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It’s the Derivatives, Stupid!
16 August 2014
(CRC)—Thomas Hoenig, vice chairman of the Federal Deposit Insurance Corporation, said in an Aug. 13 interview with Reuters that the main reason the U.S. Financial Services Oversight Board of regulators decisively rejected the big banks’ "living wills" on Aug. 8, is that the banks are trying not to touch the derivatives markets. A New York Times article today titled "Fight Brews on Changes that Affect Derivatives" reports that the big banks are resisting any regulation or change in over-the-counter (OTC) derivatives markets, thus ensuring that neither conservatorship nor bail-in can work with a big insolvent bank. Reuters, in reporting Hoenig’s remarks, says it’s the first time a regulator has publicly identified the main battleground over the "living wills." Hoenig "said the so-called early termination rights were the most pressing problem regulators found last week with" the living wills. This refers to the ability of "counterparties" anywhere in the world to break off derivatives contracts and seize the collateral associated with them, as soon as, or even before the bank’s insolvency is suspected, "aggravating its problems, and possibly triggering a market panic," according to Hoenig. Banks do not want to give up this right to seize their derivatives collateral before any threatening bankruptcy occurs, as they did with AIG Insurance during 2008. But those actions actually materially caused AIG’s imminent bankruptcy when it was bailed out. OTC derivatives cover an estimated "nominal value" of about $685 trillion out of $745 trillion derivatives globally, according to the Bank for International Settlements and Goldman Sachs research. They are a bubble growing at about 20% each year while economies contract, and now even the repurchase ("repo") markets have begun to shrink. The New York Federal Reserve Bank actually held a conference Aug. 13 on the problem of shrinking liquidity in the $11 trillion "repo" market for ultra-short-term lending among financial institutions. A disappearance of liquidity in this market caused Lehman Brothers to go bankrupt in September 2008. The big banks area claiming that Dodd-Frank regulations are causing the problem. But the Fed should examine its own policy. Liquidity in the "repo" markets mean collateral, and the primary collateral is U.S. Treasury securities. The Fed holds more than $2 trillion of those, nearly 20% of what used to be the U.S. publicly-held debt market. It has created a shortage of the collateral the "repo" markets work on. [Paul Gallagher] |