A Random Walk Down Wall Street

It’s a few days after U.S. Congress passed a major overhaul of the financial sector, specifically Wall Street investment banks.

It’s a very complicated bill and I’ll refrain from dumbing it down too much. There is one particular item worth commenting upon — if only because I have represented clients on this very issue.

Several years ago, the financial sector came up with the idea of “derivative trading,” which is the Seinfeld of financial transactions — a trade in which nothing actually happens.

A derivative trade does not create an interest in land. Nor ownership in a private company. Nor even the purchase of debt. Rather, it is a highly-leveraged bet on the market itself.

Included in derivatives was the buying and selling of “swaps.” Under this pseudo-transaction, an investment bank would enter an agreement with its own customer to “exchange streams of income” from derivative trades based upon the prime rate or LIBOR. Often the “swap” occurred in tandem with a large loan so that the bank could off-set its risk on a fixed interest rate by entering a “swap” with the borrower for the same amount of money.

Again, no funds change hands. No property is exchanged. No actual transaction takes place.

So why do it? I’ve deposed bank executives who tell me the benefits of these transactions, many of which are foisted on high wealth borrowers who are simply trying to get a loan. Sure.

In reality, the only purpose was to create an additional “transaction” on a high-value loan with a large commission built in for the bank. And these commissions were incredibly profitable, especially when times were good and everyone was taking out $$ from their properties.

So why should we care for these naive borrowers who enter derivative trades and ignorantly fork over enormous commissions? To quote Gordon Gekko: “A fool and his money were lucky to get together in the first place.”

That’s true. But if a bank is FDIC-insured, that changes the equation. Because if the fake transactions actually lead to losses for the Bank (i.e. the borrower can’t cover his swap losses or can’t repay the loan) and the losses cause the Bank to become insolvent, the U.S. taxpayer is now on the line. But that same taxpayer gets no benefit when the trades create the profit.

Heads I win. Tails you lose.

Derivate trading and “swap” trading have been unregulated for years. Even when done by FDIC-insured banks. That is ridiculous. And it needs to stop.

If a Bank wants to make fake trades with its customers, go ahead. But cut loose from the FDIC and set yourself up as a private shop bearing 100% of your own risk. And make yourself subject to consumer protection laws which prohibit false advertising (right now banks are exempt from the VA Consumer Protection Act).

You want to be the man of Wall Street. Then walk like a man. Away from the U.S. taxpayer.

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