Feb 172013

By Éric Toussaint, CADTM

From the series: Banks versus the People: the Underside of a Rigged Game! (Part 5)



“In order to facilitate the financing, insuring, and timeliness of all that trade, the volume of cross-border transactions in financial instruments has had to rise even faster than the trade itself. Wholly new forms of finance had to be invented or developed, credit derivatives, asset-backed securities, oil futures, and the like all make the world’s trading system function far more efficiently.

In many respects, the apparent stability of our global trade and financial system is a reaffirmation of the simple, time-tested principle promulgated by Adam Smith in 1776: Individuals trading freely with one another, following their own self-interest leads to a growing, stable economy.” Alan Greenspan |1|

The financial innovations presented as a panacea by Alan Greenspan have been a big flop, causing very serious economic and social damage. At the same time, the dictatorship of the markets and the ukases of the European troika have been infringing on the democratic rights of citizens everywhere. European treaties and the policies applied by successive governments have progressively chipped away at the peoples’ hard-won democratic rights: the legislative power has been increasingly dominated by the executive, the European parliament is a front piece for the European Commission, and there is less and less respect for what the electors try to say. Meanwhile, leaders hide behind the European treaties and repeat the old Thatcherite refrain: TINA (there is no alternative), to justify austerity and debt repayment. At the same time, they have been doing as much as possible to defy the economic and social rights conquered during the 20th century, on the one hand.(see Part 3 of this series); and, on the other hand, to prevent a new banking crisis from erupting. However, no seriously restrictive measures have been taken to impose a new discipline on banks and other financial institutions. The banks have not cleaned up their accounts since 2007-2008. Worse yet, they have been very active in creating new bubbles and new structured financial products.

In this fifth part of the series, |2| we look at how the banks have been bending over backwards to fund their activities, their almost total dependence on public assistance, the speculative bubbles that are in gestation, speculative financial innovations, the disastrous effects of the present banking system particularly in creating food crises, as well as the new risks that the modus operandi of banks has been creating for people. |3|

Medium- and long-term financing problems

We will first have a look at the financing side of bank operations, (i.e., bank liabilities), where banks are encountering big problems. Institutional investors (insurance companies, pension funds, other banks, and sovereign wealth funds among others) no longer have confidence in banks, and hesitate to buy their covered bonds issued in the hope of finding stable long-term financing. Even if some banks like France’s two biggest, BNP Paribas and Societe Generale or Spain’s second biggest bank BBVA, have found buyers for their bonds, the volumes issued in 2012 remain as low as in the previous years. According to the Financial Times, this might even be the worst year since 2002. |4|

As the banks cannot find sufficient long-term funding on the financial markets, they are vitally dependant on the 3-year ECB loans totalling €1 trillion at 1%, |5| and generally the liquidities made available by the central banks of the industrialised countries (particularly by the US Federal Reserve Bank, the ECB, Bank of England, National Bank of Switzerland, and the BoJ (Japanese Central Bank)).

Short-term financing problems

Much of their financing, other than deposit and savings accounts, which show no growth because of the crisis, must be found on the short-term market. According to the Liikanen report, the big European banks need €7 trillion from day to day. |6| The volume of banks’ short term debt increased significantly between 1998 and 2007, from €1.5 to €6 trillion, while from 2010 to 2012, it remained at €7 trillion! Where do banks find this short-term money? It is no longer, or hardly, available on the interbank markets, because the banks are too wary to lend each other money. They are thus dependent on Money Market Funds (MMFs) which have up to $2.7 trillion available for day-to-day trading depending on how the winds of crisis are blowing in Europe. |7| MMFs shut off the flow in June 2011, and reopen it when the ECB lent €1 trillion. |8| At any moment, they may close or restrict the flow again. The surest supply of funding is once again the central banks. The ECB has made massive loans at 0.75% (the current rate since May 2012).

The conclusion is clear: without the €1 trillion over three years and the day-to-day loans of the ECB and the national central banks linked into the Eurosystem (to which must be added the Bank of England and the National Bank of Switzerland), many big European banks would be menaced with suffocation and bankruptcy. This is more evidence that the banks have not cleaned up their accounts. They must find massive short-term funding, whereas they hold long-term assets of doubtful value. In many cases, the value of the assets on their balance sheets will not be realised when they come to maturity, and the losses suffered may absorb their whole capital.

The stock exchanges are blocked

Funding from the stock exchanges is also blocked The price of bank shares has dropped, on average, to a fifth of their 2007 level |9| (see charts in appendices). The institutional investors (insurance companies, pension funds, investment funds, banks, and others) are not inclined to buying shares of companies that are in bad shape. This is additional proof of the abysmal distance that exists between the theoretical functioning of capitalism as announced by its supporters and reality. In theory, the stock exchange is supposed to help listed companies gain access to long-term investment capital (shares are considered to be investments that must be kept for at least eight years). However, this scenario just doesn’t work, because the stock exchange is no longer a place where companies can find funding for a long time, but a place of pure speculation. That is why banks must be recapitalised with public money.

