Best of the Week
Most Popular
1. US Housing Market Real Estate Crash The Next Shoe To Drop – Part II - Chris_Vermeulen
2.The Coronavirus Greatest Economic Depression in History? - Nadeem_Walayat
3.US Real Estate Housing Market Crash Is The Next Shoe To Drop - Chris_Vermeulen
4.Coronavirus Stock Market Trend Implications and AI Mega-trend Stocks Buying Levels - Nadeem_Walayat
5. Are Coronavirus Death Statistics Exaggerated? Worse than Seasonal Flu or Not?- Nadeem_Walayat
6.Coronavirus Stock Market Trend Implications, Global Recession and AI Stocks Buying Levels - Nadeem_Walayat
7.US Fourth Turning Accelerating Towards Debt Climax - James_Quinn
8.Dow Stock Market Trend Analysis and Forecast - Nadeem_Walayat
9.Britain's FAKE Coronavirus Death Statistics Exposed - Nadeem_Walayat
10.Commodity Markets Crash Catastrophe Charts - Rambus_Chartology
Last 7 days
Will Fed‘s Cap On Interest Rates Trigger Gold’s Rally? - 30th May
Is Stock Market Setting Up for a Blow-Off Top? - 29th May 20
Strong Signs In The Mobile Gaming Market - 29th May 20
Last Clap for NHS and Carers, Sheffield UK - 29th May 20
The AI Mega-trend Stocks Investing - When to Sell? - 28th May 20
Trump vs. Biden: What’s at Stake for Precious Metals Investors? - 28th May 20
Stocks: What to Make of the Day-Trading Frenzy - 28th May 20
Why You’ll Never Get Another Stimulus Check - 28th May 20
Implications for Gold – 2007-9 Great Recession vs. 2020 Coronavirus Crisis - 28th May 20
Ray Dalio Suggests USA Is Entering A Period Of Economic Decline And New World Order - 28th May 20
Europe’s Coronavirus Pandemic Dilemma - 28th May 20
I Can't Pay My Payday Loans What Will Happen - 28th May 20
Predictive Modeling Suggests US Stock Markets 12% Over Valued - 27th May 20
Why Stocks Bear Market Rallies Are So Tricky - 27th May 20
Precious Metals Hit Resistance - 27th May 20
Crude Oil Cuts Get Another Saudi Boost as Oil Demand Begins to Show Signs of Life - 27th May 20
Where the Markets are heading after COVID-19? - 27th May 20
Silver Springboards Higher – What’s Next? - 26th May 20
Stock Market Key Resistance Breakout Is Where the Rubber Meets the Road - 26th May 20
5 Ways To Amp Up Your CFD Trading Today - 26th May 20
The Anatomy of a Gold Stock Bull Market - 26th May 20
Stock Market Critical Price Level Could Soon Prompt A Big Move - 25th May 20
Will Powell Decouple Gold from the Stock Market? - 25th May 20
How Muslims Celebrated EID in Lockdown Britain 2020 - UK - 25th May 20
Stock Market Topping Behavior - 24th May 20
Fed Action Accelerates Boom-Bust Cycle; Not A Virus Crisis - 23rd May 20
Gold Silver Miners and Stocks (after a quick drop) Ready to Explode - 23rd May 20
3 Ways to Prepare Financially for Retirement - 23rd May 20
4 Essential Car Trade-In Tips To Get The Best Value - 23rd May 20
Budgie Heaven at Bird Land - 23rd May 20
China’s ‘Two Sessions’ herald Rebound of Economy - 22nd May 20
Signs Of Long Term Devaluation US Real Estate - 22nd May 20
Reading the Tea Leaves of Gold’s Upcoming Move - 22nd May 20
Gold, Silver, Mining Stocks Teeter On The Brink Of A Breakout - 21st May 20
Another Bank Bailout Under Cover of a Virus - 21st May 20
Do No Credit Check Loans Online Instant Approval Options Actually Exist? - 21st May 20
An Eye-Opening Perspective: Emerging Markets and Epidemics - 21st May 20
US Housing Market Covid-19 Crisis - 21st May 20
The Coronavirus Just Hit the “Fast-Forward” Button on These Three Industries - 21st May 20
AMD Zen 3 Ryzen 9 4950x Intel Destroying 24 core 48 thread Processor? - 21st May 20
Dow Stock Market Trend Analysis and Forecast - 20th May 20
The Credit Markets Gave Their Nod to the S&P 500 Upswing - 20th May 20
Where to get proper HGH treatment in USA - 20th May 20
Silver Is Ensured A Prosperous 2020 Thanks To The Fed - 20th May 20
It’s Not Only Palladium That You Better Listen To - 20th May 20
DJIA Stock Market Technical Trend Analysis - 19th May 20
US Real Estate Showing Signs Of Covid19 Collateral Damage - 19th May 20
Gold Stocks Fundamental Indicators - 19th May 20
Why This Wave is Usually a Market Downturn's Most Wicked - 19th May 20
Gold Mining Stocks Flip from Losses to 5x Leveraged Gains! - 19th May 20
Silver Price Begins To Accelerate Higher Faster Than Gold - 19th May 20
Gold Will Soar Soon; World Now Faces 'Monetary Armageddon' - 19th May 20

