Institution of Risk Analysis Newsletter — “Kabuki is classical ancient Japanese folk theater performed broadly and loudly for the general public. … Kabuki on the Potomac this week fits Kabuki’s theatrical definition with lawmakers wailing loudly, uttering angry threats, and rhythmically pounding podiums in a performance of mangled metaphors and fantasy.” –The Rag Blog

Despite bringing the world economy to its knees and costing taxpayers hundreds of billions of dollars in bailouts for events such as Bear Stearns, Lehman Brothers and American International Group (NYSE:AIG), the Masters of the Universe who run the largest Wall Street firms of have learned not a thing when it comes to credit default swaps (”CDS”) and other types of high-risk financial engineering. Indeed, not only are the largest derivative dealers fighting efforts to reform the CDS and other derivative instruments that caused the AIG fiasco, but regulators like the Federal Reserve Board and US Treasury are working with the banks to ensure that a small group of dealers increase their monopoly over the business of over-the-counter (”OTC”) derivatives. Why such a desperate battle for the OTC derivatives markets? For the world’s largest banks, the OTC derivatives markets are the last remaining source of supra-normal profits - and also perhaps the single largest source of systemic risk in the global financial markets. Without OTC derivatives, Bear Stearns, Lehman Brothers and AIG would never have failed, but without the excessive rents earned by JPMorgan Chase (NYSE:JPM) and the remaining legacy OTC dealers, the largest banks cannot survive. No matter how good an operator JPM CEO Jamie Dimon may be, his bank is DOA without its near-monopoly in OTC derivatives — yet that same business may eventually destroy JPM.

The key thing for the public and the Congress to understand is that the “profits” earned from these unregulated derivatives markets are illusory and do not cover the true risk of OTC derivatives. Put another way, on a systemic basis, risk-adjusted profits from OTC derivatives are not positive over time. As with the current crisis, the net loss from the periodic collapse of what is best described as gaming activity gets off-loaded onto the taxpayer, thus OTC derivatives must be seen as any other speculative activity, namely a net loss to the economy and society. But unlike taking a punt on a pony at the racetrack, bank dealings in OTC derivatives vastly increase systemic risk, make all banks unstable and threatens the viability of the real economy. …

By no coincidence, the Geithner Treasury just announced an initiative to improve the regulation of OTC derivatives. SIFMA and the large OTC dealers are making cautious noises of disapproval, but be not fooled by this Kabuki on the Potomac. As with past legislative efforts to “reform” the banking industry or protect taxpayers from large bank bailouts, the Washington game is already rigged. …

Despite the appearance of reform, the Treasury proposal announced last week still leaves the OTC market firmly in the hands of the large derivatives dealer banks. The industry is girding for battle to make sure that the dealers keep the ball in terms of overall control of the OTC markets. Armies of lobbyists and lawyers have been marshaled by JPM, the near-monopoly player in trading and non-dealer clearing in the OTC derivatives market with nearly 50% market share and the organization with the most to lose from true regulation.

Originally banks created swaps to help their customers manage financial risks. The contracts were a customer service, designed to enhance a bank’s existing relationship with its corporate clients. But early on the banks realized they could make huge profits from small differences in the prices they charged different customers entering into the agreements. Thus was born the deliberately opaque and secretive inter-dealer world of CDS, the market between and among the dealers themselves, which has become an engine for manufacturing the appearance of profits - even while increasing systemic risk. As the demand for swaps increased, banks learned they could effectively take the fixed value they received from one customer and pass it onto another, keeping a small piece of the action. In effect the banks turned into riskless middlemen, profiting by matching buyers and sellers. …

Even worse, with the US taxpayer now owning substantial stakes in most of the large dealer banks, what incentive does the US Treasury have to eliminate the banks’ last truly lucrative monopoly? In a very real sense, without the excess rents earned from the OTC markets, large dealers such as JPM, C and GS might not be viable in their present form. Remember, on a nominal basis, OTC derivatives appear to be the most profitable activity of many large banks. It is only when you assess the OTC derivatives dealing activity of large banks on a risk-adjusted basis does the value destruction become apparent.

One can only hope that reason will prevail, especially the version of reason that now prevails in the Senate, where there is little illusion about the true nature of the relationship between the large OTC dealer banks, the Fed and the Treasury. True reform of the OTC space would force most derivatives on exchange while leaving the banks free to offer customized risk management contracts to their customers, subject to stringent capital requirements.

But JPM and the other OTC dealer banks will fight to their last taxpayer dollar to stop that from happening. The only question now is whether the smaller banks, and the large Buy Side and other non-bank participants in the OTC markets, including some of the largest investment, industrial and energy firms in the world, can deliver the message to Washington that the current reform proposals for OTC derivatives are ill-advised and contrary to the public interest. (05/19/09)
more…