Enlightened Economics

By Ron Robins. First published December 15, 2010, in his weekly economics and finance column at alrroya.com

New banking and financial industry regulations in the US and the Basle III rules for banks globally—might fail on key issues. The newly enacted US Dodd-Frank Wall Street Reform and Consumer Protection Act, despite its noble purpose to prevent further financial chaos, is unlikely to do that. And the Basle III requirements for higher and better quality bank reserves are good on paper, but full implementation is improbable amidst likely future hefty bank losses.

At the heart of the financial crises were derivatives, and as Warren Buffett the famed investor has warned, “derivatives are financial weapons of mass destruction.” Yet, after about two years of Congressional wrangling, the Dodd-Frank bill incorporates a rough future structure for derivatives but authorizes yet another committee to report back in the spring of 2011 with detailed regulations governing them. And the old expression, ‘the devil is in the details,’ is never more apt than in this instance.

Already, US Banks are calling for derivatives called ‘foreign exchange swaps’—a $42 trillion market—to be exempt from the rules.

Derivatives are major profit centres for the too-big-to-fail US banks. These banks have repeatedly told US lawmakers—who receive considerable campaign funding from them—not to restrict those profits. Because of the influence of Wall Street on the Obama Administration and the US Congress, it is difficult to be hopeful that when it comes to the detailed regulations, and especially their enforcement, that much will really change concerning US banks’ derivatives’ activities.

Two particular varieties of derivatives are at the centre of our financial debacle. They are mortgage backed securities (MBS) and credit default swaps (CDS). The latter, though originally considered ‘insurance policies’ against debt default, are now frequently gambling vehicles that incentivize the taking-down of struggling companies (AIG)—and now, governments (Ireland?).

The size of the derivative problem for US banks cannot be overstated. As Alasdair Macleod, a British banker and economist remarked on October 28, “according to the FDIC [the US Federal Deposit Insurance Corporation], outstanding derivatives held by US banks increased from $155 trn to $225 trn between mid-2007 and mid-2010. In other words, since the credit-crunch the derivative bubble in the US has grown a further 45 per cent and is now fifteen times total US GDP, literally dwarfing the banks’ total equity, which is only $1.35 trn. Consider this fact: derivative exposure is 189 times total bank equity.”

Aside from the derivatives issue, and also not addressed in the Dodd-Frank bill, are the two massive US mortgage progenitors now on US government life-support, Fannie Mae and Freddie Mac.

Fannie Mae and Freddie Mac were formerly somewhat private institutions and own or guarantee about half of all US residential mortgages. But as the real estate crises exploded and due to their potential for vast losses that could paralyse the housing markets, the US government commandeered them in September 2008.

The principle offering in the Dodd-Frank bill concerning Fannie Mae and Freddie Mac is that by January 2011 President Obama offers a proposal to Congress to bring them out of government receivership.

Thus, on the two vital issues of derivatives and real estate, the Dodd-Frank bill seems queasy and deficient. These inadequacies allow for a re-ignition of the financial meltdown at almost any time.

Acknowledging the severe problems in the banking industry, banking regulators have introduced new global banking rules. In September, the Bank for International Settlements (BIS) in Geneva, Switzerland—which sets the regulations that banks everywhere generally adhere to—issued its Basel III regulations, which are due to come into effect for all banks between 2013 and 2019.

Basel III’s most important requirement will be that banks hold higher and better quality reserves.

But the BIS may be too optimistic about the ability of many banks, particularly the too-big-to-fail banks, to reach the new reserve requirements. For instance, a Reuters report on November 21 said, “the new Basel III banking rules will leave the biggest US banks short of between $100 billion and $150bn in equity capital, with 90 per cent of the shortfall concentrated in the top six banks, the Financial Times said, citing research from Barclays Capital.”

However, these equity shortfalls may well err on the low side. In the next few years, US and European banks especially, are likely to be hit with big waves of new losses related to real-estate, derivatives, and sovereign debt.

Real estate losses because US and European banks have still not written-off their full potential losses concerning toxic MBS that they may have to buy back due to newfound paperwork improprieties related to the emerging foreclosure fraud, as well as mortgage losses generally, on foreclosed and other properties.

Additionally, banks may suffer further huge derivative losses as they are eventually forced to price certain derivative and other asset classes at more realistic appraisal values instead of the ‘mark to fantasy’ that often now exists.

And recently, an even greater potential hit to banks’ capital has arisen: the possibility of gargantuan losses on bad sovereign debt in the EU and elsewhere.

On September 13, The Economist magazine had this to say on the MBS and derivatives issue relating to Basle III. “The most serious failure in Basel III is that it doesn’t address the principal contribution of Basel II to the last financial crisis, namely, the calculation of risk-weights [for instance, risks associated with MBS]… What brought banks like Citigroup and Bank of America to their knees wasn’t direct exposure to sub-prime loans, but exposure to triple-A-rated debt backed by pools of such loans, debt which turned out not to be risk-free at all.”

The US Dodd-Frank bill either passes the buck or overlooks the very problems that led to the financial meltdown, and the Basel III regulations may be rendered impotent due to massive future bank losses. Thus, these new bank regulations are likely to fail.

As Henry Ford, the founder of the Ford car company once said about banking, “it is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”

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