Welcome to another episode of Greedy Bastards Antidote — a podcast series that zeroes in on “Greedy Bastardism” in our country, and highlights the people out there who are finding the “Antidotes.” Dylan will be talking to the heroes and the visionaries out there on the front lines of education, health care, the environment, trade, taxes, finance and government, all of whom are finding solutions to America’s biggest challenges — and doing it creatively and fearlessly.

This week, we’re focusing on the swaps market — not only to learn exactly what credit default swaps are, but why they’re one of the favorite financial products of Greedy Bastards. This is the one market that betrays every fundamental principal of American values — it is not transparent, it does not require collateral if you’re a AAA rated bank, and you can sell insurance globally on credit.  This incentivizes clients to buy them by offering  lower interest rates (and who doesn’t want that?)

To help define exactly what “swaps” are, we got to talk to someone who knows them inside and out — Christoper Whalen of Institutional Risk Analytics and author of the book Inflated: How Money and Debt Built the American Dream.  You can chat with him on Twitter @rcwhalen.

What is a credit default swap? Here’s how Dylan explains it:  “The credit default swap literally has that equivalency in which AAA rated financial institutions sell insurance, so to speak, on credit—they allow you to reduce your interest rates, they allow companies and countries and individuals to benefit from, in the short term, reduced borrowing costs because of the insurance that was purchased in the swap, as they like to call it.”  These are not transparent, because they are not traded on any public exchange.  Lack of transparency means that no one, exactly, knows where the risk is or how much risk there is.

Why do Greedy Bastards love swaps?  Dylan explains it this way.  “The genius of the Greedy Bastards maneuvering in the swaps market is the following:  After collecting the revenue for all the insurance that you’re selling and all the credit and debt of the world—by the way, the more debt there is, the more insurance you can sell—when the insurance claims come from default on that credit, you don’t have to pay a penny because you, my friend, are too big to fail,” says Dylan.  “This is a market that has been created to basically protect the profitability of these banks that could be put on exchange but the barrier to doing it is the threat to their profits and the ability to do that is from money and politics.”

What’s an example of how a credit default swap functions?  Chris Whalen provides this example:

When JPMorgan does a credit default swap with a customer, they keep the collateral.  There is no separate trust company that is part of the exchange that holds all the money the way you do in a good poker game.

So nobody knows if it’s fully collateralized or not because they’re trusting JPMorgan to operate their business in a prudential way.  Until we had the minor reforms of Dodd-Frank and the Corrigan Group before that, the dealers weren’t posting any margin with one another.  It was all naked.  And so the first thing that Corrigan did when he started getting people focused on this was to force the dealers to require minimum margins from one another.  That was the problem.  The systemic risk was actually among the big dealers.  They dealt with that somewhat but look at Dodd-Frank, they didn’t touch the bilateral relationship between the client the dealer bank.

So if I am the customer, and I’m dealing with JPMorgan, I can’t go to any other bank because all these contracts are bespoked, they’re all different.  I can’t get another bank to net me out, so that’s the problem.  On an exchange, all contracts are fungible—I want to go long, I want to go short, whatever it is, I do my trade, I don’t even know who the other counterparty is because I’m dealing with the exchange.

Swaps were just a new way for banks to generate income, even as they became less and less relevant:  “As the U.S. economy and especially Wall Street and the banks were less and less focused on funding and financing real economic activity jobs, factories, commerce, the rise of the ersatz virtual world of credit faults swaps and over-the-counter derivatives, all of these gray markets—that are unregulated, that are not traded on exchanges, that have no transparency—were really a way for banks to generate income because they could no longer make their money on the real economy,” says Chris.  “And the Fed encouraged this.  If you go back to the ‘80s, the LDC debt crises when a lot of the big U.S. banks like Citi almost failed, they realized that between technology, innovation, deregulation of markets, the profitability of the old banking business, at least as far as big banks were concerned, was ebbing.  So the solution, if you will, was for the Fed to encourage things like Basel II, this whole global regulatory mirage that we have, and at the same time they said, “Oh, it’s okay for you to create off balance sheet entities, it is okay for you to trade these derivatives that are not at all regulated or subject to disclosure,” and the banks have done exactly that,” he explains.

What is the “Antidote” to this form of Greedy Bastardism?  You want to have an exchange traded product, you want to have full public disclosure of all trading every day so we can see all prices for all trades, and you want to require physical delivery of the underlying asset,” says Chris.  “In other words, you own a bond, a loan, it could be commercial paper, even a vendor.  Let’s say you are big vendor and you have credit exposure with a bank and you want to hedge it.  That would be okay, you could deliver the accounts receivable for your insurance payment.  That’s what we need.  It’s to re-link this derivative market with the real world.  And then we’ve got something,” he explains.

