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A Ray of Hope

05/07/2014

When Congress was debating or yelling at each other about the Dodd-Frank Bill, which re-regulated large chucks of the financial services industry, one argument against passage was that regulation would chase the derivatives business out of the U.S. and into Europe.  My thought was . . . that’s bad??

The derivatives market is estimated at $700 TRILLION worldwide, of which over $300 TRILLION is held by U.S. banks.  In fact, 95% of U.S. derivatives are help by the five biggest banks, all of which are way too big to fail.  That really worries me!

To avoid Dodd-Frank regulations, the Big Five are setting up European subsidiaries to sell derivatives, which would not have any guaranties from the parent company in the U.S.  It is a small step but definitely an improvement!

Derivatives are not bad things, but large amounts of money rapidly moving in secrecy is.

A typical derivative is the credit default swap.  Say, you want to buy $10 million in bonds issued by the Greek government, but you worry they may not be able to repay the bonds when due.  So, I promise to repay for the Greek government if they do not.  You pay me a big fee for using my balance sheet as a source of repayment.  As a bondholder, you know the Greek government will repay you or, if not, I will.  Of course, that is expensive for you and profitable for me, to issue you a credit default swap.  But, wait a minute, I might have to pay out $10 million if the Greek government defaults.  So, I allocate part of the fee you paid me to buy a $9 million swap from another bank, and they will turn around and buy an $8 million swap from somebody else and so on.  But, what if the bank who issued the $7 million swap cannot pay?  Whoever issued the $8 million swap now has more risk than they expected.  And, I’m holding a $10 million swap and don’t even know who issued the $7 million swap, much less their ability to repay.  On my balance sheet, I’m only showing the net liability of $1 million even though it is much greater.  It would be much easier to evaluate a bank’s balance sheet if we knew who was holding what credit exposure.  Of course, that is one big reason banks have fought transparency.  They want to operate in secret.  (They also argue that their clients want secrecy as well.)

Once this change is implemented next year, you must buy derivatives from a European subsidiary of the Big Five.  If the credit default swap must be paid, the Big Five don’t have to pay, only their subsidiaries do.    Unfortunately, this change doesn’t prevent the Big Five from voluntarily backstopping their subsidiary, but that takes time.

So, if there is a derivatives blow-up, it must first overwhelm the subsidiary before spreading to the U.S.  I figure that gives us one additional day to sell stocks before the financial crisis arrives on our shore.  It is not a solution for the secrecy but it is a step in the right direction!  When it happens, I will sleep better . . .

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