By Martin Hutchinson
Contributing Editor
Money Morning

Former U.S. Federal Reserve Chairman Paul Volcker and Bank of England (BOE) Governor Mervyn King think that banks that are considered “too big to fail” should be broken up. The House Financial Services Committee is drafting a bill that will make banks pay for other banks’ bankruptcies.

Others have suggested reviving the Glass-Steagall Act – the 1933 legislation that forced financial institutions to separate their commercial and investment banking businesses. Glass-Steagall was repealed in 1999.

It’s enough to make your head spin. And don’t think that our elected “leaders” aren’t feeling just as overwhelmed. At the end of the day, however, there has to be a solution to the banking mess. Doesn’t there?

Leaving everything as it is isn’t an option, or at least it is a very bad option. In the short term, it may have been necessary to bail out all the major banks and investment banks – save for the unfortunate Lehman Brothers Holdings Inc. (OTC: LEHMQ).

In the long run, this has established a presumption that any financial institution that is too complicated for politicians to figure out – and that’s big enough to make them afraid of losing it – can pretty well do what it likes. And that includes paying its senior managers grossly excessive bonuses within a year of receiving a state bailout – can anyone say Goldman Sachs Group Inc. (NYSE: GS)?

This also gives these particular banks an unfair advantage in funding – and in accessing large pools of capital. The past year has demonstrated all too well that these particular institutions are only too happy to use this advantage to squeeze their smaller competitors out of the market.

On the other hand, I don’t think that bringing back Glass-Steagall – as it was – will do the job properly. Today’s investment banks just aren’t the same as they were in 1935. In fact, they’re even more sophisticated today than they were as recently as 1985.

Trading dominates investment-banking activities more than ever before. And that’s resulted in a way it never used to, and they have an impossibly tangled network of obligations to counterparties on interest rate swaps, currency swaps and now the inevitable credit default swaps (CDS).

That last derivative security, in particular, makes it impossible to imagine an investment bank with a large portfolio surviving anything but the mildest downturn. The reason: In a real recession, an investment bank will have to post collateral on all of its credit-default-swap obligations, which increase in value once money gets tight. Thus, just when it is most difficult to attract funding, investment banks with large CDS portfolios are subject to a “giant sucking sound,” as all their funds are drained away to satisfy counterparty claims on CDS portfolios.

But there are three things we can do in response: Ban credit default swaps, initiate a transaction tax and boosting capital standards. Let’s consider all three.

Three Moves to Make

I’ve been warning investors about the dangers of credit default swaps since very early in 2008, months before the problems surfaced. There actually are several reasons to ban credit default swaps, except possibly for the rare cases in which the credit-default-swap seller actually owns enough of the credit in question to cover the CDS. Let’s consider the top three:

• First, they are destabilizing to the market, because they zoom up in value in tight markets, draining their sellers of funding.
• Second, they encourage speculation on bankruptcy – they are like short selling on steroids, because the potential profit from a CDS is a large multiple of its cost.
• And third, credit default swaps mess up bankruptcy negotiations; because some creditors will be a “phantom,” either covered by the swaps, or actually “short” the credit, meaning they have an incentive to push the firm into bankruptcy.

The fact that Congress – a year after the collapse of American International Group Inc. (NYSE: AIG) – still has not banned the use of credit default swaps is a tribute to the power of the investment-banking lobby.

(Note to U.S. Rep. Barney Frank, D-MA, House Banking Committee Chairman: Ban credit default swaps now! It’s’s the one thing you can do to make up for the damage you did in shielding Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) during the housing bubble.)

There is another thing that we can do as well as banning CDS, and that is to impose a Tobin tax on trading, of some small percentage of each transaction. Much trading – especially short-term trading – is more or less just rent-seeking, making money on insider knowledge of the fund flows in the market.

When you hear that the major investment houses have electronic-stock-trading computers set up inside the stock exchange building – ostensibly, to provide them with faster access to the trading feed – you know the playing field is tilted. High-speed trading appears to earn about $5 billion a year for Goldman Sachs, the largest operator, and that $5 billion is just scooped out of the U.S. economy – without providing any value in return. A Tobin tax, even at a low rate, would yield billions of dollars in revenue to set against the budget deficit. More importantly, it would loosen the grip of the traders over the marketplace we all share.

Having banned credit-default swaps and introduced a Tobin tax, you would have solved much of the problem. The truly dangerous and damaging businesses would be eliminated – or at least would have shrunk in size – because their net profitability would be limited. (You need to do a lot of trades, each one of which would be Tobin taxed, to benefit from high-speed trading.)

The rest of the problem could be solved simply by applying stricter capital standards to banks with more than $1 trillion in assets and off-balance-sheet commitments that include derivatives and securitization vehicles. That would currently catch the top four banks – plus Goldman Sachs and probably Morgan Stanley (NYSE: MS).

For this to work, these standards would need to be applied internationally on a consolidated basis, and would have to be loophole-free. Setting them up would take time, because the big banks would battle to insert loopholes, as they did in the decade-long process negotiating the Basel II capital standards, which came into effect in January 2008, just in time to fail disastrously.

With those three protections, you wouldn’t need to break up the “too big to fail” banks. Passing a bill through Congress to do so with say a two-year delay might be helpful, however, just to have a threat to hold over them during the inevitable haggling and lobbying process for these changes.

[Editor's Note: Throughout the global financial crisis, longtime market guru Martin Hutchinson has managed to call both sides of the market correctly. During the market rebound that started in early March, Hutchinson assembled high-yielding dividend stocks, profit plays on gold, and specially designated "Alpha-Bulldog" stocks into high-income/high-return portfolios for savvy investors.

But his market calls before the meltdown that started last year were just as important. His warnings about the dangers of credit-default swaps - issued half a year before those deadly derivatives ignited the worldwide financial firestorm - would have kept investors who heeded his caveats out of ruinous bank-stock investments. In fact, Hutchinson even issued a highly accurate prediction of when and where the U.S. stock market would bottom out (a feat that won him substantial public recognition).

Experts are taking notice. And so should you.

Hutchinson is now making those insights available to individual investors. His trading service, The Permanent Wealth Investor, combines high-yielding dividend stocks, gold and his "Alpha-Bulldog" stocks into winning portfolios. And the strategy is designed to work in any kind of market- bull, bear or neutral.
To find out more about the Alpha-Bulldog strategy - or Hutchinson's new service, The Permanent Wealth Investor - please just click here.]

News and Related Story Links:

• Money Morning News Analysis:
  Ban Credit Default Swaps? These Corporate Bankruptcies Show We Should.
• Wikipedia:
  Credit Default Swaps.
• Money Morning Market Commentary:
  Credit Default Swaps: A $50 Trillion Problem.
• Wikipedia:
  Glass-Steagall Act.
• Wikipedia:
  Giant Sucking Sound.
• Money Morning Investigation of the Banking Bailout Deals:
  Foreign Bondholders – and not the U.S. Mortgage Market – Drove the Fannie/Freddie Bailout.
• Wikipedia:
  Basel II Capital Accord.
• Wikipedia:
  Tobin Tax.
• Money Morning Special Report:
  High Frequency Trading: Wall Street’s New Rent-Seeking Trick.

Last 5 posts by Martin Hutchinson

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• Has Asia Dethroned Detroit as the Auto Sector Leader? - November 6th, 2009
• Five Ways to Ride the Commodities Bull - November 3rd, 2009