On other hand, according to the same theory, the stock exchange, by the price of its shares, is the real representation of a company’s value. From this point of view, the average 80% drop in the capitalisation value of banks suggests a very embarrassing revelation for their directors and for the pundits of the capitalist system.

We should also remember that banks use part of the cash supplied to them by the central banks to buy back their own shares. There are two reasons for this: to try to stop the value of their shares from falling, and to pay their shareholders for their shares. |10|

Banks funded by money coming from drug traffickingDrug trafficking money is another source used to fund banks. On 26 January, 2009, Antonio Maria Costa, Executive Director of the United Nations Office on Drugs and Crime (UNODC), declared to the on-line Austrian magazine profil.at |11| that some interbank loans were recently funded “by money from drug trafficking and other illegal activities.” Very recently, in December 2012, HSBC (UK, the second largest bank in the world in terms of assets) accepted to pay a record fine of $1.92 billion |12| to US authorities to put an end to the lawsuits being brought against it, in particular for charges of laundering money for the Mexican drug cartels. |13|

Time bombs in European and US bank assets

As seen above, banks assets are in reality, large financial time bombs that are already ticking.
In Europe, 70% of the structured financial products backed by commercial mortgages (CMBS – Commercial Mortgage-Backed Securities) that matured in 2012 were not paid! |14| These products were sold between 2004 and 2006, just before the subprime bubble burst, and they come to maturity from 2012 to 2014. According to the Fitch rating agency, only 24 of the 122 CMBS that matured in the first 11 months of 2012 were paid. In 2013-2014, the contracts that arrive at their term amount to €31.9 billion. In 2012, JP Morgan, the biggest US bank lost $5.8 billion on the European CMBS market through its London office because of the bad management by one of its agents nicknamed “the Whale”. |15| This did not stop Deutche bank or the Royal Bank of Scotland creating new CMBS for the European market! Why do these banks get involved in these operations? Because the high risk level is compensated by the expectation of higher returns than those on other products. Keep watch!

European and US banks still have several trillion dollars of residential mortgage-backed securities (MBS) on their balance sheets, notably subprime MBS and other categories of asset-backed securities (ABS). Banks have a hard time trying to unload these securities unless they accept important losses. At the end of December 2011, MBS could be sold for no more than 43% of their nominal value, but there were very few buyers. |16| Banks are very discrete about the exact volumes of MBS they hold on their balance sheets, and even more so concerning their off-balance sheet holdings.

Collateral loan obligations (CLO) are another structured product created during the period leading up to the subprime crisis, which raises concern while at the same time enticing the most aggressive European banks, such as the Royal Bank of Scotland into the fairy circle of high risk – high profits. CLOs were sold to gain funds for investors who wanted to buy companies by taking on more debt, playing on leverage to the maximum, which is known as a leveraged buy-out (LBO). These CLOs are now reaching maturity, and their owners are wondering how they will be paid. The European market is totally flat, but the US market has come back to life, selling $39 billion in 2012. Some European banks are also purchasing them because the possible gains are high given the risks involved. |17| Fragile, handle with care.

New bombs are being set

JP Morgan and other big banks have proposed to create structured products comparable to the subprime mortgages CDOs, for credit linked to international trade. Remember that Collateral Debt Obligations (CDOs) were created out of different types of mortgages, which the banks wanted to unload by securitising them (that is by transforming mortgages into a more easily tradable security). |18| JP Morgan wants to do it all over again with export credits instead of mortgages. It was this same bank that in 1994 created the ancestor of CDOs. |19| The export credit market is $10 trillion per year. JP Morgan is trying to persuade banks that are active in this market, to structure the credits into CDOs so as to render them more liquid. The official line is that this approach will reduce assets thereby reducing the leverage effect in accordance with the new Basel III regulations on the need to increase capital ratios (see Part 6 and the Basel III accords). In fact, for JP Morgan and the other big banks that are always seeking to achieve profitable financial innovation, this is a new mine to open and exploit on a major market. |20| Here again, if the JP Morgan strategy works well there are high prospects of more damage from a new bubble.

The frantic scramble for profit causes losses

A few examples illustrate the magnitude of the risks that banks continue to take. There was the blow to Societe Generale in France (€4.9 billion) resulting from the continual mishaps of its trader, Jerome Kerviel. This affair goes back to January 2008 and we might imagine that the banks would have since taken the lesson. Not at all! In September 2011, the Swiss bank UBS announced losses of $2.3 billion through unauthorised transactions by Kweku Adoboli, manager at Global Synthetic Equities Trading in London. Again in London, as mentioned above, JP Morgan’s “whale” lost $5.5 billion for “his” bank. These affairs are only the tip of the iceberg.

