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Showing posts from April, 2011

How the bubble burst: securities, mortgages and collateral damage

In my previous post I drew attention to the lax attitude to risk of the US investment banks and institutional investors arising from the tacit government backing of investment banking, which led to them taking ever greater financial risks in search of higher and higher returns.  There has been much discussion of the collapse of the "derivatives tower" which brought down Bear Sterns and Lehmann Brothers among others, and there has been major criticism of securities trading in general and mortgage-backed securities in particular.  I think this criticism is unjustified and distracts attention from the real issue, which is the worldwide failure of retail bank lending (more on this in my next post).  So in this post I aim to debunk securities and derivatives trading and show that the investment banks that were brought down through the collapse of the "derivatives tower" were not the cause of the financial crisis, as has been widely reported, but victims of it.

First, so…

Bank breakups, red herrings and elephants

The Independent Commission on Banking (ICB) is expected to produce its interim (well, final really except for the horse trading) report on 11th April 2011. The twittersphere, egged on by various newsblogs, is full of people attempting to pre-empt its findings by shouting for the banks to be broken up.  They seem to think that if the banks are broken up into smaller units it will ensure that no bank can ever be too big (or too important) to fail.  And in particular, they believe that if banks are forced to specialise in either retail (clearing) banking or investment banking, there will be no repeat of the financial crisis.  They are wrong.

Let's consider the case of Bank A.  Bank A is a clearing bank.  Its business consists of transactional banking - current accounts, ATMS, cheque processing, automated payments.  It is big, because it needs economies of scale in order to provide streamlined processing, and it has thousands if not millions of customers worldwide.  It accepts deposit…