inflation guarantee collateral junk bonds

Dissent From a Fed Member, Cato Scholar, & UK Press
chase derivatives financial clearinghouse fees lacker fed bundled mortgages bailouts cronyism connections bubble land value tax

Latest Wall St Move Around Latest US Rule

Four powerful players voice sanity. We trim, blend, and append four 2012 articles from: (1) Bloomberg, Spt 11, on collateral by B. Keoun; (2) MarketWatch, Spt 15, on dissent by W. Spain; (3) USA Today, Spt 16, on bailouts by D. Mitchell (of the Cato Institute); and (4) The Guardian, Spt 16, on land tax by Phillip Inman.

by Bradley Keoun, by William Spain, by Dan Mitchell, and by Phillip Inman

Starting next year, traders must post U.S. Treasury bonds or other top-rated holdings to guarantee more of their derivatives trades -- now totaling $648 trillion. They’ll need to post as much as $2.6 trillion. That is multiples of the collateral currently required, since most cleared trades now are between securities dealers, where the rate nets out to about 0.005 percent.

Even though the market for Treasuries is $10.8 trillion, few bonds will be available as banks rebuild balance sheets and investors seek safety. Hence JPMorgan Chase, Bank of America, and at least five other banks plan to let customers swap lower-rated securities that don’t meet new standards in return for a loan of Treasuries or similar holdings that do qualify. If a trader defaults and his collateral is seized, then the bank loses its Treasuries and is left holding lower-grade bonds that the trader posted.

Some central clearinghouses, which collect from losers on derivatives trades and pay off winners, have responded to the collateral shortage by lowering standards, with the Chicago Mercantile Exchange accepting bonds rated four levels above junk.

Despite risks to the financial system, the reward for banks is an expanded securities-lending market that could generate billions of dollars in fees. JPMorgan and Bank of America, which have the biggest derivatives businesses among U.S. banks with a combined $140 trillion of the instruments, are already marketing their new collateral-transformation desks.

Derivatives allow buyers to bet on the direction of currencies, interest rates, and markets to protect their holdings, insure against defaults on bonds, or lock in a price on commodities. More than 90 percent of the trades are privately negotiated. That exempts them from the rules of futures exchanges, which require an initial collateral posting as a good-faith deposit to ensure bets are covered. Traders have to post more collateral, usually in cash, when positions move against them.

Often derivatives contracts aren’t backed. American International Group Inc. (AIG) needed a $182.3 billion bailout from the U.S. government after the New York-based insurer failed to make good on derivatives trades with some of the world’s largest banks.

The new business resembles the existing $5.5 trillion repurchase market, known as repo, where banks and investors can temporarily pledge their bonds to other lenders or mutual funds in exchange for cash loans. The sudden withdrawal of some participants from that market in 2008, partly because of concerns about the quality of collateral, contributed to the near-collapse of Bear Stearns Cos. and led the Fed to create a $148 billion emergency-lending program to backstop other Wall Street firms.

To read more

JJS: Why should big banks worry since we keep bailing them out?

Jeffrey Lacker, president of the Richmond Fed, was the sole dissenter in the Federal Reserve’s third round of printing more money then issuing it into the economy by buying bundled mortgages from banks.

Lacker said their spending of $40 billion per month of new notes could lead to higher inflation and interest rates.

Fed purchases distort the investment allocations of others and raise interest rates for borrowers. “Channeling the flow of credit to particular economic sectors is an inappropriate role for the Federal Reserve.”

To read more

JJS: Banks focus on mortgages, knowing that land is their constant and certain (even if fluctuating over the 18-yr cycle) source of great wealth. At least even some conservative voices oppose the bailouts.

The bailout craze in the United States is a worrisome sign cronyism is taking root.

The defining characteristic of cronyism is that politically connected businesses get special favors from the government at the expense of others. Most people oppose it because of the inherent corruption, but economists also dislike it because it lowers living standards by its misallocation of resources. Investors are less willing to put money into firms without connections.

The bailouts in the financial sector gave law-breaking firms a new lease on life -- even though they helped cause the housing bubble! The federal government could have taken over insolvent banks while protecting savers. Taxpayer money still would have been involved, but shareholders, bondholders and top executives would have taken bigger losses.

The bailouts not only put taxpayers on the hook for big losses but also created a precedent for future interventions.

Private profits and socialized losses are no way to operate a prosperous economy. Capitalism without bankruptcy, after all, is like religion without hell.

To read more

JJS: The fundamental solution is to take spending for land out of the paws of financiers. A tax could do that.

A levy on the value of land regardless of what is on it would encourage efficient use of land within planning permission rules.

Much of the debt owed to banks belonged to property developers and allowing them to go bust would mean more banks ending up in taxpayers' hands.

A more embracing LVT could be offset by reductions in income tax and getting rid of stamp duty and capital gains on property, which in turn would encourage more sales.

The OECD has argued that a switch from income taxes to wealth taxes would have the benefit of discouraging wealth hoarding in favor of work.

While most ordinary families would gain from a land tax, it is a scary prospect for older middle income households that have benefited hugely from the house price boom of the last 20 years. For some it could prove an extra burden. But their children would find it easier to afford a home.

To read more

JJS: The transition is the tricky part. That’s where government bonds could come in to play. If any owner could show a net loss, give them a treasury bond (funded from the recovered land rents).


Editor Jeffery J. Smith runs the Forum on Geonomics and helped prepare a course for the UN on geonomics. To take the “Land Rights” course, click here .

Also see:

Lessons from Old New York and New

Need versus Greed -- Inequality and the Right

Should Goldman Give Back $2.9 Billion to Taxpayers?

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