In response to my previous post, A simple remedy for a Wall Street danger, reader RajV sent me a pointer to the video below with the introductory remark:

It is mind-boggling that such controls are not already legislated on these banks. I came across this article that shows the caliber of people at the helms and the greed at work:

Michael Lewis, a member of Princeton’s Class of 1982 and author of such books as “Liar’s Poker” and “Moneyball,” speaks at the 2012 Baccalaureate in a speech called “Don’t Eat Fortune’s Cookie.”

By the way, RajV, among his other sterling qualities, is perhaps the most mathematically astute person that I have ever worked with. I presume that he won’t blush for my having said so.

Only in America ccould this Reuters article, “It’s a boson:” Higgs quest bears new particle, appear in a political blog.  Only in America would the following statement describing the standard model in physics be controversial:

It is the last undiscovered piece of the Standard Model that describes the fundamental make-up of the universe. The model is for physicists what the theory of evolution is for biologists.

I think I like the following description of the Higgs boson.

Scientists struggling to explain the theory have likened Higgs particles to a throng of paparazzi photographers; the greater the “celebrity” of a passing particle, the more the Higgs bosons get in its way and slow it down, imparting it mass; but a particle such as a photon of light is of no interest to the paparazzi and passes through easily – a photon has no mass.

A local newspaper has this column, A simple remedy for a Wall Street danger, behind a pay firewall. The article is by

James M. Stone, former chairman of the Commodity Futures Trading Commission and commissioner of insurance for Massachusetts, is CEO of the Plymouth Rock group of property and casualty insurance companies.

It should be safe to assume that James M. Stone knows what he is talking about, at least until proven otherwise.

A few quotes from the article ought to be enough to boggle your mind.

All three of the largest US banks have open derivatives positions in excess of 24,000 percent of their equity capital. Neither models nor markets can protect them from small percentage imbalances. In addition, bank trading relationships around the world are so interconnected that if one goes down all are threatened. No CEO or board of directors, however talented and honorable, can oversee trading at the multi-trillion dollar scale with perspective and precision enough to assure the avoidance of systemic impairment. Nor can any government oversight body.
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Bank lobbyists insist that all this trading is needed to facilitate commercial transactions, but don’t be fooled. The open derivatives positions at the three largest US banks exceed twice the GNP of the world. Add in large European and Asian banks, and the commercial hedging argument becomes a parody.
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Under present rules, banks are free to put us all at risk in derivatives trading without creating any offsetting cushion. Every derivatives transaction involves some basis risk (that two paired commodities will not continue to move in unison), some counterparty risk (that the trade will not honored by the other party), and some human error risk. Accountants and regulators know well that netting massive positions to zero cannot reflect true exposure.

Among other people who understand the problems of “netting massive positions to zero” are mathematicians, computer scientists, chemist, physicists, and engineers.  Let me see if I can present an example to people who might not get the implications of what Stone is saying.

Supposing that a bank’s $75 trillion in derivatives positions consist of $37,501,000,000,000 on one side of a transaction and $37,502,000,000,000 counterbalancing position.  The unbalance between these two positions is 0.003%.  That would be an amazing accuracy to achieve in any human endeavor.  The only issue is that the approximately 0.003% imbalance amounts to $1 billion dollars.

So you say, $1 billion is a lot of money, but it is small potatoes compare to $75 trillion.  Taking Stone’s figure of derivatives positions of over 24,000 percent of equity capital gives a figure of about $312 billion of equity capital.  That still seems pretty big compared to a $1 billion loss.  However, $312 billion equity capital is only 0.4% of the derivatives positions.  If there were a mistake of 0.4% in the balance of the positions that turns out to be a realized loss, then the bank’s equity capital is wiped out.

Leverage is a wonderful money making tool if it doesn’t turn against you.  Also compare the $75 trillion of private leverage to the $14 trillion in government debt that has the Republicans so concerned.

So let me cut to the chase and give you Stone’s proposed solution:

Whenever a new position is taken, there should be a mandatory accompanying reserve or capital charge. This would have a two-fold benefit. It would increase protection for both the public and the banks and it would dull the appeal of hazardously oversized trading accounts. Although regulators should set the actual amounts, imagine that the charge was uniformly 0.1 percent of the notional position value. Open positions of $75 trillion in derivatives would require $75 billion put aside, an amount large enough to make that trading scale unappealing. Charges to match the risk created would bring trading volumes back to sensible size with a minimum of new regulations and no need to outlaw useful commercial practices. They would simply acknowledge that all derivatives positions, however useful, impose some risk on the holders and the public. Current scale imposes an unmanageable risk.

It is a shame that this article is behind a pay firewall meaning that more people will not get to read the article.

July 5, 2012

RichardH has discovered that the article has emerged from behind the paywall. A simple remedy for a Wall Street danger appeared in The Boston Globe.

The UK Daily Mail has the story Presidential candidate Mitt Romney owns offshore company which means he could be even RICHER than the estimated $250million.

The use of offshore companies such as Sankaty is allowed under U.S. tax laws. They are typically set up as shell corporations by private equity and hedge funds to route investments from large foreign and institutional investors, such as large pension plans, into corporate takeovers.

The money is used to provide equity and buy up debt. In turn, the investors gain U.S. tax advantages by passing their funds through the offshore ‘blocker’ corporations, avoiding a high 35 per cent tax on earnings that the Internal Revenue Service describes as ‘unrelated business income.’

This story has details of tax dodges that most of us could never even imagine.  If Romney and his ilk were not so adept at using their financial clout in Congress to mold the tax laws to their liking, they would not be nearly as rich.  It is easy to win a game by following the rules scrupulously, when you, yourself, make up the rules to follow.

If members of Congress cannot be convicted of accepting bribes for enacting this tax treatment, then perhaps they could at least be convicted of conflict of interest.  Who do you suppose is going to bring these charges and prosecute the cases?

In the article America the greatest?, Leonard Pitts, Jr. sums it up perfectly:

True greatness, after all, is not declared. It is achieved.