A speculative bubble has developed in Corporate Bonds

Many financial market observers and many fund managers consider that a speculative bubble has developed in the Corporate Bonds sector, bonds issued by big companies. There is thus, a new bubble forming on the debt of major corporations. Why has this $9.2 trillion market been creating a bubble? The return that banks and other institutional investors get from the United States treasury and the sovereign bonds of the main EU powers is at a historical low. The investors search around for a better sector, in which there is no apparent risk: corporate bonds of non financial companies gave a more attractive return of about 4.5%. Another reason that banks prefer to purchase obligations rather than take on loans is that obligations can be easily converted into cash on the secondary market if need be. |21| This rush on bonds caused a serious drop in their yield, which fell from 4.5% at the beginning of 2012 to 2.7% in September of that same year.

A major corporation like Nestle was able to issue €500 million in 4-year obligations offering no more than 0.75% p.a. This case is exceptional, but it shows that the rush on corporate bonds does exist. According to JP Morgan, the call for bonds is such that the yield on junk bonds was in free fall during the summer of 2012, dropping from 6.9% to 5.4%. If the trend continues, institutional investors may look elsewhere for better returns. |22|

The craving for profit is such that companies succeed in issuing PIK (Pay in Kind) bonds, which were trendy before 2006-2007 then found no new buyers until 2012. These bonds receive no interest until the capital is fully paid off. Of course, the promised final repayment is high, but there is a great risk that the company borrowing will not be in a position to either pay back interest or capital when the loan matures! It would in fact be prudent of a lender to ask why a company that is unable to pay regular interest over the duration of the loan will be able to repay the full amount at the end. |23| Once again the craving for profit and the availability of liquidity (because of central bank loans) has led to a keen interest for these high risk products.

The shortage of collateral |24|

Up to 2007-2008, the financial markets experienced a period of growth and exuberance. The Bankers and other institutional investors cross lent capital and structured products to each other in a joyful asset-go-round without any verification as to the credit worthiness or the capacities of those signing a contract to assume their responsibilities when it came to maturity. For example, bankers paid insurance premiums to Lehman Brothers and AIG to cover against the risk of payment defaults without first verifying whether they had the means to pay the indemnity if need be.

In most transactions, the borrower must put up an asset as a guarantee. This is called collateral. What often happened and still does is that the same collateral is used to guarantee several different transactions. A borrows from B and puts up collateral as a guarantee. B borrows from C and uses the same collateral as a guarantee, and so on. If the chain is broken anywhere, there is the risk of not finding the collateral. As long as the markets were euphoric and nobody asked embarrassing questions about collateral, business went on as usual. Since 2008, things have not quite been the same and the co-contractor who wants collateral may insist on having assurances that it is really available if need be, that its value is authentic and of that it is of good quality. Collateral circulates less and doubtful collateral is refused. |25|

It is reasonable not to accept toxic assets such as subprime CDOs as collateral. This has led to the beginning of a shortage of collateral. In 2011 and 2012, the Franco-Belgian financial company Dexia suffered from insufficiently good collateral, and was unable to cover its financial needs. In 2012, Dexia borrowed close to €35 billion from the ECB at 1% within the LTRO framework. The enormous loans from the ECB were insufficient, so Dexia, once again, turned to the French and Belgian States, in October-November 2012 for a €5 billion recapitalisation.

According to the Financial Times, Spanish banks have become experts in the creation of collateral. They create structured ABS products from doubtful mortgage credits and other equally doubtful products, and push them on the ECB as collateral for treasury needs. |26| So the ECB accepts this custom-made low quality collateral. This example offers more evidence of how the ECB bows down to the bankers.

In the context of collateral, we must also denounce the lies concerning government bonds that are supposedly giving the banks a headache. Government bonds are a much surer form of collateral than most private financial instruments. Banks do not hesitate to offer them as prime quality collateral for ECB loans.

Sovereign debts

Indeed, let us have another look at sovereign debt. Until now, it has not caused any banking catastrophes. Nevertheless, it is evident that in countries like Spain and Italy, the banks are making important purchases of the bonds issued by their own governments. They have two good reasons for acting in this way: on the one hand, they hold large amounts of liquidities lent by their central banks at very low interest rates (0.75 to 1%); on the other hand, their own country’s bonds are remunerated at much higher rates (4 to 7%). However, the austerity policies are so brutal that it is uncertain whether these governments will always be to pay them back. This problem is not an immediate threat, but the possibility of future difficulties must be considered. |27|

Sovereign debt is not the Achilles’ heel of private banksThe mainstream media permanently repeats the story told by bankers and politicians according to which sovereign debt represents a real danger. In order to clear up this issue and take away this old sovereign debt argument from those in power, who are using it to impose antisocial policies, we must develop convincing counter-arguments, which could be based on the data provided in this series. In a recent IMF report, |28| there is a chart on the percentage of sovereign debt in the assets of private banks in 6 key countries. According to this chart, government debt represents only 2% of the assets of British banks, |29| 5% for French banks, 6% for US and German banks, and 12% of the assets of Italian banks. Japan is the only country, among the 6 mentioned, in which government debt represents an important proportion of bank assets (25%). It is not every day that the IMF agrees with our arguments. However, the conclusion we draw from this data, and the one the IMF would clearly hesitate to make, is that it would be much easier to cancel illegitimate public debt than most people could imagine!

