Nearly seven years after the global economic meltdown, the financial system remains risky.A major area of concern is the $700 trillion global swaps market. Swaps are derivative products that permit entities to exchange cash flows from different investment products: the result is a more hedged and diversified portfolio that does not require the purchase or liquidation of the underlying securities by any of the counter parties involved.
This market has been dominated by several U.S. banks including Goldman Sachs, JP Morgan Chase, Bank of America, Citigroup, and Morgan Stanley. Prior to the 2007-2009 collapse, it was virtually unregulated. The financial implosion was the result of insufficient collateral held by clearinghouses to ensure payment to the appropriate parties. That is, too often the losers were unable to pay the winners timely and in full. Notwithstanding taxpayer intervention and subsidies, risky derivative bets of this nature taken by the foreign affiliates of American International Group would have bankrupted the U.S. parent.
Despite the 2010 Dodd-Frank legislation – which required the existence of adequate capital reserves in the system – many banks transferred these trades to offshore affiliates and escaped regulation by the U.S. Commodity Futures Trading Commission. This occurred even though the affiliate is included in the consolidated financial statement of the U.S. parent company, since financial guarantees by the parent for the foreign affiliate did not exist or were removed.In a recent unanimous 4-0 ruling, the CFTC recommended that an appropriate level of collateral reserves needs to be in place for these foreign affiliates when there is no explicit guarantee for these trades by the U.S. parent company. This ruling will be applied to roughly 60 firms world-wide that deal in this area. After a comment period, the CFTC will vote again on this recommendation for approval.
Unfortunately, excluded from these rules are trades between the foreign affiliates of U.S. banks and their clients when the parent firm excludes the foreign affiliate from their financial consolidated statement or does not guarantee the affiliate’s trades. This half of the puzzle needs to be addressed as well to ensure lower systemic risk across the globe.
Another area of concern to regulators is the leverage loan market. Leveraged loans are obtained by private equity and debt groups to purchase and restructure companies. Divestitures and operating profits are then used to service and retire the debt, generating a more positive bottom line.
Since the global financial implosion, these loans skyrocketed from approximately $75 billion in 2009 to $600 billion in 2013 – a 757 percent rise. A 2013 audit by regulators showed that nearly one-third of these loans were structurally unsound. Around this time, the U.S. Federal Reserve, Office of the Comptroller of the Currency, and Federal Deposit Insurance Corporation provided more stringent guidance for financial institutions that utilize client deposits to secure these loans.
In recent years, banks have begun to exit this space: in 2014, leveraged loans in the U.S. fell to about $500 billion, and year-to-date figures for 2015 imply an annual amount of $400 billion. However, the void is now being filled by shadow banks and private debt funds that are not subject to federal regulations, since they not use client deposits for financing. The three largest firms in this space now control nearly 8 percent of the market: they are the Jefferies Group, Nomura Holdings, and Macquarie Capital. The market is seeing a strong exodus from banks under regulatory supervision to shadow banks that are not.
The banks and non-bank entities typically repackage these loans and sell them to investors. They essentially mitigate their risk by transferring it to external investors. Global investor interconnectivity that results from the massive creation of derivative products further increases world-wide systemic risk.
Bankers are not happy with this unequal treatment, since they lose business to competitors. We, as a society, should not be happy for a different reason: taxpayers may be asked once again to bailout financial institutions for their risky behavior if the process unfolds badly – as it did about seven years ago.
The economic malfunctions that we are experiencing are directly proportional to financial mismanagement over many decades. It will probably take another decade or so for us to experience more solid ground.
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