By: Karthik 

Rotten American Banking System (let me coin a name and call it “RABS syndrome

I have tried to present this article in pure but simple English that way it benefits anyone who reads it. This is an attempt to lay a picture of how rotten the American Banking system is and mainly how dysfunctional its governing bodies are. This mismanagement will have a significant adverse impact on the financial stability of this country and essentially the rest of the world. When will it happen? No person/organization can predict but the current practice cannot sustain. RABS, I can say is the mother of all financial problems this county has faced and will face for the foreseeable future, the mortgage crisis is just a drop of water when compared to this RABS ocean.

My trading knowledge in derivatives segment (option trading) has helped me understand this mess. I accidentally started this research when I first read about the Countrywide-Bank of America merger, the deeper I got into this the scarier it became. Again, this is just my understanding of what I saw, I am neither an economist nor a Finance guy, this gives me a ‘comfort’ that I could be wrong (considering the implications of RABS based on my findings, will be more than happy to be wrong).

Let me put forth a few definitions before I can start using these terms in the article;

Comptroller : A comptroller or controller is a person who supervises accounting and financial reporting within an organization.

Derivatives : A Financial instrument/contract, whose value is, derived from the value of something else (usually an underlying asset). Some common examples of derivatives are: Option trading(Calls and Puts), Futures, Commodity Contracts and Interest Rate contracts etc.

The US treasury/Government/Fed is the Comptroller of all US National banks – called as the Office of the Comptroller of the currency (OCC), they have an official website, with a proud statement at the top which says “Ensuring Safe and Sound National Banking System for all Americans”. (please visit this site before you read the rest of this article, even if it is just a click to read their statement, it is fine). They give a ‘Quarterly Report‘ on the Bank’s Derivative activities and have all their reports since the fourth quarter of 1995 published for everyone to see (for free), perhaps because of the Freedom of Information Act (FOIA).

The biggest advantages of derivatives trading is: Leverage

Those who have traded options, they are well aware of how it works, however for people who are new to derivative trading, here is a brief explanation of options;

There are two types of options:

Call Option: you buy them when you anticipate that the underlying asset will appreciate

Put Option: you buy them when you anticipate that the underlying asset will depreciate

Every option has an expiry date, which means your anticipation is tied not only to price movement but also price movement within certain period of time. Then there is a the price which is called Strike price, the price that you think is appropriate for your strategy.

Here is a small example:

Lets say you anticipate Gold to close above $1000 by June 2008 and assume today (April 03 2008) it is trading around $900. You would buy a call option (say for $10) at for a strike price of $1000 that expires in the month of June and if the price of gold goes to $1050 before the expiry of the option, you gain $40. This is because you paid a premium of $10 for that option and that premium means anything above $1000 is yours to keep , now you are suppose to get $50 because the asset has appreciated to $1050 but you have paid a premium of $10, so your net profit is $40. The more the asset appreciates the more the gain you make. Now what happens if the asset falls down below $1000, all you loose is your premium – the $10. This is exactly how options trading can give you leverage.  For detailed explanation, please refer to Options Basics an Introduction at Investopedia.

With respect to the banking system a derivative or options is a “financial contract” between various financial/banking institutions. The contract usually has an underlying asset, the asset can be anything in this world, it can be peanuts (literally), it can be oil, it can be stocks, it can be mortgage backed securities, it can be anything, except you and me (might change soon). These contracts move based on the price movement of the underlying assets. What US investment banks (for various reasons, do not have the same restrictions that of the consumer banks have) do is control these assets by owning a fraction of them in the form of options, they do this just for their own leverage/profit. The Fed has to go by the terms dictated by them, if not these investment banks will fail and so will the economy and Bear Stearns is just one of them.

Rest of the article is a decent attempt to explain how it works and what is bound to happen.

Let us discuss the report of ‘OCC’ The third quarter 2007 report – This is an official government report, so it is not prepared by just you or me or any third party organization.

Read the whole report at your leisure, if you need quick info navigate to the 21 st page of the report you will see a very scary reading. The table says that the top 25 National banks put together just own around 4% of their assets that they trade. Plus they are NOT trading in Millions or Billions, they are trading in Trillions, yes trillions. In simple terms the top 25 national banks have a total asset of 6 Trillion dollars while they trade around 172 TRILLION dollars (Remember the US GDP is around 12 Trillion). These banks are trading around 14 times worth of the US GDP, and it is reported by OCC. Isn’t it atrocious ?

Plus if you narrow down it to the top three banks (JP Morgan + Citi + Bank of America) they trade around 157 Trillion – around 91 % of the top 25 banks but they own around 3.7 Trillion of assets. Look at how much these banks are leveraged.

What happens when these underlying asset change in value (on the negative side) say by 2-5%, the hit that these banks take is unimaginable. They will not have the money to pay the loss that they will incur, and that will eventually cause them bankruptcy, exactly what happened with Bear and Stearns. So the Fed has to go in the direction of where these banks have placed their bets, since the economy cannot survive if these banks do not survive. The fed will even be willing to dump the dollar for these banks to survive (like it is doing now by lowering the interest rates).

Do you want to make any guess what these banks have been trading or what have they placed their money on ?

85% of these bets (I am sorry options) as per the above OCC report is on the “direction of the interest rates”.

THE FED HAS TO (IT HAS NO CHOICE) CHANGE THE INTEREST RATE WHERE THESE BIG BULLIES HAVE PLACED THEIR BETS. If not, they will fail and if they fail (like Bear Stearns did) the FED has to rescue. Alan Greenspan did it for Long Term Capital in the late 98 and Bernanke did it to Bear Stearns in 2008. Remember that these are peanut companies, dealing around 200-500 Billion (is 500 B small? of course relatively). Imagine what would happen if the giants like JP Morgan, who trade around 92 Trillions fail ? Who can bail them out ? What happens to the economy of this country ?

As a small scale investor, the best thing is to diversify your holdings to different types of assets: Gold, Oil, Swiss Francs, Euro and any other tangible asset that you can ….. in short run for the cover. In the meantime, this country is a very wonderful and blessed country, it has gone through a lot of hardships and fought through it bravely and has come out of it successfully, that is my only hope !


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