Shadow banking

One of the main causes of bank fragility is their off-balance sheet activities, which in some cases may be greater than their officially declared activities. The major banks continue creating ad hoc companies (Special Purpose Vehicles, MMFs) that are not considered as banks and do not have to comply with banking regulations. |30| Until now these companies could operate without control or, in the case of MMFs, with little control, lending to banks and conducting many kinds of speculative actions on a multitude of derivatives or raw materials (including foodstuffs) on futures markets or the over the counter (OTC) market, which is not regulated. The opacity is total or nearly so. Banks are not obliged to declare, in their accounts, the activities of the non-banking companies they create. The most dangerous activities are the ones conducted by Special Purpose Vehicles. If the losses of one of these companies causes their bankruptcy, the bank that created it is forced by its creditors to record this loss on its balance sheet, which may absorb the bank’s capital and cause it to go bankrupt (or perhaps be taken over by another bank or the government, or be given a public bailout). This is what has happened to Lehman Brothers, Merrill Lynch, Bear Stearns, the Royal Bank of Scotland, Dexia, Fortis, and several others since 2008.

Speculation on commodities |31|

Through their trading activities, banks are the biggest speculators on the over the counter and commodities futures markets. They have much greater means available than the other protagonists. See the website Commodity business awards (http://www.commoditybusinessawards….), where a list of important bankers and brokers on the commodities markets is available (whether on the commodities market where they are bought and sold, or on the underlying derivatives market). Among these banks, the ones most often mentioned are BNP Paribas, Morgan Stanley, Credit Suisse, Deutsche Bank, and Societe Generale.

What is more, the banks are trying to take direct control of the stocks of raw materials. This is the case of Credit Suisse which is associated with Glencore, |32| the world’s biggest raw materials brokerage company. Meanwhile, JP Morgan is seeking to purchase 61,800 tons of copper in order to influence copper market prices. |33|

These are the leading performers in the development of speculative bubbles formed on the commodities markets. |34| When the bubble bursts, the repercussions on the state of the banks will cause new damage. Not to mention, and much more seriously, the consequences on the people in the developing countries that export raw materials.

A look back at the fundamental role played by speculation in the dramatic increase in food and energy prices in 2007-2008Speculation on the principal markets in the United States on which world commodity prices are negotiated (farm products and raw materials) played a crucial role in the dramatic increase in food prices in 2007-2008. |35| These rising prices resulted in a big increase in the number of people suffering from hunger: more than 140 million additional people in one year, for a grand total of more than 1 billion (1 in 7 of the world’s population). Those involved in this speculation were not mavericks, they were institutional investors (or high rollers), including banks, |36| pension funds, investment funds, and insurance companies. Hedge funds |37| also played a role, even if they had much less impact than institutional investors. |38|

Michael W. Masters, who had been managing a Wall Street hedge fund for twelve years, provided evidence of this in his testimony before a Congressional commission in Washington on 20 May 2008. |39| He made the following declaration to this commission, which was making an official investigation into the possible role played by speculation in rising commodity prices: “You have asked the question ‘Are Institutional Investors contributing to food and energy price inflation?’ And my unequivocal answer is ‘YES’”. In his authoritative testimony, he explains that the increasing price of food and energy was not due to an inadequate supply but rather to a “demand shock” caused by the arrival of new participants in the commodities future market. On the futures market, participants buy the future production: the wheat that will be harvested in 1 or 2 years, or the oil that will be produced in 3 or 6 months. In “normal” times, the main participants in those markets are for example airline companies that buy kerosene, or food companies that buy grain. Michael W. Masters shows that in the United States, the capital allocated by institutional investors to the commodity index trading in futures markets rose from $13 billion dollars at the end of 2003 to $260 billion in March 2008. |40| During the same period of time, the prices of the 25 commodities that make up these market indices rose by 183%. He explains that it is a small market, |41| and if institutional investors such as pension funds and banks allocate 2% of their assets to it, this will change the situation drastically. The price of commodities on the futures market has an immediate repercussion on the actual price paid for these basic goods. He shows that institutional investors bought huge quantities of corn and wheat in 2007-2008, which produced a price spike.

