The Big Banks: Destabilizing Our Economy, New Edition

I nearly popped through the skylight when I saw this BusinessWeek article. The big banks are back to peddling fancy crap in a crinkly gold wrapper. It's not that we've seen this train wreck before, it's that we're still living this train wreck.

Here's one worrisome example of "innovation" I plucked out: Citigroup, JPMorgan and Bank of America are refusing to make straightforward loans to giant customers like Hewlett-Packard, UPS and FedEx. Normally they set a borrowing rate that rises and falls with short-term interest rates. Now the rate is also being tied to the credit default swap prices on the borrower's debt.

I smacked myself square in the forehead on that one. Why are we letting these banks throw a virtual noose around their customers' necks?

Here's the rub: credit default swaps are the quasi-insurance policies ("quasi" in this case mainly means they escape regulation) that are taken out against a company's debt, or bonds. As the company's fortunes slip, the price paid to insure its bonds naturally rises. So you may think: well, that's good that the banks are hitching their lending rates to this important indicator. The trouble is, this move has several very bad consequences:

(1) Credit default markets are unfortunately set up rather like a casino right now, with everyone free to speculate on everyone else's debt. You do not insure a single bond that you possess; rather you take side bets on company bonds in such a manner that for every $10 billion of debt the company has, the side bets may reach $150 billion, $300 billion, whatever. All this money sloshing around has an unfortunate and unwanted effect: these markets are susceptible to manipulation and game-playing. Now, thanks to the CDS rider on these new loans, you can look for even more manipulation, as large hedge funds try to muscle an ailing company into its grave to collect on their CDS side bets.

(2) This will help precipitate a company death spiral. Think about it: You're FedEx say. You have a couple of rocky quarters, but your long-term plan looks good. But when you stumble, the price of the credit default swaps against your debt creeps up. Your loan repayments jump higher. That puts in you in even worse straits. Suddenly you're not just stumbling, but reeling, and your loan repayments keep ratcheting upwards. So just when a company needs some relief to work out its problems, instead it's pushed steadily toward bankruptcy.

(3) The "everything goes to sh** in a recession" effect rears its ugly head too. If enough CDS-tied loans are out there, a mild downturn can accelerate into a freefall. As a few large companies beginning staggering about, they will lay off workers, and cut business orders with their partners, who will contract too, and pretty soon these bad feedback loops will leave us another big expensive mess to clean up.

I know why banks would want this bit of "innovation": it better protects them. But it's going to be worse for our economy overall. We don't need more death spiral mechanisms introduced for our large companies and economy; we need fewer. If we had some kind of meaningful financial system oversight, someone in Washington might step forward and tell these generously bailed out banks that we're in a "financial innovation" quiet period, and to just cool it for a while.

Chances of that happening, though, aren't very good.