The 'D' Word

As we all know, derivatives were put on the earth by the Devil to tempt degenerate gamblers into creating financial armageddon. That's why it looks likely that US banks will be forced to spin off their swaps desks to seperate all that evil from good, honest lending to people who can't afford it and then creating.....financial armageddon. Then all those nasty credit derivatives can rot in hell with prop trading and short-selling hedge fund bastards and all the other stuff that didn't actually cause the financial crisis.

But wait, you say - AIG stuck a grenade up it's own backside by writing CDSs and that cost some serious $$$$$. The interconnectedness between financial institutions caused by them being counterparties to each other's OTC derivatives trades played a large part in causing the credit crunch. Right?

Now, it's funny you mention AIG, because they're an insurance company, and CDSs are basically...yes, you guessed it, insurance. What AIG and a lot of financial companies did was the equivalent of saying "There has never been a non-white President of the United States, so an African American winning the election is impossible. I will bet everyone in the world a hundred billion dollars that there will never be a black President.....what? Barrack Obama you say? He won and now everyone in the World wants more money than actually exists in the World? Oh dear..."

CDSs weren't the problem - charging a low premium for insuring against risks that can't be modelled properly was the problem. If I try to get life insurance, there is plenty of data on how long people like me live - I may die tomorrow, I'll probably die when I'm about 85 and I won't live until 200. But insuring subprime mortagage bonds is different beacause: a) they have not been around for very long; and b) subprime mortgages became a larger and larger part or the mortgage market. This is the equivalent of offering life insurance to Adam and Eve, with Eve giving birth to a scientist that discovers a cure for cancer. CDSs were just a medium for taking big, leveraged bets. Like buying a house with no down payment.

To a simpleton, or politician, it still makes perfect sense to seperate this insurance business from the 'core' operations of banks. But interest rates are a bank's business - you don't need to be able to change a spark plug to effectively manage a car insurance book, but operating in the loan and fixed income markets certainly helps when working with CDSs. Unfortunately nobody is interested in that and it's set aside with any other rational view of the banking system. Let's not forget that everyone is pushing for Investment Banks' 'risky' activities to be split from the business of lending and taking deposits. But advising on M&A isn't risky. How many banks have suffered catastrophic losses from their capital markets businesses? Even prop trading, which everyone is talking about, has NEVER caused losses like those seen in the residential mortgages. Did Northern Rock have an investment banking division or write CDSs? Would Barclays have weathered the crisis better without Barclays Capital?

On the whole, investment banks use their strategic advantages to earn large fees and trading profits. All the nonsense about casino banking and prop trading and derivatives has distracted people from the fact that the riskiest thing a bank can do is lend a huge amount to one person with little of no collateral. Yes, the banks need to reduce leverage and risk, but so do borrowers. If people could not get a mortgage without a 25% deposit, we would not be in this mess. But apparently it is a God-given right for people to own homes they can't afford, even though tighter lending criteria would reduce the price of a home, and therefore make it more affordable. Would you rather pay £200k for your home with a 10%, £20k deposit or £80k for the same house with a 25%, £20k deposit? Your mortgage payments would drop enough to pay for the next 100 iPhone upgrades and all the oddly-named storage boxes in your nearest Ikea.

Nobody can get a mortgage right now without a 10% deposit. "First time buyers can't get on the ladder", the press howl, "the banks aren't lending". But this is the perfect time to really address the problems in the system. Increasing the minimum deposit amount to 11% and then gradually, perhaps by an extra 1% each year, will stop a huge shock to the market, but will also help prevent another bubble from inflating and take a huge amount of risk out of the banking system and the economy in the future. Unfortunately it will also snuff out the British dream of leveraging up, buying and selling houses until you finally achieve the promised land of a million pound house. Even though that million pound house is a 3 bed semi that you could get for half the price abroad.....

Groundhog Day

If you read financial blogs on a regular basis then you might feel like everyday is Groundhog day. Scroll down to the comments and you will see liberal use of "Wall Street", "Crooks", "Bankers", "Greed", blah, blah, blah. Why are these people so angry?



I borrow $/£500k from a "banker" because all my friends are doing it and house prices are soaring and maybe, just maybe I'll make $/£100k.



For no work whatsoever.



Lets call this scenario Lazy/Greedy/Casino Capitalism.



But wait. NO! HOUSE PRICES ARE GOING DOWN! I took a huge, huge risk and it didn't pay off.



Ah, ok the government will bail me out........No, they're bailing the bankers out. It was the bankers fault. The bankers fault! They took a huge, huge risk and it didn't pay off....



Let's call this scenario Greedy/Casino Capitalism (unfortunately we can't call it lazy as they work 14 hour days).



Ok, we have to stop this happening again. Let's stop people from buying a house without a 25% down payment. Let's stop people taking huge risks that they don't really understand. No, that will be unpopular. People want big houses. People want easy money. So...let's make a lot of noise about how we have to split up retail and investment banks (even though it was your plain vanilla mortgage lending retail banking that got us into this mess). Let's criticise the banks. And you know what, somebody sold me a kitchen knife last week and I cut myself! Let's start a campaign against him because he sold me something I could cut myself with!



Wow, this feels great. Something bad happened, and I guess you could say I should have thought about taking on an enormous debt and chopping onions with my eyes closed, but it wasn't my fault! The governement says so, the newspapers say so, everyone says so!