It is worth noting that in 2008 the Commodity Futures Trading Commission (CFTC) considered that institutional investors should not be considered as speculators. The CFTC stated that institutional investors are commercial market participants, which enabled it to argue that speculation did not play a significant role in the dramatic rise in prices. Michael W. Masters is very critical of the CFTC, but Michael Greenberger, a Law professor at the University of Maryland, was even more adamant in his testimony before the Senate commission on 3 June 2008. Michael Greenberger, who was Head of the CFTC’s Division of Trading & Markets from 1997 to 1999, criticised the laxity of other CFTC Directors, who looked the other way when they saw manipulation of energy prices by institutional investors. He cites a series of declarations by CFTC Directors worth publishing in an anthology of hypocrisy and stupidity. Michael Greenberger considers that 80 to 90% of the stock market transactions in the US energy sector are speculative. |42|

On 22 September 2008, as financial turmoil was rocking the United States, and President Bush was proposing a $700 billion bank bailout plan, the price of soy beans shot up by 61.5% driven by speculation!

Jacques Berthelot also shows the crucial role played by bank speculation in the rising prices. |43| He gives the example of a Belgian bank, KBC, which ran an advertising campaign to market a new investment product offering customers the possibility to invest in six food raw materials. To convince its clients to put their money into its “KBC-Life MI Security Food Prices 3” investment fund, KBC’s advertisement encourages them to: “Take advantage of rising food commodity prices!” It presents the “shortage of water and farm land” as an “opportunity” since there is now a “shortage of food products, leading to rising food commodity prices.” |44|

Meanwhile, the US judicial system has ruled in favour of the speculators. This is what Paul Jorion denounces in an editorial published in Le Monde. He questions the decision made by a court in Washington on 29 September 2012, which rejected a proposal made by the CFTC “that aimed to limit the volume of positions a single participant can take on commodities futures market, so that he or she alone would not be able destabilise it.” |45|

Currency speculation

Banks are also the main participants on the currency markets, which they maintain in a permanent state of instability. Approximately 98% of foreign exchange activity is speculative. Only 2% is associated with the really productive economy, Foreign Direct Investments, effective international trade of goods and services, remittances by emigrants, and credit or debt repayment). Between €3 to €4 trillion transit daily through the foreign exchange markets! Banks also trade heavily on foreign exchange derivatives, which may cause considerable damage, not to mention the damage to society because of the instability of the currencies.

Over thirty years ago, James Tobin, long time advisor to US President J.F. Kennedy, suggested throwing sand into the wheels of international speculation. In spite of all the fine talk by some heads of States, the plague of foreign exchange rate speculation has worsened. Bank and other lobbies have so far averted having the smallest grain of sand disrupt their wheels from spinning or profits from accumulating. The decision taken in January 2013 by 11 eurozone governments to impose a tax of 0.1% on financial transactions is totally insufficient.

High–frequency trading

High-frequency trading enables orders to be passed on the markets in 0.1 milliseconds (one ten thousandth of a second). The “Regulations and banking activities separation act” put before the French national assembly by Pierre Moscovici, French finance and economy minister, on 19 December 2012 contains an interesting description of high-frequency trading: “High-frequency trading is a market activity entrusted to computers running on algorithms that combine observation and analysis of the market, and the placing of orders at ever higher frequencies. They may place several thousand orders per second on the same exchange platform, sometimes causing saturation. The risks are high in case of coding errors, these may cause absurd financial movements (the quasi-bankruptcy of the ’Knight Capital Group’ in August 2012 is an example). In 2011, high-frequency trading accounted for more than 60% of the orders on the Paris stock exchange, only 33% of which created a real transaction”. |46|

High-frequency trading is clearly linked to speculative operating: manipulate the financial markets in order to influence prices and extract a profit. Specialists are well aware of the most popular methods:

Quote Stuffing: “A tactic of quickly entering and withdrawing large orders in an attempt to flood the market with quotes that competitors have to process, thus causing them to lose their competitive edge in high frequency trading”. |47| |48|

Layering, high-frequency traders may use this method to sell a block of values at the highest possible price, they place a series of buying orders at price offers up to a ceiling price, and in this way create layers of orders, once the ceiling is reached they sell massively before the price has time to go down, and at the same time cancel the invalid orders. This process relies on the filling of their competitors sales ledger with offers to buy, and then surprising the market by inversing the movement. |49|

On 6 May 2010, Wall Street experienced a “flash crash” |50| typically caused by high-frequency trading including a ’quote stuffing’ operation. The Dow lost about 998.52 points (before recovering 600) between 2.42pm and 2.52pm. A fall of 9.2% in ten minutes, unprecedented in stock exchange history. This incident spotlights the involvement of high-frequency trading that corresponds to about two-thirds of transactions on Wall Street.

Such accidents will certainly happen again. The big banks that actively use high-frequency trading are opposed to banning the system or introducing any strict controls under the pretext of maintaining the greatest possible liquidity on the financial markets.

