JP Morgan et al - Not a decent banker around

By Martin Hutchinson in Asia Times Online

In the past week, the detailed revelations from JP Morgan's grilling in the US Senate have combined with the Cyprus rescue blunder to generate one inescapable conclusion: public or private sector, European or American, there isn't a decent, competent banker among them. Truly almost 20 years of funny money and 30-40 years of misguided deregulation have drained the financial sector of the quiet competence it used to exhibit. 

I wrote about JP Morgan's "London Whale" derivatives insanities of early 2012 a few weeks ago. It demonstrated two failings that appear to me unforgivable. First, in spite of the experience of 2007-08 Morgan was still using value-at-risk as a major element of its risk management. 

Kevin Dowd and I pointed out the irretrievable flaws in this methodology in Alchemists of Loss, published in June 2010 - and we were by no means alone in doing so, though we may have had a "better mousetrap" than others in terms of an alternative risk management approach. A bank of Morgan's stature has a duty to keep up with the literature; it's as simple as that. 

The second failing is even more fundamental, because it rests on what Morgan thinks a bank should be doing. Bruno Iksil, the London Whale, was attempting to "corner the market" in an obscure and artificial credit default swap (CDS) contract. 

First, credit default swaps are not solidly based, because their settlement procedure can very easily be "gamed" - rather than the current procedure it would make more sense to select a random number between 1 and 100 as the percentage of the contract that was paid out on default. Second, index CDS contracts are doubly artificial, because the index itself is constructed as a basket of credit default swaps, none of which themselves trade with any liquidity; thus the index itself can be "gamed." Third, Iksil was trading in an "off the run" index, constructed five years previously, whose liquidity was even more restricted and whose relationship to any underlying reality was even more attenuated. 

JP Morgan would have done better to put their capital on red in Las Vegas. The CDS index Iksil was trading was so far removed from reality it was a mere gambling chip, with no underlying economic meaning. His trading volumes were so large that he controlled the market, which enabled him to report spurious profits until the beginnings of responsible risk management forced him to begin unwinding the position. His activity bore no relationship to true banking; it served no legitimate financial purpose, nor did it serve the financing or risk management needs of any client. 

This is the real problem of derivatives markets in general; the genuine client service they provide is minor, in some cases infinitesimal, compared with the gambling and manipulation activities they enable. If you are JP Morgan, and privy to a great deal of information about market movements to which less exalted institutions do not have access, you can make good money by exploiting others' ignorance. But make no mistake, the immense profits made in these markets are not secured by providing genuine service to clients, any more than Las Vegas casinos make money by providing investment opportunities to their foolish punters. In the final analysis, both activities are almost purely parasitic, and should be severely discouraged if not prohibited altogether. 

The only problem with prohibiting these activities is that the prohibition would have to be designed and enforced by public sector regulators. Public choice theory suggests that they are not capable of performing this function adequately and the Cyprus imbroglio shows just how inept and conflicted they are in reality. 

Legally, if US$7.2 billion was required for the Cyprus bailout beyond the European Union loan (the accuracy of that calculation is of course unverifiable), then the Cypriot banks' subordinated loans should have been wiped out, and the necessary amount taken from the banks' senior debt and uninsured depositors. (Any amount taken from insured depositors would have had to be made up by the Cyprus government, so would have added to the bailout need.) 

Instead, the proposed bailout took a 9.9% tax from depositors above 100,000 euros (the deposit insurance limit) and a 6.7% tax from deposits below 100,000 euros, which were theoretically insured, while leaving the modest amount of senior debt untouched. 

The Cyprus government rejected these terms, not because of the taxes' effect on small Cypriot depositors or on the Cypriot deposit insurance system, but because of their effect on the Russian mafia thugs who contribute about a third of the Cypriot banking system's deposits. One can only guess what inducements, positive and negative, the big depositors gave to the Cyprus legislature to take that position. 

