Page 2 of 4 CREDIT BUST
BYPASSES BANKS PART 2:
Bank deregulation fuels abuse By Henry C K Liu
hedge-fund
performance of 5.19% by June 30 did not surpass
market indices' rise for the period. The S&P
500 returned 6.28%, while the MSCI World TR
returned 6.71%. The biggest inflows were for
market-neutral long-short equity strategies, which
gained $14.9 billion, followed by event-driven
funds, which gained $12.2 billion. Multi-strategy
funds gained $6.1 billion during the period.
Strategies that posted net outflows included
global macro-funds,
which bet on world currencies
and sovereign debt and were down by $848 million,
and managed futures, which were down by 686.7
million. Losses of this scale are bound to have
structural effects.
The credit
derivatives overhang The most popular of
all derivative products is the interest-rate swap,
which in essence allows participants to make bets
on the direction interest rates will take.
According to the US Office of the
Comptroller of the Currency (OCC), interest-rate
swaps accounted for three out of four derivative
contracts held by US commercial banks at the end
of 1999. The notional value of these swaps totaled
almost $25 trillion; 2-3% of that reflected the
banks' true credit risk in these products, or
between $500 billion to $700 billion. The notional
amount outstanding as of December 2006 in OTC
(over the counter) interest-rate swaps was $229.8
trillion, up $60.7 trillion (35.9%) from December
2005. These contracts account for 55.4% of the
entire $415 trillion OTC derivative market. A 1%
move in the interest rate would alter interest
payments in the amount of $4 trillion, albeit much
the payment would be mutually canceling, unless in
the case of counter-party default.
The
Comptroller of the Currency Quarterly Report on
Bank Derivatives Activities shows that US
commercial banks generated a record $7 billion in
revenues trading cash and derivative instruments
in first quarter of 2007, up 24% from the first
quarter of 2006, which at $5.7 billion had been
the previous record. Revenues in the first quarter
were 82% higher than in the fourth quarter. Net
current credit exposure, the net amount owed to
banks if all contracts were immediately
liquidated, decreased $5.3 billion from the fourth
quarter to $179.2 billion. The data for the third
quarter of 2007 are expected to be very negative
to reflect market turmoil since July.
The
notional amount of derivatives held by US
commercial banks increased $13.3 trillion to
$144.8 trillion in the first quarter of 2007, 10%
higher than in the fourth quarter and 31% higher
than a year ago. Bank derivative contracts remain
concentrated in interest rate products, which
represent 82% of total notional value. The
notional amount of credit derivatives, the
fastest-growing product of the global derivatives
market, increased 13% from the fourth quarter of
2006 to $10.2 trillion in first quarter in 2007.
Credit default swaps represent 98% of the total
amount of credit derivatives. Credit derivatives
contracts are 86% higher than at the end of the
first quarter of 2006. The largest derivatives
dealers continue to strengthen the operational
infrastructure for over-the-counter derivatives
through a collaborative effort with financial
supervisors, the OCC reports. Still, counter-party
risk remains problematic.
Derivatives of
all kinds weigh heavily on banks' capital
structures. But interest-rate swaps can be
especially toxic when interest rates rise. And
since only a few business economists predicted a
jump in rates for the first half of the year when
1999 began - in fact, yields have risen 25% -
these institutions now find themselves on the
wrong side of an interest-rate gamble. Moreover,
as interest rates rise, bank income diminishes
from interest-rate-related businesses such as
mortgage lending. Interest-sensitive sources of
income will be the revenue disappointments in
2008, as in 2000, and as trading was in 1999.
Hedging feeds risk appetite The
impact of the demise of the Nasdaq index on the
wealth effect was not total. Investment banks
pitched to high-tech/Internet founders and early
shareholders to hedge capital gains by signing
away future upsides. For those high-tech swimmers
who took advantage of the offers, this amounted to
two-layer swimming trunks that allowed them to
lose the top layer without risking being caught
naked when the tide receded suddenly. It was the
financial version of a flat-proof tubeless tire
that can get you to the next service station or 50
kilometers (whichever is closer) in the event of a
puncture. It does not, however, guarantee the
driver the existence of a service station that has
not been forced to close from operational losses
within 50km.