Proprietary trading

Proprietary trading: when banks trade for themselves, is an important banking activity, producing a great amount of revenue and profit, but carrying very heavy risks. Banks engage their own resources (equity, customer deposits, borrowings) to take positions (buy or sell) on the different financial markets: stocks and shares, interest rates, foreign currency, raw materials, derivatives, futures, forwards, commodities (including foodstuffs), and their futures and real estate. Trading is definitely a speculative venture, because it is based on short-term market movements greatly influenced by their own actions. One illustration of the speculative nature of trading is Societe Generale’s €4.9 billion loss in 2008 because of the positions, taken by one of its traders Jerome Kerviel, which engaged close to €50 billion. JP Morgan allowed $100 billion dollars to been engaged by a person on its London proprietary trading department staff known as the “Whale”. The sums involved by the banks in propriety trading action are so huge that the losses can menace the survival of the bank itself.

Short selling: another speculative activity

Short selling is the sale of a stock that we do not hold at the moment, but intend to buy later to balance the end of the account. For the Banque de France: “there are two kinds of short selling”:
• Covered short-selling: in this case, the seller has borrowed (or made a borrowing agreement for) the stock that he must eventually sell at the end of the operation. In fact, the stock that this person borrows will be sold, and he promises to return the same kind of stock to the lender;
• Naked or uncovered short selling: in this case, there is no borrowed stock or borrowing agreement before the sale of the stock. The seller must buy identical stock to be able to pass it on to the buyer”. |51|

According to the French banking federation, ’short “short selling is good for market vitality (…) it increases market cash flow.” |52| Who do they think they are kidding?

Who sells short and why?

Short selling is done by a large number of market participants, such as banks, hedge funds, and financial institutions such as pension funds and insurance companies among others. It is a purely speculative activity. A speculator gambles that the price of the share concerned will fall, and if his guess is right he purchases it at a lower price than that at which he sold it, and so makes a profit. This kind of practice undermines market stability. The sharp fall in the price of bank shares during the summer of 2011 was aggravated by short selling. It is easy to understand why this kind of activity should be quite simply prohibited. |53|


As they systematically use leverage, their equity is small compared to the risks they take. From their point of view this is the desired situation: have the least possible amount of equity in proportion to their assets. A low general profit / assets ratio can produce a high profit/equity ratio, if the equity is as low as possible. Imagine a profit of €1.2 billion with assets of €100 billion, which means a profit of level of 1.2%. However, if compared to equity of €8 billion, this becomes 15% profit. If the bank using leverage, then borrows €200 billion on the financial markets to purchase further assets. the volume of assets becomes €300 billion, the equity has remained the same at €8 billion, while the liabilities have also risen by €200 billion. If the bank continues to make a profit of 1.2% that becomes €3.6 billion. With equity still at €8 billion that means a Return on Equity (ROE) of 45%. This is the fundamental reason to increase leverage by borrowing.

As we saw in Parts 2 and 4 of this series, apparently minimal losses may be quickly followed by disastrous effects and the need for a bailout. In this example, a loss of €8 billion on total assets of €300 billion (a loss of 2.66%) would wipe out the equity and result in bankruptcy. This happened to Lehman Brothers, Merrill Lynch, and the Royal Bank of Scotland, among others. The IMF’s Global Financial Stability Report published in October 2012, considers that the leverage of European banks is 23:1 without taking derivatives into account. A ratio of 23:1 considering only tangible assets (without derivatives) is very high! |54| The real leverage effect is even more important, because banks have debts and assets that are off-balance sheet (notably a significant amount of derivatives).

Conclusion: The big banks continue playing with fire, because they are persuaded that governments will save them whenever necessary. They do not encounter any serious opposition from the authorities as they continue to trade (this question will be discussed in Part 6). At the same time, they are playing an ongoing game of brinkmanship. In spite of their continual marketing efforts to regain public confidence, they have no desire to change their objectives from seeking maximum and immediate profit, and gaining as much power as they can to influence government decisions. Their force corresponds to current government leaders’ decisions to give them total freedom of action. The leaders’ moralistic tones, insisting that banks should be more restrained in their bonuses and remunerations, are only for Public consumption.

Karl Marx writes in Capital that “At their birth the great banks, decorated with national titles, were only associations of private speculators, who placed themselves by the side of governments, and, thanks to the privileges they received, were in a position to advance money to the State’. This is just as applicable to today’s banks. |55|

Banks have a colossal capacity to wreak havoc. Those who believe that a humane capitalist bank is possible must wake up and realise this is pure fantasy. The entire banking system must be withdrawn from capitalist control, and without any compensation, in order to create a public service under the control of citizens, users, and banking sector workers. |56| This is the only way to guarantee the total respect of public service precepts concerning savings and credit that are in the interest of the community.

In Part 6, the new banking regulations will be analysed.

