Why Dodd-Frank Is Inadequate

by: Karl Denninger

Here's the quote of the day:

In addition, Dimon took issue with how securities and futures regulators are implementing Dodd-Frank provisions intended to standardize derivatives that would be traded on transparent clearinghouses intermediaries between buyers and sellers of swaps.

Derivatives are used by you all, thousands of companies use it to hedge their interest-rate risk and other exposures, Dimon told his audience. You can go to any screen and price the majority of the derivatives out there.

Except that he doesn't want anyone to be able to go see the bids and offers. Why not?

Because if you can't see them, as they're not on a registered exchange, two things happen:

  • The bank can claim to be "covered" on some risky investment without having to prove the counterparty can pay. This was the entire claimed justification for TARP and the rest of the nonsense in 2008 - that if we did not bail them out there would be cascading defaults as counterparties could not pay. If these derivatives are traded on exchanges then the exchange and brokerages perform margin maintenance and both can and will issue margin calls to prevent that. Nobody gets to claim a risk is "covered" unless there's solid evidence the counterparty has the money.
  • The bank can rip you off on the spread and you have no means of detecting it. There's a lot of money made by these institutions by doing exactly that. It's legal in most of these cases, but unseemly and an exploitation of an intentionally-inefficient market.

Speaking of the latter, who got tagged for an example that went, it is alleged, way over the line? Wachoivia/Wells:

The SEC's order found that Wachovia Capital Markets violated the securities laws in two respects. First, Wachovia Capital Markets charged undisclosed excessive markups in the sale of certain preferred shares or equity of a CDO called Grand Avenue II to the Zuni Indian Tribe and an individual investor. As detailed in the order, Wachovia Capital Markets marked down $5.5 million of equity to 52.7 cents on the dollar after the deal closed and it was unable to find a buyer. Months later, the Zuni Indian Tribe and the individual investor paid 90 and 95 cents on the dollar. Unbeknownst to them, these prices were over 70% higher than the price at which the equity had been marked for accounting purposes.

If we required all derivatives to trade on an exchange this couldn't happen. You could look at the price and make your bid or offer. The exchange "double-blinds" the trade so you neither know or care who is on the other side, and you thus receive (at least in theory) the best possible price.

This sort of misconduct happens because we allow these instruments to trade off a regulated exchange so there is zero protection against abuse.

There was more in the latter case, specifically:

Second, Wachovia Capital Markets misrepresented to investors in a CDO called Longshore 3 that it acquired assets from affiliates on an arms-length basis and at fair market prices when, in fact, 40 residential mortgage-backed securities were transferred from an affiliate at above-market prices. Wachovia Capital Markets transferred these assets at stale prices in order to avoid losses on its own books.

That is, Wachovia transferred trash into the CDO instead of actually acquiring it on a fair-value basis at "arms length" for the specific purpose of avoiding recognition of a loss it had already suffered. Again, if the underlying transactions required to be exchange-traded this could not have happened.

Secrecy breeds fraud. There is a monstrous incentive to steal when you can obfuscate what's going on in the marketplace. It becomes a profit center for the "banks," but you, the customer, get hosed.

Repeatedly.

Dodd-Frank does not go nearly far enough. As I have advocated since the beginning of this mess the proper action is to force all transaction of this sort onto public exchanges where margin supervision and double-blinding of counterparties take place. If the people who allegedly are "short" (who have sold) these contracts cannot post cash margin sufficient to guarantee that they are able to meet their obligations then the contracts are factually worthless and must be torn up as a matter of law.

We are four years into this and nobody, as of yet, is willing to force these people in the banking industry to actually prove that their alleged "money good" assets and derivatives really are, in fact, money good.