Big Banks Win – Derivatives are Back

Once upon a time in the long ago we had banks that lent money to individuals and companies to expand and grow the economy. During the Great Depression lawmakers saw the need to rein in and regulate banks’ activities. The Glass Steagall Act of 1933 ruled that banks could not become involved in selling or trading securities. Separate Investment banks were organized that could underwrite and sell securities but they could not use depositor money. For 66 years until 1999 this was the way banks functioned. However, during this time the bankers lobbied hard to change this. Finally, in 1999 the Gramm, Leach Bliley Act was passed allowing banks the freedom to use depositor’s money to trade in risky derivatives. The bankers went wild leveraging the banks portfolios up to 40 to 1.

We all know what happened next. Bankers got caught up in the real estate bubble issuing mortgages to almost anyone who had a pulse. Some homeowners didn’t even make the first mortgage payment. The banks knew that they were holding worthless assets and invented a creative new tool to unload them on unsuspecting investors. It was called Collaterized Debt Obligations or CDOs. The plan was incredibly simple. Let’s package these junk mortgages and sell them to hedge funds and naïve investors. This effectively got the banks “off the hook” for any liabilities in the form of mortgage defaults.

As we know the plan blew up when the market for CDOs froze and there were no buyers. Came the stock market crash of 2008-09 wiping out 7 Trillion of household debt. Now came the bailouts, first from TARP that used taxpayer money to bail out the banks then came the Federal Reserve with its quantitative easing or QE. From 2009 through 2013 he Fed “gave” $4.5 Trillion to the bankers by buying US Treasuries and Mortgage Backed Securities (when the bank buys treasuries it credits banks’ balance sheets.)

Meanwhile, in 2010 The Dodd Frank Reform Act that that included the “Volker Rule” sought to separate banking activities by not allowing them to use depositor money to speculate or make outside investments. The Act set 2015 as the beginning date and gave the bankers 7 years to make the transition.

Sorry folks. The new $1.1 Trillion spending bill approved by Congress includes provisions that effectively gut Dodd Frank and allow banks to resume their derivatives trading without separating depositor money.

What many investors do not realize is that derivatives provide high risk/rewards with little money down. Some examples of derivatives are Forward Contracts, Futures Contracts, Credit Default Swaps, Options and Exchange Traded Funds (ETFs). One of the big dangers going forward is the plethora of ETFs being traded. Some of these like “Inverse” or “Leveraged” ETFs are very high risk. Some are thinly traded and run the same risk as we had in 2008-09 when there were no buyers and prices collapsed.

Then you can pile on any new fandangle securities that bankers come up with. During the 2008-09 stock market crash it was the Collaterized Debt Obligations (CDOs) and Credit Default Swaps (CDSs) that cause the most damage.

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