Translated by Mike Krolikowski and Charles LaVia

Part 1
Part 2
Part 3
Part 4


|1| Alan Greenspan, The Age of Turbulences, Penguin press, New York, 2007, p. 408.

|2| Part 1 of this series “2007-2012: Six years that shook the banking world” was published on 2 December, 2012. See 2007-2012: Six years that shook the banking world. Part 2 “The ECB and the Fed at the service of the major private banks” was published in 23 December 2012. Part 3 “The greatest offensive against European social rights since the Second World War” 12 January 2013, see http://cadtm.org/The-greatest-offen…. Part 4 A journey into the vice ridden world of banking on 2 February 2013, See http://cadtm.org/A-journey-into-the…

|3| The author would like to thank Olivier Chantry, Brigitte Ponet, Patrick Saurin, and Damien Millet for their advice.

|4| Financial Times, 27-28 October 2012.

|5| This loan that the ECB advanced to 800 European banks for a total of €1 trillion at 1% over 3 years was analysed in Part 2 of this series. See note 3 above.

|6| See Erkki Liikanen (chairperson), High-level Expert Group on reforming the structure of the EU banking sector, October 2012, Brussels. Erkki Liikanen is governor of the Finnish central Bank. At the initiative of Michel Barnier, eleven experts formed a work group to diagnose the situation of European banks and to propose reforms to the European banking sector. One of the interesting points of the Liikanen report is its official confirmation of the depravity of the banks, the staggering risks taken to make maximum profit. The group was created in February 2012, and delivered its report in October 2012. See : http://ec.europa.eu/internal_market…
The data concerning the day-to-day financing needs is found in chart 2.5.1, p.27. This document will hereafter be called the Liikanen report.

|7| MMFs were described in Part 4 of this series.

|8| See Part 2 “The ECB and the Fed at the service of the major private banks,” published on 23 December 2012.

|9| Liikanen report, chart 2.4.1.

|10| The shareholders who sell their shares to their bank transform their paper certificates into cash. From the fiscal point of view, it is more advantageous to receive income on a regular basis by selling some shares than to receive a dividend.

|11| http://www.profil.at/articles/0905/…

|12| This fine is high compared to the fines usually paid by banks, but compared to its assets HSBC has paid a pittance. The amount paid by HSBC to US authorities ($1,920,000,000 or €1,443,000,000) represents less than 1/1000 of its assets (€1,967,796,000,000).

|13| We will come back to this question in Part 7 of this series.

|14| Financial Times, « Europe’s property loans unpaid », 4 December 2012, p. 23, http://www.ft.com/cms/s/0/2183f122-…

|15| Financial Times, “Mortgage-backed securities make a comeback”, 15 October 2012,

|16| Financial Times, 21 December 2011, p. 24

|17| Financial Times, “Traders warn of sting in tail for crisis-era securities”, 15 November 2012, p. 24

|18| Another objective was to reduce the amount of certain products in the total volume of assets, and replace them with more profitable ones.

|19| See Gillian Tett, Fool’s Gold, Little Brown and Co. 2009.

|20| Financial Times, “Banks test CDO-style finance for trade”, 9 April 2012.

|21| Besides, consumer or business loans are reducing or rising only marginally. This is the result of the banks applying stricter conditions to making loans. They prefer to buy securities (even high risk). Medium and small companies cannot float bonds on the financial markets and so are encountering difficulties in finding finance.

|22| See Financial Times, « Fears grow bond rush will turn to price rout », 22 November 2012 and Financial Times, “Funds warn of stretched European debt rally”, 17 October 2012.

|23| James Mackintosh, “Change would pop the corporate bond bubble”, Financial Times, 25 November 2012. See also the article mentioned above.

|24| Collateral: Assets that may be transferred or considered to be a guarantee in case of the incapacity to pay back a debt or cover an engagement. Source: Banque de France.

|25| See Manmohan Singh, “Beware effects of weakening collateral chains”, Financial Times, 28 June 2012.

|26| Financial Times, « Collateral damage », 25 October 2012

|27| The central theme of this series is the necessity to repudiate the public debts and socialise the banks. In doing so (with other important measures) a positive outcome to this crisis is perfectly possible.

|28| IMF, Global Financial Stability Report, Restoring Confidence and Progressing on Reforms, October 2012 http://www.imf.org/External/Pubs/FT… , p. 52

|29| The debt figures here concern British public debt held by British banks. Ditto for the other countries.

|30| Liikanen Report, p. 77.

|31| What is briefly called “commodities” is the raw materials market. ( Foodstuffs, minerals, metals and precious metals, petroleum and natural gas products among others). Like other assets, commodity prices are in permanent negotiation whether that be on the spot market or in derivatives.

