Ben Treece: The derivative cure-allWritten by Ben Treece | | email@example.com
Recently, many readers who follow our writings or listen to Dock on WSPD have heard us comment on the highly unpopular and potentially illegal move made by Bank of America/Merrill Lynch in the past week. For those who have not caught wind of this story yet, Bank of America took a staggering number of derivatives contracts off of its subsidiary Merrill Lynch’s books and put them on its own, ensuring that its bad bets would be federally guaranteed by FDIC protection. The actions taken by Bank of America and its subsidiary are not only immoral, they violate the Federal Reserve Act — yet nobody has done anything about it.
Merrill Lynch has trillions (with a T) of dollars in derivatives liabilities which come in the form of options, futures or other hedging vehicles. According to Bloomberg, Merrill has somewhere in the ballpark of $53 trillion in outstanding derivatives contracts.
To make sure it doesn’t lose its backside if a majority of these derivatives don’t pay out (which after the recent developments in the Greek debt bailout, it would appear that many won’t), Bank of America has shifted these liabilities onto its books and away from Merrill’s.
Bank of America honestly expects the FDIC and the American taxpayer to fund its speculative investments … it is 2008 all over again.
Obviously, the FDIC cannot pay out on 5.5 times the size of the U.S. GDP if all of the contracts were to go bad, but even paying one thin dime would be a dime too much. Furthermore, the shift from Merrill Lynch to B of A was reportedly urged by the Federal Reserve. This is all very interesting considering under Section 23a of the Federal Reserve Act, this action is clearly defined as illegal. The question remains: Who will try to stop the giant? At this point, it appears nobody will.
Derivatives as a whole aren’t all bad, however, they serve as insurance against an investment, a hedge. The problem comes when we allow derivatives to become their own separate market, then they turn into a gambling pit. For example, buying home insurance is great … for your house. Buying home insurance against your neighbor’s house gives you incentive to burn it to the ground.
As an example, let’s say that Tom Pounds and Michael Miller go to the horse track and bet $5 on Seabiscuit. Tom bets Michael that Seabiscuit will win the race, but I overhear this bet and in turn bet Dock David $10 that Tom will win his bet, which is contingent on Seabiscuit winning. Dock David agrees, then goes to Dock Sr. and buys insurance on his bet for $4, saying that if he loses Dock Sr. will pay the full $10, but if Dock David wins the bet he just pays Dock Sr. the original $4. An original $5 bet now has $29 on the table.
It is with that in mind that I have the perfect solution to the derivatives markets. First, we need to separate commercial and investment banking practices again. When the two work in tandem an obvious conflict of interest arises, which ultimately hurts the consumer. We created a separation between the two in the ’30s after a banking crisis by passing Glass-Steagall, then repealed it in 1999 which opened the door for this relationship to once again thrive.
Sure enough, within 10 years of the repeal we had another banking crisis. We can thank Phil Gramm, Jim Leach and Thomas Bliley for drafting the repeal legislation and President Bill Clinton for signing it into law.
Second, make it illegal for any investment bank to engage in the creation and sale of derivatives. As I displayed in my earlier example, derivatives have become nothing more than a big gambling pit … so we should treat them as such.
I propose that the creation and sale of derivatives be moved to Las Vegas and regulated by state gaming commissions. This allows companies to hedge their investments (the way that derivatives were meant to be used in the first place) but keeps them from profiting off of the sales and commissions of these products. By shifting these products to casinos we would see a boost in local economies. Las Vegas to date has 14.2 percent unemployment, more than 50 percent higher than the national average of 9.1 percent, according to the Bureau of Labor Statistics. This will undoubtedly spark the local economy of Las Vegas, reinfuse capital back into that market and also lift a heavy regulatory burden off of an already incompetent and overworked regulatory body in the SEC.
I don’t claim to have all of the answers to our financial problems; however, now is the time to start thinking outside of the box for how to boost the U.S. economy and fix a faulty banking system. I see the protestors in Zuccotti Park on TV, and while I think that many of their ideas are misguided, I understand their frustration. The time has come to end crony capitalism and return America to the form of capitalism that led us to be a nation full of ingenuity and innovators.
Ben Treece is a 2009 graduate from the University of Miami (FL), BBA International Finance and Marketing. He is a discretionary money manager with Treece Investment Advisory Corp. and a stockbroker licensed with FINRA, working for Treece Financial Services Corp. The above information is the express opinion of Ben Treece and should not be construed as investment advice or used without outside verification.