Is it hedging or casino betting when banks go short on products they have created/sold to customers?

by Linda Beale
published on ataxingmatter April 28

Financial reform–the GOP’s “chicken game”; and is it hedging or casino betting when banks go short on products they have created/sold to customers?
Edited to add additional links 4/28/10 at 5:35pm

As the GOP blocked progress on the Senate finance bill for a third time (56-42) in their foolish game of “financial reform chicken”, hearings yesterday with Goldman executives raised many important questions and got lots of rambling answers. See, Senate Hearing on Goldman Sachs & the Financial Crisis. Why rambling?–the ABA online journal today notes that one of the principal Goldman lawyers advises that those responding at Congressional hearings take long pauses before answering and give rambling responses to questions–to use up the time of the questioner without advancing the ball in terms of information provided. See Goldman Sachs Lawyer Advises Long Pauses, Rambling Answers, ABA Journal, Apr. 27, 2010.

Re the game of chicken:

The Dems will lose if they blink first in this chicken game. In fact, the best response to the GOP chicken play is to toughen the financial reform rules: legislate a fiduciary duty of broker-dealers to their clients (since they don’t seem to believe they have even quasi duties at this point–see below and see Gerding, The Senate Goldman Hearing: Fiduciary Duties for broker-dealers? and Ribstein’s response that duties just create litigation costs); add a permanent financial institution tax on leverage and assets that will essentially force banks to downsize while appropriately charging them for the cost-of-funds advantage that they enjoy because of their size and the implicit federal guarantee–see, e.g., Leonhardt, A Bank Tax As Insurance for Us All, NY Times, Apr. 27, 2010; add a tough proprietary trading ban that wil return banks to the boring business of being bankers rather than day-traders; remove the “mark-to-model” version of fair value accounting that lets banks invent their own valuations and force them to use market quotes/actual trades for all valuations even in “disrupted” markets–and surely do not allow the FDIC to determine valuations during crisis as the Dodd bill currently does, since that is an invitation to distorted values that are adopted to enhance balance sheets; eliminate tax-free reorganizations for financial institutions; create rules as proposed by Senators Kaufman and Brown that will shrink the banks to manageable size rather than “TBTF” size, through limits on share of deposits (10% of total at insured depository institutions) and nondeposit liabilities (2% of GDP for bank holding companies, 3% of GDP for shadow banks) (the Kaufman April 21, 2010 speech on the proposed legislation is available with summary of bill on, here). On the reasons that downsizing banks makes sense, see Alford, Why dismantling too big to fail financial firms makes economic sense, Naked Capitalism, Apr. 27, 2010; Zamarripa, Big Banks Can’t Be Reformed With Small Ideas, Roll Call, Apr. 28, 2010.

Every day that the GOP votes no, add one more tough provision.

re the Goldman hearings and hedging/casino gambling:

The Senate questioners recognized the problem of a bank whose assets and liabilities are sufficiently large that its failure could derail world economies and that has (and uses) ability to create innovative financial products that amount to nothing more than casino bets in which the bank is likely the only party with all the information (e.g., synthetic CDOs, where one said thinks referenced mortgages will fail, so buys the synthetic cDO credit default swap “insurance” pay-out on the failure of the referenced mortgages; the other side thinks mortgages will continue to pay out, so “insures” the mortgages (or may not understand the product sufficiently to know that it is providing the swap insurance guaranteeing the referenced mortgages)). The concern here is that these investment banks are performing quasi-public functions (serving as middlemen in the sales of stocks and bonds, helping deals between corporations take place, etc.) but are acting with purely private greed (treating sales as a search for suckers, creating products that are toxic from the start and pawning them off on unsuspecting buyers, using flash trading schemes that permit the bank to make money off its own clients’ trade information).

The banks, of course, see themselves as merely profit-making businesses. It’s “caveat emptor” from day one. And if their risk-taking leads the economy into chaos, they don’t care as long as they come out with profits–they claim no fiduciary duties to customers, no obligations to the public (other than mandated by securities laws, and even there they have a bank-friendly reading of disclosure requirements), only the rationale of making the most bucks possible in whatever way possible. According to the bankers, their shorts are just reasonable “hedges” against loss.

This issue is central to the financialization of our economy and the need for substantive financial reform even beyond what is currently being proposed in the Senate amid the Republicans’ game of chicken.

End users of wheat are legitimately hedging when they buy futures. Issuers of corporate bonds that pay a floating rate of interest are legitimately hedging when they buy an interest rate swap under which the counterparty accepts a fixed rate of interest and pays the issuer a floating rate that it can then pay over to its bond holders.

But if we allow investment banks to create synthetic CDOS and other complex financial products that are purely casino bets (I would urge that we should just not, but it is not clear Congress has the guts to implement the kinds of severe changes that are needed here), should we allow them to claim that shorting their own products is merely a “hedge” like other end users purchase? I don’t think so. One way to disincentivize the creation of complex financial products and the endless financialization of the economy that ultimately adds no jobs and does nothing for quality of life (except for the wealthy traders and quants that create the products) is to change the risk appetite of banks. No bank should be permitted to be net short on any product it creates or any product that it sells to customers. But not being short is not enough. Banks need to be bear sufficient risk for the products they create . So we might also require banks that create and sell financial products to 1) retain a sufficient share of the interests issued to provide a reasonable equity cushion below the products sold –around 15-20% and 2) not be permitted to “hedge” those products by shifting the risk of loss off to another bank or financial entity. Odds are their appetites for creating risky would diminish significantly if they bore the risk they created and there was no prospect for bailout (another item that needs to be strengthened in the current bill and that the GOP “no” vote makes possible to do).

By the way, a letter to the editor in the Times Friedberg, Goldman Deal and the Financial Market, Apr. 27, 2010, suggests that such naked bets are “good” for the market because they help pricing. Would you claim that a bunch of people laying down a bet on “red 21” helped one know whether red 21 was a good bet and accurately priced? Certainly not. The naked credit default swap is probably not much better at predicting real value–for years, the CDS prices on even the worst subprime deal were really really low (that’s why John Paulson could make so much money off his short). Irrational bets on the long or short don’t do anything except increase volatility and increase the size of the bubble market. Pricing information gained is either too insignificant in that mix or misinformation that adds to the problem.