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The new financial "reform" bill is sending ripples of
fear through Wall Street and the international financial markets and as
with health care reform, the unintended consequences are likely to be as
significant as the short term negative market response.
The stock market was trying to recover, albeit in the context of a big decline
on Thursday afternoon. But as the Senate passed its financial reform bill, U.S.
stocks tumbled, and ended at their lowest levels of the day. Now, Wall Street
and some in the international financial arena who do banking business in the
U.S. are starting to shiver at the thought of what could lie ahead.
At the center of the problem is the derivative issue. Banks want to hedge their
risk with derivatives. The problem is that if that if the lines are blurred between
investment banks and deposit banks, there is no way of knowing what the institution
is using for collateral. That's why when things go very, very wrong, as they
did for hundreds of banks who bought CDOs on subprime mortgages, which are derivatives,
and when the CDOs went bust, the banks failed. They were using depositor money,
directly or indirectly as collateral.
The banks don't see anything wrong with that. The government, surprisingly does.
And the government is conceptually correct. The problem with this scenario, as
we have said here ad nauseum, is that this is as much the government's fault
as it is the banks' fault. That's because the government repealed the Glass-Steagall
act during the Clinton years, at the behest of then Fed Chairman Alan Greenspan
and Wall Street lobbyists. The Glass-Steagall act was put in place after the
Great Depression because this is the same sort of thing that happened then. So,
the government, actually did something right. They separated deposit banks from
investment banks.
Here's the problem, though. Glass-Steagall was a known quantity. Banks didn't
like it, but they had had 70 years of it and it was imbedded in the culture.
This new "reform" bill is an unknown. So, banks and investors are panicking,
because they don't know what's in the black box.
According to The Wall Street Journal: "The most important set of changes relate
to derivatives, which are contracts with prices tied to other market instruments.
While the House bill required some derivatives to be cleared to reduce the risk
of nonpayment, the Senate version could force Wall Street firms to keep derivatives
separate from their bank units—or even spin them off entirely." And what's most
important is this: "Clearing requires both parties to a trade to post collateral
with a central clearinghouse to ensure that each side can absorb losses." That
means that if you want to trade derivatives, you're actually going to have to
prove that you can pay off the bet if it goes against you, before you make the
transaction.
That implies that somewhere along the trade's path, someone will know what the
banks are up to. And that means that Goldman Sachs, Merrill Lynch, and the rest
of the banks who ran an off the books marekt with credit default swaps and collateralized
debt obligations (CDOs) wouldn't be able to do it in secret anymore. Instead
of a rumor, or an inside the loop secret, the risk that these banks would take,
especially with other people's money, would be known.
That bothers the banks because it would even the playing field. The rest of us
could then make better bets with them or against them, and stand to make as much
money as they do. Somehow, that's unfair?
We're not sticking up for the government on this. We think that the subprime
mortgage crisis and the resultant disasters were spawned by Clinton, Bush, and
their Congresses, whose unrealistic expectations about home ownership led to
this mess. But, Wall Street, and their international counterparts had plenty
to do with it as well, as did the migrant farm worker with a $14,000 per year
income who got a subprime mortgage on a million dollar house, and the flippers
on HGTV who would take a house, put some cosmetic work into it and sell it in
a month.
This whole thing is a tale of politicians who perhaps had good intentions, but
no real life experience putting an untested idea into play and letting a bunch
of guys with computers and unfettered greed run loose. It's also a failure of
the education system which doesn't teach children, or adults about finance, and
realistic expectations.
So why is Wall Street all worked up? Because they can't make as much money if
they don't trade derivatives. According to The Journal: "Guy Moszkowski, an analyst
at Bank of America Merrill Lynch who follows banks and securities firms, estimates
that derivatives account for half of all trading revenue at the biggest firms.
At J.P. Morgan Chase & Co., the second-largest U.S. bank in assets behind
Bank of America Corp., derivatives generate an estimated 8% of the company's
total revenue. The legislation could cut derivatives-related revenue by 30% to
50%, according to Mr. Moszkowski. Had that occurred in this year's first quarter
without any offsetting declines in fixed expenses or capital, per-share earnings
at J.P. Morgan, Goldman Sachs and Morgan Stanley would have been at least 16%
smaller than what the three companies reported. Citigroup Inc.'s profit per share
would have shrunk by 7%."
Conclusion
Health care reform is correlated with the acceleration of the number of physicians
in Texas who are opting out of Medicare. That was an unintended, but predictable
consequences, if you understand Chaos Theory. But apparently not one that Washington
either thought about or cared about that potential outcome. Or as some cynics
suggest, maybe that was their intention, to run physicians out of Medicare so
that they could save money.
Now, Washington is reforming the financial system. The consequences are not likely
to be very pleasant there either, although you have to admit, some of these crazy
things have to stop.
Our point is that Washington thinks linearly in a Chaotic Universe. They don't
understand how the world works. Wall Street thinks Chaotically, which is why
they make so much money taking advantange of the loopholes that Washington's
linear thinking leaves open.
Linear thinking expects that A + B = C, always. Chaotic reality proves that A
is not always A, B may not be B, and that C is predictably unpredictable. Thus,
outcomes are murky, and life is predictably unpredictable. You can't force linear
logic on a Chaotic Universe. Yet, Congress and politicians try to do it all time.
And they fail on a regular basis, because their line of thinking and their logic
is unnatural.
The problem is that Washington doesn't get it, while Wall Street gets it too
much, and usually goes too far in its pursuit of Chaotic solutions to problems
created by linear thinking.
The bottom line is that we are in the midst of a very dangerous time for the
financial markets, and now for the economy. And the blame will fall on Congress,
The White House, and Wall Street. The problem is that Main Street, those of us
who actuall live in the real world, are going to have to foot the bill.
We'll be on Twitter
some time today before the market closes with some updated comments.
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