Meanwhile, pension funds are
forced to jettison their old-fashioned balanced
portfolios in favor of structured finance
strategies to seek higher returns. What the
Greenspan Fed did was to penalize the general
public by devaluing their future pension cash flow
for the sins of the aggressively investing rich,
who continued to add to their wealth with
Greenspan's blessing as long as the risks of high
returns were passed on to the system as a whole.
This is what US economic democracy has come to.
Investor confidence
low Investors worldwide are unconvinced
that the US Federal Reserve can succeed in
stabilizing the US commercial-paper market, the
latest and so far biggest shoe to drop in the
spreading contagion from US subprime mortgages.
Banks are suddenly exposed to unexpected risks as
US asset-backed CP shrank by its biggest weekly
percentage since November 2000 as investors
shunned debt linked to mortgages and opted for the
safety of Treasuries.
This means that
investors prefer to lend money to the US
government, despite historically high levels of
fiscal deficit and national debt, than to
financial institutions that seek profit from
interest-rate arbitrage. Market preference for
speculative investment has vanished. Banks are
suddenly holding the bad end of a massive amount
of speculative debt instruments. When new
commercial paper is not sold to roll over the
maturing debt, borrowers must draw on bank credit
at a higher interest cost to prevent default,
leaving banks with riskier debts that the market
has rejected.
Fed accepts ABCP as
discount window collateral In the week to
August 22, after the Fed lower the discount rate
by 50 basis points to 5.75% on August 17, banks
borrowed a daily average of only $1.2 billion from
the Fed discount window, suggesting that banks
were still unsure how to use the facility to lend
to distressed clients. Officials at the New York
Fed, the central bank's liaison with Wall Street,
received inquiries from commercial banks on
whether their clients' asset-backed commercial
paper could be pledged as collateral at the
discount window.
The New York Fed issued a
statement "in response to specific inquiries" from
money-center banks on Friday, August 24, that it
"has affirmed its policy to consider accepting as
collateral investment quality asset-backed
commercial paper" for discount-window loans to
ease the liquidity crisis faced by the banks to
try to calm an essential part of the money market,
the orderly functioning of which is critically
needed to lubricate financial markets. But the
statement only trimmed slightly the abnormally
high average ABCP yield to 6.04%, still roughly 80
basis points higher than normal, even for those
borrowers who could sell commercial paper at all,
which normally would be at rates close to the Fed
funds rate of 5.25%.
On the same day, the
Fed eased regulations governing the relationship
between Citibank NA, the US bank subsidiary of
Citigroup Inc, and its broker-dealer subsidiary,
Citigroup Global Markets Inc. The regulatory
exemption allows Citibank to lend up to $25
billion to customers of the broker-dealer. Bank of
America Corp received a similar easing.
Section 23A of the Federal Reserve Act and
the Fed board's Regulation W limit the amount of
"covered transactions" between a bank and any
single affiliate to 10% of the bank's capital
stock and surplus and the amount between a bank
and all its affiliates to 20%. The banks have
agreed to limit their lending under the exemption
to $25 billion, which will constitute less than
30% of each bank's total regulatory capital.
The two banks, along with JPMorgan Chase
& Co and Wachovia Corp, borrowed a total of $2
billion two days earlier in a symbolic show of
support for the Fed's anemic actions, while noting
that they still had access to cheaper funding than
the new discount rate of 5.75%.
Until the
repeal of the Glass-Steagall Act, banking
regulation prohibited banks with federally insured
deposits from operating brokerage subsidiaries. In
the early part of the last century, individual
investors had been repeatedly damaged by banks
whose overriding interest was to profit from
promoting stocks held by banks, rather than to
enhance the interest of individual investors or
protect the security of its depositors.
After the 1929 market crash, regulators
sought to limit the conflicts of interest created
when commercial banks underwrote stocks or bonds,
which contributed to abuses that caused market
crashes. A new law, known as the Glass-Steagall
Act, banned commercial banks from underwriting
securities, forcing banks to choose between being
a regulated lender of high prudence or an
underwriter-broker with high risk appetite. The
law also
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