Karl Denninger, "Congress Has No More Excuses"

"If you haven't seen this, you need to. Christopher Whalen is a principal of a firm that rates the performance of commercial banks, Institutional Risk Analytics. I have featured some of his writing before in Tickers, but this one, submitted to The Senate Committee on Banking, Housing and Urban Affairs yesterday, takes the cake. You must read this in full but for those who are incapable of understanding it, I'll spell out details for you. Some excerpts:

'Simply stated, the supra-normal returns paid to the dealers in the closed OTC derivatives market are effectively a tax on other market participants, especially investors who trade on open, public exchanges and markets. The deliberate inefficiency of the OTC derivatives market results in a dedicated tax or subsidy meant to benefit one class of financial institutions, namely the largest OTC dealer banks, at the expense of other market participants.'

Translated: The banks make extra-large profits by extracting money from other people in the rest of the market. That is, they have effectively been given the power to levy a tax - something supposedly reserved to Congress. The taxpayers in the industrial nations also pay a tax through periodic losses to the system caused by the failure of the victims of OTC derivatives and complex structured assets such as AIGs and Citigroup (NYSE:C).

Worse, when they blow it, you eat it, not they. Why? Because they have effectively bribed the regulators to speak on their behalf and for their interests, much as allegedly happened with Stanford and the so-called Antiguan banking regulator. With CDS and more obscure types of CDOs and other complex mortgage and loan securitizations, however, the basis of the derivative is non-existent or difficult/expensive to observe and calculate, thus the creators of these instruments in the dealer community employ "models" that purport to price these derivatives. The buyer of CDS or CDOs has no access to such models and thus really has no idea whatsoever how the dealer valued the OTC derivative. More, the models employed by the dealers are almost always and uniformly wrong, and are thus completely useless to value the CDS or CDO. The results of this unfair, deceptive market are visible for all to see – and yet the large dealers, including JPM, BAC and GS continue to lobby the Congress to preserve the CDS and CDO markets in their current speculative form. The dealers, the large half-dozen banks that control this market like a cartel, are basically making it all up. There is no actual underlying pricing and therefore the price is whatever their computer model says it is, and you can't see it. Only they can, and they use this against everyone else to effectively rip off everyone trading with them.

In my view, CDS contracts and complex structured assets are deceptive by design and beg the question as to whether a certain level of complexity is so speculative and reckless as to violate US securities and anti-fraud laws. That is, if an OTC derivative contract lacks a clear cash basis and cannot be valued by both parties to the transaction with the same degree of facility and transparency as cash market instruments, then the OTC contact should be treated as fraudulent and banned as a matter of law and regulation. Most CDS contracts and complex structured financial instruments fall into this category of deliberately fraudulent instruments for which no cash basis exists.

The clear version of the above, in English: It is my view and that of many other observers that the CDS market is a type of tax or lottery that actually creates net risk and is thus a drain on the resources of the economic system. Simply stated, CDS and CDO markets currently are parasitic. These market subtract value from the global markets and society by increasing risk and then shifting that bigger risk to the least savvy market participants. And let's not forget who gets all the money. JP Morgan, Goldman, et.al.

Seen in this context, AIG was the most visible "sucker" identified by Wall Street, an easy mark that was systematically targeted and drained of capital by JPM, GS and other CDS dealers, in a striking example of predatory behavior. Treasury Secretary Geithner, acting in his previous role of President of the FRBNY, concealed the rape of AIG by the major OTC dealers with a bailout totaling into the hundreds of billions in public funds. Any questions? Chris has been one of the consistent bright lights in this mess since it began.

I have called for all swaps and other OTC derivatives to be forced onto an exchange. Why? In no small part because I know that not all derivatives can be exchange traded, and should this be forced all the "sham" products would be immediately exposed for what they are and eliminated from the marketplace. Those that are legitimate products would trade with transparent pricing, open interest and volume, thereby contracting spreads to a reasonable level and eliminating the ability of the cabal of dealers to screw their customers.

Items like FX and Interest-Rate swaps can easily be exchange traded, as the closing price can be computed daily and for most of these products a minute-by-minute price can be computed using transparent and simple formulae. The underlying instruments for these products are real and trade every day - interest rates of course are a matter of public knowledge and trades in the treasury and agency debt market, while currency pairs are quoted on a near-continuous basis. Both sorts of OTC contracts have no real reason to change hands over-the-counter, except to allow some bank to insert a hinky clause here or there that disadvantages the customer, charging an outsize spread or commission for the "privilege." Indeed there have been several major disputes over this practice between these banks and municipalities that were sold complex interest-rate swaps that in some cases came with allegations of outright bribery or inside dealing.

But when it comes to these other things like CDOs and CDS, there is no observable market price on which to base the derivative as there is no actual underlying basis. What, for example, is the "risk that GE will go out of business in the next year"? Document how you arrive at your answer please, and good luck coming up with anything that is objectively defensible. In short, the nonsense, patronage and outright fraud within both our government and the cabal of dealers must stop now.

This marks two warnings Congress has had on this matter in written testimony, the first prior to the repeal of Glass-Steagall predicting exactly what has now happened and now, this from Mr. Whalen. I have written to Congress on many occasions, including spending thousands of dollars faxing Tickers, white papers and other documents to all 535 members over the previous two years on these points. Congress seems to think that America is a bunch of dolts and will tolerate being literally stuck up at gunpoint to the tune of hundreds of billions if not trillions of dollars in a massive collusive scam that reaches all the way to the top of the American Regulatory and Political Systems.

The American people have every right to hold The Board of Governors of The Federal Reserve, The Federal Reserve Bank of New York, Henry Paulson, Tim Geithner and all 535 Congressional members personally responsible if the abuses, frauds, and scams that have been enabled by the intentional blindness and even complicity of these individuals are not stopped immediately and all past transgressions prosecuted to the fullest extent of the law.

We the people have every right to demand and expect that a passel of special prosecutors be empaneled immediately to go over each and every one of these allegations, investigate every agency including The Federal Reserve and its member banks, and where appropriate bring indictments and prosecutions for frauds perpetrated upon the taxpayers, investing public, the states and municipalities of this nation.

STOP THE LOOTING, START PROSECUTING."

- Karl Denninger, http://market-ticker.denninger.net/