Moon of Alabama Brecht quote
May 22, 2008

The Next Scam - Derivatives

Professor Roubini asks: How will financial institutions make money now that the securitization food chain is broken?

The most severe financial crisis in decades has not only damaged the balance sheet of financial institutions. It has also severely affected their P&L, i.e. the process of generating revenues and profits.

In the old “originate & hold” model (before securitization) financial institutions made money from the investment income of holding the credit risk of loans and mortgages. But in the brave new world of securitization where you “originate & distribute” the credit risk rather than hold it on balance sheet an increasing fraction of the income of financial institutions was coming from the fees and commissions involved in this securitization process. This food chain of fees on top of fees is now broken: securitization of mortgages, that was running at the annual rate of $1,000 billion in January of 2007, was down 95% to an annual rate of $50 billion by January of 2008. So the process of generating fees and commissions is broken.

In the mortgage boom everybody lived off fees: the real estate agents, the mortgage brokers, the appraisers, the smaller mortgage aggregators, the loan servicers, the investment banks that bought the mortgages and converted them into Collateral Debt Obligations, the monoline insurers that 'guaranteed' the quality of these papers, the rating agencies, the retail banks that sold the resulting AAA junkbonds to some dumb investor.

Similar chains existed for commercial real estate mortgages and leveraged buyout loans. The bigger the loans the more money was made by everyone involved, while the risk was moved away to the investor.

Now that market is dead and these people have to find a new gig. The big investment banks need a new revenue stream.

So Roubini asks if there is one.

My answer is "Yes." I believe the investment banks have already found a new scam:

Derivatives, including those based on debt, currencies, commodities, stocks and interest rates, expanded 44 percent from the previous year to $596 trillion, the Basel, Switzerland-based [Bank for International Settlements] said in a report today. The amount of credit-default swaps protecting investors against losses on bonds and loans more than doubled to cover a notional $58 trillion of debt.
Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements. Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in interest rates or the weather.

The data on the BIS report are based on contracts traded outside of exchanges in the over-the-counter market.

The investment banks who sold junk debt to investors are now selling 'protection' to the same investors against interest rate change and default of such debt. To eliminate risk for themselves they also buy 'protection' from other banks and investors. In between they generate hefty amounts of fees which again depend on the size of the transaction. This has led to the creation of another bubble. $596 trillion of derivatives is a multiple of the value of underlying real assets. It is essentially hot air but dealing it makes money.

Here's as story on the results of a fee generating derivatives scam.

Like homeowners who took out mortgages they couldn't afford and didn't understand, Jefferson County officials rejected fixed-rate debt and borrowed instead at rates that varied with the market.

The county paid banks $120 million in fees -- six times the prevailing rate -- for $5.8 billion in interest-rate swaps. That was supposed to protect the county from rising rates for their bonds. Lending rates went the wrong way, putting the county $277 million deeper into debt.
The swaps are contracts in which the county and the banks agreed to exchange periodic payments based on the size of the outstanding debt and changes in prevailing lending rates. Swaps are derivatives, which are unregulated financial contracts tied to the underlying value of a security, commodity or index.

The county bought 'protection' against interest rate changes and it turned out that the fine print read somewhat different than what the salesperson had said. With $596 billion total in derivative deals how many more of such cases are out there?

The derivative market is next big thing to blow up. If one of the big players fails, all others will be seriously affected. The Fed bailed out Bear-Stearns and has committed over half of its assets to avoid general liquidity problems. But a failing pyramid of some $600 trillion in derivatives dwarfs any central bank's capability.

That shoe still has to drop. When it does we will be in the second, bigger phase of the credit crisis. The outcome is not foreseeable but it is unlikely to be positive.

Posted by b on May 22, 2008 at 15:39 UTC | Permalink


If I underatand you even ½ way correctly, b, this means that the little guy with a fixed income (i.e. retired) is shit out of luck -- well, hell I figured on that anyway, but I had expected them to so blatantly ram it up my ass, that is as long as I could still remember to vote...

Posted by: Chuck Cliff | May 22 2008 16:22 utc | 1

If Roubini had come to understand that profit is impossible then he would not have been surprised to find that evanescent riches show by losing all value the emptiness of their content. Wealth is a purely psychological state and in order to support its supposed reality force has to be used. What otherwise is slavery or serfdom?

Posted by: JLCG | May 22 2008 17:00 utc | 2

Hi all,

I read moonofalabama occasionally. I've notice the claim that profit is illusory or only imagined. Where can I read up on this. I kinda get it, but I'd like to learn more.

Posted by: Iron Butterfly | May 22 2008 18:19 utc | 3

What the f***ing hell does any of this have to do with Adam Smith and his pin factory?

Posted by: ralphieboy | May 22 2008 19:54 utc | 4

It is very difficult to find an analysis of the actual dynamics of profit. Personally I just examine the behavior of business men and corporations and from their constant whining about " business friendly climate" "cost of labor" "health regulations" etc I conclude that their supposed profits are simply depredations of workers and the environment. For the very limited case of innovation profit there is a very good book by Schumpeter written in 1912 whose title I can't metion because it is among the books stored while my house is being painted. I don't trust economists at all because if you read their equations carefully they are full of constants variables exponents and coefficients created ex nihilo. To the guy that mentions Adam Smith I would suggest that he read The City of God by Saint Augustine the chapter where he analyses the division of labor among silver smiths. That is an eye opener for those that may think that economics is a science instead of a class apology. Anyway I am only an amateur of these things but if there is something I have learned is that one should never trust experts.

Posted by: jlcg | May 22 2008 21:49 utc | 5

The pin factory was bought out in a hostile take over in 1885.

Posted by: pb | May 22 2008 22:21 utc | 6

Has anyone taken a look at the work of Bichler and Nitzan. Their notion of differential profit is certainly fascinating. Anyone know if they are right?

Posted by: Frank | May 23 2008 0:09 utc | 7

IMO CDSs have grown along with securitization and will blow up with CDOs in the mother of all insurance cycles. My fond hope is that the next big thing is, all these laid-off financial engineers take their bedraggled models to the commercial banks and IFOs (BERD is usually the bellwether for this kind of recycling) and gin up public-private partnerships (PPPs) for developing-country infrastructure projects. Hey, if we're going to keep on bilking naive investors with our toy models we might as well give their money to actual poor people who need the money.

Posted by: ...---... | May 23 2008 1:49 utc | 8

Bichler and Nitzan summarized by Tim Di Muzio:

"...Somewhat ironically, this theorisation has instead been developed by two political economists working outside the Marxist tradition. Rejecting both the neoclassical utility theory of value as well as Marx’s labour theory of value, Nitzan and Bichler offer a power theory of value that approaches capitalism from the viewpoint of capitalisation.9 From this standpoint, there are at least two crucial questions thatmust be asked: (1) what is being capitalised?; and (2) for what purposes is this entity being financed? Rich empirical work on what Nitzan and Bichler call ‘dominant capital’ lead them to argue that (1) capital can be theorised as a form of commodified power, (2) this power is primarily aimed at shaping and reshaping the terrain of social reproduction, and (3) its accumulation must be measured differentially rather than absolutely."

I don't know if anyone can say if they are right, or if this is a good description. My take on it is that capital is certainly commodified power, but if that power is directed towards, say, a wind turbine, rather than manicures, it would be positive sum rather than just a way to enforce social heirarchy. Life is not zero sum. If you believe that you should hang it up and become a Nazi, looking to master your fellow humans.

I can't see why profits are more/less (illusionary/capable of effect) than the fiat currency of which they are composed

Posted by: boxcar mike | May 23 2008 1:56 utc | 9

Not long ago 3W NGOs rediscovered the formula for an easy and cheap Emergency Food Product which can be produced locally ... peanut butter and powdered milk gobs. If
instead those gobs were balls, dipped in vitamins, then dipped again in food wax,
jawbreakers of a kinder sort, they could be cellophane wrapped and distributed free
of charge on the clear calculus that $1B worth of EFP balls is cheaper than $500B
wars to end all wars, or whatever catchphrase de juer Bush.Con is pimping. A new
national Department of EFPBalls, with a starting budget of $183B borrowed from the
2009 Black Ops budget for perpetuating warfare-for-profit, would be able to easily
feed everyone on earth, indefinitely, although, I suppose there'd be a derivatives
market in peanut butter and powdered soy milk, as soon as the rumor hit the beltway.
I mean, feed everyone, give everyone a tarp, then go blow yourselves up, who cares?

Posted by: Sulaman Shah | May 23 2008 4:05 utc | 10


don't forget the everlasting batteries for out laptops and the gasoline pellets to power our cars

Posted by: ralphieboy | May 23 2008 6:44 utc | 11

This is just the tip of the iceberg the USS Titanic has hit

This is the iceberg the corrupt officers of the USS Titanic deliberately drove US into, because they can call up a helicopter rescue for themselves, anytime they want to

And this is the iceberg they gyned
up out of puff pastry, so their helicopters could be filled with all those $B's

Three strikes, you're underwater USA!

I'm with boxcarmike, we won't recognize the US by the time the elections roll around. After President McCain is installed as the head of the Neo-Politburo, any town in USA will look like any town in Russia, although I understand Putin is using all those oil revenues to completely rebuilt Russian infrastructure and village housing, which will create a black hole of energy and commodities inflation so dark, it will suck the air out of our living rooms ... those who've paid off their living rooms, that is.

Extra, Extra! is on!! GTG!!

Posted by: Elliot Lemiux | May 24 2008 2:30 utc | 12

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