Tag Archives: Dodd-Frank

Derivative Debacle Persists

By Barry Elias | Friday, 13 Nov 2015 06:53 AM

Taxpayers remain the backstop for risky swap derivative investments held by financial institutions.

In December 2014, the Congress rolled back provisions of the Dodd-Frank legislation as part of a must-pass government spending bill to prevent a total government shutdown. The original Dodd-Frank rules were designed to prevent future taxpayer bailouts of banks that arise from improper management of derivative contracts, including inadequate capital requirements for swaps.

The Federal Deposit Insurance Corporation (FDIC) recently estimated approximately $9.7 trillion of swap derivatives remain on the balance sheets of 15 banks that are registered as swap dealers. This represents roughly 4.4 percent of the total outstanding derivative contracts at these institutions and is comprised of $6.1 trillion in credit derivatives, $2.6 trillion in equities derivatives. and $1 trillion in commodity derivatives.

If the taxpayers did not insure these swap products, counterparties would require banks to hold more collateral to offset potential losses, and this would undermine bank profit margins. Swap trades enable financial institutions to exchange payment streams, typically to lower interest rates or currency risks.

Sheila Bair, the former chair of the FDIC, has stated the swaps repeal represented a “classic backroom deal.” “There’s no way this would have passed muster if people had openly debated it, so [the banks] had to sneak it on to a must-pass funding bill. For an industry that purports to want to regain public trust, it was an extraordinary thing to do,” said Bair.

The net worth of the financial industry has been negative for most of the past 20 years, reaching a nadir of negative $1.46 trillion in April 2007 prior to the financial crisis. Following an injection of approximately $29 trillion in credit by the federal government in the form of asset purchases, guarantees, and loans during the crisis, the financial industry reached a peak net worth of $1.93 trillion in March 2009, only to see it plummet with the end of quantitative easing: It stood at negative $809 billion in June 2015.

The financial industry has been greatly subsidized by the taxpayers for many decades. It’s time we implement the bank bail-in rather than the bank bail-out.

© 2015 Newsmax Finance. All rights reserved.

The End of Government Bailouts As We Know It

We may be witnessing the end of government bailouts as we know it.

The American International Group became a metaphor for the excesses of Wall Street. The global insurance giant found itself in this dire predicament by producing and marketing ill-conceived financial derivative products that were not properly regulated by federal authorities. The intricate and systemically fragile nature of these complex and opaque financial products metastasized throughout the global economic landscape.

The ensuing financial crisis devastated the world, severing more than $34.4 trillion of wealth off global equity markets valuations from the end of the third quarter of 2007 through the end of the first quarter of 2009 — a 54.6 percent decline to $28.6 trillion from $63 trillion, according to the Roosevelt Institute, a non-profit organization.

During this period, U.S. household wealth plummeted $13 trillion, or 19 percent — from $68 trillion to $55 trillion, according to the Federal Reserve Bank. In addition, nominal GDP contacted $500 billion, or 3 percent — from $14.8 trillion in the third quarter of 2008 to $14.3 trillion in the second quarter of 2009.

The Federal Reserve essentially took control of AIG by providing $182 billion in rescue funds, acquiring a 79.9 percent stake in the company, and replacing the chief executive officer. Despite this taxpayer support, the company issued executive bonuses of approximately $165 million and a bonus package for the entire firm of as much as $1 billion.

By the end of 2012, the U.S. government divested itself from AIG, receiving approximately $205 billion, generating a profit of nearly $22 billion.

In a recent class action lawsuit, plaintiff shareholders claimed the federal government intervention was illegal and sought $40 billion in damages. A recent ruling validated the unlawful nature of the governmental action, but the court awarded no damages. This plaintiffs plan an appeal.

Judge Thomas C. Wheeler of the United States Court of Federal Claims said the Federal Reserve did not have the legal authority to take executive control of the firm, since the Fed does not have jurisdiction over insurance firms. The repeal of Glass-Steagall in 1999 — which permitted insurance companies to engage the creation and marketing of financial products — created a regulatory vacuum for the financial business at AIG.

However, Judge Wheeler suggested this illegal activity actually added value to the firm, since the firm would have declared bankruptcy without any intervention. He therefore stipulated that the plaintiffs are not entitled to any monetary damages.

