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Financial reform — sure — repudiate OTC derivatives

Repost from Chris Whalen’s Institutional Risk Analyst:

~~~ “…  Thus we extend and pretend, a policy choice that ensures years of economic stagnation and perhaps even a new financial crisis when non-bank financial institutions start to fail due to ZIRP and the related predations of OTC derivatives. The Fed argues that the large banks cannot be restructured because doing so would cause a systemic crisis a la Lehman Brothers. But the alternative seems to be a slow death for the real economy via years of no credit, asset price deflation and double digit unemployment. And the impact of Fed manipulation of interest rates and the credit markets via ZIRP and quantitative easing often has significant unintended negative consequences. Consider another example.

Last week, IRA co-founder and CEO Dennis Santiago testified before the Los Angeles City Council on the subject of whether the city should move its business away from the larger banks. You can read the blog post by Dennis on the Huffington Post web site that describes the hearing in detail. But the hearing also illustrated how OTC derivatives are multiplying the economic pain that ZIRP is causing to interest rate sensitive investors.

The Fed’s current interest rate policy has caused the City of Los Angeles to go into the red to the tune of $10 million per year because of interest rate swaps sold to the city by Bank of New York Mellon (BK). That’s right, thanks to Chairman Bernanke and the FOMC, and an OTC interest rate swap, the City of Los Angeles must pay $10 million per year to BK so long as the Fed continues ZIRP — potentially until 2028.

By skewing interest rates down below the true rate of inflation, the Fed has levied a tax on all of the OTC interest rate counterparties that were trying to hedge against higher interest rates. And there are literally thousands of other cities, states, public agencies and insurers around the world which are caught in the unintended consequences of ZIRP. When you recall that the Fed has been and continues to be the chief cheerleader in Washington for OTC derivatives, the implications for the global economy are truly mind boggling.

Needless to say, the City of Los Angeles is not very happy with the folks at BK nor with the other large, OTC derivative dealer banks that are the chief recipients of the Fed’s largess. In fact, Los Angeles is thinking about moving billions of dollars in municipal deposits as well as nearly $30 billion in pension assets away from the largest banks in order to redress the perceived wrongdoing by BK and other large banks. You can probably guess that the City of Los Angeles will be using The IRA Bank Monitor’s Bank Stress Index to help them select high-quality, smaller banks to receive this new business windfall.

But at IRA we believe that it is better to get even than to get mad, especially when there are billions of dollars in public funds at stake. This is why we have begun to assist public sector agencies in negotiating the repudiation of OTC derivatives positions that are causing unanticipated losses to customers like the City of Los Angeles. The message to the OTC derivatives dealers is simple: Take back the deceptive, unfair and misleading OTC contract or else the public sector client will pursues any and all options. Remember that defrauding a state agency is a felony in most jurisdictions.

The fact is that with proper legal advice and support, it is possible for both public and private sector clients to force the OTC derivatives dealer banks to take back their “sacred” gaming contracts. If you know what buttons to push and which lawyer to have under retainer, it is possible to force the OTC derivative dealer bank to tear up the agreement and slither away. We know this to be true because we have helped two private sector institutions in New York achieve such a result in the past month.

If your state or public sector agency or fund has been duped into entering into a OTC derivative contract that you believe was unfair and deceptive, we want to talk to you. We’ll be glad to offer you our assistance in negotiating the termination of the OTC contract with your friendly OTC dealer bank. We’ll even suggest some very good lawyers here in New York and around the US who do not have conflicts with the OTC derivatives dealer community.

You don’t think that repudiating an OTC derivative contract is possible? Think again. Ponder the fact that the 2004 “Interagency Statement on Sound Practices Concerning Complex Structured Finance Activities” was not focused on protecting the customers from the predatory behavior of the OTC derivatives dealers, but instead on protecting the large banks from the negative reputational effects of trafficking in these gaming contracts.

When enough large, public customers of JPM, Deutsche Bank (DB), Goldman Sachs (GS) and other OTC dealers say “Foxtrot Oscar” to their tormentors, the proverbial house of cards will collapse around the ears of the Federal Reserve Board. All it takes is a few large cities, states and public pension funds in the US and around the world to be willing to challenge the large OTC dealers and say that enough is enough.

Incidentally, in case you did not see it, this week in the New York Times Gretchen Morgenson features the comments of two of our favorite observers of the OTC derivatives fiasco: author Martin Mayer and structured finance expert Robert Arvanitis. To read “It’s Time for Swaps to Lose Their Swagger,” click the link below.

As Mayer told the NYT:

“This insistence that you mustn’t slow the pace of innovation is just childish. Innovation has now cost us $7 trillion,” he added, referring to the loss in household wealth that has resulted from the crisis. “That’s a pretty high price to pay for innovation.”

Amen Martin.