The derivatives crises began as a mathematical formula, imported from physics where it was used to model heat transfer in liquids, to serve as a technique for valuing options (see the timeline). There's no conspiracy there.
The banking industry has lusted for decades after control of the accounting rule writing methodology. For a very long time this was solely the province of certified public accountants. The CPAs were challenged in their rule writing monopoly in the 1930s by the government, but this threat was cleverly beaten back by the best academic accountant in America, Henry Rand Hatfield (the subject of the blog author's master's degree thesis in 1978). The Nixon administrations wage price controls and fetish about financial instability caused the CPAs to give in during the early 70s and allow academic accountants and finance specialists to participate in the rule writing methodology with a new structure, the “Financial Accounting Standards Board.” This board produced FASB pronouncements for mandatory implementation throughout the accounting profession. This is political accomodation and professional cowardice, but hardly a conspiracy.
In 1996, the American Institute of Certified Pubic Accountants actively participated in the securities reform legislation that year which stripped individual shareholders of ownership rights. CPAs had entered political lobbying directly. They would pay dearly for swaggering around on Capitol Hill and retaining lobbyists.
When the derivatives crisis mushroomed in September of 2008, the Securities and Exchange Commission (SEC), without proper authority, prohibited the accounting profession from marking derivatives to market using FASB 157, a pronouncement dealing specifically with over-the-counter derivatives (using a principle which demands that unmarketable securities be marked to $0). The accounting profession lost control of its own professional rules, in spite of having dealt with derivatives in Financial Accounting Standards Board pronouncements FASB 119 and FASB 133.
Now, yes, this is a conspiracy by the hopelessly politicized SEC. Get it? It's a government conspiracy that will ultimately fail. It has ordered corporate auditors not to report the loss of valuation of their corporate clients' hedging instruments. The assumption is that the crisis – a group of instruments with a face (called “notational”) value in excess of a quadrillion dollars – can be managed and will not recur.
The present Treasury Secretary, Timothy Geitner, is on record saying that he seeks not to eliminate dangerous derivative instruments but to manage the risks with the instruments remaining out there in the over the counter computerland where they “live.”
Derivatives showed their true dangerous colors during the multiple failures in the 1990s (see the timeline). Bankers wanted to make money off commissions, and, in steps, they got the authority to merge with stock brokerages and with insurance companies (a forced separation legislated into existance early in the Great Depression by the Glass-Steagall Act), and then they got exemption from state regulation and from reserve requirements. These advances occurred even with a large hedge fund bankruptcy (by Long Term Capital Management, itself started by the living co-inventors of the Nobel Prize-winning formula taken from fluid physics!)
So a rump conspiracy developed to maintain the derivatives status quo as a money making machine for the banking industry, which status quo morphed into continuing those derivatives without any reserve requirements, with any failure leading to government underwriting. This is where we are now, in 2010.
It is tempting to say that a conspiracy isn't involved here, because commercial banks have been splitting their political contributions nearly perfectly between Republicans and Democrats. This is true, but a look at the smaller but more critical contributions by hedge funds shows explosive growth in lobbying and thus in political contributions, especially to the Democratic Party, whih gets most of the donations for 16 of the last 20 years. Yes, these are Democrats, the party of the people, the party of compassion, the party of the “little guy,” and the dominent party of New York State and Connecticut, the center of America's banking and insurance industries.
Political contributions from hedge funds are available on line at this link:
So, as the derivatives monster grew more important and more gluttonous, it developed a conspiratorial function which has saved it to date. But it didn't start as a conspiracy and it will end in a panic that also destroys the capital and existance of the conspirators.
The whole purpose of all of this all the way through was for the banks to make commissions on very large betting contracts, effectively insurance with no reserve requirements, on nearly-impossible events for which the banks would never have to pony up any capital as counterparties. That was the scheme. They were flirting with Fortune. The hedge fund executives and friendly bankers acting as counterparties forgot that Nemesis (vengeance) is a constant companion of the goddess they were flirting with.
Nemesis has already bankrupted nations such as Iceland, Hungary and Greece over these massive derivatives instruments.
Ireland is closer to bankruptcy. Any predictions? will the euro collapse? And when will the big, huge, people-starving-in-the-street crash come for the US?
ReplyDeleteThe stae is set for Asia taking over as the dominant region of the world. Two huge owners of US debt are in Asia--China and Japan. And China is a cash rich country.
A post-cold war victory for China?
Ireland doesn't have deep pockets. It will probably go broke. I think the euro will not "collapse," it will fracture when France and Germany return to sovereign currency to save themselves. Both nations will have to succeed in downsizing government as the UK is currently attempting to do. The G7 and the euro members need to avoid a major black swan on their stock and their bond markets in spite of the huge blocks of short term trading and huge derivatives problem. Maybe what I'm saying is that the euro will die and drag Europe down with it unless the euro nations quickly and ruthlessly increase bank reserve requirements to, at least, Canadian levels. (Canada has health bank reserves and avoided the 2008 debacle).
ReplyDeleteChina is the post-cold war victor if it finds a way to establish permanent stability as a centralized government with an open and honest bourse for equity trades. In world history, this has only been possible with a free press -- honest journalistic criticism created (!) modern remote ownership with a court decision in New York around 1735.
If China fails to do that, India can pick up all the marbles if it attacks its own gross problem of local corruption -- which has been the biggest challenge for that nation since independence in 1947 -- which Gandhi and Nehru failed to tackle and face. India has a free press and 300 million English speaking people and a viable middle class.
If China and India both face their problems, then, yes, Asia will be the economicly dominent power of the 21st century.
Yes, my next question was about Germany--It's bailing out all of Europe, plus it has a huge government with public healthcare and NATO obligations to pay for. They also have requirements based on global waarming for alternative energy development that can't possibly meet the needs of the country, one reason Merkle wants to extend the life of the nuclear power plants. How long can it continue to do that?
ReplyDeleteGermany has spent a huge wad of cash in the last 20 years starting with the reunification in 1990.
The German people don't want any reductions in public programs or big government, or cheap energy.
The Germans are intently watching the UK and whether or not the fusion government under Prime Minister Cameron can cut costs.
ReplyDeleteGerman chancellor Merkel is intensely unpopular in her own party and an insurrection is a constant threat. I don't think the German conservatives want to act without watching the UK parliament and getting some lessons learned.
What will happen in the US and when? "Ali Baba only knows." Today's blog deals with how a single firm can conjure a black swan on the major equity markets. The regulators and government are looking at this for their own purposes (a stable government bond market) while no one is concerned with whether private investors get burned or not.
No one knows when or how the US will be tested, but in the long run the US is past the point of no return and must either accept its descent from world power (like Argentina, #5 in GDP in 1929 and passing #80 on the way down now) or accept a mutinous demand from taxpayers that entitlements be cut and then sunsetted (unlikely now because taxpayers aren't frightened enough yet).
Posturing, the favorite technique of both the current and last administrations, is already shown itself to be a flop against such quick and violent changes in bourses and the value of financial instruments.