Legality seems to have been utterly irrelevant to those arranging the bailout. Instead, by arranging a "tax" that fell so heavily on small depositors, they blew a hole in deposit insurance schemes worldwide. Depositors in banks elsewhere in the EU, or indeed the United States, can no longer believe that the first $100,000 (or whatever figure is "insured") of their savings is secure. 

Inevitably, calls upon the deposit insurance scheme will be made in times of financial stress, and at those times governments can use the depositors' funds to recapitalize the banks or indeed themselves. In 2008, depositors in Western Europe and the US could be reasonably confident that their governments were in decent financial shape, so would have no need to raid their citizens' piggy banks. In the next financial crisis, thanks to years of foolish, indeed evil, monetary and fiscal "stimulus" there will be no such assurance. 

I wrote some months ago about the problems involved in going back to a world in which government bonds are no longer a reliable store of value, and suggested that such a change would reverse 350 years of financial history, taking us back to the time before the establishment of the Bank of England in 1694. 

A world in which neither government bonds nor banks are to be trusted takes us back about 400 years further. After all, Samuel Pepys only occasionally buried his money in the back garden; most of the time he entrusted it to a reliable goldsmith, the precursors to the London merchant banks. The goldsmith-bankers were new in Restoration England, but as Edward, Earl of Clarendon wrote in his memoirs around 1670, before their time, the scriveners had been available for "money business''. A world without banks takes us back before the scriveners, before the first Italian banks (Monti dei Paschi di Siena, 1472) and even before the Lombard moneylenders of the fourteenth century. 

Needless to say, pushing our financial system back close to the Dark Ages will do nothing whatever for global economic well-being. A world without banks is a world in which all trade must be financed by merchants themselves, in which investments must be financed entirely out of equity or ad hoc loans from those with money. 

While much of Silicon Valley currently finances itself on close to this basis, it is unimaginable that business as a whole can do so; the needs of fixed assets, inventory and receivables are simply too great. A world with 13th century finance is more a less a world with 13th century living standards - and for only a 13th century world population. 

We thus live in a world in which neither the managers of JP Morgan nor the financial wizards of the European Union have the slightest awareness of the basic needs of a sound financial system. 

Admittedly the two problems cancel each other out: provided governments remain solvent both the need for deposit insurance and the speculative games of the trading desks can be eliminated by going back, not to the Dark Ages, but only to 1914. At that time, banks did not have deposit insurance, so depositors were forced to assure themselves that deposit institutions were soundly managed. 

This pretty well put paid to speculative games: the Knickerbocker Trust of New York went bankrupt in 1907 through speculation in the copper market, and for at least the next two decades it was accepted that speculation had no place in a soundly run deposit-taking bank. (Investment banks existed, but they were separately capitalized and did not rely on the bank's depositors for funding.) 

Without deposit insurance, banks would have to be properly capitalized, with a tangible capital base of no less than 20% of assets - calculated not on a "Basel" formula in which some assets are defined as "low risk" and discounted accordingly, but in which all assets and liabilities are fully reflected in the balance sheet. Only with such a heavy capitalization could depositors be sure the banks would stay in business. 

What's more, derivatives, securitization and other off-balance sheet risks would have to be undertaken by separate companies that did not themselves take deposits; bank depositors would insist that all such risks be taken onto the bank's balance sheet, which would make them impossibly costly. 

In order to discourage speculative activity further, it would also be necessary to return to a strict gold standard (or other commodity standard). The 1920s gold exchange standard, with the Federal Reserve able to increase credit at will, proved impossibly dangerous to the banking system after 1929, so a banking system with an active Fed would over time prove unable to attract depositors because of its risk. 

I'm quite certain that both the management of JP Morgan and the EU bureaucracy would regard such an alternative as wholly unacceptable - it would, for one thing, restrict sharply the ability for self-remuneration of both bankers and bureaucracies (which would have to finance themselves in a bond market without bank lenders, strong intermediaries or fiat money). 