|32| Glencore was founded by Marc Rich. It is a trading and brokerage company based in Baar, Switzerland in the canton of Zoug well known to high level frauders. Marc Rich has been prosecuted several times for corruption and tax evasion. In 2011, the group claims to employe more than 2 700 persons in marketing and 54 800 persons (in 30 countries) directly or indirectly in its industrial activities. According to available data, in 2011 Glencore controlled about 60% of the world zinc market, 50% of copper, 30% of aluminium, 25% of coal, 10% of cereals and 3% of petroleum. This highly controversial society was awarded the 2008 Public Eye award as the most irresponsible of the multinationals See: http://en.wikipedia.org/wiki/Glencore. Glencore has been considering merger with the Swiss Xstrata company, also brokerage specialists See http://affaires.lapresse.ca/economi…

|33| Financial Times, « JPMorgan copper ETF plan would ‘wreak havoc’ », 24 May 2012, p. 15

|34| Of course among the powerful actors on the commodities markets are the big companies specialising in mining, production and commercialisation such as Rio Tinto, BHP Billiton, Vale do Rio Doce; in petroleum, ExxonMobil, BP, Shell, Chevron, Total… ; and in foodstuffs, Cargill, Nestlé… and many others.

|35| Much of this text has already been published in: Eric Toussaint, “Getting to the root causes of the food crisis”, 21 November 2008, http://cadtm.org/Getting-to-the-roo…

|36| In particular, BNP Paribas, JP Morgan, Goldman Sachs, and Morgan Stanley, and until they disappeared or were taken over, Bear Stearns, Lehman Brothers, and Merrill Lynch.

|37| Sovereign wealth funds are public institutions that in the vast majority of cases belong to emerging countries like China or oil exporting countries. The first sovereign wealth funds were created in the first half of the 20th century by governments that wanted to save some of their export revenues coming from oil or manufactured goods.

|38| World wide, at the beginning of 2008, institutional investors held $130 trillion, sovereign wealth funds $3 trillion, and hedge funds $1 trillion.

|39| Testimony of Michael W.Masters, Managing Member/Portfolio Manager Masters Capital Management, LLC, before the Committee on Homeland Security and Governmental Affairs United States Senate http://hsgac.senate.gov/public/_fil…

|40| “Assets allocated to commodity index trading strategies have risen from $13 billion at the end of 2003 to $260billion as of March 2008.”

|41| “In 2004, the total value of futures contracts outstanding for all 25 indexed commodities amounted to no more than $180 billion. Compare that with worldwide equity markets which totalled $44 trillion, over 240 times bigger.” Michael W. Masters points out that during that year, institutional investors invested $25 billion dollars in futures markets, which was equivalent to 14% of the market. He shows that during the first quarter of 2008, institutional investors greatly increased their investments in this market: $55 billion in the first 52 trading days of the year. Clearly enough to make commodity prices explode!

|42| See Testimony of Michael Greenberger, Law School Professor, University of Maryland, before the US Senate Committee regarding “Energy Market Manipulation and Federal Enforcement Regimes,” 3 June 2008, p. 22.

|43| Jacques Berthelot, « Démêler le vrai du faux dans la flambée des prix agricoles mondiaux » (Distinguishing what is true from what is false in skyrocketing world food prices), 15 July 2008, p. 51 to 56. On line: www.cadtm.org/spip.php?artic…

|44| http://www.lalibre.be/index.php?vie…

|45| Paul Jorion, « Le suicide de la finance » (The suicide of finance), Le Monde, 9 October 2012.

|46| « Loi de régulation et de séparation des activités bancaires », December 2012, http://www.gouvernement.fr/gouverne…
et http://www.economie.gouv.fr/files/p…

|47| Read more: http://www.investopedia.com/terms/q…

|48| http://www.nanex.net/20100506/Flash…

|49| See: http://en.wikipedia.org/wiki/High-f…

|50| The US FDIC and the SEC have produced a detailed report on the 6 May 2010 “Flash Crash” “Findings Regarding the Market Events of May 6, 2010”, http://www.sec.gov/news/studies/201…

|51| See p. 42 : http://www.banque-france.fr/fileadm…

|52| French Banking Federation activities report 2010 (Fédération bancaire française (FBF), Rapport d’activités 2010, Paris, 2011).

|53| The question of Credit Default Swaps (CDS) will be discussed in Part 6. For more information, see CDS and rating agencies: factors of risk and destabilization by Eric Toussaint, 23 September 2011, http://cadtm.org/CDS-and-rating-age…

|54| IMF, Global Financial Stability Report, Restoring Confidence and Progressing on Reforms, October 2012 p.31 http://www.imf.org/External/Pubs/FT…

|55| Karl MARX, 1867, Capital, volume I, chapter 31. http://www.marxists.org/archive/mar…

|56| As mentioned in Part 4, a small cooperative banking sector must co-exist alongside the public sector.

Eric Toussaint, Senior Lecturer at the University of Liège, is the President of CADTM Belgium (Committee for the Abolition of Third-World Debt), and a member of the Scientific Committee of ATTAC France. He is the author, with Damien Millet, of AAA. Audit Annulation Autre politique (Audit, Abolition, Alternative Politics), Seuil, Paris, 2012.



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