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Bill Black: Billions of derivative bets cannot be called a hedge but might
be allowed under weakend Volker rule

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PAUL JAY, SENIOR EDITOR, TRNN: Welcome to The Real News Network. I’m Paul Jay in Washington.

JPMorgan Chase announced they lost $2 billion in the derivatives market—more casino capitalism. What does this tell us about the continued systemic risk that the big banks (and holding the rest of society blackmail) are still involved in?

Now joining us to talk about all of this is Bill Black. Bill is an associate professor of economics and law at the University of Missouri–Kansas City. He’s a white-collar criminologist, a former financial regulator, and author of the book The Best Way to Rob a Bank Is to Own One. Thanks for joining us again, Bill.


JAY: So, first of all, is there any reason to think that this isn’t just JPMorgan, that this isn’t just some anomaly of one bank? Or is it? I mean, the way the press is playing this—and Dimon, the CEO of Morgan, is saying, well, we had some bad traders, it got out of our control, but don’t worry, we’re back on top of it. I mean, is there any reason to think this isn’t just as deeply systemic as it was in ’08?

BLACK: No, because the way the banks are fighting tells you that it is. So they’re fighting tooth and nail to be continued to be allowed to do what are called proprietary trades. And that just means they actually own the investment for their own purposes to speculate using financial derivatives. Now, Jamie Dimon himself, the CEO of JPMorgan Chase, says it’s improper for insured banks to be speculating in derivatives, except that his bank does that every minute of every day globally and is the biggest proprietary speculator in derivatives in the world.

JAY: Now, what was the speculation on in this one? This was about corporate bonds, was it?

BLACK: Well, first, remember, this area is incredibly opaque, so we’re going off of press accounts. We don’t truly know everything that was done. But here are the press accounts. Press accounts said that they had exposure to risk because of their bond holdings (so these bonds would not be derivatives) and that they decided to hedge their risk by engaging in a derivative of a derivative, purchasing sort of a derivative squared. And this derivative squared supposedly was an index of credit default swaps, of over a hundred of these credit default swaps, which are a financial derivative themselves and are guarantees against loss.

Now, these derivative of derivatives would never qualify as a real hedge. There’s been accounting literature about what a hedge is, and it’s supposed to be an offsetting position. So I’ve invested in one thing, I invest in the other, and if—the relationship between these two assets is when one goes down, the other tends to go up. Right? So it tends to offset risk. There’s no such track record of these kinds of investments. And they weren’t individual investments. These are massive sections of literally hundreds of billions of dollars of investment exposure. So there’s no possible way it would qualify as a hedge.

JAY: And my understanding is, when they started to realize—they being Morgan—that they were losing on these bets, they kind of couldn’t get out of them. They were in so heavily that to get out of them would have lowered the market value even more, and they were kind of stuck there.

BLACK: Well, again, we don’t know that that’s true, but it makes sense, and that comes to the next part. JPMorgan, because it’s the biggest and because many of these derivatives are relatively thinly traded, when it takes a massive position—and it took a massive position, measured in at least the tens of billions, and maybe the hundreds of billions, possibly even trillions because of the flaky way derivatives are counted—that was big enough that, first, it became known in the trade—people didn’t know exactly who was doing it at first, but they called it “the whale” because it was so massive. And that’s bad, because that means a single company is distorting the marketplace and the transaction, which is to say, there isn’t a real marketplace.

And as you say, in those circumstances, if I bought a huge chunk of this particular kind of derivative, if I want to sell it, whoa, I may have to take a terribly large discount. And the more I try to sell quickly, the bigger that discount—in other words, that loss—is likely to be. And that’s another reason why these things don’t qualify as a hedge.

Plus, when you do a real hedge, you have to monitor its performance. So it’s one thing that—historically it’s had this relationship that offsets. But we know sometimes historical doesn’t predict the future. So you’re supposed to—in fact, you’re required to monitor your hedges, determine whether they’re actually performing. And if they’re not performing, well, then you can’t call in the hedge and you have to fix it. And JPMorgan didn’t do any of those things.

So a hedge is supposed to, again, reduce risk of loss. Instead, this supposed hedge, which was really a speculative play, increased the losses.

Now, here’s the really scary part. They’re claiming even now that this qualifies as a hedge under the current version of the Volcker rule. And the Volcker rule was put in as part of Dodd–Frank at the suggestion of Paul Volcker for the explicit purpose of preventing exactly this kind of transaction. But the banks and the leader in the banks’ campaign against the Volcker rule has been JPMorgan and Jamie Dimon in particular, who has been brutally rude to Paul Volcker and incredibly arrogant, saying Volcker doesn’t understand anything about what he’s talking about. Now, Volcker’s the most prestigious financial person in the world, so this was really something coming from Dimon. Anyway, they not only stalled the rule; the current draft of the rule, according to JPMorgan Chase, would permit this complete non-hedge to be called a hedge and therefore to be permissible. Well, if that’s true, then they have destroyed the entire Volcker rule, and the next crisis is going to be that much bigger and that much quicker.

JAY: Well, if that’s JPMorgan’s interpretation of the current Volcker rule, it’s got to be the same interpretation all the other big banks will have, which means they’re likely all doing the same thing. So, you know, a few heads are going to roll here, and Dimon does his mea culpa on the Sunday morning talk shows. And then one scenario is life goes on. Or, six months from now, are we going to be looking back at this at the first sign of another big unraveling of the finance sector?

