Citizens Electoral Council of Australia
Media Release Friday, 19 May 2017
http://www.cecaust.com.au
Do Big Five banks fear levy will expose derivatives danger lurking beneath their books?
The Big Five (Big Four plus Macquarie) banks are frantically trying to get most or all of their derivatives obligations excluded from the government’s levy on their liabilities. The government has said the bank levy applies to derivatives, the financial bets that far exceed in size all other trades in the financial system.
For instance, while Australia’s GDP is just shy of $2 trillion, the derivatives contracts held by Australia’s banks amount to around $35 trillion. Globally, official BIS figures record derivatives at around US$500 trillion (compared with US$50 trillion world GDP), but as there is so much dodgy accounting involved, others estimate them at US$1.2 quadrillion (US$1,200 trillion).
According to James Eyres in the 15 May Australian Financial Review, Westpac, ANZ and NAB have told the government that the levy should only apply to so-called “netted” derivatives positions, while CBA has said it should not apply to derivatives at all; Macquarie, true to form, is not making its submission to the government public.
These arguments betray real panic. “Netting”, for instance, is the ruse banks use to explain away the risks involved in derivatives gambling. They deduct, from what they owe on derivatives contracts, the amount that other banks owe them, to claim that the multi-trillions in contracts represent just a few billion in liabilities.
While it may be legitimate to “net” transactions between two parties, it is bogus to apply it to derivatives. It can be compared to splitting a restaurant bill—easy among a few people, but what about a few thousand? The bubble of derivatives speculation is extremely complex, involving millions of contracts interlinking banks all over the world.
What a bank is owed on derivatives contracts by its counterparties is contingent on many other banks in the daisy chain being able to honour all of their obligations; if one of those banks fails, as Lehman Brothers did in 2008, the daisy chain of obligations can explode and the entire derivatives trade can melt down. And when it does, it is not the “netted” figure that banks have to pay, but the full, so-called “notional principal” liability in the derivatives contract.
For this reason there have been numerous derivatives disasters in recent history which have wiped out entire banks and whole chunks of the financial system, including Barings Brothers in 1995, Long Term Capital Management in 1998, and of course Lehman Brothers in 2008.
The growth in derivatives speculation by Australian banks has been extremely rapid since the 2008 crisis, more than doubling from $14 trillion to $35 trillion. These contracts are held “off balance sheet”, and three of the Big Five—CBA, NAB and Macquarie—have stopped disclosing their full multi-trillion dollar derivatives exposure, revealing only the much smaller, tens of billions “credit equivalent” exposure instead.
It is a scandal that this is allowed, especially after the 2008 crash, which proved such derivatives accounting to be
fraudulent.
As Financial Instruments Specialist Pauline Wallace of accounting giant PWC said in the 4 November 2008 Sydney Morning Herald, “I’ve always regarded it [derivatives accounting] as a bit of a magic trick. Magicians come to parties, and they make things seem to disappear. The risk is somewhere, but you never knew where,” she said.
The bank levy, if the government insists it apply to each contract, will force them to account for their full liability—both a massive accounting task, and potentially much more expensive for the banks than the initial calculations of what the levy will raise. This will actually test how real the banks’ profits are, which, given their heavy derivatives gambling, are suspiciously high in an Australian economy that is actually collapsing, losing productive jobs and industries left, right, and centre.
Glass-Steagall
The bank levy is an attempt by the government to repair its budget, but it will not repair the big Australian banks, which are heading for collapse from their dangerous speculation in derivatives and real estate. Only a Glass-Steagall separation of the banking system, which breaks up the Big Five banks into stand-alone commercial banks with deposits that are kept separated from investment banking, insurance, stock broking, wealth management and other financial services, will protect the Australian people from catastrophic banking collapse.
The Citizens Electoral Council has—since 1993!—relentlessly exposed the derivatives danger in the Australian and global financial system, and since the 2008 crash has fought for the Glass-Steagall solution to fix the banking system. All Australians are naturally concerned about their financial security, and that of their loved ones, but the current system has become such a casino that the only way to protect your own security is to fight for Glass-Steagall to protect the whole nation.
Derivatives
- A bank lends money to a homebuyer.
- The bank then sells the mortgage to Fannie Mae. This gives the bank more funds to make new loans.
- Fannie Mae resells the mortgage in a package of other mortgages on the secondary market. This is a mortgage-backed security (MBS), which has a value that is derived by value of the mortgages in the bundle.
- Often the MBS is bought by a hedge fund, which then slices out portion of the MBS, let's say the second and third years of the interest-only loans, which is riskier since it is farther out, but also provides a higher interest payment. It uses sophisticated computer programs to figure out all this complexity. It then combines it with similar risk levels of other MBS and resells just that portion, called a tranche, to other hedge funds.
- All goes well until housing prices decline or interest rates reset and the mortgages start to default.
That's what happened between 2004-2006 when the Fed started raising the Fed funds rate.
Many of the borrowers had interest-only loans, which are a type of adjustable-rate mortgage.
Unlike a conventional loan, the interest rates rise along with the Fed funds rate. When the Federal Reserve started raising rates, these mortgage-holders found they could no longer afford the payments.
This happened at the same time that the interest rates reset, usually after three years.