On January 10, 2013, I wrote a blog post about the danger facing financial institutions due to their derivative exposures. One of my readers told me that all of the TBTF (Too Big to Fail) issues was being managed by the federal regulators and that any problems within the financial system would be isolated and contained within the failing banks themselves. Rather than simply marvel at the stupidity of this reader, I decided to write another blog post.
A little background …
Financial transactions require more than one party – the opposites on the other side of transactions are called counterparties.
To value an asset you must have a willing seller and a willing buyer who agree on a valuation. Someone who makes an offer and someone who accepts an offer. Given the past history of the Federal Reserve and the United States Department of Treasury, I am not so sure about the “willing” part of the transaction anymore. Especially because the Federal Reserve, the Treasury and various regulatory agencies may have exerted a coercive influence on financial transactions in cases like Long Term Capital Management, Lehman Brothers, Bear Sterns, and others.
If there are no buyers, the value of an asset is functionally ZERO. The most important part of this seller-buyer relationship is if there is no willing counterparties to do the deal. Thus rendering the value of what is being sold as ZERO! An illiquid asset on the balance sheet is like have a rock hold down a piece of paper. It has a function, but no realizable immediate value to someone else.
In a crisis, you cannot trust a counterparty’s assets or liquidity. Due to the arcane Enron-style accounting laws designed to hide transactions rather than promote transparency, one really does not know how assets are really being treated on a financial institution's balance sheet. There are off-balance-sheet accounts that hide asset valuations from the public, auditors, counterparties and others.
And, let us not forget the fabulous 105-repo deals. Need to provide a little window dressing for public consumption – simply loan a counterparty the asset, but provide an additional 5% for the collateral AND YOU CAN BOOK THE LOAN AS A SALE! After the quarter has ended and the auditors have gone home, repurchase the asset and pay the counterparty their loan fee and you have successfully and legally lied to everyone. And in the case of Lehman, we are talking about transactions in the range of tens of billions of dollars.
“Repo 105 is an accounting maneuver where a short-term loan is classified as a sale. The cash obtained through this "sale" is then used to pay down debt, allowing the company to appear to reduce its leverage by temporarily paying down liabilities—just long enough to reflect on the company's published balance sheet. After the company's financial reports are published, the company borrows cash and repurchases its original assets.” <Source>
Mark-to-market, the express train to hell. Simply put, the value of an asset is the last recorded sale in an open exchange. It the asset is valued at $10 today and $5 tomorrow, financial institutions are required by law to mark their portfolios to the current value. In the example, erasing fifty percent of the assets value overnight. What makes this insidious is that every fire sale of assets revalues everyone’s assets, thus exacerbating the downward spiral of valuations.
So here comes Barney Frank, corrupt Ranking Member of the House Financial Services Committee …
Congressman Barney Frank today released an analysis of the provisions in the Wall Street Reform and Consumer Protection Act which address the issue of financial institutions which were thought to be “too big to fail.” The research was conducted at Mr. Frank’s request by the minority staff of the House Financial Services Committee.
The paper is presented in response to assertions that the Wall Street reform law perpetuates “too big to fail” and taxpayer bailouts of large financial institutions. It describes how in fact the law provides for the orderly dissolution of failing institutions in order to protect the broader economy. By explaining how the law creates a process for dissolving failing firms, the analysis provides the framework for an informed discussion of this topic.
Can you trust a report from someone who was complicit in the creation of the mortgage meltdown and the mechanisms that allowed the contagion to spread to the greater economy? You will notice that Barney Frank rarely refers to the legislation by its common name: DODD-FRANK! As in Christopher Dodd (D-CT), former Chairman of the Senate Banking Committee and a taker of special mortgage loans – and the corrupt Barney Frank.
I call bullshit!
The Financial Crisis and “Too Big to Fail”
At the height of the financial crisis in 2008, the Bush administration believed that it was forced to choose between doing two unprecedented and undesirable things: propping up large failing financial companies at taxpayer risk on the one hand, or on the other permitting such companies to go through bankruptcy, with potentially catastrophic results for an already weak financial system. Bush administration officials in most cases judged the risks associated with not acting to be unacceptably high.
The Federal Reserve first provided direct aid under section 13(3) of the Federal Reserve Act to support and facilitate the acquisition of Bear Stearns. Bush administration officials then let Lehman Brothers fail, but that choice proved to be highly destabilizing because the abrupt cessation of the company’s operations, combined with its interconnectedness with other financial firms, caused a freezing up of financial markets in the United States and around the world.
True enough, that financial transactions are interconnected and one financial institution can affect many other financial institutions. What really happened was that fire-sale asset valuations became suspect and asset purchasers stopped purchasing. But even more important, there was a crisis of trust – where nobody wanted to do business with Lehman Brothers at any price. Especially since a bankruptcy judge could reverse transactions if they occurred within a specific period prior to the bankruptcy filing. Because of the revelations of leveraged assets exceeding the value of the firm, nobody could vouch for the solvency of any particular firm and the system ground to a halt. Each open market sale of a distressed firm’s assets revalued the entire market’s valuations downward.