For the full conversation, check out the transcript below. 

- Meg Robertson is a digital producer for DylanRatigan.com.

 

Show Transcript

Dylan: Welcome to another episode of Greedy Bastards Antidote. Today, we’re talking swaps, Greedy Bastards’ favorite financial innovation of the past ten years. Think of a swap as an opportunity for you to collect money for, I don’t know, the Brooklyn Bridge and then when the actual bridge needs to be dealt with, well, you don’t actually own it, do you?

The credit default swap literally has that equivalency in which AAA rated financial Institutions sell insurance, so to speak, on credit—they allow you to reduce your interest rates, they allow companies and countries and individuals to benefit from, in the short term, reduced borrowing costs because of the insurance that was purchased in the swap, as they like to call it. The genius of the Greedy Bastards maneuvering in the swaps market is the following: After collecting the revenue for all the insurance that you’re selling and all the credit and debt of the world—by the way, the more debt there is, the more insurance you can sell—when the insurance claims come from default on that credit, you don’t have to pay a penny because you, my friend, are too big to fail.

And joining us today, a man with an antidote to this mighty swaps problem and this great tool of the Greedy Bastards, an old friend and neighbor and a man who knows from where he speaks, Christopher Whalen, Editor of the Institutional Risk Analyst, a weekly news analysis and commentary published on risk and, of course, the global political economy published by Institutional Risk Analytics. Chris is the author of the book Inflated: How Money and Debt Built the American Dream. You can follow him on Twitter at @rcwhalen.

With no further ado, a man fresh out of the laboratory with an antidote to fight the Greedy Bastards and their evil dastardly swaps, Chris Whalen. Just how much of a tool for the Greedy Bastards of this world is or are credit default swaps?

Chris: Well, you described it very well, Dylan. It’s a way of selling insurance on anything really; the Brooklyn Bridge is a good example. You could sell people insurance on the Brooklyn Bridge collapsing, it would have the same validity as what goes on in the markets every day. But for people who don't follow this stuff for a living the way you and I do, the way I explain this is that as the U.S. economy and especially Wall Street and the banks were less and less focused on funding and financing real economic activity jobs, factories, commerce, the rise of the ersatz virtual world of credit faults swaps and over-the-counter derivatives, all of these gray markets—that are unregulated, that are not traded on exchanges, that have no transparency—were really a way for banks to generate income because they could no longer make their money on the real economy.

And the Fed encouraged this. If you go back to the ‘80s, the LDC debt crises when a lot of the big U.S. banks like Citi almost failed, they realized that between technology, innovation, deregulation of markets, the profitability of the old banking business, at least as far as big banks were concerned, was ebbing. So the solution, if you will, was for the Fed to encourage things like Basel II, this whole global regulatory mirage that we have, and at the same time they said, “Oh, it’s okay for you to create off balance sheet entities, it is okay for you to trade these derivatives that are not at all regulated or subject to disclosure,” and the banks have done exactly that.

JPMorgan today is half of this off balance sheet swap market and it dwarfs the bank. I mean think about that, JPMorgan’s bank is really an irrelevancy compared to their swap book, which goes into the trillions and trillions of dollars. So we have this disease called “derivatives”, which is what the weight of the financial markets have tried to keep making money even though they are less and less relevant. I also always tell people banks are not special; there is nothing special about banks. We should itsrepeal all the laws that limit ownership of banks, so if Wal-Mart or Google or anybody else wants to come in, that’s fine. We’ll regulate the banks, but anybody should be able to own them, that’s the bottom line.

Dylan: I want to read you something, a quote from Dick Grasso in – from an interview that I did with him for Greedy Bastards. And I asked him specifically, “You ran the New York Stock Exchange,” and it’s interesting to choose him because obviously he was widely reviled for being a Greedy Bastard himself in the most literal of sense for his compensation and yet he still also was the architect and operator of one of the largest exchanges in the world, right?

Chris: Yeah, which is now an empty building.

Dylan: Which is now an empty building with computers. So I asked Dick, I said, “Listen what would you do? You ran the New York Stock Exchange, bonds are traded in a public environment, commodities are traded on an exchange, the only thing that really has this scale that exists off of an exchange is the swaps market being off of the exchange, it allows it to have no collateralization, have no transparency, can’t tell you what the risk is etc.”

Chris: That’s right.

Dylan: I said, “Dick, what do you do about this?” Okay? Here was his explanation, he said, “I believe that regulators should require the product, being swaps, to be registered with a central clearing agent like an exchange and thus able to be monitored globally to prevent contracts being written in excess of the debt obligations they are designed to insure.”

