What Does The Great Derivatives Wizard Know?

This blog has long argued against the non-transparent and highly subsidized derivatives activities of the megabanks while also recognizing the legitimate role of derivatives in facilitating risk management. Most recently, I suggested that any financial losses arising from turmoil in Greece, Russia or the global oil collapse could land in surprising places thanks to the derivatives markets.

Derivatives allow megabanks to sell their government backing to third parties for a lower price than what would be implied by the third party simply investing in government bonds. The megabanks under-price the risk of their derivatives transactions because ultimately the US taxpayer (and by extension the economy as a whole) bears the costs not executives at the megabanks who make millions no matter what.

Recently, the megabanks used their prodigious political power to short-circuit the efforts of lawmakers to curb the derivatives activities of the megabanks under the Dodd-Frank Act. The megabanks managed to insert a provision in an omnibus funding bill that effectively repealed the Dodd-Frank mandate that federally insured banks "push-out" their riskiest derivatives activities to other megabank affiliates. Due to their express federal insurance the bank subsidiaries enjoy higher credit ratings than the megabanks as a whole.

This stealth repeal of part of Dodd-Frank means that the banks now offer a safer, less risky derivatives product to their counterparties. That, in turn, means more pricing power, greater megabank profits and higher bonus payments to senior management.

Some megabank apologists suggest that this all matters little or that it is all about technical rules beyond comprehension. Do not buy that sanguine story. Essentially this dispute is about whether the riskiest derivatives--including credit default swaps (CDS) like those that sank AIG in 2008--can be housed in federally insured depository institutions. Huge sums are at stake. Jamie Dimon himself lobbied for this partial repeal of Dodd-Frank. Citigroup apparently drafted the bill. According to the Vice Chairman of the FDIC: "There is about $10.4 trillion in notional CDS exposure that would have been subject to the push-out, and one insured bank owns $4.6 trillion of that exposure. That is three times the amount of notional CDS AIG had when it was bailed out at a cost of $85 billion." In other words, the very derivatives (credit default swaps) that figured so prominently in the 2008 financial collapse are subject to this partial repeal, but in far greater amounts.

Government subsidies like those available to insured depository institutions should not extend to support risky derivatives transactions. The only logic behind this partial repeal is for megabank CEOs to garner excess compensation for taking on too much risk and the raw political power that the megabanks now hold in Washington.

Given the incestuous relationship of derivatives traders (a small number of global banks dominate the market) why did this regulatory indulgence make it to the top of their agenda now? Do the megabanks know something about their exposure to Greece, Russia, and the oil collapse that makes federal backing of their riskiest derivatives particularly urgent?