BLACK: Exactly. The incentive structure is terrible in banks in general because of the way executive compensation works, but it is particularly pernicious for these systemically dangerous institutions. These are the 20 largest banks in the United States, and about ten elsewhere in the world, where the administration is saying, and the Bush administration said as well, when—not if—when the next one of them fails, it will cause a global financial crisis, and therefore we’re going to bail them out. Well, they know that. If they know that they’re going to get bailed out and their creditors will get paid in full, well, then the creditors, it doesn’t make any sense for them to exercise any discipline. And so the rational strategy, say the conservative economists, is to scam the game. And the way you scam it is in very risky derivatives, by speculating in them, because—.

JAY: And in some ways they don’t even have to get bailed out. When you’re already getting essentially zero percent money from the Fed, you’re kind of getting bailed out before you need to get bailed out. You got so much cash that you can get from the Fed that in some ways some of your risk is already taken care of.

BLACK: Well, you’re subsidized as well as being bailed out. So there are two forms of subsidy to these systemically dangerous institutions. One is deposit insurance. That’s the express subsidy. But the implicit subsidy is that your creditors will be paid in full. Well, that means you can borrow money a lot more cheaply than your smaller competitors. Right? Your creditors are protected, so they don’t have to charge as much in interest rate, and that gives you a huge advantage against smaller competitors. Indeed, conservative economists, the metaphor they use is that these systemically dangerous institutions, when they compete with the smaller folks, it’s like bringing a gun to a knife fight. That’s a quotation from conservative economists. So this is crony capitalism at its worst.

JAY: Now, one of the things that’s been raised by Elizabeth Warren and Eliot Spitzer and some others is that Jamie Dimon’s actually a member of the New York Fed, and that’s—you know, they’re calling for his resignation, which I guess at least would be something symbolic, ’cause it won’t structurally change that much. But what does need to be done in terms of the Fed here?

BLACK: Well, the Fed is set up in a completely untenable conflict of interest. So the mantra of central banks worldwide is: we have to be totally independent. But that’s a footnote. That means independent from democracy. They are wholly dependent on the banks, they do the bidding of the banks, and they do it virtually worldwide.

And this is one of the symptoms and one of the means by which they control, and that is, all the supervision, virtually, in the Federal Reserve system is done through the regional banks. So these are the 12 Federal Reserve Banks of this, that, and the other place, of which New York, of course, is more equal than others by far. So this is the one Geithner came from, was president during the complete period when he failed to regulate and allowed this disaster. And as a reward for that, he was promoted to Treasury Secretary. And his boss was Jamie Dimon.

Now, imagine your boss is the person you’re supposed to regulate. That cannot work. And, indeed, that was the same setup in the federal home loan bank system among savings and loans (and I worked for one of those federal home loan banks) until 1989, when Congress answered this policy decision and it said, hey, this can’t work, this is an inherent conflict of interest. So it separated out the governmental, the regulatory function, and removed it from the federal home loan banks so that it would be purely governmental and you’d be responding only to government officials, not private officials, much less industry officials like Jamie Dimon.

So Congress needs to enforce that same policy rule. If that’s a real good rule for savings and loans, it’s an even better rule for banks, which are even more politically powerful in the modern era. But, unfortunately, there is no move in Congress to end this completely disgusting conflict of interest.

JAY: And how dangerous a moment do you think we’re in in terms of another financial unraveling?

BLACK: Well, you’re already seeing Europe going into full-scale unraveling, where the periphery is actually in Great Depression levels. And that has already the European—the entire eurozone was gratuitously put back into recession, a double-dip recession, by Germany’s demand for austerity principles. Those same kind of austerity principles are being demanded not just by Republicans but by substantial members of the Democratic Party, and even every once in a while by the president of the United States, who talks about we should be balancing the budget, which would be absolutely insane during a weak recovery from a recession. So the combination of those deficit hawks and the coming—well, the actually arrived European second crisis could easily put the United States back into a zero or even recession, zero growth or even recession within the next four to five months.

JAY: But in terms of the proprietary trading and the kind of shenanigans that led to the ’08 meltdown, where none of the banks could believe each other’s books and paralyzed all the interbank credit and such that seemed to really put things over the brink, if all this proprietary trading’s going on again and if there’s hundreds of billions of losses happening and they’re—are we not going to be right back in the same boat, where none of the banks believe any of the other banks’ books again?

BLACK: Yeah, as a white-collar criminologist, I’d really love to end the use of words like shenanigans to describe things like this.

JAY: Too mild, is it?

BLACK: Yeah, it really is part of the art of minimizing was going on. The crisis was driven overwhelmingly by fraud, and it was driven overwhelmingly by fraud in the C suites of our largest banks and savings and loans. And people need to remember that it was financial derivatives and proprietary trading in those financial derivatives that destroyed eight of the largest systemically dangerous institutions. So Lehman Brothers, Bear Stearns, Fannie, Freddie, Washington Mutual, entities like that were all destroyed by these financial derivatives. Now, we should be able to remember—I mean, this was only four years ago—actually, it was only three years ago for most of it—that this all blew up. And so we’ve lost the capacity to simply say no to the large institutions, no, you shall not do any of this.

JAY: Thanks for joining us, Bill.

BLACK: Thank you.

JAY: Thank you for joining us on The Real News Network.


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