ‘lack of transparency’? The very point the original post was making, with which you disagreed.
Now it’s true that there are some people who want to use “derivatives” to include futures contracts such as puts and calls (where there is, in fact, a physical commodity underlying the futures transaction, at least in potentio) but that’s not how most people use the term, it’s not how the original post used the term, and it’s just muddying the water. Commodity futures certainly had almost nothing to do with the big recession, and when talking about derivatives in the context of the big recession (as the post does) futures aren’t what people are talking about. The credit default swaps that ate AIG were custom, over the counter deals that nobody knew about except the two parties involved.
For your education, which seems to be lacking:http://en.wikipedia.org/wiki/Energy_derivative
Crude oil and other commodity puts and calls and swaps are derivatives, just as credit swaps are, there is no physical ownership involved, only based on the benchmark trading point market prices, thus a derivative of an actual commodity, NOT the commodity.
But banks aren’t major players in the mortgage business any more
In the old days, banks maintained ownership of the mortgages they originated
Many mortgages were originated by mortgage companies such as Countrywide (not a bank) and sold to brokerage houses such as Merril Lynch (not a bank) which then either kept the mortgages or sold them to others such as pension funds or individual investors. Unless you want to put non-bank mortgage companies out of business, and want to return to the days when only bank or S&L depository institutions could give mortgages, and then only up to the limits based on their deposits – unless you want to cut off the flow of non-bank assets into mortgages, regulating banking isn’t enough.
J: commodities aren’t derivatives.
I really don’t know what derivatives you think are not transparent in instant time Mr. Fischmann. Most all commodity markets are
“a derivative is a contractual relationship established by two (or more) parties where payment is based on (or “derived” from) some agreed-upon benchmark” http://www.psc.state.pa.us/corpfinance/derivatives.html
Perhaps the classic derivative is the CDS, the credit default swap, which is an agreement between two people that if the market price of a certain other asset (such as a bond, or a pool of mortgages, or whatever) drops below a certain value, one will pay the other a certain amount of money. These were what brought down AIG. They are not traded on any exchange, nor are their creation and sale public events.
Do you really want to see frequent financial panics and people getting wiped out in bank runs, pgessing?
How about just one simple government response to the bankers? You are on your own now.
If you eliminate the FDIC we’ll see chaos. A few banks failed in the big recession (about 700, IIRC) but if it hadn’t been for the FDIC probably every bank in the country would have been wiped out and everyone would have lost all the money they had in banks in savings, checking, of CDs. Everyone would have been trying to pull their cash out of banks (the way Lehman went down) and the banks don’t have the money to pay off all their depositors at once. People wouldn’t have been able to write checks, people would not have been able to cash checks, direct deposits and direct payments would have failed, we’d have been back to a completely cash economy – and nobody has enough cash on hand for that. It would not have been good.
EW-aif, the short answer is $2 billion in a loss to JP Morgan Chase is like a flea on an elephant. Small and inconsequential, comes to mind. Here are their business dimensions:
Revenue
US$ 89.660 billion (2011)[2]
Operating income
US$ 26.749 billion (2011)[2]
Net income
US$ 18.976 billion (2011)[2]
Total assets
US$ 2.265 trillion (2011)[2]
Total equity
US$ 183.573 billion (2011)[2]
Why anyone, like Congress, would want to call hearings and “investigate” something so inconsequential and almost normal in American business is ridiculous, or obviously just politics and pandering to a base. Businesses routinely can have losses that amount to 10% of net income, happens all the time, nothing new or concerning here.
And pgessing, I agree, ALL businesses in America should be on their own, no subsidies, no bailouts, we have very good and fair bankruptcy laws, they should be used for everyone, GM, or BOA, or Chrysler, everyone.
I have been wondering just how much the loss of $2 billion means to JP Morgan. How does this compare to their total assets? What DOES one compare this $2 billion loss to? Anyone have some way to get some perspective on this?
How about just one simple government response to the bankers? You are on your own now. No subsidies for your business and if you go under, we’re not going to bail you out. Government regulators are always trying to solve the LAST crisis. Combine that with the fact that the regulated can easily “capture” the regulators by hiring them, for example, the federal government is simply not able to or even designed to keep up with innovations in finance and banking. Cutting these companies from the government teat would solve much (if not all) of the problem.
I really don’t know what derivatives you think are not transparent in instant time Mr. Fischmann. Most all commodity markets are, see here for crude for instance, all real time, no trickery:
http://www.cmegroup.com/trading/energy/crude-oil/light-sweet-crude.html