Chris: Precisely. And this goes back to --

Dylan: It goes on though, it goes on, “This is easily accomplished by regulators and Treasury issuing cross market rules adopted by non U.S. counterparts.” Here’s where it gets interesting. “Any contracts written outside of these requirements,” Grasso says, “should be deemed null and void by regulators and classified as online gaming.”

Chris: Correct.

Dylan: You agree with that?

Chris: And that’s what these were. Historically, to what we are talking about here, Dylan, is gambling contracts that are not what are called “real bills”. In other words, in the real old days of American banking, if you issued a piece of paper, it had to be tied to an asset. In other words, you couldn’t have an imbalance between assets and liabilities. But what Dick Grasso is saying, which is very important, is that this over-the-counter market where there is no central surveillance of trading and no committee that runs your exchange, because remember all the exchange members are joint and the severally reliable, they are all tied together so they police one another. But when you go into this bilateral over-the-counter market that we have today, nobody sees the whole market. So you can have a bank that is writing really stupid positions that are going to take the whole bank down, as we saw with Lehman, for example. And even though that wasn’t an entirely swaps, it took the bank down. Believe me, they were involved in all of this stuff; same thing with Bear Stearns. Nobody knew what was going on inside that bank until the bank failed.

Dylan: I mean does anybody even know where the risk is?

Chris: -- same thing, that was the cash transaction that took them down, right? Stupidity buying the European bonds but nobody knew because it was all over-the-counter.

Dylan: Does anybody even know where the risk is today in the world?

Chris: No, the attempts to force disclosure have been thwarted. But what's interesting is that the Europeans have just banned CDS sales, short sales essentially using derivatives on European banks. So now all the pressure is landing on U.S. banks. You saw the way they traded today; they were up huge, but they had been selling off days. So every time somebody wants to go short financials, they are going to short U.S. banks now because they can’t short European banks. But the other point Grasso made, which is very important, is that if you limited a derivatives market to just people who have an economic insurable interest—in other words, they own bonds, they have a loan with somebody, whatever it is—that would be okay, but when we let people do cash settlement on these contracts and they can just gamble on whether or not your house burns down tonight, that’s a big problem because there’s no link between a derivative and the real world. If you don’t have a link between say the cash market for gold and the basis, if you will, and the futures contract, then the price is meaningless. There’s no supply and demand tension, right? But if I can write credit default swaps against Italy without having to own Italian debt, well I can write swaps all day long. And then as you said, you know, “I’m the bank writing the business, right, the customers are paying me for the insurance,” and then surprise, surprise, Italy gets into trouble and we change the rules and we don’t pay out.

Dylan: But we keep all that money…

Chris: And we keep all the money.

Dylan: …we collect it selling the insurance.

Chris: What a great business.

Dylan: I mean that’s good living. If you were to look at the viability of something like what Grasso was talking about, the ability to say, listen, we believe that risk transfer—which is what a swap is—has validity in the western financial markets if it is a definable risk, corporate or sovereign debt and it is a collateralized insurance contract traded on the exchange.

Chris: And you have to deliver the exposure when you get your insurance payment. So you have to own the bonds, whatever.

Dylan: Right.

Chris: What happened with Delphi was a big bankruptcy. There was 30 positions short Delphi for every dollar worth of debt. So the other $29 were all speculators and they had to – they had a horrible process of netting all of this out. That’s when ISDA, the Swaps Dealer Association, changed the rules and allowed cash settlements for all of these contracts. It was a hideous mistake. But again, remember, the whole point of this is to generate nominal income for the big banks, especially JPMorgan and Citi, so that they stay alive, even though the risk adjusted returns on this activity are clearly negative, Dylan. They’re destroying value. So ultimately all of the players in this market will fail. They have to. The market will collapse because the debtors will default, the participants will say, “No, thank you, I don’t want to be stiffed,” whatever. But I think this market is going to put itself out of business.

Dylan: So what is the antidote that we, all of us that worry about the prosperity of this, can focus our attention on? Is it putting swaps on exchanges…

Chris: Yes.

Dylan: …in a simple sense?

Chris: I mean let’s segment them out. Interest rate currency swaps are not really a huge issue. They’re big, they are systemic concerns, but they’re basically an extension of forward contracts. I buy Deutsche marks, I sell Deutsche marks. It’s a fairly transparent market, right? The problem is credit default swaps because there is no standardization and the industry doesn’t want standardization. The last thing they want to do is put this on an exchange.

Dylan: Because it hurts their profitability.

Chris: Oh, it would kill them. And let me get even more basic on this so people understand. When JPMorgan does a credit default swap with a customer, they keep the collateral. There is no separate trust company that is part of the exchange that holds all the money the way you do in a good poker game, right?

Dylan: Right.

