Black is White, Hedges are Bets, and Your Money is Mine (guest essay)   (June 14, 2012)

Once again we turn to frequent contributor Zeus Yiamouyiannis for a sharp analysis of why our "profits are private, losses are public" crony-capitalism is self-destructing and what is needed to move forward to a sustainable, adaptable, wealth-generating capitalism.

As we witness the riotous dissolution of corrupted capitalism, we need not wait for the history books to identify the mile markers of self-destruction. If we are to rebuild capitalism, even as it is tearing itself down, then we will need to become street-smart detectives in analyzing the current economic murder-suicide in progress.

Every fall has its tell-tale confirmations and corrupt capitalism is no exception. There arrive key points where a system’s own contradictions become so evident and self-damaging, where motive, means, and opportunity become so clear, that one can mount an informed, effective counter-offensive.

Two notable recent contradictions have surfaced in the ongoing debacle called big banking.

1) Hedges for big banks have evolved into gambling vehicles that increase risk rather than reduce risk.

2) Guaranteed savings deposits in those same big banks are being used as fodder in the high-risk investment casinos of global finance. There are no longer effective firewalls or truly secure funds.

Capitalism now means big banks profit from their so-called successes, and others pay for their failures: “Black is white.” JP Morgan has recently lost $3 billion dand counting on a ‘sure thing’: “Hedges are bets.” Investment banks are now merged with conventional banking and secured by taxpayer and depositor money: “Your money is mine.”

These capitalist tumors grow from assumptions that all gains shall be privatized, all stakes shall be “other people’s money,” and all liabilities will fall upon the patsies formerly known as represented citizens.

Everything for reckless, ill-gotten profit; nothing for prudent management

I felt like I was in the twilight zone when reading a New York Times anatomy of JP Morgan’s recent multi-billion dollar losses on some of its hedge positions.

First, these so-called hedge positions were never designed as buffers against loss. They were driven by greed, risk, and desire for profit. Genuine hedges are supposed to buffer against, rather than accentuate, loss, excess, and unwise decision-making.

“What this hedge morphed into violates our own principles,” said JP Morgan CEO Jamie Dimon, citing their recent multi-billion dollar loss. “Morphed into?” C’mon! You played the market from the start. This was no hedge. It was a gamble, and one that you lost. Capitalism that relies upon sound judgment is apparently a throwback to the time when consequences fell upon the company making bad decisions.

Ironically, the more traders stampede to a “sure profit” in certain hedges, the riskier they get. With the advent of high frequency trading and hyper-speed information access, these stampedes are more likely to occur. Risk is also amplified by converse positions. In today’s reality, those who bet against these “sure profit” moves can now employ methods to enhance their position by artificially manipulating buying and selling (naked shorts anyone?). Prospective gold mines can quickly turn into dry holes.

Nobody seems to learn when there are no meaningful consequences. Almost the same exact scenario befell Long Term Capital Management (LCTM). Both LCTM in 1998 and JP Morgan in 2012 bet on the “sure” convergence of newly issued and older treasury bond interest rates, hoping to amplify a small but relatively guaranteed profit into a huge profit by creating a large position through leveraged borrowing.

This very action and the actions of others piling on actually increased divergences by straining the Treasury market. Leveraged hedges built around amplified, “safe” profits create a fertile climate for significantly increased risk and billions of dollars of loss.

Genuine hedges increase operating profit over time by anticipating and reducing possible loss. These latest hedge mutations used by JP Morgan and others have sought to increase profit directly through betting. By using access to data and resources that others now share in the information age, LCTM and JP Morgan failed to anticipate the effects their very actions would have on the market. They needed a genuine hedge against their mutated hedge. (Maybe they should have consulted Goldman Sachs, the experts in betting against their own advice and their own customers for profit.)

When moves to create stability and safety are themselves more gambling, there is no coherence to the system, no buffer, no feedback loop. Excess is rewarded and prudence is punished. With such an operating premise, finance can only spiral into a senseless spectacle. The din is still off in the distance but getting louder as the hounds of reality refuse to be kept at bay.

Savings deposits in big banks have effectively become market casino fodder

Investment involves gambling plain and simple. Risk-return assets are not simply product purchases. If investment were just a consumable, the buyer would use the product for personal needs and see its value depreciate gradually through use. Investors have much different expectations. They are seeking a stake in an enterprise, not just a product, that will generate financial return and appreciate in value. However, this enterprise can also lose its value and leave the investor with nothing.

Even entrepreneurs who invest in their own business, as laudable as that may be, are gambling. They can lose their money for a variety of reasons, even if their business plans are well conceived, organized, and executed. There should be no guarantees with investment except those legal protections against fraud, theft, abuse, manipulation, and corruption that maintain a free enterprise system of risk and return on a transparent, accountable, and enforceable playing field. Bad luck, bad timing, and even bad management are all a fair part of free enterprise.

