Demystifying High Finance
Lending to firms and individuals involved in the production of goods and services — which most people would imagine was the principal business of a [commercial] bank — amounts to less than 10% of that total.
-John Kay, Other People’s Money: The Real Business of Finance, 2016
To understand why the banking system is still fragile today, we need to look at a further change in the way banks actually do business resulting in those huge banker paychecks. As economist John Kay says in the above quote, most people no longer understand what bankers spend their time doing.
Professor Saule Omarova of Cornel Law School agrees with Kay. In her article: Financial Innovation: Three Fallacies in the Debate, She confronts three myths that “invisibly shape and quietly distort the ongoing debate on pros and cons of financial innovation”. Myth #1 is the most potent one, about how Wall Street cultivates the false impression that most of what it does involves raising capital for productive purposes. In fact, much of what Wall Street does is pure speculation.
Let’s see what the commercial banks spend 90% of their time doing.
Lending to help people buy homes or start businesses is now a small part of what banks do. They make their outsize profits by using depositors’ money to speculate in securities markets for bigger banker profits resulting in those bigger banker bonuses.
This is not totally new. In 1914, before he was appointed to the Supreme Court, Louis Brandeis published a book whose title captures the danger in the financial system then and now: Other Peoples’ Money and How Bankers Use It.
“Other peoples’ money” refers to depositor money. Most people did not understand that bankers use depositor money to speculate in the securities market for that bigger bank profit resulting in bigger banker paychecks This investing is purely extractive. It offers nothing productive to the economy like making loans does. Additionally, while it rewards bankers with outsized paychecks, it puts the financial system at risk. This was proven when the stock market crashed in 1929 bringing down all the bank investments causing depositors’ total loss of savings and bank closures when they had no money to return to the depositors.
We will see that this was the very same problem that caused the 2008 financial crisis. But this time, it was hidden in complexity and avoided any effective restraint as was done in 1933.
We will look now to see how the new banking model that John Kay called, financialization. That means making money without producing anything.
At this point recall that the failure of the mortgage market alone did not require a bailout of the banks because they had bundled most of them up and sold them off to investors.
What brought the banks to the brink of bankruptcy? To unravel that complexity, we will first demystify derivatives, especially the collateralized debt obligation (CDO) and later the credit default swap (CDS).
A Derivative Has No Value in Itself
Here is where the confusion begins. A derivative gets its name because it has no value in itself. It derives its value in reference to an asset that does have value.
This structure was developed in a context that had some productive use in society, but we’ll see how it was adapted so it contributes nothing to society and only to banker pay.
An easy example of a productive derivative is a futures contract. You can own the right to sell pork bellies without ever owning a pig. An investor can arrange with a farmer to pay the farmer for pork bellies at today’s price and get the increase in value when the farmer sells them in six months.
A productive arrangement:
* the farmer gets immediate cash
* no risk that the price of pigs will fall
* keeps the pigs until sale.
The investor:
* takes on the price risk
* gets the price increase in the future if there is one.
We are going to see how this was adapted to create investment instruments that are purely extractive and put the financial system at risk.
The takeaway from this section so far is: The futures contract is an example of a derivative as it only has a value that it derives from the value of the pig.
Are Derivatives Still a Problem?
After the reforms of 2008 including the 800 page Dodd Frank Act, 2010, is it possible that the derivatives are still a risk to the financial system?
Attorney Ellen Brown described the current situation in an article on Sheerpost:
“ However, when Warren Buffet famously labeled derivatives “financial weapons of mass destruction” in 2002, its “notional value” was estimated at $56 trillion. Twenty years later, the Bank for International Settlements estimated that value at $610 trillion. And financial commentators have put it as high as $2.3 quadrillion or even $3.7 quadrillion, far exceeding global GDP, which was about $100 trillion in 2022. A quadrillion is 1,000 trillion “.
Those numbers are just too big to comprehend for us who are used to dealing in hundreds and thousands. Questions might arise in your mind such as:
* If total world GDP is 100 trillion, how can there be derivatives valued at 600 trillion?
* Derivatives have no value in themselves and only have value in reference to an asset. How can they be worth more than that referenced asset?
* in other words, how can there be more contracts for selling pig bellies than there are pigs?
We will have a look at these questions shortly.
Former stock broker Pam Martens of Wall Street on Parade extracted the data on the derivative holdings for the commercial bank JP Morgan Chase from a 2024 report by the Office of the Controller of Currency:
“Do the millions of Americans that are depositing their paychecks at the 5,143 branches of Chase Bank that are spread coast to coast have any idea that the OCC reported that this federally-insured banking unit of JPMorgan Chase was sitting on $54 trillion in notional derivative contracts as of March 31, 2024?
Of course, these bank customers don’t know. Ask yourself when was the last time you turned on your evening TV news and heard one word about trading corruption on Wall Street?”
So, the answer is yes derivatives are still a real risk to the financial system. Bankers are still using ‘other peoples’ money’ to speculate in risky investments just as they did before 1929 and 2008. However, in 1933, they were stopped by FDR’s reforms until that restriction was lifted in 1999 by the Gramm Leach Bliley Act. But they were not stopped by the reforms after 2008 as the above data shows- another issue we will look at after we have unpacked the complexity of derivatives.
Next, we will penetrate the fancy language of one of the derivatives that played a central role in the crash of 2008: the collateralized debt obligation (CDO).
Acknowledgement: Bank building photo by Expect Best on Pexels.
Originally published at https://jandweir.substack.com.