Chris: So nobody knows if it’s fully collateralized or not because they’re trusting JPMorgan to operate their business in a prudential way. Until we had the minor reforms of Dodd-Frank and the Corrigan Group before that, the dealers weren’t posting any margin with one another. It was all naked. And so the first thing that Corrigan did when he started getting people focused on this was to force the dealers to require minimum margins from one another. That was the problem. The systemic risk was actually among the big dealers. They dealt with that somewhat but look at Dodd-Frank, they didn’t touch the bilateral relationship between the client the dealer bank.

So if I am the customer, right, and I’m dealing with JPMorgan, I can’t go to any other bank because all these contracts are bespoked, they’re all different. I can’t get another bank to net me out, so that’s the problem. On an exchange, all contracts are fungible—I want to go long, I want to go short, whatever it is, I do my trade, I don’t even know who the other counterparty is because I’m dealing with the exchange.

Dylan: But the only barrier to putting swaps on exchanges ultimately beyond the obvious nightmare of rafting through all of the data that is there.

Chris: Oh, we could do – you and I could do it in a couple of weeks. It’s not that hard. And believe me, the boys in Chicago…

Dylan: But the biggest barrier is the threat to profits.

Chris: …they want this business. They’ve been – there’s an uneasy truce between the Chicago exchanges and the big money center banks, but that’s going to end. The Chicago boys want this business. And Grasso was right, he could have put this on the New York Stock Exchange, no question.

Dylan: From the look in his eyes when I said it to him, it looked like he would have been happy to have the opportunity.

Chris: Of course he would. Look, Dick Grasso earned every dollar he was ever paid. I always had great respect for that man. Deregulation was the problem because we all bought the Chicago school market efficiency arguments, which are clearly wrong. You know, I loved Milton Friedman but they’ve done more damage to the U.S. economy with the efficient market theory at the University of Chicago than almost anybody I can think of. Look at the FASB. We still have these ridiculous accounting rules that let the big banks report a positive quarter in Q3 even though if you strip out the fair value adjustments they lost – they actually had down quarter.

Dylan: So just to tie a ribbon on this, it’s clear that these – well, we put stocks on exchanges so that we can see what we already know that the risk is bonds, commodities – it’s the American way. If you want to buy it, you’ve got to see it, you’ve got to have the money, you take the risk, we wish you luck, good luck to you. This is a market that has been created to basically protect the profitability of these banks that could be put on exchange but the barrier to doing it is the threat to their profits and the ability to do that is from money and politics. Is that all correct?

Chris: Oh, it’s totally correct. It’s the difference between auctioning a painting at Sothebys and doing a gallery sale, okay? When you’re dealing bilaterally with JPMorgan or Deutsche Bank, whoever, you’re in a gallery sale. There’s no transparency, you have no idea what the cost and the other issues are in the market. In an auction environment in exchange, you have price discovery. There is no price discovery in OTC derivatives today. They kind of sort of trade against the bonds or the stocks or whatever it is, but there is no direct link. So as a client, you’re lost. I mean you’re totally at the mercy of the dealers. It is unfair and it goes back to the ‘20s and the ‘30s when we dealt with very similar issues. The banks have used our democratic process to erode all of those prudential safeguards, so we’ve come full circle. It’s like it’s 1925 again.

Dylan: But the good news is the antidote for the swaps market does exist, it is the exchange, and it’s really just a matter of getting to it.

Chris: Well, take them off. You want to have an exchange traded product, you want to have full public disclosure of all trading every day so we can see all prices for all trades, and you want to require physical delivery of the underlying asset. In other words, you own a bond, a loan, it could be commercial paper, even a vendor. Let’s say you are big vendor and you have credit exposure with a bank and you want to hedge it. That would be okay, you could deliver the accounts receivable for your insurance payment. That’s what we need. It’s to re-link this derivative market with the real world. And then we’ve got something.

Dylan: All right, listen. I’m just glad to know there is an antidote because these problems look so daunting sometimes.

Chris: There is nothing new here, Dylan. We’ve seen this movie before.

Dylan: All right. Listen, hopefully it ends differently than it did in the 1930s, if you know what I’m saying.

Chris: Well, because we’re going to get even more involved than we already are and we’re going to fix it.

Dylan: That’s the plan, indeed, and it’s an honor to be able to stand in the circle with you, Chris, closing and identifying and revealing the corruption that must be reconciled. Chris Whalen, Editor of Institutional Risk Analytics, worth your time and attention, particularly his book Inflated: How Money and Debt Built the American Dream. You can also find him as a contributor on Reuters and on Twitter at @rcwhalen. And he is someone that I am proud to welcome into the Greedy Bastards Laboratory with his particular antidote. Chris, we’ll talk to you sooner rather than later. Thank you again.

Chris: Thanks, Dylan.

Dylan: All right. Chris Whalen, ladies and gentlemen. We’ll talk to you next time.