What happens, however, when big banks, unleashed by the abolishment of the Glass-Steagall Act, are allowed to link their unregulated investment gambling activity with regulated and guaranteed deposit taking? A sham of a free enterprise system emerges, where public funds and guaranteed private savings are nothing more than backstopping fodder for irresponsible gambling.

Here is the key question: Is money that I deposit to a bank, money that I give to a bank? The big bank’s answer is, “Yes. We will use your money or lose it any way we choose.” My answer is, “No. Deposit means deposit. I am not lending it. I am not investing it. I am not agreeing to get a below-inflation return so I can lose my money outright. (For a too-close-for-comfort parody on this see: The Important of Saving Money)

Savings is supposed to be secure dollar storage in a financial lending service. In consideration for lenders circulating my deposited funds at higher interest, I am given a modest user fee. I am parking my money with a bank or credit union to use in safe, vigilantly underwritten lending activities. The lending institutions I patronize garner a higher interest return than they are paying out to me. Interest rates they charge others vary to compensate for default risk. Of course this does not maximize profit! It maximizes stability. That’s its purpose, and that is the purpose of guaranteeing my deposit.

This is why savings is distinct from investment. Investment is a gamble. Its purpose is to maximize profit (including minimizing loss) by wisely supporting enterprises that are managed well and that return well. At least that is the way it is supposed to be. Not so today. Big banks are treating my deposit money like an investment in a greed-driven empire with no upside for me. If banks’ stocks go up, I'm not getting a dividend. If these banks go bankrupt through unwise or unlucky gambling, either I don't get my money back, or taxpayers ending up bearing the costs.

The global financial system has turned into a rigged Las Vegas minus the neon. Instead of the gambling addict going broke and being escorted out of the casino, my livelihood and my children’s is being put on the table to allow these addicts not only to win back their money but make a killing in the process. (Of course big banks are also the gambling houses themselves, as well as the addicts, charging fees for every transaction, giving themselves hundreds of billions of dollars in bonuses, and skimming profits.)

This same condition extends not just to savings, but to the way assets and future public entitlement payments are being annexed through taxpayer bailouts and increased national debt. In fact, the present and future wealth of the entire planet is being put up for chips. “Don’t worry,” say the big banks in a slurred voice, “My rich uncles, the central banks, will make good. Deal me another hand! Hey, bring on mortgages and Social Security and put them on the betting block too.”

We are so far down the rabbit hole that even reinstituting Glass-Steagall will not be sufficient. Big banks are simply reshuffling practices in such a way that investment banking is not labeled as such. Enforced separation between investment brokering and traditional deposit taking means little if I can simply "rename" my investment brokering as something else or if I can classify my deposit taking so it is guaranteed by the FDIC even as I funnel and gamble that money. Heads I win, tails you lose again.

What can be done

The answer to this hijacking of private savings and public funds is public refusal to redeem gambling debts. This can be done in several ways:

  • Financially, citizens en masse need to coordinate taking their money out of corrupt big banks and put that money into financially strong community banks and credit unions that don’t gamble with other people’s money. If I decide to gamble with my own money with a bank-serviced investment portfolio, fine. If an investment bank decides to gamble, it can use its own capital and not mine. If I decide to let a hedge fund gamble my money for me, I should be prepared to lose it all.
  • Politically, we need to push for an enforced law with a very simple rule: “No public guarantees for private gambling” and do a much better job of ensuring that no guarantees of public funds go to any activity that is even associated with investment gambling.
  • We could charter and support state or regional banks from the national level to provide low-cost liquidity (an alternative “Fed window) to small banks and credit unions--organizations that actually make their money lending prudently to communities and enhancing the economic health of the nation and local populations. These organizations would then more effectively compete with the current corporate financial monopolies holding this country hostage.
  • Policy-wise, we could limit counter-party risk and the systemic damage caused by Big Finance’s investment gambling. (Karl Denninger has a good suggestion in these two posts: Why The JPM Trade Matters and Solution: ONE DOLLAR OF CAPITAL). Denninger’s "One Dollar of Capital" rule would “Prohibit as a matter of Federal Law… the lending of money unsecured that exceeds the firm’s capital.” However, if firms, like MF Global, can gamble with segregated customer accounts as if these accounts were their own money, this suggestion won't work for a particular bank or investment company. Hence the need for the previous strategies.

    We have a long way to go, but the hounds of reality strain closer. Instead of running from them, let’s grab their leashes and turn the hounds on the banks.

    By Zeus Yiamouyiannis, Ph.D.


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