Because of these seriously damaging economic consequences, the Bush administration concluded that bankruptcy was not up to the task of dismantling a complex financial intermediary, and the Federal Reserve again used 13(3) to support AIG.
There was nothing wrong with the bankruptcy process other than it demanded total transparency and accurate accounting. Many financial institutions were technically insolvent and that was the last thing the Administration wanted to reveal to the investing public. As for AIG, they were the counterparty who issued a form of derivative insurance against asset devaluations. Since what they were issuing wasn’t really insurance, the transaction was not regulated by insurance regulators, the foundation of the transactions were not actuarially sound, and their reserves were insufficient to absorb the payout losses. Thus AIG needed to be saved. Little is mentioned about the first payoffs of AIG to counterparties on receipt of government (taxpayer) funds. Payoffs at an unnecessary 100-cents on the dollar. Goldman Sachs got $12.9 BILLION, Bank of America/Merrill Lynch got 12 BILLION, Society General got $11.9 BILLION, Deutsche Bank got $11.8 BILLION and assorted municipalities got $12.1 BILLION.
That the government was forced to prop up troubled firms to avoid a systemic collapse clearly demonstrated that the regulators’ tool kit for managing the failure of large, interconnected financial firms, much of which was put in place when the financial system was significantly simpler, was inadequate. The provision of extraordinary government support blurred the line between liquidity support and solvency support and perpetuated the belief that some financial firms were “too big to fail” (TBTF).
And not a damn thing has changed. The big firms have grown bigger and their derivative exposure outweighs the value of the firm’s net worth many times over.
The Wall Street Reform and Consumer Protection Act ensures that the largest, most interconnected firms are less likely to fail, not by preventing them from taking risks, but rather by making sure that they manage risks prudently and are capable of absorbing losses when they make mistakes.
This is an outright lie!The Dodd-Frank Wall Street Reform and Consumer Protection Act cannot ensure catastrophic and systemic failure by regulation. There is no way for government regulators to make sure that any financial institution manages risks in a prudent manner. Like police everywhere, they respond to the crime after it has been committed. Does anybody else understand that the government’s regulatory agencies are both hyper-politicized and under-staffed? That financial reports are snapshots of what has occurred, not what is occurring?
The FSOC, backed by an Office of Financial Research, monitors the system for risks and can respond to identified threats not only by placing nonbank financial firms under Federal Reserve supervision, but also by providing for stricter regulation of systemically destabilizing activities and practices wherever they occur.
The Federal Reserve is not a government agency, it is a private corporation said to be owned by its member banks. Why a private institution would be granted sweeping powers over the United States economy and private enterprise defies reason and may well be unconstitutional given the Constitution’s Fifth Amendment regarding the government’s taking of private property without just compensation.
… the Wall Street Reform and Consumer Protection Act provides the government with a clear, definitive path to ensure that the insolvent financial firm fails instead of being put on taxpayer-financed life support. The law recognizes that bankruptcy will remain the failure mechanism for the vast majority of nonbank financial firms and bank holding companies. To address the rare situations in which the operations of a nonbank financial company or bank holding company are too complex or important to go through bankruptcy without significantly disrupting the entire financial system, the Wall Street Reform and Consumer Protection Act provides a new Orderly Liquidation Authority as an alternative path to failure.
You can’t trust the government to expeditiously find $1.2 BILLION in customer funds at MF Global or track down $6 BILLION in pallets of $100 bills lost in Iraq – and suddenly they have this miraculous ability to unwind complex financial transactions?
Bottom line …
Dodd-Frank, a creation of the democrats, is designed to enlarge government’s control over the financial engine of our economy and a method of imposing indirect taxation on the American people through transactional fees.
No matter what the government says or does, it relies on the very same people who broke the system and stole BILLIONS to ostensibly fix the problem. The problem was that the financial system was rigged in favor of the financial institutions by corrupt legislators who traded their votes for campaign contributions and voter support.
The only way out of this mess is to allow asset valuations to seek their residual values and to outlaw the use of derivatives to generate paper profits far in excess of the profits that would be generated by the sale of the assets underlying the derivative. Plainly said, we must demand the de-leveraging of the financial industry and stop the madness of financial firms who trade nothing but paper between themselves to generate increasing profits.
If the government wants to prove that their prudential regulation system works, let them solve the TRILLION dollar problems associated with Fannie Mae and Freddie Mac. And, oh by the way, clear the corruption in the stock exchanges which allowed Fannie Mae and Freddie Mac securities to trade although both were technically insolvent without the BILLION dollar infusions of taxpayer funds each quarter.
In the final analysis, you cannot believe Barney Frank or any of the other politicians who should be incarcerated for what they have done to America. If anyone wants a copy of the full report, it can be access ed at the House Financial Services Committee website.