Supporting this notion, Wheeler cited John Studzinski, vice chairman of the Blackstone Group and an advisor to AIG, who advised the board of directors to accept the government’s offer of 20 percent equity in the company, since “20 percent of something [is] better than 100 percent of nothing.”

It seems the real victims of the AIG debacle are not the AIG shareholders: they are the world that suffered tens of trillions of dollars in lost wealth.

Judge Wheeler believes the banks were treated more favorably than AIG In fact, the Fed may have had more legal authority to intervene more forcefully with them.

While the Dodd-Frank financial overhaul legislation prohibits the Fed from assisting a single institution with capital injections, the new laws are ambiguous regarding equity stakes.

Notwithstanding this ambiguity, the future climate now favors less governmental intervention, since specific terms associated with tax payer subsidies may generate litigation.

As a result, untethered tax payer assistance of financial and non-financial corporations may be on the wane.

The real test is forthcoming, as hedge funds Pershing Square, Fairholme Funds and Perry Capital along with other investors await their day in court regarding government treatment of the Fannie Mae and Freddie Mac — mortgage companies that are now operated under the conservatorship of the Federal Housing Financial Agency.

These government sponsored entities received a federal cash infusion of over $200 billion after the financial crisis erupted, with a stipulation of a 10 percent dividend. In 2012, the terms of the agreement were amended: in lieu of dividend payments, the government would receive all the profits indefinitely. By the end of June, this figure may approach $230 billion.

These investors are staking a similar claim as that sought by the AIG shareholders.

We may be witnessing the failing of too big to fail.

© 2015 Newsmax Finance. All rights reserved.

Financial Disruption Begins to Take Root

The financial industry is feeling the effects of technological disruption, competition and regulation. This portends well for the investing public and a financial sector that has grown to unsustainable proportions.

In recent years, the U.K. increased financial transparency by unbundling the fee for investment advice and asset management. A decade ago, a fund manager might not have known the fees and a commission-based adviser might have been evasive.

As expected, with more transparency, the cost of these services has begun to fall.

Fund manager fees have fallen below 1 percent of assets, down from 2 or 3 percent several decades ago. Online stockbroker platforms are beginning to charge less than ½ of 1 percent on four-figure balances, and a new fund recently introduced a performance fee-only product. Peer-to-peer lending and crowdfunding provide additional technological alternatives that further competition and place downward pressure on the cost of investing.

Unfortunately, this type of unbundling has not yet occurred in the U.S. and might take several more years.

Mutual funds typically do not advertise the transaction costs associated with fund trading, which the client is responsible for paying. These costs can average 1.44 percent annually, more than the management fees and operational expenses combined, according to Roger Edelen of the University of California, Davis; Richard Evans of the University of Virginia; and Gregory Kadlec of Virginia Tech. Small-cap funds fared much worse, with trading costs of 3.17 percent.

Some passive index funds, which do not trade shares often, offer expense ratios that are 1/10 of those for actively managed mutual funds, which can range from 1.5 percent to 2.0 percent annually.

The research indicates that the greater the trading, the lower the net return to the investor. The annual return for mutual funds with trading in the top 20 percent lagged those in the bottom 20 percent by 1.78 percent.

The average investor might pay a total of 3 percent in management and trading expenses, nearly 1/3 of the annual return of 9.6 percent for the S&P 500 during the past 86 years.

Mutual fund investors and fund advisors pay broker-dealers $8.88 billion annually for account maintenance, shareholder servicing and revenue-sharing, according to a letter from Niels Holch, executive director at the Coalition of Mutual Fund Investors, to Mary Miller, undersecretary of domestic finance at the U.S. Treasury Department, dated Nov. 14, 2014.

Holch claims these payments are not warranted based on Section 120 of the Dodd-Frank Act, which would require the Financial Stability Oversight Council to issue recommendations to the Securities and Exchange Commission that would heighten standards that lower systemic risk to the financial system.

Notwithstanding this legislative requirement, technological disruption and competition could undermine demand for these investment vehicles and encourage more transparent reporting of the true transaction costs associated with their purchase, thereby lowering investor expense.

Technology might inspire greater competition, transparency and responsible regulation that levels the financial playing field for the many.
© 2015 Newsmax Finance. All rights reserved.

The Taming of Wall Street Continues: A Prudent Strategy

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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