We Threw a (Counter)Party

The financial wizards of the world have created a derivatives market that is so intertwined and so fast moving that it seems almost doomed to failure.

The market of products like interest rate derivatives, forwards, futures, swaps and hybrid securities is so massive it boggles the mind. World GDP is approximately $50 trillion. The total value of the equities market is approximately $100 trillion. The notional value of the OTC (Over-The-Counter) derivatives market is a staggering $500 trillion, or ten times world GDP.

Part of the derivatives market is built on top of mortgaged back securities, in sort of an inverted pyramid. The mortgage debt is securitized and sold, then in an effort to hedge against risk a credit default swap is sold, and then a contingent credit default swap. Layer upon layer of derivatives stacked on top of a single loan origination (a small percentage of loans never even existing in the first place).

In his book, A Demon Of Our Own Design, Richard Bookstaber explains how the efforts of financial institutions to create safeguards and manage risk through the use of complex computer modeling, actually increases market instability. The tight coupling of transactions and counterparty risk almost guarantees an inevitable cascading meltdown. Bookstaber should know. He received his Ph.D in economics from MIT, spent 10 years as a quant at Morgan Stanley, and was director of risk management at Moore Capital Management, which at the time was one of the largest hedge funds in the world.

In the mortgaged backed securities world, there were some basic assumptions put into the models: 1. On a macro basis, the year over year rate of change in real estate prices wouldn’t be negative (or hadn’t been negative since the Great Depression) 2. Markets will always be liquid 3. Counterparties will always be solvent. All three assumptions have proven to be false.

We should ask the folks in AIG’s financial products division how everything has worked out. AIG’s website explains that “Founded in 1987 as one of the first companies in the United States focused principally on OTC derivatives markets, AIG Financial Products Corp. (AIGFP) has built a unique, client-oriented platform that today is truly global in scope.” Yippie! Fucking geniuses. What the website should say is “In an effort to create “value” out of thin air, AIGFP helped create a highly leveraged, totally unregulated, counterparty rich Chernobyl.” The largest insurance company in the world is now in receivership.

The party was a blast. Whether you attended or not, you're cordially invited to the hangover. It's likely to be horrific.

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Thanks to the Financial Services Regulatory Relief Act of 2006 and The Emergency Economic Stabilization Act of 2008 (aka The $850 Billion Bailout), the fractional reserve requirement of banks has been suspended.

The Financial Services Regulatory Relief Act of 2006 gave us this:

"SEC. 202. INCREASED FLEXIBILITY FOR THE FEDERAL RESERVE BOARD TO ESTABLISH RESERVE REQUIREMENTS.
Section 19(b)(2)(A) of the Federal Reserve Act (12 U.S.C. 461(b)(2)(A)) is amended - (1) in clause (i), by striking "the ratio of 3 per centum" and inserting "a ratio of not greater than 3 percent (and which may be zero)"; and (2) in clause (ii), by striking "and not less than 8 per centum," and inserting "(and which may be zero),".
SEC. 203. EFFECTIVE DATE.
The amendments made by this title shall take effect October 1, 2011.

The Emergency Economic Stabilization Act of 2008 gave us this:

SEC.128 ACCELERATION OF EFFECTIVE DATE.
Section 203 of the Financial Services Regulatory Relief Act of 2006 (12 U.S.C. 461 note) is amended by striking "October 1, 2011" and inserting "October 1, 2008".

So as of Wednesday of last week, banks are no longer required to hold anything in reserves to back your deposits. Zero. However, the FDIC limit has been increased from $100,000 to $250,000 so please stay calm and please withdraw as little cash as possible. Thank you in advance.

Signed,

Everyone

P.S. Our fractional reserve banking system is dead. Banking is now 100% shell game. Based on this change, we shouldn't see any new bank failures since it's now impossible to fall below reserve requirements. There are none.