Washington & Wall Street: Too Big to Fail and the Detroit Bankruptcy

the bogey man known as “systemic risk” to gain advantage over the other creditors .

In order for the OTC casino to work, the derivatives contracts had to be given special priority in bankruptcy. Speculative derivative instruments such as credit default swaps (CDS), which caused the failure and government bailout of American International Group, could never exist in significant size were in not for the safe harbor from bankruptcy for derivatives created by Congress in the 1980s and 1990s. Members of Congress from both parties were paid very well for their treachery.

The intellectual author of the “systemic risk” canard was my former boss, E. Gerald Corrigan, once the head of the Federal Reserve Bank of New York until his sudden resignation in 1993. Corrigan was the apprentice of none-other than Paul Volcker, the enabler of the big banks and father of the concept known as “Too Big to Fail.”

The legal safe harbor for derivatives contracts in bankruptcy enables a huge speculative industry and also represents an enormous subsidy to the largest TBTF banks. Seton Hall Professor Stephen J. Luben has discussed this issue in numerous articles and papers. Derivatives could never trade the volume and breadth of instruments that are seen today if these contracts were subject to the authority of the bankruptcy courts.

The safe harbor for derivatives in bankruptcy is essentially a tax on the other creditors of insolvent entities, who must shoulder losses while the counterparties in the derivatives markets get paid 100 cents on the dollar. The whole ridiculous argument made by Volcker, Corrigan and former Treasury Secretary Tim Geithner regarding systemic risk is ultimately why Goldman Sachs and other counterparties of AIG were paid in full after the US government rescue.

"Speculative derivative instruments such as credit default swaps (CDS), which caused the failure and government bailout of American International Group, could never exist in significant size were in not for the safe harbor from bankruptcy for derivatives created by Congress in the 1980s and 1990s. Members of Congress from both parties were paid very well for their treachery."

I used to think Senator Charles Grassley was a square in the go-go late 90's when he didn't go for getting rid of Glass Stegal and the other 2 Clintonian Banking and Brokerage reforms.

Man was he right on.

There is a video of Chris Shays going mano-e-mano with Barney Frank where he talks about Moral Hazard.

The whole Financial world, Sarb-Ox and Dodd - Frank were all centric on "systemic risk". Systemic risk my @$$ what about moral hazard? Don't any of these people or these legislators have a Christian Conscious and know the fundamental difference from right and wrong or am I just a nave from Fly-Over Country?

Beam me up Scotty, no intelligent life on the House and Senate Finance Committees or K-Street...

OK, I am going to show my ignorance. I have tried to read and understand exactly what derivatives are and for the life of me I can’t. I have a B.S., have tried to stay on top of things and consider myself somewhat intelligent. Yet, I just can not understand how derivatives work. Just one of those things I just can’t wrap my fingers around.
If someone could explain it to me, I would appreciate it.

Thanks

It's a general term for numerous different types.

The basic concept is for hedging one's bets. While it's a very simple concept from the simplest point of view, the whole field is quite a large and complex subject.

Very simple example:

Say I'm an investor, long in oil futures, so I'll make profit if the price of oil goes up, say, at a point 6 months in the future. But I'll lose money if it goes down.

You own an airline, and if the price of oil goes up in 6 months, you'll be paying more for your jet fuel and that will cost you quite a bit of money. On the other hand, if the price of oil stays low, so will your fuel costs.

We can both take the opposite side of the future price of oil bet - and we'll both be happy whether the price goes up or down, because for both of us, if the price moves in the wrong direction for us and we lose money because of that, our bet will pay off, offsetting our loss. If the price moves in the right direction, we'll be able to afford to pay off on the bet.

Of course there are are many forms of this type of contract, and many that are useful are ones.

The main hazard with them is counterparty risk. If during that 6 months, in our example above - if the one who has to pay off on the "bet" goes bankrupt or has severe financial difficulties - then the payment might not be able to be made. Yuck, I was counting on that payoff.

Now, what if I had other contracts with other people. And due to me not getting paid - what if I can't pay other people under other contracts ? Big yuck.

Here's an overview article, Derivative (finance)

The article has an overview of criticisms. As always, the devil is in the details, and we find that those that take advantage of their own size and influence, i.e., the usual suspects, i.e., financial elites, wind up passing off risk while grabbing up profits, and at the same time using the concept of "systemic risk" (which was actually introduced by them and passed off, even to the taxpayer), to push for bailouts when they desire them, push against regulation they don't want, and push for legislation or regulation that in the final analysis benefits them more than anything else.

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