Market Oracle FREE Newsletter


Blueprint for Battling Credit Default Swaps and Avoid Another Financial Crash

Stock-Markets / Market Regulation Oct 29, 2009 - 07:14 AM GMT

By: Money_Morning


Best Financial Markets Analysis ArticleMartin Hutchinson writes: Former U.S. Federal Reserve Chairman Paul Volcker and Bank of England (BOE) Governor Mervyn King think that banks that are considered “too big to fail” should be broken up. The House Financial Services Committee is drafting a bill that will make banks pay for other banks’ bankruptcies.

Others have suggested reviving the Glass-Steagall Act – the 1933 legislation that forced financial institutions to separate their commercial and investment banking businesses. Glass-Steagall was repealed in 1999.

It’s enough to make your head spin. And don’t think that our elected “leaders” aren’t feeling just as overwhelmed. At the end of the day, however, there has to be a solution to the banking mess. Doesn’t there?

Leaving everything as it is isn’t an option, or at least it is a very bad option. In the short term, it may have been necessary to bail out all the major banks and investment banks – save for the unfortunate Lehman Brothers Holdings Inc. (OTC: LEHMQ).

In the long run, this has established a presumption that any financial institution that is too complicated for politicians to figure out – and that’s big enough to make them afraid of losing it – can pretty well do what it likes. And that includes paying its senior managers grossly excessive bonuses within a year of receiving a state bailout – can anyone say Goldman Sachs Group Inc. (NYSE: GS)?

This also gives these particular banks an unfair advantage in funding – and in accessing large pools of capital. The past year has demonstrated all too well that these particular institutions are only too happy to use this advantage to squeeze their smaller competitors out of the market.

On the other hand, I don’t think that bringing back Glass-Steagall – as it was – will do the job properly. Today’s investment banks just aren’t the same as they were in 1935. In fact, they’re even more sophisticated today than they were as recently as 1985.

Trading dominates investment-banking activities more than ever before. And that’s resulted in a way it never used to, and they have an impossibly tangled network of obligations to counterparties on interest rate swaps, currency swaps and now the inevitable credit default swaps (CDS).

That last derivative security, in particular, makes it impossible to imagine an investment bank with a large portfolio surviving anything but the mildest downturn. The reason: In a real recession, an investment bank will have to post collateral on all of its credit-default-swap obligations, which increase in value once money gets tight. Thus, just when it is most difficult to attract funding, investment banks with large CDS portfolios are subject to a “giant sucking sound,” as all their funds are drained away to satisfy counterparty claims on CDS portfolios.

