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Jon Talton

Analysis and commentary on economic news, trends and issues, with an emphasis on Seattle and the Northwest.

February 26, 2010 at 10:05 AM

The sickness inside America’s capital markets, now a U.S. export

Once upon a time, in a different America, the capital markets were all about providing the funding to start and expand businesses, improve productivity and, of course, create jobs. But since the 1990s, the biggest banks and the unregulated shadow banking system have found they can make higher profits by selling and trading exotic securities that have little, if anything, to do with the real economy.

If you’ve been watching the Greek crisis, you know Goldman Sachs and other big banks used derivatives to help Greece mask its growing debt, and all the time reaping huge fees. The New York Times reports that Goldman and others have also bought credit-default swaps – yes, the same instruments that nearly collapsed AIG and the economy — to bet against Greece. “It’s like buying fire insurance on your neighbor’s house — you create an incentive to burn down the house,” Philip Gisdakis, head of credit strategy at UniCredit in Munich, told the newspaper.

As Greece’s financial condition has worsened, undermining the euro, the role of Goldman Sachs and other major banks in masking the true extent of the country’s problems has drawn criticism from European leaders. But even before that issue became apparent, a little-known company backed by Goldman, JP Morgan Chase and about a dozen other banks had created an index that enabled market players to bet on whether Greece and other European nations would go bust.

Last September, the company, the Markit Group of London, introduced the iTraxx SovX Western Europe index, which is based on such swaps and let traders gamble on Greece shortly before the crisis. Such derivatives have assumed an outsize role in Europe’s debt crisis, as traders focus on their daily gyrations.

A result, some traders say, is a vicious circle. As banks and others rush into these swaps, the cost of insuring Greece’s debt rises. Alarmed by that bearish signal, bond investors then shun Greek bonds, making it harder for the country to borrow. That, in turn, adds to the anxiety — and the whole thing starts over again.

It was tragic irony that the story appeared on the same page as one detailing the health problems bedeviling average Americans who are losing their jobs as a result of this financial mischief.

This is the kind of financial mischief that not only continues to risk creating another Great Panic — with the losses picked up by taxpayers — it’s one of the key illnesses of what was once the Great American Jobs Machine. Now comes news that the Federal Reserve is investigating its buddies on Wall Street over the Greek mess. (And the trouble may not be limited to Greece).

This isn’t rocket science. Outlaw credit-default swaps. Heavily regulate derivatives. Bring transparency and regulation to the shadow banking system. Re-erect the wall between federally insured commercial banking and risky investment banking. Tax high executive compensation at Eisenhower-era levels. That the banking industry is so adamantly opposed to reform, and seeks to own the Senate and House, ought to tell you something.

These are institutions that owe their lives to American taxpayers. Imagine if all the money out there that’s going into the current trading swindles were actually deployed to create and build productive economic activity. You might have something like…well, the America we once knew, as opposed to a nation facing a downdraft on its future.

Today’s Econ Haiku:

New housing data

Leaves green-shoot seekers left with

Desert landscaping

Comments | More in Bailout, Banking

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