Regulation for Financial Sanity

Government’s Important (and Reduced) Role

The Federal Deposit Insurance Corporation (FDIC) just reported that U.S. banks lost money at a $100 billion annualized rate during the fourth quarter of 2008.  Sounds grim, but it only describes the visible part of the iceberg our financial Titanic has hit.  AIG, a giant insurance company, alone has been covered by the Federal Reserve for $150 billion in losses on derivatives on pools of subprime mortgages, with no end to its hemorrhaging in sight.  According to the FDIC, as of the third quarter of 2008, a total of $13.6 trillion in assets, supported by $1.3 trillion of equity capital, was held by commercial banks in the United States.  But derivatives (held primarily by four banks) totaled $177.1 trillion, or $136 for every dollar of capital.  This massive amount of leverage means that a sneeze (such as derivatives of $2.5 trillion in subprime-mortgage pools) could give the banking system pneumonia.  In fact, it did.

Granted, the banks holding these derivatives diligently “cover” their positions with offsetting derivatives, which are determined by complex econometric software on powerful computers designed to “assure” such coverage.  This is the same sort of “assurance” that Long-Term Capital Management, Bear Stearns, and Lehman Brothers relied on.  But the models failed to prevent unanticipated misbalances, and those companies, like AIG, went insolvent.  How many...

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