Making Recessions Great Again: Trump Aims To Bring Bailouts Back To The Banks

This is the third in a four part series on the Financial CHOICE Act. You’ll find the second article here and a summary of the Act here.
(Luke Sharrett/Bloomberg)

(Luke Sharrett/Bloomberg)

There is a great unanswered question about the banks that were on the brink of bankruptcy in 2008: Who did they owe all this money to?

One day in 2008, we suddenly got the bad news that all the major financial institutions across America, indeed across the globe, were zombie banks— they had no money to lend and couldn’t pay their debts.

The private mortgage companies, like Countrywide Financial, had indulged in predatory lending, luring people who could not afford houses into mortgages by teaser rates causing an unjustified rise in housing prices. The investment banks played their part by purchasing these mortgages, disguising them in bundles with prime mortgages and passing them off to investors as AAA safe.

When the higher rates kicked in, the housing market collapsed — but the banks had sold most of these toxic mortgages to investors. So why were the banks in need of taxpayer bailouts?

We have Michael Lewis’ The Big Short to thank for a glimpse of the answer. That movie traces the road to financial victory of four small hedge fund managers. We also know from the accolades given to him for doing the greatest trade ever by an admiring Wall Street, that John Paulson scored $20 billion himself. But we don’t know how much of the bank debt was owed to other hedge funds — if there is such a study, I can’t find it.

AlHowever, what we can do is estimate debts from other sources. British economist, John Kay, tells us 90% of what banks do today is trading (betting) among themselves.

Banks project the false image that most of what they do benefits society. Once that was true, but bank business models have radically changed. Our grandfathers’ banks are not our banks. As Kay says, banks no longer primarily serve their community, they serve their executives.


Betting Other People’s Money

So, besides the hedge funds, who else did the bankers owe? From what Kay says it must’ve been each other. They bought and sold high-risk synthetic derivatives with each other. A synthetic derivative, as its name suggests, is a creature of human imagination. As Goldman Sachs VP, Fabrice Tourre, described one of them to his girlfriend in an email:

“When I think that I had some input into the creation of this product (which by the way is a product of pure intellectual masturbation, the type of thing which you invest telling yourself: ‘Well, what if we created a ‘thing,’ which has no purpose, which is absolutely conceptual and highly theoretical and which nobody knows how to price?’) it sickens the heart to see it shot down in mid-flight…It’s a little like Frankenstein turning against his own inventor ;)”

Tourre was describing a complex derivative. Let’s take a simple example in form: One banker says. “I’ll bet $1 billion of my bank’s money that the Japanese stock market will go up tomorrow at 4 PM.” Another banker says, “You’re on baby. I’ll put up $1 billion of my bank’s money that it won’t.”

Now that sounds way too fanciful to believe, but that actually happened. That’s basically the scenario of Nick Leeson, of Barings Bank—and this type of unproductive (to us) pure gambling continues unabated to this day.

Leeson lost his bet on the Japanese stock market and made history. But he was followed by several other traders who took similar kinds of pure betting risks and lost — and this continued after 2008. Here are a few that became public: Jérôme Kerviel, a trader at Société Générale, France’s third-largest bank, a loss of €4.9 billion; Junior trader Kweku Abdoli of the London office of UBS took a loss of $12 billion.

Bruno Iksil of JPMorgan Chase & Co. worked in a part of the bank, the Chief Investment Office (CIO), whose job was to hold down the bank’s risk level by cautious investment strategies deserves special mention. His fellow traders stood so in awe at the size of his many bets that they searched for an adjective to capture them finding it in the casinos of Las Vegas where the highest of high rollers is called a Whale. When the Whale beached, it caused a loss of $6.2bn. That didn’t affect JP Morgan’s share price because a billion or so loss is a minor blemish on a bank’s mighty balance sheet.

The size of the losses obscured the nature of these completely selfish and unproductive bets for their own profit. Their only offense (by banker code) was exceeding their betting limit.

Kweku had a limit $100 million of bank capital that he was allowed to put at risk. He was a low-level trader. Do the math. How many traders like Kweku had — and have — authorization to bet with millions of dollars of bank money for their own commissions. Nobody has done that study.

There we see the new model of banking in action — using bank assets to earn commissions for themselves.

The new banker ethic of paycheck over country was best revealed in the bailouts when bankers used that money to continue their obscene level of pay and bonuses unabated.

From Bailouts To Dodd-Frank

Now we need a brief diversion into a bit of legal geek background: In bankruptcy, it is generally accepted that secured creditors get most of their money (secured creditors are usually banks that have mortgage like charges on the assets); unsecured creditors are lucky to get 10 cents on the dollar (unsecured creditors are any creditor that does not have a mortgage like security and includes, for example, bond holders), and shareholders get zilch.

If the banks had been permitted to go bankrupt, then those hedge fund guys would have been unable to collect their winnings, and the executives’ piggish pay would have come to a full stop. A truly satisfying result.

There was a problem. Because the banks had made all these bets among themselves, they were so interconnected that it even one fell, that one would bring down all the others. This condition is masked by the word “contagion” as if the banks were helpless victims instead of the instigators of a dangerous practice.

Our whole monetary system would collapse. We would be back to barter.

The then head of Treasury, Ex-Goldman Sachs CEO, Hank Paulson, presented the choice to the public as between the evil of total economic collapse or bailout.(There were alternatives but not presented SEE: To prevent a repeat of this blackmail situation, The Democrats and Republicans agreed that insolvent banks should be governed by the Orderly Liquidation Authority (OLA).

The bankruptcy process (like all legal procedures) has the velocity of a wagon wheel revolving through deep mud. In a bank crisis, there is a need for speed. If the public hears the word bankruptcy, there will be a massive run on the banks.

Dodd-Frank permits the FDIC (the Federal Deposit Insurance Corporation), as receiver under the OLA, to quietly walk into the bank head office, immediately take over the bank, discharge the Board of Directors, and transfer the bank assets free of most debts to a new bank instantly created for the purpose, and that has the legal right to use the name of the insolvent bank. No customer will be any wiser because the FDIC also has the funds to make sure that when a customer goes to an ATM, they will get the cash they want.

But the OLA was also given new powers to ensure that the senior executors would not get any of this funding. They must be fired. The FDIC also has the power to claw back two years of salary and bonuses.

As part of the debt disallowance, the FDIC would have the discretion not to pay on any of the fancy financial debts like the toxic CEOs and Credit Default Swaps that were the subject of The Big Short. All of these debt disallowance provisions are actually less extreme than what would happen in bankruptcy.

The shareholders of the old bank would become shareholders of the new bank that has arisen stealthily from the broken bricks of the old. So, in that way, it is better for shareholders than bankruptcy. Banks seem to be able to bounce back with proper management.

If the OLA is removed, we will be back to the forced choice of bankruptcy or bailout.

There is hope. While the House has passed the Financial CHOICE Act, it yet/still requires a 60-vote majority to pass in the Senate. Knowledge of the harmful effect of the financial Choice Act can spark opposition to defeat it! Pass it on.


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