But there are three things we can do in response: Ban credit default swaps, initiate a transaction tax and boosting capital standards. Let’s consider all three.

Three Moves to Make

I’ve been warning investors about the dangers of credit default swaps since very early in 2008, months before the problems surfaced. There actually are several reasons to ban credit default swaps, except possibly for the rare cases in which the credit-default-swap seller actually owns enough of the credit in question to cover the CDS. Let’s consider the top three:

  • First, they are destabilizing to the market, because they zoom up in value in tight markets, draining their sellers of funding.
  • Second, they encourage speculation on bankruptcy – they are like short selling on steroids, because the potential profit from a CDS is a large multiple of its cost.
  • And third, credit default swaps mess up bankruptcy negotiations; because some creditors will be a “phantom,” either covered by the swaps, or actually “short” the credit, meaning they have an incentive to push the firm into bankruptcy.

The fact that Congress – a year after the collapse of American International Group Inc. (NYSE: AIG) – still has not banned the use of credit default swaps is a tribute to the power of the investment-banking lobby.

(Note to U.S. Rep. Barney Frank, D-MA, House Banking Committee Chairman: Ban credit default swaps now! It’s’s the one thing you can do to make up for the damage you did in shielding Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) during the housing bubble.)

There is another thing that we can do as well as banning CDS, and that is to impose a Tobin tax on trading, of some small percentage of each transaction. Much trading – especially short-term trading – is more or less just rent-seeking, making money on insider knowledge of the fund flows in the market.

When you hear that the major investment houses have electronic-stock-trading computers set up inside the stock exchange building – ostensibly, to provide them with faster access to the trading feed – you know the playing field is tilted. High-speed trading appears to earn about $5 billion a year for Goldman Sachs, the largest operator, and that $5 billion is just scooped out of the U.S. economy – without providing any value in return. A Tobin tax, even at a low rate, would yield billions of dollars in revenue to set against the budget deficit. More importantly, it would loosen the grip of the traders over the marketplace we all share.

Having banned credit-default swaps and introduced a Tobin tax, you would have solved much of the problem. The truly dangerous and damaging businesses would be eliminated – or at least would have shrunk in size – because their net profitability would be limited. (You need to do a lot of trades, each one of which would be Tobin taxed, to benefit from high-speed trading.)

The rest of the problem could be solved simply by applying stricter capital standards to banks with more than $1 trillion in assets and off-balance-sheet commitments that include derivatives and securitization vehicles. That would currently catch the top four banks – plus Goldman Sachs and probably Morgan Stanley (NYSE: MS).

For this to work, these standards would need to be applied internationally on a consolidated basis, and would have to be loophole-free. Setting them up would take time, because the big banks would battle to insert loopholes, as they did in the decade-long process negotiating the Basel II capital standards, which came into effect in January 2008, just in time to fail disastrously.

With those three protections, you wouldn’t need to break up the “too big to fail” banks. Passing a bill through Congress to do so with say a two-year delay might be helpful, however, just to have a threat to hold over them during the inevitable haggling and lobbying process for these changes.

Money Morning/The Money Map Report

©2009 Monument Street Publishing. All Rights Reserved. Protected by copyright laws of the United States and international treaties. Any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), of content from this website, in whole or in part, is strictly prohibited without the express written permission of Monument Street Publishing. 105 West Monument Street, Baltimore MD 21201, Email:

Disclaimer: Nothing published by Money Morning should be considered personalized investment advice. Although our employees may answer your general customer service questions, they are not licensed under securities laws to address your particular investment situation. No communication by our employees to you should be deemed as personalized investment advice. We expressly forbid our writers from having a financial interest in any security recommended to our readers. All of our employees and agents must wait 24 hours after on-line publication, or 72 hours after the mailing of printed-only publication prior to following an initial recommendation. Any investments recommended by Money Morning should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company.

Money Morning Archive

© 2005-2019 - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.

Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules