Washblog

First, it's really important that Progressives stop being intimidated by all this Wall Street language. I'm not the smartest guy in the world, I'm not particularly industrious and I don't have an MBA, but I understand swaps and derivatives as well as anybody needs to who's not involved in the business.

Swaps and derivatives can get as complicated as any other mental version of a Rube Goldberg contraption, but the basics are very basic. When you're a bank you lend money at interest with a risk of not being paid back. All a bank does - every minute of every day - is try and make sure that the risk of not being paid back - expressed as a percentage probability - is smaller than the interest rate on the money they loan. And that's it.

Think of all the loans banks make - or "write", in their lingo - as single pieces of paper with lots of stuff written on them - like baseball cards. For banks, the swaps and derivatives markets are simply a place where they literally "swap" these pieces of paper - the loans - like baseball cards. At these swaps desks, they also help other people swap their own baseball cards. In fact, that's what the do mostly - swap other people's baseball cards.

Like guys who use their baseball cards to represent imaginary baseball teams, at the end of the day, these fellows at the swaps desks all tote up what happened in the market and decide how many hits, runs, walks and errors everybody had on their imaginary teams.

And that's the problem: These "teams" of swapped loans are imaginary - but only until the moment the game suddenly stops and the banks have to count the wins and losses in real money rather than baseball cards.

From Bloomberg's Article on the "New Democrats'" Position:

The New Democrats, in the letter, say that another measure in the bill -- a ban on proprietary trading, known as the Volcker rule after its author Paul Volcker, the former Federal Reserve chairman -- would better achieve the goals of the Lincoln provision.
The coalition says that the Volcker rule would allow regulators to separate the riskiest trading activities from commercial banking, while allowing the banks to use swaps for customer-driven trading and to hedge their business risk.

Please note that phrase: "use swaps....to hedge their business risk."

Inslee and Larsen are opposing a move to force banks to move their "swaps desks" away from the regulated, insured bank balance sheets the financial system depends on. They will counter that they are for the "Volcker Rule", which seeks to protect these same balance sheets by making sure the banks only engage in trading swaps and other derivatives for their clients and do not expose their own balance sheets to the risk inherent in the derivatives market. The Volcker Rule seems to make sense. It simply tells banks that it's okay to swap other guys' baseball cards, just don't risk any of the bank's baseball cards.

Aye, but there's the rub: banks would still be able to use swaps and derivatives to "hedge their business risk" just not for "proprietary trading". That led me to this (paraphrased) conversation with a financier friend of mine:

"So what's the difference between 'hedging' and 'proprietary' trading," I asked.

"I don't know - whose money is at risk?"

"But if the bank is hedging its own "business risk" doesn't it have to put its own money at risk?"

"Hedging is supposed to reduce risk."

"Does it always?"

"No," he said, slightly uncomfortably, "not always."

"So sometimes it increases risk."

"Well , theoretically I guess it always increases risk - but with the purpose of reducing risk."

"So, theoretically-speaking, hedging always increases risk and when a bank hedges its own business risk it always uses its own money."

"Well, it's-."

"- so hedging is where a bank uses its own money and increases its own risk, and proprietary trading is the same thing"

"No, prop desks [proprietary trading offices at banks] trade to make money. When swaps desks trade to hedgethe bank's positions it's to decrease risk."

"And thereby increase reward."

"Right."

"And money is the reward."

"A decreased risk/reward ratio is the reward."

"So X/reward = reward?"

"That's right."

"So "reward" equals infinity?"

"I have to go back to work now."

"Just one more question: Is it possible for a prop desk to lose money on the same day a swaps desk makes money hedging the bank's positions?"

"Prop desks can lose money, but when they're hedging the bank's positions swaps desks can't really make money."

"I'm sorry, how is that possible?"

"When a prop desk makes or loses money, it makes or loses the bank's money. When a swaps desk hedges the bank's positions, it reduces the risk of the loans we make on behalf of the depositors."

"Or increases the risk."

"Possibly. Theoretically."

"But for the customers, not the bank, so it's okay then."

"That's right."

"So reward really is equal to infinity."

"I'm hanging up."
 

You can see the kind of tortured reasoning Congress is up against, but again, the reality is simple.

When my friend said "the bank's money" what he meant to indicate was that in one hand the bank holds depositors money and the loans and investments the bank makes with that money. In the other hand, the bank holds its own capital - gotten from profit it has made and stock it has sold. So in this sense "the bank" is really more like an insurance company. Its job is to come in and supply its own capita if, for some reason, the depositors need their money back in a hurry. So Volcker figured that if he got the "prop desks" away from the bank's money it was like taking AIG FP out of AIG.

Problem solved? No. The problem at AIG FP was that their portfolio of swaps and derivatives exposed AIG's balance sheet to such an enormous, potential loss while the traders who were running it thought the risk was very small. Even though swaps and derivatives activity has relatively low risk on a day-to-day basis, it has extremely high potential risk. The only real way for people to know how much they stand to lose is to make them pay cash. When you're trading baseball cards at this level, you're talking about trillions of dollars of risk being shuttled back and forth. It's okay for these guys to be doing this, but only so long as everyone giving them the money to do it knows exactly how much they stand to lose.  

That's why the Cantwell approach is superior - it will make banks pay cash for hedging rather than making massive, hidden gambles with our financial system. The simple answer is that you put the guys who trade baseball cards out there, on their own. You give them some cash to play with and if you win, you win, and if you lose, you lose - but you always know your limits.

Limit the exposure. Let the traders innovate and create. Let them change the business. Banks don't want the business to change and Inslee, Larsen and the rest of the "New Democrats" are trying to hold back the tide in order to keep a bunch of bankers fat and happy.