However, by their ineffable folly, they have brought such a world (or the much worse dystopia where we lose 750 years of financial progress altogether) very much closer. 

Martin Hutchinson is the author of Great Conservatives(Academica Press, 2005) - details can be found on the website www.greatconservatives.com - and co-author with Professor Kevin Dowd of Alchemists of Loss (Wiley, 2010). 

So how long can the US hold the world to ransom with the dollar?

Satyajit Das

On 8 November 2010, the German finance minister Wolfgang Schäuble told the Wall Street Journal: "The USA lived off credit for too long, inflated its financial sector massively and neglected its industrial base."

US gross government debt currently totals around $16trillion (£10trn). The US government holds around 40 per cent of the debt through the Federal Reserve and government funds. Individuals, corporations, banks, insurance companies, pension funds, mutual funds, state or local governments, hold 25 per cent. Foreign investors, China, Japan and "other" (principally oil exporting) nations, Asian central banks or sovereign wealth funds hold the rest.

Historically, America has been able to run large budget and balance of payments deficits because it had no problem finding investors in US Treasury securities. The unquestioned credit quality of the US, the unparalleled size and liquidity of its government bond market, ensured investor support. Given its reserve currency and safe haven status, US dollars and US government bonds were a cornerstone of investment portfolios of foreign lenders.

During this period, emerging countries such as China fuelled American growth, supplying cheap goods and cheap funding – recycling export proceeds into US bonds – to finance the purchase of these goods. It was a mutually convenient addiction .

Asked whether America hanged itself with an Asian rope, a Chinese official told a reporter: "No. It drowned itself in Asian liquidity."

Given the sheer quantum of US debt, foreign investors may become increasingly less willing to finance America. Japanese and European investors, struggling to finance their own government obligations, may simply not have the funds.

Given its magnitude and the lack of political will to deal with the problem of debt and public finances, the US is now deploying its FMDs – "financial extortion", "monetisation" and "devaluation" – to finance its requirements.

In a form of extortion, existing investors like China must continue to purchase US dollars and bonds to avoid a precipitous drop in the value of existing investments.

Debt monetisation – printing money – is another strategy. The US Federal Reserve is already the in-house pawnbroker to the US government, purchasing government bonds in return for supplying reserves to the banking system. Expedient in the short term, monetisation risks setting off inflation. The absence of demand in the economy, industrial over-capacity and the unwillingness of banks to lend have meant successive "quantitative easing" has not resulted in higher inflation to date. But the risks remain.

Monetisation is inexorably linked to devaluation of the US dollar. The zero interest rates policy and debt monetisation is designed to weaken the dollar. As John Connally, the US Treasury Secretary under President Richard Nixon, belligerently observed: "Our dollar, but your problem."

Despite bouts of dollar buying on its safe haven status, the US dollar has significantly weakened over the last two years, losing around 20 per cent against major currencies since 2009. As the dollar weakens US foreign investments and overseas income gain in value. But the major benefit is in relation to debt owned by foreigners. As almost all its government debt is denominated in US dollars, devaluation reduces its value.

This forces existing investors to keep rolling over debt to avoid realising losses. It encourages them to increase investment, to "double down" to lower their average cost of US dollars and debt. It also allows the US to enhance its competitive export position.

Major investors in US government bonds now find themselves in the position John Maynard Keynes identified: "Owe your banker £1,000 and you are at his mercy; owe him £1m and the position is reversed."

Valery Giscard d'Estaing, the French finance minister under Charles de Gaulle, famously used the term "exorbitant privilege" to describe the advantages to America of the dollar's role as a reserve currency and its central role in global trade.

That privilege now is not only "exorbitant" but "extortionate". How long the world will let the US exercise it is uncertain.

Satyajit Das is a former banker and author of "Extreme Money" and "Traders, Guns & Money"