Saturday, May 12, 2012

The London Whale: The Massive Gambles our Regulators and Banks are taking and why You will pay

We have all heard of the London Whale and his role in betting $100 billion (that's $100,000,000,000)on derivatives and losing several billion for the proud and now humbled JPMorgan.

And there's one article you just have to read to understand why this can happen, has happened, and will happen, and why you – the ordinary taxpayer in the Western countries – will end up paying for the debacles, while the shareholders and managers of the investment banks like JPMorgan make out like bandits.

But first, for a little bit of irony.
Carney of the Bank of Canada

Mark Carney, the governor of the Bank of Canada, had this to say recently:

Carney said he still regards household debt — which currently is at a near-record 151 per cent of disposable income —as the No. 1 domestic risk to the Canadian economy, but he suggested the recent data was encouraging.

Imagine that?  Poor schmuck Canadians are the biggest domestic risk to our economy because we have taken out large mortgages?

Now let's talk about what is really happening, and why the regulators (like the Bank of Canada and the Harper government) are gambling with our civilization by allowing the banks and investment funds and mutual funds to place huge gambles, with little of their money involved, but with the taxpayers having to step up to rescue the financial system and individual banks if things go wrong.

The hypocrisy is that our nation’s big financial institutions, protected by implied taxpayer guarantees, oppose regulation on the grounds that it would increase their costs and reduce their profit. Such rules are unfair, they contend. But in discussing fairness, they never talk about how fair it is to require taxpayers to bail out reckless institutions when their trades imperil them. That’s a question for another day.

AND the fact that large institutions arguing against transparency in derivatives trading won’t acknowledge that such rules could also save them from themselves is quite the paradox.

“These regulations are not just protecting the United States taxpayer,” Mr. Greenberger said. “They protect the banks themselves. The best friend of these banks would be laws that prevent them from shooting themselves in the foot. The fact is, they can’t do it themselves.”

Behind the really big threat to our domestic economy and to the economies of the European Union and the USA, lies the biggest ponzi scheme that the world has ever seen. 

If the luckless Bruno Iksil was able to act as if he was a hidden whale – "[he] was dubbed the 'London Whale' in credit markets due to the size of the trading positions he took, but for years he stayed well below the surface avoiding detection" – it is because he and traders like him work for banks who have been blessed by our politicians and regulators with the right to use virtually none of their own money but to place huge bets in the enormous derivatives market.

That derivatives market is a Ponzi scheme through and through. It is little understood by regulators, by politicians, by citizens and by those who invest in it.

It is a Black Hole of ignorance, supposed science, moral turpitude and enormous consequences for our system.

What are bankers doing when they place bets in derivative market, and why is it such a threat to all of us?

This helps explain it:

Before Thursday, JPMorgan chief executive officer Jamie Dimon strongly opposed the rule, arguing that his bank and many others had already shut down their risky trading departments. Now he admits that JPMorgan is stuck with “egg on our face” because the latest loss proved that even so-called hedged positions are extremely dangerous. A hedged trade is one that a financial institution will set up to reduce – or, ideally, eliminate – the risk of losing money if the market moves against it.

David Shimko, a derivatives and risk management consultant who teaches at New York University’s esteemed Courant Institute of Mathematical Sciences, argues that it is almost impossible to remove all risk in any trade. Even worse, most banks don’t try.

If you look closely enough at the trading activity of bank treasury departments, he said, you can see “they’re not really hedging. They’re just speculating. But the trades happen to be classified as hedging for accounting purposes.”

He offered a simple example. Gasoline refineries are exposed to two key commodities: the oil they buy, and the fuel they sell. To hedge themselves against oil, a refinery can purchase long-term contracts at predetermined prices. In its accounting statements, this makes it appear as though it has cut its risk in half, because one of two commodities is hedged.

But what the refinery has really done is put all of its eggs in one basket – its business is now it is wholly dependent on gasoline prices. Extrapolate this many times over and you start to see what happens in credit derivative markets every single day.

Alan White, a derivatives professor at the University of Toronto’s Rotman School of Management, agrees. Asked whether hedges are ever risk-free, he said: “The answer is never, or almost never.”

This is a big problem, he added, because these trades employ massive amounts of leverage. In other words, banks borrow enormous sums of money to amplify their potential gains. But debt also amplifies losses. If someone borrows $5 to invest in a $10 stock, a 20-per-cent drop in the stock price amounts to a 40-per-cent personal loss. (Because the $5 that was borrowed must be paid back, the $2 loss is absorbed by the investor alone and $2 is 40 per cent of his original investment.)

This scenario is more extreme in the derivatives world, where leverage isn’t employed at a simple 2-to-1 ratio, but often at 15 to 1, Mr. White said. That means any losses in the market are amplified by 15 times, and offers an explanation of how JPMorgan lost $2-billion in just six weeks.

But while leverage has been talked about for years, spurred by the shocking revelation that many investment dealers toyed with 40-to-1 ratios leading up the financial crisis, investors are still shocked every time there is a new credit loss. Their attitude: This again?

Just to make it very clear: Our politicians and our regulators are allowing fools to gamble with huge sums by only putting up $1 for every $40 that they can borrow from depositors (that's your money in the bank) and from funds lending them money.

And the governments have to step in to rescue banks which fail and pump huge sums into the system to save us fromt these fools.

And this is the size of that huge Ponzi scheme:

In large part, this is because few people understand just how big the derivatives market is. According to the Bank for International Settlements, the total value of outstanding derivatives globally was $648-trillion, as of Dec. 31. That beats the stock markets many times over. “There’s this whole business out there that investors scarcely know about,” Mr. White said.

Every term, he tells his derivatives students the same thing. “You probably don’t know it, but this is the biggest market in the world – by a long shot.”

Think about that: these bankers have placed bets many times bigger than the world economy! And they rely on finding a Bigger Fool to work on the other side of their deals, and if this fails, for the governments to bail them out.

So let's take up our pitchforks and demand of our politicians and regulators that they stop the banks and mutual funds and others playing in this unregulated Ponzi scheme.

Let us take the matches away from these fools before they burn our world.

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